Visiting Scholar Allan  H. Meltzer

Less than 25 years ago, the Federal Reserve ended the Great Inflation that plagued the 1970s and early 1980s. Harvard's Martin Feldstein and other economists are now urging the Fed to repeat past mistakes because they believe a loose monetary policy is necessary to head off an economic downturn they see coming our way.

Beginning in 1967 and throughout the 1970s, the Fed responded to rising unemployment with rapid monetary expansion. The public, workers, bond holders and others quickly recognized that it was more determined to prevent unemployment from rising than to reduce inflation. So markets expected and got higher inflation. Chairman Arthur Burns offered many irrelevant reasons--unions, monopolies, the welfare state--for inflation. The public learned his sequence. Anti-inflation policy soon brought rising unemployment. The Fed abandoned its anti-inflation policy and brought on the next inflation. Why plan that lower inflation would become permanent when it never did?

The Federal Reserve staff also produced inflation forecasts that systematically underestimated inflation year after year. Economists' forecasts may be better than others, but they are not very good.

Two of the changes that Paul Volcker introduced in 1979 were to increase the Fed's emphasis on fighting inflation and diminish its concern about the unemployment rate, and to pay little or no attention to forecasts. Transcripts of meetings show Mr. Volcker repeatedly praising the Fed staff but neglecting its forecasts. His successor, Alan Greenspan, did the same. They ran the most successful high-growth and low-inflation policies in modern times.

Mr. Feldstein and others offer a scenario for the unfolding of recent credit and housing problems that ends in a deep recession. He calls for a one percentage point reduction in the federal funds rate to partly overcome the disaster he foresees. Much of his analysis depends on forecasts or guesses about declines in house prices and failures of credit markets that are outside the range of past experience. But it is not difficult to find an alternative forecast that is far less gloomy. Many economists, including many at the Fed, foresee a more benign outcome--a slow growth rate for a few quarters but no recession. Only time will tell which is correct. At present, markets seem to accept the more favorable outcome.

With annual inflation at 2% or more and unit labor costs rising at a 5% rate, loose fed policy risks reviving the latent fears that it is willing to permit higher inflation now to respond to a forecast that unemployment may rise. That returns to the policy that made the Great Inflation costly and durable.

The better policy is to wait until the very mixed data of the moment forms a pattern. High-frequency data is often revised. It often has transitory aberrations that do not persist. Unfortunately, after a major change in underlying conditions, we know even less than usual about the future.

Good monetary policy makers should be watchful but would wait for better indications of the future. Leave the federal funds rate alone for the present, but show concern and give equal weight to avoiding higher inflation and recession. Don't be afraid to disappoint the market.

There are more immediate problems. And as usual, Congress is looking for scapegoats. Two issues call for attention.

First, more financial regulation is not the answer to the subprime mess because regulation just induces innovation to circumvent it. Regulated and monitored banks found ways to shift the risk from their balance sheets to other unregulated investors. The shifted risks are no longer within supervised banks. Much of the risk has been shifted out of banks to hedge funds, pension funds and foreigners. No one knows where it all is. We find out when the holders fail or ask for help.

Nor will more regulation of hedge funds solve the problem. Money will move elsewhere. The better solution is market discipline. Imprudent lenders lose. They fail and others learn from the failures. This will not eliminate future mistakes, but neither has regulation.

Second, we should recognize that all recent crises and disruptions began with a remarkable degree of herd-like behavior. In the housing debacle, sophisticated investors bought claims based on no money down, no credit record, no relevant data. What were they thinking? Were they thinking?

Herd-like behavior arises because the managers put their personal interest far ahead of the interests of the investors in their funds. In 2004 and 2005, the managers reported great earnings and received magnificent bonuses. Straying from the herd by refusing to participate is likely to cost not just the bonus but the job.

So the incentives are wrong. We could have learned that from the international debt problems of the late 1990s or the dot-com collapse. Now, we can learn it again. The incentives for managers invite instability. They gain, but we lose. The only way to teach institutions to change the incentive structure is to let the ones that made too many bad decisions fail.

Allan H. Meltzer is a visiting scholar at AEI.