In defense of Greenspan on Solow’s criticism

Robert Solow wrote an article about Greenspan, his successes and his mistakes, Alan Greenspan Is Still Trying to Justify His Bad Decisions; What the maestro doesn’t understand.

Even though I agree with what Solow said about Greenspan’s early years, I want to defend Greenspan during the years after the 2001 recession. There was something not even Solow understands to this day. I start with what Robert Solow said here…

“Hindsight leaves no doubt that it would have been a great idea to prick the housing bubble early. But imagine that Greenspan and the Fed had done so. Suppose they had tightened credit, pushed interest rates higher, put an end to the housing boom, and thus—very likely—created a standard recession like so many of the others. They would surely have been pilloried for destroying a nice prosperity in midstream and creating painful unemployment.”

The economy was not going to fall into a recession if interest rates had been raised back in 2003. That view is an error that many economists still have. The economy was no where near the natural level of GDP (effective demand limit) and still had plenty of traction to overcome higher interest rates.

Back up a bit, in 2001, I would say that the Fed rate was too high. The economy was falling into a contraction and the Fed rate was 3.5%. Then as the economy began to recover in 2002, the Fed rate returned to a balanced path back to their previous target. Then the Fed rate started to slide lower in 2003. Inflation had gone down to 1.4%. And even went to 1.3% in 2004. So the Fed lowered the interest rate in response to the inflation rate.

But another thing took place in 2003 that neither the Fed nor Robert Solow saw. The natural level of real GDP in terms of labor and capital utilization shifted in 2003. The Fed didn’t sense this until 2005. Then they reacted by raising the Fed rate fast towards a path of balance. The Fed must have been thinking that they had more spare capacity to work with to get the economy back to full employment of labor and capital. But there wasn’t as much spare capacity as they thought.

I do not blame Greenspan. I cannot even blame Robert Solow for not knowing this. They both do not have a working model for the effective demand limit.

This video explains in more depth the movement of the Fed rate during those years.


It is unfair to criticize Greenspan. The shift of the natural level of real GDP was not seen by anyone. In fact, the more recent shift after the crisis of 2008 is still not seen by anybody. Thus, even Solow continues to make the same mistake in judgement.

I can foresee a moment when the Fed realizes the natural level of real GDP is closer than they think and has to tighten policy quickly, like Greenspan did back in 2005. Will Robert Solow criticize Ben Bernanke in the future for holding the Fed rate down too low? If he doesn’t criticize now, he shouldn’t in the future. Like Solow said, “Hindsight leaves no doubt that it would have been a great idea to prick the housing bubble early.”

Solow is criticizing from hindsight. I understand what Greenspan was thinking and what he was reacting to. I do not blame him. The invisible shift of the natural level of real GDP took him and others by surprise.

The problem now is that the more recent shift will surprise even the likes of Solow.