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Paul A. London

Paul A. London

Posted March 11, 2009 | 06:56 PM (EST)

Refocusing the Federal Reserve


Ben Bernanke's speech to the Council on Foreign Relations on March 10 was important both for what he said and for what he did not say. I want to pass quickly over what he said and get to the second category --- what he did not say.

What he said essentially was that the government has to better supervise financial markets to prevent financial crises like the one occurring now. Dealing with financial panics, Bernanke recognized, is why the Congress set up the Federal Reserve in 1913, but it clearly let this crisis blossom and no one wants that to happen again.

Bernanke discusses the Fed's 96 year old mandate in relation to four separate but interrelated issues: 1) Businesses that are "too big to fail", 2) "Strengthening the Financial Infrastructure," 3) "Procyclicality in the Regulatory System," and 4) "Systemic Risk Authority." What he said about these issues is worth reading, but the key point is this. These are issues that have to be addressed to avoid "financial panics" like the one that led to the creation of the Fed and that for hundreds of years have been the weak underbelly of our private enterprise system.

What Bernanke did not say, is that the Fed for more than 50 years has focused on something other than the dangers of financial meltdowns. Bernanke never mentioned inflation in his March 10 speech, yet his predecessors being with William McChesney Martin in 1951 and continuing through Alan Greenspan who left in 2006, hardly focused on anything else. Indeed when Bernanke inherited Greenspan's mantle, it was thought that he would have to be as concerned about inflation as Greenspan had been.

So the question is why since 1951 did the Fed's leadership, the gliterati of American business, the Republican Party and the deans of conservative economic academia led by Milton Friedman seem to forget the reason the Federal Reserve was created, and treat it as though it should have been named the Federal Anti-Inflation Authority. I answered this question in my book early in this decade (The Competition Solution: The Bipartisan Secret behind American Prosperity). My answer then and now is that blaming inflation on "the government," i.e. on the Fed's monetary policy and on "government spending," was a ploy to disguise the role of monopoly in the private sector in inflation. Blaming the Fed and the government for inflation was a way to disguise the fact that monopoly power in the private sector, uncontrolled by competition, was inflation's principal cause. Businesses did not want this dirty secret to get out. Nor did anti-government conservatives for whom the fear of inflation was a gift that kept on giving. They wanted to pretend that competition was always strong. Blaming the Fed and government spending for inflation and all other bad economic outcomes was a perfect political solution.

My book is full of examples of inflation as a result of monopoly. The OPEC cartel's role in driving up energy prices is a perfect example of the point, but there are plenty of purely domestic ones. The costs of telephone calls was too high in the U.S. until the AT&T monopoly was broken up, and they have been falling ever since. Transportation costs were too high until competition was restored to that sector between 1978 and 1980, after which transportation costs fell like a rock. Steel prices kept rising in the U.S. until 1982, when U.S. car companies, forced to compete with German and Japanese imports, told the steel companies they would have to compete for their business. Steel prices did not rise for the next 20 years, and quality improved enormously. Retail mark-ups were too big until Wal-Mart came along and drove costs out of that sector.

Health care costs are today's example of inflation as a result of market power. They rise relentlessly in America because there are hundreds of local monopolies feasting on the fact that it is impossible to compare health care prices. Only competition can force health care prices down. Nothing the Federal Reserve or the government does will bring them down unless there is more competition.

Bernanke's speech was important. He wants the Fed to do what it was created to do in 1913, police speculators to avoid financial meltdowns. What he has to remember, however, is that weak regulation of speculation was what powerful interests wanted and what they pushed politicians to support. Private enterprise, when there is competition, does amazing things, and I deeply believe in it. But what its champions refuse to admit is what Adam Smith recognized clearly, that governments have to make business compete so that they do not get so much power that they hurt others, and eventually themselves. Bernanke and the new administration will have to fight to get the kind of financial regulation that he calls for in his speech.