We can’t trust the economy to an algorithm

  • By James McCusker
  • Thursday, May 14, 2015 1:42pm
  • Business

On May 1, John C. Williams, the president of the Federal Reserve Bank of San Francisco, gave a speech at Chapman University in Orange, California. That wasn’t unusual, but the subject of the speech was. He spoke of the “dilemma” of the Federal Reserve’s independence and of the increasing volume of commentary recommending “…more oversight and greater transparency.”

He also spoke of the Congressional response to that commentary, in the form of, “…legislative proposals designed to constrain the Fed’s freedom of action in monetary policy and other spheres.”

Just 390 miles north of Chapman, at Stanford University, is the author of perhaps the most popular constraint, economist John Taylor, who recommends that the Federal Reserve’s monetary policy decisions be replaced by what is essentially an algorithm. Popularly called the “Taylor Rule,” it specifies the size of the interest rate change needed to respond to changes in the inflation rate and productive capacity utilization.

The idea of a Federal Reserve staked out and bound, Gulliver-like, by rules appeals to some members of Congress, but we have to wonder sometimes how priorities are set in our Capitol.

Sometimes the Congress seems to spend a lot of its time on what psychologists call “displacement activity.”

Displacement activity works very simply. When there are important things to be dealt with we sometimes prefer to spend our time and energy on easier things. Writers facing deadlines sharpen lots and lots of pencils. Managers concoct unnecessary meetings or even interview candidates for non-existent jobs rather than complete performance reviews. Politicians pursue issues that lack organized constituencies and are unlikely to produce political blowback.

The independence of the Federal Reserve fits in that category. Congress has lots of important things to debate and thorny problems to resolve, but instead some Members choose to spend time worrying about lassoing the Fed because it’s just too darned independent. In other words, the Federal Reserve doesn’t depend on Congressional approval for either its operating budget or its monetary policies.

It works both ways, of course. Congress does not depend on the Fed to finance its operations, either — at least not directly. The costs of the chronic federal deficit are very closely related to the Federal Reserve’s actions in regulating interest rates.

Railing about the Fed’s independence is something of a tradition in the Congress. In fact, as Mr. Williams points out in his speech, central bank independence has been a contentious issue in our country for the past century. And since the Fed will be just 102 years old this coming December, that pretty much takes care of its entire history.

We might think that legislators would still be thanking the Fed for keeping Wall Street’s lights on during the financial crash, and for quietly financing much of the government’s economic recovery efforts in the aftermath of the crisis. But that is not how politics works.

The Fed is a very powerful force in the American economy and to many citizens its operations are mysterious. More likely, though our central bank’s monetary policy actions are not wrapped in mystery but in econo-speak. Generations of America’s high school and college students have had the operations of the Federal Reserve explained to them by economists — whose legendary communications skills may be why so many people neither understand nor care about the Fed or what it does.

Why do some people and some legislators, then, still care so much about what the Federal Reserve and how it’s organized? There are basically two sometimes overlapping schools of thought. The first believes that the Fed’s failures prior to the financial system crash were systemic, that it is too close to the financial institutions it regulates and is influenced by their thinking. The second believes that responsibility for monetary policy belongs in the hands of our elected representatives in Congress.

Both groups want to simplify the system, some by linking the currency to gold or some other metallic standard; and some by shifting monetary policy from discretionary actions to a fixed formula.

Then there are those of us who believe that our sleep-walking economy and dreary employment picture encourage unfair criticism of the Fed’s performance. No one wants to recognize the limits of monetary policy to create prosperity. The best it can do is to encourage economic growth and hope that private individuals and industry take it from there.

Right now there are too many unknowns and uncertainties in our knowledge of the economy to entrust our monetary system to an algorithm or to Congress. The wise choice, then, is to put our best people in position and let them make the decisions that are necessary to encourage economic growth and promote maximum employment, stable prices, and moderate long-term interest rates.

James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.

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