Why did the Federal Reserve’s Open Market Committee raise interest rates when it appears the economy may be slowing? That good question has no definitive answer, but a couple of possible responses.
The first is that the Fed must weigh myriad factors in trying to balance goals of strong economic growth, low unemployment, low inflation and even buoyant stock markets. After weighing many considerations, the committee decided that the dangers of inflation trumped concerns about unemployment or slowing growth. Restricting growth of the money supply was the lesser evil.
This view is widely held by the general public, elected officials and, apparently, business economists. It dominated news reports.
A second explanation is that in the long run central banks like the Fed cannot do anything to influence employment, the unemployment rate, the pace of economic growth or the real value of stocks, bonds or real estate. All the Fed can do is prevent inflation or deflation.
Moreover, the money supply grew too rapidly for too long. Indications of overall inflation are widespread. Contrary to what many people think, monetary policy changes take a long time to significantly change anything. FOMC members are experienced economists who realize these stark realities. They did the right thing or at least moved in the right direction.
This second view, I venture, is held by a majority of academic economists. It certainly is the view of most under age 40. It is, in my view, the correct one, even though it contradicts the popular wisdom.
Indeed, it’s worth asking why a flawed and discredited economic theory continues to dominate popular thought. History shows that when nations delude themselves on economic choices, they tend to make bad decisions. Argentina and Japan are two recent examples. The United States should not become another.
The flawed theory that continues so predominant among the media, elected officials and the general public is what we call Keynesianism. John Maynard Keynes himself explained why this idea continues to be so strong, even 25 years after its real-life flaws became evident.
At the end of his most important book, Keynes writes: ” … in the field of economic and political philosophy there are not many who are influenced by new theories after they are 25 or 30 years of age so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest.” Substitute “reporters and Wall Street pundits” for “agitators” and you have a perfect explanation of why non-economists interpreted Tuesday’s Fed action the way that they did.
Most anyone who has ever studied economics has been indoctrinated in Keynesian theory. (In fairness to Keynes, what we call “Keynesianism” includes his ideas as interpreted and abused by later scholars. Like Marx, Keynes died before ever seeing his ideas actually put into practice.)
Keynesians believed that governments could control not only inflation, but also unemployment and economic growth by manipulating taxes, government spending and the money supply. Changing the money supply usually changes interest rates.
This theory hit its high point 45 years ago, when University of Minnesota economist Walter Heller was John F. Kennedy’s economic guru. By 1980, however, the application of Keynesian prescriptions to the economies of the United States and other industrialized nations had not brought about prosperity, stable prices and low unemployment. Instead, most such nations had faltering growth. Inflation and unemployment were not only high, but also rising. Clearly, something was not working.
Some economists, such as the monetarists led by Milton Friedman, had always rejected Keynes’ ideas. Others, a group called Rational Expectationists, found flaws in Keynesian thought at the level of high theory. And many nondogmatic pragmatists, including me, became convinced that Keynesian aspirations of economic micromanagement simply did not work in practice.
With monetary policy, much experience and theory show that all a central bank can do is maintain stable prices. That is, it can control the money supply to avoid either inflation or deflation.
But a central bank cannot change either unemployment or economic growth in anything except the very short term. Attempts to do so are not just ineffective, but often harmful. That is precisely what brought us to the stagflation of the late 1970s.
Fifty years ago, Milton Friedman emphasized that when the money supply grows much faster than the total production of goods and services, inflation results. In the last five years the money supply has grown by 36 percent and the gross domestic product by under 14 percent. The consumer price index increased at an annual rate of 6.4 percent in the first quarter of 2005.
Except for die-hard Keynesians, that is all the information the FOMC needed Tuesday. It needs to slow money growth. That will raise interest rates. Short-term rates still need to double. The longer that takes, the worse it will be for our nation.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.