Alan Meltzer’s Three Laws of Regulation:

1. Lawyers and bureaucrats regulate, but markets circumvent regulation.
2. Regulations are static. Markets are dynamic.
3. Regulation is most effective when it changes the incentives of the regulated.

Meltzer's new book: Why Capitalism?

A review of the headlines of the past decade seems to show that disasters are often part of capitalist systems: the high-tech bubble, the Enron fraud, the Madoff Ponzi scheme, the great housing bubble, massive lay-offs, and a widening income gap. Disenchantment with the market economy has reached the point that many even question capitalism itself.

Allan H. Meltzer disagrees, passionately and persuasively. Drawing on deep expertise as a financial historian and authority on economic theory, he provides a resounding answer to the question, "why capitalism?" Only capitalism, he writes, maximizes both growth and individual freedom. Unlike socialism, capitalism is adaptive, not rigid--private ownership of the means of production flourishes wherever it takes root, regardless of culture. Laws intended to tamper with its fundamental dynamics, such as those that redistribute wealth, fail. European countries boasting extensive welfare programs have not surpassed the more market-oriented United States. Capitalism does require a strong legal framework, Meltzer writes, and it does not solve all problems efficiently. But he finds that its problems stem from universal human weaknesses--such as dishonesty, venality, and expediency--which are not specific to capitalism. Along the way, he systematically analyzes the role of government, positing that regulations are static, but markets are dynamic, usually seeking ways to skirt the rules. Regulation is socially useful if it brings private costs into line with social costs (for example, the cost of taxes to hire policemen compared to that of the impact of rampant crime); if it doesn't, regulation simply invites circumvention.

Open Letter For Fed Independence

Amidst the debate over systemic regulation, the independence of U.S. monetary policy is at risk. We urge Congress and the Executive Branch to reaffirm their support for and defend the independence of the Federal Reserve System as a foundation of U.S. economic stability. There are three specific risks that must be contained.

First, central bank independence has been shown to be essential for controlling inflation. Sooner or later, the Fed will have to scale back its current unprecedented monetary accommodation. When the Federal Reserve judges it time to begin tightening monetary conditions, it must be allowed to do so without interference. Second, lender of last resort decisions should not be politicized.

Finally, calls to alter the structure or personnel selection of the Federal Reserve System easily could backfire by raising inflation expectations and borrowing costs and dimming prospects for recovery. The democratic legitimacy of the Federal Reserve System is well established by its legal mandate and by the existing appointments process. Frequent communication with the public and testimony before Congress ensure Fed accountability.

If the Federal Reserve is given new responsibilities every effort must be made to avoid compromising its ability to manage monetary policy as it sees fit.

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Allan Metzer declines to sign the petition.

“I wrote them back and said, ‘the Fed has rarely been independent and it strikes me that being independent is very unlikely,’” in the current environment, Meltzer tells Deal Journal.

It isn’t that Meltzer, a political economist at Carnegie Mellon University’s Tepper School of Business, thinks the Fed’s recent role rescuing such financial institutions as Bear Stearns, Fannie Mae and Freddie Mac is sound monetary policy. Rather, he faults the committee of academics that drafted the petition for not coming up with constructive ways to keep the Fed independent in face of the current fiscal and political pressures. “It basically says do the right thing,” he says. “That is not very effective.”

Meltzer says history is replete of instances when the Fed bended to political pressure. In the 1930s, the Fed kept interest rates low to help finance government spending for New Deal programs and, later, World War II. In the 1960s, the Johnston administration pressured the Fed to keep rates low to finance its fiscal spending, causing inflation to accelerate. At other times, the Fed has resisted political pressure, as in the 1920s, when Congress wanted it to lower rates to help struggling, over-leveraged farmers, or in 1980s, when the Fed didn’t lower rates even as unemployment soared.

“Now we have the present Fed, which is not at all independent,” Meltzer says. He thinks the current proposal to make the Fed the top regulator of all financial institutions that pose systemic risk is a “terrible idea.”

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