When economists talk about the economy’s incredible run during the last two decades, not all are willing to give Alan Greenspan the credit he deserves for the experience. In a recent article in the Wall Street Journal, Milton Friedman discussed the Fed’s record of the last 15 years. The famous economist began by stating what the relevant role of the monetary authorities should be: “The basic responsibility of the Federal Reserve is to produce as close an approximation as possible to price stability.”
Perfect. He next went on to say that
The Fed controls one thing and one thing only: the volume of its own obligations — That is, high-powered money or the base. (The Fed controls the amount of high-powered money through open-market operations: when it buys securities it adds to the base; when it sells securities, it subtracts from the base.)
And here was how he graded the Greenspan Fed:
The contrast between the periods before and after the middle of the 1980s is remarkable. Before, it is like a chart of the temperature in a room without a thermostat in a location with very variable climate; after, it is like the temperature in the same room but with a reasonably good though not perfect thermostat, and one that is set to a gradually declining temperature. Sometime around 1985, the Fed appears to have acquired the thermostat that it had been seeking the whole of its life.
This was all sweet music, and it seemed as though Friedman would next sing the praises of the Greenspan Fed (giving it the credit it deserves for maintaining price stability for so long). Instead, he hit a sour note:
The obvious question: whence the new thermostat? Why just then? Given the near coincidence of the improved behavior and Alan Greenspan’s tenure as chairman of the Fed, it is tempting to conclude that Mr. Greenspan was the new thermostat. I am a great admirer of Alan Greenspan and he deserves much credit for the improvement in performance, yet this simple explanation is not tenable. It is contradicted by the simultaneous improvement in the control of inflation by many central banks at about the same time, including the central banks of New Zealand, the United Kingdom, Canada, Sweden, Australia, and still others. Many of these central banks adopted a policy known as inflation targeting, under which they specified a narrow target range for inflation — 1% to 3%, for example. But inflation targeting and non-inflation targeting central banks did about equally well in controlling inflation, so explicit inflation targeting is not the answer.
Professor Friedman’s conclusions are wrong — and to understand why you need to consider the effects of a domestic price rule.
Such a rule is based on monetarist principles that inflation is too much money chasing too few goods. When the inflation rate falls below the target range, it is evidence of a shortage of money. At this point the monetary authorities can automatically add money to the system — an open market operation where the central bank purchases bonds does the trick. If, on the other hand, the inflation rate moves above the target range, the proper response can sell bonds and thus reduce the quantity of money circulating in the economy.
The price rule provides a central bank with an adjustment mechanism whereby the shifts in money demand are automatically accommodated. The same thinking holds for the exchange rate.
Consider an economy where the focus on the exchange rate is not to let the domestic currency appreciate against the U.S. dollar. Whenever the currency appreciates, the foreign central bank is forced to print domestic currency to cheapen the foreign exchange value of its national currency. In the absence of any transportation costs, purchasing-power parity will hold and the domestic inflation rate will equal the foreign inflation rate plus the exchange-rate depreciation.
In this example the foreign inflation rate, while shadowing the U.S. inflation rate, will always exceed it. In contrast, if the foreign central bank focused on not letting the exchange rate depreciate, the foreign inflation would always be below U.S. inflation.
The generalization of the intervention mechanism is that of a central bank that sets a target range for the foreign exchange value of its currency and intervenes to keep the currency within the bands. When this is the case the inflation rate of foreign countries will be around that of the U.S. By fixing the exchange-rate targets, the countries are in effect adopting a price rule — or “inflation targeting.” And it’s in this sense that Professor Friedman underestimated the impact of inflation targeting on the behavior of the world central banks.
Central banks that have adopted a tight exchange-rate target range have in effect adopted a price rule (China and the Yuan are a clear example of this). Viewed this way many of the countries not counted by Friedman as following an inflation target were in fact doing so. By targeting the exchange rate vis-á-vis the U.S. dollar, they were targeting the U.S. inflation rate. The exchange-rate targeting in effect produced a global price rule.
So, contrary to Friedman’s conclusions, the Fed’s “thermostat” was no accident — its origin can in fact be traced to the change in operating procedures at the Fed that were implemented by Paul Volker. The move away from the quantity targeting of the 1970s proved to be destabilizing as opposed to the price rule that automatically accommodated for shifts in the demand for money. The thermostat invention was Volker’s, but Alan Greenspan perfected it and he deserves all the credit in the world for the price stability of the last 15 years.
But the concern with the maestro is that he never fully disclosed how he did it; there’s really no way of ascertaining when he is behaving correctly or not, other than judging the results produced by his actions.
That is why he has deserved much of the criticism he has received since 1999 — in the last few years, the Fed’s stop-and-go policies pushed the economy to the verge of deflation and contributed to the recession. But the inflation numbers also suggest that Greenspan has not strayed too far from the price rule. If anything, the data seem to suggest that he has widened the band of the inflation target range in order to accommodate other objectives. If he has, these are actions unbecoming of the Federal Reserve. As Friedman put it so nicely, the role of the Fed is produce as close as possible an approximation to price stability.
The Fed found appears to have found a way to run the thermostat — the problem is that it is not disclosing how it does it. And if there is no operating manual for posterity, we don’t know whether the maestro’s successor — or the maestro himself — will in the future operate the thermostat in the correct manner.
The situation is reminiscent of the strophe from the song Richard Harris and Donna Summer made famous, MacArthur Park:
MacArthur Park is melting in the dark
All the sweet, green icing flowing down
Someone left the cake out in the rain
I don’t think that I can take it
‘Cause it took so long to bake it
And I’ll never have that recipe again
Same holds for the domestic price rule. It took fairly long to get here, it’s melting, and we do not have the recipe. It’s time for the cooks at the Fed to disclose their operating procedures.