Federal Reserve System ; Monetary policy - United States ; Books - Reviews

Brian Motley

English

Research Papers in Economics

FRBSF WEEKLY LETTER
June 17, 1988
Temple Secrets
Last October, Simon and Schuster published a
new book about the Federal Reserve System en-
titled Secrets ofthe Temple by William Greider.
The book received extensive coverage in the
press and has been a best-seller in the nonfiction
category for several months.
The book's sub-title, How the Federal Reserve
Runs the Country, suggests that the Federal
Reserve is a powerful influence in our nation's
economy. A major conclusion of the book is that
this influence generally has been harmful, espe-
cially during the last ten years when the Federal
Reserve has focused on inflation as a major con-
cern of policy. Greider argues that although the
Fed has been successful in bringing down infla-
tion, the costs of doing so have been extremely
high compared to the benefits of stable prices,
which have been oversold. Most economists,
however, would beg to differ.
The Volcker years
Secrets ofthe Temple is an account of the Vol-
cker years at the Federal Reserve, beginning with
Paul Volcker's appointment as Chairman of the
Board of Governors by President Carter in August
1979 and ending with the succession of Chair-
man Greenspan eight years later. Mr. Volcker is
criticized in the book for espousing stable money
growth as essential to a healthy economy. In fact,
Greider argues, a vigorously expanding economy
is inconsistent with a monetary policy that em-
phasizes stable money. The closing pages, written
Or;) the eve of the book's publication, describe last
October's stock market crash as a "single illumi-
nating moment" in which the orthodox faith in
stable money was shown tobe an illusion.
Throughout the book, Greider emphasizes the
effects of the Federal Reserve's actions on the dis-
tribution of income and wealth in our society
between those who own financial wealth and
those who do not. He argues that the debate
between stable money and inflation really is a
debate over which group will reap the larger
share of the rewards from economic growth.
Greider views the events of the last ten years as
another historical episode in the continuing con-
flict between these opposing groups.
The effects of inflation
The early chapters of the book describe the
events leading up to the Federal Reserve's adop-
tion of a new, reserves-based operating proce-
dure in October 1979. The book argues that the
rising inflation of the late 1970s chiefly hurt the
small minority of the population who owned fi-
nancial assets, and that inflation actually im-
proved the position of many Americans, perhaps
even the majority of them. Middle-income home-
owners were the big winners from inflation. And
the poor and the elderly, he argues, largely were
protected from rising prices because social se-
curity and other benefit programs were indexed
to the inflation rate.
Although Greider recognizes that rising prices
frightened and angered almost everyone, he ar-
gues that it was financial markets that clamored
for a change in policy. Investors, he says, "were
in revolt" and "demanded emphatically that the
government do something to stop inflation!'
Thus, the change in Fed policy is characterized
as the response of the Federal Reserve to the
owners of financial wealth,.yvhom Greider re-
gards as the Fed's major constituency.
Money as a policy target
The book provides a thorough and accurate de-
scription of the way the Federal Reserve's Trading
Desk alters the supply of bank reserves and thus
affects both the level of short-term interest rates
and the growth of the money supply. Mr. Greider
explains the trade-off between a policy strategy
that focuses on controlling short-term interest
rates versus one that emphasizes money growth.
He describes the debate within the Board of
Governors in 1979 and 1980 over the Chairman's
plan to tackle inflation by controlling money
growth more closely and thus allowing wider
fluctuations in interest rates. Greider reports that
Governor Henry Wallich, who was considered a
"hawk" on inflation, argued strongly against the
new approach, which he described as "a pactFRBSF
with the devil." "Sometimes you have to deal
with the devil;' was Chairman Volcker's reported
reply.
Greider explains the theory underlying the Fed's
new, more monetarist approach, but argues that
Chairman Volcker adopted the money-based pro-
cedure mainly for tactical reasons, and not be-
cause he accepted thistheory. According to
Greider, Volcker did not believe that the FOMC
would be willing to vote explicitly for the sub-
stantial increase in interest rates that would be
needed to bring inflation under control. But a
procedure that allowed the Fed to attribute high
interest rates to "market forces" would diminish
political pressures on the Federal Reserve, and
make FOMC members more willing to go along.
Nonetheless, Greider admits that the new pro-
cedure also was designed to "jolt" the financial
markets and convince them of the System's re-
solve to bring inflation under control.
Federal Reserve "temple"
One of the recurring themes in Greider's book
is that the Federal Reserve System is not part of
the elected government in Washington. He de-
scribes the Federal Reserve as a "temple" where
"priests" operate in secret, largely insulated from
public pressures, and carryon activities that are
a mystery to most citizens. Thus, he argues that
the policy to reduce inflation not only caused
undue pain to large numbers of Americans, but
also was imposed by an agency that was not
accountable to their elected representatives.
Instead, the Federal Reserve's actions mainly
reflected the interests of the owners of financial
capital.
Greider also faults the Federal Reserve for pursu-
ing a monetary policy that pulled in the opposite
direction of fiscal policy during this period. Spe-
cifically, Greider argues that the disinflationary
monetary policy was at odds with the expansion-
ary fiscal policy favored by the Congress and
the President. The book implies that the System
thwarted the public's will in this period, and
failed to make clear that its anti-inflation policy
would cause sharply slower economic growth.
Fed should foster moderate inflation
In Greider's view, then, the disinflationary mone-
tary policies followed during the Volcker years
not only redistributed wealth in an undesirable
J
direction, but also hurt the overall performance
of the economy. Greider suggests that rising
prices, in fact, boost the overall performance of
the economy, in contrast to the orthodox view.
In the final pages of his book, for example, he
argues that easy money and rising prices excite
the "animal spirits" of businessmen, giving them
the prospect of expanded profits that encourage
them to plunge forward with new ventures: "the
'reckless booming anarchy' that fosters great
achievements:'
He suggests that the periods in U.s. history in
which stable money growth has been empha-
sized have been periods of slow economic
growth, whereas those in which stable money
has been de-emphasized have been periods of
boom. The Federal Reserve, he concludes,
should abandon its concern with "sound
money" and seek to foster moderate infla-
tion, because this will redistribute wealth
in a "positive" direction and also stimulate
economic growth.
An economist's view
Most economists would disagree with Mr. Grei-
der's contentions that stable money thwarts vig-
orous economic expansion and that economic
growth can be stimulated by an easy money pol-
icy and moderate inflation. Although more rapid
money growth at first may produce lower interest
rates, this effect is only temporary. When infla-
tion is anticipated, interest rates generally rise,
leaving the real, or inflation-adjusted, cost of bor-
rowing unaffected by the inflation. It is the level
of re'al interest rates that ultim'ately determines
the pace of capital accumulation and economic
growth.
A second reason for doubting that inflation
would lead to faster economic progress is that in-
flation tends to make the economy less efficient.
Since some prices rise more than others, individ-
ual households and businesses find it more diffi-
cult to interpret how any single price change
affects their own situations. As a result, infla-
tion may make for bad decisions that inhibit
economic growth. For example, a manufacturing
firm that finds it can sell its product at a higher
price may conclude that demand for its product
has increased and hence decide to increase pro-
duction. But if this price increase actually re-
flected a general rise in prices, the decision tocommit more resources to production will turn
out to be a mistake, and the firm will find that its
costs increase by as much as the increase in its
sales.
Greider's argument that inflation redistributes in-
come and wealth away from owners of capital
and financial assets into the hands of wage-earn-
ers also is suspect. Although the inflation of the
1970s apparently was associated with a redistri-
bution of wealth from capital to labor and from
lenders to borrowers, most economists argue that
this occurred because people did not anticipate
the rise in prices and therefore did not factor it
into their contracts.
A similar redistribution of wealth likely would
not occur if people were to know that moderate
inflation was an official goal of Federal Reserve
policy. Rather, such a policy would cause interest
rates to rise since lenders would demand higher
returns to offset rising prices. Indeed, the experi-
ence with inflation over the last twenty years has
made the public much more sensitive to the ef-
fects of rising prices. As a result, the response to
faster inflation probably would be a good bit
quicker now than it was in the past.
Concern for sound money
The book provides a good description of the
mechanics of monetary policy and the tech-
niques used to control monetary growth. The
suggestion that the Federal Reserve's experiment
with monetary targeting after 1979 was mainly a
tactical device, although not unique to Mr. Grei-
der, probably does contain an important grain of
truth. However, there also were sound economic
reasons for targeting a monetary aggregate, since
there is a substantial body of evidence that prices
and money tend to move together. This historical
link between money growth and inflation has
weakened in more recent years but was still quite
strong in the early eighties.
Because the relation between the stock of money
and the growth of aggregate demand has become
less reliable in recent years, the Federal Reserve
has de-emphasized the aggregates as targets for
policy. A number of observers have argued that
the conduct of monetary policy has become
more difficult precisely because the Federal
Reserve currently lacks a reliable intermediate
target. Thus, this change shows that monetary
targets had more than tactical significance for the
System.
The facts do not support Greider's suggestion that
the Administration and the Federal Reserve were
working at cross-purposes during the early
1980s. It is clear that the Administration strongly
favored bringing down inflation, though it hoped
that this could be done without a slowdown in
economic growth.
Finally, there is a basic inconsistency in Greider's
view that the Federal Reserve mainly responds to
the interests of the owners of financial capital,
who are hurt by rising prices and so demand sta-
ble money. This view cannot explain why the
System permitted a rise in the rate of inflation
during the 1970s that seriously harmed the hold-
ers of financial assets in the first place.
In point of fact, the uncertainties and inequities
caused by inflation hurt not only participants in
financial markets, but others as well. Those who
are smart enough (or lucky enough!) to forecast
inflation correctly frequently benefit at the ex-
pense of those who guess wrong. It is because
the damaging effects of inflation extend beyond
financial markets and often are distributed in a
rather random way that the Federal Reserve dem-
onstrates a continuing concern for sound money.
Brian Motley
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may beaddressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
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Temple secrets

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