THE REVIEW- "The Anguish of Central Banking" by Arthur Burns

Read time: 13 minI would like you to approach these articles as though you were sitting down to read a chapter of a book. Note that they will be published every other Tuesday, not weekly as originally anticipated.

Arthur Burns was chairman of the Federal Reserve from February 1, 1970 to January 31, 1978 - 7 years and 364 days (one day short of 8 years!). He served under President Richard Nixon and was Chairman of the Fed when the monumental decision to close the Gold Window was officialized on Aug 15th, 1971.

I recently came across a lecture delivered by A. Burns in 1979 at the annual Per Jacobson Foundation Lecture.

Burns was chairman during the high inflation period of the 70s and the topic he chose to discuss “The Anguish of Central Banking” recounts the difficulties the FED faced in tackling inflation during those years.

Not only is his lecture incredibly relevant today but the similarities between some of the historical facts he recounts and what we are currently experiencing are eerie, to say the least. 42 years later it is as though the Lecture was written for today.

If you would like to read it for yourselves it is only 12 pages and may provide you with deeper insight and better entertainment than staring at your screen and watching the markets every tick.

https://fraser.stlouisfed.org/files/docs/publications/FRB/pages/1985-1989/32252_1985-1989.pdf 

Arthur’s speech was introduced by his predecessor and the longest serving Fed Chairman, William McChesney Martin with the following words

So let us see what Burns can tell us about the “Anguish of Central Banking”

He asks two important questions:

• “Why is the worldwide disease of inflation proving so stubborn?”

• “Why, in particular, have central bankers, whose main business one might suppose is to fight inflation, been so ineffective in dealing with this worldwide problem?"

And he goes on to emphasize this last point by saying:

“By training, if not also by temperament, they (Central Bankers) are inclined to lay great stress on price stability, and their abhorrence of inflation is continually reinforced by contacts with one another and with like-minded members of the private financial community. And yet, despite their antipathy to inflation and the powerful weapons they could wield against it, central bankers have failed so utterly in this mission in recent years. In this paradox lies the anguish of central banking.

Apart from reminding us that Central Bankers operate in an echo chamber of self-reinforcing ideas, something which should hardly be surprising given that most meetings end with unanimous votes, broad consensus, and no dissents, the most interesting point Burns brings up is the difficulty they faced in taming inflation, despite "the powerful weapons they could wield against it".

Given that inflation is trending at 40 year highs and most major Central Banks have expressed their determination and intent to curb it, asking ourselves how successful their efforts might be, and what historical precedents we can refer to, seems relevant.

The economic consensus at the time explained the rise of inflation in 3 stages:

1. "In the mid-1960s the governmental fine tuning inspired by the New Economics and the loose financing of the war in Vietnam.

2. Factors that led to subsequent strengthening of inflationary forces, the devaluations of the dollar in 1971 and 1973, the worldwide economic boom of 1972-73, the crop failures and resulting surge in world food prices in 1973-74, the extraordinary increases in oil prices that became effective in 1974, and the sharp deceleration of productivity growth from the late 1960s onward.

3. Attention is turned to the process whereby protracted experience with inflation has led to widespread expectations that it will continue in the future, so that inflation has acquired a momentum of its own."

Despite acknowledging these points Burns highlights another less appreciated issue:

“I believe that such analyses overlook a more fundamental factor: the persistent inflationary bias that has emerged from the philosophic and political currents that have been transforming economic life in the United States and elsewhere since the 1930s”

Burns then goes to great length to describe the changes that occurred post the Great Depression:

“The breakdown of economic order during the Great Depression was unprecedented in its scale and scope, and it strained the precept of selfreliance beyond the breaking point. …. Succour finally came through a political idea that the federal government had a far larger responsibility in the economic sphere than it had hitherto assumed.”

“In less than a decade the government became a leading actor on the economic stage.“

He is here referring to the New Deal(1930s) who’s “measures laid the foundations of an activist government”.

“Under the New Deal the federal government undertook extensive projects of public construction and offered work relief as well. It gave direct relief to the needy—a function previously performed only by local authorities or private charity. It established unemployment insurance and old-age pensions. It took steps to raise wages and prices with a view to fostering economic recovery. And beyond these innovative actions, the federal government greatly extended the range of its regulatory activities. It intervened massively in the securities market, in banking, in the public utilities industry, in the housing market, and in the farm sector; and it gave labor unions broad new rights and powers.

Set aside your political beliefs and opinions for a moment and let us turn to Burn's discussion relating to what was occurring between the 40s and 60s.

If you wanted to know where the full employment mandate came from look no further:“the Employment Act of 1946 explicitly proclaimed the federal government's responsibility to promote "maximum employment," and this came to mean "full employment" as a matter of law as well as popular usage. “

Moving on in time, some of the themes of the 1960s:

“The rapid rise in national affluence did not create a mood of contentment. On the contrary, the 1960s were years of social turmoil in the United States, as they were in other industrial democracies. In part, the unrest reflected discontent by blacks and other minorities with prevailing conditions of social discrimination and economic deprivation—a discontent that erupted during the "hot summers" of the middle 1960s in burning and looting. In part, the social unrest reflected growing feelings of injustice by or on behalf of other groups—the poor, the aged, the physically handicapped, ethnics, farmers, bluecollar workers, women, and so forth."

"In part, the unrest reflected a growing rejection by middle-class youth of prevailing institutions and cultural values."

Sound familiar?

“In the innocence of the day, many Americans came to believe that all of the new or newly discovered ills of society should be addressed promptly by the federal government."

Sound familiar? I believe, for better or for worse, it is an objective fact that social movements of all kinds increasingly pervade and dominate both the political discourse and economic sphere.

“Once it was established that the key function of government was to solve problems and relieve hardships—not only for society at large but also for troubled industries, regions, occupations, or social groups—a great and growing body of problems and hardships became candidates for governmental solution. “

Ok, so maybe now you're thinking, yes some of this sounds familiar but what point are you trying to make?

Well Burns goes on to say:

“The Congress responded by pouring out a broad stream of measures that involved government spending, special tax relief, or regulations ...

Many results of this interaction of government and citizen activism proved wholesome. Their cumulative effect, however, was to impart a strong inflationary bias to the American economy”

“The philosophic and political currents that transformed economic life and brought on secular inflation in the United States have run strong also in other industrial countries. Rising economic expectations of people, wider citizen participation in the political arena, governmental commitments to full employment, liberal income-maintenance programs, expanding governmental regulations, and increasingly pressing demands on government for the solution of economic and social problems—all these became common features of the industrial democracies.”

“This weighting of the scales of government policy inevitably gave an inflationary twist to the economy, and so too did the expanding role of government regulation.”

The important point Burns makes is that the increased dependence on, and involvement of the government in all aspects of the economy and social life was inflationary.Like today, it is hard to imagine that politicians, as always beholden to voters, would have found it easy to stray from this path.

Moving on to the Central Banks and their role in all of this, Burns highlights that they themselves were not immune to such political and philosophical currents.

“The worldwide philosophic and political trends on which I have been dwelling inevitably affected their (Central Bankers) attitudes and actions. In most countries, the central bank is an instrumentality of the executive branch of government—carrying out monetary policy according to the wishes of the head of government or the ministry of finance."

Burns drops another golden nugget here, by reminding us that Central Banks are not at all independent or free of political influence, quite to the contrary, they are an extension of the executive branch of the government and you could argue that their main job is to fund them, other than acting of course as lenders of last resort during times of crisis.

“At any time within that period, it could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.”

“…quite apart from the fact that some members of the Federal Reserve family had themselves been touched by the allurements of the New Economics.”This last quote just makes me think of MMT.

Burns goes on to make a surprisingly honest (for an Economist) note on Monetary Theory:

“Monetary theory is a controversial area. It does not provide central bankers with decision rules that are at once firm and dependable. To be sure, every central banker has learned from the world's experience that an expanding economy requires expanding supplies of money and credit, that excessive creation of money will over the longer run cause or validate inflation, and that declining interest rates will tend to stimulate economic expansion while rising interest rates will tend to restrict it; but this knowledge stops short of mathematical precision.”

Another golden nugget from Burns whose view is quite different from today’s consensus which assumes the Fed to be infallible and the tools it wields to be endowed with surgical precision. He also points out, in stark contrast to today's narrative, that central banks are prone to error, especially in a period of high inflation.

“In a rapidly changing world the opportunities for making mistakes are legion.”

“Moreover, the emergence of an inflationary psychology in industrial countries has imparted an asymmetry to the consequences of monetary errors, even if the errors themselves occurred as often in one direction as the other.”

As he approaches his conclusion Burns turns to the further complications posed by the ingrained psychology of higher inflation expectations

“They are accustomed, as are students of finance generally, to think of high and rising market interest rates as a restraining force on economic expansion. That rule of experience, however, tends to break down once expectations of inflation become widespread in a country.”

No doubt the Fed today remembers this lesson well and wants to avoid at all cost inflation expectations un-anchoring, on this point they have been particularly vocal and clear.

The whole point of this article is to ponder how successful they might be.

Burns then goes on to make some points regarding interest rates and their impact during times of higher inflation, I will only recall one quote here

“…an "inflation premium" thus gets built into nominal interest rates. In principle, no matter how high the nominal interest rate may be, as long as it stays below or only slightly above the inflation rate, it very likely will have perverse effects on the economy; that is, it will run up costs of doing business but do little or nothing to restrain overall spending.”

If Burns is right, then a Fed Funds rate at 4% (note at the time of writing we are still at 2.5%) will hardly be enough to put the lid on inflation which is currently running around 8%.

Zooming past Burns’ other comments on the consequences of inflation expectations un-anchoring, I will end this review with some of his concluding remarks

“My conclusion that it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies does not mean that central banks are incapable of stabilizing actions; it simply means that their practical capacity for curbing an inflation that is continually driven by political forces is very limited.”

And so here he foreshadows history and calls for a Volker moment a few years before Volcker himself took office.“I have therefore reluctantly come to believe that fairly drastic therapy will be needed to turn inflationary psychology around. “

The key takeaway from all of this is that Central Banks found it extremely difficult during the 70s to curb inflation that was primarily driven by social and political forces.

As an investor, I am often reminded of Mark Twain's quote:

Undoubtedly no two moments in history are alike, I am not here arguing that the next decade will match the 70s, but it may rhyme! After all, we have inflation at 40-year highs in a time where demands for social justice and economic support for individuals and business has never been higher. Whether one chooses to give it the political adjective of populism or not, it is beyond doubt that the current political movement in spirit and objective resembles very much that described by Burns, and Covid only served to pour fuel on the fire.

Moreover, if we look at the political decisions inflation is currently forcing upon politicians it is hard to see how they are not in and of themselves inflationary!Governments worldwide are being forced to fight the cost of living and energy crisis by passing fiscal support packages with hand outs for those most in need.

I provide one of the latest examples below:

These measures may largely be necessary, however, if Arthur Burns has anything to teach us, it is that the likelihood of inflation getting back to 2% in this environment is quite low.

A new inflationary regime may well be setting in, and as investors, we must at least entertain the consequences that higher inflation for longer mean for our portfolios.

I hope you enjoyed this Review and found it interesting.

Thank you for reading,Antonio Nobile C.

I am not a Financial Advisor & this is not financial advice

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