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A COLUMN BY MICHAEL J. HICKS

Why Federal Reserve is a necessary, yet imperfect, institution

Front-runner for post has good handle on issues.

Tuesday, September 24, 2013 - 8:57 am

With Janet Yellen the clear front-runner for Federal Reserve Chair, rampant speculation regarding her approach to monetary policy fills blogs and editorials. That is silly, of course. The Fed is a voting body with clear minutes of the many meetings she has attended as a voting member. Moreover, Yellen, like any real scholar, leaves a long and transparent trail of research on an especially broad range of topics. There is little reason to speculate about her approach.

Despite Yellen's credentials and experience, there will continue to be criticisms of the Federal Reserve, both from the extreme left and extreme right. It is worth exploring these concerns.

From the left, the Fed is often disparaged for being too close to the banking industry. Many on the left detest bankers as venomous villains of capitalism and enemies of the poor. The barest accumulation of facts should defeat this viewpoint, but it is a visceral, not intellectual, position. The Federal Reserve, the biggest regulator of banks, maintains a think tank of some 600 economists who study banking and monetary policy. It could hardly be far removed from the banking sector and discharge its duties.

On the right, the Fed is viewed as a tacit enabler of the growth of government, and for that reason is to be distrusted. We Hoosiers should be especially wary of such silliness. The Fed was born of the inability of state and federal governments to finance the Civil War and Spanish American War. Nowhere was the folly of a weak banking system more apparent than in Indiana, where our governor, Oliver Morton, had privately financed the Indiana regiments who marched to save the union in the summer of 1861. His is the sole statue to appear outside our Statehouse.

The Federal Reserve is a necessary institution. It is also an imperfect one, and it is there where helpful criticism is warranted. The most salient concern about Fed actions is surely linked to its dual mandate of promoting full employment and maintaining low inflation. The fact is that these two goals are necessarily in tension.

Among economists there is no real disagreement about the nature of the problem: there is a trade-off between unemployment and inflation. The problem is that the speed and size of this trade-off is very uncertain, and there lies the policy criticism of the Fed.

We know that if the Fed increases the supply of money in circulation, this acts to artificially stimulate the economy, reducing unemployment but risking inflation. We also know that this only works in the short run. Eventually, inflation or even the fear of inflation will slow the economy and reduce employment. A mistake could lead us into a period of high unemployment and high inflation.

This is a powerful tool, and many argue that we should set clear rules that limit human discretion. Others favor thoughtful decision-making by an appointed body. Either way, the Fed chair needs to understand the research on these issues. Yellen does.

Michael J. Hicks, Ph.D., is the director of the Center for Business and Economic Research and a professor of economics in the Miller College of Business at Ball State University.