By Allan H. Meltzer who is an American Economist and the Allan H. Meltzer professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. He is the author of a large number of academic papers and books on monetary policy and the Federal Reserve Bank. Dr. Meltzer’s two volume books, “A History of the Federal Reserve”, are considered the most comprehensive history of the central bank. He is considered one of the world’s foremost experts on the development and application of monetary policy. Currently he is also President of the Mont Pelerin Society. Dr. Meltzer originated the aphorism “Capitalism without failure is like religion without sin. It doesn’t work.”
This is a monthly column written by Professor Meltzer for Defining Ideas of the Hoover Institution.
After the unprecedented financial events of the past decade, several Congressmen and Senators recently proposed steps to rein in the Federal Reserve’s broad powers over monetary policy and commercial bank regulation. Like many of their constituents, the authors and supporters of the new rules are fed up with both Fed bailouts of large banks and the financing of government deficits at historically low interest rates.
The proposed changes would require the Fed to announce and follow a rule for monetary policy and stop using taxpayer funds to bailout large banks and financial firms. Both changes are welcome and long overdue.
When Congress created the Federal Reserve in 1913, it created an independent central bank. At the time, members understood that, unless it is restricted, a central bank can create inflation by issuing money to buy government debt. To avoid that outcome, the new law forbade the Federal Reserve to lend directly to the U.S. Treasury.
Almost immediately, the Federal Reserve circumvented the law during World War I by subsidizing commercial bank purchases of government debt. A few years later, it began to buy and sell government securities in the market place. This did not violate the prohibition against direct dealings with the Treasury, but it completely circumvented the law. The Fed had discovered a way to print as much money as it wished. In World War II, in the 1960s and 1970s, and after 2009, it abused its authority by buying up government debt at low interest rates.
The Constitution gives Congress the responsibility for monetary policy. The Federal Reserve is its agent. Central bank independence protects the public against inflation only if Congress limits Fed discretion. A properly functioning monetary system must balance rules that restrict discretion against operating independence. An independent central bank does not permit the government to direct its actions and it must not finance the government’s budget deficit. President Woodrow Wilson, the story goes, did not invite the members of the Federal Reserve Board to White House dinners because he did not want to influence them.
Shift to the present. The relationship has completely changed. The Chair of the Federal Reserve has a regular lunch with the Secretary of the Treasury and meets with other administration officials. At such meetings, the Fed discussed the December 2015 decision to raise an interest rate it controlled from zero to 1/4% after more than two years of public discussion and delay. Delay increased uncertainty about future interest rates and monetary policy. The media circus that preceded and accompanied the rate change never noted that after the small increase, the interest rate remained at least two percentage points below equilibrium. The important real rate—the rate the Fed sets minus the inflation rate—is negative. That’s too low in a growing economy.
The Fed’s decision to surrender its independence creates problems at home and abroad. At home, the low interest rate policy induced many retired people to invest in risky securities instead of the relatively safe bank securities that they formerly bought. The prices and market values of the more risky securities will fall as interest rates rise. That will bring substantial losses to bondholders. Retired people will be among those most likely to lose when rates rise and bond prices fall. We should expect to learn about these and other tragic cases.
Abroad, emerging market banks and financial investors will lose when bond prices fall. Foreign banks and governments hold a large share of U.S. government debt. China is the largest holder. It is selling our debt to reduce future losses, but its holdings are too large to avoid large losses. These examples are but two of the many changes that higher interest rates will bring.
A further effect that should not be neglected is the increase in government interest payments and the budget deficit. As interest rates rise, interest payments on the $18 trillion of outstanding government debt will be the largest source of new government spending.
The Federal Reserve is no longer independent. It gave away its independence in 2009 when it began to buy unprecedented quantities of government debt to keep interest rates from rising. Former Chairman Bernanke rushed into print to claim credit for Federal Reserve policy. His enthusiasm came too soon; it was like celebrating a big football win at half time. We will not know whether the policy brought stability as long as the financial markets have not absorbed all of the $2.5 trillion of idle reserves on bank balance sheets. The Fed has not announced a plan for retiring these reserves. Doing so without causing inflation, recession, or both requires skills that the Fed lacks.
The Fed may succeed, but its history is not encouraging. In the past, it produced the Great Depression, the Great Inflation, and most recently the Great Recession. A big postwar inflation was the price paid to end the WWII debt policy. A large recession restored price stability in the early 1980s. The current supply of excess reserves is much greater than in the past.
In its first 100 years, its best period is called the Great Moderation. That lasted from 1986 to about 2002. Chairman Greenspan more or less followed a monetary rule. Instead of responding to noisy monthly and quarterly data, as the Fed usually does, Greenspan directed policy toward the medium-term. There were fewer ups and downs and more stable Fed actions. The economy responded by keeping inflation low, growth relatively steady, recessions very short and mild, and recoveries prompt. No period of discretionary policy has done as well. Economists offered many reasons for the improved results. My strong belief is that a more stable, predictable Fed policy—following a rule instead of discretion– was the main reason.
Recently, the House of Representatives voted to reduce the Fed’s unlimited discretion over interest rates and monetary policy by requiring the Federal Reserve to adopt a rule for monetary policy. It left the choice of rule to the Fed; it was required to choose one and to compare it periodically to the well-known Taylor Rule developed by my Hoover colleague, John B. Taylor. In our uncertain world, no rule will work well all the time. The House bill recognized uncertainty about the future by permitting the Fed to sidestep the rule temporarily in an emergency.
Fed Chair Janet Yellen declined to adopt a rule. Despite the evidence that the Fed’s forecasts, which guide its policy, are often wide off the mark and that discretionary policy based on forecasts has a poorer record than rule-like policy, the Fed refuses to limit discretion. Congress must use its Constitutional authority to require the Fed to adopt and follow a rule. Recently, about 25 economists—including Nobel laureates and former Federal Reserve policymakers and senior staff—signed a statement urging Congress to adopt the proposed rule.
Federal Reserve regulatory policy has been even harder to improve. The very big banks use their influence and contributions to persuade key members of Congress to prevent legislation from coming to a vote. Laws like the Dodd-Frank Act of 2009 and government regulation favor the largest banks, so they have grown in size and influence while smaller banks have closed. From 2007 to early 2015, the number of commercial banks declined from more than 8,000 to about 5,000. Many of the banks that disappeared serviced small and mid-sized companies as well as newly started companies. Lending was local, so reputation and character played a large role.
Because the largest banks were considered too-big-to-fail (TBTF), they were less risky than others. They could borrow at lower rates than their large competitors that were not TBTF. The competitors sold out to the TBTF banks, so these giant banks have become bigger. They now make more than 50 percent of all loans.
Regulation has discouraged competition. U.S. banking has become like the banking cartels abroad. A principal cause of the mistaken policy is the Dodd-Frank law giving bank regulators, especially the Federal Reserve, responsibility for insuring bank safety. The Fed issues rules that are very costly to follow. The largest banks hire people to do what is required. Small and medium-sized banks cannot afford the cost, so they close. The low interest rate policy after 2008 added to the difficulty of profitable lending.
A far better way of protecting banking safety against risky lending and unforeseen events restores the bankers’ responsibility. It strengthens the bankers’ incentives to behave prudently. Instead of commanding actions that regulators choose, regulators should require the very largest banks to hold much higher equity capital reserves. Then, loan losses are borne by the banks’ shareholders, not the public, bankers have an incentive to lend prudently, and principal stockholders and directors monitor bank management. I helped to write a bipartisan bill co-authored by Senators Brown (D-Ohio) and Vitter (R-Louisiana) that requires the very largest banks to hold 15 percent equity capital. The bill remains in a Senate committee. The big banks prefer regulation to equity capital requirements that would end TBTF, so they lobby against reform.
But until Congress changes how banking is regulated in this country, we should expect more economic turmoil and stagnant growth. Rules for monetary policy and regulation will improve future policy and help to restore economic stability