Us Banker Has A Big Say In Our Economy

Sydney Morning Herald

Sunday June 23, 1996

Glenda Korporaal

IN THE early '80s, US magazine Institutional Investor had a front page cover featuring nothing but a cigar resting in an ashtray with its smoke lazily curling its way up the page.

Nothing more was needed.

Everyone knew that the magazine was writing about the most powerful men in America, the cigar-smoking chairman of the Federal Reserve Board, Paul Volcker.

More than any one person, Paul Volcker, who was president of the US central bank ("the Fed") from 1979 to 1987, was the man who broke the back of inflation in the US.

It was a trend that was eventually transmitted around the world, even to traditionally higher inflation countries such as Australia.

Last week, Volcker's successor, Alan Greenspan, the man who has helped ensure that inflation has remained on the mat in the US (and therefore in other Western economies) was confirmed by the US Congress for his third, four-year term.

Most Australians have never heard of Paul Volcker or Alan Greenspan. Yet US Fed chairman would be the one of the most influential foreign policy makers when it comes to the daily economic lives of the average Australian.

A strong Fed chairman means lower US inflation, lower interest rates over the longer term and a sounder US economy, which always helps underwrite the outlook for a sounder world economy. A strong Fed chairman means steady long-term economic growth rather than short-term world booms and busts.

A weak Fed chairman means higher US inflation, concerns about the US economy and, over time, concerns about the outlook for the world economy and nervous international financial markets.

Because of the dominance of US financial markets, any change in attitude or interest rates in the US will have an impact on our interest rates or the value of the Australian dollar or both.

Two months after he was appointed by President Bush in 1987, Dr Greenspan was the man who prevented the Wall Street sharemarket crash of October 1987 from turning into a more serious world-wide economic crisis by pumping money into the US banking system.

But, in early 1994, Greenspan's concerns about inflation getting out of control saw him jack up US interest rates. Australia soon followed suit, putting up its interest rates by about the same amount in several moves.

The unexpected move by the Fed chairman was the first time that a major central bank had launched a pre-emptive strike against inflation - that is, put up interest rates before inflation had started to get out of control again. It provoked a worldwide crisis in the bond markets. It was the reason that many people holding managed investments found out at the end of 1994 and 1995 that their managers were reporting embarrassingly low investment returns. But it did what it was intended to do: produced a gradual slowdown in the US economy in 1995 (the same happened here for similar reasons).

It helped signal to players and financial markets that the Fed was serious about countering any renewed outburst of inflation.

Paul Volcker was a Democrat who was reappointed to the job by Republican President Ronald Reagan before the 1984 presidential election. Reagan would have wanted someone more malleable but not to re-appoint the impressive Volcker could have caused problems in the financial markets.

Similarly, Democrat President Bill Clinton would probably have preferred a Fed chairman a bit less concerned about inflation and a bit more prepared to slash interest rates as he heads into the 1996 elections. But he offered Greenspan, a Republican who was an economic adviser to Republican Presidents Nixon and Ford, another term because of his credibility with financial markets and other economic decision makers.

The Economist notes that, largely due to his pre-emptive strike of 1994, "the American economy is enjoying one of its longest cyclical recoveries - and with continuing low inflation. The widely cited 'misery index' - the sum of the country's unemployment and inflation rates - has fallen to one of its lowest recent levels".

The Greenspan reappointment has some important implications for Australia. It means the US is in for a period of continued low inflation. The US economy will not be booming but rather enjoying more sustained long-term growth.

It means that Australians will have to continue to learn to live in a low inflationary environment.

It means that Australia cannot afford to appoint as Reserve Bank chief in September (when Bernie Fraser retires) someone who is out of step with Greenspan. It's not a time to be experimenting with central bankers who may be accommodating to politicians but lack experience and credibility with financial markets.

The Australian central bank does not follow everything that the US Fed does. And the economic circumstances in the two countries differ. Greenspan cut US interest rates last year and once early this year but the Reserve Bank - which was expressing concerns about a possible wages (and thus inflationary) outbreak - didn't budge.

But our economic policies must not get out of step with the anti-inflationary, low Budget deficit policies that Greenspan advocates.

To do otherwise would mean that all the painful progress that has occurred in Australia in holding down inflation over the past few years could go up in smoke.