Defending the U.S. FED’s Power With Myths

By: LewRockwell

Donald L. Kohn is a powerful man, as Vice-Chairman of the Board of Governors of the FED. He shouldn’t have this power. Nor should the FED have the power it has. Not under the U.S. Constitution. Not in a nation of free men and women. And not if we want a sound economy.

The FED is coming under increasing attack. Kohn’s Nashville speech on April 18, 2009 attempts to defend the FED. He defends the FED with numerous myths.

Kohn begins:

"Our objective [sic] is to promote maximum sustainable employment and stable prices over time. These goals are enshrined in law, and they also make sense in economic theory and practice."

Ideas like these are superficially plausible. They are picked up and repeated in the press. They are accepted by the public. Sadly, they are accepted even by trained economists, who should know better. Tragically, these ideas embody all sorts of myths. They are false statements. They are bad for the people made to live under them. They are wrong as rationales.

Yes, these objectives are enshrined in law passed by Congress. But these laws are unconstitutional, no matter what the Supreme Court has judged. The Constitution does not enumerate a Congressional power to establish a central bank. It nowhere, even remotely, gives the Congress the power to promote "maximum sustainable employment." Nowhere, even tangentially, does the Constitution give Congress the power to manipulate prices, through a central bank or otherwise.

More generally, the Constitution does not give Congress the power to control the economic activities of Americans through central banks or in any other ways for the sake of these goals. Thus, at the base, if we carefully inspect the foundation of the FED, we find that Kohn is standing on Constitutional quicksand to support his power.

Nonetheless, Congress has, over a long period of time that stretches back to early Supreme Court rulings, assumed these powers. This, of course, Kohn accepts. But what he and others are blind to and do not admit is that this power is not different in kind than the power of the Politburo of the Communist Party of the Soviet Union. When Congress chose its goals and decided to use power over money, credit, taxes, borrowing, and government spending programs to achieve them, it assumed a central commanding position over every American’s economic life. The Congress may not yet regulate everything from shoe sizes to firmness of toothbrush bristles, but it is getting there. And when it does apply its powers, to regulate the efficiencies of engines and the preservation of insects, its applications of power are at least as thorough and potent as those in the Soviet Union.

Congress is made up of people who respond to divided and conflicting interests. This Congressman wants a museum and that one wants a bridge. The President wants a car run on fuel cells. All of them want, for a time, a war in Iraq. After a good deal of wheeling and dealing, they produce a law, which most of them have not read. It is a rare event if the result is either practical or sensible. Ordinarily, it has consequences that harm most of us for the benefit of some of us.

Since the actual goals of those who govern through power are not the stated goals, the resulting laws are neither practical nor sensible for most of us. A law that sets up goals of maximum sustainable employment and price stability and empowers the FED to achieve these goals is no exception. Why?

The stated goal itself, of maximum sustainable employment, is neither well-defined nor sensible. No one knows what the term even means. Congress passes a vague law and then leaves it to others, like the FED, to say what the law means. This in itself is an improper and unconstitutional procedure.

The FED doesn’t know what employment is or even what it means. A person who has a garden at home is not counted as employed, but if he trims a neighbor’s shrubs for pay, he is employed. People go in and out of the work force at their own discretion; labor force participation alters. When they do work, they work one or more jobs at varying levels of activity of their own choosing. People shift from work in the market to work that is not measured as marketplace employment.

If unemployment rates are used, no one knows whether the maximum sustainable rate is 3, 4, 5, 6 or some other percent. No one knows what sustainable means. It suggests a level of employment that is kept up. But who knows what rate should be kept up? Employment shifts with changes in demand for different products, with changes in technology, and with changes in where production is sourced. Besides, what sense does it make to try to keep employment up or at some level if people in their personal decisions don’t want it to be kept up?

None of the three terms – maximum, sustainable, and employment – is a definite economic concept. It is plain wrong to think that a goal that strings these terms together makes economic sense. Even in the most practical ways of defining what such a goal means, it’s a senseless goal.

But let us go deeper. I posit a sensible goal: that each of us, with our own life and property, is able to do what we can to achieve what we conceive of as our own happiness. This goal is achievable at the personal level through personal decisions. The personal decisions may lead to some collective or joint decisions and collective institutions that centralize some decisions, but these, if they come about, will arise from a decentralized (or market) process of personal acceptance, freely decided upon. There is no such process that leads to the collectivization of economic decisions in Congress. It is impossible for voting methods to translate or aggregate personal desires for happiness into an aggregate item like maximum sustainable employment. If Richard and Louise vote to hire Lemma to protect the rats that are infesting Jacob’s barn, the social outcome is not necessarily good or sensible. Maximum sustainable employment is not a measure of the happiness or welfare or achievements of individual persons in a society.

This goal that Kohn accepts is not different in character from the Pharaoh commanding people under his rule to work producing wheat and pyramids, so as to have maximum sustainable employment. The Pharaoh may enhance his own happiness by selecting and educating certain persons, or by choosing others to serve as his army. But his happiness is not the happiness of those whom he rules.

Donald Kohn is one of our money and credit Pharaohs. He commands the high-powered money supply. He creates credits and loans for those whom he chooses. He indirectly commands the tides of money and credit. Should he have this power? He cannot have it without trenching upon the rights and property of the rest of us in society. He certainly should not have it for the purpose that he claims, which is to promote maximum sustainable employment, because that purpose makes no sense either in economic terms or in terms of the happiness of individual persons in society.

The second goal that Congress and the FED posit is "stable prices over time." Central bankers worldwide constantly talk about price stability, even as they inflate their money supplies and cause prices to rise in their countries. The web site of the Central Bank of the Republic of Turkey near the top of the page says "The primary objective of the Bank shall be to achieve and maintain price stability." Their CPI rose 10 percent in 2008. This is better than in 2001 when it rose 54 percent. They are not going to achieve price stability with their money supply rising 25 percent a year. One cannot take the talk of central bankers about price stability seriously.

Price levels are notoriously difficult to measure due to variations in prices, quality, availability, location, product innovation, product improvement, product deterioration, and consumption patterns, among other things. Neither is it obvious that stability is a desirable thing. When the prices of data storage and computers fall with no loss in quality, this is not a bad thing. If the world actually starts to run out of oil and price rises for that reason, this will encourage alternative energy sources. This will not be a bad thing. When improved production methods bring down prices, real wages rise. Wage-earners regard this as a good thing. When the FED inflates, it neutralizes these income gains and robs savers. Price stability does not translate into improvements in the happiness of wage-earners under these conditions.

The next sentence in Kohn’s speech reads:

"Central banks are uniquely suited to promoting price stability, and they contribute to maximum employment and growth over time by eliminating the uncertainties and distortions of high and unstable inflation."

This is pure fantasy. Since 1971, central banks worldwide have brought far greater price instability than under even an attenuated convertibility of central bank notes into gold. The explosion of derivatives has partly been because of the added volatility in exchange rates, interest rates, commodity prices, goods prices, and stock prices. If anything is unique in promoting price stability, it is gold! Both before and after 1971, there are many cases of devaluations, monetary inflations, and monetary collapses concomitant with central banking. Never have central banks had more prominence or power than in the years leading up to the current severe recession. Kohn in this statement is living in some kind of never-never land.

He goes on to describe, in textbook fashion, how the FED officials approach the economy and use their influence over financial conditions:

"A balance between aggregate demand and potential supply is needed to maintain price stability..."

"...we have been able to use our control of the federal funds rate to make the adjustments to financial conditions needed to foster our objectives for prices and employment."

The FED’s idea is that when aggregate demand and supply experience short-term shocks, such that prices and employment change, the FED counteracts the shocks. If the economy goes into recession and prices fall, the FED pumps up the money supply to maintain employment and the price level.

This model, which pervades economics thinking and textbooks, has fatal problems. Robert Higgs has pointed out several in a recent article. Aggregate demand ignores the wishes and choices of the millions of Americans in the complex economy. It refers only to final demand and ignores all the intermediate productive choices. It ignores the prices of different goods (relative prices) in favor of the (single) price level. The model treats people like mechanical cogs in a machine.

There are other serious problems. Kohn’s statement and model refer to the short run, not the long run. Textbooks invariably show that long-run aggregate supply depends, not on money prices, but on real variables like labor and capital. In the long run, the FED determines the price level and price stability, through its control of high-powered money; aggregate demand and supply do not.

The FED does not know whether it is observing short run or long run changes in prices and employment. It cannot separate them. In practice, the FED acts as if all changes are short run. It constantly toys with financial markets. As a result, the FED’s own actions create shocks to the economy’s prices and employment. Since the economy is complex, dynamic, and people act with unpredictable lags, sometimes years later, when the shocks cumulate or the economy responds, the FED responds to the shocks of its own creation. It thinks they are exogenous short-term shocks when they are the results of its own actions. The FED chases its own tail. In doing so, it perpetuates and exacerbates the boom-bust cycle.

The FED acts as if the economy’s adjustments to prices and employment should be counteracted, when, in fact, the adjustments may be just what is needed to create a healthy and balanced economy. The economy, in its decentralized and profit-maximizing ways, adjusts to shocks more quickly and in more diverse and effective ways than through the crude, ill-timed, and politically-motivated manipulations of monetary and fiscal policies. The latter invariably distort economic activity.

Of course, there are other well-known problems. The FED does not know how much financial easing or tightening to apply to achieve its goals. It does not know how large the effects of its actions will be or when they will appear in the economy. It does not know how the expectations of market participants may change. Its actions distort economic activity.

The thrust of these remarks is that Kohn’s story of a rational FED process to achieve worthwhile economic goals is fictional. The goals are crude central-planning goals, as in state socialist economies. They are arbitrary and poorly defined. Even in theory, they do not correspond to social welfare. They do not connect to the choices that individuals might make to enhance their happiness.

The real economy is something like the human body. It has many parts that work together in an almost miraculous fashion. Just as the body can withstand shocks, so can the economy. Just as the body can recover from illness, so can the economy. The body has systems and sub-systems that equilibrate its deviations from normality. The economy similarly balances itself through the system of prices, profits and losses, and mobility of productive factors. The economy does not need the FED crudely to force feed it with gobs of money and debt when it observes the economy going through a slowdown. This will undermine the patient’s recuperative powers and interfere with it regaining its natural strength.

The current downturn has elicited gargantuan responses from the FED. This signals that the central-banking system is much nearer to its end than its beginning, 96 years ago. Notwithstanding Mr. Kohn’s adroit justifications for the FED, and notwithstanding its favorable treatment in economics textbooks and courses, the institution of central banking has no sound rationales for its existence and power. There is no good reason for a monopoly supplier of a forced currency. The FED is living on myths. It is living on borrowed time.

April 21, 2009

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

Michael S. Rozeff writes:

http://www.lewrockwell.com

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