The Money Connection

Among Washington s prominent public landmarks, the Federal Reserve is not in the first rank. Located near the Lincoln Memorial and constructed in classical style, its plain-looking exterior belies an elegant interior of marbled lobbies and staircases, befitting its role as the symbolic citadel of the American economy. Through its influence on interest rates and the money supply, "the Fed"—as it's colloquially known—was a prime accomplice in the Great Inflation. Its responsibility stemmed from the truism that all major inflations involve "too much money chasing too few goods." America s worst peacetime inflation occurred because the government, through the Fed, created too much money.

The Fed didn't light the fire, but it did supply the oxygen that kept the fire burning, and once it refused to supply the oxygen, the fire diminished. Without the Fed's acquiescence, the Great Inflation could not have occurred.

It was Milton Friedman who popularized the argument that inflation "is always and everywhere a monetary phenomenon in the sense that it can be produced only by a more rapid increase in the quantity of money than in [economic] output." Friedman's dictum merely restated the classical "quantity theory of money," which dates at least to the Scottish philosopher David Hume (1711-1776). The basic concept is intuitively obvious, as a simple example shows. Suppose a society produces ten widgets and has a money supply of $10. Then the price of each widget is $1. If the money supply doubles to $20 and the country still produces ten widgets, each widget fetches $2. The result is 100 percent inflation.* For minor inflations, there may be other causes: demand outrunning supply (because, say, population temporarily grows faster than food production) or monopolistic business and labor practices. But Friedman's dictum applies to all inflations exceeding a few percentage points annually, and it certainly applied to America's. As commonly defined in the 1950s and 1960s, the money supply consisted of circulating cash and checking

* In this illustration, I have ignored the turnover of money, what economists call "velocity." The same money can be—and is—used to finance many transactions. Although velocity is important for technical debates about economic policy, it merely modifies—and does not disprove—the quantity theory of money. In general, higher inflation increases money velocity. People spend their money more rapidly because they don't want to hold on to something whose value is constantly cheapening.

accounts in banks. In the 1950s, money-supply growth of 23 percent mainly accommodated the needs of an expanding economy. By contrast, growth was 44 percent in the 1960s and 78 percent in the 1970s. Inflation worsened accordingly.1

Just why the Fed acceded to double-digit inflation is a central part of our story. The most poignant explanation came from Arthur Burns, Fed chairman from 1970 to 1978. When Nixon appointed him, Burns was one of the nation's most respected economists. A pipe-smoking former professor at Columbia University, he was considered the preeminent expert on U.S. business cycles and had headed the National Bureau of Economic Research, a prestigious scholarly body. Despite these impressive credentials, Burns's performance as Fed chairman was dismal. During his tenure, inflation rose from 5.9 percent to a peak of 11 percent in 1975. In 1978, it was still 7.7 percent. The economy also suffered its then-worst post—World War II recession from 1973 to 1975. Burns knew that his reputation had been tarnished, perhaps ruined. In September 1979, he gave a long lecture called "The Anguish of Central Banking." It was a defense, an apology and an effort to rescue his legacy. ("Central banks" refer to government-created banks, like the Fed, that generally regulate a nation s money and financial system.)2

Burns conceded that the Fed "had the power to abort inflation at its incipient stage fifteen years ago or at any later point." If inflation is too much money chasing too few goods, the Fed could have fought it by supplying less money. Indeed, the Fed had stepped "hard on the monetary brake" in 1966, 1969 and 1974, Burns said. Unfortunately, the initial effects were a slower economy and higher unemployment—cardinal sins in the new political climate. So each time the Fed had relented too quickly before inflation was broken, bowing to criticism from Congress and the administration. The Fed couldn't, Burns argued, defy public opinion. Post-World War II prosperity, he said, had "strengthened the public's expectation of progress." The Employment Act of 1946 required maximum employment. Congress had created new social programs (food stamps, Medicare) and expanded old ones (Social Security). The Fed had to provide the money to pay for the new benefits. The Fed could not flout "the will of Congress to which it was responsible." The Fed's role in fostering inflation was, therefore, "subsidiary." The real villains, claimed Burns, were "philosophic and political currents" that created inflationary pressures. Defeating inflation required a new "political environment."

There was much truth to Burns s account. The social and political climate had shifted; the Fed could not stay completely aloof. Although the Fed is nominally "independent" and its members are not elected, they cannot regularly defy broad public expectations. They must either do what government leaders want or persuade them that the Fed's policies are desirable, even if unpleasant. Barring this, the Fed's "independence" is vulnerable. The seven Fed governors are nominated by the president and approved by the Senate; the selection and approval (or disapproval) of new appointees allow political leaders to register dissatisfaction and exercise influence. If that fails, the president and Congress can curb the Fed's power by modifying its legal status. So Burns s thesis was half correct. What was misleading was his implication that the Fed was dragged against its will into fostering inflation. In reality, it was complicit. The Fed shared and followed the (mistaken) beliefs about managing economic growth and achieving "full employment." Only belatedly did it recognize its errors.

The process by which the Fed influences the economy is akin to printing money but, in practice, is slightly more complicated. To increase the money supply, the Fed buys U.S. Treasury securities from banks and other dealers. The Fed deposits the money to pay for them in the bank accounts of the sellers. This is new money—in effect, created out of thin air. Banks and other sellers now have more money. If banks wish to convert these new deposits into currency (paper money), they can get dollar bills from the Fed. One way or another, banks have more to lend. Credit is more ample; the money supply expands. Short-term interest rates tend to decline. To reverse the process—squeeze money and credit—the Fed sells Treasury securities to banks. Presto, money goes out of circulation as banks make payment for these securities to the Fed. Banks have less to lend; credit availability shrinks; interest rates tend to rise.* What matters is how these powers are exercised and for what purposes.

We now think of the Fed as a bastion of economists. Ben Bernanke, the present Fed chairman, once taught at Princeton. His predecessor, Alan Greenspan, was a private economic forecaster. Many other economists have become Fed governors, and the Fed's huge economic staff churns out a constant stream of studies. But this was not always so. For decades, bankers and business executives dominated. William McChesney Martin, Jr., Fed chairman from 1951 to

* As a technical matter, the changes in deposits are usually made in the accounts that commercial banks have at one of the twelve regional Federal Reserve banks.

1970, was so skeptical of economic forecasts that he forbade the staff from making them until 1966. Fed officials saw their role as preventing bank panics and policing credit markets. The Fed did share central banks' traditional hostility to inflation, but it also strove to stabilize interest rates so that the government could more easily sell its bonds. To some extent, these goals conflicted. "Until the 1970s, the Treasury sold all notes and bonds at fixed interest rates, and the Fed followed an 'even keel' policy, holding rates fixed during the weeks surrounding [debt offerings]," writes economist Allan Meltzer of Carnegie Mellon University, author of a history of the Fed. The Fed's mission changed as economic ideas changed.3

The mid-1960s were a watershed, when the Fed's orientation shifted. Pressured from without and from within, it gradually adopted the ambitions and analytical framework of the "new economics." In 1965, Sherman Maisel, a professor at the University of California at Berkeley, became the first academic economist to be appointed a governor since Adolph Miller (1914-36). Staff turnover elevated many younger Keynesian economists to positions of influence. In making policy, the Fed gradually deemphasized financial conditions and adopted the Keynesian goals of aiming for maximum performance. If the economy seemed below potential output and full employment, the Fed would try to narrow the gap by reducing interest rates and increasing money growth. If the economy seemed above its targets—risking higher inflation—then the Fed could raise interest rates and tighten money growth. The Fed turned "activist," says Athanasios Orphanides, a former Fed economist who exhaustively studied the period. It would try to steer the economy along its most productive path. The prevailing analogy was that an economy that had ample "slack"—meaning unemployed workers and spare industrial capacity—could not generate higher "demand-pull" inflation. People still looking for jobs would hold down wages; companies competing for extra sales would hold down prices. "Most of the economics profession was convinced that the model worked fairly well," said Orphanides.4

But, as we now know, it didn't. In targeting "full employment" and "potential output," the Fed consistently overestimated both. As Orphanides has shown, the errors were huge. Before 1977, the Fed reckoned "full employment" to be an unemployment rate between 4 percent and 4.5 percent. In fact, later estimates put the actual figure closer to 6 percent. Below that threshold, the labor market would turn increasingly inflationary as employers bid for scarce workers. The Fed also overestimated productivity growth: gains in output from greater efficiency. For most of the 1970s, economists in and out of government assumed continuation of the productivity growth of the early postwar decades, generally 2.5 percent to 3 percent annually. In fact, productivity growth for much of the late 1970s barely exceeded 1 percent a year.

The consequences of these mistakes were devastating. All during these years, the Fed's policies were too expansionary. The "slack" in labor and unused capacity assumed to exist often didn't. In early 1976, as the economy emerged from the deep 1973-75 recession, the economy was reckoned to have an "output gap"—aka, "slack," or the difference of what it was producing and what it might—of 12 percent. This was massive; later estimates put the output gap at a modest 2 percent. In early 1979, the output gap was estimated at about 2 percent; later estimates indicated there was none. In effect, the Fed was deliberately driving the economy into territory that, if reached, would generate ever-higher inflation. The Fed is often said to "step on the accelerator" to increase economic growth and "apply the brakes" to slow growth. Too often in the 1970s, the Fed stepped on the accelerator because it believed it was on an economic superhighway. There was litde danger in speeding up. In reality, its blurred vision meant that it was actually speeding along a dirt road, littered with gravel and boulders. If it didn't apply the brakes, there would be a crack-up.5

When inflation inevitably worsened, the Fed reacted—acknowledging that it had left the highway—by tightening money and credit. Slowdowns or recessions (those of 1966, 1969-70 and 1973-75) ensued. But unfailingly, these responses were inadequate, because (as Burns noted) they were abandoned too quickly. Inflation abated briefly, and then the errors were repeated. It is possible to argue that if the Fed had gotten its assumptions about "full employment" and "potential output" correct, it could have operated successfully with the same basic economic model. Policy would have been less expansive and more restrictive. The economy would have been less inflationary and more stable, as a study by Orphanides and Fed economist John C. Williams suggests. Superficially, the blunders seem mosdy technical: the economic equivalent of a bridge collapsing because engineers miscalculated its load capacity.6

But this verdict is too narrow. The larger truth is that all the errors were in the same direction—in the direction of trying to accelerate economic growth and achieve "full employment." The Fed's mistakes reflected the powerful political and intellectual imperatives of the time, which reinforced one another. What was politically convenient was also rationalized intellectually. The Fed told itself that it could accomplish what political leaders and the public wanted it to accomplish. It is necessary to understand why the Fed was so vulnerable to these new pressures. There were many reasons, the most basic of which is almost always overlooked.

0 0

Post a comment