The Tea Party won’t purify the market by tying the Fed’s hands

Matt O’Brien has a thought-provoking piece on Wonkblog at the Washington Post.

It’s about the curious business of the modern Republicans turning their back on what most mainstream economists would now view as ‘sound money’.  Namely the active use of the Fed Funds Rate in pursuit of stabilising some weighted sum of inflation and real activity.

The movement has sufficient weight behind it that it leaves its imprint in Bernanke’s opening blogs, where he feels obliged to explain how you can’t simply set the interest rate and take your hands off the wheel, allowing markets to sort the rest out;  and that the Fed is not setting interest rates ‘artificially low’ right now, but is instead accommodating weak demand/strong savings in pursuit of the goals Congress mandated it.

What the Republicans of this ilk are not aware of is that in so far as the theory informs policy, the Fed is actually trying to do its best to recreate conditions that would obtain in an idealised, undistorted market.  When people talk about the natural interest rate, and the Fed chasing it with the Fed Funds Rate, they are referring to this idealised real rate that would clear the market for savings in a perfect market economy.  Far from distorting the market economy, the Fed is trying to purify its outcomes.

But there is a lot that branch of the US political system does not get.

As I wrote a while ago, it has an equally puzzling approach to fiscal policy.  Concerned that the Federal government won’t pursue sound fiscal policy, that debt will get out of hand, perhaps be defaulted on or inflated away, it launches repeated attacks on the Federal government budget threatening to prevent it from making good on its existing debt.  The effect being to risk raising the cost of finance for governments, which makes debt management harder, not easier, and reduces, rather than increases private investment [the cost of funding for which is always priced off government debt].  And as collateral damage, it creates corresponding fluctuations in the liquidity of Treasuries, which is the equivalent of the Fed yanking around interest rates for the fun of it.  Something that adds to the chaos in markets, rather than purifying them.

This is no doubt bound up with the Tea Party’s distaste for all the manifestations of Federal government.

The founders debated long and hard whether to allow the Federal government to issue its own debt.  And perhaps the Tea Party still think they were onto something.  They and the other Republicans who pay heed to them might not have realised that we have 250 years of monetary and public choice economics to tell us that debt financed Federal spending, and active fiscal policy is a good thing.

The Federal Reserve was likewise a manifestation of evil for the states-rightsers (mostly Democrats then, before the two main parties switched scripts) and was created and abolished once before its current incarnation was set up in 1914.

Modern states-rightsers – the Tea Party – perhaps consider abolition too ambitious, but think that fixing the Fed’s instruments, or narrowing its objectives, will take the actual economy closer to a Founder’s vision of an unfettered one.  We have to hope that most people continue to think this view misguided.