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National Review

Managing the Economy: More Than the Fed Can Do

Editor’s Note: The following is a lightly edited extract from The Enduring Tension: Capitalism and the Moral Order, which was published by Encounter Books. What happens when the task is more complicated, such as managing the entire national economy? The champions of bureaucratic rationalization claim that it is superior to pluralist capitalism because it can make the market work better than simply allowing it to seek its own levels. But let us see. Consider the Federal Reserve System, which has been the top expert manager of the U.S. economy since President Wilson signed the Federal Reserve Act in December 1913. The Fed’s prestige is so high that Morgan Stanley’s chief global strategist, Ruchir Sharma, called it “the central bank of the world.” There is near-universal agreement among finance experts that the Fed’s most powerful tool — manipulating the federal funds rate — can keep the U.S. financial system in balance, and through it the whole global system. When Janet Yellen became chairman in 2016, after eight years of tepid economic growth, she aimed to reassure a nervous investor class that her agency was firmly in control. Yellen announced that the Fed did not need to resort to that ultimate rate tool, but would continue relying on its more modest “quantitative easing” bond-purchasing tool for an indefinite period. At first the market shuddered, but it soon calmed down to the soothing voice of its overseer, who would scientifically control the fragile U.S. and world economies with the current program, keeping the big gun ready in case things got worse. Brian S. Wesbury and Bob Stein of First Trust Advisors had routinely questioned the Fed’s Delphic pronouncements, and explained that there was no longer any ultimate federal-funds weapon: “In the past, the Fed manipulated the funds rate by making reserves ‘scarce’ or ‘plentiful.’ It withdrew reserves to push rates up and added reserves to push rates down — a simple ‘supply and demand’ calculation.” But once the Fed injected $2.6 trillion in “excess reserves” into the economy to fight the 2007–08 recession, there could no longer be any scarcity. “As long as banks have excess reserves, they do not need to borrow reserves from other banks to meet their reserve requirements,” so Fed manipulation becomes irrelevant. The federal funds rate was “an anachronism.” All the Fed can do, the First Trust analysts later noted, is create or destroy bank reserves “by buying or selling bonds, to or from, banks.” Rate hikes do not tighten money unless the Fed is shrinking bank reserves. Controlling the rate simply becomes a calming action to quiet the market’s animal spirits. “The Federal Reserve has convinced itself, and many others, that it has ultimate control over the economy,” but it does not. Sharma agreed that the Fed’s years of “loose policies,” building up vast reserves, simply immobilized it. While the Fed eventually did start reducing assets, its proposals were vague, small-bored, and based on current conditions and pragmatic corrections rather than a comprehensive plan. Sharma’s research even demonstrated that the stock market was no longer being driven by private market trading but was following political signals from the Fed. He found that the S&P 500 had gained 699 points since January 2008, but “422 of those points came on the 70 Fed announcement days.” This was a new form of over-rationalized capitalism. Between 1960 and 1980, Fed announcements had had little market effect, and between 1980 and 2007 those announcements had had only half as much influence as they would subsequently. When 60 percent of stock-market gains have come on dates that the Fed made a policy announcement, the stock markets have been driven not by capitalist supply and demand, but by investor reactions to mostly misguided governmental calculations. Earlier, in 2014, the Bank for International Settlements (BIS) observed that it once appeared that “economic science had conquered the business cycle” after the Great Depression. There had been inflationary recessions in the 1970s and 1980s, but “long expansionist runs” from 1961 to 1969, and from 1991 to 2001. BIS noted, however, that even with multiple billions of dollars of stimulus spending, Federal Reserve policy since 2007 had failed to increase U.S. output, which was then 13 percent below where it would have been if previous growth rates had continued. The pattern was similar in other capitalist countries: output was 19 percent below earlier projections in Britain, 12 percent below in France, and 3 percent below in Germany. In fact, analysts had ignored the fact that bank and treasury stimulus did not work in the 1930s, 1970s, or 1980s either. By 2014, the idea that central banks could actually control economies was seriously in question. As early as the financial crisis of 2007–08, it seemed clear that those in charge at Treasury and the Fed were operating by the seat of their pants each day, without any guiding plan, in the face of enormous market complexity. Indeed, all three top managers of the crisis — Ben Bernanke, Timothy Geithner, and Henry Paulson — would later essentially admit as much in their book on the subject, Firefighting. As the title suggests, they conceded that they had simply been putting out fires on the spot, with no comprehensive, rationalized plan to direct the markets. Casey B. Mulligan, a professor of economics at the University of Chicago, argued that the unintended effects of firefighting based on instinct might even have made things worse. He maintained that the incentives to work, earn, and recover had been reduced by the stimulus programs, the six-year “emergency assistance” for the long-term unemployed, the expansion of the food-stamp program, the mortgage-assistance programs, and the like. The result was the lowest labor-force-participation rate in 30 years and a historically slow recovery. By 2020, the former head of the Fed’s research and statistics section, David Wilcox, conceded that “long-term interest rates are already too low by historical standards for [the Fed’s] other tools to be fully capable of delivering the punch that will be needed to meet the next recession.” Economists from the San Francisco Fed and the University of California looked at all funds-rate increases in the United States, Germany, Japan, and Britain between 1955 and 2018, and concluded that economies are actually driven by “factors outside policymakers’ control.” In the face of the 2020 coronavirus work shutdowns, the Fed was encouraged by almost all experts to take bold action on the funds rate to stimulate the economy. It then took what the media called its “most dramatic action since 2008,” followed the very next day by the largest drop in stock prices to that date. “The Federal Reserve is now effectively spent,” wrote Greg Ip, the chief economics commentator for the Wall Street Journal. That only left the Fed offering more loans to private businesses, which was actually a more appropriate central-bank function. The other major response was a $2-trillion-plus stimulus in March 2020 that had positive aspects, but no serious economist could still believe that this historically high spending — swelling the already massive debt — could actually revive the economy even if people were able to go back to work.