The New Myths by Ramesh Ponnuru

What made the recent situation dangerous is that in the Fed today, the monetarist faction also has believed that monetary policy needed to be tightened. This faction is convinced that growth in the monetary aggregates (Ml, M2, etc.) has shown monetary policy to be too free and easy. Jerry Jordan, the president of the Federal Reserve Bank of Cleveland, and William Poole (St. Louis) have warned that this is a harbinger of inflation. Allan Meltzer and the Shadow Federal Open Market Committee have agreed. Until markets tumbled, then, much of the professional advice heard by Fed chief Alan Greenspan called for further tightening. This persisted even as the gold price and other commodity prices were sinking lower, and the interest rates on long bonds were falling below the level of short-term bonds—a reliable indicator of too-tight money.

Bruce Bartlett, a Reagan and Bush Treasury official, points to what may well be the problem. “Global financial turmoil and the growth of underground economies have greatly increased the demand for dollars in foreign countries,” he wrote recently. Now, “more than half of all the U.S. currency in circulation is outside the U.S. Lawrence Kudlow, chief economist of American Skandia, also argues that the real problem is a “global thirst for greenbacks” which Fed officials and economists either do not understand or have been unwilling to accommodate. The Fed is “conducting the wrong debate,” according to former assistant Treasury secretary Paul Craig Roberts. The real issue is whether “the flat yield curve”—when long-term interest rates are below short-term ones—“is a sign the Fed is deflating the world economy.”

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What made the recent situation dangerous is that in the Fed today, the monetarist faction also has believed that monetary policy needed to be tightened. This faction is convinced that growth in the monetary aggregates (Ml, M2, etc.) has shown monetary policy to be too free and easy. Jerry Jordan, the president of the Federal Reserve Bank of Cleveland, and William Poole (St. Louis) have warned that this is a harbinger of inflation. Allan Meltzer and the Shadow Federal Open Market Committee have agreed. Until markets tumbled, then, much of the professional advice heard by Fed chief Alan Greenspan called for further tightening. This persisted even as the gold price and other commodity prices were sinking lower, and the interest rates on long bonds were falling below the level of short-term bonds—a reliable indicator of too-tight money.

Bruce Bartlett, a Reagan and Bush Treasury official, points to what may well be the problem. “Global financial turmoil and the growth of underground economies have greatly increased the demand for dollars in foreign countries,” he wrote recently. Now, “more than half of all the U.S. currency in circulation is outside the U.S. Lawrence Kudlow, chief economist of American Skandia, also argues that the real problem is a “global thirst for greenbacks” which Fed officials and economists either do not understand or have been unwilling to accommodate. The Fed is “conducting the wrong debate,” according to former assistant Treasury secretary Paul Craig Roberts. The real issue is whether “the flat yield curve”—when long-term interest rates are below short-term ones—“is a sign the Fed is deflating the world economy.”