This is the third of the current series of articles on the Federal Reserve’s conduct of monetary policy based on a series of conferences at the American Enterprise Institute (AEI). The subject of this one is a March 22 event titled “Mend It, Don’t End It: Revamping the Fed for the 21st Century.”
AEI’s James Pethokoukis introduced a panel of three scholars by reviewing the poor record of performance of the Fed over its first 100 years in thwarting the tendency of the U.S. economy to experience periodic panics and recessions or depressions that set back economic growth and the long-term improvement in the standard of living for Americans.
Pethokoukis charged that the Fed’s first century has been defined more by its failures, as seen in the Great Depression of the 1930s, the Great Inflation of the 1970s and the Great Recession of the 2000s, than by its successes. He cited critics from the center-right who accuse the Fed of fostering inflation and asset bubbles due to its penchant for engaging in loose monetary policy, most recently through its seemingly unending iterations of quantitative easing.
The most severe critics would contend that the Fed has had a century to prove itself, and given the record, it would be better to get rid of the Fed than to look forward to more decades and centuries of potentially even more damaging economic mismanagement by the Fed. The reason this will never happen, other than the obvious difficulty of dismantling any government program once it has established a powerful constituency — in this case Wall Street and the money center banks — was suggested at the last AEI event by Alex Pollock, namely that the Fed fosters the financing of the enormous fiscal deficits the U.S. government run in good times and bad.
The historic Accord with the Treasury of 1951 was supposed to affirm the independence of the Fed from the Treasury, but over the intervening decades, and more recently under Fed Chairman Ben Bernanke, the Fed has reverted to its default role of walking two steps behind the Treasury.
The significance of this event is to place before students and observers of monetary policy the argument that the Fed could improve its record by adopting a philosophy called “market monetarism,” which Pethokoukis suggested could be “the first economic theory birthed by bloggers, albeit ones with Ph.D.’s in economics.”
The first presenter, David Beckworth, assistant professor of economics at Western Kentucky University and former international economist at the Treasury, laid out a theory that the extensive and expensive purchases of the Treasury and agency securities that receive so much attention account for only 15 percent of the total the Treasury funds and that this has been the case since 1970. The rest, he argues, is accounted for by institutional holdings of institutional investors — T-bills, mortgage-backed securities, commercial paper, repurchase agreements acquired through the so-called “shadow banking system,” because the traditional banking system is not sufficient to satisfy the demand for “safe assets” by the private sector, a demand that increases in times of stress.
Beckworth contends that the traditional definition of money is too narrow and must be extended to encompass the sum of safe assets held by both the government and the private sector. By this measure, he argued, the money supply since 2008 has been tight, not loose, and the extraordinary measures the authorities have taken were necessitated by their failure to choose a broad enough target in managing the economy.
According to this theory, the target should be “nominal GDP [gross domestic product], and if the government provides sufficient liquidity to keep this measure close to its long-term trend, the private sector will feel less stress, more confidence and be more willing to make sufficient investment in safe assets to provide a base for reasonable economic growth with acceptable rates of inflation and unemployment, fulfilling both parts of the Fed’s dual mandate.”
Scott Sumner, an economics professor at Bentley University, elaborated on Beckworth’s ideas by pointing out that the idea that low interest rates can indicate tight policy, not loose, is traceable to Milton Friedman and his critique of the protracted tight monetary policy employed by Japan.
Sumner assured the audience that the Fed would not have to do as much intervention if it maintained a steadier course all along, and he cited Australia as done by maintaining steady growth of nominal GDP.
Anticipating the question of whether a relatively accommodative policy would create asset bubbles, Sumner cited the record of Benjamin Strong, governor of the Fed Bank of New York from 1914 until 1928, of avoiding intervention in the stock market, a policy that ended with his death in 1928. With Strong gone, his successors felt free to pop the stock market bubble, contributing to the Great Depression.
Beckworth adheres to the view of Bernanke that it is not the Fed’s job to identify bubbles and contain them before they can lead to financial busts.
Ryan Avent, economics correspondent for The Economist, took up the discussion from this point, recalling that the Fed was created to reduce the damage to the economy from booms and busts and suggesting that the Fed has learned a lot from its first 100 years of experience.
Avent blamed the Depression on the Fed’s ideological adherence to the gold standard, and he acknowledged that in the 1970s, Fed policy became unanchored and gave rise to a wave of inflation. He concluded that by making the adjustments to Friedman’s monetarism that the theory of targeting nominal GDP calls for, the Fed can alleviate the unnecessary suffering caused by recessions, something he believes a commodity standard could not achieve.
Ironically, following the gold standard led to the Depression and then to higher tariffs and the welfare state. Therefore, according to Avent, economists from the center-right are increasingly coming to realize the promise nominal GDP targeting holds for improving the performance of the Fed and of the U.S. and global economies.
As a viewer of the event, I wished that the panel had included a critic who might have challenged some of the blithe assumptions of the presenters. For example, what measures, including more effective bank regulation, should be taken to deal with the propensity of institutional investors to follow the Fed’s lead into investments in assets that are supposed to be safe but turn out not to be, such as highly rated sovereign debt?
It might also be helpful to challenge the assumption that the authorities can manage the economy deftly enough to prevent recessions; therefore, any recession that does occur indicates a policy failure and calls for the government to lots of whatever assets private investors no longer want, because they have lost confidence in the purveyors of those assets.
The aforementioned Alex Pollock, for example, challenges the notion that the government should act to “restore confidence,” so that trading in dodgy assets can proceed, warning that, “A confident investor is a stupid investor.”
The theory that government experts can produce optimal policy decisions predates the establishment of the Fed. These ideas will continue to be explored by today’s experts during this anniversary year.
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