Inner Workings of the Fed

0:00Our next speaker is Dr. Peter Klein. Peter, why don't you come up here?

0:09Peter is a professor of economics at, excuse me, teaches economics at the University of Missouri, also taught at the University of Georgia, teaches in Copenhagen, the author or the editor of five books. But I want to mention one new thing about Peter and make an announcement that he's going to be joining the Institute in the Institute as our Executive Director. I'm looking forward to having him come to Auburn. I'll just tell a couple of stories. I remember this was in 1988 when Peter was leaving Chapel Hill and going to get his PhD at Berkeley and wrote to the Institute for some help. And I read his letter and Judy Thomason is our publications editor, ," he reminded me the other day of just how a gog I was when I saw this letter and I immediately called Murray Rothbard and I said, Murray, I've just gotten the most extraordinary letter from a student I've ever seen and may I fax it to you and if you agree with me, would you

1:08talk to Peter? So Murray was very excited, he did indeed talk to Peter and Peter was very close to Murray, to the late Bert Blomert, who was our chairman at that time and I could Tell many other stories about Pete Otis, mentioned one other, as a postdoc you spent a year internship with Bill Clinton's Council of Economic Advisors. So about four or five months after he finished his year in Washington, I get a visit from a local FBI agent. He's wanting to check out Peter's bonafides and see if he's a security risk because he's going to have this internship. Thank you so much, Lew. Thanks to all of you for being here. It's been my privilege and honor to be associated with the Mises Institute for many years since my graduate school days and I'm delighted for the opportunity to join the staff and to continue to work with all My remarks today on the inner workings of the Fed are based on testimony that I gave

2:28in May of this year to the Domestic Monetary Policy and Technology Subcommittee of the House Financial Services Committee. That's the subcommittee, of course, headed by Ron Paul. It was a very interesting day to spend with the congressmen on the committee. There are a number of distinguished panelists, including Professor Jeff Herbner, who's a professor at Grove City College and also a senior fellow of the Mises Institute, John Taylor, a very famous monetary theorist from Stanford University, some of you have heard of the so-called Taylor Rule for monetary policy associated with Professor Taylor, Alice Rivlin, who's a long-time Brookings Institute scholar, former Vice Chair of the Board of Governors of the Federal Reserve System, somewhat less sympathetic to the views that Professor Herbiner and I purported.

3:18And the fifth member of the expert panel was the liberal polemicist James Galbraith, son of the well-known polemicist John Kenneth Galbraith. So you can imagine that a variety of views were presented on this panel on the nature of the Federal Reserve System. System, and possible improvements to the Fed and to the institution of central banking more generally. Now, as you know, under Representative Paul's leadership, the House Financial Services Committee and this subcommittee in particular has been somewhat more aggressive in addressing fundamental issues of monetary theory and policy than had been the case before. So a number of distinguished scholars have testified before that committee, including Professor Salerno on an earlier occasion. Professor Herbner was with me as well, both discussing some of the technical details of monetary theory and policy. And so when I appeared before the committee, I thought rather than repeat what my fellow previous and one of my fellow panelists was saying, I would focus on a slightly different aspect of the Federal Reserve system and central banking more generally, not only how it works in theory, and what

4:33What actions the Fed has recently taken and the harm that these actions have done to the economy. But a little bit about how the Fed operates in practice. The Fed, of course, is an institution filled with staffers from the chairman on down. It's like all other human institutions. It has its foibles and its quirks and its peculiarities. So what is it that the Fed actually does? How does the Fed actually work? Or from the perspective of organization theory, management theory, the principles of organizational governance, how is the Fed operated, how is the Fed organized, how is it managed, how is it governed, what are its objectives, what are the formal objectives, what are its informal de facto objectives, how is it structured, what kinds of incentives do people working How are they evaluated, monitored, governed, disciplined?

5:32Do they face any competition? Do they have any external check and balance? Well, of course, you know the answers to most of these questions already. The Federal Reserve, like other central banks, is an economic planning agency. Central banks are government, or what they call quasi-government entities, with a legal Legal Monopoly on Monetary Policy, in some cases Fiscal Policy, de facto, working hand in hand with the fiscal authority, the Treasury and the U.S. case. Many countries, the Fed also has a legal monopoly on bank regulation. These organizations are headed by political appointees and usually staffed with civil servants, technocrats from prestigious universities like Princeton, I'm sorry Steve to bring that up again.

6:20They are nominally independent of the political process, so imagine that you have an agency, an organization with vast discretionary authority, headed by smart and ambitious people with almost zero oversight, governance, no checks and balances. What would you expect an organization like that to do, to be very conservative, keeping is intervening its activities very limited, intervening only when absolutely necessary, performing up to the task exactly as mandated. Of course you wouldn't expect that at all, right? Even well-intentioned, well-educated, nominally competent individuals placed in a situation like that would have the temptation, the ability to engage in whatever kinds of interventions they desired.

7:21And of course, that's exactly what we've seen throughout the history of central banking, particularly the Federal Reserve system in the United States. I mean, if nothing else, the Fed, under Chairman Bernanke's leadership, has been particularly innovative. Now, when we talk about, you know, in the private sector, we have a big Apple store just a block or so down the street on 5th. We like it when Apple is innovative, right? We like it when research organizations like the Mises Institute are innovative. Do we want government entities with their vast authority and without any external check to be innovative? Well, I mean, I think that question sort of answers itself if you think about monetary policy in particular.

8:06So remember that organization like the Fed, what are the things that the Fed is authorized to do, that the Fed is tasked, tasks that the Fed has to perform? Well, the Fed controls the monetary base, sets the discount rate, sets reserve requirements, acts as a lender of last resort, regulates bank lending and other bank activities. And in the United States since the 1980s, you have the so-called dual mandate, where the Fed is charged with maintaining stable prices and maintaining full employment. Now these are of course impossible tasks for any central planning agency to perform, and they're certainly tasks that we would not want a central planning agency even to attempt.

8:57But remember that the way the mandate has been interpreted and the way these tasks have been enumerated is in a way that de facto gives the Federal Reserve system the authority to do almost anything that it wants. So when you look at the Fed's balance sheet, David Stockman talked about the sheer magnitude of the Fed's balance sheet, but also if you look at the composition of the balance sheet, The Fed, by custom, until Chairman Bernanke, invested exclusively in U.S. Treasury bills, and there's language in the Federal Reserve Act requiring the Fed to invest in these particular safe, quote-unquote, assets. But there's an emergency escape clause. There's a clause in the legislation that allows the Fed to own other assets under extreme In extreme emergencies, under special circumstances, the Fed may trade in other kinds of securities.

9:55Well, of course, that's a loophole wide enough to drive a Manhattan-sized city bus through. So of course, the Fed has taken advantage of this loophole to invest in the so-called toxic assets and to purchase any kind of securities that it wants. So essentially, Bernanke can intervene in financial markets in any way that he wants, in any way that he wants. Now I needn't belabor this audience with details of the financial crisis. The green span Bernanke credit bubble, the relaxation of underwriting standards that Walter Block already discussed, TARP and the bailouts and so on, the injection of trillions of dollars into the US economy by Chairman Bernanke and, of course, his predecessor, Zero Interest Rates and so on. You know, quantitative easing now, quantitative easing tomorrow, quantitative easing forever, as David Stockman reminded us. And of course the effect of virtually every action the Fed has taken since 2008 has been to perpetuate exactly those structural imbalances that constitute the financial crisis and the recession to begin with. Of course

11:10First, what the Fed has done is precisely the opposite of what the Austrian School economists would prescribe for such an emergency. When malinvestments are revealed, the most effective course, the course that is best for the economy in the short to medium run and certainly in the long run, is to liquidate these malinvestments, to free up these resources and get them reallocated to higher valued uses as quickly as possible. And of course every action taken by the Fed, of course the US Treasury and other agencies since 2008 has been to perpetuate the malinvestments, to make sure that the structural imbalances remain as long as possible indeed forever. But I don't want to talk to you now about these specific policy moves because most of you are familiar with them and they have been addressed and will be addressed by other speakers too.

12:01Really what I want to talk about is sort of the Fed as a central planning agency more more generally, right? Now most economists, most decent economists, understand that central planning is not an effective way of organizing the economic system. So whether they be from the Chicago school or sort of modern technocrats trained at MIT, all but a few, you know, hardened socialist economists understand that markets are better ways of allocating resources than government planners. But for some reason, with the exception of the Austrian School, most economists believe that money and the monetary system constitute exceptions to this general principle.

12:47They argue that for the monetary system, for money and for the banking system, it's essential to have a single decision-making body with vast discretionary authority, with no competition, of course for its own services, limited oversight, effectively no oversight whatsoever to what this planning agency will do, almost unlimited authority within its sphere, and that this agency should be run by an apolitical, sorry, an elite core of apolitical technocrats, like you know, distinguished professors from Princeton University, and of course Ben Bernanke was a very distinguished mainstream monetary scholar before his appointment at the Federal Reserve System. Now, of course, to an Austrian economist, this is a recipe for disaster. This is a recipe for disaster. Everything that we know about economic planning, about centralized economic planning, tells us that planners, if they have the wrong theoretical model in mind, they lack the information to be effective within their assigned sphere, they have no No incentives to make decisions that are in the interest of the economy as a whole, there's

14:02no market test for their services, no matter how well-intentioned a central planner may be. And I'm not claiming that our current monetary central planners are well-intentioned, but even if they were, such a setup cannot possibly be an effective way of allocating resources in an economy. If anything, if the collapse of central planning in the Soviet Union and the Eastern Bloc and Communist China has taught us anything, it's the lessons of Mises and Hayek and Rothbard have been vindicated by history. I was speaking to one of our participants here during the break, what can we do? Is there a way that we could demonstrate to our fellow citizens and to policymakers the and the Superiority of Free Markets Over Central Planning with a small colony or with some enterprise zone kind of experiment, well, I mean, I think that would be terrific.

15:00But anyone who cannot see already that central planning has failed in every instance that it's been tried will not be convinced by any experiment that we've performed tomorrow. The lessons of history are glaringly obvious and, of course, we have the theories of Mises and his followers to explain to us exactly why central planning does not work. For some reason, people think that money, economists, many economists think that money and the monetary system is an exception to this rule. Now, those who favor central banking, some of those who favor central banking, of course, have been critical of specific moves by this chairman or that chairman. There's a lot of debate in the technical literature and the policy literature about things like so-called inflation targeting versus nominal income targeting.

15:50My old professor and Obama advisor, Christina Romer, is a proponent of nominal income targeting by the Fed instead of inflation targeting. Should the Fed's dual mandate be repealed with the Fed tasked only with maintaining stable prices and not responsible for full employment? These are nibbling around the edges. These are trivial issues relative to the central issue of whether we should have the Federal and the Federal Reserve System at all. Walter Block mentioned Milton Friedman's fixed money growth rule. So Friedman, of course, thought that the government should control money, that we should have fiat paper money, but the government should be restricted in its ability to print money effectively.

16:37The fiat government money supply should grow at a fixed rate, 3% per year, 2.5% per year. Professor Taylor has come up with a version of this argument where instead of a fixed rate there should be a formula, a mathematical formula that is public and transparent according to, you know, you take the employment rate and some other macroeconomic aggregates and you plug them into a formula and that tells you how fast the money supply should increase. The point of these sorts of reforms is to constrain the ability of the Fed to intervene actively in the economy. The debate is usually framed about rules versus discretion, that discretionary monetary policy creates uncertainties, it gives the Fed the authority to intervene in ways that are harmful.

17:31Why not tie the Fed's hands by asking it to abide by fixed rules? Well, if you like fixed rules, I have one that's even better than a legislative, statutory-mandated growth rate of a fiat currency. And that's to have commodity money, right, such as the gold standard, to take the monetary system completely out of the hands of central planners, right? It's like Doug French's example with the nuclear power plant, you know, you don't build the nuclear power plant and then try to constrain the actions of the nuclear power plant's operators. Well, don't do this and don't do this, we're going to give you a policies and procedures manual to try to make sure you don't, you know, blow us all to kingdom come. Well, a better solution if you're worried about that is not to build the plant in the first place.

18:19You don't get a bomb ready and then tell people, please don't set it off, right? It's better not to have the bomb in place at all. If you like fixed rules over discretion in the conduct of monetary policy, well, why Why not have a monetary system that is completely outside political and technocratic interference whatsoever? And that's exactly what proponents of the gold standard would favor, and that's why it's favored. What about guys like the chairman, right? I mean, I don't know Ben Bernanke personally. For all I know, he is well-intentioned. He certainly has the technical training that give you all the plaudits in the academy. The problem is not Ben himself. Let me give you an example. Back in 2008 when the Troubled Assets Relief Program, or the TARP, was being discussed, there were to their credit a number of economists, mainstream economists and Austrian economists, who were critical of the TARP.

19:15They said that, well, maybe bailing out these failing financial institutions is not exactly setting up the right system of incentives, we're worried about moral hazard and so on. It's a very interesting essay written by Greg Mankiw, who was a former chair of George W. Bush's Council of Economic Advisors, a very well-respected economist, professor at Harvard, and a pretty good economist on most microeconomic issues. Ben Bernanke had the following to say about the economists who were critical of the TARP. A group of economists had circulated an open letter critical of the chairman, saying that the TARP didn't sound like a good idea. Here's what Greg Mankiw said, I know Ben Bernanke well.

20:00Ben is at least as smart as any of the economists who signed that letter or are complaining on editorial pages about the proposed policy. Moreover Ben is better informed than the critics. The Fed staff includes some of the best policy economists around. In his capacity as Fed chair, Ben understands the situation. If I were a member of Congress, Mankiw goes on, I would sit down with Ben privately to get his candid view. If he thinks the bailout is the right thing to do, I would put my qualms aside and follow his advice. So, you know, just imagine Representative Paul going into Bernanke's office and saying, Ben, what should we do? I, you know, I put my qualms aside and go with you, Ben. I mean, this is, you know, it almost boggles the mind that any thoughtful person would think this is the right way to handle economy-wide central planning.

21:00You make sure the guy in charge is smart and has a good staff. You ask him what he thinks we should do and that's what we do, okay? There was a paper by another, by the economist Lawrence Ball recently, an NBER working paper, all about the psychology of the chairman, the psychology of Bernanke. Ball was trying to understand why some policies pursued by the Bernanke Fed are a little different from what Bernanke espoused as a Princeton professor. Why hasn't he done the things that he said the Fed should do when he was writing as an academic? The ball's proposed explanation is that Bernanke is kind of shy and withdrawn in meetings and he lets others dominate the discussion and he sort of fell victim to group think at some of the meetings of the open market committee and so on.

21:52I mean, look, why on earth would you want a monetary system? Why would you want a system in which the most important markets in the economy, the financial markets are subject, you know, their control and manipulation is subject to the personality of one guy. Right? I mean, we want a monetary system where we could care less what Bernanke's personality is, right? He's stuck in his office at Princeton teaching and he can be shy or aggressive and nobody cares. Putting that much authority in the hands of one guy where the outcome depends on his personality, I mean, that's not an economic system that I You know, I discussed in my testimony some of the controversy over the so-called independence of the Fed. A lot of economists have said, well, Ron Paul's push to audit the Fed and calls to make the Fed more transparent are problematic because then you'll have Congress in charge of monetary policy, and that's worse than having Ben Bernanke in charge of monetary policy.

22:54I mean, I'm not so sure, of course, what the defenders of independence mean by independence is lack of any external constraint. And of course, I certainly do not want the average congressman deciding the value of my money. But asking sort of an elite core of technocrats to decide the value of my money is not much of an improvement in my view. Again, as I What we want is a monetary system in which the value of my money is independent both of the whim of Congress and the whim of the technocrats. Now, as an intermediate step, my view is that the bill to audit the Fed or moves to make the Fed more transparent would certainly be substantial improvements.

23:42The fear of congressional interference is highly overblown, I think, relative to the value that would come from opening up the secret books and finding out what the Fed is actually doing. The popular outrage could likely be enough to constrain the Fed in ways that it is not constrained now. You know, the whole idea of the Fed as a lender of last resort is, of course, another problem with government monetary systems that have that kind of policy over their banking system. The theory of moral hazard, what economists call moral hazard, explains how all of us, when protected from any harmful consequences of our actions, will take different actions than we otherwise would. We'll be less cautious, more reckless. We won't think through the and the potential consequences of our decisions if the consequences fall on somebody else.

24:37I discussed in my testimony the improvements that would follow from eliminating the Fed's role as the lender of last resort which prompted the statement from Dr. Rivlin that a banking system without a lender of last resort would be bizarre. So she thought this was a bizarre The usual argument that you hear is that, well, unlike other kinds of businesses, banks and financial institutions are closely linked to each other through derivatives and other kinds of complex financial transactions, and the failure of one bank could bring down the and the entire system. To which I would point out, in a complex, modern economy, almost all industrial firms are closely linked to other industrial firms through complex networks of transactions, contracts, partnerships, alliances and so on. I mean, if you ask people, well, do you think that, say that the Nike Corporation is really in financial distress, if Nike were were to go bankrupt. Well, I mean, that could put some, that could pose a problem for some

25:55of Nike's suppliers, for some of Nike's customers, for other apparel manufacturers with whom Nike has contractual relations. But, you know, we don't think this would somehow bring down the entire shoe industry or bring down the retail clothing industry such that we need, A shoemaker of last resort to step in and supply the shoe liquidity that the market clearly needs. So in conclusion, if you design a government planning agency, even within not an economy-wide Planning Agency, but one that is tasked specifically with the conduct of monetary policy and bank regulation and so forth.

26:45You make this a government agency without any competition, immune from any sort of oversight, without any kind of external governance or constraint, and you give it effectively an unlimited mandate to manage the system as it sees fit. The results, predictably, will be the kind of catastrophe that we have seen in the last several years and we're seeing now and even more so with yesterday's announcement. The kind of monetary system that we do want is one in which the value of money, the characteristics of money, what goods and services constitute money, the form in which monetary exchange takes place, the monetary calculations of entrepreneurs, where all of these are independent not only of political interference, but independent of technocratic interference as well.

27:40So I say to Professor Bernanke, you know, thank you for your service. Please return to your office at Princeton University where you can, you know, espouse your doctrines to an audience of undergraduates rather than having your hand on the controls of the entire U.S. economy. Thank you very much.