Fixing the Market Means Fixing the Fed

To anyone with any knowledge of math and economics, it must be a great mystery how the U.S. national government can keep spending so wildly—now with debt in the multiple trillions. How can this massive debt be kept under any kind of control?

The answer is simple. Cumulative debt is reduced by inflating money so that true debt becomes worth much less and easier to pay off over time. When this old man columnist graduated from college way back in 1959, the best economics professor there told us that if we earned $10,000 a year in our lifetime, we could consider ourselves successful.

Does this sound ridiculous given today’s incomes? The Inflation Calculator, however, shows $10,000 in 1960 is equivalent in purchasing power to about $100,093.24 today, an increase of $90,093.24 over 62 years. The dollar had an average inflation rate of 3.79% per year between 1960 and today, producing a cumulative price increase of 900.93%.

Encouraged by the Treasury and Congress, the U.S. Federal Reserve central bank simply pushes the debt away by inflating money so it becomes cheaper to pay off.

While this may sound like a reasonable solution as long as people and Congress keep demanding to spend more than they will pay in taxes, it often gets out of hand. Hyper-inflation usually has been associated with war or international events, hitting 10% or more four times since World War II, and running over 5% two other times—until today’s present domestic heights near 9 percent, the highest since 1981. Fed chair Paul Volcker and Ronald Reagan broke that inflation, but it took years and only reversed just in time to save Reagan’s reelection in 1984.

So all we need to do is follow their lead again, right? In Law & Liberty’s October forum, financial expert Alex J. Pollock explained why the Volcker toughness probably could not happen today.

But are there factors, four decades later, making the parallels less close? For example, international investor Felix Zulauf “thinks the Powell Fed is quite different from the Volcker Fed, and not just because of the personalities. It’s in a different situation and a different financial [and political] zeitgeist. He doesn’t think the Fed, or any other central bank can get away with imposing the kind of pain Volcker did and will stop as soon as this year. (italics added)

Commenting on Pollock’s article in Law & Liberty, Texas Tech University economics professor Alexander William Salter was likewise not very impressed with today’s Fed.

Despite being on the job for more than a century, the Fed still fails at basic monetary policy. Our inflationary woes show central bankers never learned the lessons of the Volcker disinflation, as Mr. Pollock ably shows. Left to itself, as it’s been for too long, the Fed won’t get any better. Instead, it will get worse—involving itself in more while delivering less. To quote the economist and social philosopher Frank Knight, “The time has come to take the bull by the tail and look the situation square in the face.” We need Congress to rein in the Fed.

Salter’s solution is to limit the Fed’s discretion.

Currently, the Fed has a dual mandate: full employment and stable prices. This is needlessly vague. The Fed should have a single mandate, one focused on keeping steady the demand side of the economy. Forcing the Fed to hit a single target variable would increase price stability without sacrificing employment.

Congress should end the Fed’s present, too-complex dual mandate of full employment and stable prices and instead focus upon a single stabilizing function. Salter says that “Many economists, myself included, favor targeting aggregate demand directly. Stabilizing nominal GDP (which equals aggregate demand) works better than stabilizing the dollar when the supply side of the economy is weak.”

But he adds: “implementing a nominal spending target can be tricky. Furthermore, the public might not understand how this rule works. Given the public demands to whip inflation, it’s almost certainly better politics for Congress to pick an inflation target, despite its imperfections.” Recognizing the limits of his solution, he concludes

Policy wonks often make the perfect the enemy of the good. To get control of the Fed, we must resist this temptation. Even a flawed rule is better than no rule at all. Mr. Pollock reminds us the Fed will make the same mistakes all over again if left to its own devices. It’s time to break the cycle. As long as we’re stuck with a central bank, we should give it an unambiguous mandate and watch it like a hawk.

But must we be stuck with such an imperfect system? Professor Salter is correct about not frustrating the good for the perfect, but would a single goal really be much better than the present flawed rules? A new book by British Reuters columnist and investment analyst Edward Chancellor gets down to the central problem of the Fed trying to micro-manage something as complex as a monetary system operating without effective restrictions. It has an off-putting title—The Price of Time: The Real Story of Interest—but focuses on the center of today’s fettered capitalism, with almost 400 pages exposing how the world economy actually works and what must be done to provide real limits.

A single Chancellor quote from Richard Nixon’s Treasury Secretary John Connally in 1971 neatly summarizes all one really needs to know about how the economic world has worked ever since. As the U.S was fully abandoning the gold standard (after FDR’s 1933 partial abandonment), Connelly explained the economic future to the world’s economic leaders. Now, with the end of any gold restraints, you and the world are going to operate under a U.S. “dollar standard,” and all must realize that “The dollar is our currency but your problem.”

As Chancellor explains the new regime,

Central bank reserves [assets] are mostly composed of dollar-denominated securities (US Treasury bonds and agency debt) which unlike gold can be issued without limit. As the keeper of the world’s reserve currency the United States doesn’t need to maintain its own foreign-reserves, nor worry about its balance of payments. There is no limit on how many dollars flow abroad nor how much the United States borrows from foreigners.

The result is that the Federal Reserve is able to borrow basically without limit and that the U.S. became “the world’s largest international debtor” with the largest government spending.

It would truly take a modern Andrew Jackson to have the courage to fix our failed government banking system and substitute an effective golden mechanism necessary to forge a real market-based economy.

Domestically, the Fed’s new power did come to dominate all, eventually even private exchanges. Morgan Stanley’s Ruchir Sharma demonstrates that the stock market was basically driven by private stock trades until the government’s drastic actions taken to control the 2008 Great Recession unnerved investors to follow the Fed announcement days rather than market ones. Sharma found the S&P 500 had gained 699 points since January 2008, but “422 of those points came on the 70 Fed announcement days.” Between 1960 and 1980, Fed announce­ments had little market effect, and between 1980 and 2007 those announcements had only half as much influence as they would subsequently. After 2008 when 60 percent of stock market gains have come on days the Fed made a policy announcement, stock markets follow rather than lead.

As Chancellor demonstrates, Fed leadership has not produced the positive or stable results promised but instead had produced 14 recessions since the Great Depression, including the Great Recession of 2007-2009, with long periods of prosperity merely between 1961-69 and 1991-2001. The near-zero interest rates resulted, as Chancellor demonstrates (and was obvious to me in 2013), in an initial surge, but sustained near-zero interest rates and exploding debt would produce today’s runaway inflation.

Chancellor identifies the critical error of the Fed policy aiming at long-term, stable, and low-interest rates. If interest rates are forced to any stable level over time, but especially to rates near zero, an economy loses the essential ability to obtain some sense of the market’s future. Interest rates are simply the best guess of a very broad group of those with money at risk as to what the future economy might look like. Not allowing interest fluctuations deprives any signal—the oldest and most important one—of what is going on in the market below the artificial rate, especially becoming blind to budding inflations.

It is important to recognize that Chancellor wrote his book before the Fed finally woke up to today’s roaring inflation. Being the world’s monetary paper alternative to gold has great benefits and does make the rest of the world follow U.S. policy and its results—both good and bad. And since the U.S. can force the rest to follow its errors, they can produce world inflation and recessions. For years, The Wall Street Journal cited French economist Jacques Rueff warning of such a weakness, but it has been strangely silent lately. As Chancellor documents historically, the cat was out of the bag with the end of gold, which had some rough runs historically but during its heyday had facilitated the historic U.S. economic market growth miracle.

That real gold standard basically ended in World War I as the major nations all relied on inflationary debt and turned to a weaker Gold Exchange Standard where the Fed and other central banks did not regularly exchange gold, mostly held in the U.S. In 1928, future Nobel Economics Laurate F. A. Hayek and others criticized this empowered Fed for forcing artificial price stabilization through credit controls between 1922 and 1929, which Chancellor and others blame for the 1930s Depression and the end of the gold standard. None of this avoided or ended the following Depression which required World War II to weaken the world economy enough to allow an unoccupied U.S. to become an island of prosperity into the 1960s.

The world finally recovered, especially Europe, Japan, and the Asian Tigers, and then later China and India. While still the dominant world bank, the Fed became less able to maintain its stable-prices goal and thus became less successful in manipulating foreign economies. U.S. markets remained freer than most of its competitors but more and more regulated and in debt. When the three leaders most responsible for combating the 2008 Great Recession—Fed Chair Ben Bernanke, N.Y. Fed Chair Tim Geithner, and U.S. Treasury Secretary Hank Paulson—wrote a book explaining how they handled the crisis, they titled it Firefighting, emphasizing the ad-hoc rather than rationalist basis for their decision-making.

Chancellor’s solution is to go back to those like Hayek who foresaw the problems with central banks freed from any real limiting measure independent of government. Chancellor advocates ending government’s unconstrained attempts to micromanage incredibly complex market-wide monetary “stability” and allow the market to send interest-value signals to reveal real demand and supply levels. If effective gold or materials commodity measures cannot be devised today, he suggests a refined digital currency linked to gold. That is, of course, the last thing the Fed or Treasury micromanagers want.

But very recently Wall Street Journal Chief Economics correspondent Nick Timiraos was granted a full two pages to explain that the global central bank order may be coming to an end. And, as Chancellor notes, artificially low interest rates benefit the investing rich over the poor—hardly a neutral policy morally.

It is interesting that a longtime critic of the Federal Reserve and gold supporter like business administration economist Judy Shelton was actually nominated to the Fed board in 2020. Not surprisingly, she was publicly opposed by 130 top academic economists and 78 Fed alumni-types, and her nomination failed in the Senate. But it was only by a 47-50 vote. She actually was appointed earlier to the European Bank for Settlements.

It is difficult, of course, to differentiate what is “the good” and what is “the perfect” in periods of economic and political stress. It would truly take a modern Andrew Jackson to have the courage to fix our failed government banking system and substitute an effective golden mechanism necessary to forge a real market-based economy. But as Franklin Roosevelt proved, if things get bad enough, people will accept radical change.