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For release on delivery
7:20 p.m. E.S.T.
December 5, 1996

The Challenge of Central Banking
in a Democratic Society
Remarks by
Alan Greenspan
Board of Governors of the Federal Reserve System
at the
Annual Dinner and Francis Boyer Lecture
The American Enterprise Institute for Public Policy Research
Washington, D.C.
December 5, 1996

The Challenge of Central Banking
in a Democratic Society
Good evening ladies and gentlemen.

I am especially pleased

to accept AEI's Francis Boyer Award for 1996 and be listed with
so many of my friends and former associates.

In my lecture this

evening I want to give some personal perspectives on central
banking and, consequently, I shall be speaking only for myself.
William Jennings Bryan reportedly mesmerized the Democratic
Convention of 1896 with his memorable " shall not crucify
mankind upon a cross of gold."

His utterances underscored the

profoundly divisive role of money in his time—a divisiveness
that remains apparent today.

Bryan was arguing for monetizing

silver at an above-market price in order to expand the money

The presumed consequences would have been an increase in

product prices and an accompanying shift in the value of net
claims on future wealth from the "monied interests" of the East
to the indebted farmers of the West who would arguably be able to
pay off their obligations with cheaper money.
The debates, before and since, over the issue of our money
standard have mirrored the deliberations on the manner in which
we have chosen to govern ourselves, and, perhaps more
fundamentally, debates on the basic values that should govern our
For, at root, money—serving as a store of value and medium
of exchange—is the lubricant that enables a society to organize
itself to achieve economic progress.

The ability to store the

fruits of one's labor for future consumption is necessary for the


accumulation of capital, the spread of technological advances
and, as a consequence, rising standards of living.
Clearly in this context, the general price level, that is,
the average exchange rate for money against all goods and
services, and how it changes over time, plays a profoundly
important role in any society, because it influences the nature
and scope of our economic and social relationships over time.
It is, thus, no wonder that we at the Federal Reserve, the
nation's central bank, and ultimate guardian of the purchasing
power of our money, are subject to unending scrutiny.

Indeed, it

would be folly were it otherwise.
A central bank in a democratic society is a magnet for many
of the tensions that such a society confronts.

Any institution

that can affect the purchasing power of the currency is perceived
as potentially affecting the level and distribution of wealth
among the participants of that society, hardly an inconsequential
Not surprisingly, the evolution of central banking in this
nation has been driven by such concerns.

The experiences with

paper money during the Revolutionary War were decidedly

"Not worth a Continental" was scarcely the epithet

one would wish on a medium of exchange.

This moved Alexander

Hamilton, with some controversy, to press for legislation that
established the soundness of the credit of the United States by
assuming, and ultimately repaying, the war debts not only of the
fledgling federal government, but of the states as well.



controversial was the chartering of the First Bank of the United
States, which, although it had few functions of a modern central
bank, was nonetheless believed to be a significant threat to
states rights and the Constitution itself.
Although majority controlled by private interests, the Bank
engaged in actions perceived to shift power to the federal

Such a shift was thought of by many as a fundamental

threat to the new democracy, and an essential element of what was
feared to be a Hamilton plan to re-establish a powerful

The First Bank—and especially its successor Second

Bank of the United States—endeavored to restrict state bank
credit expansion when it appeared inordinate, by gathering bank
notes and tendering them for specie.

This reduced the reserve

base and the ability of the fledgling American banking system to
expand credit.

The issue of states' rights and concern about the

power of the central government reflected the free wheeling
individualism of that time.
the election of 1832.

The Second Bank was a major issue of

Earlier in that year, President Andrew

Jackson had vetoed the bill to extend its charter, and the
election became a referendum on his veto.

The outcome was a

resounding victory for Jackson and the death knell for the Bank.
It has not been easy, however, to separate often seemingly
conflicting threads in the debate between advocates of state
powers over money and those seeking a national role.

When Andrew

Jackson vetoed the charter renewal of the Second Bank of the
United States, for example, he argued for the severing of the

-4grip on the economy of easterners and especially foreigners, who
owned a significant stock interest in the bank.

Ironically, by

helping to create what was perceived to be an unstable currency,
he set the stage for the later development of a full-fledged gold
standard, the institution that Bryan railed against in 1896 from
much the same populist philosophical base as Jackson.
After the Civil War, redemption of the paper greenbacks
issued during the war brought an era of a gold-standard induced
deflation, which, while it may not have thwarted the impressive
advance of industrialization, was seen by many as suppressing
credit availability for the rural interests of the nation, which
were still a majority.

The general price level declined for more

than two decades, which meant borrowers were paying off their
loans in more expensive dollars than those they borrowed.
Not surprisingly, mounting pressures developed for reform,
with Bryan bearing the standard for subsidized silver coinage,
that is, free silver.

Though Bryan lost to McKinley in 1896 (and

again in 1900), the rural-based pressures for a more elastic
currency did not diminish and ultimately were reflected, in part,
in the creation of the Federal Reserve.
Nonetheless, many of the proponents of banking reform in the
1890s, and in the aftermath of the Panic of 1907, were suspicious
of creating a central bank.

In very large measure, those

concerns underlay the various threads of reform that were joined
together in the design and creation of the Federal Reserve System
in 1913.

Its founding followed a prolonged debate on the balance

-5of power between the interests of the New York money center banks
and the rest of the nation, still largely rural.

The compromise

that resulted from that debate created twelve regional Reserve
Banks with a Washington presence vested with a Federal Reserve

Its purpose was to "furnish an elastic currency,

establish a more effective supervision of banking in the United
States, and for other purposes."

Monetary policy as we know it

today, was not among the "other purposes."

That evolved largely

by accident in the 1920s.
Even with a central bank, the gold standard was still the
dominant constraint on the issuance of paper currency and the
expansion of bank deposits.

Accordingly, the Federal Reserve was

to play a minor role in affecting the purchasing power of the
currency for many years to come.
The world changed markedly with the advent of the Great
Depression of the 1930s, and the evisceration of the gold

The upheaval, and still festering fear of New York

"monied interests," engendered the Banking Acts of 1933 and more
importantly of 193 5, which vested more of the Federal Reserve's
authority with the Board of Governors in Washington.


World War II, and through 1951, however, monetary policy was
effectively subservient to the interests of the Treasury, which
sought access to low-cost credit.

With the so-called Federal

Reserve-Treasury Accord of 1951, the Federal Reserve began to
develop its current degree of independence.

-6Although in the 1950s and early 1960s there were short-lived
bouts of inflation that caused momentary concern about sustained
increases in the price level, these events did little to shake
the conviction of most that America's economic and financial
structure would indefinitely and effectively contain any
inflationary forces.

This prescription certainly seems to have

been reflected in the low inflation premium then embedded in
long-term bonds.
That this view was profoundly wrong soon became apparent.
The 1970s saw inflation and unemployment simultaneously at
relatively elevated levels for some time.

The notion that this

could occur was nowhere to be found in the conventional wisdom of
the economic policy philosophy that developed out of the
Keynesian revolution of the 1930s and its subsequent empirical

Moreover, these models embodied the view that

aggregate demand expansion, from almost any level, would
permanently create new jobs.

When that expansion carried the

economy beyond "full employment" there would be a cost in terms
of higher inflation—but only a one-time increase in inflation,
so that there existed a permanent trade off between sustainable
levels of inflation and employment.
The stagflation of the 1970s required a thorough conceptual
overhaul of economic thinking and policy-making.

Monetarism, and

new insights into the effects of anticipatory expectations on
economic activity and price setting, competed strongly against
the traditional Keynesianism.

Gradually the power of state

-7intervention to achieve particular economic outcomes came to be
seen as much more limited.

A consensus gradually emerged in the

late 1970s that inflation destroyed jobs, or at least could not
create them.
This view has become particularly evident in the communiques
that have emanated from the high-level international gatherings
of the past quarter century.

That inflation could reduce

employment was a highly controversial subject in the mid-1970s
when introduced into communique language drafts.

At the meetings

I attended as Chairman of the Council of Economic Advisers, the
notion invariably induced extended debates.

Today in similar

communiques such language is accepted boiler plate and rarely the
focus of discussion.

This shift in attitudes and understanding

provided political support in 1980 and thereafter for the type of
monetary policy required to rebalance the economy.
Despite waxing and waning over the decades, a deep-seated
tension still exists over government's role as an economic

This tension is evident in Congressional debates,

campaign rhetoric and our ubiquitous talk shows.
It should not be a surprise that the very same ambiguities
and conflicts that characterize the rest of our political life
have their reflection in the nation's current view of its central
bank, the Federal Reserve.

With regard to monetary policy, the

view—or at least the suspicion—still persists in some quarters
that an activist, expansionary policy could yield dividends in
terms of permanently higher output and employment.


evident to the public at large, and that policy may have to
reverse course from time to time as the underlying forces acting
on the economy shift.

This process is not easy to get right at

all times, and it is often difficult to convey to the American
people, whose support is essential to our mission.
Because the Fed is perceived as being capable of
significantly affecting the lives of all Americans, that we
should be subject to constant scrutiny should not come as any

Indeed, speaking as a citizen, and not Fed Chairman, I

would be concerned were it otherwise.

Our monetary policy

independence is conditional on pursuing policies that are broadly
acceptable to the American people and their representatives in
the Congress.
Augmenting concerns about the Federal Reserve is the
perception that we are a secretive organization, operating behind
closed doors, not always in the interests of the nation as a

This is regrettable, and we continuously strive to alter

this misperception.
If we are to maintain the confidence of the American people,
it is vitally important that, excepting the certain areas where
the premature release of information could frustrate our
legislated mission, the Fed must be as transparent as any agency
of government.

It cannot be acceptable in a democratic society

that a group of unelected individuals are vested with important
responsibilities, without being open to full public scrutiny and

-10To be sure, if we are to carry out effectively the monetary
policy mission the Congress has delegated to us, there are
certain Federal Reserve deliberations that have to remain
confidential for a period of time.

To open up our debates on

monetary policy fully to immediate disclosure would unsettle
financial markets and constrain our discussions in a manner that
would undercut our ability to function.

Nonetheless, we continue

to look for ways to expand the flow of information to the public
without compromising our deliberations and purposes.

We have

recently commenced to announce all policy actions immediately,
federal funds rate changes as well as discount rate changes, and
have expanded the minutes of the Federal Open Market Committee.
For many years, the Federal Reserve has maintained what we
trust is a highly sophisticated day-by-day, near real-time,
evaluation of the American economy and, where relevant, of
foreign economies as well.

We are able, partly through our

twelve Reserve Banks, to monitor continuously developments in the
real world.

The information supplied about local conditions by

the directors of the Reserve Banks has been frequently useful in
identifying emerging national trends and in evaluating their
underlying regional implications.
The issues with which we are confronted differ in urgency
over time.

Inflation concerns were not a dominant factor in

economic forecasting in the 1950s and early 1960s, for example.
Since the late 1970s, however, such concerns have become an
important element in policy-making.

More recently inflation has

-11been low, but its future course remains uncertain.


development of comfortable product, but tight labor, markets has
been a crucial factor in short-term economic forecasts of recent
months—a phenomenon for which there is scant historic precedent.
There is, regrettably, no simple model of the American
economy that can effectively explain the levels of output,
employment, and inflation.

In principle, there may be some

unbelievably complex set of equations that does that.

But we

have not been able to find them, and do not believe anyone else
has either.
Consequently, we are led, of necessity, to employ ad hoc
partial models and intensive informative analysis to aid in
evaluating economic developments and implementing policy.


is no alternative to this, though we continuously seek to enhance
our knowledge to match the ever growing complexity of the world
At different times in our history a varying set of simple
indicators seemed successfully to summarize the state of monetary
policy and its relationship to the economy.

Thus, during the

decades of the 1970s and 1980s, trends in money supply, first Ml,
then M2, were useful guides.

We could convey the thrust of our

policy with money supply targets, though we felt free to deviate
from those targets for good reason.

This presumably helped the

Congress, after the fact, to monitor our contribution to the
performance of the economy.

I should add that during this period

we maintained a fully detailed analysis of the economy, in part,

-12to make sure that money supply was still emitting reliable
signals about the state of the economy.
Unfortunately, money supply trends veered off path several
years ago as a useful summary of the overall economy.

Thus, to

keep the Congress informed on what we are doing, we have been
required to explain the full complexity of the substance of our
deliberations, and how we see economic relationships and evolving
There are some indications that the money demand
relationships to interest rates and income may be coming back on

It is too soon to tell, and in any event we can not in

the future expect to rely a great deal on money supply in making
monetary policy.

Still, if money growth is better behaved, it

would be helpful in the conduct of policy and in our
communications with the Congress and the public.

In the absence

of simple, summary indicators, we will continue our detailed
evaluation of economic developments.

As we seek price stability

and maximum sustainable growth, the changing economic structures
constantly present more analytic challenges.
I doubt the tasks will become any easier for the Federal
Reserve as we move into the twenty-first century.

The Congress

willing, we will remain as the guardian of the purchasing power
of the dollar.

But one factor that will continue to complicate

that task is the increasing difficulty of pinning down the notion
of what constitutes a stable general price level.

-13When industrial product was the centerpiece of the economy
during the first two-thirds of this century, our overall price
indexes served us well.

Pricing a pound of electrolytic copper

presented few definitional problems.

The price of a ton of cold

rolled steel sheet, or a linear yard of cotton broad woven
fabrics, could be reasonably compared over a period of years.
But as the century draws to a close, the simple notion of
price has turned decidedly ambiguous.
unit of software or a legal opinion?

What is the price of a
How does one evaluate the

price change of a cataract operation over a ten-year period when
the nature of the procedure and its impact on the patient changes
so radically.

Indeed, how will we measure inflation, and the

associated financial and real implications, in the twenty-first
century when our data—using current techniques—could become
increasingly less adequate to trace price trends over time?
So long as individuals make contractual arrangements for
future payments valued in dollars, there must be a presumption on
the part of those involved in the transaction about the future
purchasing power of money.

No matter how complex individual

products become, there will always be some general sense of the
purchasing power of money both across time and across goods and

Hence, we must assume that embodied in all products is

some unit of output and hence of price that is recognizable to
producers and consumers and upon which they will base their

Doubtless, we will develop new techniques of price

measurement to unearth them as the years go on.

It is crucial

-14that we do, for inflation can destabilize an economy even if
faulty price indexes fail to reveal it.
But where do we draw the line on what prices matter?
Certainly prices of goods and services now being produced—our
basic measure of inflation—matter.

But what about futures

prices or more importantly prices of claims on future goods and
services, like equities, real estate or other earning assets?
Are stability of these prices essential to the stability of the
Clearly, sustained low inflation implies less uncertainty
about the future, and lower risk premiums imply higher prices of
stocks and other earning assets. We can see that in the inverse
relationship exhibited by price/earnings ratios and the rate of
inflation in the past.

But how do we know when irrational

exuberance has unduly escalated asset values, which then become
subject to unexpected and prolonged contractions as they have in
Japan over the past decade?
into monetary policy?

And how do we factor that assessment

We as central bankers need not be

concerned if a collapsing financial asset bubble does not
threaten to impair the real economy, its production, jobs, and
price stability.

Indeed, the sharp stock market break of 1987

had few negative consequences for the economy.

But we should not

underestimate or become complacent about the complexity of the
interactions of asset markets and the economy.

Thus, evaluating

shifts in balance sheets generally, and in asset prices

-15particularly, must be an integral part of the development of
monetary policy.
The public examination of Federal Reserve actions extends
well beyond our stewardship of monetary policy,

our overall

management of the Federal Reserve System should, and does, come
under considerable scrutiny by the Congress.

Since we expend

unappropriated taxpayer funds, we have an especial obligation to
be prudent and efficient with the use of those funds.

I am not

particularly concerned about the one-third of our annual
$2 billion budget that is expended to provide financial services
to the private sector in competition with other providers.


services include the clearing of checks, the operation of the
Fedwire system, and the processing of automated clearing house

We are reimbursed for those services, and at

competitive prices still make a reasonable profit for the

If we became inefficient and uncompetitive, we would

be priced out of the market, and eventually out of that line of
An additional one-sixth of our expenses are for providing
services to the Treasury and other agencies of government for
which we are subject to reimbursement with appropriated funds.
For the remainder, which mainly covers monetary policy,
supervision and regulation of banks, and currency operations, we
have to be especially diligent, for there is no external arbiter.
The rapidly changing technologies of recent years are
pressing us to review thoroughly our structure and operations.

-16We have already engaged in major consolidations of operations
when such consolidations have been made cost effective by the
newer technologies.

Although in my experience the Federal

Reserve System has been responsible, efficient, and has performed
well, the rapidly changing external environment frequently
requires us to rethink our role and mission.

Even where we can

be competitive, it is not the role of a government agency,
especially one vested with an unsurpassable credit rating, to
seek out all available market opportunities.

Accordingly, where

specific priced services have become effectively and
competitively provided by private sector suppliers, the Federal
Reserve needs to reassess whether the extent of our participation
in those services fulfills a reasonable public purpose.


are, of course, certain services that the Congress has, and will
in the future, deem appropriate for us to subsidize.

But these

areas presumably will remain circumscribed.
As a step in our periodic reassessment, a special committee
of Federal Reserve Board governors and Reserve Bank presidents
has been set up to review our priced services operations and
other Systemwide activities.
Another step has been to engage outside accounting firms to
audit the Federal Reserve Board and the twelve Reserve Banks. We
had been quite satisfied with the Board as general auditor of the
Reserve Banks since 1914.

But the range of activities and the

reach of the Federal Reserve in recent years requires us to
address the perception that we are auditing ourselves without the

-17full arm's length relationship deemed appropriate in today's
Finally, the substantial changes under way in bank risk
management are pressing us to continuously alter our modes of
supervision and regulation to keep them as effective and
efficient as possible.
Most importantly, all of our recent initiatives, especially
the strengthening of the payments system and supervision, are
critical to a central mission of the Federal Reserve, to maintain
financial stability and reduce and contain systemic risks.
mission is an extension of our monetary policy.


Our country can

not enjoy the long-run "maximum employment and stable prices"
objectives we are given for monetary policy if the financial
system is unstable.

In this regard the successes that most

please us are not so much the visible problems that we solve, but
rather all the potential crises that could have happened, but
Doubtless, the most important defense against such crises is

Recent mini-crises have identified the rapidly

mushrooming payments system as the most vulnerable area of
potential danger.

We have no tolerance for error in our

electronic payment systems.

Like a breakdown in an electric

power grid, small mishaps create large problems.


we have endeavored in recent years, as the demands on our system
have escalated (we clear $1-1/2 trillion a day on Fedwire), to

-18build in significant safety redundancies.

This has been costly

in terms of equipment and buildings.
Along with our other central bank colleagues, we are always
looking for ways to reduce the risks that the failure of a single
institution will ricochet around the world, shutting down much of
the world payments system, and significantly undermining the
world's economies.

Accordingly, we are endeavoring to get as

close to a real time transaction, clearing, and settlement system
as possible.

This would sharply reduce financial float and the

risk of breakdown.

Meaningful progress has already been made in

this direction.
This evening, I have tried to put current central banking
issues in historical context.

Monetary arrangements, including

central banks, naturally are under constant scrutiny and

This is no less true of the Federal Reserve in 1996

than of the gold standard in 1896.

Central banks need to respond

patiently and responsibly to the commentary, and we need to adapt
to changing circumstances in markets and the economy.
A democratic society requires a stable and effectively
functioning economy.

I trust that we and our successors at the

Federal Reserve will be important contributors to that end.