Tuesday, October 20, 2015

The Suckling Fed: A Central Bank Acting without License

One of the problems with monetary policy these days is that it seems level-headed and responsible and yet there is still something sadly wrong with it.  It seems correct and rational because the economy continues to have risk factors and we have a Fed with very powerful tools. So why not let the Fed continue to support the economy?

The answer is that while it all seems warm and fuzzy, there isn’t any real precedent or theory to support this kind of behavior. Pardon my little walk through history to make my case.

The Fed joined the central bank game in 1913. It didn’t have much to do during the Gold Standard days. After WWII we had something called the Gold Exchange Standard and the Fed was supposed to be pretty passive in that system too – though some people would argue that it was Fed activism that caused the US to have to embarrassingly admit they screwed up a very lovely system. President Nixon notoriously closed the Gold Window because we could not continue to honor our pledge to buy gold for $32 an ounce. We had depreciated the dollar and had to end the system or go broke.  

When I first learned monetary theory in the olden days of yore, there was a very simple idea that guided monetary policy. An economy needs money to make transactions. The Fed should make sure there is enough money to sustain a normal pace of economic growth. That was pretty simple. The Fed was not supposed to deliver babies or groceries or pizza. It was supposed to let money grow at a nice easy pace commensurate with long-run growth. Snore.

If you are still awake you might point out that the modern Fed has a dual mandate to keep inflation below 2% while pursuing a fully employed economy. That’s true but even those words do not support what the Fed has been doing the last few years. There is a difference between being a lender of last resort and being a lender of first resort. Let me explain.

Even some ardent conservatives believe the Fed should be the lender of last resort. That means that when we have an emergency that requires liquidity in the economy, most of us believe the Fed should provide that liquidity.  When the emergency vehicle comes to your house you are glad it contains a medical professional who will administer to your heart attack. The Fed performed that role in the beginning of the recent financial crisis. Give them a gold star. They did the right thing. It helped.

But just because the emergency doctor gets your heart going it does not mean you want her sitting in your living room watching reality TV and eating your butter drenched popcorn on a daily basis. Dude, go home. I am okay. Go help someone else.  

And that is the root of the problem with the Fed. Janet does not want to go home and leave us along. You might say – but she has plenty of support and authority from modern macroeconomics. Neo-Keynesians and even a few monetarists might agree that the Fed can provide stimulus and support for an economy entering a recession. The Keynesians have models that show a little bit of stimulus can go a long way. Monetarists might fret that such actions would cause higher inflation but both groups of economists admit that stimulus could be effective in moving us away from the worst of the recession.

But what none of them can show with or without models is why the Fed needs to keep suckling the baby. You and I know of mothers who are breast feeding their kids at age 14. Hey gal, it is time to give up on that. Enough is enough. I could not possibly do better than you in imagining all the reasons why breast feeding beyond even three years old could have some negative impacts down the line. Summarizing:

·        The Fed should be lender of last resort --- yes
·        The should stimulate the economy in a recession – maybe
·        The Fed should keep stimulating the economy until every last man and woman is employed – No No No.
·        The Fed should keep stimulating the economy until inflation rages --- No No No

Our Fed has absolutely no historical or theoretical support for what they are doing today. Can you name a time when the Fed successfully engineered the economy six years after the previous recession? They are freelancing in the worst way. Remember when the Fed chair used to meet with Congress annually and lecture the legislatures about prudent budgets and runaway debt? No longer. The ideal of an independent fiscally responsible Fed is sadly gone. 

Instead today what we have is a Fed that supports the government in its progressive agenda. What they are doing has no support in economics. What they are doing today is everything about progressive ideology. It is a sad precedent for the Fed and for the country. Maybe you haven’t noticed but despite all their so-called good work, the Fed remains skeptical about the economy. Instead they should admit that they are out of their province. Instead, they should be back yelling at Congress to fix what’s really wrong with the economy. They should be restoring more normal interest rates and money. They should leave us alone. 

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