- Why was the Fed generally so ineffective before the late 1980s?
- Why has macroeconomic volatility declined since the late 1980s?
The long and at first seemingly salutary reign of Greenspan the Great (1987–2006)wohlstetter.typepad.com/letterfromthecapitol/2006/02/greenspan_the_g.html and the auspicious beginning of the rule of Bernanke the Bald (2006–present)www.princeton.edu/pr/pictures/a-f/bernanke/bernanke-03-high.jpg temporarily provided the Fed with something it has rarely enjoyed in its nearly century-long existence, the halo of success and widespread approbation. While it would be an exaggeration to call Federal Reserve Board members the Keystone Kops of monetary policy, the Fed’s history is more sour than sweet.
Central bankers use tools like open market operations, the buying and selling of assets in the open market, to influence the money supply and interest rates. If they decrease rates, businesses and people will want to borrow more to build factories and offices, buy automobiles, and so forth, thus stimulating the economy. If they increase rates, the opposite will occur as businesses and people find it too costly to purchase big ticket items like houses, boats, and cars. Unlike communist central planners, central bankers do not try to directly run the economy or the various economic entities that compose it, but they do try to steer aggregate behavior toward higher levels of output. In that sense, central banks are the last bastions of central planning in otherwise free market economies. And central planning,en.wikipedia.org/wiki/Planned_economy as the Communists and the Austrian economists who critiqued them discovered, is darn difficult.en.wikipedia.org/wiki/Austrian_School
This is not a history textbook, but the past can often shed light on the present. History warns us to beware of claims of infallibility. In this case, however, it also provides us with a clear reason to be optimistic. Between 1985 or so and 2007, the U.S. macroeconomy, particularly output, was much less volatile than previously. That was a happy development for the Fed because it, like most other central banks, is charged with stabilizing the macroeconomy, among other things. The Fed in particular owes its genesis to the desire of Americans to be shielded from financial panics and economic crises.
The Fed itself took credit for almost 60 percent of the reduction in volatility. (Is anyone surprised by this? Don’t we all embrace responsibility for good outcomes, but eschew it when things turn ugly?) Skeptics point to other causes for the Great Calm, including dumb luck; less volatile oil prices (the 1970s were a difficult time in this regard);www.imf.org/external/pubs/ft/fandd/2001/12/davis.htmless volatile total factor productivity growth;en.wikipedia.org/wiki/Total_factor_productivity and improvements in management, especially just-in-time inventory techniques, which has helped to reduce the inventory gluts of yore.http://en.wikipedia.org/wiki/Just-in-time_(business) Those factors all played roles, but it also appears that the Fed’s monetary policies actually improved. Before Paul Volcker (1979–1987), the Fed engaged in pro-cyclical monetary policies. Since then, it has tried to engage in anti-cyclical policies. And that, as poet Robert Frost wrote in “The Road Not Taken,” has made all the difference.www.bartleby.com/119/1.html
For reasons that are still not clearly understood, economies have a tendency to cycle through periods of boom and bust, of expansion and contraction. The Fed used to exacerbate this cycle by making the highs of the business cycle higher and the lows lower than they would otherwise have been. Yes, that ran directly counter to one of its major missions. Debates rage whether it was simply ineffective or if it purposely made mistakes. It was probably a mixture of both that changed over time. In any event, we needn’t “go there” because a simple narrative will suffice.
The Fed was conceived in peace but born in war. As William SilberIn the interest of full disclosure, Silber was once my colleague, but he is also the co-author of a competing, and storied, money and banking textbook. points out in his book When Washington Shut Down Wall Street, the Federal Reserve was rushed into operation to help the U.S. financial system, which had been terribly shocked, economically as well as politically, by the outbreak of the Great War (1914–1918) in Europe.www.pbs.org/greatwar At first, the Fed influenced the monetary base (MB) through its rediscounts—it literally discounted again business commercial paper already discounted by commercial banks. A wholesaler would take a bill owed by one of its customers, say, a department store like Wanamaker’s, to its bank. The bank might give $9,950 for a $10,000 bill due in sixty days. If, say, thirty days later the bank needed to boost its reserves, it would take the bill to the Fed, which would rediscount it by giving the bank, say, $9,975 in cash for it. The Fed would then collect the $10,000 when it fell due. In the context of World War I, this policy was inflationary, leading to double-digit price increases in 1919 and 1920. The Fed responded by raising the discount rate from 4.75 to 7 percent, setting off a sharp recession.
The postwar recession hurt the Fed’s revenues because the volume of rediscounts shrank precipitously. It responded by investing in securities and, in so doing, accidentally stumbled upon open market operations. The Fed fed the speculative asset bubble of the late 1920s, then sat on its hands while the economy crashed and burned in the early 1930s. Here’s another tidbit: it also exacerbated the so-called Roosevelt Recession of 1937–1938 by playing with fire, by raising the reserve requirement, a new policy placed in its hands by FDR and his New Dealers in the Banking Act of 1935.
During World War II, the Fed became the Treasury’s lapdog. Okay, that is an exaggeration, but not much of one. The Treasury said thou shalt purchase our bonds to keep the prices up (and yields down) and the Fed did, basically monetizing the national debt. In short, the Fed wasn’t very independent in this period. Increases in the supply of some items, coupled with price controls and quantity rationing, kept the lid on inflation during the titanic conflict against Fascism, but after the war the floodgates of inflation opened. Over the course of just three years, 1946, 1947, and 1948, the price level jumped some 30 percent. There was no net change in prices in 1949 and 1950, but the start of the Korean War sent prices up another almost 8 percent in 1951, and the Fed finally got some backbone and stopped pegging interest rates. As the analysis of central bank independence suggests, inflation dropped big time, to 2.19 percent in 1952, and to less than 1 percent in 1953 and 1954. In 1955, prices actually dropped slightly, on average.
This is not to say, however, that the Fed was a fully competent central bank because it continued to exacerbate the business cycle instead of ameliorating it. Basically, in booms (recessions) business borrowing and the supply of bonds would increase (decrease), driving rates up (down). (For a review of this, see Chapter 5 "The Economics of Interest-Rate Fluctuations".) The Fed, hoping to keep interest rates at a specific rate, would respond by buying (selling) bonds in order to drive interest rates back down (up), thus increasing (decreasing) MB and the money supply (MS). So when the economy was naturally expanding, the Fed stoked its fires and when it was contracting, the Fed put its foot on its head. Worse, if interest rates rose (bond prices declined) due to an increase in inflation (think Fisher Equation), the Fed would also buy bonds to support their prices, thereby increasing the MS and causing yet further inflation. This, as much as oil price hikes, caused the Great Inflation of the 1970s. Throughout the crises of the 1970s and 1980s, the Fed toyed around with various targets (M1, M2, fed funds rate), but none of it mattered much because its pro-cyclical bias remained.
Stop and Think Box
Another blunder made by the Fed was Reg Q, which capped the interest rates that banks could pay on deposits. When the Great Inflation began in the late 1960s, nominal interest rates rose (think Fisher Equation) above those set by the Fed. What horror directly resulted? What Fed goal was thereby impeded?
Shortages known as credit crunches resulted. Whenever p* > preg, shortages result because the quantity demanded exceeds the quantity supplied by the market. Banks couldn’t make loans because they couldn’t attract the deposits they needed to fund them. That created much the same effect as high interest rates—entrepreneurs couldn’t obtain financing for good business ideas, so they wallowed, decreasing economic activity. In response, banks engaged in loophole mining.
By the late 1980s, the Fed, under Alan Greenspan, finally began to engage in anti-cyclical policies, to “lean into the wind” by raising the federal funds rate before inflation became a problem and by lowering the federal funds rate at the first sign of recession. Since the implementation of this crucial insight, the natural swings of the macroeconomy have been much more docile than hitherto, until the crisis of 2007–2008, that is. The United States experienced two recessions (July 1990–March 1991 and March 2001–November 2001)www.nber.org/cycles/cyclesmain.html but they were so-called soft landings, that is, short and shallow. Expansions have been longer than usual and not so intense. Again, some of this might be due to dumb luck (no major wars, low real oil prices [until summer 2008 that is]) and better technology, but there is little doubt the Fed played an important role in the stabilization.
Of course, past performance is no guarantee of future performance. (Just look at the New York Knicks.) As the crisis of 2007–2008 approached, the Fed resembled a fawn trapped in the headlights of an oncoming eighteen-wheeler, too afraid to continue on its path of raising interest rates and equally frightened of reversing course. The result was an economy that looked like road kill. Being a central banker is a bit like being Goldilocks. It’s important to get monetary policy just right, lest we wake up staring down the gullets of three hungry bears. (I don’t mean Stephen Colbert’s bearswww.youtube.com/watch?v=KsTVK9Cv9U8 here, but rather bear markets.)
- The Fed was generally ineffective before the late 1980s because it engaged in pro-cyclical monetary policies, expanding the MS and lowering interest rates during expansions and constricting the MS and raising interest rates during recessions, the exact opposite of what it should have done.
- The Fed was also ineffective because it did not know about open market operations (OMO) at first, because it did not realize the damage its toying with rr could cause after New Dealers gave it control of reserve requirements, and because it gave up its independence to the Treasury during World War II.
- The Fed’s switch from pro-cyclical to anti-cyclical monetary policy, where it leans into the wind rather than running with it, played an important role in decreased macroeconomic volatility, although it perhaps cannot take all of the credit because changes in technology, particularly inventory control, and other lucky events conspired to help improve macro stability over the same period.
- Future events will reveal if central banking has truly and permanently improved.