The vote standard: either people want to get rid of inflation or they don't.

AT THE HEIGHT of Lebanon's protracted civil war the governor of the Banque du Liban, the country's central bank, locked himself inside the bank's West Beirut headquarters, with about $5 billion in gold and foreign currencies for company. He did not set foot outside for more than two years, eating, sleeping, and tending his flowers in a small two-room apartment on the top floor. Secure against pillage by either side in his sandbagged redoubt, he issued bank notes, paid interest on government debt, and struggled to support the Lebanese pound. Well, almost secure: last spring, gunmen burst in and tried to abduct the governor. They roughed him up, but were forced to flee when bank guards arrived and opened fire. The minister of finance later issued a public apology. The gunmen, after all, were his.

Few central bankers have had to go to quite such lengths to safeguard their independence from political interference. Yet over much of the industrialized world, they must feel similarly besieged. Hardly a week goes by without one official or another in the Bush Administration badgering the Federal Reserve to ease monetary policy, with notable recent success. In Japan, months of bickering between the finance minister and the governor of the Bank of Japan over interest rates helped set off last year's 50 per cent fall in the Nikkei Dow. Even the famously independent Bundesbank was rudely overruled on the terms of German monetary union by the Kohl government. Central banks are supposed to be autonomous, de jure or de facto, in all of these countries. But you'd never know it these days.

By contrast, in countries where central banks have historically been under political control, the trend is the other way. Public figures in Britain, including former Chancellor of the Exchequer Nigel Lawson, are calling for an independent Bank of England. Newly democratic Chile is the first country in Latin America to establish an independent central bank; Argentina may follow. The countries of Eastern Europe are taking the same step, led by Poland and Hungary. The radical economic liberals in New Zealand's Labor government even went so far as to tie the salary of the governor of the Reserve Bank to his success in fighting inflation.

These competing tendencies met head-on in two bills first introduced in the last Congress. One, sponsored by Representatives Byron Dorgan (D., N.D.) and Lee Hamilton (D., Ind.), would have given the treasury secretary a vote on the Federal Open Market Committee, which sets Fed policy (it was later changed to say the secretary should meet regularly with the committee). It would also require immediate release of the minutes of each meeting, and allow a new President to install his own choice as chairman a year after taking office. The other bill, sponsored by Representative Stephen Neal (D., N.C.), would direct the Fed to cut inflation to zero over five years. Though ultimately unenforceable, a legislative ban on inflation would help immunize the Fed from Washington's vociferous cheap-money lobby.

The same struggle is being played out in Europe. At German insistence, the new European central bank the European Community is contemplating will be given the statutory duty of maintaining the purchasing power of the European Currency Unit (ECU). Policy will be set by a council made up of the governors of the 12 nations' central banks (plus five to seven full-time directors) independently of other EC bodies. At French insistence, however, the council of finance ministers will control exchange-rate policy, which implies control of interest rates. And there is no guarantee of the independence of each country's central bank (though member states are supposed to move toward this)-leaving open the chance of political interference by proxy.

The arguments in these civil wars are always the same. The Roundheads, invoking democratic principle, insist that central banks must be accountable to elected authorities. The Royalists defend the central banks' divine right to set monetary policy independently. Monetary policy, in the Royalists' view, would inevitably lean to inflation if left to the vagaries of democratic politics. A politicized Fed would find it harder to take unpopular but necessary steps to maintain price stability. As the arch-Royalist Economist put it, "Any government that insists on access to the printing press cannot be trusted with it."

Royalists argue that an independent central bank is still accountable, in the end. Central bankers are appointed to fixed terms by elected officials. If the people don't like what they're doing, they can always elect politicians pledged to replace them. The New Republic's Michael Kinsley calls it "democracy on a long fuse." Still, this ought to give democrats some pause. The analogy is frequently drawn with the Supreme Court, which is also "unaccountable." But that's because the Court must often protect minorities from the tyranny of the majority. The implication in the case of the Fed, as Kinsley acknowledges, is that the majority must be protected from itself. This strikes at the heart of democratic governance. Nobody suggests that a similarly appointed agency set tax policy.

We appear to be faced with an intractable dilemma: grant independence to a central banker who, however sound on inflation, remains unaccountable; or hand control over policy to elected politicians with a taste for easy money. Must we choose between democracy and stable prices? Isn't there some middle ground here? Yes, there is: Elect the Fed.

Taxation without Representation

THE WHOLE ISSUE of whether the Fed should be "independent" or "accountable" stems from a failure to define our terms: Accountable to whom? Independent of what? Let's not blame the people for the sins of their leaders. It isn't democracy that monetary policy must be protected from, but government. It's perfectly legitimate to argue that something as critical in its effects on the economy as monetary policy-Paul Volcker was once profiled as the Second Most Powerful Man in America-should be subject to democratic control. But it should be direct control.

The case for keeping monetary policy out of the Capitol Hill/White House axis is grounded not in aristocratic distrust of democracy, but in that bedrock American principle of separation of powers-in this case, fiscal and monetary. The old reason for this was to prevent governments from shaving the present value of public debt by debasing the currency in which it is denominated. if it could prevail upon the central bank to buy some of its debt, the government could take the pressure off interest rates-which doubtless pleased private debtors, too. Since the time of the first coinage, this has been the favorite means for governments and vested interests to plunder the populace. Inflation is a tax that can be levied without consent, indeed without warning. So it's eminently democratic to deny government this power, on another bedrock American principle: No taxation without representation.

The sophistication of financial markets means the state has a harder time nowadays cheating its creditors: bonds drop like mine canaries at the first whiff of inflation. The only way the Fed can achieve a reduction in real interest rates is to engineer a larger amount of inflation than bond markets anticipate. Markets would soon wise up to that, however, demanding a higher nominal rate to compensate, which means the Fed would have to raise inflation yet higher, and so forth. Infinite inflation for marginally lower rates isn't much of a bargain.

That also means there's no longer anything in it for private borrowers: the Fed can't drive down real interest rates for them either. Whatever electoral benefits there may once have been from inflation have disappeared. The only people who have an explicit stake in easy money today are those trading in areas of the economy that serve as inflation hedges. Real-estate speculators do not form a large political constituency.

A lot of people think this means inflation is no longer a threat. Millions of investors around the world rendering instantaneous judgment on national monetary policies impose a ruthless discipline, willy-nilly. Former Citicorp Chairman Walter Wriston calls it the "information standard." If there are no fiscal or electoral gains to governments from inflation, then rationally that should be the end of it.

The reason why we should wish to keep the government's hands off the monetary levers all the same is that the government is no longer a free agent, capable of rational choice. It has been taken hostage. Debt of all kinds, public and private, has grown so bloated as to invite a full-blown crisis in the event of a serious contraction. Total corporate liabilities now amount to more than 55 per cent of gross national product, up from 45 per cent a decade ago. Gross public debt is equal to 60 per cent of GNP, up from 37 per cent. The federal deficit has ballooned to $318 billion in fiscal 1991; state and local governments add another $40 billion, and counting. Throw in mortgages, credit cards, and other consumer debt, and the U.S. debt-to-GNP ratio has leapt to 200 per cent. It was just 140 per cent at the start of the 1980s.

More and more of this debt is in short-term maturities, creating cash-flow concerns: debt payments now absorb a record 37 per cent of pre-tax profits. Less and less is covered by assets, increasing the likelihood of default. In the event of widespread default, the financial system, already exposed to real-estate and Third World loans, and shaken by the S&L crisis, would implode. Revenue to the government would collapse; the magic of compound interest would soon take the national debt into the stratosphere. So although the Fed, like every other central bank, insists that price stability is its goal, no one believes it. Even the current mild recession was more than the Fed could stand. With inflation at 5 per cent at the beginning of an expansion, and the financial imbalances in the system largely uncorrected the Fed is still cutting short-term interest rates. But long rates have refused to follow them, a sign of the market's suspicion.

Credibility Gap

THIS credibility gap is crucial. Monetary policy involves a complicated exchange of expectations between government and public, each circling warily about the other in a dance of mutual anticipation. The public scrutinizes the authorities carefully, trying to guess future policy moves; the authorities must in turn try to predict public response to policy as a factor in their own economic projections. If, for example, the public expects higher inflation, economic agents will ask for higher prices, wages, and interest rates to keep pace. If policy instead tightens and inflation falls, catching the public unawares, the economy will be starved of the demand people thought would support prices. Lower inflation plus higher nominal wages and interest rates means that real wages and interest rates rise. Costlier labor and capital means less employment and investment-in other words, a recession.

So if a government wishes to reduce inflation without recession, it's vital that people understand the policy it intends to pursue. Just as important, they must believe the announced policy really will be carried out. And if they are truly to believe it, they must believe the government would go ahead even if they did not. For just as policy affects expectations, expectations affect policy. The government knows that if the people guess wrong about its policy, it may cost them both a recession. But if the people know the government is unwilling to bear that cost, then they can guess what they like, knowing that government will adjust policy to "ratify" their expectations. Conversely, the greater the public's conviction that the authorities are determined to tighten money growth, no matter what the costs, the lower those costs are likely to be: expectations of lower inflation would keep wage and price demands in line. Successful monetary policy, in short, like nuclear deterrence, depends u on a credible threat.

Once it is generally believed the monetary authorities will do anything to stave off a debt-default crisis, economic agents will be encouraged to behave in ways that invite one. There are two possible results, neither palatable. Either wages and prices spiral, in the knowledge that the Fed would always pump up demand enough to accommodate them. Or inflation is kept in check, but only by repeated doses of recession and high unemployment. In other words, the Fed must either confirm or confound expectations that it lacks the stomach to fight inflation. The more entrenched those expectations, the likelier it is that the Fed will be forced to confirm them with higher and higher inflation, for the nastier the recession would be otherwise. It took a recession just to get inflation back down to 5 per cent from 6 per cent. Think what would happen on the road to zero inflation-or from 10 per cent back to 5 per cent. Now remember that every price- and wage-setter is thinking the same thing.

Inflation thus becomes a one-way bet. Expectations of ease invariably prove self-fulfilling: fearing to disappoint expectations, the Fed would err on the high side. All that is needed to set the spiral off is for someone to get the idea of testing the Fed's resolve. What would give anyone that idea? The debt. It doesn't matter how tough the Fed talks: so long as it is within the fold of government, the debt undermines its credibility. The percentage play is always to ask for more.

Why would an independent Fed be any more willing than the government to risk a recession in pursuit of price stability? Who would want a recession, after all, even if they aren't the world's biggest debtor? But escalating inflation and escalating debt are not the only possible outcomes here. The third-which would lessen the chance of fiscal crisis, and with it the terrors of recession-is an immediate decline in debt relative to GNP. That is, the policy choices are not just tight money or loose money, but fiscal tightening or ease as well. Alas, the sort of savage spending cuts and/or tax increases required would hurt a lot of people, not least the politicians responsible for carrying them out. For the President and Congress, the certain costs of cutting spending are worse than the potential costs of a fiscal crisis, especially so long as the monetary safety valve remains available.

Suppose an independent Fed closed that option, however. Since it is not responsible for fiscal policy, the Fed does not bear the political costs associated with a fiscal tightening. And yet the Fed could impose fiscal discipline indirectly. A government without recourse to the printing press is no longer the perfect credit risk: creditors would start to dictate terms. The Fed wouldn't have to stare down the markets, as before: it would just have to stare down the government. The markets would do the rest. But to do that the Fed must be the equal in moral authority of Congress or the President.

Not So Independent

IT'S ALL VERY WELL just to pass a law stating that the central bank is autonomous. But if true, this is undemocratic, and if false, it is worthless. In practice, the latter has more often been the case: central banks have proved not to be so independent as all that. Certainly in the U.S., the tendency of monetary growth to speed up in the year or so before presidential elections has been long noted. Over the past three decades, prices have more than quadrupled, supported by a tenfold increase in money supply. William McChesney Martin did it for Johnson; Arthur Burns did it for Nixon and Carter. Even Volcker, the inflation-killer, did it. In the 1985 Plaza Accord, Treasury Secretary James Baker pledged the U.S. to driving down the dollar, thus committing the Fed to a looser monetary policy. The Fed obliged. And so it continues. In the shadow of a presidential election, and with the Fed chairman's own term up for renewal, the Fed has dropped the discount rate twice already this year.

It could not be otherwise. No central bank, no matter how independent it is on paper, has the legitimacy to stand up to a democratically elected government determined to get its way. It doesn't matter what the terms of its charter may be: if necessary, the government would change the legislation. Whether the central bank should be "independent" or "accountable" is a false issue: if it's not accountable, it won't be independent. An unelected Fed imposing its will on the government is an intolerable usurpation of democratic authority. Elected, it's good old cheeks and balances.

For that matter, inflation is not only a matter of meddling by wastrel politicians: it's often unclear whether the central bank itself is sincere in its devotion to stable prices. Contrary to popular belief, central bankers are not, as a rule, doctrinaire monetarists. Most display an enduring belief in the possibilities of "fine-tuning." Alan Greenspan is no exception. Indeed, it's difficult to tell what if anything is guiding Fed policy, given the secrecy surrounding its deliberations and the chairman's penchant for the oracular. One week it's commodity prices, the next the yield curve, the week after that it's the dollar. Every year the Fed dutifully announces targets for growth in the various money-supply aggregates, but no one believes it has any intention of sticking to them. Central-bank independence is therefore not a sufficient (though it is a necessary) condition for honest money. A clear, unambiguous mandate for stable prices would be as instructive to the Fed as to the other branches of government.

To escape the corrupting influence of fiscal and monetary debauchees, some economists suggest taking policy out of the authorities' hands altogether. Monetarists favor a rule holding the rate of growth of the money supply to a steady year-in, year-out figure. Supply-siders advocate returning to a gold or commodity standard. Since each dollar could be converted into gold at a fixed price, central banks would have to maintain a steady value for money, or see a run on their reserves. Or the currency could be fixed at a given rate of exchange with that of another country. This can be a useful alternative if the benchmark chosen-the Deutsche Mark, say-is resolutely anti-inflationary.

Nobel laureate Friedrich von Hayek has taken the opposite tack. Far from fixing currencies against one another, Hayek advocates allowing them to compete in the same market-to let anyone, domestic or foreign, issue and circulate any currency he wishes. Competing currencies would guarantee price stability: a currency losing purchasing power would soon find itself losing customers.

There are problems with each of these alternatives-How do you measure the money supply? Who controls the supply of gold on world markets? Is the Deutsche Mark as stable as we thought? What if all currencies inflate together?-but the weakness common to all is that they beg the question of political will: any government that could summon the nerve to put itself on the gold standard, let alone to privatize the mint, would have no trouble running a stable monetary policy. Absent that will, rules are no substitute. Richard Nixon found the gold standard little obstacle to his inflationary designs in 1971: faced with the reserve constraint, he simply took the U.S. off the gold standard.

Political will derives from popular will. The express preference of the people for stable prices is in the end the sole assurance of the authorities' resolve.

The Vote Standard

TO RECAP: Any sound monetary regime must separate the fiscal and monetary powers. To safeguard that separation, the monetary power must have its own base of legitimacy. The only way in a democracy to guarantee that legitimacy is through a popular mandate. That's as it should be: it simply won't do to tell people they must accept whatever an unelected, unaccountable central banker tells them is good for them. The solution follows. Put monetary policy, not on the gold standard, but on the vote standard. Elect the Fed.

This could be accomplished on any one of several models: parliamentary, if regional representation were considered important; or direct election of the chairman, as the representative of all the people. Some reshuffling of duties might also be in order: banking supervision could be hived off to another government agency, while the Fed would be given sole responsibility for exchange-rate policy.

I hear the skeptics. Would the people vote for honest money? Or would they be swayed by a sweet-talking soft-money salesman? Maybe they would-once. The best advertising in the world won't sell a bad product a second time. Monetary policy is undoubtedly a complex issue. But if you want voters to make responsible choices, you have to give them responsibility. Once introduced into the domain of popular sovereignty, monetary policy would be discussed with the same frequency and intensity as taxes, increasing public awareness and understanding of monetary issues.

A democratic Fed would have to talk openly with the public, making less likely any miscalculation as to its intentions, and with it any consequent dislocation in the real economy. And the public could in turn speak with a clearer voice. We get inflation now because in a presidential election, people's views on Fed policy get buried in the mix. They only come to the fore when inflation is already out of hand. The citizens should be able to choose their monetary policy in isolation from other concerns. Not only is this more democratic, but it makes for better government: the voters will have nobody but themselves to blame if inflation follows.

There would, moreover, be a third party in this conversation: capital markets. If a candidate promising loose money were leading in the polls, interest rates would rise sharply; if the tight-money candidate then pulled ahead, they would immediately drop. The lesson that the road to lower interest rates runs through lower inflation could never be brought home more forcefully. Bond markets would act as a consumer guide for the electorate, rating the monetary soundness of the candidates. Perhaps people would still vote for the loose-money candidate. But I doubt it.

Like its sister, protectionism, inflation is not the vote-getter its proponents believe. The greatest orator in American history, William Jennings Bryan, made the greatest speech in American history on behalf of the free minting of silver ("You shall not crucify mankind on a cross of gold!"). He ran three times for President, and lost every time. Given a choice between double-digit inflation and double-digit unemployment, the public will not hesitate to take unemployment. They may not grasp the economic implications of inflation, but they can feel its political message in their bones. Like the graffiti that once covered New York subway cars, inflation sends a constant, inescapable signal: No one's really in charge here. Trust in the currency is trust in the state; when one is betrayed, the other suffers.

That's why, when inflation began to climb exponentially in the late 1970s and early 1980s, the public in country after country turned to politicians with the will to control it. No one was under any illusion that it would be easy, and it wasn't. We went through the worst recession since the Great Depression. But the same leaders were re-elected time and again. The great-some would say the only-achievement of Ronald Reagan was to restore American self-confidence. That had much more to do with the conquest of inflation than of Grenada.

Inflation Is Not Forever

GOVERNMENTS may come and go, but it seems inflation goes on forever. It doesn't have to be this way. Inflation is not some mysterious, intractable ailment, beyond the ken of man. It is indeed one of the few social ills entirely within the competence of the state to cure, because it is the creation of the state in the first place. All you need is will.

It comes down to this: Either people want honest money, or they don't. If they do, they haven't been getting it, and they won't get it until they have the means to tell both governments and central bankers, very clearly, that that's what they want. If they don't, then there's no good argument for forcing it upon them. If what they really want is inflation, let them vote for it. That, after all, is democracy.