Monetary Mayhem: the Consequence of Discretion

Photograph by Kevin Dietsch / Getty

The President of the United States is not the most powerful man in America. The leaders of the House and Senate, whose whips may set the leviathan Federal government barreling in whichever direction they please, do not top the rank. The nine Justices of the Supreme Court, a half dozen of whom can permanently alter the very meaning of the Constitution, are far from the most commanding figures in Washington. Rather, the true heart of American power lies not on Capitol Hill, but two miles westward, nestled between the Vietnam War Memorial and a Dunkin’ Donuts. 

The Federal Reserve is the single most consequential institution in American history and its leaders, Chairman Jerome Powell and the eleven other members of the Federal Open Market Committee (FOMC), are the most influential figures in the global economy. Established in 1913, the Federal Reserve is tasked with controlling the quantity of money for the United States. This deceptively simple role gives the Fed unspeakable power over the American economy and, given the dollar’s dominance in global markets, over the whole world. Its decision to grow or shrink the amount of currency can make or break entire nations. If it should err too far in one direction unemployment rises, investments fall, and businesses collapse; move too far in the other and inflation spikes as imports crumble and defaults mount. 

Given the central bank’s immense power, it has naturally been organized as a highly technocratic body, placed far above the grubby mitts of mere politicians. Half of FOMC hold PhDs, with the remainder having decades of experience in business and finance. The Washington office alone counts over 400 PhD economists on its payroll. But even this wealth of expertise has not freed the Federal Reserve from error. 

Throughout its history the Fed has repeatedly made egregious mistakes with catastrophic human consequences. The institution's dual mandate from Congress – to maintain low unemployment and low inflation – allows a great deal of discretion on the part of policymakers. Far too often this results in one half of the mandate being ignored, often in favor of trying to overcorrect for the bank’s most recent mistakes. The 26% increase in the total quantity of money since January 2020 and the resultant return of inflation can be seen as little more than an attempt to rectify long standing criticisms that the Fed was far too hawkish following the Financial Crisis and allowed unemployment to remain high well into the 2010s.  

If the Federal Reserve hopes to maintain its dignity as a monetary authority, Congress must institute a new mandate that constrains the bank’s abilities, forcing it to adhere to a predictable, rules-based order. 

Goldbugs Need Not Apply 

Criticism of the Federal Reserve is almost always followed by suggestions that America should abolish the institution and return to a ‘gold standard’ – a system where the supply of money was limited by the supply of gold. This false binary masks the reality that the central bank had existed within a gold standard for most of its life, but this fact is often omitted either out of malice or, more likely, genuine ignorance on behalf of most adherents. But supporters of metallic money are correct in their assessment that the abandonment of the gold standard has led to a rapidly depreciating dollar. 

The cost of living in the early 20th century was remarkably similar to that of the 18th century. A time traveler could easily hop into his machine and buy the same basket of goods in agrarian colonial America and industrial interwar America for comparable prices. This fixation on the long run, however, cloaks the extreme volatility of the system. 

It is not true that America had little to no inflation under the gold standard. Prices would frequently rise by 5 to 35% in one year only to fall further the next. Under commodity regimes, increases in the demand for money wrought on by rising incomes quickly run up against the fixed money supply. This raises the purchasing power of gold relative to goods, otherwise known as deflation. In the short term consumers enjoy higher standards of living, but businesses soon close in the wake of falling real revenues. A wave of unemployment reigns, incomes begin to fall, prices once more rise, and the cycle begins anew. Far from an anchor of stability, the gold standard created an environment where people could not be certain that the country in three years time would be in the grips of hyperinflation or grinding depression. 

The reason to maintain the Federal Reserve at all is disappointedly consequentialist. Through its ability to increase the quantity of money during periods of uncertainty – that mechanism gold advocates explicitly wish to destroy – the bank can lessen both the frequency and severity of economic downturns. The half century prior to the Great Depression was marked by 15 separate depressions and a cumulative 283 months of sub-potential output. In contrast, the 52 years following the Nixon Shock were scarred by a mere seven depressions for just 59 months. 

By increasing the quantity of money when times get tough, the Fed can dramatically lessen human suffering. Goldbugs not only lack a meaningful alternative to achieve this end, they aggressively argue monetary stimulus makes downturns worse. When historic data unequivocally rejects this thesis, they rail against the validity of econometrics and mathematical modeling more broadly. It is for this reason their ilk have been routed from every last respectable university economics department. The Federal Reserve system is not heaven-sent, but the dogmatists who push for its abolition are pure ideologues posing as economists. 

NGDP, Easy As One, Two, Three

This is not to excuse the many failures of the Fed, whose memory extends only far as its most recent round of public shaming. Despite being assigned by Congress to be the lender of last resort, the institution from which distressed banks may receive short-term loans, the Federal Reserve allowed 4,000 banks to become insolvent during the Great Depression, a third of the national total. The credit crunch felled the money supply by 30%, depressing activity even further and leading to a staggering 25% unemployment rate. 

After allowing an otherwise mundane financial panic to fester into the largest economic decline in human history, America’s central bank spent the bulk of the post-war period trying to compensate for past negligence. Whenever the mere suggestion of recession loomed, the Fed soon dusted off its printing press. But the cure-all was not to last, after thirty years of repeated stimulus the rate of inflation soon topped 13%, only brought down through a painful Fed-induced recession. The doves now discredited, the Fed marched into the new millennium with hawks at the helm, determined to never allow high inflation to once again rear its ugly head. While successful in this goal for nearly three decades, this miserly monetarism had the side effect of worsening the trauma of the 2008 financial crisis. Inflation remained under 2%, but the pre-crash unemployment low of 4.4% was not seen again until August 2017.

The current dual mandate permits the bank to follow whichever mode of macroeconomic management is in vogue. Rapid fluctuations between prodigality and austerity is no way to manage personal finances, let alone the largest economy on Earth. If America hopes to be any more than a victim of the whims of financial fashionistas, Congress must shackle the Fed to focus on one just target – nominal GDP. 

Nominal gross domestic product (NGDP) is a measure of national income that counts both changes in real income as well as changes in the overall price level. If a nation increases its production of goods and services by 2% while inflation clocks in at 1%, then the nominal GDP growth for that year would be 3%. Conversely, if real GDP falls by 2% and inflation climbs to 5%, then NGDP would still have grown by 3%. 

By requiring the Federal Reserve to target a set rate of NGDP growth, the bank would retain the necessary ammunition to combat downturns while fettering its capacity to overshoot. If the rate of growth in real incomes were to taper or fall, the Federal Reserve would respond by growing the quantity of money by a predetermined and widely anticipated amount. If prices rise too quickly, the bank would react by destroying money by a preplanned total. Technological progress, geopolitical strife, and shifts in consumer sentiment would all leave their mark on what is produced and where, but through it all NGDP would remain constant. Rather than relying upon the best judgements of a fallible committee, monetary policy would be conducted by a long series of mathematical formulas. 

Such a reform would provide a degree of long term stability not offered by the present inflation-unemployment hybrid system. Businesses and individuals alike want to know what the future entails and, in lieu of trustworthy psychics, look to governments for guidance. But existing arrangements offer no guarantee of what’s to come. It could be that in twenty years the FOMC will be staffed by the greatest minds in a generation, capable of wisely determining the best course of action. Or it could just as likely be staffed by heterodox loons who consult tea leaves. Depersonalizing the foremost technocratic institution will decouple its policy decisions from the personal competencies and value judgements of those who pull its levers. Investors would know exactly what decisions would be made in what time frame given defined conditions. 

Criticisms of NGDP targeting are not without merit, though they vary widely in quality. An instinctual critique among some is likening it to communist central planning, which did target real GDP. The difference between the two is not mere semantics: real GDP targets focused on how much was produced, while nominal GDP targets emphasize the value of dollars. The decision to set a dollar’s worth equal to one-thirty trillionth of RGDP is no less arbitrary than setting the dollar to one-twentieth an ounce of gold, a favorite of such types. A far more thoughtful appraisal would highlight the practical difficulties of NGDP targeting. The impact of any macroeconomic policy decision comes with a delay, and this lag in data could result in over- or undershooting the target. This problem could be ameliorated through the creation of an NGDP futures market where buyers could ‘bet’ on the actual NGDP growth for the year and the Fed could adjust its behavior until futures prices matched the target.  

An institution as powerful as the Federal Reserve requires an inhuman degree of competence to function well. In spite of the abundance of economic experts in its halls, it far too frequently allows itself to become blind to its own mandate at incalculable human expense. To prevent a repeat of past catastrophes, the Federal Reserve must be fundamentally reformed in order to save it from itself.