A downside of a career teaching economics is that when old age and hypertension strike, it’s hard to read US financial news, especially about the Federal Reserve, without having a spike in blood pressure. It’s not the news itself, but the insane way some media reports it.
Last week we had the first meeting of 2022 of the Fed’s Open Market Committee. This prompted the following, from an article by Barrons: “There is a long-held belief that Federal Reserve chairmen are economic maestros.” No, there has never been such a belief by anyone who knows the Fed or has a good understanding of economics. All the texts of macroeconomic theory, “principles” as well as “intermediates”, insist on the limited power of any central bank and on the long and variable delays before which any change in monetary policy affects the real economy.
Any economics student who takes a money and banking course towards the end of a bachelor’s degree will learn this in great detail. And anyone exposed to groundbreaking economic theory from the mid-1970s to this millennium learns how the 1960s illusions of “fine-tuning” an economy have been disproved. At best, micromanaging fiscal or monetary policy is ineffective. Most often, it has perverse and harmful effects.
The term “maestro” was used by journalist Bob Woodward in a lovely and venerable 2000 book about Alan Greenspan. It should have embarrassed the author at the time and will certainly be a stain on Woodward’s long-term reputation, given how Greenspan’s ideological approach to financial regulation contributed to the global financial meltdown that began to unfold a few years later. Uneducated journalists may like the “maestro” trope, but I challenge them to find any economist who has ever used that term.
Then consider the question that begins in a January 27 Bloomberg article: “How willing is the Federal Reserve to let stocks slide? For Wall Street and household investors, it has become a legitimate question. After all, the Fed stepped in when stocks fell one day in 1987, shortly after Greenspan replaced Paul Volcker as president. The central bank acted again after the September 11 attacks and, after initial hesitation in August 2007, loosened money when the covered bond bubble burst in 2008-09.
So apparently many believe this is happening even though virtually all economists would say that central bank policies should aim for no effect, up or down, on stock prices.
This is especially relevant now, as we have been in a 14-year bubble in stock and housing prices fueled by the Fed’s extended zero interest rate program. Would the prices of stocks, cryptocurrencies, farmland in the Midwest or homes in Shoreview be nearly as high without the Fed’s unprecedented monetary expansion from 2008 to 2021? No, definitely not!
All of this is problematic for many economists and for the discipline as a whole. A century ago, Irving Fisher, one of the greatest American economists of the 20th century, argued that a central bank should consider as wide a range of prices as possible when deciding how to manage the money supply. That should include real estate and company stock prices, Fisher said.
But economists have largely dismissed this. Despite the Fed’s stated mission to temper consumer inflation, the argument is that no one can know what the “right” price of a half-section of Jackson County is or what a slice “should” be in Target or Facebook. And if you don’t know what the correct price is, you can’t know if it’s going up or down too much.
The prices of consumer and producer goods and services can be measured, and there is agreement on the zone in which changes in these range from benign to dangerous. They are therefore the key measure for central banks. But the current consensus is that central banks should simply ignore long-term asset prices. Economists are generally consistent: the Fed shouldn’t pay attention to rising stock and house prices, and it shouldn’t when they fall.
I think ignoring rising asset prices is a huge mistake – not just in doctrine but in actual practice – that will play out in the months and years to come. But my view is not widely shared by other economists and certainly not on Wall Street.
The problem is that, in practice, the fear of “contagion”, of panicked and bankrupt households losing their assets, of panicked businesses and Wall Street financial firms dragging down the economy as a whole, always creates pressures. The central bank must intervene to prevent the economy from tipping over the brink! The Fed and other central banks are giving in to such sentiment.
The fear is well founded. Events in the United States in 1873, 1893, 1907, and 1929-1933 showed just how bad things can get. About 150 years ago, the British journalist and economist Walter Bagehot classically stressed the need for central bank intervention in such cases.
Yet repeated interventions create “moral hazard” – incentives for actions such as excessive risk-taking that benefit some individuals but harm society as a whole. Former Minneapolis Fed President Gary Stern, along with his colleague Ron Feldman, detailed this in their 2004 book, “Too Big to Fail: The Hazards of Bank Bailouts.” Libertarian monetarist Allan Meltzer, a Carnegie-Mellon professor who wrote the definitive history of the Federal Reserve, agreed. That is, he agreed, until things went wrong. In early 2008, as the financial meltdown unfolded, with Bear Stearns collapsing in March and Lehman Brothers faltering in October, Meltzer denounced the bailouts on national television. But a few years later, he blames the Fed for not having intervened to save Lehman!
I bet we will face a similar situation again before the next presidential election. Nobody, economists, politicians, titans of Wall Street or anyone else, has a good plan to react when this happens. In the meantime, the stock market response from economists is that the Fed should not intervene at any time to stop a decline in stock prices, no matter how deep.
Then there are questions like “should the Fed raise interest rates or sell bonds,” as well as what it should do about climate change, high unemployment among minority youth, etc Expect to hear these questions during upcoming confirmation hearings for Biden’s new appointments to the Fed Board of Governors. The answer is that interest rates versus money supply versus buying and selling bonds are all slightly different sides of the same question. The other issues are irrelevant to the Fed except as side effects of the Fed’s secondary role as regulator of the banking system.
Above all, there is really only one question, because a central bank can only do one thing: control the level of reserves in a country’s banking system. It’s a vital task, but it also means the Fed simply doesn’t have the tools to solve all the ills as some people fantasize.
St. Paul economist and writer Edward Lotterman can be reached at [email protected]