The Federal Reserve: Between a Rock and a Hard Place

The more the Board of Governors fights infla tion the worse infla tion gets. The new look in Federal Reserve policy that was presen ted with fanfare last October was designed to enable the Federal Reserve to restrict the growth of “the” money supply, whatever that may be. According to the mainly monet ar ist theory that guided this action, restrict ing the growth of “the” money supply would lead, over a number of years, to an end of infla tion. The theory is that infla tion could be gradu ally elim in ated without undue hard ship. The results of the first six months of the new policy posture are in. The

record is dismal. Instead of infla tion’s dimin ish ing, the rate of increase of prices has accel er ated. Furthermore, during the first months of 1980 we have seen a free fall in bond prices take place which, if carried through to the books of finan cial insti tu tions that hold bonds and mort gages, undoubtedly makes many leading insti tu tions “walking bank rupts”; their net worth at market prices is negat ive. Overt bank ruptcy has been avoided because the market ing of debt instru ments at compet it ive interest rates has enabled walking bank rupts to fulfill matur ing oblig a tions. But such insti tu­ tions are carry ing assets that yield yester day’s interest rates with liab il it ies on

which they pay today’s much higher rates. Such losses on the carry mean that the walking bank rupts of 1980 are bleed ing to death. The economic record is not all bad, however. As we recite the list of

dismal indic at ors-infla tion at more than 16 percent, interest rates above 20 percent, unem ploy ment at 6 percent, slow growth, a dollar under continu ing inter na tional pres sure, and mount ing trade defi cits-we must recog nize one over rid ingly import ant virtue of our post­World War II economy: there has not been a deep and long­lasting depres sion. What is more, in spite of credit crunches, liquid ity squeezes, and banking debacles in 1966, 1969-70, and 1974-75, the finan cial system has not gone through an “inter act ive” debt defla tion such as regu larly occurred in the gener a tions before World War II. There is some thing about the struc ture of today’s American economy that

has made it immune to the finan cial crises and deep depres sions that took place earlier in our history. At the same time there is some thing about its struc ture that makes the economy prone to accel er at ing infla tion. The two are linked: immunity to finan cial crises and deep depres sions is one side of a coin; suscept ib il ity to accel er at ing infla tion and exotic diseases like stag fla­ tion is the other. To do better in the 1980s than in the 1970s we need to under stand this linkage, which means that we have to go beyond the mon ­ etar ist percep tions of how our economy works.