September 21, 1994
"The Federal Reserve's Wringer"
San Jose Mercury News
By Timothy Taylor
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IT SOUNDS like simple common sense. The Federal Reserve Act of 1978 says that
in determining interest rates and the amount of credit in the economy, the Fed
should take both unemployment and inflation into account.
But Alan Greenspan, the chairman of the Federal Reserve, would like to see
the law changed. He believes that the Fed should ignore unemployment and pursue
only one target: low inflation. An overwhelming majority of Federal Reserve officials
in this country and central bankers around the world agree with him.
Alan Blinder, the eminent Princeton economist who was Clinton's first appointment
to the Fed, disagrees. At a recent conference in Jackson Hole, Blinder stunned
the group of central bankers by arguing that the Fed should sometimes cut interest
rates to spur demand in the economy and reduce unemployment.
Their dispute is more than academic. In America's single most important economic
story of 1994, the Federal Reserve has now raised interest rates five times this
year: on February 4, March 22, April 18, May 17, and August 17. Higher interest
rates discourage borrowing, which reduces the aggregate demand in the economy.
In turn, lower demand both holds down pressure for inflationary price increases,
and also slows down the economy. So has the Fed, in a well-intentioned effort
to nip inflation in the bud, been strangling the economic recovery?
Probably not. Even Clinton administration economists, like Laura Tyson at the
Council of Economic Advisers, have readily accepted that the economic recovery
brought a danger of rekindled inflation, and that higher interest rates were an
appropriate splash of cold water. Even Blinder, who is clearly unafraid of speaking
out, has supported the rise in interest rates.
But when unemployment starts rising again -- and it surely will, sooner or
later -- then the dispute over whether the Fed should react will become central.
The mainstream view, Greenspan's belief that the central bank should worry
about inflation and not unemployment, begins with evidence from international
comparisons of central banks. Some countries, like Germany and New Zealand, require
their central bank to focus only on low inflation. Others, like the United Kingdom,
require the central bank to take direction from elected government officials,
which generally means helping to stimulate the economy by cutting interest rates
and making credit available.
When a country's central bank has the single goal of low inflation, many researchers
have found that its average inflation is lower. Economists Alberto Alesina and
Larry Summers confirmed this finding for 16 developed nations from 1955 to 1988.
In work done at the Federal Reserve Bank of San Francisco, Carl Walsh confirmed
the finding for a sample of 60 countries.
More surprising is that these same studies show that having the central bank
pursue low inflation does not appear to reduce a nation's economic growth or raise
its unemployment. The explanation for these results involves understanding inflation,
unemployment, and implementation.
Inflation is not about a particular increase in prices. Instead, inflation
is when everyone begins to expect such increases, so that they become built into
wages, interest rates, prices, and the whole economy. When the central bank has
a single goal of low inflation, it tends to stifle inflationary expectations before
Unemployment has two causes. "Cyclical" unemployment happens when
the economy falls into recession. "Structural" unemployment is determined
by the incentives firms have to hire people, which is partly determined by factors
like payroll taxes, and by people's incentives to work, which is partly determined
by the level of unemployment and welfare benefits available.
Since the U.S. economy has been growing for over two years, most of the remaining
6 percent unemployment is structural, and the Fed can't do much about it. To reduce
this unemployment, we need to rethink the disincentives to hire and to work that
are built into our tax and benefit systems.
Blinder's point at Jackson Hole was that a central bank can fight cyclical
unemployment. It can make credit more available and stimulate demand in the economy,
thus encouraging businesses to hire.
Blinder is right in theory, but most central bankers believe he is wrong in
practice. For a central bank to stimulate the economy successfully, it has to
know how much and how quickly banks, businesses and consumers would react to easier
borrowing. Then, it must calculate how much and how quickly to reduce interest
But based on the hard evidence of the international comparisons, it seems very
hard to make these decisions with the necessary precision and timeliness. Instead,
when a central bank tries to fight unemployment, it usually triggers a cycle of
As a result, the country ends up with just as much unemployment as before,
but a higher inflation rate. If the government wants to fight cyclical unemployment,
the central bankers argue, it should do so with tax cuts or government job programs.
When Greenspan's term expires, Blinder could be the next chairman of the Federal
Reserve. For the sake of the U.S. economy, he needs to learn and respect the difference
between a theoretically correct academic argument and the practical conduct of
central bank policy.
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