Inflation Is A Choice: Kevin Warsh On Fixing The Federal Reserve | Hoover Institution

It's great to be back. You hid the most important thing, which is the investment firm. I happen to work for the greatest investor in the history of the world, a guy named Stan Druckenmiller.

But you were trying to keep that discreet, I appreciate that. I just wanted to boast about my friend and partner.

[LAUGH]

[LAUGH] In central banking, we are taught to keep our criticisms quite closeted. So I didn't do a very good job of that in those same remarks, Peter. I described this as a love letter, more than a cold critique. You might not have taken it as the love letter, I'm not sure the current incumbent did.

It's a love letter because the institution's as important as your setup would suggest. It's a love letter because if the institution can reform itself, then there can be great things for the institution and the country. But it does mean that it's time to get things back on track. I should say one other thing. This is our third experiment at a central bank in the United States. And it's our third experiment, not because the first two went so well, they went poorly.

This isn't like winning a third Super Bowl, Peter, where the more you get, the better. And the first two failed because they lost the consent of the governed. They lost their ability to deliver on what they promised. And this isn't a history lesson, but you can think about the Jacksonians of prior times say that central bank seems like they're trying to focus and they're all preoccupied with those special interests on the east coast and they've lost track of what's happening to us in the center of the country. It's a version of what worries me today. And so the central bank's going on more than 100 years and if they reform themselves, they're gonna have another great hundred. Absent that I worry.

So, Milton, I was blessed to be a student of his, and when he came here, he had a huge effect on not just me, but generations of students that followed. I've spent some considerable time in the archives of the Hoover Institution looking at what Milton would say, for example, the Federal Reserve chairman. There's a beautiful book by our own Jennifer Burns that includes some of that correspondence. But I had them search and give me all the letters that went back and forth between Paul Volcker and Milton Friedman, and Alan Greenspan.

In the middle of the Carter administration, I don't have the precise date.

Correct.

He serves 17 years until Ben Bernanke shows up.

In 2006.

The only reason why I know that is I recall being a junior White House staffer when I found out that not only had Chairman Bernanke, who had come to the White House from the Federal Reserve and was going back to serve the big shoes of Alan Greenspan, but he wanted me to come with him and take his old job as Fed governor. So I remember that.

I remember that date.

And in that correspondence of Milton, the thing that's amazing about him is he was constantly revisiting his priors. He was constantly asking whether the data and conclusions he came to one year were still relevant the next, whether his judgments on the institution were still relevant the next. And in much of the correspondence during the Volcker years, and the Greenspan years, he was quite comforted by changes in approach, by new ways of thinking about the economy, by success that would come to be known as the Great Moderation. So I wouldn't say that Milton thought that the Federal Reserve was a terrible institution, he thought they had bad periods and good. I can only speculate what he would say about the great inflation of the last half a dozen years and how he would have foreseen it. He would have warned of it, and in all likelihood the Fed wouldn't have listened.

Almost.

Yeah, so I believe what Milton and you just channeled, which is inflation is a choice. As you said at the beginning of this setup, inflation and ensuring price stability was granted to the Federal Reserve by the Congress most recently in a review of its statutes in the 1970s. So that there would be one agency that would be responsible for prices. No more blaming the other guy. We're giving the baton to you, the Central Bank. Go after it and get it. Now you wouldn't know from recent commentary of the last several years that inflation were a choice. In fact, during the run up to the great inflation last five or six years, what did we hear about the causes of inflation? It was because of Putin in Ukraine.

It was because of the pandemic and supply chains. Well, Milton would be outraged to hear that. And in my own subtle way, I was troubled to hear it as well. Those things lead to a change in prices. After all, in a market economy, the prices change in Walmart every day.

That's how the market economy works. It's not the Central Bank's role to police those prices. But that's not what inflation is, that's a one time change in the price level of a widget. Inflation is what happens if that one time change in the price level becomes self fulfilling. That is higher prices beget higher prices. That means inflation ends up finding its way into every kitchen table and every boardroom. Because you don't know as a decision maker what the price level is going to be. That's not about Putin and the pandemic, that's about the Federal Reserve. That's about the Central Bank. And I'm afraid in recent years this is probably because central banks are part of our culture as we do a little bit of, well, it's not my fault, it's someone else's fault. And I think that's what Milton would be most outraged by in recent times. The Central Bank can hit any price level that it wants, any inflation level that it wants. We might not like how they do it, but the idea that they should be blaming someone else strikes me as quite antithetical to good economic history.

If I might, so they got it back under control and then I suspect this is a little psychobabble from an economist. Then they got complacent about inflation being under control. Somehow after the period of what we call the Great Moderation, where prices were more or less stable for a period of more than a generation, I think some in my profession thought this was easy and in fact that it was under control because we had all gotten so very good at this. We'd all gotten perhaps a little complacent with this business. But economics isn't that easy. And it's really because of the most recent crises of '08 and 2020 that I suspect we took our eye off the ball.

That's exactly right. And we don't wanna sound as though, boy, every year was perfect and central bankers didn't make any mistakes, but the mistakes were relatively small and manageable. And for viewers, I think, inflation is still this very abstract concept. We want the change in prices to be such that in the economy, such that no one's talking about it. That's how we know we've done our job. And what do we know about the last five or six years? It's almost everything anyone will talk about.

There is no status quo ante to return to. I have many of our friends on the right who believe well let's just bring the gold standard back, the world has moved on. Might it have been better or worse had we made different choices along the way, but you have to deal with what's right in front of you, I think that's what Orwell said. And there has to be a third choice between let the machine do it and let's have full discretion of a central banker's latest whims. I think you and I might have learned from Edmund Burke of conservatism, it's a resistance to whimsical, we central bankers past and present need to resist whims. There's a way to have clarity about the reaction function of Central Banks to incoming information. And if Milton were with us today, I hesitate to put words in the great man's mouth, but I think he would say that there had been too much scientism, scholasticism, trying to make precise that which we have still imperfect understandings of. Most of us in economics that are better than average, we try to focus to the left of the decimal point, not to the right of the decimal point. Now if we were better at our craft, if we were smarter, we'd be physicists and mathematicians, and most of us that are in this business, we started in one of those fields and then we came to economics because frankly it was easier. And so we don't have a perfected understanding of how the economy works. If we did, we could create the machine. We could create the formula. But the economy's changing every day, it's incredibly dynamic. And so I hesitate to say we have a perfected rule.

Are you drawing a causal relationship there, Peter?

I'm scared where the rest is going.

Yeah, so first of all, we keep bringing up this word money. I should say a word about that.

Milton believed, as you suggest, that monetary policy and inflation is about money. That is heretical in the modern academy. That is not taught in introductory economics. At most of these elite universities, most came from a different school. Not this monetary school, but more of a Keynesian school. And in that Keynesian school, money barely comes up. In fact, if you look at the transcripts of the Federal Reserve, they tape most of the words that we utter inside the Federal Open Market Committee. You're gonna have to look a long time until you see that word money. I think money, strangely enough, has something to do with monetary policy. It has been absent from the discussion. I think is part of the reason why this great inflation came back. Because while Milton himself, I don't believe, would have held exactly to the model he had in his mind 30 years ago, he would have said money has something to do with it. And in the run up of the great inflation around the time of the COVID crisis, we saw a surge of money, both money as best we measure it and velocity as best we see it.

It is non-existent in most discussions among modern economists. Now, Milton used to say, this is the last ode to Milton. Then we'll get to current events.

Milton, I was a 19 or 20 year old and there was a small group of us around the table, a little larger than this. And I asked him some question, probably trying to show off that I knew something about something of which I didn't. And he said, Kevin, the only thing we understand in economics is Econ 1. Everything else is made up. And I remember thinking, Peter, maybe the old man's losing it. Maybe he sort of passed his day. The Nobel Prize was given some period before that. I didn't know until the financial crisis of which you now speak that the old man was exactly right. No one predicted it, no one saw it. Because all we really know about economics, we teach in Econ 1. And at least in the Econ 1, before the schools of economic thinking took over at these elite departments, we said that money has something to do with monetary policy. And I still believe that to be true.

So I teach on occasion in this business school not far from where we're taping. And for years I would talk about the global financial crisis and they'd look at me and these students would have some recollection. Now, they weren't exactly in business, but they remember how their parents would have come home, or they remembered watching it on TV. Now, when I talk of the global financial crisis, they had heard of it, and I could have easily been talking about the Great Depression. So it was some time ago. How it felt to me is, I was 35 years old and I had finally found myself to this august position because of President Bush and Ben Bernanke. And I was in this beautiful office, and for about six or eight months, life was grand.

Someone would come in and put wood in the fire. Someone else would restock this little pitcher of ice water and I thought things were good. Little did I know that was the calm before the storm. I would say it in retrospect, it was scarier than it felt at the time because we were in some ways in the bunker together. While I don't know if Ben Bernanke would at all be comfortable with what I said at the IMF G30 meeting a few weeks ago, he was a heck of a strong, good battle commander. We were all in the bunker together and he was very open to a small group of people who could get around a table like this and fight about what's happening and why. And he was quite open to heretical ideas. I wonder whether there's such permitted heresy in the profession or at the central bank these days. But in the darkest days of that crisis, which maybe we get a gentleman's B for how we handled it, we could have done more sooner. We made plenty of mistakes. We had some successes too. The real economy was deteriorating faster than we had any historical reference of. Financial markets were down 60, 70% in equity prices. And maybe most alarming, the treasury market auctions. The auction for the most important security in the world, which is synonymous with the dollar. People weren't showing up in the auctions, at least at the beginning. Bid-ask spreads were wide and we were worried that the American economy was at the very cliff.

Yes.

So I'd say it goes back to first principles.

This third experiment of Central Bank, the one you referenced, the one that we're still living in, created in 1913, was created in 1913 in response to a panic that had preceded it less than a decade before. Central banks were first created, or this generation of central banks, to respond to just this sort of situation. A panic in the old days, what we now call a deep recession or financial crisis, is when markets aren't working, when there are spreads between what buyers are willing to pay and sellers are willing to sell. And the job of the Central Bank is to show up with all sorts of money. There's that dirty word again. And get those markets to function, not to set prices, but to make sure that buyers and sellers could clear. And the central bank was there to provide liquidity when no one else would. We were the backstop and are the backstop to the banking system, not just in the US but in the rest of the world. Because if we blew it, it would have been even worse for the rest of the world. So that's what we did in crises. And some of your and my friends on the right, including at institutions we care deeply about their views, then were you should let the system burn down, a phoenix will rise from the ashes. You really have no business in doing this, that's not my view. My view is the Central Bank was created to respond to panics. We had one, we recognized it belatedly, but then we showed overwhelming force. And the word you used, I think is the right word. It was an emergency.

So you're prepared to cross more lines than you would in benign times. You're prepared in some sense, as Paul Volcker famously said, to go to the very edge of your authority. But there was an implicit promise we made to each other around the table that we made to the Treasury Department, the Congress, and I would broadly say, to the rest of the US Government. When the crisis ends, we'll get out of this. We will go back to being a rather boring Central Bank. That's on page B12 of the newspaper. Six little paragraphs. The Fed met today and they raised or cut interest rates a quarter of a point. But from that moment until this moment, the Central Bank became front page news and I will argue, played a bigger role than our founders would have been comfortable with, and the founders of a Central Bank should be comfortable with.

You keep printing a trillion here and a trillion there. It's gonna catch up to you, Peter. I mean, back in your day in Washington and in my day, various parts of the economic institutions would spend millions on this project or billions on that. We are a big and strong economy. We can tolerate these sorts of things, even if these projects aren't perfect. But when the Federal Reserve prints trillions, especially in benign times, it changes everything. And it almost is a signal to the rest of Congress we're doing it and so can you. So let's just go back to the essence of quantitative easing for a moment. QE1, which by the way, at the time we tried to market it, this worked for about a week as credit easing. That was our preferred nomenclature. QE sort of took off without us. And what did we say then? We debated internally whether to do this. And the story goes something like this, Peter. Secretary Paulson, he's issuing bonds on Monday and Tuesday. What do you say we buy them on Thursday and Friday? And I don't believe in betraying the confidences of those that were sitting around tables. But I recall one person saying, well, that sounds like a Ponzi scheme. What else do you have to save us from the global financial crisis? Explanations were given. Small versions of this were done by the Bank of Japan about a decade prior, but nothing quite like this. And we weren't quite sure how it would work. But it turns out it worked and it was radical at the time. Now, if you turn to economic textbooks, even introductory economics, they talk about this as like standard operating procedure. It seemed like a roll of the dice then, but we were in roll of the dice time, so we took it. But that was QE1. I supported it, and I supported it with many colleagues under the view of we're gonna put this very dangerous, risky stuff back behind the covered glass until there's another crisis. We really never did that. So the story you are going to tell about the subsequent QEs during a period that I would say was reasonably strong growth, reasonably stable financial markets, reasonable periods of stable prices, we start doing it for all seasons and all reasons, and in so doing we raise the bar for when another crisis hits. Because whatever you were doing couldn't possibly be enough. I should only note one other thing. You're cleansing my biography and I should be grateful I resigned.