The Fed's Not the Cavalry in this Crisis
Iwan Morgan is Professor of U.S. Studies and Head of U.S. Programmes at the Institute for the Study of the Americas [ISA]. He was previously Professor of Modern American History and Head of Department of Politics and Modern History at London Guildhall University and Professor of American Governance at London Metropolitan University. He has also taught at Indiana University-Purdue University at Fort Wayne as a Fulbright Educational Exchange Lecturer.
Most recently, Professor Morgan's work The Age of Deficits won the American Politics Group's 2010 Richard Neustadt Book Prize.
On August 9, the Federal Open Market Committee, the central bank's main monetary policy body, announced that the short-term interest rates under its control would be held at their ultra-low level for a further two years in order to boost U.S. economic recovery. In June, it had committed to only a few months of holding down the federal funds rate, broadly interpreted as meaning to the end of the year at most. At the same time, however, it held back from launching a third installment of quantitative easing so soon after the completion of the last one. Wall Street reaction was generally but not universally positive, with majority opinion holding that the Fed had gone as far as it could without appearing panicky. Nevertheless, the dryly worded central bank statement was an effective admission that it did not expect a real expansion in jobs till mid-2013 and did not possess the magic wand to produce one.
The Fed's limited impact in pursuit of economic recovery contrasts starkly with its reputation as the guarantor of economic growth during the final decade of the twentieth century. Journalist Bob Woodward celebrated its success in this earlier era with a book unblushingly entitled Maestro: Greenspan's Fed and the American Boom, published in 2000. It is unlikely that anyone will write a similar book about Bernanke (or about Greenspan post-2000 for that matter). The problems facing the current chair, however, are of a different order to those confronting any of his recent predecessors.
Bernanke heads an institution more renowned for fighting inflation than boosting jobs. The Fed's reputation had sunk to a low ebb in the seventies because of its efforts to balance price stability and job growth in an era of stagflation. In the eyes of critics, its failure to pursue a consistently tight money policy was instrumental in producing the high inflation of that decade. On becoming chairman in 1979, Paul Volcker set out to restore the central bank's credibility on this score by adopting a tough policy of controlling money stock growth (quantitative tightening in today's lingo). As a consequence of this three-year dose of monetarism, consumer price inflation was brought down from 13.3 percent in 1979 to 3.2 percent in 1983, but at the cost of the worst recession since the 1930s in 1981-82. The Fed withstood the criticism from the White House and Congress that it kept its foot on the monetary brakes too long and too hard because it had the support of Wall Street. A far from enthusiastic Reagan administration therefore had little choice but to appoint Volcker to a second term as chair in 1983. Inflation remained low for the rest of the eighties, but even after monetary easing ended the recession in late 1982 unemployment did not sink to its 1980 level until 1986.
Alan Greenspan continued his successor's strategy of making inflation the Fed's number-one priority and not trading this off against employment concerns. Greenspan's anti-inflation raising of interest rates in 1988-89 helped slow the economy into recession in 1990, to George H.W. Bush's fury, and his restoration of these in 1994, to Bill Clinton's anger, restrained the recovery in the interests of keeping inflation low. Only when he was convinced that productivity gains from high-tech innovations now constrained inflation did Greenspan ease interest rates to produce the great boom of 1996-2000. His foot, however, went back on the monetary brakes when inflation revived in 1999-2000, which was a factor in precipitating a new recession in early 2001. Greenspan eased again in response to this downturn and the 9/11 shock, but moved back to tightening in 2005 to curb house price inflation, a response that created difficulties in the sub-prime mortgage market that led in turn to the toxic consequences of 2007-08.
While Bernanke is committed to the continuation of easy money, the Fed is not united in support of this because the anti-inflation priority is deeply embedded into its institutional culture. In the August 8 Open Market Committee vote on holding interest rates low for two years, the Dallas, Minneapolis and Philadelphia Reserve Bank presidents dissented in a 7-3 split—the first time since 1992 (when Greenspan favored ease to boost recovery from the 1990 recession) that a chairman has encountered a 'rebellion' of this scale. The cause of this disagreement was concern that the Fed was letting inflation rise because of its focus on employment and economic growth. It is open to question, therefore, whether Bernanke will have sufficient support on the twelve-person committee if he opts for a further round of quantitative easing.
It is even more open to question, perhaps, if a third round of QM would have any more effect in boosting employment than the previous two. To date, easy money may have helped to stop the recession turning into a slump, but it has not helped twenty-five million Americans to get full-time jobs.
In today's climate of economic uncertainty and job insecurity, ordinary Americans are more inclined to save money if they possibly can than to continue their borrowing habit to fund consumption. The best way of breaking this concern is to put money back in people's pockets through fiscal actions—ranging from infrastructure investments to employment tax cuts and unemployment insurance extension—to create jobs directly or indirectly. Fiscal policy also has better distributive effects than monetary policy in helping those most in need. As Greenspan himself admitted in his Harvard commencement address of 1999, when the boom he helped to create was at its peak, "The gains have not been as widely spread across households as I would like." It may be heresy to say so in today's political climate, but the Keynesian multiplier represents the best chance of boosting employment and expanding income amongst the working and middle classes.
The Fed chair was the chief manager of prosperity in the era when inflation was deemed the number-one economic problem, but times have changed. The president should resume that role now that unemployment is the principal concern, and presidential fiscal policy is needed to address it. Whether Barack Obama can accept this, and, even if he does, is able to break free of partisan fetters to take up that responsibility is another matter.
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