, Research Paper
If “taxation without representation” could rally the colonists against the British Crown in 1776, tight money and ruinous interest rates might be cause for populist revolt in our own day. Federal Reserve monetary policy also has onerous social burdens, measured by huge changes in aggregate output, income, and employment.
The imperious Fed, much like the English Crown two centuries ago, formulates and carries out its policy directives without democratic input, accountability, or redress. Not only has the Fed’s monetary restraint at times deliberately pushed the economy into deep recession, with the attendant loss of millions of jobs, but also its impact on the structure of interest rates and dollar exchange rates powerfully alters the U.S. distribution of national income and wealth. Federal Reserve shifts in policy have generated economic consequences that at least equal in size and scope the impact of major tax legislation that Congress and the White House must belabor in public debate for months.
Popularized studies of Federal Reserve performance in recent decades convey the image of the Fed seated in its Greek temple on Constitution Avenue, with Chairmen Volcker and Greenspan elevated to the realm of the gods. From centers of economic power around the nation – Wall Street, Capitol Hill, the White House, and corporate boardrooms – the classical Greek chorus intones its defense of Federal Reserve independence.
On the surface, central bank independence seems an eminently reasonable, appealingly simple solution for an agonizingly complex and muddled process of making economic policy in this postindustrial, electronically linked, and computerized global economy. The independent central bank is an institutional concept that complements well the counterrevolution now underway in U.S. budget policy. Washington’s fiscal policy is locked into a deficit-cutting mode for the near future, while Congress is determined to retreat from all discretionary spending, regulatory intervention, or measures to improve equity in the distribution of national income and wealth.
With the federal fiscal policy on automatic pilot, the Fed’s monetary policy could be removed entirely from the inefficiencies and confusion of the democratic process. But this deceptively simple conception poses profound questions for the process of democratic representative government in the United States as it pertains to managing the nation’s economy. Federal Reserve independence has a direct impact on the daily lives of most Americans in their “pursuit of happiness,” of which their economic welfare is a major element.
Since World War II, the Federal Reserve, together with policy makers on Capitol Hill and the White House, gradually worked out strategies for achieving a balance between tolerable rates of unemployment and inflation. The government was determined to prevent the recurrence of the kind of massive unemployment suffered in the Depression of the 1930s.
In 1944, President Franklin Roosevelt set forth the basis for his postwar domestic program in an “Economic Bill of Rights.” His number one priority was “the right to a useful and remunerative job.” Congress soon passed the historic Employment Act of 1946 with strong Democratic and Republican support. It gave the federal government explicit responsibility to promote “maximum employment, production, and purchasing power.” (This was subsequently amended and strengthened in the Full Employment and Balanced Growth Act of 1978.)
In the 1950s and 1960s, both Republican and Democratic administrations pursued the generally accepted goals of full employment, sustainable growth, and minimal inflation. Economic managers shifted weight among the several objectives as the economy moved up and down over the business cycle. During those decades, American economists in the mainstream shared a broad consensus that backed counter cyclical policy aimed at a mix of full employment and reasonable price stability. We now look back on those decades as a period of golden growth” in U.S. economic history.
By the mid-1970s, however, the oil price shocks and the emergence of stagflation shattered the consensus among economists. Arthur F. Burns, chairman of the Federal Reserve Board, described the new world after the first oil price shock had driven the economy into a deep recession in testimony before Congress (October 11, 1974). According to Bums, one of the nation’s most distinguished researchers of the business cycle, the recession was extremely unusual, because it was accompanied by “galloping inflation” and “booming” capital investment: said Burns, “I have been a student of the business cycle for a long time, and I know of no precedent for it in history.” Thus, by the mid-1970s, soaring oil prices fueled a rising consumer price index (CPI) at double-digit rates in 1974 and again in 1979-80. (Once those oil price crises had passed, however, CPI inflation settled down to relatively modest rates during the past twelve years.(1))
Meanwhile, the unemployment rate had also shifted erratically higher in the 1970s. Unemployment became a persistent problem, alleviated with only a few years of improvement until very recently. In the period of golden growth from 1950 to 1974, the unemployment rate rose above 6 percent in only two recession years (1958 and 1961). In the years of oil price crises and economic and financial turbulence, from 1975 to 1993, the unemployment rate fell below 6 percent in only four years (1979 and 1988-1990).(2)
The oil price shocks and the persistence of intolerable rates of both unemployment and inflation -labeled stagflation – tore apart whatever consensus might have existed among economists. As a result, the broad agreement on economic theory dissolved, as did the basis for economic policy at the national level. The U.S. economic malaise created conflict among those economists and policy makers in the Federal Reserve System who designed and carried out monetary policy, as well as among those at the Treasury, the White House, and in Congress who created tax laws and carried out fiscal policy.
The intractable economic crisis led to the election of Ronald Reagan in 1980. His administration adopted a radical “supply-side” economic strategy that linked a high-deficit fiscal policy to a tight “monetarist” policy at the Federal Reserve. This historic reversal of policy amounted to a counterrevolution against the “New Economics” revolution that Kennedy’s economists had launched in the 1960s (on the counter-revolution, see the outline of supply-side economics documented in the Economic Report of the President, 1982; the New Economics revolution is outlined clearly in the Economic Report of the President, 1962). The Kennedy policy mix, in sharp contrast to Reaganomics, had built upon a tightly controlled budget policy with low real interest rates.
The supply-side Reagan counterrevolution had several profound consequences: first, the Economic Recovery Tax Act, passed in August 1981, opened up a structural deficit in the federal budget that was a major cause for the U.S. national debt to rise from $909 billion at the end of 1980 to $2,600 billion when Reagan left office at the end of 1988, and to $4,000 billion when Bill Clinton was elected president at the end of 1992.(3)
The on-budget deficit had reached $340 billion in the last year of Republican rule (5.7 percent of GDP). The uncontrolled explosion of the federal budget deficit left the Clinton administration no real choice but to attack the fiscal problem aggressively. Because of Clinton’s budget package passed in 1993, the steep decline of interest rates, and the revival of growth, the deficit has declined faster than expected to some 3.8 percent of GDP in 1994, and to about 2.5 percent estimated for 1995.
The second major result of the twelve Reagan-Bush years is that fiscal policy is now locked into a stabilization mode, and therefore paralyzed as a tool for achieving full-employment growth under the mandate of the Employment Act of 1946. Indeed, a steadily declining budget deficit so far in the Clinton administration has dragged down real growth of GDP and slowed the creation of jobs. Therefore, monetary policy has become the only instrument of macroeconomic policy to cope with short-run cyclical problems and long-run growth.
This shift to a tighter fiscal policy has spread abroad to other major countries and has now become an international pattern. From Sweden to Great Britain, Germany, and Italy, politicians have tightened central government budgets to cut down deficits and to reduce intervention of government in the private sector (Steinmo, 1994). In many countries, we can observe the push to “privatize” nationalized industries, reduce government regulation and free up markets. All across the board, governments are retreating, both as a stimulus to aggregate demand and as an instrument to regulate markets, influence the allocation of resources, and redistribute national income more equitably. This transformation of policy was occurring at a time when OECD countries had 35 million unemployed and 15 million more underemployed.
The remarkable retreat from active fiscal policy, and the role of government as a regulator of economic power and an instrument of economic justice, is another result of the extraordinary philosophical counterrevolution carried out during the Reagan experiment. Government in all its activities from federal to state and municipal levels – even including public education in local communities – was believed to be “part of the problem, not the solution” of the chronic U.S. economic malaise.
The historic retrenchment of the public sector at federal, state, and local levels gained momentum when the Republican landslide in the 1994 mid-term elections wrested control of both the U.S. House and Senate from the Democrats. The new majority, led by Newt Gingrich, attacked the very foundations of FDR’s New Deal welfare state, and the Federal Reserve emerged clearly as the only institutional instrument to carry out macroeconomic policy.
The supremacy of the Fed:
Apart from the upheaval in Congress, the year 1994 also signaled the beginning of another cycle of Federal Reserve monetary restraint. On February 4, 1994, Chairman Alan Greenspan announced a quarter-point hike in the Federal funds rate, the first such rise since 1989. Following that decision, interest rates bottomed out and climbed higher, following seven consecutive increases in the Fed funds rate from 3 percent to 6.0 percent(4); the Federal Reserve discount rate was raised from 3 to 5.25 percent. By early November 1994, thirty-year bond yields had pushed through the 8 percent level, rising from their cyclical low of 5.78 percent in the Fall of 1993; as the national economy slowed markedly in response, thirty-year yields have dropped back toward 6.5 percent by early Summer 1995.
As Greenspan had explained, the 1994 restraint was a preemptive strike against the emergence of future inflation. This argument seemed unconvincing, since the economy was improving only moderately well at that time. Even though real growth was picking up, unemployment was falling, and the federal deficit was declining, accelerating inflation was, however, nowhere a visible problem.
These deliberate steps to raise the entire spectrum of money and long-term capital rates, despite the fact that inflation had remained at a fairly stable and moderate rate of 3 percent, had generated widespread criticism from Wall Street analysts and bond traders, leaders of U.S. manufacturing and labor, members of Congress from both parties, and academic economists (see the Challenge Symposium, January-February 1995). The Fed’s actions in 1994 and the chairman’s explanations of the FOMC’s motivations are causing analysts to reexamine the Fed’s policy strategies over the past fifteen years. In retrospect, the Federal Reserve’s performance in the turbulent economic times since the early 1970s raises many questions in a number of major policy areas. The three major functions of the Federal Reserve should be thoroughly examined within the debate over central bank independence:
1. The conduct of monetary and credit policy: This should include an examination of the Fed’s selection of the ultimate goals of policy – price stability versus full employment growth. The Federal Reserve clearly operates under the goals set down in the Federal Reserve Act (including, of course, all the contemporary amendments): the Federal Reserve System and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates” (Board of Governors of the Federal Reserve System, 1994, p. 17). The Fed’s ultimate goals are also related to the objectives laid down by Congress in the Employment Act of 1946 (”maximum employment, production, and purchasing power”). The Board of Governors, however, seems to set a narrower policy target (zero-rate inflation, for example) that appears at times to conflict with the policy program of Congress and/or the administration.
Beyond these ultimate objectives defining the performance of the nation’s economy as set by the body politic, the Federal Reserve has considerable flexibility in setting intermediate target variables and day-to-day operating targets. At various times the Fed has experimented with a variety of money and credit aggregates as guides to achieve the ultimate performance goals. But even in formulating and carrying out policy concerning intermediate targets, the Fed is subject to congressional requirements under the Humphrey-Hawkins Act (1978), amending the Employment Act of 1946. Accordingly, the Fed must announce its targets for growth of money and credit in February of each year and review progress toward the intermediate goals and the economy’s response at midyear. Meanwhile, the system operates on a daily basis directly on money rates (Federal funds, for example) to achieve the desired level of member bank reserves (excess and borrowed reserves) through day-to-day open-market purchases and sales of government securities, and by lending to the banks through the Fed discount window.
Apart from the conduct of monetary policy, two other distinct functions should be examined carefully in any discussion of central bank independence:
The regulatory and supervisory role of the Federal Reserve over the banks, other financial institutions and the foreign exchange, money, and credit markets.
The lender-of-last-resort function to prevent massive bank failures and breakdowns in the money, credit, and foreign-exchange markets.
Functions 2 and 3 are clearly related.
Particularly since the oil price crises of the 1970s, inflation has been at the nexus of debate on the Fed and monetary policy. In the popular mind, inflation has become the subversive force in the capitalist, free-market economy. Even knowledgeable observers in government, experts in the private sector, and certainly Fed officials seem willing to acquiesce to any decision that is made in the name of fighting inflation. To win that battle, a veil of secrecy clouds the Fed’s deliberations and activities. The central bank orchestrates public relations campaigns to present as persuasive a case to the media as possible for raising interest rates and tightening liquidity. Fed chairmen Arthur F. Burns, Paul Volcker, and Alan Greenspan are famous for their testimonies that disclosed really nothing in substance to the Congress, while Board members have often leaked selected information or even disinformation to the press and sympathetic congressmen.(5)
Even the public debates of monetary policy have not been characterized by intellectual honesty and analytical consistency. Some years before his appointment as vice chairman of the Federal Reserve Board, the highly respected academic economist Alan Blinder, in comments on the Fed’s goals in the early 1980s, found the FOMC to “place far more weight on low inflation, and far less weight on high employment, than the goals of the body politic . . . the Fed sets up smoke screens – just as its professed conversion to monetarism in 1979 was a smoke screen for pushing interest rates up.” Blinder was pointing to the Fed’s deliberate deceptions in public statements – “fondness for baloney”, as he called it, that were a cover-up for “surreptitiously promoting unemployment” (Blinder, 1994). All in the name of fighting inflation!
More recently, former Chairman Henry B. Gonzalez of the U.S. House Committee on Banking, Finance and Urban Affairs released a study detailing the Fed’s concerted efforts to conceal from the public and Congress secret transcripts of its FOMC meetings. For seventeen years the Board concealed these secret transcripts, and in late 1993 deliberately planned to deceive and mislead the Congress in testimony before the House Banking Committee (U.S. House of Representatives, 1994).
These troubling relations with Congress and the larger public reflect in large part the divergent slants on central bank independence as viewed from Capitol Hill and the Board of Governors. While these problems should be rather easily corrected, the Fed faces a far more intransigent problem. There is no adequate theory of inflation to guide the FOMC in designing and carrying out an effective anti-inflationary policy. Monetary policy is still approached from the theoretical perspective of the quantity theory of money, a nineteenth-century conception inappropriate as we enter an entirely different twenty-first-century system of institutions, using very different means of payment and financial instruments. Contemporary policy requires new definitions of the most basic concepts – money and credit – not just in a national framework, but in a global system of fully integrated national components.
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.
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.
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.
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