GROWTH'LL TAKE CARE OF ITSELF:

The Fed Cannot Fix Itself (Frank Shostak, June 2, 2004, Mises.org)

In his speech on May 20, 2004, a Fed Governor, Ben Bernanke, argued in favor of a gradual approach to interest rate policy settings. According to Bernanke, because policy makers do not have precise knowledge of how the economy will respond to a given change in interest rates it is logical that policy makers should proceed cautiously.

In other words, inadequate knowledge regarding how the economy works makes it appropriate for policy makers to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions.

Furthermore, Bernanke holds that the gradual approach allows central bank policy makers to have greater influence over long-term interest rates. This in turn permits the Fed to have more direct influence over the future course of the economy. In other words, he holds that long-term interest rates are driven by the expectations of financial markets participants about the likely future course of short-term interest rates, which are in turn closely linked to expectations regarding the federal funds rate.

Consequently, according to Bernanke,

In a gradualist regime, an increase in the federal funds rate not only raises current short-term rates but also signals to the market that rates are likely to continue to rise for some time. Because they reflect the whole path of expected future short-term rates, under a gradualist regime
long-term rates such as mortgage rates tend to be relatively sensitive to changes in the federal funds rate. Thus, gradualism helps to ensure that the FOMC will have an effective lever over economic activity and inflation.

It would seem, therefore, that the formula for making the economy healthy is to make the central bank's policies transparent and predictable. According to Governor Bernanke, it would appear that transparent policies are good for the health of the economy because this doesn't disrupt the fluctuations of relative prices of goods and services. Consequently it is held that this allows the economy to move along the path of stable economic growth.

Although Bernanke believes in a market economy, he doesn't trust the notion that the economy can look after itself. There are always various shocks that can throw it off the stable growth path and pose a threat to the economy's well being. He believes that it is the role of the central bank to put the economy back on the right path because without the Fed's intervention the economy could even fall into a black hole.

Thus if the economy falls below the path of stable economic growth it is the role of the Fed to put it back on this path by means of monetary pumping and the lowering of interest rates. If, however, the economy exceeds the stable growth path the central bank must push the economy back onto the path by slowing monetary pumping and lifting interest rates.

Read the excellent new book, Deflation: what Happens When Prices Fall, by Chris Farrell, and it's awfully hard to avoid the conclusion, shared by Milton Friedman and John Maynard Keynes (in his monetarist phase, that nothing in economics (and little in society) is more important than keeping stable the value of money:

"We see, therefore, that rising prices [inflation] and falling prices [deflation] each have their characteristic disadvantage. The Inflation which causes the former means Injustice to individuals and to classes--particularly to investors; and is therefore unfavorable to saving. The Deflation which causes falliing prices means Impoverishment to labor and to enterprise by leading entrepreneurs to restrict production, in their endeavor to avoid loss to themselves; and is therefore disastrous to employment.... Thus Inflation is unjust and Deflation is inexpedient.[...] But it is not necessary that we should weight one evil against the other. It is easier to agree that both are evils to be shunned."

"We leave Saving to the private investor, and we encourage him to place his savings mainly in titles to money. We leave the responsibility for setting Production in motion to the business man, who is mainly influenced by the profits he expected to accrue to himself in terms of money. Those who are not in favor of drastic changes in the existing organization of society believe that these arrangements, being in accord with human nature, have great advantages. But they cannot work properly if the money, which they assume as a stable measuring-rod, is undependable. Unemployment, the precarious life of the worker, the disappointment of expectation, the sudden loss of savings, the excessive windfalls to individuals, the speculator, the profiteer--all proceed, in large measure, from the instability of the standard of value." [...]

The Individualistic Capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring rod of value, and cannot be efficient--perhaps cannot survive--without one.
-John Maynard Keynes, A Tract on Monetary Reform

Sadly, being merely human, even that's probably more than we can manage.

MORE:
-BOOK SITE: Deflation (Harper Collins)
-ESSAY: Why We Should Fear Deflation (J. Bradford DeLong, Brookings Panel on Economic Activity, March 25-26, 1999)

Posted by Orrin Judd at June 2, 2004 1:01 PM