Maintaining a stable value of money is one of government’s most important roles. The dual mandate of the Federal Reserve is probably a mistake, as the goals of maintaining full employment and a stable currency are often in conflict.
Inflation is similar to taxes in that it distorts economic decision making and thus is a serious drag on the economy. If variation in the nominal value of money must be constantly protected against and accounted for the normally difficult economic decisions of business and life become a great deal more complex and more difficult.
A reasonably stable money value is a requirement for a productive economy.
Inflation favors debtors and penalizes savers. Lenin said that the way to crush the middle class is to grind it between the millstones of taxation and inflation.
Government should attempt to act as a stabilizing force in times of economic crises, but the Federal Reserve’s temptation to alleviate every financial crisis both creates an inflation bias and allows the economy to avoid small self correcting setbacks, and so builds the fuel for a major financial conflagration.
The financial crisis of 2008-2009 was caused primarily by a collapse in housing prices brought on by a bubble precipitated by excessively loose lending standards of Fannie Mae and Freddie Mac. The Federal Reserve and the Treasury saved us from a much worse financial catastrophe by massively expanding the money supply and buying up troubled assets, saving banks, etc. The government recovered most of the money it lent the failing banks who were failing more because of excessive leverage in a liquidity crisis rather than poor business practices. The banking system operates normally with too much leverage for most banks to withstand a major liquidity crisis unless the government steps in to provide some relief. Government should require banks to operate with less leverage but not so much less that it would never be required to use emergency measures to re-liquefy the economy under any conceivable liquidity crisis. The whole principle of the banking system is built on leverage and the economy cannot function smoothly without it. There should be no stigma against the Federal Reserve and the Treasury re-liquefying the economy through the banking system in the event of a major liquidity crisis and loss of confidence that threatens a major depression. When banks are rescued by the government it is done, and it should be, in a way that almost wipes out the existing equity ownership and it should only be done at times of major liquidity crises, otherwise it introduces serious moral hazard.
As the contagion of both optimism and pessimism is inherent in human nature, so booms and busts are characteristic of capitalism. Massive financial crises are the result of a massive loss of confidence in the financial system and one of the greatest threats to capitalism and democracy.
The Great Depression was so deep and lasted so long primarily because of a massive contraction through the banking system in the supply of money and multiple other, and major, government policy mistakes. The appropriate government policy when confidence in the financial system is collapsing is to massively increase the money supply through the banking system and the worse the collapse in confidence the more difficult this is to do. The Goldilocks solution is for the government to begin increasing the money supply before the situation reaches the catastrophic level but not so early as to encourage moral hazard, a very tricky business, and if the Fed fails to properly rebalance its swollen balance sheet after dealing with one financial crisis it will have little ammunition to deal with the next one.
It is important to understand why monetary stability is so beneficial to the economy and how destructive both inflation and deflation are when significant.
The government has often played a major role in past financial crises and government mistakes interact with decisions in the private economy to produce bubbles and bursts.