"Fisking" Modern Monetarism

OPINION / That '70s Show
By ALLAN H. MELTZER
February 28, 2008; Wall Street Journal / Page A16

The title of this message is slightly off. Alan Meltzer (AM) is not really an old-time Monetarist, because that view (as defined by Milton Friedman) is basically dead. (It morphed into something called "new Keynesianism.") However, even though AM does not believe in the idea that the money supply should be kept growing at a slow and constant rate (the key tenet of high Monetarism), he is of that tradition: to him, the Fed must fight inflation, forgetting all other goals.

My comments are in dark type, his in light type. If you want his full article unscathed, see the link above.

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.

An independent central bank is supposed to maintain the value of the currency and prevent inflation. 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.

Contrary to AM, a true "independent monetary authority" does not have to "maintain the value of the currency and prevent inflation." (These really are one goal, by the way.) A truly independent central bank (CB) can do anything it damn well pleases. No one could complain or do anything about it. But AM isn't really calling for an truly independent CB.

AM is advocating a political position by making an assertion of fact: he's calling for one that's independent of any democratic control -- so that the citizens cannot hold the CB accountable in any way. This kind of institution would instead be responding only to political pressure from Wall Street and the banks. He then hopes that its priorities would be totally dedicated to fighting inflation. His hopes are likely to be dashed, since the Fed is partly a creature of Wall Street, which is not just concerned with inflation.

By the way, the view that unemployment “ticked up a bit” during the 1970s is totally wrong. The overall rate jumped from 4.9% to 5.9% in 1972, while it had already been pretty high by 1960s standards before that. It soared from 4.9% in 1973 to 8.5% in 1975 and then stayed high (above 7%) for two years. AM has likely never experience unemployment and thus does not know what “ticking up” means.

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.

AM is presenting the theory of the “credibility” of the Fed. If the CB isn't a strict task-master, the story goes, workers won't cut their money wages much in recessions (relative to productivity, but for simplicity let's ignore that). Similarly, businesses do not cut prices. There's some truth to that idea, but it's radically incomplete and therefore wrong. Back in the 1970s, the persistence of inflation and the rise of stagflation was much more than just a matter of "inflationary expectations."

First, there was the wage/price spiral. This is something that existed mostly autonomously from expectations and the credibility of the Fed. Workers find that their money wages are falling behind inflation and thus strive to raise them -- or to get a cost-of-living escalator built into their contracts. They were able to do this because their were stronger labor unions in the private sector than nowadays. Then, the employers push the costs of the higher wages onto consumers by raising prices. Back during the 1970s, they had the pricing power needed to pull this off.

Price hikes encourage further wage inflation. Despite the recession of the early Nixon years, which AM likely applauded, the price/wage spiral continued. This inflationary hangover meant that we saw the first "stagflation."

By the way, the Fed really wasn't in charge of the economy back then the way it was now, so its credibility was irrelevant to this discussion. It only gained its current status with the complete transition to a floating exchange rate system. Back in the 1960s and very early 1970s, the dollar was fixed to gold and other currencies, so the Fed was forced to focus its efforts on keeping it fixed. It was unleashed starting in August 1971, when Nixon started the process of letting the dollar go. The Fed soon replaced the federal government as the macroeconomic maestro.

Second, and more importantly, there were two major oil shocks during the 1970s (1973-4 and 1979-80). These occurred due to political events (the 1973 Arab-Israeli war and the Iranian revolution) and had nothing to do with the Fed's credibility or lack thereof. The oil-price hikes, rather than the price/wage spiral or inflationary expectations had much more to do with causing the rise of inflation. Part of this impact was due to the newly-floating dollar: oil prices would be hiked in dollar terms, but then a depreciating dollar would undermine the oil revenues’ purchasing power, so that prices had to be hiked again (to protect the petro-princes).

Third, the rate of profit had fallen since the 1960s. As I've argued elsewhere, this encouraged business to raise prices more than usual. (Falling profit rates, all else equal, cause rising stagflation.) It wasn't a matter of passively responding to wage increases. It was the start of what the late labor leader Doug Fraser called a "one-sided class war" aimed at restoring profitability.

It's beginning to happen again. Unlike the response of wages and prices in the low inflation 1990s, expectations of rising inflation now delay or stop price and wage adjustment, inhibiting growth.

When AM says "inhibiting growth," I presume that he's following the convention among economists and referring to growth in the ability of the US to produce (potential output, the "supply side"). He's not referring to growth of demand, which is what most journalists mean. Because it’s clear that the kind of tight monetary policy he’s advocating causes slower growth of demand.

He's assuming that any kind of inflation hurts the supply side. That doesn't make sense. In standard orthodox theory, long-term supply-side growth is unaffected by inflation (unless it gets to Zimbabwean levels). Getting beyond the orthodoxy, inflation can actually make the economy more flexible, serving the employers' needs. You've got an employee (or a bunch of them) who you can't get rid of and whose wages are "too high"? Well, let inflation reduce the impact of the cost.

As noted, he's also assuming that anti-inflation recessions help supply-side growth. That does not follow either. Recessions stomp on private investment, weakening a key source of normal capitalist growth. There seems to be a correlation -- called Verdoorn’s Law -- between the growth of demand and the growth of supply, with demand leading the process. So sustained and deep recessions of the sort that AM is advocating actually can hurt supply-side growth.

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.

Here, AM is referring to the fact that the US went through a severe recession, with unemployment rates near 10% in 1982 and 1983 -- under the guidance of the Fed's Paul Volcker. Making things worse, it was a "double dip" recession, hitting in 1980 and then in 1981-82.

This "Great Recession" occurred for several reasons. First, people were sick of inflation at the time. But more importantly, it was an expression of the revenge of finance capital: creditors and owners of paper assets (bonds, stocks) had found their paper losing value due to inflation, so they helped the resistable rise of Volcker to the pinnacle of power, shoving aside the "weak" William Miller. It was a part of the one-sided class war mentioned above, involving not just a simple recession but the breaking of unions (think PATCO) and the smashing the old industrial heartland (Michigan, Indiana, Pennsylvania, etc.) The strict task-master had arrived.

Free market orthodoxy ruled. It was better to simply throw large numbers of workers out of work rather than increasing the inflation-fighting efficiency of the recession using wage and price controls. (Contrary to the standard story, wage/price controls complement recessions in fighting inflation rather than being a substitute.)

It worked! Inflation decreased, while labor unions in the private sector went on a seemingly final death march. Of course, Volcker does not deserve all of the credit. The drastic fall of oil prices in 1986 and after (due to the collapse of OPEC, having nothing to do with the Fed’s “credibility”) put a big nail in the coffin of stagflation.

Economic forecasts are not very accurate; still, the International Monetary Fund, the Congressional Budget Office and even the Federal Reserve do not forecast recession in 2008. The Fed thinks that the unemployment rate may rise to 5.3%, below the postwar average. In any event, it cannot do much to change economic activity or unemployment experienced in the next few months, and the Fed anticipates stronger growth in the second half of the year. Why the haste to cut interest rates drastically?

The experience of everyday people “in the trenches” of the economy suggests that something very much like a recession is happening right now, whether or not the economy falls in the exact way that technically defines a “recession.” And if forecasts aren’t accurate, why does AM use them?

The freezing up of short-term financial markets called for more borrowing. The Fed's response was creative and correct. It recognized that its responsibility as lender of last resort required bold action to maintain the payments system; and it delivered.

It seems that AM ignores the repeated nature of the credit freeze. It’s more of a structural problem right now, rather than being something that can easily be solved using lender-of-last-resort lending.

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. And in the postwar years, although it often failed to do so, it was expected to safeguard the purchasing power of our money and maintain economic growth.

The Fed was supposed to resist pressures from Wall Street?? The main impetus for its creation occurred because the ultimate Wall Street insider -- J.P. Morgan -- was no longer up to the task of handling financial panics. The private sector had failed, so the public sector took over. The whole idea is not only protect the value of the currency (prevent inflation) but to protect Wall Street’s goodies.

For Wall Street, the pressure for lower interest rates is based on a hope that bond and mortgage yields will decline and their losses will be limited. Often long-term rates fall when the Fed lowers short-term rates -- and since bond and mortgage prices rise when their rates fall, the losses of investors in these instruments will be reduced. For Congress and the administration, there is a need to show "concern" by doing something in an election year. These are not the concerns that should influence an independent central bank.

It is truly bizarre that AM does not acknowledge the housing mess, in which falling house prices are causing increasing numbers of homeowners to have “negative equity” and increasing numbers of financial institutions to find that their assets are worthless -- or at least worth much less than they counted on. The latter, of course, is what spurred the aforementioned credit freezes.

Surely Mr. Bernanke and his colleagues remember what happened in the 1970s. They console themselves with the belief that they will respond to any inflation that occurs by promptly raising interest rates. That repeats the commitments made repeatedly in the 1970s, which the Fed was unwilling to keep. The blunt fact is that there is rarely a popular time to raise interest rates. [even when inflation is high?] And with the growing streak of populism in the country, it will become more difficult.

Oh my god! People are beginning to be populist! What next, democracy?

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. In the 1970s, because the Fed shifted from one goal to the other and back again, it achieved neither. Both inflation and unemployment rose on average, then fell together in the 1980s -- after the Fed controlled inflation.

One problem with this assertion is that even though unemployment generally fell in the 1980s is that unemployment started taking on greater meaning. The intensifying neoliberal policy revolution (initiated by Volcker and Reagan) raised the cost of losing one’s job, so that any given unemployment rate had more impact in restricting wage demands. And the fall in inflation rates was not just due to breaking the back of the price/wage spiral but also the drastic fall in oil prices.

After 1985, Fed policy kept inflation and unemployment low. The result was 20 years of growth, and three of the longest peacetime expansions punctuated by short recessions.

Not mentioned are the institutional changes that weakened the wage half of the price/wage spiral and the increasing amount of international competition in product markets, which sapped the price half. To the very model of a modern monetarist, it’s all the Fed’s doing. And, following the tradition of Milton Friedman, if things go wrong, it’s all the Fed’s fault. It's never because the Fed faces irreconcilable goals, such as saving Wall Street while avoiding inflation.

We should not throw this policy away. Federal Reserve independence is a valuable right which should not be discarded. The Fed should insist on its obligation to prevent inflation and sustain growth, not sacrificing inflation to lower unemployment before the election.

What obligation? The Fed’s obligation is much more complicated than that, if you actually read the laws.

But let’s drop that issue and conclude by tying up two loose ends. First, I referred above to “sustained and deep recessions of the sort that AM is advocating.” He does not explicitly advocate a sustained and deep recession as much as assert that the current recession (if it occurs) will be mild, with perhaps a minor up-tick in unemployment. (People need a vacation, anyway, right?)

The other loose end is that the economy currently seems to fit AM’s story. In the private sector and most of the public sector, workers lack the bargaining power to raise wage. Most businesses don’t have much power to raise prices any more and are more like victims of supply and demand. So if inflation persists, it seems like it would be due to inflationary expectations and (dare we say it) the lack of credibility of the Fed.

The problem is that even if the economy is imitating the economists’ model of the perfect market, that can be a disaster. With consumers in debt up to their necks and home equity collapsing, it looks like we’re going to have a massive collapse of consumer demand. No longer will middle-to-upper-class consumers live it up on credit. No longer will working-class and poor consumers meet their obligations in the face of stagnant wages using credit. It’s crunch time. Private investment will likely be blocked by fears of disaster and increasingly important corporate debt and unused capacity (as the demand for their product falls). It’s possible that the government’s military campaigns and the revival of exports will pump up the economy, but nothing is guaranteed. Both of those encourage inflation, which simply makes the Fed’s job harder and encourages moderation in recession-fighting.

As Bernanke knew in the early 2000s, deflation (a general fall in prices) is possible. It was made possible by the undermining of worker bargaining power and employer pricing power. With consumers in deep debt, falling prices are a total disaster. (A consummate orthodox economist, Irving Fisher, pointed this out in 1933, having just seen it happen.) Suddenly debts and interest payments become more important, encouraging waves of bankruptcy and further cuts in consumption. People begin to expect deflation and delay spending (if they can) to take advantages of future “deals.” The fall in prices becomes credible, so people believe in it.

Okay, we cannot predict that such a debt deflation will occur. But the point is that AM’s hoped-for mild recession might easily cause it. It's quite possible that Monetarist policies combined with the neoliberal changes in the economic structure could reap a whirlwind.