Journal Issue

Book notes Will the Fed stay in good hands?

International Monetary Fund. External Relations Dept.
Published Date:
March 2005
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The successful performance of the U.S. Federal Reserve—the Fed—over the past 25 years owes much to Paul Volcker and Alan Greenspan, the two men who have headed the institution over this period. Will Greenspan’s eventual successor be able to follow in their footsteps? According to three new books, the Fed’s strong track record and institutional changes in recent years will do much to ensure that the Fed remains effective.

If the Federal Reserve had “retired” in 1978 at the age of 65, its career would have been considered fair-to-middling at best. The Fed is almost universally blamed for worsening, if not causing, the Great Depression of the early 1930s by applying the brakes when it should have been stepping on the accelerator. Then, just as things were finally beginning to improve, the Fed nearly brought the economy crashing down again by doubling reserve requirements in 1936—37. Much later, in the 1970s, the Fed again made a serious misstep when it failed to keep U.S. inflation in check.

That the Fed now enjoys a solid reputation despite these failures is due in large part to Volcker’s conquest of inflation in the early 1980s. The personal qualities of the man who whipped inflation are the focus of New York Times columnist Joseph Treaster’s book, Paul Volcker: The Making of a Financial Legend,.

Whipping inflation

Treaster notes that finding the right person to tame inflation was a tough task. David Rockefeller had already turned down the job, later commenting that “I would have been responsible for implementing a set of draconian policies to wring inflation . . . . As a wealthy Republican with a well-known name, and a banker to boot, it would have been extremely difficult for me to make the case for tight monetary policy and sell it to a skeptical Congress and an angry public.”

Volcker, a Democrat, was considerably less vulnerable on those counts, and his personal austerity, already well-known, made it unlikely that he could be charged with leading the good life while inflicting pain on others. Volcker, says Treaster, took delight in cheap cigars and bargain suits. On his first day as president of the Federal Reserve Bank of New York, the unusually tall Volcker found his legs would not fit under the elegant mahogany desk his predecessors had used. His solution? Have carpenters fit blocks to the base of the desk. He also had the New York Fed’s official limousine replaced with a sedan.

As Chair of the Fed, Volcker continued to live “more like a graduate student than a prince of power and influence,” writes Treaster. He lived in a one-bedroom apartment on F Street amid university students, watched the news on a 10-inch black-and-white television set, and lugged his dirty laundry in a suitcase to his daughter’s home to run it through her washing machine.

Volcker also raised interest rates to record levels and kept them there until he had vanquished inflation. By the summer of 1982, he was able to note in a speech that “the forces are there that would push the economy toward recovery . . . . I would think that the policy objective should be to sustain that recovery.” It took Alan Greenspan, then in the private sector, to translate into plain English Volcker’s characterization of the Fed’s decision: “They have eased,” said Greenspan, who went on to replace Volcker in 1987.

You can stand the truth!

Alan Blinder in The Quiet Revolution: Central Banking Goes Modern says that having Greenspan succeed Volcker “at the helm is a bit like the New York Yankees’ good fortune in being able to replace Joe DiMaggio with Mickey Mantle in center-field. You cannot expect to do that consistently.” Nevertheless, Blinder, a professor at Princeton University who served as Vice Chair of the Fed in the mid-1990s, offers three reasons why the institutional changes over which Volcker and Greenspan have presided will ensure that the Fed stays on a sound course.

The first is the revolution in how much central banks tell the public. It used to be that central bankers thought it best to keep their thinking secret and issue only guarded statements about their actions. Blinder notes that “as late as 1993—hardly the Middle Ages—the Federal Reserve did not even disclose its monetary policy decisions at the time they were made. Instead of an official announcement, markets were forced to guess what the FOMC [Federal Open Market Committee] had decided—which gave professional Fed-watchers a clear advantage over amateurs.” Indeed, Blinder relates that when he became Vice Chair in June 1994, the Fed’s press officer explained the rules of engagement to him, including an admonition that “we don’t talk about the economy.”

Only a decade later, the consensus is that it is better for central bankers to be open with the press and the public. Making the central bank more transparent improves the quality of monetary policy, says Blinder. The central bank knows that it has to provide “the legislature and the people a full and honest accounting of what it is up to and why.” This forces central bankers to think harder about their actions and take better and more coherent policy actions.

Though all in favor of this trend, Blinder cautions that “transparency can and should stop short of voyeurism.” He is thus against the immediate release of the verbatim transcripts of FOMC meetings, which at present are provided after five years. Immediate release will, he cautions, “limit frankness and everyday banter, prevent people from taking ‘devil’s advocate’ positions, and otherwise stifle debate.”

Who’s the boss?

The second institutional change is that, despite the dominance of Volcker and Greenspan, monetary policy at the Fed and at other central banks is increasingly being made by committee. Blinder says that Greenspan leads the FOMC “with a velvet glove, not an iron fist.”

There are several advantages of having monetary policy decided by committee. By reflecting the consensus view of several individuals, the committee is less likely to be volatile in its opinions or to adopt extreme positions. Also, pooling knowledge is useful when there is uncertainty about the state of the economy or the effect of monetary policy decisions on the economy.

The third change for the better is that “central banks, which used to pride themselves on lording it over the markets, have been showing them increasing deference in recent years.” Blinder says this is a healthy development because “market prices succinctly summarize the collective wisdom of a vast number of people with diverse beliefs and access to different information. To believe that you can outwit the markets on a regular basis requires an extreme hubris that few, if any, modern central bankers have.”

Trading places

These institutional changes have occurred amid a broad movement toward granting central banks their “independence”—that is, freedom from political interference. This allows not just the chair but all the members of the monetary policy board to do their jobs based on technical assessments of the economic situation, not on the likely political fallout. It’s a point that Laurence Meyer emphasizes in A Term at the Fed: An Insider’s View. Writing about his stint on the FOMC, Meyer terms the Fed “a safe harbor, a place consciously constructed to keep us away from the political winds. So you won’t see much of politics in this book.”

Indeed, such politics as Meyer does describe is of the “trading places” variety: members of the FOMC who might have been tagged “doves” based on their political leanings ended up urging tighter monetary policy than those who have been thought of as “hawks” With U.S. growth unusually strong in the mid-1990s, a difference of opinion emerged among the FOMC on the likely cause of this exceptional growth performance and therefore the appropriate policy response.

Greenspan, a Republican appointee, was of the opinion that the strong growth was due to productivity increases in the economy and was thus unlikely to trigger inflation. Democratic appointees such as Meyer pinned their faith on a traditional relationship between demand-driven growth and rising inflation, and they urged an increase in interest rates to choke off the incipient inflation. Greenspan was able to steer the FOMC toward his view, and Meyer graciously concedes that Greenspan “turned out to be right. His call on the productivity acceleration was truly a great one.”

Speculating about who will succeed Alan Greenspan is a fun parlor game, but it’s unlikely his successor would or could turn back the clock on such changes as bipartisanship, clear communication with the public, and the deference shown to fellow FOMC members and the markets. The reforms seem to be here to stay, and the Fed looks likely to remain a strong and effective institution.

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