There is an almost religious belief expressed in many editorials that the independence of the Federal Reserve guarantees wise and objective decisions in economic policy matters. Some of us are inclined to challenge this view.
Although a staunch monetarist, Milton Friedman has nothing good to say about the historical efforts of the Federal Reserve to regulate the economy. In his 1983 book, he wrote: “From 1929 to 1933, far from preventing bank failures and bank collapse [it] actually produced them....The Federal Reserve System...allowed [runs on thousands of banks starting in December 1930] to develop and banks to fail...producing by far the worst and most disastrous panic in American history. From 1929 to 1933, the quantity of money in the United States fell by one-third.”186
Agreeing with this judgment of counterproductive policy, the more progressive economist Lester Thurow noted: “In 1931 and 1932...economic advisors such as Secretary of the Treasury Andrew Mellon were arguing that nothing could be done without risking an outbreak of inflation—despite the fact that prices had fallen 23% from 1929 to 1932 and would fall another 4% in 1933....” Some sixty years later, the same mistake was being made, he observed: “By raising interest rates in 1994 the Fed killed a weak American recovery that had yet to include many Americans and slowed a recovery that was barely visible in the rest of the industrial world....”187
Unlike most industrialized countries, which have a central bank at the heart of their financial operations, the U.S. has created a pyramid of banks. Under the Federal Reserve Act of 1913 twelve regional Federal Reserve Banks, authorized to issue currency, were set up with capital supplied by member banks and placed under the control of the Federal Reserve Board (FRB),
which controls rediscount rates on loans made by the district banks.
The FRB Board of Governors is appointed to staggered 14-year terms, only one expiring every second year, which severely limits the power of any President to influence their decisions. Their control of the money supply gives them a veto over economic expansion and a means of bringing about recessions and depressions.
Central bank independence
Until recently other industrialized nations differed from the U.S. in that their elected governments controlled both monetary and fiscal policy. The FRB in America had, and continues to have, independent control of monetary policy, while fiscal policy, which involves expenditures and taxes, remains in the hands of Congress.
Shortly after the British Labour Party won a majority in Parliament in May 1997 and Tony Blair became Prime Minister, the Bank of England was given independent authority to set interest rates. Analyzing this move, Richard W. Stevenson in The New York Times noted a trend for nations to give increasing autonomy to their central banks.
“The Bundesbank in Germany is generally considered the most independent of all central banks,” he wrote, noting that new legislation in Japan will provide more autonomy to the Bank of Japan, and similar steps have been taken in France, Chile, and New Zealand. The European Central Bank, planned to go into effect in 1999, will be free of any direct control by member nations and virtually independent of the political leaders who are to appoint the central bankers. Stevenson observed that “unlike the Bundesbank, which by law is focused solely on price stability,” the Federal Reserve’s mandate “extends to supporting full employment as well.” He didn’t comment on the FRB’s amnesia concerning this duty, which it also has by law.
Bankers, of course, applaud this trend. Stanley Fisher of the International Monetary Fund (IMF) stated their point of view in an article: “Political systems tend to behave myopically, favoring inflationary policies with short-run benefits and
discounting excessively their long-run costs. An independent central bank, given responsibility for price stability, can overcome this inflationary bias.”188
Objectivity of the FRB
The long staggered terms of the FRB members make them largely independent of the President and Congress. It is debatable whether they should be free of the obligation to answer to somebody. In any case, don’t think they are non-political—after all they are bankers with the priorities and conservative leanings of their profession, and almost all bankers belong to the same party. With their power to clamp down on credit, they can either let the economy roll during an election year, favoring an incumbent president seeking reelection, or create a recession that virtually assures his defeat.
The FRB controls the money supply by making changes in the interest rates banks pay for funds borrowed from the regional Federal Reserve Banks or from other banks, and/or conducting “open market” operations which affect banks’ lending abilities as the result of purchases or sales of government bonds. The first obstacle to objective and scientific control of the money supply is the lack of a truly satisfactory measure of the money supply, which is supposed to be the amount of cash and cash equivalents in circulation. This always includes checking account balances because they can be drawn on like cash.
Savings accounts or time deposits can require advance notice for withdrawal, although at most times this is waived by the banks, so the question arises whether such balances should be included in the money supply. As credit cards have come to be used in place of checks for many purposes, shouldn’t they be considered cash equivalents? And what about mutual fund investments that can be converted to cash by a phone call? A variety of definitions has led to a handful of different money supply measurements, M1, M2, M3, etc.
Money supply vs. interest rate criteria
In October 1979, when Federal Reserve Chairman Paul Volcker returned from an international monetary conference
determined to pursue a tight monetary policy to restore confidence in the dollar, he declared that the FRB would focus on stabilizing the growth rate of the money supply rather than stabilizing interest rates. Brockway (1985) has pointed out that “if the money supply merely kept pace with the increase in GNP, M-1 would have reached $858 billion by 1983, instead of the $521 billion it did reach....It is because of scarcity that money can earn interest; and the more severe the scarcity, the higher the interest.”189
Blinder (1987) inferred that Volcker used the monetarist doctrine about the money supply to shield him from the angry reaction he expected from Congress and the public if he admitted his campaign of disinflation would require excruciatingly high interest rates. Interest rates zoomed to a peak in 1981 (nearly 19% prime rate), a sharp rise in unemployment followed, and the policy was exposed as a disaster. The experience of 1981-83 contradicts the monetarist contention that the velocity of money (how frequently it changes hands through transactions) is essentially constant, Blinder pointed out, and velocity “fell between summer 1981 and spring 1983 at rates no one dreamed possible.”
“According to monetarism,” he added, “the way to slow inflation is to bring down money growth. But money growth actually accelerated during the critical period of declining inflation.” While inflation dropped from 8.7% in 1981 to 5.2% in 1982 and 3.6% in 1983, the money supply growth rate rose from 5.2% to 8.7% and 10.4% in those same three years. “With velocity falling rapidly, these money growth rates were not sufficient to provide the economy with the liquidity it needed.” The editorial page of The Wall Street Journal pronounced monetarism dead in December 1985, and early in 1987 Chairman Volcker told Congress that the FRB no longer had any targets for the growth rate of M1.190
FRB under Greenspan
Under the chairmanship of Alan Greenspan, appointed by Reagan and reappointed by Clinton, the FRB has watched for signs of economic growth and stifled it by raising interest rates and thereby restricting the availability of credit. Again in 1994 the
Thurow pointed out in a 1996 article that little improvement is possible for the economy under FRB policies: “Suppose that productivity (the output per hour of work) rises by 2% a year, and that the labor force increases by 1% annually. To prevent layoffs of those no longer needed with improved productivity, and to employ the new workers, the GDP must grow by 3% a year. But the [FRB] limits economic growth to 2% in order to battle inflation [by] raising interest rates whenever growth reaches 2% or 2.5%.”191
Previously the United States experienced a much higher rate of economic growth. “From the early-nineteenth-century introduction of steam power through the dawning of the age of the microchip in the post-World War II era,” according to a 1997 article by Professors Bluestone and Harrison, “real economic growth in America averaged 3.8% per year.”192
The austerity Greenspan recommends for others does not apply to himself, according to Reich’s description of a luncheon meeting at Greenspan’s private dining room on the top floor of the Federal Reserve Building in Washington: “The room is tastefully decorated—an antique clock, a Louis XIV sideboard, fresh cut flowers. The view of the Mall is spectacular. The table is set for two—linen tablecloth, heavy silverware, china plates and bowls, cloth napkins. This is the true center of power in the United States. Greenspan controls the Federal Reserve Board, the Board controls short-term interest rates, and short-term interest rates have a deciding influence on whether people have jobs....”193
Greenspan was paid a fee by the subsequently convicted Charles H. Keating, Jr., to write a letter in 1985 seeking a waiver from the Federal Home Loan Bank in San Francisco, in which he praised Keating’s management (although Keating had signed an SEC consent decree in 1979 to a complaint that he arranged fraudulent loans) and described Lincoln as “a financially strong institution that presents no foreseeable risk to the Federal Savings and Loan Corporation.” Keating’s Lincoln Savings $2.6 billion failure was the most expensive of all the S&Ls.194 As Congress belatedly showed concern about megamergers of banks and other businesses in Senate Judiciary Committee hearings of June 1998, Greenspan again saw no risk, praising “the complexity and dynamism of modern free markets.” He waved aside Senators’ concerns about negative effects on employment, competition, and local credit availability.195 24. THE BUGABOO OF INFLATION
The subject of inflation has spawned a host of misconceptions, such as (1) that inflation hurts people of modest means, (2) that inflation always comes from wage increases, (3) that the Consumer Price Index (CPI) exaggerates inflation, and (4) that there is no inflation unless it shows up in the CPI.
During the Cold War the fear of Communism was closely followed by the fear of inflation, both whipped up by political speeches, editorials, and pronouncements of pundits. President Gerald Ford in 1974 declared that “inflation, our public enemy number one, will, unless whipped, destroy our country, our homes, our liberties, our property, and finally our national pride, as surely as any well-armed wartime enemy.”196 Blinder expressed astonishment: “Destroy our homes? Gee, I thought inflation destroyed my mortgage instead.”197
President Reagan, British Prime Ministers Thatcher and Major, and Chilean dictator Pinochet all boasted of halting inflation, although in each case it was at the cost of sharp and painful spurts in the rate of unemployment. The same scenario has been followed in numerous countries around the globe under pressure from the World Bank and the IMF. Outstanding among the inflation fear-mongers in the U.S., of course, is the Chairman of the Federal Reserve Board. Sometimes market analysts explain a drop in the stock market after good economic news as due to fears of inflation. When they are more precise, they report that investors fear the FRB will raise interest rates to counter the inflation the FRB expects to result.
Typical of such events is one described in an AP news item published on March 25, 1997, just before a quarter-percentage-point interest rate hike that was followed by a sharp drop on Wall Street: “Even though inflation shows no signs of worsening, the Federal Reserve is apparently preparing to raise interest rates for the first time in two years.... The nation’s inflation rate is actually lower so far this year: 2.3% for January and February compared with 3.3% for all of last year....In
congressional testimony last week, Greenspan stressed the ‘importance of acting promptly—ideally preemptively—to keep inflation low.’”
Blinder (1987) pointed out that escalator clauses in contracts could provide insurance against inflation, but businesses and individuals rarely choose to use them. “The apparent reluctance to write indexed contracts suggests that people are willing to pay only small premiums against long-term inflation risks,” he stated. “Yet society pays huge premiums for anti-inflation insurance when it keeps millions of people unemployed. Something seems amiss here.”198
Eisner, in his 1994 book, TheMisunderstood Economy, challenged the assumption that low inflation is good news, pointing out that for every buyer there must be a seller. He cited the many years when rapid increases in housing prices made it seem almost impossible to lose money in housing, resulting in housing and construction booms in many areas. Making it clear he was referring to moderate inflation, not continuously accelerating inflation, he observed: “Higher inflation has been associated with lower real interest rates, greater tax advantages, and hence more investment...more production, and more employment,” except when caused by higher external costs such as huge oil price increases “accompanied by repressive government policies to combat it.”
Noting that banks and savings and loan associations are hurt by rising interest rates as inflation grows, he questioned whether their self-interest should be allowed to dictate policies slowing the economy and creating substantial unemployment in a war against inflation.199
Groundless fear of inflation
How dangerous is inflation? Because prices and wages tend to rise and fall together, inflation is really immaterial to those who neither owe money nor have fixed investments. Debtors benefit by paying off loans in depreciated dollars, until they borrow again and have to pay higher interest rates. Inflation causes bonds to lose value (especially long-term bonds), but investors who have learned to diversify may offset this by gains in their
stock portfolios. Retirees are hurt by inflation if they depend only on annuities and/or bonds at fixed rates and if pensions are not adjusted for cost of living.
Inflation has been called the “cruelest tax,” supposedly most harmful to the poor. However, the prices paid by the poor rise neither faster nor slower during inflation than the prices paid by others. The poor have been hurt when welfare payments failed to keep pace with inflation. The poor and middle-class working families suffered when inflation outran adjustments in income tax exemptions, but much more costly to them have been the joblessness and the difficulty of repaying debt resulting from the FRB’s cure for inflation.
For people with investments, however, inflation means paying higher taxes on interest, dividends, and capital gains because the tax rates are not adjusted for inflation. As Blinder put it in 1987: “Inflation is indeed a cruel tax—but only if your income comes mostly from interest, dividends, and capital gains.”200 Before fretting too much about the wealthy, though, let’s remember that their tax advisors have been rather effective in finding ways to minimize their taxes.
Is inflation really the worst thing that can happen to the economy? In the extreme, of course, runaway inflation can be disastrous, as in Germany in the 1920s and Brazil almost any time. The U.S., however, has often paid an exorbitant price in unemployment and lost production to avoid inflation (over one trillion dollars of GNP in 1982-86, by Blinder’s estimate). The economists of the banking system, though, have long regarded inflation as a much greater threat than unemployment. Whenever employment improves, they go into a panic over fears of inflation.
Fear of inflation from wage increases
Among the statistics that worry the FRB the most are those that show improvement in average wages and/or reduction in the level of unemployment. Their reasoning is something like this: if the pool of unemployed labor declines, workers will fear less for their jobs and may successfully ask for wage increases, which their employers will pass on to their customers in higher prices, and that, of course, is inflation.
Economists recognize two theories of inflation: demand-pull (too much money chasing too few goods) and cost-push (wages, raw materials, and/or profits rising faster than production), and both could possibly be occurring at the same time.
The demand-pull theory only makes sense when the factors of production are fully utilized. It is characterized by shortages of goods and backlogs of orders. Since the 1970s the U.S. economy has been characterized by considerable excess capacity and numerous plant closings, while actual unemployment has greatly exceeded the official tally, so the theory doesn’t seem to apply to this recent period.
The cost-push theory, on the other hand, explains the inflation of the 1970s that subsided in 1982. It wasn’t, as some would say, due to powerful unions forcing wages up too much, nor was it due to sudden spurts in corporate profits. Clearly, the push came from a drastic rise in cost of raw materials, specifically petroleum. Since then, there has been none of the double-digit inflation that was so worrisome then, nor have workers been able to force wages up because labor unions have grown weaker and weaker.
Politicizing the CPI
It is strange that when he is not scaring Wall Street with inflation fears, FRB Chairman Alan Greenspan wears his Social Security expert’s hat and tells Congress the Consumer Price Index, compiled by the Bureau of Labor Statistics, overstates inflation by as much as 1.5 percentage points. In 1997, with the CPI averaging only 2.8% over the previous four years this must have meant Greenspan thought the true rate of inflation was a mere 1.3%, so why did he and his FRB raise interest rates?
Politicians trying to cut social security, military pensions, etc., have welcomed his theory that the CPI exaggerates inflation, which he based on a study by two economists on his staff. Since the Federal Reserve recruits economists who reflect the attitudes of bankers, worrying a great deal about inflation and very little about unemployment, we should have considerable reservations about their economic conclusions.
Of course, the CPI is imperfect, as are other vital economic measures such as GNP, the balance of payments, and even the federal deficit, but for economic analysis we use them, lacking any better measures. They need to be calculated consistently by non-political experts, such as the BLS, which has calculated the CPI for half a century, not by Congress.
Looking for cover on a politically sensitive issue, Congress set up a commission in June 1995 to recommend changes in the CPI, but all the economists appointed had already said the CPI was too high. The panel announced its findings in mid-September without conducting any original research, and, to nobody’s surprise, reached the same conclusion its members had previously expressed at congressional hearings. It was as if a jury were picked from people who had all previously declared themselves in favor of a guilty verdict. Economists who differed, some pointing out that elderly pensioners experience higher than average price increases in such areas as out-of-pocket medical expense, were excluded from the commission.
The usual arguments for the CPI overstatement position involve substitute goods, discount stores, quality improvements, and reduction of prices on new products. Their logic breaks down when these factors are closely examined. If consumers substitute cheaper and less desired products, such as hamburger for steak, the products should not be considered equal. Likewise, when customers switch to discount stores that offer less service, their money does not buy as much satisfaction.
The CPI already includes extensive adjustments for product quality even though consumers often have no choice about new features, while quality deterioration, such as stonewalling by companies over insurance claims, downgrading of air travel comfort, and the frustration of automated telephone systems, is ignored. Product improvement certainly does not apply to meat because the Agriculture department now gives the “choice” label to products that would not have qualified before the 1980s. Price reductions as newly introduced products reach mass markets are, of course, irrelevant to people who wait for affordable prices instead of following fads.201
As Congress continued in 1997 to use CPI revision for a back-door invasion of Social Security, trade associations became very inventive, as revealed in a syndicated column by Marilyn Geewax. To “prove” prices haven’t been going up, she quoted the American Petroleum Institute on gasoline, the National Cattlemen’s Beef Association on food, and the National Broiler Council on chicken—respectable trade associations but hardly impartial!
The oil industry used the device of measuring cost by the mile rather than the gallon, ignoring the consumer’s expense of acquiring a car with better gas mileage. No claim was made that the gasoline at a higher price per gallon was any better quality. The beef industry said families spend a smaller percent of disposable income on food, but didn’t mention the shift away from beef. Again, the higher price of their product, beef, went unmentioned. The poultry industry relied on over 50 years of factory workers’ wage gains to show they could buy more chicken—measured per hour of wages rather than per dollar.202 Unmeasured inflation
Greenspan has been credited by financial and business speakers for stopping inflation, yet, as suggested above, some price increases don’t show up in the official index. Without going into detail about procedures or problems of the FRB at this point, let’s look at forms of inflation that have existed but not been recognized in the official statistics. One built-in factor is the cost of higher interest payments resulting from FRB inflation fighting.
In 1991 economist Edward Hyman of the ISI Group invented something he called “the New Misery Index” (echoing the political concept of the Misery Index equal to the sum of unemployment and inflation rates that had described stagflation). Hyman constructed his index by combining the rise in taxes, medical payments, social security contributions, and interest payments as a percentage of personal income. Those four categories, which took 24% of personal income in 1960, had risen to 40% by 1990—with the largest increase coming during the 1980s.
Kevin Phillips (1993) described some of the hidden costs mainly missed by the official index during the 1980s: virtually unregulated inflation in the cost of health care, automobile insurance, legal and financial services, bank fees, and college tuition; the prices of small items from weekly newsmagazines and shoeshines to contact lens solution and per-hour charges at parking garages that were soaring at three to four times the CPI rate; and the onrush of governmental charges ranging from federal taxes to miscellaneous governmental fees.