Limiting the Fed

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

In a provocative speech this week, Charles I. Plosser, the president of the Federal Reserve Bank of Philadelphia, proposed a new approach for the Federal Reserve System. The Fed, he said, should focus only on controlling inflation, strictly limit the assets it buys, follow a more rules-based approach to setting interest rates and place binding constraints on its emergency lending activities.

Of course, this is not so much a new set of ideas as an attempt to return to a much more traditional perspective on how the Fed should operate - not back to the pre-1930s gold standard, but perhaps back to the early days of Fed independence in the 1950s.

Mr. Plosser is concerned about the recent expansion of the central banking mandate and activities. He is right to want to shift norms around what the Fed does, but unfortunately his proposals in this speech underplay the Fed’s responsibility for the nation’s recent economic crisis, as well as what has happened to the financial system in recent decades.

Getting the Fed off the hook for regulating the system could make sense, but only if there was much more structural change in and around banking than Congress has mandated or that the Fed seems willing to push for.

Mr. Plosser’s concerns are expressed in eloquent and plain terms. He was speaking at a recent Cato Institute conference, “Was the Fed a Good Idea?”; some attendees apparently had a more negative view of the Fed. In fact, some participants seriously propose to end the Fed as we know it.

Mr. Plosser’s approach is more measured. He fully understands and emphasizes that the Fed has made important contributions over the last 100 years.

He is also not overly focused on the literal meaning of “price stability.” One awkward truth for most modern central bankers is that they say they want stable prices, but what they really mean is inflation at or around 2 percent a year.

This is enormously annoying to traditionalists who hark back to the gold era of the late 19th and early 20th centuries, when prices sometimes went up and sometimes went down. Now prices and wages only go up; the question is each year is just by how much.

Allowing prices to rise steadily is a deliberate policy, intended to avoid the deflation (i.e., falling prices) experienced during the Great Depression. When you borrow in dollars and prices fall, you end up owing more in real terms - with the likely consequence that you will soon be unable to afford the payments.

Mr. Plosser’s main point is fair: the Fed may in recent decades have taken on too much responsibility for reducing short-term fluctuations in employment. The famous “Greenspan put” was all about limiting the downside in financial markets and also in the real economy.

But at the same time, Fed policy contributed to the buildup of risks in the financial sector before September 2008.

In recent discussions of former Treasury Secretary Timothy Geithner’s career, for example, much has been made of the fact that the government recovered the value of its investments in financial-sector companies.

This is true, but we should not overlook the fact that - as president of the Federal Reserve Bank of New York from 2003 to early 2009 - Mr. Geithner was in charge of the analytical and policy team that should have seen trouble brewing but that remained remarkably complacent. The cost to the economy and to millions of people - jobs lost, mortgages foreclosed and persistent unemployment - is huge.

I am sympathetic to Mr. Plosser’s core point: the Fed has taken on too much, with the result that it creates moral hazard in the financial system.

But remember that Lehman Brothers was not saved in September 2008; it was allowed to go bankrupt, with devastating consequences to the world’s financial system (again, not anticipated by the Fed).

Just saying with regard to big banks, “let them fail,” is not satisfactory when this can cause a global financial meltdown. We no longer have the financial system of the 1950s.

Mr. Plosser would be on stronger ground if he were to support structural changes in the financial system, such as making the largest banks smaller, so that any one of them could fail without causing a worldwide recession. (To be fair, Mr. Plosser has tackled the issue of too big to fail more directly in other speeches. Again, I find much to agree with in his analysis, but to my mind he does not pursue his own reasoning to its full logical conclusion.)

Mr. Plosser is right to want to scale back the role of the Fed. Unfortunately, unless he also scales back the largest banks and the risks that they and other parts of the financial system can pose, his suggested solution would become a noncredible commitment.

If American regulations are minimal - or not enforced by the Fed - and a global megabank actually fails (think of Goldman Sachs or JPMorgan Chase), the choice again before officials would be unsavory bailout or another Great Depression.

Which would the Fed choose? It would always choose the bailout, putting us right back where we have been for the last five years: ex post downside insurance to key parts of the financial system provided for free by the official sector.

That kind of favoritism in credit policy - helping some companies and some sectors over others - is exactly the kind of arrangement that Mr. Plosser criticizes so effectively. To limit the Fed, we need to limit the concentration of risks in the financial system.