REFLECTIONS ON MONETARY POLICY AND ITS FUTURE.

• Author: Hensarling, Jeb

This discussion, moderated by John B. Taylor, took place at the Cato Institute's 38th Annual Monetary Conference on November 19, 2020. The transcript has been edited for publication,

Taylor: It's a real honor to have this conversation with Jeb Hensarling and Phil Gramm, two giants of legislation affecting financial and monetary policy. Jeb, of course, was former chairman of the House Financial Services Committee, and Phil chaired the Senate Banking Committee. I have testified before their committees, so for me to have the chance to ask them questions, rather than be subject to their questions, is a treat.

Although this conference will focus on digital currencies, our conversation will be more general, covering the impact of the pandemic on Federal Reserve policy, central bank policy more broadly, and, toward the end, consider the digital dollar.

So, first of all, there's a question about the impact of COVID-19 on policy. Of course, it's had a big impact on actual decisions made at the Fed and, for that matter, on our budget policy. The question is whether those actions are going to change policy in an even bigger way going forward. The Fed's balance sheet has grown to more than $7 trillion. Should the Fed have a more rules-based policy going forward? What about "flexible average inflation targeting?" What are the long-term implications of what's been happening?

Hensarling: Well, if I could, John, just a few acknowledgments. Number one, as an undergraduate at Texas A&M back in the 1970s, I invested $25 of hard-earned money to become a sustaining member of Cato just so I could read their quarterly journals. It was one of the best investments I ever made. In a time when government continues to grow and liberty continues to contract, I cannot think of a more important think tank than Cato. Second, I should say that there was no greater single authority who impacted our policy deliberations when I served as chairman of the House Financial Services Committee than John Taylor. I vividly recall being called by President Tramp to ask my opinion on who he should nominate as chairman of the Federal Reserve. I was flattered that the president asked my advice. I recommended Dr. Taylor and spent five minutes going through the reasons. Well, it wasn't the first or last time the president didn't take my advice. Moving on to Senator Gramm, it's so great to be with my friend, mentor, and conservative icon. Many years ago, I signed up for a Money and Banking course at Texas A&M University. Phil Gramm taught me economics then, and he's still teaching me economics.

Now that I've got all these accolades out of my system, John, I'll attempt to answer your questions. I think that, in many cases, the Fed's extraordinary measures today regrettably can become ordinary measures tomorrow. I think a number of these measures were indeed called for, because COVID-19 is probably the greatest single shock to our economic system since the Great Depression, Thus, in the short run, many people may be putting Fed Chairman Jay Powell on a pedestal, but the question is: Will he be taken down in the long run? There are many problematic features of what the Fed has done from a long-run perspective. Most importantly, when taboos are broken, they tend to stay broken; when genies are out of the bottle, they tend to stay out of the bottle.

The Fed's huge balance sheet allows it to engage in credit policy (the composition of the balance sheet is by definition credit policy), which inherently auto-resides in fiscal policy--but should auto-reside with Congress. The drift of monetary policy into credit and fiscal policy is a very dangerous precedent. It is going to be very, very challenging for Chairman Powell, at the appropriate time, to shrink the balance sheet and get out of the business of credit policy. In addition, we now know that the Fed is taking on credit risk that it has never taken on before. Consequently, the balance sheet can certainly be injurious to future taxpayers, and it is one more way that the Fed's independence could be compromised.

There is also the problem of "moral hazard" (i.e., taking on risky assets when the costs can be shifted to other parties). Clearly, there was a reason for the Fed to intervene when the federal government, for all intents and purposes, put the economy into an induced coma via the lockdowns in response to COVID-19. However, once you start creating a social safety net under business enterprises, they will take on more risk and exacerbate the trend away from shareholder capitalism toward stakeholder capitalism. Indeed, once the government provides a safety net, ultimately there will be greater political influence upon the free-enterprise system. We're seeing the Fed go from practicing monetary policy, to blurring the lines between monetary and fiscal policy, to totally engaging in fiscal policy. Thus, I think there are many long-run challenges that, if left unaddressed, we will wake up to find our central bankers have become central planners.

Taylor: Jeb, thank you very much. Phil, would you like to comment?

Gramm: Yes. First of all, I guess I should say that I also recommended John Taylor to become Fed chairman. It shows you how much influence...