And Still More

With regard to the Volcker recession in the early '80s, this was clearly a case where monetary policy did make a difference, albeit not one that we would want to repeat. Randall Wray puts this incident in perspective:

Milton Friedman played the biggest role in promoting the Fed as the all-powerful Wizard of Oz, spinning dials and controlling the money supply which then determines output and employment. However (according to Friedman), the Fed is not to be trusted, hence, should be constrained by a constant-rate-of-growth-of-money-supply rule. This was finally tried in the disastrous early 1980s great monetarist experiment run by Fed Chairman Paul Volcker (simultaneously attempted in Thatcher’s UK). I say disastrous because it wiped out half of our thrifts (home mortgage lenders-but not before helping to set off a wave of fraud that was the subject of Bill Black’s book). By the mid-1980s the Fed had given up money targets, and had also abandoned the Friedmanian myth that money and output are closely correlated-with money driving output.

In truth, central bank policy has always determined the overnight interbank lending rate (the fed funds rate in the US). Leaving to the side regulatory and supervisory power, that really is all the central bank does. There is no evidence that changing the overnight interest rate (within the usual range) has any significant or predictable impact on the economy. It truly is a Wizard of Oz-if one recalls that the Wizard behind the curtain actually had no power at all. What is unfortunate is that for a very long time policymakers believed that economic policy could be left to the “omnipotent” Fed-which means that the truly powerful fiscal policy has been neglected.