Don't Know Much About History, Anniversary Edition: Everything You Need to Know About American History but Never Learned (Don't Know Much About®) (88 page)

Central Bank:
A national bank that operates to control and stabilize the currency and credit conditions in a country’s economy, usually through the control of interest rates (
monetary policy
). The Federal Reserve is the central bank of the United States.

Consumer Price Index (CPI):
A measure of the average change over time in the prices paid by consumers for certain goods and services. The CPI, announced on a monthly basis, is considered the broadest measure of the country’s rate of
inflation
(see p. 561). Another statistical gauge, the Producer Price Index, or PPI, measures costs that producers—factories, manufacturers, farmers, etc.—pay to make and deliver their goods. Higher producer prices often lead to higher consumer prices as the business passes along its higher costs. During the 1990s, many economists argued that the CPI overstates the real inflation rate by as much as 1 percent because of difficulties in gauging prices on a national scale and out-of-date comparisons.

Discount Rate:
The interest rate that the twelve Federal Reserve banks charge to private commercial banks, savings and loan associations, savings banks, and credit unions to borrow reserves from the Fed. This rate is controlled by the board of governors. In recent times, this rate has been the key means the Fed uses to set interest policy.

Easing or Tightening:
To
ease,
or make credit more available, the Fed pumps money into the nation’s banking system by buying U.S. Treasury bonds. This causes the
Fed funds rate
to go down, making it easier for consumers and businesses to borrow money. Normally used to fight a slow-growth economy or recession (negative growth), easing encourages the economy to grow as consumers and companies buy more “stuff.”

To
tighten
credit, the Fed sells U.S. Treasury bonds, which withdraws money from the banking system. With the money supply decreased, banks become less willing to lend, making borrowing more difficult for businesses and consumers. When short-term interest rates rise, the economy’s growth usually slows. Tightening credit is the Fed’s main tool for fighting inflation.

Federal Open Market Committee (FOMC):
A twelve-member committee that meets eight times a year (about every six weeks) to assess the state of the economy and set guidelines for the Federal Reserve regarding the sale and purchase of government securities in the open market. Chaired by the reserve chairman, the FOMC consists of the seven governors and the presidents of the twelve Federal Reserve banks, but only twelve people vote in the committee. They are the seven Fed governors, the president of the New York Federal Reserve Bank, and four of the other eleven Federal Reserve Bank presidents, who serve one-year voting terms on a rotating basis.

Fed Funds Rate:
The average interest rate at which federal funds actually trade in a day. The Fed influences interest rates by
easing or tightening
through either the sale or the purchase of U.S. Treasury bonds, and this rate is controlled by the Federal Reserve’s Federal Open Market Committee, or FOMC (see above). It is the rate that banks charge one another for overnight loans—a key “short-term” interest rate. The funds rate affects overall credit conditions in the country and is the Fed’s main weapon against both inflation and a slow growth economy, or recession, a shrinking economy.

Fiscal Policy:
The government’s plan for spending and taxing. (It differs from monetary policy, which the Fed controls; see p. 562.)

Gross Domestic Product (GDP):
Once known as the Gross National Product, this is the broadest measure of the output of a nation’s economy—the total amount of all goods and services that a nation produces. Measuring the GDP determines whether the economy is growing or contracting and how fast it is moving in either direction.

Inflation:
Simply put, too many dollars chasing too few goods, usually the result of demand outstripping supply. The result is rising prices, as measured by the
CPI
(see p. 560). While price increases are generally necessary to sustain business profits and wage growth, a rapid rise in prices of all goods and services is considered a danger to the economy. Fighting inflation and keeping a lid on sharp price rises are some of the key goals of the Fed.

Monetary Policy:
The central bank’s actions to influence interest rates and the supply of money available in the economy.

Productivity:
Simply, the statistical measure of the average hourly output of workers. Ideally, productivity gains allow efficiencies that both reduce consumer costs and increase profits, which can then be shared with workers, increasing the standard of living. Productivity is viewed as a key to restraining inflation as the cost of goods falls because they are cheaper to produce.

During the 1990s, Alan Greenspan came to accept the theory that rapid and lasting gains in American productivity—the result of technological advances and a better educated and trained workforce, among many other factors—were the key to sustained economic expansion with little inflation.

Recession:
A nationwide decline in overall business activity characterized by a drop in buying, selling, and production, and a rise in unemployment. Many economists consider a nation’s economy in a recession if the output of goods and services falls for six consecutive months, or two quarters. When a recession grows worse and lasts longer, it becomes a
depression
.

Stocks:
Certificates representing partial ownership in a corporation and a claim on the firm’s earnings and assets. Stocks of profitable corporations normally yield payments of dividends, a portion of the corporate earnings distributed to shareholders. At its most basic, the value of stock often rises and falls as a company meets, or fails to meet, earnings expectations.

During Alan Greenspan’s tenure at the Fed, which began in 1987, the American economy did some remarkable things. For ten years beginning in 1991, the economy grew steadily, sometimes rapidly, with relatively low inflation. Once upon a time, they called it the “Goldilocks economy.” Jobs were being created at a record clip, pushing unemployment ranks down to unprecedented peacetime levels. Inflation was tame. Corporations were making money. People had jobs and record numbers were investing in the stock market, primarily through their company’s retirement plans. Everything seemed to be “just right,” as Goldilocks would say.

New technologies, relative peace in the world with the end of the Cold War, the growth of global markets, and freer trade were all credited for powering this economic engine. But to many people, the guiding hand behind this remarkable economic turnaround was the sometimes inscrutable Alan Greenspan.

Chairman of the board since 1987, Alan Greenspan was appointed by President Reagan to replace Paul Volcker, a Democrat. An imposingly tall, cigar-smoking, powerful personality, Volcker had been responsible for setting interest rates extremely high in an attempt to battle the excessive inflation of the late 1970s. Volcker’s chairmanship had lasted from 1979 to 1987, and his bitter anti-inflation remedy of high interest rates had worked over the long haul, reducing the inflation rate from 13.3 percent to just 1.1 percent. However, the policy was also responsible, in large measure, for Jimmy Carter’s inability to get the economy moving, one of the chief reasons he was so handily trounced by Ronald Reagan in 1980. Reagan’s political team was going to name a Fed chairman that they hoped wouldn’t similarly cripple Reagan’s presidency.

They thought they had found him in a Republican economist who had made a fortune in economic forecasting and was a free-market true believer. Born in 1926 in New York City, Alan Greenspan was a Depression-era child whose mother, a furniture store salesperson, and father, a self-educated stock market analyst, divorced when he was three. He attended George Washington High School in upper Manhattan where he was, coincidentally, three years behind future secretary of state Henry Kissinger. From there, he went on to study clarinet and piano at what later became the Juilliard School of Music, dropping out after two years to play in a big band. Always a lover of statistics and numbers, he enrolled at NYU while still in the band to study economics, graduating summa cum laude in 1948, and getting his master’s degree in economics in 1950. In 1952, he married a painter who introduced him to the influential writer Ayn Rand, the Russian-born novelist whose best known works are
The Fountainhead
(1943) and
Atlas Shrugged
(1957). Devoutly anti-Socialist and antireligious, Rand set forth a moral and economic philosophy, called Objectivism, based on individualism and self-interest. Greenspan was a committed disciple of Rand’s philosophy, which eschewed government interference and celebrated the individual over the greater society.

During the 1950s, Greenspan and a partner formed an economic consulting team that forecast changes in the economy and made a considerable fortune during the postwar boom years. During the 1970s, he had served as an economic adviser to President Ford. He was also given high marks for chairing a bipartisan commission charged with shoring up the Social Security system. Following that, he was working in the private sector when the call came from Ronald Reagan.

Two months after he took office in August 1987, Greenspan faced a Wall Street crisis of near 1929 proportions. On one day in October, the stock market lost 508 points, more than 22 percent of its value, in the Crash of ’87. The nation’s largest financial institutions, which were facing huge investment losses along with the customers who owed them money, were in danger of cracking and crumbling. It was a potential repeat of the Great Crash of 1929, when the stock market collapse had begun a run on banks that led to the downfall of the American banking system. Nearly sixty years later, if one or more of the companies in the very elaborate network of banks and brokerage houses that made up the world’s financial system had failed to make payments, or even delayed payments, a devastating domino effect might once again have been triggered. The next morning, Greenspan issued a terse announcement: “The Federal Reserve Bank, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial system.”

The statement, meant to soothe roiled nerves on Wall Street, would have been meaningless without action behind it. Like two Dutch boys putting their fingers in the leaking dikes, Greenspan and the New York Fed Bank president worked the phones to executives of the nation’s largest banks, getting them to extend credit to some of their insolvent debtors, and promising that the Fed would back them up. It was done behind the scenes. It broke some rules, but it was what the Fed had failed to do in 1929. And this time, the dikes held.

Greenspan’s 1987 gambit made him a hero on Wall Street. Five weeks after the stock market crisis, a
Wall Street Journal
headline read: “Passing a Test: Fed’s New Chairman Wins a Lot of Praise on Handling the Crash.” And he parlayed his success into new power. Before the Greenspan era, the FOMC voted as a body on each change in interest rates. In the aftermath of the 1987 crash, Greenspan persuaded his colleagues to give him new powers by changing the process. While the committee would vote on an overall policy direction—either in the direction of raising or cutting interest rates—the timing and size of rate setting were left to the chairman. As Bob Woodward writes of this shift, the FOMC was “basically ceding operational control to Greenspan.”

The powerful post of chairman became even more powerful. In other hands, this much power might have been dangerous. But the consensus is that Greenspan’s swift, decisive actions and behind-the-scenes reassurances had prevented a greater meltdown. During the next few years, he headed off several other potential global financial catastrophes, including the huge banking losses of the 1990s, the collapse of the Mexican peso in 1994, the “Asian contagion” of 1998, when several newly important Asian economies basically failed, a collapse of the Russian ruble following the end of Soviet rule, and the failure of Long-Term Capital Management, an investment firm whose failure might have brought down a number of large banks, possibly setting off another domino effect with devastating consequences for the financial markets.

Greenspan did that by building consensus among his fellow central bankers, with a deft mastery of minute details of the working of the American economy. He established credibility as an inflation fighter, which reassured Wall Street. But he also began to realize that the old economic rules had changed. Perhaps most important, he rolled up his sleeves—literally—to work with statisticians and realized that the changes in technology and other efficiencies in productivity meant that the economy could grow and unemployment fall without appreciable inflation.

Ironically, the Republican banker–inflation fighter was viewed by some as one of the reasons behind a Republican president’s defeat. Republicans, including George Bush himself, later said that Greenspan had been responsible for his defeat in the 1992 election. Years later, Bush said in a 1998
Wall Street Journal
interview, “I think that if interest rates had been lowered more dramatically that I would have been reelected President, because the recovery that we were in would have been more visible. I reappointed him, and he disappointed me.” While some economists agree that Fed rate cuts came too late and too slowly during the recession of 1990–91, the causes for Bush’s defeat were probably more complex than Greenspan’s interest rate decisions and more likely hinged on the Perot candidacy. (See “Can a man called Bubba become president?” p. 545.)