Greenspan's Age of Tranquility

Was this luck -- or Greenspan's skill? The answer: some of both.

To understand why, you have to grasp that the American economy is completing a quarter-century cycle dominated by the fall of inflation from 13.3 percent from 1979 to 1.9 percent in 2003. This steady disinflation triggered a virtuous chain reaction of lower interest rates, higher stock prices, greater wealth, and strong consumer and business spending. Here's how it worked.

Interest rates dropped because lenders needed less protection to compensate for the erosion of their money. A 10-year Treasury bond fetched 13 percent in 1982, 8 percent in 1987 and 5 percent in 1998. As rates declined, people shifted funds into the stock market and later into housing. Share prices and home values rose, making Americans wealthier. Many Americans substituted this added wealth for annual savings. They spent more from current income and borrowed more. In 1982, the personal savings rate was 11 percent of disposable income; by 2005, it was barely over zero. The Great American Shopping Spree kept the economy advancing.

Meanwhile, strong economic growth, low inflation, rising profits and high stock prices attracted trillions of dollars of overseas investment. Because foreigners wanted dollars -- and bought them by selling their own currencies -- the dollar remained highly valued internationally. In turn, the strong dollar made imports into the United States cheaper. This sated U.S. consumers and restrained inflation.

Other factors also cut inflation. In the 1990s, oil prices dropped. Productivity growth -- old-fashioned efficiency -- increased, probably reflecting the impact of computers. Greenspan also cites globalization. From 1989 to 2005, he writes, the number of workers worldwide engaged in export-oriented industries rose from 300 million to 800 million -- a reflection of the entry of China and India into the global economy. All these new workers put downward pressure on "wages, inflation, inflation expectations, and interest rates, and accordingly significantly contributed to rising world economic growth."

In part, Greenspan was a happy bystander to all this good fortune. But he also helped create it. The Fed's easy-money policies in the 1970s led to double-digit inflation. Through a severe recession, Paul Volcker -- Greenspan's predecessor -- had cut inflation to 4.4 percent by 1987. Greenspan's Fed continued the assault, but more gently. Four times (1988-89, 1994-95, 1999-2000 and 2004-2006), it raised short-term interest rates to check price increases. Someone less convinced that inflation is dangerous might have let it drift up. Greenspan's Fed also deftly supplied credit in those scary moments (such as the 1987 stock crash) when financial panic was a threat.

Unfortunately, disinflation's benefits -- the huge drop in interest rates, the big increases in stock and home values -- can be enjoyed only once. This favorable cycle has ended. Indeed, it has left a hangover, as higher stock prices and home values both inspired damaging speculative "bubbles." Good times often foster their own undoing. People become overly optimistic, giddy, careless, complacent. Businesses become sloppy and sometimes criminal in pursuing growth and profits. Greenspan's successor, Ben Bernanke, has inherited the hangover.

As for Greenspan, his outlook is decidedly somber. Oil prices have already soared, reversing globalization's impact on inflation. He sees little relief. He thinks productivity growth will slow at best to 2 percent annually, down from about 3 percent from 1995 to 2005. He fears that inflation will gradually move to 4 to 5 percent and, in the process, raise interest rates and hurt stock prices. He worries that the nation hasn't faced the costs of the aging baby boomers. If he is right, the age of tranquility may slowly become his age of turbulence.