Why the Fed's monetary policy has been a failure.

• Author: Ranson, R. David

Passing its 100th birthday, the Federal Reserve is receiving unprecedented scrutiny. We (the public) are living through the consequences of its attempts to bolster the U.S. economy through exceptionally low interest rates and the conversion of great quantities of debt to money. Although these efforts are ongoing, we are disappointed. Even with the help of strenuous actions on the fiscal side, economic and credit-market recovery from the recession of 2008-09 was notoriously slow. It took 15 quarters for U.S. real GDP to pass its pre-recession high in the fourth quarter of 2007, compared to only 7 quarters following the deep recession of 1981-82. On a per capita basis, there was an even starker contrast between the two recoveries. Moreover, the Fed remains a suspect in the genesis of the financial crisis that precipitated the Great Recession. The ultimate test of its role as overseer and regulator of the commercial banking system met with a very poor result.

Questions concerning the Fed's record can be asked at two levels: (1) Has the economic outcome been poor because the Fed made too many errors of judgment? Or (2) were its policies based on erroneous beliefs about how the economy works? If either is true, with or without mistakes, perhaps the Fed's efforts were inherently ineffective. My view that monetary policy might even have contributed to economic stagnation comes from several concerns:

* Fed thinking about the credit market is at odds not only with Adam Smith's Invisible Hand, or its modern reformulation by Hayek in terms of market price signals, but with standard microeconomics.

* Expectations that current monetary policy tools will have the desired effects on credit volume and economic growth lack straightforward empirical verification in the long sweep of U.S. history.

* As a creation of the banking industry, the Fed long ago became its designated protector. It is motivated to give priority to prolonging the life and maintaining the profitability of existing financial institutions even where that might conflict with competition and general economic health.

* In decisions relating to inflation and unemployment, the Fed overrelies on "headline" statistics of public debate that have been politicized and tend to obscure more than they reveal.

I address these considerations in turn.

Fed Policy versus Free-Market Thinking

The U.S. economy is broadly capitalist and competitive, and Americans have a respect for the invisible guiding hand of market forces. To place a central bank in a governing role at the hub of the monetary system represents an opposite philosophy. In no other major sector is the general level of prices pegged and re-pegged by federal authority. It's the antithesis of free-market thinking to imagine that the Fed has unique or superior knowledge to impose an interest-rate structure that will better allocate credit.

Banks claim unique status in the economy. Politicians see them as a fragile credit-allocation mechanism without which the economy could barely even function, but which require government assistance and supervision. In no other industry is there general acceptance of need for a supplier or demander of last resort.

Even in a credit crunch like the one that hit in 2007, it's unclear what the Fed's injections of funds did to help. They were designed to ease the stress felt by banks caught with assets for which there was no demand at acceptable prices. But the economic collapse came anyway.

Despite the common usage of the ambiguous word "liquidity," making cash plentiful is not the same as making markets liquid. A liquid market is one in which there are plenty of willing buyers and sellers and the volume of transactions is sufficient to allow each investor to trade without materially affecting the price. An illiquid market is one in which buyers and sellers are temporarily holding back from normal trading and prices are pushed around by individual transactions.

A "liquidity crisis" is something else again: a situation in...