Fed up: the problems of the Federal Reserve.

IT WAS THE MOST STRIKING IMAGE OF Bill Clinton's first speech to Congress. Every news report mentioned it: Hillary Clinton, dressed in a bright red suit, flanked on one side by John Sculley, CEO of Apple Computer, and on the other by Alan Greenspan, chairman of the Federal Reserve. Bill Clinton, as usual, had grabbed the symbols of '80s success--of high-tech entrepreneurship (never mind that Sculley had come from Pepsi) and low inflation--even as he bashed the supposed decade of greed.

That was February 1993. Hillary Clinton has since taken to wearing pink and giving press conferences to defend her own slice of '80s excess. John Sculley has been pushed out of Apple. And the clock is ticking for Alan Greenspan, whose term expires in 1996. His likely successor is Alan Blinder, whom Clinton recently appointed vice chairman of the Fed.

Blinder is no Alan Greenspan. Though a well-credentialed economist, he is a Keynesian who looks askance at tight money. He was appointed with Janet Yellin, another inflation dove. If you think Clinton can change the Supreme Court with two new justices, wait till you see what he does with two new Fed members.

These appointments come amid much political grousing about the Greenspan Fed's vigilance against inflation. Clinton himself is gingerly with his criticism, for fear of scaring the bond markets. Others aren't so discreet. Writing in The New York Times, Lester Thurow declares, "The Federal Reserve Board has been spooked by the ghost of inflation.... The Fed is intent on killing a very weak recovery that has yet to include most Americans."

Many in Congress agree. And Banking Committee powers Sen. Paul Sarbanes (D-Md.) and Rep. Henry Gonzalez (D-Tex.) regularly attack both Greenspan's policies and the Fed's independence and secrecy. Last year's discovery that the Fed had secret transcripts of its Federal Open Market Committee's policy-making meetings heightened the pressure for openness, with some effect. The Fed has started announcing its moves in public, explaining when it's raising interest rates by how much. Such announcements reduce suspicion, rumors, and insider trading based on leaks. But they don't eliminate the fundamental problems of the Fed, problems of knowledge and politics.

FOR THE LAST DECADE OR MORE, WE haven't thought much about those problems. Despite populist complaints from both supply-siders and leftists (notably William Greider in his 1987 book Secrets of the Temple), most Americans have been satisfied enough with the Fed's performance not to pay it much attention.

The Clinton Fed could change all that. The notion still reigns in some Democratic circles that there's nothing like inflation to put people back to work. Clinton, for his part, makes a fetish of keeping interest rates low--an unrealistic goal when expanding economies in Asia, Latin America, and parts of the old Eastern bloc will drive up the demand for credit and thus the price of money. Meanwhile, the budget deficit exerts steady pressure to inflate so the government can pay off creditors in cheaper dollars. The next decade may not look at all like the past one.

"The current system," writes Brown University economist William Poole in the journal Jobs & Capital, "depends almost entirely on the good sense and good management of the Federal Reserve and on the Fed's political skills in heading off the inflationist tendencies that exist in every Congress and every administration. This arrangement leaves us at great risk, and these risks have not disappeared just because the Fed has been so successful over the last 10 years or so."

Brown alludes to the Fed's most obvious problem: political pressures to tinker with the money supply to favor borrowers over lenders and, in some cases, political incumbents over challengers. To check these pressures, we have an insulated, unaccountable Fed, offending both those who support unbridled majority rule and those who support limited government.

Writes Milton Friedman, "I have found that few things are harder even for knowledgeable nonexperts to accept than the proposition that twelve (or nineteen) people sitting around a table in Washington, subject to neither election nor dismissal nor close administrative or political control, have the power to determine the quantity of money--to permit a reduction by one-third during the Great Depression or a near doubling from 1970 to 1980. That power is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative."

The courts are similarly insulated and for similar reasons. The law, like the money supply, is a background condition on which individuals and enterprises base their plans. Both should be neutral, treating all citizens equally. In theory, monetary neutrality is, in fact, more easily defined than legal neutrality: It is an undistorted money supply whose growth rate matches the economy's, permitting price changes that reflect only supply and demand, not inflation or deflation.

But coming up with a technical definition of neutrality is a lot easier than producing neutral results. Even the best-intended Fed officials screw up; they misgauge the pace of economic growth or misunderstand what the money supply is doing. Indeed, many current criticisms of the Fed are driven less by a lust for inflation than by a disagreement about what is really happening in the economy.

Technical and institutional changes make mistakes even more common. Measures of the money supply have gotten notoriously difficult to track in recent years, thanks to deregulation and innovations in financial markets. Friedman's proposal of a fixed rate of increase in the money supply, established by statute or constitutional amendment, looks harder and harder to achieve, even if such a law could be passed.

SO WE ARE BACK TO THE OLD PROBLEMS OF economic regulation, the old reasons the government cannot effectively or fairly set prices or choose industrial winners: A centralized bureaucracy can never match the information flows of a decentralized market. And such a bureaucracy can never permanently resist the temptation to play favorites.

To surmount these problems, F.A. Hayek, among others, advocated free competition in money--allowing banks to issue and back their own currencies, free of legal tender laws that enforce a single standard. Rather than pick monetary winners and losers, the government would let competition sort things out. And, Hayek predicted, the demand for stable money would produce neutral currencies. The end of '70s inflation took some of the intellectual momentum out of such ideas. The Clinton Fed may restore it.

We are a long way from a political situation that would permit free competition in money. But we do have an increasingly global economy, in which national currencies compete, and a host of new financial instruments that let investors hedge against the risks of inflation and deflation. In the long run, it matters more whether Washington permits the free development of such instruments--including now controversial "derivatives"--than whom Clinton puts on the Fed.

When Hillary Clinton sat between Greenspan and Sculley, she did more than claim a piece of the '80s. She set up a contrast with implications for the '90s and beyond. Apple Computer is a monument to the unpredictability of the economic world, in which individuals make choices and create value no outsider would have foreseen. The Fed symbolizes just the opposite: centralized control and technocracy, the hubris that declares the economy predictable and easily managed. It will take more than Hillary Clinton's red suit to create a world in which Apple fits comfortably next to the Fed.