2. Market chatter and rumor mongers have lately suggested that Dr. Greenspan himself is starting to feel he was less than correct in his actions in 1998 and 1997 in dealing with some called "irrational exuberance." And a good thing too, because he has much to feel guilty about, in my estimation.

Dr. Greenspan's worst error isn't publicized nearly enough. The mistakes began in the fall of 1998. At that time, the Fed's last move had been a 1/4 point tightening move in March 1997. But in the fall of 1998 a global financial crisis was threatening to break loose, with problems ranging from a currency and economic melt-down in Russia to contagion spreading into the Pacific to LTCM's liquidity crunch. So the Fed eased by a 1/4 point in September 1998 and a 1/4 point in November 1998. With the benefit of hindsight, they pumped too much liquidity into the system in the fall of 1998 . . . . . . . and as a result, by June of 1999 they were back to tightening again.

Now in each case, the fall of 1998 and the summer of 1999, the stock market "bubble" began to deflate. If the Fed has been less aggressive in easing in late 1998 (or hadn't eased at all !), the bubble might have been gently deflated then . . . . . or, if the Fed had stuck with the supposed tightening program begun in June 1999, the bubble might have deflated in the autumn of 1999.

INSTEAD, Greenspan made the biggest, gnarliest mistake of his long career: pumping enormous amounts of liquidity into the monetary system in late 1999 in anticipation of either a psychology-driven "millenium" money-in-the-mattress credit crunch or some awful problem with Y2k computer software. It was a hard call, but he got it dead wrong. The excess money flooded into the stock market instead. From 10/18/1999 through late March 2000, the NASDAQ market went up 97% !

Whatever else you can say about Greenspan, the great money flood of October, November and December 1999 was an enormous mistake that inflated the bubble into hyperspace dimensions that may never be seen again. Especially if the backside of the bubble kills all of us.

Or as they say back home, "Dear Lord, please give me just ONE MORE BOOM, and this time I promise not to piss it all away !"

I seem to recall some overtightning just prior to the slide. Timing on lowering and raising didn't seem right to me. Also there was no excuse for maintaining margin requirments at 50% when it was clear that margin was being used unwisely by too many folks.

The problem with margin requirements is that they're so easily circumvented.

With regulation split between the CFTC and SEC and the Fed, raise the margin on brokerage accounts and: the development of futures contracts on new index products and individual stocks is accelerated, the attractiveness of options on stocks becomes much greater, and brokerage accounts migrate off-shore (Grand Cayman, Belize, Bermuda, lots of places) where margin requirements are outside the Fed's jurisdiction.

Some observers think that Greenspan prattled on too much about the productivity promise of the "New Economy". Fed chieftains are supposed to be grumpy old codgers whose job description clearly entails jawboning into the wind when business is booming. At his worst, Greenspan got perilously close to cheering on the boom.

Okay, I've got my Scan-Tron, where are the True/False questions?

Detailed instructions on how to fail this exam ...

1. Answer that Brad is looking for: the small open economy model, which is inappropriate to the USA.

Answer that he ought to get: the market cares about deficit paths not current year deficits, and if the tax cut was stimulative enough, it might lead to smaller deficits in future.

2. Greenspan could have tightened margin requirements and shouldn't have been sucked into the productivity-based new economy arguments (cf: Ray Fair's recent paper demonstrating that the only "new" thing about the new economy was the PE ratio of the SP500). The question is largely ill-formed, however, as Greenspan's mistake had little to do with bubble-bursting. There is no way that the 1998-01 bubble could have been burst with more expensive money; it was a genuine mania like the one of the 1920s, which expensive money did nothing to curtail. But raising rates during 1999 and 2001 would have given him more ammunition to cut them when the bubble burst of its own accord, and might have helped reverse the current a/c deficit which exacerbated things by dragging foreign money into the US. I concur with the poster above that failing to reverse the Y2K repo injection was an inexplicable mistake.

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3. This is essentially a question about Goodhart's Law on one axis and Stiglitz' theories of banking on the other. Not sure why Brad is encouraging a 2x2 matrix approach, other than to beat up on Milton Friedman for advocating narrow banking and narrow aggregates. A contrarian answer would play up scepticism about the usefulness of inflation targeting through forecasting models at turning points (the only points at which policy is interesting!). If I was taking this exam, I'd take the opportunity to bring in the Post-Keynesian perspective that the correct function of the monetary policy authority is to provide cheap money, while inflation should be fought by an incomes policy! (or at least, that recessions are a blunt instrument of anti-inflationary policy). I hope that anyone who starts talking about the slope of IS and LM curves gets thrown off the course, but I know that they won't.

4. Here's an answer I bet nobody will give: pi *, phi and theta are uninteresting political paramaters dependent on what one thinks about the badness of unemployment and inflation. The best you can do is to have an estimate of the hysteresis in unemployment and the consequences of the long-term unemployed. All of Barro's work shows that phi ought to be a step function equal to zero for values of pi below 10% and about three for values above, smoothed in some way to take account of policy lags and financial dislocations. U* is a broken parameter anyway; one of the things we can usefully do these days is to chuck out the natural rate hypothesis as a modelling assumption and guesstimate U* for policy purposes on the basis of institutional evidence from agents on the ground.

So the only interesting parameter is r*. R* is determined by the solution of a programming problem where the maximand is the degree of consumption smoothing possible for an individual in the economy and the constraints are the productivity of capital and the wage/output ratio. In other words, it's a demographic factor, which is determined by the savings available under the PIH, the physical rate of return on those savings and the extent to which the younger workers will tolerate the alienation of that physical return by the older capital-owners.

5. Deaton is right and that's pretty much all there is to it. I have no idea why anyone would take the gerrymandered utility functions as being remotely convincing.

6. My answer to this would involve regular use of the phrase "Bastard Keynesianism", more for the pleasure of using it than anything else. I think that Bastard Keynesianism is a monstrous misstep, so I doubt I'd do very well on this one, but I'd probably suggest that behavioural economics has added about as little to this question as to any other, in that you can justify most any policy you want by appealing to a behavioural model under which the behaviour you want to emphasise is important, and everyone knows how easy it is to generate empirical confirmation of the hypothesis you want to prove. I'd suggest that the only conclusion one can draw is that the bolting on of behavioural models to standard linear-constrained-optimisation economics is just another procrastination technique whereby economists put off the day when they have to actually study the sociological literature rather than just ridiculing it.

>If I was taking this exam, I'd take the opportunity to bring in the Post-Keynesian perspective that the correct function of the monetary policy authority is to provide cheap money, while inflation should be fought by an incomes policy!

In Britain in the 1970s, the heyday of statutory and non-statutory incomes policies, every macho trade union leader made it his personal business to bust the going policy to prove his virility amid soaring inflation. With that and the enthusiasm of successive governments for escalating public spending, one outcome was calling in the IMF in 1976 to bail out the collapsing exchange rate of the Pound. Another was negative productivity growth over the decade in what were then leading state-owned industry sectors such as coal and steel and a large chunk of the motor industry post 1975 after the largest producer was nationalised. Cheaper money - and money was cheap in the early 1970s - would have meant an even bigger bubble in house prices than there was unless, of course, controls on house prices were introduced with all the appropriate bureaucracy to apply the controls.

>>every macho trade union leader made it his personal business to bust the going policy to prove his virility amid soaring inflation. With that and the enthusiasm of successive governments for escalating public spending, one outcome was calling in the IMF in 1976 to bail out the collapsing exchange rate of the Pound. Another was negative productivity growth over the decade in what were then leading state-owned industry sectors such as coal and steel and a large chunk of the motor industry post 1975 after the largest producer was nationalised<<

I seem to remember that there was also an oil crisis or two, wasn't there, Bob?

>I seem to remember that there was also an oil crisis or two, wasn't there, Bob?

But the oil price hikes of 1973/4 and 1978 hit all the industrialised economies and they didn't all do as badly as Britain did in containing inflation or as miserably in productivity growth.

"The rapid inflation of 1974-5 was also a reflection of the Labour Government's demand policy which could be described as partially accommodating. Rather than reduce inflation through a tight demand stance the government chose to introduce a series of supply-side instruments which included price controls, subsidies, and voluntary wage restraint. Its reluctance to introduce an extinguishing demand policy was, in part, determined by its desire to maintain a low rate unemployment but was also probably influenced by the experience of 1970/1, which implied that inflation had become less sensitive to such pressures. Whatever the reason, the failure to adopt deflationary policies ensured that inflation continued to rise into 1975, even though in most industrial countries it peaked in the previous year. And this, together with the system of wage bargaining, helps to explain why the inflationary effects and the adjustment problems associated with the supply-shocks appear to have been worse in Britain than in most other Western countries." NWC Woodward in Crafts and Woodward (eds): The British Economy Since 1945; OUP (1991), p. 203-4.

Incomes policy may be a feasible policy option in small country economies, as in the case of the Netherlands where: "Real wages increased only very slowly, at less than 1 per cent a year on average between 1979 and 1990. Wage differentiation between various sectors remained very low compared to other countries." Bart van Ark et al in Crafts and Toniolo (eds): Economic Growth in Europe Since 1945; CUP (1996), p. 311.
However, the like of that was not feasible in Britain during the 1970s, given industrial relations legislation as it was then and the size of the state-owned business sector which meant there were virtual state monopolies in the supply of coal, gas, electricity, bulk steel, and telecoms, all with powerful industry-wide unions. By many accounts, Ireland now has a highly centralised system of wage bargaining and a small country economy. Even so, with loss of monetary policy through joining the Eurozone, Ireland currently has the highest annual inflation rate in the EU at 4.7% - for comparison of current inflation rates in the EU, see chart for Table 7 at: http://www.statistics.gov.uk/pdfdir/cpi0103.pdf

Btw for comparison, the UK's latest inflation rate on the same HICP index is 1.6% while the EU average is 2.1%

On the public spending hike in the UK in the mid 1970s as a percentage of GDP, at a time of unprecedented inflation for the post-WW2 period, see Figure 1.1 in: http://www.ifs.org.uk/public/bn25.pdf