Wall Street Rules

06/21/2006 12:00am

Dean Baker
Truthout, June 21, 2006

See article on original website

The idea that the government, or some arm of government, is controlled by a special interest group naturally prompts outrage. The government should be answerable to the public as a whole, not special interests that have extraordinary political power.

For this reason, it was striking to see a piece (“Confusion From the Fed Head“) in the Washington Post’s Outlook section in which Richard Yamarone, an investment analyst, matter of factly asserted that Wall Street controls the Federal Reserve Board of Fed. As Mr. Yamarone put it, “The Fed chairman may be appointed by the president and confirmed by the Senate, but his real bosses are on Wall Street.”

This statement is an incredible indictment of the U.S. political system. The Fed has far more direct impact on the U.S. economy than any other agency of the government. It can control how many people in the United States have jobs. While the media tend to speak of the Fed’s actions in euphemisms, when the Fed raises or lowers interest rates (its main policy tools) it is deciding whether the economy should create more or fewer jobs.

Cuts in interest rates are intended to boost the economy. Lower interest rates make it easier for families to buy cars and homes and for businesses to invest. If more cars and homes are sold and more factories or offices are built, then more people are employed. In the opposite case, if the Fed raises interest rates, it makes it harder to buy cars and homes and for businesses to invest. This means that fewer people will be employed.

As a practical matter, it is often easier for the Fed to destroy jobs than create them. Sometimes lower interest rates will not be sufficient to boost the economy. (A worker concerned about losing her job may be reluctant to buy a new car regardless of how low the interest rate falls.) By contrast, if the Fed raises interest rates high enough, it can be sure that it will eventually slow the economy and reduce employment.

The Fed generally decides to throw people out of work when it gets concerned about inflation, as is the case at present. The logic is simple; if unemployment increases, then workers will find it more difficult to push up wages. Bosses will decide that they can just hire another worker from among the unemployed if their current workers ask for pay increases. Since wages are a cost to businesses, if wages rise less rapidly, then costs will rise less rapidly, and firms will probably slow the pace at which they raise their prices. In other words, by using unemployment to slow wage growth, the Fed can restrain inflation.

It is important to understand that this method of restraining inflation does not affect everyone equally. The people who lose their job when the Fed raises interest rates tend to be factory workers, retail clerks, and custodians, not doctors, lawyers, and CEOs. In other words, the Fed controls inflation by forcing the middle class and poor to face higher unemployment and take pay cuts.

There is also an important racial component to the Fed’s inflation fighting. As a rule of thumb, the unemployment rate for African Americans tends to be twice the overall unemployment rate, while the unemployment rate for African American teens is typically six times the overall average. This means that if the Fed pushes up the overall unemployment rate from 4.5 percent to 6.5 percent, it will raise the unemployment rate for African Americans from roughly 9.0 percent to 13.0 percent. It will raise the unemployment for African American teens from roughly 27 percent to 39 percent.

It is important to understand these facts when we hear it asserted (correctly) that the Fed answers to Wall Street. The most disadvantaged people in society are the ones who suffer when the Federal Reserve Board decides to clamp down on inflation. While many economists pretend that the decision to raise interest rates to slow inflation is an exact science, like physics, the fact is that they have almost no idea how inflation moves through the economy. The vast majority of the economics profession got inflation completely wrong in the nineties.

What does this mean? Wall Street doesn’t like inflation. It hurts profits, end of story. Therefore, Wall Street demands that the Fed raise interest rates to throw poor people and African Americans out of work. That isn’t the assessment of a crazed radical. You heard it from an investment analyst in the Washington Post.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer. He also has a blog, “Beat the Press,” where he discusses the media’s coverage of economic issues. You can find it at the American Prospect’s web site.

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