AMERICAN ENTERPRISE INSTITUTE MEND IT, DON'T END IT: REVAMPING THE FED FOR THE 21ST CENTURY MODERATOR: JAMES PETHOKOUKIS, AEI PANELISTS: RYAN AVENT, THE ECONOMIST DAVID BECKWORTH, WESTERN KENTUCKY UNIVERSITY SCOTT SUMNER, BENTLEY UNIVERSITY 10:30 AM – 12:00 PM FRIDAY, MARCH 22, 2013 EVENT PAGE: http://www.aei.org/events/2013/03/22/mend-it-dont-end-it- revamping-the-fed-for-the-21st-century/ TRANSCRIPT PROVIDED BY: DC Transcription – www.dctmr.com JAMES PETHOKOUKIS: Welcome to our AEI panel today “Mend It, Don’t End It: Revamping the Fed for the 21st Century.” This is AEI’s third panel this week on the Fed and if anyone made all three panels, there’s no prize for you other than way to go. In its 100-year history, the Federal Reserved has become more defined by its failures than its successes. The Fed played essential role in the Great Depression of the 1930s, the Great Inflation of the 1970s, and arguably the Great Recession of the 2000s. And now, some Fed watchers worry that the U.S. Central Bank is making another historic error, this time by keeping interest rates at very low levels and by maintaining its massive bond buying program, known as quantitative easing, despite a recovering economy. This opinion is particularly relevant among center-right policymakers. Almost universally, they see the Bernanke Fed as undertaking a reckless monetary experiment that will only end in tears. As Texas Governor Rick Perry quotably said, back in 2012, when he was beginning his presidential run, if this guy Bernanke prints more money between now and the election, I don’t know what you all will do with him in Iowa, but we treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treasonous in my opinion. Many on the right, and to be fair, some on Wall Street, and even at the Fed itself fear the Fed’s, in their view, extremely loose monetary policy will eventually create much higher inflation or dangerous asset bubbles. They also view the Fed as enabling Washington’s out of control deficit spending. While many libertarians and followers of Ron Paul would like to end the Fed perhaps, many congressional Republicans would be happy merely changing the Fed’s legal mandate to one that focuses solely on keeping prices stable. As they see it, the Fed’s job is to keep inflation at 2 percent or so and nothing more. And right now, the Fed, as I say on Twitter, is not doing it right. At this point, let me quote Oliver Cromwell, who in 1650 wrote The Church of Scotland, making the following plea: “I beseech you in the bowels of Christ, think it possible that you may be mistaken.” One purpose of this panel today is to explore the idea that the current consensus center-right view of the Bernanke Fed and how to conduct monetary policy in general may indeed be mistaken. And we all tend to do this through the lens of market monetarism, perhaps the first economic theories birth by bloggers, albeit ones with Ph.D.s in economics. Market monetarism is actually an update of the monetary policy theories of Milton Friedman and to broadly generalize, market monetarists might argue the following. One, an overly tight Fed, in 2008, turned a period of economic weakness or even a mild downturn into the Great Recession, a minor replay of the Great Depression. Low interest rates today are likely assigned monetary policies too tight rather than too easy. The Bernanke Fed’s bond buying program, unemployment targeting, and new communications strategy have actually moved the Central Bank in the right monetary direction toward a strategy of targeting the level of nominal gross domestic product. And it is NGDP targeting that is essential to market monetarism. Instead of directly trying to keep inflation stable and unemployment low, the Fed should instead announce its intension of taking whatever action is necessary to maintain a long run nominal GDP growth rate target. This rules-based approach will create, we hope, a long run economic certainty for business, investors, and consumers, and make it less likely the U.S. would again suffer another severe recession or financial crisis. Incoming Bank of England Governor Mark Carney, Goldman Sachs Chief Economist Jan Hatzius, and former White House Economist Christina Romer are among the bankers and economists who broadly embraced the market monetarism critique. To explore the idea of rethinking how the Fed and foreign central banks should operate, we have – and I don’t use this phrase lately, an all-star panel here. Starting at the very end – I’ll quickly go through their bios – starting at the very end, we have David Beckworth, an assistant professor of economics at Western Kentucky University, and a former international economist at the U.S. Department of the Treasury. He’s done research on the measurement of monetary policy, the transmission mechanism through which it works, and its impact on the global, national, and regional economies. He’s published in various academic journals and is the editor of the recent book Boom and Bust Banking: The Causes and Cures of the Great Recession. He’s blogging at Macro and Other Market Musings, has been cited by the Washington Post, New York Times, Financial Times, and many fine other publication. In the middle, we have Scott Sumner, who’s taught economics at Bentley University for the past 29 years. He researches monetary economics, particularly the role of the gold standard in the Great Depression. He’s also researched liquidity traps and how monetary policy can be effective at the zero interest rate bound. His policy work has focused on the importance of expectations, particularly policies aimed at targeting expectations in the futures market. He’s been writing blog posts at the MoneyIllusion.com and he has a book coming out later this year, I think late summer, on the Great Depression. And sitting next to me, we have Ryan Avent, economics correspondent at the Economist and the primary contributor to the economics blog Free Exchange. His work has appeared also in the New York Times, New Republic, Bloomberg, Reuters, the Atlantic, and the Guardian. Before joined the Economist, he’s worked as an economic consultant in Washington, D.C., and he’s author of the 2011 book The Gated City, which I just downloaded this morning on my Kindle, no joke. I think we’ll start off at the very end. Professor Beckworth. DAVID BECKWORTH: Thank you. This morning, I want to invoke Milton Friedman and make the case that money still matters, and I want to use this perspective to show that one of the key reasons for the prolonged economic slump is a monetary slump. I want to use this observation then to kind of make sense of what the Fed should be doing going forward and along the way maybe address some of the criticisms that have been raised about the Fed and some of its policies to date. So I want to begin by noting what I think is one of the more important lessons learned about money from this crisis, and that is our standard notions of what is money, the standard view – what my textbooks I use with my undergrads show – it presents too narrow measure of money. Typically people, when they think of money, they think of M2 or retail money assets, assets that households would use, small firms would use, cash, checking accounts, saving and time accounts, many market funds, the transaction assets that we use to facilitate exchange. Well, one thing that this crisis revealed is that there’s a whole other class of investors, institutional investors. They’ve always been there, but we weren’t as aware as we were now – are now – that they also have assets they use as money. These institutional investors use Treasury bills, mortgage-backed securities, commercial paper, repos, and for them, they have a much larger transaction volume. They have larger dollar amounts that they have to use, to facilitate, to trade. And the traditional commercial banking system just isn’t sufficient. So they – you know, they’ve turned to the shadow banking system. And I’m sure you’re all aware that there is a run on this shadow banking system and in effect, it was a run for the money, the assets that make up to shadow banking system funds. So when we want to think about a proper measure of money, we want to include both retail money assets and institutional money assets. So I want to do that and look at a couple of measures this morning that tried to reflect the fact that there are, both retail money assets and institution money assets being used, and see what it tells us. This first measure comes from Gorton and his co-authors in a 2012 paper – it’s the blue line you see on the screen – and they call this a safe asset measure, but it’s effectively a measure of assets. It facilitates transactions or it’s money effectively. And as you can see the blue line growing and it collapses in about mid-2008 and falls. Now, if you look on the screen, you can see that it’s now surpassed the pre-crisis level, but by several measures, it’s still not adequate. Let me point out several to you. I’ve put on the screen there a gray dashed line and a black dashed line.