>> and dr. rivlin? you will not remember, but many years ago i ran into you walking down the street, and you were very, very kind to me. you spent literally 10, 15 minutes just talking to me on the street about some, a couple also esoteric issues so i have always been very appreciative of your time. >> thank you. glad you have that memory. i think asset bubbles are a real problem for the fed, but not because of the balance sheet effect. because monetary policy is not a good tool for dealing with asset bubbles. it's a good tool for dealing with general price inflation. so the fed needs different tools. credit, specific credit controls, and controls on excessive leverage to deal with bubbles, and the dodd/frank act does put them in that business,

and i think that's good. >> well, could current fed action and even dr. galbraith's opinion, could the current fed balance sheet, the mechanics there, could it also be leading to a bond bubble right now? if we start to move towards more normalized interest rates, have we created so much paper that ma may move rates when we start to move? >> i don't think is has to. i think the fed can get its balance sheet down quickly. it's always much easier for the fed to be less accommodative than more. and i'm not -- i'm not worried about this astonishing balance sheet. it's very big, but right now the reason to worry would be to -- that we had general inflation, and we don't. >> dr. galbraith?

>> i think it would be very hard for -- >> you may have to hit your mike. >> i think it would be very hard for the federal reserve to raise interest rates rapidly, and i don't think it's likely to do so. is there a situation -- one way to interpret your question, ask whether there is a situation in which the markets might sell off u.s. bonds rapidly without that being controllable by monetary policy action. i think that's also unlikely under present conditions. what the markets have shown us is that in adversity, people want to hold u.s. bonds. they want to hold u.s. bonds over practically any other asset because we are the largest, most liquid, and completely reliable market in the world for safe liquid assets. >> in no -- i'm sorry. pardon me, sir, but how much more capacity do you believe is pragmatic for the fed to continue to grow at? go to a $4 trillion? $5 trillion?

how big do these balance sheets get? >> an interesting question for which, congressman, i don't have an answer. >> mr. chairman, thank you. yield back. >> thank you very much. we're going to have a brief second round if you're able to stay, but i have a question for dr. rivlin and also for dr. klein. i don't want to get into so much on the cause, but i'm trying to get an assessment on how serious you think the world financial crisis is. a lot of us, you know, put a lot of blame on monetary policy and federal reserve and the dollar reserve standard and excessive debt in these issues. we're not going to resolve that today, who is to blame, but do you consider the world financial swaying to be a mess or just something that will be taken care of soon and there's not that much to worry about? >> i'm very worried about europe. i think the austerity policies

are the wrong policies at the moment, but they have -- they'll make the situation worse, and that could be bad for us. the long-run debt situation in europe is serious, but at the moment i would focus attention on their getting out of the recession. for us, i think we've got to get out of this recession, too, but we've got to get our long-run debt under control. i think we can, but we haven't. >> all right. could you follow-up, dr. klein? give me your assessment? >> oh, i think it's a huge crisis, both in europe and in the u.s., with tremendous consequences. not only the crisis itself but in my view the response to the crisis by the monetary authority. the hugely accommodative policy, the zero interest rates and so on, have taken a bad situation and sown the seeds for making that situation much, much worse. of course, we haven't seen

substantial rises in the overall price level since 2008, but if you look at the amount of money that has been pumped into the system, increase in bank reserves and so on, there's simply no theoretical model of which i'm aware, no empirical study that i can cite, in which those kinds of actions do not have very serious long-run consequences on price inflation. so i think we haven't seen the worst of the results that current policy is bringing about. >> thank you, and i yield to mr. clay. >> thank you, mr. chairman. i would like to start with a panel-wide question, perhaps you can briefly try to answer it. starting with dr. herbener. do you think the federal reserve's monetary policy execution would be more

effective if it set explicit inflation targets and were held accountable to those targets? >> not really. i think when the -- when the fed engages in any kind of expansionary monetary policy, they always generate the same ill-effect in the economy. they always generate some kind of credit expansion which leads to a pattern of malinvestments, even when they keep overall price levels stable. they generate asset price increase within the price level and these malinvestments, we've seen in the 1920s, very similarly also in the 1980s, so even if there were stable price level targets that the fed could hit, they would still generate the same kind of financial

instability and patterns of malinvestments and then the necessary liquidation that we see in the bust. >> how about dr. klein, your opinion? >> i think posing the problem as a trade-off between, say, inflation targeting as opposed to targeting nominal income is sort of a false dichotomy. something representative paul mentioned in the first round was the idea of increased productivity resulting in decreases in prices as, of course, we see in many industries, computers, information technology, and so on. there's no reason that we should expect or desire, quote/unquote, stable price level of 2% a year or whatever in a growing economy we might easily expect the price level to fall. that's exactly what happened during the 19th century in the u.s., which was the period of the strongest sustained economic growth in u.s. history. that increased growth, which was driven by productivity

improvements, resulted in a decreasing of price levels. there's no reason for policy to prevent that. >> thank you. dr. taylor? >> we already have an inflation target. the fed has announced 2%. in the meantime we continue to do this highly interventionist policy. seems to me that is not enough, and that's why people are talking about the mending. returning to recording about the strategy of the fed. i think you need more than that to get out of the terrible situation we're in now. >> thank you. dr. galbraith? >> i think explicit targets can be useful. in the humphries/hawkins law there was an interim target for 4% unemployment, 3% inflation, to be achieved after four years. it took 22 until alice rivlin was running things and it actually happened, but the difficulty i think was in

setting too ambitious a target and allowing too long a time frame for there to be real accountability. if you're going to set targets, it should be on an interactive basis and something where you can come back in a year and say, look, how did you do in relation to those targets and what have you learned about the world from your experience? that would make a useful contribution, it seems to me. >> dr. rivlin, your opinion? >> i would agree with that. i think the 2% target is about right. i wasn't a big enthusiast of setting an explicit target, but 2% is about right. as long as you don't take it too seriously. because there might be reasons to deviate in one direction or another. >> thank you so much. mr. chairman, i yield back. >> i now recognize the gentleman from arizona for a follow-up. >> thank you. we were sort of hitting on the question i was concerned with dr. taylor and then moved to dr. klein. how big can the balance sheet get? >> i already think it's too big. >> can you pull the mike closer, please?

>> i think the quantitative easing, qe 1 and qe2, were not appropriate. that's why the balance sheet is as big as it is. if we had just done the interventions during the panic period, the balance sheet would already be back to normal, and i don't see any evidence that -- i've done research on qe1, and i think that it's already too big. i do worry about the size of it already because it has to be pulled out or there will be a bubble. in fact, right now we are already running a risk of a bubble, because of the commitment to hold rates so low for so long. i think, when you talk about bubbles and we talk about the fed's efforts to stop bubbles, i think the problem really is more, is the fed causing bubbles, rather than the responsibility to deal with them. so i see that concern in the housing bubble. i have seen other bubbles in the past. and you think about bubbles, let's not forget the fact that

the fed itself can and in fact has in the past caused bubbles and it may be doing that again right now. >> dr. klein? >> yes, i agree strongly with what dr. taylor has said about the fed being the cause of bubbles and the idea the fed needs additional tools to be able to pop bubbles when they emerge is taking the wrong view of the nature and sources of those bubbles, but as to your question about the balance sheet, i agree with dr. taylor but would add it isn't just the overall size of the balance sheet that matters. it's the composition of the balance sheet, and my concern as a microeconomist in looking at quantitative easing and other interventions by the fed it's not so much their effect on the fed's overall balance sheet but the effect on particular firms and industries. the winner picking, preventing restructurings that are needed to get the economy back on the right track is just as important as looking at the overall size of the balance sheet. >> dr. galbraith and then we're going to bounce back. >> do you have a comment on,

first, how big the balance sheets can get, and does the mix or the size create both a distortive effect on the allocation of capital? >> as i said earlier, i don't have a clear view on how big the balance sheet might get. i do think that as one looks at the composition of the balance sheet, what's in the portfolio, one has to evaluate the quality of the assets, and that is a process which has ramifications for the financial structure going forward. and there comes a point when you do need to address those questions. >> okay. doctor? >> i would justed a one thing. most -- i think most of us would agree that the real problem is, how exactly is the fed going to unwind the balance sheet, not how big is it going to get? but what will be the process by which they take these assets off the their books, and what

will the repercussions be in the markets when they begin this process seriously of unwinding things? >> there goes by bond bubble concern. but what do i know? dr. rivlin, you've also been outspoken both on fiscal policy and you know -- you know, that's always been appreciative to have other voices out there saying we have some great difficulties. has the fact that the fed has been able to grow its balance sheets to such extraordinary levels, has in many ways, has that been a way to help congress avoid fiscal policy? >> i don't think so. i think the congress has not wanted to face up to the hard choices, and they -- the fed's buying bonds is a small part of

the whole world buying bonds, as dr. galbraith said. counter to reality, the world believes that we are a very safe investment. >> but in u.s. sovereign debt issues over the last 24 months, hasn't the fed represented close to half? >> i don't know exactly what the figure is, but right now we can't have a rapid reduction in our national borrowing because it would derail the recovery. so i don't think the fed has much of a choice. i would be cautious about increasing the balance sheet much further. i don't think there's an answer to your very good question about how big can it get, but right now i think we need a double kind of fiscal policy. it shouldn't be too severe in the short run, but we've got to get the long-run debt under control.

>> mr. chairman, thank you. >> i recognize mr. green from texas. >> thank you, mr. chairman. i thank you and the ranking member for calling us to this hearing today, and i thank the witnesses for being in attendance. mr. chairman, i also want to thank you, because i'm one of the members who signed the letter requesting such a hearing, and i thank you for honoring the request. to the witnesses, let's start with something very basic. the bills that we have range from tweaking to the abolishing of the fed, and i'm curious as to how many of you are of the opinion that we should totally eliminate the fed? is there anyone who thinks that it should be abolished? one, two persons think that we should simply abolish the fed. and if you could, just give me a quick, if you can, summary of why you think the fed should be abolished and then i'd like to

hear from your colleagues as to why you think we should maintain it. just quickly, because obviously time is of the essence and i'll start with you, is it mister herbener? >> herbener. >> all right, sir. >> the fed should be abolished because the conduct of monetary policy under the fed can bring no benefit to society at large. as i mentioned -- >> in your opinion -- does the fed, will make bad decisions every time? there will be no good decisions made? it can't have the positive impact on the economy? >> i would say that there is no other instance where the government has completely monopolized the production of something on the market. >> all right. i'm going to have to accept that as your answer and prove to the as your answer and move to the next person. mr. klein? >> yes. i mean, we can talk about the federal reserve system per se as an example of a central bank or the institution of central banking more generally.

in my written testimony i give reasons why the institution of central banking is not only unneeded but is also harmful to a market economy. >> in your opinion there should not be a central bank in the united states of america? >> yes, sir. we don't have a central automobile manufacturer or central dairy or a central computer -- >> how do you juxtapose that with the central banks around the world where major countries all around the world have central banks? >> what i'm expounding is not the majority view but that partly makes it incorrect. >> i think that makes it a fair statement. mr. taylor? >> i think we should reform the fed. i think the evidence especially in the last few years is that the policy's not working. i look back in history and i see the '80s and '90s part of the time where alice rivlin was on the fed and things worked pretty well. intervening, like we're doing

now, a more steady as you go policy. a lot of focus on the overall stance of policy, and it worked. so i think we need to get back to that. i call it a rules-based policy. not more statistic policy and some of the reforms discussed today will help us get back to that. >> next, please. >> i think on the whole, congressman, the 20th century was better than the 19th and having a central bank was a modest useful part of the institutional structure it gave us a fairly successful century. i'm very cautious about taking radical institutional steps when there is very little going on in the world that would give us confidence that they would be stabilizing rather than destabilizing. >> doctor? >> i feel strongly that we need a strong and independent central bank. i think the evidence of the 19th century is not as encouraging as some would think, and the idea that the world's greatest economy could make do without a

central bank, without a lender of last resort, without a monetary policy seems to me quite bizarre. >> now, doctor, thank you. let me go back in reverse order and start with you first, doctor, and the question is would we be at a disadvantage if we had no central bank and other major economic powers had central banks? >> i think we would be. and i think we'd lose our pre-eminence as the, as a great -- >> would it impact currency supremacy? the dollar, as you know, is a fairly well-accepted currency around the world? would it have an impact on the dollar? >> yes, i think it would. >> let me go to the next person, please. >> yes, i think it clearly would have an impact. it would make the dollar a much,

a dollar, u.s. treasury bonds much riskier. >> mr. taylor, then quickly? >> i don't recommend abolishing the fed. i recommend reforming the fed. >> would we be at a disadvantage, sir, if we -- mr. klein, if we had no central bank and other countries did? >> of course it depends exactly how such a reform would be implemented. look, right now people are fleeing from the dollar and heading towards hard assets like precious metals. >> sir? >> if the dollar was backed by gold, i don't see how that could harm our -- >> you would back the dollar with gold? >> yes, sir. >> thank you, mr. chairman. >> thank you. i now recognize the gentle lady from new york. >> i'm sorry. thank you, mr. chairman. i have a thought for us as we conclude, and i thank you so much for your insights, each of you. it strikes me that the size of the fed's balance sheet is going to be largely determined, given the structure of our representative democracy, by the

will of the american people to take in hand what we have created for ourselves at this juncture in our history. is there any sense that, really, it's going to take a lot of political will, if you will, to get our fisc in order, for us really to -- unless there's some significant change in the role of the fed or the structure of the fed, i think so much of it's going to lie in how we manage our federal budget going forward. panel, dr. rivlin, since i missed you last time. >> i strongly agree with that. i served on the simpson/bowles division and the dough men chi/rivlin commission, and there are other groups that have all come to the conclusion that we really need to get our fiscal house in order so that the debt is not rising faster than our economy can grow.

and that's going to take hard decisions. we've got to do it. >> thank you, dr. rivlin. thank you for your service. it is must appreciated. dr. klein, since i -- i'll flip back around. >> of course, i agree. this is a tremendous political challenge. whether it takes a major crisis to call forth the political will to make the necessary changes i don't know, but i would hope that this body and others would be able to push things in the right direction without waiting for the bottom to fall out. >> right. dr. herbener, do you think what we're viewing in europe we should take as a portent of things to come if we don't do something? >> well, i think our situation is perhaps even more precarious than theirs, given what the fed has done in the -- in the wake of the crisis to bail out the banking system. so, again, it's going to take strong action against some of the political interests that exist here to turn things around before, as dr. klein said, there's a crisis and then we have to do something. >> right. dr. taylor, your thoughts?

>> well, fiscal policy is certainly a mess right now, and it's got to be fixed or we will be like europe, but please don't forget about monetary policy. it tends to be arcane, tends to be people tune out, it's difficult, but it see essential right now to get right. i don't want to see a future where quantitative easing becomes the new monetary policy, when the economy slows down we do gigantic quantitative easings. we don't even know their effect, how large it should be. it is very dangerous, and i think it will take some oversight exercised by congress to prevent that in the future. >> in view of what you said, dr. taylor, regarding the fed's purchase of treasuries and the proportion of treasuries that have gone to the fed, isn't there a certain crowding out effect that we might also be witnessing? >> eventually, of course. but in the meantime, actually the figure is 77%. >> yes. >> the amount of debt increase in fiscal year 2011, 77% of that

was the fed. and that's a gigantic amount, and so crowding out, i believe there is crowding out about that. even if the economy's weak, yes. in a weakened economy. >> so the federal budget concerns and the federal investments are crowding out the private -- >> part that occurs because of >> crowding out occurs because of the deficits and the borrowing and even in a weak economy i believe it occurs, but as the economy picks up, it will be even more of a concern. >> right. and we're also artificially, if you will in a sense, because of what the fed is endeavored to do, artificially making the picture for treasuries look a bit rosier than it would be if we had a real marketplace for them. >> what i think the fed is doing now with respect to oversized balance sheet and effectively dictating what the short-term interest rate will be, it doesn't set it in the market. it dictates by telling what the reserves interest rates will be on reserves. so it's effectively as the fed has replaced the entire money market with itself. >> right. >> and i tell you, we just don't know all the implications of

that. nobody at this panel knows the implications of that. the sooner we get back to normal and the interest rates set according to reasonable methodology and reported to the congress the strategy, the better off we'll be. >> it becomes an uber bank in a sense. >> yes. >> thank you all. thank you again, chairman. >> thank very much. i want to thank the panel today for your time and your testimony. i found the hearings very fascinating, because even though we might not agree on the cause and exactly what we have to do, it seemed like there was a general consensus we have a problem and we have to deal with it. it's not just the united states, it's worldwide, and my guess is that some day we will seriously not only look at the management of a central bank or whether or not we really need a central

bank, but ultly matly, i think what we'll have to do is talk about the nature of money, the definition of money, because it's pretty hard to manage something you can't even define. once again, thank you very much for coming today.