Reprinted from Law and Liberty
Say what you will about Karl Marx, the man knew how to flip a phrase. His remark about history repeating itself, first as tragedy and then farce, certainly applies to the continued failure of American monetary policy. Alex Bullock’s insightful article reminds us that the Federal Reserve has faced similar challenges in the past and overcame them with a combination of economic wisdom and strong leadership. Unfortunately, both are short on Fed today.
As Mr. Bullock acknowledges, inflation is “an internal effect of government and central bank behavior”. Under the guise of stabilizing the virus-ravaged economy, politicians and bureaucrats have worked together to flood markets with excess liquidity. The combined government budget deficit for 2020 and 2021 was nearly $6 trillion. $3.3 trillion (about 55% of the deficit) in government bonds ended up on the Fed’s books. In fact, the central bank has monetized a large portion of deficit spending. Monetary policymakers were lulled into a false sense of security by weak price pressures from 2008 to 2020, and were unprepared for the subsequent wave of inflation. Consumer prices are now rising at a staggering 8.5 percent annually, the fastest since 1981.
We’ve been here before. Mr. Bullock tells the story of Federal Reserve Chairman Paul Volcker’s determination to crush inflation. Volcker’s program caused a severe recession, drawing strong condemnation from politicians from both the left and the right. However, Volcker insisted and was eventually acquitted. Inflation fell to manageable levels, the economy boomed, and President Reagan reappointed him to lead the Fed. Unfortunately, Volcker’s victory wasn’t the last word on inflation. There is no such thing as the end of history, especially not in economic policy. The temptation of governments and their central banks to overprint [and] Government deficit monetization “is always with us. This temptation now prevails over fiscal and monetary prudence.
Rethinking the Federal Reserve
Volcker was made of tougher materials than the current president, Jerome Powell. Moreover, the political pressures on the Federal Reserve are higher than they have been in decades. While central bank officials insist they are committed to an “average” 2 percent inflation rate, there is no way to sustain future inflation – let alone deflation – enough to achieve that goal. The Fed’s credibility, which Volcker and his successors painstakingly won, was shot at. “The pain of inflation is now inevitable,” warns Mr. Bullock.
Looking back, creating the Federal Reserve was a mistake. The Federal Reserve Act of 1913 was intended to strengthen the national banking system, which admittedly had many flaws. The Fed’s main purpose was to facilitate emergency interbank transfers to stave off financial panic. Instead, it gradually turned into a fully-fledged central bank. The American public did not really approve of critical technocrats. In the post-World War II era, it became a reality.
The Federal Reserve cannot be justified by its beneficial consequences. Recessions in the age of central banks have been as frequent and severe as ever. Inflation, which before the Federal Reserve was largely unknown in peacetime, has become a regular occurrence. reduce inflation volatility It is one of the clear improvements of the Federal Reserve. But even that is not certain. Before the Fed, inflation volatility was high due to wartime financing measures: suspending the gold standard, printing money, and redeeming paper when things settled down. After the Fed, the Great Moderation (1984-2007) made central bankers look more capable than they are now.
Today, the Federal Reserve is a juggernaut. With nearly $9 trillion in assets and the ability to pay interest on excess reserves, the Federal Reserve has tremendous power to allocate credit, affecting investment and capital structure throughout the economy. It is abusing its regulatory power by interfering with environmental and social policy on the flimsy pretext that these issues are related to financial stability. Developing climate stress tests and advancing research on “structural racism” in economics is not exactly central banking best practice. The central bank also acts as the academic gatekeeper. As a large producer and supporter of monetary policy grant, the Federal Reserve has a significant influence on the sub-area of economics that studies the effectiveness of the Fed. The Fed’s good reputation among this crowd is neither surprising nor convincing.
Despite being in the job for more than a century, the Fed continues to fail basic monetary policy. Our inflationary problems show that central bankers have never learned the lessons of Volcker’s de-inflation, as Mr. Bullock aptly explains. If left to itself, because it has been for too long, the Fed will not improve. Instead, it will only get worse – getting herself involved in more while offering less. Quoting the economist and social philosopher Frank Knight, “It is time to take the bull by its tail and look the situation in the face.” We need Congress to rein in the Federal Reserve.
Like Peter Bottky, Daniel Smith and I discussing that Money and the rule of lawThe only way to make the Federal Reserve effective and accountable is by achieving a specific outcome objective. Central bankers have too much discretion to set monetary policy objectives. The absence of barriers is one of the main causes of inflation today. But there is no reason why things should go this way. Congress can and should intervene.
Currently, the Federal Reserve has a double mandate: full employment and stable rates. This is unnecessarily vague. The Fed should have a single mandate that focuses on maintaining demand-side stability in the economy. Forcing the Fed to reach a single target variable would increase price stability without sacrificing employment.
There is some appetite for that in Congress. A bill currently before the House Financial Services Committee, the Price Stability Act of 2022, calls for a “capital employment” component of the mandate. This makes stable prices the only criterion. Despite the improvement, the state remains undetermined. Congress must choose a concrete inflation target: requiring the Fed to provide a clear growth path for the purchasing power of the dollar. Provided inflation is appropriately low, the exact number is not very important. What matters most is the fixation of inflation expectations in the market. A predictable monetary policy facilitates short-term flexibility as well as long-term contracting. Since the Fed cannot make credible commitments through a self-approved rule, the content and enforcement of the objective should be the purview of the legislature, not the central bank.
The only way the Fed can reduce unemployment is by stabilizing what economists call aggregate demand: aggregate spending on goods and services at current market prices. When aggregate demand collapses, the Federal Reserve can keep the dollar’s value on its growth path by providing the market with needed liquidity. This stabilizes production and employment as a byproduct. Thus, having a separate employment clause in the Fed’s mandate is redundant. It’s also dangerous: Central bankers will use any excuse they can make, which is good for them but expensive for the economy. It is better to turn off this option.
Inflation target is not the universal economic remedy. When there are supply side problems, inflation targeting can destabilize the markets. Transportation issues, sudden increases in energy supplies, and a host of other considerations tend to drive up prices. The Fed will have to contract aggregate demand to keep inflation in the target range. We’re still getting a stable dollar, but that’s probably at the cost of a recession.
Many economists, including myself, prefer to target aggregate demand directly. The stabilization of nominal GDP (which is equal to aggregate demand) works better than the stabilization of the dollar when the supply side of the economy is weak. However, implementing a nominal spending target can be challenging. Moreover, the audience may not understand how this rule works. Given public demands to hit inflation, it would almost certainly be better if Congress chose an inflation target, despite its flaws.
Lawmakers must resist the temptation to interfere in the day-to-day affairs of monetary policy. It is appropriate for Congress to choose the Fed’s targets. But it is inappropriate for politicians to administer the smallest details to central bankers, especially when partisan agendas come into play. For now, the risks of politicized central banks are greater on the left than on the right, but that could change.
Politicians often make perfection the enemy of the good. To take control of the Federal Reserve, we must resist this temptation. Even a defective base is better than no base at all. Mr. Bullock reminds us that the Fed will make the same mistakes again if left to its own devices. It’s time to break the cycle. As long as we are stuck with a central bank, we should give it an unequivocal mandate and watch it like a hawk. Monetary policymakers respond to the people’s representatives, in the assembled Congress. Let’s remind them.