When the United States Federal Reserve System becomes a fixture on page A1 of the Wall Street Journal, it means that either the U.S. economy is in trouble or the global financial system is under stress. As everyone reading this magazine knows, for the year and a half since the summer of 2007, it has meant both.
It is no wonder that fears about the future of the economy, the financial system, and the Fed’s ability to perform its tasks have been widespread, and recent assessments from market commentators range from the gloomy to the very dark. Some have warned that the global economy is at the brink of the next Great Depression, with the U.S. leading the way; that only massive reregulation can save the banking industry; and that the Fed is no longer in control.
Much of this commentary, however, lacks perspective, and perhaps no one has a more complete perspective on the interrelationships between the economy, the financial system, and the Fed than Allan Meltzer, who holds an eponymous endowed chair as the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon University’s Tepper School of Business. Meltzer, born in 1928, has been studying monetary economics since the late 1950s, and is completing his definitive History of the Federal Reserve. (The first volume, covering the years 1913 to 1951, was published by the University of Chicago Press in 2003 and ran 800 pages; the second installment, which will bring the history forward to 1986, is due to be published in two volumes running 1,400 pages in October 2009.)
In both of its major roles, the Fed has been (and is being) tested by the economic crisis of late 2008. The first test has to do with its role as the manager of U.S. monetary policy, setting short-term interest rates for interbank borrowing in the United States. The Fed is charged with striking the right balance between economic growth and inflation, and, given the size of the U.S. economy and the importance of the dollar in world trade, its decisions ripple out and affect financial institutions throughout the world. The second test has been connected to its role as lender of last resort, when the imminent failure of a financial institution creates a potentially systemic risk in the markets. Even before the U.S. Congress began debating its Wall Street bailout plan in September, the Fed had made unusually aggressive forays into the credit markets to forestall the collapse of the mortgage finance industry, extending emergency loans through its “discount window” to investment banking companies, including Bear Stearns, which was shut down and sold to J.P. Morgan Chase & Company in March 2008, and to AIG, the troubled insurance company. No matter what the aftermath is on Wall Street, the U.S. economy is likely to face both recession and rising inflation, the latter for the first time in a generation. To someone currently seeking stability and reassurance, none of this is good news.
However, Allan Meltzer is impatient with comparisons of the current situation to the Great Depression. The economy circa 2008, in his view, is in a slowdown that appears to be modest, and from which it should recover in routine fashion. And although the financial system is under great stress, Meltzer does not think that anything we have seen so far suggests great danger. The Federal Reserve, he believes, has made only two major errors in its 94-year history. One was permitting the monetary deflation that worsened the Great Depression; the other was unleashing what economists call the Great Inflation, which saw the U.S. inflation rate rise from about 1 percent in early 1965 to nearly 14 percent in 1980. But in addition to these mortal sins of policymaking, the Fed, in Meltzer’s view, has been guilty of many more venial ones.