Allan Meltzer is probably the foremost watcher today of Federal Reserve monetary policy. He certainly has the greatest depth of expertise. Meltzer has made a distinguished career of it, not the least of which is his authorship of the most detailed history of the Fed, from its roots into the current century.
Drawing upon that background, the Hoover Institution published a brief piece by Meltzer on the growing and deserved frustration with Federal Reserve monetary policies, “Fed Up With The Fed.” Federal Reserve monetary policies have built up some major economic and financial imbalances that promise to be difficult and likely painful to resolve. These include the multi-trillion dollar balance sheet of the Fed, the $2.5 trillion in excess bank reserves that it has pulled in to help finance its ballooned assets, and the $18 trillion federal budget deficit that the Fed has facilitated through its accumulation of assets (of which Treasury securities make up the largest portion).
Perhaps the most important point in his brief piece is this: “An independent central bank does not permit the government to direct its actions and it must not finance the government’s budget deficit.” Meltzer argues that the Federal Reserve has already surrendered its independence. He also argues that it can get it back by following a rules-based approach to monetary policy, itemizing the Fed’s sad and dangerous history of failure when its governors thought that they were wise enough to manage a discretionary policy. The record shows that when the Fed’s monetary policy has been led by a discretionary approach, its discretion gets captured and steered for short-term political purposes, with universally bad outcomes.
I have to mention that in the latter part of Meltzer’s piece he wanders out of his expertise and into bank regulation and gets lost. This regulatory argument is unconnected to his monetary policy views, so its many errors should not take away from his monetary policy advice. He fails to recognize that after the large banks were encouraged by regulators to absorb large failing financial firms (like Merrill Lynch, Bear Stearns, Wachovia, and Washington Mutual), they have actually been declining in size. Contrary to his assertion that the largest banks make half of the loans in the nation, the entire banking industry today makes only a third of all loans, and its market share is shifting to nonbanks. His biggest departure from his own sound philosophy is when he argues that government rather than the market place should determine how much excess capital banks should hold. The markets would be much better regulators of the right mix of debt and equity in a bank’s balance sheet, if the wise folks in government would let them.