Despicable Fed: The anguish of central banking

In theory our central bankers are independent from the government. In practice the Federal Reserve is under constant pressure from the president and Congress.

Demands to lower interest rates and increase the money supply intensify in the months before each election. The Fed is often bullied into sacrificing long-run price stability for the sake of short-run boosting of economic growth and adding temporarily a few thousand extra jobs. Thus monetary policy adds to the natural volatility of global markets and compounds the problems of our elected officials' fiscal irresponsibility.

This is the reason why many of my colleagues advocate limiting the role of the central banking system to keep inflation below 3 percent and act as a lender of last resort in those rare occasions when the country experiences serious financial crises. To achieve this we have to repeal the "dual mandate" and insulate the Fed from the unhealthy influence of the White House and the warring factions within the legislative branch of our government.

To see the dangers of letting elected public servants influence the decisions of our monetary authorities, one only needs to recall the series of economic fiascoes under the Keynesian doctrine of the 1960s and 1970s.

When William Martin Jr. tried to quench inflation in 1965, President Lyndon Johnson invited the Fed chairman to his Texas ranch for some spanking: "You went ahead and did something I disapproved of and can affect my entire term here … that's a despicable thing to do."

When Nixon picked Arthur Burns to replace Martin, he made it clear that monetary policy would only serve as a handmaiden to the White House's counter-cyclical fiscal policies: "I'm counting on you, Arthur, to keep us out of recession." When the Fed tried to suppress inflation by raising interest rates, the president called its chair to the Oval Office and "persuaded" him to cease and desist: "I don't want to go out of town fast."

In a 1979 lecture titled "The Anguish of Central Banking," Burns reflected on his time in office, admitting that the Fed was unable to defy "the will of Congress," that the Keynesian "philosophical and political currents had created irresistible inflationary pressures," and that dealing with the problem would require a new "political environment." And the winds of change were already blowing hard with Milton Friedman's success in converting many economists away from the Keynesian doctrine.

In his book The Great Inflation and Its Aftermath, Robert J. Samuelson recalled how President Jimmy Carter interviewed Paul Volcker for the job of Fed chairman, held briefly by G. William Miller. Being influenced by the monetarist counter-revolution, Volcker bluntly told the president, "I favor a tighter policy." Unable to persuade others to take the job, Carter got stuck with a Friedmanite in the Fed.

Next week I'll tell of the last attempt to save the full-employment doctrine and how a new political environment cured America of its Keynesian malaise.