By all means, eliminate the Fed´s double mandate

Luigi Zingales is right in one dimension – the “eliminate” one. But the choice is not between “full employment” and “price stability”, both of which are pretty vague and hard to define.

It might be too late to reverse the politicization of the Supreme Court, but Congress can still use its power to save the Fed (FDTR), namely by passing laws that restrain the central bank’s activism.

The first step would be the elimination of the double mandate. Unlike the European Central Bank, which is in charge only of price stability, the Fed has two main legislated goals: promoting full employment and promoting stable prices.

This gives the Fed too much flexibility, pushing it to substitute for the government in designing economic policy. The temptation to act in this way is particularly strong when Congress is divided and paralyzed. It is precisely this substitution that makes the Fed politically vulnerable. The central bank can be independent or activist; it cannot be both. Independent is better.

Zingales mentions the single mandate – price stability – of the ECB. But look at what happened to the EZ countries. Also, back in 2008 a major reason for the plunge in US NGDP was the FOMC´s undivided attention to the risk of inflation from the rise in oil and commodity prices.

And that´s another drawback of the “price stability” mandate: it´s badly suited to absorb supply shocks.

My take: Economic stabilization presumes NOMINAL stability, and that´s the province of the Fed. So require the Fed to have a single mandate. That being to keep nominal spending evolving along a stable growth path. Instead of an inflation target the Fed would pursue a NGDP Level Target.

And this has been unwittingly tried, with great success, for more than twenty years with the result being the “Great Moderation”, a period of low and stable inflation, stable growth and low unemployment.  (And, please, don´t come charging with accusations that it bred all sorts of bubbles).

Who would want to ask for more?

6 thoughts on “By all means, eliminate the Fed´s double mandate

  1. “(And, please, don´t come charging with accusations that it bred all sorts of bubbles)”

    That wouldn’t be an accusation , it would be a statement of fact:

  2. Marko – According to your “fact”, stability, like smoking, is dangerous to your health!
    I like charts, but the one you linked doesn´t tell a story, at least to me. Don´t reason from a price change. Go out and dig to find the factors that drove prices. Just because they went up doen´t mean there was a bubble.

  3. Marko–

    Is the Fed responsible for every bubble?

    There were some valid reasons for the private sector to leverage up on housing, as seen in this chart.

    By 2007, nationally, USA house prices had not seen sustained drops in generations, and thousands of mortgages could be pooled into MBS, and then resold.

    That seemed like a very, very safe investment, and the private-sector thought they were safe, the private-sector ratings agencies gave the MBS product highest ratings. And there was a global capital glut.

    Market booms and busts there have been since man invented markets, from tulip bulbs to Florida land to who knows what. In the USA, Amish Shaker furniture was very, very hot in the 1990s, but now not so much. Blame the Fed?

    Even if we had a gold standard, if we had free banks that had fractional reserves, they would have lent on housing (the safest investment imaginable, and especially though MBS), and the MBS rated AAA bonds would have been good sellers. But without a central bank, when the housing market tumbled, we would have had a Great Depression for generations, rather than a deep recession (and that is with the Fed bumbling). The gold banks would have runs, and collapsed.

    So, Marko, we should have an activist Fed (or ECB or Bank of Japan) that anticipates and prevents bubbles before they even happen? Wow, that’s magic. I wish I knew when these bubbles were going to happen, so I could invest in them. Oh, you mean no one knows in advance when bubbles are going to happen? So how is the Fed responsible for bubbles, then? The Fed will know when there are bubbles?

    Botom line: Market Monetarism is the answer, not silly Theo-Monetarism, or a demented slavish devotion to stability of subjective nominal indexes of prices.

    To paraphrase Ben Franklin: He who seeks economic security through price stability will lose both.

  4. The Fed was aware of the rampant mortgage fraud in 2003-2004 via reports from the FBI. Additionally , appraisal trade groups notified regulators that they were being pressured into giving inflated valuations , and 49 of 50 states’ attorneys general sounded the alarm on the scam as well , which ended up ruining Spitzer’s sex life when he had the nerve to alert the public to this fact by writing an editorial in the national press. The gov’t responded to these warnings by pre-empting state’s ability to prosecute the fraud , and Greenspan warned that anyone that tried to put a stop to it would do so over his dead body.

    The Fed could have easily prevented the worst of the bubble through regulatory action if they didn’t want to use interest rate policy to do so.

    So , yes , the Fed knew there was a bubble , but they also knew that it was the only thing driving economic growth , so they let it ride. That’s the paradigm we operate under nowadays. The virtuous cycle of workers’ wages linked to productivity gains that drove sustainable economic growth in the past is no more.

    Bubbles are us , bub. If you have an idea for the next one , I’m sure Obama and Bernanke would love to hear about it.

    • Student Loans are looking ripe for bubbling:
      1.) Magnitude is approximately commensurate with a mortgage – students are picking up 5-50K per year in debt over 4-6 years.
      2.) “Backed by the Federal Government” – since they passed a law that you can not bankruptcy out of it.
      3.) No assets to seize in the event of default – an education is an intangible asset and most 21-23 year olds do not own anything that can be taken and liquidated to recoup the losses caused by defaulting.
      4.) Anyone with a pulse can get a student loan.

      The student loan situation looks very similar to the housing situation prior to the crash. I do not know if student loans are able to be packaged and bundled for investment like MBS were but I would imagine that a pervasive accumulation of debt that does NOT get repaid is bad for the economy in general.

  5. Marko–

    Well I liked the part about ruining Spitzer’s sex life. True story—while in NY in 2001, about midyear, I bumped into a guy from Kroll tailing Spitzer.

    Hard to see next bubble–gold and energy maybe.

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