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Dethrone King Bernanke and Court to Keep Recovery

Author: Amity Shlaes, Former Hayek Senior Fellow for Political Economy
July 28, 2009
Bloomberg

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The Queen of England recently heard from her nation's economic experts, who wrote to apologize for their profession's inability to predict the financial crisis.

It's different in the U.S. Here, economists don't apologize to the throne. They sit on it.

The throne in the U.S. is the post of chairman at the Federal Reserve. As currently configured, this office is more powerful than Elizabeth II's, with almost unlimited discretionary authority to intervene in the world economy.

The Fed was created in 1913. Lawmakers strengthened its powers in the 1930s and then again after World War II by effectively charging it with watching over not only money but economic growth generally.

Until 1971, there existed a mechanism that served as a check on the Fed's discretion, at least theoretically. It was the gold standard (later, the gold exchange standard). If the Fed created too much money, capital went abroad to less inflationary venues. That in turn forced the economy to contract. Central bankers controlled money creation because they didn't want to be blamed for a recession.

President Richard Nixon broke that mechanism when he took the country off the gold exchange standard in August 1971. Since then, the economy has been in the hands of the king -- the Fed chairman -- and his counts and barons, the members of the Federal Open Market Committee.

The record of central bankers suggests that they aren't deserving of their royal status.

Awful Choices

Central bankers always argued that there was a tradeoff between unemployment and inflation: the country had to pick one of the two poisons. Then the 1970s brought both poisons -- joblessness with inflation.

Former Fed Chairman Alan Greenspan, current Chairman Ben Bernanke and many of their economic colleagues all failed to predict the current crisis. Worse, they may have helped cause it by keeping interest rates too low this decade.

Why did the Fed keep rates low? We can guess that the events of Sept. 11, 2001, and the start of the Iraq War in 2003 are part of the answer. The U.S. didn't want economic trouble at home while it was fighting abroad. What's clear is that rates were kept low in part for an arbitrary reason: because Greenspan, then Bernanke, felt like keeping them there.

Bernanke's Promise

In 2002, when Bernanke was still a mere count in the Fed court, he spoke at an event honoring his fellow economist, Milton Friedman. Bernanke recited the errors of the Depression- era monetary authorities, errors Friedman himself had first pointed out: they forced an epic deflation and banking credit crisis on Americans.

Bernanke then promised that he and his Fed colleagues "won't do it again."

Fast forward to Sunday in Kansas City, where Bernanke, now chairman, said the current crisis might already be worse than the Great Depression. In other words, the Fed policy of the current decade has worked insufficiently, or hasn't worked, or has made matters worse. Hardly the festive results both Bernanke and the late Friedman hoped for. Yet the more trouble their arbitrary policy causes, the more ennobled our central bankers seem.

Washington has the power to end this monarchy. It can replace economists with economics -- rules-based mechanisms that automatically curtail Fed discretion. This offers the possibility of experimenting with economic models and letting Congress keep or toss them, according to performance.

Follow the Formula

One such experiment could involve the Taylor Rule, named for Stanford University economist John Taylor. It says the Fed should aim to set short-term interest rates following a formula that measures inflation, employment and the pattern of interest rates.

In a damning book released in February, Taylor showed that interest rates diverged from his rule for much of this decade. Had the Fed followed the Taylor Rule, it wouldn't have loosened rates as much as it did, and that might have slowed the housing boom.

Friedman himself was skeptical about too much discretion and sought a legislated rule on monetary policy. He "wanted the rate of growth for money to be fixed to the rate of growth of the economy," recalls Don Boudreaux, chairman of the economics department at George Mason University.

Let Markets Rule

Others advocate a new gold standard, which would make the movement of money more automatic, even to the point of "free banking." Such a system would have no central government bank. The market, not Washington, would determine the survival or death of financial institutions. It's not a new idea: George Selgin of West Virginia University wrote a book about how British manufacturers in the early 19th century successfully challenged the Crown for control of their country's money.

Right now, thousands of pages are being typed in hundreds of summer houses in an effort to blame Greenspan or Bernanke, or perhaps their colleagues at the Treasury Department, another imperial institution.

The trouble is not Bernanke or Greenspan or even their respective courts. The trouble is that the throne exists in the first place.

(Amity Shlaes, author of "The Forgotten Man: A New History of the Great Depression" is a Bloomberg News columnist. The opinions expressed are her own.)

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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