David R. Henderson  

The Federal Reserve as Central Planner

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John H. Cochrane of the University of Chicago has an excellent op/ed in today's Wall Street Journal, "The Federal Reserve: From Central Bank to Central Planner." [If you are blocked from the Journal, you can go to John's site and find it there.] In it, he makes the case that the Federal Reserve under Ben Bernanke has become a central planner. I'm not sure if John knows this--I'm guessing he doesn't--but he's plowing ground that Jeff Hummel plowed over a year ago in his 2011 article, "Ben Bernanke versus Milton Friedman: The Federal Reserve's Emergence as the U.S. Economy's Central Planner."

Herewith some excerpts from Cochrane followed by some excerpts from Jeff Hummel.

Cochrane:

A revealing example of where we are going emerged last spring, admirably documented on the Fed's website. Using its bank-regulation authority, the Fed declared that the banks that had robo-signed foreclosure documents were guilty of "unsafe and unsound processes and practices"--though robo-signing has nothing to do with the banks taking too much risk.

The Fed then commanded that the banks provide $25 billion in "mortgage relief," a simple transfer from bank shareholders to mortgage borrowers--though none of these borrowers was a victim of robo-signing.

The Fed even commanded that the banks give money to "nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development." Why? Many at the Fed see mortgage write-downs as an effective tool to stimulate the economy. The Fed simply used its regulatory power to help meet that policy goal.


Hummel:
Both Ben S. Bernanke and Milton Friedman are economists who studied the Great Depression closely. Indeed, Bernanke admits that his intense interest in that event was inspired by reading Milton Friedman and Anna Jacobson Schwartz's Monetary History of the United States, 1867-1960 (1963). Bernanke agrees with Friedman that what made the Great Depression truly great rather than just a garden-variety depression was the series of banking panics that began nearly a year after the stock-market crash of October 1929. And both agree that the Federal Reserve (the Fed) was the primary culprit by failing to offset, if not by initiating, that economic cataclysm within the United States (Ip 2005). As Bernanke, while still only a member of the Fed's board of governors, said in an address at a ninetieth-birthday celebration for Friedman: "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again" (2002b).

This seeming similarity, however, disguises significant differences in Friedman's and Bernanke's approaches to financial crises, differences that have played an enormous yet rarely noticed role in the recent financial crisis. Not only have those differences resulted in another Fed failure--not quite as serious as the one during the Great Depression, to be sure, yet serious enough--but they have also resulted in a dramatic transformation of the Fed's role in the economy. Bernanke has so expanded the Fed's discretionary actions beyond merely controlling the money stock that it has become a gigantic, financial central planner. In short, despite Bernanke's promise, the Fed did do it again. [emphasis his]


If you want more detail on Bernanke's move to central planning, you'll find it in the Hummel article.

One jarring sentence in John Cochrane's piece is this:

The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s.

Note that Cochrane gives zero credit to Milton's tireless co-author, Anna J. Schwartz.

Elsewhere in his piece, Cochrane writes:

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed's independence, allowing it to do one thing--conduct monetary policy--without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

Three years ago, while Bernanke's moves to central planning had been going on for many months, 386 economists signed a letter calling for the Federal Reserve to be independent of Congress. Many of them were colleagues of John Cochrane. I wonder how many of them did due diligence before signing. Were they even aware that the Fed had become a central planner? Hopefully, John Cochrane's piece and the Hummel piece that backs it up will be noticed. It's hard to advocate giving huge discretionary power to a large federal agency and at the same time advocate not being able to monitor it, let alone control it.


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COMMENTS (10 to date)
Bill Woolsey writes:

A version of Hummell's paper is chapter 6 of Boom and Bust Banking: The Caues and Cures of the Great Moderation.

http://www.independent.org/store/book.asp?id=100

Joe Cushing writes:

I don't know how it is even legal for a private company to write laws that other private companies have to follow.

david writes:

It was always implicit in the idea of a helicopter drop that the Fed would have to decide who the money goes to.

You can always take the hard Austrian/post-Keynesian line and argue further that even open-market operations favour certain borrowers over others, since in practice the Fed system has a select number of institutions which can borrow directly from the Fed.

Shayne Cook writes:

While not disputing Cochrane's and Hummel's basic premise, I am concerned that both - and others critical of Bernanke and the Fed - seem to frame and base their criticism within the context of the U.S. economy alone.

The U.S. currency is the global reserve currency and the default/preferred global transaction currency, not just the currency of the U.S. economy. That U.S. currency global status is extremely beneficial to the U.S. economy in a variety of ways, from decreasing U.S. and global trade transaction costs to providing a large and deep demand for U.S. dollars in global markets - increasing/sustaining U.S. purchasing power.

Those benefits, and the global status of the U.S. currency that provides them, are crucially important to the U.S. economy. Especially so given that the U.S. has changed from being "price-maker" for an increasing variety of global goods, to a "price-taker" for those global goods.

I suspect that evaluation/criticism of Fed policies should be made within that global context. Irrespective of whether current/recent Fed policy is viewed as sub-optimal for the U.S. economy alone, Bernanke and the Fed have thus far preserved the global standing of the U.S. dollar, and thereby preserved the U.S. economic benefit resulting from that global standing.

Joe Cushing writes:

Shayne,

"That U.S. currency global status is extremely beneficial to the U.S. economy in a variety of ways..."

Everything you said is correct however you didn't include some other important things that are true. Fiat currencies can only exist at the point of a gun. Within a country, this is done by pointing guns at people who print up real currency--asset backed currency that people would prefer over the fiat currency. Without the gun, asset backed currency would push out forever inflating fiat currency. Of course they don't usually shoot the guns, most people will take the lesser punishment of allowing the state to put them in a steel cage. The gun is there in case currency printers resist being chained up and put in a steel cage.

If you want to take your fiat currency global, the process is the same. Here is how it works. The US tells large oil producing countries that if they will accept only US dollars for oil, they will receive our "protection." The US uses the word protection in a similar way to how the mafia uses the word. The military will protect those who use US dollars and it will wage war on those who don't. Now if you are say Spain, and you want to buy oil from Saudi Arabia, You need US dollars to do it. This makes having a reserve of US dollars very important to your economy. wolla, you have a global fiat currency.

Gaddafi was trying to create a gold backed currency because he recognized that our global fiat currency is doomed to collapse and he saw the gun in the room. He's dead. He would not be dead if he were taking only US dollars. Iran is accepting Euros and Gold for oil. We have an embargo on Iran and the political class is beating the drums of war.

Without the global fiat dollar, we would not need to endure the cost of maintaining a global empire. This cost is far greater than any benefits we get for having a global dollar. The cost includes taxes and debt to support our 700 military bases and the blood of those who die in our wars--which includes terrorist attacks on our soil.

Shayne Cook writes:

Joe:

You seem quite vested in your point of view. I'll respectfully disagree. I consider your "gun to the head" analogy very substantially overstated.

There is no one holding a gun to my head, nor is there anyone holding a gun to the heads of those with whom I voluntarily exchange my Federal Reserve Coupons for their goods and services. As for Spain's trades with Saudi Arabia, and the myriad global equivalents, the very same benefits realized by the U.S. economy are realized by those global trading partners - reduced transaction costs and a globally accepted medium of exchange, store of value and unit of account.

There is a very common misconception, Joe, that I suspect you may have. The misconception is that because the U.S. currency - a fiat currency, as you note - is not "backed" by a shiny metal, it isn't "backed" by anything. Indeed, the U.S. currency is "backed" by the entire productive capacity of the entire U.S. economy. And quite frankly, I'll take that "backing" over any shiny metal any day of the week. If I actually want to own a shiny metal, it turns out I can exchange my Federal Reserve Coupons for some at the coin shop any day of the week.

I'll concede your fiat-currency concerns are somewhat valid, though. There is no time in human history when a purely fiat currency has achieved the current status of the U.S. dollar. So I don't consider it at all proven that a fiat currency can serve that role for extended time frames. It will certainly require sound and expert management in order to survive in that role - or at the very least, avoidance of gross mismanagement. And the Fed thus far has avoided gross mismanagement, in the global context.

As an aside, I'm not convinced your citing the regimes of Gaddafi and Iran as favoring a Gold-backed currency serves your argument very well.


Joe Cushing writes:

Shayne,

A few counter points:

The purpose of the shiny metal is not so much to back the currency as to control it. It's not the fed that miss manages it, so much as it is the over spending by the government that does so. The government over spends and this prompts the fed to print to pay for it. This is how it is working here and it is how it always seems to work. Our Dollar has lost 96% of it's value and most of that has happened since it became fiat. I see the sings of a dollar collapse coming. The power to mine gold is about 1 trillionth the power of the fed to print. Zimbabwe proved that.

On the global leaders: Of course the leaders of Iran and Gadafi are people we don't like. They have been made out to be terrible people by our government and media. They very well probably are terrible but probably not in the ways they have been made out to be and certainly in no worse of a way than the people running Saudi Arabia or any number of other countries in Asia, Africa, and the Middle East. What makes them special, and therefore enemies, is the point I raised above about them trying to break from from the petro dollar.

Seriously, can't you think of anything Iran has truly done to harm the US? They talk a big game but it is the US that is harming Iran. Maybe that's why they talk the way they do. After all, we are, in a sense in a war with them already--even though they have not attacked us or harmed us in any way. This is of course except for selling oil for gold/euros.


Cochrane:

The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s.

An historian of economic thought would say that the idea goes back at least as far as the Bullionist debate of the 1800-1819 period.

Shayne Cook writes:

Joe:

I understand the logic of your (and others) counter points regards the merits and limitations of a fiat currency. I merely consider that logic myopic and out of context, not inherently wrong or misguided. See my first comment.

You are correct in noting that a fiat currency is subject to the possibility of, and detrimental effects of, over-printing. That is an artifact of fiat currency that was noted by Benjamin Franklin over 200 years ago. Benjamin Franklin also noted that when a fiat currency is over-printed, it auto-corrects for that error by automatically devaluing. He, and I, consider that a "feature", not a "bug". But again, a fiat currency must be managed well in order for it not to become a "bug". See my second comment.

I'm just not at all impressed with the theory/technique/expedient of using shiny metal quantity limits or production rate limits as the mechanism for controlling or constraining government over-spending as you and others suggest. In the first place, those same constraining characteristic would apply to the entire U.S., and now global, economies - severely constraining wealth production. And there is exactly no reason to believe it would actually be effective in constraining an out of control government. Such governments merely bypass the constraint by theft. That has been true throughout human history.

Where we are like-minded ...

Just about exactly 4 years ago, the "Bailout Bill" was being proposed and discussed. I considered it to be an abomination then, and I still consider it to be an abomination - but for different reasons. At the time, I projected that, at the very least, it would induce a non-trivial inflation in the U.S. economy. It was after all, at $700 Billion, approximately 5% of then U.S. GDP. As you know, that was "swamped" by subsequent fiscal deficit spending AND dramatic increases in the Fed balance sheet. As those measures were being implemented, I knew they would be inflationary. (You expressed your concerns as a pending "collapse of the dollar"). And I was wrong.

I don't like being wrong, so I had to find out why I had been wrong - why expansion in these scales didn't induce inflation, or "dollar collapse". And the answer is that I was being as myopic then, as others are now - constraining my thinking to the borders of the U.S. economy alone. What I had missed in my projections then was that the U.S. dollar is, for nearly all intents and purposes, the de-facto global trade currency, not just the U.S. currency. And the global economy was fully capable of assimilating any excess U.S. currency being created - without inducing inflation, or devaluing. That is the point of my first comment.

Regards you comments on Iran, Gaddafi, et.al., suffice to say I don't fully agree with you. But I'm also not at all impressed with U.S. government Middle East foreign policy activities of the past 12 years.

Dennis writes:

Shayne, what do you think the limits of this demand for the US Dollar are?

Isn't it extremely dangerous to be so dependent on this global demand for US Dollars? There must be a limit to that right? There cannot be an infinate demand?

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