Tuesday, February 26, 2008

Is the Federal Reserve Pursuing the Wrong Goal?

In the last six months, the Fed has gone from being concerned primarily with easing the credit crunch to avoiding a recession. It has lowered interest rates dramatically, even as inflation statistics reveal a disquieting flareup. Today's wholesale price index showed a 7.5% increase from a year ago. The word "stagflation" reverberates in the punditry.

Since the Fed appears intent on preventing a recession it does not predict, even at the cost of letting inflation get halfway out the barn door, it's worth asking whether the Fed is pursuing the right goal. Recessions, of course, are undesirable. But is the Fed properly giving such a large proportion of its time and attention to this one problem?

While we hesitate to get lawyerly, Section 225a of Title 12 of the United States Code provides that "[t]he Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In other words, the Fed is supposed aim for "maximum employment, stable prices, and moderate long term-interest rates."

This provision of law doesn't say anything about avoiding any and all recessions. Recessions involve some increase of unemployment. Does that mean, however, that the Fed should take out all the stops to prevent a recession, even at the cost of allowing inflation to slip out of control? Hardly. Section 225a lists "stable prices" as a co-equal goal of the Fed. It can't disregard one of its principal legal responsibilities in order to conduct a hot pursuit of another.

Furthermore, Section 225a focuses on the long term. Recessions are a short term phenomenon. Maximizing employment for the long term is best served by keeping inflation under control. Low inflation encourages saving and investment, an industrialized economy's equivalent to plowing and planting. The rapid cheapening of earnings caused by a runaway inflation leads to profligacy and speculation, the antithesis of saving and investment.

Section 225a doesn't require the Fed to promote "full" employment. It uses the term "maximum" employment. The Fed doesn't have to ensure that everyone who wants a job gets one. It is simply obligated to try to promote as much employment as possible, consistent with serving its other goals of stable prices and moderate long-term interest rates.

The last time the Fed chose to make combating recession its principal priority was in the 1970s. We know how that ended: a newly appointed Chairman Paul Volcker had to raise interest rates sharply at the end of that decade in order to quell the inflationary beast, and, in the process, threw the United States into its deepest recession since the Great Depression. He also set the stage for the long period of low inflation and considerable prosperity that we've enjoyed since 1983. An entire generation of Americans has been born and raised to adulthood without experiencing either a bad recession or serious inflation. It's no wonder that so many people think it's okay to have no savings, carry a lot of debt, and buy houses and cars with no money down.

The Fed of the 1970s faced a choice, and tried to have it both ways. In the face of dramatic increases in oil prices and a substantial federal deficit, it tried to stave off recession while letting inflation run riot. The price we eventually paid was severe. Today's Fed faces a similar choice. The advantage it has is the knowledge of what happened in the 1970s. No one wants a return of disco or leisure suits. Even more importantly, no one wants the Fed to take the stern measures Chairman Volcker had to take. Alan Greenspan was very lucky because he got to follow in Paul Volcker's footsteps. Ben Bernanke isn't half as lucky, since he has to follow in Alan Greenspan's footsteps. In a democracy, government officials are tempted to take the easy way out and placate their constituencies. But greatness in government comes from leadership. Abraham Lincoln, Franklin Delano Roosevelt and Winston Churchill didn't placate. They made difficult choices and led. Paul Volcker demonstrated that Fed Chairmen can do the same. What will today's Fed do?

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