So the chain of causation was long and opaque. The linkages from open market operations (adding to bank reserves) to commercial bank credit creation (adding to the money supply) to credit-fueled additional spending (adding to GDP) resembled nothing so much as the loose steering gear on an old jalopy: turning the steering wheel did not necessarily mean the ditch would be avoided.
Most certainly there was no possible reason to believe that M1 could be managed to an unerring 3 percent growth rate, and that, in any event, keeping M1 growth on the straight and narrow would lead to any predictable rate of economic activity or mix of real growth and inflation. In short, Friedman’s single variable–fixed money supply growth rule was basically academic poppycock.
The monetarists, of course, had a ready answer to all of these disabilities; namely, that there were “leads and lags” in the transmission of monetary policy, and that given sufficient time the money multipliers and velocity would regress to a standard rate. Yet that “sufficient time” caveat had two insurmountable flaws: it meant that Friedman’s fixed rule could not be implemented in the real day-to-day world of fast-moving financial markets; and more importantly, it betrayed the deep, hopeless political naïveté of the monetarists and Professor Friedman especially.
THE MONETARIST CONE:
SILLY PUTTY ON THE WHITE HOUSE GRAPHS
As to practicality, I had a real-time encounter with it during the Reagan years when the Treasury’s monetary policy post was held by a religious disciple of Friedman: Beryl Sprinkel. Week after week at White House economic briefings he presented a graph based on the patented “monetarist cone.” The graph consisted of two upward-sloping dotted lines from a common starting date which showed where the money supply would be if it had been growing at an upper boundary of, say, 4 percent and a lower boundary of, say, 2 percent.
The implication was that if the Fed were following Professor Friedman’s rule, the path of the actual money supply would fall snugly inside the “cone” as it extended out over months and quarters, thereby indicating that all was well on the monetary front, the only thing which mattered. Except the solid line on the graph tracking the actual week-to-week growth of money supply gyrated wildly and was almost always outside the cone, sometimes on the high side and other times on the low.
In other words, the greatest central banker of modern times, Paul Volcker, was flunking the monetarists’ test week after week, causing Sprinkel to engage in alternating bouts of table pounding because the Fed was either dangerously too tight or too loose. Fortunately, Sprinkel’s graphs didn’t lead to much: President Reagan would look puzzled, Jim Baker, the chief of staff, would yawn, and domestic policy advisor Ed Meese would suggest moving on to the next topic.
More importantly, Volcker could easily explain the manifold complexities and anomalies in the short-term movement of the reported money supply numbers, and that on an “adjusted” basis he was actually inside the cone. Besides that, credit growth was slowing sharply, from a rate of 12 percent in 1979 to 7 percent in 1981 and 3 percent in 1982. That caused the economy to temporarily buckle and inflation to plunge from double digits to under 4 percent in less than twenty-four months. Volcker was getting the job done, in compliance with the monetarist cone or not.
In fact, the monetarist cone was just a Silly Putty numbers exercise, representing annualized rates of change from an arbitrary starting date that kept getting reset owing to one alleged anomaly or another. The far more relevant imperative was to slow the perilous expansion of the Fed’s balance sheet. It had doubled from $60 billion to $125 billion in the nine years before Volcker’s arrival at the Eccles Building, thereby saturating the banking system with newly minted reserves and the wherewithal for inflationary credit growth.
Volcker accomplished this true anti-inflation objective with alacrity. By curtailing the Fed’s balance sheet growth rate to less than 5 percent by 1982, Volcker convinced the markets that the Fed would not continue to passively validate inflation, as Burns and Miller had done, and that speculating on rising prices was no longer a one-way bet. Volcker thus cracked the inflation spiral through a display of central bank resolve, not through a single-variable focus on a rubbery monetary statistic called M1.
Volcker also demonstrated that the short-run growth rate of M1 was largely irrelevant and impossible to manage, but that the Fed could nevertheless contain the inflationary furies by tough-minded discipline of its own balance sheet. Yet that very success went straight to an even more fatal flaw in the monetarist fixed money growth rule: Friedman never explained how the Fed, once liberated from the external discipline of the Bretton Woods gold standard, would be continuously populated with iron-willed statesmen like Volcker, and how they would even remain in office when push came to shove like it did during the monetary crunch of 1982.
In fact, Volcker’s reappointment the next year was a close call because most of the White House staff and the Senate Republican leadership wanted to take him down, owing to the considerable political inconvenience of the recessionary trauma his policies had induced. Senate leader Howard Baker, for example, angrily demanded that Volcker “get his foot off the neck of American business now.”
Volcker survived only because of Ronald Reagan’s stubborn (and correct) belief that the Fed’s long bout of profligacy had caused inflation and that only a period of painful monetary parsimony could cure it. The next several decades would prove decisively, however, that the process of American governance produces few Reagans and even fewer Volckers.
So Friedman unleashed the demon of floating-rate money based on the naïve view that the inhabitants of the Eccles Building could and would follow his monetary rules. That was a surprising posture because Friedman’s splendid scholarship on the free market, going all the way back to his pioneering critique of New York City rent controls in the late 1940s, was infused with an abiding skepticism of politicians and all of their mischievous works.
Yet by unshackling the Fed from the constraints of fixed exchange rates and the redemption of dollar liabilities for gold, Friedman’s monetary doctrine actually handed politicians a stupendous new prize. It rendered trivial by comparison the ills owing to garden variety insults to the free market, such as rent control or the regulation of interstate trucking.
IMPLICIT RULE BY MONETARY EUNUCHS
The Friedman monetary theory actually placed the nation’s stock of bank reserves, money, and credit under the unfettered sway of what amounted to a twelve-member monetary politburo. Once relieved of the gold standard’s external discipline, the central banking branch of the state thus had unlimited scope to extend its mission to plenary management of the nation’s entire GDP and for deep, persistent, and ultimately suffocating intervention in the money and capital markets.
It goes without saying, of course, that the libertarian professor was not peddling a statist scheme. So the implication was that the Fed would be run by self-abnegating monetary eunuchs who would never be tempted to deviate from the fixed money growth rule or by any other manifestation of mission creep. Needless to say, Friedman never sought a franchise to train and appoint such governors, nor did he propose any significant reforms with respect to the Fed’s selection process or of the manner in which its normal operations were conducted.
This glaring omission, however, is what made Friedman’s monetarism all the more dangerous. His monetary opus, A Monetary History of the United States, was published only four years before his disciples, led by George Shultz, filled the ranks of the Nixon White House in 1969.
Possessed with the zeal of recent converts, they soon caused a real-world experiment in Friedman’s grand theory. In so doing, they were also implicitly betting on an improbable proposition: that monetarism would work because the run-of-the-mill political appointees—bankers, economists, businessmen, and ex-politicians who then sat on the Federal Open Market Committee (FOMC), along with their successors—would be forever smitten with the logic of 3 percent annual money supply growth.
FRIEDMAN�
�S GREAT GIFT TO WALL STREET
The very idea that the FOMC would function as faithful monetary eunuchs, keeping their eyes on the M1 gauge and deftly adjusting the dial in either direction upon any deviation from the 3 percent target, was sheer fantasy. And not only because of its political naïveté, something Nixon’s brutalization of the hapless Arthur Burns aptly conveyed.
Friedman’s austere, rule-bound version of discretionary central banking also completely ignored the Fed’s susceptibility to capture by the Wall Street bond dealers and the vast network of member banks, large and small, which maintained their cash reserves on deposit there. Yet once the Fed no longer had to worry about protecting the dollar’s foreign exchange value and the US gold reserve, it had a much wider scope to pursue financial repression policies, such as low interest rates and a steep yield curve, that inherently fuel Wall Street prosperity.
As it happened, the Fed’s drift into these Wall Street–pleasing policies was temporarily stalled by Volcker’s epic campaign against the Great Inflation. Dousing inflation the hard way, through brutal tightening of money market conditions, Volcker had produced the singular nightmare that Wall Street and the banking system loathe; namely, a violent and unprecedented inversion of the yield curve.
With short-term interest rates at 20 percent or more and way above long-term bond yields (12–15 percent), it meant that speculators and banks could not make money on the carry trade and that the value of dealer stock and bond inventories got clobbered: high and rising interest rates mean low and falling financial asset values. Accordingly, the Volcker Fed did not even dream of levitating the economy through the “wealth effects” or by coddling Wall Street speculators.
Yet once Volcker scored an initial success and was unceremoniously dumped by the Baker Treasury Department (in 1987), the anti-inflation brief passed on to a more congenial mechanism; that is, Mr. Deng’s industrial army and the “China price” deflation that rolled across the US economy in the 1990s and after. With inflation-fighting stringency no longer having such immediate urgency, it did not take long for the Greenspan Fed to adopt a prosperity promotion agenda.
First, however, it had to rid itself of any vestigial restraints owing to the Friedman fixed money growth rule. The latter was dispatched easily by a regulatory change in the early 1990s which allowed banks to offer “sweep” accounts; that is, checking accounts by day which turned into savings accounts overnight. Accordingly, Professor Friedman’s M1 could no longer be measured accurately.
Out of sight was apparently out of mind: for the last two decades, the central bank that Friedman caused to be liberated from the alleged tyranny of Bretton Woods so that it could swear an oath of fixed money supply growth has not even bothered to review or mention money supply. Indeed, the Greenspan and Bernanke Fed have been wholly preoccupied with manipulation of the price of money, that is, interest rates, and have relegated Friedman’s entire quantity theory of money to the dustbin of history. And Bernanke claims to have been a disciple!
Constrained neither by gold nor a fixed money growth rule, the Fed in due course declared itself to be the open market committee for the management and planning of the nation’s entire GDP. In this Brobdingnagian endeavor, of course, the Wall Street bond dealers were the vital transmission belt which brought credit-fueled prosperity to Main Street and delivered the elixir of asset inflation to the speculative classes. Consequently, when it came to Wall Street, the Fed became solicitous at first, and craven in the end.
Apologists might claim that Milton Friedman could not have foreseen that the great experiment in discretionary central banking unleashed by his disciples in the Nixon White House would result in the abject capitulation to Wall Street which emerged during the Greenspan era and became a noxious, unyielding reality under Bernanke. But financial statesmen of an earlier era had embraced the gold standard for good reason: it was the ultimate bulwark against the pretensions and follies of central bankers.
WHEN PROFESSOR FRIEDMAN OPENED PANDORA’S BOX: OPEN MARKET OPERATIONS
At the end of the day, Friedman jettisoned the gold standard for a remarkable statist reason. Just as Keynes had been, he was afflicted with the economist’s ambition to prescribe the route to higher national income and prosperity and the intervention tools and recipes that would deliver it. The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.
There were massive and multiple ironies in that stance. It put the central bank in the proactive and morally sanctioned business of buying the government’s debt in the conduct of its open market operations. Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed.
Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers to foster that very thing. Under their auspices, the Fed was soon gorging on the Treasury’s debt emissions, thereby alleviating the inconvenience of funding more government with more taxes.
Friedman also said democracy would thrive better under a régime of free markets, and he was entirely correct. Yet his preferred tool of prosperity promotion, Fed management of the money supply, was far more anti-democratic than Keynes’s methods. Fiscal policy activism was at least subject to the deliberations of the legislature and, in some vague sense, electoral review by the citizenry.
By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance. When in the fullness of time, the FOMC lined up squarely on the side of debtors, real estate owners, and leveraged financial speculators—and against savers, wage earners, and equity financed businessmen—the latter had no recourse from its policy actions.
The greatest untoward consequence of the closet statism implicit in Friedman’s monetary theories, however, is that it put him squarely in opposition to the vision of the Fed’s founders. As has been seen, Carter Glass and Professor Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it.
Consequently, the difference between a “banker’s bank” running a discount window service and a central bank engaged in continuous open market operations was fundamental and monumental, not merely a question of technique. By facilitating a better alignment of liquidity between the asset and liability side of the balance sheets of fractional reserve deposit banks, the original “reserve banks” of the 1913 act would, arguably, improve banking efficiency, stability, and utilization of systemwide reserves.
Yet any impact of these discount window operations on the systemwide banking aggregates of money and credit, especially if the borrowing rate were properly set at a penalty spread above the free market interest rate, would have been purely incidental and derivative, not an object of policy. Obviously, such a discount window–based system could have no pretensions at all as to managing the macroeconomic aggregates such as production, spending, and employment.
In short, under the original discount window model, national employment, production prices, and GDP were a bottoms-up outcome on the free market, not an artifact of state policy. By contrast, open market operations inherently lead to national economic planning and targeting of GDP and other macroeconomic aggregates. The truth is, there is no other reason to control M1 than to steer demand, production, and employment from Washington.
Why did the libertarian professor, who was so hostile to all of the projects and works of government, wish to empower what even he could have recognized as an incipient monetary politburo with such vast powers to plan and manage the national economy, even if by means of the remote and seemingly unobtrusive steering gear of M1? There is but one answer: Friedman thoroughly misunderstood the Great Depression and concluded erroneously that undue regard for the gold standard rules by the Fed du
ring 1929–1933 had resulted in its failure to conduct aggressive open market purchases of government debt, and hence to prevent the deep slide of M1 during the forty-five months after the crash.
Yet the historical evidence is unambiguous; there was no liquidity shortage and no failure by the Fed to do its job as a banker’s bank. Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves. Consequently, commercial banks were not constrained at all in their ability to make loans or generate demand deposits (M1).
But from the lofty perch of his library at the University of Chicago three decades later, Professor Friedman determined that the banking system should have been flooded with new reserves, anyway. And this post facto academician’s edict went straight to the heart of the open market operations issue.
The discount window was the mechanism by which real world bankers voluntarily drew new reserves into the system in order to accommodate an expansion of loans and deposits. By contrast, open market bond purchases were the mechanism by which the incipient central planners at the Fed forced reserves into the banking system, whether sought by member banks or not.
Friedman thus sided with the central planners, contending that the market of the day was wrong and that thousands of banks that already had excess reserves should have been doused with more and still more reserves, until they started lending and creating deposits in accordance with the dictates of the monetarist gospel. Needless to say, the historic data show this proposition to be essentially farcical, and that the real-world exercise in exactly this kind of bank reserve flooding maneuver conducted by the Bernanke Fed forty years later has been a total failure—a monumental case of “pushing on a string.”
The Great Deformation Page 37