IF NOTHING ELSE, the 1981-1982 recession removed the Federal Reserve from obscurity. Virtually everyone now accepts that "the Fed" (as it is familiarly known) is what Maxwell Newton says it is: "the power center that controls the American economy." It does not control everything--no one does--but it controls more than anyone else.
The paradox is inescapable. In an era when the economy dominates politics, the most powerful government economic agency enjoys apparent autonomy. It is nominally independent from the White House and, if technically accountable to Congress, does little more than report its activities. The Fed is, in fact, the classic embodiment of the independent authority which, shielded from direct political pressures and managed by nonpolitical appointees, is supposed to govern in the "public interest."
All this is widely believed, but wrong.
Wrong, not because the people who run the Fed are unconcerned with the "public interest." Not because they are political puppets. In general, the people who run the Fed have been technocrats--economists and bankers for the most part. And they have generally striven to "do good" in the best sense of the word. The fact is that few institutions involved in matters so sensitive and central to politics can hold themselves above politics. The Fed, for one, does not.
During the past 35 years, the Fed has accepted the economic passions and fads of the times. It has adapted to the prevailing political climate. The central question is whether there is a better way to regulate the nation's money and credit markets than this pattern of haphazard accommodation.
Newton, the financial editor of The New York Post, believes monetarism is the answer. Until a few years ago, monetarism belonged to the jargon of economists. In the last half of the 1970s, it climbed into popular usage and --along with capitalism, communism, socialism, Keynesianism and a few other "isms"--captured a place among the influential doctrines and dogmas of our time.
Monetarism argues that a reasonably predictable relationship exists between the money supply, on the one hand, and inflation and economic growth on the other. An old idea, it lapsed into disuse during the Keynesian enthusiasm of the early postwar years. Because its simplest formulation is that "inflation is too much money chasing too few goods," it roared back into fashion with the resurgence of inflation.
Like most monetarists, Newton holds the Fed responsible for inflation and, because he believes inflation explains many of the economy's other ills, he can logically blame the Fed for these, too. In a technical sense, of course, the monetarists are correct. Money growth (with money defined as cash plus checking accounts) rose from an annual average of 2.2 percent in the 1950s to 7 percent in the 1970s. If this increase hadn't occurred, neither would the ensuing inflation. Nine out of 10 economists (maybe 10 of 10) would agree that a generalized inflation--as opposed to individual price increases --can occur only if supported by rising volumes of money.
But the monetarists are correct only technically. To blame the Federal Reserve, they need to accept the myth of its independence. Being independent, the Fed could then be held responsible for its successes and failures. But, if it is not truly independent, then the fault must lie--at least partially--elsewhere. The analysis become infinitely more complicated and subtle, because it must consider all the other forces--social, political, intellectual--that impinge on the Fed's nominal independence and affect economic policy.
Because Newton accepts the myth of the Fed's independence, his account is unavoidably flawed. It is true that, on paper, the Fed enjoys enormous freedom. Although its seven-member board is appointed by the president and approved by Congress, members have 14- year terms. The Fed does not face budget control by Congress, because its expenses are funded by the interest received on commercial bank reserves deposited at regional Federal Reserve banks. Other congressional guidance is minimal. Beginning in 1975, Congress required the Fed to set semi-annual targets for growth of the money supply. But the Fed, not Congress, sets the targets. And there is no requirement to hit them and no penalty for not doing so.
But political realities differ from these legal requirements, as Newton's account confirms. Writing of William McChesney Martin, chairman of the Fed between 1951 and 1970, Newton says he "worked for Truman, Eisenhower, Kennedy and Johnson. . . . The demands of the different presidents were met." The same could be said of all Martin's successors: Arthur Burns (1970- 1978); G. William Miller (1978-1979); and Paul Volcker (1979-present).
What obscures and confuses this cooperation, though, is that it occurs by osmosis. Both the White House and the Fed act as if the Fed is independent. The Fed has almost complete autonomy in the week-to-week and month-to-month operating decisions that immediately affect the money supply and interest rates. Rarely does the president order the Fed to do this or that. Indeed, the Fed and the White House sometimes publicly disagree. Although these conflicts are usually well reported in the media, they do not differ significantly from the internal disputes that wrack any administration.
To keep its operating freedom, the Fed abides by the broad objectives of the White House. In the 1950s, policy reflected the rabidly anti-inflationary orientation of Eisenhower. In the 1960s, it accommodated the Kennedy-Johnson expansion. In the 1970s, it vacillated betweennfighting inflation and recession. And, in 1980 and after, it epitomized the reaction against double-digit inflation, a policy first embraced by President Carter and then--more tenaciously--by President Reagan.
Two other anomalies further confuse the relationship.
First, the chairman of the Fed usually represents an important influence within the administration. Even if he meets only occasionally with the president (Volcker has met about a half-dozen times with Reagan), there are regular and routine contacts with the secretary of the treasury, the chairman of the Council of Economic Advisers and the director of the Office of Management and Budget. And second, the Fed's nominal independence allows the White House to distance itself from unpopular actions, even if it tacitly supports them. One suspects that if President Reagan decides to replace Volcker, whose term as chairman expires this summer, the reasons will be entirely political: a judgment that by abandoning Volcker he can separate himself from the recession without losing credit for lower inflation.
Newton and other monetarists want the Fed to adhere to a rigid rule for money growth: one that would, in their view, permit expansion without fueling inflation. When the Fed has failed to control the money supply, they claim that it is too independent. But the reality is the opposite. The Fed doesn't rigidly control money supply because it is not independent and because there is no political consensus to do it. What the monetarists call bureaucratic intransigence, others would term political accountability.
The economic critics of monetarism contend that a fixed money supply rule won't work. The experience since late 1979, when the Fed announced its determination to take money targets more seriously, buttresses their opposition. Since then, of course, not only has the economy experienced the worst slump of the postwar period, but the Fed has encountered serious technical problems in settling upon a workable definition of money. If money can't be defined, how can it be controlled? Many critics argue for a return to the old policy objective: control o, on f interest rates.
Monetarism wasn't popular in the 1960s because the prevailing politics--the Kennedy-Johnson New Economics--aimed to eliminate the business cycle. Because most monetarists never claimed they could accomplish this feat, they were politically useless. When inflation became the main problem, their usefulness increased because they had a simple and plausible explanation for inflation. But, as their remedy for inflation increased unemployment, their political standing has waned.
The ultimate end, of course, is control not just of interest rates or money supply but of the entire economy's performance. And the ultimate frustration is that no policy made up of targets--for interest rates or money supply--can be expected to achieve the desirable goal of constant, inflationless expansion. When an accommodating Fed sought this utopia in the 1960s and 1970s, it kept interest rates too low for too long. Money growth accelerated and, as predicted by monetarists, so did inflation. This always poses a dilemma for the Fed: trying to restrain interest rates by pumping out more money only aggravates inflation. But ending a severe inflation (consumer prices rose 26 per cent between 1978 and 1980) almost inevitably entails slump, because a declining money supply collides with a rising price level.
So monetary policy involves--and ought to--political choice. The relevant question is what economic doctrine constitutes the best political choice for the country. Monetarism, taken sensibly and with a proper dose of skepticism, has as much (and possibly more) to offer than most of its rivals. It is true that the breakdown of the distinction between checking accounts and savings accounts confuses the definition of money, which has traditionally been considered the stuff people spend, not what they save. Other technical problems arise from the growing internationalization of money and credit markets. But all theories of monetary.control must contend with these changes.
Monetarism's chief virtue is that it imposes economic discipline. Newton and other monetarists are almost certainly right in arguing that the existence of a crude monetary rule--that is, a determination to hold money growth within predetermined limits--over the past two decades would have improved the economy's performance. It would have operated as a break on rising inflation. Modern democracies, prone to expectations that exceed economic realities, need discipline. The escape from discipline has, in the end, lowered unemployment only temporarily and, by aggravating inflation, probably worsened long- term joblessness.
Newton's account is crisply written and, if sometimes too laden with technical detail, reasonably clear. He has a firm grasp of the intricacies of monetary policy and the operations of the nation's financial markets. He has, rightly, taken a view of economic history stretching back to the 1950s. Some of his personal sketches--most notably, the transformation of Arthur Burns from an aloof, academic economist into one of the most skillful and influential economic bureaucrats of our time--make compelling reading. But by focusing so obsessively on the alleged sins of the Fed, he misses the essence of the modern economic problem.
Monetarism (or any economic doctrine) cannot simply arrive by intellectual fiat. It requires an underlying political consensus. Newton's analysis, like that of most monetarists, ends where it ought to begin. If monetarism is ever to be politically and socially acceptable, it requires wider public understanding of the limits of any economic policy --limits which, if understood, might inspire self-restraint on the part of business and labor in raising prices. Likewise, it cannot easily work without specific policies that would reduce the economy's existing inflationary bias. That bias is now deeply embedded in government programs, the market power of business and labor and the tax laws.
The Fed's nominal independence is an anachronism. If it gives the Fed freedom to operate quickly, no small asset in a sluggish political system--it does not provide an ultimate sense of purpose or public authority. Inconsistent and unstable monetary policies are the usual result.