A portrait of Milton Friedman hangs at the entrance to the Stauffer Auditorium at Stanford University’s Hoover Institution. It carries no identification, and doesn’t need any. All who enter here can be counted on to recognize the patron saint of contemporary free-market economics. And so it was two days last week, when the leaders of what might be dubbed monetary fundamentalism gathered under Friedman’s watchful gaze.
Stanford’s John Taylor, a former Treasury official and academic who created an eponymous and influential rule for setting interest rates, pulled together sitting and former presidents of Federal Reserve banks, along with prominent academics and former members of the European Central Bank board. They discussed a new framework for running the world’s central banks.
The cries from this boil of hawks may not have changed much over the decades, but more than five years since the financial crisis roiled the world’s financial markets and economies they deserve a fresh listen.
The views vary, but there is a common creed: The U.S. central bank has expanded its discretionary powers in monetary and credit policy in ways that threaten its existence. This isn’t mere traditionalism. It is an admission by powerful central bankers that they understand their own limitations, and they would rather see their powers circumscribed than fail abjectly, since failure could lead to the dismantlement of Fed independence.
Richmond Fed President Jeffrey Lacker stated it with some delicacy: “Entanglement in the distributional politics of credit allocation inevitably threatens the delicate equilibrium underlying central bank independence, which has been so essential to monetary stability.”
But there’s something more – a growing recognition that too much is expected of the Fed, and of other central banks. In the absence of meaningful support from fiscal policy, central banks have become the only stimulative game in town – particularly in the town of Washington. Each new power granted to non-elected monetary authorities creates cover for politicians’ inaction. That’s unhealthy for markets, the economy – and ultimately the Fed.
It’s tempting to dismiss this crew as old white guys railing at newfangled ways. With the exception of Kansas City Fed President Esther George, that was actually the case at the Stanford confab. Speakers one-upped each other with references to the Hawk Pantheon, from ancients like Adam Smith and Walter Bagehot to the more modern, Paul Volcker and Friedman (notably absent, but lingering in the air were the Austrians). The location was right: a temple dedicated to the president whose slow response to the 1929 stock market crash is usually thought to have turned a financial setback into the Great Depression.
But the Taylorites are not mere monetary policy Luddites. Two things have undeniably occurred since the 2008 financial crisis: Central bankers have been called upon to do extraordinary things, and political comity has taken a turn for the worse. And one may have enabled the other.
Consider all the Fed has done to save the world. There has been experimental monetary policy, including three waves of quantitative easing, leading to a multitrillion-dollar expansion of the central bank’s balance sheet. The Fed has gone out further on the risk spectrum in the types of assets it has purchased, and by extending its own maturities through the so-called Operation Twist.
It has also expanded its credit policy remit, participating in the rescues of AIG and Bear Stearns, converting Wall Street securities houses to banks. What’s more, it has in practice taken on the role of macroprudential regulator by effectively agreeing to monitor the financial markets for all incipient bubbles.
At the same time, America’s political body has fractured. Hopes for a “Grand Bargain” on spending and taxation just a few years ago proved vain. Instead, there is hardened partisanship. Deficits have shrunk, but by legislative accident, not by anything like intelligent design.
Monetary policy has been forced to pick up much of the slack, entrenching a form of massive moral hazard. The Fed fundamentalists recognize the risk. As Philadelphia Fed President Charles Plosser put it to the Stanford crowd: “We need to do what we know we can do well.” The more tasks attached to the Fed, “the harder it gets for us to do what we are best at.”
Politicians, voters and investors have perhaps grown accustomed to thinking of central bankers as wizards. But these days, they are more like explorers hacking their way through a snake-infested swamp. It would be healthy to acknowledge the limits of their abilities, before failure exposes them. It might even get legislators back in the business of, well, legislating.