One of the absurd ideas that took hold in the late 1990s was that the Federal Reserve, presided over by the almost-infallible Alan Greenspan, had essentially conquered the business cycle. The Fed could (the reasoning went) maneuver the economy with deft changes in interest rates to avoid the twin evils of inflation and recession. Along with the extravagant belief in the Internet and computers, the faith in the Fed underpinned the period's enormous economic optimism.
We know now that the optimism was overdone, though explanations for this vary. The most popular theory is that Greenspan goofed. With hindsight, his reputation exceeded his performance. He gushed too much about the potential of new technologies and, thereby, fed stock speculation. He and the Fed also moved too slowly to pop the stock market bubble. The theory is convenient, because it suggests that pilot error caused many of the economy's present problems.
It's also wrong. All economic expansions ultimately end, because miscalculations occur and the future cannot be foretold. The irony of our present situation is that belief in Greenspan's infallibility helped cause, and then end, the boom. Believing the business cycle conquered, people -- as consumers, managers and investors -- began spending freely and sometimes frivolously. This couldn't continue indefinitely. It didn't.
Of course, Greenspan isn't above criticism. He has gushed too much about technology. But suppose he hadn't said a word. It's doubtful that the stock market would have behaved much differently. His speeches didn't cause the mania, which was fed by the press, cyber "experts," CEOs, stock analysts and average Americans who -- playing with the Internet, cell phones and Palm Pilots -- envisioned a glorious future. Why not invest in stocks of the future?
The other criticism is that, if the Fed had popped the market bubble, the economy wouldn't have suffered adverse aftereffects. The market boom affected production and jobs. High stock prices meant companies could raise investment capital easily. The ferocious investment boom by dot-coms and telecoms followed. Consumers went on a spending binge, based in part on their bulging stock portfolios. The Fed (it's said) could have minimized or prevented these excesses.
In a speech in August, Greenspan replied to critics. Except in retrospect, he said, the Fed couldn't have identified the market bubble. Critics regard this claim as, at best, insincere. On several occasions, Greenspan himself suggested the possibility of a bubble. But it's one thing to suspect that the market has gone berserk and another to be certain enough to take action. Did the bubble arrive when the Dow hit 8,500? How about 9,247? Or maybe 10,003? The answer still isn't clear.
Even if it had been, Greenspan said, the Fed couldn't have popped the bubble painlessly. Trying to bring the market down through higher interest rates might have triggered a recession. Commentators found the speech glib and self-serving. It was a public relations disaster and intensified the criticism of Greenspan.
But he is mostly right. The critics don't cite precedents when the Fed -- or any other central bank -- has painlessly popped speculative bubbles, because there may not be any. In a recent speech, Ben Bernanke, a Princeton economist now on the Federal Reserve Board, recalled the one instance when the Fed did attack stock speculation: the late 1920s. It is not a happy precedent. In January 1928, the discount rate was 3.5 percent; by August 1929, it was 6 percent, the highest level since 1921. The stock market peaked in September and crashed in October. The Great Depression of the 1930s ensued. (To be fair, the market crash, though it started the Depression, didn't cause its length or severity.) Wait a minute, say critics. The Fed could have squelched speculation without wrecking the economy. All it had to do was raise "margin" requirements. Margin requirements govern how much stock people can buy with borrowed money. The present requirements, dating to 1974, are 50 percent: Half of any stock purchase can be made with cash, half with credit. Requiring more cash and less credit would have (the theory goes) stifled speculative borrowing. Sounds simple.
The trouble is that borrowing wasn't a big force behind the market's stupendous rise. At the market's peak in March 2000, all stocks were worth about $17 trillion. Margin borrowing then (also the peak) was about $280 billion -- less than 2 percent of the market's value. The point, made by both Greenspan and Bernanke, is that once a true speculative boom gets going it can't be stopped gently.
There are larger lessons. All the criticisms of Greenspan suggest, either explicitly or implicitly, that had he and the Fed performed better, they could have kept the economy out of trouble. Even now, the faith remains strong that the Fed can rescue the economy from its present difficulties. (Indeed, the Fed's key policymaking group meets today and may cut interest rates.) Perhaps these hopes will be fulfilled, but there's no guarantee. In truth, the Fed influences the economy mainly through one small instrument: the Fed Funds rate. This is the interest rate on overnight loans, mainly among banks. Almost everything else is outside the Fed's direct control: long-term interest rates (on mortgages, for instance), which are influenced by inflationary expectations; the state of the world economy; public confidence; managerial competence; government regulations. The list is almost endless.
To suppose that the Fed can steer the economy is a fantasy -- pleasing but wrong. It is now being dislodged, slowly and painfully, from public consciousness.