.. 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. The Fed’s attack on speculation in the Spring of 1994, in the guise of inflation fighting, should warn Congress and the White House that a thorough revamping of the Federal Reserve and our financial regulatory institutions is long overdue. We need a more powerful central bank, with tools that can effectively control money and credit whether its growth originates in the banks or other financial institutions. We need a separate, independent, consolidated financial regulatory agency that can blow the whistle on excessive speculation and other behavior that undermines productive investment, economic growth, price stability, and a stable financial system. The Clinton Treasury proposal for revamping bank regulation offers an opportunity to join anti-inflationary monetary policy with bank regulation. It urges creation of a unified Federal Banking Commission to regulate the activities of banks and bank holding companies.
The Federal Reserve stood in vehement opposition (see Greenspan, March 2, 1994, and Reinicke, 1994), joined en masse by the major commercial banks. The Fed’s less than exemplary regulatory role in the wave of bank crises since the late 1970s does not lend much support to its demand to retain its authority and power to regulate major banks, as a function complementary to, and supportive of, monetary policy. Nonetheless, in an ideal world, I strongly believe that an effective central bank should have broad authority and effective power to regulate large banks and bank holding companies. It should intervene forcefully when those institutions are putting the safety and soundness of the money and credit system at risk. Only when armed with this authority and power to intervene forcefully in reining in the high-risk and speculative activities of huge multinational banks and financial institutions can the Fed effectively restrain money and credit growth in boom periods like the 1980s. But, with that authority and power must also go a heavy responsibility for open, public accountability of its intervention.
As the Federal Reserve is now constituted, along with the duplication of regulatory agencies, the great danger of the theoretical foundations of the Fed policy is that it completely abstracts from the concentrations of political and economic power in banks and financial institutions. The theory assumes competition among thousands of small banks, but the banking system diverges dramatically from that theoretical model. Restraining the growth of bank reserves, monetary aggregates, or nudging up money rates will have virtually no impact on the operations of huge multinational banks that easily manage their nondeposit liabilities in global markets as the Fed pushes the structure of market rates up and down. This contemporary reality of concentrated power that has deeply eroded central bank monetary policy is never addressed in Congress, the White House, or at the Fed. Yet, increasingly, the power of multinational banks to evade national efforts to manage macroeconomic policy seriously undermines national goals (Kaufman, 1994). Once the huge multinational banks engage in financial speculation beyond the powers of the national central bank to control, the market itself does not impose much discipline.
Moreover, since banks like Citicorp, Continental Illinois, and others have been deemed too large to be allowed to fail by policy makers in the Fed, the Treasury, and other government agencies, the banks really have boundless freedom. No longer can we talk about monetary policy in abstraction from bank regulatory policy. The two must go together. We can now learn from a whole string of financial crises and banking failures in the past twenty years to form intelligent judgments about more effective oversight coupled with monetary policy restraint (Wolfson, 1994). In the late 1970s and the early 1980s, regulators at the Federal Reserve and the comptroller of the currency acted belatedly and timidly.
Senior bank managements repeatedly evaded and resisted the Fed’s efforts to restrain highly risky activities.(8) Banks struggled to survive wave after wave of crisis stemming from bad loans to developing countries, energy credits, and real estate speculation. By 1984, for example, Chicago’s Continental Illinois Bank collapsed in the wake of its reckless expansion which the Federal Reserve and the comptroller of the currency failed to restrain. It led to the nationalization of that bank by the U.S. Treasury at taxpayer expense. During the next ten years, the collapse of oil prices and the crash of the real estate boom sent shock waves from California to Texas to New York and New England.
Nine of the ten largest banks in Texas failed. By 1990, New York’s Citibank was awash with bad real estate loans; it held more than any other bank in the country. Clearly, the federal regulators, including the Federal Reserve, failed to prevent problems from snowballing into systemic proportions. Yet, in its monetary policy decisions, the Federal Reserve acted decisively to tighten the growth of money and credit, and to push up the structure of interest rates. Monetary restraint did not, however, prevent many banks from failing.
To the contrary, higher interest rates (i.e., high costs of funds) simply pushed the banks into new and riskier businesses at higher rates. During the last half of the 1980s, nearly 900 commercial and savings banks failed; in 1991 and 1992 more than 100 banks failed each year. The number of problem banks on the Federal Reserve’s list of institutions requiring close scrutiny reached a peak of nearly 1,600 in 1987 and still remained at more than 1,000 as recently as 1991. According to Chairman Greenspan, That 1991 figure was especially disturbing because, by then, it included some major institutions, which boosted the assets of problem banks to more than $600 billion (Greenspan, September 22, 1994). Indeed, so extremely far did the big banks stretch their resources that, by 1992, the United States faced an almost unprecedented situation with many of its largest banks operating on – or conceivably, over – the edge of insolvency (Barth, 1992; p. xxi).
The significant improvement of individual banks and the whole industry since 1992 was in large part a result of the dramatic decline in interest rates and the rise in bond prices until early 1994. The Fed’s new cycle of high interest rates in 1994 virtually reversed that preceding decline in interest rates; some institutions no doubt suffered losses as bond prices declined in that process. The lesson that emerges from these episodes of the 1980s and 1990s is that the Federal Reserve and other regulators have failed to prevent the problems of banks and other financial institutions from snowballing into systemic proportions. Given the huge social costs that the United States has suffered from both Federal Reserve monetary and regulatory policy, reining in central bank independence is long overdue. Notes: 1 See Appendix Table B-6 from the Economic Report of the President, 1994.
2 See Appendix Tables B-40 and B-52 from the Economic Report of the President, 1994. 3 Economic Report of the President, 1994. 4 The Federal Reserve raised the Federal funds rate target on February 4, March 22, and April 18 (by 1/4 percentage point each time); May 17, August 16 (by 1/2 percentage point each time); November 15, 1994 (by 3/4 percentage point); and February 1, 1995 (by 1/2 percentage point each time), for a cumulative increase from 3.0 to 6.0 percent. It raised the discount rate by 1/2 percentage point on May 17 and August 16, 1994, by 3/4 percentage point on November 15, 1994, and by 1/2 percentage point on February 1, 1995, for a total increase from 3.0 percent to 5.25 percent. 5 See, for example, business and press criticism of Chairman Greenspan and Governor Wayne Angel in Newsweek, June 28, 1993, p.
44. 6 See, for example, the plunge in capacity utilization rates in appendix B-52 in the Economic Report of the President, 1994, for the years 1973-75 and 1981-82, along with the labor unemployment rates. 7 This important testimony is in Greenspan (1993). 8 See the detailed accounts of Federal Reserve Chairman Volcker’s efforts to compel senior management to change its strategies in order to prevent failure of the Continental Illinois Bank in 1984, described in Greider (1987), pp. 624-632.