The central event of this volume is the Great Inflation of the 1970s, which Meltzer attributes to three principal factors: erroneous economic theory, the political context in which the Federal Reserve operates, and inflationary expectations.
Allan H. Meltzer’s long-awaited second volume of A History of the Federal Reserve does not disappoint. Like the preceding volume, it is both exhaustively researched and meticulously detailed. At more than 1,200 pages, it is likely to provide many productive hours of reading to investment professionals and scholars of monetary economics alike. Analytical overview chapters at the beginning and end of the book, along with conclusions at the end of most chapters, help prevent readers from getting bogged down in the occasional minutiae.
Whereas the central event of volume 1 was the Great Depression of the 1930s and the Federal Reserve’s role in it, the central event of volume 2 is the Great Inflation of the 1970s. Meltzer attributes this episode in the Fed’s history to three principal factors. The first is erroneous economic theory:
Volume 1 showed the importance of the gold standard and, even more, the real bills doctrine that had a powerful role in sustaining the Great Depression. This volume documents the role of Keynesian thinking in creating the Great Inflation and mainly monetarist thinking in bringing inflation back to low levels.
Under Keynesian theory, which dominated macroeconomics from the 1950s to the 1970s, full employment and price stability were policy objectives that existed in tension. As a practical matter, price stability was treated as a secondary objective to full employment. Fighting inflation was deferred to a later date, and this postponement ended up being indefinite. Keynesian economics also holds that monetary policy and fiscal policy should be coordinated. As a result, the Federal Reserve financed a large part of the government’s fiscal deficits, thereby exacerbating inflationary pressures. Furthermore, Fed officials did not yet distinguish between real and nominal interest rates, so when nominal interest rates were high, monetary policy was thought to be restrictive even though elevated inflation should have indicated otherwise.
Second, Meltzer points to the political context in which the Federal Reserve operates. Short-term political pressures tend to be in the direction of expansionary policy, with insufficient regard for the longer-term inflationary consequences. Against these currents, the Fed is supposed to be a bulwark on behalf of price stability. Not until the chairmanship of Paul Volcker, however, did the Fed truly think of itself as politically independent.
Meltzer depicts Volcker as a hero, and rightfully so:
The FOMC and Paul Volcker deserve our praise…for sustaining the disinflationary policy until inflation fell…Volcker had support from a few governors and presidents throughout, but he also had opposition much of the time. Success depended on his persistent concern to reduce inflation, and his firm belief that failure would make [price] stability more difficult to achieve.
But Volcker also enjoyed a measure of political support without which he might not have been able to accomplish what he did. In the early 1970s, the general public did not yet consider inflation a major problem. Back then, the Fed might not have been able to sustain the anti-inflationary policies it adopted under Volcker. Meltzer describes the Fed as not insensitive to the seemingly constant threat from the U.S. Congress to enact restraining legislation if it did not like Fed policy. By the late 1970s and early 1980s, however, the mood had changed. The public had come to think of inflation as the main economic problem—even greater than unemployment. In addition, Meltzer notes the “strong support from President Reagan and principal members of Congress.” Reagan, in particular, understood the importance of price stability. He encouraged Volcker and gave him the necessary political cover to do what needed to be done, even as senior administration officials wanted him to put pressure on the Fed to lower interest rates.
According to Meltzer, the third key element in the Great Inflation is inflationary expectations. In the pre-Volcker era, people saw that the Fed was not serious about fighting inflation and thus began to expect inflation, which consequently became a self-fulfilling prophecy. The decisive change occurred in 1981, when the Fed tightened monetary policy in spite of relatively high unemployment. As a result, people came to expect lower inflation, which, in turn, moderated wage and price increases and thus reduced inflationary pressures. The benefits of this experience remain with us to this day. People appear to believe that if inflation were to get out of hand again, the Fed would repeat what it did under Volcker, which is particularly useful today as the Fed continues to fight the global financial crisis with unprecedented amounts of monetary stimulus. Meltzer has been a vocal critic of the Fed’s actions in response to the crisis because of their potentially inflationary consequences. So far, however, signs of heightened inflationary expectations have been rare.
After it conquered the Great Inflation, the Fed continued to recognize that it was the entity responsible for keeping inflation in check. It no longer prioritized employment over price stability, having learned that in the long run, an environment of price stability enhances rather than reduces employment opportunities. Meltzer also notes the reinforcing mechanism of the credit markets, in which higher interest rates occasionally signal concerns about potential inflation flare-ups, which prompts the Fed to act before such flare-ups get out of control.
In an opus as monumental as this, some minor factual inaccuracies are bound to creep in. The Fed did not maintain the federal funds target rate at 1 percent “from 2003 to 2005” but, rather, began raising it in June 2004. The late Fed governor who warned of dangers in the housing market is Edward M. Gramlich, not “Edmund.” The author of the classic Secrets of the Temple: How the Federal Reserve Runs the Country is William Greider, not “Grieder.” Meltzer is correct that managers of the Fed’s trading desk and portfolio were traditionally recruited from within the Federal Reserve Bank of New York, but this pattern was broken in January 2007 with the appointment of William C. Dudley, who was previously chief economist at Goldman Sachs.
Meltzer is arguably too pessimistic when he states that the Fed’s political independence “did not survive” its actions in response to the financial crisis, many of which were undertaken in collaboration with the U.S. Treasury Department and other government entities. The Fed’s political independence has never been absolute, even during the Volcker era. Fed governors, including the chairman, require presidential appointment and U.S. Senate confirmation. The Fed’s chairman is required by law to appear before Congress twice a year. And Congress can always curtail the Fed’s authority through legislation. In a democracy, such political constraints are arguably not even undesirable. The Fed’s political independence unquestionably took a hit during the crisis, but unless Meltzer’s dire inflationary predictions come true, it may well recover over time.
Nevertheless, these are only minor blemishes in an otherwise truly magnificent treatise. A reader’s only regret should be that this volume ends in 1986 and Meltzer, now 82 years old, has no plans to write a third volume covering the subsequent period, which includes the so-called Great Moderation and the recent global financial crisis. This is not just a case of wanting more of a good thing. Recent monetary policy controversies, such as the optimal rate of inflation and the advisability of targeting asset prices, are scarcely covered in the book; a discussion of their origins could be instructive in those ongoing debates.1
—J.H.T.