Apart from monetary theory, the theory of the economic system underlying Fed strategy is essentially a nineteenth-century conception that is closer to myth than to reality. Economic policy based on such a conception disregards the huge concentrations of economic and financial power that characterize the private sector today. Without recognizing the reality of huge power blocs in the money and real economies, central bankers are unlikely to gain control of financial speculation in domestic markets or to curb massive international capital flows that have already effectively defeated concerted central bank intervention to stabilize exchange rates.
The emergence of stagflation in the 1970s splintered the economics profession regarding the theory of inflation and the means to combat it. The rise in the price level was not simply the result of excessive growth in the monetary aggregates, and therefore restraining monetary growth was not a satisfactory remedy. Central bankers like Arthur F. Burns, and Henry Wallich, and other researchers including Arthur Okun, Abba Lerner, David Colander, and Sidney Weintraub searched deeper into the economy’s institutional workings for more effective anti-inflationary mechanisms (see Pechman, 1993, esp. pp. 3-141). Their anti-inflation solutions involved variations of an incomes policy to supplement monetary and fiscal policies.
CEA Chair Schultze described the complex process of inflation in 1978 (Schultze, 1978, p. 150). Even when excess demand was not a problem (as in 1977-78), he observed, inflation can persist at unacceptable rates (i.e., the underlying rate of 6 to 6 1/2 percent in those days). Expectations, cost – push, food price spikes, OPEC oil price hikes, and dollar depreciation were identified as inflationary causes that fed into wages, prices, rent, and lease contracts at every stage of production. Even before Schultze, “cost-push” inflation theories had been developed by Okun, Weintraub, and others. “Conflict theories” of inflation as a process involving the straggle over income shares in a world of structural change had been developed in the early 1950s by A.J. Brown and Joan Robinson. There were theories based on “rational expectations” (Guttmann, 1994).
Some conservative Republican economists were acutely concerned about attacking the new inflation of the 1970s. Arthur F. Burns, after completing his tenure as Federal Reserve Board Chairman (February 1970 to March 1978), advised in his 1979 Per Jacobsson Lecture that central banks “will be able to cope only marginally with the inflation of our times” (p. 22). But years earlier, at the beginning of his chairmanship, Burns had already outlined a broad anti-inflationary program in his well-known speech at Pepperdine College (December 7, 1970) for a society that properly “values full employment, monetary and fiscal tools are inadequate for dealing with sources of price inflation … from excessive wage increases.” Burns came to the conclusion, that it is “desirable to supplement our monetary and fiscal policies with an incomes policy,” and even advocated “a high-level price and wage review board” (Burns, 1978, pp. 113-114).
Mandatory wage-price controls were part of President Nixon’s New Economic Policy (August 15, 1971). In 1974, when inflation accelerated after the first oil price shock, Burns urged President Ford to adopt some form of wage-price controls. In that instance, the CEA chairman, Alan Greenspan, persuaded the president that wage-price controls were out of the question. Though Burns had unquestioned credibility as a consistent conservative, he frequently and wisely approached anti-inflationary policy in a pragmatic way, supporting bipartisan efforts to hold down the costs of high unemployment, when inflation was attacked with monetary and fiscal restraint.
Thus, it is ironic that by the end of the 1970s, when the oil price shocks had demonstrated the complex causes pushing the CPI higher, virtually all conservative economists vehemently opposed incomes policy and pushed for classic central bank restraints and eventually full-blown monetarism. Once the central bank earned “credibility” in the persistent use of conventional monetary restraints, they argued, embedded inflationary expectations would subside and inflation be brought under control. This alternative approach is spelled out in a series of policy analyses published by the American Enterprise Institute under the direction of the late William Fellner (1978, 1979, 1981-82). Under their advice, policy would be aimed at bringing down the growth rate of nominal GNP gradually. Fellner cites Phillip Cagan’s econometric analysis on reducing inflation by slack demand, advising that it would take three years, “an optimistic guess,” and “five years or somewhat more” as a “pessimistic guess” to get a positive credibility kick for the central bank’s monetary restraint (Fellner, 1978, pp. 10-41).
This kind of theoretical and operational guide was the prevalent intellectual underpinnings for the Volcker experiment in monetarism and subsequent Federal Reserve programs under the Reagan-Bush administrations. The policy was essentially a monetarist strategy that only had to be held consistently and persistently. Little mention was made of the economic costs from unemployment and lost output (Fellner, 1978).
In retrospect, the policy experience of both Republicans and Democrats in the past twenty-five years leads to the realization that economic slack with persistent high levels of unemployment of workers and unutilized plant capacity did not and cannot cure inflation, as measured by the CPI. Aggregate demand policy, operating through monetary, fiscal, and exchange rate measures, is a highly inefficient strategy for fighting inflation. When it does succeed moderately, it succeeds at extremely high costs. Charles Schultze, CEA Chairman, had recognized that monetary curbs “would require a long period of very high unemployment and low utilization of capacity” (1978, p. 150). It might take at least six years of economic slack to cut the inflation rate from 6 percent to 3 percent with the resultant loss of $600 billion (1977 prices) in output.(6) Even if the inflation target were successfully reached, the sad consequence is that subsequent efforts to revive aggregate demand and to restore growth in output and jobs would soon generate renewed price pressures. The gains might, at best, be temporary!
By the end of the 1970s, two broad policy alternatives existed. One, essentially Keynesian, acknowledged the complex supply conditions of inflation and recognized the high costs of monetarist restraint. The other, essentially monetarist, deliberately belittled the short-term unemployment costs. Policy makers settled for the second. Despite all the evidence from the 1970s through the early 1990s regarding the great inefficiencies and painfully high costs of a slack-demand “credibility” strategy, this view prevails today among policy makers and central bankers (Mussa, 1994, pp. 111-114; Feldstein, 1994, pp. 4-12).
The Fed’s anti-inflation efforts exclusively with classic monetary restraint have produced very high costs of unemployment in 1974-75, 1980, 1981-82, and 1990-91. They also had an impact on the distribution of income and wealth as powerful as any changes in federal tax policy. Congress, however, can pass tax legislation affecting income distribution only after the most excruciating public scrutiny, and then the president must sign it. The Federal Reserve, on the other hand, has no such built-in checks and balances.
Since the oil price shocks of 1973-74, and again in 1979-80, inflation fears have steeled economists and policy makers to ever greater resolve to fight “a great battle . . . waged against the demon of inflation that had damaged and distorted the U.S. economy since the late 1960s” (Mussa, 1994, p. 81). Cool-headed analysis has not prevailed in trying to determine whether inflation is essentially monetary, nonmonetary, or structural in origin. Yet, even Milton Friedman made that point very clearly in a now-forgotten debate with Robert Roosa, published in an AEI book (see Milton Friedman, 1967). Changes in relative prices, or the real terms of trade, do feed into the CPI, but such impulses (from oil price and agricultural price jumps) are not a monetary phenomena and cannot be corrected by central bank restraint (see Barrel, 1984, pp. 20-22; see also Rostow, 1978). At least half the decline in the CPI inflation rate in the early 1980s was attributed directly to the fall in oil prices (McClain, 1985). Monetary restraint might have contributed to the oil price fall by depressing global demand but only by imposing the highest unemployment since the Great Depression – 9.7 percent in 1982 and 9.6 percent in 1983.
That such huge periodic costs of errant monetary policy should be tolerated for some twenty years with apparently little learned from the repeated episodes – indicates the power of the inflation myth on the popular mind. That such costs have been totally disregarded in public forums on monetary policy is sufficient grounds for reigning in central bank independence.
Federal Reserve Chair Alan Greenspan served as President Ford’s CEA chairman and closely advised President Reagan. His conservative credentials are firmly established. Despite the heavy economic and social costs of Volker’s monetarist experiment in fighting inflation in the early 1980s, Greenspan pursued the Fed’s anti-inflationary efforts with particular zeal, periodically talking about a stable price level, or zero-inflation rate as a sensible Fed objective. He saw control over the money supply as the key target.
But by mid-1993, Greenspan’s congressional testimony revealed his own disappointment with the state of monetary theory.(7) He conceded that the “historical relationships between money and income, and between money and the price level, have largely broken down, depriving the [monetary] aggregates of much of their usefulness as guides to policy.” The chairman went on to point out that the so-called “P-star” model that links a long-run relationship between M2 and prices has also broken down (Greenspan, 1993, p. 8).
Long before this time, Milton Friedman and most monetarists had conceded as much, and many returned to the drawing boards for new designs. Indeed, Chairman Volcker had given up his monetarist experiment ten years earlier. Disillusionment with the monetarist model was based on the failure of velocity to remain constant. Every new wave of financial innovations, new instruments, new financial institutions, and new congressional legislation have all played havoc with the stability of the monetarist model and eroded its usefulness as a guide to central bank operations and shattered its reliability as a predictor of the economic results.
The laws of money and credit may, unfortunately, be valid for only the shortest time periods, as they are constrained by very specific institutional parameters. The institutional structures themselves will bend under stress and give way entirely to new emerging structures and new technologies. Those upheavals of the real world can quickly embarrass the brightest and most knowledgeable central bankers. In the end, they are dealing with the creative genius of financial entrepreneurs – Schumpeter’s model of creative destruction – not the immutable laws of physics.
Yet, despite these theoretical “breakdowns,” in his 1993 testimony, Greenspan suggested still another theoretical strategy. The Fed should assess the equilibrium term structure of real interest rates: “Maintaining the real rate around its equilibrium level should have a stabilizing effect on the economy, directing production toward its long-term potential” (p. 8). This vision may be quite true in theory, but practically useless to central bankers for three reasons: (1) How we measure real interest rates is not a simple exercise, especially for long maturities. (2) More difficult is the task of measuring an equilibrium structure of real interest rates. This is a challenging intellectual exercise for doctoral dissertations and learned journal articles. Its science diverges too far from the real world of policy-making “artists,” who must practice the “art of central banking,” as R.G. Hawtrey saw it. (3) Perhaps most important, this guide to long-term equilibrium rates cannot be of much help to the central bankers coping with week-by-week change from one short-run disequilibrium to the next. In the long run, institutional parameters will very likely be quite different.
The Federal Reserve’s preoccupation with the “threat” of future inflation during 1993-94 is difficult to rationalize when the CPI rose at a fairly stable rate of 3 percent. The increased volatility in the stock, bond, and foreign-exchange markets is not explained by the solid evidence of steady but modest progress in the real economy of the United States, the most balanced in over two decades.
The observer soon had to come to the conclusion that inflation is the Fed’s excuse for raising interest rates, but not the real problem. The real problem seems to have been the emergence of financial speculation in the money, credit, and exchange markets on an international scale. Perhaps most disturbing is that monetary policy was being driven by the Fed’s need to maintain control over speculation and the mushrooming growth of financial institutions outside its policy reach. In this world of dynamic financial transformation, the full employment growth goals of the Employment Act have become a secondary priority. Goals of financial regulation had superseded goals of macroeconomic performance.
The financial press has provided evidence for this view of speculation out of control: the Fed’s hikes in the federal funds rate in seven steps during 1994-95 triggered an abrupt unwinding of speculative positions of banks, brokerage houses, mutual funds, hedge funds, and other financial institutions. Individual speculators managing multibillion dollar portfolios like George Soros have played a pivotal role. Even major industrial corporations and state and local governments – Procter and Gamble or Orange County, California, are examples – have, perhaps unwittingly, participated by handing over their excess cash for interest-earning instruments that promised very high returns at low, “hedged” risks. Many such institutions have incurred huge losses; Orange County has gone bankrupt. These events show clearly how the historic transformation of the U.S. financial system is undermining the Fed’s effectiveness to carry out both monetary policy and financial regulation. The Fed’s fulcrum for policy – the commercial banking system – is shrinking relative to the mushrooming growth of financial institutions outside the banking system, and beyond the direct policy reach of the Federal Reserve.
The Fed is properly worried about speculation. Especially so since the burgeoning financial economy now dwarfs the real economy. Financial market gyrations affect the life savings, jobs, and incomes of millions of American families, not just the fortunes of the superrich. The opportunities and risks are not restrained by national borders, but are global in scope. For example, the foreign-exchange markets operate around the clock with trading in foreign exchange that adds up to roughly a trillion dollars a day. By comparison, U.S. exports and imports add up to just over a trillion dollars in a year – 1993 – when the trade deficit to be financed amounted to a mere $138.7 billion.
The magnitude of the speculation problem is illustrated by the exploding size of the U.S. financial industry. Just during the decade of the 1980s, the assets held by the investment companies that Americans love so much mutual funds and money market funds – registered a nearly eightfold increase. The U.S. mutual fund industry alone has now accumulated some $2 trillion of assets. That is comparable to the total deposits of the entire commercial banking system. Meanwhile in the 1980s, the assets of insurance companies tripled to reach $1.9 trillion in 1990. The assets of pension and trust funds nearly quadrupled to $1.9 trillion, and the assets of finance companies nearly quadrupled to $781 billion (see Edwards, 1993).
What happened to the commercial banks during the same time? Total assets of the banking sector doubled to a little more than $2.6 trillion. But, relative to the other sectors of a ballooning financial industry, the banks’ position has steadily declined. Early in this century, commercial banks held somewhat over half (55 percent) of all financial intermediary assets. Since then, commercial banks have lost nearly 30 percentage points of market share – down to about 27 percent of financial assets in 1990. This is significant for the effectiveness of the Federal Reserve in both of its roles in carrying out monetary policy and regulation both functions aimed at controlling the growth and quality of money and credit.
The Fed’s “inflation” cry in 1994 was not a statement conveying information – indeed it was consistently disinformation – but a plea for help. The central bank had lost control of money and credit by means of the conventional instruments operating through the commercial banking system. The Fed’s effectiveness grows weaker as the commercial banks shrink and other financial institutions encroach on their functions as depositories and lenders.