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Friday, June 16, 2006

Monetary Policy. Myth. History.

You may share the angst of Ben Bernanke as he watches incipient inflation rising in his crystal globe, its awful power to strip the economy of value looms ever larger. Should he strike with the only tool he has, the short-term interest rate?

Or from fear of shutting down the economy, should he let the noxious cauldron percolate a while longer? The cries from Wall Street plead for mercy, but he is firm in his discipline.

I don't care how much their suits cost or who is licking their shoes to make them so shiny, this tableau is a myth. No matter how many people believe, it doesn't make it so.

For one thing, the interest rate is not the only button on the monetary policy console. It does not have to do double duty. In fact, in cost-push inflation, it does little to help control inflation. We have come to the point of Wizard of Oz economics, where so long as the man behind the curtain is not called out, his power reigns. It has led to absurd chains of reaction, where good economic news is bad for the Market because of what the Fed will think.

Now we hear rumblings of how it is employment levels that are dangerous. That whole nonsense was disproven in the 1990s, theoretically by Nobelist Robert Eisner and then empirically when unemployment dropped to near historic lows without tickling inflation.

How did the central bank get complete control of one-half of economic policy? Representative governments of other industrial countries have not been so generous to the money lenders.

A concise history.

Prior to 1951, the Federal Reserve operated as did many "independent" agencies, like the FAA, FCC, SEC, and so on down the list of acronyms with oversight duties, but only limited policy-making authority.

Then, in the darkest days of the Korean War, with President Truman's approval ratings in the W zone, with Douglas MacArthur grandstanding his way across the country, and with the Treasury Secretary in the hospital, a clandestine agreement was reached between the Federal Reserve and an undersecretary of the Treasury named William McChesney Martin.

The "Treasury Accord" ceded control of monetary policy -- interest rates and money supply -- to the Fed. William McChesney Martin found a home as chairman, ostensibly as the administration's man. In fact, he brought the control of monetary policy firmly into the camp of the central bank. Years later Truman happened to meet him on a street. He left the Fed chief with a single word. "Traitor."

Control of interest rates and monetary targets had been essential in the successful handling of the enormous federal debt accrued during World War II. The successful transition from war to peace would have been impossible without it. Bankers chafed, however, under the experience of the post-war inflation. Of course, they targeted their criticism to profligate politicians, not to the policy.

But the timing of the coup had little to do with economic circumstances. Inflation had become a non-issue, even with the Korean War. The politicians were responsible. Truman would leave office as the only postwar president to net a budget surplus during his administration. The timing had everything to do with political opportunism. The president had other battles to fight and could not risk a showdown with the staid and stuffy.

An economic policy to be effective must have its two major parts -- fiscal and monetary policy -- working together. Otherwise a jobs policy, for example, such as promoting public works and modest deficit spending can be completely undone by a tight monetary policy which shuts down investment. Or in the current situation, a reckless accumulation of debt by the federal government can be exacerbated by a compliant Fed.

Truman's chair of the Council of Economic Advisers Leon Keyserling later estimated that hundreds of billions of dollars were lost to the economy just through the 1970s from excess interest costs, and this was before the big debt binges of Reagan and the two Bushes.