Bhidé and Phelps: Central Banking Needs Rethinking. By Amar Bhidé and Edmund Phelps
The Fed's monetary policy is hazardous, its bank supervision ineffectual.
The Wall Street Journal, July 16, 2013, on page A15
http://online.wsj.com/article/SB10001424127887324879504578597721920923596.html
The Federal Reserve did well to supply liquidity after Lehman Brothers failed in September 2008 and the world was plunged into financial crisis. But since then the Fed's monetary policy has been increasingly hazardous and bank supervision by the Fed and other regulators dangerously ineffectual.
Monetary policy might focus on the manageable task of keeping expectations of inflation on an even keel—an idea of Mr. Phelps's in 1967 that was long influential. That would leave businesses and other players to determine the pace of recovery from a recession or of pullback from a boom.
Nevertheless, in late 2008 the Fed began its policy of "quantitative easing"—repeated purchases of billions in Treasury debt—aimed at speeding recovery. "QE2" followed in late 2010 and "QE3" in autumn 2012. Fed Chairman Ben Bernanke said in November 2010 that this unprecedented program of sustained monetary easing would lead to "higher stock prices" that "will boost consumer wealth and help increase confidence, which can also spur spending."
It is doubtful, though, that quantitative easing boosted either wealth or confidence. The late University of Chicago economist Lloyd Metzler argued persuasively years ago that a central-bank purchase, in putting the price level onto a higher path, soon lowers the real value of household wealth—by roughly the amount of the purchase, in his analysis. (People swap bonds for money, then inflation occurs, until the real value of money holdings is back to where it was.)
True, stock prices did rise in real terms in 2009-10. But surely that rebound in share prices from the panic of 2008 was mainly due to a stunning rise in after-tax corporate profits, much of it overseas. Stock markets did not begin their recent breakout until late 2012, by which time other factors were at work, such as Washington's heightened concern over continuing fiscal deficits on top of already high public debt and entitlements. Had Fed purchases raised stock prices to levels that caught the eye of business owners, the purchases might have prompted accelerated business investment, a powerful creator of jobs. But the rise was evidently too little and too late to hasten markedly the recovery.
Moreover, the Fed's quantitative easing appears not to have increased confidence and may have reduced it. No one—the Fed included—knows how much more it will buy or how much of its mountain of Treasurys will be sold back to the market. The Fed said it would end easing at serious signs of faster inflation. But as the housing bubble that preceded the financial crisis showed, imprudent speculation can be destructive without high inflation. Today we have banks, insurance companies and pension funds leveraging their assets and loading up on credit risks because prudence cannot provide acceptable returns.
The cost of this uncertainty can be considerable. An attendant foreboding may lie behind some of the depression in business investment—even if myopic traders in bonds and currencies are impervious to it and too-big-to-fail banks go on making one-way bets. Also, the time and money that businesses give to innovation and efficiency gains are squeezed if the businesses are distracted by the uncertainties surrounding monetary policy.
This ambiguity notwithstanding, President Obama commends Mr. Bernanke for "helping us recover much stronger than, for example, our European partners." Sure, the European Central Bank did not adopt quantitative easing. But the delay in Europe's recovery plausibly derives from the severity of its fiscal and banking problems and its structural disadvantages, such as inflexible labor markets and lack of institutions for early renegotiation of debts.
The Fed attributes persistent joblessness in the U.S. to a deficiency of aggregate demand, which the Fed blames on foreigners' thrift. But if the West's problem were simply that, it long ago would have increased its money supply to meet the increases demanded and would have invested in businesses at an increased pace to take advantage of the cheap credit.
Households have maintained their strong propensity to consume, persuaded that their retirement incomes will be topped up with entitlements. But consumer-goods production—giant machines needing only a guard and a dog, as some wag put it—is generally not labor-intensive enough to provide high employment at normal wages. A central bank's monetary policy, no matter how ambitious, cannot solve this structural problem.
What we do need from the Fed is reform of the ways banks are regulated and supervised. Tough, on-the-ground examination of individual banks not only helps keep them solvent, such scrutiny can also prevent out-of-control money growth without suppressing productive lending. Similarly, rules that discourage banks from relying on yield-chasing hot money will limit the runs and panics the Fed has to fight.
Unfortunately, over the past couple of decades, bank regulation, like the Fed's macro-interventions, has become more top-down and formulaic.
Until the 1980s, for instance, bank examiners would assess how large a capital buffer each bank should have, taking into account its specific risks instead of relying on internationally standardized ratios.
Dysfunctional rules have also sustained the growth of monolithic megabanks that have little interest in traditional productive lending.
Unsurprisingly, the Fed's aggressive monetary easing has helped large companies already flush with cash issue bonds at low rates, while small businesses have struggled to secure working-capital loans.
In a modern economy some areas of top-down control are likely to be unavoidable. But that does not mean we should settle for institutions that are less participatory or accountable. It is not desirable that seven people on the Federal Open Market Committee have the power to intervene on a massive scale based on theories that may or may not be right and do not reflect a popular consensus.
America has a constitutional takings clause, as well as checks and balances on the state's power of eminent domain. Such matters as tax laws and budgets are subject to votes rather than being left to "experts." These arrangements are as much about legitimacy and consent of the governed as they are about economic efficiency.
Congress passed the Federal Reserve Act in 1913 mainly to forestall and contain panics, discourage speculation and improve the supervision of banks, not to steer the economy. Indeed, the Federal Reserve System was set up as 12 more-or-less independent reserve banks to assuage concerns about centralized control and capture by financial interests.
Restoring the modest foundational aims and diffused governance of the Fed would be good for our economy and good for our democracy.
Mr. Bhidé, a professor at Tufts University's Fletcher School, is the author of "A Call for Judgment: Sensible Finance for a Dynamic Economy" (Oxford, 2010). Mr. Phelps, the 2006 Nobel laureate in economics and director of Columbia University's Center on Capitalism and Society, is the author of "Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge and Change," forthcoming from Princeton University Press.
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