The most dangerous idea in central banking, explained

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Donald Trump standing at a podium.

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A former top Fed official calls for monetary policy to sabotage Trump.

Former New York Federal Reserve President William Dudley thinks the Fed should “refuse to play along” with President Donald Trump’s game and stop offering monetary stimulus that offsets the economic damage of Trump’s trade policies.

It’s a striking thesis, and articulating it publicly will almost certainly further stoke President Trump’s paranoia about what’s happening at the Fed.

It’s also not a thesis that has much support. The leading Fed watchers on the left immediately denounced Dudley’s proposal, and obviously, conservatives are not going to embrace the idea that the Fed should sabotage Trump.

But while Dudley’s suggestion is a little wild, it’s worth understanding that it’s far from unique. Something broadly similar to Dudley’s ideas — though focused on the budget deficit rather than trade — was central to American politics in the early 1990s and again to the dynamics of the eurozone crisis in the early part of this decade.

In other words, while the Fed is extremely unlikely to adopt Dudley’s views, that’s probably in part because Dudley is a Republican and, historically, disciplinary monetary policy has been used by central banks to constrain the left.

That doesn’t mean progressives should fight fire with fire, but it does mean they should give some thought to how they might plan to counter this kind of strategy the next time they get a chance to govern the country.

Dudley wants the Fed to punish Trump

Dudley writes that Fed policymakers “place little weight on how their actions will affect decisions in other areas, such as government spending or trade policy,” and says this is good because “staying above the political fray helps the central bank maintain its independence.”

Conventional wisdom is that this exact same logic applies to Trump’s trade war with China.

The Fed’s tools can’t fully offset the harms of trade disruption, but they can partially offset them, and to the extent the Fed can help, it should. That’s what Fed Chair Jerome Powell said at Jackson Hole — and even though the observation that the Fed actually can’t fully undo the harm seems to have sent Trump into a paroxysm of rage, it reflects a responsible outlook on the Fed’s role in the government.

But Dudley wants a new approach. He argues that the Fed should “state explicitly that the central bank won’t bail out an administration that keeps making bad choices on trade policy, making it abundantly clear that Trump will own the consequences of his actions.” He claims this would have three benefits; deterring further escalation of the trade war, demonstrating the Fed’s independence, and leaving it with more room to cut rates in the face of some other problem in the future.

And then Dudley gets really extreme, arguing that “Trump’s reelection arguably presents a threat to the U.S. and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives,” and that “if the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will affect the political outcome in 2020.”

This is a drastic overreach of the Fed’s mandate

Obviously, no government institution is ever truly “above politics” in the way that most institutions like to claim to be.

But the notion that the Fed’s mandate to achieve good economic outcomes extends to the point where it should try to deliberately sabotage the reelection of bad presidents gets into fairly outrageous territory. CIA officials and the top military brass have professional responsibilities to advance American national security. Since elections have serious national security implications, one could take that as a license to sabotage the reelection campaigns of presidents whose policies they disagree with. But while national security officials do, in fact, sometimes meddle in partisan politics — it appears that the threat of FBI leaks was an important part of the calculus leading to James Comey’s infamous letter to Congress about Anthony Weiner’s laptop — this is bad behavior that should be discouraged, not extended to a broader set of agencies or publicly valorized by influential former senior officials.

Nobody is really embracing Dudley’s view, which was immediately denounced by Employ America’s Sam Bell and everyone else I follow in the niche world of progressive monetary policy.

Dudley’s milder suggestion that the Fed shouldn’t try to offset the harms of trade war is not quite as problematic as the idea of manipulating election results, but it still goes well outside the Fed’s actual legal mandate. The central bank is supposed to aim for a balance of maximum employment and low and stable inflation. It’s true that trade wars make it harder to do this, but that’s no reason not to try.

After all, no president pursues perfect economic policy, and no Fed chair has perfect insight into which economic policies would be perfect anyway. Central bankers stepping outside their mandates and trying to control other aspects of economic policy has a history, but it’s not a particularly appealing one.

There is a real history of central bank meddling

Back in 1993, Fed Chair Alan Greenspan made it pretty clear to the then-new Clinton administration, the Democratic majority in Congress, and the public that he wanted a policy focus on deficit reduction. Indeed, even after Democrats pushed an unpopular deficit reduction package through — one that paired tax increases with a broad range of spending cuts — he kept publicly agitating for more deficit reduction.

In a narrow sense, this worked.

Historians and journalists have documented that President Clinton was often frustrated with Greenspan, but unlike Trump, he kept his criticisms quiet. The deficit fell, Greenspan delivered growth-supportive monetary policy, the economy boomed, and Clinton was very popular by the late 1990s. But in part because of the focus on deficit reduction, he didn’t have much in the way of signature progressive policy achievements. And then when George W. Bush became president, Greenspan changed his view on deficits and suddenly became a huge fan of regressive tax cuts.

This, of course, is part of a larger policy seesaw. The Reagan administration opened up huge deficits thanks to regressive tax cuts. The Clinton administration closed those deficits with a mix of tax hikes and spending restraint. Then Bush opened up huge deficits with regressive tax cuts. The Obama administration closed them with a mix of tax hikes and spending restraint. And now Trump is opening up huge deficits with regressive tax cuts.

If regressive tax cuts were actually paired with spending cuts, they would be unpopular and wouldn’t pass. But if you let Republicans explode the deficit and then pressure Democrats to narrow it, you can obtain a sustainable tax-cutting agenda. And, indeed, back in 2010, Bush-appointed Fed Governor Kevin Warsh openly called for the Fed to take a more punitive approach to the Obama administration’s policies. Former St. Louis Fed President William Poole made the same argument in a piece for the Cato Institute in 2012.

At around the same time, the European Central Bank was actually putting these ideas into practice in an extremely dangerous way.

As Philipp Rösler, at the time vice chancellor and economics minister of Germany, explained, “if you take away the interest rate pressure on individual states, you also take away the pressure for them to reform.”

ECB officials were not quite so bold in their public statements, but informal discussions with officials in Frankfurt made it clear that this was their thinking, too.

Pro-growth monetary policy was supposed to be a reward for good behavior, something to deliver after countries like Spain and Greece made policy changes (primarily pension cuts and making it easier to fire workers) that ECB officials approved of. Simply delivering pro-growth monetary policy was seen as an unworthy bailout of bad policy. Unlike Greenspan’s efforts, this was not really effective at producing reform — it mostly just made millions of people poorer and set European politics on a course of destabilization and far-right populism.

Progressives should take this threat seriously

The Fed is not going to do what Dudley suggests for three clear reasons:

  1. Virtually everyone on the Board of Governors is, at this point, a Trump appointee who has no reason to want to sabotage Trump’s reelection.
  2. The business community, which does want Trump to chill out with the trade stuff, likes Trump overall thanks to his regressive tax cuts and lax regulatory enforcement, so there will be no interest group support for the idea of sabotaging Trump.
  3. Progressive monetary policy thinkers don’t like this idea, and nobody is calling for it.

The real risk of central bank meddling is not during the Trump administration, but during the next administration. At that time, the constellation of forces will be totally different. The board, for starters, will be mostly Trump-era holdovers. And if Trump’s successor is a progressive, the business community will be eager to restrain new left-wing policy ideas. The conservative policy community also takes a different view of such matters. While progressives who favored pro-growth monetary policies under the Obama administration have generally continued to support them under Trump, conservative think tanks and policy organizations spent the Obama years denouncing monetary stimulus.

Clinton’s administration navigated these shoals largely by bending to Greenspan’s preferences, which worked in a narrow sense but handicapped progressive governance.

Obama-era tensions were muted by the fact that the White House team sincerely wanted to prioritize deficit reduction, and his first-term Treasury secretary, Tim Geithner, was himself a former top Fed official who was not that enthusiastic about monetary stimulus.

But whether the next president is Joe Biden or Bernie Sanders or Elizabeth Warren or Kamala Harris or someone else, they will likely want to prioritize expansion of health insurance coverage or investments in reducing greenhouse gas emissions. And to do that effectively, they’ll need to be prepared for the possibility of winning a political fight with the Fed.