A central bank is better able to resist political pressures if it has public support. The German Bundesbank and the Swiss National Bank established firm reputations as opponents of inflation that earned the respect and support of their countrymen. One way to gain and hold support is to operate in a known and predictable way, as Issing prescribed at the head of this chapter. Being successful is important.
Federal Reserve history has two major crises—the Great Depression of the 1930s, and the Great Inflation of the 1960s and 1970s and subsequent 1980s disinflation. Together these events occupy more than thirty years of the seventy-three-year history to 1986 considered in these volumes. The years of relatively stable growth and low inflation were many fewer until recently; 1923 to 1928 and 1952 to 1964 stand out. From the end of the Great Inflation to 2007, the United States experienced three of its longest expansions interrupted by relatively mild, brief recessions. Federal Reserve policy contributed to the change sometimes called “the great moderation.” This chapter looks at some major past errors and some changes that contributed to better outcomes. Then it suggests some further changes, many of which FOMC members proposed on occasion.
The two principal sources of policy errors resulted from political interferences or pressure and mistaken beliefs. Volume 1 of the history made the case for mistaken beliefs or incorrect theory—mainly the real bills doctrine as a decisive cause of the failure to take effective action to limit, prevent, and end the Great Depression. A different set of beliefs and failure to resist political pressures caused the Federal Reserve to start and continue the Great Inflation. To end high inflation, Paul Volcker made two major changes. He increased Federal Reserve independence, and he gave greater weight to reducing inflation and permitted the unemployment rate and interest rates to rise as required to control inflation.1
1. Federal Reserve officials in the 1970s often gave concern about interest rate changes as a reason for failure to control money growth. This may have been a statement about perceived political constraints or a complaint that inflation could not be controlled when government ran budget deficits. Perhaps both. Some recognized also that they failed to develop a mediumterm strategy or the means of implementing it.
At its founding in 1913–14, the Federal Reserve was a system of semiautonomous regional banks with a supervisory board in Washington.2 This arrangement was a compromise that reconciled populist fears that bankers would run the new system for their benefit with bankers’ fears that the political authorities would run it for theirs. The compromise set off a struggle for control mainly between the Board in Washington and the New York reserve bank. Autonomy contributed to the Federal Reserve’s failure in the early 1930s. The Banking Acts of 1933 and especially 1935 greatly reduced Reserve bank autonomy, greatly reduced the role of the bank’s outside directors, and centralized control in Washington. The Banking Act of 1935 created the legal structure of the central bank that remains today.
The Board remained under the guidance of the Treasury from 1934 to 1951. It did not begin to exercise control until after the 1951 Accord. In the early years of the Martin era, 1951–54, the System agreed to the changes necessary to consolidate the Board’s control and weaken the authority of the banks, especially New York.
External events made inevitable this change from a semi-autonomous system of banks to a central bank. In 1913, the United States was emerging as one of several world or regional powers. Financial markets had not consolidated. It was possible to have interest rates set regionally. London was the global center of finance, and European powers such as Britain, France, and Germany struggled for international dominance. Existence of the Federal Reserve created a national market in the United States that later brought regional interest rates closer together.
Occasionally, members of Congress question the role of the reserve bank presidents as members of FOMC, the presence of member bank directors on the boards of the reserve banks, and the fact that reserve bank presidents vote on national monetary policy but are not confirmed by the Senate. The usual response to comments of this kind stresses the importance of local information in interpreting national policy and the value of having different opinions voiced at FOMC meetings. The Federal Reserve has not committed to a single analytic model. At times, differences in approach gradually changed policy analysis and operations. Examples are the emphasis the St. Louis bank president gave to money growth and the Minneapolis bank gave to rational expectations. Also, the presidents and their staff use anecdotal information acquired in discussions with local leaders to modify their forecasts or judgments.
2. McAfee (2004, 29) wrote, “Our formal legislated structure still describes 12 unaffiliated specialized national banks run by their directors.” He points out that practice strayed far from original intent and legislation.
In a country as large and diverse as the United States, differences in interpretation of events and their future implications are both inevitable and useful. If the members of FOMC accepted a precise model or a common rule, regional and analytic differences would be of lesser importance. That has not happened and is unlikely. The advantages of having the regional banks express differences of opinion should not be forsaken. Mark Willes, an effective and outspoken member of FOMC as president of the Minneapolis bank, emphasized the importance of independent research departments at the reserve banks as a major source of strength in the system (Willes, 1992, 8). Also, St. Louis, aided at times by Richmond and San Francisco, was an early proponent of an effective anti-inflation policy. President Ford (Atlanta) raised pertinent issues at many meetings in the 1980s, and Presidents Stern and Hoenig urged an end to too big to fail.
By 1950, and in the years that followed, the United States was a superpower of unparalleled strength. It proposed and brought to fruition an international order built upon the International Monetary Fund, the General Agreement on Tariffs and Trade, the World Bank, and, in the political sphere, the United Nations. The central financial markets had moved to New York or developed there. Monetary actions by the Federal Reserve influenced conditions at home and abroad. The original design would not have survived in the new conditions.
The Federal Reserve in 1951 was not well equipped to manage either the domestic or the international economy. Congress had approved the Employment Act of 1946 and the Bretton Woods Enabling Act of 1944. The former committed the government to preventing a return of the Great Depression by promising “maximum employment and purchasing power” but did not define either. The latter tied the dollar to gold and made the dollar the central currency in the international monetary system. No one mentioned that a central bank could not expect to realize both commitments unless it maintained low inflation or price stability.
The Federal Reserve resolved the conflict by accepting domestic concerns as its responsibility. The Banking Act of 1933 had restricted its international role; the Treasury took responsibility, although it relied on Federal Reserve members and staff for advice, recommendations, and assistance in financing currency support operations.
Volume 2, books 1 and 2, summarizes the main developments and actions in the years 1951 to 1986. It considers three main topics: the relation of Federal Reserve policy to monetary theory; the independence of the Federal Reserve; and inflation and disinflation. The Federal Reserve made many errors, as the text notes. Some of the principal errors reflected prevailing beliefs in the academic profession and elsewhere in society. These contributed to the weakening of independence and the persistence of inflation.
In addition to its two central banking functions—monetary policy and lender of last resort—the Federal Reserve regulates and supervises financial institutions. During the years discussed in this volume, there were several banking regulators. The Comptroller of the Currency, part of the Treasury, supervised and examined national banks. In the early 1960s, the Comptroller pushed deregulation, putting pressure on an often reluctant Federal Reserve to follow.
Regulations are often written by lawyers who approach problems
and crises by introducing new prohibitions and restrictions. They have been slow to recognize that markets often respond to regulation by innovating to circumvent the regulation. Government securities funds and money market funds circumvented restrictions on rules that prohibited small buyers from purchasing Treasury bills and certificates of deposit that paid market interest rates. Protection of large banks as “too big to fail” encouraged mergers and giantism. One justification for deposit rate regulation was protection of thrift institutions that lent on home mortgages. This was a costly error. Markets developed money market funds to circumvent ceiling rates at banks and thrift institutions. Inflation and regulation combined to eliminate most thrift institutions and to force removal of most interest rate restrictions. Taxpayers paid between $120 and $150 billion to cover the losses of failed thrift institutions.
Central bankers spent several years developing risk-based standards. This raised the cost to banks of risky loans. In the current, internationally competitive, open financial system, to circumvent regulation banks removed risky assets from their balance sheets. Risk did not disappear. Risk shifted from the regulated, supervised, and monitored banks to many places. We learn where the risks have moved when failures arise. This policy is inconsistent with a proper lender-of-last-resort function. More regulation cannot solve this problem. Risky assets will gravitate to less regulated markets and institutions.
Time will pass before lawyers recognize that they must rely more on incentives and less on regulations that prohibit or require action. Market discipline—which often means failures—is a costly way to teach prudent and effective risk management. The principal alternative is effective internationally agreed incentives. Experience with recent efforts to agree on common rules for risk management that create incentives for stabilizing behavior suggest two major impediments. Lawyers have a large role in regulation; they emphasize command and control. Devising incentives for stability in a global economy is a challenge that economists have not accepted.3
Bagehot (1873) is famous for proposing a crisis rule: lend freely at a penalty rate against acceptable collateral. Central bankers who cite this rule often neglect another main message. Bagehot did not criticize the Bank of England for failing to lend. He insisted that the Bank announce its policy in advance and follow it. In more than ninety years, the Federal Reserve failed to announce its strategy for responding to crises. Sometimes it lends against collateral; sometimes it supports failing institutions with help from other agencies like the Federal Deposit Insurance Corporation. Past practice provides no guide to future conduct. By failing to announce a strategy, the Federal Reserve encourages failing institutions to press for assistance, urging help to avoid calamity. Absence of an explicit policy increases uncertainty. As Bagehot emphasized, market chaos continues until policy is known and implemented.
SOME PRINCIPAL ERRORS
In the years 1951 to 1986 the Federal Open Market Committee never formulated or accepted a theory relating its actions to economic outcomes. Under the convention known as the “Riefler rule,” the Board’s staff did not make explicit forecasts until the mid-1960s. The staff then began to build an econometric model of the economy and to revise it from time to time. But judgmental forecasts coexisted with econometric forecasts, and the staff adjusted the econometric forecasts using judgment and new information. By the 1980s the Board’s staff and the staffs of several reserve banks used econometric models to forecast and brief their principals. There was neither a common model nor general agreement on what it should contain. More importantly, the members of FOMC and its chairman remained appropriately skeptical about the relevance or accuracy of their staffs’ models.
In the 1960s, many in the economics profession believed, or perhaps hoped, that large econometric models would provide consistently reliable forecasts of economic variables. In the 1970s, Robert Lucas (1976) showed why these hopes would not be realized. Economic outcomes depend on expectations. Responses adjust; people learn from observation and experience. Often large changes occur after forecasts have been made.
3. The Shadow Financial Regulatory Committee and several similar groups are exceptions to this statement. A main incentive is the compensation arrangement. Investment banks pay large bonuses. This encourages purchases and sales of highly risky assets that pay large commissions.
At the start of the period, in the 1950s, the Federal Reserve relied mainly on judgments about market conditions. Chairman Martin had no interest in economic or monetary explanations of events. Winfield Riefler, his main staff adviser, used a simple rule of thumb to guide policy actions—on average keep the sustained growth of money about equal to output growth. The FOMC met every three weeks to make a decision for the next three weeks. It did not follow Riefler’s rule or any other. Members used several different policy indicators ranging from explicit values of free reserves, borrowing, or interest rates to color, tone, and feel or money market conditions. No one reconciled the members’ statements, and no one could because the members did not have an agreed framework. That left decisions to the account manager and perhaps to Martin.
The 1950s were atheoretical and procyclical. Members interpreted interest rate increases or reductions in free reserves as tighter (more restrictive) policy and increased free reserves as easier (less restrictive) policy much as they had used borrowing in the 1920s. Often the main reason for the direction of change in free reserves was a change in member bank borrowing. In a slowing economy the public borrowed less, and the member banks repaid borrowing from the Federal Reserve. The Federal Reserve interpreted the increase in free reserves as evidence of easier policy mainly because free reserves rose and short-term interest rates declined. But fewer reserves meant a decline of the monetary base and money; to a monetary economist, the decline meant that policy was more restrictive. In recovery and expansion the opposite occurred. The mistaken interpretation of borrowing and interest rates contributed to procyclicality of monetary policy.
The System’s standard explanation reasoned that banks were reluctant to borrow. When they repaid, they reduced their assets; they contracted, reducing aggregate reserves. But with fewer aggregate reserves, other banks borrowed, expanding money and credit. The Federal Reserve continued to hold this mistaken interpretation of borrowing even after it became clear that borrowing increased when it became profitable to borrow. Eventually the staff model made borrowing depend on the profitability of borrowing, but the FOMC was slow to accept that idea.
Although recessions occurred in 1953–54, in 1957–58, and in 1960–61, the Federal Reserve successfully maintained prosperity and low inflation to the mid-1960s. Despite the deficiencies and errors of its framework, policy was more successful than in the late 1960s and 1970s. Under its 1951 Accord with the Treasury, the Federal Reserve regained much of its independence, but it retained responsibility with the Treasury for successful debt management. Its role was to maintain unchanged money market conditions, called even keel, when the Treasury sold securities. During the Eisenhower years, the administration favored balanced budgets except during recessions. Consequently, fiscal actions and deficit finance put much less pressure on interest rates than in later years, so money growth and interest rates remained generally moderate, and inflation was generally low. President Eisenhower expressed concern about unfavorable long-term consequences of anti-recession policy. After the deep 1957–58 recession, the Eisenhower administration promptly reduced its large budget deficit and rejected tax reduction because of its long-term budget consequences. The Federal Reserve moved to reduce inflation, reestablishing price stability by 1961. This was one of the rare occasions when policy acted to achieve long-term stability. This policy decision did not prevent tax reduction. The new administration reduced tax rates in 1964. More than thirty years later, President Clinton rejected proposals for tax reduction. The second Bush administration implemented them soon after taking office.
President Eisenhower started holding regular meetings to discuss economic policy that
included Chairman Martin, but he did not pressure Martin and respected central bank independence. Principal members of Congress criticized the Federal Reserve’s “bills only” policy. With support from many academic economists, they blamed the increase in long-term interest rates for slow growth. This was an analytic error; it claimed that the Federal Reserve could change the shape of the yield curve.
This claim became the basis of policy in 1961. The Federal Reserve accepted administration urging to buy long-term and sell short-term debt. Evidence suggests that the policy failed to achieve its objective of twisting the yield curve.
A major change occurred in the 1960s. The new administration gradually introduced activist Keynesian policies.4 In addition to “twisting the yield curve,” it urged the Federal Reserve to coordinate its operations with administration fiscal actions, called policy coordination. Many academic economists favored coordination. In practice, this meant financing more of the budget deficit by monetary expansion. This reduced central bank independence but did little harm as long as deficits remained small.
A History of the Federal Reserve, Volume 2 Page 76
