The reports of my death are greatly exaggerated.
—MARK TWAIN, 1897
No one knew it at the time, of course, and after two recessions within three years, no one dared assume it, but the expansion that began in November 1982 was destined to last into 1990, making it the second longest in U.S. business cycle history at the time. (The expansion from June 2009 to February 2020 would later shatter all records.) Just like the 106-month expansion of the 1960s, the long cyclical upswing of the 1980s eventually reignited breathless claims that the business cycle was dead1 (which it wasn’t) and ushered in what came to be called the Great Moderation (which it was).2
Figure 9.1 offers one depiction of the Great Moderation, which was indeed great. The name refers to the sharp reduction in the volatility of real GDP growth from quarter to quarter or year to year that began around 1984. (Inflation was also low and reasonably stable for most of this period.) The specific measure shown here is the eight-quarter, moving-average standard deviation of real GDP growth. But except for details and timing, four-, twelve-, or sixteen-quarter windows would show a similar pattern. The particular volatility measure shown in figure 9.1 dropped from an average of 4.5 percent over the quarters spanning 1949:1 through 1983:4 to just 0.8 percent from 1983:4 through 2019:4, after which no one thought much about “moderation” of any kind. As can be seen in the figure, the decline in volatility was abrupt, and not even the Great Recession of 2007–2009 brought it back to its previous level except for a few fleeting quarters.
FIGURE 9.1. Standard deviation of real GDP growth rate, 1949–2019.
Source: Author’s computations from Bureau of Economic Analysis data.
Once this phenomenon was noticed by scholars, a cottage industry developed to explain what had happened. Was the decline in volatility due to improved stabilization policy, to structural changes in the economy (e.g., better inventory management or the shift from goods to services), or just to better luck in the form of smaller shocks (e.g., less volatile commodity prices)? Stock and Watson’s (2002) thorough, though early, analysis of multiple time series covering the period from 1959:1 through 2001:3 concluded that the reduction in variance—which was smaller in their shorter sample than in figure 9.1—could not be attributed to structural changes. Rather, they estimated that it stemmed from a combination of improved monetary policy (10–25%), identifiable good luck in the form of smaller productivity and commodity price shocks (20–30%), and unidentifiable good luck in the form of smaller stochastic shocks. Better fiscal policy, they concluded, played a trivial role. In short, monetary policy helped a little in producing the Great Moderation, but it was mainly a long streak of good luck.
Subsequent research suggested a somewhat larger role for countercyclical monetary policy, but essentially no one has attributed much (if any) of the Great Moderation to improvements in fiscal policy (Gali and Gambetti 2009; Benati and Surico 2009). And no wonder. As hinted already and as this and coming chapters will show, one main reason why fiscal policy played such a small role in moderating the business cycle is that it was not used much for stabilization purposes after Ronald Reagan’s first term. Rather, over the years 1984–1997, federal tax and spending policy turned almost exclusively toward one overriding goal: reducing the budget deficit, which is definitely not what Walter Heller meant when he spoke of fiscal policy serving as a “balance wheel.”
As noted in chapter 8, the Reagan tax cuts ballooned the deficit into the 4–5 percent of GDP range beginning in fiscal year 1982, and it remained above 3 percent of GDP virtually every year through fiscal year 1993. Whether the economy was weak or strong and whether monetary policy was easing or tightening, fiscal debates in this period invariably revolved around cutting spending or (more rarely) raising taxes. None of this talk sounded much like “fine-tuning,” or any kind of “tuning” for that matter. In fact, current Congressional Budget Office data show only one fiscal year (1987) between 1984 and 2002 in which the standardized budget deficit or surplus moved by as much as 1 percent of GDP. Fiscal stabilization policy—in the sense of using timely changes in spending or taxes to manage aggregate demand—went into hibernation.
I will deal with the focus on the budget deficit in more detail in chapter 10. For now, it is worth mentioning that the one big fiscal policy action of President Reagan’s second term was tax reform rather than either lowering taxes (as in 1981) or raising them (as in 1982). The Tax Reform Act of 1986 was also, in the view of many economists (including me), the finest tax law Congress has passed in the postwar era and maybe ever. But its passage required a bit of a political miracle.
Like seemingly all presidents, Reagan bemoaned the complexity of the Internal Revenue Code. In his January 1984 State of the Union address, he called upon the Treasury Department to deliver a comprehensive tax reform plan by December—that is, after the November 1984 election, thank you. But tax reform was far from a major point of emphasis in Reagan’s speech. His now-famous “clarion call” for reform actually consisted of exactly one paragraph:
Let us go forward with an historic reform for fairness, simplicity, and incentives for growth. I am asking [Treasury] Secretary Don Regan for a plan for action to simplify the entire tax code, so all taxpayers, big and small, are treated more fairly. And I believe such a plan could result in that underground economy being brought into the sunlight of honest tax compliance. And it could make the tax base broader, so personal tax rates could come down, not go up. I’ve asked that specific recommendations, consistent with those objectives, be presented to me by December 1984. (Reagan 1984a)
The Treasury’s nonpolitical professional staff was brimming with ideas for reform and now had their marching orders: Simplify the tax code. Don’t use reform as a way to raise revenue. Don’t touch the mortgage interest deduction (though that instruction was not in the speech). And please don’t report back until after the election.
These skilled technocrats made good use of their newfound freedom. When the Treasury’s initial handiwork was published in November 1984 (U.S. Department of the Treasury, Office of the Secretary 1984), political hair started catching on fire all over Washington. “Judging by the anguished squeals that greeted what came to be called ‘Treasury I,’ you might have thought the document proposed repealing the bill of rights, reinstituting slavery, and outlawing motherhood” (Blinder 1987a, 161). It didn’t do any of these things, of course. Rather, the Treasury careerists had behaved like the well-trained professional technocrats they were and had proposed sending a large herd of sacred cows (not including the mortgage interest deduction) off to the slaughterhouse.
Corporate investment incentives, some of which had originated in the 1981 tax cuts, would be slashed. So would tax breaks that the oil and gas, real estate, finance, and defense-contracting industries had enjoyed for years. A variety of fringe benefits for workers would lose their tax-exempt status. Perhaps most audaciously, capital gains would be indexed and then taxed like ordinary income, ending a politically sensitive tax preference that dated back to 1921. The list went on, with virtually every item sounding an alarm bell in some lobbyists’ offices.
It’s a good bet that most of these reform ideas came as surprises to Secretary Donald Regan, a former CEO of Merrill Lynch, who introduced the plan by emphasizing that it “was written on a word processor” and thus easily changed (Wicker 1985b). This was not exactly a ringing endorsement of the Treasury staff’s handiwork! Changes came quickly as the political class discovered what the proposal included, and lobbyists descended on the Treasury and White House to get much of it excised. When the next draft, called “Treasury II” (U.S. Department of the Treasury, Office of the Secretary 1985), was submitted to Congress in May 1985, it had been politically scrubbed. Nonetheless, it was still identifiably a tax reform bill, not a tax cut. Paul Samuelson gave it this half-hearted endorsement in a newspaper column: “The present mishmash is a bit worse than the new rigamarole” (Samuelson 1985). He was ungenerous. The “rigamarole” was a big improvement over the “mishmash.”
Tax reform next met up with the U.S. Congress, where fairness is in the eye of the beholder, concern with economic efficiency is hard to find, and rigamarole is beloved as a wonderful way to dispense favors. The first stop on the Hill was at the House of Representatives, where the Committee on Ways and Means was chaired by the old-school (and very effective) congressman Dan Rostenkowski (D-IL) of Chicago. By the time a bill emerged from Ways and Means, many loopholes had been restored, a bunch of new ones had been added, Rostenkowski was admitting that “we have not written a perfect law” (Wicker 1985a), and few were disputing his assessment.
The scene then shifted to the Republican-controlled U.S. Senate, where prospects for reform looked even bleaker. Senate Finance Committee Chair Bob Packwood (R-OR) had already declared his opposition to tax reform. It was therefore no surprise that as the committee set out to craft its own bill, the proceedings were dominated by senators who seemed to have a lot of friends who deserved loopholes. As Senator Daniel Patrick Moynihan (D-NY) memorably put it, “We commenced to overhaul the tax code … and with the best of intentions made things steadily worse. On the day we voted the depreciation life of an oil refinery to be five years, something told us our immortal souls were in danger” (Moynihan 1986). Tax reform looked dead.
But it wasn’t. Persuaded by some combination of Senator Bill Bradley’s (D-NJ) substantive arguments in favor of reform, some serious reelection difficulties back home in Oregon, and the allure of a superlow 27 percent top income tax rate,3 Packwood executed a complete 180-degree turn in April 1986, announcing a radical plan to eliminate most itemized deductions in return for sharply lower tax rates. It was the economists’ age-old dream: broaden the base, lower the rates. But this time it had real political force behind it, not just advocacy from a bunch of eggheads with no political clout. Before the lobbyists could effectively man the battlements, Packwood jammed an amazingly clean reform bill through his committee and then through the whole Senate on an astonishing 97–3 vote.
At that point, Congress had two very different bills on its hands: a loophole-laden House bill and a comparatively clean Senate bill. Compromising the many differences between the two looked to be a difficult and delicate political task. But the action in the Senate had changed the political dynamic dramatically. Rostenkowski’s astute antennae had picked that up, and he surprised everyone by joining forces with Packwood. The two chairs then fashioned a compromise that passed both houses easily and was signed into law by President Reagan. One committee staffer, who watched in astonishment as the two chairs batted down one proposed amendment after another in the House-Senate conference, penned the following bit of doggerel:
Here’s to the tax-reform conference,
Home of low rates and high drama
Where Rosty speaks only to Packwood
And Packwood speaks only on camera.
(BIRNBAUM AND MURRAY 1987, 281)
The act of political jujitsu that got the Tax Reform Act of 1986 (TRA86) passed is an interesting story in and of itself.4 But this book concentrates on economics, not politics, and in particular on macroeconomics. And macroeconomically, the act was not a big deal. It is far too simple just to count up projected revenue gains and losses and net them out. In terms of impact on GDP, not to mention allocative effects, one tax dollar is not the same as every other. Nonetheless, the net effect of tax reform on the budget is a reasonable place to start. Reagan wanted the reform to be revenue neutral, and Congress delivered approximately that (CBO 1998b, 25, table 10).
Allocative effects are an entirely different matter, however. Most obviously, the tax sheltering industry—which had enjoyed major outposts in real estate and oil and gas for decades—was decimated. “There is little doubt that investments in tax shelters have all but disappeared since the enactment of TRA86,” wrote one tax expert a decade later (Samwick 1996, 194). Resources flowed out of rental housing and other tax-favored investment activities. Relative to the status quo ante, the reform also favored equity financing over debt, dividend payouts over retention (which generates capital gains), S corporations (which are pass-throughs taxed at the owners’ personal rates) over conventional C corporations, and much more. The tax changes were complicated and comprehensive. But on balance they did not have major effects on aggregate demand.
On the monetary front, the Volcker Fed had eased up in the closing months of 1982, as noted earlier, and interest rates began to fall. Though interrupted by occasional increases—due to Federal Reserve policy moves, the business cycle, or both—the drop in both real and nominal interest rates would turn out to be a major phenomenon of the Great Moderation and after. It is an exaggeration, but one that does little violence to the facts, to say that the ten-year Treasury rate has been basically falling since the fall of 1981 (when it peaked just below 16%), a period of about forty years.
Many factors underpin this stunning development. The most obvious reason for lower nominal interest rates is, of course, the decline of expected inflation. But real rates also fell, and that development presumably traces to changes in the worldwide balance of saving and investment. One clear element is the rise of China, with its huge saving rates. Another may be that newer technologies require less investment than older ones did. Compare Facebook with the Grand Central Railroad. All that said, a full answer is not yet in, and economists will be wrestling for years with the question of why interest rates fell so much and for so long.
There were, however, a few times during those decades in which rates rose, and one of them is of particular interest here. As figure 9.2 shows, the ten-year Treasury rate declined steadily and sharply from its September 1981 peak into the 10 percent range by the spring of 1983. But then, with the economy rapidly picking up steam (the average annual growth rate over the six quarters from 1983:1 through 1984:2 was a jaw-dropping 7.8%), interest rates began to climb. By May–June 1984, the ten-year rate was back up to nearly 14 percent.
These large rate increases were natural and certainly not a product of any deliberate Federal Reserve tightening. In fact, one might more legitimately attribute them to Reagan’s expansionary fiscal policies than to anything the Volcker Fed did. But the unemployment rate was still high in July 1984 (7.5%), and the Reagan White House, thinking mainly about the November election, did not relish higher interest rates.
FIGURE 9.2. Ten-year Treasury yield, 1979–1987.
Source: Board of Governors of the Federal Reserve System.
One day that summer, Volcker was summoned to a White House meeting with the president. On arrival, he found Reagan sitting with his chief of staff, the formidable James Baker, and looking “a bit uncomfortable” (Volcker 2018, 118–19). While Reagan remained silent, Baker delivered a simple and direct message: “The president is ordering you not to raise interest rates before the election.” Notice the commanding verb here—ordering. That, of course, vastly eclipsed the president’s authority. Volcker reports being “stunned,” and he was not one to take orders. But he was not planning to raise rates anyway. So he merely “walked out without saying a word” (119), which must have left Baker nonplussed. In any event, monetary policy was essentially unchanged through the 1984 election.
For most of the remainder of Volcker’s second term, the central bank’s attention was focused more on a series of banking crises and near-crises, including the savings and loan (S&L) fiasco discussed below, and international issues, such as the Latin American debt crises and the Plaza Accord, than it was on conventional monetary policy. The funds rate never rose much above 8 percent or fell much below 6 percent during that time.5 All part of the Great Moderation, you might say.
Inside the Fed, however, Volcker had to quell what he called an “attempted coup” by the four Reagan appointees: Vice Chair Preston Martin and Governors Manuel Johnson, Wayne Angell, and Martha Seger. At a routine Federal Reserve Board meeting on Monday, February 24, 1986, “Martin made an out-of-the-blue proposal to cut the Federal Reserve’s discount rate” (Volcker 2018, 142), which passed on a 4–3 “party line” vote. Volcker felt ambushed and threatened to resign. Angell and Martin offered Volcker a second vote, which the chair won. Had the coup worked, the stock market might have crashed that very day. Instead, it waited until October 19, 1987.
As mentioned in chapter 8, the value of the U.S. dollar also became a major issue for the administration, the Fed, and other nations in the 1984–1987 period. The Plaza Accord of September 1985 helped push the dollar down from its dizzying heights, and the Louvre Accord of February 1987 subsequently tried (less successfully) to arrest its fall. But exchange rate issues were still in the air as the expiry of Volcker’s second four-year term (August 1987) approached. The biggest questions in the world of monetary policy in the United States and abroad became whether Reagan would reappoint Volcker, who had by then acquired Olympian stature but had shown himself to be less than pliant, and whether Volcker would accept another four-year term.
Had the decision been up to the financial markets, there is no doubt that Volcker would have been reappointed by acclamation—and chained to his desk. But the decisions belonged to Reagan and Volcker. Motivated in part by his wife’s ill health, Volcker had been thinking (and talking to his wife) about leaving for years. He was torn between his personal obligations and his strong attachment to public service. Reagan’s top aides, including James Baker, who by then was secretary of the treasury, presumably wanted Volcker out (Woodward 2000, 19–21). But Reagan himself either equivocated or was inscrutable.
Volcker reports that Baker “told me that, in effect, it was my responsibility to stay” at a meeting in late May 1987. Yet “my overall impression [was] that he would not be personally heartbroken by my decision to leave” (Volcker 2018, 149–50). When Volcker informed Reagan on June 1 that he did not want to continue in office, “Jim Baker was delighted. ‘We got the son of a bitch,’ he told a New York friend” (Woodward 2000, 24). So, the answer to the classic question “Did he jump or was he pushed?” may have been both.
In any case, Reagan—or perhaps Baker—had a replacement ready: Alan Greenspan. Greenspan subsequently became as much of a monetary god as Volcker. But in the summer of 1987 Greenspan was new to the Fed, untested, and viewed as suspiciously political. He had, after all, been closely associated with the disgraced Richard Nixon, who had appointed him chair of the Council of Economic Advisers shortly before resigning in August 1974.
To last as long as it did, the Great Moderation had to survive a number of hazards that imperiled it. One such hazard was the S&L debacle. The relevant events are sometimes called the S&L crisis, but that seems a grave misnomer for something that took years to develop and then years to fix. It was more like a slow-motion train wreck followed by an agonizingly slow repair job.
While the details are complex, the basic source of the debacle was simple: S&Ls, or more generally thrift institutions, were designed to lend long and borrow short. That sounds like the normal sort of maturity transformation that banks and other financial intermediaries perform routinely. But there was an important quantitative difference: S&Ls concentrated on loans that were very long, such as thirty-year fixed-rate mortgages, and financed themselves with deposits, which can turn over quickly. When the maturity mismatch is that extreme, rising interest rates can do more than just drive the market value of a thrift institution’s assets (mainly mortgages) below the market value of its liabilities (mainly time deposits, which remain at par), thereby leading to economic (but not regulatory) insolvency. If rates rise sharply enough, they can even push the cash outflows from interest payments on deposits (which adjust relatively quickly) above the cash inflows from preexisting fixed-rate mortgages (which do not), thereby causing operating losses and, potentially, acute illiquidity.
Both of these feared events occurred when the Federal Reserve jacked up interest rates sharply under Volcker’s post-1979 monetary policy (figure 9.3). In the summer of 1977, the thirty-year mortgage rate was almost 9 percent and the rate on three-month certificates of deposit was a bit over 6 percent, leaving S&Ls a comfortable net interest margin. By early 1980 that margin was gone or had turned negative, leaving quite a few thrifts either insolvent on a mark-to-market basis or headed there. In 1978, a mere 1.4 percent of thrift assets were held in institutions that were operating in the red, a sign of a healthy industry. By 1980, that figure was over 30 percent, a sign of a sick industry. And by the second half of 1981 it was over 90 percent, a sign of a virtually dead industry (White 1991, 70, table 5.3).
FIGURE 9.3. Interest rates on thirty-year fixed-rate mortgages and three-month certificates of deposit, 1975–1985.
Source: Board of Governors of the Federal Reserve System.
But these zombie thrifts were allowed to stagger on for years. Because S&Ls did not keep their books on a mark-to-market basis, they remained technically solvent for both Generally Accepted Accounting Principles and regulatory purposes long after they were economically insolvent. The huge gap between regulatory capital (which looked fine) and true economic capital (which in many cases was gone) allowed regulators and Congress to keep these institutions alive rather than shut them down. The latter would have required paying off the insured depositors, something legislators were less than eager to do.
Staying alive, however, meant continuing to lend, and many thrifts gambled for redemption by making increasingly risky loans. In consequence, the industry grew rapidly during the years 1983–1985 even though it was in its death throes, a case of backwards capitalism. After 1985, however, declines in real estate values, especially in Texas, hammered the final nails into the thrifts’ coffins as did the Tax Reform Act of 1986, which devastated real estate tax shelters. So, most of the S&Ls that had gambled for redemption lost their gambles. On top of all that, there was a disgraceful amount of fraud personified by but not limited to Charles Keating and the infamous Keating Five.6
Congress and the Reagan administration also made a gamble but one of a different sort: that they could keep the lid on the problem until after the 1988 election. That gamble paid off, though it required such devices as irresponsible deregulation (e.g., allowing expanded lending powers), regulatory forbearance, and even allowing or encouraging accounting chicanery plus, of course, closing down some of the worst thrifts, which drained the deposit insurance fund.7 Through such legerdemain, the Potemkin village managed to remain standing even as the underlying problem worsened. But the public’s anger mounted along with the banks’ losses. There was anger at the industry, anger at the regulators who had failed to prevent the debacle, and anger at politicians for “bailing out” the ill-behaved banks.
It was left to the new Bush administration, elected in November 1988, to finish the job, which it did starting with passage of the Financial Institutions Reform, Recovery, and Enforcement Act in August 1989. The act tightened regulation of S&Ls, recapitalized the deposit insurance fund (though inadequately), raised insurance premiums on both thrifts and banks to bring more revenue into the fund, and established the Resolution Trust Corporation (RTC) to dispose of the assets acquired from insolvent thrifts, a task that took years.
In the end, about one-third of the nation’s three thousand S&Ls failed. The budgetary arithmetic was unpleasant. Taking over an institution with negative net worth left a financial hole that the RTC—which is to say, the taxpayers—were obliged to fill. Slightly hysterical early estimates of the costs ran as high as $500 billion,8 which was over 8 percent of GDP at the time, a daunting figure. In the end, however, the cleanup efforts themselves plus a strong economy helped raise real estate values and, commensurately, reduce the RTC’s and thus the taxpayers’ bill to “only” about $130 billion, or 2 percent of GDP (GAO 1996).
There was an important if obvious lesson here. But it was somehow lost on members of Congress who, years later, refused to support the Troubled Asset Relief Program in 2008. If the government steps in to buy bad assets on a large scale, whether directly or indirectly, the prices of those assets will rise, which will reduce the cleanup bill. The S&L cleanup presented a large bill nonetheless, one that contributed both to continuing large federal budget deficits and to political anguish.
The stock market crash of 1987 presented a second potential hazard to the Great Moderation. It was also Alan Greenspan’s baptism by fire as Fed chair. Greenspan’s first day in office was August 11, 1987. The stock market, which had been on an almost uninterrupted climb for five years, began to swoon that very month, and it got worse in October. Then on a single frightening day—Black Monday, October 19, 1987—the Dow Jones Industrial Average shed almost 23 percent of its value, nearly matching the percentage drop on Black Tuesday, October 29, 1929. Market participants were shell-shocked, as was the Reagan White House. And both turned to the Fed for salvation. Hardly anyone, it seemed, gave a thought to using fiscal policy to cushion the impending blow to aggregate demand.9
As luck would have it, Greenspan had been scheduled to travel to Dallas that day to address the American Bankers’ Association. He and his colleagues decided it would look panicky if he cancelled the speech. So, Greenspan boarded the plane for the three-hour flight from Washington to Dallas that morning, even though the Dow was already down about 200 points (roughly 9% at the time). There were no telephones on airplanes in those days, so the rookie Fed chair must have had quite a nerve-racking flight. When he landed, he immediately asked one of his Federal Reserve Bank of Dallas greeters where the market had closed. The answer seemed reassuring at first: “It was down five oh eight.” Thinking that meant a mere 5.08 Dow points, Greenspan breathed a sigh of relief: “Great, what a terrific rally.” But the pained expression on his colleague’s face suggested anything but relief. The Dow had actually fallen an amazing 508 points.10 At 2021 levels of stock prices, that would be over 8,000 points on the Dow—in one day!
What caused the great stock market crash of 1987? Despite volumes of study, we still don’t know11 and probably never will. Some commentary at the time blamed James Baker’s not-very-veiled threat to depreciate the dollar, which came on the Saturday just before Black Monday. But that explanation always seemed thin to me. Others blamed “portfolio insurance,” a new-fangled way to automate trading, in this case leading to heavy computerized selling into a falling market. In the end, Robert Shiller’s survey-based nonexplanation may provide the best explanation: the main “news” that motivated selling that day was reports that other people were selling (Shiller 1989, 379–402). Panicky selling induced more panicky selling, and portfolio insurance accelerated that.
When a nation’s stock market crashes, there are two sorts of possible reactions by its central bank, each with many variants:
Wrong decision. You can prop up the stock market any way you can to prevent further losses and maybe even to restore some of the destroyed wealth. In 1987, that would have meant slashing interest rates despite the strong economy.
Right decision. You can make it clear—both by words and by actions—that you stand behind the financial system, especially the banks, and will serve as the lender of last resort as much as necessary to confine the damage.
The Greenspan Fed made the right decision. The next day, it issued a statement that was short but to the point: “The Federal Reserve, consistent with its responsibilities as the Nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.” In plain English, or at least as plain as the Fed was willing to be at the time, the discount window was now wide open to any banks—and maybe even to any brokerage houses—that might need it. Those reassuring words did the trick. Hardly any banks actually showed up looking for loans, the Fed accommodated a sharp but brief surge in demand for excess reserves, and the threat of a general financial panic dissipated quickly. The stock market even made up over half of its Black Monday losses within days and all of them (remember, it was almost a 23% drop!) in less than two years.
The response to the crash wasn’t really a hard call, but Greenspan had clearly done the right thing. He had also displayed calm under pressure and proven that he could handle a financial crisis as well as Volcker could. No one at the time talked about a “Greenspan put” under equity values; that talk would come later. Rather, everyone seemed happy and relieved at the new Fed chair’s stellar performance. The Greenspan legend had begun.
|
Q1 |
Q2 |
Q3 |
Q4 |
|||||
|---|---|---|---|---|---|---|---|---|
|
1987 |
3.0% |
4.4% |
3.5% |
7.0% |
||||
|
1988 |
2.1% |
5.4% |
2.4% |
5.4% |
||||
|
Source: Bureau of Economic Analysis. |
||||||||
Most important to macroeconomic history, the October 1987 stock market crash made nary a dent in the strong recovery. Table 9.1 shows the annualized growth rates of real GDP over the eight quarters of 1987 and 1988. Not only was there no recession, but you can’t even detect an impact of the crash—which happened early in the bold-faced fourth quarter of 1987—in these numbers.
Neither could the Federal Open Market Committee (FOMC) as it watched the data unfold in real time. Immediately after the crash, the committee provided more reserves to the banking system, and the federal funds rate, which was then managed in a very wide range (5–9% before the crash and 4–8% after), drifted down by about 100 basis points. After that, the funds rate did not change much for months, as shown in figure 9.4.
As 1988 progressed, however, sighs of relief at the Fed gave way to concern about potential overheating and a consequent rise in inflation. Remember, memories of high inflation and of the pain the Volcker Fed had inflicted to end it were still fresh in central bankers’ minds. From early 1987 to early 1988, the unemployment rate trailed down gradually from 6.6 percent to 5.7 percent, a number that was at or below most economists’ estimates of the natural rate at the time. That view of the natural rate of unemployment was supported by the performance of inflation: core Consumer Price Index inflation crept up from 3.8 percent in the year ending December 1986 to 4.4 percent in the year ending March 1988. Not much, but the Fed did not want to get “behind the curve.” So, the FOMC decided at its March 1988 meeting to “increase slightly the degree of pressure on reserve positions.” Those words were code for a rate hike of 25 basis points, but the FOMC was saying nothing in public back then. America’s secretive central bank stuck to code words—even for internal purposes!
FIGURE 9.4. Effective federal funds rate, weekly, 1987–1991.
Source: Board of Governors of the Federal Reserve System.
The 1988–1989 tightening cycle lasted about a year, during which time the Fed raised the funds rate by about 3.25 percentage points and then, importantly, stopped (see figure 9.4). Real GDP growth slowed down commensurately from an average of about 3.8 percent in 1988 to an average of 2.8 percent in 1989, a modest deceleration. Consistent with that, inflation, which had been creeping up slowly in 1987 and the first half of 1988, basically flatlined at around 4.5 percent in the second half of 1988 and throughout 1989. The episode had all the makings of a perfect soft landing at the so-called NAIRU (nonaccelerating inflation rate of unemployment), the holy grail of monetary policy. Then another oil shock hit.
This time it was not from the Organization of the Petroleum Exporting Countries (OPEC) but instead from Saddam Hussein, whose army invaded oil-rich Kuwait on August 2, 1990. The price of a barrel of crude oil (West Texas intermediate) skyrocketed from around $16 in July to over $40 in October. While the 1990 oil shock was short (it was over by February 1991), it was not sweet. The violent spike in oil prices was enough to push the country into the short recession of 1990–1991 and to destroy the Fed’s hopes of a soft landing. GDP growth, which had averaged about 3 percent during the first half of 1990 (a nice pace for a soft landing), plummeted to an average of −1.7 percent over the next three quarters. The National Bureau of Economic Research dates the business cycle trough as March 1991, but the unemployment rate kept rising until the middle of 1992, leading journalists to dub the 1991–1992 period “the jobless recovery.” The long expansion of the 1980s was over.
On the price front, core Consumer Price Index inflation rose from a low of 4.3 percent in the fall of 1989 to a high of 5.6 percent in early 1991. Headline inflation rose more, of course, because of oil prices, topping 6 percent in the final four months of 1990. The FOMC responded to this inflationary uprising by raising the federal funds rate sharply (by 100 basis points) but only briefly (for about a month in January 1991), despite the recession (see figure 9.4). After that, the FOMC reverted to its previous policy of bringing the funds rate down to help the economy recover. At its last meeting in 1991, a December 20 conference call, the Board of Governors slashed the discount rate by an eye-catching 100 basis points, and the FOMC, in the tortured prose of the day, voted to allow “part of the reduction in the discount rate to be reflected in the federal funds rate.” The funds rate ended the year at around 4.25 percent, as compared to a 3 percent inflation rate.
The U.S. economy had finally run out of good luck, and so had President George H. W. Bush. At first, the military response to the Persian Gulf War (1990–1991) shot his presidential approval ratings into the stratosphere—to as high as 89 percent in a February 1991 Gallup poll. But then the economic response to the oil shock pulled that rating back down to 61 percent in October 1991 and eventually to as low as 29 percent in July 1992. Bush blamed his electoral defeat on Greenspan’s monetary policy, which he deemed insufficiently expansionary (Wall Street Journal 1998). The president had a point, though a more accurate villain would have been Saddam Hussein.
Alan Greenspan (1926—)
Maestro of the Federal Reserve
Life is full of ironies. As a dyed-in-the-wool conservative, Alan Greenspan, the Federal Reserve chair with the second-longest tenure in office,12 would steadfastly deny that policy makers have the ability to fine-tune the national economy. Yet that’s just what he did, with amazing success, for more than eighteen years. Greenspan’s Olympian reputation as a monetary policy maker was tarnished late in his career by his neglect of the Fed’s regulatory duties in the years leading up to the financial crisis of 2008–2009. But as a monetary policy maker, his record is hard to match.
Greenspan was born in New York City to parents who divorced, leaving him to be raised by his mother, with whom he remained close until her death. An intellectually gifted and musically talented student, he studied first at the Juilliard School in New York but then gave up on a potential musical career in favor of economics. Greenspan earned his bachelor’s degree (1948), master’s degree (1950), and PhD (1977), all in economics, from New York University. Notice the date of his PhD. It came long after he had established himself in both business and government.
Greenspan’s first career was as a business economist heading his own small firm, Townsend-Greenspan. He interrupted that to serve as chair of the Council of Economic Advisers for President Gerald Ford from 1974 to 1977 but then returned to his firm. President Reagan tapped Greenspan to replace Paul Volcker in 1987.
By the time Greenspan took over the leadership of the Fed, inflation had been vanquished, and the Great Moderation had begun although no one knew that at the time. It seems fair to say, however, that Greenspan’s monetary policies contributed to that moderation. In particular, as described in this chapter, the Fed nearly achieved a “perfect soft landing” in 1989 and then actually succeeded in executing one in 1994–1995 (see chapter 11).13 Shortly thereafter, Greenspan made what has been called his “great call” (Meyer 2004) by recognizing—before almost anyone else—that rapid growth in productivity in the late 1990s would enable the economy to grow faster without igniting inflation.14
Over his long and successful tenure as Fed chair, Greenspan became a kind of national guru on all things economic. He had a blind spot, however, when it came to financial regulation, where his deep belief in laissez-faire led him to place excessive faith in financial markets’ ability to assess and handle risk. The Fed’s regulatory neglect in the 2004–2006 period left a blemish on Greenspan’s overall record. But his record on monetary policy was stellar.
One might argue that monetary policy had done its job well by 1984. Inflation had been vanquished, the economy was roaring back from a terrible recession, and the Great Moderation was just beginning. Had the Fed not been forced to deal with two calamities—the 1987 stock market crash and the oil price spike of 1990–1991—Alan Greenspan and Company might have lived the quiet life for a decade. But that was not to be.
Fortunately, the 1987 crash left essentially no trace on the macroeconomy. But the 1990–1991 oil shock caused yet another bout of stagflation, albeit of a smaller magnitude and much shorter time frame than either OPEC I or OPEC II. The Fed, of course, understood well by 1990 that it could not fight both the stag and the flation components of stagflation at once. Its compromise allowed a short spike in inflation and a modest recession. Reasonable choices, it seemed to many.
Where was fiscal policy in all this? Apart from the 1986 tax reform, which was micro policy not macro policy, approximately nowhere. Or, to be more precise, it was totally preoccupied with the budget deficit, which is the subject of the next chapter.
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1. For one example, see Kilborn (1987a).
2. The term seems to have been coined by James Stock and Mark Watson (2003) but was popularized by Federal Reserve governor Ben Bernanke (2004).
3. That top rate was subsequently raised to 28 percent to get a bit more revenue.
4. It is told, among many places, in Birnbaum and Murray (1987).
5. In those days, the federal funds rate target range was about 400 basis points wide (e.g., 8–12%), and the FOMC took its target ranges for the Ms seriously.
6. Among many sources that could be cited on Keating and other S&L crooks, see Mayer (1990).
7. In those days, S&Ls had their own insurance fund, run by the Federal Savings and Loan Insurance Corporation, which was later merged into the Federal Deposit Insurance Corporation.
8. For one example, see Thomas (2000), who wrote that “the public did not realize the monster Congress had created until taxpayers got the roughly $500 billion bill for bailing out the thrift industry.”
9. The Congressional Budget Office’s time series on the budget deficit/surplus as a share of GDP shows virtually no change between fiscal 1987 and fiscal 1988.
10. This story is told in many places. My source is Greenspan (2007, 105).
11. See, for example, the multivolume Brady Report (Presidential Task Force on Market Mechanisms 1988).
12. Martin edges out Greenspan by a few months.
13. Full disclosure: I was vice chair at the time.
14. Greenspan saw this coming before it showed up in the data. More disclosure: I was among the many skeptics. See chapter 11.