President Bush has nominated former Princeton University economist and former Federal Reserve Gov. Ben Bernanke to take over the reins of the Federal Reserve from Alan Greenspan, who is retiring. If confirmed, Bernanke will be only the 14th Fed head since the institution’s inception in 1913. The question is, should you care?
I think you should, and I’m not saying this just because I’m an economist. Economists agree that, among all the government institutions in Washington, the Fed has the most impact on our daily lives. The policies of the Fed affect everything from the prices we pay to the wages we earn to how long recessions last. Here’s how:
Do you know who controls the amount of money in circulation? If you say the president, Congress, or your local bank, you’re wrong. It’s the Fed. Through its influence over the value of assets in banks’ vaults, the Fed can increase or decrease the amount of cash in circulation.
So does this mean we’d want someone overseeing the Fed who wants to flood the economy with greenbacks, effectively making us all appear richer? Not really. That’s because there’s a potential downsize to pumping up the supply of money too rapidly, and it’s inflation. If the amount of money spent increases faster than businesses can make things for consumers to buy, prices rise faster, which is just another way of saying higher inflation.
Interest rates, especially on short-term loans, can also be manipulated by the Fed. Yet again, there are tradeoffs in pushing interest rates higher or lower. Lower rates favor borrowers, but hurt those who are investing in certificates of deposit, money market funds, and similar investments. The reverse is the case for higher interest rates — they help investors, but hurt borrowers. So any Fed chairman must balance the desires of both borrowers and savers in setting short-term interest rates.
Then there’s the influence of the Fed on the business cycle of the economy. To understand this, think of the economy as a party. We’d like everyone to have fun at parties (for the economy, we’d like people to have jobs and prosper). But too much fun and frivolity can get parties out of control, possibly leading to drunkenness and fights (in the economy, too much spending can lead to inflation, speculation, and market plunges). On the other hand, a dull party can leave people disappointed and unhappy (as in an economic recession).
Think of the Fed as the chaperon of the party. It uses its powers over money and interest rates to try to keep the party going on an even keel, avoiding the ups and downs of booms and busts. But this is as much of an art as a science, and past Fed heads have approached this responsibility in different ways. For example, when the economic party needs controlling, some like the quick, lights-out approach. Others like the gradual tack of talking revelers into moderation.
Dr. Bernanke will soon go before the Senate for confirmation hearings. Presumably, we’ll then learn much more about his views on the economy and the role of the Fed. I’ll certainly pay attention — and I suggest you do, too.
Walden is a William Neal Reynolds distinguished professor at North Carolina State University and an adjunct scholar of the John Locke Foundation.