The Priesthood of Central Bankers

The Priesthood of Central Bankers

Mini Teaser: Central bankers have amassed unprecedented power, and yet lack serious political counterweights.

by Author(s): Christopher Whalen

The late 1970s and the 1980s were difficult years for the United States as issues such as employment, inflation and trade competition with other nations came back to political prominence. For the first time since World War II, the poor economic outlook revived American fears of inflation or worse. Policy makers struggled for solutions. In 1978, Congress made long-run growth, low inflation and price stability the explicit goals of Fed policy through the Humphrey-Hawkins Act. In America, you understand, growth can simply be legislated. But the powerful demographic force of the post-WWII baby boom drove national priorities and inflation, forcing Fed chairman Paul Volcker to raise interest rates well into double digits in 1979 to cool the fires of inflation. Volcker’s bold political stroke set the stage for the economic expansion in the 1980s under Ronald Reagan.

By the early 1990s, the United States had lived through a real-estate boom and bust with the savings-and-loan crisis. Fed policy was increasingly focused on keeping interest rates low to spur consumer activity and jobs, with little concern about inflation. America turned inward in its search for jobs and growth, and naturally turned again to housing as a solution. Depression-era agencies such as Fannie Mae and the Federal Housing Administration “were repurposed by the Clinton administration to direct social policy through the housing and mortgage markets,” author and financial analyst Joshua Rosner told a subcommittee of the House Financial Services Committee this March. “In 1994, the [Clinton] Administration set about to ‘raise the [home] ownership rate by 0.5%–1.0% per year for the seven years, from 65% to 70% by the year 2000.’” The years of subprime boom and bust that followed under President George W. Bush were only made possible by Bill Clinton’s housing policies. In place of the military-industrial complex that propelled U.S. growth from the 1950s to the 1980s, the affordable-housing lobby used public policy to drive employment and growth from the 1990s onward. The 2007 subprime crash, like the crash of 1929, was merely the climax of more than a decade of housing-market speculation.

SINCE THE 2007 crisis, while Congress has hid its head in the sand with respect to fiscal issues, the Federal Open Market Committee (FOMC) effectively has managed both fiscal and monetary policy. By keeping rates artificially low compared to the true rate of inflation, the Fed subsidizes the U.S. Treasury’s debt load to the tune of hundreds of billions of dollars per year.

Meanwhile, Washington’s subsidy for the U.S. banking system amounts to hundreds of billions more annually, far more than the industry reports in profits. Subsidies for the banks range from federal deposit insurance to low interest rates maintained by the Fed to federal guarantees for mortgages and small-business loans. To pay for the subsidy of artificially low interest rates, individual, institutional and corporate savers pay a repressive tax levied by the central bank in the form of quantitative easing, where the Fed buys financial assets from commercial banks and other private institutions in order to inject more fiat money into the economy. Irwin, who falls into the camp of those who tend to lionize central bankers, likens the U.S. central bank’s low-interest-rate policy to a modern version of alchemy, but old-fashioned, nineteenth-century socialist redistribution from savers to debtors is perhaps a more accurate description of the policy direction of the Bernanke Fed.

Irwin uses seventeenth-century Sweden and a story familiar to students of economics to illustrate his dubious “alchemist” metaphor. A Swedish banker named Johan Palmstruch creates an early model of a modern central bank, Stockholms Banco. The bank uses various metals to back its activities, but one day it runs up against an age-old problem of money and banking—liquidity. Palmstruch quickly discovers the magic of issuing unbacked paper money to provide additional liquidity, but eventually the bank fails. He is tried for fraud and imprisoned.

“All it took to create wealth where there’d been none was some paper,” writes Irwin of the Swedish experience, “a printing press, and a central bank, imbued with the power from the state, to put it to work.” Sadly, with the rise of modern central banking, people who “create” such money are no longer thrown into prison. Even as recently as the 1920s, the business of finance was seen in classical—that is, negative—terms, but today investment banking and even central banking are considered acceptable by many parts of society.

Early in his book, Irwin uses a couple of additional examples of central banking as a backdrop for the rest of the volume. He covers the failure of the Overend, Gurney & Company bank in the 1860s in the United Kingdom, Jackson’s assault on the Second Bank of the United States, the hyperinflation of Weimar Germany and the secret meeting at Jekyll Island prior to the creation of the Federal Reserve System in 1913. Following this background, Irwin gets his readers to 1971 and Nixon’s decision to close the gold window.

In a chapter titled “The Anguish of Arthur Burns,” we learn of a fundamental reality of central banking—namely, its intimate relationship to politics despite pretensions of independence. Irwin draws on the diaries of former Fed chairman Burns to capture his distress over the decision to break the link between the dollar and gold. “The gold window may have to be closed tomorrow because we now have a government that seems incapable, not only of constructive leadership, but of any action at all,” wrote Burns, leaving some readers wondering, no doubt: What would he say about Washington today?

Burns was probably the last Fed chairman to recognize any limits on his actions in terms of monetary policy. Irwin, betraying his journalistic background, places much blame on Burns for his failure to control rising prices in the 1970s. This is probably an oversimplification. In fact, demographics, free trade and external shocks such as rising oil prices, which Irwin notes, probably did more to spur inflation than the specific actions taken or not taken by the FOMC.

Indeed, Burns’s contemporaries considered him a “tight money” Fed chairman. He operated in the poisonous political environment that swirled around Washington during the Nixon years, making concepts like central-bank “independence” ridiculous. Moreover, Volcker was a protégé of Burns, so drawing a great distinction between the two is not particularly useful. “To attribute the inflation of the first part of the 1970s solely to Burns’s leadership is wrong,” wrote Fed economist Robert Hetzel in 1998. “Monetary policy under Burns’s FOMC was never as expansionary as vocal congressmen urged and, through 1972, was less expansionary than the Nixon Administration desired.” He adds that the inflation of the 1970s “represented the failure of an experiment with activist economic policy that enjoyed widespread popular and professional support. Burns was part of a political, intellectual, and popular environment that expected government to control the economy.”

WHEN IRWIN recounts the transition from Burns to G. William Miller and then to Paul Volcker, he falls into the familiar trap of Volcker hero worship, crediting Volcker with leading the great struggle against inflation beginning in 1979. But as I noted in my 2010 book Inflated, although Volcker was nominated by a conservative Southern Democrat, Jimmy Carter, his Republican predecessor, Gerald Ford, took the battle against inflation every bit as seriously. Few commentators adequately note the irony of the Democrat Volcker engineering the 1971 decision by the Republican Nixon to devalue the dollar and then, eight years later, being asked by Carter to fix the inflation problem unleashed by that very action.

Volcker did break the back of inflation and, for a while at least, restored public confidence in the ability of Washington to manage the economy. William Silber, writing in Volcker: The Triumph of Persistence, notes that Volcker “earned his unparalleled credibility over the course of his professional career by approaching public service as a sacred trust.” But had not Volcker broken that trust by embracing a pure fiat currency? It can be argued that, while Volcker did defeat inflation in the late 1970s and early 1980s, his more significant action came in 1971, when he set the course for decades of American fiscal dissolution and the financial crises that followed.

Irwin notes that Volcker’s success in fighting inflation made it possible for his successor, Alan Greenspan, to keep interest rates low, again part of the collective (and false) Washington narrative that gives Bill Clinton and Robert Rubin credit for balancing the budget during the 1990s. In fact, swelling contributions to Social Security from aging baby boomers took enormous pressure off the Fed and the Treasury Department during this period. So great were the cash inflows to Social Security, we should recall, that officials warned about the disappearance of public Treasury bonds. The Fed’s purchases of Treasury and mortgage bonds today are on a scale with the positive cash inflows from the baby boomers of two decades ago, but the cash flow of Social Security is now negative.

While restoring public credibility to the Fed was certainly helpful to Alan Greenspan and his colleagues on the FOMC after Volcker left in 1987, the central bank was entering a period of relative calm. The neoliberal philosophy of free markets and deregulation was grafted on to Washington’s New Deal apparatus, fueling nominal growth along with mounting public deficits. Then came the great effort to promote home ownership, fostered by Bill Clinton, well-placed members of Congress such as Barney Frank of Massachusetts, and the government-sponsored enterprises Fannie Mae and Freddie Mac. That begat the wave of housing investment that would become the massive housing bubble of the last decade. Alan Greenspan became the high priest of the period of expansion known as the “great moderation,” but the wave Greenspan’s FOMC rode was demographic—a product of the famous baby-boom generation, which drove the U.S. economy, as well as cultural trends, for decades. It dominated American life, including consumer purchases, housing, saving, education and government spending.

Pullquote: Since the 2007 crisis, while Congress has hid its head in the sand with respect to fiscal issues, the Federal Open Market Committee effectively has managed both fiscal and monetary policy.Image: Essay Types: Book Review