The Federal Reserve did not adopt a rule, but it encouraged the belief that it aimed at a 1 to 2 percent inflation rate, presumably in the deflator for personal consumption expenditure net of food and fuel prices.16 Economists then opened discussion of what in addition a central bank should announce. Some proposed announcing a path for expected interest rates or policy actions. Others proposed publication of quarterly forecasts for output and inflation or financial market risk.17 Some smaller central banks publish their interest rate projections. They are price takers in the interest rate market. The Federal Reserve is a price setter; its announcements carry weight in world markets, so it must be cautious about what it announces. A possible rule of thumb is to release information that it believes will not mislead the public and the market. The information should enhance, or at least not diminish, Federal Reserve credibility.
Many central banks make explicit their objective of controlling inflation, and they recognize the central role of inflationary expectations in the inflationary process. This, also, could be a major change for the Federal Reserve.
The Federal Reserve has not tried to agree on a common framework for analyzing the economy and its actions. The best that it can expect to do is agree on a rule such as the Taylor (1993) interest rate rule or the Meltzer (1987) and McCallum (1988) rule for monetary base growth. These rules are compatible with several different models or frameworks. FOMC members with different views can base their decisions on a rule without trying to agree on the model that determines the economy’s path. These rules are relatively simple, an advantage in communicating them.
Fischer (1994) and Blinder (1998) proposed that the political authority should choose the central bank’s objective, leaving the central bank freedom to choose how to achieve the objective. Few countries go as far as the Europeans who set the objective—price stability—in law. The United States law in 1946 called for maximum employment and purchasing power and left to officials to decide on the interpretation. In 1977, Congress amended the Federal Reserve Act to make the objective maximum employment, stable prices, and moderate long-term interest rates. In practice, the Federal Reserve chooses its objective aware that congressional committees and the public have to be informed. This procedure permits the Federal Reserve, as in 1979–82, to take unpopular action to achieve a popular medium-term goal. Independent choice of objectives can be valuable. Congress can, if it chooses, demand a different objective, as some members started to do in 1982.
16. This measure is subject to larger revisions than the consumer price index. As noted above, for “rule” one should read “rule-like behavior.” Blinder (1998, 37) objected to treating rules based on outcomes as rules because central bankers had to make judgments to adapt to changing circumstances. Announcing the “rule” informs the public about the bank’s medium-term objectives. In November 2007, it brought back overall price inflation in addition to “core” measures.
17. FOMC has announced and published forecasts semiannually for thirty years. In November 2007, it changed to quarterly frequency and extended the range of its forecasts to three years ahead.
One of the lessons of Federal Reserve history is that coordination agreements with other central banks fail and are abandoned. The basic reason is that the primary objective of modern central banks in principal countries is domestic. International coordination introduces a conflicting objective, usually the nominal exchange rate. The gold exchange standard, the Tripartite Agreement, Bretton Woods, and the Louvre agreement all failed. One or more countries was unwilling to put exchange rate stability ahead of domestic employment and price stability.
It is well-known that no country can achieve internal and external stability acting alone. To achieve some of the advantages of international coordination while pursuing domestic goals, the major central banks—the Federal Reserve, the European Central Bank, and the Bank of Japan—can announce a domestic inflation target, preferably a common target. The common target would gradually remove or reduce changes in expected inflation as a source of exchange rate adjustment, leaving real exchange rate adjustment as the principal reason for change. Each country would manage its policy without active coordination (Meltzer, 1987).
This system permits small and medium-sized countries to fix their exchange rate to one or more of the large countries. They benefit by having a fixed exchange rate and importing low, or preferably zero, inflation. The three major countries benefit by facing fixed exchange rates at small and medium-sized countries while permitting real and nominal exchange rate adjustment to changes in productivity, tastes, and demands.
In recent years, some economists have proposed that central banks should respond to asset price changes as well as output and inflation. In many papers, Karl Brunner and I introduce asset prices and expected returns to capital as variables important in the transmission of monetary policy. These models separated markets for money and credit. The underlying structure had three assets: base money, government debt, and real capital. Recent work by Goodfriend and McCallum (2007) brings a modern version of money and credit market interaction.18
18. Earlier Bernanke and Blinder (1988) introduced a “credit channel.” They add bank lending as a distinct asset market and implicitly combine bonds and real capital, so assets consist of money, credit, and a mix of bonds and real capital.
Empirical estimates from these models provide information about the response of reported inflation and output to asset prices. A major problem for central banks and others is to determine whether asset price changes reveal inflationary pressures, productivity changes, or changes in the expected return to capital that raise or reduce the real value of assets. Central banks should not respond to asset price changes. If they can identify the inflationary component, central banks should respond to expected inflation from this source as from any other. That is, they should follow rule-like behavior.
The Federal Reserve should increase its effort to develop a common framework for analyzing the economy and the transmission path by which policy and other changes influence its objectives. Currently, there are three approaches. First is an elaborated version of the IS-LM model supplemented by a Phillips curve and some expectations model. This has been used and modified for decades. It was the source of persistent, large errors in forecasting inflation. Second is the analytic model developed by Woodford (2003), which emphasizes the role of rational expectations as the link between a short-term interest rate and other relative prices. Third is the relative price transmission mechanism (Brunner and Meltzer, 1993 and elsewhere). It highlights the central role of asset prices and the expected return to real capital in the transmission of policy and other impulses. In this model, monetary policy changes the relative price of current and future consumption and the relative price of new and existing capital.
CONCLUSION
This chapter summarizes some of the main lessons learned by the Federal Reserve and other central banks from experience and actions. Central banks are much more professional and, as a consequence, better equipped to avoid major mistakes of the past. Through much of the last half of the twentieth century, central banks struggled to find an alternative to the gold standard rule and the rule for balanced budgets. Economists pointed out that the gold standard was procyclical and that discretionary monetary and fiscal actions could produce well-timed policy changes that would improve welfare. They ignored the discipline that the two rules maintained. The result was a large inflation lasting many years and reaching many countries. One result of the Great Inflation was renewed effort to develop stabilizing rules for the conduct of monetary policy. Following the German Bundesbank’s relatively successful results, the Maastricht Treaty adopted the Bundesbank’s objective—price stability—as the policy objective. Progress can continue. Useful steps include more attention to rule-like behavior, more attention to medium-term consequences, less attention to noisy quarterly or monthly data, and a common international inflation rule that increases nominal exchange rate stability. Reliance on the
Taylor rule as a medium-term guide is a good place to start. In conducting its function as regulator of financial firms and lender of last resort, the Federal Reserve should give more attention to incentives, and less to command and control, and it should announce and follow a rule or strategy for crises. Lawyers and bureaucrats write most regulations. Markets decide how and whether to circumvent them. Regulation will be more effective if it takes account of the incentives it creates and adjusts its rule to give incentives for improved behavior.
Large future budget deficits to pay for promised social security and health care benefits will likely challenge the Federal Reserve in the future. Inflation is one way of reducing the real value of these promises. If Congress is unwilling to reduce promised benefits or raise tax rates, the Federal Reserve will be pressed to expand money growth to finance deficits. Adopting a non-inflationary rule may help to reduce pressures to inflate.
Experience in the twenty years following the Great Inflation suggests the size of the welfare gain from avoiding inflation and disinflation. The economy experienced three of the longest periods of growth with only two relatively mild recessions. Per capita disposable income increased 33 percent, an average of 1.6 percent a year. Real aggregate personal consumption rose from $4.2 trillion to $8.2 trillion, $200 billion per year. Inflation remained low. This is an enviable record that monetary policy should seek to repeat regularly.
To end this history, it is useful to repeat from the start of Volume 1 the advice Henry Thornton ([1802] 1962, 259) gave independent central bankers two hundred years ago. The policy should be
to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction; in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself. . . To suffer the solicitations of the merchants, or the wishes of government, to determine the measure of bank issues, is unquestionably to adopt a very false principle of conduct.
EPILOGUE: THE UNITED STATES IN THE GLOBAL FINANCIAL CRISIS OF 2007-9
Events following the start of the housing, mortgage, and credit market crises in summer 2007 opened a new chapter in Federal Reserve history. Never before had it taken responsibility as lender of last resort to the entire financial system, never before had it expanded its balance sheet by hundreds of billions of dollars or more over a short period, and never before had it willingly purchased so many illiquid assets that it must hope will become liquid assets as the economy improves. Chairman Ben Bernanke seemed willing to sacrifice much of the independence that Paul Volcker restored in the 1980s. He worked closely with the Treasury and yielded to pressures from the chairs of the House and Senate Banking Committees and others in Congress.
Events highlighted several of the flaws in Federal Reserve policy discussed in this volume. Current pressures dominated longer-term objectives. The Board had never developed or enunciated a lender-of-last-resort policy. Markets had to observe its actions and interpret the statements as always in the past. Instead of reducing uncertainty by offering and following an explicit lending policy rule, it continued to prevent some failures while permitting others. It failed to give a believable explanation of its reasons and reasoning.
One of the main failings of monetary policy in 1970s was the neglect of longer-term consequences of near-time actions. Whenever the unemployment rate rose to about 7 percent, the members abandoned any concern about the inflationary consequences of their actions. Preventing inflation had to wait. When the right time came, it didn’t remain long enough to end inflation. Raising interest rates and slowing money growth raised the unemployment rate, so policy became expansive again. The result: inflation and unemployment both rose.
Marvin Goodfriend, Alan Greenspan, Robert Hetzel, Andrew Levin, John Taylor, and Peter Wallison provided helpful comments. Fallout from the crisis continues as this is written.
We seem likely to repeat these mistaken actions. In 2008, the Federal Reserve increased its balance sheet from about $800 billion to more than $2.2 trillion. Many of the assets it acquired are illiquid. The market’s demand for reserves rose because participants were frightened and uncertain, and lacked confidence that financial fragility and failure would end. Once confidence begins to return, the Federal Reserve will have to absorb a large volume of reserves. The 1970s problem will return in an exaggerated form.
Economists and central bankers have discussed policy discretion for many years. Discretion enabled the Federal Reserve to make the many mistakes discussed in this volume and to facilitate the risky loans that are the source of credit and economic problems after August 2007. The main lesson of these experiences should be that monetary policy should remain consistent with a rule, not a rigid rule but rule-like behavior that responds both to short-term fluctuations in output and employment and to maintaining low inflation. Discretion has made too many errors.
In 2008 Congress approved $700 billion for the Treasury to use to support banks and financial institutions. The Treasury lacked a coherent plan and frequently allowed its actions to differ from its statement, adding to uncertainty and lack of confidence in policy. By year-end the Treasury had helped 206 banks, and the Federal Reserve had lent $100 billion to support a large failed insurance company. At year-end, President Bush advanced loans to prevent bankruptcy by General Motors and Chrysler, and the Federal Reserve accepted GMAC as a bank so that GMAC could borrow at the discount rate. GMAC immediately offered zero percent interest rate loans to borrowers with less than median credit ratings, precisely the type of loans that caused the crisis.
Financial problems spread to many other countries. Asset owners ran to the dollar and U.S. Treasury securities for safety. This pushed Treasury bill rates to zero or slightly above and lowered longer-term rates. Managing the reversal of these flows will be a major challenge for the Federal Reserve in the future.
Current housing and credit market problems gave rise to expected new claims blaming financial deregulation and hailing the end of Americanstyle capitalism or, in more extreme instances, the end of capitalism. It is hard to ignore such comments, but it is just as hard not to laugh. Despite active criticism and frequent condemnation, capitalism in one form or another has become the dominant form of economic organization throughout the world because only capitalism provides freedom, improved living standards, and an ability to adapt to cultural and institutional differences.
Those who blame recent deregulation are careful not to cite examples. The most recent major change in 1999 repealed the Glass-Steagall prohibition of combined investment and commercial banking. No other country adopted that rule or had a crisis caused by failure to do so. Many years ago, George Benston (1990) showed that proponents of the rule did not make a substantive case when they claimed that combined investment and commercial banking was a cause of the Great Depression.
Members of Congress, as usual, looked for scapegoats to blame for financial failures. Others proposed new regulations to increase governmental control of financial firms. Most proposals of this kind presuppose the reason for the financial failures. In this essay, I discuss seven sources of current problems and how systemic problems can be reduced. Bear in mind that most financial firms borrow short to lend long. That arrangement means that crises will occur when there are sudden changes in the economic environment or expectations. Not all crises can be avoided. Risks will remain, but they can be reduced.
SEVEN CAUSES
Repairing the weaknesses of the U.S. financial system that contributed to the crisis requires changes in the practices of the Congress, the administration, the Federal Reserve, and managers of financial institutions. To succeed, changes must recognize the incentives they create. This section discusses seven problems that contributed to make the crisis severe. It suggests changes to reduce risk and uncertainty.
Congress and the Administration
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Homeownership has long been regarded as a source of social stability, a public good that Congress and administrations of both parties encourage. Intervention takes several forms. Mortgage interest has remained tax deductible through several tax reforms including 1986, when most other interest payments lost that benefit. The Community Reinvestment Act (1977) encouraged home ownership by lower-income groups. The act gave citizen groups the opportunity to pressure banks to increase inner city lending by rating banks according to how much credit they supplied to low-income borrowers. The ratings influenced decisions to permit mergers and branches. In 1995, Congress strengthened the act. The American Dream Downpayment Act (2003) subsidized credit for low-income individuals. When that act passed, President Bush said that it was in the national interest to have more people own their home. He neglected to add “if they invested in them.” In 1999, the Federal Housing Administration introduced the down payment assistance program that permitted no-down-payment loans.
In 1931, Congress urged the Federal Reserve to help the mortgage and housing markets by buying mortgages. The Federal Reserve declined, saying that was not its responsibility. Congress then established the Home Loan Bank System and followed with other agencies to support housing and the mortgage market. The Federal National Mortgage Association (FNMA, called “Fannie Mae”) opened in 1937. Its mandate was to increase liquidity of the mortgage market by buying mortgages. It expanded in the 1960s and became a privately held entity in the late 1960s. The market treated its debt as subject to a federal government guarantee, although the guarantee did not become explicit until the Treasury replaced the management and took control in 2007. The Home Loan Banks chartered the Federal Home Loan Mortgage Corporation (FHLMC, called “Freddie Mac”) to operate like Fannie Mae. It too lacked explicit guarantee of its debt until the Treasury assumed control. In addition, the Government National Mortgage Association (GNMA) is a government corporation that guarantees mortgage securities backed by federally insured or guaranteed loans issued by government agencies such as the Federal Housing Administration (FHA) and other agencies. Unlike Fannie Mae and Freddie Mac, GNMA does not own mortgages or mortgage-backed securities. Its guarantee subsidizes homeownership by lowering the interest rate on the mortgage.
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