Monetary Policy on the 75th Aniversary of the Federal Reserve System.

This book contains an array of theoretical and empirical articles evaluating the historical role of the Federal Reserve System. The papers were all presented in a conference organized by the research and public information department of the St. Louis Fed held in 1989 on the occasion of the 75th anniversary of the founding of the Federal Reserve System. The invited authors include academics from the Monetary, Keynesian and the New Classical camp as well as central bankers. This book will serve as a useful reference for the students of monetary and macroeconomics, policy makers, politicians and the ordinary citizen. With a few exceptions the articles are readable, of good quality, and deal with monetary issues that are likely to remain important for research and public policy in the 1990s. The book however fails to provide any unified view of what ought to be the role of the Fed in the future.

There are three sections in the book each containing the invited papers and the comments in each of the three sessions held. In an eight page preface, the editor has donc a good job of summarizing the main issues raised and debated in the conference. However, he has not tried to address the fundamental question: Did the Fed contribute positively to the wealth and welfare of the U.S. economy?

In the first session, Allan Meltzer reviews 75 years of monetary policy making by the Fed with the primary focus on the period since the early 1960s. His conclusions, known to the students of monetary policy as the "monetarist critique," unequivocally suggest that the Fed has mostly looked at the wrong variables resulting in a record of bad policies. Meltzer presents evidence that the growth rate of money has been higher in each recent business cycle expansion than in the expansion immediately before. This procyclical pattern in monetary growth has contributed to the underlying inflation without the benefit of greater economic stability. Unless fundamental changes are made and the Fed held directly accountable for its actions, Meltzer is pessimistic about the future performance of the Fed.

In comments supportive of Meltzer's conclusions, Jeffrey Miron reports that his examination of data since 1870 reveals that the output growth in the post war era has been nearly a full percentage point lower compared to the 1870-1913 period, and the inflation rate of 4.7% since 1947 contrasts unfavorably with the slight decline in the price level during 1870-1913. K. Alec Chrystal in his comparison of the U.S. monetary policy experience with that of Switzerland, Germany and Japan finds the Fed's performance wanting. Donald L. Kohn who has the perspective of a central banker is however critical of Meltzer's conclusions. While he acknowledges that there were problems with the Fed policy in the 60s and 70s, he points out that the "monetarist experiment" of 1979-1982 also had many unpleasant surprises.

In the first paper of the second session, Alex Cukierman develops a model to rationalize why the Fed prefers to smooth interest rates. In his model, Fed's systematic switching between the competing goals of price stability and financial stability results in interest smoothing but an inflationary bias. Michelle Garfinkel finds Cukierman's definition of financial stability somewhat vague. She offers a model to illustrate that the inflationary bias in Cukierman's model may simply be the result of his focus on a one-shot Nash equilibrium.

In his paper, Edmund Phelps debates whether the Fed should have price stability as its primary goal. Phelps is clearly uncomfortable with this goal as the costs (lost output and employment) may far exceed the benefits from lower (near zero) inflation. He also shows how a supply shock could be exacerbated if a rule prevents the Fed from making an accommodating change in policy. Manfred Neumann is critical of Phelps for not offering a consistent framework to evaluate the relationship between each policy and the goal. He proposes a monetary constitution that would lead to the "ultra-conservative central banker," making price stability the sole objective for the Fed.

In the first paper of the third session, William Barnett (with Melvin Hinich and Piyu Yue) extend their earlier research on the construction of Divisia monetary aggregates. They introduce risk to produce measures of money stock including one called "Theoretic M2." The empirical improvements of these measures (with risk neutrality or risk aversion) over the current measures are impressive. The authors conclude that the Fed should abandon the simple-sum measures it uses in favor of new measures. Julio J. Rotemberg revises Barnett's measures of the user cost of financial asset making it insensitive to base-period selection. He also suggests a revised currency-equivalent measure (CE) in which the errors from expected return estimates are not carried permanently. Barnett's reply offers a proof that the suggested CE index indeed measures the stock of money under stationary expectations.

Charles I. Plosser, in the tradition of the "real business cycle theory" asks why the Fed should even bother with variations in output. The arguments are familiar. First, years of theoretical work have failed to bring consensus on the nature of the transmission mechanism. Second, theorists who claim to have made the connection between nominal money and real output have often been careless, failing to distinguish between monetary policy changes that involve variations in the reserve requirement and those which don't. Plosser presents results from statistical tests which tend to support the thesis of neutrality of money even in the short run. In his comment, N. G. Mankiw disagrees with the thrust of Plosser's argument though accepting that significant correlations between changes in the nominal stock of money and output are difficult to establish. He points out that even if all output changes are caused by real forces, monetary policy can still be a useful tool.

Although there is a good mix of arguments (between supporters and opponents of discretionary monetary policy) and studies (between theoretical and empirical), one cannot escape the view that the central bankers were somewhat underrepresented. It would have been proper and highly instructive for the organizers to invite ex-chairmans of the Fed for their insights on these issues. A paper on the role of the Fed during the stock market crash of 1987 would have been useful. After all one of the most important role of the Fed is to be the lender of the last resort. Also disappointing was the absence of a study on the role of the Fed policy or lack thereof with regard to one of the greatest financial crisis, namely, the Savings and Loan debacle of the 1980s. The academics as expected failed to reach any common ground. The Monetarist said the Fed has failed. The Keynesians said that any restrictions on Fed's discretionary powers will crimp its abilities to do the job. The New Classicals said the Fed is irrelevant at least on the output count. With these differing opinions coming from the academic world, what can we expect from the Fed over the next 75 years? Let us hope the Fed continues to climb the learning curve and 75 years hence when scholars gather to evaluate its past performance they find it easier to conclude that the Fed positively contributed to the wealth and welfare of the U.S., indeed, the world economy.