In June 2003, while discussing the vote that would take the federal funds rate to its then-lowest point, 1%, Alan Greenspan committed what may have been the greatest monetary sin of modern times. The focus for much of the discussion was Japan, that country’s central bank pioneering at that early date all the things the Fed and other majors would do later. It wasn’t working, and some American officials, including Greenspan, were unnerved.
CHAIRMAN GREENSPAN. One is that I don’t think we know enough about how the private financial system works under these conditions. It’s really quite important to make a judgment as to whether, in fact, yield spreads off riskless instruments—which is what we have essentially been talking about—are independent of the level of the riskless rates themselves. The answer, I’m certain, is that they are not independent.
This is not a small, trivial matter. As it would turn out, everything hinged on whether or not he was right. Unfortunately for the world, he wasn’t.
The nuts and bolts of this issue were the basis for my talk in Toronto the day after the eleventh anniversary of August 9, 2007. I’ll post the video for it in the coming days.
The short version is this: the central bank is central and therefore dictates monetary hierarchy. This is the lack of independence the “maestro” was certain about. Predictable monetary hierarchy is the basis for monetary policy’s intended predictable influence on the economy. Hierarchy is order; the lack of it equals, well, chaos.
Just one day after August 9, his certitude, which his successor Bernanke possessed in far greater supply, was shattered. Money rates began to move independently and the system has never gone back.
The most embarrassing example of this breakdown came in federal funds itself. The effective rate just wouldn’t respond to any central bank inputs. It’s still misbehaving to this day.
