Seven Questions: That 70s Show at the Fed

Brendan Smialowskiy/Getty Images In the dark: Allan Meltzer worries that the Federal Reserve is repeating the mistakes it made in the 1970s.

Foreign Policy: How do you think Federal Reserve Chairman Ben Bernanke has handled the past few months?

Allan H. Meltzer: There are good points and bad points. The good points are his taking seriously and actively the function of window of last resort. Theres a shortage of money in the market because banks dont want to let go of the cash they have. So, hes tried to ease that problem by providing cash in a number of imaginative ways. Also, he basically allowed Bear Stearns to fail and wiped out the equity and replaced the management. That was a positive step.

Less attractive is the fact that he put up $30 billion at the taxpayers risk to close the deal. It seems to me that the Fed was out-negotiated by JP Morgan. They were too anxious to close the deal by Sunday night, and the bank took advantage of them. On monetary policy, I think the Fed is repeating the mistakes that they made in the 1970s. They shift from being concerned about inflation to being concerned about unemployment and back again. But raising interest rates is always difficult.

FP: Some people have raised the specter of stagflation, the idea that you might get the worst of both worlds — a slowing economy and a return of inflation.

AM: Thats a real risk. If the problem that we have now was caused by short-term negative real interest rates, then the solution cant be to have short-term negative real interest rates. And we already see signs that thats working perversely. There are ads on TV that say, You can buy a car with no down payment and no interest payments for many months or a year. Thats a sign of the same kind of thing that got us into this problem. And that happens because short-term real interest rates are too low.

FP: By pushing interest rates continually down, could the Fed could set off another bubble like we saw with the housing market?

AM: I think that is a real risk. Also, theres reason to question the policy. If people dont want to lend at 3 percent then why would they want to lend at 2.25 percent? That doesnt make a lot of sense. Its not that there is a shortage of reserves in the market. People are uncomfortable giving up their reserves so theyre holding onto them. Lowering interest rates isnt going to change that. Whats going to encourage them to be more active is the belief that the housing problem is going to end. But many of the things Congress is doing add to the problem because if [people holding real estate assets] think Congress is going to bail them out, why cut the price? There needs to be a decline in the price of housing assets. The quicker that occurs, the sooner this problem will go away.

I hear over and over again that the defaults on mortgages are the worst since the Great Depression. Well, let me put that into context. The defaults recently are 6 percent. During the Great Depression they were 50 percent, so its hardly a reasonable, objective comparison. Its a way of frightening people. And who are they trying to frighten? Well, theyre trying to frighten the government and the Federal Reserve into bailing them out.

FP: Which raises the moral hazard question. As a policymaker, how far can you go to prevent a crisis before you start encouraging people to take risks on the taxpayers backs?

AM: I dont believe that as a long-run matter that the system can survive if the bankers make the profits on the upside and the taxpayers take the losses on the downside. I dont see any reason why the taxpayers will permit that system to exist. Either the people who make the profits have to take the losses, or theyre not going to be allowed to make those profits.

FP: How would you solve that problem?

AM: Well, we used to have rules that limited what the government could do. And we dont have those rules any more, so every problem becomes a problem that Congress thinks it has to do something about. This is what good old de Tocqueville worried about back in the 19th century. How could a democracy operate if people can make their demands to the government and get them satisfied? Well, we put restrictions on them in the 19th century and even in the early 20th century. People worried about the gold standard; people believed in a balanced budget.

FP: But the Federal Reserve has put U.S. taxpayers on the line here, too. And the Federal Reserve is not an elected body, so how do you feel about that?

AM: I just completed the second volume of a fairly large history of the Federal Reserve. One of the questions I asked myself was, this is supposedly an independent agency. How independent is it in fact? Paul Volcker was clearly an independent Federal Reserve chairman, but most of the time, they yield to Congress, the administration, and Wall Street. So then they dont exercise their independence and theyre certainly not exercising it now. They must think that they were very brave on Tuesday because the market was expecting a 1 percent cut in the Federal Funds rate and they only gave them three quarters of a percent. Mostly, they are pushed by the market. Now, why is the market pushing them? Well, they have a lot of bonds, long-term debt thats worth less than the face value. If the Fed cuts interest rates, theres a good chance the value of those bonds and mortgages will go up. So, they want to be bailed out.

FP: Some people have said that Bernanke is running out of tools and that hes going to get to a point where its like hes pushing on a piece of cooked spaghetti.

AM: I have been working in this field since the 1950s. I have never seen a recession or a possible recession when people didnt say the Fed wont be able to do it for this or that reason. Its never true. It isnt true now. The Fed can print money. Theres no limit to how much money they can print. So, theyre not going to run out of material.

Allan H. Meltzer is the Allan H. Meltzer professor of political economy at Carnegie Mellons Tepper School of Business and author of A History of the Federal Reserve, Volume 1, 1913-1951 (Chicago: University of Chicago Press, 2002).