Looking Back:

A retrospective conversation with William Poole

[Monetary policy]

The decade that you spent as president of the Federal Reserve Bank of St. Louis was marked by a series of crises, such as the Asian financial meltdown of the late 1990s, the 9/11 attacks and the current subprime mortgage crisis. How would you characterize the turbulent era during which you served?

I used to think of monetary policy as dealing with generally normal periods interrupted by shocks. I’ve decided that it’s really the other way around. In fact, the Fed has had to face a whole series of shocks interrupted by occasional periods that we call “normal.” If you were to take the 10 years as a whole and divide it between periods of shocks or the threat of shocks vs. the “normal” periods, I think you’d find a lot more months in the first category.

What have you learned about the best role for the Federal Reserve to play during times of crisis?

To start with, central bank credibility and low and stable inflation expectations are of critical importance. Earning that confidence is the most important thing the Fed can do in dealing with shocks as they occur. If the Fed doesn’t have that underlying confidence, then all sorts of things can go wrong and, indeed, the Fed may find itself willy-nilly taking policy actions intended to maintain or restore credibility rather than dealing with the current problem, whatever it might be. So, most of the work in dealing with the crises comes before they even happen. Where the Fed is now is a consequence of earning that credibility starting with Paul Volcker and then dealing successfully with a whole series of issues during the Volcker, Greenspan and now Bernanke eras.

Does the public expect too much from the Fed in response to crises?

You can probably address that question on several levels. There’s a natural tendency for people in the markets to look to government to help them. And, often, it’s very self-interested. They want to be bailed out—it’s just that simple. They want someone to fix their mistakes. You see it across the board. People think that if the government will give them some money, why not take it. … It seems that the people who most often talk about regulation tying them in knots and being costly are some of the first to come asking for help and to be bailed out. So, there is nothing Fed leaders can do except make sure to have a correct, disciplined policy and then be visible in explaining the rationale for the policies they want to follow. You have to be prepared to resist pressures from Congress and make use of the independence that the Federal Reserve structure provides.

Could you give a broad historical overview of what you refer to as the monetarist vs. fiscalist debate?

The word “monetarism” refers to the way the debates were framed in the 1960s and ’70s. Fundamentally, the argument at that time was about a few propositions that have been largely resolved. It’s also important to understand that the debate was really a pre-rational expectations debate. (See explanation.) One of the issues being argued was the relative power or influence of monetary policy and fiscal policy. The Keynesian tradition (see explanation) coming out of the 1930s was that monetary policy was pretty much a sideshow, and the aggregate economy was controlled by fiscal policy. Milton Friedman (see explanation) disagreed. He said that monetary policy was central to understanding the business cycle.

How did the monetarists and fiscalists differ when it came to their views on inflation?

The monetarists thought that inflation was costly and damaging to the economy. The fiscalists argued that inflation wasn’t all that costly. … The fiscalists believed that there could be a constructive tradeoff in that you could actually obtain lower unemployment if you were willing to accept somewhat higher inflation. That view was resisted at a somewhat intuitive level and then at a very, very explicit theoretical level by Friedman in his presidential address to the American Economic Association in December of 1966. There continued to be an argument for a while. The fiscalists would say, “We understand Friedman’s theory, but the world doesn’t really work quite that way, and, in fact, there is a tradeoff.” The view that there was a tradeoff had a great deal to do with Federal Reserve policy mistakes because that was the prevailing view of the Federal Reserve—with the lone exception of St. Louis. … There was a whole series of policy mistakes that led to gradually rising inflation—sometimes not so gradual—at costs greater than anticipated, including, lo and behold, costs in terms of employment and certainly economic stability. So, over the course of the ’70s, the debate was resolved in favor of what had been the monetarist position.

Four decades later, where does the theory of monetarism stand? Furthermore, have you changed your views about monetarism over the years?

Monetarism has become mainstream economics. We know now the following: Inflation is costly, only the central bank is responsible for inflation, the Phillips Curve (see explanation) is vertical in the long run, and there is no inflation/employment tradeoff. Those are all part of macroeconomics today. … There is another issue that was not directly connected with monetarism, but you might say was sort of a fellow-traveler issue: Friedman was very much a believer in the market system and distrustful of government. He had great respect for market efficiency and great skepticism about government efficiency. So, the people who were on the monetarist side of the debate tended to have that same view. I don’t know of any activist government interveners who are monetarists. They just didn’t ever go together. Monetarists generally have great respect for markets. It’s not to say that market decisions are infallible, but you will ask a question two, three, four times before you decide that markets are making a mistake. And I think that part of it certainly survives as being extremely important in my thinking. The immediate successors of the monetarist debate of the ’60s are people like Bob Lucas and Tom Sargent (see explanation) and the rational expectations theorists. They were the immediate intellectual heirs of the debate. I certainly come from that tradition, and a lot of my speeches have been oriented toward developing the practical application of those ideas to understanding and managing monetary policy. I don’t think my views on monetarism have changed in particular. Those views are still very much a part of my thinking.

Does the Federal Reserve’s decentralized structure still make as much sense now as it did when the Fed was created?

I think the rationale has changed over time. Part of the rationale was that regional Reserve banks could pursue different monetary policies to address differing regional needs. That argument has disappeared—there can be only one national monetary policy. But part of the original rationale has survived. If you look back at the Federal Reserve Act in 1913, there was tremendous distrust of Washington and New York. That’s one reason why you had Reserve banks spread around the country—so that you would have decentralized power. The argument for decentralized authority still stands, but this case is not very well appreciated by the general public. A lot of people think of a centralized system as being more efficient, perhaps more democratic, if it’s run out of Washington. I think those views are fundamentally wrong because I believe that the original conception of not having all the authority concentrated in New York as the financial center or Washington as the political center remains valid.