The Fed Has No Clothes

January 18, 2011

by Jerry O’Driscoll  

Philadelphia Fed President Charles Plosser gave a major speech on Monday at the Central Bank of Chile.  In the polite language of central bankers, the speech constitutes a systematic criticism of not only current Fed policy but of the Fed’s entire response to the financial crisis.

Plosser’s speech updates Milton Friedman’s 1967 presidential speech to the AEA and quotes from it. “…We are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making.”

In Friedman and Plosser’s analysis, the sole contribution monetary policy can make is price stability. What, in the current context, can monetary policy not achieve? Plosser enumerates impossible goals of monetary policy.

  • Short-run stabilization of the real economy is “beyond the scope of monetary policy.”
  •  Attempts at short-run stabilization are likely to provide stimulus when not needed and vice versa.
  • Stabilization policies “risk distorting price signals and thus resource allocation, adding to instability.”
  • “…Monetary policy cannot reverse the sharp decline in house prices when the economy has significantly over-invested in housing.”

Plosser calls for a monetary rule, not just in normal times but also in crisis times. The lender-of-last resort function should be rules-based and not involve credit-allocation or bailouts of particular firms. He correctly identifies both as fiscal policy not monetary policy. He repeats his call for the repeal of section 13 (3) of the Federal Reserve Act, the so-called emergency-lending provision. He also wants the Fed’s balance sheet limited short-term U.S. government securities. These last two policies would have prevented the Fed bailouts of the last two years.

It is radical speech by a Fed president and (this year) voting member of the FOMC. Plosser is, of course, an accomplished economist and founder of real business cycle theory. The speech echoes not only well-known monetarist themes but also Austrian ones (the distortion of relative prices by monetary policy). It is well worth reading.

9 Responses to “The Fed Has No Clothes”

  1. J Oxman Says:

    While I appreciate the radicalness of such comments coming from a Fed president, his interpretation of misallocation of resources does not seem to coincide with the Austrian concept. Also, he seems to fear deflation generally, which is a very monetarist/neoclassicist point of view. Nevertheless, the openings for Austrian insights to enter the mainstream seem to be getting bigger.

  2. N. Joseph Potts Says:

    Monetary policy not only will not, but even cannot, provide stability in prices as good as the stability that a stable regime of NO policy would provide.

    Monetary policy has NO benefits to confer upon society, nor does the kind of money (fiat) that enables and requires such policy. It does endow government with vast powers that it could not attain by any other means.


  3. […] is this as unusual as I think it is? I’m going to reproduce Jerry O’Driscoll’s full post (from ThinkMarkets): Philadelphia Fed President Charles Plosser gave a major speech on Monday at […]

  4. Bob Layson Says:

    Nation state monies and monetary policies are the problem. They are a necessary and sufficient condition for price and output instability in national and world markets.

    The only monetary role for government is to tax and to pay its bills in the commercially mined and minted money that consumers have come to prefer for exchange and value storage purposes. Such money would be metallic and prices would be set in units of mass of metal of a certain purity (for convenience it is not always necessary for the coins to change hands so much as the ownership and this can be done electronically through the bank network).

    Only governments insist, for obvious reasons, that money is something with a name and an authorized monopoly issuer – itself.

    For an economy to grow it is not necessary for money stocks to be continually swollen and per unit purchasing power continually diluted as a result.

  5. Richard Ebeling Says:

    I think Jerry’s point in bringing this speech by a Fed President to our attention is that even within the “halls”of the monetary central planning agency there are those who challenge the wisdom and ability of a central bank succeesfully micro-managing the monetary system in pursuit of short-run policy goals.

    The Fed has been on an especially discretionary “binge” of manipulating money, credit, interest rates, the housing markets, the exchange rate of the dollar, the funding of Federal goverment deficits, etc in the present economic crisis.

    Given that the Federal Reserve is not going to be abolished any time soon (even if some of us “wish” it were possible), it would be a better “second” or “third” best if the monetary authority reduced it disruptive and distorting “monetary mischief.”

    Prices, wages, interest rates should be determined by market-based competitive supply and demand, not by government regulation or monetary manipulation.

    If the Fed were to follow a monetary policy closer to Friedman’s rule, the monetary-induced misdirections of resources, and distorted relative price structure, would at least be minimized.

    However, it is worth remembering that in his 1986 presidential address before the Western Economic Association (published the next year in “Economic Inquiry”), Friedman said that Public Choice theory had convinced him that it will never be in the longer run interest of politicians, bureaucrats, and special interest groups for the central bank to follow the type of montary rule he had long advocated. And that, on reflection, he, Friedman, had been wasting his time in supporting a monetary policy prescripton that would never be politically expedient for those at the reins of monetary policy to follow.

    Richard Ebeling

  6. von Pepe Says:

    Thank you for the analysis Dr. O’Driscoll. I like your demarcation between monetary and fiscal policy. I really enjoyed Prescott’s consistent emphasis on the short-run.

    As a side note on the mainstream, we have krugman finally engaging:

    http://krugman.blogs.nytimes.com/2011/01/19/great-leaps-backward/

  7. Shawn Says:

    I am inclined to agree with Plosser on his suggestion of repealing the emergency lending provision. Not because it has no effect–it clearly does–but because the repeal will force financial firms to maintain their own liquidity and make more conservative investment decisions.

    If you give your kid an allowance and tell him that is all he gets and to spend it wisely, you should tell him ‘no’ when he spends it all and wants you to buy him the candy bar. Eventually he won’t ask.

  8. Andreas Hoffmann Says:

    Nice post. I have just read the speech.

    I agree that it is harsh for somebody from within the Fed System. Good to see that opposition starts gains support.


  9. […] Lack of financial discipline by governments such as Greece is surely to blame, but it was government regulation of private business that was loudly demanded  to rectify financial risk in the wake of the previous emergency, not regulation of government itself. As for other policy responses that have had at best an ephemeral effect, click the highlighted text for Mario Rizzo on fiscal stimulus and Jerry O’Driscoll on the Federal Reserve. […]


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