Between the responsibility to manage the money supply and additional tasks taken on under Dodd-Frank, the Federal Reserve has a big role in the economy. They can't force the economy to perform well, but they certainly can screw it up if they don't know what they are doing. Do they know what they are doing? Unfortunately, all the evidence points to "no." I hope I am wrong, but I don't think I am.
In another important op-ed in the Wall Street Journal on Tuesday, John Cochrane of the University of Chicago calls attention to the trendy idea among our economic policy institutions that central banks can and should "intensively monitor the whole financial system and actively intervene in a broad range of markets toward a wide range of goals including financial and economic stability." Cochrane refers to this 2011 report from the IMF laying out the agenda for so-called "macroprudential policy," meaning the use of a menu of macroeconomic policy tools by which geniuses with Ph.D.s from Ivy League institutions, or maybe from the ENA, can spot instability coming in an economy and use the magic of instantly changing regulations and an infinite check book to put everything right. A bubble is brewing? We'll buy bonds! We'll sell bonds! We'll increase reserve requirements! We'll decrease reserve requirements! We'll increase capital requirements! We'll decrease capital requirements!
Cochrane is extremely dubious, to put it mildly. Me too. The idea that ivory tower geniuses can spot an incipient bubble and fix it by changing rules and meddling in the financial markets, when serious market participants committing large amounts of their own money cannot, is completely preposterous. Can anyone identify even one example where bureaucrats have spotted and corrected for a financial bubble in a timely way?
Let alone that the proposed cure is virtually guaranteed to worsen the disease rather than cure it. Threaten to change the main rules randomly, arbitrarily and with little or no notice just as things are starting to go wrong -- How can that possibly work? Markets thrive on stable rules. Here's what James Madison had to say about this in Federalist 37:
Stability in government is essential to national character and to the advantages annexed to it, as well as to that repose and confidence in the minds of the people, which are among the chief blessings of civil society. An irregular and mutable legislation is not more an evil in itself than it is odious to the people. . . .
Well today we have dispensed with the need for "legislation," but we can have "irregular and mutable" regulations changeable on whim by bureaucrats with fancy academic credentials but with no practical experience in the world. If they knew what they were doing, they would promptly disclaim any ability to perform these tasks. But they have way too much hubris for that.
Meanwhile, how are they doing at their other job, managing the money supply? You may be thinking, we're now through QE I, II, III and maybe a few more, and inflation doesn't seem to have taken off. Could they be doing something right? Don't count on it.
The world history of sovereigns expanding the money supply is a history of one disaster after another. Why not this time? Well, today they don't just print the currency; most of the money supply manipulation is more indirect. The money supply is mostly bank accounts. The Fed buys bonds, creating "monetary base," and the banks then lend out the money in several rounds, creating the bank accounts that form the money supply. Except that today the banks are mostly sitting on the multiple trillions of dollars of monetary base that has been created by QE I, II, and III. Don't believe me? Check out this graphic of "excess reserves" from the St. Louis Fed. (Apologies that it is not currently possible to import the graphic into this web site, which is systematically rejecting all graphics. But please look at the graphic, which is very dramatic.) The graphic shows that since at least 1950 until late 2008, when QE I began, the banks promptly lent out all available monetary base created by the Fed, leaving "excess reserves" of a flat zero. From the start of QE I, excess reserves have shot straight up. Today they are close to $2 trillion. Given that the money supply (M2) is currently between $10 and 11 trillion, and that reserve requirements are mostly 10%, that means that the money supply could promptly triple as soon as the economy starts percolating and the banks lend out the excess reserves. It hasn't happened yet, but it could happen at any time. When the money supply triples, unless output simultaneously triples (impossible), then the price level will triple. Some would call that a 200% inflation.
I think the people at the Fed believe that they are such geniuses that they will be able to see this coming and manipulate some regulation or other to stop it just in time. Again, there is no empirical example of bureaucrats actually having this ability.
According to Ezra Klein today on Bloomberg, the "overwhelming favorite" candidate to take over the chairmanship of the Fed is uber-genius Larry Summers. How much of a genius? Well, besides being former President of Harvard, Larry Summers is the one whose June 2 article in the Financial Times claimed that "rapid deficit reduction" would lead to decline in "output and jobs," and a "weaker economy," that would cause "our children" to end up with "more debt and less capacity to bear the burden it imposes." I guess he's never heard of Singapore!
Again, all the evidence is that the people at the Fed have a huge amount of hubris and no idea whatsoever what they are doing. And it's about to get worse!