The record of economists, including those at the Federal Reserve, over the past half century has been discouraging. The two greatest blunders are well-known: policies that fed double-digit inflation in the 1970s, reaching a peak of 13.5 percent in 1980; and the more recent failure to prevent the 2008-09 financial crisis and Great Recession, sending unemployment to 10 percent.
Unfortunately, there are many other lapses. Economists generally have been unable to predict the onset of recessions. Since at least the 1970s, they have routinely missed turning points in productivity, for better or worse (“productivity” is economist-jargon for “efficiency”). More recently, they’ve been surprised by the plunge in long-term interest rates and by a lengthy stretch of low inflation.
The dirty secret of economics is how much economists don’t know. Their ignorance is increasingly relevant, because there is growing agitation among economists to stage a grand debate over the role of monetary policy – how the Fed influences interest rates, credit conditions and the money supply.
“Fed Is Urged to Rewrite Its Playbook,” headlined a recent New York Times story. It explained: “[A] growing number of experts, including some Federal Reserve officials, say it is time for the Fed to consider a new approach to managing the economy.”
What would that be? One proposal would have the Fed create 4 percent inflation, roughly double the present rate, by pumping more money into the economy. This approach, the argument goes, would stimulate spending and give the Fed greater latitude to cut interest rates in case of recession (higher inflation generally leads to higher interest rates).
It’s an awful idea. The purported advantages are mostly academic; they make for good scholarly discussions but are of dubious value in the real world. The truth is that economists hardly have a clue what the short- and long-term consequences of raising inflation to 4 percent would be. Indeed, they don’t even know whether they could hit that target. Markets might keep inflation lower; or an overzealous Fed might unleash so much money that inflation spurts higher.
Proposals like these constitute busy-work for economists. They can write research papers, organize conferences and, of course, implement new policies. Luckily, not all economists have drunk the Kool-Aid. “The Fed is not going to adopt a 4 percent inflation target,” former Fed Chairman Ben Bernanke recently told a conference. “It’s just not going to happen.”
Since World War II, the Fed’s finest hours have involved undoing its own mistakes. Under Paul Volcker, the Fed crushed double-digit inflation in the early 1980s. A quarter century of solid economic growth followed, overseen by Alan Greenspan. Bernanke’s quick response to the financial crisis (along with Treasury Secretaries Hank Paulson and Timothy Geithner) arguably averted a second Great Depression. This, obviously, is a big deal. In the 1930s, unemployment peaked at 25 percent.
No one denies that the Fed’s goals are ambitious and not always compatible. By law, it’s supposed to pursue “stable prices” and “maximum employment” – terms undefined by Congress. (The Fed has defined price stability as 2 percent inflation; maximum employment is reckoned as an unemployment rate of about 4.6 percent.)
In addition, as Harvard economist Martin Feldstein argued recently in the Wall Street Journal, the financial crisis emphasized the importance of preventing crashes in financial markets: those for stocks, bonds and other instruments.
“The combination of overpriced real estate and equities [stocks] has left the financial sector fragile and has put the entire economy at risk,” Feldstein wrote. If prices crashed, they could weaken confidence, slow spending and cause a recession, he warned. The contradictions are clear. Low interest rates may boost job creation, but they may also fuel financial speculation.
Perhaps some brilliant economist will devise a theory that reconciles all the Fed’s potentially contradictory goals. But it hasn’t happened yet, and we should resist the seductive notion that there’s some superior system that, as the Times’ story put it, would constitute “a new approach to managing the economy.”
The Fed is not omnipotent. The best it can do under the present state of knowledge is to muddle along, selecting its priorities and embracing new policies (low interest rates, bond purchases) that respond to what seems the most urgent need of the moment. This is essentially what the Fed has been doing for the last decade, and for all its shortcomings, it has contained inflation and worked reasonably well.
What we should fear is some over-ambitious economic program that promises to make us better off but does the opposite.
Robert J. Samuelson is a columnist for the Washington Post Writers Group.
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