What Policymakers Should Learn from the Failures of the Federal Reserve

In a previous article, I argued that our elected representatives have a responsibility to actively foster a healthy economy — that the nature of modern fiat money means “[w]hat is important about the budget is whether it is inflationary or deflationary, not whether [it is] balanced or unbalanced.” The Federal Reserve’s response to the financial crisis and subsequent limits of their ability to influence economic outcomes provide important evidence in support of this position.

On the occasion of economist Milton Friedman’s 91st birthday, then Federal Reserve Chairman Ben Bernanke gave the keynote speech.  Friedman and co-author Anna Schwartz articulated what became known as the monetarist perspective, pinning responsibility for the Great Depression with the Federal Reserve. 

In a later book, Friedman wrote, “The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933.”

To which Bernanke, the most powerful voice in the world economy, declared, “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Unfortunately, Friedman’s analysis and the Fed’s ability to influence broader economic outcomes and increase the quantity of money in circulation is proving limited.

No doubt 8 years into our own financial crisis we have seen improvements resulting from the restructuring of debts, spending stabilizers and new sources of energy investment, but for most economies — especially Europe — continued downward revisions persist, including in the U.S. which had negative growth in the first quarter of 2015. This despite the most extraordinary measures from the Fed, including massive purchases of worthless assets at 100% of the value from banks and near zero interest rates since 2008.

While recently released growth figures show growth of 2.3% in the second quarter and positive revisions to the first quarter, the report also includes a revised figure for 2011-2014 growth from 2.3% to 2%. This represents a continuation of the worst economic recovery since World War II and the worst six-year period of economic growth since 1935. 

These numbers will be spun as positive signs for the Federal Reserve to raise interest rates in September. By its own measure of success, inflation, it has failed to increase the quantity of money enough to come close to its target growth rate for almost 3 years. 

The continual decline in the unemployment rate masks the fact that the percentage of the population measured as working or looking for work is only just coming off a 36-year low.
Despite the good headline-grabing numbers, the continual decline in the unemployment rate masks the fact that the percentage of the population measured as working or looking for work is only just coming off a 36-year low.

The reality is low rates fostered by the Fed serve the narrow interests of banks reliant on lending spreads for income and businesses and individuals most capable of borrowing — mostly for capital gains, further exacerbating income inequality without improving productivity. Corporate bonds once issued for capital investment are instead used for stock buyback schemes.

Capitalism in the 21st century isn’t for allocating resources for investment as we’ve been led to believe. Rather as rebel venture capitalist Nick Hanauer sees it, shareholders and financiers “aren’t providing capital to the corporate sector, they’re extracting it,” meaning Fed policy has only resulted in the continued enrichment of those already with means merely as a matter of consequence.

Given the Fed’s 8 years of failure to facilitate even its narrow inflation targeting objectives, how do we increase the quantity of money in circulation and support the public interest?

Ha Joon Chang provides a starting point in his book, Economics: The User’s Guide. Channelling Roman statesman and orator, Cicero, he argues the first, most important question is, ‘Cui bono?’ (Who benefits?). In this regard, it is clear from the onset of the crisis that central bankers have been looking after their own.

Federal Reserve Vice Chairman Stanley Fischer, teacher and mentor to many prominent economists, has been the strongest banking voice in this regard and his comments are truly telling.

“There is general agreement in the United States that public infrastructure could do with a lot of investment,” he said. “There’s nothing we can do about it, we would much prefer that there was an active public infrastructure investment program, but it isn’t happening.”

In other words, politicians and the public don’t get it even if we acknowledge government investment is the only mechanism left to prevent deep recessions. 

A number of proposals have filtered up that sound crazy but would work. The financial crisis’ own Paul Revere, Steve Keen, has called for a debt jubilee, wherein debtors must use money created by the central bank to pay down or pay off debt. Those not in debt can use the payment as a free windfall to spend or invest as they see fit.

Allowing the public to pay down debts, or deleverage, is viewed as a primary policy concern, but not without moral hazards. Prominent Modern Monetary Theory voice Warren Mosler has been calling for a suspension of the FICA tax, a measure that would immediately put money in the pockets of consumers and increase spending or demand for goods and services.

Both proposals rely on unprecedented, never before conceived coordination between elected governments and central banks with efforts to use the budget as a tool to manage the quantity of money in circulation.       

Populist movements like Ron Paul’s “End The Fed” take a different view, looking instead to cut out the central bank completely, fearing their actions will induce unlikely Weimar Germany-type hyperinflation. Paul’s proposed return to the gold standard was problematic in its own time and an evolutionary relic of democratic capitalism. 

While I agree with Paul’s assertion that “in the post-meltdown world, it is irresponsible, ineffective, and ultimately useless to have a serious economic debate without considering and challenging the role of the Federal Reserve,” challenging the Fed means finding an alternative consistent with capitalism’s evolution.

Our economic experts in the Federal Reserve system failed in their public duty to oversee the financial sector safety before the crisis. Now their continually revised playbook is still not up to the task.

If, as Milton Friedman claims, the task is as simple as increasing the money supply, then using the federal budget to invest this money in public goods is the best solution. It’s unrealistic and imprudent to expect banks to disregard risk and economic indicators to lend money into the economy with uncertain returns when they can speculate on stocks, commodities, and foreign currency movements instead. We know this and so do they.

All that’s missing is a new solution to empower our elected representatives to invest with our federal budget in public goods and employment for a strong sustainable economy. Money is a creature of law — only sovereign governments have the authority, power, and flexibility to issue a stable currency necessary for a sustainable and just economy. Let’s make them act on it.

Photo Credit: Tischenko Irina / shutterstock.com