The most misunderstood aspect of the success of the Reagan led supply side revolution was the monetary aspect. The idea adapted from Robert Mundell’s theory was that the Fed should focus ONLY on monetary matters and that fiscal policy should focus on policies such as employment and economic stimulus. The effectiveness of the supply side revolution was the restoration in the value of the dollar by monetary means COMBINED with the stimulative effect of lower taxes and less regulation, which is just another form of taxation.
Simply making the dollar worth a dollar is a daunting task in an age of fiat current and rapidly changing global competition. The Fed was not formed to stimulate the economy and it was often blamed, sometimes justifiably, for contributing to periodic weakness and making cyclical recessions worse. Milton Friedman and Bernanke both believe that improper Fed action made the recession much worse. But one cannot ignore the contribution of an even greater lack of understanding on the impact of fiscal policies like trade protectionism, higher taxes and a massive expansion of the government mandate.
In the Wall Street Journal Opinion Journal Online this point is given its necessary importance in The Fed’s Bipolar Mandate – Time to repeal the Humphrey-Hawkins Act of 1978.
But with Humphrey-Hawkins, Congress ordered the central bank to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” The political context in that age of Jimmy Carter will sound familiar. U.S. unemployment was stubbornly high and the fiscal policies (tax rebates) of a Democratic Congress had failed to stimulate. So the politicians decided to conscript the Fed in its job creation mission by ordering the ostensibly independent central bank to target employment as well as prices.
The larger problem with the dual mandate is that it inevitably makes the Fed a political actor. Fed governors are forced to pretend they can be economic saviors, able to rescue workers and business from the consequences of failed fiscal and regulatory policies. This is precisely what the Fed is being asked to do today, using QE2 to save the Obama Administration from a 9.6% jobless rate despite trillions spent on economic stimulus, foreclosure mitigation and cash for clunkers. Mr. Bernanke has too often made the Fed appear to be an agent of the Treasury, as he did again yesterday in Frankfurt by blaming China’s pegged currency for U.S. economic ills.