Running the Treasury

Posted: Dec 26, 2000 12:00 AM
George W. Bush's choice of Alcoa Chairman Paul O'Neill as Treasury Secretary indicates that Federal Reserve policy is very much on the president-elect's mind. It appears that O'Neill's primary qualification for the job is a long-standing close relationship with Fed Chairman Alan Greenspan. The fact that he is also a good friend of Vice President-elect Dick Cheney apparently sealed the deal. Bush remembers well that the Fed brought on the 1990-91 recession that destroyed his father's re-election hopes in 1992. Then, as now, Greenspan was worried that the economy was growing too fast. To prevent rapid growth from stimulating inflation, the Fed began tightening monetary policy in March 1988. It continued tightening for more than a year, raising the federal funds interest rate from 6.5 percent to 9.75 percent in February 1989. Then, as now, Greenspan promised a "soft landing" for the economy. But monetary policy affects the economy only with a lag. By the middle of 1989, the economy was already showing the effects, recording zero growth in the third quarter. At this point, the Fed began to ease monetary policy, dropping the fed funds rate. But it did so in tiny increments of a quarter of a percentage point here, a quarter of a percentage point there. Not surprisingly, the economy did not respond. By the middle of 1990, the economy was in a full scale recession. Everyone knew it except Greenspan. As late as October of that year, he told his fellow Fed members, "The economy has not yet slipped into a recession." According to the National Bureau of Economic Research, the recession officially began in July 1990, ending in March 1991. Consequently, the Fed did not increase its easing, and continued to dribble out tiny quarter point rate cuts every so often. By March 1991, at the trough of the recession, when the economy was declining at a 3 percent annual rate, Greenspan still had the fed funds rate at 6 percent. Treasury Secretary Nicholas Brady, for whom I worked, was livid at the slow pace of Fed easing. But the Fed is an independent institution, and the Fed chairman cannot be fired. Hence, the administration ultimately has no way of forcing the Fed to do anything. However, in mid-1991, the Bush administration did have a bit of extra leverage because Greenspan's term as chairman of the Fed was about to expire. Brady thought he had an agreement with Greenspan to ease monetary policy more aggressively, and on that basis recommended his reappointment. President Bush thereupon renominated Greenspan for another four-year term as Fed chairman in July 1991. Yet there was no change in monetary policy. Rate cuts continued at their previous slow pace. As a result, going into the election year of 1992, many Americans believed that the recession was still continuing. This gave Bill Clinton his best issue in the campaign -- "It's the economy, stupid" -- and ultimately the White House. George W. Bush remembers this history well, having watched his father cope with a recession caused by the Fed, and with no power to change its policies. By 1992, Secretary Brady became so frustrated with Greenspan that he stopped his regular meetings with him, feeling that they served no purpose. Instead, Brady began speaking out in public ever more forcefully about the need for Fed policy to get the economy going, but to no avail. I said at the time that Brady's public campaign against the Fed was counterproductive. The Fed can never allow itself to be seen as kowtowing to administration pressure, and must defend its independence. Therefore, even if Greenspan wanted to ease monetary policy more aggressively, he could not do so with the Treasury Secretary appearing to pressure him into it. In any case, the economy of 1992 was basically decided by Fed policy in 1991. By 1992, it was too late for the Fed to do anything to help Bush at the polls. The same is true now. Next year's economic growth has largely been determined by what the Fed has already done. It has been tightening monetary policy since June 1999, raising the fed funds rate to 6.5 percent. And as in 1988 and 1989, Greenspan is telling us not to worry, that he will engineer a soft landing. And as then, it appears that this will not be the case. Even the Fed itself now admits that a hard landing is more likely. As it said in its Dec. 19 statement, "the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future." That is as close as the Fed ever gets to predicting a recession, and that is why the stock market crashed afterwards. Now O'Neill has been given the responsibility for nudging the Fed toward easing. Presumably, George W. Bush has learned from Brady's mistakes, and chosen someone for Treasury Secretary who is already on good terms with Greenspan, and knows how to keep his advice private and out of the newspapers. If this is the case, Bush may have made an outstanding choice, recognizing that he and his other economic advisers can deal with the tax cut and other issues in the Treasury's portfolio. But only the Treasury Secretary can deal with the Fed chairman one-on-one. It might have been simpler if Bush had simply named Greenspan as Treasury Secretary and then made O'Neill Fed chairman. In any case, it appears that Bush has chosen a Treasury Secretary well qualified to speak to Greenspan about the need for lower interest rates. As a corporate CEO in a manufacturing business, O'Neill knows better than any Wall Street financier about the devastating effect of tight money on commodity prices, production and jobs. My first reaction to O'Neill's appointment was surprise, since he was not on anyone' short list for Treasury Secretary, and did not have the financial background secretaries normally have. But I now believe he is an inspired choice, given the overriding importance of Fed policy to the nation's economic well-being, and hence Bush's success as president.