Selgin on the Fed

by Don Boudreaux on March 26, 2009

in Monetary Policy

Here's a prescient op-ed from the great money-and-banking economist George Selgin.

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{ 37 comments }

Daniel Kuehn March 26, 2009 at 8:10 pm

I think the title oughta be "Alan Greenspan played a part in igniting the conflagration that Ben Bernanke is now trying to smother". It's a good article, but I think it blames the Fed too generally where it should be blaming Greenspan more specifically.

I think it's premise is fundamentally wrong, though. People ARE blaming Greenspan. He has emerged as perhaps the chief culprit of this bust for precisely the reasons the article lays out.

I think it's dangerous to blame the Fed in general for mistakes made by specific chairs. Greenspan was reckless – he created the '01 bust, funnelled the air from that bubble into a housing bubble, which as we know is now busted as well. That's a far cry from the responsibility and rationality demonstrated by a Volcker or a Bernanke.

It's the argument you hear out of Peter Schiff and Ron Paul all the time too. But you can't blame the institution of the Fed for the mistakes of Alan Greenspan. Institutions are only as effective as the people who lead them.

ben March 26, 2009 at 8:26 pm

That is a prescient article. I thought Friedman's idea of a single rule for central banks had been discredited – but Selgin resurrects it here and with very good reason, given the Fed's performance this decade.

Watch the Austrian school become mainstream over the next five years and watch Keynesian economics, having been cited in support of massive political irresponsibility and very substantially damaging the US economy, finally, at long last, die.

ben March 26, 2009 at 8:30 pm

responsibility and rationality demonstrated by… Bernanke

Surely you jest.

Institutions are only as effective as the people who lead them.

Selgin cites the rules the Fed operates under, saying it is required by law to fine tune, which unhelpfully brings the particulars of who is leading into play. Selgin is saying write simple rules that minimise the risks of an irresponsible chairman.

Daniel Kuehn March 26, 2009 at 8:37 pm

Ben -
Bernanke follows the rules that Selgin cites – and he's acting quite predictably right now.

You tout Selgin and Austrian school at the same time – don't you think that's a bit of a contradiction? The inflation targeting he's talking about strikes me as highly anti-Austrian. What happened to "end the Fed".

Keynesianism, Friedman, and the inflation-targeting consensus are all essentially on the same wavelength on monetary policy at this point. Whether essentially political figures like Greenspan or Bernanke end up implementing it is another story.

Please stop using "Keynesian" as a catch-all phrase for fiscal and monetary irresponsibility.

vikingvista March 26, 2009 at 8:47 pm

Almost the entirety of the Fed's history has been an exercise in bad decision-making. In fact, Greenspan probably has the best record of any of them, because of his tenure prior to 2001. And it is hard to argue that Greenspan was less qualified for that position than anyone else.

An institution that is so disasterously vulnerable to one man's decision (as DK seems to think) is inherently unstable and needs to be restructured.

A Congressional mandate for the Fed to ONLY target inflation, and ONLY for the purpose of domestic price stability, and to be mostly predictably guided by publicly known rules, would go a long way toward reforming the Fed.

Oil Shock March 26, 2009 at 8:56 pm

A Congressional mandate for the Fed to ONLY target inflation, and ONLY for the purpose of domestic price stability, and to be mostly predictably guided by publicly known rules, would go a long way toward reforming the Fed.

How will that rectify this problem that you identified:

An institution that is so disasterously vulnerable to one man's decision (as DK seems to think) is inherently unstable and needs to be restructured.

Bill Stepp March 26, 2009 at 8:57 pm

Daniel Kuehn,

There is no question that Greenspan was an incompetent Fed helmsman (contrary to Friedman), but the real point is that the Fed is a Soviet-like monetary planning body with a monopoly of U.S. currency to anchor that. (Don't try free banking at home.)
Selgin's book _The Theory of Free Banking_ (pp. 104-5) goes to the heart of the problem in its discussion of interest rate targeting, which the Fed has been doing since the 1980s, having given up then on its earlier fool's errand of price level targeting.
He writes:

"The achievement of monetary equilibrium by interest rate pegging (or tageting) could only be an incredible, and short lived, stroke of luck (p. 105, endnote omitted)."

What we need badly is to abolish the Fed and to replace it with free banking and a gold standard. Keynesians and politicians wouldn't like this one bit because that would derail their dream of more state control over our lives and wallets.
Helicopter Ben might have to go back to Princeton and teach economics.

Oil Shock March 26, 2009 at 9:02 pm

Helicopter Ben might have to go back to Princeton and teach economics.

Will that be a viable position for Helicopter Ben?

vikingvista March 26, 2009 at 9:06 pm

"What happened to "end the Fed"."

The goal is to end the ability of the government to manipulate the value of its currency.

Daniel Kuehn March 26, 2009 at 9:10 pm

vikingvista -
I'm fine with these proposed reforms of the Fed. Isn't that what I was advocating?

Bill -
There was some targeting since the 80s, but Greenspan abandoned it. He brought rates far lower than targeting rules called for.

You know what rates those targeting rules are calling for now? My understanding is around -6%. Hence the quantitative easing by Ben Bernanke who seems to garner so few fans here.

Oil Shock March 26, 2009 at 9:17 pm

Imagine an Island with population for 4 people: Frank Farmer, Charlie Chef, Mike Miner, Sam Smith.

Frank grows grains for all the other three, Charlie bakes and cooks for all the other three, Mike Mines Iron & coal, and Sam makes tools for all the other three. They sleep in caves and live their lives.

Frank saves some grains for that proverbial rainy day. Mike saves some coal and steel, just in case the mine collapses, or if he falls sick. Charlie pickles some vegetables and meat, just incase. Sam keeps few extra tools, just in case he becomes handicapped.

One fine day, Barry Bum washes up the shore of the Island. The islanders welcome Barry. They had an overdose of confidence. Out of the goodness of their heart, they feed Barry the first day. Barry promises that he will pay them back with interest. Next day, Barry eats another meal and gives them an IOU. All of a sudden, Charlie realizes that there is more demand for his cuisines, he starts to serv up his savings. He realize that he needs more utensils, which comes from Sam's savings. Sam suddenly realizes that he needs to replenish his savings, and demands more from Mike's savings. Charlie demands more grain from Frank and that starts to deplete Frank's savings. This goes on for some time as everybody keeps themselves busy. Barry in the mean time takes a vacation to a near by island for a couple of days and comes back ( Home equity extraction ). Once the savings gets depleted, people work harder and produce a little bit more than they used to, to feed the extra person Barry.

Then proverbial rainy day arrives; Charlie falls sick and decides to cash the IOUs he has recieved from Barry. However, Barry has nothing to pay his debts with and hence no way for Charlie to repay his own debts back to Frank or Sam. This causes Sam to realize that he has no way of paying Mike. A credit crunch takes shape. They also realized that there is no need to do the extra work to keep feeding the unproductive Barry. Suddenly Charlie stop producing for Barry, hence he demands less from Frank and Sam.

Ed Empircal Economist comes to the picture and says, there is a lack of confidence. Charlie needs to start feeding Barry as if nothing has happened. He says aggregate demand is going down. See all the idle tools now? Government needs to take over and put these "idle" resources to use.

The reality is, economy was consuming more than it was producing, thus depleting the savings. It was malinvested in unproductive activities. May be, just may be, all the tools and savings allocated to making baking utensils need to re-allocated to some productive activity. May be they need to make pull-carts to transport the produce and iron ore.

If you introduce money into this island's economy, nothing changes. When the farmer produces 100 island dollars worth of grains and produce, converts it to cash and save 10 island dollars, that savings exist as real goods in the economy. Same goes for Mike Miner, Charlie Chef, Sam Smith. When an entreprenuer borrows money to invest, he is actually creating claims against these savings of real resources and putting them to use.

Printing a bunch of money and throwing into the island is not going to make the savings re-appear overnight. The depleted savings have to be rebuilt. Dropping interest rates to -6% is not going to change the real savings overnight.

Real life characters are unlikely to lend to Barry the bum to the point of their ruin. Which is the reason why Gary Government, takes away the risk by guaranteeing all the loans, implicitly or explicitly. Gary cosigned the mortgages for the consumers and cosigned the deposits on behalf of the bankers.

vikingvista March 26, 2009 at 9:22 pm

"How will that rectify this problem"

It will remove contradictory goals, and in particular the goal of fixing recessions. By following a predictable algorithm, the only important decisions to be made are the original decision of what algorithm to use, and later decisions about whether or not that algorithm will in a particular instance promote the singular goal of fixed (preferably zero) inflation.

And by focusing only on maintaining the value of the dollar, we have at least the same goal very similar to a gold standard.

Merely ending the Fed is a very bad idea. It puts the Fed's current powers directly into the hands of the likes of Pelosi and Obama. The reasonableness of ending the Fed died with the gold standard.

Oil Shock March 26, 2009 at 9:27 pm

Merely ending the Fed is a very bad idea. It puts the Fed's current powers directly into the hands of the likes of Pelosi and Obama. The reasonableness of ending the Fed died with the gold standard.

No. The reasonableness of the idea didn't die. I agree that it is not reasonable to expect that to happen, unless a major political crisis happens on a global scale. I don't wish for such a crisis.

Daniel Kuehn March 26, 2009 at 9:32 pm

Oil Shock -
Ed is wrong and you are right about the causes of the crisis in this situation. I'm not sure what this proves. Do you think this is fundamentally different from what I'm saying?

Nobody is saying that Barry passing out IOUs when times are good is going to solve anything.

You aren't the only one that knows the importance of saving, or the problems of malinvestment and it's causes. That's what confuses me the most – why do Austrians think they're the only ones that believe those things?

I agree with the causes of the crisis on the island that you identify, and you haven't really provided an analogy to a Keynesian solution.

So… I guess we agree thus far?

I'd vote Barry off the island for behaving like that.

Daniel Kuehn March 26, 2009 at 9:33 pm

And forgive me if I was wrong to assume that you think you're the only one who believes that… people don't seem to like me extrapolating too much here! :)

Bill Stepp March 26, 2009 at 9:36 pm

He brought rates far lower than targeting rules called for.

You know what rates those targeting rules are calling for now? My understanding is around -6%. Hence the quantitative easing by Ben Bernanke who seems to garner so few fans here.

Daniel,

What targeting rules are you referring to?
Granted, Easy Al tried to push the Fed funds rate to one percent because of his unwarranted fear of deflation, but any way you slice the cake, that was well below the world natural rate of interest.
Any btw, Bernanke's global savings glut was a fantasy. Yes, the Chinese et al. were saving more than they had, but the savings rate in the U.S., a bigger economy, was trending toward zero.
Interest rates of -6%? Who are you kidding?

Daniel Kuehn March 26, 2009 at 9:51 pm

Bill –
RE: "What targeting rules are you referring to?"

Sorry, should have clarified. No formal rule at all – not the type that Selgin is advocating and I'm agreeing with. But since Volcker they have been more predictable, with the exception of Greenspan's limbo moves ("how low can you go?").

RE – "Interest rates of -6%? Who are you kidding? "

Not kidding at all. This is what the Tobin Rule says at this point, as I understand. I'm not sure what targeting reforms Selgin has in mind, but they're going to be related to the Tobin rule somehow. I may be wrong – I thought I heard -6%. Whatever it was, it was surprisingly negative. This is why Bernanke is moving towards quantitative easing right now, because he can't lower it below 0% like the rule calls for.

Bret March 26, 2009 at 10:24 pm

Selgin wrote: "By injecting the new money they create into credit markets, central banks create an artificially high demand for long-term investments"

I thought long-term investments were good.

If I didn't know better, I'd guess from Selgin and the commentary here that there had never, ever been a bubble prior to the invention of the Fed.

Bubbles happen.

Oil Shock March 26, 2009 at 10:35 pm

You aren't the only one that knows the importance of saving, or the problems of malinvestment and it's causes.

Of course not. I am not smart enough to even think that I know something that no one else in the world knows. However I doubt if the last administration and the current one know. If they do, they are being purposefully deceptive.

I'd vote Barry off the island for behaving like that.

THen we are in agreement. I say let the deadbeats go bankrupt, let the bankers go bankrupt. Let Automakers and and their union workers go bankrupt.

Now I doubt your sincerity when you say we are in agreement. Because you seem to be in agreement with inflation targeting, -6% interest rates, redistribution of income to the Barrys of our economony.

G. Selgin March 26, 2009 at 11:03 pm

For Daniel Kuehn: Yes, long-term investments are good–unless they are sponsored by artificially low interest rates, and for that reason unsustainable. Ever hear of "too much of a good thing"?

As for bubbles before the Fed: sure, they occurred, but central banks have proven to be especially potent bubble-creators.

With a little effort, you could come up with such reasonable interpretations of my arguments yourself. Try it and see!

dg lesvic March 27, 2009 at 2:47 am

Prof Selgin,

Congratulations on your great work.

I'm a great admirer of my old teacher, Larry White, too, though I believe both of you have taken a position on deflation that I would question.

Correct me if I'm wrong, but I believe both of you have said that deflation per se was a bad thing, and needed to be counteracted by political intervention.

Unless I am misinterpreting you, I would disagree with you on that.

But, nonetheless, you're doing great work, for which we're all indebted to you.

Thank you very, very much.

dg lesvic March 27, 2009 at 3:02 am

Prof Selgin,

As I recall now, you distinguished between deflation (sic) i.e., falling prices, brought about by technological progress, and that brought about by political policy.

The former was good, and should be left alone; the latter was bad, and needed correction, by a political authority.

I would say that there should be no more political intervention in the one than in the other case, that two wrongs, two interventions, will not make things right.

Better to get the politicans out of the economy as soon as possible, and let the market itself clean up their messes.

Crusader March 27, 2009 at 4:35 am

Daniel – I assume that Milton Friedman did not have unlimited trust and faith in all capitalists. But he did have faith in the entire market to correct mistakes or downright fraud.

Daniel Kuehn March 27, 2009 at 5:44 am

G Selgin and others -
Brett was asking about long-term investments and bubbles, not me. I am quite convinced by the "Austrian" argument about malinvestment caused by low interest rates, and the special role of central banking in booms and busts/

My concern is that basing monetary and fiscal policy off of that single insight is a little one sided.

Daniel Kuehn March 27, 2009 at 6:02 am

Crusader –
I'm not 100% familiar with everything that Milton Friedman thought, but I think you have to distinguish between his earlier economic career, and his later career – which was essentially as a libertarian salesman/cheerleader. I think most people know the "Freedom to Choose" Friedman – what I'm saying is that the lifetime income/natural rate of unemployment Friedman is very consistent with where a lot of Keynesians are on monetary policy right now. Many people think of Friedman and monetarism as a sub-set or special case of broader Keynesianism. Whether that is consistent with the "Freedom to Choose" Friedman or not, I don't know. As far as I know, he never dropped his advocacy for a central bank and inflation targeting.

L Burke Files March 27, 2009 at 11:28 am

Oil Shock – send you analogy to the FT as a letter to the editor, they may like enough to publish it.

BTW heard from B. Bum, He thinks your wrong and a cultural elitist and that since you cannot appreciate his culture he should be protected by G. Gov from your flagrant attacks on him. Expect litigation to follow.

:-)

JP March 27, 2009 at 12:55 pm

Prof Selgin,

I'd like to push back on your analysis a little. There is something that is just a little off about it that I'd like to attempt to articulate.

If the market is functioning correctly then the Fed simply acts as a valve on the economy. It supplies more credit when the economy is slowing down, and less credit when it gears up. I think everyone is in agreement with this textbook definition of things.

What the Fed presumes in order for it to do its job is that new investment tools for individuals and the combined new economic landscapes they produce are natural and organic elements of the market, identified by intelligent market actors. What those tools and landscapes are not, the Fed supposes, are tumorous growths created by fiat out of a governing entity like our Congress.

The housing market, artificially supported and incentivized by the US Congress was the underlying drain on the resources of the United States over this last period. To claim that the Fed is responsible for identifying and correcting for all of Congress's many resource misallocations is to presume a superhuman capacity in the Fed and absolve the Congress of wrong doing.

Better that Congress be held responsible for its activity.

The human circulatory system knows not when it pumps blood what areas the blood will travel. The blood will find both healthy limbs and tumorous growths. Is it the bloods fault for supplying a tumor with life sustaining resources? It is the heart's fault for increasing circulation to a body mass now containing an abnormality? No. The heart pumps assuming the health of the system. It's task is vital but it must rely, as all the body parts must, upon the steady hands of a surgeon to cut out resource hungry growths.

The Fed is no surgeon, it is only a pump and valve. The Congress incentivized home ownership and the market created a landscape and group of investment tools around those incentives. The Congress then failed to cut out the growth on the market that it had created. The Fed merely pumped. The Fed allowed the market to feed a Cancer, true. But the role of the carcinogens and also that of the surgeon must be given to those who originate the incentives, the US Congress.

Oil Shock March 27, 2009 at 1:08 pm

JP,

Too much pumping could cause high blood pressure or cardiac arrest.

It supplies more credit when the economy is slowing down, and less credit when it gears up

Real credit comes from savings. Fed can't create savings, no matter how hard they try.

Pingry March 27, 2009 at 2:55 pm

George Selgin supports inflation targeting here:

"The Fed must be taken out of the fine-tuning business. Instead, it must observe a strict and unambiguous monetary rule, such as one calling for the Fed to announce and stick to an inflation-rate target. As it happens, chairman Ben Bernanke favors such a rule."

How interesting!

Explicit Inflation targeting (unlike Greenspan's implicit form) as proposed by people like Bernanke, Mishkin, Gertler, Woodford and others relies on an explicit, positive rate of inflation, and yet Selgin, of course, has been an advocate of allowing the 'good' type of deflation to occur when productivity increases.

To me, I see nothing wrong with keeping to a positive inflation target when this productivity occurs, provided that the target continues to remain low and with minimal variability.

After all, as the classical economists remind us, we must pierce the veil of nominal activity to see the real long-run reasons for real increases in living standards.

And this can be done in an inflation targeting regime, so why risk unhinging the nominal anchor? Why risk allowing 'good' deflation from the productivity increases of the late 1990's only to b threatened with the 'bad' deflation which we worried about during the previous recession, particularly in 2003?

–Pingry

Daniel Kuehn March 27, 2009 at 2:57 pm

Oil Shock -
RE: "Too much pumping could cause high blood pressure or cardiac arrest."

You're missing JL's point. He's saying essentially that money is fungible. We didn't have a housing bubble solely because the Fed pumped more money into the system – we have it because Congress essentially channeled that money towards housing. Selgin places the distortions at the feet of the Fed. To a certain extent, that's acceptable. All of us here have agreed that Greenspans rates were too low. What JL points out is that Greenspans mistakes were magnified in certain sectors by the distortions of Congress and lax regulators.

Oil Shock March 27, 2009 at 3:04 pm

You're missing JL's point.

JP might have been playing the devil's advocate, but he was trying to exonerate Fed's responsibility in the crisis. Sure there were other factors involved and I have never denied it. You are missing my point.

Daniel Kuehn March 27, 2009 at 3:29 pm

Oil Shock -
Your point – that too much blood will increase blood pressure and cause cardiac arrest – is something that everyone on this board, including JP, seems to be agreeing with. Your point is a trivial point because everybody agrees with it.

You didn't even comment on JP's main point – hence, you missed his point.

Oil Shock March 27, 2009 at 4:17 pm

His main point is false. Because fed can't pump real credit, because they can't create real savings. Everything Fed does is equivalent to pumping fluids into your body while keeping all orifices tightly closed.

Sam Grove March 27, 2009 at 4:38 pm

I thought long-term investments were good.

Only if they return on the cost of investment.
Investment is an allocation of resources into future production. The investment is justified if the future productivity pays for the cost of investment and interest and is otherwise profitable.

Sam Grove March 27, 2009 at 4:43 pm

As far as I know, he never dropped his advocacy for a central bank and inflation targeting.

Friedman did have second thoughts on the matter.

G. Selgin March 27, 2009 at 5:29 pm

Pingry is correct about my favoring deflation at the rate of productivity growth. His own preference for a low positive inflation rate so long as it isn't variable actually get's things quite wrong, for all things considered, if you're going to allow some inflation, you should at least allow the rate to vary with changes in the rate of growth of productivity. As I observe in _Less Than Zero_, the claim the the price system works best when P or inflation is constant is simply wrong. The general level of _output_ prices should vary to reflect the reality of changes in the price of output relative to that of factors of production. Bear it in mind: what's usually called "the price level" is an output price level. So keeping it constant when productivity varies means forcing the input price level to fluctuate–which is worse.

Concerning Friedman's views on currency monopoly, I discuss them in some detail here:

http://www.cato.org/pubs/journal/cj28n2/cj28n2-12.pdf

Mark March 30, 2009 at 10:30 am

Whilst I agree with the general points the article makes with regards monetary policy at the heart of our troubles, its conclusion is somewhat misguided, as it is the root cause of the economic and financial malaise. Whilst I am aware that the American Fed doesn't have an explicit, clear-cut inflation target, it is certainly implied in its actions (at least in the run up to the crisis). Let us not forget that the crisis was caused by lax monetary policy from the start of the decade, in order to try to avoid deflation. However, this wasn't a "debt" deflation, as feared by many now, but a "good one". It arose as a consequence of the opening of the likes of China to international trade, who offered much cheaper goods than were previously available. This is equivalent to shifting outward the international aggregate supply curve, naturally putting downward pressure on prices, but also raising output. The stringency of inflation targets (particularly here in the UK) didn't take into account the possiblility of this "good", imported deflation, and the direction of monetary policy had to be inflationary in order to meet the inflation target, spawning the credit bubble.

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