The economic prosperity of the last 20 years, in many respects, can be attributed to the triumph of central banking. Led by the indomitable Paul Volcker, America’s Federal Reserve was central to this outcome. The single-minded discipline of monetary austerity succeeded in ridding the US of the inflationary excesses that had built up during the 1970s. As a result, inflation targeting became the rage in other central banks around the world, most notably in Germany’s once proud and now marginalized Bundesbank. Inflation was vanquished from the macro scene and central bankers became the new icons of the ensuing prosperity.

That was then. In the end, the successes of inflation targeting sowed the seeds of their ultimate demise. The very process of disinflation unleashed powerful rallies in equity and fixed income markets that became central to the new prosperity. Since the inflationary excesses of the 1970s had gone to such extremes, the road to price stability was long and arduous. That made for an equally long transition in financial markets that benefited investors beyond their wildest dreams. As inflationary expectations and interest rates fell, the vicious cycles spawned by accelerating inflation were transformed into the ultimate in virtuous cycles that only a powerful and lasting disinflation could unleash. Yet out of this glorious disinflation a new inflation was borne -- asset inflation. And central bankers didn’t have a clue how to deal with it.

They still don’t. The Bank of Japan was the first victim of the new inflation. Asset bubbles in equity and property markets in the late 1980s created enormous excesses in Japan’s real economy and in its financial system. The history of Japan’s pre- and post-bubble period tells us that the BOJ was late in recognizing the perils of what was to come. Its monetary policy stance was too accommodative in the late 1980s, thereby nurturing the build-up of the bubble. And it was too restrictive in the early 1990s, failing to appreciate the deflationary risks that always get unleashed in the aftermath of a popped asset bubble. Some 13 years after its bubble crested in 1989, Japan is still picking up the pieces. An alternative approach by the BOJ could have made a real difference.

It’s different in America -- I guess it always is. But the similarities with Japan should not be ignored. America’s asset bubble created its own set of distortions in the real economy. Capital spending went to excess as Corporate America became convinced it could acquire Nasdaq-like multiples through open-ended investment in new information technologies. Remember the e-based IT spending frenzies associated with B2B and B2C? The Y2K panic was the icing on this rapidly rising cake. Consumers also got lured into the bubble, increasingly viewing outsized equity returns as permanent substitutes for saving the old-fashioned way -- out of their paychecks. By the end, the very fabric of the US economy had been transformed -- the bubble had become the heart of the New Economy.

Like the BOJ, the Fed did nothing to stop it. Sure, there was the December 1996 musing by Alan Greenspan over "irrational exuberance." There was even a 25 bp tightening some three and a half months later, presumably aimed at addressing those concerns. But that assault on the bubble -- if you want to call it that -- was short-lived. Facing a torrent of political criticism for tampering with the democracy of the markets, the so-called independent US central bank did an about-face. Any further tightening was shelved, and the bubble took on a life of its own.

But it wasn’t just policy accommodation that nurtured the excesses of America’s asset bubble. The rhetorical flourishes of Chairman Greenspan took perceptions of the New Era to an entirely different level. He became almost evangelical in his passion. In a January 2000 speech before the Economic Club of New York, he maintained that "the American economy was experiencing a once-in-a-century acceleration of innovation, which propelled forward productivity, output, corporate profits, and stock prices at a pace not seen in generations, if ever." As the bubble was cresting in early 2000, Greenspan repeatedly stressed that "(w)hen historians look back at the latter half of the 1990s a decade or two hence, I suspect that they will conclude we are now living through a pivotal period in American economic history." This rhetoric -- more than policy -- was an unequivocal signal that the financial markets took quite seriously. It depicted a central bank that was more than willing to tolerate open-ended economic growth, largely because of the extraordinarily unique foundations on which Greenspan claimed it was built. Since there was no urgent need to fight inflation in this New Era, there wasn’t any reason to worry about interest-rate risk to financial markets. That was the buy signal every investor and speculator dreamt of.

Many don’t see it that way, of course -- not the least of whom is Alan Greenspan, himself. His recent speech at a Fed symposium in Jackson Hole, Wyoming (Economic Volatility, August 30, 2002) offers a strong defense of Fed actions during and after the bubble. In my opinion, it misses the basic point. The Fed chairman depicts the bubble as something that can only be identified after the fact; let the record show, he had it figured out as far back as September 1996 (see my February 27, 2002, dispatch in the Global Economic Forum, "Smoking Gun"). Moreover, he went on to stress that there is little that the Fed could have done to avoid it -- including an increase in margin requirements that a few of us were advocating at the time (see my March 27, 2000, opinion piece in Barron’s "It’s a Classic Moral Hazard Dilemma."). This argument never hinged on the linchpin role of margin debt per se, but more on the increasingly urgent need of the Fed to send a signal -- any signal -- that it took the perils of the bubble seriously. With all due respect to Alan Greenspan, his defensiveness misses the basic point. By condoning the bubble and the New Economy excesses it spawned, the Fed had become a lead actor in its own "prisoner’s dilemma." Such deep-seated denial makes it exceedingly difficult for the central bank to come to grips with the toughest problem it faces today -- the lingering excesses of a post-bubble economy.

The European Central Bank is currently faced with a variation on this same theme. And the risk is that it will fall victim to the same syndrome -- a failure to address the perils of a post-bubble era. While equity-driven wealth effects never took the Euroland economy to the excesses reached in Japan and the United States, the legacy of this post-bubble era poses an equally profound dilemma for the ECB. Fixated on price stability and the unrelenting inflation fighting that such a strategy implies, the ECB is all but ignoring the perils of an increasingly deflationary world. After the September 6 meeting of European finance ministers, ECB President Duisenberg argued that the official policy rate of 3.25% is "appropriate for the present situation and the foreseeable future." Never mind if that future includes evidence of a growing shortfall in the Euroland economy and the risk that the outlook could worsen in the event of an oil price shock sparked by a US invasion of Iraq. A mandate is a mandate, and the ECB’s single-minded fixation on price stability has never seemed stronger -- especially with a headline inflation rate that is still hovering near the upper portion of the ECB’s 0-2% price stability band (see Joachim Fels’ September 6, 2002, dispatch in the Global Economic Forum, "The ECB to the Rescue? Don’t Bet on It!").

Europe’s lack of pro-growth policy stimulus is disturbing, to say the least -- especially in the current environment. It’s not just the ECB that may be wrong-footed. The recent strengthening of the euro -- and the likelihood of further currency appreciation to come -- in conjunction with an inflexible fiscal policy as dictated by the strictures of the Stability Pact, only adds to the region’s deepening deflationary perils. Yet it doesn’t have to be that way -- the central bank does have the opportunity to change course. The unwillingness of the ECB to face up to these risks is consistent with the prevailing mindset of the other major central banks around the world. Fixated on the inflation targeting of yesteryear, the authorities are unwilling or unable to give active consideration to the possibility of deflation -- a classic by-product of a post-bubble world.

In short, central bankers are still fighting the old war while the enemy has established a new front. This has been the policy blunder that I have long feared the most. Nearly three years ago in Singapore, I was regaled with the lessons of what has been dubbed as Churchill’s most ignominious military defeat -- General Percival’s loss to the Japanese in the Battle of Singapore (see my October 11, 1999 dispatch in the Global Economic Forum, "Sinister Twilight"). Confident that the enemy would come by sea, Percival aimed his fixed artillery south, encased in concrete bunkers that could not fire in a different direction. The Japanese, of course, came from the north -- through the swampy Malay Peninsula, and the seemingly impervious citadel of Singapore fell in a matter of days. Old wars and old demons haunt all of us. Just like Percival, today’s policy makers don’t even know there’s a new war. Sadly, that may well go down in history as one of the greatest failures of central banking.