|Intro. [Recording date: December 2, 2010.] Reminder: On Twitter as EconTalker. Topic today: Has the Fed Been a Failure? Could also put an exclamation point instead of question mark--not a traditional way to title a paper. Has the Federal Reserve improved economic performance since its establishment in 1913? Mainstream view at least until recently--lender of last resort; it's eliminated the bank runs and panics of the 19th century. Early years marred by the Great Depression, but once understood, we got the Great Moderation, great prosperity. You and your co-authors disagree. Let's start with the role of the Fed as the lender of last resort. Hasn't that been a good thing? Wasn't the 19th century this tumultuous set of bank panics and bank runs that we don't have to worry about any more? What's the evidence on that issue. The 19th century was marred by bank panics and runs but it's important to realize that the few studies that try consistently to account for panics find that until the Bank Holiday of 1933, the panics were not less frequent or less severe than they had been before the Fed. If anything you find an increase in panics and an increase in severe panics, although it's true that the majority of these occurred during those last three years of the period in question, banking panics of the 1930s. There were about 5 of them in all, including the most severe ever. Afterwards you don't have panics to the same degree as before, but as we argue in our paper, what really brought panics to a halt for a while was first, the Reconstruction Finance Corporation (RFC) which bought tremendous amount of bank stocks in 1933 and the Federal Deposit Insurance Corporation (FDIC) and Federal Savings and Loan Insurance Corporation (FSLIC) by providing deposit insurance eliminate what had become one of the more important proximate causes of the panics before the 1930s. The RFC was a Hoover New Deal agency. Unfortunately, not well-appreciated; far more instrumental than the Fed was in allowing the banking system to be reopened after the National Bank Holiday without renewed withdrawals and panics. Another thing at least as influential--the withdrawal of gold from the banking system was suspended by executive order during the Bank Holiday. The big run that started at the end of February 1933 and continued till the National Holiday was mainly a run on gold because people feared devaluation. Once they couldn't get gold any more that took that motive away.
|Bank runs generally. I'm a depositor in a bank; I put my money in the bank, with the promise the bank will do two things: it will pay me some interest along the way and it will give me my money when I ask for it; and when I ask for it, it will be there. The bank in turn, in order to pay that interest, keeps not 100% of the money in the vault. They lend it--they are an intermediary. The risk, though, is if everybody showed up on the same day to get their money out, it wouldn't be there, as George Bailey explains in It's a Wonderful Life. There's no reason to think everybody will show up on the same day unless people fear they won't be able to get their money out. That's where the idea of a bank run or bank panic occurs. Not just a bad piece of luck that everybody at the same time wants their money out; it's some kind of uncertainty or fear that the bank is not solvent. Talk about what happened before FDIC insurance and before the Fed, what in the 19th century led to these runs and how did the market respond? First, important to note that even though a lot of economists are fond of theories that people run on banks just because of fear, the historical record overwhelmingly shows that bank runs, in the absence of insurance, have tended to be runs on banks that were in danger of failing, and not because of the runs but because of bad loans. It wasn't animal spirits. Animal spirits are much overrated as a factor in historical bank runs. Usually people run on banks that were on the verge of insolvency at the time of the run or heavily involved with other banks that were in that situation, indirect basis for fearing they were in trouble. True also in U.S. experience; in the United States runs and panics have been much more common than in other countries, and what's even more revealing is if you look at different banking systems in the 19th century, especially when they tended to be different--today all more or less the same as far as the role of central banks and insurance--you find that runs and panics were a much bigger problem in the more regulated system. And the United States is at the top of that list among industrialized nations at the time. When you go to systems that were relatively less regulated, you find that panics were either unknown or infrequent. Why would regulation encourage panics? Let's take the United States, since regulations there did the most harm. The kinds of regulations I'm talking about included restrictions on branch banking. Most chartered state banks couldn't branch; there were some exceptions. National banks couldn't branch at all until the McFadden Act of 1927 allowed them to branch only in those state jurisdictions where the state banks could branch; so that didn't make much of a difference. The lack of branch banking alone made for a system of very weak banks and lots of them. The argument there would be if I'm a standalone bank and can't branch out geographically, one place, then I am at the mercy of economic forces in that one geographical area. So if there's a factory layoff that significantly affects homeowners in that area, they won't be able to pay their mortgages back; as a result, my mortgages will go bad and I may have trouble honoring my promises. Really comes from the first principle of finance: if you want to have a safe portfolio and avoid insolvency you need to be able to diversify. In those days, banks could not buy and sell loans as they can do today. Weren't many marketable securities out there besides the Federal ones. Banks were heavily dependent on the success on the firms and farms in the local economy. When you had local shocks, they easily succumbed to those shocks and runs were often in response to the perception that banks were in danger of failing or that some local banks had already failed, which was a good predictor that others were in trouble.
|What was the argument--issue of branch banking, also called unit banking--what was the public choice or non-public choice argument there? What explains why we passed those restrictions? What was the public argument and the underlying public choice reality? Has to do with the manner in which banking was treated as a business. Unlike other businesses, historically you couldn't start a bank with a general incorporation procedure, at least that was the case universally until 1937, so you had to get a specific act of the legislature in order to get permission to start a bank. Government privilege that was jealously guarded. Every banker who succeeded would line up and oppose the entry of other banks, particularly in their town. Created a tradition of restricting bank charters to unit banks in individual towns, tradition that prevailed until the 1990s. From an established unit banker's point of view it was a no-brainer to want to keep other banks from being able to compete in their territory. They particularly feared invasion by the New York banks because a bank that was in New York had access to that central money market, so had a competitive advantage; could perhaps profitably branch into the rest of the country. Conversely, unit bankers in the country didn't expect they could get a foothold in New York, so opening up wouldn't give them a symmetrical advantage. Are you suggesting that if I lived in Cincinnati, OH, in 1850, I only had one bank to choose from? In major cities over time the number of banks grew. In Ohio you might not have had much of a choice because back then they had a state monopoly. But in some cities you would have had a choice; depended on the attitude of the state legislators. You had a choice, but within those choices they were all where they happened to be physically. All unit banks. So a successful bank that wanted to open a branch on the other side of town to compete with another existing bank wouldn't be able to. Hard time. There was another thing contributing to the support for unit banking, best summarized by Bray Hammond in his book about banking before the Civil War: attitude was banks are dangerous and monopolistic, therefore we should have as few of them as possible. This was the prevailing attitude of the public, not of the bankers themselves. What you've got was a persistent unit banking structure that was only finally completely broken down by the reform of the 1990s. Back to the Fed: as a lender of last resort, the fact that a banker has a window he can go to, to get liquidity, was not an important ender of the bank-run phenomenon. Ended by the provision of deposit insurance, at least as a panic-stopper. What role did the Fed play, what role has it played as a lender of last resort, and what is the justification, benefits or costs? The Fed has acted as a lender of last resort, as an emergency lender, but not as a classical lender of last resort necessarily on those occasions. It did do some last-resort lending during the crises of the early 1930s, in February 1932 for example, but only to member banks. Did not see itself as responsible for other banks, and that left a lot of banks in the cold. Afterwards it tended to play an emergency lending role increasingly starting in the 1970s and massive interventions during the recent crisis. According to the classical lender of last resort doctrine, usually attributed to Walter Bagehot in his book Lombard Street. Bagehot was the second and most famous editor of The Economist magazine back in the 1870s, and there is still a Bagehot column in the magazine. What he said in response to crises in the English banking system was that the Bank of England had a public responsibility to do something it hadn't been doing up to that point, which was to see to it that external drains of specie did not result in its clamping down on credit, but rather that it kept the flow of credit going to the private sector while raising its interest rates to stem the outflow of gold. Specie is gold or silver. Bagehot was making a recommendation for the English banking system, but it's important to note that in doing so he explicitly said the English banking system was deeply structurally flawed because it had a central bank. If it hadn't been for this central bank which was capable of mismanaging money in a way that could ultimately trigger external drains of gold or specie, there wouldn't have been any need for advising it to act in a more publically responsible manner. Bagehot expressly points to the relatively free Scottish system of the time, not as free as it had been before Peel's Act of 1845, as an ideal system and makes it clear that in that kind of decentralized monetary system you don't need a lender of last resort. A lender of last resort according to Bagehot if you are stuck with a central bank is a central bank that lends freely at high rates of interest, but only to solvent firms, during times of crisis.
|Idea would be that as a bank, if I made a lot of horrible loans, and as a result when people showed up to get their money I didn't have enough to pay them, and I go to the central bank and say: I just need a little bit of liquidity here because I'm a little short this month. If you are short this month because you made a lot of bad decisions, Bagehot would say: Don't lend them money. If it was just randomly a lot of people showed up this month for their money, but I'm solvent, meaning the expected flow over time--the income--is large enough to cover the outflow, then a loan is okay. Crucial microeconomic distinction. Bagehot had sound microeconomics as a basis for what he was recommending. It was not that the central bank should try to save or bail out insolvent institutions--institutions whose assets before they experienced runs were more than their liabilities. The job of the lender of last resort was to prevent spillovers from the failure of insolvent institutions or international specie outflows from bringing down otherwise solvent institutions by making sure those solvent institutions don't fail for lack of liquid reserves. Lombard Street available on Econlib. If you read the last page you'll see where what he is doing is what we would call today a second best solution to the crises in England. The first best solution would be some form of free banking. The Fed's record has been one of persistently violating Bagehot's rule to lend only to solvent institutions and let the insolvent one's fail so that we have an efficient market situation. A situation where people are responsible for their actions and pay a price if they act recklessly. The reason it's crucial is not only to not throw good money after bad, but you also create a moral hazard problem. That moral hazard problem itself can become one of the more potent causes of irresponsible lending. Look what the Fed has done. It bailed out Franklin National--in the 1970s--and it was insolvent when the Fed bailed them out. Did they know that? They had good reason for deeply suspecting it. Every time the Fed does that, it raises the ante, because of moral hazard; there will inevitably be an even bigger failure from insolvency when this happens. So along comes Continental Illinois, 1984, which was unquestionably insolvent--few could have doubted it at the time. Monolog podcast, by Russ, on this issue. Soften question: challenged you: did they know they were insolvent? The key thing is not--they didn't delve into every bad loan--but they knew they'd made a bunch of bad loans, knew they were in trouble because those loans were not paying as they were supposed to; but in addition, the justification for these rescues--and they were rescues of the creditors of these institutions--was not: Oh, they just need a little bit of time. It was: If they fail, the systemic problem is going to be too horrible. They didn't pretend that they were solvent. They didn't care. They appealed, for the first time in the case of Continental Illinois to what's come to be known as the Too Big to Fail doctrine. This doctrine was supposedly a reason for ignoring Bagehot's microeconomically sound advice because the spillovers would be too big. On the face of it it makes no sense. If big spillovers are what you are worried about, then big support for the still-solvent firms is what's called for. There is no reason to bail out any firm because of big spillover effects it might cause if those spillover effects can be avoided by Bagehot's means of making sure there is ample liquidity for all the still-solvent firms in the market. Moreover, Too Big to Fail has always been a lie in every instance. In the case of Continental Illinois, there were the usual gloom and doom statements by the authorities about what would happen to the rest of the economy if it failed, but eventually it was determined--by George Kaufman--that only two banks would have lost more than half their capital in the aftermath of the failure of Continental Illinois if there had been no support for its creditors. Same thing happened with Long Term Capital Management (LTCM), 1998. There, there was also a private rescue alternative that the Fed authorities short-circuited with a sweeter deal. Although in that case, the Fed did not rescue the creditors of LTCM. They orchestrated a rescue by private firms. Semi-coercive and instead of another rescue that would have taken place. The case of LTCM, Continental Illinois, Franklin National--none of those justified any sort of departure from Bagehot's principles, and I do not believe that the departures in the recent crisis, even more dramatic, have been any more justified.
|Challenge you systemic risk argument. You argued that if you are worried about systemic risk, you should offer the liquidity to the solvent banks. But isn't the argument the following? Had Continental Illinois failed and not been bailed out to lenders to Continental Illinois, two other banks would have gone bankrupt. They would have lost half their capital. So the question is: were they solvent or not? You are saying: those two weren't solvent. But isn't it possible that if enough banks had lent money, if they were so interconnected--and this is the argument, I hate it by the way, about the current crisis--so many banks were interconnected, so many had lent or were holding overnight loans, repo loans of Bear Stearns or Lehman Brothers, that had Bear Stearns been allowed to fail, so many creditors would have gone bankrupt, and in turn other guys expecting them to pay wouldn't be able to receive, so the whole system is kind of insolvent. No one bank, but a domino effect. What is your response to that argument? It is an assertion without evidence. We are expected to take it as a matter of faith; as with the boy who cried wolf, we know from past assertions of that type that they have been untrue. It wasn't true of Continental Illinois, of LTCM. Of course, Lehman Brothers was allowed to fail, and the spillover effects from that turned out to be surprisingly minor, as Peter Wallison has shown. Not so sure about that. Hard to know. Unclear. If Bear Stearns had been allowed to go under, the effects of a Lehman collapse would have been different. Once Bear Stearns creditors were rescued, that encouraged people to think that Lehman would be rescued as well. I'm agnostic about what we learned from Lehman's collapse. But you have to concede the fact that there was a great deal of unease when Lehman went under because of, say, money market funds, which had lent Lehman money. Which they shouldn't have! I think they lent them money because Bear Stearns had been rescued, in search of higher yield. In the aftermath of Lehman's collapse, the Fed backstopped the money market funds. So we don't really know the full impact of the Lehman collapse, but I would argue that it doesn't tell us a lot. We have to be very careful here. There are two questions here. One is the Too Big to Fail question of whether the interconnections were such that the insolvency of Lehman meant that other firms were bound to become insolvent if it failed. On that score, I don't think the spillover effects were substantial. The other kind of spillover effect is the kind Bagehot was arguing central banks should prevent, and that is where panic generated by one firm's failure, one insolvency, leads to a run on or shortage of liquidity for otherwise solvent institutions. That's what seems to have happened to all of the money market funds with the single exception of Reserve Primary. Reserve Primary really was insolvent; and Bagehot would say to let them fail, or not fail in this case--wasn't a question of failure--it was a question of breaking the buck. Which means not being able to pay 100 cents on the dollar to the investors. So people who had bought money market funds on the presumption--strange presumption but it's what we have because of habits and the regulatory environment--that your capital is totally safe. Turns out it wasn't. Not a matter of failure because the fund doesn't have any liabilities that are fixed. Just a matter of paying what the assets are worth. No evidence that any other money market fund was going to break the buck, let alone go broke. Therefore, to the extent that you had a liquidity crisis affecting the funds, that's not a reason for not letting Lehman itself fail. How would you categorize the famous meeting where Hank Paulson called in something like 20 of the nation's largest banks, the CEOs, and said: I'm giving you a lot of money right now; you have to take it; here's a little slip of paper to sign for it. He argued at the time that that was a way of reducing any liquidity constraints on these banks. They were all forced to take it on the grounds that that way we wouldn't know if any of them were insolvent or illiquid. The claimed worry was, if it was voluntary, the banks that took it would then be viewed as candidates for failure and there would then be a run on them. What's your take on that episode? I think that's probably correct. What Bernanke and Paulson were worried about was a repeat of what happened back in the 1930s when the RFC was forced to disclose who it was lending to; this supposedly contributed to runs on the banks receiving funds from it. Though actually the evidence for that has been questioned. Appears not to have been so severe as sometimes been claimed. What would Bagehot say about this? I would say same as him. If we have a lot of banks that won't fail and therefore don't want this support, what we have here is an arrangement designed to protect insolvent institutions, partially by making sure no one can tell they are insolvent even as they are being bailed out. I don't see the rationale for that. Wouldn't the claim be there could be an illiquid but solvent institution? An illiquid institution need not fear that there would be any stigma from borrowing from the Fed. Such an institution normally, with adequate liquidity provision to the open market, would also have been able to borrow from those banks that did not suffer from a lack of liquidity. The open market situation after Lehman's failure and after Reserve Primary's breaking of the buck was very bad, and the Fed needed to provide liquidity at that time because interbank liquidity seemed to be seizing up. But it's important to realize that it didn't do that. It was too busy making sterilized loans to insolvent institutions to attend to the illiquidity of the general market.
|What should it have done? I think it should have aggressively engaged in open market operations without any sterilization instead of lending to particular insolvent institutions. Should have considered making open market purchases of a broader range than usual. Nothing in Bagehot that says central banks should only buy Treasuries. Bagehot wrote at a time when they made loans instead of engaging in open market operations, but a relaxation of the Treasuries-only policy would have allowed the Fed to purchase other kinds of assets in the open market, private assets, but not for more than they were actually worth, would have been beneficial at that time. Contemporary example: I think the argument the Fed would respond with to your criticism is we were at a point where many of the assets these banks were holding were mortgage-backed securities; their prices were either in free-fall or hard to assess, and therefore it was hard to know who was liquid, illiquid, or who was insolvent. Buiter has an answer to that question as well, proposal he made some time ago in the course of an argument that there is never any need for the Fed to do other than engage in open market operations and then let the market determine where the liquidity went. If you design the open market with a Dutch auction or something like that, you can pretty much allow the auction to determine the value of the securities and do so in a way that will avoid the moral hazard problem. So there is a way that the Fed could have opened up open market purchases even to the very questionable assets without exposing itself or ultimately the taxpayers to risk of loss by buying them at artificially inflated prices. One last comment: my view is that even if all these arguments by those who wanted more intervention--even if they are right, even if there is all this interlocking systemic risk, once you accept that, the evidence for it is weak--it's just asserted because these guys all interact with each other. But suppose it's true. Suppose when the first domino falls you knock them all down. Once you say that, you basically create a welfare program for Wall Street that allows them to perpetually enlarge themselves with borrowed money, inflate the size of their institutions, make riskier and riskier bets and pay themselves well. Until it collapses. But they get rescued and then move on and do it again. It's a vicious cycle, and there's no way it's going to do anything but get worse; or you have to resort to such draconian regulation of the banking system to offset the effects of moral hazard that you end up without a financial system that can cater to the financial needs of an advanced capitalist economy. You've got a public utility. There's another reform that's relevant here. Allowing firms to fail--the spillover effects that that has depend on the way the failed firms are resolved. Bankruptcy in principle, if it's done quickly enough, can actually be a perfectly good way of minimizing the spillover effects. It has been noted that bankruptcy procedures can be too slow-moving to meet the needs of avoiding spillovers in the case of financial failures, but here the English proposal, legislation that requires larger financial firms, the ones that might be considered too big to fail, although nobody from the Fed or elsewhere has told us where the cutoff is, to create so-called Living Wills. These are specific plans that the institutions themselves come up with that would amount to procedures for expediting bankruptcy by specifying exactly what should happen in the event that they are insolvent. Sensible reform and that's what should be done in the United States. Who would think that's a good idea? You and me; maybe some of our listeners. The delay in bankruptcy makes it hard to let firms fail, so why don't we speed that process up or even create some regulations? The alternative would be let's keep the current system that continually bails out people who have made bad loans, and large, rich, giant institutions. How would that play out politically? There's a tendency to think about: what is the best policy. That's not what actually happens. Political sausage factory. In that world, the banks get a lot more say than you and me. There are a lot of economists who benefit from the size and power of the Fed, and they too think it's a good idea to avoid systemic risk and not go through this messy bankruptcy procedure. Political incentives for which policy emerges and which would be the best one; might not be the same thing.
|Other aspect of the Fed: the smoother of the business cycle. The claim is the 19th century was full of recessions and depressions, whereas the 20th century--had that little thing in the 1930s, awful, and until recently the business cycle had been tamed. We had the Great Moderation and if you just look at the data, it's clear that the Fed seems to have smoothed things. When I interviewed Milton Friedman in 2006 he argued that yes, the general smoothing of monetary growth that the Federal Reserve had learned to do led to better economic performance. What's your verdict on that? The present state of research is such that we no longer can view things in that more optimistic way. Already when you interviewed Milton Friedman, revisionist work had been done, mostly by Christina Romer and some by other economists, and some since 2006 that has drastically changed our understanding of the volatility of output and the length and severity of recessions before the Fed's establishment in 1913. Bottom line is new research suggests that the post-war business cycle has not been less severe overall than the pre-Fed business cycle. That is, contractions have not been less frequent, shorter, less severe, and output has not been substantially less volatile. That's going to hold post-war period. It doesn't deny the existence of the Great Moderation. Concerning the Great Moderation, however--roughly 1982-2007, lasting through the whole Greenspan era--nobody denies that, but two facts: First, most recent data suggests that the Great Moderation has ended. So, whatever was going on there if it was an improvement in monetary policy, well apparently the moderation is over. That shouldn't surprise anyone. It's just an outlier! One data point! Next time it won't happen because we'll learn from it! The other thing is that since the Great Moderation there has been a large body of research devoted to asking what is the cause of this Great Moderation, or what was the cause? That research has steadily chipped away at the early presumption that improved monetary policy was behind it. That research has either attributed it to a decline in the number of external shocks the economy was exposed to--the Good Luck hypothesis, this was just a period when we were lucky because we hadn't been exposed to as many fundamental disturbances as had been the case in the past. Or the research has said there have been structural changes, but it wasn't improved monetary policy; other changes have been behind the Great Moderation. More dynamism. Globalization, financial innovations, changes in demography, in the management of inventories. Host of factors. Same studies that have identified these factors have also tested the alternative hypothesis of improved monetary policy and reject that as a likely cause. Tough question: if you are out there right now you might think: That's right, the Fed stinks. Sympathetic to that viewpoint, but going to challenge my own biases here. Isn't it true that any of these exercises trying to assess the quality of the Fed's performance--let's admit the fact that the macro economy is a very complex beast, alive, emergent phenomenon, we don't measure it very accurately. Trying to compare the Fed's performance from 1913 to the present, to the pre-1913 period is kind of silly because the data we have available for earlier period is horrible, messy. And what you do is going to confirm your biases. If you like the Fed--I'll play John Taylor here--you could argue that if the Fed had followed the behavior it had followed previously, we wouldn't have had the current crisis; Great Moderation would have continued. Aren't we just indulging our prejudices when we have these kinds of arguments? Sure, prejudice is always a factor in driving the kind of research people do. Don't think you can ever get away from that. People start out with priors, and they pursue those priors. Your question about whether we can make useful comparisons between the system after and before 1913: it's an absolutely essential question. What our research in the paper is trying to do, motivated by the following observation: if you were to ask almost any economist today whether the Fed is worth keeping, whether it's been successful or not, you would have gotten a positive answer, and that answer would have been based on conventional wisdom about the empirical record. Most people are happy to defend the Fed without performing a fancy, elaborate and perhaps even impossible counterfactual exercise to determine whether their optimism or faith in the Fed is justified. What our paper is trying to do is say: The evidence out there showing an initial case showing that the Fed clearly has made things better. Give us a little of that evidence. Evidence based on the most recent statistical studies concerning what has happened to the variability of output, number of banking panics, the length and frequency of recessions, the lender-of-last-resort conduct of the Fed, the price level behavior, the predictability of inflation in the price level--all of those statistics don't show a clear improvement. That is not saying that therefore we know that another system would have worked better. Our limited claim is simply that based on the available studies today, there is no reason for thinking the Fed has been successful or that no system could possibly be better; and we need to do more systematic research about alternatives. We need to stop being complacent about the Fed. It's a burden of proof argument: most people's priors are that the 19th century was hell; since 1913 it's been great except for the Great Depression and the current financial crisis. But the 19th century had some really bad depressions: Depression of 1894, not as good a level of data but really bad depression. What you are suggesting that when you actually look at the data we have, it's the burden of the Fed defenders to make the case. Is that a good summary? Yes, it is.
|Want to turn to the alternative arrangements, but want to ask intermediate question first. As economists we are trained to think of the Fed as kind of like the handles that run the taps in a bathtub. Some cold water, some hot water; want tub to go up, you turn the water on; might have a couple of handles to determine if it's hot or cold water, but you have those tools. You want it to go down, you pull the plug to drain it; you can even control the rate at which it drains. A technocratic view of the Fed as a tool. If we step back for a minute--and this is a little bit unpleasant but I think important--if we weren't so tied to the Fed, because we are all interested in monetary policy as economists, why would we ever think it would work that way? I'm not going to suggest that Ben Bernanke or Alan Greenspan are bad men--we are all human beings, with flaws and high IQs, but other than that, normal human beings. Would the model for the Fed be a public choice model? I would never think they are going to run the taps or their other choices like hand out the towels like they do in a textbook that says how it could work. That would be silly. I would expect them to be a political institution, responding to economic actors that have a big incentive to influence their decisions--that would be the banks. Why would I come to the conclusion that what the Fed does most of the time is help the banks rather than the rest of us? How do you think that model, which is very alien to the way most economists think about the Fed--they think of it as this running the bathroom tub metaphor--but if you took a slightly less attractive, almost sinister view, not a conspiracy: not like the banks call up Bernanke or Greenspan or any previous Chairs and say the bag of money will be on the stairs, make sure you are good to us tomorrow. Not that but just that the general forces encourage keeping Wall Street happy, keep the large banks happy because they influence how the President behaves. They make donations to their parties; and as a result the President wants to make the Fed chair happy, and the Congress--etc. Cynical? I think that is a realistic view of the Fed. I tend in my own work to give it the benefit of the doubt and to emphasize more the informational challenges that make it highly difficult, practically impossible to operate the tasks in the ideal manner that textbooks suggest. But I think in fact the reality is mostly the public choice reality you have in mind. Simply not ever going to behave the way the textbooks say it and other banks behave. My focus is on economists. What appalls me is the way economists idealize the Fed and other central banks, writing in textbooks about the way they performed as if it was actually the ideal way they could perform and the only way they could perform--in the absence of information that's not actually available to them. What I really would like to do is change the way economists talk about central banking and monetary policies. I don't expect them to go whole hog for a public choice explanation for these institutions of the sort you find plausible and I also find plausible, but I would at least like to see them handle them according to the way they have performed in reality to some extent--that is, to stop portraying them in textbooks as if they behave ideally when we have all the evidence we need to see they are after all constantly making often very severe mistakes. Brief story about the informational challenge, which is a huge challenge. When I was in chemistry class--maybe 10th or 11th grade, maybe earlier than that--we had a lab room. Two faucets; attached to each was a hose. The hoses were long. You would take the hoses and fill up beakers and other scientific apparatus. There was one kid in the class, mischievous boy, who liked to get the hoses all tangled up in the basin of the sink. You'd be holding your hose; but it turned out that the handle you thought it was attached to was the other one. So the water would be coming out too fast in your hose, so you'd tell the guy or you'd reach yourself and turn it down. Turned out you were turning down the other guy's hose; and when he saw the volume of his was going down, he'd take his handle and turn it up. 'Course he was turning up his hose. We had what we'd call an unstable feedback loop. That's what the Fed has done many times. It thinks it has tight money, so it loosens, when actually it's got loose money. So it's making things worse. Other times, it thinks it's got loose money, so it tightens. Scott Sumner podcast. Informational problem to keep with the bathtub metaphor: you don't realize the tap is open. Murky in the bathroom, lights are off sometimes; you are not even sure whether you are turning on the sink or the bathtub tap. Ambiguity of the data the Fed is using and the way it has to talk about it, as if it totally in charge at all times would be a relevant thing for textbooks to talk about, and nightly news as well. Think if people really understood how the Fed makes its decisions, the finger-in-the-wind manner in which it is forced to determine the course of monetary developments that can have overwhelmingly important effects on the whole economy, they would be shocked. It is not like a smoothly operating machine. This is not a matter of not having the right people in charge. It's just the way the system is. It does perhaps do the best it can; perhaps it doesn't merely cater to special interests in the banking industry or to the whim of the Administration, but the tools it has available to it are deeply flawed and limited in their ability to deliver. We need to think about a better mechanism. Should mention that when I talk about this cynical view of people helping their politically powerful friends, not talking about particular change in the Federal funds rate; I'm thinking about its discretionary activity when it goes out and orchestrates the LTCM bailout or encourages the Treasury to do things that I think are extremely destructive.
|Alternatives. We could imagine two types. One type is to change the institution utterly: replace the Fed with something else. The other would be to restrain the Fed in particular ways. Let's talk about large changes. What might we do if we eliminated the Fed? What would be the alternative arrangements, if any? What would we need to worry about if we got rid of a central bank? Fine line; impossible to define a line between a reform that gets rid of the Fed and one that doesn't. Becomes a semantic issue. Let me say that if we are to keep a fiat money--a money, the value of which doesn't depend on convertibility in some commodity like gold--then we have to have a means for guaranteeing the scarcity of this stuff which is not naturally scarce. Paper is cheap to print. In a minimal sense, having a fiat money means having a public monetary authority if only in order to safeguard the paper stuff from being augmented to an extent that causes it to steadily lose value. Or unsteadily, erratically. When you have a fiat standard, you need an institution that makes sure you are not printing oodles of the stuff. Minimal task. Need to make sure private agents aren't making replicas of the stuff, either. If that counts as the central bank, then you can't get rid of a central bank. You can only do so according to that very basic definition by having a commodity-based standard, like a gold standard. In that case there is absolutely no need for a central authority to guarantee the value of the monetary unit. As people claim in justifying the Fed, a sudden discovery of gold could arbitrarily change the amount of money in the system, and without a Fed you wouldn't be able to offset that. Very good example of how people, economists included, fail to distinguish between some ideal performance of the central bank, ideally managed paper money, and reality. The relevant comparison should be not between how much the price level might change under a gold standard because of supply shocks and how much it would change if you had an ideal central bank making sure to manage the fiat money correctly. It should be between what the gold standard is likely to generate by way of instability in the price level and what central banks seem likely to generate. The most extreme examples of gold supply shocks that people usually come up with--don't know if they are actually more extreme ones--are the Gold Rush in the late 1840s in the United States and the great price revolution of the 16th century when all the gold was found in the New World and started finding its way to Europe. Leading to inflation. If you take the inflation rates that occurred in those episodes and annualize them, they are trivial. They are less than the Fed's current supposed inflation target of 2%. And much less than the 3% they are talking about for a target of 3% for expected inflation of prices. People don't know their history. There's never been a supply shock that caused an inflation rate under a gold or silver standard that we would consider today a high rate of inflation. What about deflation? Argument would be through private or government decision-making, possibly as Doug Irwin talked about on a podcast recently, research on the way France hoarded gold in other countries. Regarding Doug Irwin's work, let's bear in mind that he's talking about an episode that took place not under the classical gold standard, but under the inter-war gold standard, which was a completely different beast. It was a jury-rigged setup that heavily depended on the central banks of especially former belligerent nations of WWI. It depended on them cooperating with each other by having them treat claims of the Bank of England is if it were cash itself, and allowing those claims to accumulate instead of cashing those claims in for gold. The idea was to allow England, especially, to get away with returning to its pre-war gold parity in the 1920s without having to go through the massive deflation that normally would have been called for to restore that parity because the English money stock and price level were much higher when it restored the parity than they had been for a given level of reserves prior to WWI. Whole set of trying to run a gold standard on the cheap depending on other banks' cooperating; and when the Bank of France stopped cooperating, it all came tumbling down. House of cards. Why did they do that? Why didn't they stick with the pre-war gold standard that didn't require this cooperation? England would bear too high a cost? Why was that? The only way England could have gone to the pre-war gold standard--a classical gold standard mechanism could have been restored in the 1920s, but there were only two ways to do that. First, if you chose to go back to the pre-war definitions, the pre-war convertibility or par values, then big deflation was necessary because pre-war parity required pre-war price levels in the absence of special arrangements like the Gold Exchange Standard aimed at economizing on gold but also subject to collapse. Alternatively, and this would have been the more sensible approach, England and other countries could have let bygones be bygones; could have reestablished a gold standard but with new parities reflecting the reality of new higher price levels since WWI. That would have been the easy solution. What Barry Eichengreen and others say when they claim the gold standard caused the Great Depression, what they mean is that the gold exchange standard collapsed and contributed to the general collapse. When they say that abandoning the gold standard was the only way out, they neglect the alternative of a classical gold standard with modified parities to reflect the reality of inflation post-WWI. What role does the war itself play in this? Why did WWI disrupt? Is that because they couldn't make the normal transfers? What was going on there? The belligerent countries wanted to resort to inflationary finance to cover the expenses of the war. They wanted to spend more than they could spend without printing money. To do that, they had to abandon the gold standard. The United States didn't go off entirely, but it did impose gold embargoes. On the other hand, it didn't inflate as much as the other countries. It did inflate a lot but nothing compared to England or Germany--at least Germany by 1923. Wartime finance that led to the temporary abandonment of the gold standard. A gold standard works best if you are going to actually stick to it. But if you are going to abandon it and have massive inflation--and there are cogent reasons for going back because the gold standard has undeniable advantages--then it may be prudent to go back but with a different exchange value, different par value for gold. This, England was reluctant to do. It wanted to have its cake and eat it, too; other countries to a lesser extent, too. Some good reasons. The ultimate consequence of their attempts to restore the pre-war gold standard parities without having to endure the price level adjustments that a true restoration would have required led to the creation of this house of cards known as the Gold Exchange Standard, that was very prone to collapse. Depended in a way the gold standard did not on central banks' practicing forbearance to the extent they were creditors.
|In the paper you talk about some of these alternatives; also about keeping the Fed in place, requiring it to follow some arbitrary rule such as Milton Friedman advocated at times, steady growth rate of 2-3% in high-powered money, or a Taylor rule, which would link Federal funds rates to inflation and growth. Problem with all these is they don't really solve the informational challenge. Textbook, don't have reliable measures at a point in time of what the price level is doing or what money is doing. What alternative--putting aside political realities--what would be consistent with the information challenge? The key word here is "centrally." The only way to avoid major errors of monetary change connected with informational deficiencies, if not with political forces, is to decentralize decision-making in the money supply, which means decentralizing the money supply itself. Long been an advocate to providing to the private market place responsibility in providing private money and restoring it not to any one private agency but to a system of private agents. We now have all the eggs in one basket. If the Federal Open Market Committee (FOMC) get it wrong, the whole country gets it wrong. Don't let one firm monopolize those markets, don't let the mistakes of one firm into the mistakes of the whole nation. Also depends on there being incentives for private behavior conducive to all stability; theory suggests it can be. Not going to work with a crummy banking system dependent on government bailouts such as exists today in the United States, so the first step has to be to wean our system off government guarantees, reducing economy's dependence on a central authority as a source of money.