Thursday, February 28, 2008

Allan Meltzer Goes for the Fed Jugular

Allan Meltzer gets shrill in this Wall Street Journal article. He argues (1) the Fed is becoming more politicized and, as result, (2) is making some decisions that will be very costly in the future. What is really causing Allan all this angst is the specter of 1970s-style stagflation. He experienced this stagflation firsthand and the subsequent 'cleansing' Paul Volker's Fed had to undertake to bring back macroeconomic order. Melzter does not want to see it happen again.

That '70s Show
Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday -- where he warned of a steeper decline and suggested that more rate cuts lie ahead -- leave little doubt on both counts

... In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten... People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.

... One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.

... The freezing up of short-term financial markets called for more borrowing... But the rush to bring real short-term interest rates to negative values is an unseemly and dangerous response to pressures from Wall Street, Congress and the administration. The Federal Reserve became "independent" in 1913 so that it could resist pressures of that kind.

... The Fed's recent behavior is in sharp contrast to the European Central Bank. The ECB keeps its eye on both objectives, growth and low inflation. It doesn't shift back and forth from one to the other. The Fed should do the same.


  1. Meltzer refers to the sturdy ECB but that hawkish institution is itself coming under pressure according to the Daily Telegraph:
    The euro has surged to an all-time high of $1.51 against the dollar, prompting bitter complaints from European industry and setting off a sharp sell-off in sovereign bonds from southern states deemed least able to withstand a super-strong currency.

    A top aide to French President Nicolas Sarkozy fired a shot across the bows of the ECB yesterday, demanding that "monetary policy must remain within reasonable bounds". The comments are a clear hint that Paris may try to force a change of tack by invoking Maastricht Article 109, which gives EU politicians the power to dictate exchange policy. France has lacked allies for use of this so-called "nuclear option", but this may change now that a number of eurozone countries are in trouble.

  2. An unforunate development for sure. I hope the ECB can weather ths storm.