With Mitt Romney recently opining that any further increases in the money supply would be inflationary, the Federal Reserve and its policies are becoming increasingly visible issues in the 2012 presidential race.
Unfortunately, it appears from reader reactions to last week’s column there is much public confusion about the Fed as an institution, about the roles of elected officials in monetary policy and about what such policy can and cannot do in an economy. In that column, I argued that we still face circumstances in which the Fed might need to further increase the money supply and that Rick Perry’s suggestion that it would be treasonous to do so is flat wrong.
The reader comments I got, some supportive, some critical, touched on a variety of issues raised in the column. It seems useful to respond to them in a few general groups.
First, I am aware that many reputable economists oppose the Fed’s ongoing low-interest rate policy. I am skeptical about it myself and, in last week’s column and others, have noted that this policy is controversial among economists. But that is a separate issue from whether or not we might find ourselves in a situation in which it still would be best for the Fed to further increase the money supply.
The numerous prominent skeptics of the Fed’s current policy include old monetarists like Alan Meltzer and moderate Keynesians like John Taylor, a former Treasury official in the George W. Bush administration and an advisor to John McCain in 2008. They also include Joe Stiglitz, a liberal Democrat, Keynesian, former chief economist at the World Bank and Nobel laureate, as well as sundry Wall Street pundits.
It is a mistake, however, to assume that these economists’ criticism of ongoing Fed policy means they would necessarily oppose aggressive Fed money creation if we once again stood at the edge of a financial abyss as we did in September and October 2008.
If the chances of such a crisis were zero, Perry’s warning against “treason” would be unimportant. But they are considerably greater than zero. U.S. citizens need to understand we are not yet out of the woods of a potential financial crisis, and that the Fed might once again have to choose money creation as a least-bad alternative.
Second, while many in the general public believe that presidents cause or cure inflation, economists don’t. Forty years ago there was a debate within the discipline in which liberals fretted about resource prices and union and corporate monopoly power as causes of inflation. Conservatives sided with Milton Friedman, who argued that “inflation is always and everywhere a monetary phenomenon.” In other words, if the general price level is going up, it is not because autoworkers got too generous a contract or because oil companies act as a cartel. It is because the Fed is increasing the money supply too fast.
The conservatives won that argument hands down. Central banks cause inflation and deflation. The role of presidents and congresses is largely limited to the extent they control or influence the central bank. Here in the United States, that influence is limited to the president’s responsibility of naming Fed governors, the Senate’s role in confirming such appointments and the right of both houses of Congress to demand testimony from Fed officials. Yes, the legislative and executive branches are responsible for budget deficits, which may complicate efforts to curb inflation, but that is a minor factor.
The Fed’s decision-makers caused the great inflation of the 1970s, largely under the leadership of Arthur Burns, chairman from 1970 to 1978. And it was Fed officials under the leadership of Paul Volcker who ended it, starting in the fall of 1979. Richard Nixon played a role in initiating this inflationary period by appointing Burns. Jimmy Carter helped perpetuate it by naming G. William Miller, the Fed’s most hapless chairman ever, and helped end it by choosing Volcker. It seems pretty clear neither Nixon nor Carter really understood the import of what they were doing. Gerald Ford played no role whatsoever. The public can think whatever they want about these presidents and the congresses that sat during this era, but among economists and economic historians, there is no controversy. It was bad Fed policies that caused the inflation and good Fed policies that ended it.
Third, it is true that further increases in the money supply, all other things held equal, increase the probability of inflation. I myself have pointed that out repeatedly in columns over the past 30 months. That is the basis for Mitt Romney’s very reasonably expressed opinion this week. It is at least one consideration in the dissents of three Fed district bank presidents, including Minneapolis’ Narayana Kocherlakota, at the most recent meeting of the Fed’s policy-making Open-Market Committee two weeks ago. It also is the basis for criticisms from the prominent economists cited earlier.
There are, however, dangers on both sides. It is not an easy question of “increase the money supply and have inflation” or “leave it alone and have prosperity and stable prices.” The Great Depression, Japan’s experience since 1989 and other historic episodes teach us that deflation can be at least as great a hazard as inflation. There are dangers on both sides. Respected economists associated with each political party are divided on this issue.
Finally, yes, the Fed did make enormous mistakes in the past decade, particularly in the runup to the debacle’s unfolding in 2007. Yes, it failed in making monetary policy and it failed as a financial regulator. But only a small minority of economists and a minuscule number of elected officials criticized it in real time. With the possible exception of Ron Paul, I don’t remember anyone in Congress, or any governor for that matter, calling for higher interest rates in the decade from 1997 to 2007. Nor did many editorial writers sound the alarm. And while the Fed has made many mistakes, a modern economy like ours needs a central bank, plain and simple.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.