Thus, last Wednesday, Ben Bernanke discussed the possibility that if the U.S. economy performs well, the Federal Reserve would reduce and eventually stop its "quantitative easing" policy of buying U.S. Treasury bonds and various mortgage-backed securities. Everyone knows this needs to happen sooner or later, but Bernanke's comments raised the possibility that it might be sooner rather than later, and at least for a few days, stock markets dropped and broader financial markets were shaken.
Various blog commentaries and press reports referred to Bernanke's action as taking away the "punch bowl" (for example, here, here, and here).
The "punch bowl" metaphor seems to trace back to a speech given on October 19, 1955, by William McChesney Martin, who served as Chairman of the Federal Reserve from 1951 through 1970, to the New York Group of the Investment Bankers Association of America. Here's what Martin said to the financiers of his own time, who presumably weren't that eager to see the Fed reduce its stimulus, either:
"If we fail to apply the brakes sufficiently and in time, of course, we shall go over the cliff. If businessmen, bankers, your contemporaries in the business and financial world, stay on the sidelines, concerned only with making profits, letting the Government bear all of the responsibility and the burden of guidance of the economy, we shall surely fail. ... In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects--if it did not it would be ineffective and futile. Those who have the task of making such policy donl t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just
when the party was really warming up."
Monetary policy in the 1950s got a lot less attention than it does today: indeed, there was a significant group of economists who believed that it was completely ineffectual. The old story told by Herb Stein in his 1969 book, The Fiscal Revolution in America, was that President John F. Kennedy used to remember what Martin did by "the fact that William McChesney Martin was head of the Federal Reserve, and that "Martin" started with an "M", as did "monetary," so he knew that monetary policy was what the Federal Reserve did. (Apparently he was not bothered by the fact that "fiscal" and "Federal Reserve" both start with an "f".)"
But Martin viewed monetary policy very much as a balancing act. As he once said in testimony before the U.S. Senate: “Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing.” (In the Winter 2004 issue of the Journal of Economic Perspectives, where I've been managing editor since 1986, Christina Romer and David Romer wrote "Choosing the Federal Reserve Chair: Lessons from History," which puts Martin's views on monetary policy in the context of other pre-Bernanke Fed chairmen.)
Martin held the view that monetary policy could be useful in reducing the risk of depressions and inflations, but that it wasn't all-powerful. In the 1955 speech, he said:
"But a note should be made here that, while money policy can do a great deal, it is by no means all powerful. In other words, we should not place too heavy a burden on monetary policy. It must be accompanied by appropriate fiscal and budgetary measures if we are to achieve our aim of stable progress. If we ask too much of monetary policy we will not only fail but we will also discredit this useful, and indeed indispensable, tool for shaping our economic development. ...It seems to me that at least some of the current discussion of the Fed has a similar tone to what Martin is describing of exaggeration in both directions. Some critics argue that the extraordinary monetary policies undertaken since the later part of 2007 are useless. On the other extreme, other critics argue that if only those extraordinary policies had been pursued with considerably more vigor, the U.S. economy would already have returned to full employment. In other words, the Fed is either ineffectual or all-powerful--but the truth is likely to exist between these extremes.
"Nowadays, there is perhaps a tendency to exaggerate the effectiveness of monetary policy in both directions. Recently, opinion has been voiced that the country' s main danger comes from a roseate belief that monetary policy, backed by flexible tax and debt management policies and aided by a host of built-in stabilizers, has completely conquered the problem of major economic fluctuations and relegated them to ancient history. This, of course, is not so because we are dealing with human
beings and human nature.
"While the pendulum swings between too little or too much reliance upon credit and monetary policy, there is an emerging realization more and more widely held and expressed by business, labor and farm organizations that ruinous depressions are not inevitable, that something can be done about moderating excessive swings of the business cycle. The idea that the business cycle can be altogether abolished seems to me as fanciful as the notion that the law of supply and demand can be repealed. It is hardly necessary to go that far in order to approach the problems of healthy economic growth sensibly and constructively. Laissez faire concepts, the idea that deep depressions are divinely guided retribution for man's economic follies, the idea that money should be the master instead of the servant, have been discarded because they are no longer valid, if they ever were."
My own sense, as I've argued on this blog more than once is that that extraordinary monetary policy steps taken by the Fed made sense in the context of the extraordinary financial crisis and Great Recession from 2007-2009, and even for a year or two or three afterward. But the Great Recession ended four years ago in June 2009. The extreme stimulus policies of the Fed--ultra-low interest rates and direct buying of financial securities--don't seem to pose any particular danger of inflation as yet, but they create other dislocations: savers suffer, and some will go on a "search for yield" that can create new asset market bubbles; money market funds are shaken; and banks and governments that can borrow cheaply are less likely to carry out needed reforms. And of course, there is the problem of economic and financial problems that arise when the Fed does take away the punch bowl. For discussion of these concerns, see earlier blog posts here, here, here and here.
My own sense is that there are times for monetary policy to tighten and times for it to loosen, and the very difficult practical wisdom lies in knowing the difference. In a similar spirit, Martin started his 1955 speech this way: "There's an apocryphal story about a professor of economics that sums up in a way the theme of what I would like to talk about this evening. In final examinations the professor always posed the same questions. When he was asked how his students could possibly fail the test, he replied simply, ''Well, it's true that the questions don't change, but the answers do.""