Alternatives to the Fed?

AuthorMcCallum, Bennett T.
PositionFederal Reserve - Essay

I must begin by saying that I have been extremely disappointed--the word "appalled" may be more accurate--by several developments over the last two years involving the Federal Reserve. It was, I believe, appropriate that the Fed would respond with expansionary monetary policy in the face of a major macroeconomic downturn, which it did. But it did not have to do so by means of operations that incorporated major excursions into credit policy, as well as monetary policy, and thereby into the unauthorized exercise of fiscal policy. (1) By engaging in such operations on a very large scale, the Fed's actions are almost certain to have detrimental effects on the Fed's independence--and thereby on its resulting ability to focus attention on what should be its principal objective, namely, price level stability. Furthermore, the Fed has not been moving quickly--if at all--to explain and correct this situation.

All in all, the recent experience has had the effect of moving the Fed away from the type of policy behavior that mainstream academic analysts have been promoting over the past 15 years--namely, an activist but rule-based monetary stabilization policy that emphasizes the avoidance of significant inflation while 'also avoiding deflation. In saying this, I do recognize that the term "inflation targeting" has been gradually corrupted so as to permit excessive aspects of "fine tuning'" relating to output and employment levels, but by and large I believe that the academic literature has been mostly constructive and that much of the commentary tending to discredit it on the basis of recent events has done so mistakenly.

Monetary Policy and Exchange Rates

In previous writings, I have argued that monetary policy and exchange rate policy are linked together so intimately that they should be considered as two sides of the same coin. From that perspective, it seems an unfortunate anachronism that official exchange-rate responsibility is assigned to the Treasury or Finance Ministry in many economies, including the United States, Japan, and to a small extent--even the European Union. But, in any case, this topic in turn leads us to contemplate other types of monetary regimes--arrangements other than fiat money, managed by a national central bank, in the context of floating exchange rates.

In this regard there are, I believe, three main alternatives that need to be discussed. These are the gold standard, private competitive supply of money, and the Yeager-Greenfield plan for an automatically stabilized unit of account. For "all three of these, a major outlet for sympathetic and scholarly discussion has been the Cato Journal. For this, the Cato Journal deserves much credit, even from readers who are basically supporters of the fiat-floating regime. I will attempt to provide some relevant considerations in the remainder of my presentation.

The Gold Standard

There are many critics of the gold standard among economists who are ardent believers that any monetary arrangement should have price stability as its overriding objective; one might mention Allan Meltzer, Anna Schwartz, and Leland Yeager. One reason for criticism is that while a traditional gold standard tends to protect an economy from major inflations or deflations over a decade or more, it permits a substantial amount of variability at the business-cycle frequency (see, e.g., Bordo 1981). The difficulty that I wish to emphasize here is different, however; it is one stressed in Friedman (1961)--one of his less-famous papers. My own way of thinking about this point begins with the assumption that any gold-standard arrangement today would be one in which the nation's monetary authority (MA) stands ready to exchange gold, at a fixed rate and in both directions, for the principal paper medium of exchange-let us use the term "dollars" and also assume that the medium of exchange (MOE) is the medium of account (MOA). (2) This fixed price is supposed to be maintained indefinitely. But if the MA has the capability of adjusting this price, then there is no permanent anchor for the price level even if dollars are at each point of time convertible into gold. The problem is that the population of the United States--like that of other countries--is full of congressmen, businessmen, union leaders, nonprofit organizations, voters, television commentators, and miscellaneous individuals who will be frequently clamoring for the MA to raise or lower the medium-of-exchange price of gold (or whatever is the standard commodity). An increase would then possibly be stimulative but only temporarily and would be followed by price increases for goods in general, that is, by a burst of inflation. Historically, the gold standard provided a reasonable degree of price level stability over long spans of time because the population at large had at that time a semi-religious belief that the price of gold should not be varied but should be maintained "forever." (3) But today the same political forces that impinge upon the Fed to be inflationary under our present arrangement would work through this alternative channel under the suggested gold system. Friedman (1961) referred to such a system as a "pseudo gold standard" and pointed out that it amounted...

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