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First the good news. The House Financial Services Committee has held a hearing on “Legislation to Reform the Federal Reserve on its 100-year Anniversary.” The hearing focused on a bill introduced by Scott Garrett and Bill Huizenga which would require the Fed to provide Congress with a clear rule to describe the course of monetary policy. Now for the bad news. The rule is to be an equation showing how the Fed would adjust interest rates in response to changes in certain economic variables. And the star witness before the committee proposing his own version of such a rule is renowned neo-Keynesian economist, ex-Bush official Professor John B. Taylor.
Inputs into the so-called “Taylor Rule” involve key magnitudes such as “the neutral rate of interest” and “the natural rate of unemployment” as well as the “targeted rate of inflation.” One might have hoped that the Republicans by now would have realized that monetary reform should involve first and foremost jettisoning neo-Keynesian economics. Even the most talented Fed official cannot know the neutral level of interest rates (whether for short, medium, or long maturities) or the natural level of unemployment. And as to inflation targets, these should be scrapped in any monetary reform and replaced by the aim of monetary stability broadly defined to include absence of asset price inflation and a very long-run stable anchor to goods and services prices.
First, Set Interest Rates Free
An essential component of monetary reform should be setting interest rates free. This means no more official pegging or guidance of short-term interest rates and no attempt to manipulate in various ways long-term interest rates. Markets can do a better job of discovering the neutral rates of interest (across different maturities) and positioning market rates at any time relative to these so as to guide the economy along an equilibrium path than any set of well-informed and even well-meaning Fed officials. This is all on the big assumption that the reformers can design a monetary system around a suitable firmly placed pivot.
Under the gold standard the pivot was a fixed price for gold alongside the widespread use of gold coins. And so the amount of high-powered money in the world grew in line with the above ground stock of yellow metal, which occurred at a glacial, but flexible pace. The demand for high-powered money was itself a fairly stable function of income and wealth. And so the system was well-anchored. Yes, there were imperfections, including the advent of fractional-reserve banking which meant that the demand for high-powered money became less stable. Yet given the absence of deposit insurance and too-big-to-fail and only limited lender of last resort roles banks could be counted upon to have a strong demand for reserves (mainly in the form of gold) to back their deposits. Moreover the obligation to convert customers’ deposits into gold coin on request buttressed this demand for high powered money from the banks.
More Steps Toward Proper Reform
As a matter of practical politics the Republican Congressmen may well conclude that an imminent return to gold is unfeasible. But they could consider in the light of these considerations how best to re-secure the pivot to the US monetary system by creating high-powered money for which demand would be stable and the rate of increase in supply flexibly very low. The steps toward this end would include:
· Abolishing the payment of interest on bank reserves.
· Strict curtailment of lender of last resort function.
· Long-term abolition of deposit insurance.
· Fed withdrawal from creating liquidity in debt markets (no more eligible bills, repo-transactions, etc.).
· Issuance of large-denomination notes (adding to the demand for currency, a key component of high-powered money).
· A legal attack on monopoly power in the credit card business which results often in payers of cash not enjoying a discount.
In this suitably reformed system there would be a huge demand for high-powered money (whether in the form of currency or reserves held by the banks) highly distinct in function from any alternative assets. This demand would not depend on legislating artificially high reserve requirements which bank lobbyists would surely whittle down over time. That was the Achilles heel of the briefly successful monetarist experiment in Germany during the 1970s and early 1980s, as the bankers were finally able to bring political pressure toward lowering reserve requirements such that monetary base no longer was a secure pivot to the monetary system. Accordingly, the Bundesbank gradually shifted to explicit pegging of short-term interest rates albeit subject to a medium-term target for wider money supply growth.
Turning back to the US, even with the reforms suggested, there would still be the difficult question of how to determine the growth in supply of high-powered money. Without a gold connection there has to be some degree of discretionary control in this process, albeit constrained by a quantitative guide (such as an average 1 to 1.5-percent rate of expansion per annum, similar to the expansion rate of above ground gold over the past century) and ultimately constitutionally-embedded legal restrictions.
High-powered money as defined by such a monetary reform would be a far cry from the present situation where the size of the Federal Reserve balance sheet has been recording explosive growth for many years and where the main form of high-powered money, excess reserves, pays interest at above the market rate to the banks. The Republicans in their pursuance of monetary reform would do well to propose some initial steps which would prepare the way for bolder change at a later date with the aim of creating a stable supply and demand for high-powered money.
A key step would be the immediate suspension of interest payments on reserves (which only started in 2008) coupled with a rapid timetable for disposing of the Fed’s massive portfolio of long-term fixed-rate bonds. The Bernanke Fed, and now the Yellen Fed, has used this portfolio as a means of manipulating long-term interest rates (with this depending on an emperor’s new clothes effect whereby markets attach unquestioning importance to the Fed’s massive holdings in forming their expectations of bond prices) and of scaring investors into real assets so adding to the strength of their asset price inflation virus injections.
One suggestion for a rapid timetable would be the Treasury and Fed entering into a deal in which the long-term fixed-rate T-bonds held by the Fed would be converted into long-term floating rate debt and into short- or medium-term T-bills. This would mean less accounting profit under the present structure of yields for the Fed and a lower cost of borrowing for the Treasury. But who really cares about such bookkeeping between the federal government and its monetary agency? In turn the Treasury would announce a long-term timetable for raising the ratio of long-maturity fixed to floating rate debt in the overall total outstanding.
Rome was not made in a day. And the Republicans are certainly not in a position to legislate radical monetary reform. But that is no excuse for a careless decision by the would-be reformers to veer into a cul-de-sac under the misleading directions of Professor Taylor.
