Price Stabilization and the Fed

April 13, 2010

Price Stabilization and the Fed

Our Federal Reserve System has an impossible job. It has too many goals and inadequate means of control to achieve them. Here’s a list of goals:

“Stabilize” price levels, increasing smoothly at some “optimum” rate.

Maintain some “optimum” rate of “growth” of the U.S. economy.

Prevent bubbles of asset prices such as house prices and the stock market.

Satisfy the political demand for a small boom in the run-up to each election, to keep the incumbents in power. 

Provide the government with funds (the stealth tax) to fund wars and such.

Maintain stable exchange rates with foreign currencies to balance import and export rates.

That’s an imposing list of 6 goals. If you think some of these goals are in direct conflict with each other, I agree. If you wonder what some of these goals mean, you’re not alone. I think even the Fed itself is unsure of what they’re trying to do. The Fed certainly has trouble deciding on priorities among those goals. And from the succession of booms, bubbles, recessions, and depressions in the past century, I would say the Fed was a dismal failure. This should be no surprise, since the Fed has just 3 clumsy controls with which to achieve all these goals. The controls are:

Open market operations. The Fed essentially pays the bills of the government with counterfeit money. This is the stealth tax.

Setting the Fed discount window interest rate. This “window” is where the banks borrow from the Fed, and hopefully controls the interest rate at which the banks extend credit. This is also a stealth tax to subsidize unsustainable business expansion

Regular Fed public statements, hopefully to moderate public fear or euphoria. Perhaps many people, like me, assume that each such statement is the opposite of the truth.

My experience with electronic control systems says that you need 6 independent control inputs to achieve 6 independent goals, and if the goals conflict, you’ll be lucky to even partially achieve all of them.

Of course, the Fed certainly achieved the goal for which it was initially created; to finance the British and American action in World War 1. , but at great cost to all the generations of the 20th century, in terms of freedom, economic development and stability, and lives lost in that war and all of our wars since then.

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