Fortunately, President Warren Harding pursued tax and spending cuts that promoted an extraordinary recovery. Confidence in the Fed recovered too. According to Adolph C. Miller, an original Fed governor, people came to believe the Fed could tame “the terrors of the business cycle.”
But it seemed there were problems with the way the Fed was set up. Economic historian Allan Meltzer reported that “many of the principals responsible for policy were weak men,” adding that “lines of authority between the individual reserve banks and the Board were unclear, hence a source of periodic frictions and disputes.”
From the beginning, there were conflicting views about what the Fed should do. Benjamin Strong insisted that maintaining a stable price level was a top priority. He also used Fed policy to help restore the gold standard in Europe.
But by the late 1920s, most Fed officials believed their job was to support lending for businesses. Meltzer observed that “the Federal Reserve failed to achieve either its domestic or its international goals.”
In 1928, the Fed intended to curb the stock market boom, in part because lending for financial transactions — such as stock speculation — wasn’t considered to be the Fed’s responsibility. When it became apparent that the Fed had overplayed its hand and ushered in the Great Depression, Fed officials didn’t consider that to be their concern.
In 1935, President Roosevelt signed the Banking Act, which transferred more decision-making authority from regional Federal Reserve banks to the Federal Reserve Board. The assumption was that centralizing power would enable officials to enforce good policies faster.
Unfortunately, the law couldn’t guarantee that there were good policies. In July 1936 and January 1937, the Board drastically raised the percentage of bank capital that had to be held as reserves and couldn’t be loaned out. By suddenly making it harder for employers to obtain capital, the Fed unwittingly played a major role triggering the depression-within-a-depression of 1937–1938.
More than a half-century later, in 2002, Ben Bernanke, then a Fed governor, acknowledged the Fed’s role in these calamities: “We did it. We’re very sorry. We won’t do it again.”
As the years went by, Congress asked the Fed to perform more and more functions: maintaining high employment, economic growth, price stability, interest-rate stability, financial market stability and exchange-rate stability. Often policies intended to fulfill one objective conflicted with other objectives. Multiple objectives made the Fed’s policies more unpredictable, since private sector employers didn’t know which objective might be a top priority — and for how long.
It was especially difficult to anticipate what the Fed might do, because apparently officials couldn’t agree on rules to guide their policies. Meltzer reported that one Fed governor “received hundreds of pages of material, but none explained how the Federal Reserve made decisions. There was no written record and no agreement among the participants.”
Fed officials generally have focused on short-term events affecting unemployment, consumer prices, stock prices or the dollar — though the Fed can do little about these things, because its policies take a while to play out through our large, complex economy. William McChesney Martin, Fed chairman from 1951 to 1970, was preoccupied with short-term events, and he was unable to control long-term developments such as inflation.
Sometimes Fed officials made bad decisions because they used analytical methods that turned out to be wrong. For instance, President Kennedy’s Council of Economic Advisors introduced the “Phillips Curve” to guide policy recommendations, and it was adopted by the Fed. This analytical tool predicted that higher inflation would reduce unemployment. But both inflation and unemployment went up!
The Fed has made serious mistakes because of political pressures. In 1971, President Nixon was worried that unemployment might derail his efforts to win re-election the following year, and he began pressuring Fed Chairman Arthur Burns to help him. Burns was caught on tape pleading with Nixon: “I have done everything in my power to help you as president, your reputation and standing in American life and history … . No one has tried harder to help you.”
Burns gunned the money supply, and what became known as the Great Inflation gathered momentum.
The very success of a Fed policy can have terrible unintended consequences. Fed Chairman Alan Greenspan became known as the “maestro” who mysteriously interpreted statistics in his bathtub. He was credited with maintaining a remarkably stable economy for more than a decade.
Whenever there was a crisis, he promoted easy money. He did this after the 1987 stock crash, the Gulf War, the Mexican peso crisis, the Asian currency crises and the failure of a large hedge fund. Many people came to believe the Fed would always step in to minimize downside risk, and therefore they could be high rollers. So Greenspan’s policy was a factor responsible for the dizzy dot-com bubble and crash.
Determined to make sure the economy had recovered from that, Greenspan made money available at bargain rates, providing powerful incentives for people to load up on debt, much of which was spent on housing. The Fed’s inability to recognize the developing bubble offers a reminder that officials didn’t have a crystal ball and were unable to anticipate consequences of their policies.
As late as May 17, 2007, Chairman Bernanke said: “We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”
Intended to save our economy, the Fed has turned out to be perhaps the biggest single source of economic instability. It’s the big pig at the trough, and it’s unpredictable. It doesn’t follow any rules consistently. When it moves, everyone else can be badly knocked around.
The very unpredictability of the Fed causes uncertainty that discourages investors and employers from making commitments for the future — an important reason why we’re experiencing a sluggish, jobless recovery now.
Theoretically, the Fed might be able to work if there were perfect people, but there don’t seem to be any of those around. After almost a century of the Fed’s often violent roller-coaster rides, it’s hard to see what might be accomplished with one more bit of tinkering such as with interest-rate targets.
It’s time to begin planning for an orderly dissolution of the Fed before it does us any more harm.
