Oct 2, 2019

Jim Dorn on the History of Monetary Policy in Washington D.C. and its Future

David Beckworth Senior Research Fellow , Jim Dorn

David Beckworth: Our guest today is James Dorn. Jim is a vice president for monetary studies at the Cato Institute, and is the director of Cato's annual Monetary Policy Conference. He has written widely on Federal Reserve policy and monetary reform. He has also edited more than ten books, including The Search for Stable Money, and The Future of Money in the Information Age. Jim joins us today to discuss the history of monetary policy in Washington D.C. over the past four decades, as well as some of his own recent work. Jim, welcome to the show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

Jim Dorn: Thank you, David.

Beckworth: Great to have you on. Now, I kind of cut my teeth on monetary policy reading some of your work in the Cato Journal, and the authors you've published there, and your conferences. I remember in grad school coming to your Cato Monetary Policy Conference, it was a real treat, and the thing that's neat about this is it's been going on for 36 years. And 37th in the fall here. But 36 years of monetary policy in Washington, D.C., so you've kind of seen the ebbs and the flows of the interest, and the developments in monetary policy. Is that fair?

Dorn: Yeah. When I first started, the first conference was in 1983, and of course what you had was you're in the great inflation period, and stagflation, and very volatile monetary policy. Stop-go monetary policy. So, the first conference was on the search for stable money, and that topic is still relevant today, but it was even more relevant at that time, because of the erratic monetary policy that was being conducted.                             

After that, of course you had the Great Moderation with Greenspan, and I would say interest in monetary policy diminished somewhat, and the Phillips Curve was dead, or we thought. It has nine lives, apparently. And I remember Allan Meltzer, who came to many of our monetary conferences, and was a good friend, as was Karl Brunner, his co-author on many projects, Karl and Allan actually canceled one of the Shadow Open Market Committee meetings during the Great Moderation, because they said, "We don't need to meet. The Fed's doing everything pretty well."                               

And of course, their whole function was to be critical of Fed policy, so that's an indicator of how things changed after Volcker basically tightened monetary policy, and we got back to a fairly stable price level. And then of course the Great Recession came about, and the crisis of 2008, and everything perked up again with respect to rethinking the whole framework for monetary policy, and of course the Fed adopted a new operating framework, and a lot of people that studied economics back in the 70s and 80s, if they didn't read about what was going on now, they would have no idea of how monetary policy is conducted.                                        

And my colleague George Selgin, of course, has done a lot of work on the floor system. So, I think right now, I've never seen really anything like what's happened since 2008, with the huge increase in the power of the Federal Reserve. Starting with TARP, and then quantitative easing, interest paid on excess reserves, a new operating system, all of the new regulatory issues. I doubt that the Shadow Open Market Committee would cancel a meeting now.

Beckworth: Right. Well, how does this compare to the early 80s? So, you mentioned your first conference was in the early 80s, so Paul Volcker's leading the Fed. There's a double-dip recession. It's very intense. In fact, the unemployment rate actually gets higher than what we saw in 2008, although it was a shorter recession, much sharper recovery. Were people as cynical, and as concerned and critical of the Fed then as they are now?

Dorn: Oh, definitely. In fact, we had inflation rate peaking pretty much in about 1980, 13 percent or so. The federal funds rate, nominal federal funds rate was almost 19 percent at one point. Mortgage rates were very high. Nixon put on the wage price controls, of course, in 1971. August, 1971. And then the Bretton Woods system, the gold window was closed in 1971, and then in 1973, Bretton Woods faded away, basically, so you had a different type of international economic system, and we did a lot of work on that, as well.                               

But I remember at our first conference, the keynote speaker was Fritz Machlup. This was actually his last speech, and the title of his speech was “The Political Economy of Inflation.” He talked a lot about inflation, and Karl Brunner gave a talk, I think it was a luncheon talk, or maybe the dinner talk, and Karl's talk was on “Has Monetarism Failed?” Because you know they were targeting the money supply for a while, and that seemed to work okay, but it faded away, too, because congress basically never put teeth into the law, and the Humphrey-Hawkins Act was passed, but the monetary targets that were in the Humphrey-Hawkins Act, they were voluntary targets. You had to say why you might have missed them.                                        

The Fed chair had to testify twice a year. They still do that, but they don't talk about money supply targets anymore, and the link between money, and prices, and income was weakened considerably by the now accounts, and sweep accounts, and things like that. So, at that time, there was a lot of criticism of the Fed for not following a monetary rule of some sort. Especially the monetarists, so Brunner argued that no, monetarism hasn't failed. It hasn't really been tried per se.                                        

And what he meant by monetarism goes back to David Hume and others, is simply that money and variations in its quantity, relative to the demand for money, is a fundamental cause of inflation and business fluctuations, as Clark Warburton pointed out as well, much later. So, I think that underlying our conference was the idea that we wanted to improve the monetary regime. We wanted to widen the range of debate on monetary issues, and we wanted to get the best people around to get engaged in that debate, and we were successful on all those grounds, and also to get a diverse group of people, including many people, high-level people from the Fed.                                

We had Greenspan speak at three conferences over the years when he was in office, and then we had Bernanke speak, and many other Fed officials, and so on. So, we tried to expose them to other ideas that they wouldn't get over at the Federal Reserve Bank. Including Leland Yeager's idea for a forecast-free monetary regime, and George Selgin, Larry White on free banking issues, so we were trying to educate people, too, on sort of Hayek's view of monetary policy, competitive currencies, but in a friendly environment, rather than a hostile environment.                                        

And I think we've been very successful at that, and I think it's very important to take a rational view, and to allow monetary alternatives to be discussed in a high-level conference like our conference has become.

Beckworth: Yeah, you've had some really interesting personalities there. You mentioned some of them, but you've had also Robert Mundell, you mentioned Karl Brunner, Anna J. Schwartz, Milton Friedman. In fact, you had a conference for Milton Friedman, kind of looked back at his great monetary history with Anna J. Schwartz, and reflected upon what they had learned since then. Greenspan, Ben Bernanke. I believe at the Ben Bernanke conference, he actually introduced the Summary of Economic Projections at that particular conference. Is that right?

Dorn: When he spoke at one of our conferences early on, the title of his talk was “The Fed's Road Toward Greater Transparency.” And I believe he did introduce the Summary of Economic Projections at that conference.

Beckworth: Yeah. Big innovation at the time.

Dorn: Yes. Yeah, so that was... It got a lot of press coverage, and the Summary of Economic Projections, if we project forward from that conference... In our last conference, we had Jeffrey Frankel speak, from Harvard, and Jeff, as you know, is sympathetic towards a nominal GDP targeting type regime. But he also made a very good suggestion, and that was to add to the Summary of Economic Projections a line which would give a projection on the growth rate of nominal GDP, which is the sum of the growth rates, of course, of inflation and real economic growth.

They list those separately now, but he thought some measure of total spending, a single variable, should be listed, so that we could look at that, and if we think in terms of maybe you want three percent real growth and two percent inflation, so you want a level targeting of five percent and if you miss that, you can make up for it. That would be a good thing, because you could basically, even if you didn't have a firm rule, you could look at that and…It would give you a better stance of monetary policy than just looking at short-term policy interest rates.

Beckworth: Yeah, I was at that conference, and it really was I think a clever way to make that point front and central. I mean, I think he proposed putting it at the very top of the SEP, so first thing you see is nominal GDP forecast. Let me go back to the early 80s. I want to just spend a little bit more time there, because I am really not old enough to fully appreciate everything that happened, other than what I've read in books.                                        

And I guess I want to get a sense, so in the early 80s, when you had this first conference, and there were a lot of great monetarists there, as you mentioned, was the critique more about the Fed and the government allowing this kind of unmoored inflation taking off, or was the critique more about the severe pain? I mean, really, really sharp recession that Paul Volcker engineered, and some would say he didn't have to do it so intensely, but was there debate on both those points, or one more than the other?

Dorn: Well, what happened actually was the Phillips curve mentality was greatly diminished by people speaking at that conference, because you had stagflation. You had high unemployment, and you had inflation which was a result of very rapid money growth before Volcker started to tighten things up under Arthur Burns. And Burns, by the way, not only was he chairman of the Federal Reserve during Nixon's wage price controls early on and so forth, and he gave Nixon the monetary policy that he wanted. He also gave Carter the monetary policy he wanted in the early Carter Administration.

And in fact, Burns was on this Committee on Investments and Dividends, CID, which a lot of people don't remember. He was appointed chairman, and what he did on that commission, his task was to keep interest rates low. So, he didn't have to worry about inflation, because inflation was repressed by the price controls. And meanwhile, he could promote low interest rates.                                        

What happened was you had a lack of credibility at the Federal Reserve. The Federal Reserve's reputation was highly tarnished, and it lost its independence to a large extent, and it wasn't congress that dodged things, it was the fact that the executive branch, including the Treasury Department, which was spokesman for the White House. Connally, in particular. They wanted low interest rates, and they got what they wanted from the Fed chairmen. And Volcker, when he came in, changed that around, because Reagan wanted to allow him to tighten the money supply and get rid of the inflation, and they thought in long-term sense that once they got the inflation under control, then the markets could operate more smoothly, and unemployment should revert to a more natural level. And that's exactly what happened.                                        

So, the Fed gained credibility, tremendous credibility under Volcker. It had lost it before that. Bob Weintraub, who spoke at our conference a number of times, and was on the... He was an economist for the Subcommittee on Domestic Monetary Policy. He wrote a very important article back in 1978, in the Journal of Monetary Economics, which discussed the congressional... how the congressional committees and so forth operated to try to guide monetary policy. And of course, they had the resolution 133 back in ‘77, I think it was, and then Humphrey-Hawkins was passed, that made the Fed responsible for having these monetary targets, and reporting to congress.                                        

But what Weintraub pointed out was that that wasn't sufficient, because the presidents still got what they wanted pretty much after that. And the Treasury-Fed Accord of 1951 was never a done deal. The Fed has always been under tremendous pressure to finance deficits, and that happened during the Johnson Administration with the war in Vietnam, and the War on Poverty, and Johnson wanted... Just like Trump, he wanted low interest rates, spur the economy, so he'd get reelected.                                

Things haven't changed very much in that sense. We still don't have a monetary rule. It's still a pure discretionary regime. During the Great Moderation, we sort of had an implicit demand rule. Bill Niskanen has written about this, and of course John Taylor, with his rule. But we don't really have that today at all, so there's a lot to be worried about today with respect to the uncertainty of monetary policy.

Beckworth: I recently had Robert Samuelson on the show. [He] writes for the Washington Post now, and he has a book on the Great Inflation. Part of the book covers the wage controls, price controls, and I think it's an important point to highlight, that we've tried them before and they didn't work, because there has been suggestions, let's try them now. Let's push the limits. Some advocates of MMT, for example, but even others have said, "Let's really push, push, push fiscal capacity, and if inflation rises, we can have these other tools."                                        

I think it's important to remember we tried them before. They didn't work out so well. But just one last, again, takeaway from that early first conference. By the time you guys met, was Paul Volcker a revered hero? Was it recognized what he was doing, and was there gratitude? Ah, finally someone who's bringing some order to monetary policy, or was it too early in the experiment, still?

Dorn: Everybody hated Volcker.

Beckworth: Oh, they hated him. Okay.

Dorn: Oh yeah.

Beckworth: Even the folks at the conference.

Dorn: Not at the conference so much, but the general public. I mean, the backlash-

Beckworth: Enemy number one.

Dorn: Because of the high unemployment rate. And we had a recession, significant recession, but Volcker stuck to his guns, and that's what you have to do. You have to stick to your guns, and Reagan allowed him to do it, to his credit.

Beckworth: Yeah, but at your conference, and these monetarists in ‘83 were like cheerleading, supporting the steps that he had been taking at that point.

Dorn: Yeah. Beryl Sprinkel was there. Other people. I think Jim Meigs might have been there. Anna Schwartz. Karl Brunner. Meltzer.

Beckworth: All right. All right.

Dorn: Yeah. They thought they were doing the right thing. They might have changed the target a little bit, the way they targeted it-

Beckworth: Sure, but they-

Dorn: But they were happy with what they were doing.

Beckworth: Well Jim, in some small part, you gave Paul Volcker a vote of reassurance through the conference. Let him know he's not alone during that tough time. All right, let's move forward in time. Always want to touch on some of your other conferences you had, just because they're interesting, and again, they speak to the ebb and flow of interest in monetary policy.                    

Again, I was looking through your past issues of the Cato Journal, so all these conferences are published in one of the issues of the Cato Journal during that year or the following year. And you had a conference in ‘84, I believe, on debt. “World Debt and Monetary Order.” So, tied to this double-dip recession were all these emerging markets that had huge debt burdens, dollar-denominated debt burdens. They crashed. Eventually we get their Brady bonds out of all this. But that must have been interesting times, too, talking about the struggling Latin American countries that had to bear the burden of the recessions.

Dorn: Oh, absolutely. Argentina, other countries. I actually did a book down in Argentina on the debt crisis down there. It was published in Spanish down there, but our conference was on dollars, deficits, and trade, and Bill Niskanen and I actually edited a book on that. We had people like Rudi DORNbusch in the book, and Jan Tumlir. And the problem with the twin deficits, fiscal deficit and trade deficit and so on, and one of Greenspan's talks actually was on the evolving U.S. payments imbalance.                      

So again, we're... What's Trump talking about? Trade imbalance and so forth. Although Greenspan was much more knowledgeable about this, and took a fairly rationale approach on it, and Greenspan also gave a talk later on on monetary policy in the face of uncertainty. And that's one thing that a lot of the monetarists and others were emphasizing. The great degree of uncertainty in a regime that's based more on discretion than on some type of rules. The international system now, of course, one of the big things... At another conference we had in London, actually, we had a conference in Mexico City, and we had a conference in London.                                

The one in Mexico City was on monetary arrangements in the Americas after NAFTA, so that was an important conference.

Beckworth: Interesting.

Dorn: And Roberto Salinas Leon, who's an old friend, he and I edited a book on that, and we had a lot of internationally-known economists at that conference, as well. But the one in London was on global monetary order. It was interested in... That was back in 1990, so we discussed the Euro, and the emergence of the Eurozone. Sir Alan Walters was there. He gave one of the keynote talks. He was very skeptical of creating the Euro.                                        

Anna Schwartz was, too, because there was never really a solid monetary union without a prior political union, and they saw political problems arising from the Eurozone.

Beckworth: So this is 1990, you guys were discussing the challenges of moving towards the Euro.

Dorn: Yeah. And we had-

Beckworth: Very critical view back then.

Dorn: And we had another major conference on the Euro, actually in the United States. But yeah, so the conferences not just looked at domestic monetary policy. We were interested in global monetary policy, and John Taylor just gave a paper on a rules-based international monetary regime. Now, Karl Brunner had an idea a long time ago. In fact, he wrote about this back in the 1980s. He wanted a club of global financial stability, and his prescription was basically that we shouldn't look at coordination among governments, forced coordination among governments. Each major player should have their own domestic monetary rule, and then they could join this club, and it would be a club of major countries, similar to Bretton Woods, but this would be based upon a domestic monetary rule that would guide the long-term growth of the money supply.                               

In fact, if you look at section 2A of the Federal Reserve Act, as amended in 1977, section 2A now reads even different than that. The one in ‘77 had a clause in there about letting the monetary aggregates, money and credit growth should be consistent with long-run real growth. It's a monetary rule in a sense, and the ‘77 amendment basically said, "Okay, this is what... They should have targets and things like this, but nobody can be held accountable. The Fed can change its mind. Just has to say why it changed its mind."                                        

Okay, so later on, they took that clause out. If you read section 2A today, it just says, "Commensurate with money, the monetary aggregates should grow commensurate basically with real output growth. And this will help us achieve the goals of stable prices, maximum employment and long-term interest rates that are kind of normal. Moderate long-term interest rates." So, a lot of the people saw that as long-run goals, but Fed policy had been very myopic, and that's because most of the... A lot of the presidents have been myopic. They want to get reelected. Congress, myopic.                           

So, there's been some movement in the last several years... In fact, Brady wanted to... He introduced legislation, and Hensarling did also, to have basically a centennial commission on monetary policy, to talk about rules, and suggested... in some of the legislation, actually suggested a rule. It would be a benchmark rule, sort of like a Taylor rule, but nothing has become of that yet.

Beckworth: I know the FORM Act was a big part of that conversation, at least.

Dorn: That's right.

Beckworth: And I know there's been a lot of discussion about that. You just alluded to something interesting. You alluded to the Fed being influenced by all these presidents, and you had a conference on this idea about political business cycles. So, maybe just summarize for our listeners, what is a political business cycle?

Dorn: Well, a political business cycle is motivated by the election cycle, and the presidents want an accommodative monetary policy to keep the economy expanding, which means they want low short-term interest rates, at least, if not long-term interest rates, which we get now through... or at least try to get through quantitative easing and things like that. So, there's been a lot of debate on political business cycle, because some people find that the Fed exercises independence, and under some presidents you get kind of a political business cycle, like Burns with Nixon, and Carter, and so forth. Johnson.                                

And then others you don't, like with Volcker, with Reagan. Weintraub wasn't looking so much at a political business cycle in some of the work he was doing. He wasn't saying that the Fed always caters to ease money and so forth during election. What he was saying is the Fed ultimately, it seems, bows to the executive branch, and to the White House, so if Reagan and other presidents, like Eisenhower, for example, wants stable money, lower inflation, they'll get that. If other presidents want high money growth, low interest rates and so forth, they can get that.                               

Now, Greenspan was probably the best, in the sense that he had this Great Moderation, and he followed kind of an implicit rule. When he went away from that, and they held interest rates too low for too long, as Anna Schwartz points out in the early 2000s, that helped lay the basis for the financial crisis. They've never admitted that, but I think you can make... That's part of the deal. That's part of the argument, possibly.                                        

Right now we have real interest rates that are negative, and that does not seem to be the natural state of affairs, because even though demographics and other things might lead to lower natural rate of interest, let's say, you wouldn't expect a negative Wicksellian-type interest rate, because as long as time preferences are positive, and as long as capital has some positive productivity, you could argue that interest rates, real interest rates should not be negative.                                        

When you get real interest rates are negative, and then you get an inverted yield curve, something's upside down. It doesn't seem right. And these are things that of course we're concerned about right now, but it goes way back into the monetary history literature, and one thing-

Beckworth: Well, let me ask this about the political business cycle if I may.

Dorn: Sure.

Beckworth: What you're suggesting is that even that idea, kind of it ebbs and flows of independence, so Greenspan seemed to have crafted some independence for the Fed, became the norm, whereas before him, maybe not so much. We take it for granted. And now Trump seems to be kind of chipping away at some of that independence, and as you said, the president wants low interest rates going into an election, which has been something that's happened before. Trump is not the first president to want this, it's just that we haven't seen it past few presidents.                             

So, we shouldn't be surprised, but maybe disappointed.

Dorn: Yeah, well, Trump obviously has been much louder than other presidents. Calling the Fed's policy very destructive, and ridiculing the quantitative tightening, and everybody hears it, okay? They used to do it in private. Lyndon Johnson might get somebody out at the ranch and corner him.

Beckworth: Right. I've heard that story. Got him up against the wall, physically threatened him.

Dorn: Yeah. But the Fed seems to be more swayed by the Wall Street stock market, and you look at for example in December, when they increased... the Federal Open Market Committee increased the target range by 25 basis points, basically, so it's between two and a quarter and two and a half percent. And that was the fourth increase in 2018. Trump didn't like that at all.                             

Now, they were worried about different things, but in January at the American Economic Association, when I was there, and Janet Yellen, and Ben Bernanke, and Jerome Powell were all on stage, and Powell got up and he started talking about, "We need to be patient." Because the markets tanked after they increased the rates in December, as you remember.

Beckworth: Yep.

Dorn: And the Fed's changed its stance since then. Now, I think there's probably a pretty strong argument that the December rate increase was a mistake. If you look at the growth rate of nominal GDP, it was about five percent at that time, which would be about what you'd want it to be. And therefore, the way monetary policy is run now, it's totally data dependent, but data changes, and it's revised and so forth, and nobody can predict the future. I mean, interest rate forecasting has been a disaster for the most part. Nobody's been close. Nobody was predicting at the beginning of the year what long-term rates would be now.

Beckworth: Two percent. Right.

Dorn: Yeah, so those long-term bond rates, by the way, may be due to the fact that things are bad in Europe, too, and other places. But you have negative real rates in Europe, so-

Beckworth: Yeah, that's a question I was going to ask. You argued earlier that negative real rates seem unnatural, but if I look around the world, it seems to be fairly common, and in many cases with central banks tightening, they're not easing, so maybe... Is there any argument to be made that it is... something natural is causing this to happen globally?

Dorn: Well, I think it's the policy of the banks, themselves, that are forcing rates... charging people, for example, in various countries in Europe, rates to hold deposits at the central bank. Instead of paying them, like we do, interest on excess reserves, they're charging them. So, when you do that, you can basically call that a negative interest rate. It's not due to natural forces or anything.

Beckworth: What about the longer 10-year yields, like Switzerland, Germany, those countries have negative 10-year nominal yields, right?

Dorn: Yeah.

Beckworth: Doesn't that seem more market-driven on the long end?

Dorn: Yeah, I think it probably is somewhat market-driven. Although quantitative easing has probably led... The first batch of quantitative easing didn't have much effect, but later on, Gagnon and other people have done empirical work to show that the quantitative easing was one reason that longer-term rates went down. Forward guidance is another reason, because if you keep short-term rates... If you think the longer rate is propelled by short-term rates, and expectations, if the expectations that rates are going to be held lower for longer through forward guidance, that could affect market sentiment and so forth.                              

So, there's arguments that you could get into, but I think that negative rates are an anomaly, although some people want to use them, and they want to get rid of cash as a result, to make those easier to engineer.

Beckworth: Speaking of Joe Gagnon, which you just mentioned has done work on quantitative easing, let's go to the most recent Monetary Policy Conference, and talk about some of the papers that were presented there. And full disclosure, I was one of them.

Dorn: Yes.

Beckworth: So we'd be glad to discuss mine, too, if you're interested in it. But let's chat about that. Let's chat about some of the papers, some of the discussion. In fact, one of the papers there speaks to this very thing, this very topic of negative interest rates. So, walk us through. What were the issues covered at the most recent conference, and how do they reflect the times we live in?

Dorn: Well, we spent a lot of time on the operating system, the new operating system, so called floor system, away from the old corridor system that we had, where reserves were kept modest, and they could simply change the supply of reserves to get the fed funds rate that they wanted. And now the reserves are so abundant that basically the Fed no longer... There's no really federal funds market any more. The Fed administers rates by using interest on excess reserves, and the overnight reverse repo rate, so it's a much different system now.                                

And the Fed has made a decision, basically, to continue this system, and they want to provide for ample reserves, which means that they don't want necessarily the amount that they have now, but they want to have that sweet spot, where they can still operate as a floor type system. And the problem with the... and this was discussed at the conference. George Selgin and others discussed it.                                        

The problem with interest on excess reserves, if that rate is above the opportunity cost, the market rate, like the one-year Treasury, let's say, which it was for some time, then there's a big demand for banks to hold reserves at the Fed rather than lend them out. And Phil Gramm, at his talk at the conference, basically was critical of this type of regime, because it interferes with the so called monetary transmission mechanism, whereby in the past if you had open market operations, and you're buying securities in the open market, it adds to the base money, to the reserves, and then the commercial banks can lend that out if it's profitable to do so, and that affects nominal income and prices. That's the route that it takes through the interest rate mechanism.                                

They changed the focus after 2008 more towards a Bernanke-type wealth effect, whereby they would keep interest rates low for longer, and use quantitative easing and forward guidance basically to encourage people to take risk, and to buy more risky assets, and that's what I think helped propel the stock market. Of course, there were real factors, too. Trump's tax cut and so forth. But for many quarters and years, the economy was growing very slowly, but the stock market was going up by double digits.                             

So, if you look at the financial pages every day, you see that all they talk about is Fed policy. What's the Fed going to do? So, Phil Gramm's been critical of Fed policy and the way things are working, and he almost takes an Austrian viewpoint, that the interest rate is a intertemporal price, and it's an important thing to coordinate decisions and capital markets, and when the Fed comes in and it misprices credit and risk, that encourages more risk taking, and that disturbs the capital markets.                               

And that has real effects, and Claudio Borio, who spoke at our conference, he spoke at that conference, but spoke at, I think a year or two before that, emphasized the importance of trust in a monetary regime. And he's also worried about the mispricing of credit, and that the Fed and other central banks are, without being guiding of any type of monetary rule, have gained more power, and they've distorted intertemporal prices.                                

So that was one theme. Other people, like yourself, and Gagnon even, Jeff Frankel, interested in talking about nominal GDP targeting, what you call level targeting, in particular, where you make up for misses. And that that would be a better system than inflation targeting, because you don't have to worry about supply-side shocks. You allow them to be absorbed by price level changes, basically.                               

You hold M times V constant, basically. You allow them to adjust to each other through... actually through markets, and you make it known that you're going to allow for a limit. Let's say five percent, or four percent growth in nominal GDP. And this is becoming more and more popular. Scott Sumner has also worked on this, and Scott talked about ten lessons from the monetary crisis, and one of the lessons of course is that as you pointed out, and Scott and other people, that initially they tighten monetary policy. Because the Fed basically sterilized... Any type of quantitative easing that was going to be used was sterilized, and also by using the interest on excess reserves, so it wasn't lent out.                                        

And there was a lot of uncertainty in the monetary regime, and also other areas in the economy, so banks... There wasn't much of a demand for private investment funds and so forth during that time. Now that the economy started to grow again, and Trump cut taxes, and so on, Phil Gramm's worried that in this type of thing, what's going to happen is a market interest rates are going to be sets such that long-term rates start to increase normally because of the high deficits, because of the economies heating up, and for other reasons. And this could throw off Fed policy. The Fed would have to follow the market, in other words. Which the Fed has to do anyhow, ultimately.                                        

So, we talked about some of these things. Vincent Reinhart had a very interesting paper on an unconventional assessment of unconventional monetary policy. And if you remember at the conference, since you were there, one of the major points he made was that when you set a precedent of encouraging risk taking, by keeping rates lower for longer, and forward guidance, and so forth, you sort of create a moral hazard problem. It's like a Bernanke put, with a Greenspan put, or now the Powell put. If the markets expect you to cave in every time, and you don't have any other stands for monetary policy, like nominal GDP targeting and so forth, then down the road the Fed credibility is going to be, "Well, Fed's just bluffing, and they're going to cave in."                                        

And this can lead to bubbles in asset markets, and if the bubble bursts, as they all do at some point, you can then have a boom-bust type cycle, and lead to recession. Now, Claudio Borio wasn't at this... Well, he was at this conference, but he's worried about that, too, in his writing at the Bank for International Settlements.                                        

And one other paper I've already mentioned briefly was Jeffrey Frankel's paper, which I think I already made the point on the what do you want to do with Summary of Economic Projections.

Beckworth: Right. Yeah. It was a great conference, and one of the papers there, though, we alluded to earlier, was Andrew Levin and Michael Bordo's paper about negative interest rates, and I want to ask this question, kind of going back to your comment about negative rates, negative real rates, quantitative easing, the moral hazard problem, the point made by Vincent Reinhart. One of the puzzles the Fed faces is despite all these developments you've mentioned, negative real rates, QE, intervention here and there, everywhere, we still have really low inflation, right?                                

We have, in fact, below target inflation, and the Fed itself has... Stroking its chin, acting puzzled. So how do you interpret that? Because you outline these potential indicators that would indicate it's being too easy, but on the other hand, we don't see hardly any traction. In fact, nominal GDP growth is below the average of what it was before the crisis. Inflation seems to be growing slow, so what's going on there?

Dorn: Well, I would say that we don't have inflation in the traditional sense of the word. But we certainly have asset price inflation. So, maybe that's what is showing up. More of an Austrian-style model. That's one possibility. And you got to remember, too, that ultra-low interest rates, even negative interest rates have harmed a lot of people. In fact, a friend of mine who ran a big fund at one of the investment firms, he's retired now, but he said the biggest cost to seniors is the negative interest rates. Which have been, he said, engineered by the Fed. And he's a very astute financial analyst.                                        

And that's true. There has been a cost. If you have a million bucks in a money market fund, you're getting about 25 basis points on it. And then you have to pay tax on the interest you earn. So, people are actually saving more, because they have to make up for saving they can't do, so... But that saving is not going into private investment. The banks are basically buying Treasury security and so forth. This is combined, too, with the credit... The Fed, as Charlie Plosser and others have pointed out, has been engaged in credit policy more than just pure monetary policy, with buying up huge amounts of mortgage-backed securities.                                        

And it's also, by paying interest on excess reserves, it can use that... When it gets that, it reverts back to the Treasury. The Treasury can use that to make it look like the deficits aren't as high as otherwise, too. So, we've got all these interventions into what would be nice if we had this nominal GDP rule, or some other rule that would lend certainty. I don't see the problem as too little inflation. Rather, I see it as too much discretion, and too much power, and Charlie Calomiris has focused in various conferences on the rule of law, and how the Fed, through its creation of various facilities during the crisis and so forth... Larry White's pointed this out, too, has undermined the rule of law.                               

Jim Grant, who you know well, just wrote a nice book on Bagehot, said in all the history of central banking and banks, there's never been a period where you had negative real interest rates for... engineered by banks, per se. He said it's unnatural. For some of the reasons I've stated. So remember, you can't measure or see the natural rate of interest. It's a concept, just like demand-supply curves are concepts. Blackboard economics, like Coase used to talk about.                                        

And a lot of the forecasting models that we have, and the Fed's models included... You have to have models, I suppose. I'm not against modeling. But they certainly... Nobody predicted the Great Recession. And predicting interest rates is very, very difficult. So, I think so we don't get lost among the trees, we look at the bigger picture, we go back to the fact that we need to improve the monetary regime, so that it operates to bring about prosperity in a free society, and that's one of the main objectives of our center here, and also the conference.                                        

As you know, these are highly complex topics, and I've been studying this for over 40 years, and I went to graduate school, and studied with Leland Yeager, and learned a lot of monetary economics. A lot of the stuff I learned at that time has been turned around to a certain extent, although the basic truths still remain, I think. But Leland got involved more in terms of thinking in how we could get a decentralized monetary system that is forecast-free.

Beckworth: What does that mean, forecast-free?

Dorn: Well, I think it's like the gold standard, which was... It had sort of an automatic adjustment system.

Beckworth: I see. Okay.

Dorn: That the supply of money, we don't know what the optimal supply of money is, but if it's driven by the demand for money, and it leads to price stability over a long period of time, not... I mean, during the gold standard, the price level changed, went up and down, but over a long period of time, it was stable. That type of system doesn't require central planning, or a central bank. The central bank can be involved in that, but it could be a private central bank, like the Bank of England was.                                

But we need to think outside the box, too, in terms of why couldn't the market supply competing currencies? And that's why this digital age is important, with the information age, and talk about digital currencies, and maybe some algorithm that would lead to a stable supply. There's a stable... Stable now it's called. I guess the currency. Larry White's looking into a lot of this stuff.                            

But there's a lot of exciting avenues opening, and I think the Fed's credibility at this point is not great. And if we go into another period where we have stagflation, which is not impossible, then there might be an opening. But even during hyperinflations, we still go back to a central bank, so what we want to do is improve the operation of the current system, and see if we can't do better.

Beckworth: Speaking of the digital age, Marc Andreesen famously said, "Software will eat the world." I wonder if you foresee a world where AI, smart machines, having access to real-time universal data, so putting aside privacy issues for the time being, imagine a smart machine monitoring every bank account, every transaction, every financial move, can in real time figure out real money demand shocks, and adjust... So, it's kind of a mix between monetary policy on pilot, but also you could argue kind of discretion.                                

Do you see a future like that, where machines, kind of in real time, do monetary policy?

Dorn: I doubt it.

Beckworth: Okay.

Dorn: I don't think there's any political or… motivation. Just think of all the 300 or more economists on the Board of Governors that work there from top schools. They wouldn't have anything to do. So, you've got special interests that would like to keep... work on monetary policy issues. And I'm a libertarian, and I like freedom, but I want sound money, too, so can we bring it about by a freer system? Well, we can certainly improve on the system we have now.                                        

And I think we need to study economic history, to learn from the past. From 1983, when I started these conferences, to now, the search for stable money is still on. It's just a question, there's different things going on, and different things that we've never even thought about before, like these negative interest rates, and digital currencies, and things like that. So, I'm not sure I really want the Fed to get involved in digital currency. I'd rather have the markets do it. And the Fed's already involved in too many things. They ought to split off regulation, and let... I think financial markets took a big hit in the sense of their credibility, because everybody thought, "Well, these financial markets always work fine. We don't need any regulation and so forth."                                

And then we get overregulation, then the pendulum swings back somewhat. So, our center is concerned not only with monetary policy, but with financial regulation. Try to get a more market-oriented picture of that.

Beckworth: So, what would be, in your view, the ideal system for the Fed to follow? So, you could play God for a few minutes here, and you could snap your fingers, and boom. Given the world we live in, where technology is, where things are in terms of global capital flows, all those issues, how would you design an optimal monetary regime?

Dorn: Well, one of the panels at this year's monetary conference, which is going to be on November 14th here at Cato, is on an optimal monetary system for a free society.

Beckworth: All right, so come and find out, huh?

Dorn: And the people that are going to be on that panel have thought about this a lot. George Selgin, my colleague. Dino Falaschetti, he's former Chief Economist on the House Financial Services Committee. Will Luther, who you know well. And Steve Hanke. So, we'll get a picture.                                        

In terms of my own thinking, I used to just sort of like the idea of a simple rule, like Friedman's money growth rule, and Anna Schwartz said if we actually had that at one point, maybe all these other alternatives, and all accounts and all this stuff wouldn't have emerged, velocity would have been more stable, and it would have worked fairly well. So, we never really tried it, and I think that's what Karl Brunner would probably say, too, and Alan Meltzer.                                        

But I'm attracted to this nominal GDP level targeting, for the reasons we discussed a little bit earlier. But on the other hand, I also think that we ought to allow for experimentation with digital currencies, and maybe somebody's going to come up with something we could never anticipate. I don't believe quite in designing systems. I think they're very hard to design, because we don't have the information. We don't have the knowledge. Rather an evolution of systems that will occur. Maybe some type of parallel monetary system. Which would keep the Fed on its toes.                                

I remember George Selgin thought the Euro would be good, in the sense that it'd be a competitive system to the Fed. He didn't say it would be the best system, but at least be some competition. And Hayek even initially talked about competing national currencies, and then went to private currencies and so forth. But you have to be realistic what you can accomplish, but you also have to have some ideal in mind, and I guess my ideal is I'm in favor of monetary freedom, and capital freedom, and individual freedom, and the rule of law. So, we can use that to shape a system.                           

I think we should discuss the classical gold standard and system. It was consistent with the rule of law. It put constraints on the fiscal system. They issued consols, which were bonds into perpetuity. You could never issue those today. So, there's a lot more trust in that particular type of system.                             

But of course when things went bad, they basically put convertibility on the shelf, and that's what we did with certain things when the monetary targeting... Well, when the gold cover for the dollar... It used to be... 1945, it was I think 25 percent. They ended that by 1977. Johnson got Congress to change the law, so they ended the gold cover for both deposits and currency. And Weintraub, Bob Weintraub thought that putting a limit like that on was good. It was at least some type of limit, and when they got rid of that, of course dollar production, money supply went up even more, and eventually led us to go off any kind of vestige of the gold standard in 1971. Well, 1971... Let's see, was it... 1967. Humphrey-Hawkins was 77. 45. Yeah, 1945 was 25 percent.                                

And then Johnson, it must have been 1967. But I'd have to check the dates.

Beckworth: Okay. That's fine. Yeah.

Dorn: Anyway, the gold cover was taken off, and we no longer have any cover for Federal Reserve notes. Simply pure fiat money.

Beckworth: But you're suggesting put something rules-based in play, and then let experimentation maybe open up new opportunities. I mean today, Facebook announced its own digital cryptocurrency. Was it Libra, the name of it?

Dorn: Yeah.

Beckworth: And it's going to be kind of a... my understanding, a stable coin type cryptocurrency, so who knows? Maybe Facebook will be the next great thing in monetary systems.

Dorn: Yeah, you just don't know.

Beckworth: Yeah.

Dorn: But we have to allow experimentation.

Beckworth: Yep, exactly.

Dorn: But we have to be able to explain how a market-oriented monetary system would operate. We have to have some knowledge of that. Otherwise you're just operating in the dark, and nobody's going to go along with that. You have to have some, because there's network effects and everything, you have to be able to explain why this may be a stable system, or why it may not be a stable system.

Beckworth: And that's the task of your Monetary Policy Conference, and the center here at the Cato Institute.

Dorn: That's right.

Beckworth: Well, our time is up. Our guest today has been DORN. Jim, thank you so much for coming on the show.

Dorn: You're welcome. It's a pleasure.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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