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He’s Got the Whole World in His Hands

Inflation, Unemployment, and Monetary Policy

by Robert M. Solow, by John B. Taylor. The Alvin Hansen Symposium on Public Policy, edited and with an introduction by Benjamin M. Friedman
MIT Press, 120 pp., $12.00 (paper)

1.

There are essentially three perspectives on the current state of America’s continually expanding economy and the dilemmas it poses for policymakers.1 The first, the so-called “new era” view, holds that the spread of computers, the Internet, and other forms of information technology have increased productivity so much that we no longer have to worry about inflation, limits to economic growth, or the business cycle. As more goods are produced per hour of work, spending by consumers and producers will increase but it will not outstrip rising economic productive capacity; prices will remain steady or rise gradually. While this argument surely overstates the case, there is little question that the recent acceleration in productivity has helped keep inflation in check, and that, as Federal Reserve chairman Alan Greenspan believes, it “owes importantly to new information technologies.”2

The second, more traditional view claims that there are well-established limits to how low unemployment can fall, or how fast the economy can grow, without triggering ever-accelerating inflation. These limits are thought to be unemployment rates of 5 to 6 percent, or growth rates of about 3 percent, and we have exceeded them by a large margin. As shown in the chart on page 36, the unemployment rate is just over 4 percent, the lowest it has been since 1970, and the economy has been growing at approximately 4 percent a year since 1996, about a third faster than its average from 1991 to 1998, yet inflation has fallen to less than 2 percent a year. Most conventional economists and other experts who still maintain this position believe that inflation has been kept in check only by special factors such as the Asian financial crisis, falling commodity prices, and the lack of pressure for higher wages for workers, but that these forces are weakening, and the Federal Reserve should act to slow the economy before it is too late.3

The third perspective, articulated most forcefully by Robert Solow in Inflation, Unemployment, and Monetary Policy, admits that there are limits to growth and unemployment, but holds that we don’t know what they are. In his view the harm to the economy caused by restricting growth prematurely through higher interest rates is very great, and that caused by a rise in inflation relatively modest. Solow therefore believes that the Fed should not act to restrain inflation until it becomes a visible problem. Fortunately, Greenspan has basically followed a flexible, pragmatic course close to the one Solow recommends.

Greenspan’s power as head of the Federal Reserve—the Fed—is immense, but the institution he heads is not well understood. The Federal Reserve System is the central bank of the United States. It is essentially a bank both for other banks and for the federal government, with responsibilities to maintain the smooth functioning of the financial system and, through its monetary policies, to promote price stability and economic growth. The financial panic of 1907, in which J.P. Morgan performed many of these functions, underscored the need for such an institution.4 The Fed was established in 1913, nine months after his death, and has hardly changed in eighty-five years. The system consists of the Board of Governors in Washington, D.C., and twelve regional Federal Reserve Banks located in major cities around the country. The seven governors are chosen by the president to serve staggered fourteen-year terms and have to be confirmed by the Senate. The chairman and vice chairman of the Board are also chosen by the president and confirmed by the Senate, for terms of four years. Of all these, only the chairman has become a nationally known figure.

The system resembles a corporation in which the regional reserve banks are the operating subsidiaries. The chairman can be seen as a CEO who dominates the Board of Governors. The board sets broad policy and oversees the operations of the regional banks. Those regional banks carry out the system’s day-to-day activities, such as clearing checks and wiring funds among banks, supervising member banks, and acting as banker for the federal government. When the government wants to raise money to finance its spending, the reserve banks hold auctions of Treasury bonds and other securities and credit the Treasury’s checking account. Almost all of our currency consists of Federal Reserve notes—note the caption above the picture on any bill—which are issued by the reserve banks but must be backed by Treasury and other federal government securities. The Fed earns more than $20 billion a year from the interest it receives on its portfolio of government securities and the fees it charges for its services; after covering its expenses, it remits its profits to the Treasury.5

In addition to these routine tasks, the Federal Reserve is responsible for conducting monetary policy, that is, for adjusting the supply of money and credit in order to keep the economy growing rapidly, but without inflation. The goals of monetary policy, “maximum employment” and “stable prices,” were established by Congress but are sufficiently vague that the Fed has considerable leeway in interpreting them. Because it is free to operate without interference from elected officials, the Fed is one of the few government institutions that can be relatively independent of politics. It helps that governors are appointed for very long terms—fourteen years—and that the Fed finances itself and does not depend on congressional appropriations. On the other hand, the Fed’s chairman and vice chairman are appointed for only four years, and while their terms do not coincide with the president’s, some chairmen such as Nixon’s appointee Arthur Burns clearly seemed concerned to help the administration politically.6

Inflation “hawks,” such as the editors of The Economist, want the Fed to reduce even the threat of inflation, with less regard for the unemployment this may produce. Others, such as ex-chairman Paul Volcker, think the Fed should aim for “reasonable price stability,” which he defines as “a situation in which ordinary people do not feel they have to take expectations of price increases into account in making their investment plans or running their lives.” Still others, such as populist critics of the Fed like William Greider, “new era” advocates, and the Wall Street Journal‘s editors, would have the Fed concentrate on reducing unemployment and stimulating growth, and pay much less attention to inflation.

These differences over monetary policy cut across traditional political lines. Greenspan was in his youth a member of Ayn Rand’s inner circle, a proponent of the gold standard, a director of domestic policy research for Richard Nixon’s 1968 presidential campaign, and chairman of the Council of Economic Advisers under Gerald Ford.7 Still, he has been relatively “dovish” on inflation, willing to accept the risk that full employment will not necessarily cause a dangerous rise in prices; so far he has been proven right. Clinton’s recent appointee Laurence Meyer, on the other hand, is one of the Fed’s most hawkish members, together with conservative economists William Poole and Jerry Jordan, presidents, respectively, of the Federal Reserve Banks of St. Louis and Cleveland; from all reports they believe interest rates should be substantially raised before inflation actually picks up.

No matter how these policy differences are resolved, the Fed almost always conducts monetary policy through “open market operations,” that is, by buying or selling in the open market US government securities such as short-term Treasury bills, intermediate-term notes, or long-term bonds. When it buys these securities, as it did last fall when the global financial crisis threatened the American economy, money flows into the banking system and interest rates fall; when it sells them, money flows out of circulation and into the Fed’s coffers, and interest rates rise. On June 29 and again on August 24, the Fed issued orders to its trading desk at the Federal Reserve Bank of New York to sell just enough government securities so that interest rates would rise by a quarter of a percent. These actions by the Fed reversed two thirds of the rate reductions it enacted last fall to calm the financial markets.8

The Fed is highly respected now because the economy has done relatively well for almost two decades, particularly when compared to the 1970s, and because monetary policy was instrumental in getting it back on track. As shown in the accompanying chart,

Chart

particularly difficult problems with inflation began to develop in the mid-1960s when spending for the Vietnam War increased markedly but few measures were taken to slow down the rest of the economy. (Fearful of the political repercussions of higher interest rates or tax increases, Lyndon Johnson simply asserted that we could have both “guns” and “butter.”) From less than 2 percent a year in 1965, the rate of inflation rose to almost 6 percent in 1970, and then more than doubled to over 12 percent in 1980, stimulated in part by the sudden decision of the OPEC cartel to raise oil prices in 1973 and 1979.

The unemployment rate also doubled during the 1970s, rising to about 8 percent in 1980. This was contrary to our experience in the 1950s and 1960s, when inflation rose at the same time that unemployment fell, largely because increased spending strained the economy’s capacity to produce and kept up the demand for workers. Unemployment peaked at more than 10 percent in late 1982, at the end of the most severe recession since the Great Depression. By then, inflation had receded below 4 percent, where it stayed for most of the 1980s, even as the unemployment rate dropped to less than 6 percent. Since the relatively mild recession of 1990-1991, inflation has fallen to less than 2 percent and unemployment to just over 4 percent.

Paul Volcker became chairman of the Fed in August 1979 and was largely responsible for the turnaround in the economy and, as a consequence, the high reputation of the Federal Reserve. Its two preceding chairmen, G. William Miller and, before him, Arthur Burns, did little to contain the buildup of inflation during the 1970s. Miller was appointed by Jimmy Carter in early 1978 and served only eighteen months before Volcker replaced him. Miller had little experience in making economic policy and was burdened by the problems he had inherited from Burns. Before Richard Nixon appointed him chairman in 1970, Burns had been a professor of economics (and mentor to Alan Greenspan in the 1950s) at Columbia University, president of the National Bureau of Economic Research, and a highly regarded student of the business cycle. He had also served as an economic adviser to President Eisenhower. According to William Greider’s Secrets of the Temple, Burns did not try hard enough to reduce inflation because he was playing politics. First he collaborated with “the economic pump priming that helped Richard Nixon win a landslide victory in 1972,” and then he tried to ingratiate himself with Carter in the hope that he would be reappointed in 1978.9

  1. 1

    The economy has been growing since December 1982 except for a mild recession that lasted only three quarters of a year, from June 1990 until March 1991. The expansion that began in April 1991 is our longest peacetime expansion. If it lasts until February 2000 it will be the longest we have ever had.

  2. 2

    New era” claims have arisen in prosperous times throughout the last century. See Martin S. Fridson, It Was a Very Good Year: Extraordinary Moments in Stock Market History (Wiley, 1998). For a skeptical view about whether the spurt in productivity growth over the last three years to approximately 2 percent a year, roughly double its average from 1973 to 1995, can be sustained, see Jeff Madrick’s recent article in these pages, “How New Is the New Economy?” The New York Review, September 23, 1999.

  3. 3

    Most economic expansions since World War II have ended in essentially this way: spending by businesses, consumers, and the government eventually outstripped the economy’s capacity to produce, generating, in turn, inflation, restrictive monetary policy, and recession.

  4. 4

    See Jean Strouse, Morgan, American Financier (Random House, 1999), Chapter 28.

  5. 5

    See The Federal Reserve System: Purposes and Functions, Board of Governors of the Federal Reserve System, Washington, D.C., 1994, especially Chapters 1 and 7.

  6. 6

    Alan Blinder points out that the rationale for Federal Reserve independence—the fact that making monetary policy requires specific skills and experience, and that the costs of fighting inflation are felt before the benefits and thus would be unpalatable to most politicians—applies as well to other government functions such as setting tax policy. See Central Banking in Theory and Practice, pp. 54-59, and “Is Government Too Political?” Foreign Affairs, November/December 1997, pp. 115-126.

  7. 7

    See Steven K. Beckner, Back from the Brink: The Greenspan Years (Wiley, 1998), pp. 11-14, and David B. Scalia and Jeffrey L. Cruikshank, The Greenspan Effect: Words That Move the World’s Markets (McGraw-Hill, forthcoming in November 1999), pp. 3-7.

  8. 8

    The Fed’s open market operations are geared to the “federal funds rate,” the interest rate on overnight loans among banks, which it can control. Changes in the federal funds rate affect other interest rates such as mortgage rates but the Fed’s control over these other rates is not nearly as direct. The Fed has two other tools of monetary policy but they are far less important than open market operations. It rarely changes “reserve requirements,” the fraction of their deposits that banks, savings and loans, and credit unions must hold in reserve against potential withdrawals, because it is such a blunt instrument. On the other hand, changes in the “discount rate,” the interest rate that banks pay when they borrow reserves from a regional reserve bank, do not have much impact and are used only to complement open market operations. The discount rate is largely symbolic because most banks borrow reserves from other banks in the federal funds market.

  9. 9

    Greider, Secrets of the Temple (Simon and Schuster, 1989), pp. 66-67.

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