Alan Greenspan, Federal Reserve chairman, warned on Friday that high asset prices and growing protectionist pressures will complicate the task for his successor, stressing the importance of maintaining a flexible economy.
A continuing commitment to flexibility would help the U.S. adjust to shocks and financial imbalances, Greenspan said, opening the Federal Reserve's Jackson Hole Symposium, sponsored by the Kansas City Fed.
Sounding one of the key themes of his 18 years at the Fed, Greenspan said that this was the best way to deal with shocks to the economy and imbalances, including today the booming housing market and the related matter of the U.S. current account deficit, which stands at 6 per cent of GDP and rising.
This flexibility meant that imbalances "can be rectified by adjustments in process, interest rates, and exchange rates rather than through more wrenching changes in output, incomes and employment," he said, pointing to the economy's resilience, from the 1987 stock market crash through to the period of shocks in recent years including the September 11 attacks and the high oil price.
Greenspan warned that growing protectionist pressures were a threat to this flexibility. Global competition, he said, has been a boon for the U.S. economy, with competition spurring innovation and new technologies. Global competition has also made life difficult for workers, who face competition from workers in developing countries, but these concerns should be met with education and training and not with trade barriers, he said.
Greenspan said that "fear of change" had also stopped the U.S. from dealing with long-term fiscal reform, notably the failure to deal with Social Security reform. In the past he has warned that the ageing of the US population, and associated rises in pension and health costs, will mean there have to be big tax increases in the absence of early reforms.
"The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks.
Greenspan gave a brief history of monetary policy over the U.S. central bank's 90-year history. Attempts to find simple rules or single indicators to guide monetary policy - such as the money supply, commodity prices or the yield curve have failed. Central bankers have to take into account a broad range of economic and financial indicators, in trying to understand the constantly changing structure of the economy.
The rise in stock, bond and house prices and the sharp rise in household wealth relative to income in recent years has been a particularly important development, he said, contributing to the very low personal savings rate and the build-up of household debt to fund asset purchases.
"Our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period," he said. "Our forecasts and hence policy are becoming increasingly driven by asset price changes."
The greater stability of the economy, with monetary policy and globalisation both playing a part, in part explains the rise in asset prices, he said. But it was dangerous to assume this would continue and that the low risk premiums that have boosted asset prices will be sustainable.
"Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."
Greenspan's approach to monetary policy is to deal with the consequences of asset price movements for business and household spending rather than targeting particular levels for stock or house prices.
Following the bursting of the stock market bubble, the Fed cut its target interest rate to an unprecedented low level, helping to stimulate the housing market and consumer spending and avoiding a Japanese-style slump. But Fed policymakers have expressed increased concern in recent months about the booming housing market, which has been supported by the still low level of long-term interest rates.
Greenspan, who is scheduled to step down at the end of January, after more than 18 years in the job, addressed about 100 people at the Fed's select summer retreat, including central bankers from 30 countries. Jean-Claude Trichet, president of the European Central Bank, Mervyn King, governor of the Bank of England, and Zhou Xiaochuan, the governor of the People's Bank of China, were in the audience, the first time the top Chinese banker has attended.