16 August 2015

‘The Fed’s policy is terrible, and nobody can stop them’


Karen Horn interviews Allan Meltzer

(Allan H. Meltzer University Professor of Political Economy at the Tepper School of Business at Carnegie Mellon University Pittsburgh)

HORN: Professor Meltzer, we’re here in the train from Zurich to Freiburg. The Swiss national bank (SNB) has returned to a floating franc-euro exchange rate in January, as a result of which the franc sky-rocketed. But the Swiss rather dislike being a safe haven, as this makes it difficult for their industry to export their goods and for their hotels to attract guests. As a world-renowned specialist in monetary theory and policy, do you think the SNB made the right decision? And what do you think is going to happen in Switzerland?

MELTZER: Yes, the SNB did the right thing. Its main task is to prevent inflation. Faced with the planned ECB decision to print massive amount of euros, it acted to prevent a flood of euros from coming to Switzerland. This is a problem the SNB has had before. In the 1970s, it had to develop tactics for preventing a flood of dollars from raising swiss inflation. At the time, inflation in 1973 reached double digits. This time the SNB is trying to avoid repetition. Yes, appreciation will hurt exports, but it lowers import prices that consumers pay for food and fuel.

HORN: Don’t we have here a case where the developments in the financial markets are totally disconnected from the developments in the real market, to the undeserved distress of real industry? The Swiss farmers, hotel owners and chemical firms are paying the price for the euro crisis and for the ECB’s printing money. Is that appropriate or even fair?

MELTZER: Fair? When did the EU or the ECB accept concern for third countries? When Bretton Woods ended, countries abandoned any claim to avoid policies that harmed others. I do not believe a fixed exchange rate system can be rebuilt, but we should try to limit inflation rates in the US, Eurozone, Japan and China to 0-2 percent. Some enforcement must be added.

HORN: What do you think about the monetary policies that have been applied recently in the United States and in Europe? Money has become really cheap. What do you think about the so-called “quantitative easing” strategy?

MELTZER: I once gave a talk about this at the Federal Reserve Bank of Chicago. I tried to open their eyes to the three major mistakes that they have made. In the United States, the Federal Reserve system has built 2.7 trillion dollars of excess reserves. You think they have a program for getting rid of that? Of course they don’t, and it is going to take years! Eliminating these excess reserves without causing inflation, recession, or both, will be a major challenge for the future. As soon as the money isn’t parked at the Fed anymore but enters the real economy, it won’t fail to push prices up. When there is too much money circulating, prices always go up: inflation is a monetary phenomenon. And why is it that they have built these huge excess reserves? They did so because they made a huge mistake.

HORN: Which one?

MELTZER: A mistake of analysis. It is very simple: We don’t have a monetary problem in the United States. We have real problems. Yes, the American economy is picking up, mainly thanks to cheaper energy. But we still have high tax rates, we have terrible regulation, and we have an anti-business climate that becomes more and more dramatic. Last summer, the “Economist” magazine had a very lucid lead article under the headline “the criminalisation of American business”[1] – and this is a truly troubling development.

HORN: The commentator in the magazine wasn’t shy of words, judging that America’s regulatory agencies are worse than the Sicilian mafia, the People’s Liberation Army in China and the kleptocracy in the Kremlin. Let me quote: “The formula is simple: find a large company that may (or may not) have done something wrong; threaten its managers with commercial ruin, preferably with criminal charges; force them to use their shareholders’ money to pay an enormous fine to drop the charges in a secret settlement (so nobody can check the details). Then repeat with another large company. The amounts are mind-boggling.” In order to avoid a damaged reputation, the corporations go more and more for secret settlements. This practice is undermining the rule of law.

MELTZER: Oh yes, and they are right, it’s disastrous. So you see, these are the true problems that we face. To restore investment and growth, the government should reduce tax rates, deregulate, and stop criminalizing corporations. We don’t have a monetary problem in the United States, but the Federal Reserve keeps printing money. Their policy is the worst ever, and nobody can stop them, since the Fed can’t be hold accountable. Following the recent financial crisis and in its aftermath the Federal Reserve has engaged in fiscal actions, debt management, and has multiplied the size of its balance sheet. No agency of government should have as much independent authority. In the United States, we profess to have a limited government, but the Federal Reserve has acquired unlimited authority. And it uses it in a terrible way. When the reserves start to pile up at the banks, and the banks aren’t using them, why on earth do they think that they have to print even more, if the banks don’t know what to do with the reserves that they have already? I gave them several examples where they should have seen, at least by 2009, that what they were doing wasn’t working on the problem, and that problem was not a monetary one. That’s the first mistake they made.

HORN: And the second?

MELTZER: The second mistake they made is that there has been too much response to the short term. Not so much now, but for years, the Fed would emphasize the employment growth. One month, when the employment number comes out, it is a good number. And the next month, that same indicator goes down. These data are very volatile. All that it results in is a lot of noise. The market would of course always follow what the Fed says. If the Fed said that they pay attention to Ouija boards we would all buy Ouija boards. The problem of the market is figuring out what the Fed is going to do. But the Fed bases its actions on something that has very little meaning. It overreacts to current events and just increases uncertainty.

HORN: And you think that these mistakes are due to a flawed theory?

MELTZER: Yes, and that’s the third mistake. Despite the fact that the crisis we went through was a credit crisis, i.e. that the banks lent too much money to the mortgage borrowers, the economists at the Fed don’t have money and credit in their models. That’s plain silly! If you  know anything about monetary history, and I have written a book about this[2], you know that money and credit are essential. The reason they give for neglecting these aggregates is usually that they are unstable. But that is not true of medium- and longer-term values! When my friend Otmar Issing was responsible at the Bundesbank, they certainly paid attention to this, and they ran a very good policy. The Federal Reserve doesn’t do that any longer. Well, you wouldn’t be surprised that the President of the Federal Bank of Chicago didn’t really like what I told them. But I wasn’t expecting him to like it.

HORN: And what about the ECB?

MELTZER: The central problem of the ECB is also not a monetary problem. I know that the market people would like the ECB to print more money than it already has. In fact, the ECB was not very expansive in the past.  That is about to change. If the ECB added a little bit of money printing, that wouldn’t be a terrible problem. But of course it is going to do more than a little. The central problem is that you have economically strong countries like Germany and the Netherlands, where the relative prices are much higher than in Italy, Greece, and Spain. So you have to adjust. There are three things that you can do in order to adjust. You can inflate the rich countries, but that’s unrealistic, that’s not going to happen. You can deflate the other countries, and that’s what is happening. This kind of adjustment is a long, slow, and painful process. And the third thing you can do is take all the troubled countries, including France, perhaps especially France, unite them in a block, create a separate currency for this block, and float it down in order to adjust the prices. Because that’s what has to happen. These countries need to make the adjustment, they need structural reforms in order restore growth, and once that’s done, they can go back and join the group of the strong euro again. I’m not saying the reforms will be painless this way, but they will be even more painful if there is no possibility to devaluate. But the core message is really this: You need to implement reforms in order to make the euro system work. That’s my proposal.

HORN: So you recommend a soft euro zone for the weaker countries and a strong euro zone for the flourishing ones. Don’t you worry about the side effects of the weaker countries leaving the strong euro, the psychological shock this would create, the capital flight this would entail, the write-offs it would imply, and the recession that it might prompt?

MELTZER: That’s how problems due to economic divergence were solved ever since 1945 in Europe and before the euro was created. Italy and France devaluated regularly, and the world economy didn’t go bust.

HORN: Do you think the euro was a good idea in the first place?

MELTZER: For economic reasons, I’m not strongly in favour of a fixed exchange rate system. And in the case of the euro, I was sceptical about the wisdom of eliminating exchange and interest rate changes to adjust differences between countries. The current system puts too much emphasis on labor and product price adjustment, the principal and practically speaking the only market adjustment left. Such a system can only achieve full employment and price stability if all member states substantially modify their costly welfare and regulatory systems. Anyway, a common currency is what the Europeans wanted. And they wanted it because they think it will help to prevent another war in Europe. That surely has to be an overriding interest for everybody in Europe and not only in Europe. We certainly don’t want another big European war. So we have to make the system work in order for the Europeans to come together. That’s what my proposal of a soft euro zone is for. But what worries me at the moment is that when you look at Germany, France, even Britain, even though it is not part of the euro zone, the political opposition to the European system as a whole is growing steadily. I don’t think that the new euro-critical, nationalist parties will come to power, except perhaps the ultra-right “Front National” in France. But what will happen everywhere is that, politicians being politicians, even the old, established parties will move toward that direction. That will be a way to slow down integration and to return to the old ways. That is currently the great risk in Europe.

HORN: Earlier this year, the ECB bought more than 1 trillion euros worth of government bonds. They considered that further “Quantitative Easing” was necessary, especially given a slightly negative inflation rate. And not much later, the elections in Greece brought Syriza to power, a party from the far left. What is your assessment of this?

MELTZER: The political result in Greece shows the dissatisfaction that exists in several other countries. Voters want improvements in outcomes.  Years of trying to adjust by forcing deflation has brought improvement in Ireland, Spain and Portugal but not in large countries France and Italy.  Nationalist parties in France, Germany, Netherland, Spain, Sweden and the UK often do not limit criticism and opposition to the common currency project.  Often they oppose the idea of union.  That’s a serious nationalist threat to the agreement by France and Germany to develop common interests as a way of preventing nother European war. Rising nationalism is a threat to that essential step.  I doubt that all the nationalist parties will gain majority positions, but the risk is that politicians in the major parties will move toward the voters to lure tham back from the nationalists.

HORN: What you said about the Fed actually has to do with their mandate. It is very different from the mandate of the ECB. The Federal Reserve Act states its statutory objectives for monetary policy as being maximum employment, stable prices, and moderate long-term interest rates. The ECB has a two-tier approach, looking at monetary indicators, focusing on money supply and inflation, and looking also at general economic indicators such as employment and growth, insofar as these influence the development of prices.

MELTZER: As an economist, just from the standpoint of economics, I prefer a single mandate. But as a political economist, I understand that something like that won’t work in the United States. There has to be some explicit consideration for unemployment. In the history of the Federal Reserve, the two best periods in the more than one hundred years of its existence were 1923 to 1928, when they were on the gold standard, and 1986 to 2002, when, without officially agreeing to it, they more or less followed the Taylor rule.

HORN: A rule that considers three factors, the actual versus targeted inflation levels, the actual versus full employment levels, and the appropriate short-term interest rate consistent with full employment. This rule suggests that the Fed should increase the interest rates in times of high inflation, or when employment is above the full employment levels, and should decrease the interest rates in the opposite situations.

MELTZER: Yes. I would really like the Federal Reserve to be required to follow that rule and to have an obligation inform Congress and the public of what it expects unemployment and inflation to be two or three years in the future. If it failed to meet its pre-announced targets, it would have to offer an explanation and resignations. That would be very helpful. Remember, what did that period from 1986 to 2002 do, when the Taylor rule was being followed? It produced the so-called Great Moderation, a period with low inflation, good employment, very short recessions and quick recoveries. It was a very good period. Why was it so much better? Fundamentally it was because instead of a very short-term response to what was happening every day in the market, Alan Greenspan had a longer-term strategy, and the Federal Reserve responded to both unemployment and inflation. It worked very well. That was a very good period, but unfortunately, they gave it up.

HORN: And disaster was the consequence. Didn’t Greenspan fail exactly because the Taylor rule was never officially adopted, i.e. because the Chairman kept a discretionary leeway that was totally contrary to the very idea of a fixed rule?

MELTZER: That’s true, but he did have a long-term strategy, and the failure was also due to the fact that they didn’t worry about credit. And the Fed also did something which I think was foolish. They changed the regulation, making prudence the responsibility of the regulators. The problem with that is that the regulators don’t have the incentives to regulate properly and in 2007/8 of course they didn’t do it properly. The Fed let the big banks set up subsidiaries which were able to hold mortgages. Before the crisis, all the big banks had not just one or two, but ten to twenty examiners looking at every transaction that the banks made. I once asked the chief examiner of the New York Fed how many transactions they did question and reject. The answer was: None.

HORN: Oh dear. But what needs to be done, according to you, in order to make the banking system safe and stable?

MELTZER: To make the banking system safe and stable, it is my idea that we need to introduce an equity capital requirement of 15 percent for banks. That’s what I want. In this I argue just like Martin Hellwig and Anat Admati in their famous book[3]. And the managers must get the right incentives, in such a way that if they are not careful enough and incur excessive risks, the principal stockholders will get a chance to say to them: “What in the name of goodness are you doing? Why are you taking these risks without the capital? Don’t do that!” Managers must be held responsible for the prudence of their bank, for being careful. The Federal Reserve and other regulators would just have the task of monitoring the capital requirements. Outside auditors would certify that the requirements are met.

HORN: Where do the 15 percent come from? Hellwig and Admati and others wouldn’t mind even higher ratios.

MELTZER: In the Great Depression, in the years from 1929 to 1932, the worst crisis ever, not a single large New York bank failed. Not one. The reason was that they held 15-20 percent of equity capital. By requiring banks to pay for their mistakes, the system gave bankers strong incentives to lend prudently. The problem was, as a matter of fact, that the examiners would go to the banks and look at the portfolio of loans, where everything was counted at face value. But the banks held railroad bonds, and those were going down. So the examiners would take into account that the railroad bonds were low in price, they would value them back and see that the bank was insolvent, and thus they would urge the bank to throw the railroad bonds on the market. And then they would go on to the next bank, and – surprise! – the railroad bonds would be even lower in price. Given this problem, President Herbert Hoover and Andrew Mellon, the Secretary of the Treasury, met with the large New York bankers and explained that they wanted to set up something they called the National Credit Commission. ,We are asking each one of you to give us 50 million dollars that we can invest in the capital of this commission, and it will buy the railroad bonds when they come on the market. That will make the market function better.’ In 1931, 50 million dollars was a lot of money. The bankers said yes: ,We are willing to do it, but life is uncertain, so if we get into trouble, we would like to be able to use this to borrow from the Federal Reserve’. But the Federal Reserve said refused. So this plan didn’t work. This was in the summer and fall of 1931. In the winter of 1932, Hoover then created the Reconstruction Finance Corporation instead, which was government agency doing the same thing. We knew at that point that the large banks not only didn’t have large losses, but they had 50 million dollars worth of idle capital. That’s where the 15 percent come from. No large New York bank at that time had less than 15 percent of equity capital.

HORN: But this lesson wasn’t learned forever. At the beginning of the 2007/8 crisis, the banks in the United States had less than 10 percent of equity capital on average.

MELTZER: In the hearings for the Dodd-Frank act I testified four times and I essentially told this story.

HORN: The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into federal law by President Barack Obama on July 21, 2010. It brought the most significant changes to financial regulation in the United States ever since the regulatory reform of the Thirties.

MELTZER: A little later, one day, the Republican senator David Vitter from Louisiana called me and asked whether I could come down and talk to his staff. He wanted to know what needed to be in a bill aiming to prevent future bail-outs. I said: ,15 percent equity capital against all the assets, without any of those weights that the banks use trying to play down their gains.’ And so they wrote the bill. Vitter got Senator Sherrod Brown, a liberal Democrat, to team up with him, so it was a bipartisan bill.

HORN: It is easy to see your influence there. Brown and Vitter were calling for institutions with more than $500 billion in assets to have equity capital equal to 15 percent of their assets. Banks with at least $50 billion, such as Fifth Third and BB&T, would have to set aside 8 percent. Community banks, those below the $50 billion threshold, would be exempt because they typically have large reserves. The bill hasn’t yet been successful. Why is that?

MELTZER: The big banks don’t like it, and I can tell you why they don’t like it: they benefit from the system, since they are too big to fail. So what has happened to the banking system is the following: because they are considered too big to fail, the large banks borrow in the money market at lower rates than anyone else. So the next-sized banks can’t compete. So what do they do? They sell out. That’s why Chase was bought by the Chemical bank and then merged with J.P. Morgan to become JPMorgan Chase; the Bank of America bought Countrywide Financial and Merrill Lynch; Wells Fargo bought Wachovia; and the PNC Bank in my city, Pittsburgh, bought a Cleveland bank. What has happened is that instead of having market shares of 15 to 20 percent of the lending market, the largest banks now hold 50 percent because they had become so much bigger. That’s not a good thing, because it’s less competitive. It’s to their advantage. I think that in the new Congress, we will have a chance.

HORN: Let’s come back to monetary policy. How important is it to have a clearly defined monetary rule? It’s certainly good for the public, because they will know what to expect…

MELTZER: … and for the central bankers as well, because they will know what to do. It works on both sides.

HORN: Yes, but on the other hand, discretion is very attractive: for central bankers, because it gives them leeway, and for politicians who try to influence the decisions of the central bank, because they want to be able to react to current events and see immediate results. If this is to be avoided by a rule, what kind of rule would you recommend?

MELTZER: Well, we are making a little progress in the United States. The House of Representatives has approved a rule. It is a good rule, even though it has some flaws. Its substance is the Taylor rule. The rule won’t force the Federal Reserve to use the Taylor rule explicitly, they can use any rule that they want, but the Fed would have to compare whatever rule it follows to the Taylor rule. That’s a good step in the right direction.

HORN: What are the chances in the Senate?

MELTZER: A few weeks ago, I got an e-mail that I never expected to get. It came from a member of the National Economic Council in the Obama administration, and he asked whether I would talk to them. I wrote back and said ‘of course’. So we had a conversation about what needed to be done. It went very well. In order to make clear my view I said to him: ‘you probably understand that I’m not very friendly to this administration’. And he answered: ‘Of course we know that.’ A few days later, I got another e-mail and he asked whether I would be willing to come to the White House and talk to him and his colleagues. And so I went. I wasn’t the only one they talked to, of course, they also talked to John Taylor and to Anat Admati, Martin Hellwig’s coauthor, and certainly other people.

HORN: Why were they doing this?

MELTZER: The Republican House of Representative had passed 300 bills that didn’t get through the Senate, because the head of the democratic Senate majority sat on the bills. This was before the election, but like most people everybody expected that the Republicans were going to take the Senate – and it was clear that the president wouldn’t be able to veto 300 bills. At one point in the conversation, they asked me: ‘If you were in our position, what would you do?’ And I said: ‘As you know, there are 300 bills. I would go through them, figure out which ones am I willing to compromise on, and I would then begin to work out my strategy for when the election is over.’ The heads nodded. In this sense, I am a bit optimistic that we will see some progress.

HORN: What makes you think that your bill, the Brown-Vitter bill, will be one of those that will pass?

MELTZER: You never know. Politicians always say that they’ll try to get a real problem solved, but those are only words, and we have to see what it means in practice. One thing is clear however: The Senate can’t veto 300 bills. They’ll have to make some changes to some of the bills, perhaps. But the Brown-Vitter bill, my bill, is one of the bills that are bipartisan, and therefore it has a good chance. We will pull up equity capital perhaps not to 15 percent, but higher than what it has been. In 2007/8, at the beginning of the crisis, some of the banks had only one percent equity capital. They met their capital requirement by borrowing money. They had high-quality bonds which they insured, so that a company like AIG was bearing the risks and the banks didn’t care about the risks they were taking. That was a stupid, unstable system. We have to get rid of that. Instead of making the regulator responsible, the incentives have to work in such a way as to make the regulated responsible for making sure that we have a safe system. The banks will have to bear the risk. That’s how the system works. They will want to earn enough to cover the 15 percent, but if they take too many risks doing this, risks that they will have to bear, they will get in trouble with their big stockholders who will say to them: “What are you doing with our money?”

HORN: Talking about money, please tell us why the Taylor rule is so good.

MELTZER: No system, no rule is going to work permanently. Life is just too uncertain. We have to allow for the fact that there will be days, weeks, or months, when the central bank will have to deviate from the Taylor rule or any other rule. The Taylor rule worked very well from 1986 to 2003, and it satisfies the political constraint of wanting to do something about unemployment as well as inflation, and politically, that is probably something that in America we have to admit. I cannot think that we would have anything different from that. There are people who say that they want to have a pure inflation target. But even when Otmar Issing was running the ECB, they had a inflation target, but they also paid attention to the unemployment rate as well. In a democracy, you have to pay attention to unemployment, because people care about it.

HORN: Issing once told me that in the beginning, he was very fond of the idea of having a fixed rule, and he especially liked Milton Friedman’s concept according to which money supply should be in tune with the long-term rate of GDP growth. Over time, however, he grew critical of the Friedman rule, because he realized that the underlying aggregates change their meaning over time, and that makes a policy based on them unstable. What is your take on this? Is discretion totally off-limits?

MELTZER: I regard myself as a good friend of Issing. He did a very good job at the ECB. Here is my answer. I have studied the one hundred years of history of the Federal Reserve. There is absolutely no question that the two best periods were the periods when they operated under a rule. As I said before, there will be times where you will have to deviate from the rule, and that’s OK. They will say that we are in a circumstance now where the rule doesn’t help us, but we will come back to the rule when we have found some stability. That’s fine. The Taylor rule has produced a very, very good economy. That was the best period we ever had. No discretion ever came close to that. It was discretionary policy that produced the Great Depression the Great Inflation and many periods of inflation and recession.

HORN: You mentioned earlier that the current economic models and theories mostly ignore money and credit.

MELTZER: Mine does. But all this has been lost. Back in the old days, Jim Tobin, who was a strong Keynesian, and Karl Brunner and I, who were not, both came up with models independently in which the transmission of monetary policy mainly went through asset prices. When you expand the money supply, the stock market prices rise, the housing prices rise, the existing asset prices rise. That makes it cheaper to build new assets, and so you get investment in housing and in capital. If you look at the huge increase in the stock prices in America, you don’t see the investment. Investment is the weakest part of the recovery. You see the rise in housing prices, but you don’t see a strong building effort. It is better, but it is not strong the way it has been in the past. Therefore I am very critical of them for not paying attention to credit. Instead, they worry about the Philips curve.

HORN: Why is that?

MELTZER: They argue that this is the only model in which you get a relationship between nominal and real variables. But that is simply not true. The Tobin model and the Brunner/Meltzer model does have a relationship between nominal and real variables, and it is one that seems to have a lot of evidential support too. The fact of not getting investment should worry the Fed! What we need is to improve the climate for investment, and that is a real problem, not a monetary problem. The two very good chairmen of the Federal Reserve in my lifetime, Paul Volcker and Alan Greenspan, both threw out the Philips curve. Volcker made public speeches, he told Congress, he talked to the public, he told the staff at the Federal Reserve that he didn’t trust the Philips curve. He had what I call the anti-Philips curve. He said the way to get more employment was low expected inflation. That’s the anti-Philips curve. Now they are back to the Philips curve at the Fed, it was under Ben Bernanke that they returned to it. That’s unbelievable: There is just enormous econometric evidence from very good scholars saying that the Philips curve is not very reliable. And nevertheless that’s what they use.

HORN: Hasn’t there been enough theoretical work and empirical evidence to show that the Philips curve doesn’t exist? Even Keynesians have recognized this. I’m thinking of Edmund Phelps’s work, which was more or less simultaneous to Milton Friedman’s attack on the Philips curve.

MELTZER: That’s right. Everybody has! And since that time, there has been a lot of work by good people who are neither Keynesians nor Monetarists, they are just econometricians, and they all show that the Philips curve is not reliable. So why pay attention to it?

HORN: Why do they?

MELTZER: Because they don’t know anything else.

HORN: Then you should talk to them!

MELTZER: Oh, I do, but they won’t listen.

HORN: What do you think about the way monetary theory has been developing recently?

MELTZER: I have great respect for Michael Woodford. He is a very smart and capable man. But I have no belief that what he does is right. Again, there is no money and no credit in his models. I asked him: ‘How can you throw away all monetary history and say it doesn’t matter?’ After all, monetary history is a history of money and credit. Woodford says it’s not important. How can you not look back to the crisis of 2007/8 and say that this was credit crisis. And now, what are they doing? Not at the Fed, but government. They put a 20 percent down payment on houses, and that was a good thing. When I bought my first house I was a poor assistant professor, and 20 percent was the rule, that’s what we had to put down. After the crisis, we went back to 20 percent. But now they lowered it again, and we are back at 3 percent, and so they are asking for the same trouble over again. Not even a decade has passed and they are back doing the same thing they did before.

HORN: Creating the next bubble.

MELTZER: Exactly. I mean, I understand the political pressure. Poor people owning their own house, that’s a very desirable thing, of course. But what does it mean? When you give them a house with a down payment of 3 percent, what do they own?

HORN: Exactly 3 percent, right? To conclude, let me widen our view. What do you consider to be most important economic challenge we face today? What is the most serious economic problem?

MELTZER: The most important thing is to continue the enormous progress we have made since WW II in raising living standards all over the world. We have lived through a unique period. In the history of mankind there has never been anything like the seventy years since WWII. More people and more countries have had their living standard raised. That’s the economic challenge: to maintain the progress. The political challenge of course is to maintain the peace. Without that, nothing else matters. In order to maintain the progress, however, we have to find humane ways to reduce the welfare state, because it is killing the productivity.

HORN: Are we on the right track in that respect?

MELTZER: No. Not at all. One of the biggest problems in the political-economic interrelation is that the politicians and the pressures from the public force very short-run solutions. We have to do something today, and that rules out finding solutions. Let me give you what I think is a telling example. At the end of WWII, we set in place the right institutions for free trade, long-term monetary stability, economic help to the underdeveloped countries – and that was a long-term program. But what is our long-term program now? There isn’t anything like that. We don’t have one. These days, all the countries are reacting to their near-term problems without really ever thinking about a long-term strategy that would tell us where are and where we have to go. That’s very hard on the young people, especially those people who don’t have jobs now. It’s terrible for them. Perhaps it will help if we can bring ourselves to pass the Atlantic and Pacific agreements on free trade. The free-trade strategy, as we know from experience, works very well. But we have to be very careful in negotiating the agreements that we don’t put so many restrictions on them that they actually won’t work.

HORN: This short-termism, the short-sightedness of government action, is indeed a standard predicament of democracy. How do you get a long-term strategy when government will be a different one in a few years’ time?

MELTZER: That is indeed a problem. For me, that’s the difference between where we were in 1945 and where we are today. We came out of the war with the determination to prevent the return of many of the pre-war problems. The result was establishment of institutional arrangements that attempted to restrict governments to follow rules. Bretton Woods is an example, but so was Nato and the Coal and Steel agreement. Unfortunately, the US did not act in a way that permitted the fixed exchange rate agreement to remain, and the continental European countries became free riders by cutting defense spending and free riding on US military strength. Today, the US and many other countries avoid medium-term strategies and respond to near term events and announcements. Switzerland is often an exception. The Swiss gain shows in several ways. One is that the franc was worth 20 US cents after the war. Recently it was worth 1.20 USD.

A German translation of this interview has been published in Perspektiven der Wirtschaftspolitik 16/2, 2015

[1] The Economist, 30. August 2014. http://www.economist.com/news/leaders/21614138-companies-must-be-punished-when-they-do-wrong-legal-system-has-become-extortion

[2] Allan H. Meltzer (2001, 2009), A History of the Federal Reserve, Chicago, 2 vols.

[3] Anat Admati/Martin Hellwig: The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It. Princeton University Press, Woodstock 2013.


Karen Horn is a German author, journalist and lecturer in the History of Economic Thought