A Flawed Approach to Monetary Policy

Markets work best when property rights are well defined and government is limited to its legitimate functions of protecting persons and property.
September 17, 2013 • Commentary
This article appeared in Orange County Register on September 17, 2013.

The 2008-09 financial crisis greatly expanded the power of the Federal Reserve under Chairman Ben Bernanke. Now that his term is ending, the focus is on the choice of a successor. That choice, however, diverts attention from a more serious issue: namely, the institutional flaws in the present U.S. monetary regime and its bias against capital freedom.

Today, we have a monetary system in which the dollar is a pure fiat money and the Fed is a purely discretionary monetary authority operating outside the bounds of a monetary constitution. The Fed’s near‐​zero interest rate policy and quantitative easing have distorted asset prices, increased risk‐​taking, and laid the basis for another panic once interest rates begin to rise.

It is disingenuous for Chairman Bernanke to say, as he did in May at a banking conference in Chicago, that the Fed is “watching particularly closely for instances of ‘reaching for yield’ and other forms of excessive risk‐​taking, which may affect asset prices and their relationships with fundamentals.”

The Fed’s strategy for some time has been to hold rates near zero and prop up asset prices to fuel consumption while penalizing those who save for the future. The Fed’s financial repression (i.e., suppressing nominal interest rates and causing after‐​tax real rates to be negative) has led to malinvestment, while its large‐​scale purchases of longer‐​term Treasuries and mortgage‐​backed securities under quantitative easing have placed it squarely on the side of big government and in the center of credit allocation.

The Fed should not be directing capital to the housing sector; it should let free capital markets allocate credit based on fundamentals. The Bernanke Fed has shown a basic mistrust of markets, parroting the liberal political class. Indeed, the goal of the Fed’s new macroprudential policy is to use its monetary and regulatory powers to oversee the entire financial system.

Such intervention will upset the spontaneous market order by undermining the rule of law, introducing institutional uncertainty, and politicizing investment decisions. The Fed will gain more discretionary authority and move further from a rules‐​based monetary regime. The free‐​market adjustment process (with its information processing price and incentive system, and its “creative destruction”) will be thwarted in favor of central bankers and their professional staffs, none of whom foresaw the financial crisis.

The Fed’s unconventional monetary policies have greatly expanded the Fed’s balance sheet and its leverage. Fed assets have ballooned to more than $3.5 trillion, compared to less than $1 trillion in December 2007. The monetary base has exploded, but most of the increase has not shown up in the monetary aggregates or inflation because commercial banks are holding huge excess reserves at the Fed, on which they earn a risk‐​free return of 0.25 percent, and have little incentive to make loans at ultra‐​low rates. Such policies, according to Stanford economist John B. Taylor, “perversely decrease aggregate demand and increase unemployment while they repress the classic signaling and incentive effects of the price system.”

Markets work best when property rights are well defined and government is limited to its legitimate functions of protecting persons and property. They also work best when a monetary rule limits discretion and ensures sound money — that is, maintains the long‐​run purchasing power of money. The U.S. Constitution was designed to prevent erratic money and to enshrine sound money. As Nobel laureate economist Milton Friedman wrote, “We have forgotten that the original Congress prohibited states from emitting bills of credit and gave Congress only the power ‘to coin money, regulate the value thereof, and of foreign coin.’ As I read the original Constitution, it intended to limit Congress to a commodity standard.”

In the same essay, written for the House Republican Research Committee in 1984, Friedman discussed alternative monetary regimes and stated that “the best change of all would be to abolish the Fed completely.”

It is time to judge the Fed’s 100‐​year history and to consider the constitutionality of a pure discretionary fiat money regime. Rep. Kevin Brady, R‐​Texas, drafted a bill to create a Centennial Monetary Commission. That is a step in the right direction. We should assemble the best monetary minds and have a real debate over the fundamental flaws in the Federal Reserve System, not just a debate over who will be the next Fed chairman.

About the Author
James A. Dorn

Vice President for Monetary Studies, Senior Fellow, and Editor of Cato Journal