There is much dispute about the efficacy of countercyclical monetary policy. In part this is due to disagreements about economic theory, or about the size of certain parameters. But much of it reflects different assumptions about the extent to which political pressures prevent the Fed from following appropriate policies, the degree to which its policies are influenced by its own bureaucratic interests, and the efficiency with which it makes policy. Hence, I invited a number of economists and political scientists, most of whom have worked on these problems, to write chapters for a volume dealing with Fed behavior. The resulting chapters cover many aspects of Fed policy, such as its actual independence, its devotion to the public interest, and biases and inefficiencies in its policy-making.

The picture that emerges in these chapters differs sharply from the traditional “textbook” view, which has monetary policy being made by an independent central bank, totally devoted to the public interest, using the most sophisticated tools of economic analysis. In that textbook view, it is only a lack of certain information, such as the absence of reliable forecasts, that constrains the Fed's policy-making. The chapters in this volume show how implausible that textbook view is. Yet this book is not just another exercise in Fed-bashing. It is not the Fed's fault that its actual independence is sharply circumscribed. Nor is the Fed the only organization whose policy-making is influenced by self-interest, by biases, and by cognitive difficulties. I suspect that the Fed has a much better record than do most other government agencies, or the universities, for that matter.

The case against discretionary monetary policy rests on two bases. One is technical: Monetary policy has long and variable lags, and forecasts are inaccurate. The second is that monetary policy is not made by a philosopher-king who efficiently uses all available information and always puts the public interest ahead of his own interest. Friedman argues that one need not attribute evil intent to Fed officials to conclude that they often put the Fed's self-interest ahead of the public interest.

Nonetheless, many economists seem to interpret the monetarist's belief that the Fed does not wholeheartedly pursue the public interest as an attack on the integrity of Fed policy-makers. Many economists know these policy-makers personally and know them to be devoted public servants. Hence, they find any attack on the Fed's intentions entirely implausible.

INTRODUCTION

In this chapter, I explore how an economic theorist might explain or model a concept such as corporate culture. While the theoretical construction that is given is far from inclusive (which is to say that many aspects of corporate culture are not covered), I conclude that economic theory is moving in the direction of what seems a reasonable story. But before that story can be considered told, we must employ tools that are currently missing from the economist's tool kit. In particular, we require a framework for dealing with the unforeseen.

I can give two explanations for why I present this topic. The first concerns how economists (and those weaned on the economic paradigm) deal with the topic of business strategy. If we take Porter (or Caves or Spence) as the prototype, business strategy could roughly be called applied industrial organization. The firm and its capabilities are more or less taken as givens, and one looks at the tangible characteristics of an industry to explain profitability. It sometimes seems, in this approach, that there are good industries (or segments of industries) and bad: Find yourself in a bad industry (low entry barriers, many substitutes, powerful customers and suppliers, many and surly competitors), and you can do nothing except get out at the first opportunity. Now, this is assuredly a caricature of the Porter approach. The size of entry barriers, relations with suppliers/customers, and, especially, competitive discipline within an industry are all at least partially endogenous.

In the 1950s and 1960s, the main line of conceptual development in most of the social sciences was contradictory to that in economics. In most social sciences other than economics, the single most influential framework was probably the one the late Talcott Parsons presented. Economics, on the other hand, was not influenced by this framework and even proceeded along an opposing line. Diversity and debate are, of course, desirable, so these differences had their uses. Still, in another respect they were (or should have been) troubling. The substantive domains of the social sciences overlap a great deal, so the mutually contradictory frameworks sometimes led to opposing results that could not all be true. Scientific progress normally leads to scientific consensus, presumably because results become so compelling that all competent investigators are persuaded and professional disagreements focus on new and not-yet-settled issues that are, in turn, eventually often also resolved.

In more recent years, the theoretical evolutions of the different social sciences have perhaps been more encouraging. The habits of thought in these sciences are probably not so different now as they were a couple of decades ago. Significant numbers of leading people in each of the social sciences are working along quite resonant lines. Work is also going on in different disciplines that is cumulative across disciplines. This is clearly true, for example, in the work on the Arrow paradox, on the theory of deterrence and strategy, on collective action and public goods, and on spatial models of political interaction.

POSITIVE POLITICAL ECONOMY

Recent advances in interdisciplinary research in economics and politics have created the field of positive political economy. This new research tradition is distinct from both normative and historical approaches to political economy. The former emphasizes value judgments about the distribution of wealth and power and derives optimal outcomes or arrangements according to postulated standards of evaluation. The latter focuses atheoretically on thick historical description. In contrast, positive political economy, on the one hand, seeks out principles and propositions against which actual experience can be compared in order to understand and explain, not judge, that experience. On the other hand, although ultimately interested in real phenomena, positive political economy is explicitly theoretical. Its focus is on microfoundations, and it is grounded in the rational-actor methodology of microeconomics. Thus, its most distinguishing characteristics are its coherent and unified theoretical view of politics and economics, its strongly interdisciplinary nature, and its concern with explaining empirical regularities.

Moreover, in contrast to either of the separate fields of economics and political science, positive political economy emphasizes both economic behavior in political processes and political behavior in the marketplace. In emphasizing the former it uses an economic approach – constrained maximizing and strategic behavior by self-interested agents – to explain the origins and maintenance of political institutions and the formulation and implementation of public policies. In emphasizing the latter it stresses the political context in which market phenomena take place.

In this chapter a conceptual framework developed from the insights of X-efficiency (XE) theory is employed to analyze the behavior and performance of the Fed. Our analysis makes two major points of departure. First, the extreme public-choice and neoclassical perspectives are regarded as limiting cases. In our framework, the Fed attempts to strike a trade-off between (1) increasing its own organizational welfare (publicchoice perspective) and (2) increasing public welfare (neoclassical perspective). Second, from the perspective of XE theory, we regard completely optimal behavior by the Fed as a limiting case, because this perspective allows for the existence of behavior that is less than completely optimal behavior, or X-inefficient behavior. However, this contention does not imply that Fed policy-makers are selfish or incompetent. X-inefficiency is a ubiquitous phenomenon that exists (at least to some degree) in almost all organizations, in spite of best intentions and vigilance. The precise extent of X-inefficiency in an organization may be controversial. Its potential existence should not be ruled out on a priori grounds.

Ideally, this assertion should be backed by numerous examples of Xinefficiency in the Fed. However, because there is always considerable controversy about the precise optimal monetary response in a specific situation, it is difficult to assert with certainty that a given Fed response or behavior is X-inefficient. Janis and Mann (1977) concede that within an organization, frequently it is impossible to carry out adequately controlled field experiments that permit unambiguous determination of the causal impact of alternative decision-making styles and procedures. Our problem is even more intractable because the responses themselves are controversial.

Introduction

The Federal Reserve System is perhaps the most controversial nonelected element of the government of the United States. Journalists and voters vilify it, Congress and the president seek to dominate it, and scholars argue about it. Our focus is on the literature that considers the political accountability and responsiveness of the U.S. monetary authority. This body of work has undergone a clear evolution over time, going from a view of the Fed that took for granted its autonomy toward a perspective that debates the agency's independence and seeks to illuminate the avenues of political influence on it.

Because of the importance of the Fed in shaping monetary and overall economic policy, it is a powerful weapon. If political actors could gain control of it and learn how to use it effectively, there is little question that the executive, the Congress, and other external actors could better their own lot by providing useful service to grateful constituents. The question is, can political actors influence the Fed, and if so, how? The literature contains some hints that both the Congress and the executive have at least occasionally succeeded in influencing monetary policy, presumably to their electoral benefit. But these results are controversial, and the only real agreement to date is that there exists no consensus on their validity.

We shall not presume in this brief setting to describe at length the issues in this controversy or to take a position on them. Instead, our goal is to trace the evolution of scholarly work on the Federal Reserve's political accountability.

My concern here is with a central debate in modern political economy – the degree to which constituency interests are accurately represented by democratic institutions. Those on one side of this debate believe that legislators accurately represent constituency interests. Such representation may not lead to the policy the median voter most prefers because special interest groups carry more political weight than would be proportionate to the number of voters who are members of them. But, just as wealthy people secure larger shares of private sector output than poor people do, so organized groups secure larger shares of public sector output. In this sense, voter sovereignty prevails in politics as effectively as consumer sovereignty prevails in markets. From this perspective, their constituencies effectively control legislators (Becker 1983; Peltzman 1984, 1985).

Those on the other side of the debate believe that legislators exercise significant freedom from the preferences of their constituencies and that they exercise this through political behavior that deviates from behavior that would serve their constituencies. Presumably, deviations favor legislators' ideological preferences, not those of constituencies. Because this view sees that the interests of constituencies diverge from the behavior of legislators, it relies on the proposition that agency cost in politics is important enough to allow legislators to retain office even when they substitute their own political preferences for their constituencies' interests (see Kalt and Zupan 1984, in press).

“Leaning against the wind” is a distinctively telling metaphor that communicates to an audience of laypeople and nonprofessionals what the Federal Reserve is up to in a way that the phrase “contracyclical monetary policy” cannot. The metaphor was introduced by Chairman William McChesney Martin in congressional testimony just after the famous Accord in 1951. According to Ralph Young (private communication, August 6, 1976), he used it frequently for dramatic expository effect in informal colloquy before large groups, and its main purpose was “[Fed] political and public relations.” The phrase appears only rarely in the official minutes of the Federal Open Market Committee (FOMC). Nevertheless, I think that so apt a metaphor deserves a permanent place in the literature that attempts to describe Federal Reserve monetary policy. The connotation of the phrase “leaning against the wind” is clear enough. The policy response of the Fed to cyclical disturbances is to moderate disturbances in output, employment, and prices.

The performance of the U.S. economy during the 1950s was blemished by the occurrence of two recessions (1953–4 and 1957–8), interspersed by a mild inflationary boom (1954–7). Some Federal Reserve critics, such as Brunner and Meltzer (1964, pp. 51–2), Lombra and Torto (1973, pp. 48–9), and Guttentag (1966), regarded the Fed's responses to those cyclical disturbances as suboptimal. They ascribed the Fed's unsatisfactory behavior solely to a defective policy strategy attributable to an alleged discrepancy between policy action and policy intent. Presumably, the intent of the policy-makers was strongly countercyclical, whereas their understanding of how monetary policy was to work was defective.

Institutions are the humanly devised constraints that shape human interaction. They reduce uncertainty by providing a structure to political, social, and economic exchange. In order to understand the role of institutions in making choices we must rethink our views about human behavior and then explore the costs of exchange. In this chapter I shall first briefly examine the behavioral assumptions used in economics in order to develop a transaction-cost theory of exchange. I then apply the framework to both economic and political exchange. I conclude with a brief discussion of the implications of the theory for analyzing institutions.

THE BEHAVIORAL ASSUMPTIONS OF ECONOMICS

The basic behavioral assumption of neoclassical economics makes a direct connection between expected utility and outcomes with no intervening dilemmas of uncertainty. There are no institutions in such a setting. They are unnecessary precisely because this behavioral assumption ignores the uncertainty that arises from the incomplete and imperfect processing of information, a pervasive feature of human interaction. Institutions reduce the costs of human interaction from those that would be found in an institution-free world (although there is no implication in that statement that they are “efficient” solutions).

The behavioral assumptions of economics have recently been the subject of a good deal of critical scrutiny (Hogarth and Reder 1986), which has focused on the anomalies of intransitivity, preference reversal, framing, and inconsistent processing of subjective probabilities. Less attention has been given the much more fundamental issue of which behavioral assumptions are consistent with the existence of institutions.

To appreciate the textures and aromas of exquisitely flavored foods and sauces, one needs to cultivate an educated palate. Similarly, to appreciate the Federal Reserve's complex role in the evolution of U.S. monetary and regulatory policies and policy structures, one needs to cultivate an informed political-economic perspective on the Fed's evolving bureaucratic interest and on the various battles for turf in which this agency becomes involved.

Top Federal Reserve officials portray monetary stabilization and financial regulation as multidimensional services that, because of potentially valuable informational spillovers, are best produced together and run by their agency. Implicit in that conception is a presumption that Fed officials operate a politically inert and farsighted enterprise, passionately dedicated to the goals of economic efficiency and macroeconomic stability. Far from acquiescing in that presumption, this chapter emphasizes that efforts to protect the Fed's bureaucratic self-interest introduce myopia and distributional politics into Fed policy decisions and public statements.

The analysis offered here is intended as an antidote to traditional writings on the U.S. Federal Reserve System. Most macroeconomists portray the Fed as a politically inactive institution whose virtually only business is to use its “big three” policy weapons (open-market operations, reserve requirements, and the discount rate) to fight the excesses of the business cycle. This chapter depicts the Fed as a politically sensitive bureaucracy whose marketing activity and capacity for financing continuing clientele subsidies are at least as important as its production of stabilization services.

The monetary experience of Japan over the past decade provides an example of a nation that has effectively stabilized its domestic inflation rate in the face of major internal and external shocks, while simultaneously avoiding recession. Japan did experience a short period of double-digit inflation around the time of the 1973 oil price shock that was higher and initially more disruptive than in the United States. However, Japan's response to that experience was the introduction in 1973 and 1974 of an explicit price stabilization strategy that quickly reduced the nation's “core inflation” to the lowest among the major industrial countries.

Four important aspects of the relative performances of the U.S. and Japanese economies since 1975 are shown in Figure 11.1. The panels on the left show that monetary growth and inflation in Japan have been more stable than in the United States. The panels on the right show that Japan has experienced a smaller degree of disruption in the real and financial sectors, as reflected by the unemployment rate and the gap between unregulated and regulated interest rates.

This chapter focuses on the differing monetary policy experiences of the United States and Japan as an explanation for the differences between the two nations' macroeconomic performances. We attempt to isolate reasons for the differences in monetary policy experiences. In particular, we argue that the differences cannot be found in the technical characteristics by which the Federal Reserve (FR) and the Bank of Japan (BOJ) formulate and execute monetary policy; rather, the differences are more fundamentally rooted in the institutional and political environments in which the two central banks operate.

The Cambridge series on the Political Economy of Institutions and Decisions is built around attempts to answer two central questions: How do institutions evolve in response to individual incentives, strategies, and choices, and how do institutions affect the performance of political and economic systems? The scope of the series is comparative and historical rather than international or specifically American, and the focus is positive rather than normative.

The simultaneous treatment of these two central questions is at the heart of the field of positive political economy. On the whole, the chapters collected in this volume avoid normative judgments and steer a course midway between broad historical generalization and detailed microtheoretical reasoning. Within these limits, they contain a broad set of views of the theoretical structure of the field. Chapters survey both microroots and macrophenomena in the evolution of First World and Third World political economies. Much of the volume is addressed to organizational development, discussed from diverse perspectives that stress the roles of reputation and unforeseen contingencies, of factional competition for amenity potential, and of the cost of attempting to influence collective actions. In later chapters, several contending approaches are represented in discussions of varied units of analysis that have founded research programs: individual decisions, exchange transactions, rent seeking, and indivisibilities.

Nevertheless, while displaying much diversity of approach and content, the chapters of this volume share an underlying unity of purpose: to demonstrate how economic and political outcomes reflect choices constrained by institutions while also explaining why and how, in view of the outcomes, such institutions should have developed.

Twenty-five years ago William Dewald and Harry Johnson (1963) published their path-breaking Federal Reserve reaction function. By regressing an indicator of Fed policy on the Fed's goal variables, such as the unemployment rate and the price index, they tried to replace vague talk about the Fed's response to economic conditions with more rigorous econometric procedures. Not surprisingly, their work gave rise to an extensive research effort. Has that effort been successful? One way to approach that question is to see if Fed reaction functions generally have reached similar conclusions, so that one can say that certain results have been well established. Another way is to ask if the results reached by the use of Fed reaction functions are robust with respect to more or less arbitrary differences in specifications. Unfortunately, as this chapter will show, neither of those conditions has been met.

This is unfortunate, because a reliable Fed reaction function is needed for at least three purposes. One obviously is to predict Fed actions. Another is to evaluate Fed behavior. This is relevant for the debates about monetary rules and the appropriate degree of Fed independence. A third purpose is to aid in estimating the policy multipliers for econometric models. As Stephen Goldfeld and Allan Blinder (1972), among others, have shown, omitting the central bank's reaction function in an econometric model can lead to serious estimation errors.

There exist two types of reaction functions that answer quite distinct questions. One, which may be called an “intentions function,” asks how the Fed wants to change aggregate demand when, say, the unemployment rate changes.

The impulse to study politics scientifically is both old and persistent. Aristotle collected 158 constitutions in order to generalize about events and institutions in the Politics. Early in the Renaissance, Machiavelli revived the Aristotelian program in the Discourses and The Prince, although he did not seem to have as clear a vision of the scientific method as did Aristotle. Late in the eighteenth century, when the term political science came into general use, John Adams studied republics in exactly the Aristotelian spirit and with, perhaps, an even bolder claim for political science:

By the twentieth century, however, hardly anyone shared Adams's faith in the relative certainty of social and physical science. Surely few people now believe that our laws of political life are as certain or as useful for making predictions as are the laws employed in sending a man to the moon or in eradicating smallpox. In 1778, however, when Adams started his book, electricity had been identified but hardly understood, chemistry consisted mainly of the story of phlogiston, and no one had ever thought that bacteria were connected with disease.