Allan Meltzer on the Fed, Money, and Gold
May 19 2008

Allan Meltzer of Carnegie Mellon University talks with EconTalk host Russ Roberts about what the Fed really does and the political pressures facing the Chair of the Fed. He describes and analyzes some fascinating episodes in U.S. monetary history, discusses the advantages and disadvantages of the gold standard and ends the conversation with some insights into recent Fed moves to intervene with investment banks. This is a wonderful introduction to the political economy of the money supply and central banks.

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Gene Epstein, Barron's economics editor, talks to EconTalk host Russ Roberts about the virtues of the gold standard relative to fiat money. Epstein argues that privately issued money, backed by gold, would lead to an economy with much greater price...
John Taylor on Rules, Discretion, and First Principles
John Taylor of Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about his new book, First Principles: Five Keys to Restoring America's Prosperity. Taylor argues that when economic policy adhere to the right basic principles such as keeping rules...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Ben Smith
May 19 2008 at 9:59am

Usually I am very impressed with the quality of discussion on Econ Talk. This podcast, however, fails to meet my expectations. Meltzer shows a rigidity of thought and inflexibilty in applying models to practical situations. He seems to blindly adhere to economic models regardless of unrealistic assumptions; often leading to contradictory conclusions. Also, he often makes claims without qualifying them with data or evidence.

Think Twice
May 19 2008 at 8:34pm

This is one of the best econ talk I have listened to. Few understand monetary policy; it is such a mistry even to professionally trained economists. Meltzer gets it. Not only Meltzer understands monetary policy, he knows how Fed would behave, and future consequences of the Fed’s decisions today and yesterday, as well as behavior of bankers. Meltzer is the expert among economists. I am eager to read his new book. I wish there will be more econ talks like this.

Adam Ruth
May 20 2008 at 3:34pm

I would like to hear an interview with Nathan Lewis, the author of “Gold: The Once and Future Money” which has a very different take on monetary policy and the gold standard. He makes some very compelling arguments in favour of the importance of price stability and low taxes.

Mark Koyama
May 20 2008 at 5:38pm

I thought this was excellent. Meltzer is extremely insightful. I also appreciated his historical perspective. It is rare to find an economist who combines insight with historical wisdom.

Pedro P Romero
May 20 2008 at 7:45pm

Meltzer is one of the best on Monetary Theory. I just thought that an additional question was in order: ‘what does he think about Hayek’s proposition ’bout the denationalization of money?’ a theoretical answer would have suffice.
Also, this talk points out the rich source that the history of monetary institutions can provide for public choice – rent seeking behavior.

May 21 2008 at 3:14am

In the podcast it is mentioned that the rising US government deficit is responsible for the recent devaluation of the US dollar relative to foreign currencies.

I do not understand this relationship. Could someone explain?

Is this because investment in US government bonds is becoming less attractive for foreigners as our increasing indebtedness means that our ability to repay becomes more suspect, and the subsequent reduction in demand reduces foreigners demand for US dollars. So exchange rates adjust to the new relative demand for dollars and foreign currencies?

It seems like there would be a potential for a vicious circle of dollar depreciation here, with the falling dollar making future investments less attractive to foreigners, and then causing further depreciation from reduced investment interest.

Pedro P Romero
May 21 2008 at 11:58am

Gerard there is partial answer to your own question in your 2nd paragraph. But what I understood was that when the fiscal deficit is financed by issuing debt that is bought with foreign saving, this will work until US inflation is relatively low and interest rates are competitive. If foreigners perceive dollar inflation and low interest rates they would sell their dollar-denominated assets reinforcing the inflation and depreciation of the dollar.
The discussion about the difference between a deficit financed either by a tax rebate or an increase in money supply is great. Meltzer answer is based on the ricardian equivalence. His analysis of the money balances is purely wicksellian too.

May 21 2008 at 12:21pm

What a treat to listen to a monetary economist like Meltzer for an hour.

As Meltzer says, when an individual’s cash balance is increased, they can choose to buy not only goods but also make investments. This drives prices of goods and or investments up. We may have not seen huge changes in goods prices since the 70s, but we have seen investment price changes. Just look at stock markets, and more recently real estate.

Russ, when you say that the Fed’s performance over the last 30 years is superior to before, I think you are mainly thinking about the Fed’s effects on goods prices and not assets prices. Over the last 30 years we have seen plenty of Fed-influenced asset bubbles, including the most recent real estate craze. Sorry, but I don’t think the Fed has gotten any better at not influencing the economy in a detrimental manner.

Now that you’ve had a few monetarists (Cowen and Metlzer), any chance we can hear you talk to a free banker, say Larry White?

Scott Anderson
May 21 2008 at 2:33pm

I very much enjoyed this podcast. I would like to ask a question regarding the tax rebate discussion. I must say that I am biased to fewer taxes as long as there is less government spending and I am biased towards a permanent reduction in taxes so that more money is in the hands of the private sector rather than the public sector because I believe the private sector is always more efficient and effective at prividing what the public wants.

Now the question. If a temporary tax cut is distributed to the tax payers and if the tax payer’s barrowing rate is higher than the government’s, isn’t there a net benefit to the public in that they are swaping personal rates on debt for government rates on debt?

This is not a statement but a genuine question.

David Johnson
May 21 2008 at 3:37pm

I too was disappointed. It seemed like I was listening to a warmed-over Keynesian apologizing for the Fed. Does no one see the problems inherent in a money monopoly beholden to political whim?

I would like to hear a reasoned discussion of the monetary supply from a market, not government, perspective. What about a commodity standard? Free banking? Alternatives to the Fed? Competive currencies? Etc, etc.

Pedro P Romero
May 21 2008 at 3:41pm

Scott, in intertemporal terms and keeping government expenditures constant, taxpayers have to pay higher taxes in the future to pay the debt. Therefore they will be saving in the present at the market rate (borrowing rate whatever). At the moment of the rebate the government increases its debt in detriment of the private sector aggregate debt. crowding out effect.

Scott Anderson
May 21 2008 at 7:31pm

Thank you for the answer but I am still a little confused in that a consumer may be barrowing at say 6% on their mortgage and 11% on their credit card but the government cuts them a check that displaces some of that debt and then barrows at say 3.9%.

To add to that, if there is a glut of saving and US treasuries are the beneiciary because it is the world’s reserve currency (in other words a better return for a given similar governement risk), it seems like there is a perverse incentive for the government to assume some protion of consumer debt to the benefit of the consumer (or their heirs). I don’t believe there is any free lunch, so I am grasping to find how that rate differential is made up in the market. Is it the value of the dollar?

Thank you agiain for responding.

Scott Anderson
May 22 2008 at 8:56am

The above question does have relavency (in my mind). If the fiscal policy can increase cash balances of individuals while lowering their rate of borrowing(it is like lowering the interest rate along the yield curve – open market operations) then it is creating monetary policy with the tax rebate. Interstingly, the Fed can create fiscal policy with Section 13(3) of the Federal Reserve Act of 1932. It can lend to “anybody against anything, as long as five governors declare the need for such lending” -Paul McCulley as it is currentlt doing with the Primary Dealer Credit Facility and with the bail out of Bears Sterns.

So a second question realted to the first. Who has the hand on the tiller of fiscal and monetary policy? Are the policies aligned and how is that policy controlled by the democratc process? Both the Federal Reserve and Congress can make monetary and fiscal policy, it seems, outside of the intent of the constitution??

These are questions not statements.

May 22 2008 at 4:03pm

I loved the pod cast but I wished that you had asked him about fractional reserve banking and if he thought that it could be ended. It seems to me that fractional reserve is the root of monetary fluctuation problems. Some have gone as far to call it fraudulent reserve banking suggest that it is based on immoral fraud and so can never work.

Also it seems to me that the assumption the gold standard would have continued to cause more variance in un-employment assumes that employers and employees would not learn that they these things are temporary and adjust.

Also a little more variance in un-employment might have a good side in that it might teach people to save more.

BTW Russ if you read this I would like to hear you interview Richard Vedder, Bryan Caplan and/or John Taylor Gatto about school.

May 22 2008 at 5:10pm

Hi, Floccina.

Your question about fractional reserve banking was quite astonishing:

It seems to me that fractional reserve is the root of monetary fluctuation problems. Some have gone as far to call it fraudulent reserve banking suggest that it is based on immoral fraud and so can never work.

I’m wide-eyed. You surely don’t mean that you think banks should hold 100% of a depositor’s cash as reserves? I think you’ve been led down a long pike. If banks hold 100% of deposits as reserves, they cannot lend. They become nothing more than steel mattresses. Are you saying that a bank that lends your money is defrauding you? I don’t think you want to say that!

Requiring banks to hold 100% reserves would most definitely not end monetary fluctuations. The money supply itself fluctuates having nothing to do with what banks do. Requiring 100% reserves would not end the printing of money by whatever authority is authorized to print it. Historically, monetary fluctuations long preceded the modern banking industry.

When a bank receives cash from a depositor, it has two basic choices. It can hold the entire deposit–100% reserves–or it can lend some of it out. The fraction it doesn’t lend out–say 3%–is its reserve expressed as a percentage of its total deposits–its “fractional reserve.”

If it holds 100% in reserve it would be like a depositor putting his cash under his mattress. The only additional value to a depositor from putting his cash in a bank might be that the bank has a steel reinforced vault. For that benefit, a depositor would ordinarily pay a bank.

But banks have evolved historically from mere strongholds stockpiling 100% of their depositors’ cash deposits into what we call financial intermediaries. That is, banks and their depositors know that their deposits are mostly sitting around and could be put to better use. Banks know that their primary role is to match bond buyers–depositors–with bond sellers–borrowers. We describe that by saying that banks intermediate between depositors and borrowers.

Every bank knows that its customers want a balance between the activities of holding something in reserve lest the depositor want some cash back immediately and doing some lending, rewarding the depositor with a cut of the proceeds. Consequently banks don’t lend every cent they receive in deposits. Some days the depositor may want to show up at the teller window with no notice and get back some cash. Other days the depositor may want to be in the pool of lenders, benefiting from the interest paid by the borrowers.

Modern governments often require banks to hold a fractional reserve percentage that approximates the amount banks would hold of their own accord. That is, if a bank would typically hold back 3% of its deposits and only lend the rest, a government might actually legislate a reserve requirement of 3%. (Ironically, that cash can’t then be used in a crisis to pay out depositors who show up and ask for cash against their deposits. Particularly in a bank run, the bank can’t actually use those reserves to pay those standing in line begging for cash because the government legislated that they hold it back in reserve!)

Are you arguing that business cycles would not happen if modern bank intermediation didn’t exist? There might remotely be an argument along those lines based on some readings of historical evidence. I doubt that it’s the case. It’s conceivable that the existence of banks can cause a lag or delay or magnification of a business cycle once the cycle is set in motion. But neither banks nor bank lending of deposits are the cause of underlying monetary instability. And the cost of prohibiting banks from lending the way they have evolved naturally would be exorbitant. We’d have to forego banks as we know them and return to hiding our cash under our mattresses or paying banks to provide us with their vaults. For that privilege we’d pay through the nose and still experience the monetary fluctuations imposed by the monetary authority.

More likely, the existence of banks and fractional reserve lending has smoothed real fluctuations that would otherwise have beset the modern economy, fluctuations from which we’ve escaped without ever realizing what the technology of modern banking brought us.

Ethnic Austrian
May 22 2008 at 6:50pm

Every bank knows that its customers want a balance between the activities of holding something in reserve lest the depositor want some cash back immediately and doing some lending, rewarding the depositor with a cut of the proceeds.

The concept of fractional reserve banking doesn’t appear to be widely understood by customers. A lot of doomsday cultists capitalise on that and “expose” the fractional reserve system, claiming that it is some kind of immoral fraud. And a lot of people actually feel betrayed. Just watch the popular Money As Debt video as an example.

Maybe banks should be required to make the system more transparent. They could give customers options of different types of accounts with different fractional leverage and coresponding interest rates.

Modern governments often require banks to hold a fractional reserve percentage that approximates the amount banks would hold of their own accord. That is, if a bank would typically hold back 3% of its deposits and only lend the rest, a government might actually legislate a reserve requirement of 3%. (Ironically, that cash can’t then be used in a crisis to pay out depositors who show up and ask for cash against their deposits. Particularly in a bank run, the bank can’t actually use those reserves to pay those standing in line begging for cash because the government legislated that they hold it back in reserve!)

The purpose of the 3% requirement is in place to stop banks from arbitrarily inflating the money supply. Nobody prevents the banks from keeping more deposits than required to avoid the bad press of bank runs.

[Link fixed. Thanks, Ethnic Austrian. The video “Money As Debt” illustrates various misunderstandings, quoting modern economists out of context, confusing the money supply itself with bank processes that result only as secondary followups, and characterizing those bank processes as deceptive by leading a viewer through an imaginary story of a creative but deceptive Middle Age banker and treating that as the norm. The video has it right when it says that “Money, most of us believe, is created by the government” and when it then says “It’s true.” Everything after that is misleading, interweaving facts with peculiar fantasy. The video was not created by an economist or anyone with any training in economics, but by an artist, Paul Grignon. On Grignon’s website,, he notes that he created it at the request of Canadian lobbyist group United Financial Consumers, –Econlib Ed.]

May 23 2008 at 7:13am


I enjoyed your work as always. I like others was surprized when you guest argued that there was a material difference between a $100 check and the mail and a rebate check of $100. I agree with both sides above Meltzer is an expert on Fed banking, but he also has a Keysian point of view. Would it be surprizing to find out that Russ Roberts had a libertarian point of view? It is only in the clash of view points that we learn to improve our ideas.

Russ, I would add another physical analogy to your consistent question about interest rate setting vs. money supply. I would argue the it is like looking at particles in space vs. phase space (Newtonian Dynamics, Ralph Baierlein, 1983, PP51-54). The space of the particle is discribe by its location. The speed can be derived from the spacial information by differentiation. In phase space only 1 spacial dimension and the speed are provided. There by the conversely from the spacial frame, the location particle can be derived from integrating the velocity in conjuntion with know single dimension.

The point being that both completely discribe the location, it is that different insights can be gained from different perspectives.

Back to the economics people talk about interest rate because that is what they understand and see and deal with every day. The Fed is affecting money supply for the purpose of creating stable risk (interest rates). And while indeed the Fed has control over 1 small aspect, the Fed is trying to hedge the market to try to keep it stable.

I would argue that you can see that the Fed hedges by the fact that when risks go up, the Fed ussually goes down. And just as other hedge investments, this only works when there is underlying strength in the economy to create more value than the prevailing market wisdom.

Ron Hardin
May 24 2008 at 8:27am

The Fed does not know or care about the money supply, only about whether it’s too big or too small.

One trick is to think of money in a way that makes it obvious that money is not wealth in the aggregrate. Namely that dollars are a ticket in line to say what the US economy does next, namely something for you. It obviously looks like wealth to one person but obviously is not wealth to the nation as a whole, which is the correct viewpoint.

The Fed regulates the number of tickets so that their number matches what the economy is capable of doing at once. If there are too few tickets, the economy chokes off, doing less than it could. If there are too many tickets, the economy is overwhelmed and starts raising prices. In the middle is just right – full busy economy but no inflation.

The way the Fed increases the number of tickets, when it thinks there are too few, is to buy back governemt debt. The way it decreases the number of tickets is to sell government debt.

The government debt route provides a way to change the number of circulating tickets without being heavy-handed as to where the increase or decrease is concentrated in the economy. It’s the broadest possible intervention.

That in turn prevents making unnecessary waves when the Fed intervenes.

That in turn makes possible leading indicators of inflation that are orthogonal to the intervention – the Fed does not blind itself when it intervenes.

The interest rate the Fed makes decisions about is an output from the economy. The more debt the Fed buys back, the lower that interest rate is. But the more choked off the economy is for tickets, the higher that rate is. So if the Fed decides, based on leading indicators of inflation, that we need more tickets, it simply lowers the target for that interest rate, and buys back government debt until the economy puts that interest rate at the Fed’s target.

It serves as a smooth aiming point for a month so that the Fed can try out the new policy, sensitive to the economy and changing with it.

The recent Fed alternate intervention with Bear Sterns has the interesting side-effect of leaving the Fed blinded to inflation by its own intervention, and it will have to grope for a while until the waves settle down to find out the effect.

May 24 2008 at 9:22am


Thank you for your ticket analogy. I thought it was very well done.


May 25 2008 at 12:05am

Russ, very interesting podcast. As an undergrad, and now as a grad student, I have enjoyed Meltzer’s work and respected his opinions. If you have the chance to speak with him again, could you please ask about how the use of “core” inflation values versus headline inflation has affected monetary policy? Mostly I’m curious about whether he thinks this is a positive development. Thank you.

May 25 2008 at 7:57am

Ethnic Austrian said, among other excellent observations:

Maybe banks should be required to make the system more transparent. They could give customers options of different types of accounts with different fractional leverage and coresponding interest rates.

Transparency is always the ideal. I couldn’t be more with you here. But why should a government create legislation to require it when it is offered already? Is transparency only a U.S. option that is already in place?

In my town in the United States and I believe all over the U.S., banks have been very transparent along these lines since the early 1980s. The information is already available. If I want more information than I can find on their website, I do have to take the initiative to ask some questions.

When I ask my bank for more details, say about their ordinary reserves or about the interest rates they offer on a given day, how they calculate those reserves or interest rates I receive as a customer, and what else I might need to know, my bank manager has always been immediately forthcoming.

One service I get from my local bank is that the manager immediately knows the answers. That’s a service I probably pay for in lower interest rates.

The purpose of the 3% requirement is in place to stop banks from arbitrarily inflating the money supply. Nobody prevents the banks from keeping more deposits than required to avoid the bad press of bank runs.

You are right that banks commonly hold more than the required reserves. They usually do it as a service to their customers.

All a bank customer has to do is ask his bank what their policy is.

Every requirement that the Fed is asked to set–e.g., standards for all banks–risks requiring that small local banks that are responsive to their customers spend their limited resources to instead conform to the extreme national or international standards of major national or international banks. I know that if my small local bank has to spend its resources conforming to international reporting standards, it’s going to cut back on the great service it offers me in answering my questions.

Before requiring bank compliance, why not require asking your banker? The compliance is likely already in place via competition.

May 25 2008 at 5:03pm

Most of the radicals who are against fractional reserve banking have a strong pessimistic bias but there may be a idea there worth consideration. Just because in the first world the fractional reserve system seems to be working reasonably well, does not mean that it cannot be improved on.

Presumably in a 100 percent reserve system the customers would have to pay for a demand deposit account and saving accounts would subject to fluctuations like a bond fund. This would solve the problem of bank failures contracting the money supply.

Here is another video that uses the word “fraudulent” is regard to fraction reserve banking.

Mickey Barnhill
May 26 2008 at 12:08am

I thought the interview was excellent, certainly among the best. A three hour discussion would easily have held my attention, and I would be very interested in a follow-up interview. Thank you for providing perhaps the most intellectually stimulating part of my day. It was a real treat.

May I also suggest a discussion regarding Markowitz and Sharpe’s Modern Portfolio Theory and Capital Asset Pricing Models (CAPM). I’m not an academic, but from my limited, research, it appears that Fama and French showed MPT to be invalid. It is safe to say that practically the entire investment industry has adopted MPT and CAPM; if the theory isn’t valid, couldn’t it have serious ramifications?

Ethnic Austrian
May 26 2008 at 5:16am

Maybe banks should be required to make the system more transparent. They could give customers options of different types of accounts with different fractional leverage and coresponding interest rates.

Transparency is always the ideal. I couldn’t be more with you here. But why should a government create legislation to require it when it is offered already? Is transparency only a U.S. option that is already in place?

The legislation exists already. The governement simply doesn’t enforce contracts which are misleading or incomprehensible and does award damages.
If Starbucks warns you that coffee is in fact hot, it might be a good idea for banks to explain that they don’t stash the cash, but instead lend it out to other people and that they may not even be able to pay you back in the worst case scenario.

May 26 2008 at 5:22pm

Ethnic Austrian with all bank accounts FDIC insured and with no one having lost money on a bank failure in the last 60 years what motivation would depositers have to use accounts with less risk, or to look for safer banks?

Paul Vreymans
May 28 2008 at 8:50am

I appreciated the deep monetary insights Prof. Allan Meltzein provides so convincingly in this podcasts. I’ll remember from his arguments that the FED’s monetary policy is the result of repetitive political pressure for low interest rates and short term consumption boosts and that the FED’s policy therefore lacks a reasonable balance between short term growth concerns and the long term price stability.

The FED’s thereby time after time took the side of the banking sector against the interests of the private business and the interests of the public at large. Why else has the FED turned a blind eye to the criminal banking practices of reselling worthless mortgages as triple-A paper? Why else has the FED exclusively used the interest instrument to control money supply and why did it never make use of the instrument of imposing a safe minimal reserve requirement?

To my opinion Russ’ criticism on the FED’s policies is much too friendly as the institution failed in all its key responsibilities. The FED failed to provide long term price stability by making the US$ losing 97% of its 1913 buying power. The loss of real buying power by America’s hard working middle class in spite of unmatched productivity gains is caused by the inflation the FED intentionally generates. The FED is also cheating the public with forged (m2) money supply figures, provides phony (core) inflation rates consequently making growth data fake. (see: Shadow Government Statistics – )

The FED failed to provide long term monetary stability and even brought the world’s economy at the verge of collapse in several financial crises, each time causing poverty to millions of innocent victims. Loose monetary policy was the direct cause of the LTCM debacle and the housing and internet bubbles or at least failed to avoid these crises and progressively let American debt inflate to an unserviceable level. Most recently the FED failed to discern the biggest speculative frenzy in history as well as the destructive power of new types of financial derivatives and their excessive leverage of 1 to 50 and therefore compromised the trustworthiness of the whole American Banking Sector.

I wished that Russ Roberts had been more severe in his condemnations and had taken advantage of this interview to raise the fundamental question about the effectiveness of the FED’s interest policy. In this podcast Russ gives the impression of still taking the Keynesian fallacies for granted that an increase of the money supply provides sustainable growth stimulus and that the FED can effectively manage the business cycle while there is plenty of scientific evidence that increasing the money supply only causes inflation and has no positive effect on real growth or wealth whatsoever:

1. Robert Lucas in his Nobel Prize speech demonstrated that the only significant effect of increasing the money supply is increasing inflation, which obviously slows down growth in the long run. So any attempt to boost growth through reducing interest rates is therefore counterproductive. ( see : )

2. More recently a comprehensive study of Prof. Chevallier (Univ. of Nice) covering 47 years of FED monetary policy (1960-2006), demonstrates that EMS (Excessive Money Supply = M3 in excess the growth rate of the real economy) even is INVERSELY related to real growth, providing empiric proof EMS can impossibly stimulate growth . (see this graph
and this graph

The fact is that increasing the money supply can only create a (very temporary) ILLUSION of wealth. This is even more so today than when Lucas investigated the matter in 1995 as increasing demand for consumer goods no longer benefits local American production but is going to Chinese and overseas manufacturers as Prof. Meltzein argues in this podcast. Increased demand consequently can no longer boost American employment nor the American Economy.

The fact is that artificially low interest rates ( which have in fact been negative for a almost a decade now) reduces saving and increases debt and future debt service charges resulting in poverty in the long run.

Allan Meltzer’s conclusion that a country that wont experience small recessions (which are dating even from biblical times) will end up having a big one is most pertinent and alarming. (min 00:19:50). The present credit crunch might very well bring a VERY big recession or even the second great depression and hopefully hasten the end of this unsustainable fiat monetary system before it causes more damage to our wealth.

Read more here :

Jun 16 2008 at 1:29am

I think the interviewee and interviewer should have started out with a basic introduction about the gold standard and how that would work (or worked in the past.) This would have helped me make more sense of the podcast as I am just a layman.

I also want to ask if 100% guarantee meant 100% reserves, i.e. banks would end up just being safety deposit boxes for gold essentially?

Alex Douglas
Jun 21 2008 at 6:57pm

We should be careful when calculating the damage done by recessions. If I’m not mistaken, money supply-induced recessions are accompanied by economic booms so that the net loss to the economy is simply a question of stability and perhaps only very minor growth losses.

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Podcast Episode Highlights
0:36Intro. Russ was taught as grad student in 1970s that the Federal Reserve (the "Fed") controls the money supply via open market operations; but what we hear of late is that they control interest rates. They control one interest rate, the Federal Funds rate--the rate at which banks sell their reserves to each other. Fed sets that interest rate so as to maintain reasonable levels of employment and prices. Is it a posted rate or do they use open market operations? In principle they could set it, but in practice they use open market operations to make it binding. Friedman podcast: they claim they are manipulating the interest rate but in actuality they are controlling the money supply. They think of themselves as controlling the interest rate and take daily open market operations to maintain the interest rate. In the 1970s they set for themselves a level of reserve growth that they wanted to maintain but they didn't do it. What's schizophrenic about this: taught that money supply is key component for inflation, but man on the street believes that it's the interest rate. If the economy is growing too quickly, the Fed raises interest rates; if the economy is growing too slowly, the Fed cuts interest rates to "stimulate the economy." That certainly is the way the Fed thinks about it, and man on the street accords with what they say they are doing. A better way to think about the problem is that the Fed puts out money, which changes the amount of real money balances. If people have more money balances than they want to hold they spend them on goods and assets and vice versa. It's a better way to think about it, but it's not the way journalists write about it. Ben Bernanke, Chairman of the Fed, knows both of those stories. You can't talk about interest rates in the plural--the Fed only controls one interest rate. Argument seems absurd, so why does Bernanke talk about it that way? Senators: You talk to me about money supply but my constituents are interested in interest rates. Historically true. Very few occasions since the 1930s that the Fed actually practiced independence--only Volker era. Bernanke is being leaned on by the Congress and accedes to them; expands economy trying to respond to the short-term pressures instead of how do we get a balanced growth path with low inflation and low unemployment. That brings him to the interest rate. Holders of mortgage bonds: if he lowers interest rates they will have smaller losses. They are on his back to cut the interest rate he controls hoping that the rates they worry about will also come down. Fed on paper is independent but it has incentives to respond to political pressures. In reading the minutes of the Fed it has always responded to Congress. Volker had the help of the public because by the end of the 1970s the public wanted to reduce inflation. By summer of 1982, even he eased up.
10:50Even Supreme Court responds to political pressures. Fed's power is delegated, Congress could change it. Wouldn't be easy for Congress to change it, so it hangs on to a measure of independence. Other incentives: no Chair of the Fed wants to be perceived as causing a recession, whether it is the fault of the Fed or not, or for a recession to occur on the watch of a Fed Chair because it will be put at his feet. Cutting the interest rate--expansionary monetary policy--with a goal of making the economy keep growing, runs the risk of a steep increase in the rate of inflation which will surely increase nominal interest rates that he does not control, which in turn affects the economy. As inflation rises, lenders want a premium for what they are lending because it will not be worth as much when they get it back. It depends on the Fed's ability to forecast what's going to happen. Economists are not very good at that kind of forecasting, the pressures from Congressman, Wall Street, and the Administration are pushing the Fed to focus on these short-term movements. May be in a recession but not a depression; the economy is not in that kind of trouble. Latest data show that the economy is holding up very well. What the Fed can do is focus over the longer term; but it doesn't want to do that because of the pressures. Discussions at the Meetings over the last 25 years is mostly over what's happening now, only short term consequences, not long term consequences. Recently, some improvement: two voting members have publically dissented; four or five do not like the current policy. Only 4 banks out of 12 asked for the recent reduction in the interest rate, so directors and managers of those banks were not happy with the reduction of the interest rate.
16:22History of the Federal Reserve, Vol. I is out, U. of Chicago Press; Vol. II later this year. Open Market Committee minutes. Since 1913, the Fed has some degree of independence but responds to political forces. But the Fed's performance in the last 30 years is much superior to its performance in its early days, volatility of prices, inflation, money supply. What's different today? From 1985-2001 the Fed followed an intermediate term strategy instead of attending to the short run movements of unemployment under Paul Volker. Having gotten inflation down to 3 or 4% he looked ahead at a longer term; followed by Greenspan. The Great Moderation. Now back to focusing on short term, thinking you could focus on interest rates forgetting about inflation. But that was the mistake made in the early 1970s. Look at real GDP over the last century. First 50 years are more volatile than the last 50 years. Less severe recessions, even starting before Volker. Random or due to explicit Fed policies improving? Until about 1930 we were on the Gold Standard. Fisher, Keynes, Marshall: you had to conduct a pro-cyclical policy: when gold flowed in, economy had to expand; when it flowed out economy had to contract. People thought they could do better at managing unemployment. Under gold standard, we were a heavily agricultural nation. Now we much more dependent on employment. Since the 1950s, Martin era (head of the Fed for 19 years), generally stable policy, very good in the 1950s. During that period, President Eisenhower, very much against fiscal deficits, wanted a balanced budget; therefore the Fed was not under pressure to finance debt. Under Kennedy okay; under Johnson, Great Society, Vietnam War expanded, deficit increased, and under Martin the Fed financed it.
23:25What do you mean by the Fed financed the debt? Cause of something is only the proximate cause, have to look deeper. Federal Government was expanding welfare programs, didn't want to raise tax rates, borrowed to finance it. Johnson was a strict believer that high interest rates were bad. Pressured Martin, who operated under a view that we should coordinate policy. If government ran a deficit, Fed would not raise interest rates. Though Martin didn't fully believe in that view he responded to the pressures. In 1965 he begged Johnson to increase tax rates, but Johnson couldn't get the tax rate increase through till 1968 surtax. Keynesians first screamed that they wanted an increase in tax rates but as soon as it passed they started to scream overkill, it would hurt the economy, we're going to have a recession; Martin gave in. At the time, in the 1960s, less integrated world capital markets, so if U.S. borrowed more, it would force interest rates up to ensure that the bonds could be sold. That would spill over into other sectors discouraging other activity. The Fed expanded the money supply enough to hold interest rates down so that the Federal Government could do the borrowing. Period of moderate to low inflation initially. Then came the Great Society. Fed financed that. Martin, committed to fixed exchange rate, Bretton Woods system tottering and 6% inflation in U.S. Indirectly the spending of the Johnson administration led to inflation. Aimed for unemployment not above 4%; and coordinated policy; those two things led to the inflation. Once we had it we had to suffer some pain to get rid of it. Nixon; Ford; Carter not very good till very end when public claimed inflation was the number one problem, hired Volker. Carter solution was that the way we were going to control inflation was through the mistaken idea of having guideposts and guidelines were supposed to tell industry how to set prices; mistake.
30:14Not so much the wisdom of the particular Chair of the Fed or advances in understanding monetary policy or economic theory but rather understanding of the public, Congress, and President that pressures the Fed. We do learn and research does matter. Around the world there are many countries that have inflation targets: controls inflation and we understand, from Friedman, that it takes a couple of years till today's policy gets translated into inflation. Longer run focus results. U.S. doesn't do this, though. Taylor Rule (John Taylor): concentrate on both the loss of output and the rate of inflation; work on both all the time, don't keep shifting from one to the other; pretty well accepted in many countries. Fed looks at it but doesn't do it. But Fed's only got one instrument, one lever--it can't control both at once. But it can pay attention to both at once and moderate its policy so it doesn't expand too much to hold down the policy of a recession and then think it's going to reverse that and hold down inflation. Taylor Rule says: Think about the medium term, aim for both.
33:41Inflation generally and its impact on our standard of living. Fed is viewed by as degrading the value of the dollar; but if there were steady low inflation economic actors would respond to that and would expect it and Fed would be relatively harmless. Real risk is uncertainty, swings in inflation, unpredictability of it. Bubble in housing in part because Fed made it very profitable to borrow. Now we are again holding the interest rate way below where it should be to balance the risks of inflation and unemployment. Since the late 1970s inflation has been kept in a narrow band; but it is difficult for the Fed to keep that course, unlikely that they will. Would we be better off with an alternative to the Fed? During the great inflation of the 1970s, people expended a lot of energy figuring out how much to invest and how, real costs; and we wiped out the Savings and Loan industry, massive losses, $200 billion paid by taxpayer. Housing is a sacred cow in every Congressional district. Couldn't allow the interest rates at S&Ls to rise; ended up cheating the public, who couldn't receive market interest rates. Market created the money market mutual fund, offering honest interest rates, but drained money out of the S&Ls; finally repealed the holding of interest rates too low at S&Ls. Is there an alternative to the Fed? Want to get away from the day-to-day emphasis. We haven't convinced the economics profession, let alone the general public. Inflation target would drive us toward a medium strategy.
40:24Should we go back to a gold standard? Virtue in the gold standard: you can only have a moderate amount of price instability. But we'd have to tolerate bigger fluctuations in employment and output. Also, other countries would have to do it simultaneously. In theory, would we grow faster under a gold standard--wouldn't people be able to focus on the real variables without worrying about price instability? Yes, but output variability would be larger. In 1913, was it claimed that employment swings would be more moderate? No. Gold standard at that time was just accepted. Discussion about the Fed in 1913 was very little about economics. Mostly about who would control the Fed. Wilson, others in Congress, set up board in Washington to supervise the system; regional banks run like businesses; set off internal argument about who would run that system. Regional banks did, till Great Depression. After that, authority transferred to Washington. Some who are worried about the Fed and the dollar argue that under a gold standard the dollar would have a real value; now it's just a house of cards. Price level did stay stable over the long term, though not year to year, under a gold standard. Easier to predict prices for retirement. We've lost that advantage; can't provide same long-term certainty. But we've gained greater control over the medium and short term, which we claim that we want. Historically under the gold standard we were an agricultural nation. Any small loss of income today seems to be a greater disaster. Risk of going back to a gold standard: deflation. Average level of prices would be falling as output grew. Irving Fisher: have to tie the price of gold to a basket of commodities. Why would mild deflation be worrisome? Might not be. Seven periods when prices fell. Can't see a difference in recoveries from recessions during mild deflation than mild inflation--exception was the Great Depression. Expectation was that inflation would continue and continue--till we devalued the dollar. By the end of WWII we had about 70% of the world's gold stock. Fed made another mistake, 1958 recession, decided to sterilize, stop buying gold. Friedman emphasized increases in reserve requirements.
50:20Stimulus checks just went out from Washington, idea being that if consumers have more money in their pocket they will spend it and stimulate the economy. Very Keynesian idea. Permanent income theory: temporary changes in tax rates or government, people will save it. What is the meaning of a tax cut without a spending cut? Carter, $50 rebate, canceled. Bush, temporary payment coupled with a permanent tax cut. Most people save it or pay down debt. China. On the supply side of the economy: What is the difference between government printing money, put in mailboxes, please go out and spend it; versus government announces they are cutting taxes? Wouldn't they have virtually the same impact? If in equilibrium before, in the first case, I now have more money, more cash balances, so I will spend it down. If it's known to be temporary won't businesses just raise their prices? Not immediately. Output would expend temporarily. Tax rebate story: government has now accumulated more debt, which doesn't happen in the money-printing story. People know they have to pay that some day, so they save it all. Fiscal stimulus will not have even a temporary effect because nothing has changed as far as your wealth is concerned. (You have to pay the finance in future taxes some day.) A tax cut that is not accompanied by a spending cut, or a tax cut in rates that is accompanied in spending increases, is really a tax increase. If we don't cut spending all we've done is create more debt, which we have to service via a future tax increase. Misleading statement by Dick Cheney to Paul O'Neill: Reagan showed that "deficits don't matter." He should have added: only if foreigners buy the debt. Even then we owe that money and some of that charge is now coming home in the form of the depreciation of the dollar. Standardly we claim the reason we don't want to run deficits is because it will raise interest rates and slow down the economy, but it has not done that. If foreigners hold the debt the interest rate stays stable. Mercantilist, only works as long as they are willing to take the losses with the inflation that is coming along. Avoids social consequences of supernormal growth rates for them; subsidizes us by buying our debt. Good deal for us: they give us goods and we give them paper. Herb Stein would say, Unsustainable trends have to end.
1:00:53Why is it unsustainable? U.S. spends more than it takes in in taxes, does it by borrowing. Taxes today versus taxes tomorrow isn't the issue; the right question is: Is the spending for good uses? Suppose budget deficit (not talking about the trade deficit) stays same percentage of total spending, so no risk that the U.S. government will not honor its promises, though they do have a worry that those dollars may not be as valuable. Can we not run that system for a very long time? Have to keep rolling it over. In order to get them to do that we have to make it more attractive, which we do by depreciating the dollar. That's a consequence, not a plan or strategy. When the dollar declines, our wealth declines in the sense that if you were to take a trip to Europe five years ago you would have had to pay much less. European goods and services cost more. Initial effect is that we are poorer. Sustainability: cost of sustaining Federal budget deficits is that we are going to lose some purchasing power outside the United States, holding everything else constant? Spending today on less productive uses. Lose on the productivity side, attempt to bail out those who made mistakes buying houses. No productivity gain from that at all.
1:05:20Bear Stearns: Fed guaranteed a significant portion of their assets in order to facilitate their sale. Change in Fed's role. What would have happened if the Fed did nothing? Fed in its 90 year history has never announced what its policy would be. Creates a great deal of uncertainty. What the Fed did in Bear Stearns was to protect the payment settlement system, which is a responsibility of the Fed. They were convinced that if they did nothing at all there would be a run on all the other investment banks. Had to do something. One choice was to follow the policy Congress had laid out after the failure of the S&Ls. Policy was: make them fail: stock holders are wiped out, stock holders take the loss. Mistake was that they said they had to have this done by 7:45 in the evening to beat the opening of the Japanese stock market. Initial price was $2/share; wanted to avoid political implications. Why was JPMorgan the only company that was bidding? Only three, including JPMorgan, had stayed out of the mortgage debacle, so only a few had the resources. Media play up the decline in the housing prices as something of a disaster. But to get to the new equilibrium housing prices have to fall. The quicker it gets there the better; at the moment, uncertainty. Banks will lend overnight to investment banks, short term, but don't want to lend even over 30 days because they don't know what is in the portfolio of the bank to which they are lending. What could Fed have done instead? Could have followed Walter Bagehot's rule, editor of The Economist in the 19th century: lend freely at a penalty rate. And in a few hours the market was quiet. Difficulty in evaluating the portfolio isn't merely in knowing the quality of the loans, but that when housing prices are falling it's harder to assess the risk. Plus complex instruments all in a pool. Outsider looking at Bank X with mortgage packages--who knows what's in there? People are walking away from paying their mortgages. Gamble people are making is that if housing prices continue to rise it doesn't matter how junky the portfolio is. How was it that the MBAs out of the best business schools in the world were buying and selling pieces of paper that they knew were not worth much? Answer is that their incentives are very bad: make short term profit and they get big bonuses. Why did the CEO of Bear Stearns, who was worth about a billion and now only a hundred million leave these incentives in place for those MBAs? Maybe he didn't realize housing prices could fall. Maybe he was playing bridge or golf and wasn't paying attention. Maybe he relied being "too big to fail"--implicit guarantee by Fed. Bad incentives in the market: governments of the major lending developed countries got together and agreed on the Basel Agreement: if you hold risky assets you have to have more capital. What did they do? Market figures out how to circumvent the lawyers' rule. Invented assets they didn't have to hold on their balance sheets. CEO of Bear Stearns encouraged this behavior; CEO of JPMorgan Chase to a much less extent. Management mattered.

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