learning objectives
- 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 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.)
key takeaways
- 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.
