Hayek Warned About Janet Yellen's Conceit In the '70s
When economist Friedrich Hayek received the Nobel Prize in 1974, his acceptance lecture was a warning to economists and all social scientists about the dangers of scientism and the pretense of knowledge. More specifically, Hayek was concerned that social scientists, when adopting the tools of the physical sciences, were misapplying quantitative methods that are not capable of describing complex orders in the same way that, for example, the laws of physics can explain gravity.
Hayek was especially worried about efforts by his contemporaries to manipulate the correlation between employment and aggregate demand through monetary policy, which culminated in the disastrous inflation-ridden economies of the 1970s. While these policies were reversed in the 1980s for the better, the financial collapse of 2008 has seen a renewed interest in a more aggressive use of monetary policy to boost employment and economic growth, which should bring a renewed interest in Hayek's cautionary lecture.
Ben Bernanke's legacy at the Federal Reserve will be quantitative easing, with the Fed focused on purchasing long-term bonds and asset-backed securities in an attempt to lower long-term interest rates and spur economic growth. With interest rates hovering just above zero, quantitative easing became the Fed's new tool of choice for engaging in discretionary economic policy. Janet Yellen, Bernanke's dovish replacement, is likely to continue easy money policies, and, if necessary, quantitative easing. One Fed official has suggested that the Federal Reserve will have racked up $1.5 trillion in new assets before quantitative easing winds down. With stubbornly high unemployment and continued slow growth, perhaps it is time to revisit Hayek's concerns.
Economists focus on wages and prices, and have a general idea about the relationship between them, but Hayek claimed that economists do not-and cannot-possess information about the particular structure of wages that produce equilibrium. A general increase in wages and prices can be modeled, but it is far more difficult to model which set of wages and prices correctly matches labor markets to output in a way that promotes employment and economic growth. Because of these difficulties, Hayek claimed that many economists "happily proceed on the fiction that the factors which they can measure are the only ones that are relevant." This is akin to looking for the car keys under the lamppost because that's where the light is. And as it turns out, quantitative easing may have some peculiar effects on the economy.
Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, has been skeptical of the Fed's quantitative easing program and notes that the program has had disparate effects on the economy. In effect, the quantitative easing program is a very discretionary form of credit allocation; the assets that the Fed chooses to purchase "[target] specific industries, sectors or firms," making quantitative easing an expensive form of fiscal policy. In line with Hayek's concern, the Fed's current monetary policy is affecting different parts of the economy in different ways, something that general models cannot capture. A recent blog post on Sober Look examines some of the distributional impacts of quantitative easing and finds that financial asset valuations have increased sharply, providing a tidy windfall to those with the resources to invest in equities. At the same time, hourly wages have remained stagnant, suggesting those not invested in the stock market did not fare so well.
From Hayek's perspective, this suggests that current Fed policy is supporting a misallocation of resources that may only be viable as long as the Fed continues its quantitative easing program: "What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganization of economic activity." Although Hayek was speaking to the inflationary practices of his time, quantitative easing raises similar concerns; unwinding the massive balance sheet of the Fed will prove to be a serious challenge. The mere mention of tapering makes markets skittish, and while the Fed has shown an openness to continue current policies until the employment outlook improves, it cannot continue to pile up purchases at the rate of $85 billion a month.
Economists may differ on the best way forward, but they would be wise to heed Hayek's call for humility. Given the limits of our knowledge about complex orders like an economy that includes millions of consumers, firms and businesses, it may be prudent to tread lightly with monetary policy, avoiding arbitrary interventions in the marketplace. Rather, let the Fed focus on price stability, providing the certainty required for those in the marketplace to make rational decisions that lead to an allocation of resources more conducive to economic growth.