Tuesday, February 19, 2008

It's Time to Reconfigure the Fed's Modus Operandi

Our central banking network, called the Federal Reserve System, has several functions one of which is coordinating overnight exchanges between banks around the country and insuring a smooth flow of banking transactions in general. The Fed regulators are also responsible for the oversight of some bank operations (although some have accused them of laxity in this regard).

The job should stop here, but unfortunately there's more. A third thing the Fed does--or at least is supposed to do--is maintain just the right amount of purchasing media in circulation to support the economy's needs, nothing more and nothing less.

The centralized maintenance of the money supply is a superhuman task. Some economists believe that it could be much better performed by a private banking system. (For more on this idea, see Breaking the Banks: Central Banking Problems and Free Banking Solutions, published at the American Institute for Economic Research.)

But there's even more to their job. According to the Federal Reserve Board's Congressional mandate, they are also required "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." (Source.)

That's like handing over to your local supermarket manager the responsibility for maintaining the stability of your job, your salary, the purchasing power of your money, your available credit, and the supply and demand of everything you buy.

Economists are not in agreement regarding the feasibility of centralized control of the money supply, never mind of accomplishing this Congressional mandate, i.e. whether the status of the economic science is competent to allow any person(s) to undertake such responsibilities. The Fed has had to utilize existing "scientific" tools that are of necessity inadequate to achieve these goals, even by their own admission.

Federal Reserve Chairman Ben Bernanke said, in November of last year, "because our knowledge of the structure of the economy is incomplete and future economic disturbances are often unforeseeable, economic forecasting is a highly uncertain enterprise. The only economic forecast in which I have complete confidence is that the economy will not evolve along the precise path implied by our projections." I applaud his openness, revealing courage and humility, two qualities that some former Chairmen have not possessed.

I am not alone in my evaluation of the Fed's incapacity to fulfill its duty. To quote just one other skeptic, here is what economist Milton Friedman has said about this subject:

"Any system which gives so much power and so much discretion to a few men that mistakes--excusable or not--can have such far-reaching effects is a bad system.... Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality.... [M]oney is much too serious a matter to be left to the Central Bankers." (From Capitalism and Freedom.)

When you read Wall Street news tickers like this one from the bond markets, you get a sense of how much the economy's short- and medium-term well-being is dependent upon the Fed. Before making any decisions, stock market players and industry leaders all look to the Fed to see what their next move will be.

Why are the Fed movements so important? Because the use by our central bankers of exceptional powers to affect the supply of purchasing media, and the credit that goes with it, creates an uncertain playing field in which players can no longer make long-term plans. Instead, they must become Fed-watchers.

In other words, our vital economic equilibrium no longer depends upon predictable market parameters but rather upon what the central bankers do--even what the individual members say. One wrong word or action can literally make or break an economy, or at least that's what the Fed-watchers believe.

Friedrich Von Hayek, another great economist, once said in The Road to Serfdom, "If the individuals are to be able to use their knowledge effectively in making plans, they must be able to predict actions of the state which may affect their plans."

Our money managers might do better to replace themselves by a computer, as Friedman himself once remarked only half in jest. Scientists like John B. Taylor have searched for a computer-like formula that might aid the Fed in managing the stock of money. It's possible that a solid rule like his Taylor Rule would furnish much better results than allowing central bankers the discretion to move economic parameters as they see fit.

Even if such a rule would not be perfect (perfection doesn't exist), surely predictability is better than hunch, no matter how educated.

As for what the central bankers think about this idea, here's an excerpt of a speech by Fed Governor Mishkin:

"Monetary policy will [...] never become as boring as dentistry. Monetary policy will always have elements of art as well as science. (That is good news because it will keep life interesting for monetary economists like me.)" (Source.)

Maybe it's time to get rid of the artists and try the Taylor Rule. Even if it doesn't produce perfection, surely the market's renewed capacity to plan ahead would cure much that ills us today.

And if that doesn't work, we should go back to the gold standard or something like it, coupled with a private banking network where reputations count and sound commercial banking controls the money supply. (For more on this, see the chapter on commercial banking in Cause and Control of the Business Cycle by E.C. Harwood, published also by the American Institute for Economic Research.)

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