Reflections on Allan H. Meltzer's Contributions to Monetary Economics and Public Policy

David Beckworth, David Beckworth

• Publisher: Hoover Institution Press
• Year: 2019
• ISBN:
  9780817923068
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Allan H. Meltzer (1928–2017), a leading monetary economist of the twentieth century, is memorialized in eleven essays by prominent economists. Among his achievements, Meltzer transformed the field of central banking and dissected the economic disasters of the 1930s and late 2000s, as well as the avoidance of disaster in the 1970s. Focusing on his landmark A History of the Federal Reserve, 1913–1986, the first section argues that the Fed's biggest successes are tied to its adherence to classical monetary theory and also examines the monetarist counterrevolution. Next, the book turns to Meltzer's thinking on the monetary transmission mechanism and his close work with Karl Brunner on the Brunner-Meltzer Model; it argues that Meltzer's understanding of monetary economics could be used to measure the impact of the Fed's activities. Finally, Meltzer's contributions to public policy are examined, including his proposed reforms to the International Monetary Fund and his activities at the Carnegie Mellon Graduate School of Industrial Administration. The conference papers that compose this volume celebrate Meltzer's fifty-year career at Carnegie Mellon. The book ends with a transcribed interview, conducted just a few months before his death, in which he shares sharp-witted insights about economics and his legacy. Contributors: Michael Bordo, James Bullard, Joshua R. Hendrickson, Robert Hetzel, Peter N. Ireland, Robert Lucas, Edward Nelson, Gerald P. O'Driscoll Jr., Charles Plosser, George Selgin, and John Taylor.

CHAPTER 1

Making the Rules and Breaking the Mold: Allan Meltzer, 1928–2017

JOHN B. TAYLOR

Allan Meltzer, who died in May 2017 at the age of eighty-nine, had a long and productive career, fundamentally affecting the fields of economics, central banking, and, more broadly, economic policy. An extraordinary scholar, he immersed himself in the practical world of policy making in many ways. He had a unique ability to understand, explain, and improve the interface between the fields of economics and economic policy.

For Meltzer, it was not enough to develop a novel theory of the economic impact of monetary policy, which he did in his research on the financial system starting with Swiss economist Karl Brunner. He also examined the institutions responsible for policy through his landmark two-volume work A History of the Federal Reserve (HFR) and the Carnegie-Rochester Conference Series on Public Policy, which he cofounded with Brunner.

For Meltzer, it was not sufficient to show empirically that policy mistakes caused poor economic performance. He also researched why the mistakes were made, including by developing, with Scott Richard and Alex Cukierman, theories of political economy and decision-making. It was not enough for him to conduct research and teach at Carnegie Mellon University, where he was a professor. He also threw his hat into the ring of real-world policy making, serving on the US president’s Council of Economic Advisers (CEA), chairing the Meltzer Commission on international monetary reform, writing reports for Congress, and often testifying in congressional committees on monetary policy.

It was not even enough for him to have had a profound impact on central banking; he also delved into the operations of the whole market system, asking the key question in the title of his book Why Capitalism? and answering that capitalism is “the only system that the world has ever known that produces both growth and freedom.”

CRITICISM WAS NEVER PERSONAL

In engaging with actual policy, Meltzer never held back criticism of policy decisions and policy-making institutions when he felt strong criticism was warranted. But he avoided personal attacks or impugning people’s motives. Regarding US Federal Reserve Board decisions, for example, he wrote in HFR that, “although I find many reasons to criticize decisions, I praise the standards and integrity of the principals” (Meltzer 2010, x).

Meltzer’s views on monetary policy began to take form in his research with Brunner, whom Meltzer noted was his “teacher, dissertation supervisor, later my co-author and lifelong friend.” They wrote twenty-five papers together on policy, many focused on a model of the monetary transmission process. The modeling research began in the 1960s, and the key framework was later called the Brunner-Meltzer model. Meltzer went on to develop this framework further and apply it in practice.

The model was unique in the way it incorporated the determinants of both the supply of money and the demand for money, going behind the scenes of the quantity equation of money employed by Irving Fisher and Milton Friedman. The model showed how the economic effects of changes in the money supply involved a complex channel with credit flows, wealth effects, interest rates, and asset prices. Today, many macroeconomic researchers are trying to incorporate credit into popular macro models because changes in credit flows had such a noticeable and devastating impact during the global financial crisis. Meltzer had incorporated these features into his thinking fifty years ago.

Based on this theoretical and empirical research, Meltzer came to a particular view of how to evaluate monetary policy that gave clear advantages of predictable rule-like decisions for the policy instruments, whether the interest rate or the monetary base. He then applied this framework consistently over time to actual policy, uncovering policy mistakes in the midst of policy successes. More than any other monetary economist, he looked for and examined the reasons for the mistakes, and he focused on two basic reasons: political interference with policy and mistaken beliefs about policy. This led to his recommendations about how central banks should be governed and how monetary policy should be conducted, which have had an important impact.

THE FED’S MISTAKES IN THE 1930s AND 1970s

Meltzer argued that the Great Depression of the 1930s was largely caused by a mistake made by Fed officials who allowed the money supply—currency and deposits—to fall by 28 percent. He looked for the reasons for that mistake and concluded the problem was mainly a faulty belief at the Fed about how monetary policy works. He found evidence in the Fed’s own records that it had used misleading indicators, such as nominal interest rates or bank borrowings, as measures of monetary tightness, when economic theory pointed to the real interest rate and broader monetary aggregates, such as currency and deposits. For this reason, the Fed decided that open market purchases were not necessary because low member bank borrowings and low interest rates were a sign of monetary ease. Meltzer showed that the alternative, correct, view, that the central bank should control deposits and currency, was known outside the Federal Reserve system at the time but was not reflected in the Fed’s decisions.

“So certain was the System about the correctness of its actions and its lack of responsibility for the collapse that I have found no evidence the Board undertook an official study of the reasons for the policy failure,” he wrote in HFR (Meltzer 2002, 413). Meltzer also argued that the Great Inflation of the late 1960s and 1970s was due to a policy mistake—this time a large increase in money growth and a corresponding effort to keep interest rates too low. Again, Meltzer looked for the reasons for the policy mistake. One reason was the Fed’s mistaken belief in the Phillips curve, which said that higher inflation would reduce unemployment permanently.

But a second reason was political. The Fed agreed to coordinate its actions with the US administration’s fiscal policy, a practice that meant the Fed would try to keep interest rates low. A third reason was also political. As the 1972 election approached, Fed chair Arthur Burns became convinced that the unemployment rate required to reduce inflation would be politically unacceptable. He became the leading proponent of wage and price controls, and let money growth increase. So, both Meltzer’s categories of reasons for mistakes were to blame.

VOLCKER RECAPTURES LOST FED INDEPENDENCE

The end of the Great Inflation and the start of the Great Moderation of price and output stability was a different story. There was an absence of the big mistakes and a corresponding emphasis on more predictable rule-like behavior. Meltzer stressed Fed chair Paul Volcker’s reliance on a framework in which inflation is a monetary phenomenon with no long-run Phillips curve trade-off. He emphasized how Volcker recaptured much of the independence the Fed had lost during the Great Inflation and was, thereby, able to resist political interference and take the necessary steps required to restore stability.

Going deeper, Meltzer wrote how Volcker was ideally suited for preventing the mistakes. Volcker had “the background and experience to be a successful chairman.… Foreign central bankers and New York bankers knew him and had confidence in him. He was knowledgeable and strong-willed, and determined and committed to the task” (Meltzer 2010, 1012).

During the Great Moderation, which continued under Volcker and much of Alan Greenspan’s term as chair, the Fed did not succumb to political pressures or faulty theories. Meltzer was again critical of monetary policy for its role in the global financial crisis.

He argued that it was a mistake for the Fed to depart from a rule-like policy and keep rates unusually low in the years before the crisis. The explanation for these policy mistakes appeared to be in the “mistaken beliefs” category: a mistaken view that rule-like policy was not necessary and that a return to discretion was OK. Meltzer was also critical of quantitative easing after the crisis and said that the Fed’s lender-of-last-resort actions during the crisis had no clear strategy. On the political side, he argued that the Fed seemed willing to sacrifice much of the independence Volcker had restored in the 1980s.

In sum, Meltzer concluded that the Great Depression was mainly due to bad economics: mistaken beliefs about interest rates and bank borrowings; that the Great Inflation was a combination of both factors, with political pressures dominating near the end as beliefs changed but policies did not; that the Disinflation avoided big mistakes of either type as the Fed regained independence and restored basic monetary fundamentals, which continued into the Great Moderation, a period of more rule-based policy; and that the global financial crisis and its aftermath was a return to a combination of both kinds of errors. Meltzer’s research, thus, led him to a clear policy conclusion, as he wrote in the second volume of HFR, published in 2010: “Discretionary policy failed in 1929–33, in 1965–80 and now.” And it is equally clear and convincing that “the lesson should be less discretion and more rule-like behavior” (Meltzer 2010, 1255). This considered assessment, based on years of research and study, is, perhaps, his most fundamental contribution to central banking.

HFR was itself a “monumental accomplishment,” to use the words of economic historian Michael Bordo (2006, 613). Meltzer examined transcripts of meetings of the Federal Open Market Committee; notes and interviews with Fed officials; records at the New York Fed and other regional banks; papers from presidents of the United States and their assistants; and the records of Congress, the Treasury, the CEA, foreign monetary officials, academics, and journalists. He insisted that policy makers express their views and explain their decisions in their own words and, thus, frequent quotes of policy makers are found throughout HFR. He connected complex series of events, transforming his painstaking research into “an exceptionally clear story,” as economist David Laidler described it (2003, 1256). By making so much information accessible in a readable and manageable form, he contributed greatly to economics and central banking.

CONGRESSIONAL HEARINGS

Meltzer’s work over the years advising Congress and many administrations is another part of his impact on policy. There is no better way to understand this influence than to have watched him in action. I recall a 2015 hearing at the Senate Committee on Banking, Housing, and Urban Affairs about monetary reform, where he was a witness (Meltzer 2015). I sat next to him at the witness table, listening carefully. Meltzer was remarkably clear, articulate, and convincing, directly addressing senators on the committee, both Democrats and Republicans. Indeed, both sides seemed to be listening carefully, in part because he was so obviously nonpartisan. In answering a question about a lender-of-last-resort proposal by Senator Elizabeth Warren, he said, “I congratulate you, Senator Warren, for keeping this issue alive.”

Meltzer spent a lot of time at this hearing explaining the merits of a bill that would require the Fed to describe its rules or strategy for monetary policy. In his opening, Meltzer said,

We need change to improve the oversight that this committee and the House Committee exercises over the Fed. You have the responsibility. Article I, Section 8 gives that to you. But you do not have the ability to exercise authority.

You are busy people. You are involved in many issues. The chairperson of the Fed is a person who has devoted his life to monetary policy. There is not any series of questions that you can ask on the fly that they are not going to be able to brush aside. That is why you need a rule.

I agree with John Taylor about some of the reasons for the rule, but I believe one of the most important is that Congress has to fulfil its obligation to monitor the Fed, and it cannot do that now because the chairman of the Fed can come in here, as Alan Greenspan has said on occasion, Paul Volcker has said on occasion, and they can tell you whatever it is they wish, and it is very hard for you to contradict them.

So you need a rule which says, look, you said you were going to do this, and you have not done it. That requires an answer, and that I think is one of the most important reasons why we need some kind of a rule.

Later in the hearing, Senator Sherrod Brown asked, “Dr. Meltzer, be specific, if you would, about your thoughts about the audit-the-Fed proposals.” Meltzer answered,

Suppose you found out that the Fed chooses its policy using a Ouija board. What would you be able to do with that? What you want to do is get something which permits you to see that the policies that are carried out, are carried [out] for the benefit of the public.… What I think the Congress needs to do, it needs to face up to its responsibilities. Its responsibility is to be able to say to the Fed: “You told us you were going to do this, ...

Table of contents

• Cover
• Advance Praise for Reflections on Allan H. Meltzer’s Contributions to Monetary Economics and Public Policy
• Frontispiece
• Title Page
• Copyright
• Contents
• About Allan H. Meltzer
• Introduction
• Chapter 1: Making the Rules and Breaking the Mold: Allan Meltzer, 1928–2017
• Chapter 2: Allan Meltzer and the History of the Federal Reserve
• Chapter 3: Allan Meltzer: How He Underestimated His Own Contribution to the Modern Concept of a Central Bank
• Chapter 4: “They Profess to Fear That for Which They Dare Not Hope”: How the Fed Contributed to the Great Depression and the Great Recession by Boosting Banks’ Demand for Reserves
• Chapter 5: Allan Meltzer’s Model of the Transmission Mechanism and Its Implications for Today
• Chapter 6: The Monetary Base in Allan Meltzer’s Analytical Framework
• Chapter 7: Monetary Policy and the Interest Rate: Reflections on Allan Meltzer’s Contributions to Monetary Economics
• Chapter 8: Allan Meltzer and the Search for a Nominal Anchor
• Chapter 9: The Meltzer Commission
• Chapter 10: Memories of Allan Meltzer
• Chapter 11: Allan Meltzer’s Contributions to Public Policy Thought as Applied to the Federal Reserve
• Chapter 12: Macro Musings: Allan Meltzer
• Published Works of Allan H. Meltzer
• About the Contributors