Treasury's little buddy: the Federal Reserve's World War II-style monetary regime is both not working and producing extraordinary inequality.

• Author: Brenner, Reuven

When governments spend beyond their means, be it due to wars or by compounding mistakes, the options for paying for the spree are unattractive. Governments can impose higher taxes; can wipe out a portion of bondholders' wealth by inflating and devaluing, repaying debts with a debased currency; or can do a combination of the above. Not for the first time in its history, the United States has managed to avoid either of these choices for now. Using the Federal Reserve's toolkit, the government lowered its interest cost from $451.2 billion in FY2008 to $415.7 billion in FY2013, even as the federal debt soared from $10 trillion in 2008 to $17 trillion in 2013.

Though Fed Chairman Ben Bernanke has likened the "quantitative easing" policy to the monetary regime adopted during the 1940s, the analogy he draws is mistaken: He has been carrying out fiscal policy--simple, though not so pure. In a 2002 speech, he declared that the Fed policies were successful during 1940-1951, but he fails to point out that the Treasury imposed them to pay down the debts of World War II, and the Fed was not an independent entity then:

"Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2.5 percent on long-term Treasury bonds for nearly a decade.... The Fed was able to achieve these low rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today.... At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills." [emphasis added].

Well, no. Bernanke is wrong. The pegging had nothing to with a "sufficiently determined Fed," but with a very determined Treasury that was worried about the budgetary impact of higher interest rates. The Fed was actually carrying out its policy under strict orders from the Treasury, even though by 1948 it was warning about the rise in inflation (which the official numbers underestimated because of price controls). Marriner Eccles, the Federal Reserve chairman at the time, testified that "under the circumstances that now exist, the Federal Reserve System is the greatest potential agent of inflation that man could contrive." It was only the 1951 agreement with the Treasury that made the Fed more independent. Even then, the Fed had to contend with President Harry Truman and Treasury Secretary John Snyder's staunch defense of the low interest rate peg. They wanted the Fed to finance the Korean War the same way it helped finance World War II.

Briefly: The Fed was executing a fiscal policy to help pay for World War II and, after 1945, to service the accumulated debt. Patriotism induced 1940s-1950s savers to buy the government's low-coupon bonds, though the Treasury did rely on movie stars, musicians, and Norman Rockwell posters in its pitch for the "Victory Bonds." Nobody was rationalizing the "tax the savers" policy with macroeconomic gobbledygook and new jargon about keeping price levels stable or controlling unemployment. Currently, by contrast, the Fed is avoiding public discussion in clear language and, most recently, is departing from even its official "unemployment" mandate. The Fed is using the orthodox but wildly inaccurate macro jargon to link its "QE" policy to the unprecedentedly low labor participation rate. In its present mode, the Fed is contributing--perhaps inadvertently--both to slowing down the pressure on Washington to find solutions to the fiscal problems the United States is facing, and to raising a host of new, unintended ones.

Although Bernanke also suggested that holding down long-term interest rates can work even better nowadays than it did seventy years ago, we believe the opposite to be true. The Fed's present policies are not only having no discernible positive effects, but are laying the foundation for many negative ones. The adverse consequences arise not only from the Fed engaging in fiscal policy, but also from the drastically increased inequality within the United States since 2008.

Several special circumstances during the 1940s helped sustain Fed policies similar to today's without some of the current side effects. First, the Fed had political support for its actions. To start with, the...