Allan Meltzer knows better than most that the annals of economics are filled with failed predictions, so he is understandably reluctant to say when the second and final volume of his magnum opus, A History of the Federal Reserve, will be completed. His firmest statement on the matter: "It's coming."
Whenever it comes, volume 2 will truly be welcome. Volume 1, on the Fed's first four decades, sold out in six months and a second printing was ordered—a remarkable response to a footnote-filled, 800-page book on monetary history.
The book has brought Meltzer considerable acclaim. Speaking at its publication party in November 2002, Federal Reserve Chairman Alan Greenspan noted that while "one may not always agree with the conclusions regarding specific episodes," Meltzer's volume is "an indispensable input for monetary economists and economic historians alike." At an awards dinner in February 2003, President George W. Bush introduced Meltzer as the featured speaker for whom he was "just a warm-up act." The media have eagerly sought his opinions on tax cuts, deflation and other matters of economic policy, and whispered that he might be the "next Greenspan." (Not true, he says.)
Monumental though it is, A History of the Federal Reserve is simply the capstone in a long career of accomplishment spanning from Ivory Tower to White House. Meltzer has developed economic models, advised central banks, worked for presidents, overseen congressional studies, organized the famous Carnegie-Rochester Conference Series, written scores of articles and books, and—of course—critiqued the Federal Reserve.
This Region interview—in which Meltzer discusses the failures of the Fed, the difficult relationship between theory and policy, and current controversies from deflation to international bailouts—is testament to the fact that his current focus on volume 2 has neither narrowed his intellectual curiosity nor diminished his remarkable productivity.
FAILURES OF THE FED
Region: You've modestly titled your book A History of the Federal Reserve.
Meltzer: Yes. The publisher asked me whether I wanted to call it The History of the Federal Reserve. I said that was a bit too much for me, so A History is fine.
Region: In it you clearly and painfully describe the Fed's early failures to do precisely what was intended: to stabilize the economy. You explain how the Fed stood by passively during crises or even acted procyclically, exacerbating problems. Yet you also point out that monetary theorists—Henry Thornton, Walter Bagehot and Irving Fisher, in particular—had already laid out very clear principles for how a central bank should act in such situations to promote stability.
Why were policymakers unable to see what was happening during the Great Depression and implement the right tools? And do you think that the gap between theory and policymaking has diminished over time?
Meltzer: Let me come back to that last question. On the first part, a lot of my delving into the history is to establish two points. One is that they did what many so-called sensible people at that time would have done. That is, it wasn't that they were chicane or evil, or that they wanted to destroy the country or that they had peculiar notions about what their responsibility was. They were acting in the way that most people acted at the time. The Federal Reserve Act was written to create a passive institution. That is, they were not supposed to engage in countercyclical policy. That's something that came later, and they didn't think that was their responsibility. Second, the authors of the Federal Reserve Act relied on the gold standard to maintain stability.
There's a wonderful sentence in the book that summarizes that so well. In 1931 or '32, Governor—now we would call him president—Norris of the Philadelphia Reserve bank said if we were to do an expansive policy now, we would be putting out reserves when people don't need them, and we would have to pull them back when they do. And that typifies the view held by many academic economists at the time, with a few exceptions like Irving Fisher, who was regarded as way out of the mainstream.
Fisher was one of the greatest economists ever. He made major contributions. But he was a peculiar personality. Gottfried Harbeler told me the story about Fisher being invited to Harvard as a distinguished speaker. And he gave them a lecture not on economics but on temperance, vegetarianism, and so on, things that he believed in strongly. (I didn't know this when I started the Shadow Open Market Committee with Karl Brunner, but Fisher had something called the Sound Money League with branches all over the country promoting his ideas about how to run monetary policy.)
Region: One of Fisher's major contributions was to clarify the difference between real and nominal interest rates.
Meltzer: Yes, and one of things that's really puzzled me in writing the history was that he didn't talk about that during the Great Depression. He talked about debt deflation and the need to get money growth, but I never found that he talked about the difference between nominal and real interest rates. And if there was any time when the difference was enormous, that was the time. He went to see Eugene Meyer, the chairman of the Federal Reserve Board (the early name for the Board of Governors), and said to him, do you know that demand deposits adjusted are declining, and the chairman said, "What are they?"
Region: Most of the governors accepted the "real bills doctrine" (see sidebar), and much of their focus was on credit markets, true?
Meltzer: Credit and interest rates. The strong belief was that, and the quote that I like so much from Norris was that, when banks want to borrow, we'll be here to lend. But until they want to borrow then it's wrong to increase reserves.
And their idea of inflation was not that prices were rising—because during 1929, even in 1928, prices were falling. But they worried about inflation. So you have to figure out what they meant by that. What they meant is that the central bank was expanding credit based upon nonreal bills.
The real bills idea is a very simple one. If banks lend on real bills, then production and money both increase. When you lend for inventory, firms build the inventory. There's a supply of output to match the increase in money. When firms sell the inventory, they pay off the loan and you don't get any permanent increase in money. Prices remain stable. Whereas, if you finance a house or land or securities from the stock exchange, there is no real output as they viewed it. Now that was a false theory. It had been shown to be a false theory as far back as Thornton around 1800. But that was what they believed.
A main theme of my book is that people look at the world through the glasses that they wear. It isn't that you don't know what's going on. It's that you interpret things that are going on in light of the way in which you look at the world. And so during the Depression they said, whenever firms are ready to borrow, we'll be willing to lend, we're eager to lend. But if nobody wants to borrow, there's not much we can do. That was their view of the world.
THE THEORY/POLICY GAP
Region: What then establishes worldviews for policymakers? This leads us back to the question of how theory influences policymaking, and whether that gap has diminished.
Meltzer: An optimistic view is that we don't make the same mistakes, but we make new ones. It is a disappointment to me that some of the best policies have been made by people who do not attach themselves at all to any specific theory but really just try to look at the data and make judgments. I think Chairman Greenspan does not have some overriding view of the world that he tries to impose on the data. Quite the opposite. He looks at the data, and he tries to figure out what is happening in the world and doesn't have any very precise theory.
I think another good period was the early Martin period, where the Fed was guided by a simple rule. Over the long term it wanted to keep the rate of growth of money about equal to the rate of growth of output. They talked about that a lot in the 1950s. But Chairman Martin and most other officials didn't have any idea about how what they did today influenced either money or output over any long period of time, and they were never very interested in having such a view. Martin was perfectly happy to operate on his judgment about events and had little confidence in economic analysis. But those are some of the best periods in Fed history. Of course, the Martin Fed ended by starting the great inflation of the 1970s.
Region: That's interesting given your perspective, I believe, that rules rather than discretion should be dominant.
Meltzer: Yes. I wish it came out a different way. I think there is lots of evidence that monetary economics has something to say about what happens. But I wish the history came out with a message that said, we have a well-articulated theory and if you apply that theory, this will work out. I don't think that that's the message that comes out of the history that I've read so far, and I'm now well into the 1960s and I've looked at a lot of the 1970s.
I think we certainly got the major mistakes in policy because we ignored the lessons of monetary economics—the Great Depression and the great inflation. And I think we could have avoided those crises and those problems much better if we had paid some attention to monetary theory and followed a rule. So when I say that I wish it were true that economic theory were able to enlighten very well how the central banks should operate, I'm really talking more about short-term policy concerns that dominate actions. Over the longer term the rules do work out pretty well. That is, if you have excessive money growth, you have inflation. If you have deficient money growth, you get deflation. I think that works out pretty well and in many different periods, and I've got lots of charts in the early book and will have more of the same in the later volume that show that works out reasonably well. But it doesn't work out in the sense of being able to guide the policy from week to week or quarter to quarter. There is far too much emphasis on current changes that are often transitory or later revised.
TIME CONSISTENCY AND POLICY RULES
Region: Can you elaborate, then, on your views of the importance of policy rules as a means of diminishing the likelihood of time-inconsistent policies?
Meltzer: I would say that there are two ways in which rules are important. First, let's take a particular rule that many economists advocate—inflation targeting. As far as the trade-off between inflation and unemployment is concerned, as far as getting the right inflation rate, it's hard to make a very strong case that countries with inflation targeting do better than others. There's not a robust relationship there.
But where it matters is, it alerts the markets to what you're going to do and what you have to do. And that has an important effect on people's long-term expectations. You can build those in other ways. The Federal Reserve has worked very hard to establish its credibility. This is a case where academic research has very much influenced the way in which the central bank behaves. It's the role of information, the development of models of credibility, the sort of thing that your own Ed Prescott and [Carnegie Mellon University's] Finn Kydland did.
It certainly has had a great deal to do with the way central banks now think about their problems. It's been a real change from thinking, we're a secretive organization, we don't have to tell anybody anything about what we do—which is really the attitude of the 1920s and 1930s. Modern central banks recognize that they make the policy in the markets. The markets are watching them and they're watching the markets. There's really a harmony of interest there that the central bank can build on if it lets them know what it's going to do, so that they're not surprised. And that I think is the effect of economic theory working very much on central banking policy. Even relatively atheoretical people—I would include many of the governors—accept that that part of economic theory is useful and helpful.
Now as far as rules are concerned—it's important to convey the idea that you have a long-term strategy which you're going to implement, that you're not going to let the growth of money get too far away from the growth of output, for example. That seems to be, on average, a pretty good rule. There is a conflict in central banks between the political/social pressures to do something about a problem now and having to deal with the later consequences of what you did. That's where rules help you, as guidelines for telling people we really have to be alert to the fact that there is a downside to this expansive policy.
Unfortunately, there's a downside. As [Alex] Cukierman and I developed, credibility is a stock that can be used to surprise markets. That's the time-inconsistency problem, and without a rule a central bank can always use its credibility to achieve some end. A rule is a way of imposing discipline. The central bank has to say: These are our inflation targets. We're going to be in trouble if we don't maintain them when we get off the right path. The market enforces the rule.
THE 1951 TREASURY ACCORD
Region: Could you talk a bit about the 1951 Treasury-Fed Accord? You've said it began the evolution toward the modern Fed. It seems a very significant event in Federal Reserve history—in U.S. political history in fact—but it's little known and poorly understood.
Meltzer: Even at the time it was little known. The newspapers didn't play it up as a big deal. It was not considered a major event. This was partly because they put out a very low-key communiqué saying simply that they were going to issue a 2 3/4 percent bond, above the 2 1/2 percent ceiling in effect since 1942.
But what it did was to give the Federal Reserve its independence and gave it a chairman who, in volume 2, I describe as the person who designed the modern Federal Reserve. Remember that the Fed didn't do much in the 1930s and wasn't allowed to do much in the 1940s. Even in the 1920s, it was mainly a passive institution. But in 1946, we had passed the Employment Act, followed by the Federal Reserve-Treasury Accord in 1951.
That's really the remarkable difference that you see. In the 1950s and the 1960s, politicians are suddenly very interested in what the Fed does because employment is something that they know about. They now understand much better than they did before that this institution has something to do with the jobs that are created for constituents. And it also has something to do with inflation, which constituents don't like. And it also has something to do with interest rates, and high interest rates are not something that constituents like very much. So they suddenly became very interested. And the increased number of hearings shows that congressional interest rose, and White House interest grew significantly also.
Woodrow Wilson wouldn't invite members of the Federal Reserve Board to parties at the White House because he didn't want to influence them. Franklin Roosevelt was at the other extreme. Henry Morgenthau, Roosevelt's Treasury secretary, would say to the Federal Reserve, look, if you're not going to engage in expansive policies, I'm going to use the Treasury trust accounts. Well, by the time we get to the '50s, there are other ways in which they can influence things and one of them is congressional hearings, lean on the chairman, try to get them to do things, start regular meetings between the Fed chairman and the president and other officials, later called the quadriad.
Woodrow Wilson would not let them in the White House. Now we have regular meetings between the president and his economic advisers like the secretary of the Treasury and the chairman of the Federal Reserve. The political relationship between the Fed and the White House became very different in the '50s and even more in the '60s. Lyndon Johnson was not a man who cared much about the niceties of structural relationships. He wanted what he wanted today. That becomes a very different milieu for an independent agency. And the meaning of independence under those circumstances changes.
Region: You've anticipated my next question, asking for a preview of the key issues in volume 2, and perhaps a progress report. In his very complimentary remarks on the publication of volume 1, Chairman Greenspan asked if you couldn't move the timeline up a bit for volume 2. So, if I might ask, how is it coming?
Meltzer: It's coming. It's coming. [laughs] And I've really cut down on a lot of the other activities in my life and am trying to concentrate on that because at my age you know that the number of years ahead of you is smaller than the number of years behind you. I am well into the 1960s.
What are some of the major events of the book? Of course, front and center is the great inflation, which is the analog for this period of what the Great Depression was for the first 37 years. But there are several other key events. There's the breakdown of Bretton Woods and the fixed exchange rate system, and the interaction of the Federal Reserve with various administrations. Then, as I said, the political activity just increases enormously, so in addition to all the material at the Fed, we now are using the enormous collection of papers that are in the presidential libraries.
One of things that is difficult in reading the history is seeing exactly what the point of contention is. People don't use words that say, for instance, you're dumb and getting dumber, but you can see that there is conflict. That conflict is easier to understand when you see the presidential papers, when they're writing their private memos to the president explaining their positions. That throws a lot of light onto what's going on. It also opens up parts of the discussion.
I'll give you an example. There's an interesting experience that ends with President Johnson calling McChesney Martin to his ranch and just chewing him out because the Federal Reserve had raised the discount rate in 1965. Martin doesn't back down immediately, that is, he keeps the discount rate up. He defied the president. But what struck me about that incident was that as early as June, Martin had made a speech at the commencement of Columbia University in which he compared what was happening in '64, '65 to what had happened in 1928. And talked about the dangers of another Great Depression. And then nothing happened. The Fed didn't do anything. No action at all. And there's nothing in the minutes that gives you a clue as to why he didn't do anything.
Well, when you read the presidential papers and the letters and phone calls between the chairman and Johnson, you understand that Johnson was leaning very hard on him. Johnson hides the budget numbers showing how much the war in Vietnam is going to cost. (I might say, just as the current administration tried to keep a tight lock on what the war in Iraq was going to cost.) Johnson was not willing to come out with those numbers. At one point Johnson says to Charles Schultze, who was the budget director, you know I'm giving you this number, and there are only three people who know it: McNamara, me and now you. If it leaks, I'll know where it came from.
But Martin found out; he had his own sources. And he had found out what the budget deficit was going to be or at least what it appeared to be, and that it was $8 billion or $10 billion larger than what the president was admitting to. Some in the administration wanted the president to raise tax rates during that period and to put on a tax surcharge. Eventually he did do that, but only much, much later in 1968. Martin waited for that in 1965, and he didn't push to do anything. Now, I wouldn't have found out about all that if I hadn't gone through the presidential library and gotten all that material. The memos and conversations throw a lot of light on the personalities that are always, at least in my opinion, very important for reading history. The presidential libraries have an enormous amount of material that bears on the things that I'm talking about and brings them alive.
I found papers from the 1920s which talk about the individuals and you get some sense about why people do the things they do, because of the orientation they have, the kind of people they are, and you get more of that out of the presidential libraries.
For example, just in the part that I was working on last night about President Kennedy. The French—our friends, the French—are threatening to convert all their dollars into gold, and at that time France was doing very well. This is 1962. And Kennedy says in meetings with the French that if they start to do that, we’ll take our troops out of Europe. He tells them that our balance of payments deficit because is caused by having to finance NATO and foreign aid and all that. So we’ll take our troops out of here and that will close the balance of payments deficit.
De Gaulle doesn’t believe him. He says they won’t do it because it’s not in their interest to do it. In the end, Kennedy sent some emissaries to negotiate with the French. He decides that the only way that he can do this is not to admit U.S. weakness. He doesn’t want to ask for relief from them. He wants them to ask for changes in the Bretton Woods agreement, which would be in our mutual interest. One of the things he’s willing to do is to end the Bretton Woods agreement, way back in ’62—we’re only in the fourth year of convertibility—and replace it with a much more multilateral arrangement. James Tobin wrote a proposal for him that makes the multilateral arrangement.
They’re willing to give up what the French are always complaining about, that the United States is getting a great advantage. Tobin, George Ball and possibly President Kennedy don’t see that there’s a great advantage. They much prefer to get to a multilateral system. They’re not able to do that because the French don’t want to do anything. Then shortly after this, the Cuban missile crisis opens. This in August of ’62 and the Cuban missile crisis is in October of ’62, so Kennedy is busy with other things and this problem disappears from the radar screen.
Region: We all look forward to volume 2.
Meltzer: Me too.
THE SHADOW OPEN MARKET COMMITTEE
Region: Speaking of presidents, is it true that we have President Nixon, Arthur Burns and the wage and price controls to thank for the Shadow Open Market Committee? Did they motivate you and Karl Brunner to create the SOMC?
Meltzer: Yes, indirectly. The wage and price controls were an example of what we thought of as bad policymaking. When they were announced, Brunner and I organized a group of people to write a letter to the newspapers expressing that viewpoint. I did a lot of the work of rounding up that group and writing the piece. We didn't have e-mail; we didn't have fax machines. We had to do this over the telephone. And every time you change a paragraph, you've got to call everybody and tell them about the change. That was hard work.
But we wanted to say something. We'd been concerned for quite a long time that many newspapers and business magazines believed that the way to talk about policy was to ask somebody who was extreme on one side—who said, for example, well, the only solution to inflation is the gold standard—and then quote another person who said, well, the only solution is wage and price controls. That didn't represent the bulk of systematic academic thinking, nor was it likely to be effective. But that was the kind of thing that you got. We needed to try to get a dialogue going about the causes of the problems that we had, and possible solutions to the problems. So that was one thing.
The other thing was that I was often in the position of having to comment on things after they happened. And I thought, it's easy (or easier) to see the truth after the event occurs, but it's not as easy before. I thought we ought to put ourselves on the line with our policy views, our ideas on what was causing various problems and how to deal with them. Those were the two major elements.
Brunner and I decided we were going to try to do this, and to get publicity for it we called it the Shadow Open Market Committee. Bill Wolman, who later became the editor of BusinessWeek, was one of the people who really helped put this together; Jim Meigs, a former University of Chicago student, then working in the financial markets, was another. We organized it, and got a very strong, favorable initial reaction from the press.
That was the origin of the Shadow Open Market Committee. It still continues. I don't have very much to do with it anymore. I thought we had made our message clear, people knew what we stood for, and we had delivered the message as well as we could. There really wasn't a lot of point in my continuing that, and I got busy with doing other things. I had wanted to leave much earlier, but the need to leave became pressing when I took on the job of heading a commission to look into the international financial institutions.
THE MELTZER COMMISION
Region: Let's turn to that. From 1999 to 2000, you chaired the International Financial Institution Advisory Commission, better known as the Meltzer Commission. And it issued very strong recommendations calling for the overhaul of lending policies and operations of the IMF, World Bank and other international agencies. Are you satisfied with the progress that's been made on those recommendations?
Meltzer: Well, yes and no. When it began my wife said to me, you know, this is going to be a lot of work, and you're going to be very busy. What do you expect to accomplish? I said, not very much. And she said, then why are you doing it? I said, because if you don't, you never accomplish anything, you sacrifice the chance.
But no, we didn't just disappear into a file drawer. We actually managed to get some changes made. And believe it or not, even though the commission has long since gone, I continue to press for changes. We were very fortunate to get an administration that was sympathetic to what we did—subsequent to our work, that is. When we were working on it, we had an administration not at all sympathetic to what we were trying to do and very negative about our report. Later some of them changed their minds about some of our proposals. For example, they did finally agree that giving grants to poor countries—monitored grants—was better than making loans. That has become at least, in part, accepted now. It's become the law. We had the great good fortune to have people like the present President Bush who promoted that idea, Paul O'Neill when he was Treasury secretary who pushed that idea, and John Taylor who had to do the hard work of getting it implemented. But it did get implemented. Now the World Bank is trying to make hash out of it, and that's going to be a continuing problem for the Treasury to try to make it work. But that was a potentially big reform.
We got a lot of small changes at the International Monetary Fund. The biggest issue remains outstanding. But let me back up and say I started with the view that I didn't think the IMF was a good organization or had any reason to exist. I really did change my mind as I learned more about it. I decided there really is what economists call an externality—that is, some benefit to the general public larger than the private benefits that individual countries get. Trying to maintain global financial stability—that's a major reason why the IMF exists, and that's what they should concentrate on. The most important steps, as far as I'm concerned, is first to shift from what I describe as a command-and-control operation to an incentive-based operation. Second is to get more floating rates.
The question is: How do we get incentives into the system? In many ways, it's like raising your children. You can tell them and tell them and tell them what they ought to do, but until they decide it's a good thing to do, there's not much effect. Well, the same thing is true by and large with countries. The people in the country have to want the reforms, or politically it's just not going to happen, no matter how many documents they sign.
They need to have incentives. And the way to get them to have incentives is to say, here are a few things that you ought to do, and that we at the IMF have found to be good for stabilization of countries. For example, have a banking system where there's enough capital, and the government keeps its hands out of the lending policies. Allow foreign banks to compete on equal terms, as near equal terms as you can, within the country. Have either a hard fixed or a floating exchange rate. Keep a fiscally prudent policy.
That way, we divide the world into three groups. If countries follow the suggested policies, they should be automatically eligible for IMF loans. If they don't, they shouldn't get any loans and the IMF won't bail them out. Lenders will say, gee, these countries are on the good list, and we're going to lend them more money at lower interest rates because they are less risky. And these other countries are on the bad list and if we lend to them, we want a big risk premium. Now the finance minister, or prime minister or president of a country can say, you know, if we adopt stabilizing policies, we're going to get more money at lower interest rates. So that's a big incentive.
Those are the first two groups. The third group is, to take a practical example, what do we do with Uruguay, which is doing things more or less right but has Argentina as a neighbor causing it to have problems? The IMF should say, let's help them, and it did. We'll bail them out because they're the innocent victim of what happened in a neighboring country, and our job is to see that crises don't spread. But we're not going to help the Argentinas of the world; we're going to get them to either live with the risk or reform. And it's up to them to decide which they want to do. We can't force them.
That, I think, is the heart of international monetary reform. And many people at the IMF accept that. They tried to establish something called the CCL, contingent credit lines, which implemented an idea very similar to this. They won't take the next step, and say if you don't get the money that way, we won't give it to you unless you're victim of a third party. And I think that's the big step we have to take; it's a hard one for politicians to want to attach their names to.
At the World Bank, aside from the monitored grants business, we haven't
been very successful. I started with the view that the World Bank
was relatively good and probably doing useful things. But you know,
they lend about $20 billion a year; it takes 9,500 full-time employees
to do that. God knows how many others are there on
part-time or consulting services, but not on the official payroll. And they have very little to show for their work. The places where they have success are places like China, where they're a drop in the bucket as to the total amount of capital that comes to China. The places where they have failure are places where they're the principal lender. They haven't been able to create the incentives for those countries to want to do the right thing. That's one thing we're continuing to try to do, trying to push them in the direction of getting more responsive to incentives.
In the 21st century, we have large parts of the poorest world where there isn't potable water, there aren't sanitary sewers, there isn't inoculation against measles—all of those things. People talk about AIDS, and AIDS is in the headlines, but lots of children die of measles, and for about 5 cents a person we know how to inoculate people against measles. So it just seems wrong that we don't have a system in place to do some of those things.
MELTZER COMMISSION CRITICS
Region: As you’re well aware, when the commission’s recommendations were first issued, they were strongly criticized by officials at the IMF, the U.S. Treasury Department and elsewhere as being counterproductive. For example, some said that following your recommendations would actually exacerbate moral hazard rather than diminish it. How did you respond to these criticisms?
Meltzer: For the most part I took the view that I didn’t have to respond, that time would work to our advantage if it worked at all. And I think that’s been true. That is, I think we’ve moved from being some fringe group out on the edge urging things that people found unpalatable. About a year or so later, the Economist magazine said something to the effect that we had laid out the blueprint for the reform of these institutions. There was a shift in views, and people found our recommendations more palatable.
And as I said before, we got a new administration that didn’t have as much conflict over the writing of the report—had none, in fact—whereas there’d been a lot of conflict with the Clinton Treasury. So they looked at it with a clear eye, and the people at the IMF were more friendly. They got new leadership, and the new leadership wanted to do something to make the institution more effective.
You know, they had increased their authorizations—not their lending—by about a quarter of a trillion dollars during the 1990s. That’s a lot of money. The IMF went from a small organization that was lending a few million here and there to an institution that was bailing out countries with $40 billion or $50 billion dollars, or $60 billion or $70 billion. It was time to get serious.
And when Dr. Köhler came in as managing director, he did a thorough evaluation of what had been done—because we weren’t the only report at the time. He wanted to know what were the criticisms and the recommendations. I talked to him on several occasions, and I believe he sincerely set out to try to rectify some of those problems. People began to take our report more seriously, not speak from their pre-fixed political positions but to look at what we’d actually said instead of what they thought we had said. At least some of the problems were caused by the fact that I had written something years earlier which said we should abolish the IMF. Some people read anything I wrote in the light of that. But I had changed my mind.
You know, Keynes once was accused of having changed his mind and being inconsistent. But he said, when the facts change I change my opinion. What do you do?
Region: The problem of moral hazard is central to the issue of bailouts, of course, and you've mentioned the examples of Uruguay and Argentina. Some critics of the Meltzer Commission said that your recommendations would increase moral hazard. What was your response to that specific criticism?
Meltzer: On the few occasions where it was made when I was present, I asked them to give me examples of how they thought my recommendations would increase moral hazard. I never got what I thought was a valid argument about that, and I don't hear that complaint anymore at all. There were two arguments made. One was that we had overstated the importance of moral hazard. I think that's wrong. And second, that we would create more moral hazard. I think the second argument went away fairly quickly. The first one was a more serious argument.
There's been some research on that since that time. I believe that it's still true that moral hazard is a big problem. Banks and other lenders receive interest rates that include often large risk premiums. When the crisis comes, the IMF supplied the funds that paid off the loans. The lenders were paid to bear risks, but they didn't bear them, until recently, after our report.
It's certainly a political problem, as all policy problems are political problems. The fact that "policy" and "politics" have the same root is not an accident. You have many examples where the current finance minister wants to push the problem off into the future, if he can get out and leave the problem to his successor.
But the big part of the moral hazard problem comes from the fact that the IMF lends money at favorable interest rates. The countries supported their exchange rate. The private lenders fled with their money. The country substituted low interest rate loans from the IMF and the development banks. This encourages the kind of behavior we have seen repeatedly—that is, not dealing with the policy problem early. How much reform have we seen in Argentina either when the IMF was there or when the IMF left? We don't see much reform. What that tells me is they're not ready to reform. And promises from them will not be very valuable until they make up their mind that they want to implement reforms. That's where a big part of the political problem arises. We have to think about what incentives are there for the people who are making the decisions to choose reform and convince their public that reform is good policy.
I remember going to Peru at one point. They were just at the beginning of their reforms. The finance minister came with a list of reforms that was far more extensive than anything the World Bank or IMF had come to them with. You didn't have to worry about the country, about what they were going to do, because they wanted to do more than you were telling them to do. And they implemented reforms because that was the thing that they had decided to do.
I'm a very strong believer that the incentives that work in the political process are not the same everywhere. The way we get reform is when people decide to reform. And when they do decide, it may be useful to help them. But the institutions can change the decisions by changing incentives and giving up command and control.
REGULATORS AND STABILITY
Region: The United States has suffered fewer financial crises since the end of World War II. To what extent would you attribute that greater stability to the Fed's role in bank regulation and being lender of last resort, and to what extent does the credit go to FDIC deposit insurance as a means of preventing bank panics or bank runs?
Meltzer: Let's start at the end of that question. The FDIC provided that service since the 1930s, but we know from the 1980s and especially the 1990s that the difficulties in the FDIC, and especially in the Federal Savings and Loan Insurance Corp., became more of a problem than a help. On the whole, however, ending the gold standard and having a bank safety net ended the run from deposits to currency and currency to gold. That enhanced stability.
I would put very great importance on the response to the 1971 Penn Central crisis; it was, I think, the first time that the Fed acknowledged that it was the lender of last resort, not just to banks but to the entire financial market. You see that happening in every subsequent crisis, especially in 1987.
That's now ingrained, and it sets up an expectation that people expect the Fed to support the system, and the Fed does it. That lesson has been learned and appropriately so. I put a lot of weight on the lender of last resort function and the recognition that all systemic financial problems are Fed problems.
Region: And bank regulation?
Meltzer: Well, bank regulation has improved some. In the 1980s, I went to so many conferences talking about the problems of the savings and loan associations. I stopped going because there was nothing new to say. And yet it was very hard to get regulators to do anything about that. It was certainly hard to get Congress to do anything about it.
After the final denouement, if you will, of the S&L crisis, we got better—not good but better—banking regulations. We got a version of the Benston-Kaufman plan for putting subordinated debt in the banks, and closing the banks, or at least changing the management before we got to negative net worth. Those were steps in the right direction. And they are, going forward, very important. We have improved the capital in the banking system.
We still have a lot of work to do that Governor Ferguson is now responsible for, which is to try to get the international accord on these issues. That's turned out to be a very difficult thing to do because of the differences in the banking systems around the world. And also because, to some extent, they've gone about it with a command-and-control approach of trying to figure out what the risks are rather than doing the more difficult work of trying to align the incentives of the banks with the incentives of the public and the regulators.
You have to make banks want to do the right thing, and you have to find a way to give them incentives to do that rather than to say these kinds of assets are risky and those kinds of assets are less risky, and so on. We're never going to be able to do that. And every time we set up a system, we're going to find that these smart, well-paid people are going to find a way around it. That's what they do. The history of banking in the 1950s, '60s, '70s was exactly that, you know, find how close can you get to the regulation but not quite cross the line, and then do it. Basel II is very complex. We know that what I describe as a command-and-control system will not work.
OPTIMAL POLICY VS. POLITICAL REALITY
Region: In A History… you write that big policy changes come about largely through crisis. Does this imply that theory is only a guide, but doesn’t by itself lead to change?
Meltzer: Yes, we have to work with people and institutions. We can develop rules for optimal policy, but we have to recognize that those rules are applied under circumstances that are political, and by human beings. And that’s the difference between engineering inanimate objects and trying to work in a policy process where you have lots of conflicting interests. Few things get to the top policymaker unless they’re highly controversial and have to be decided between competing factions where somebody is going to get hurt and somebody is going to be helped.
So optimal models that work in economics are very useful for thinking through what are the details of a better policy. But we have to remember that what is optimal as far as the model is something very different from what is feasible in terms of the politics of the society. One of the things that I did in my career that interested me a lot was to develop a research and teaching program in political economy, to try to blend the elements of politics with the elements of economics, because policy is an important part of an economic process.
When you talk to a congressman or senator, the first thing he’s concerned about is, what will that do to my constituents. That’s what he’s paid for. So it’s not a criticism to say he thinks about that. But he doesn’t think about the question in terms of efficiency. He’s not against the efficiency of the system, but he thinks about it in terms of who gains and who loses and what does that do to my voters. And am I willing to do this in the public interest if my opponent in the next election is going to charge me with having done something against the best interest of the citizens of Pennsylvania or Pittsburgh and so on, and how much of that can I afford to do. I think those are legitimate calculations. That is the system that we have.
And as a long-term thing, from a theoretical point-of-view, you want to bring those elements to bear on policy. Optimal policy has to include who gains and who loses and how much weight they’re going to have in those decisions. The political economy program that we started here at Carnegie Mellon began to move on a lot of those issues.
Region: You've been quoted as saying that current concerns about deflation are "nonsense." Could you elaborate on that?
Meltzer: Yes. There's never, never, in any historical example that I know, been a case in which you had a deflation where you have rapid money growth, a large and rising budget deficit and a deflating currency. Because you have deflation, you may get a depreciating currency and a budget deficit, but you don't get deflation under the circumstances of having those things. They don't cause deflation. We have set everything in motion to have a problem—not immediately, but at some point—of inflation, not deflation.
And second, the history of the Federal Reserve—and even the prehistory of the Federal Reserve—shows that we've had lots of deflations. We had one in 1920-21, we had one in 1937-38 and in 1948-49, and in the last two we had zero interest rates, literally zero nominal interest rates. And one was a very mild recession, '48-49, two were fairly deep recessions, but not because of the deflation. They were deep recessions because of the reversal from the very high monetary and fiscal stimulus to monetary or fiscal contraction.
Region: So concerns about a liquidity trap are unfounded?
Meltzer: Liquidity trap comes out of bad modeling. Economists
have a model in which there's one interest rate, and that's the one
that is mostly used by people who do the policy work. And that's just
wrong. As a long-term story, of course, all the differences between
long-term and short-term interest rates, between returns on stocks and bonds, between domestic and foreign rates, presumably all that washes out in the long term. But during the period of transition,
long-term rates move relative to short-term rates, stock prices move relative to bond yields. And there isn't that tight relationship that would be required so that you could get a liquidity trap. You'd have to get all those yields to zero; we never have seen that. And even Keynes, who proposed that there might be a liquidity trap, said, of course, this is something that we've never seen, but it's a theoretical possibility. Well, we've never seen it.
When Marriner Eccles, the chairman of the Fed in the 1930s, was testifying in Congress, one of the congressmen said to him, what you’ve described is just like pushing on a string. And he said, yes, yes, that’s it. Pushing on a string. You can pull on a string, but you can’t push on a string. Well, that aphorism, which is about as good as most aphorisms, was an excuse for the fact that he hadn’t done anything for the previous three years. Literally, literally, there was not an open market operation from 1934 to 1937. None.
ASSET PRICES AND BURSTING BUBBLES
Region: The Fed was strongly criticized for not deflating the so-called stock market bubble before it burst in 2000. Now the Fed is coming under criticism for not taking seriously a bubble in the housing market. Do we really have accurate models of asset prices that enable us to determine whether we've got a bubble or not? And what steps, if any, should central banks take to curb irrational exuberance, if it can be identified?
Meltzer: My answer to that—and I think the 1929 experience but also the 1990s experience bear this out—is that the problem is to separate out what are the expected increases in real earnings, and what are the inflationary influences that are affecting the stock market. If you could separate it neatly, you could put on one side that so much of this is the result of productivity growth, and on the other side, is the expected inflation rate. If you could really do that and you knew what those expected inflation rates were, well then, you don't need to know about the stock market, because you know the thing that the Fed needs to know: What are the expected inflation rates? If I really believe those expected inflation rates, I'm going to do something about them.
Now, I have to say that Brunner and I have built many models, like Jim Tobin, in which stock prices were a key element in the transmission of monetary policy. So I do believe that asset prices matter, and I believe it much more than most models where they don't have asset prices at all. But what drives the housing market, as a current example, is the fact that the prices of old houses are going up. And that means it's a good idea to build new houses because the relative price tells you to. Resources are being pushed into the housing market because interest rates are low and the asset prices of the existing stock are very high, so you want to build substitutes. It's not mainly a wealth effect that people talk so much about. It's just that relative prices are working to allocate resources.
Now when the stock market rises, then old capital sells at a higher price relative to the production cost of new capital. You get production on the new capital, other things equal. Those are driving forces, and I think they're very important for analyzing what goes on. And they're a critical feature in the transmission mechanisms that Brunner and I worked on in the '60s and '70s, and they're not a part of most models. So I'm quite comfortable with the idea that asset prices are important. But if the Fed can separate out those two effects, then it knows what the expected rate of inflation is to a degree that it has confidence in. It should do something about the expected rate of inflation no matter what's happening to the asset prices.
That's my answer. And the same thing is true about the housing bubble.
I don't see the housing bubble as having anything to do with long-term
inflation. Maybe that's why housing prices are rising, but I don't
believe that's the main reason. I believe that you have a lot of people
who have a lot of wealth, and one of the ways that is both
tax-advantaged and advantaged in other ways is to consume wealth in the form of more space and better housing.
FINANCIAL PAYMENTS SERVICES
Region: Financial payments services—check services, cash disbursements, automated clearinghouse transactions—have been part of the Fed system since its early days. Why do you think the Fed got into that and what role should the Fed play in new emerging services?
Meltzer: The Fed got into it because one of the tasks of the early Fed was to improve the quality of the U.S. financial system. It wanted to get rid of nonpar collection. That was a big goal of the Fed way up into the '50s, getting rid of nonpar collection—the fact that banks would charge for receiving checks and cashing checks just as they do now, for example, for wire transfers. The Fed believed that it was in the public interest to get rid of the nonpar collection system and admission to the Fed required you to agree to par collection. Since that was a major source of revenue for many small banks, that was a reason for small banks not to join the Fed.
But more generally what the Fed did—and I talk about that as one of their advantages—one of the things we got from the Fed was it unified the national money market. They had to be concerned with the payments system because there was not at that time a private market trying to solve the problem of how we manage the payments system, how we speed up the payments system, how we speed up the processing of checks.
I was in Albania not very many years ago, and they told me that it took something like 10 days or more for a check to go from Tirana, the capital, to some place that was 50 or 100 miles away. It's not that big a country—10 days. And you know, we think a day, two days. That's a real advantage of making the payments system efficient, reducing the float that occurs, reducing the amount of cash balances people have to hold because of float. Those are real public benefits, and the Fed has provided those benefits.
Now there are people in the market who will do check processing and so on. The Fed has now put itself into a competitive business. I think that system is working quite well. I know from talking to various Reserve bank presidents they really work very hard to make sure they have the most efficient, lowest price check processing system so they get a share of the business. I don't see anything wrong with having a public competitor that competes on equal terms, especially one that tries to set a standard for efficiency. Now as we go forward, we see globally that there again are efficiencies that can be achieved in integrating those global markets.
INFLUENCE AS AN OUTSIDER
Region: From time to time, your name has been mentioned in the media as a potential successor to Chairman Greenspan, and you've modestly demurred, pointing out that the age gap between the two of you isn't that great. But it does raise an interesting hypothetical. You've had a great deal of influence on monetary policy and conduct as a relative outsider. Do you think you could have been even more influential had you taken a more direct policymaking role?
Meltzer: Hard to answer, and I've never given it a lot of thought. My first experience in government was in the early days of the Kennedy administration. I had done some things for Congress before that, but I was a relatively young man. I worked in the early days in the Kennedy administration, in Treasury, but not for very long. I found it less attractive than being an academic, to put it mildly. And the only other time I worked in government on a regular basis was as an adjunct member of the Council of Economic Advisers in the Reagan administration. I didn't want to take a full appointment, and I only took the job because it was the last four months of the administration. I knew I didn't have to go beyond Jan. 20, 1989, and that was good.
Region: I ask the question because in A History you make such a strong point about the right economic ideas being out there—from Thornton to Fisher—but they weren't being heard by policymakers.
Meltzer: That's right. So I've tried to do things to get them heard. Having worked in government, having been around government for a long time, I suppose I might appreciate more than most economists that implementing ideas is more than just having them. There's always a political process, and there are all the people who are tugging and pulling in various directions. A big part of the job of being chairman of the Fed is the political job. It's selling ideas, establishing your own personal credibility and strength, and having people have confidence in you. I think Paul Volcker did that very well. Alan Greenspan did that very well. Bill Martin did that very well. And even Burns, who was a terrible chairman, managed to establish himself as a font of wisdom. People trusted him even though they shouldn't have.
That's a big part of the job—the job of selling ideas. This comes down to whether you're going to be able to have whatever influence you can have, from the outside or from the inside. And I think that's a question of personality and taste. In any case, I've been very happy with being on the outside. When I had to write a little autobiographical statement recently, there was a question about "how much time do you work?" My answer to that was, a lot of the time I don't know whether I'm working.
Region: Thank you very much.
Meltzer: It's been my pleasure.
More About Allan H. Meltzer
Awards and Honors
Meltzer's A History of the Federal Reserve, Vol. 1: 1913-1951, is reviewed in the December 2003 issue of The Region.