Allan Meltzer on the Fed, Money, and Gold

Episode Summary

Executive Summary: Russ Roberts and Alan Meltzer discuss how the Fed actually operates, arguing it mostly targets a short-term interest rate but should focus on money growth and medium-term inflation control. Meltzer emphasizes political pressure, the risks of reacting to recessions too quickly, the benefits and limits of inflation targeting, the historical causes of inflation, and the Fed’s crisis role in Bear Stearns.

Main Topics: How the Fed operates: interest rates vs. money supply (Priority: 5/5): Meltzer explains that the Fed publicly focuses on the federal funds rate, but this is implemented through open market operations and still affects money growth. He argues the classic money-supply story remains more accurate than the modern rate-centric narrative. Political pressure and limited Fed independence (Priority: 5/5): The conversation highlights how Congress, Wall Street, and administrations pressure Fed chairs to avoid recessions and keep borrowing costs low. Meltzer argues the Fed is never fully independent in practice. Inflation, expectations, and medium-term policy (Priority: 5/5): Meltzer argues that stable, predictable inflation is far less harmful than volatile inflation, and that the Fed should use a medium-term strategy or inflation target rather than react to every short-term shock. Historical roots of inflation and the Great Inflation (Priority: 4/5): Meltzer traces inflation to political accommodation of fiscal deficits, especially during the Johnson era, and contrasts that with Volcker and Greenspan’s more disciplined medium-term approach that produced the Great Moderation. Gold standard vs. discretionary fiat money (Priority: 4/5): The discussion compares the old gold standard, which brought long-run price stability but bigger swings in output and employment, with modern monetary policy that gives more control over business cycles but less long-run certainty. Fiscal policy, deficits, and stimulus (Priority: 4/5): Meltzer criticizes temporary tax rebates and deficit-financed spending as weak or misleading stimulants, arguing that without spending cuts they mainly create debt and future tax burdens. Bear Stearns and lender-of-last-resort intervention (Priority: 5/5): The final segment examines the Fed’s emergency intervention in Bear Stearns, defending the goal of protecting the payment system while criticizing the ad hoc, opaque nature of bailout decisions and arguing for clearer rules like Bagehot’s.

Key Arguments: The Fed says it controls interest rates, but operationally it uses open market operations and its actions also affect money growth and inflation. Most journalists, politicians, and the public focus on interest rates because that is what is politically salient, which shapes Fed communication. Short-term recession avoidance often crowds out longer-term inflation control; Meltzer argues the Fed should resist that pressure. Inflation is especially damaging when it is uncertain or volatile, because it distorts saving, investment, inventories, and long-term planning. The Great Inflation was tied to political accommodation of deficits, especially under Johnson, when the Fed helped finance fiscal expansion. Volcker succeeded by refusing to prioritize short-term employment over inflation reduction; Greenspan benefited from a similar medium-term orientation. The gold standard offered long-run price stability but required larger fluctuations in output and employment, which modern societies find politically intolerable. Temporary fiscal rebates are largely saved or used to pay down debt, so they are poor tools for boosting real demand. Large budget deficits are ultimately unsustainable because they must be rolled over and eventually raise concerns about dollar depreciation and future taxation. The Bear Stearns rescue aimed to protect the payment and settlement system, but the Fed’s ad hoc bailout policy creates uncertainty and moral hazard. Better crisis policy would be to let equity holders fail, protect the system, and lend freely at a penalty rate against good collateral.

Data Points: Fed control target: One interest rate - Meltzer says the Fed really controls a single rate, the federal funds rate, not all interest rates. Volcker policy horizon: About 2 years - He says it took roughly two years of perseverance for Volcker’s anti-inflation policy to work. Great Moderation period: 1985 to about 2001 - Meltzer describes this as a period when the Fed focused more on medium-term outcomes. Federal Reserve founding: 1913 - Used as the starting point for the Fed’s history and institutional discussion. Martin era: 1951 to 1964 - Meltzer cites this as a relatively stable anti-inflation period before fiscal pressures intensified. Inflation in 1961-62: Close to zero - He says inflation got very close to zero during the early Martin era. Inflation by end of Martin era: 6% year over year - He attributes this to deficit accommodation during the Johnson years. Inflation target lag: A couple of years - Meltzer says monetary policy affects inflation with roughly a two-year delay. Savings and loan bailout cost: $200 billion - He cites the taxpayer cost of the savings and loan crisis as an avoidable consequence of policy distortions. Fed dissents: 2 public dissents - He notes recent dissents inside the committee as a sign of disagreement with policy. Banks seeking discount rate reduction: 4 of 12 banks - He says only four banks requested the most recent discount rate reduction, implying discomfort with inflationary policy. Housing sector: Major trouble - He identifies housing as weak due partly to too-low interest rates for too long. Inflation target countries: Many countries - He notes that countries like Britain, Sweden, and Australia use inflation targeting. Temporary rebate example: $50 - He references a Carter-era rebate proposal that was later canceled. Bretton Woods end: A few months after Martin left office - He links the collapse of the fixed exchange-rate system to the inflationary policy period. Bear Stearns stock price: About $10/share vs. over $100 earlier - He uses this to explain that shareholders were wiped out in the rescue process. Gold stock by end of WWII: About 70% of the world's gold - He says the U.S. accumulated gold during the 1930s and 1940s, expanding money supply. Housing share of imports: At least 12% - He cites this to argue that stimulus spending leaks abroad through imports.

Pivotal Quotes: "The Fed puts out money. It changes the amount of real money balances... If people have more money balances than they want to hold, they spend them either on goods or on assets." — Alan Meltzer: Explaining the classical monetary transmission mechanism versus the popular interest-rate story. "A country that won't experience a small recession will end up having a big one." — Alan Meltzer: On the danger of excessive short-term recession avoidance and delayed inflation control. "The Fed did in Bear Stearns was to protect the payment and settlement system." — Alan Meltzer: Defending the rationale for intervention while questioning the lack of clear rules.

Implications: Listeners should expect the Fed to remain politically constrained and often short-term oriented. Meltzer’s view implies that stable inflation requires medium-term rules, skepticism toward temporary stimulus, and clearer crisis-lending standards to avoid future bailouts and moral hazard.