Article Twenty-Seven MILTON FRIEDMAN The Case for Overhauling the Federal Reserve Changing the Fed's monetary tactics may help, but the System needs basic reform. We should end its money-creating powers, make it a bureau of the Treasury, and freeze the quantity of high- powered money. Monetary policy can be discussed on two very differ- ent levels: the tactics of policy-the specific actions that the monetary authorities should take; and the strat- egy or framework of policy-the ideal monetary insti- tutions and arrangements for the conduct of monetary policy that should be adopted. Tactics are more tempting. They are immediately relevant, promise direct results, and are in most re- spects easier to discuss than the thorny problem of the basic framework appropriate for monetary policy. Yet long experience persuades me that, given our present institutions, a discussion of tactics is unlikely to be rewarding. The temptation to concentrate on tactics derives in considerable part from a tendency to personalize poli- cy: to speak of the Eisenhower, Kennedy, or Reagan economic policy and the Martin, Burns, or Volcker monetary policy. Sometimes that approach is correct. The particular person in charge may make a major difference to the course of events. For example, in Monetary History of the United States, 1867-1960, Anna Schwartz and I attributed considerable impor- tance to the early death of Benjamin Strong, first gov- ernor of the Federal Reserve Bank of New York, in explaining monetary policy from 1929 to 1933. More frequently, perhaps, the personalized approach is mis- leading. The person ostensibly in charge is like the rooster crowing at dawn. The course of events is decid- ed by deeper and less visible forces that determine both the character of those nominally in charge and the pressures on them. Monetary developments during the past few decades have, I believe, been determined far more by the insti- tutional structure of the Federal Reserve and by exter- nal pressures than by the intentions, knowledge, or personal characteristics of the persons who appeared MILTON FRIEDMAN, a 1976 Nobel laureate, is a senior research fellow at the Hoover Institution, Stanford University, and Paul Snowden Russell Distinguished Service Professor of Economics at the University of Chicago. This article is adapted from "Mone- tary Policy for the 1980s'' in To Promote Prosperit~, edited by John H. Moore and published by the Hoover Institution Press. (3 1984 by the Board of Trustees of the Leland Stanford Jr. University. to be in charge. Knowing the name, the background, and the personal qualities of the chairman of the Fed, for example, is of little use in judging what happened to monetary growth during his term of office. If the present monetary structure were producing satisfactory results, we would be well advised to leave it alone. Tactics would then be the only topic. Howev- er, the present monetary structure is not producing satisfactory results. Indeed, in my opinion, no major institution in the United States has so poor a record of performance over so long a period yet so high a public reputation as the Federal Reserve. The conduct of monetary policy is of major impor- tance; monetary instability breeds economic instabil- ity. A monetary structure that fosters steadiness and predictability in the general price level is an essential precondition for healthy noninflationary growth. That is why it is important to consider fundamental changes in our monetary institutions. Such changes may be neither feasible nor urgent now. But unless we consider them now, we shall not be prepared to adopt them when and if the need is urgent. The tactics for avoiding a crisis Three issues are involved in the tactics of monetary policy: adopting a variable or variables as an interme- diate target or targets; choosing the desired path of the target variables; and devising procedures for achieviny that path as closely as possible. The intermediate targets. The Fed has vacillated between using one or more interest rates or one or more monetary aggregates as its intermediate targets. In the past decade, however, it joined monetary au- thorities in other countries in stressing monetary growth. Since 1975, it has been required by Congress to specify explicit numerical targets for the growth of monetary aggregates. Although many proposals have recently surfaced for the substitution of other targets- from real interest rates to sensitive commodity prices to the price of gold to nominal GNP-I shall assume that one or more monetary aggregates remains the intermediate target. In my opinion, the selection of a target or of a target path is not and has not been the problem. If the Fed had consistently achieved the targets it specified to Con- gress, monetary growth would have been highly stable instead of highly variable, inflation would never have become the menace it did, and the United States would have been spared the worst parts of the punishing re 244 Section Five Monetary Theory cession (or recessions) from 1979 to 1982. The Fed has specified targets for several aggregates primarily, as I have argued elsewhere, to obfuscate the issue and reduce accountability. In general, the differ- ent aggregates move together. The exceptions have essentially all been due to the interest-rate restrictions imposed by the Fed under Regulation Q and the associ- ated development of new forms of deposit liabilities. And they would not have arisen if the Fed had achieved its targets for any one of the aggregates. The use of multiple intermediate targets is undesira- ble. The Fed has one major instrument of monetary control: control over the quantity of high-powered money. With one instrument, it cannot independently control several aggregates. Its other instruments-pri- marily the discount rate and reserve requirements-are highly defective as instruments for monetary control and of questionable effectiveness in enabling it to con- trol separately more than one aggregate. It makes far less difference which aggregate the Fed selects than that it selects one and only one. For sim- plicity of exposition, I shall assume that the target aggregate is M, as currently designed. Selection of another aggregate would alter the desirable numerical targets but not their temporal pattern. The target path. A long-run growth rate of about I to 3 percent per year for M, would be roughly consis- tent with zero inflation. That should be our objective. Actual growth in M, was 10.4 percent from fourth quarter 1982 to fourth quarter 1983; 5.2 percent from fourth quarter 1983 to fourth quarter 1984. A crucial question is how rapidly to go from such levels to the I to 3 percent range. In my opinion, it is desirable to proceed gradually, over something like a three- to five- year period, which means that the rate of growth should be reduced by about 1 to 1.5 percentage points a year-a very different pattern from the erratic ups and downs of recent years. The Fed has consistently stated its targets in terms of a range of growth rates. For example, its initial target for M, for 1983 was a growth rate of 4 to 8 percent from the fourth quarter of 1982 to the fourth quarter of 1983. That method of stating targets is seri- ously defective: it provides a widening cone of limits on the absolute money supply as the year proceeds and fosters a shift in base from year to year, thereby frus- trating accountability over long periods. This is indeed what happened. In July 1983, Chairman Volcker an- nounced a new target of 5 to 9 percent for the second quarter of 1983 to the second quarter of 1984 but from the second-quarter 1983 base, which is 3 percent (6 percent at an annual rate) above the top of the earlier range. A better way to state the targets is in terms of a central target for the absolute money supply plus or minus a band of, say, 1.5 percent on either side-about the range the Fed has specified for annual growth rates. [Since this was written and initially published, the Council of Economic Advisers has made the same suggestion, and Chairman Volcker has expressed sup- port for such a change.] Procedures for hitting the target. There is wide- spread agreement both inside and outside the Federal Reserve System that current procedures and reserve regulations make accurate control of monetary growth over short periods difficult or impossible. These pro- cedures and regulations do not explain such long sus- tained departures from the targets as the monetary explosions from April 1980 to April 1981 or July 1982 to July 1983 or the monetary retardations from April 1981 to October 1981 or January 1982 to July 1982. However, they do explain the wide volatility in mone- tary growth from week to week and month to month, which introduces undesirable uncertainty into the economy and financial markets and reduces Fed ac- countability for not hitting its targets. There is also widespread agreement about the changes in procedures and regulations that would en- able the Fed to come very much closer to hitting its targets over fairly short periods. The most important such change was the replacement of lagged reserve accounting, introduced in 1968, by contemporaneous reserve accounting comparable to that prevailing from 1914 to 1968. The obstacle to controlling monetary growth posed by lagged reserve accounting has been recognized since 1970 at the latest. Unfortunately, the Fed did not act until 1982, when it finally decided to replace lagged by contemporary reserve requirements. However, it delayed implementation until February 1984-the longest delay in implementing a changed regulation in the history of the Fed. There was no insuperable technical obstacle to implementing the change more promptly. The other major procedural changes needed are: 1. Selection by the Fed of a single monetary target to end the Fed's juggling between targets; 2. Imposition of the same percentage reserve re- quirements on all deposit components of the selected target; 3. The use of total rather than nonborrowed re serves as the short-term operating instrument; 4. Linking of the discount rate to a market rate and making it a penalty rate (neither this change nor the preceding was feasible for technical reasons under lagged reserve accounting; they are now feasible, but neither has been adopted); 5. Reduction of the churning in which the Fed en- gages in the course of its so-called defensive open- market operations. Even without most of these changes, it would be possible for the Fed to put into effect almost instanta- neously a policy that would provide a far stabler mone- tary environment than we have at present, even though it would by no means be ideal. The obstacle is not feasibility but bureaucratic inertia and the preservation of bureaucratic power and status. A simple example will illustrate. Let the Fed con- tinue to state targets for M, growth. Let it estimate the change in its total holdings of U.S. government securi- ties that would be required in the next six months, say, to produce the targeted growth in M,. Divide that amount by 26. Let the Fed purchase the resulting amount every week on the open market, in addition to any amount needed to replace maturing securities, and make no other purchases or sales. Finally, let it an- nounce this schedule of purchases in advance and in full detail and stick to it. Such a policy would assure control over the mone- tary aggregates, not from day to day, but over the longer period that the Fed insists is all that matters. It would enable the market to know precisely what the Fed would do and adjust its own actions accordingly. It would end the weekly guessing game that currently follows each Thursday's release of figures on the mon- ey supply. The financial markets have certainly dem- onstrated that they have ample flexibility to handle whatever day-to-day or seasonal adjustments might be needed. It is hard to envisage any significant adverse effects from such a policy. A few numbers will show how much difference such a policy would make to the Fed's open-market activities. In 1982, it added an average of $176 million a week to its total holdings of government securities- an unusually high amount. In the process of acquiring $176 million, it purchased each week an average of $13 billion of securities and sold nearly as much. About half of these transactions were on behalf of foreign central banks. But that still leaves roughly $40 of purchases or $80 of transactions for every one dollar added to its portfolio-a degree of churning of a custo- mer's account that would send a private stockbroker to Article 27 The Case for Overhauling the Federal Reserve 245 jail, or at least to limbo. Increased predictability, reduced churning, the loss of inscrutability-these are at the same time the major reasons for making so drastic a change and the major obstacles to its achievement. It would simply upset too many comfortable dovecotes. A framework for basic reform The chief problem in discussing the framework of monetary policy is to set limits. The subject is old, yet immediately pertinent; numerous proposals have been made, and few, however ancient, do not have contem- porary proponents. In view of my own belief that the important desiderata of structural reform are to reduce the variability of monetary growth, to limit the discre- tion of the monetary authorities, and to provide a stable monetary framework, I shall limit myself to proposals directed at those objectives, proceeding from the least to the most radical. Imposing a monetary rule on the Fed. I have long argued that a major improvement in monetary policy could be achieved without any significant change in monetary institutions simply by imposing a monetary rule on the Fed. From an economic point of view, it would be desirable to state the rule in terms of a mone- tary aggregate such as M, that has a close and consis- tent relation to subsequent changes in national income. However, recent years have demonstrated that the Fed has been unable or unwilling to achieve such a target, even when it sets it itself, and that it has been able to plead inability and thereby avoid accountability. Ac- cordingly, I have reluctantly decided that it is prefer- able to state the rule in terms of a magnitude that has a somewhat less close relation to national income but that unquestionably can be controlled within very nar- row limits within very brief time periods, namely, the Fed's own non-interest-bearing obligations, the mone- tary base. In Free to Choose, my wife, Rose, and I proposed a specific form of rule as a constitutional amendment: "Congress shall have the power to authorize non-in- terest-bearing obligations of the government in the form of currency or book entries, provided that the total dollar amount outstanding increases by no more than 5 percent per year and no less than 3 percent. "It might be desirable to include a provision that two-thirds of each House of Congress, or some similar qualified majority, can waive the requirement in case of a declaration of war, the suspension to terminate 246 Section Five Monetary Theory annually unless renewed." A constitutional amendment would be the most ef- fective way to establish confidence in the stability of the rule. However, it is clearly not the only way to impose the rule. Congress could equally well legislate it, and, indeed, proposals for a legislated movroan,: rule have been introduced in Congress. I remain persuaded that a monetary rule that leads to a predictable long-run path of a specified monetary aggregate is a highly desirable goal-superior either to discretionary control of the quantity of money by a set of monetary authorities or to a commodity standard. However, I am no longer so optimistic as I once was that it can be effected by either persuading the mone- tary authorities to follow it or legislating its adoption. Congressional attempts in the past decade to push the | Fed in that direction have repeatedly failed. The Fed I has rhetorically accepted monetary targets but never a firm monetary rule. Moreover, the Fed has not been willing even to match its performance to a rhetorical acceptance of monetary targets. All this suggests that a change in our monetary institutions is required in or- der to make such a rule effective. Separating regulatory from monetary functions . A modest institutional reform that promises considerable benefits is to separate the regulatory from the mone- tary functions of the Fed. Currently, regulatory func- tions absorb most of the Fed's attention. Moreover, they obscure accountability for monetary control by confusing the two very separate and to some extent inconsistent functions. As has recently been proposed in a study of the Federal Deposit Insurance Corporation, the Fed should be stripped of its regulatory functions, which would be combined with the largely overlapping func- tions of the FDIC, the Federal Savings and Loan Insur- ance Corporation, and the comptroller of the currency. Such a combined agency should have no monetary powers. It also might well include the operating func- tions of the Federal Reserve Banks-the monitoring of reserve requirements, issuance of currency, clearing of checks, reporting of data, and so forth. A separate monetary-control agency could be a very small body, charged solely with determining the total quantity of high-powered money through open-market operations. Its function would be clear, highly visible, and subject to effective accountability. Ending the independence of the Fed. An approach that need involve relatively little institutional change- although it is far more drastic than the preceding-and that could be implemented by legislation would be to end the independence of the Fed by converting it into a bureau of the Treasury Department. That would end the present division of responsibilities for monetary and fiscal policy that leads to the spectacle of chairmen of the Fed blaming all the nation's ills on the defects of fiscal policy and secretaries of the Treasury blaming them on the defects of monetary policy-a phenom- enon that has prevailed for decades. There would be a single locus of authority that could be held responsible. The immediate objection that arises is that it would make monetary policy a plaything of politics. My own examination of monetary history indicates that this judgment is correct, but that it is an argument for, not against, eliminating the central bank's independence. I examined this issue at length in an article pub- lished more than two decades ago entitled "Should There Be an Independent Monetary Authority?" I con- cluded that it is "highly dubious that the United States, or for that matter any other country, has in practice ever had an independent central bank in [the] fullest sense of the term.... To judge by experience, even those central banks that have been nominally indepen- dent in the fullest sense of the term have in fact been closely linked to the executive authority. "But of course this does not dispose of the matter. The ideal is seldom fully realized. Suppose we could have an independent central bank in the sense of a coordinate constitutionally established, separate orga- nization. Would it be desirable to do so? I think not, for both political and economic reasons. "The political objections are perhaps more obvious than the economic ones. Is it really tolerable in a de- mocracy to have so much power concentrated in a body free from any kind of direct effective political control? . . . "One [economic] defect of an independent central bank . . . is that it almost inevitably involves dispersal of responsibility.... "Another defect . . . is the extent to which policy is ... made highly dependent on personalities.... "A third technical defect is that an independent central bank will almost inevitably give undue empha- sis to the point of view of bankers. "The three defects I have outlined constltute a strong technical argument against an independent cen- tral bank." The experience of the past two decades has led me to alter my views in one respect only-about the impor- tance of personalities. They have on occasion made a l great deal of difference, but additional experience and study has impressed me with the continuity of Fed policy, despite the wide differences in the personalities and backgrounds of the persons supposedly in charge. For the rest, experience has reinforced my views. Anna Schwartz and I pointed out in Monetary History that subservience to congressional pressure in 1930 and 1931 would have prevented the disastrous mone- tary policy followed by the Fed. That is equally true for the past fifteen years. The relevant committees of Congress have generally, though by no means invari- ably, urged policies on the Fed that would have pro- duced a stabler rate of monetary growth and much less inflation. Excessively rapid and volatile monetary growth from, say, 1971 to 1979 was not the result of political pressure-certainly not from Congress, al- though in some of these years there clearly was pres- sure for more rapid growth from the Administration. Nonetheless, no political pressures would have pre- vented the Fed from increasing M, over this period at, say, an average annual rate of S percent-the rate of increase during the prior eight years-instead of 6.7 percent. Subordinating the Fed to the Treasury is by no means ideal. Yet it would be a great improvement over the existing situation, even with no other changes. Competitive issue of money. Increasing interest has been expressed in recent years in proposals to replace governmental issuance of money and control of its quality by private market arrangements. One set of proposals would end the government monopoly on the issuance of currency and permit its competitive issue. Another would eliminate entirely any issuance of money by government and, instead, restrict the role of government to defining a monetary unit. The former set of proposals derives largely from a pamphlet by F. A. Hayek entitled Choice in Currency: A Way to Stop Inflation. Hayek proposed that all spe- cial privileges (such as "legal tender" quality) at- tached to government-issued currency be removed, and that financial institutions be permitted to issue currency or deposit obligations on whatever terms were mutually acceptable to the issuer and the holder of the liabilities. He envisaged a system in which institu- tions would in fact issue obligations expressed in terms of purchasing power either of specific commod- ities, such as gold or silver, or of commodities in general through linkage to a price index. In his opin- ion, constant-purchasing-power moneys would come to dominate the market and largely replace obligations Article 27 The Case for Overhauling the Federal Reserve 247 denominated in dollars or pounds or other similar units and in specific commodities. The idea of a currency unit linked to a price index is an ancient one-proposed in the nineteenth century by W. Stanley Jevons and Alfred Marshall, who named it a "tabular" standard-and repeatedly rediscovered. It is part of the theoretically highly attractive idea of widespread indexation. Experience, however, has demonstrated that the theoretical attractiveness of the idea is not matched by practice. I approve of Professor Hayek's proposal to remove restrictions on the issuance of private moneys to com- pete with government moneys. But I do not share his belief about the outcome. Private moneys now exist- traveler's checks and cashier's checks, bank deposits, money orders, and various forms of bank drafts and negotiable instruments. But these are almost all claims on a specified number of units of government currency (of dollars or pounds or francs or marks). Currently, they are subject to government regulation and control. But even if such regulations and controls were entirely eliminated, the advantage of a single national currency unit buttressed by long tradition will, I suspect, serve to prevent any other type of private currency unit from seriously challenging the dominant government cur- rency, and this despite the high degree of monetary variability many countries have experienced over re- cent decades. The recent explosion in financial futures markets offers a possible new road to the achievement, through private market actions, of the equivalent of a tabular standard. This possibility is highly speculative-little more than a gleam in one economist's eye. It involves the establishment of futures markets in one or more price indexes-strictly parallel to the markets that have developed in stock-price indexes. (The Commodities Futures Trading Commission has authorized the Cof- fee, Sugar, and Cocoa Exchange to begin futures trad- ing in the Consumer Price Index as of June 21, 1985.) Such markets, if active and covering a considerable range of future dates, would provide a relatively cost- less means of hedging long-term contracts against risks of changes in the price level. A combination of an orthodox dollar contract plus a properly timed set of futures in a price level would be the precise equivalent of a tabular standard, but would have the advantage that any one party to a contract, with the help of specu- lators and other hedgers in the futures market, could have the benefit of a tabular standard without the agreement of the other party or parties. Recent changes in banking regulations have opened 248 Section Five Monetary Theory another route to a partial tabular standard on a substan- tial scale. The Federal Home Loan Bank has finally authorized federally chartered savings and loan associ- ations to offer price-level-adjusted mortage (PLAM) loans. Concurrently, the restrictions on the interest rate that can be paid on deposits by a wide range of financial institutions have been eased and removed entirely for deposits of longer maturities. This would permit financial institutions simulta- neously to lend and borrow on a price-level-adjusted basis: to lend on a PLAM and borrow on a price-level- adjusted deposit (PLAD), both at an interest rate speci- fied in real rather than nominal terms. By matching PLAM loans against PLAD deposits, a bank would be fully hedged against changes in inflation, covering its costs by the difference between the interest rate it charges and pays. Similarly, both borrowers and lend- ers would be safeguarded against changes in inflation with respect to a particular liability and asset. As yet, I know of no financial institutions that have proceeded along these lines. I conjecture that no major development will occur unless and until inflation once again accelerates. When and if that occurs, PLAMs and PLADs may well become household words and not simply mysterious acronyms. Freezing high-powered money. The final propos- al combines features from most of the preceding. It is radical and far-reaching, yet simple. The proposal is that, after a transition period, the quantity of high-powered money-non-interest-bear- ing obligations of the U.S. government-be frozen at a fixed amount. These non-interest-bearing obligations now take two forms: currency and deposits at the Fed- eral Reserve System. The simplest way to envisage the change is to suppose that Federal Reserve deposit lia- bilities were replaced dollar for dollar by currency notes, which were turned over to the owners of those deposits. Thereafter, the government's monetary role would be limited to keeping the amount constant by replacing worn-out currency. In effect, a monetary rule of zero growth in high-powered money would be adopted. (In practice, it would not be necessary to replace deposits at the Federal Reserve with currency; they could be retained as book entries, so long as the total of such book entries plus currency notes was kept constant . ) This proposal would be consistent with, indeed re- quire, the continued existence of private institutions issuing claims to government currency. These could be regulated as now, with the whole paraphernalia of re quired reserves, bank examinations, limitations on lending, and the like. However, they could also be freed from all or most such regulations. In particular, the need for reserve requirements to enable the Fed to control the quantity of money would disappear. Reserve requirements might still be desirable for a different though related reason. The new monetary economists argue that only the existence of such gov- ernment regulations as reserve requirements and pro- hibition of the private issuance of currency explains the relatively stable demand for high-powered money. In the absence of such regulations, they contend, non- interest-bearing money would be completely dominat- ed by interest-bearing assets, or, at the very least, the demand for such money would be rendered highly unstable. I am far from persuaded by this contentlon. It sup- poses a closer approach to a frictionless world with minimal transaction costs than seems to me a useful approximation to the actual world. Nonetheless, it is arguable that the elimination of reserve requirements would introduce an unpredictable and erratic element into the demand for high-powered money. For that reason, although personally I would favor the deregu- lation of financial institutions, thereby incorporating a major element of Hayek's proposed competitive finan- cial system, it would seem prudent to proceed in stages: first, freeze high-powered money; then, after a period, eliminate reserve requirements and other re- maining regulations, including the prohibition on the issuance of hand-to-hand currency by private insti- tutions. Why zero growth? Zero has a special appeal on political grounds that is not shared by any other num- ber. If 3 percent, why not 4 percent? It is hard, as it were, to go to the political barricades to defend 3 rather than 4, or 4 rather than 5. But zero is-as a psychological matter-qualitatively different. It is what has come to be called a Schelling point-a natural point at which people tend to agree, like ''splitting the difference" in a dispute over a monetary sum. More- over, by removing any power to create money it elimi- nates institutional arrangements lending themselves to l discretionary changes in monetary growth. Would zero growth in high-powered money be con- sistent with a healthy economy? In the hypothetical long-long-run stationary economy, when the whole economy had become adjusted to the situation, and population, real output, and so on were all stationary, zero growth in high-powered money would imply zero growth in other monetary aggregates and mean stable velocities for the aggregates. In consequence, the price level would be stable. In a somewhat less than station- ary state in which output was rising, if financial inno- vations kept pace, the money multiplier would tend to rise at the same rate as output, and again prices would be stable. If financial innovations ceased but total out- put continued to rise, prices would decline. If output rose at about 3 percent per year, prices would tend to fall at 3 percent per year. So long as that was known and relatively stable, all contracts could be adjusted to it, and it would cause no problems and indeed would have some advantages. However, any such outcome is many decades away. The more interesting and important question is not the final stationary-state result but the intermediate dy- namic process. Once the policy was in effect, the actual behavior of nominal income and the price level would depend on what happened to a monetary aggregate like M, rela- tive to high-powered money and what happened to nominal income relative to M,-that is, on the behav- ior of the money multiplier (the ratio of M, to high- powered money) and on the income velocity of M, (the ratio of nominal income to M,). Given a loosening of the financial structure through continued deregulation, there would be every reason to expect a continued flow of innovations raising the money multiplier. This process has in fact occurred throughout the past several centuries. For example, in the century from 1870 to 1970, the ratio of the quantity of money, as defined by Anna Schwartz and me in Monetary History, to high-powered money rose at the average rate of I percent per year. In the post-World War II period, the velocity of M, has risen at about 3 percent per year, and at a relatively steady rate. This trend cannot, of course, continue indefinitely. Above, in specifying a desirable target for the Fed, I estimated that the rise in velocity would slow to about 1 or 2 percent per year. However, a complete end to the rapid trend in velocity is not in sight. There is no way to make precise numerical esti- mates, but there is every reason to anticipate that for decades after the introduction of a freeze on high- powered money, both the money multiplier and veloc- ity would tend to rise at rates in the range of historical experience. Under these circumstances, a zero rate of growth of high-powered money would imply roughly stable prices, though ultimately, perhaps, slightly de- clining prices. What of the transition? Over the three years from 1979 to 1982, high-powered money grew an average of 7.0 Article 27 The Case for Overhauling the Federal Reserve 249 percent a year. It would be desirable to bring that rate to zero gradually. As for M, growth, about a five-year period seems appropriate-or a transition that reduces the rate of growth of high-powered money by about 1.5 percentage points a year. The only other transitional problem would be to phase out the Fed's powers to create and destroy high-powered money by open-mar- ket operations and discounting. Neither transition of- fers any special problem. The Fed, or its successor agency, could still use part of the existing stock of high-powered money for similar purposes, particular- ly for lender-of-last-resort purposes, if that function were retained. The great advantage of this proposal is that it would end the arbitrary power of the Federal Reserve System to determine the quantity of money, and would do so without establishing any comparable locus of power and without introducing any major disturbances into other existing economic and financial institutions. I have found that few things are harder even for knowledgeable nonexperts to accept than the proposi- tion that twelve (or nineteen) people sitting around a table in Washington, subject to neither election nor dismissal, nor close administrative or political con- trol, have the power to determine the quantity of mon- ey-to permit a reduction by one-third during the Great Depression or a near-doubling from 1970 to 1980. That power is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power. In the system I have just described, the total quantity of any monetary aggregate would be determined by the mar- ket interactions of many financial institutions and mil- lions of holders of monetary assets. It would be limited by the constant quantity of high-powered money avail- able as ultimate reserves. The ratios of various aggre- gates to high-powered money would doubtless change from time to time, but in the absence of rigid govern- ment controls-such as those exemplified by Regula- tion Q, fortunately being phased out-the ratios would change gradually and only as financial innovations or changes in business and industry altered the propor- tions in which the public chose to hold various mone- tary assets. No small number of individuals would be in a position to introduce major changes in the ratios or in the rates of growth of various monetary aggre- gates-to move, for example, from a 3 percent per year rate of growth in M, for one six-month period (January to July 1982) to a 13 percent rate of growth for the next six months (July 1982 to January 1983). 250 Sectlon Five Monetary Theory Conclusion Major institutional change occurs only at times of cri- sis. For the rest, the tyranny of the status quo limits changes in institutions to marginal tinkering-we muddle through. It took the Great Depression to pro- duce the FDIC, the most important structural change in our monetary institutions since at least 1914, when the Federal Reserve System began operations, and to shift power over monetary policy from the Federal Reserve Banks, especially that in New York, to the Board in Washington. Since then, our monetary insti- tutions have been remarkably stable. It took the severe inflation of the 1970s and accompanying double-digit interest rates-combined with the enforcement of Reg- ulation Q-to produce money-market mutual funds and thereby force a considerable measure of deregula- tion of banking. Nonetheless, it is worth discussing radical changes, not in the expectation that they will be adopted prompt- ly but for two other reasons. One is to construct an ideal goal, so that incremental changes can be judged by whether they move the institutional structure to- ward or away from that ideal. The other reason is very different. It is so that if a crisis requiring or facilitating radical change does arise, alternatives will be available that have been carefully developed and fully explored. International monetary arrangements provide an excellent example. For decades, economists had been exploring alterna- tives to the system of fixed exchange rates-in particu- lar, floating exchange rates among national currencies. The practical men of affairs derided proposals for floating rates as unrealistic, impractical, ivory-tower. Yet when crisis came, when the Bretton Woods fixed- rate system had to be scrapped, the theorists' impracti- cal proposal became highly practical and formed the basis for the new system of international monetary arrangements. Needless to say, I hope that no crises will occur that will necessitate a drastic change in domestic monetary institutions. The most likely such crisis is continued monetary instability, a return to a roller coaster of inflation about an upward trend, with inflation acceler- ating to levels of 20, 30, or more percent per year. That would shake the social and political framework of the nation and would produce results none of us would like to witness. Yet, it would be burying one's head in the sand to fail to recognize that such a development is a real possibility. It has occurred elsewhere, and it could occur here. If it does, the best way to cut it short, to minimize the harm it would do, is to be ready not with Band-Aids but with a real cure for the basic illness. As of now, I believe the best real cure would be the reform outlined above: abolish the money-creating powers of the Federal Reserve, freeze the quantity of high-powered money, and deregulate the financial system. The less radical changes in policy and procedures suggested in the section on tactics seem to me to offer the best chance of avoiding a crisis. These tactical changes are feasible technically. However, I am not optimistic that they will be adopted. The obstacle is political: as with any bureaucratic organization, it is not in the self-interest of the Fed to adopt policies that would render it accountable. The Fed has persistently avoided doing so over a long period. None of the tactics that I have proposed is new. The proposed changes would have made just as much sense five or ten years ago-indeed, if adopted then, the inflation and volatility of the past ten years would never have occurred. The proposals have had the support of a large fraction of monetary experts outside the Fed. The Fed has resisted them for bureaucratic and politi- cal, not technical, reasons. And resistance has been in the Fed's interest. By keeping monetary policy an ar- cane subject that must be entrusted to "experts" and kept out of politics, incapable of being judged by non- experts, the Fed has been able to maintain the high public reputation of which I spoke at the outset of this article, despite its poor record of performance. One chairman after another, in testimony to Con- gress, has emphasized the mystery and difficulty of the Fed's task and the need for discretion, judgment, and the balancing of many considerations. Each has stressed how well the Fed has done and proclaimed its dedication to pursuing a noninflationary policy and has attributed any undesirable outcome to forces outside the Fed's control or to deficiencies in other compo- nents of government policy-particularly fiscal policy. The testimony of the four most recent chairmen of the Fed documents their pervasive concern with avoiding accountability-a concern with which it is easy to sym- pathize in view of the purely coincidental relation be- tween their announced intentions and the actual outcome. Clearly the problem is not the person who happens to be chairman, but the system. Article 27 The Case for Overhauling the Federal Resenve 251