Commentary | Economic Growth

The Federal Reserve: Reality vs. Myth

Opinion pieces and speeches by EPI staff and associates.


The Federal Reserve Reality vs. Myth

By Jeff Faux


I’m very pleased to introduce as our first speaker, Jeff Faux, the president of the Economic Policy Institute. EPI was founded by Mr. Faux and several prominent economists in 1986. Mr. Faux has researched, written and published studies on a wide variety of subjects from the global economy to neighborhood community development, from monetary policy to political strategy. He’s been a consultant to governments at all levels, including business, labor unions, and community and citizen organizations. He sits on the boards of directors of several national organizations and two national magazines and received a presidential appointment to the national advisory council on economic opportunity. In previous years he has worked as an economist with the U.S. Office of Economic Opportunity and the US Department of State, Commerce and Labor — three departments. He has management experience in the finance industry. He has been a small businessman, a blueberry farmer and a member of a municipal planning board in the state of Maine. His recent publications are too numerous to list, but whenever I think of Mr. Faux, I think of what he has meant to the economics profession, and how he has kept his feet on the ground. Although able to deal with many abstract concepts, he always asks the question, economics, as if people matter. How do we achieve that goal?


Well, good morning!

We are this morning dealing with an institution of mythical proportions, as the title of this conference suggests. And the way that you know you’re dealing with an institution of mythical proportions is that The New York Times, The Washington Post respond to attacks against you with the suffix, “-bashing.”

Last night, when I was thinking about what I was going to say this morning, I did a little Lexis-Nexis search on “bashing.” Turns out that “Fed-bashing” has more cites in The New York Times, in The Washington Post, than “corporate-bashing.” So you see, we’re dealing with an institution of mythical proportions greater than those of even the modern business corporation. So the Fed, as it was said of Caesar’s wife, is above suspicion — nay, perhaps more like Caesar, if you will, because the chairman is appointed by acclamation of the Senate and is the supreme ruler of the American economy.

Now why do I say that? Again, my reference is the newspaper of record. A few days after George Bush was inaugurated last January, The New York Times hailed the arrival of the “Greenspan/Bush” era, which succeeded the “Greenspan/Clinton” era. Now, how do we justify that kind of statement in a democracy? Well, Caesar’s wife was above suspicion because Caesar decided she was. And the Fed is above suspicion because the media and the gatekeepers to the political dialogue in America have decided it is.

As the Financial Market Center has told us, all of the members of the Federal Reserve Board are multi-millionaires, schooled in the financial competition of dog-eat-dog, where greed is the supreme virtue. In fact, the social Darwinist model of society upon which the Fed bases its policies is one in which everyone is motivated by greed for money. But purveyors of the conventional wisdom react in horror when watch-dog groups like the Center raise the possibility that Fed board members might be motivated by — greed for money. So the model of society is apparently modified: everyone is motivated by greed except people who get appointed to central banks. There they become altruistic, selfless seekers for the larger good.

This extraordinary story about human nature is supported by many, many other myths, like IMF studies which tell you that because the United States has an independent central bank, and the United States is richer than Uzbekistan, which doesn’t have an independent central bank; therefore, independent central banks must be the secret of an affluent society.

Well, myths matter because they change the definitions of reality and the way that people look at the world. And a case in point I’d like to talk about this morning is what the New York Times called the “Greenspan-Clinton presidency.” The story of that relationship, written in several books and I don’t know how many articles, is that the wise, high-minded expert chairman of the Federal Reserve convinced the new president — a member of the profligate Democratic Party, addicted to deficits — that budget deficits threaten the country.

If you remember, this story starts after Ronald Reagan and George Bush “the first” spent up our national debt from $1 trillion to $4 trillion in the space of 12 years. Now, Greenspan’s assertion to Clinton was that deficits create politically unacceptable inflation because it destroyed the previous Democratic president, Jimmy Carter. And when you bring that story up to Democrats, their knees shake in horrible fright as they remember those days. Their terror is reinforced by all right-thinking editorial writers in all right-thinking newspapers who believe that federal deficits lead to politically unacceptable inflation.

By definition, myths don’t have to be supported by the facts, so this qualifies as a myth. The facts are somewhat different. Now, I’m not talking here about economic theory. I’m not talking about the theory of the NAIRU or other esoteric notions debated by tenured professors and central bankers. I’m just talking about the historical facts.

The first fact is that if you define politically unacceptable inflation as a level of inflation that threatens incumbents, which is a reasonable definition, then something well over a five percent increase in the Consumer Price Index is politically unacceptable inflation by historic terms. The second fact is that, taking five percent as the threshold of unacceptable inflation, Greenspan’s scenario that an overheated economy fueled by federal deficits causes inflation is in fact not true. The notion that federal deficits create this wage/price spiral that spins inflation out of control, and the first thing you know, you’re in Argentina in the 1980s or Germany in the 1920s, is just based on no American fact. Other than in times of war or external energy price shocks, there is no consistent relationship between federal deficits and the rate of inflation.

Now this is just simple history; it’s not complicated. The last flare-up of the consumer price index occurred in one month during the Persian Gulf War. The several before that occurred in the 1970s as a result of energy-price shocks from outside the economy. The one before that occurred during the war in Vietnam.

The one before that occurred during the Korean War. The one before that occurred in the aftermath of World War II, when price controls were lifted, and the one before that occurred in World War I.

Now I have not gone back before 1914, because that was when the modern consumer price index was created. But at least since the first decade of the last century, we have not seen the threat that Alan Greenspan convinced Bill Clinton was imminent to the economy. Now Alan Greenspan is unlikely to be ignorant of this history. So what is going on here? What is the story that better fits the facts than the notion that Greenspan was concerned about the deficit?

What best fits the facts is that Greenspan’s goal had nothing to do with the deficit. It had everything to do with government spending. After all, he is an ideological conservative, an acolyte of Ayn Rand, and someone who came to this
job with a package of contempt for the notion of government as a helping hand or a safety net in the economy.

Despite pious expressions of concern in 1996 that we were entering into a period of irrational exuberance, Alan Greenspan accommodated the Wall Street excesses of the late 1990s. There is no doubt about that. He refused to dampen the “irrational exuberance” by decreasing the amount of stock buying on margin. This would have targeted deflation at the place in the economy where the excesses were coming from — that is, the financial markets. Instead, he blessed the New Economy hype and the notion that we were in some sort of a transcendent world, beginning in about 1995, in which business cycles and the old notions of an economy that actually produces goods and services became obsolete.

Alan Greenspan became the patron saint of the Enron economy, this rapacious, snake oil culture which ran worthless stock to insupportable heights. When it was clear that we were heading for a bust in 1999, Alan Greenspan cut credit, but not to the speculators. He raised interest rates for the economy as a whole, and ultimately pushed us over the edge. Enron stock sold at $90. As of Friday, it was about 75 cents. Life imitates art. Several decades ago, Woody Allen made a movie in which the characters asked, “Well, what does a financial advisor do?” The answer was, “A financial advisor tells you what stocks and bonds to buy until you run out of money.”

Now, what’s interesting about this, as Ralph suggested in his introduction, days after the Bush inauguration last January, Alan Greenspan turned 180 degrees on the deficit issue. He backed Bush’s tax cut, suddenly explaining that, well, you know, too much debt reduction wasn’t necessarily a good thing. He backed Bush’s tax cut when a 12-year-old child could tell you would it lead to federal deficits. The Democrats, of course — poor bewildered creatures, always getting caught in the headlights of the Republicans — were “stunned.” As well they might have been. Convinced by Greenspan, they had spent the eight Clinton years, paying off Ronald Reagan’s debts, sacrificing the needs of their own working people constituency on the altar of deficit reduction, only to wake up at the end of this eight years to find out they had been completely snookered.

It turned out it wasn’t the deficit that Greenspan was after. It was the Democratic domestic agenda. The result is that they had little to show for eight years in the presidency. Among other things, that presidency failed in its historic mission to bring national health care to the United States. Today there are 44 million people without health care and that figure keeps growing. There was no money. The money had to go to deficit reduction.

“Wait till we reduce the deficit,” Democrats told their supporters. “Then we can start spending on education and health care and the things that the economy needs.” Then it was, “Wait till we balance the budget.” Then it was, “Wait till we generate a surplus.” Then it was, “Wait till we eliminate the national debt.” Even Clinton complained, reportedly, that they were acting like a bunch of Eisenhower Republicans. Poor Al Gore never got it. He told the Wall Street Journal during the campaign that if a recession came when he was president he would cut the federal budget, “just as a corporation has to cut expenses when revenues fall off.” The Democratic standard-bearer at that point was to the right of Herbert Hoover.

Now, the final tragic absurdity to this story is that the Democrats under Clinton, having paid off the debts of Reagan and Bush by abandoning their own constituency, got to hand over this hard-won surplus to George W. Bush, who promptly gave it away to his constituency in a $1.3 billion tax cut. The Democratic leadership is still so stunned with this that they’re not demanding a rescinding of the tax giveaway to the rich.

Now, there is one reasonable defense of Bill Clinton — and that is, he had no other choice. Otherwise, Greenspan would not have accommodated economic growth in the 1990s and would have, by keeping interest rates high, destroyed his presidency. That is the one reasonable defense. If true, it is a remarkable indictment of our democracy. Just think about it. It means that the Federal Reserve chair has the power to blackmail the president of the United States into pursuing his agenda rather than the elected presidents.

Now, we’re not talking personal scandal here, we’re talking about the scandal of a huge concentration of power beyond the reach of democratic institutions. Beyond the issues of central banking and economics; it’s about democracy. The task, therefore, is to expose these destructive myths to our citizens, to get into a dialogue, to try to educate, to get the information out, to bring the interests of workers, consumers and citizens to the tables where a small number of excessively wealthy people make decisions that determine their economic future.

Yes, it’s hard. The language of central banking is obscure, deliberately obscured, in my view. The press, the Senate and the House revel in Alan Greenspan’s charming obfuscation. And it’s kind of interesting: there is a parallel of sorts, between the obfuscation of Alan Greenspan going up to the Congress week after week or month after month and saying things that nobody understands, and the prospectuses during the late 1990s and the hype of the financial analysts and financial marketeers telling people things that they couldn’t understand.

My favorite was the prospectus for an initial public offering that said in English that, due to growing costs in this industry, this firm may never make a profit.

So I want to congratulate you on this conference. You got a great lineup of people. I think that Ralph Nader and his organization are doing a great service to the country by keeping this issue alive. And to paraphrase Patrick Henry in another context, if this be Fed-bashing, let’s make the most of it.

Thank you.

Jeff Faux is the president of the Economic Policy Institute.


See related work on Economic Growth

See more work by Jeff Faux