Political Economist

The Fed in action

The time when the Carter administration decided to nominate Paul Volcker as a new chairman of the Fed, the U.S economy in the late 1970s was facing up exactly the same threats as this case. The Fed led by Paul Volcker started to tight money supply in order to fight against persistent inflationary pressures.

Traditionally, the Fed had rights to regulate various financial resources including overall money supply, credit markets derived from the original money and bond market. In the early 1970s, however, the US congress already passed the law targeting the deregulation of the banking system. This bill included the abolition of market barriers which had traditionally prohibited potential financial asset holders from starting banking businesses, and the deregulation of credit markets.

Thus, when Volcker was nominated as a new chairman, he found that the only option for the regulation of the financial market was the control of the supply of money by trading government bonds. This is the determinant of the “federal fund rate.” Once the federal fund rate is determined by the Fed’s “open market operation,” this will also determine other commercial bank’s interest rates accordingly. Combined with the Fed’s right to urge bank to maintain certain range of reserve rate, this monetary policy will affect overall economy indirectly.

Paul Volcker and his committee started to fight against inflation by reducing overall supply of money. If the Fed started to sell Treasury bonds at higher interest rates, this would absorb huge amounts of money previously abundant in the real market. Furthermore, if the Fed started to raise its federal fund rates, financial asset holders would start to buy government bonds. In this way, the Fed under Volcker’s leadership tried to tighten the valve through which the blood flew into every part of a living body. The Fed and Volcker expected unprecedented economic frenzy would subside through its contractionary monetary policy.

As interest rates rose in financial markets, many potential customers would be discouraged from buying at the higher prices. Customers who still wanted to buy despite the higher interest rates would find it harder to obtain loans. Many farmers who borrowed at the higher interest rates in order to buy land and expand production facilities started to learn the hard way in the face of high pressure of repayment. Many families who borrowed at the higher interest rates in order to buy homes and cars started to realize that they were burdened with higher interest payment. They went into deeper debt to compensate for their shrinking incomes and interest payment.

However, the impact of higher credit did not fall on evenly all American people and enterprises. Some were forced to go without. The millions of American who depended on borrowing started to suffer additional distress – consumer, farmer, home builders, auto dealers, business of every type in small scale started to suffer from high interest rates without understanding the behind economic logic.

Contrast to situations of ordinary citizens, those who lend money would naturally gain from higher interest rates. At that time, “among individuals, the top 10 percent of American families owned 72 percent of corporate and federal bonds held by individuals plus 86 percent of state and local bonds. Among institutions, commercial banks owned about 20 percent of the outstanding Treasury debt and another 10 percent was owned by insurance companies and other corporations. The same people likely to hold the bonds in their personal portfolios also owned the stock of the corporations and banks that owned bonds.”(372)

At any rate, the Fed under Volcker’s leadership started to control overall quantity of money instead of regulating interest rates directly. In economics, there are only two ways to achieve certain range of interest rates. One is to control overall quantity of money, and the other is the regulation of real interest rates indirectly through the Fed’s bonds trading. Volcker and other Board members adopted officially new monetarist rule when they tried to fight against inflation.

Pendulum swung – from liberal Keynesian to conservative monetarism

We should pay a little attention here to the theoretical and ideological terrain of the time in order to understand the behind logics underlying the Fed’s monetarist rules. Since the Great Depression in the 1930s the U.S federal government and most other western industrialized countries had adopted the same in nature expansionary government’s fiscal and monetary policy under the guide of Keynesian economics.

The US federal government had invested its federal budget on public work projects such as infrastructure constructions and buildings on behalf of private corporations through its expansionary fiscal policy in order to stimulate the “aggregate demand” in the private economy. Through its monetary policy, the US Federal Reserve pumped out more money thereby leading to and maintaining lower interest rates favoring private entrepreneurs to invest on more productive capital. All of this policy mix naturally produced temporal fiscal deficits in the federal budget.

However, liberal administrations from Franklyn D. Roosvelt to John F. Kennedy argued that once the economy gained its momentum engineered by therapeutic federal government’s deficits, the increased economic activity would compensate for the budget deficit shortfall in the medium or long run. The increased demand for goods from “demand side” would lead wealth owners and corporations to invest in new factories and plants, and this in turn would result in offering much more employment opportunities. In this way, the devastated economy in the era of the Great Depression and war would recover its normal process of capital formation and secure capitalist economic growth.

This liberal Keynesian economics had really worked until it faced new economic phenomena called “stagflation” in the mid-1970s. From then on, the US economy had to deal with stagnant economic growth combined with growing threat of inflation at the same time. It was Milton Friedman who already anticipated similar economic results almost 10 years ago. In 1963, Friedman published with coauthor Anna J. Schwartz, A Monetary History of the United States, 1860-1960. In this book, Friedman argued that Keynesian economics was totally wrong. Unlike Keynesian’s wishful thinking, he argued, interventionist government’s monetary policy has devastated real economy.

With respect to the role of monetary policy, he observed that both the original collapse of 1929 and the long lasting economic contraction of the real economy in 1930s were partly caused by and surely exacerbated by the Federal Reserve’s failure to provide adequate money supply. Instead of trying to manage the overall quantity of money in accordance with the pace of economic growth, the Fed pumped out too much money and eased the credit when the actual economic situation is on the process out of recession thereby leading to fervent economic bubble and burst. On the other hand, the Fed had tightened money too much when the money for various investments was really needed the most.

In this way, Friedman argued that the Fed played a role in exacerbating the devastating effects of business cycles than otherwise might not be necessary. Thus, the Fed should revise its unique roles from trying to manage real interest rates to offering adequate quantity of money to secure ‘the overall stability’ of economic system - stable backgrounds for the overall economy.

Friedman also warned that if the Fed did not change its traditional roles, its reckless monetary policy would result in continuous inflation combined with the effects of “crowding” private investment out of the market. In the face of federal deficits combined with high inflationary pressures, his monetarist argument had gained wide recognition and acceptance from both academia and politicians.

If you remember the term “economic policy entrepreneurs” used by Paul Krugman in his book, Peddling Prosperity – Economic Sense and Nonsense in the Age of Diminished Expectations(1995) to designate those who sold profound economic ideas to politicians in the simplistic way, Friedman’s monetarism was the best selling ideas adopted by a group of conservative economic policy entrepreneurs called “supply siders” in real politics from the mid-1970s. In the end, faced with intense criticism from both monetarism of academics and supply siders of Republican Party, the Fed had to change its target of monetary policy from the management of interest rates to the management of aggregate money supply.

In the face of massive tax cuts

There was another reason why the Fed chairman tried to tighten money supply extremely. Since 1980 newly elected president Ronald Reagan adopted massive tax cuts policy, guided by supply siders who argued that US citizens had been suffered from heavy burdens of federal taxes. They maintained that reduced tax burdens would induce much more investments (saving) and this would in turn bring about economic prosperity. Aided by his economic advisors, Reagan asked the congress to approve a three-year reduction in individual income taxes rates, totaling 30 percent.

To foster business expansion, he proposed additional tax relief for corporations as well as relief from federal regulations. All together, this supply side economics would reduce the federal government’s revenue by a total of $540 billion over five years. Reagan promised that the federal government would produce a balanced budget by 1984 once the economy gained momentum through his federal tax cuts and its effects. But, considering his another agenda, federal budget increases for military defense industries, Reagan’s proposed tax reductions would lose $100 billion a year in government revenue.

Nonetheless, the US congress passed this tax legislation in 1981. Volcker and other Fed committee members considered this federal government’s fiscal deficits as another ominous source for higher inflationary pressures in the near future. Even though the components of the federal budget expenditures became different from previous fifteen years of liberal administration’s deficits (from public work projects and social security spending to military subsidies combined with massive federal tax cuts), the Fed chairman and other precautious financial investors had learned that huge federal deficits were usually predicates for continuing price inflation.

That was why Volcker warned continuously against Reagan administration’s massive budget deficits, and had adopted aggressive tight money policy throughout his tenure. “The direct cause of the higher rates was the bond market and the Fed, reacting together. Both feared the same thing – the inflationary potential of the deficits – and both moved protectively, ahead of the fact. The Fed moved short-term rates higher, expressing the same anxiety as the bond market.” (402)