Meltzer’s History Lesson

I recently had the pleasure of reading, and then writing a review of, Allan Meltzer’s monumental A History of the Federal Reserve, Volume 2 which is published in Book 1 and Book 2. The lesson from this thorough 2,112-page history (volumes 1 and 2 together) deserves careful consideration by policymakers today.

It is a history of policy successes and policy failures. The failures are the Great Depression of the 1930s, the Great Inflation of the 1970s, and the Great Recession of recent years. The successes are the Great Disinflation of the early 1980s and the Great Moderation which succeeded it. What caused these successes and failures? Meltzer focuses on two types of policy errors: (1) succumbing to “political interferences or pressure” and (2) basing policy on “mistaken beliefs.” Failure comes from making one or both of these errors; success comes from avoiding them.

He argues that the Great Depression was mainly the second source of error: mistaken beliefs about the real bills doctrine. The Great Inflation was a combination of both types of errors, but failure to resist political pressure dominated because when beliefs changed in the 1970s, policies did not. The Great Disinflation was marked by an absence of both types of errors as Paul Volcker regained independence and restored basic monetary fundamentals about the impact of changes in the money supply and interest rates. The Great Moderation was a period where independence was solidified and rules-based policy, grounded in fundamentals, was followed. The Great Recession was a return to a combination of both kinds of errors, a departure from rules-based policies that worked in the Great Moderation and a loss of independence as the Fed engaged in fiscal and credit allocation policy.

Meltzer’s historical research thus leads him to conclude from the past that “Discretionary policy failed in 1929-33, in 1965-80, and now,” and to recommend for the future that “The lesson should be less discretion and more rule-like behavior.” While I registered some disagreements with parts of Meltzer’s history in my review article, I think his overall conclusion and recommendation are largely correct.