Imagine the scene at the Federal Reserve some months hence: A group of nerdish Ph.D.s pores over the latest economic data and output from the Fed’s own sophisticated computer models. One, peering intently at a computer screen, suddenly calls out to her colleagues, “There! There it is! I know balance when I see it!”
I’ll bet I’m not the only person who experienced déjà vu when reading an Associated Press story previewing today’s Federal Open Market Committee meeting. The story cited economists who think the Fed will stop raising interest rates when the targeted Fed funds rate reaches some “neutral” level “where economic activity is neither stimulated nor slowed.”
The story goes on to cite the Fed chairman: “Greenspan hasn’t said what constitutes a neutral funds rate. ‘But we probably will know it when we are there because we will observe a certain degree of balance which we had not perceived before,’ he said.”
Greenspan sounds like the late Supreme Court Justice Potter Stewart. In a 1964 opinion involving an early film by director Louis Malle, Stewart said he could not define pornography, but “I know it when I see it.” (For the record, Stewart saw the film and did not deem it pornographic.)
In “The Brethren,” his 1979 book on the Supreme Court, Bob Woodward describes how the justices reviewed films involved in such cases. When a particularly vivid scene flashed on the screen, a mischievous young law clerk, protected by the darkness of the screening room, would call out. “There it is; I know it when I see it.”
Fed economists may soon make similar subjective identifications of interest rates reaching some “neutral” position. They will “observe a certain degree of balance” not perceived before. Or won’t they?
I am no monetarist ideologue, but we are on dangerous ground here. The subjective nature of “I know it when I see it” rendered Stewart’s criteria unworkable as a practical legal criterion. Greenspan’s “certain degree of balance” is nearly as subjective and equally unworkable as a basis for policy.
It sounds eerily like the observations on “the tone and feel of the markets” that Fed officials made as we racked up a 300 percent increase in the Consumer Price Index between 1967 and 1982. If we learned anything from the 1970s, it should have been that feeling one’s way along until you find a situation that seems right rarely improves matters.
Some may object that monetary policy is not a science and that subjective elements of experience and judgment are always a part of real-world policy-making. That is true.
It is also true that monetarist economists, who have always wanted monetary policy to be determined by rules rather than discretion, have not found a foolproof rule to follow. In the 1950s and 1960s, they argued central banks should simply let the money supply grow at a steady, moderate rate about equal to the growth of real economy. But experience in the 1970s and 1980s demonstrated that money supply measures were too volatile in the short-run to serve as a reliable guide for the FOMC to use on a meeting-to-meeting basis.
The monetarists were entirely correct, however, that entirely subjective approaches usually end in trouble.
The Alan Greenspan that Ronald Reagan appointed to the Fed 18 years ago knew this. Future biographers will argue about why he changed. But he has changed.
There are all sorts of indications that the Fed has maintained far too loose a policy far too long. Arguments about whether tightening of the money supply should stop when the Fed funds rate reaches 3.5 or 4 percent ignore fundamental evidence that there is too much liquidity sloshing around the U.S. economy.
This excessive liquidity is evident in an over-valued stock market and in unsustainable housing prices. Both are due to real interest rates that are well below historical averages. Both are due for some “correction,” and in both cases the longer it takes before the correction occurs, the harsher it will be.
Greenspan and the 11 other people who constitute the FOMC are all bright, experienced people with a great deal of knowledge about the U.S. economy. All have the best interests of the nation at heart.
It is inevitable, however, that they have some vested interest in current policies. If one has voted repeatedly to continue extremely low interest rates, it is hard to speak up now and say, “We have been far too complacent.” It is part of human nature to try to muddle through.
Humorist Peter Finley Dunne famously observed that the New Deal-era Supreme Court read the election returns. Greenspan and other FOMC members read the newspapers. As long as reporters and commentators continue to focus on the issue of short-term micromanagement, the FOMC will be tempted to do the same. Authoritative foreign publications such as The Economist and the Financial Times have warned of speculative bubbles in the U.S. economy for some time now. The U.S. media need to do the same.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.