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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
- The Allan H. Meltzer Professor of Political Economy and
Public Policy, 1997 to present, at Carnegie Mellon University,
where he has taught since 1957
- Visiting scholar, American Enterprise Institute for Public
Policy Research since 1989
- Co-founder of the Shadow Open Market Committee; member,
- Chairman, The Gailliot Center for Public Policy, Graduate
School of Industrial Administration, Carnegie Mellon University
- Consultant to the World Bank and various central banks
- Chairman, International Financial Institution Advisory
Commission, U.S. Congress, 1999-2000
- Economic Advisory Panel to the Congressional Budget Office,
- President's Council of Economic Advisers, 1988-1989
Awards and Honors
- Irving Kristol Award, American Enterprise Institute for
Public Policy Research, 2003
- Distinguished Fellow, American Economic Association, 2002
- Lifetime Achievement, Money Marketeers, New York University,
- Man of the Year in Finance, Pittsburgh, 1995
- Distinguished Professional Achievement, UCLA, 1983
- Fellow, National Association of Business Economists
Teaching and Research Interests
- History of U.S. monetary policy
- Size of government
- International financial reform
- A History of the Federal Reserve, Volume 1, 1913-1951,
- Money, Credit, and Policy, 1995
(Economists of the Twentieth Century)
- Money and Income: Issues in Monetary Analysis,
1992, with Karl Brunner
- Political Economy, 1991, with A. Cukierman and
S. F. Richard
- Keynes's Monetary Theory: A Different Interpretation,
- Authored more than 300 articles in academic journals and
finance and economic publications
- Various articles for the Financial Times, Los
Angeles Times, New York Times, Wall Street
Journal, Washington Post, National Review
- Appearances on CNN and CNBC, PBS NewsHour and Wall Street
- Doctorate and master's degrees in economics, University of
California, Los Angeles
- Bachelor's degree, Duke University
Meltzer's A History of the Federal Reserve, Vol.
1: 1913-1951, is reviewed in the December 2003 issue of The Region.