The Federal Reserve Isn't the Image Pundits Imagine It To Be, and Never Has Been
In the intricate web of global production, a simple item like a pencil involves contributions from various parts of the world. This is just one example of the complex nature of economies, a complexity that is often overlooked in centralised control efforts, such as the Federal Reserve's (Fed) mandate for price stability.
The Fed's price stability mandate aims to keep inflation around a target (usually 2%) to avoid cyclical instability and protect potential economic output. However, critics argue that this approach may overlook the broader dynamics and "human knowledge" embedded in decentralized market interactions.
The "I, Pencil" essay, originally by Leonard Read, serves as a powerful illustration of this argument. The essay demonstrates how no single person knows how to make a pencil entirely; it results from spontaneous order where millions contribute through voluntary exchanges responding to prices. This complexity challenges the notion that a central authority like the Fed can perfectly stabilize prices without unintended consequences.
The Boeing 747, a type of airplane, is another example of this global cooperation. With over six million different parts manufactured globally, it underscores the complexity of economies and the limitations of top-down price controls or mandates in managing them efficiently.
Economists like John Cochrane question the Fed's role in prices, arguing that economies are not machines but rather collections of individuals and their innovations. He believes that the Fed's focus on "price stability" is too simplistic and overlooks the myriad global inputs that go into the production of common goods.
Innovators find ways to produce more for less, leading to falling prices, which is a sign of economic growth. This dynamic is evident in the production of everyday items, from pencils to smartphones, which claim inputs from six different continents.
Price movements in a market economy organise production by signalling what to produce more or less of. Rising prices indicate fewer dollars for other purchases, while falling prices signal more. This natural coordination is a testament to the power of market prices and the limitations of centralised control.
The Phillips Curve, a discredited economic theory suggesting economic growth causes prices to rise, is often cited as the basis for the Fed's price stability mandate. However, evidence suggests that price movements balance each other, and fluctuations do not necessarily indicate inflation or deflation.
In conclusion, the "I, Pencil" essay serves as a reminder that central banks, including the Fed, may not have the ability to precisely control inflation or prices without disrupting the natural coordination and knowledge embodied in market prices. It supports skepticism towards rigid mandates on price stability by highlighting the dispersed, tacit knowledge that price signals embody in a free market. As economies continue to evolve, it is crucial to consider these arguments when evaluating the role and effectiveness of central banks like the Fed.
[1] Federal Reserve policymakers. (n.d.). Price stability. Retrieved from https://www.federalreserve.gov/monetarypolicy/price-stability.htm [2] Board of Governors of the Federal Reserve System. (n.d.). Inflation targeting. Retrieved from https://www.federalreserve.gov/monetarypolicy/inflation-targeting.htm [3] Federal Reserve Bank of St. Louis. (n.d.). Inflation targeting. Retrieved from https://www.stlouisfed.org/topics/inflation-targeting
John Cochrane and John Tamny, both renowned economists, question the Federal Reserve's focus on price stability, suggesting that it overlooks the broad dynamics and human knowledge embedded in decentralized market interactions. Finance and business sectors, as well as the production of common goods like pencils and airplanes such as the Boeing 747, underscore this complexity.
Economists like Cochrane argue that the Federal Reserve's mandate for price stability might inhibit economic growth by overlooking the myriad global inputs that contribute to the production of common goods, which are complex phenomena that challenge the notion of a central authority's ability to perfectly stabilize prices without unintended consequences.
