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The Fed Often Gets Monetary Policy Right
By Christopher M. Russo
In his Discourse review of “Money and the Rule of Law” by Peter Boettke, Alexander Salter and Daniel Smith, Thomas Hogan forcefully argues for rules-based monetary policy. Indeed, what if monetary policy were set by mathematical formulas rather than the discretionary judgment of us featherless bipeds?
Hogan, following the book’s authors, claims that a rules-based monetary policy approach would reduce economic uncertainty and political influence, resulting in better outcomes for ordinary Americans. He frames the 2007-08 financial crisis and its aftermath as a consequence of the Federal Reserve’s discretion and says that the Fed still has not learned from its mistakes during the Great Depression.
Hogan and the authors of “Money and the Rule of Law” clearly care about getting monetary policy right. I share their concern for the ordinary Americans left behind by the nation’s economic policies. I have criticized Fed policy, on the outside as well as on the inside, including on issues of discretion and favoritism. Nevertheless, I believe Hogan’s comments miss the mark in three specific areas.
First, Fed policymakers are not Soviet commissars attempting to “run a complex economy”; their goal is more limited and modest in scope. Second, Hogan’s scattershot critique of the Fed’s performance is misleading. While imperfect, the Fed’s response to the 2007-08 financial crisis was orders of magnitude better than its response to the Depression. Third, the Fed does operate within the rule of law set forth by the Constitution and federal statutes.
The ‘Knowledge Problem’ Framework Doesn’t Apply
Hogan asserts that the Fed’s attempt to “manage the economy” will necessarily fail due to “knowledge problems.” The knowledge-problem critique originates from the work of F. A. Hayek. In “The Use of Knowledge in Society” (1945), Hayek criticizes the idea that central planners could coordinate nationwide economic production by gathering and using data on citizens’ diverse preferences, many needs and scarce resources. Moscow planners simply lacked the necessary dispersed knowledge of the people of Odessa, Leningrad and beyond. Of course, the Fed’s objective is much simpler than was the Soviet Union’s goal: keeping money growth on an even keel, not planning the nationwide production of guns and butter.
As a consequence of the Fed’s limited scope, Hogan’s critique requires much stronger claims about the Fed’s ignorance. Per Hogan, Fed officials lack even basic knowledge of how one might conduct monetary policy. He asserts that they don’t have any “accurate data” and that there is “no agreed-upon theory” by which they could analyze such data.
Let me leave aside the Herculean feats by Fed scholars and staff to collect accurate, real-time data on economic and financial conditions. Readers can browse these examples and judge for themselves. Instead, I’ll focus on the issue of economic theory.
True, no aspect of economic theory has universal agreement, even among professional economists. Even so, there really is a “mainstream” of economic theory used by the vast majority of practicing economists. Think of it as a shared framework for analysis, akin to a shared language. It’s emerged from our attempts to synthesize the works of luminaries like Adam Smith, John Maynard Keynes and Milton Friedman—and, yes, also Hayek, among many others.
You might argue that mainstream theory is wrong. Boettke—my Mercatus colleague—certainly does. Elsewhere, he distinguishes his “mainline economics” from mainstream economics. Others outside the mainstream divide themselves into Austrian economists, post-Keynesian economists, feminist economists, Marxist economists, etc. If these scholars choose to engage with the mainstream, then their views should be considered on the merits, not dismissed under the pretense of settled science. Nevertheless, contra Hogan, there is broad agreement on the fundamentals of inflation, unemployment and asset prices. Mainstream economics really is mainstream.
The Fed Learned Its Lesson From the Great Depression
Mainstream economics is also informed by history. In 1963, Friedman and Anna Schwartz published “A Monetary History of the United States, 1867-1960.” In their pathbreaking study, they argue that the Fed’s mistakes compounded a series of banking panics, ultimately leading to the Great Depression. But the principal mistake identified by Friedman and Schwartz was the Fed’s failure to prevent sharp declines in the money supply, leading to the failure of sound banks. It had not “ignored its legal limitations . . . in favor of whatever seemed viable at the time.” Quite the opposite—the problem was the Fed’s failure to act.
Indeed, as an eminent economic historian of the Depression, former Fed Chairman Ben Bernanke was committed to not repeating those mistakes. Celebrating Friedman’s achievements on his 90th birthday, Bernanke concludes his speech by saying, “Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.” Under Bernanke’s leadership during the 2007-08 crisis and beyond, the Fed’s aggressive actions were his faithful execution of this vow.
A clear majority of top economists favor Bernanke’s actions during the financial crisis. Still, reasonable people can disagree. In his new book “The Money Illusion,” my colleague Scott Sumner argues that Bernanke’s Fed should have provided even more money, even more quickly. Others criticize the Fed’s emergency lending to nonbank financial firms, an authority granted by Congress for “exceptional and exigent” circumstances.
We Already Have a Monetary Constitution
Ultimately, Hogan and the authors call for a “monetary constitution.” However, the U.S. Constitution is already a monetary constitution: It provides the legal basis for Congress’ power to create the Fed. The Fed’s structure, authorities and responsibilities are codified by the 1913 Federal Reserve Act, as amended. For example, Congress restructured the Fed’s governance in the 1935 Banking Act, clarified its objectives with the 1977 Federal Reserve Reform Act and curtailed its emergency lending powers with the 2010 Dodd-Frank Act. The Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy explains its lawful framework for decision-making. The Fed is audited, overseen by Congress and subject to judicial review.
You might argue that the Fed clearly violates the Founders’ intent: “No State shall . . . make any Thing but gold and silver Coin a Tender in Payment of Debts.” Alas, all the worse for constitutionalism. While rules may be useful, mere parchment neither substitutes for human judgment nor binds sovereignty. “Rule by rules” is really “rule by rulemakers.” Ultimately, even more rules are not a panacea for our dysfunctional government. Rather, I offer to you the wisdom of Aristotle’s “Politics”: It is best to be ruled by the best.