Editor's note: Every Sunday Fortune publishes a favorite story from its magazine archives. This week we turn to a 2005 Fortune look at the economic issues Ben Bernanke faced as he prepared to take over Alan Greenspan as U.S. Federal Reserve Chairman. After news broke this week that Larry Summers has dropped out to be a candidate for the next Fed chair, Janet Yellen has widely been reported to be the frontrunner. Whoever takes over, the new chair will be dealing with a far different economy. Here's a look back.
There are big issues facing us as Ben Bernanke takes over the great Greenspan. The trouble is, there's not a whole lot he can do about them.
By Justin Fox
What kind of economy will Ben Bernanke inherit when he takes over from Alan Greenspan as Federal Reserve chairman in February? (We're assuming he'll breeze through his Senate confirmation, possibly before you read this.)
The answers flowing from the nation's ranks of Fed watchers mostly have to do with whether a Bernanke-led Fed will keep raising short-term interest rates. The majority opinion is that, by the new chairman's first meeting in charge of the rate-setting Federal Open Market Committee, scheduled for March 28, the combination of almost two years of rate hikes, high energy prices, and a deflating housing bubble will have cooled down the economy enough that Bernanke will lay off. A minority argues that growth is currently so robust that a slowdown won't come next year. A few even speculate that, whatever's happening in March, Bernanke will push for at least one last rate hike just to show he's not an inflation wimp.
That's what the Fed watchers talk about, and if you buy or sell bonds for a living, it makes sense to listen. It's less evident, though, why the rest of us pay attention. There are far bigger economic issues these days than the question of whether Ben Bernanke will raise interest rates a quarter-point in March: things like housing prices, job insecurity, stagnant pay, the looming crisis in public and private pensions, the dysfunctional health-care system. With the possible and partial exception of housing prices, they are all matters that Ben Bernanke won't be able to do anything about as Fed chairman. But during the Greenspan era Americans became so accustomed to looking to the Fed to solve economic problems that we don't seem to realize how many of today's biggest economic decisions are in our own hands and those of the people we elect--not the appointees and bureaucrats at the Fed's temple on Constitution Avenue.
We have learned over the past two decades to think of the economy on the Fed's terms. Given that the Fed's view of the economy is significantly more informed and rational than any other that we're likely to hear on a daily basis, that isn't all bad. But the Federal Reserve is a single-minded operation with a single significant economic tool at its disposal. To wield a crude analogy: The economy is a plane, and the Federal Open Market Committee--headed by the Fed chairman and consisting of the Fed governors in Washington, D.C., the president of the New York Fed, and a rotating cast of other regional Federal Reserve Bank presidents--controls the throttle. But that's all it controls. Repairs, refueling, route, choice of plane, allocation of seats between first class and economy--not to mention in-flight dining and entertainment--are the responsibility of others. The hand at the throttle can keep the engine from overheating or the plane from stalling out, but that's about it.
Stalling out and overheating were of course big problems for the U.S. economy in the 20th century--with the Great Depression of the 1930s being the most significant stall and the Great Inflation of the 1970s and early 1980s the worst overheating. The realization that the Fed could actually stop inflation in its tracks dawned on Americans in the mid-1980s, after chairman Paul Volcker led a brutal but successful campaign to do just that. His successor, Greenspan, demonstrated in his reaction to the 1987 stock market crash that the Fed could prevent stalls, then showed in the "soft landing" of 1995 that it could halt inflation without throwing everybody out of work. With that, the myth of the all-powerful chairman was born.
As Greenspan himself has been trying to explain in speeches lately, it wasn't all his doing. Many things outside the Fed's control have changed to make its job--and that of central banks around the world--a lot easier. Increasing integration of the global economy, the decline of labor unions, deregulation, new communication and production technologies, and perhaps most of all the rising power and diversity of financial markets have combined both to keep inflation under control and to render the economy far less susceptible to shocks like sudden increases in energy prices. Academic observers--including Fed chairman--elect Bernanke, in a 2004 speech--have taken to calling this change the "Great Moderation." Instead of the sharp swings in economic activity that characterized the U.S. before the 1980s, we now have economic boomlets and bustlets happening all the time, in different industries and different regions.
The Fed's hand at the throttle of the economy can keep the engine from overheating or stalling out. But that's about it.
Stagnant pay. The pension crisis. The health-care mess. Those are matters that Ben Bernanke won't be able to do anything about.
That's been swell news for central bankers. For the rest of us it's been a mixed blessing. "If you look at the economy today, it's meta-stable. Lots of people can fail, and the system can remain quite strong," says Eamonn Kelly, the CEO of Global Business Network, the consulting and forecasting firm that evolved out of Royal Dutch/Shell's famed scenario-planning operation. "You're not dependent on single lines of connection anymore. Anything that goes wrong in the system, you can route around it pretty quickly." Partly as a result, the U.S. hasn't had a year of negative GDP growth since 1991 (vs. four from 1974 to 1982). Pity those, however, who get routed around: "It's not like it's meta-stable for every actor," says Kelly. "For individuals it's less secure than it used to be."
That is the perversity at work when we speak in Fed-speak: Some of the very changes that have made the Fed's job easier over the past quarter-century have made our lives harder. Jobs are less secure, and benefits like health care and pensions are less certain, than in the decades following World War II. That makes it far harder for workers to force pay raises and far easier for a central bank to keep inflation in check. The Fed view of the world is not quite as worker-unfriendly as it was in the mid-1990s, when the stock market rose whenever the unemployment rate went up because that meant the Fed wouldn't have to raise rates. But there's still something strange about worrying along with Alan Greenspan whether the employment cost index is rising too quickly when the employment cost index is what we get paid. The fact that most of the rise in employment costs in the past three years has come in the form of increased spending on health care and pensions makes it even worse: The Fed feels the need to crack down because employment costs are rising, but after adjusting for inflation, wages and salaries have actually been declining for the past two years (see chart at the beginning of this article). The point is not that the Fed should ease up: Focusing on stable prices as the sole criterion of success has worked well for the world's central banks over the past two decades. The point is that while it's great that the Fed has gotten the business cycle (somewhat) under control, the business cycle isn't the only thing that matters to our economic lives.
The most important economic measure of all is the standard of living. It increased dramatically and across the board in the U.S. in the 1950s and 1960s. Since then it's been a mixed bag. The most dramatic downer is that the average hourly wage, adjusted for inflation, is lower now than it was in 1973. But overall household wealth is up, per capita consumer spending is up, and the number of really rich people is way up. The great news of the past decade is that labor productivity has been rising at a much faster pace than in the 1970s and 1980s. But while those productivity gains made their way into paychecks in the late 1990s, that has since stopped. The main culprits appear to be competition from the rising economic powers of China, India, and the Internet; skyrocketing health-care costs; pension-funding shortfalls; and unceasing pressure to keep costs down from those global financial markets the Fed likes so much.
This is not a problem that necessarily calls for a massive government solution. It is the sheer free-market vibrancy of the U.S. economy that will probably be its greatest strength in the decades to come. But in a more competitive world, there will be far less room for error in economic policymaking. To thrive, the U.S. needs to churn out better-prepared high school graduates; it needs to lower health-care costs or at least allocate them more rationally; it needs to find a way to pay for the baby-boomers' retirement that doesn't bankrupt all our old-line corporations or result in huge tax hikes; and it needs to find a way to stop borrowing so much money from foreigners. Sure, it will help if the Fed does a competent job with monetary policy, but that's not what's going to determine the economic possibilities for our grandchildren.
Yet we seem to have gotten so used to leaving economic policy in the hands of the Fed that those who should be addressing the issues outlined above have been able to get away with going AWOL. Greenspan may deserve the flak he gets from Democrats for reawakening the deficit monster by giving tacit support to President Bush's 2001 tax cuts. But it wasn't the Fed chairman who voted for the cuts and signed them into law, and it certainly wasn't he who launched the federal government on a spending binge that has now surpassed Lyndon Johnson's. (It should also be noted that most of the Bush tax cuts make economic sense, if they are eventually accompanied by spending cuts or hikes in other taxes.) The White House and Congress also have so far shown no interest in making hard decisions about health care, and while corporation pension legislation may pass this year or next, it will probably be just a Band-Aid. As for Social Security, the President did talk about shoring it up but backed down after running into a wall of resistance on Capitol Hill. Congress and the White House have responded to economic competition from overseas mainly with saber rattling and protection for that industry of the future, textile manufacturing.
Why are we letting them get away with this? Mainly because American voters don't like hard decisions any more than politicians do. But it is also because certain segments of informed America and official Washington suffer from the delusion that the truly critical decisions about our economic future will soon be in the hands of the scholarly, bearded, former Princeton economics-department chairman about to take charge of the temple on Constitution Avenue. Sorry, folks, it's time to get over our collective Greenspan-era dream. The really big choices are in the hands of the politicized rabble of the White House and Capitol Hill. Yeah, those guys. The ones we elected.
In this month's Fortune poll, we ask readers whether they buy the argument put forth in our recent feature by Allan Sloan and Doris Burke, "Surprise! The Big, Bad Bailout is Paying Off." So? What's your take?
Take Our PollAug 9, 2011 11:38 AM ET
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