The Federal Reserve was a Bad Idea Collection of Conference Proceedings

Collection of Conference Proceedings
for
The Federal Reserve was a Bad Idea
Conference at Wake Forest University
February 11 - 12, 2011
Organized by the Economics Department at Wake Forest University and sponsored by the BB&T Center for the Study of
Capitalism at Wake Forest University Schools of Business.
Opening Comments by Robert Whaples, Professor and Chair, Department of Economics, Wake Forest
University
J. Daniel Hammond, Wake Forest University
“Milton Friedman and the Federal Reserve: Then and Now”
Discussant Response: Michael Salemi, UNC Chapel Hill
John A. Allison, Wake Forest University, BB&T Chairman and CEO (retired)
“The Practical Impact of the Federal Reserve on Decision Making in Large Financial Institutions”
John A. James, University of Virginia
David F. Weiman, Bernard College
“Panics and the Disruption of Private Payments Networks: The United States in 1893 and 1907”
Thomas Sargent, New York University
Keynote Address, “Drawing Lines in U.S. Monetary and Fiscal History”
Jeffery Miron, Harvard University
“Bank Failures and Output”
George Selgin, University of Georgia
Lawrence H. White, George Mason University
“Has the Fed Been a Failure?”
Discussant Responses: Doug Pearce, NC State University (written and included, but not delivered)
Robert Whaples, Wake Forest University
Richard Sylla, New York University
“U.S. Growth and Stability With and Without a Central Bank”
Discussant Response: Sandeep Mazumder, Wake Forest University
John H. Wood, Wake Forest University
“A Comparison of the Independent Treasury and the Federal Reserve System as Congress’s Agents for
‘The Regulation of the Currency’”
Opening comments by Robert Whaples
The purpose of this conference is not to invite a bunch of Fed-haters to
sit around in an echo chamber, bashing the Federal Reserve. Rather it’s
to grapple seriously with our conference’s provocative title proposition:
the Federal Reserve was a bad idea. Our purpose is not to air Jekyll
Island conspiracy theories but to carefully examine all the facets of the
historical record to debate the Fed’s performance.
Our title assertion can’t be proven a priori, it requires a careful
examination of history. In a democracy all government programs
deserve continued inspection. The Fed was born following an economic
crisis that occurred about 100 years ago. Following our recent financial
crisis, we deserve to give the status quo at least as much scrutiny as it
was given a century ago.
My co-organizer, John Wood, is fairly convinced that the Fed was a bad
idea. My knowledge of monetary history is much shallower than his, so
I am agnostic on the question. I hope to weigh and sift the evidence
presented to reach an informed conclusion by the end of the conference.
I hope that all of the presenters will ultimately relate their papers back to
this ultimate question.
If we decide that the Fed was, indeed, a bad idea, we’ll also need to
simultaneously think about why it was a bad idea. Was it the grand
scheme or was it in the details? Was it bad for some, most or all? Was
it a failure due to bad doctrine, bad personnel, outside pressures or some
other reasons? Did it have to be a bad idea?
Paper presenters will have 30 to 40 minutes, depending on the length of
their paper. Two discussants will have 10 minutes each. This will leave
plenty of time for comments, questions, and answers and for discussion
– for pondering our ultimate question.
Milton Friedman and the Federal Reserve: Then and Now
J. Daniel Hammond
Hultquist Family Professor
Department of Economics
Wake Forest University
What would Milton Friedman say about the question we are asking at this conference,
“was the Federal Reserve a bad idea?” The question has particular relevance for us in
light of the recent financial crisis and recession, and innovations in Federal Reserve
policy in reaction to these events. But we cannot know what he would say, since his death
on November 16, 2006 was just over a year before the latest recession began and three
months before the Federal Home Loan Mortgage Corporation announced that it would no
longer purchase the riskiest subprime mortgages and mortgage-backed securities. So
Friedman didn’t remark on the recent monetary and financial problems. His last word on
monetary policy, “Why Money Matters,” was published in the Wall Street Journal the
day after he died, on November 17, 2006. So my presentation will be partly speculative,
what might Friedman say if he were participating in this conference. But most of my
presentation will be historical, for there is an historical record in what Friedman wrote
about the Federal Reserve. Although Friedman’s ideas evolved, there was an underlying
consistency. And the consistency in Friedman’s views has a counterpart in the
consistency he saw in the Federal Reserve’s history. So while recent financial and
economic problems may appear to mark a turning point in monetary and financial affairs,
Friedman saw a continuity running through the many events and personalities that make
up the Fed’s history since its founding in 1914. This allows us to bracket, fairly closely I
suggest, what we might hear from Friedman if he were here with us this weekend.
1
The historical record from which I will draw includes more than Friedman’s
judgments about the Federal Reserve and monetary policy. It also includes Friedman’s
approach to business cycle analysis. Milton Friedman’s era was also the era of generalequilibrium mathematization of economics, the era of mathematical economists who
looked on Friedman’s approach as outdated. Comparing Friedman’s approach to
economic analysis and policymaking with the foremost exemplar and proponent of
mathematization of economics, Paul Samuelson, can help us understand our current
situation. What I am suggesting is that a three way comparison of Friedman, Samuelson,
and policy-making at the Federal Reserve today will help us to see not only that
Friedman was largely correct in his misgivings about central banking at the Federal
Reserve, but that he was also more generally correct in his misgivings about the postWorld War II rush to bring economists’ expertise to bear on matters of what we might
call economic engineering of prosperity and stability. This is the context in which I will
set the question of whether there should be a Federal Reserve.
Let’s start with what we can gather in a straightforward manner from the record of
Friedman’s written work. What did Friedman say over the course of his career about the
Federal Reserve’s performance over its history and how would the current crisis fit into
that history? Next we will compare Friedman and Paul Samuelson on the matter of what
and how much can be done about the business cycle. Then we will get into the matter that
is necessarily more interpretative – what might Friedman say about the Federal Reserve
today?
2
Friedman on the Federal Reserve
Friedman and Anna J. Schwartz began their long-time collaboration on the NBER
money and business cycles project in 1948, shortly after Friedman wrote “A Monetary
and Fiscal Framework for Economic Stability” (Friedman 1948). Friedman had studied
business cycles under Wesley C. Mitchell at Columbia University and taught business
cycles at the University of Wisconsin, but he had little previous experience with central
banking. From Mitchell, Friedman learned that price rigidities and lags in response were
key elements of business cycles. The proposal in his 1948 paper was designed to mitigate
their effects. What he proposed was that fractional reserve deposit banking be eliminated,
the federal deficit be wholly monetized, and that the federal budget be balanced on a fullemployment basis. He analyzed the likely performance of the economy under this system
compared with the performance under the status quo of descretionary policy decisions,
and concluded that the “automatic,” non-discretionary policy rule would reduce
instability. Friedman stressed throughout the article that his evidence on policy lags was
conjectural, and he called for research on the actual timing of lags.
Anna Schwartz brought experience and expertize in money and banking to the
monetary project. She had compiled a data series for currency covering the period 1917
to 1944, and was working on the companion series for bank deposits. In spring 1948 she
sent Friedman a list of readings on monetary and banking history, warning him that the
literature was pretty bad, but suggesting that he would acquire less misinformation from
the readings on her list than from others. Friedman spent the summer reading and joined
Schwartz in the work of compiling data. This is a point worth noting. Friedman and
Schwartz began their monetary project not by reading monetary theory or
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macroeconomic theory, but by building data and reading banking history. And this was to
beome a hallmark of their approach to monetary economics; their work was empirical
and historical.
Friedman formed his first tentative judgment about the question addressed in our
conference after reading the materials suggested by Schwartz. This was that the Federal
Reserve had on balance been a destabilizing force since 1914, and that the nation might
have been better off had the Fed not been created. He and Schwartz did not address the
counterfactual question directly in their best known work, the Monetary History (1963),
but they came close by concluding that on balance the Fed had been a source of monetary
instability.
The reform measure finally enacted [in response to the banking panic of
1907] – the Federal Reserve System – with the aim of preventing any such
panics or any such restriction of convertability in the future did not in fact
stem the worst panic in American economic history and the severest
restrictions of convertability, the collapse of the banking system from
1930 to 1933 terminating in the banking holiday of March 1933. That
same reform, intended to promote monetary stability, was followed by
about thirty years of relatively greater instability in the money stock than
any experienced in the pre-Federal Reserve period our data cover, and
possibly than any experienced in the whole of U.S. history, the
Revolutionary War alone excepted (Friedman and Schwartz, A Monetary
History of the United States, 1867-1960, 1963).
4
Friedman gave a preview of the Monetary History and his evaluation of the case
for alternative monetary institutions in his 1959 Millar Lectures at Fordham University
(M. Friedman, A Program for Monetary Stability, 1960) and a 1960 lecture at the
University of Virginia (M. Friedman, “Should There be an Independent Monetary
Authority?,” 1960). In the Fordham lectures, he reviewed the case for government
involvement in money and banking -- arguments based on the real resource cost of a
commodity money, the technical monopoly character of a fiduciary monetary system, and
the historical record of nearly universal government regulation of money. He also
reviewed American monetary history. He then switched attention to strategy, concluding
that:
The central problem is not to construct a highly sensitive instrument that
can continuously offset instability introduced by other factors, but rather
to prevent monetary arrangements from themselves becoming a primary
source of instability. What we need is not a skilled monetary driver of the
economic vehicle continuously turning the steering wheel to adjust to the
unexpected irregularities of the route, but some means of keeping the
monetary passenger who is in the back seat as ballast from occasionally
leaning over and giving the steering wheel a jerk that threatens to send the
car off the road (M. Friedman, A Program for Monetary Stability, 1960, p.
23).
The proposals Friedman made were in the direction of streamlining and simplifying
policy, and protecting the public from arbitrary use of power by policymakers. He
proposed confining monetary policy to a single instrument, open market operations;
5
requiring 100% reserves on all bank deposits; and requiring that open market operations
be guided by a money stock growth rate rule. This rule might be mandated by Congress,
as he suggested in the Virginia lecture, or it might be adopted by the Fed itself. Friedman
acknowledged that his proposal for a fixed money stock growth rule was counterintuitive.
In theory “leaning against the wind,” i.e., discretionary policy, looked better than a “do
nothing” fixed money growth rate rule. But Friedman predicted that in practice the rule
would provide more stability than discretionary “leaning against the wind.”
Why? First, because the empirical evidence suggested that changes in the growth
rate of the money stock had effects that were long and variable.1 This meant that in order
to effectively lean against the wind, the Fed would have to lean against future winds. Not
only that. Because of the variability of the lag, they would have to lean against a wind
that would be blowing at an uncertain time in the future. Second, he opposed leaving
policy open to Fed officials’ discretion because countercyclical policy was open to
different interpretations as to content. For example, is the policy objective price level
stability or low unemployment, or both; and how stable and how low; and stable and low
over what time frame? It was too easy to agree that the Fed should lean against the wind
because that directive was a container with a “stabilization” label, but without definite
content. Therefore, people with diverse ideas of the content could agree ex ante that the
Fed should lean against the wind, but have little basis for agreement ex post about
whether it had effectively done so. Friedman thought that disagreement, uncertainty, and
lack of accountability were built in to any system without a clear policy target.
1
On average 16 months from the peak in money growth to the peak in general business activity, and 12
months from trough to trough, with the range of lags from 6 to 29 months for peaks and 4 to 22 months for
troughs.
6
Why should the policy rule be defined in terms of the money stock rather than say
the price level or the unemployment rate? Here again, Friedman’s concern was for clear
lines of responsibility. It was not useful to make the Fed responsible for something that
they were only partially able to control. The Fed had total control over their balance sheet
and over nothing else, but the money stock was closer to their balance sheet in the causeeffect chain than were the inflation rate and other macroeconomic variables. This
closeness had two dimensions, time lags and cause-effect links.
In the mid-1980s Friedman revisited the question of monetary institutions (M.
Friedman, “Monetary Policy: Tactics Versus Strategy,” 1987). By this time he had come
to believe that fundamental reform was needed. As a matter of tactics, he remained in
favor of setting a single monetary aggregate growth rate target and using open market
operations as the policy instrument. Central bankers had the technical ability to pursue
stabilizing policy via a monetary growth rate rule. They may have had the desire to do so.
But the institutional cards were stacked against them. The results he expected from a
monetary aggregate growth rate target were “increased predictability, reduced churning,
[and] loss of inscrutability.” But, “these are at the same time the major reasons for
making so drastic a change and the major obstacle to its achievement. It would simply
upset too many dovecotes” (M. Friedman, “Monetary Policy: Tactics Versus Strategy,”
1987, p. 367).
The institutional (strategy) reform Friedman proposed was to take monetary
policy away from the Fed – take it away from the Fed and not give it to anyone else. That
is, he suggested freezing the quantity of high-powered money. Private institutions would
continue to be allowed to issues claims on high-powered money, as deposits but also as
7
hand-to-hand currency. There might or might not be reserve requirements. Friedman
favored eliminating them. With the stock of high-powered money frozen, the money
stock and volume of monetary transactions would be determined by the money multiplier
and velocity of circulation.
The great advantage of this proposal is that it would end the arbitrary
power of the Federal Reserve system to determine the quantity of money
and would do so without establishing any comparable locus of power and
without introducing any major disturbances into other existing economic
and financial institutions (M. Friedman, “Monetary Policy: Tactics
Versus Strategy,” 1987, p. 379).
Friedman expected that the result of such a reform would be price level stability or mild
deflation, with greater stability in growth of real income than the Federal Reserve had
achieved.
The Fed’s Reaction to the Financial Crisis and Recession
Now we turn to the recent financial crisis and recession. The St. Louis Fed’s
timeline of events and policy actions in the financial crisis (http://timeline.stlouisfed.org/)
begins three months after Friedman’s death with the announcement by the Federal Home
Loan Mortgage Corporation that it would no longer purchase the most risky subprime
mortgages and mortgage-backed securities. At the time, late February 2007 the federal
funds rate target was 5.25%. By the end of year the target had been reduced to 4.25%, the
FOMC had announced that “downside risks to growth have increased appreciably”
(August 17), and created the Term Auction Facility for provision of funds to depository
institutions against a wide variety of collateral. President Bush signed the Economic
8
Stimulus Act of 2008 (PL 110-185) on February 13, 2008. The Fed created a second new
lending facility, the Term Securities Lending Facility, on March 11, 2008, and announced
three days later that they were “monitoring market developments closely and will
continue to provide liquidity as necessary to promote the orderly functioning of the
financial system.” Later that month the New York Fed announced that it was providing
term financing for the merger of Bear Stearns with JP Morgan. In September the Fed
created another new lending facility, the Asset-Backed Commercial Paper Money Market
Mutual Fund Liquidity Facility and began purchase of federal agency discount notes.
October 2008 was a month of several new initiatives. President Bush signed the
Emergency Economic Stabilization Act of 2008 (PL 110-343), which created the
Troubled Asset Relief Program; the Fed created the Commercial Paper Funding Facility
to provide a liquidity “backstop” to U.S. issuers of commercial paper; the Federal
Reserve Board authorized the New York Fed to “borrow” up to $37.8 billion in fixed
income securities from AIG in return for cash collateral; and the Fed created the Money
Market Investor Funding Facility. In November the U.S. Treasury became a shareholder
in AIG, the Fed joined the Treasury and FDIC in a bailout of Citigroup, and the Fed
created the Term Asset-Backed Securities Lending Facility. These policy innovations are
not quite what Friedman meant when he looked for “increased predictability, reduced
churning, [and] loss of inscrutability.”
On December 11, 2008 the NBER Business Cycle Dating Committee announced
that a recession had begun in December 2007. According to Friedman’s estimates the
average trough-to-trough monetary policy lag was twelve months. If that was the case,
under the best circumstances the FOMC would have softened their policy in December
9
2006. They did not do so. At their December 12, 2006 meeting the FOMC voted to hold
the federal funds rate at 5.25%, where it had been since it was raised by 25 basis points in
June of that year. The sole dissenter at the December meeting preferred an increase to
5.50%. The committee’s statement read:
Economic growth has slowed over the course of the year, partly reflecting
a substantial cooling of the housing market. Although recent indicators
have been mixed, the economy seems likely to expand at a moderate pace
on balance over coming quarters.
Readings on core inflation have been elevated, and the high level of
resource utilization has the potential to sustain inflation pressures.
However, inflation pressures seem likely to moderate over time, reflecting
reduced impetus from energy prices, contained inflation expectations, and
the cumulative effects of monetary policy actions and other factors
restraining aggregate demand.
Nonetheless, the Committee judges that some inflation risks remain. The
extent and timing of any additional firming that may be needed to address
these risks will depend on the evolution of the outlook for both inflation
and economic growth, as implied by incoming information
(http://www.federalreserve.gov/newsevents/press/monetary/20061212a.ht
m).
10
Twelve months before the recession began, twelve months being Friedman’s estimate of
the average length of the monetary policy lag, the FOMC did not see the recession
coming.
Friedman and Mathematical Economists on the Business Cycle
The question of how much economists know about the business cycle, and thus
how much expertise they can bring to the policymaking table, including crucially their
ability to forecast business conditions, was an important part of what separated
Friedman’s views from the mainstream over the course of his career.2 A good place to
begin seeing this difference is in the late 1940s, as Friedman and Schwartz were
beginning their monetary project for the NBER. Recall that Friedman had little
experience with monetary economics at the outset. But his two most important mentors,
Arthur F. Burns and Wesley C. Mitchell, had instilled in him firm convictions of how to
do economics. From Burns he learned the Marshallian approach to economics, which
involved use of relatively low-brow theory in close relation with measureable entities –
theory that could be used to extract useful information from data. From Mitchell,
Friedman learned National Bureau techniques for analyzing data on business cycles and
he also learned that constructing economic data is as important as constructing economic
theory.
We can see Friedman’s early perspective on business cycle analysis in his review
of Jan Tinbergen’s Business Cycles in the United States of America, 1919-1932.
Tinbergen’s book was one of the early attempts to estimate coefficients of a general
equilibrium model of the business cycle, work for which he was awarded the very first
Nobel Prize in Economic Science (shared with Ragnar Frisch). Tinbergen and Frisch
2
See (Hammond 1996).
11
were cited “for having developed and applied dynamic models for the analysis of
economic processes” (http://nobelprize.org/nobel_prizes/economics/laureates/1969/#).
Friedman was less impressed in 1940 than the Nobel committee later was in 1969. He
wrote of the estimates:
Tinbergen’s results cannot be judged by ordinary tests of statistical
significance. The reason is that the variables with which he winds up, the
particular series measuring these variables, the leads and lags, and various
other aspects of the equations besides the particular values of the
parameters … have been selected after an extensive process of trial and
error because they yield high coefficients of correlation (M. Friedman,
“Review of Business Cycles in the United States of America” by Jan
Tinbergen, 1940, p. 659, emphasis in original).
Friedman quoted his teacher Wesley Mitchell to the effect that a statistician can take
almost any pair of data series and manipulate them to obtain a high correlation coefficient
between the two. What Tinbergen failed to do is to test his model with data from outside
the sample that he used to estimate the coefficients. Friedman did such a test in a
rudimentary form and found that the model did not explain the out-of-sample
observations very well.
A decade later Friedman commented on another test of a general equilibrium
business cycle model. In this case Carl Christ tested the model on out-of-sample data, as
Friedman had suggested for Tinbergen. But Friedman was still not impressed with the
results. He set up an alternative, and extremely simple, model in which the values of
endogenous variables were predicted to be unchanged from period to period. This was in
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effect running a contest between a highly sophisticated theory of the business cycle and
“we know nothing about the business cycle.” “We know nothing” won the contest!
Friedman concluded that economists using the big general equilibrium “system” models
were striving for something well beyond their reach. Greater progress would be made in
“analysis of parts of the economy in the hope that we can find bits of order here and there
and gradually combine these bits into a systematic picture of the whole (M. Friedman,
“Comment on 'A Test of an Econometric Model for the United States, 1921-1947,'” by
Carl Christ, 1951, p. 114).
We tend to think of Friedman as a “monetarist” and economists on the other side
of debates about business cycles as Keynesians. But the critiques we just examined were
before Friedman was a monetarist. The position he represented was the NBER approach
to business cycle analysis. His opponents in the 1940s tended to be Keynesians, but the
pressing issue was not so much what one thinks are the causes and cures for the business
cycle, but how one searches for answers to the question and how much is known. A good
illustration of this debate is in Arthur Burns’s 1946 annual report of the NBER, where
Burns was Director of Research. Burns criticized Keynesians for presuming that they had
figured the business cycle out, and for relying on theory with scant resort to economic
data other than highly aggregated data. Keynesians saw compensatory fiscal policy as the
solution to the cycle. Refering to a set of assumptions behind the analysis, about the
shape and stability of the consumption function, the relative size of consumption effects
of tax cuts and tax hikes, and so forth, Burns concluded:
Although assumptions such as these may be extremely helpful at a stage in
our thinking about an exceedingly complicated problem, it seems that the
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inferences to which they lead cannot be regarded as a sceintific guide to
governmental policies (Burns, Economic Research and the Keynesian
Thinking of Our Times, 1946, p. 11).
Burns continued:
Keynes’ adventure in business cycle theory is by no means exceptional.
My reason for singling it out is merely that the General Theory has
become for many, contrary to Keynes’ own wishes, a sourcebook of
established knowledge. Fanciful ideas about business cycles are widely
entertained both by men of affairs and by academic economists. That is
inevitable as long as the problem is attacked on a speculative level, or if
statistics serve only as a casual check on speculation. To develop a reliable
picture of the business cycles of actual life it is necessary to study with
fine discrimination the historical records of numerous economic activities
… Work on this plan is costly and time-consuming; it means turning back,
revising, rethinking, redoing; it often leads to disappointments and taxes
patience. But there is no reliable shortcut to tested knowledge (Burns,
Economic Research and the Keynesian Thinking of Our Times, 1946, p.
21).
Friedman’s, Mitchell’s, and Burns’s approach to business cycle analysis and their
sense of what was known and unknown about cycles was viewed as out-dated by many in
the midst of enthusiam for Keynesian theory and mathematization of economics and
statistics. Economists developed a hubris for which experience at the National Bureau
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provided immunity. This hubris is in full flower in Paul Samuelson’s writings about the
business cycle.
Samuelson was a mathematical economist, whose work was by and large pure
theory, without empirical data. In the autobiography he wrote for the Nobel Prize
Samuelson quotes an earlier autobiographical piece in which he proclaimed himself “the
last ‘generalist’ in economics.” And he was indeed a generalist in subject matter if not
method. Lloyd Metzler’s review of Samuelson’s Foundations of Economic Analysis
(Metzler 1948), which was Samuelson’s Ph.D. dissertation, noted that the book was a
contribution to economic method, with illustrations of the method from a variety of fields
such as taxation, international trade, business cycles, money and banking, and
employment. But problems in these fields were not treated with depth. That is, the
analysis made no use of institutions and data. What Samuelson’s method offered in place
of depth was unification. It was mathematically difficult, but offered in the unification a
kind of simplification, for economic analysis in the disparate fields could be reduced to
problems of equilibrium and maximization. Metzler admired Samuelson’s contribution,
but was skeptical that analysis could be taken very far without resort to empirical
evidence. This would be a limitation, for example, “in the study of complicated and
unsymmetrical systems such as one encounters in business cycle theory” (1948, p. 910).
Samuelson’s was the second Nobel Prize in Economics. Assar Lindbeck opened
the 1970 presentation speech by calling attention to the formalization of two sides of
economics, statistical analysis and economic theory. The previous year Frisch and
Tinbergen were honored for their contributions to the formalization of statistical theory
and analysis -- econometrics “designed for immediate statistical estimation and empirical
15
application” (Lindbeck, 1970). Samuelson was being honored for his contributions to the
formalization of economic theory, “without any immediate aims of statistical, empirical
confrontation” (Lindbeck, 1970).
Nonetheless, Samuelson regarded economics and all science as empirical. In the
opening chapter of his textbook Economics (1948), he wrote:
It is the first task of modern economic science to describe, to
analyze, to explain, to correlate these fluctuations of national income.
Both boom and slump, price inflation and deflation, are our concern. This
is a difficult and complicated task. Because of the complexity of human
and social behavior, we cannot hope to attain the precision of a few of the
physical sciences. We cannot perform the controlled experiments of the
chemist or biologist. Like the astronomer we must be content largely to
“observe” (Samuelson, Economics, 1948, p. 4).
And a few pages later:
Properly understood, therefore, theory and observation, deduction and
induction cannot be in conflict. Like eggs, there are only two kinds of
theories: good ones and bad ones. And the test of a theory’s goodness is its
usefulness in illuminating observational reality. Its logical elegance and
fine-spun beauty are irrelevant. Consequently, when a student says,
“That’s all right in theory but not in practice,” he really means “That’s not
all right in theory,” or else he is talking nonsense (Samuelson, Economics,
1948, p. 8).
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Several of Samuelson’s earliest papers were on macroeconomics, including
“Interactions Between Multiplier Analysis and the Accelerator Principle” (1939) and
“The Theory of Pump-Priming Reexamined” (1940). These two articles provide us with a
view of how the mathematical formalist of Foundations handled macroeconomic theory
when most people writing in macroeconomics did so with more words than mathematical
symbols, more diagrams than theorems and proofs. Samuelson’s older contemporaries
were economists such as J.M. Keynes and Alvin H. Hansen, and Friedman’s mentor
Wesley C. Mitchell.
In the 1939 article Samuelson sought to generalize multiplier analysis along lines
begun by Hansen. Samuelson’s contribution was to move the analysis from arithmetical
examples to algebraic analysis of income sequences contingent on a government
expenditure stimulus, i.e., mathematization of multiplier-accelerator theory. Samuelson
produced a four-way taxonomy of the behavior of income under different assumed
combinations of multiplier and accelerator coefficients. He warned that his analysis
assumed a constant marginal propensity to consume and a constant accelerator coefficient,
although these would actually change with the level of income. The analysis was thus
strictly a marginal analysis to be applied to the study of small oscillations.
Nevertheless, it is more general than the usual analysis. Contrary to the
impression commonly held, mathematical methods properly employed, far from
making economic theory more abstract, actually serve as a powerful liberating
device enabling the entertainment and analysis of ever more realistic and
complicated hypotheses (Samuelson, “Interactions Between the Multiplier
Analysis and the Principle of Acceleration,” 1939, 78).
17
In the 1940 article Samuelson considered whether a countercyclical fiscal deficit
might be self-eliminating, i.e., whether the income generated by the fiscal stimulus might
produce enough tax revenue to close the deficit. He presented no explicit mathematical
analysis in the article, beyond a reference to the 1939 piece, but reasoned to a theorem of
multiplier analysis – “that the increase of expenditure of an extra dollar cannot result in
increased tax revenues of as much as a dollar even though all succeeding time is taken
into consideration” (Samuelson, “The Theory of Pump-Priming Reexamined,” 1940, 503).
He derived this conclusion from analytical assumptions and analytical
presumptions. By analytical assumptions I mean assumptions the role of which was to
simplify and thus facilitate analysis. By analytical presumptions I mean presumptions
about the nature of the economic system. In the first category were the assumptions that
induced private investment is proportional to the increase in consumption from one
period to the next, and that prices remain unchanged. In the second category were
presumed actual characteristics of the economy. These were that:
(1) “the economic system is not perfect and frictionless so that there exists the
possibility of unemployment and under-utilization of productive resources” …
(2) “there exists the possibility of, if not a definite tendency toward, cumulative
movements of a disequilibrating kind” …
(3) “the average propensity to consume is less than one, at least at high levels of
national income” …
(4) “even in a perfect capital market there is no tendency for the rate of interest to
equilibrate the demand and supply of employment” …
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(5) “there exist no technical difficulties to prevent the government from financing
deficits of the magnitudes discussed.” (Samuelson, “The Theory of PumpPriming Reexamined,” 1940, 492-94).
Samuelson gave no justification for these presumptions other than that they were
regarded as fundamental in recent business cycle literature.
He divided economic downturns into two categories, (1) downturns that arise
from exhaustion of investment opportunities, and (2) downturns that arise from inventory
accumulation based on expected but unrealized price increases. He suggested that the
Great Depression belonged at least in part in the first category, i.e., the Depression was
caused in part by exhaustion of investment opportunities. With regard to recessions that
are caused by unwarranted inventory accumulation he suggested that “waiving the
difficulties of quickly engineering a spending policy, there seems to be every reason in
this case for the government to act promptly so as to maintain the national income and aid
in the orderly reduction of inventories” (Samuelson, “The Theory of Pump-Priming
Reexamined,” 1940, 497).
Notice how much is swept aside by Samuelson’s waiver of the difficulties of
quickly engineering a spending policy – all of the politics of budget writing plus the
matter of targeting expenditures at the industries that have surplus inventories. Also
notice that if Samuelson’s two categories are exhaustive, then no downturns begin in the
public sector, from misguided fiscal policy or monetary policy. What Friedman and
Schwartz were to later conclude about the Great Depression and what many economists
believe exacerbated the recent real estate bubble is ruled out a priori.
19
At a 1959 AEA session on price level stability Samuelson and Robert Solow
devoted more than half of their discussion to impediments to the use of historical data for
identification of different types of inflation -- demand-pull, cost-push, and demand shift.
The authors were critical of one-sided explanations of inflation for these typically ignored
the “intricacies involved in the demand for money,” relied on aggregate ex post data and
partial equilibrium analysis, and failed to account for the possibility that effects may
precede causes. Following this rather pessimistic rendering of the problems involved in
evaluating historical instances of inflation, Samuelson and Solow turned to A.W.
Phillips’s “fundamental schedule relating unemployment and wage changes” in the U.K.,
the Phillips Curve. From a scatter plot of U.S. data on unemployment rates and increases
in hourly earnings, a plot without actual numerical values, they offered suggestions about
the Phillips Curve for the U.S. They began by noting deficiencies in the data:
The first defect to note is the different coverages represented in the two
axes. Duesenberry has argued that postwar wage increases in
manufacturing on the one hand and in trade, services, etc., on the other,
may have quite different explanations: union power in manufacturing and
simple excess demand in the other sectors. It is probably true that if we
had an unemployment rate for manufacturing alone, it would be somewhat
higher during the post war years than the aggregate figure shown. Even if
a qualitative statement like this held true over the whole period, the
increasing weight of services in the total might still create a bias. Another
defect is our use of annual increments and averages, when a full-scale
study would have to look carefully into the nuances of timing.
20
A first look at the scatter is discouraging; there are points all over the
place. But perhaps one can notice some systematic effects (Samuelson and
Solow, “Analytical Aspects of Anti-inflation Policy,” 1960, 188).
The systematic effects that they inferred in the plot were:
1. 1933 to 1941 are sui generis; if there is a Phillips curve it has a positive slope.
The anomaly is the result either of NRA pricing codes or of structural
unemployment.
2. The data for the early years of World War II are also atypical, though less so.
3. The remainder of the data “show a consistent [Phillips curve] pattern”
4. The Phillips curve shifted upward “slightly but noticeably” in the 1940s and
1950s. In the earlier period “manufacturing wages seem to stabilize absolutely
when 4 or 5 per cent of the labor force is unemployed,” but since 1946 “one
would judge now that it would take more like 8 per cent unemployment to keep
money wages from rising.”
5. The data may or may not represent an aggregate supply curve. If so, the
movements along it indicate demand pull and shifts indicate cost push. But if
employers in anticipating full employment give wage increases during slack
periods, this makes it problematic to interpret the Phillips curve relationship as an
aggregate supply curve.
Samuelson and Solow conclude on this pessimistic note:
We have concluded that it is not possible on the basis of a priori reasoning
to reject either the demand-pull or cost-push hypothesis, or the variants of
the latter such as demand-shift. We have also argued that the empirical
21
identifications needed to distinguish between these hypotheses may be
quite impossible from the experience of macrodata that is available to us;
and that, while use of microdata might throw additional light on the
problem, even here identification is fraught with difficulties and
ambiguities (Samuelson and Solow, “Analytical Aspects of Anti-inflation
Policy,” 1960, 191).
Despite their pessimistic acknowledgment of the difficulties, Samuelson and Solow
ventured “guesses” portrayed in their figure 2, which is a smooth, non-linear Phillips
curve “roughly estimated” from the most recent twenty-five years of data. The guesses
are that:
1. five to six per cent unemployment is required to have wage increases that match
productivity growth,
2. four to five percent inflation is required to keep unemployment at three per cent.
They warned that the policy trade-offs indicated by their Phillips curve were at best shortterm. The trade-offs could well change in the future. Nonetheless, their diagram and
inferences are surprisingly precise in light of the serious difficulties they brought to light
about drawing inference from the data.
Shortly after he presented the paper with Solow at the 1959 AEA meeting,
Samuelson wrote an evaluation of Federal Reserve policy. The primary question on his
mind was what might be inferred from both the Fed’s policy record and criticisms that
the Fed has waited overly long to ease credit conditions in 1957. Samuelson took issue
with two lines of criticism – the claim that monetary policy was powerless and the claim
that the Fed would gain from a fixed policy rule. His argument against a policy rule was
22
based on the same presumption as Milton Friedman’s argument for a policy rule – that
little was known of the complexities of the macroeconomy. Where Friedman drew the
implication from economists’ ignorance that a rule could be used to minimize mistakes,
Samuelson drew the implication that the rule itself was likely to be ill designed and thus
exacerbate business cycles. He advocated policy based on two principles: “prudent man”
forecasting and willingness to respond quickly to changing conditions.
I would say that the problem of lags should predispose us even more
toward the following view: instead of adapting policy passively to the
recent past, the authorities should try to form a judgment of what a prudent
informed man thinks the rough probabilities are for a couple of quarters
ahead and should take action accordingly, being perfectly prepared to
change their tack as new evidence becomes available to modify these
prudent probabilities (Samuelson, “Reflections on Monetary Policy,” 1960,
264).
Who is the “prudent informed man”? Is he a mathematical economist?
We have seen something of Friedman’s approach to business cycle analysis in our
review of his writings on the Federal Reserve. Tellingly for understanding his approach
to business cycles, Friedman called for study of the length and regularity of monetary and
fiscal policy lags. In contrast with Samuelson’s ability to begin and finish a formal
theoretical project on his own in a brief time, Friedman’s empirical and historical work
involved a team of researchers including not only himself and Anna Schwartz, but a host
of students in the workshop in Money and Banking.3 Where Samuelson’s goal was a
3
In the early years his students included Phillip Cagan, David Meiselman, John J. Klein, Richard T. Selden,
and Eugene Lerner.
23
unified theory of disparate economic phenomena, Friedman’s goal was an empirically
verified theory of one particular economic phenomenon, the business cycle. He presented
the first somewhat complete results to the Joint Economic Committee of the U.S.
Congress in 1958, a decade after his call for this research.4 By that point, Friedman had
modified his rule to the familiar constant growth rate at 3 to 5 percent per year. He wrote:
The extensive empirical work that I have done since that article [“A
Monetary and Fiscal Framework for Economic Stability” (1948)] was
written has given me no reason to doubt that the arrangements there
suggested would produce a higher degree of stability; it has, however, led
me to believe that much simpler arrangements would do so also; that
something like the simple policy suggested above would produce a very
tolerable amount of stability. This evidence has persuaded me that the
major problem is to prevent monetary changes from themselves
contributing to instability rather than to use monetary changes to offset
other forces (Friedman, “The Supply of Money and Changes in Prices and
Output,” 1958, p. 106, n. 19).
Friedman and Schwartz’s “Money and Business Cycles” (1963) illustrates the
difference in Friedman’s heavily empirical approach to macroeconomics and
Samuelson’s approach as we have seen it in several articles. Friedman and Schwartz
used thirty-two pages to present and analyze extensive data records of money and
business cycle turning points, with data covering the period from 1867 to 1960. They
observed first that the money stock tended to rise rather than fall through most business
cycle contractions. They removed the positive trend from the series by taking logarithmic
4
See also Friedman (1959, 1960, 1961).
24
first differences and examined patterns in rates of change in the money stock over deep
and mild contractions. Then they presented the data both in charts and in numerical tables
to uncover the cyclical timing and amplitude of money growth through NBER reference
cycles. In their analysis everything is out on the table. Friedman and Schwartz made
interpretive judgments about patterns in their data, as Samuelson and Solow did about
hourly earnings changes and unemployment, but they presented all the information
readers would need to make their own judgments.
Their conclusions for major business cycles were that:
1. There is a one-to-one relation between money changes and changes in money
income and prices, …
2. The changes in the stock of money cannot consistently be explained by the
contemporary changes in money income and prices (Friedman and Schwartz,
“Money and Business Cycles,” 1963, 50).
By this they meant that although causation goes both ways between money and nominal
income, money has an active role in the business cycle.
There seems to us, accordingly, to be an extraordinarily strong case for the
proposition that (1) appreciable changes in the rate of growth of the stock
of money are a necessary and sufficient condition for appreciable changes
in the rate of growth of money income; and that, (2) this is true both for
long secular changes and also for changes over periods roughly the length
of business cycles. To go beyond the evidence and discussion thus far
presented: our survey of experiences leads us to conjecture that the longerperiod changes in money income produced by a changed secular rate of
25
growth of the money stock are reflected mainly in different price behavior
rather than in different rates of growth of output; whereas the shorter
period changes in the rate of growth of the money stock are capable of
exerting a sizable influence on the rate of growth of output as well
(Friedman and Schwartz, “Money and Business Cycles,” 1963, 53).
From their analysis of the evidence Friedman and Schwartz provided their own version
of what Samuelson strived for and was generally acknowledged by other economists to
have attained – a unified theory of economic phenomena. Only for Samuelson the
unification was in the mathematical method of constrained optimization. Friedman and
Schwartz’s unification was in observed empirical regularities, in a monetary theory of
business cycles.
Friedman and Schwartz were well aware that their explanation of business cycles
was in competition with others, such as the Keynesian theory that investment was the
prime cause.
It is perhaps worth emphasizing and repeating that any alternative
interpretation must meet two tests: it must explain why the major
movements in income occurred when they did, and also it must explain
why such major movements should have been uniformly accompanied by
corresponding movements in the rate of growth of the money stock. The
monetary interpretation explains both at the same time. …
We have emphasized the difficulty of meeting the second test. But
even the first alone is hard to meet except by an explanation which asserts
that different factors may from time to time produce large movements in
26
income, and that these factors may operate through diverse channels –
which is essentially to plead utter ignorance (Friedman, “The Supply of
Money and Changes in Prices and Output,” 1958, 54).
Conclusion
Paul Samuelson was a vigorous advocate for the mathematization of economics,
recognizing the particular virtue of math in laying bare logical relationships. But
mathematical general equilibrium did not equip him to say much at all about economic
conditions and the policies conditions called for at any particular time and place. This
task was left to the “prudent informed man.” In a 1967 discussion with Arthur Burns,
Samuelson described his forecasting technique:
I am not now referring to the regressions of the computer but I am
speaking now of the regressions of the mind, the intuitive forecasting
which I do. The other day a colleague of mine … said to me, “Paul, how
long do you think it will take before a computer will replace you?”... I
thought for a moment, and as the question seemed to be asked in a mean
way, I replied, “Not in a million years” (Burns and Samuelson, 1967, pp.
92-93).
Friedman was more modest about what he knew, less sanguine about what any experts
knew, and believing in the power of monetary policy, more wary of the potential for
harm from misguided policies. In the words of his mentor Arthur Burns, Friedman
believed that “there is no reliable shortcut to tested knowledge.” The program in
business cycle research on which Friedman and Schwartz embarked in 1948 was begun
by Wesley Mitchell at the beginning of the twentieth century. After more than half a
27
century of painstaking research the results were still “provisional.” The project had
produced knowledge, but not of the type and detail that would allow macroeconomic
fine-tuning.
What might Friedman say about the Federal Reserve today? Friedman reflected
on Alan Greenspan’s tenure as Chairman of the Board of Governors in January 2006.
Over the course of a long friendship, Alan Greenspan and I have generally
found ourselves in accord on monetary theory and policy, with one major
exception. I have long favored the use of strict rules to control the amount
of money created. Alan says I am wrong and that discretion is preferable,
indeed essential. Now that his 18-year stint as chairman of the the Fed is
finished, I must confess that his prerformance has persuaded me that he is
right – in his own case (M. Friedman, “The Greenspan Story: ‘He Has Set
a Standard’”, 2006).
The measure by which Friedman judged Greenspan’s performance was maintaining price
level stability, i.e., preventing inflation. This was, in his view, the only justifiable
objective of monetary policy. He made no mention of preventing recessions or financial
bubbles. This was not because he regarded price level stability as the only desideratum.
Certainly the longest business cycle expansion in the twentieth century, from March 1991
until March 2001, was in the back of Friedman’s mind. But he saw price level stability
as the only goal the Fed could reasonably expect to accomplish, and in preventing
inflation he believed the Fed would “as if by an invisible hand” mitigate recessions.
Friedman by nature expected people to be well intentioned. If they disagreed
among themselves, or with him, he assumed the disagreement was an honest
28
disagreement over facts that could be resolved by investigation and education. Not
unconnected to this he had a great deal of the Progressive-era faith in science as the
solution to social problems. But as time passed and old debates dragged on he became
increasingly aware that misguided economic policies are not always mistakes due to
ignorance. Often policymakers, be they at the Fed, in Congress, or in the bureaucracy, are
getting just what they want – power. Thus as we have seen, Friedman moved from design
of tactics for central bankers to a proposal that monetary control be taken away from the
central bankers.
Would he advocate doing away with the Fed? We can be sure that events over the
past four years would be cause for reconsidering his appreciation of Alan Greenspan’s
tenure at the Fed, and that he would decry the capricious innovations in Fed policy that
we have witnessed. He would not look favorably on power wielded in an arbitrary way
by unelected officials. But whether we would be better off without the Fed depends very
much on the alternative. The American public has come to presume that Samuelson’s
“prudent men and women” can run the economy. I suspect that Friedman might tell us, if
he were here today, that if the American people unlearn this myth, it may not matter so
much whether we have the Federal Reserve or some other central banking institution. The
institutional matters will follow the public’s newfound wisdom about what government
can and cannot accomplish.
29
References
Burns, A.F. Economic Research and the Keynesian Thinking of Our Times. Annual
Report, New York: National Bureau of Economic Research, 1946.
Burns, A.F., and P.A. Samuelson. Full Employment, Guideposts, and Economic Stability.
Washington, D.C.: American Enterprise Institute, 1967.
Friedman, M. "A Monetary and Fiscal Framework for Economic Stability." American
Economic Review 38 (June 1948): 245-64.
Friedman, M. A Program for Monetary Stability. New York: Fordham University Press,
1960.
Friedman, M. "Comment on 'A Test of an Econometric Model for the United States,
1921-1947,' by Carl Christ." In Conference on Business Cycles, 107-14. New
York: National Bureau of Economic Research, 1951.
Friedman, M. "Monetary Policy: Tactics Versus Strategy." In The Search for Stable
Money, by J.A. Dorn and A.J. Schwartz, eds., 361-82. Chicago: University of
Chicago Press, 1987.
Friedman, M. "Review of Business Cycles in the United States of America by Jan
Tinbergen." American Economic Review 30, no. 3 (September 1940): 657-660.
Friedman, M. "Should There be an Independent Monetary Authority?" In In Search of
Monetary Constitution, by L.B. Yeager. Cambridge, MA: Harvard University
Press, 1960.
Friedman, M. "The Supply of Money and Changes in Prices and Output." In The
Relationship of Prices to Economic Stability and Growth: Compendium.
Washington, D.C.: U.S. Government Printing Office, 1958.
30
Friedman, M. "The Greenspan Story: ‘He Has Set a Standard’." Wall Street Journal,
January 31, 2006: A. 14.
Friedman, M., and A.J. Schwartz. A Monetary History of the United States, 1867-1960.
Princeton, N.J.: Princeton University Press for the National Bureau of Economic
Research, 1963.
Friedman, M., and A.J. Schwartz. "Money and Business Cycles." Review of Economics
and Statistics, 45 Supplement (February 1963): 32-64.
Hammond, J.D. Theory and Measurement: Causality Issues in Milton Friedman's
Monetary Economics. New York and Cambridge: Cambridge University Press,
1996.
Lindbeck, A. Presentation Speech, 1970 Nobel Prize in Economics.
http://nobelprize.org/nobel_prizes/economics/laureates/1970/press.html.
Metzler, L. "Review of Foundations of Economic Analysis." American Economic Review,
December 1948: 905-10.
Samuelson, P.A. Economics. New York: McGraw-Hill, 1948.
Samuelson, P.A. Foundations of Economic Analysis. Cambridge, MA: Harvard
University Press, 1947.
Samuelson, P.A. "Interactions Between the Multiplier Analysis and the Principle of
Acceleration." Review of Economics and Statistics 21 (May 1939): 75-8.
Samuelson, P.A. "The Theory of Pump-Priming Reexamined." American Economic
Review 30 (September 1940): 492-506.
Samuelson, P.A. “Reflections on Monetary Policy.” Review of Economics and Statistics
42 (August 1960): 263-69.
31
Samuelson, P.A., and R.M. Solow. "Analytical Aspects of Anti-inflation Policy."
American Economic Review 50 (May 1960): 177-94.
32
J. Daniel Hammonds
“Milton Friedman and the Federal Reserve: Then and Now”
Comments
Michael K. Salemi, UNC-Chapel Hill
February 11, 2011
1.
The organizing theme for the conference is the question: “Was the Federal Reserve a Bad
Idea”? Hammonds attempts to answer this question through interpretation of the ideas of
Milton Friedman.
a.
In the introduction, Hammonds writes “… a three way comparison of Friedman,
Samuleson, and policy-making at the Federal Reserve today will help us see not
only that Friedman was largely correct in his misgivings about central banking at
the Federal Reserve, but that he was also more generally correct in his misgivings
about the post World War II rush to bring economists’ expertise to bear on
matters of what we might call economic engineering of prosperity and stability.”
b.
In the conclusion, Hammonds writes “Would he (Friedman) advocate doing away
with the Fed? We can be sure that events over the past four years would be cause
for reconsidering his appreciation of Alan Greenspan’s tenure at the Fed, and that
he would decry the capricious innovations in Fed policy that we have witnessed.
He would not look favorably on power wielded in an arbitrary way by unelected
officials.”
c.
Along the way, Hammonds argues that Friedman understood that knowledge of
the business cycle was difficult to attain and that what little knowledge there was
depended on careful empirical analysis of the sort on display in the Monetary
History. In contrast, Hammond argues that model builders such as Samuleson
substituted mathematical sophistication for empirical analysis.
d.
The problems I have with Hammonds are basically two.
i.
First, to my mind Hammond confuses normal counter cyclical policy
conducted by the Fed during the Greenspan-Bernanke period with the
extraordinary policy that the Fed has undertaken since 2008.
ii.
Second, to me the criticism of Samuelson is at best outdated. It is an
understatement of the highest order to say that a great deal of work on the
connection between business cycle fluctuations and monetary policy has
been done over the last 20 years and to say that a lot of that work has been
done with the kind of respect for the data that Friedman would applaud.
2.
The Federal Reserve and Counter Cyclical Policy
a.
As Hammonds acknowledges, Friedman is on record as applauding Greenspan’s
stewardship at the Federal Reserve even though Greenspan changed the federal
funds rate in response to changes in the state of the economy. William Poole (The
Fed’s Monetary Policy Rule, Fed St. Louis Review, Jan/Feb 2006) shows that the
Taylor rule provides a close approximation to the actual federal funds rate during
the Greenspan years.
b.
Hammonds criticizes the Fed for not beginning to lower the funds rate in
December of 2006, one year before the NBER date for the onset of the Great
Recession. I find this ironical.
i.
Hammonds provides no evidence that Fed policy provided less stimulus to
the economy in December 2006 than a “k percent” rule would have
provided.
ii.
Indeed, it would be interesting to run a horse race between a “k percent
rule” and a Taylor-type rule. But to do so would require a model. A long
time ago, Neil Wallace reminded graduate students at the University of
Minnesota that it takes a model to beat a model.
iii.
Most of the criticism about counter cyclical policy that has been directed
at the Fed in the last couple of years has suggested that the Fed kept short
term rates too low for too long after 911. Bernanke himself addressed this
criticism in the paper he presented at the 2010 ASSA meetings (Bernanke,
Ben “Monetary Policy and the Housing Bubble,” ASSA Meeting Paper,
January 3, 2010). In a nutshell, Bernanke argued:
a)
Using real time data rather than ex post data revisions leads to the
conclusion that the Fed did not keep the funds rate too low after
911.
b)
International data suggest that the inflation of the housing price
bubble is better explained by our current account deficit than by
low short term interest rates.
3.
The Federal Reserve and Crisis Policy
a.
b.
Protection of the Payments System
i.
In Monetary History, Friedman and Schwartz clearly speak out against the
Bank Holiday of 1933 and the suspension of payments that it implied.
ii.
On several occasions, Greenspan took extraordinary action to make sure
that the payments system did not freeze up (October, 1987 after Black
Monday, the Latin American Debt Crisis)
iii.
Bernanke likewise routinely explained that the extraordinary initiatives
taken by the Fed during the sub-prime crisis were meant to keep the
payments system operating.
iv.
The difference between the crisis faced by Bernanke and those faced by
Greenspan was the growth in the shadow banking system that had
occurred in the past 20 years. The payment system is no longer the
banking system.
Growth of the Money Stock during the Great Depression
i.
Friedman criticized the Fed for allowing the money stock to fall during
between 1930 and 1933. See Chart 31, Monetary History, p. 333
ii.
The data describing excess reserves presented in the following table
suggests to me that Bernanke was highly sensitive to Friedman’s criticism
of the Fed’s action and inaction during the Great Depression.
I am less convinced than Hammond that Milton Friedman would have decried “…the capricious
innovations in Fed policy that we have witnessed. He would not look favorably on power
wielded in an arbitrary way by unelected officials.” I will concede, however, that the jury is still
out on whether the initiatives taken by the Bernanke Fed will rekindle inflation.
J. Daniel Hammonds
“Milton Friedman and the Federal
Reserve: Then and Now”
Comments
Mi h l K.
Michael
K Salemi,
S l i UNCUNC-Chapel
Ch
l
Hill
February 11, 2011
Comments on Hammonds
1
Comments on Hammonds
Comments on Hammonds
2
Comments on Hammonds
Comments on Hammonds
3
Comments on Hammonds
4
Was The Fed a Mistake?
I’m Page West and I direct the BB&T Center for the Study of Capitalism.
John Allison is the retired Chairman and CEO of BB&T Corporation, the 10th largest financial
services holding company headquartered in the United States. He began working at BB&T in
1971, became its president in 1987 and was elected Chairman and CEO in 1989.
During his tenure as CEO the bank grew from $4.5 million to $152 billion. In 2009, he joined
our faculty here in the schools of business at Wake Forest as a Distinguished Professor of
Practice.
John is a Phi Beta Kappa grad of UNC-CH where he received his B. S. in business
administration. He also received a master’s degree at Duke University. He is a graduate of the
Stonier graduate school of banking and has received honorary doctorate degrees from six
universities. He received the Corning Award for distinguished leadership and was inducted into
the NC Business Hall of Fame and received the Lifetime Achievement Award from The
American Banker.
He was recognized by Harvard Business Review as one of the top 100 most successful CEO’s in
the world over the last decade.
John has made a real difference in so many people in so many ways by instilling principles such
as reason, independent thinking, integrity, self-esteem amongst BB&T’s 30,000 employees and
millions of clients. This has allowed BB&T employees to live more satisfied lives with greater
financial security.
On college campuses throughout the U.S., the efforts of the BB&T Charitable Foundation to
establish programs elevating economic and philosophical underpinnings of free market principles
is helping a whole new generation of young people better understand the issues we face today. It
is really a distinct pleasure that I have at Wake Forest to work with John since he joined our
faculty. Please join me in welcoming John Allison.
1
DISCLAIMER: THIS ARTICLE IS TAKEN FROM A VERBAL PRESENTATION.
Thanks, Page. Good afternoon. It is truly a pleasure to be here. It is an honor to be able to talk
to such a distinguished group. I am personally very interested in the subject of this conference. I
will make a background comment. I am not making an academic presentation. Even though I
am a professor of practice, I am not really an academic. I am really a CEO, so this is a CEO
presentation, but I think there will be some important academic insights.
2
Let me tell you about my research.
My research has been conducted over 37 years as a banker, including being on a bank board, for
a total of 40 years at BB&T and as the CEO for 20 years during that period. I was the longest
serving CEO of any major financial institution in the U.S. when I retired. Also, I have had many
meetings with other CEO’s over that period. I have effectively been conducting inductive
research for 40 years.
What every CEO of large financial institutions knows in the United States is that while you
technically work for the board/shareholders, you effectively work for the Federal Reserve.
CEO’s are fired by the Federal Reserve, which they usually do through a board process. There is
fundamental control of large financial institutions in the U. S. by the Fed. CEO’s of publicly
traded banks do not often criticize the Federal Reserve. They know there is tremendous risk in
being critical of the Fed.
3
My focus is on Human Action. Those of you who study economics know that this term comes
from Ludwig Von Mises’ great book. My presentation is not exactly in the Von Mises context.
However, sometimes academics fail to realize that there are human beings making decisions and
that important decisions are not made normally in the type of environment academics assume.
There is not perfect information. There is a great amount of confusion. Almost never is
information close to being perfect. Also, even CEO’s like myself, and I view myself as a long
term CEO, recognize that their company has to stay in business for the short term to be in
business in the long term. So when academics talk about long term maximization that is not how
businesses, in fact, work and business leaders do not have perfect information. Mathematical
approaches can be very helpful in certain instances. However, mathematical analysis is often
misused. When it becomes the Holy Grail, it typically leads to bad decision making.
Keynes macro-economic theory is fundamentally flawed. It is not surprising that government
stimulus programs never work. Keynesians fail to recognize the fact that in the real world
people that have been construction workers for 15 years can’t suddenly become computer
engineers. There is a transition issue that is non-trivial in the real world in terms of
interchangeability. Stimulus programs result in massive resource misallocations and reduce
productivity.
4
I have known many people at the Federal Reserve. There are many very bright people involved
in monetary policy at the Federal Reserve. They are well intended and highly educated.
The regulatory group is not as bright. They often cannot hold the “big picture” and are typically
unable to see the forest for the trees. They have tunnel vision. The regulatory side and the
monetary side of the Fed are often in conflict.
However, even the best Fed officials are guilty of what the great free market economist,
Frederick Hayek, described as “Fatal Conceit.” This is a form of arrogance in believing you can
do the impossible. No matter how smart you are or how good of mathematical models you are
working with, it is impossible to integrate the economic activity of 7 billion people on this
planet.
In evaluating outcomes, there is often an impossible standard created for free markets. People
tend to look at things after the fact and see so called market failures. These market failures are
typically Monday morning quarter backing. In fact, free markets are perfect, perfect in the sense
of the best possible. Aristotle dealt with that issue in 300 BC. People say perfection is
impossible; if it’s impossible it isn’t perfect. Perfection is the best possible. Calling the plays on
Monday for last Saturday’s game which is the perspective of government bureaucrats, and some
academics, (who do not have to make real time decisions with imperfect information) is not how
it works in the real world.
The Fed has almost a 100% error rate in terms of projecting the direction of economic activity
when the markets turn, i.e. when it matters. The only time they’ve called the right direction
5
change in my 40 year career was when the Fed raised interest rates rapidly in the early 1980’s to
stop rampant inflation.
The Fed has three primary roles: payments system, regulatory, and monetary policies. Monetary
policy and regulatory policy often work against one another.
6
The Fed owns the payments system which is their ultimate control of the economy. The Fed also
controls most of the clearing system. The Fed’s clearing system is subsidized to keep private
competitors out of the marketplace.
In addition, the Fed adds an additional subsidy for small institutions and non-banks which has
slowed technological progress as larger banks have had to wait on their smaller competitors.
Also, this focus has created quality control problems as most privacy issues originate with nonbank activities through the Fed clearing system.
A major current payment systems issue is the new financial bill (Dodd-Frank) which is creating
new price controls on debit card transactions. This is a very bad idea. The Durbin Amendment
which creates this price control was passed to get Senator Durbin to vote for the bill. Durbin
insisted on this amendment to satisfy his large retail political contributors, especially Walgreens
and Walmart.
This is a major subsidy for large retailers at the expense of low income consumers and bank
shareholders. In order to enable low income consumers to become part of the banking system,
banks started offering free checking. To pay for free checking, banks charged overdraft fees and
debit card fees. The banking regulators have placed significant limitation on overdraft fees and
the Durbin Amendment will make debit card transactions unprofitable for banks. This will be
the end of free checking for low income consumers. Many of these consumers will drop out of
the banking system and will incur significant indirect cost.
Price controls always are economically destructive. In addition, congress wants to control the
price of debit cards, but not the price of bread, milk or gasoline, much more essential items.
I was on the board of The New York Clearing House, a private, bank owned association. We
competed with the Fed, but were far more efficient.
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The Fed clearing house is like the post office. If you think the post office is a good thing, you
should think the Fed clearing house is a good thing. The only good news is that check clearing
volume are in a free fall with banks clearing directly electronically. So except for the impact of
debit card price controls, the payment issue has become less important.
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My goal is to concretize the extraordinary destructive impact of regulations on the banking
industry. For this purpose, my discussion will include the FDIC, OCC, OTS and State Banking
examiners in addition to the Fed.
You can make an argument that the problem is not the Fed, but Congress that passed bad laws.
My discussion will focus on the impact of regulations. You can choose to assign blame to
Congress and/or the banking regulations. CEI recently estimated total annual regulations costs at
$1.75 trillion. In the banking industry, regulatory cost exceeds income taxes. If you had asked
me as a bank CEO would I rather get rid of income tax or regulations, it would be an easy call.
Taxes are much less destructive than are regulatory burdens on banks.
There are a few areas where the Fed is a good thing. It is impractical for banks to operate across
state lines with a maze of different rules so there is a role for the commerce clause to properly
interpret how to manage interstate commerce. Also, you can make the argument that Congress
would be worse than the Fed.
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Regulations in the industry over the years have been justified due to the existence of federal
deposit insurance. The theory is that taxpayers are subsidizing the banking business. That’s an
interesting theory because, in fact, the FDIC is a coinsurance pool, and the subsidy comes from
the healthy banks to unhealthy banks. BB&T has been paying FDIC insurance since 1933.
We’ve never needed it. We have subsidized our inefficient, incompetent competitors.
A number of years ago, a banking consultant, Bert Ely, designed a private co-insurance pool that
could replace the FDIC. Both the securities and insurance industries have similar co-insurance
programs with far better loss experience than the FDIC.
The FDIC is an extremely political organization that always under-estimates the risk individual
banks are taking in the good times, because they do not want to make bank managers, who have
political contacts, unhappy in good times. In bad times, they always overly regulate.
A private insurance pool, where the banks in the pool were “at risk” (versus government
employees who are never “at risk”) would be far tougher in regards to individual bank risk
taking.
Guess who was opposed to privatizing FDIC insurance? Two ends of the size spectrum.
Community banks that are highly subsidized by FDIC insurance and the very large NYC banks.
Why would the large banks care? Because they know that we would not allow them to have the
low capital level that the FDIC permits. If a very large bank was going to be in our insurance
pool, we wanted more capital. We knew as competitors they were the high rollers, taking
enormous risks, and they were grossly undercapitalized. If we had this private insurance pool,
Citigroup would have had dramatically more capital going into the recent financial crisis. A
private insurance pool would have substantially reduced the irrational risk and under-capitalized
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that contributed to the financial crisis (although the Fed’s monetary policy and government
housing policy are the primary causes of the crisis as we will discuss.)
The existence of the FDIC destroys market disciple. For example, a number of banks failed in
Atlanta. We took over one of those failed banks. It is a typical story. Ten or so guys in the
motel business got together and raised a little capital. They leveraged that capital by paying
above market rates for certificates of deposits with the depositors relying on federal insurance.
The bank then loaned the money to their friends in the motel business. They all went broke and
the FDIC lost 40 cents on the dollar.
On a more significant level, Golden West, CountryWide, WAMU, all large institutions which
effectively failed, financed high risk (subprime) loan businesses using high cost certificates of
deposit. They built in-cap branches all over the country and paid very high rates on CDs. They
then used the money to fund their high risk loan portfolio. They never could have raised the
capital to fund their high risk loan portfolio without FDIC insurance. It became a vicious cycle
because the higher rates they pay on their deposits, the higher risk home loans they needed to
make to cover the funding cost.
Regulations are implemented very unevenly both over time and in relation to individual
institutions. In my career we have seen both instances. Countrywide, which effectively failed,
was a tremendously politically connected institution. They influenced public policy. It’s an
interesting story. Countrywide used political pull to change the accounting system. People don’t
realize this but we don’t have a private accounting system in the U.S. We have a government
owned system. The SEC, a government agency, makes the accounting rules in the U. S.
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For many years S&L’s and banks portfolioed home loans. Countrywide did not have a large
deposit base and, therefore, wanted to sell the loans in the secondary market. Accounting for
home loans was on a cash basis which was simple and reliable.
Countrywide, through its political contacts and with the support of Freddie Mac and Fannie Mae
“encouraged” the SEC to radically change the accounting rules. The new rules significantly
incented the sale of home mortgages into the secondary market, by accelerating income from
mortgage originators. This accounting change helped Countrywide increase its market share and
effectively forced many banks to stop portfolioing home mortgages and start selling the
mortgages in the government market primarily to Freddie and Fannie.
At BB&T, we moved most of our production from our portfolio to the secondary market due to
the accounting change (and Freddie/Fannie cost advantages due to their government subsidy).
The new accounting rules permanently increased front end revenues for selling vs. portfolioing
(as long as production increased). This accounting issue strongly encouraged Countrywide, et al,
to drive production growth by taking increasing risk because if production volumes fell, they
would suffer a double reduction in revenue. Also, banks spend millions of dollars nonproductively hedging an accounting entry, where there is not real economic risk.
Regulators effectively make the laws. Congress passes “sound good” broad laws. The
regulators interpret the law in a wide range. They can change the law any time they want to and
they do. They change often.
Many regulations, in my view, are unconstitutional because they are so broad. However, who’s
going to fight the regulators. You know that fighting your regulators is a losing battle. Even if
you ultimately win, it will take 10 years, and the regulators will have put your company out of
business.
I am going to give you some concrete examples. By the way, every regulation I am going to talk
about has been created during my career. These are all new laws that we somehow lived without
before.
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First, let’s discuss Fair Lending. Sounds good. It’s supposed to eliminate racial discrimination,
in the banking business. It probably was a legitimate idea in the 1960s.
However, by the time this law got implemented it was an illegitimate idea because everybody in
the banking business was trying to develop any business they could. There was no motivation to
racially discriminate. Fair lending laws were energized under Bill Clinton. This is an interesting
story. The Boston Fed performed a study which theoretically proved that there was racial
discrimination in the banking businesses. The study turned out to be tremendously flawed,
because they did not consider all the factors that are legitimately used in loan decisions. They
just looked at the debt to income ratio. Debt to income ratio is one indicator. But those who
have ever been in the lending business know that it is a very secondary indicator. The primary
indicator used to make loan decisions is character. The biggest predictor of future behavior is
past behavior. If the borrower hadn’t paid in the past, no matter what their income is, the
probability of default goes up. Secondarily, the continuity of income is critical. It matters if you
have been employed for 5 years or 1 year. When relevant factors are considered, the Fed study
turned out to be a joke.
When Clinton got elected, he had a lot of support from the minority community. Based on the
flawed Fed study, he was concerned. He created quotas for the banking examiners to find banks
guilty of discriminating. The idea from Clinton is that everybody “knows” banks are
discriminating. A lot of banks admitted to racial discrimination because the way the system
worked the fines were pretty small. However, Clinton got big articles in the newspapers. BB&T
was audited by the compliance arm of the FDIC. To my surprise, the examiners claimed we
were racially discriminating. Given our culture, racial discrimination would be a horrible sin. I
asked the examiners to give me the name of the people who were discriminating. I wanted to
personally fire them that day. The examiners said no one was discriminating. Interesting? I
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then asked if there was a system or process causing discrimination. No, according to the
examiners. How then did the discrimination happen? No answer from the examiners.
We then carefully examined the 13 loans (out of hundreds of thousands of loans) where they
claimed we were discriminating. In every case, we decided the loans made should have been
made and the loans turned down should have been turned down. BB&T had not racially
discriminated. We refused to admit to doing something wrong when we did not do it. The FDIC
stopped all our mergers in process, referred our case to the Justice Department and offered a
number of other threats.
Then an interesting event happened; the Republican “revolution” when Newt Gingrich was
elected to congress occurred on Tuesday. On Thursday, the examiners went home and never
mentioned this discrimination process again.
A very similar regulatory event occurred under the current administration for the same reasons.
Again, when the Republicans were elected in the fall of 2010, the examiners backed off.
The Community Reinvestment Act was supposed to eliminate redlining in the banking business.
Redlining was theoretically a form of discrimination focused on income levels in communities.
The Community Reinvestment Act played an important role in the financial crisis. It gave a
moral sanction to subprime lending. It became necessary for banks to become subprime lenders
to some degree. If the bank didn’t comply with the Community Reinvestment Act, it could not
do mergers. In a consolidating industry if your company could not do mergers, it was out of
business.
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The Community Reinvestment Act did not generate enough loans on its own to have a huge
economic impact, but it set up a context where banks were supposed to do more subprime, high
risk, lending. Banks were not designed to be high risk lenders. One of the causes of the
financial crisis was errors in rating subprime mortgage instruments by the rating agencies
(Standard & Poor’s, Moody’s and Fitch). One reason they misrated the risk is because they
looked at the CRA portfolios of banks. The loss results from the portfolios misled S&P, et al.
First, these were rapidly growing portfolios. Mathematically, rapidly growing portfolios have
trailing loss numbers. And the second thing, because the Fed was helping create a housing
bubble, when the loan went bad the losses were small, because the house could be sold to cover
most of the loan amount.
Standard and Poor’s, Moody’s and Fitch used the results from the Community Reinvestment Act
bank loan portfolios. They miscalculated the loss ratios for subprime lending business and under
estimated the risk.
Bill Clinton still wasn’t happy with the increase in the home ownership rate for low income
borrowers.
In September 1999, I remember this very clearly, he required Freddie and Fannie to have half
their loan portfolios in affordable housing, subprime mortgages. These giant government
sponsored enterprises would never have existed in a free market. The government guaranteed
their debt.
Freddie Mac and Fannie Mae were so big that ½ their portfolio was much bigger than the
legitimate subprime (affordable housing) market. A number of economists predicted that
Freddie and Fannie would get in trouble if they achieved this goal. Also, if they were to go
broke, they were big enough to take out the U. S. economic system. It could happen in 10 years.
Nine years later it happened.
I was on a committee of the Financial Services Roundtable trying to do something about Freddie
and Fannie. It became clearly evident that they were going broke. However, Congress refused
to act. First, there was a religious belief in affordable housing. Secondly, Freddie and Fannie
were big political contributors to both parties.
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Sarbanes-Oxley was supposed to eliminate fraud in reaction to WorldCom and Enron. The
banking industry already had a similar law as a result of the early 1990’s thrift crisis. So, this
was a redundant system on a redundant system.
An example of the self-defeating nature of the regulatory environment is the misuse of the
accounting system “justified” by Sarbanes Oxley. On one side, banks are under regulatory
pressure to help borrowers under stress re-finance their mortgages at a more favorable interest
rate than the borrower would otherwise qualify for. However, the bank has to classify the
refinanced mortgage as a restructured debt. On the other side, the regulators require banks to
have more capital for restructured debt. Therefore, if the bank does what the public policy
section of the regulations desire and helps a borrower, the safety and soundness regulators will
probably punish the bank by requiring it to increase its capital position. Catch 22.
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Do you know how many terrorists have actually been caught and convicted because of the
Patriot Act? None. Zero terrorists caught and convicted. I don’t think they’ll ever catch any
terrorists because of the Patriot Act. What are the odds of one of our tellers catching a terrorist?
Would not we report this any way?
The only person of significance caught by the Patriot Act is Elliott Spitzer. He’s a bad guy.
However, he got caught for soliciting prostitution. While in some ways, this is poetic justice, it
should scare you. Think about it. They caught the governor of a state for soliciting prostitution
using a law designed to end terrorism. This is Big Brother. The incentives in the act are very
distorted. We have to report anything we think is a suspicious activity. But, here’s the penalty
system. If we report something than in fact is nothing – there is no penalty. If we fail to report,
we can get penalized $50 million. Much innocent activity is being reported under the Patriot
Act.
The Privacy Act is supposed to prevent banks’ from invading your privacy. However, the Patriot
Act forces banks to violate your privacy. The laws are directly contradictory.
The myth is that the banking industry was deregulated. We were not deregulated. We were
misregulated. The regulatory burden was the worst in my career up to the present time. The
regulators were focused on the Patriot Act and Sarbanes Oxley. There was no focus on safety
and soundness. Because banks have limited resources many resources were shifted from
traditional risk management to focus on Sarbanes and the Patriot Act to satisfy the regulators.
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T.A.R.P. is often described as the banking industry “bailout.” Many people consider TARP to be
successful. I was managing BB&T’s loan portfolio in the early 1980’s when we had a very
serious economic correction and was CEO in the early 1990’s when much of the thrift industry
failed. In neither case, did we have a panic, even though the economic environment was at least
as challenging as that of 2008.
TARP was the result of the gross mismanagement of the process by the banking regulators,
Federal Reserve and Treasury. They made unending mistakes. First, they shouldn’t have saved
Bear Stearns. This sent a terrible message to the marketplace.
Then they saved Citigroup, but they let Wachovia fail. They saved Goldman, saved AIG, and
then they let Lehman fail. Now, the market knew the reasons they saved AIG is because the
Secretary of the Treasury, Paulson, was worried about the counterparty risk for Goldman. The
reason they didn’t save Lehman was perceived to be because Paulson hated Lehman because
Lehman hadn’t helped with Long Term Capital. The market knew that the decisions were being
made arbitrarily; there was no plan, no defined process, and no rule of law.
One of the main goals of TARP was to save General Electric. GE has a very large high risk
lending business. They were financing overnight using the commercial paper market. The
commercial paper market collapsed. The Fed stepped in and bailed GE out. It is not surprising
GE is becoming the ultimate crony capitalist. They are one of the beneficiaries of TARP.
The counter party risk was grossly exaggerated. BB&T had derivative contracts will all the
major firms. However, we managed our risk by reserving cash collateral for exposure with other
financial firms. We lost nothing when Bear and Lehman failed and would have had very
controlled losses if other major firms had failed. All major financial institutions knew Bear
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Stearns was not a systems risk. If the government would save Bear, it was anticipated they
would save any major financial institution.
I was adamantly opposed to TARP. I wrote Congress. I lobbied against TARP. I was the only
CEO of a major bank publicly opposed to TARP. However, when TARP got passed, BB&T
agreed to participate.
I had an interesting experience. The day after TARP passes, our regulator at the FDIC gave me a
call, and they do this very obliquely. They will deny this is what was said, but this is what was
said.
“We have these capital ratios for banks that go back 20-25 years. Based on these ratios, BB&T
is overcapitalized. However, we have decided we need new capital ratios. We don’t know what
these new capital ratios will be, but we are confident if you don’t take the TARP money you will
be undercapitalized. We have an audit team ready to audit BB&T.” We said please send us
TARP funds.
Why did the Fed do this? Bernanke is an academic and a student of the Depression. During the
Depression, Roosevelt tried to save individual financial institutions. It didn’t work because the
market jumped on the specific firm. In 2008, there were three large financial institutions getting
ready to fail. If the Fed tried to save them individually, the markets were going to jump on them.
If the Fed forced all the large banks, all the $100 billion banks and over, to participate and said
that they were doing this from a systems perspective. The market will then not target specific
banks. So, they forced all the large institutions to participate in the TARP program. Several
CEO’s of large healthy institutions had the same experience I had.
TARP was a rip-off for healthy institutions. We paid a huge penalty price, a high interest rate,
and gave warrants in our stocks. It cost BB&T $50 to $100 million. The regulators came back
and did the stress test to see if we had enough capital and, of course, we had enough capital. In
fact, BB&T did not experience a single quarterly loss; therefore, we had to have enough capital.
Dodd-Frank does not deal with the too big to fail issue. If anything the law made it worse. In
my career, Citigroup has failed three times and been saved by the government. Every time
they’ve gotten bigger and worse. I’ll make a prediction. In 15 years, Citigroup will fail again
unless something radically changes. There is a major incentive for larger institutions, like
Citigroup, with implicit government guarantees to take huge risks. The government will always
save them.
The clearest example of the destructive nature of government bailouts is Chrysler. Chrysler was
failing in the 1980’s and was saved by the U. S. taxpayers. Chrysler operated marginally for a
number of years, and then failed again in 2008. The company is now owned by the Italians.
What if Chrysler had not been bailed out by the U. S. taxpayers in the 1980’s? The plants,
equipment, workers would not have disappeared. Some of Chrysler’s resources would have
gone to Ford and GM, improving the quality of their operations. Even more important the
management and unions would have learned a very different lesson. The lesson they learned
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from the bailout is that government will always save them. If Chrysler had been allowed to fail,
management, and especially the unions, would have learned that they need to better manage their
business because they will not be bailed out.
Also, some of Chrysler’s resources could have gone to a new private, non-union automobile
manufacturer. This company might have been extraordinarily successful. There is a total misconception about the genius of the Japanese auto companies. Their main genius was not to
employ union labor in the U. S. plants. This non-union strategy explains most of the cost/quality
difference between the U. S. and Japanese auto companies. Without the Chrysler bailout of the
1980’s, a private non-union American owned manufacturer could be the most successful auto
company in the world and the U. S. auto industry would be much healthier today.
The Federal Reserve’s enforcement of anti-trust law is totally irrational. They use a standard
called the Herfindahl ratio developed in the 1960’s around loan and deposit market shares. It
may have made sense in 1960, but certainly not today. It uses counties and MSA’s for
measurement purposes, and completely ignores telephones and the internet.
Here is an example of the irrationality of this standard. Several years ago, BB&T bought a small
bank in the mountains of North Carolina. We had to divest a $25 million branch. However, the
Fed allowed Wells Fargo and Wachovia to merge into a $1.5 trillion institution without any
divestiture. The anti-trust rules of the Federal Reserve have caused consolidation/concentration
in the industry.
The way BB&T competes against large competitors is to have dominant market shares where we
can drive efficiency in our business. It is easier to do this in rural markets. We can own rural
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markets to drive efficiency. This allows us to compete against much larger companies such as B
of A and Wells Fargo.
I would argue the regulators like large institutions because they have a more comfortable feeling
for their ability to control that kind of institution. The Fed has created an oligopoly in the
banking business which is very dangerous. Very large institutions are perceived to be too big to
fail and have political clout. I don’t believe that they are too big to fail. However, if the
regulators believe these companies are too big to fail, they should be broken up. They are crony
capitalists and pose major systems risk.
The Federal Reserve had plenty of authority to deal with the issues that led to the financial crisis.
They simply did not see the problems. It is ironic that the Fed would complain about their
inability to manage the “shadow banking” system, in that they were largely responsible for its
creation. By imposing colossal regulatory costs on the regulated financial institutions, they
created a major price advantage for non-regulated firms.
It addition, all financial activities ultimately clear through the Federal Reserve because it owns
the payments system. Much of the non-regulated activity cleared through JP Morgan Chase, B
of A, and Citigroup. The Fed could have easily regulated the shadow banking system through
controls in these institutions They simply chose not to because they had no idea a financial crisis
was brewing.
The regulators also have an obsession with mathematical modeling which comes from
academics. As I said earlier I think mathematical models can be useful, but they can be
deceptive. We were told over and over if BB&T just had mathematical models like Bear
Stearns, Citigroup and Wachovia, who all effectively failed, we’d be in great shape. We
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produced those models and one of my rules was do not take the models seriously. Give the
models to the regulators. Models are only as useful as the judgment of the experts who have
experienced the unpredictability models cannot capture.
You may remember that when the financial crisis hit, the Europeans were laughing at us initially,
and then all of sudden a bunch of the European banks failed. Why is that? BASEL is an
international capital standard using mathematical models to determine capital. Using BASEL,
the European banks had very little capital. In the U. S., BASEL had not been fully implemented,
thank goodness.
Another problem with mathematical models is that the “tails” (improbable events) are much
bigger than expected. Secondly, even a one percent probability, given enough time is certain. If
you build your house in a 100 year flood plain, you will have a flood. Most importantly, human
behavior under stress cannot be mathematized.
Citigroup has powerful political contacts. They spend large amounts on lobbying. They are
crony capitalists. If you have an implicit government guarantee as Citi has, it is to your
advantage to maximize leverage. Citigroup systematically increased its leverage over the years
to maximize its return on equity. As Citi increased its leverage smaller banks were effectively
forced to follow or they would have a lower return on equity and be vulnerable to being
acquired.
Let me share an important philosophical point, if we had separation of business and state as we
have separation of church and state, crony capitalism could not exist. In fact, crony capitalism is
really crony socialism. The fact that Congress can dole out economic favors makes crony
capitalism (crony socialism) possible.
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One of the fundamental problems with bank safety and soundness regulations is that regulators
are constantly changing credit standards. The OCC significantly contributed to the real estate
problems of the early 1990’s by tightening typical lending standards.
This current cycle 2008 - 2011, regulators played a major role in making real estate market
values fall deeper than they needed to go economically. As a concrete example, the risk grade
standard at BB&T was arbitrarily and destructively tightened by banking regulators. We have a
risk rate system of 1 – 10. One is wonderful and ten is bad. The regulators arbitrarily decided to
lower the grades. A risk grade 4 suddenly became a risk grade 6. Many credits were pushed by
the regulators into the substandard categories where it is difficult to work with borrowers.
The regulators created performing non-performers. This is where the client is paying the interest
on the loan, but forward income projections, indicate they can’t keep paying. So the banks had
to put the loan on non-performing status which means the bank can’t lend the borrower any more
money. The real estate ends up being sold which drives down values in the market.
The worst case is forced reappraisals. For example a borrower has a subdivision, where lots are
selling but much slower than predicted. But he’s selling enough lots to pay his interest and
paying some principle. There is a balloon payment on the loan. It matures and the FDIC
requires a new appraisal of the real estate. Of course, the value of the real estate has fallen. The
borrower is supposed to make a big cash lump sum payment which he cannot do. The bank ends
up foreclosing on the property driving down the real estate market.
Academics study monetary policy issues. The regulatory arm of the Fed along with the FDIC
and OCC often act counter to monetary policy. The irony is that the regulators (with political
support) have tried to keep banks from foreclosing on homeowners and at the same time have
forced many, many builder developers out of business. They have simultaneously driven
residential real estate prices lower than they needed to go and kept the market from clearing.
Quite a feat.
No question that BB&T is not making loans we would make and putting people out of business
we would not, because of the banking regulators. This is true for the whole banking industry.
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Banking examiners under regulate in good times and grossly over regulate in bad times. They
exaggerate the economic cycles. The reason they under regulate in good times is many bankers
have strong political connections. If the regulators push them hard in the good times, the bankers
will go to their congressman who will come down on the regulators. Since the banking
regulators are life time bureaucrats, why make people unhappy and get criticized. After all the
economy is doing well and the regulators will rotate to another bank soon.
On the other hand, during the tough economic times, there is congressional and administrative
pressure to get those “evil” bankers. The regulators respond to this incentive by irrationally
tightening regulatory standards. The banking regulators made the recent recession deeper and far
longer than it needed to be by irrationally tightening credit standards. Today, BB&T did not
make some loans it would have (should have) made because of the banking examiners. We put
some businesses out of business that we would not have except for the banking examiners. This
reaction is totally consistent with public choice theory.
In my hundreds of direct and indirect interfaces with multiple regulators, in every conflict
between the public good and the good of the regulators, the regulators always act for the
regulatory good. Liberals are incredibly naive to believe anything different.
As an example, BB&T took over a large failed financial institution, Colonial, with assistance
from the FDIC. We had followed this bank for years and decided not to acquire it because we
observed their excessive risk taking in large real estate credits. We were confident they would
someday get in financial trouble.
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However, the banking examiners never identified this high risk strategy until the bank had
already failed. Why is this? The CEO of the bank was very politically connected. Why cause
trouble in the good times, when the CEO would have his congressional friends make problems
for the local examiners and the regulatory agency.
In my whole banking career, I cannot think of a single instance when bank examiners identified a
major problem bank before everyone else already knew there was a problem.
The existence of the FDIC is very dangerous in this regard. The public and investors assume the
bank regulators know what they are doing and if a bank is a problem, they will identify it. This
encourages investors/depositors to keep funding a financial institution long after the company
should have failed. If Underwriters Laboratory made 5% as many mistakes as the FDIC, they
would be out of business.
I am discussing monetary policy with much trepidation. We’ve got many here who know a lot
more about monetary policy than me. I’m going to offer you the banker’s view of monetary
policy. While, I will focus on the human action side, I do have a theory. A few months after I
went to work for BB&T I read The Theory of Money and Credit by Ludwig Von Mises, (1912).
I think it’s the best book on monetary policy, on banking, ever written by far. I don’t even think
there is a close second. There has been a lot of analysis since the book was written. I’ve tested
Von Mises’ theory against reality and every time it’s right. I think it’s a profoundly insightful
theory of monetary policy. Anyway, based on both the theory and my own experience, I don’t
see how the Fed sets interest rates.
How can they do it? Everybody knows from socialism’s failure that experts cannot set prices.
That’s one of the reason’s communism failed. You can’t set prices without market information.
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An interest rate is just a price. It is the most important price in the economy. And, the Fed is
setting the price, when we know that you can’t set prices without market information. And all it
is is a price control. This is no different than debit card fees being controlled or apartment rental
rates in New York being controlled.
The Fed is arbitrarily setting the most important price in the economy, based on gut instinct,
mathematical models, and Keynes failed economy theory. We know elitist price setting always
fails. The Fed knows this for every product and service except interest rates. If the Federal
Reserve sets the right interest rate, they are just lucky.
I can’t set the right price (interest rate) either. I don’t know if interest rates are too low or not. I
do know that it is having an effect on our clients. I also know that businesses are speculating on
farm land, commodities and gold instead of investing in job creating enterprises.
I know setting interest rates too low has consequences. I don’t think there are many of our
borrowers making decisions to do investments different than if interest rates were 2.5% higher.
Decisions are based on cash flow projections, driven partly by confidence in the value of the
dollar.
In early September, 2007, we had a meeting of the Financial Services Roundtable CEO’s with
Bernanke. There were 25 CEO’s from the 50 largest banks at a table with Bernanke. They gave
us a few minutes to talk. Every CEO in that room said the economy is in serious trouble. Our
businesses are falling off the charts. We were all very worried and had become worried in
March, 2007, when the housing market hit a wall and that impacted all of our businesses and we
said “Wow.” I remember Dick Kovacevich who was CEO of Wells Fargo stood up and pounded
on the table and said this economy is in trouble. In this discussion, Bernanke says I hear what
you are saying, we may have some issues, but I am more worried about inflation right now. Our
models say that you bankers are just over reacting. A few months later Bernanke woke up and
acted. I guarantee that if the bank CEO’s had been making the decisions, we would have cut
rates a lot sooner. We would have cut them back in May when the housing market started to
collapse.
I would like to perform a thought experiment based on my observation of these large bank CEO
conversations. I am certain that had these CEO’s been making interest rate decisions, the
decisions would have been materially different than the interest rates actually set by the Fed. I
do not mean the CEO’s sitting around a table trying to maximize the “public good” would have
made better decisions.
Instead, I think the CEO’s making independent decision trying to maximize their individual
bank’s profits (and control risk) with no concern for the public good in competition with one
another would have created a different (and better) interest rate structure. In this competitive
environment, the market (with the CEO’s as a proxy) would not have driven interest rates as low
as Greenspan did in the early 2000’s, would not have raised rates as fast as Bernanke did, and
would not have inverted the yield curve.
26
I also think that trying to eliminate natural market corrections is very destructive. When the Fed
keeps businesses in business that shouldn’t be in business, they push the problems into the future
and create bigger problems.
What happens is the business leaders think the Fed will bail them out and you hear that over and
over again. I will keep up my bets, at the worst case; the Fed is not going to let us fail.
Creative destruction is a very healthy process. The market is an experimentation process.
Unsuccessful businesses need to fail, if we keep them from failing, resources are not freed up for
more productive uses.
27
The Fed made a series of significant mistakes leading up to the financial crisis. Greenspan
created negative real interest rates in the early 2000’s in order to avoid his fear of deflation.
Negative real interest rates are an extraordinarily strong incentive to borrow. Because there were
few investment opportunities at the time, most of the funds borrowed ended up in the residential
real estate markets, (which was inflating rapidly) laying the foundation for the real estate bubble.
Greenspan was particularly adamant that the risk was deflation because of excess global savings.
AT BB&T, we resisted Greenspan’s arguments for several years. However, we finally became
convinced he would hold interest rates low for an extended period of time and decided to invest
in intermediate term government bonds.
Near the end of his term, Greenspan realized they had made a mistake and started raising rates
and Bernanke quickly focused on inflation, not deflation. They systemically raised the Fed
Funds rate 425% in two years and inverted the yield curve. Because interest rates were starting
up from such a low base, the level of interest rates was not destructive. However, the change in
interest rates was destructive. This is one of the fastest percentage increases in interest rates in
history. Can the students in the audience imagine what would happen to their personal finances
if Wake Forest raised tuition 425% in 2 years?
Of course, all the intermediate and long term bonds which banks had purchased at low rates,
because of Greenspan’s insistence that deflation was the issue, suffered massive losses, rapidly
impacting bank earnings.
Bernanke’s inverted yield curve was a disaster for the banking industry. By the way, markets
never invert yield curves, only the Fed can invert the yield curve. In this case, the inverted yield
curve lasted a whole year which is a very long time for a yield curve inversion.
28
Invested yield curves are highly correlated to recessions. However, Bernanke was adamant this
inversion would not cause a recession and the Fed’s economic forecast remained optimistic.
To make a profit, banks borrow short and lend long. An inverted yield curve creates negative
margins in the banking business. Banks were buying watermelons for $10 and selling them for
$8. However, the banking industry has a unique characteristic in that yields can be increased by
taking greater risk. Faced with negative margins and major losses in their bond portfolio and
considering the optimistic economic forecast of the Fed many banks decided to increase the risk
profiles in their lending and investment businesses in order to stay in business in the short term.
It is not surprising that a disproportionate percentage of the bad loans in the industry were made
during this period.
An example of this phenomena is what happened to Merrill Lynch in the CDO market. Merrill
had been tranching its mortgage backed CDO’s and making a profit selling the “A, B and C” risk
based tranches. When Bernanke inverts the yield curve, the only asset they could hold with a
positive spread was the “C” tranches. In addition, according to the Fed/Bernanke, there were
good times ahead. So they decided to continue to sell the A and B tranches and hold the “C”
tranches. Merrill was making record profits 9 months before they effectively went broke. Of
course, when the real estate bubble burst, they lost 100 cents on the dollar on the “C” tranche
(which was really an “F” because S&P, et al had dramatically misrated the risk).
It is mathematically impossible to have a massive misinvestment (bubble) in the economy unless
the Fed provides the money. The Fed has to provide the money (and typically the psychological
incentives) for banks to expand their lending capacity. Yes, velocity changes. However, the Fed
can easily observe velocity increases and react accordingly.
29
The most destructive type of inflation is “hidden inflation.” When those rare events occur where
there is a major and systematic improvement in productivity prices should be failing. This
occurred in the 1920’s with unprecedented advances in technology, automobiles, electricity,
telephones, radio, etc. If the quantity of goods being produced per input of production is rising
rapidly prices should fall. This hidden inflation led to the stock market boom/bust of the late
1920’s.
The same phenomena occurred in the early 2000’s slightly driven by technological
advancements but primarily by the emergence of China and India as they moved towards free
markets. Greenspan’s efforts to keep prices from falling created very misleading price
information. These higher than appropriate prices encouraged the Chinese to keep producing
and the U. S. to keep borrowing as the Chinese invested their net positive cash flows into U. S.
debt. This hidden inflation caused many bad investment decisions to be made, especially over
spending (excess consumption) in the U. S. focused in residential real estate.
Bubbles are an old story. While markets can make misinvestments, bubbles are practically
always driven by over expansion of the money supply by central banks (and their predecessors).
In the late 1800’s, many banks were state chartered. To get a charter, the banks had to agree to
buy bonds issued by their state government. Most of these bonds ended-up invested in
subsidized rail road construction. There was a massive over expansion of railroads with many
railroads failing. This was a state government induced bubble forced through a semi-private (but
state controlled) banking system.
This is an interesting story relevant to today. How did Freddie Mac and Fannie Mae end up
controlling house financing in the U. S.? There was an article in the Wall Street Journal this
30
morning indicating that 95 percent of the housing market in the U. S. is controlled by the
government (Freddie/Fannie/FHA). This is a new phenomenon. It happened through
government policy and unintended consequences that provide a lesson for today. In early 1970’s
when I got my first house, I went to the local savings and loan, put 20% down, and got an 8
percent, 30 year fixed rate mortgage. This is how 95% of people in American financed their
home purchase. The S&L’s had been the dominate player in home financing for 50 years and
had very low loan loss rations. They held the loans and cared about quality. Also, they knew the
local markets.
The savings and loan industry was systematically destroyed by government policy. It started
with Lyndon B. Johnson. He wanted to have the war in Vietnam and he wanted to have The
Great Society, but he didn’t want to tax anybody. So, the Federal Reserve printed bunches of
money fueling rampant inflation in the 70’s. In the early 1980’s the Fed finally tried to bring
inflation under control and raised the prime rate to 21%. CD rates went up to 15% and the
savings and loans are holding 8% mortgages. Lots of savings and loans failed. Then, they got
help from their regulator, the FSLIC, now the FDIC. By the way, when the regulator does a very
bad job, as in this case, (the results cost the taxpayers $300 billion), guess what happens to the
regulators. They get a job as another regulator. That’s exactly what happened. And, some are
still there working for the FDIC. Anyway the regulators encouraged the savings and loans to
hedge their home mortgage portfolios. You cannot hedge a home mortgage portfolio because
home mortgages do not have prepayment penalties. So, when interest rates start falling everyone
refinances their mortgage.
Then, the regulators say that S&L’s can’t make money in the home mortgage, but need to get
into the commercial real estate business, financing hotels, shopping centers, etc. in which they
had no expertise. (Of course, some crony capitalists in the industry joined in this bandwagon.)
The S&L’s then helped create a bubble in the commercial real estate that burst in the early
1990’s and took out most of the rest of the industry. That’s when Freddie and Fannie took over
the home mortgage business. It’s a very interesting phenomenon. We were a home mortgage
lender and had been in the business since the 1960’s. We wanted to grow our business, but we
could not compete against the government. Freddie Mac and Fannie Mae were leveraged 75 to 1
(and ultimately 1,000 to 1), because the Federal government guaranteed their debts.. They had
the lowest cost of capital. You can’t compete against the federal government. They drove all the
private lenders out of the marketplace.
Here’s another interesting story. One of the more destructive products that was privately based
was what was called a “pick-a-payment” mortgage. For example, you owe $1,000 in interest
each month, but you only pay $500 on the loan, so each month you owe more on your mortgage.
That product was invented by Golden West which Wachovia bought and was one of the reasons
that Wachovia failed.
Why did Golden West get into the pick-a-payment mortgage business? Because they could not
compete with the federal government. If Freddie and Fannie had not existed it is likely the picka-payment mortgage would not have been created. At the least, there would have been many
fewer pick-a-payment mortgages.
31
Making economic calculation is an interesting challenge. If you are trying to run a bank you
have to make informed economic educated guesses and you’ve got to guess what the groups of
experts at the Fed, who control you, want you to do and what they might do. This makes
economic calculations much harder. You’ve got to stay in business in the short term. Greenspan
could kill any bank by artificially manipulating interest rates. How do you bet against
Greenspan? Anytime that the economy started correcting, he saved the high risk takers.
We keep making the same mistakes. I made a speech not too long ago to a forum that had one of
the retired presidents of the Federal Reserve that I had known for a long period of time. I was
very critical of the Fed. I was nicer than I am today, but not much, but at the end of the speech I
thought he would criticize me royally. He walks over and says, you know John 90% of what you
said is true. Unfortunately, he said the Fed is a highly political institution. He said he went to
the University of Chicago and studied under Milton Friedman and was an advocate of sound
money and free markets. However, he often ended up voting for monetary policy decisions
because of indirect pressure from Greenspan. He also said the primary goal of the Fed,
practically speaking because of political pressure, is low unemployment, not controlling
inflation.
Ken Thompson was the Wachovia CEO who acquired Golden West, the “pick-a-payment”
mortgage lender. Right before he bought Golden West, he wanted to buy BB&T, but we were
not interested in selling. I talked to Ken right after he bought Golden West. He said he strongly
believed the Federal Reserve was not going to let the housing market plummet. They were going
to bail it out. He said Golden West is a good bet because the Fed will protect the housing
market. Of course, Golden West was a major reason for Wachovia’s failure. The Fed fooled
Ken.
32
Government policy created the financial crisis. We do not live in a free market in the U. S. We
live in a mixed economy. The mixture varies by industry. Technology is probably 20%
government; 80% free. Financial services is probably 70% government; 30% free. Not
surprising the most regulated industry in the economy is the one with the biggest problems.
The Federal Reserve created a bubble by “printing” too much money and holding interest rates
far below market rates. The bubble ended up in the housing market because of Freddie and
Fannie, government sponsored enterprises that would not exist in a free market and the
affordable housing policies of congress.
When Freddie Mac and Fannie Mae failed, they owed $5 trillion and had $2.5 trillion of
affordable housing/subprime loans. They absolutely dominated the subprime market. The
bubble deflated destroying wealth and well-being and destroying millions of jobs. A number of
financial institutions made really bad mistakes. I would have let them fail. However, the
mistakes were secondary and in the context of government policy.
33
The Fed is the enabler of massive government debt. A state can borrow a lot of money because
it can tax. However, the federal government can tax and print money. It is naïve to believe that
politicians will be self-disciplined and the Fed is a political institution.
The experts at the Fed will be politicized; it’s the nature of the beast. Back to my point about
these are human beings making politically based decisions – human action. I personally think
right now what the Fed is doing is very risky. Trying to eliminate unemployment by printing
money has never, ever worked.
The Fed is adding $600 million to the monetary base. Banks lend 10 to 1 that is $6 trillion worth
of liquidity. How do you undo that without driving interest rates up rapidly which is going to
kill the financial industry? You can’t plan for that kind of change in interest rates, so how do
you undo what the Fed has done without severe consequences?
By the way, a primary cause of unemployment is the minimum wage level. We’ve got a lot of
displaced construction workers that have to learn how to do something different. They will have
to start by being paid less until they learn a new skill. Congress raised the minimum wage 41%
in the face of a recession. The law of supply and demand is a law. It is a law, just like the law of
physics. Politicians and Left wing economists cannot make it go away. If the price of milk is
suddenly raised tomorrow to $300 per gallon, there would be a lot of unsold milk
You know who the victims of the minimum wage are – teenage minorities. I think it’s immoral.
They end up selling drugs and they go to jail, because they cannot get a job. Of course, extended
unemployment compensation creates an incentive not to work.
34
Is debasing the value of money a fraud? Is holding interest rates below the natural market rate a
form of theft? My mother is 85 years old. She has been living on the interest on her savings.
She is now consuming her principle, because of the Fed’s arbitrarily imposed low interest rates.
Even though I will take care of her, she is worried that her money will not last her lifetime.
Bernanke is “stealing” from my mother and causing her unjust psychological pain.
I think in 20 to 25 years, the United States will have some really severe economic problems if we
don’t change direction soon. Consider deficits in social security, Medicare and unfunded
government pension plans (which collectively total $100 trillion), annual operating deficits of
$1.3 trillion, the retirement of the baby boomers, and a failed K-12 education system.
In 20 to 25 years, the U. S. will go “broke” unless we change direction. Countries do not go
broke like businesses. Usually they print money and create an authoritarian government. In
1940 Argentina had as high a standard of living as the U. S. They chose statism and got the
consequences. We are the next Argentina.
The problem is fixable, but not without pain. We have terminal cancer, if not treated. The good
news is it is treatable. The bad news is chemotherapy is painful.
Philosophically, we need to return to the principles that made America great. Life, Liberty and
the Pursuit of Happiness: Individual Rights, limited government, and free markets. Keynes and
the politicians have it backwards. They believe demand creates supply. In fact, it is new product
innovation (supply) which creates demand. Thank of all the products and services that exist
today which did not exist 150 years ago: refrigerators, electric stoves, dishwashers, TV’s, radios,
automobiles, airplanes, computers, cell phones, smart phones, medical technologies, debit cards,
comprehensive on-line information, knowledgeable doctors, nuclear reactors, nuclear physicists,
35
medicines, etc., etc. In fact, the vast majority of people are working in jobs to provide products
and services that have been invested in recent times. Entrepreneurs create jobs by creating new
products and services that improve human well-being. Government regulations slow/destroy
innovation and therefore destroy the job creation process.
My view, obviously, is that the Fed was a very, bad idea. If I were in charge, I would eliminate
the Fed and restore private banking based on a market chosen standard of value, probably gold.
The Fed is a political institution and it’s very naïve to believe that a group of elitists can make
better decisions than markets.
The Fed has consistently made different decisions than the market would have made and the
market decisions would have been dramatically better.
I do recognize that the transition is non-trivial. However, allowing the Fed to continue “as is”
creates a fundamental threat to the future of the United States.
36
Panics and The Disruption of Payments Networks: The United States in 1893 and 1907
John A. James
Department of Economics
University of Virginia
PO Box 400182
Charlottesville, VA 22904
James McAndrews
Federal Reserve Bank of New York
33 Liberty St.
New York, NY 10045
David F. Weiman
Department of Economics
Barnard College, Columbia University
New York, NY 10027
.
JEL codes: E42, G21, N11, N21
Keywords: panics, payments systems, restriction of cash payments, domestic exchange rates,
correspondent banking networks
Corresponding author: John A. James
Office telephone- 1-434-924-3525
Office fax- 1-434-982-2904
Abstract
Panics in which banks temporarily restricted the redemption of their deposit liabilities in cash
were virtually regular events in the United States before the establishment of the Federal Reserve
System. Here we examine the disruption of the intercity or interregional payments system caused
by the restriction of cash payments in the panics of 1893 and 1907. Daily domestic exchange rate
data from major regional financial centers allow us to chart the effects of the panic and
subsequent cash restriction (in New York) across cities. In turn we show that the degree of
disruption to domestic exchange markets in regional financial centers over this period was
increasingly a function of their place or centrality in intercity correspondent networks rather than
local conditions. We then provide both qualitative and quantitative evidence on the effects of
these cash restrictions and payments disruptions. Although the private payments networks based
on the correspondent banking system which had developed to clear and settle interregional or
intercity transactions in the pre-Federal Reserve period were normally quite efficient
arrangements, when the convertibility of New York balances was threatened or limited, these
networks were also important channels for transmitting financial pressures. Such restrictions in
turn had serious consequences for payments settlement at both the local and interregional level
and consequently for the level of economic activity
-2-
Panics were virtually regular events in the United States before the establishment of the
Federal Reserve System. We define a panic here as an event in which holders of bank liabilities,
notes or deposits, demand that banks convert their debt claims into cash in sufficient numbers
that collective action on the part of the banking system becomes necessary. In the roughly half
century between the end of the Civil War (1865) and the founding of the Federal Reserve (1914),
there were seven financial crises which may be classed as panics. Indeed, Bordo (1985, p.73)
observes that “the United States experienced banking panics in a period when they were a
historical curiosity in other countries.” Milder ones, such as those in 1884 and 1890, could be
dealt with by issues of clearing-house loan certificates alone. But more severe instances, as in
1873, 1893, and 1907, also resulted in suspensions or restrictions of cash payments at par, in
which banks temporarily restricted or denied altogether the redemption of their deposit liabilities
in cash (specie or legal tender notes) (Calomiris and Gorton 1991, pp. 96-100).
In this paper we examine the nature and consequences of intercity payments system
disruptions in the panics of 1893 and 1907. We focus on three primary issues. First, the turmoil
in the intercity payments system over the course of the two panics reveal fundamental changes in
the character of interbank relationships under the National Banking System over the late
nineteenth and early twentieth century which were less apparent during normal times. In
particular, after 1893 New York banks began to assume an even more integral role in mediating
long-distance payments and in supplying banks with central-bank-like services (James and
Weiman 2010). And in turn in the aftermath of the 1907 panic the apparent vulnerability of the
national payments system to panics and suspensions in New York spawned a reform movement
to create the Federal Reserve, which then nationalized the clearing-settlement functions of New
York banks. We therefore examine here what the panics of 1893 and 1907, as well as the nonpanic of 1914 at the beginning of World War I, reveal about the changing role of New York in
the interregional payments system.
Second is the role of the payments system in transmitting financial pressures across cities
during panics. During panics and cash payment restrictions ready access to New York funds was
-3-
impeded (i.e., they became less liquid), so we concentrate on dislocations in interior markets for
New York funds which in turn interfered with the transferal of balances to meet local or nonlocal payments needs. While studies of panics have usually been limited to just New York banks
and financial markets (e.g., Mishkin 1991; Donaldson 1992, 1993)1 and/or on the causes and
patterns of bank suspensions and failures, here we examine their impact on the correspondent
payments network, more specifically on regional financial centers.
Finally, we consider potential real effects of payments system dislocations resulting from
restrictions of cash payments during panics. Serious payments system disruptions are of course
still possible in the modern economy. Gridlock, for example, was prevented after the September
11 attacks only through swift and decisive intervention by the Federal Reserve (McAndrews and
Potter 2002). But the issue takes on particular relevance for the pre-Federal Reserve period,
when both local and non-local transactions were cleared and settled through private payments
networks. As we describe in the next section, New York correspondent banks were central in
these networks. They constituted the “clearing house of the country” in O.M.W. Sprague’s
phrase (1910, p. 126), holding interior banks’ (excess) clearing and secondary reserves.
Consequently, payments restrictions especially in New York could significantly reduce access to
“good funds” for local and non-local payments and thereby impede normal operations of
production and exchange (i.e., reducing liquidity of banks’ clearing and secondary reserves).
The plan of the paper therefore is as follows: Section 1 is a brief description of the
institutions and operations of the interregional payments system before the Federal Reserve, a
time in which there was no formal government role; section 2 outlines the chronologies of the
Panics of 1893 and 1907 and their impact on interior cities as measured by changes in domestic
exchange rates. We take the longer view first, so Section 3 is concerned with what these panics
reveal about the changing nature of the payments system over time. Sections 4 and 5 focus
1
Carlson (2005), who looks at the pattern and causes of suspensions of interior banks in
the panic of 1893, and Wicker (2000) are notable exceptions. Tallman and Moen (1995) pay
close attention to the course of the panic of 1907 in Chicago.
-4-
instead on more immediate effects– in 4, the dissemination of panic pressures across space, while
the economic impact of payments system disruptions due to the restrictions of cash payments
during panics is addressed in section 5. Section 6 concludes.
1. Private Payments Networks
After the demise of the Second Bank of the United States, making payments at a distance
posed a difficult problem in a country characterized predominately by independent unit banks
with no central monetary authority or integrated nationwide banking system (see Knodell 1998).
It could have been accomplished by shipping specie to the payee, but a system of intercity
payments involving the physical transfer of cash to settle every transaction would have been a
costly one indeed. Unlike the product side, interregional integration of the system of collecting
and clearing financial obligations could not be internalized along Chandlerian (1977) lines
through the formation of large-scale enterprises, due to the prohibition against branch banking.
Monetary integration, then, depended on the formation of a “national” banking system to transfer
deposits among banks without corresponding shipments of cash. Instead, independent banks
developed two types of private networks to facilitate interbank transactions, local clearing houses
and correspondent relationships.
1a. Correspondent banking networks
Banks instead formed two types of networks to broker interbank transactions – local
clearing associations and correspondent relations. During the 1850s banks in New York, Boston,
Philadelphia, and Baltimore began to form clearing associations for the collection and clearing of
local checks (Cannon 1910; Gorton and Mullineaux 1987). The spatial gap in the payments
system between local clearing houses and between city and country banks was filled by the
development of the correspondent banking system. In the antebellum period “country” banks
began routinely to maintain reserve balances in commercial centers, notably Boston and New
-5-
York, for the redemption of note issues (see Myers 1931; Weber 2003). By mid-century a tiered
system of bank correspondents with New York as a national center mediating interregional
payments had begun to emerge (Bodenhorn 2000, pp. 192-198). The organizational form of the
networks of independent banks which developed was a rather novel one, based on longer-term
relationships between banks, something between the tighter clubs of urban clearing-houses,
which restricted membership and actively monitored operations, and the competitive market.
Technological and organizational innovations by railroad and telegraph companies beginning in
the 1850s greatly reduced the costs of shipping information and goods, laying the foundation for
a more integrated, national market (Chandler 1977) and increasing the need for non-local
payments.
The shipment of specie was, of course, an obvious way of settling such accounts, but
rarely used in non-local, non-retail transactions (Colwell 1860, pp. 135, 190, 262, 447). Most
intercity financial transactions instead involved the use of a bank credit instrument of some type–
in the immediate aftermath of the demise of the Bank of the United States primarily bank notes,
somewhat later supplanted by the use of drafts. The bank draft, a check drawn by one bank
against funds deposited in another (financial center) bank authorizing payment to a named
individual, shared the security, convenience, and efficiency advantages of checks, while avoiding
the idiosyncratic information problems. As the draft developed as a general means of non-local
payment, so also did the correspondent banking system mature, being two sides of the same coin.
This in turn allowed for a quite efficient system of essentially net collective settlement of nonlocal payments– transactions between parties whose banks shared the same city correspondent
could be settled as an intrabank “on us” transfer of funds; those between parties whose banks had
different correspondents in the same financial center involved only a transfer of funds within the
local clearing-house, greatly reducing the necessary shipment of reserves (Garbade and Silber
1979, pp. 5-6; Goodfriend 1991, p. 11)
The emergence of New York as the preeminent commercial center meant that maintaining
a New York correspondent became increasingly important for interior banks. Even in 1835 net
-6-
bankers’ balances held in New York amounted to $4.40 million as compared with $2.93 million
in Philadelphia and $1.03 million in Boston; by 1850 that total had risen to $12.51 million vis-àvis $2.45 million in Philadelphia and $4.17 million in Boston (Bodenhorn 2000, p. 196). Almost
600 out of 700 incorporated U.S. banks by that time maintained New York accounts (Myers,
1931, p. 115). In turn, New York developed as the national center mediating interregional
payments. New York funds became the readily acceptable means of payment everywhere
because so many agents made payments there. Drafts or other credit instruments payable in New
York City drawn on the local bank’s correspondent account there consequently became the most
common medium for settling debts not just between interior cities and New York, but even
between agents in different communities.
In the period after the Civil War however both the structure and function of the
correspondent banking system began to change. First of all, the use of drafts on New York
represented only an intermediate stage in the evolution of interregional payments. Banks in the
postbellum period were increasingly primarily banks of deposit rather than banks of issue (see
James 1978, pp. 22-27) with the overall ratio of deposits in commercial banks to currency rising
from 1.50 in 1870 to 2.03 in 1880, then more than doubling the 1870 value to 3.22 in 1890, and
more than doubling again to 6.67 by 1910 (Carter, et al. 2006, p.3-604). Checks offered distinct
advantages to bank customers, as compared with drafts, in making non-local payments. For one
thing, the use of checks was clearly more convenient for payers, who avoided the transactions
costs (the trip to the bank) and fees of purchasing drafts. Moreover, with the purchase of a draft
the payer’s account was debited immediately, while with a check it was not debited until the
check was collected. Nevertheless, because of informational problems, the non-local use of
checks in payment was initially quite limited. The use of checks in non-local payments began to
rise considerably roughly circa 1880, and by the early twentieth century it was estimated that
about 95 percent of the wholesale trade in the country, transactions most likely to have been nonlocal, was paid for by checks (Kinley 1910, pp. 196-199).
The institutional structure of correspondent banking system, originally dictated by the
-7-
pattern of drafts drawn used to finance non-local transactions, later served as the framework to
facilitate the interregional clearing and collection of checks. The move from drafts to checks
necessitated major changes in clearing procedures for out-of-town items. Banks were not
obligated to redeem checks promptly or at par unless they were presented for collection at their
office. Rather than most collections being focused in a central locale, New York, as under the
draft system, collection points became much more dispersed. Although clearing of out-of-town
payments had become significantly more complicated, the correspondent banking system
provided a framework in which to facilitate them. It could have been considered negligence for a
bank to collect checks by sending them to the paying bank through the mail, making the paying
bank also the collecting agent (Spahr 1926, p. 104). Banks therefore would increasingly rely on
their correspondent relations for the collection and clearing of individual checks. Typically, local
banks would send their out-of-town checks to their city correspondent for collection. It, in turn,
would forward them to one of its country (i.e., non-New York) correspondents in the vicinity of
the paying bank, which would present the item at the counter for payment. Even though clearing
had become more involved, settlement procedures remained relatively unchanged. Settlement
was generally accomplished by the issue of a draft on a financial center, usually New York, in
interregional transactions. The concentration of reserves and efficiency of settlement that
developed with the draft system continued in spite of the change in the standard payments
instrument from drafts to checks.
Second, with more complex trade patterns and increased intraregional or intrastate trade,
regional correspondent networks developed in which regional financial center banks held
correspondent accounts of hinterland country banks (Conzen 1977; Redenius 2003; Weiman and
James 2006). Redenius (2003) describes the evolution of such networks in Indiana and Georgia
after 1880. The proportion of Indiana country bank interbank deposits held within the state
which had been close to zero in 1870 rose to more than one-quarter by 1900; in Georgia in 1900
the figure was more than half (p. 16). Most banks however maintained their New York
relationships for interregional transactions. In Georgia, while the share of banks with Atlanta
-8-
correspondents grew from around 20 per cent in 1880 to almost half after the turn of the century,
the share with New York correspondents never fell below 90 per cent. In Indiana there was a bit
more erosion, with shares of those with Chicago correspondents rising from over a third to
almost 60 per cent, those with Indianapolis correspondents increasing from under 15 per cent to
almost 50 per cent, while those with New York correspondents fell from over 90 per cent to
about two-thirds over the period (pp. 14-15).
What emerged therefore was basically a tiered system of bank correspondents with banks
in regional financial hubs (e.g., Boston, Philadelphia, Chicago, St. Louis, San Francisco, and so
forth) holding correspondent accounts of hinterland country banks and New York as a national
center mediating interregional payments. This more elaborate payments network is illustrated by
the diagram in Figure 1 which shows New York correspondents at the center of a tiered hub-andspoke network. Table A1 shows the pattern of interstate cash flows into and out of selected
cities for four years as reported by local clearing houses to the National Monetary Commission
(Kemmerer 1910, pp. 276-357). Flows to and from New York are also reported separately in
addition to those to and from the eastern region. Note that the channels of substantial cash flows
in regional financial centers such as Boston, Philadelphia, Cincinnati, and San Francisco2 were
almost always limited to those between the given city and its hinterland (Boston and New
England, Philadelphia and the East/Mid-Atlantic, Cincinnati and points in the South and
Midwest, San Francisco and the West coast, etc.) and between the city and New York. Other
interregional flows, such as between Boston and the South, Cincinnati and the West, and so
forth, were generally negligible or zero. Interregional payments from such cities therefore must
have been overwhelmingly intermediated by New York balances rather than through
correspondent accounts in other regional financial centers. In turn, in most smaller cities here
intercity dealings were almost exclusively with the regional financial center (Providence and
2
We omit here the other central reserve cities, Chicago and St. Louis, which were closer
to interregional financial centers. Also, intrastate cash flows were not reported, so these figures
generally omit interactions between regional financial centers and their immediate hinterlands.
-9-
Boston, Wilmington and Philadelphia, Little Rock and St. Louis) rather than New York directly.
The tiered structure is evident in these flows.
Even though the New York share of total due to banks held in national banks was
declining over this period as this more complex network developed, from 46 per cent in 1893 to
33 percent in 1906, New York retained its place as the focus of the interregional payments
system. Banks throughout the country settled their check transactions via a New York
correspondent, either directly by debiting or crediting their New York balances or indirectly
through the mediation of correspondents in regional centers. Banks in regional centers
maintained a New York correspondent for this purpose as well as to serve their local business
customers. Additionally, they functioned as clearing nodes, forwarding checks to and from
hinterland banks for collection, but also settled check transactions within their market area.
1b. Domestic exchange markets
New York balances or exchange were traded among local banks in interior cities, thereby
allowing them to adjust the level of their correspondent accounts. Business customers sold
exchange to their banks by depositing drafts or checks drawn on a New York (or other money
center) bank. Banks would remit these items to their correspondent for collection and receive
payment usually in the form of ledger entries to their correspondent balances, rather than
shipments of cash. Thus, in the course of providing routine payment services to business
customers, banks would deplete and replenish their correspondent balances. In turn, at any point
in time, they could find themselves with deficient or excess correspondent balances. To remedy
these imbalances, banks could arrange to ship cash to or from their correspondents, but would
then incur significant transactions costs.
As an often cheaper alternative, banks developed a local wholesale or interbank market in
exchange where they bought and sold surplus correspondent balances. Such a transaction – e.g.,
the purchase of a New York balance with vault cash – simply converted one form of excess (or
clearing) reserve into another and so enabled banks to manage their overall portfolio of excess (or
-10-
clearing) reserves. The price of New York funds, the domestic exchange rate, therefore was a
function of the forces of local demand and supply and a direct measure of the cost of making
long-distance payments. These internal exchange rates, representing the premium or discount
which $1000 in New York funds commanded in the local market, were commonly quoted in the
business or financial press,. A positive number indicated New York exchange sold at a premium,
and a negative figure, a discount. Thus, if the rate in St. Louis was $1.00, $1000 in New York
sold for $1001.00 locally, or at a .10 percent premium.
This system of internal or inland exchange rates was a fixed rate regime in normal times
since the value of a dollar (in terms of gold) in New York was the same as that of one in Chicago.
The spot price of New York funds in Chicago however could differ from the mint parity exchange
rate (one) within the currency points, the cost of shipping cash from Chicago to New York or vice
versa, without eliciting an interregional/intercity currency flow (analogous to the gold points in
the foreign exchange market under the gold standard). Weekly domestic exchange rates reported
in Bradstreet’s magazine for six cities are shown in Figure 2 for the period between the major
panics, September, 1893 to September, 1907. The graphs convincingly show that in normal times
the range of fluctuations was quite circumscribed. In many or most cases an eyeball test seems
sufficient to establish the bands. However in periods of panic and restrictions of cash payments,
when cash was not readily obtainable at par, the usual bounds defined by shipping costs would not
apply, as we shall see.
2. The Panics of 1893 and 1907 and Their Impact Across Cities
The New York stock market collapsed in early May, 1893 with the failure of the National
Cordage Trust. Nevertheless, most of early financial disruptions occurred in interior cities rather
than in New York with panics and bank runs in several interior cities. In June 1893 runs on
banks began in Chicago, Omaha, Milwaukee, spreading to the Pacific Coast (Los Angeles, San
Diego, and Spokane). Cash drains from New York banks to the interior began (Wicker 2000, pp.
-11-
65-77).3 4 In response to these drains on June 15 the New York Clearing House authorized the
issuance of Clearing House certificates as a precautionary measure. These loan certificates,
granted by a special committee Clearing House to members upon application and presentation of
appropriate bank asset collateral, could be used to settle adverse balances at the clearing house.
They thus functioned in effect as a currency substitute in settling local interbank balances and
prevented currency drains to other local clearing-house banks.
In July 1893 interior bank suspensions intensified, and there were city-wide panics in
Kansas City, Denver, Louisville, Milwaukee, and Portland, Oregon (Wicker 2000, pp. 65-77) .
With continued external drains on reserves on August 3 New York banks restricted cash
payments, strongly limiting but not completely prohibiting cash payments to liability holders.
This decision was followed immediately by banks throughout the country. The restriction in New
York was not however complete and banks continued to ship cash to some degree to interior
banks drawing down their bankers’ balances (Sprague 1910, pp. 177-178, 182). The period of
restriction for New York banks lasted around one month with resumption there beginning on
September 2. A chronology of the panic appears in Table 1.
In Figure 2 we present daily domestic exchange rates for the panic period from five major
3
During periods of financial crisis interior banks clearly must have experienced strong
cash withdrawal demands due to hoarding as well as to the more standard needs of (retail) trade
and meeting payrolls (usually paid in currency). See Andrew (1908a).
4
The drop in the Treasury gold reserve below $100 million in April 1893, which
amplified fears that government liabilities might be redeemed in silver rather than only gold as
had been the practice, was often been identified by contemporaries as the harbinger of the crisis.
Sprague (1910, p. 169) however noted that bank failures and suspensions “occurred principally in
the West and Southwest, where there is no evidence that people were distrustful of silver
money... Distrust of the solvency of the banks rather than dissatisfaction with the circulating
medium was clearly the direct cause which brought about runs upon banks and the numerous
failures and suspensions.” DuPont (2008) however has suggested that agricultural distress may
have played a role in initiating the panic in the west in the early summer.
Hanes and Rhode (2009) argue persuasively that financial crises between 1879 and 1914
were fundamentally rooted in adverse cotton harvests which created fertile financial conditions
for disruptions.
-12-
financial centers-- Boston, Chicago, St. Louis, San Francisco, and New Orleans– as reported to
the New York Times. Figure 3 supplements with weekly exchange rates (every Friday) from
Bradstreet’s for six more cities– Philadelphia, Cincinnati, Louisville, Milwaukee, Kansas City,
and Memphis. The cash restriction and resumption dates are marked by vertical lines. Regional
patterns differed. Exchange rates move strongly negative in the weeks before New York
suspension in Chicago, St. Louis, and Kansas City (in Milwaukee the quotes simply disappear just
before and just after restriction). Since domestic exchange rates represent the price of New York
funds in terms of local vault cash, when local reserves are relatively scarce New York exchange
should sell at a discount (i.e., local funds at a relative premium), while when New York funds are
relatively scarce they should command a premium. In contrast, in Eastern cities, such as Boston
and Philadelphia, New York exchange rather than going to a discount in the weeks before
restriction rises to a significant premium (falling to a substantial discount in Philadelphia
afterwards, but not in Boston). In Southern cities such as New Orleans and Memphis there was
little evidence of disturbance before the restriction date.5
During the panic period, exchange rates clearly become much more volatile, attaining
values far outside the normal currency shipping point bounds.6 Rates during the period of
restriction rose as high as $8 in Boston and $10 in New Orleans and Philadelphia. On the flip
side, they fell at points as low as -$8 in St. Louis, -$18 in Philadelphia, -$20 in Milwaukee, and $30 in Chicago.7 In July/August 1893 the standard deviation of the exchange rate, for example,
was over 5 times larger in St. Louis, over 10 times larger in Boston, and 26 times larger in
5
Contrary also to the situation in the midwest, it was reported that in Charleston “New
York exchange is scarce” (Bradstreet’s, August 5, 1893, p. 496).
6
Widely cited figures from just after the turn of the century put express rates per $1000
on currency shipments between New York and four cities as follows: Chicago, 50¢; St. Louis,
60¢; New Orleans, 75¢; San Francisco, $1.50 (Johnson 1905, p. 82).
7
In St. Paul and Minneapolis New York exchange was an “unquotable commodity,”
“unsalable at any price” (Bradstreet’s, August 5, 1893, p. 496; August 12, 1893, p. 513). But
interestingly, the changes in exchange rates in Kansas City and Louisville during the city-wide
panics in late July were not as dramatic as in a number of other places.
-13-
Chicago than in a non-panic year.8
In 1893 financial disturbances originated in the interior leading to a crisis in New York,
but in 1907 the panic was closer to those in 1873 and 1884 where the initial crisis among New
York banks radiated out to the interior.9 On October 16 when a copper corner by Augustus
Heinze collapsed so also did two brokerage house which were involved and runs developed on
three banks associated with Heinze. Assistance from the New York Clearing House preserved the
Heinze banks, but the financial disturbance began in earnest less than a week later with runs on
New York trust companies– first the Knickerbocker, followed by the Trust Company of America
and the Lincoln Trust. Although a money pool organized by J. P. Morgan fended off disaster for
the trust companies in the near term, interior bank withdrawals from national banks led the New
York Clearing House to issue clearing-house loan certificates and suspend cash payments on
October 26. Spreading from New York, virtually a nationwide restriction of cash payments
resulted. A. Piatt Andrew was able to identify only fifty-three cities with populations over 25,000
where restriction did not occur (1908b, p. 503).10 Cash payments were not resumed in New York
until after the first of the year, a period of suspension more than twice as long as in 1893. Again,
the chronology appears in Table 1.
Figure 4 presents daily domestic exchange rates in six financial centers (including St. Paul
this time), with weekly rates for five more appearing in Figure 5. The restriction date in New
8
Sprague (1910, p. 297) cautions that in panic periods “the quoted rates of exchange
were often without much significance” since markets might have been so disorganized that the
rates were “purely nominal, representing little or no actual transactions.” Nevertheless, such
extreme values might still be a useful indicator of the state of the market.
9
Odell and Weidenmier (2004) argue that the after effects of specie drain caused by the
San Francisco earthquake of 1906 had left New York banks low on gold reserve and more
vulnerable to shocks than usual.
10
In the aftermath of the panic pleas for restraint came not only from government and the
financial community but also from above. Archbishop Farley, for example, “pointed out that the
chief thing to be feared in connection with the ship of finance was that during the squall some its
passengers might jump overboard.” Mgr. Lavelle at St. Patrick’s cathedral also “cautioned
against unwise action on bank depositors”(Chicago Tribune, October 28, 1907).
-14-
York is marked by a vertical line as before. In contrast to 1893 when the panic moved from
interior points to New York, we might expect to observe “normal” conditions in regional domestic
exchange markets until the unexpected shock of New York banks’ suspension in late October
1907. The patterns of exchange rates show a striking similarity across Eastern and several
Midwestern (Chicago, St. Louis, St. Paul) cities here; rates increased sharply after cash restriction
by New York banks.11
3. Differences in Exchange Rate Behavior between 1893 and 1907
An eyeball comparison of domestic exchange rate movements in 1893 (Figures 2 and 3)
with those in 1907 (Figures 4 and 5) indicates striking differences. First, in the other central
reserve cities of Chicago and St. Louis average exchange rates moved from strongly negative in
1893 to positive in 1907. By 1907 the pattern of New York exchange in financial centers across
the country looked like that of Boston in 1893 with a sharp rise in the New York premium.
Again, New Orleans stands apart here. Second, the range of exchange rate fluctuations was
generally much smaller in 1907 than in 1893. During restriction New York exchange rates in
Chicago ranged over almost $30; in 1907 the range was $3. In Boston the figures were $6 and
less than $3 respectively, while in San Francisco they were $15 and $2. Table 2 summarizes the
behavior of local domestic exchange rates during the two panics based on the daily data and
illustrates the differences. Two measures of duration are used here– the first from the beginning
of the panic to the resumption of cash payments; the second from the beginning of the restriction
period.12
11
Weekly rates however in Cincinnati, Milwaukee, and Kansas City however seem
generally to have been little affected by the New York panic and cash restriction. And as for the
South, New Orleans and Memphis, Sprague (1910, p. 297) notes that exchange was at a discount
or at par because due to cotton sales in the late autumn banks there were able to draw money
from the Northeast.
12
. The period of Panic Onset is dated from the issue of clearing-house loan certificates
in New York-- in 1893, June 21, and in 1907, October 21; the periods of cash restriction began
August 3, 1893 and October 26, 1907.
-15-
One factor contributing to the decreased fluctuations of 1907 might have been that the
number of days in which local domestic exchange markets did not seem to function (the gaps
between the dots in Figures 2-5) was much higher in 1907 than in 1893. In Chicago, for example,
where the range of exchange rate movements had been the widest in 1893, in 1907 there were no
quoted transactions in domestic exchange at all for more than a week after the cash restriction
date. In San Francisco in 1907 the market essentially disappears with no quotes for two months
after suspension (Figure 4). The number of days over the period in which domestic exchange
rates were not quoted is reported in Table 2. In every comparison save one (panic onset in St.
Louis) the number of no quote days is higher in 1907 than in 1893, usually substantially so. In
Chicago there were only 2 no quote days in the period of cash payments restrictions in 1893 but
there were 20 in 1907; in Boston the figures were 2 and 8, respectively; in St. Louis, 8 and 13; in
New Orleans, 3 and 24; in San Francisco, 1 and 46. The number of cities for which no quote was
reported on a given day is displayed in Figure 6. The rather random pattern of no quote days in
1893 could have been in part the result of idiosyncratic reporting as well as idiosyncratic
disturbances. But in 1907 the pattern is much more evident, with no quote days rising around the
restriction date. Perhaps even more interesting is the fact the domestic exchange market
disappears completely in Louisville (weekly and hence not reported in Table 2 ) after the 1907
panic (and hence also not shown in Figure 5) and flatlines in Memphis.
Although there was certainly variation across cities, there appear to have been three
significant differences then in the behavior of domestic exchange rates in major Midwestern
financial centers between 1893 and 1907. First, New York exchange generally sold at a
substantial discount in 1893 and at a premium in 1907. Second, exchange rates were much more
volatile in the panic of 1893 than in 1907. Third, the number of days in which there seemed to
have been no activity in the domestic exchange market was much higher in 1907 than in 1893.
We argue that these differences in the behavior of domestic exchange rates reflected fundamental
changes in correspondent bank relationships and the nature of the intercity payments system
between 1893 and 1907.
-16-
3a. Increasing centrality of New York in the payments system
With the nationalization of markets and increased internal trade, the breakdown of “island
communities” in favor of far-reaching geographically integrated product and factor markets (see
Wiebe 1967; Conzen 1977), in the later nineteenth century, the volume of interregional or
intercity financial transactions zoomed. In turn, New York exchange, the standard settlement
medium for non-local payments, took on greater importance. The increased use of checks as a
payments instrument in intercity/interregional transactions reinforced the importance of New York
exchange.13 The shift from drafts to checks altered the reserve management problem for banks.
With drafts the demands on city correspondent accounts at a point in time had been completely
predictable, but of course this was not the case with checks. Banks faced greater uncertainty
about their customers’ long distance payments and in turn the demand for clearing balances. This
greater prominence of New York exchange is reflected in the rise in its share of base money or
assets used in interbank settlements, currency plus New York bankers’ balances, the proportion of
New York exchange growing by more than half from around 15 percent in 1893 to over 25
percent in 1906.14
As New York balances assumed greater importance to interior banks, banks were
increasingly reluctant to run them down in panic times when such balances could not have been
easily replenished. For example, in times when loan certificates could be used to settle clearinghouse balances, banks might be reluctant to sell exchange.15 In selling exchange, the resulting
13
Irving Fisher (1911, p. 298) found a pronounced increase in the velocity of bank
deposits, much of which must have been due to increased non-local payments over this period.
From 1896 to 1910 it rose by almost half– from 36.6 to 52.7-- while the velocity of currency
hardly changed (from 18.8 to 21.0).
14
Similarly, we see the share of New York exchange relative to the sum of New York
exchange plus vault cash in state and national banks growing by around a third between 1896 and
1906 (Carter, et al., pp. 3-635, 3-643).
15
See Roberds (1995) for a detailed discussion of clearing-house loan certificates as a
source of liquidity during financial crises.
-17-
favorable balance would have been settled in loan certificates, and if the bank had faced an
unfavorable clearing-house balance it could have met it by taking out loan certificates itself.
Therefore, each bank might have to be more reliant on its own resources for New York balances
(Sprague 1910, p. 294).
If in normal times collections roughly balanced remittances, the levels of New York
correspondent accounts would have remained relatively stable. However in abnormal times, if
some banks, say those from Chicago, delay or discontinue remitting to New York, then other
banks, say those from St. Louis, cannot rely on inflows to replenish their New York bankers’
balance accounts. Interior banks would, as a result, be similarly reluctant to sell New York
exchange and the premium on it would rise. Sprague (1910, pp. 295-296) notes that while “the
extent to which banks in different cities delayed or refused to remit to New York on items
collected by them for other banks can not be determined, . . . there can be no question that banks
in certain cities, in these as well as other matters, adopted a policy wholly designed to strengthen
themselves regardless of consequences.”16 Here again in times of uncertain settlement prudence
dictated strategies to maintain levels of New York balances.17
16
An agent reported to Bradstreet’s from Philadelphia: “The scarcity and high rate of
exchange on New York has no doubt militated against the customary prompt settlements with
that city, the banks for the reason named being unwilling to part with their currency” (July 29,
1893, p. 480). Similarly, Noyes (1894, p. 26) observes that in 1893 even before formal cash
restrictions “country banks were charged with refusing to remit their cash collections... The
express companies did a very large business, during the panic, in presenting out-of-town checks
at the banks on which they were drawn, and bringing the money to the city bank whence the
check was remitted. The out-of-town banks frequently resisted this by paying in silver dollars or
fractional coin. Domestic exchange between two great Eastern cities was at one time fixed by
the express charges for transporting silver dollars.” And as well “banks in some larger cities
were next accused of withholding similar remittances.”
17
Such coordination failures in which the failure of one bank to make expected payments
in turn impairs the ability of other banks to make payments as well, creating a downward cycle,
could certainly occur today in a regime based on real-time gross settlement (McAndrews and
Potter 2002, pp. 62-64). Under the national banking system, local clearing and settlement
through the clearing-house was net, so coordination was not an issue, but the continuous clearing
and settlement of out-of-town items through New York correspondents made such disruptions
possible.
-18-
The dramatic discounts at which New York exchange sold (or premia which local vault
cash commanded) in the panic of 1893 in many/most interior cities therefore reflected the
importance of cash and the scramble for it in local markets.18 What changed fundamentally
between 1893 and 1907 was not necessarily that local demands for cash had become less intense,
although in 1907 the widespread issue of cash substitutes did increase the local supply of funds in
most cities (Andrew 1908b), but that New York exchange had become more valuable. New York
exchange had become more important in monetary arrangements with increased internal trade and
use of checks as means of payment, thereby making the maintenance of balances in New York
accounts a critical consideration. Thus, the generally large discounts for New York exchange in
1893 gave way to premia in 1907.19
3b. Changes in volatility of exchange rates
As bankers’ balances became more important, New York banks after 1893 began
effectively to assume some central banking functions in assisting their interior correspondents in
managing their New York exchange accounts. Lines of credit – that is, routine overdraft
privileges – were increasingly substituted for the local wholesale exchange market. Instead of
buying additional balances from a neighboring bank, local banks simply borrowed reserves from
their correspondent (Lockhart 1921, p. 142). Borrowing rather than buying exchange became a
more attractive, less costly alternative over time. The local exchange market only pooled the
reserves of banks in a particular location and so was ultimately constrained by the region’s
18
In the Panic of 1873, which originated in New York not in the interior, domestic
exchange rates in Chicago also fell dramatically, reaching levels of -$35, again indicating the
importance of cash in the local market relative to New York exchange in the earlier period.
19
The more general rise in the price of New York exchange in the 1907 panic across
cities might also be taken as evidence of increasing integration of the interregional payments
system. Certainly by 1893, when domestic exchange rates during the panic in Boston were rising
rather than falling, the Eastern United States had become a closely integrated area, economically
and financially. But by the 1907 panic the pattern of New York exchange in financial centers
across the country looked like that of Boston in 1893, a sharp rise in the New York premium.
-19-
balance of payments, while, in contrast, banks in New York pooled the excess reserves of banks
from many areas and so were able to diversify against transitory and seasonal flows of funds.
Interior banks then minimized the risk of transitory shortfalls arising in the course of trade by
holding greater correspondent balances. And by holding excess reserves they purchased a credit
line and so if necessary would borrow the difference. As a consequence, the volatility of domestic
exchange rates declined markedly in the period after 1893 (James and Weiman 2010).
Ironically then as New York balances became more important as means of settlement, the
importance of the local domestic exchange market in adjusting the levels of those balances waned.
Over time the overarching structure within which New York balances were managed evolved
from an essentially horizontal one involving dealings among banks in a given city to a vertical one
across cities, namely in dealings between interior banks and their New York correspondents. To
be sure, the ability of New York banks to offer routine overdraft privileges depended on the
shocks to individual bank correspondent account levels being relatively idiosyncratic, so such
operations were undoubtedly more limited during financial crises.
The question thus becomes to what extent did this quasi-central bank function of New
York banks in providing liquidity to interior correspondents during normal times extend to
abnormal or panic times. To be sure, these overdraft privileges would surely have been strained
during financial crises (although reserve pressures on New York were clearly eased by the issue of
clearing-house loan certificates),20 The prima facie evidence for New York banks having been
willing and able to continue to aid interior banks in stabilizing their bankers’ balance levels is the
relatively low levels (in absolute value terms) and volatility of domestic exchange rates in 1907 as
compared to 1893.21 In view of the substantial cash drains from New York to the interior
20
Noyes (1894, p. 21) observes that even in the 1893 panic interior banks were
“clamorous for ‘rediscounts’; in other words, for the purchase from them for cash of paper
already discounted for their own customers... and the larger banks responded.”
21
Nonetheless, there is still possibly something of a puzzle here. First of all, note that
local banks always could have shipped vault cash to New York to build up their balances there.
Rates should have then been bounded above by the usual costs of shipping cash to New York
-20-
(Kemmerer 1910) before and during the cash restriction period, something must have happening
on the supply side to keep exchange rates from soaring.
3c. Changes in no quote days
The substantial increase in the number of days in which no quotes in the domestic
exchange market were reported, as evidenced in Table 2 and Figure 6, also probably contributed
to the greater stability of exchange rates in 1907. Rather than rates taking on extreme values as in
1893, in 1907 the market seems to have just disappeared instead. There are two alternative
scenarios here. The first is that New York exchange was so valuable at that time that banks were
not willing to part with it at any price, so the market simply collapsed. The second would be that
banks wanting exchange were not willing to pay any price for it since some of their needs at least
could be satisfied by their New York correspondent. In view of the relatively moderate rates
generally on the days when trading resumed, we deem the latter case to be the more plausible. In
Figure 4 note that in Boston, Chicago, St. Paul, and St. Louis the no quote days around the time of
the announcement of restriction of cash payments are followed by gradually rising exchange rates
through the middle of November. Such a pattern would be consistent with, during the early phase
of the panic, initial pressure on New York balances to supply funds to country customers of
regional financial center banks offset by the provision of liquidity by New York banks. However
as New York banks became unable or unwilling to continue to provide liquidity over the first part
(i.e., 50¢ per $1000 from Chicago, 60¢ per $1000 from St. Louis). But obviously they were not.
The rates in Figure 4 move outside the bounds of normal currency shipping points, except
perhaps in New Orleans and San Francisco. Why were local banks, for example, willing to pay
higher prices for New York funds rather than shipping cash? One possibility is that these higher
rates, outside the shipping points, reflected the price of immediacy in a thin market. To the
extent that remittances must be met right now today (and in panic times they might have been
more unpredictable than in normal times), there would not be enough time to dispatch currency
to settle accounts, a process that might take a couple of days. Another might have been that
bankers’ balances for some local banks had already been reduced to dangerously low levels. And
the net flows of cash in this period were out of New York rather than into New York (Kemmerer
1910).
-21-
of November this was reflected in upward pressure on exchange rates.22
3d. The currency premium
During periods of cash restriction, when the convertibility of bank balances into currency
at par could have been limited, a free market developed in New York (most importantly) and
other cities in which currency could have been purchased with deposits (at a premium, needless to
say). Demanders of cash would have included merchants, firms which needed to meet payrolls,
and interior banks which needed to meet the withdrawal demands of their country correspondents.
In lieu of being able to convert their New York balances into cash without restriction on demand,
these banks had the option of using these balances in New York to buy currency and then ship it
home. Thus, even during periods of restriction there should have existed bounds to movements in
domestic exchange rates determined by shipping costs, although of course they were not nearly as
tight as in normal times.
We calculate the new (restriction periods) bounds to exchange rate movements based on
the buying currency premium in New York in 1893 and then simply the reported currency
premium in 1907 (Sprague 1910, p. 187; also Noyes 1894, pp. 27-28 ). Figure 7 shows the
relationship between the negative of the New York exchange rate, the value (in terms of deviation
from par) of local vault cash in terms of New York balances, and the currency premium in New
York plus currency shipping costs, in effect the cost of obtaining cash in New York and
repatriating it. It is shown here for Chicago, the most graphic case, during the periods of cash
restriction in 1893 and 1907. In 1893 the value of a local dollar in terms of New York funds was
almost always less than the cost of obtaining a dollar of currency in New York and shipping it
home. Furthermore, the (negative of the) domestic exchange rate tracked the currency premium
quite closely. In 1907 in contrast the exchange rate changes sign and shows no relation to the
22
This certainly seems to have been the factor underlying the large rise in domestic
exchange rates in St. Louis. “A great deal of money has been withdrawn from New York by
local institutions [in St. Louis]. This has been indirectly the cause of the spectacular market in
domestic exchange” (Wall Street Journal, December 23, 1907).
-22-
currency premium.
This relationship is reinforced by a panel regression of daily domestic exchange rates
during restriction in our five cities on the daily currency premia in 1893 and 1907 (t statistics in
parentheses). In 1893 the estimated coefficient is rather large and significantly negative. The
local cost of domestic exchange moved with the currency premium in New York, with a decline in
the currency premium associated with a decline in the relative value of local vault cash (increase
in New York exchange rate). In 1907 the estimated coefficient is much smaller and
xrateit = -0.2454 currencypremium1893t + 0.0595 currencypremium1907t + 1.4024
(-6.02)
(1.61)
(2.12)
2
R = .1254 ; NOBS = 202
insignificantly different from zero. Domestic exchange rates had been decoupled from the
currency premium, reflecting the decreased substitutability of cash and exchange and the
increased importance of New York exchange.
3e. The non-panic of 1914
Anticipating a large gold outflow if the British liquidated their holdings of American
securities in the days leading up to the outbreak of World War I, Secretary of the Treasury
William McAdoo pressured the governing board to close the New York Stock Exchange on July
31, 1914 (and it remained shut for over four months, until December 12). The closure had the
effect of making call loans collateralized by securities, which constituted a significant portion of
the asset portfolio of New York banks, illiquid and especially of those with a substantial
correspondent banking business. As Sprague (1915, p. 514) noted, “Obviously, the payment of
collateral loans could not be insisted upon when there was no market in which either borrowers or
bankers could sell securities.”23 He goes on: “At the time of the closing of the stock exchange,
23
This was not quite true in practice since there was a Curb market on New Street during
this time, although its volume was just a fraction of that on the NYSE (Silber 2007, pp. 104-115).
-23-
indications were not lacking that the same influences were at work which in past crises had
occasioned the dislocation of the banking machinery of the country. . . It is evident that anxiety
over the situation was having its customary effect in precipitating withdrawals of balances by
banks in other parts of the country and Canada” (1915, p. 517). Furthermore, the gold outflows in
late July might “inspire fear” and lead to a stampede into cash (Silber 2007, p. 66).24
At this time the Federal Reserve System was still being set up, with opening day not
coming until November 16. However instead the executive committee of the New York Clearing
House met on Sunday, August 2, and agreed, as in previous crises, to the issue of clearing-house
loan certificates. More importantly, liquidity was injected into the banking system through the
provisions of the Aldrich-Vreeland Act, a temporary measure passed in the aftermath of the Panic
of 1907 to provide some breathing room while the configuration of a central bank could be
established. It was originally scheduled to expire on June 30, 1914, but the Federal Reserve Act
extended its final date for one more year. In times of financial crisis national banks would be
allowed to issue asset-backed emergency currency, with a nationwide ceiling of $500 million set.
A progressive tax on currency outstanding based on time in circulation would ensure timely
retirement.
On July 31, the day the stock exchange closed, McAdoo invoked the Aldrich-Vreeland
Act, although in its original form it offered little relief to New York banks. Emergency currency
could only be issued by banks which had already issued national bank notes valued at at least 40
percent of their capital, and most New York banks had many few national bank notes outstanding
than that. In a meeting on August 2 New York bankers told McAdoo that they needed emergency
currency. Frank Vanderlip of National City Bank said, for example: “We certainly do. . .
Probably more than anybody else. We have more country correspondents than any other New
York bank” (Silber 2007, p. 71). As a result, an amendment to the Act suspending the 40 percent
24
A New York Times editorial (August 4) argued: “Probably never has the world
witnessed a more general embarrassment of commercial relations. Its relation to our troubles in
1907 is about the same as a conflagration to a fire” (quoted in Silber 2007, p. 66).
-24-
requirement, allowing banks to issue emergency currency up to 125 percent of capital and
removing the $500 million ceiling sped through Congress.
Even before the passage of the bill (on August 3) $46 million of emergency currency had
been delivered to the New York Subtreasury (and “if a greater amount should be required many
millions could be transferred within five or six hours” (New York Times August 4, 1914, p. 4)).
The largest initial demanders were the banks with the most correspondents– National City, Chase,
Park National. But once the currency was available, the need for it in New York waned.25 No
suspension of cash payments occurred in New York or anywhere else in the country. By the end
of August the Wall Street Journal was already asking, “Is emergency currency surfeiting the
interior?” with the usual August outflow of cash from New York replaced in 1914 by an inflow
(Wall Street Journal August 31, 1914, p. 8; also September 7, 1914, p.8). Total emergency
currency outstanding peaked at $368.8 million in the last week of October.
The issue of Clearing House loan certificates began on Monday, August 3. Some $20
million of them, it was estimated, were used in Monday and Tuesday clearings, however once the
emergency currency became available, it quickly displaced the loan certificates. Emergency
currency was allowed to be used in settling balances at the Clearing House and could be paid out
to depositors as well. Moreover, the Clearing House loan certificates cost the banks 6 percent
interest, while the emergency currency cost 3 percent for the first three months (Wall Street
Journal August 5, 1914, p. 8)
The 1914 experience reinforces the importance of New York settlement media in the
national payments system, this time the remedy coming in the form of Aldrich-Vreeland
emergency currency rather than Clearing House loan certificates. But it is clear that New York,
particularly those with many interior correspondents, banks were the principal focus in the
25
“An officer of one of the largest banks in New York says: ‘The emergency currency
issue has obviated any fright which may have been caused. My bank had telegrams from nearly
every out-of-town correspondent asking “can we get it,” meaning money or anything to build up
reserves. I replied “yes.” The result of my telegrams was that the out-of-town banks wired in
return “I do not want it.” ‘ “ (Wall Street Journal August 6, 1914, p. 1).
-25-
expeditious amendment and implementation of the Aldrich-Vreeland Act. If building up the cash
balances of interior banks had been the principal concern, that could have been done directly
rather than shipping currency to the New York Subtreasury even before the amended act had
passed.
4. Differences in Severity across Cities
The impact of panic and cash restrictions clearly differed dramatically across cities as well
as across time. What factors might influence the severity of the impact of a panic on the local
domestic exchange market? Here we examine the extent to which domestic exchange dislocations
or perturbations were associated with the balance sheet structures of local banks. Such data for
national banks were available for five call dates per year at the reserve city level in the U.S.
Comptroller of the Currency annual reports.
4a. As measured by domestic exchange rate movements
There are two measures of panic disruption which we could use here, the average and/or
range of domestic exchange rates or the number of days over the period in which quotes did
appear in periodicals but there is no quote for the city in question. As argued above, as interior
banks were increasingly able to borrow from their New York correspondents after 1893 they
might not generally have been forced to pay extreme prices for exchange in the market in times of
crisis; under such circumstances the domestic exchange market simply collapsed, and there was
no trading. Both therefore are measures of stress in internal exchange markets,26 and it seems
prudent to control for the one while using the other as a dependent variable. The extent of
involvement of reserve city national banks (and central reserve cities, Chicago and St. Louis) in
the correspondent banking system is captured by the ratio of “due to banks,” correspondent
26
Both here are calculated over the period of cash restriction, but similar results obtain
over the period from the panic onset. By the same token, due to banks ratios relative to total
assets rather than deposits produced similar results.
-26-
balances of country banks held in, say, Chicago, to individual deposits, predominately local
claims, or by the ratio of net interbank claims (net due to banks defined as “due to banks” minus
“due from banks,” bankers’ balances held in other reserve city or central reserve city banks) to
deposits. The balance sheet data are taken from the call date immediately preceding the onset of
the panic– the second, May 4, for 1893 and the fourth, August 22, for 1907. The estimation results
from panel regressions with fixed effects on both daily and weekly data are reported in Table 3.
The limited number of observations alas constrains us to just a couple of independent variables,
although richer specifications would of course be quite interesting.
Even though the overall fits of the regressions are not that impressive, the results are
nevertheless quite suggestive. First of all, perhaps unsurprisingly, the number of no quote days is
statistically significantly inversely related to the average exchange rate during restrictions and vice
versa. More interestingly, the higher the ratio of net due to banks to deposits in interior cities, the
higher the average level of domestic exchange rates (or alternatively, the more important deposits
were relative to net due from banks, the lower the exchange rate or the more valuable local
reserves were relative to bankers’ balances). Similarly, the number of no quote days was also
positively associated with the relative level of obligations to interior or country banks.
Furthermore, it was the level of due to banks, obligations to interior country banks, that was the
statistically significantly more important factor in creating stringency in the local market for New
York exchange. These results hold regardless of whether based on the more detailed daily data
with fewer cities or on the less detailed weekly data based on more cities.
After the panic of 1893 bankers’ balance holdings became much more important relative
to individual deposits for national banks in many regional financial centers (James and Weiman
2010). For example, between our 1893 and 1907 call dates the ratio of due to banks to deposits
roughly doubled in Chicago and St. Louis and almost did so in Cincinnati, St. Paul, and San
Francisco.27 In turn, these banks held higher levels of balances in New York, but generally
27
Chicago- .64 to 1.28; St. Louis- .65 to 1.28; Cincinnati- .39 to .66; St. Paul- .33 to .51;
San Francisco- .36 to .66. In Philadelphia the increase was even larger, .23 to .82.
-27-
somewhat less than proportionally since the ratio of net due to banks to deposits increased a bit in
most cities. The premia on New York exchange which one generally observes in 1907 reflect,
among other things, the increased role of the correspondent banking system and the position of
New York in that system.28
4b. As measured by intercity cash flows
A quantity measure, intercity cash flows, collected by Kemmerer (1910) for his National
Monetary Commission study, represents an alternative index of panic severity in interior cities.
Based on circulars sent to clearing houses in major money centers, he reported the monthly cash
flows into and out of each city by their geographical origin and destination respectively. The
series covers the period 1905 to 1908 for most cities (and thus includes the months of November
and December 1907 in particular).29 There are then two possible measures of intercity cash flows.
28
To be sure, things are complicated by the fact that some of our cities– Chicago, Kansas
City, Louisville, Milwaukee– experienced local banking panics in 1893 which may have led to
discounts on New York exchange there, but the pattern is more general than that and such local
distress can not account for the large discounts in other cities such as Cincinnati or St. Louis,
where also the value of vault cash relative to New York funds rose dramatically.
29
Surveys were received from 32 city clearing houses (26 were usable) reporting
monthly cash inflows and outflows. The sources and destinations of these flows were typically
listed as states rather than specific cities. But it seems reasonable to take flows from Chicago to
New York to have been directed to New York City and flows reported from New York City to
Illinois to have been primarily directed to Chicago. There are therefore two possible measures of
intercity flows which do not necessarily coincide. First of all, New York City clearing house
banks reported cash inflows and outflows to all Illinois (Chicago) banks whether they belonged
to the local clearing house or not. Second, the Chicago clearing house reported cash inflows and
outflows to all New York banks regardless of their clearing house status (thus including trust
companies). Indeed, Chicago also illustrates a problem with some interior city (in contrast to
New York) reports– the Chicago clearing house had 20 members (Cannon 1910, p. 276) but only
eight to ten of them reported cash flows to the NMC (Kemmerer 1910, p. 53). Generally
however the two series are reasonably close, so the choice of reporting city is not crucial to the
pattern of results. Finally, these data are reflective of intercity cash flows but not of total inflows
and outflows since typically intrastate flows are not covered. For example, cash flows between
New York City and the rest of New York state or between Chicago and the rest of Illinois are not
reported.
-28-
The first (nycflow) is cash shipments reported by New York banks to and from interior points, say
Chicago, plus transfers of cash by New York banks to the interior accomplished through the U.S.
Subtreasury in New York City;30 the second (cityflow) is cash flows to and from New York as
reported by interior, say Chicago, banks.
Table 4 presents inflows, outflows, and net flows of cash from New York to nine interior
cities, as reported by the New York Clearing House (nycflow), for the panic months of October,
November, and December 1907. New York is the reference point, so a negative net flow figure
indicates a net drain of cash from New York to the interior city. The first three columns show
value in $1,000; the second three show the ratio of the 1907 figure to the 1905/06 average for the
respective months; the last three columns relate the size of the flows to reserves on hand (specie
plus legal tender notes) at the call date immediately preceding the panic. First of all, it is clear
that the restriction of cash payments in New York on October 26 did not stop the cash outflows
from the city. The currency drain from New York to interior reserve city banks continued, often
at increased volume, during the restriction period of November and December. These outflows
were generally much larger than usual (as compared with the average monthly flows for 1905 and
1906), as evidenced in the middle three columns of Table 4.31 Moreover, they were generally
30
The U.S. Treasury was willing to transfer cash for New York banks to interior
Subtreasuries via telegraph at rates equal to express charges (Kemmerer 1910, pp. 129-131, 361).
31
Curiously, these strong cash outflows from New York occurred in months when New
York exchange generally sold at a significant premium in interior cities. Perhaps this could be
reconciled if most of the outflow occurred in the days immediately following restriction when the
domestic exchange market disappeared in many cities. For example, the subsequent high
exchange rates in Philadelphia and St. Louis were attributed to banks having “drawn down their
balances at New York so low that they cannot supply New York exchange for mercantile and
other remittances to this city” (Wall Street Journal, November 15, 1907, p. 8). In the days around
the announcement of restriction in New York in Chicago. Because of the uncertainties of the
payments restrictions, “Chicago banks refused to increase their credits in New York for the
reason that they did not want evidences of money instead of money itself.” While domestic
exchange was offered, there were no bids, “a most significant circumstance” (Chicago Tribune,
October 25, 26, 1907). However, less than two weeks later $1.50 a thousand was bid, but none
was offered (Chicago Tribune, November 5, 1907).
-29-
large relative to cash on hand prior to the panic. Most cities here experienced at least one month
in which inflows were equal to a quarter to a third of prior call date reserves on hand (and even
more in San Francisco).
The cross-section regressions reported in Table 5 relate the magnitude of net cash flows
between New York and interior cities to the balance sheet structure of reserve city national banks
– levels of due to banks, due from banks, and individual deposits– at the call date (August 22)
immediately preceding the panic. Since the sale of New York balances in the local domestic
exchange market, converting New York funds into local vault cash, represented an alternative to
drawing down balances there directly, we also include an index of the activity of the domestic
exchange market, the number of weekly observations in which no quotes were listed, as an
additional independent variable. In panel I the dependent variable is the total net flow of cash
between New York and the interior city; in panel II it is the difference between the 1907 flow and
the 1905/06 average. The first two columns use flows as reported by the New York Clearing
House (an outflow from New York to an interior city is negative); the next two use flows as
reported by the interior city clearing house (a flow from New York to the interior city is positive).
Columns 1 and 3 cover the months of October, November, and December; columns 2 and 4 cover
only the restriction months of November and December.
Again, regardless of the specific specification, the general tenor of results is quite
consistent. The less active the local domestic exchange markets, as measured by the number of no
trades reported weeks, the larger the intercity flows (outflows from New York in columns 1 and 2;
inflows into interior cities in columns 3 and 4). The larger the level of due from banks, the
smaller the level of net outflows to the interior rather surprisingly (except for column 1 in panel II,
where the estimated coefficient is not significantly different from zero). More importantly, the
size of due to banks liabilities, country banks accounts in reserve city banks, was a strong and
statistically significant influence on the volume of New York outflows during the last part of
1907. This results holds in every specification. Moreover, the magnitude of the estimated
coefficients of duetobanks are also consistently much larger than those of local deposits, which
-30-
are also generally not statistically significantly different from zero except in columns 3 and 4 of
Panel II. Due to bank liabilities rather than local deposit liabilities appear to have been the
primary factor underlying the volume of cash outflows to reserve city banks during the panic.
Both the price evidence on domestic exchange rates and the quantity evidence on the size
of cash flows from New York to regional financial centers point in the same direction. The local
disruptions of the exchange market, as measured by exchange rate movements, no trade days, or
the volume of net cash flows, in interior financial centers were strongly related to the level of due
to bank liabilities at reserve city national banks. Withdrawals by hinterland country banks rather
than by local depositors must have been the principal factor leading to the pressure on the intercity
payments network (Noyes 1894; Sprague 1910). This is unfortunately primarily a inference
(albeit a strong one) however because it is not possible to measure cash drains to the hinterland
from reserve cities directly-- the NMC cash flow data do not include intrastate movements.32
5. Payments Disruptions and Their Impact
Friedman and Schwartz (1963, pp. 163-168) have famously contrasted the response to
panics under the national banking system (pre-1914), restrictions of cash payments, with that in
the Great Depression under the Federal Reserve System. In the earlier period such restrictions
were argued to have mitigated the effects of panics by stopping bank runs. Bank failures, as a
consequence, were, if not completely arrested (e.g., see Wicker 2000, pp. 78-80), certainly greatly
reduced, thereby damping the rate of monetary contraction.33 To be sure, they conceded (1963, p.
32
However the Chicago Clearing House did report currency shipments to country banks
of $37,694,250 in contrast to currency received from the east of $10,505,740 in October, 1907
($30,200,500 and $9,620,000 respectively in October 1906) (Chicago Tribune, November 7,
1907).
33
These “therapeutic” effects of cash restrictions have been questioned in turn by
Dewald (1972) and Timberlake (1984), but on the other hand consider Dwyer and Hasan (2007).
We follow Friedman and Schwartz’s terminology of restrictions of cash payments instead of the
more common contemporary term of suspension to distinguish it from the temporary closure of
particular beleaguered banks.
-31-
698) that such restrictions may have caused “severe but brief difficulties,” but with little or no
elaboration. Here we now consider the downside effects of cash payment restrictions– there was
one significant aspect that was not stabilizing, disruptions of the payments system.
5a. Potential aggregate supply effects of payments restrictions
Modern-day studies of the effects of panics and financial crises have concentrated on the
transmission channels of changes in interest rates and/or credit availability (e.g., Mishkin 1996).
Recent research in macroeconomics though has raised the possibility that monetary changes might
affect the real economy through changes in aggregate supply as well as changes in aggregate
demand. Contemporary studies have generally emphasized the impact on investment in working
capital (and consequently on the firm's short-run ability to produce), but at a more basic level the
“hemorrhaging” of payments networks which delayed the transfer of good funds in settlement of
transactions, purchases of labor or commodity inputs, would have had (much more) pronounced
real effects through aggregate supply dislocations as well (Barth and Ramey 2002; Christiano,
Eichenbaum, and Evans 1997; Christiano and Eichenbaum 1992 ).
Aggregate supply dislocations could occur for several reasons. One channel described in
modern monetary theory is based on the idea that money acts as a social memory device for the
economy (Kocherlakota 2000). If there is a disruption in the system by which agents in the
economy make long-distance monetary transfers, as occurred during the panics under review, the
agents must turn to less well-suited instruments (such as cash transfers) to accomplish the
information-tracking task that the drafts and checks performed during normal times. This results
in an increase in information costs for producers as the preferred means of transferring and
tracking transaction information is out of service. Because of this monetary role of payment
systems, a disruption in their operation represents a supply shock.
Shocks that disrupt payment networks can have effects on broader measures of financial
liquidity which today could be observed in bid-ask spreads in financial markets, for example.
Empirical evidence shows that various measures of financial market liquidity in the U.S. Treasury
-32-
bonds as well as in the stock market are reduced during periods of crises; in addition, unexpected
injections of money can have positive liquidity effects in these markets (Fleming, 2003; Chordia,
Sarkar, and Subrahmanyan 2004). Theoretical work suggests that delayed settlement in the
payment system can exacerbate the resolution of uncertainty and credit risks which regular
settlement is designed to achieve (Koeppl, Monnet, Temzelides 2005). These disruptions caused
by the banking crises we study delayed settlements for both financial and real transactions. If the
counterparties could not costlessly resort to alternative means of settlement, which we assert they
could not do, then real risks and uncertainty in the economy were persisted longer than
anticipated, reducing the ability of counterparties to take on new transactions or to extend
additional credit.
5b. Cash restrictions and substitutes in the panic of 1907
By limiting access to their money center accounts, withdrawal restrictions can
seriously if not fatally compromise the liquidity of local banks, and in turn deprive their customers
of the means to effect vital transactions such as meeting payrolls. Moreover, if agents are
liquidity-constrained and so prefer to (or out of necessity must) finance their current payments on
the basis of their current cash flows, these disruptions can set off a downward spiraling chain
reaction through the payments system. The magnitude of such payments disruptions will depend
on many factors, but most obviously and directly the greater frequency of local cash payments and
local banks’ excess (clearing) reserves held as vault cash. These two factors are clearly related. If
the non-bank public conducts a larger share of its transactions in cash – or equivalently if banks
function more as “coat checks” storing customers’ cash until needed – banks will tend to hold
larger shares of their excess reserves as vault cash. Excess cash reserves will provide banks with
an initial buffer that may tide them over a short, mild suspension shock. If it persists, however,
customers’ normal and “panicky” cash demands will deplete banks’ excess reserves. Responding
in kind, local banks will also restrict payments, which will have more severe effects because of
-33-
customers’ greater reliance on cash payments.
In the alternative scenario banks economize on their excess cash reserves, because
their customers conduct a larger share of payments in drafts and checks – so called “credit
instruments.” Unlike cash payments, they can be settled through the transfer of correspondent
deposits through the (local or distant) clearinghouse without any withdrawal of funds. In turn,
they hold larger excess correspondent balances because of uncertain clearing demands, especially
from customers’ less predictable check payments. In this case the impact of a cash restriction is
potentially greater, especially if customers run on the banks and increase their cash relative to
deposit transactions. On the other hand, the impact of a restriction will be weaker, if customers
continue to rely on some form of bank money, which can be settled through the transfer of their
“frozen” correspondent balances.34
As we have argued here and elsewhere (James and Weiman 2010), the Panic of 1893
and resulting Great Depression was a significant watershed in the formation of the modern U.S.
payments system, characterized by the greater use of check transactions relative not only to bank
drafts but also to cash. With the diffusion of deposit banks and check transactions, more cities
formed local clearing-houses to mediate local payments and interbank settlement depended more
on banks’ correspondent balances, not vault cash. Consequently, payments restrictions in 1907
would have had more devastating impacts, at least in theory, if panicky bank customers lost
confidence in banks and increased their relative demands for cash and cash payments instruments.
Given the differences in velocity between cash and checks (Fisher 1911), real effects could have
been even greater in magnitude than would have been predicted by simple money multiplier
effect.
34
Again, the willingness of banks and the public to hold these “coat checks” rather than
convert them into cash is crucial. Otherwise, situations might become as in Louisville in 1893,
where business was “almost at a standstill, banks declining to receive country checks even for
collection and preferring not to handle New York exchange” (Bradstreet’s, August 12, 1893, p.
511).
-34-
We qualify this last prediction, because it abstracts from the complementary
institutional innovation of the clearing-house organization which enabled banks to mount a
collective, not individual, response to the withdrawal restrictions. Clearing-houses had assumed a
critical lender of last resort function, supplying member banks with loan certificates as substitutes
to cash reserves for their clearing-house settlements (Timberlake 1984; Roberds 1995). During
the 1907 panic, they greatly broadened the scope of their quasi-central-bank authority by issuing
low-denomination loan certificates which circulated as cash substitutes. Of dubious legal
authority, this innovation could effectively tide local banks over the potential restrictions storm, if
it restored customers’ confidence in the banking system, not individual banks.
Andrew (1908b, p. 502) chronicles local cash payment restrictions during the Panic of
1907. Inquires sent to banks in all cities with populations greater than 25,000 revealed that in
two thirds of them banks restricted cash payments to some degree, with Washington, DC being
the only financial center not to restrict. In some cities bank customers were limited to a total cash
withdrawal (of, say, $25 or $100); in others, daily withdrawals were restricted to $25, or $50, or
$100 per day; in many or most cities including New York the restrictions were “discretionary.”35
Such limitations on the ability of bank customers to convert their deposits into cash most probably
had serious and immediate effects.36 The Comptroller of the Currency (1907, p. 70) noted that
“all domestic exchanges were at once thrown into disorder and the means of remittance and
collection were almost entirely suspended... This [derangement of the machinery for making
35
Refusals by New York banks to pay out cash for their interior correspondents in 1907
are described in Senate Document No. 435 (U.S. Senate 1908). In 1893 restrictions were
discretionary as well. “The majority of New York institutions continued to pay cash on demand
to all depositors, and those which did refuse cash payments not only offered to such depositors
checks on other banks, but cashed small checks without inquiry,” but “the banks which did shut
down on cash payments to depositors included several of the soundest institutions in the city”
(Noyes 1894, pp. 26-27).
36
Kroszner (2000, p. 162), however au contraire argues “the temporary suspension of
cash payments in late 1907, while causing some inconveniences, allowed the banks to continue
to provide payments functions...”
-35-
collections and remittances] has interfered with every kind and class of business and led to great
curtailment of business operations of every kind.”
To the extent that checks were not readily acceptable everywhere and that recipients
were not content simply to deposit them into their accounts, bank liabilities did not fully fulfill
their role as a medium of exchange. Rockoff (1993) argues that this fact alone represented a
decrease in the quality-adjusted money supply and could have disrupted planned spending.
Moreover, business firms, unable to procure cash to meet payrolls, were forced to layoff workers
and shut down plants. Sprague (1910, pp. 202-203) notes that while in July, 1893 newspapers
published many accounts of factories closing due to failures, inability to make collections or to
obtain credits from banks, by August, after restriction, the most frequently cited cause had become
the inability to procure cash to make payrolls. Toward the end of the month however some
factories began to reopen and cash payments were restored in September.
Difficulties in meeting cash payrolls appeared to have been less pronounced in 1907
than in 1893 (Sprague 1910, p. 290)37 even though Andrew judged the 1907 panic as the more
disruptive to local payments. “Probably the most extensive and prolonged breakdown of the
country’s credit mechanism which has occurred since the establishment of the national banking
system... Even during the critical periods of 1873 and 1893 it is unlikely that as many banks
limited the payment of their obligations in cash” (1908b, p. 497). The 1907 panic was
characterized by the extensive issue of local emergency currency or currency substitutes.38 Banks
in many localities issued small denomination clearing house certificates, obligations of the
clearing house which could circulate from hand to hand (as opposed to the traditional large
denomination ones used in interbank settlement); clearing house checks, again typically in small
37
Although the Chicago Tribune (November 23, 1907) notes that “some plants are idle
because of the difficulty experienced in obtaining cash with which to pay employees...”
38
These instruments were employed in 1893 as well, although not to the extent as in
1907. See Warner (1896).
-36-
denominations and payable through the clearing house (i.e., not convertible into cash), but drawn
on particular banks; cashier’s checks in convenient denominations which were “practically
circulating notes”; New York drafts in denominations of $1 up (in Birmingham); negotiable
certificates of deposit to be used in local payments; or, finally, pay checks drawn by bank
customers upon their banks in small denominations and used for payments of wages (widely used
in Pittsburgh) (1908b, pp. 506-512).
Clearing house loan certificates in large denominations for interbank settlement
however constituted the great bulk (over 70 percent of the total) of the measurable issues of
emergency currency in the 145 largest independent cities polled by Andrew. This was true in both
reserve and non-reserve cities. The results of a regression with the total volume of cash
substitutes issued by city in 1907 on the balance sheet structure of national banks (as of
September 1906) and dummy variables for reserve city status are reported below (t statistics in
parentheses).
Totalissuei = .1254 Duetobanks i - .1283 Duefrombanks i + .0458 Individualdepositsi
(3.17)
(-3.65)
(1.91)
+ 7591.479 Centralreservecityi + 528.285 Reservecityi - 1.760 Populationi - 132.673
(2.99)
(0.58)
(0.59)
(-0.16)
Adjusted R2 = .9877; NOBS= 33
Note first of all the symmetry in the effect on the volume of cash substitutes issued
between duetobanks and duefrombanks-- one dollar more in obligations to other banks increasing
the amount of cash substitutes created, while a one dollar increase in interbank balance holdings
decreasing it by a similar amount. More importantly here however, the level of interbank
balances held by national banks in the city had a much stronger influence on the volume of issue
than did the level of individual deposits (both have significantly positive estimated coefficients
-37-
however). This result holds even allowing for differences in reserve city status across cities. In
particular, central reserve cities seem to have faced much stronger withdrawal demands from their
correspondents (given the level of duetobanks), resulting in the issue of more cash substitutes.
Such a result supports the observations of contemporaries (Sprague 1910; Andrew 1908a) who
primarily blamed country correspondent banks for the large withdrawals creating pressure on
reserves and leading to cash restrictions and the issue of substitutes rather than local individual
depositors.39 Finally, population is included in the regression as a scaling factor.
Andrew estimated the volume of cash substitutes outstanding during the 1907
restrictions at over $500 million, as compared with a currency stock of $1,810 million in 1907 IV
(Friedman and Schwartz 1970, p. 65). “For two months or more these devices furnished the
principal means of payment for the greater part of the country, passing almost as freely as
greenbacks or bank-notes from hand to hand” (1908b, p. 515).40 To be sure, these instruments
must have been imperfect substitutes for true currency, and this deterioration of the quality of the
money stock may have had some adverse effects, but at the same time they must have relieved
some of the pressure on local banks’ vault cash. After all as we have seen, during the 1907
restriction New York exchange was typically at a substantial premium ( until late in the period in
39
The Comptroller of the Currency (1907, p. 70) for example observed “that there has
actually been more of a panic among the banks themselves than there has been among the people.
The banks have been fearful as to what might develop, and finding their usual reserve deposits
only partially available, if available at all, they have been compelled in self-protection to gather
from every source all the money they could possible reach... With the exception of the first
excitement in New York and smaller runs in other places, there has really been surprisingly little
excitement or uneasiness among the people.”
Note as well that clearing-house certificates, which most directly addressed the needs of
country bankers’ balances holders by freeing up cash to be paid out to them, constituted the great
bulk of cash substitutes created. Local currency substitutes, which would have been of little use
to country banks, were quantitatively much less important overall.
40
We don’t know the total volume of cash substitutes created in 1893, but we can
compare the magnitudes of the largest component, large-value clearing house loan certificates-$238 million in 1907 as compared with an issue of $69.1 million in 1893 (see Table 1).
-38-
any case), indicating that however scarce local reserves may have been, New York exchange was
even scarcer. Andrew (1908b, p. 516) concluded that the substitutes “worked effectively and
doubtless prevented multitudes of bankruptcies which otherwise would have occurred.”
5c. Potential real effects of cash restrictions
The issue of currency substitutes must have mitigated the problems in making local
payments to some degree, even though converting New York balances into vault cash during
restrictions remained quite costly. There was no such substitute available however to offset the
dislocations of the non-local, interregional payments system.41 The timeliness and predictability
of intercity payments was disrupted, with the only alternative being shipping currency (if
available), a process which clearly delayed final settlement of transactions. Such interferences
with making payments at a distance and hence with the smooth functioning of the payments
system should have had an adverse effect on internal trade. Bradstreet’s in 1893 noted “the clog
to trade shown by prohibitive rates for New York exchange at centers east, west, and northwest”
(August 5, 1893, p. 495). Similarly, the Wall Street Journal observed in 1907 the
“disorganization of domestic exchanges which prevents the free movement of commodities for
export” (December 2, 1907, p. 8).42
41
A resolution of the Merchants’ Association of New York passed November 21, 1907
read in part: “Checks payable ‘through clearing-house only’ are useful for local settlements, but
do not pay non-local debts. The business of all large manufacturing and mercantile concerns is
chiefly non-local, and cannot go on if local funds are everywhere tied up. Interstate exchange is
essential to the conduct of interstate business, and this constitutes the greater part of our domestic
exchanges. Provision for the settlement of local indebtedness is helpful, but provision for the
settlement of non-local indebtedness is essential, and, therefore, still more helpful” (Bankers’
Magazine, December, 1907, p. 970).
42
The grain trade seemed to have been particularly affected. “Naturally, there has been
some dislocation of the nation’s business, notably in domestic exchanges, which has reacted on
the collecting and forwarding forces by a time stopping the buying of wheat in the Northwest and
of cotton at the South” (Bradstreet’s, November 2, 1907, p. 698). By mid-month, “One
especially hopeful sign has been renewal of grain purchases in the Northwest, exchange checks
-39-
It is, of course, impossible here to isolate precisely the impact of payments disruptions
alone from the concurrent effects of credit contraction during panics and cash restrictions.43 In
1893 panic and also payments disruptions preceded general cash restrictions in several interior
cities; in 1907 panic and cash restrictions were only days apart (October 21 and 26). That said,
the economy did seem to go into a tailspin during periods of restrictions of cash payments.
Monthly figures for four quantity measures of trade and economic activity– freight ton-miles, pig
iron production, the Babson (physical quantity) index of business activity, followed by the MironRomer monthly index of industrial production (U.S. Bureau of the Census 1949, pp. 332-334;
Moore 1961, p 130; Miron and Romer 1990)– for 1893 and 1907 are presented in Figure 8. The
NBER-dated business cycle peaks were in January, 1893 and May, 1907 (Burns and Mitchell
1946, p. 78). Clearly the graphs show little indication of a serious downturn in either case until
the onset of the financial panics in May, or particularly in June, 1893 and October, 1907, after
which time the indicators fall sharply. The months bracketing the restriction periods– July and
September in 1893, October and January (1908) for 1907– are marked by vertical lines. The
pronounced declines in the series during the cash restrictions period in 1907 are evident. In 1893
the sharp decline begins in June but accelerates after July, with cash restrictions, although this is
less evident to the untrained eyeball.44,
45
Moreover, rather dramatically in virtually every case the
on larger interior markets being the medium of exchange, thus allowing of the resumption of
grain forwarding...” (November 16, 1907, p. 730). In the flour trade, “shipments [were] falling
off by reason of difficulty in financing drafts, and the wheat price is now secondary to the
question of finance” (Bradstreet’s, November 23, 1907, p. 747).
43
For example, between the May 4 and October 4 call dates in 1893 loans of national
banks fell by almost 15 percent (Sprague 1910, p. 208).
44
Log-linear regressions on time from June to September, 1893 show statistically
significant sharper rates of decline after July.
45
Railroad earnings could be another measure of the volume of trade. While they ran
higher in 1893 than in same month in 1892 for the first half of the year and then declined by
almost 5 percent relative to 1892, in August, the month of suspension, the figure was more than
-40-
decline stops and/or the series turn up with the resumption of cash payments in September, 1893
and January, 1908.46
The declines over the periods of cash restrictions in 1893 and 1907 in most cases were
quite comparable. The Miron-Romer industrial production index, for example, declined by 16.7
percent between July and September in 1893 and by 21.7 percent between October 1907 and
January 1908.47 The period of cash restriction was twice as long in 1907 as in 1893, so if one
thinks of the effects of restriction as being a continuing process– the difficulty of obtaining cash to
meet local payrolls or of making payments at a distance– then the per month real effects of
restriction in 1907 were less severe than in 1893, even though the cash restrictions in 1907 have
been characterized as both more widespread and more severe than in 1893 (1908b, p. 497). There
are a couple of reasons why this may have been so. First, of course, the issue and use of local
cash substitutes was much more extensive in 1907. Second, by around the turn of the century
checks had become standard payments in interregional transactions (Kinley 1910). To the extent
that recipients were willing simply to deposit checks received in their accounts, rather than
attempting to cash them, and in turn use the proceeds to issue checks of their own, there would
not have been a total collapse of the payments system, although collections may have been rather
slower.
13 percent lower than for the comparable month in 1892 (and 10 percent lower in September
after resumption) (Commercial and Financial Chronicle, February 25, 1894).
46
Sprague (1910, pp. 201-02) notes for 1893, “Much of the decline in August, with the
subsequent partial recovery, can only be ascribed to the trade paralysis produced by the financial
situation at that time.” Of course, the economy only stabilized rather than bounced back after
resumption, but “after the beginning of September the course of the crisis of 1893 was no longer
a banking affair” (p. 209).
47
Freight ton-miles fell by 10.8 percent between July and September, 1893 and by 10.4
percent between October, 1907 and January, 1908. The declines in pig iron production were 42.2
and 52.8 percent, respectively, while in the Babson index they were 12 and 18 percent.
-41-
6. Conclusions
The private payments networks based on the correspondent banking system which had
developed to clear and settle interregional or intercity transactions in the pre-Federal Reserve
period were normally quite efficient arrangements. However when the convertibility of New
York balances was threatened or limited, these networks were also important channels for
transmitting financial pressures. Such problems intensified as New York exchange became more
and more important in the payments system. Cash restrictions in turn had serious consequences
for payments settlement at both the local and interregional level and consequently for the level of
economic activity. The degree of disruption to regional financial centers over this period was a
function of their place in these intercity networks rather than local conditions. Banks in reserve
cities with larger holdings of bankers’ balances from country banks relative to individual deposits
experienced greater strains in 1907. On the other hand, the increasing acceptance of checks
relative to cash mitigated some of the real shock.
Most contemporary writers (e.g., Noyes 1894; Sprague 1910) thought restrictions of
cash payments were disasters, and monthly evidence from 1893 and 1907 suggest that the
downturns intensified during these periods. In the more recent literature, the effects of these
restrictions have been usually minimized or neglected. Even though widespread bank failures
were avoided, the medicine may nevertheless have had serious debilitating effects. Richard
Grossman (1993) demonstrates that cyclical downturns were more severe in the national banking
period when associated with a financial crisis than when they were not. His simulations show that
a relatively small bank failure shock could have led to a 2 percent decline in real GNP, while a
large shock would have been catastrophic. Based on the timing of the bank failures and the
immediacy of the effects on output, it seems reasonable however to suppose that some of the
short-run adverse effects, perhaps most, of what Grossman attributes to bank failures may well
have been the impact of payments system disruptions.
Prevention of such widespread and severe disruptions of the payments system in the
-42-
wake of financial crises was the fundamental financial reform issue to many or most
contemporaries and led directly to the establishment of the Federal Reserve system. A principal
feature of the new central bank was the nationalization of the interbank settlement network. Fed
institutions such as the gold settlement fund and Fedwire (for telegraphic transfers of reserves)
replaced their private analogues, New York balances held to settlement payments and the
domestic exchange markets.
The Fed’s takeover of the interbank settlement system was not peculiar to the U.S.
payments system. According to the most recent survey of payments systems by the Bank for
International Settlements (2005), central banks own and operate the main large-value (interbank)
payments network in virtually all developed economies, either outright or in a partnership
arrangement. What distinguishes the U.S. payments system from that of other countries and
remains controversial to this day was the Fed’s entry into the check clearing system and the
relative efficiency of public and private clearing systems (Stevens 1996; Lacker, Walker, and
Weinberg 1999; Gilbert 2001). However even today in the face of the increased privatization of
the payments system spurred in large part by the Monetary Control Act of 1980, the Federal
Reserve still plays an potentially crucial role as the clearing house of last resort in financial crises
(Summers and Gilbert 1996; James and Weiman 2005).
Acknowledgments: We gratefully acknowledge comments from seminar participants at the World
Cliometrics Congress, Dalkeith, Scotland; Symposium on “Asymmetric Monies: Revisiting
Global Monetary History from the Viewpoints of Complementarity and Viscosity”, University of
Tokyo; and the London School of Economics.
-43-
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-50-
Table 1: Panics of 1893 and 1907
1893
1907
Panic onset
May 1
Oct 21
Issue of Clearing House
loan certificates in NYC
June 21
Oct 26
Aggregate loan certificate
issue, NYCH ($ million)
16.6
41.5
Maximum amount
outstanding ($ million)
15.2
38.3
Bank reserves of NYCH
members ($ million)*
95.6
121.0
Ratio of maximum
certificates issued
to reserves
15.9 %
31.7 %
Loan certificate issue
nationwide ($ million)
69.1
238.1
Restriction of cash
payments in NYC
Aug 3
Oct 26
Resumption of cash
payments in NYC
Sept 2
Jan 1
* on May 6, 1893; Oct 19, 1907.
Sources: Andrew (1908b), p. 507; Sprague (1910) , pp. 34, 145, 163, 261-62, 432-33 ; Roberds
(1995), p. ; Wicker (2000), pp. 9, 121.
-51-
Table 2: Domestic Exchange Rates during the Panics of 1893 and 1907
1893
1
Panic Onset
1907
Restriction
2
3
Panic Onset
Restriction4
Boston
Minimum
Maximum
Average
No quote days
-.45
6.00
.77
6
0
6.00
1.92
2
-.875
2.00
.36
10
-.875
2.00
.39
8
Chicago
Minimum
Maximum
Average
No quote days
-30.00
.375
-6.26
5
-30.00
-.25
-12.14
2
-.50
2.50
.52
24
-.50
2.50
.56
20
-5.00
6.50
1.19
14
-5.00
6.50
1.40
14
St. Paul
Minimum
Maximum
Average
No quote days
St. Louis
Minimum
Maximum
Average
No quote days
-8.00
.50
-3.25
16
-8.00
0
-5.38
8
-1.25
8.00
4.32
14
-.25
8.00
4.79
13
New Orleans
Minimum
Maximum
Average
No quote days
-1.50
10.00
.68
6
-1.50
10.00
.17
3
-.75
0
-.56
27
-.75
-.50
-.58
24
San Francisco
Minimum
Maximum
Average
No quote days
-.05
20.00
3.52
9
0
15.00
6.22
1
-2.00
0
-.48
46
-2.00
0
-.88
46
1
June 21-Sept 2, 1893;2 Aug 3-Sept 2, 1893;3 Oct 21,1907-Jan 1,1908;4 Oct 26, 1907-Jan 1, 1908
Source: New York Times (1893),Wall Street Journal (1907)
-52-
Table 3: Balance Sheet Panel Regressions
(t statistics in parentheses)
I. Daily data1
Independent variable
xrateaverage
notradedays
-3.8015
(2.92)
notradedays
-2.5265
(-3.33)
notradedays
Dependent variables
netduetobanks/deposits
duetobanks/deposits
113.186
(3.30)
60.3037
(4.52)
xrateaverage
-0.1947
(-2.92)
xrateaverage
-0.3114
(-3.33)
27.6489
(5.62)
21.2247
(4.61)
-53-
R2
Prob>F
-26.500
(-2.12)
.0143
.0987
-25.056
(-2.83)
.0592
.0452
-7.1764
(-4.28)
.0007 .0251
-9.4111
(-3.87)
.0011
constant
.0429
II. Weekly data2
Independent variable
notradeweeks
notradeweeks
xrateaverage
-0.1276
(-1.64)
notradeweeks
Dependent variables
netduetobanks/deposits
4.7174
(1.61)
-0.1765
(-2.82)
duetobanks/deposits
4.3287
(3.04)
xrateaverage
-2.1784
(-1.64)
xrateaverage
-3.0133
(-2.82)
27.0337
(2.74)
20.0548
(4.20)
constant
-1.3318
(-1.19)
R2
.0001
Prob>F
.2616
-2.7321
(-2.59)
.0017
.0410
-9.9676
(-2.93)
.0770 .0610
-13.847
(-4.42)
.1347
1
Boston, Chicago, St; Louis, New Orleans, San Francisco
2
Boston, Philadelphia, Cincinnati, Chicago, Milwaukee, St. Paul, St. Louis, Kansas City, New Orleans, San Francisco
-54-
.0096
Table 4: Cash Flows between New York and Interior City Banks as Reported by the New York Clearing House, 1907
City
netflow
$1,000
outflow
inflow
Relative to 1905/06
netflow
outflow
inflow
Relative to reserves on hand
netflow
outflow
inflow
I. Central Reserve Cities
Chicago
October
November
December
-8631
-17231
-9507.9
8633
17241
9539.9
2
10
32
1.45
4.98
2.03
11.503
68.96
9.79
4.00
.
0.14
-0.13
-0.26
-0.14
0.13
0.26
0.14
0.00
0.00
0.00
St. Louis
October
November
December
-2701
-7587.2
-4941.5
2701
7588.2
5002.5
0
1
61
1.04
2.72
5.16
9.39
18.97
200.1
.
.
2.44
-0.10
-0.28
-0.18
0.10
0.28
0.19
0
0.00
0.01
Boston
October
November
December
-8105
-1667
342
8452
1900
674
347
233
1016
4.79
-7.23
0.51
19.41
1.18
0.23
0.80
0.14
0.35
-0.36
-0.07
0.02
0.38
0 .09
0.03
0.02
0.01
0.05
Philadelphia
October
November
December
-7921
-6477
-746
8810
7171
2977
889
694
2231
10.05
3.77
-0.60
8.77
8.09
0.96
0.89
0.78
0.72
-0.30
-0.25
-0.03
0.34
0.27
0.11
0.03
0.03
0.09
II. Reserve Cities
-55-
Cincinnati
October
November
December
-293
-2494.5
-942.9
660
2695.5
1248.9
367
201
306
0.52
-9.07
-6.44
2.09
6.06
3.27
3.15
0.45
.80
-0.04
-0.37
-0.14
0.10
0.40
0.19
0.05
0.03
0.05
Milwaukee
October
November
December
-723
-595
-162
723
603
362
0
8
200
10.71
34.0
3.24
10.71
34.46
3.24
.
.
.
-0.14
-0.12
-0.03
0.14
0.12
0.07
0
0.01
0.04
Minneapolis/St. Paul
October
November
December
-1040
-895
55
1045
895
256
5
0
311
8.56
-4.25
0.06
2090.0
3.31
0.28
10.0
0
0.34
-0.29
-0.25
0.02
0.29
0.25
0.07
0.00
0
0.09
New Orleans
October
November
December
-892
-2117
-3143.5
910
2196
3193.5
18
79
50
0.34
0.77
0.86
0.51
1.32
1.37
7.20
52.67
16.67
-0.34
-0.80
-1.19
0.34
0.83
1.21
0.01
0.03
0.02
San Francisco
October
November
December
-2723
-13163.6
-2858.5
3694
13169.6
3441.5
971
6
583
-4.47
5.12
0.71
5.81
3.29
0.83
1.55
0.01
1.78
-0.27
-1.32
-0.29
0.37
1.32
0.35
0.10
0.00
0.06
Source: Kemmerer (1910), pp. 276-357.
-56-
Table 5: Cash Flow Regressions
(t statistics in parentheses)
I. Total intercity net cash flows
Dependent variable
Independent variable
nycflow
(1)
(2)
-3452.56
-3423.20
(-6.79)
(-7.83)
cityflow
(3)
(4)
4685.74
3762.08
(16.53)
(18.38)
duetobanks
-0.1943
(-6.79)
-0.2153
(-6.76)
0.2815
(13.81)
0.2176
(14.78)
duefrombanks
0.2305
(4.46)
0.3574
(6.22)
-0.4156
(-11.06)
-0.3913
(-14.42)
deposits
-0.0147
(-1.43)
0.0025
(0.21)
-0.0090
(-1.22)
0.0061
(1.15)
constant
-2233.76
(-2.12)
-3246.57
(-2.79)
1419.36
(1.65)
852.47
(1.37)
notradeweeks
R2
.9749
.9527
.9895
.9922
NOBS
9
8
9
8
-57-
II. Difference between 1907 and 1905/06 net cash flows
Dependent variable
Independent variable
nycflow
(1)
(2)
-2287.449
-2041.272
(-4.58)
(-5.00)
cityflow
(3)
(4)
3414.618
2446.614
(10.51)
(13.60)
duetobanks
-0.0845
(-2.33)
-0.1412
(-4.76)
0.2416
(10.33)
0.2142
(16.55)
duefrombanks
-0.0200
(-0.31)
0.1796
(3.35)
-0.2872
(-6.67)
-0.3393
(-14.23)
deposits
-0.0080
(-0.61)
0.0031
(0.29)
-0.0338
(-4.00)
-0.0106
(-2.27)
constant
484.479
(0.36)
-1304.725
(-1.19)
1437.90
(1.46)
1021.318
(1.87)
R2
.9150
.9139
.9707
.9899
NOBS
9
8
9
8
notradeweeks
-58-
Figure 1
-59-
Figure 1: Weekly Domestic Exchange Rates for Selected Cities, 1894-1906
-60-
Figure 2: Daily Domestic Exchange Rates in the Panic of 1893
-61-
Figure 3: Weekly Domestic Exchange Rates in the Panic of 1893
-62-
Figure 4: Daily Domestic Exchange Rates in the Panic of 1907
-63-
Figure 5: Weekly Domestic Exchange Rates in the Panic of 1907
-64-
Figure 6: Number of Cities by Day for Which Domestic Exchange Rates Are Not Quoted
-65-
Figure 7: Currency Shipping Points and Domestic Exchange Rates, 1893 and 1907
-66-
Figure 8: Monthly Indicators of Economic Activity in 1893 and 1907
-67-
-68-
Where to draw lines: stability versus
efficiency
Thomas J. Sargent∗
September 6, 2010
Abstract
What kinds of assets should financial intermediaries be permitted
to hold? What kinds of liabilities should they be allowed to issue?
Should a government or a central bank offer explicit deposit insurance
or implicit deposit insurance by acting as a lender of last resort? This
paper reviews how tensions involving stability versus efficiency and
regulation versus laissez faire have for centuries run through macroeconomic analysis of these questions.
1
Introduction
The appropriateness of governmental responsibility for the monetary system has of course been long and widely recognized. . . .
This habitual and by now almost unthinking acceptance of governmental responsibility makes thorough understanding of the
New York University and Hoover Institution; email: [email protected]. This
is the text of the Phillips Lecture, given at the London School of Economics on February
12, 2010. I thank Marco Bassetto, Gadi Barlevy, Francesco Caselli, Christina DeNardi,
Ricardo Lagos, Carolyn Sargent, Cecilia Parlatore Siritto, Nancy Stokey, and François
Velde for helpful comments on earlier drafts.
∗
1
grounds for such responsibility all the more necessary, since it
enhances the danger that the scope of government intervention
will spread from activities that are to those that are not appropriate in a free society, from providing a monetary framework to
determining the allocation of resources among individuals.
Milton Friedman (1960, p. 8)
This essay is about wise and timely things that macroeconomic theory
has to say about where to draw lines between (1) markets for money and
credit, and (2) monetary and fiscal policies. Historically, it has been difficult
for American statesmen to agree about how to draw those lines. By shedding
light on the tensions and trade-offs involved in drawing those lines, macroeconomic theory helps explain why. The issues are so formidable that the most
brilliant economic minds have swerved, or been tempted to swerve, from one
extreme position to another. Ambiguities and uncertainties about the path
forward arise partly because the choices are difficult and involve conflicts of
interest that thrust us beyond macroeconomics into politics. Nevertheless,
macroeconomic theory helps by characterizing how choices affect aggregate
risk and how that risk is allocated among citizens and foreigners.
A companion paper (Sargent (2010)) uses U.S. historical examples to illustrate processes that have created, temporarily resolved, and then often
reopened monetary and fiscal policy ambiguities. That paper describes histories of political struggles about four aspects of U.S. monetary and fiscal
arrangements: (i) whether to allow an inconvertible paper currency to be a
legal tender for public and private debts; (ii) whether the U.S. federal government should redeem impaired debts of state governments; (iii) whether
and how the U.S. government should implement a gold standard; and (iv)
whether to have a national central bank and, if so, what responsibilities
to assign to it. Debates over these issues were fought long and hard and
resolutions of them were temporary. Statesmen who argued one side when
young advocated the opposite side of an issue when older (James Madison
2
and Henry Clay on a U.S. Bank and Salmon Chase on legal tender), possibly
to revert again to one’s youthful position when even older (Salmon Chase
on legal tender). I offer these examples to illustrate statesmen’s struggles
with what we now call time-consistency problems; their mixed success in
using constitutional clauses to improve outcomes by tying their successors’
hands; and the ways that a coherent fiscal and monetary policy occasionally
emerged from intentions to implement grand principles, but more often from
a haphazard sequence of improvisations and compromises made under the
shadow of the government’s intertemporal budget constraint.
This paper tries to shed light on these historical struggles by acknowledging ambiguities brought to us by a collection of economic models designed to
inform us about the consequences of assembling monetary and fiscal policies
in different feasible ways. I focus on models that bear mainly on historical
controversy (iv) above, namely, the proper role of a central bank, but that
also shed light on aspects of the other three topics. Versions of these models
are quite old because the policy issues that inspired them are even older.
I mainly refer to rational expectations models, formalized in the 1970s and
1980s, themselves descendants of older models that were constructed to understand what central banks should do, and where, if anywhere, lines should
be drawn to separate credit from money markets. The rational expectations
hypothesis sharpens these models by highlighting how agents’ expectations
of future government actions affect outcomes today and shape the changing
predicaments into which government officials are cast. I play by the rule that
it takes a model to beat a model.
Recurrent outbursts of a long battle over the appropriateness and scope
of the ‘real bills’ doctrine run through the history of our topic. I interpret
the real bills doctrine either as advocating free banking or as recommending
that a central bank stand ready to purchase sound evidences of commercial
indebtedness at an interest rate set with an eye to promoting prosperity.
Authored by Adam Smith, the real bills doctrine has both been attacked as
3
a dangerous fallacy and defended as the backbone of sound monetary policy.
The real bills doctrine is alive and well today, and it provides justification
or consolation for the massive holdings of private securities on central bank
balance sheets.
By rationalizing positions taken both by advocates of the ‘real bills doctrine’ and their opponents, our formal models frame what seem to be difficult
policy choices. Studying these models makes it easier to appreciate why great
American statesmen such as Madison and Clay changed their minds. In the
same vein, Milton Friedman was also tempted to change his mind about
whether to recommend financial laissez faire or strict regulations designed to
put impermeable barriers between markets for money and credit.
An enduring issue that is especially pertinent today is exactly how to
define a real bill. Can banks manufacture ‘real bills’ by packaging risky securities? It has been claimed that financial intermediaries promote economic
efficiency by facilitating loan maturity transformation, liquidity provision,
and risk-sharing; that these activities also make the financial system fragile
by exposing it to runs; and that arresting runs requires central banks to act
as lenders of last resort and government to supply deposit insurance. After
describing two models that offer opposite perspectives on lenders of last resort and deposit insurance, I shall cite work that argues that a well designed
regulatory system has to manage time consistency issues that resemble those
observed in our historical examples.
2
Efficiency versus stability
The shifting opinions of politicians and voters mentioned in the introduction
and documented in Sargent (2010) become more understandable when we
recognize that ‘model uncertainty’ about what a central bank should do has
prevailed among leading economists (and sometimes even within the mind
of a single economist). For hundreds of years, a tension between economic
4
efficiency and financial stability has run through economists’ thinking about
banks and central banks. The names of the liabilities (bank notes and bills of
exchange in the 18th century, bank notes and deposits in the 19th and 20th
centuries, claims on money market mutual funds and maybe even credit
default derivatives in the 21st century), and the names of the assets (selfliquidating commercial loans in the 18th and 19th centuries, sovereign debt in
the 20th, and mortgage backed securities in the 21st century) have changed,
but the underlying theoretical issues endure. What kinds of assets should
financial intermediaries be permitted to hold, and what kinds of liabilities
should they issue? Regulating banks’ portfolios can foster a stable price level
and stable monetary (narrow) aggregates, but at the cost of creating rateof-return wedges (i.e., situations in which different people face different rates
of return on assets carrying the same risks). These rate-of-return wedges
open incentives for evasion and impose costs in terms of economic efficiency.
Later, I shall use writings of Milton Friedman to illustrate a tension between
stability and efficiency and the conflicting policy recommendations to which
they can give rise.1
I shall organize my discussion around a centuries old contest pitting a
free banking or real bills policy against a narrow banking policy that was
rationalized by the quantity theory of money and that was embodied in both
Peel’s Bank Act of 1844 and the original Chicago plan for banking reform.
1
A presumption that it is good for the relative prices of some assets (interest rates on
assets not called money) but not others (an asset called money) to fluctuate over time
and across contingencies pervades the literature on these issues. Often, a preference for
price stability cannot be represented for reasons internal to the models being used to study
how to attain stability. That there are poorly understood forces for prices to be sticky
comes through clearly in the striking evidence about the consequences of pure changes in
monetary units of account in the early 18th century. See Velde (2009).
5
3
The real bills doctrine
The real bills doctrine emphasizes the efficiency gains associated with financial competition. It prescribes disarming legal barriers that separate money
and credit markets. Legal barriers to competition can either be torn down
directly to allow unrestricted financial intermediation, or else circumvented,
by having a central bank issue notes that it uses to purchase enough private loans to eradicate the rate of return wedges that the legal barriers were
designed to sustain.2
The author of the real bills doctrine, Adam Smith (1806, bk. II, ch. II),
conducted what today we call a small-country analysis when he took as given
the price of gold in terms of consumption goods. Starting from a system in
which gold coins alone served as money, Smith argued that a country could
improve the allocation of resources by allowing banks to issue notes backed by
assets that take the form of safe short-term evidences of private indebtedness
(which he called ‘real bills’).3 It is feasible for the bank notes to be convertible
on demand into gold because the short term loans backing them are risk-free.
This policy would prompt private agents to rearrange their cash holdings in a
way that would induce a country as a whole to export the gold coins displaced
by the more convenient-to-hold but ‘good-as-gold’ bank notes and to use the
proceeds to finance imports of goods to be consumed or invested. Smith said
that this operation would have no impact on the domestic price level but
2
See Sargent and Wallace (1982) for an account of how central bank open market operations can circumvent legal restrictions on denominations that intermediaries are permitted
to issue.
3
In saying that “ . . . a bank discounts to a merchant a real bill of exchange drawn by
a real creditor upon a real debtor and which as soon as it becomes due is really paid by
that debtor,” Smith (1806, p. 44) indicates that he is thinking about low risk IOUs.
6
that it would make the country better off.4,5
3.1
Criticism of real bills doctrine
Smith’s analysis, which presumed a commodity standard, later came to be
understood as promising that the money supply could be trusted to regulate
itself if a central bank were freely to rediscount banks’ holdings of safe private
securities at an interest rate set “with a view of accommodating commerce
and business.”6 That prescription came in for widespread criticism especially
after the price level anchor that Smith had assumed disappeared when fiat
money replaced gold. With promises to convert bank notes into gold no
longer anchoring the price level, some monetary economists asserted that a
limit on the quantity of fiat currency had to be imposed, and this, or so it was
claimed, the real bills rule could not do. Critics asserted that discounting
short term private evidences of indebtedness at a fixed interest rate would
unhinge both the quantity of fiat money and the price level. The real bills
4
Smith’s argument for using bank notes that are intermediated evidences of safe private indebtedness to economize on gold was adopted and carried forward by Ricardo and
Keynes. Antecedents for Smith’s idea are to be found in the writings of John Law, a
writer and public financier whose reputation had suffered so badly after the collapse of the
Mississippi bubble that Smith chose not to mention his works. Antoin E. Murphy found
and published John Law’s long-lost manuscript Law (1994), originally written in about
1705. See Murphy (1997) for a fascinating account of Law’s life and ideas.
5
Why did Smith choose to include extensive passages on money in a book remembered
today for attacking mercantilism and advocating free trade? Smith’s advocacy of financial
deregulation to economize on the stocks of gold and silver tied up as money was an
important component of his criticism of mercantilism. Smith described mercantilism as
a set of restrictions on trade designed to protect a country’s commodity money from
disturbances to supplies and demands for goods emanating at home and abroad. See
Smith (1806, bk. III, ch. I). Smith did not attack a straw man. His is one of the most
coherent and persuasive accounts of mercantilism that I have read. See Sargent and
Smith (1997) and Durdu et al. (2009) for formal models that cast a version of Smith’s
policy proposal against forms of over saving that are associated with mercantilist policies.
I view Smith’s proposal for a form of free banking as being an important part of his
comprehensive package of policy proposals to dismantle mercantilist restrictions on trade
without having adverse effects on a domestic monetary system.
6
The words in quotes are from section 14 of the Federal Reserve Act of 1913.
7
‘doctrine’ became known as the real bills ‘fallacy’.7
3.2
Indeterminacy under real bills?
This criticism of the real bills doctrine has been cast in terms of Wicksellian
price level and money supply indeterminacy under a policy that pegs an
interest rate. The reasoning uses a Keynes-Hicks portfolio balance or LM
curve Mp = L(r, Y ), where r is the nominal interest rate, Y real output, M
the money supply, and p the price level, in the following way. When Y is
pinned down by a full-employment or ‘natural rate of output’ condition and
when the government or central bank puts loans on tap by offering freely
to exchange money for bonds or capital at a set interest rate, the portfolio
balance equation determines real balances Mp . But it determines neither
the numerator M nor the denominator p separately. Versions of such an
analysis are presented by Sargent and Wallace (1975) and Sargent (1987b,
pp. 96-99), both of which cast indeterminacy results in terms of 1960s vintage
models. These models depended sensitively on special assumptions about
private actors’ preferences over portfolios that were embedded in the function
L(r, Y ). These assumptions represent what Leontief (1947) called ‘implicit
theorizing’ because they were not derived explicitly from preferences defined
over properties of asset returns. In particular, those models adopted what
Tobin (1961) interpreted as Keynes’s assumption that government bonds are
perfect substitutes with private bonds and equity, but imperfect substitutes
with government issued money. Obtaining a determinate price level and
money supply in these 1960’s vintage models requires pegging the money
supply, not an interest rate.8
7
For example, Ahamed (2009) mentions the real bills doctrine often, but always as a
mischievous and discredited misconception.
8
Policy rules that set an interest rate schedule as a function of the price level could also
be used to restore determinacy in some formulations. However, such rules seem difficult
to interpret in terms of an instruction to the bank’s trading desk to put loans on tap.
8
3.3
Real bills partly rehabilitated by Tobin
Tobin (1961, 1963) enriched the asset menu and the assumptions about private actors’ portfolio preferences beyond those elementary Keynesian ones.
He then focused attention on how outcomes of open market operations depend not only on the liabilities emitted by the central bank, but on the assets
that ‘back’ those liabilities. For example, Tobin (1961) interpreted Keynes as
assuming that government bonds and capital are perfect substitutes and focusing his theory of liquidity preference on the margin between money versus
a bonds-capital aggregate. Tobin said that if one had to work with only two
aggregates of assets, it was better to make government bonds perfect substitutes with money and to focus on a money-bonds versus private capital
margin.9,10
Tobin typically used models with a sticky wage that diverted attention
away from how to sustain a nominal anchor (a sticky wage or a sticky price
is a nominal anchor). But his work had very much of a ‘real bills’ flavor
because it asserted that you can not judge a monetary policy by looking only
at the liability side of banks’ balance sheets.11 ,12 For Tobin, it was important
to distinguish ‘outside’ (unbacked) from ‘inside’ (backed by private assets)
money. Tobin advocated a research program that would apply portfolio
theory to analyze central bank open market operations.
9
Tobin’s preferences over asset aggregation schemes come from observing the correlations of returns on the component assets.
10
John Stuart Mill asserted “The issues of a Government paper, even when not permanent, will raise prices; because Governments usually issue their paper in purchases for
consumption. If issued to pay off a portion of the national debt, we believe they would
have no effect.” Mill (1844, p. 589), as quoted by Friedman and Schwartz (1982, p. 30),
who cite this passage as an example of faulty doctrine.
11
Tobin’s work had very much an anti-naive-quantity theory flavor because he recommended not focusing exclusively on aggregates of banks’ liabilities.
12
For example, Tobin (1955) sets up a model so that central banks’ open market exchanges of money for government bonds have no effect, but exchanges of money for capital
do.
9
3.4
Real bills rehabilitated in general equilibrium
To complete Tobin’s research agenda required working with general equilibrium models whose all-cards-on-the-table nature makes them immune from
the Leontief (1947) ‘implicit theorizing’ barb. This was accomplished when
Wallace (1981), Chamley and Polemarchakis (1984), and their followers brought
key insights of Modigliani and Miller to bear on analysis of monetary and
fiscal policies. Modigliani and Miller (1958) and Stiglitz (1969) described
conditions that rendered an enterprise’s liability structure irrelevant, given
the structure of its assets. Wallace, Chamley and Polemarchakis, and others
fashioned appropriate notions of government assets and liabilities that would
allow them to apply the Modigliani and Miller and Stiglitz insights to identify circumstances under which open market operations and other related
government liability-management policies are relevant.
I interpret papers cast in the mold of Wallace (1981) and Chamley and
Polemarchakis (1984) as ‘back-solving’ exercises.13 These back-solving exercises consist of the following steps: For a given monetary-fiscal policy,
first determine an equilibrium price system and allocation. Then freeze the
allocation and price system and attempt to solve the model’s equilibrium
conditions for a class of monetary-fiscal policies that support the same equilibrium. By doing this, Wallace (1981), Chamley and Polemarchakis (1984),
and their followers constructed nontrivial equivalence classes of policies that
support the same allocation and price system. Selections from within such an
equivalence class of policies can be said to be ‘irrelevant’. These irrelevance
classes bear out many of the real bills hunches present in Tobin’s work.
General equilibrium models like those of Wallace (1981) and Chamley and
Polemarchakis (1984) are also very good vehicles for describing the tensions
that pit the gains in stability against the losses of efficiency brought by
13
‘Back solving’ means exchanging the mathematical roles of what we usually think are
endogenous (prices and allocations) and exogenous (endowments and monetary and fiscal
policies) variables.
10
financial regulation.14
3.5
Real bills versus the quantity theory, or efficiency
versus stability
To analyze claims made for and against the real bills doctrine, Sargent and
Wallace (1982) and Smith (1988) adopted versions of the overlapping generations model of Samuelson (1958). The overlapping generations model is
a natural vehicle for this purpose because it can be rigged so that objects
that resemble both inside and outside money are traded in equilibria with
aggregate fluctuations.15 The structure of endowments and preferences can
be arranged to make an unbacked fiat money issued by a government be
valued within a competitive equilibrium. This government issued liability
pays zero nominal interest and plays the role of outside money. Sargent
and Wallace (1982) and Smith (1988) used within-generation heterogeneity
of endowments and preferences to motivate private borrowing and lending.
Private IOUs available in zero net supply are safe assets that can be used to
back inside money, i.e., they are Adam Smith’s ‘real bills’.
3.5.1
Fluctuations ignited by fundamentals
To inject aggregate volatility that impacts the credit market and the money
market, Sargent and Wallace (1982) assume a strictly periodic inter-generational
pattern in the endowments of the people who are natural borrowers, a class
of rich agents who are relatively well endowed later in their lives. These rich
borrowers issue safe interest-bearing IOUs that are purchased by rich lenders
(rich agents who are well endowed early in life). Poor lenders might also hold
14
Wallace (1989) offers a characterization of potential irrelevance of open market operations in terms of an absence of apparent arbitrage opportunities in an equilibrium price
system.
15
Many of the ideas can also be represented in the context of models in the style of
Bewley (1980, 1983), but versions of these models with aggregate fluctuations are more
difficult to work with than are overlapping generations models with short-lived agents.
11
some of them too, but only if there is adequate financial intermediation. The
rich lenders are naturally holders of large denomination ‘bonds’ while the
poor lenders are naturally holders of small denomination ‘money’. The poor
lenders can hold claims on the large denomination loans issued by rich private
borrowers only indirectly, that is, only if banks purchase private IOUs and
use them to back small denomination notes or deposits that the poor lenders
can afford. The endowment patterns of rich and poor lenders are constant
across generations, so the demand for credit from the rich borrowers is the
only source of instability in money and credit markets.
The Sargent and Wallace (1982) model environment is constructed to represent the quantity theory case for imposing legal restrictions that separate
markets for credit and for money, and to raise questions about it. When legal
restrictions in the form of a minimal denomination for liabilities that banks
can issue are in place, poor lenders are confined to holding outside money
while rich lenders will choose to hold the IOUs issued by the rich borrowers.16 The legal restriction preventing production of inside money props up
the demand for outside money and leads to rate-of-return wedges that indicate that credit and money markets have been decoupled.17 Rich lenders get
higher rates of return than do poor lenders holding assets with identical risk.
With money and credit markets thus separated, an equilibrium exists with
a constant price level; poor lenders hold outside money while rich lenders
hold private securities that yield a positive but fluctuating nominal rate of
16
This restriction is designed to mimic Peel’s Bank Act of 1844.
A legal restrictions theory can also be used to rationalize the cash-in-advance restrictions in the models of Lucas and Stokey (1983), Lucas (1986), and Sargent (1987a, ch. 5).
Furthermore, paying interest on government-issued fiat currency emerges as a necessary
condition for solving a Ramsey problem (see Lucas and Stokey (1983) and Lucas (1986)).
The optimal policy eradicates the rate-of-return wedges opened up by the legal restrictions
protecting the money market from competition with the credit market. Another way to
implement the optimal policy is to permit free entry of intermediaries offering risk-less liabilities backed by risk-less assets purchased in the credit market. Arbitrage profits tempt
entry into this intermediary business in any equilibrium having a positive nominal interest
rate.
17
12
return. Fluctuations in the rate of return on private loans are driven by the
demand for credit emanating from the periodically varying endowments of
rich borrowers. Those fluctuations do not affect the money market, which is
protected by the legal limits on producing inside money. Here the quantitytheory-inspired legal restrictions stabilize the price level by separating the
markets for credit and money. For the quantity theory of money to fit the
data in this regime, ‘money’ should be defined as outside money.18
Evidently, the restrictions that separate money and credit markets achieve
price level stability at a cost in terms of economic efficiency. Because different agents face different rates of return on assets with identical risks, the
equilibrium allocation of resources is not Pareto optimal. A Pareto optimal
allocation can be attained by implementing a real bills policy that creates a
sufficiently large quantity of inside money backed by private IOUs. This can
be done in superficially different but economically equivalent ways. One way
is to instruct a central bank to circumvent the legal restriction on note size
by purchasing private IOUs and using them to back inside money in the form
of small denomination notes that the poor lenders can hold. This can lead to
one of two possible outcomes, depending on whether or not endowments and
preferences of the overlapping generations imply a low or high interest rate
equilibrium without fiat money.19 In the low-interest-rate case, in which the
economy is naturally short of borrowers, there exists an equilibrium in which
fiat money continues to be valued and interest rates on inside and outside
money are equated. In this equilibrium, the nominal rate of interest is zero,
but now the price level fluctuates because fluctuations in the demand for
credit affect the supply of inside money. A quantity theory equation linking
the price level and a money supply will still fit the data, but now it is necessary to define money as the sum of outside and inside money. This real bills
equilibrium is Pareto optimal, but not Pareto superior to the quantity theory
18
This conforms with a Chicago tradition in the 1950s and 1960s that one should define
‘money’ by choosing among monetary aggregates that explain the price level best.
19
See Samuelson (1958) for an analysis of these cases.
13
equilibrium that separates the money and credit markets. Moving from one
equilibrium to another produces winners and losers.
Using a central bank open market strategy is not the only possible way
to eliminate barriers between credit and money markets. Another way to
implement the same Pareto optimal allocation is simply to remove the legal
restriction and to permit unfettered financial intermediation, also known as
free banking. This will lead to the same equilibrium price level as well as the
same allocation.
Thus, in the case in which the economy is naturally short of borrowers,
removing barriers between money and credit markets creates instability in
the price level and the money supply but leaves fiat money valued. But
in the high interest rate case in which the economy has enough borrowers,
removing barriers between money and credit markets causes fiat money to
become worthless as the economy switches to a commodity standard. Here,
legal restrictions protect the value of fiat money. However, in this case it is
also true that an equilibrium without valued fiat money is Pareto optimal.
3.5.2
Fluctuations coming from sunspots
In the Sargent and Wallace (1982) model, with or without restrictions that
separate money and credit markets, fluctuations in the price level, interest
rates, and allocations emanate from fluctuations in fundamentals. Smith
(1988) observes that historically concerns about adverse effects of waves of
optimism and pessimism not linked to fundamental sources of fluctuations
seem to have motivated some proposals to separate money and credit markets. To represent and evaluate those concerns, Smith constructs an overlapping generations structure in which regulations to separate credit and money
markets succeed in eradicating equilibria that depend on sunspots. Smith
describes restrictions that move the economy from an equilibrium with excessive fluctuations driven by sunspots to one without sunspots. Removing
those restrictions produces winners and losers, so equilibria with and without
14
legal restrictions that draw lines between money and credit are not Pareto
comparable. As with the Sargent and Wallace (1982) model, the welfare
comparisons that Smith performs sharply expose some of the ambiguities
that necessarily confront a policy maker pondering whether he or she should
want rates of return on some assets to be stable while accepting that other
rates of return on other assets are not.
4
The Chicago plan for 100% reserves and
Milton Friedman’s improvements
Sargent and Wallace (1982) and Smith (1988) designed their quantity theory
regime legal restrictions to emulate the Chicago plan for 100% reserve requirements that Friedman (1960, p. 65) credited to Henry Simons and Lloyd
Mints. Friedman modified the original Chicago plan to correct defects that
he said were associated with the inefficiencies and incentives for avoidance
brought by the legal restrictions that prevent people from exploiting the arbitrage opportunities presented by the rate of return discrepancies that prevail
in equilibrium under the original Chicago plan. Friedman (1960, ch. 3) suggested two ways to overcome these difficulties. The first is to pay interest on
reserves, to be financed either through taxation or through earnings on the
central bank’s portfolio.20 The second is to ‘move in the opposite direction’
advocated by Gary Becker (1956) by abandoning restrictions on intermediation and permitting free banking (Friedman (1960, ftnt. 10, p. 108)).21
20
Notice that this is an early version of the ‘Friedman rule’ later proposed in Friedman
(1969). That financing details form essential parts of the plan is a good example of how
monetary and fiscal policies are inextricably linked.
21
The tensions between efficiency and stability run through the vast literature critically
evaluated by Friedman and Schwartz (1986).
15
4.1
General equilibrium analysis of Friedman’s improvements
Subsequent researchers aimed to clarify the sense in which these two proposals are really opposites. As we shall see, when interest payments are financed
from earnings on the central bank’s portfolio, they are not opposites. Sargent and Wallace (1985) and Sargent (1987a, pp. 177-182) study versions of
Friedman’s proposal in the context of two different general equilibrium models with potentially valued fiat money, an overlapping generations model in
Sargent and Wallace (1985), and a cash-in-advance model in Sargent (1987a,
pp. 177-182).22 Both models reveal that while Friedman’s proposal to pay
interest on reserves eliminates the inefficiencies and incentives for avoidance
that concerned Friedman, they have side effects that come from erasing the
lines between money and credit markets imposed by the original Chicago
plan.
When interest payments are financed by earnings on the government portfolio, either no equilibrium with valued fiat money exists, or there is an equilibrium with a zero nominal interest rate and an allocation equivalent to one
that would emerge under free banking. Thus, a proposal to pay interest on
reserves financed by earnings on the central bank’s portfolio is equivalent
in its economic effects on relative prices and quantities to the ‘move in the
opposite direction’ advocated by Gary Becker.
When payments of interest on reserves are financed by taxes, both models
reveal that while Friedman’s proposal to pay interest on reserves eliminates
the inefficiencies and incentives for avoidance that concerned Friedman, it
does so by making the price level either indeterminate or infinite because it
eradicates the barriers between the money and credit markets. These outcomes emerge because paying a market rate of interest on reserves makes
reserves into as good an investment for banks as are the alternative assets
22
Both models assume lump sum taxes.
16
that earn that market rate, rendering the demand for reserves indeterminate.
When the demand for reserves becomes indeterminate, so do the taxes that
have to be raised to pay interest on reserves. In the overlapping generations
model, the market interest rate itself as well as tax rates and total tax collections are indeterminate. Similar results prevail under a cash-in-advance
model, but here the interest rate becomes determinate under tax financing
even though the price level and taxes are indeterminate.23 ,24
4.2
Indeterminacy theme
A specter of indeterminacy runs through the literatures that convey economists’
thoughts about real bills doctrine, the quantity theory of money, and proposals to supply an ‘optimal quantity of money’ by paying interest on reserves.
Avoiding the Wicksellian indeterminacy of the price level and money supply
alleged to be endemic to a real bills policy motivated restrictions to separate markets for money and credit. Those restrictions worked, but they produced collateral damage in the form of equilibrium rate-of-return wedges that
indicate inefficiencies and avoidance vulnerabilities. Implementing intereston-reserves proposals to correct those rate-of-return discrepancies reignite
indeterminacies.
4.3
Paying interest on reserves subverts independence
of the central bank and the fiscal authority
From Friedman (1960) onward, analyses of schemes to pay interest on reserves financed by taxes have highlighted the fiscal ramifications of such a
23
See Sargent (1987a, pp. 177-182). Lucas (1986, p. 124) proposes a closely related
scheme with interest payments on currency to be financed by government earnings from
private IOUs that it purchases in period 0. Lucas does not emphasize the indeterminacy
lurking in his scheme, but I believe it is there nonetheless.
24
Things are somewhat different in interesting ways in Bewley models and extensions of
Townsend turnpike models. See Ljungqvist and Sargent (2004, pp. 594–597) and Manuelli
and Sargent (2010).
17
policy. The interdependence of monetary and fiscal policies inherent in such
policies is one more illustration of how the sequence of government budget
constraints make the ‘independence of the Fed’ a fiction. That it is perhaps a
useful fiction comes from comparing what seem to be diametrically opposed
proposals for coordinating monetary and fiscal policy made by Milton Friedman. Friedman (1953) proposed a debt management policy in which the Fed
purchases 100% of all debt issued by the Treasury and thus automatically
and immediately finances 100% of all government deficits. Later, Friedman
(1960) proposed that the Fed increase the monetary base at k percent per
year, thereby telling the Treasury that it will finance at most a small part of
any large deficit. In hesitating between such apparently opposite proposals,
Friedman was struggling to find a way for a determined monetary authority
to get the upper hand over the fiscal authorities in what can become a game
of chicken presented by the unpleasant arithmetic of the government budget
constraint.25
4.4
Take away points
In summary
• Proposals to separate money and credit markets introduce inefficiencies. Proposals to construct optimal policies in the fashion of Friedman
(1960) strive to reduce or eliminate those inefficiencies. But those proposals all end up reintegrating the credit and money markets.26
• Proposals to pay interest on reserves financed by earnings on the central
bank’s portfolio are economically equivalent to implementing a real
25
See Sargent and Wallace (1981) and Sargent (1993, ch. 2).
This is brought out forcefully in the analysis of Lucas and Stokey (1983), who analyze a
setting in which the ‘Friedman rule’ that aims to eliminate a rate-of-return wedge between
money and short-term risk-free bonds emerges as part of an optimal policy rule. The
Friedman rule or something closely approximating it has emerged as optimal policy in a
variety of environments.
26
18
bills or free banking regime. They therefore undo the stabilizing effects
sought by the original Chicago plan for separating markets for money
and credit.
• Proposals to pay interest on reserves financed by taxes also subvert
restrictions designed to separate markets for money and credit. In
addition, they further confuse the line between fiscal and monetary
policy and raise substantial issues about central bank independence.
• There are winners and losers in moving from a regime that separates
money and credit markets to one that unfetters intermediaries.
5
Another line: fighting bank runs versus discouraging excess risk-taking
I have described how Milton Friedman and other economists have struggled
with tensions between stability and efficiency in deciding where to draw the
line between money and credit markets. I now discuss closely related issues
that at heart shape alternative visions of the proper roles of lenders of last
resort and deposit insurance. Because of how they alter incentives of banks’
owners, depositors, and other creditors, government lender of last resort and
deposit insurance activities raise questions about the same fundamental public policy issue that I have been discussing throughout this paper, namely,
“what assets and liabilities should banks be allowed to hold and to issue?”
5.1
Deposit insurance is good
In the Diamond and Dybvig (1983) model, ‘banks’ enable risk-sharing and
maturity transformation that can improve the allocation of resources by al-
19
lowing society to exploit investment opportunities efficiently.27 But with
first-come, first-serve deposit contracts, there are multiple equilibria, and
some of these are not good. In a no-run equilibrium, outcomes are good.
Maturity transformation facilitates risk-sharing and the appropriate financing of long-lived projects (the allocation is Pareto optimal). In an equilibrium
with a ‘run’, risk-sharing and maturity transformation break down and the
allocation of resources is Pareto inferior.
In this environment, government supplied deposit insurance works like a
charm by knocking out bad equilibria. The government removes equilibria
with runs by promising payoffs that will be made only off the desirable and
unique no-run equilibrium. This means that in equilibrium, deposit insurance
ends up being costless.
How would someone armed only with the Diamond and Dybvig model
approach the events of fall 2008? The model asserts that explicit deposit
insurance immunizes banks from runs. That means that FDIC insured banks
should be protected from runs. But the model interprets a ‘bank’ to be any
intermediary that conducts maturity transformation by issuing shorter term
liabilities to fund longer-term assets. In 2008, that meant not just institutions
that called themselves banks, but also money market mutual funds, special
purpose vehicles known as shadow banks, insurance companies, and even
parts of companies manufacturing durable goods like automobiles. Because
they were not insured by the FDIC, such intermediaries were vulnerable to
runs. It was natural to apply the Diamond and Dybvig model to argue
27
Also see the closely related earlier paper Bryant (1980) and the enlightening comparison of the models of Bryant and Diamond and Dybvig by Allen and Gale (2007,
ch. 3). Allen and Gale (2007, Sec. 3.7) emphasize that the Diamond-Dybvig model relies
on sunspots to ignite runs while the Bryant model and Allen and Gale (1998) rely on depositors’ views about the prospects for economic fundamentals. Allen and Gale (2007) cite
empirical evidence favoring fundamentals over sunspots as causing bank runs in practice.
Green et al. (2009) interpret the model of Atkeson and Lucas (1992) as an infinite-horizon
version of a model like Diamond and Dybvig’s and by extending it to include capital
discuss how liquidity provision interacts with business cycles. Atkeson and Lucas (1992)
extend a model of Green (1987).
20
that the contagion that rapidly gathered steam in the fall of 2008 could be
arrested by extending deposit insurance to all such Diamond and Dybvig
‘banks’ (institutions whose maturity mismatches made them vulnerable to
a run); that by doing so aggressively, the contagion would be arrested; that
the ultimate cost of doing so would be small because adverse events that
pass high costs to the government would occur only if the run failed to be
arrested, an outcome that the government’s extension of deposit insurance
had eliminated.
In this way, the Diamond and Dybvig model justifies the aggressive extension of ‘deposit insurance’ to previously uninsured creditors of non-bank
financial intermediaries. It also inspires hope that a more serious breakdown
has been avoided by using a policy that will not impose substantial costs on
tax payers.
While this application of the Diamond and Dybvig paper offers grounds
for optimism, cautionary words in the concluding section Diamond and Dybvig (1983) should cause us to think again. There the authors noted that
by studying deposit insurance within a model that rigorously excludes moral
hazard, they had purposefully excluded a countervailing force that had been
analyzed by Kareken and Wallace (1978) in a paper that offers a very different
perspective on deposit insurance.
5.2
Deposit insurance is bad
In the Diamond and Dybvig model, deposit insurance is unambiguously good.
In the model of Kareken and Wallace (1978), deposit insurance is unambiguously bad when unaccompanied by a set of portfolio regulations that prevent
banks from taking the excessive risks that deposit insurance tempts them to
accept.
Kareken and Wallace studied an economy with complete markets that
provide individuals ample opportunities to take or avoid risk. Like Diamond
and Dybvig, Kareken and Wallace assumed rational expectations, so deposi21
tors ‘see through’ intermediaries and view themselves as holding shares of a
bank’s portfolio. Kareken and Wallace compared two scenarios that might
conceivably confront banks and their depositors. In the first scenario, a bank
can attract depositors who want to hold risk-free assets if and only if it holds
a risk-free portfolio.28 In this scenario, banks are safe in equilibrium because
withdrawing depositors would immediately punish banks that do not hold
safe portfolios.
In Kareken and Wallace’s second scenario, a government guarantees deposits, so depositors have no reason to be concerned about the riskiness of
a bank’s portfolio. Nevertheless, a bank’s shareholders do because shareholders’ value is maximized when a bank becomes as large and as risky as
possible. The deposit insurance allows shareholders to gamble on favorable
terms with other peoples’ money (the tax payers’), and shareholders want to
do this as much as possible. The bank is bound to fail sooner or later, and
then the government will have to pay the depositors. Note that the moral
hazard problem is not solved by having the share holders take losses when
adverse events occur. The Kareken and Wallace model assumes that share
holders do take losses when a bank fails, a risk that they accept. The problem occurs when the bank’s creditors expect not to take losses, enabling the
bank’s shareholders to gamble at the tax payers’ expense.
In this way, Kareken and Wallace isolated the moral hazard problem created by improperly priced government-supplied deposit insurance. Kareken
(1983) used the Kareken and Wallace analysis to argue that financial deregulation without accompanying reform of deposit insurance would be putting
‘the cart before the horse’.
28
This situation approximates the ‘natural’ competitive banking system of Bagehot
(1920, p. 68) wherein banks experience a ‘preservative apprehension’ (Bagehot (1920,
p. 106)).
22
5.3
Aligning political incentives
In framing a government which is to be administered by men
over men, the great difficulty lies in this: you must first enable
the government to control the governed; and in the next place
oblige it to control itself.
number 51.
James Madison, Federalist Papers,
The Diamond and Dybvig and the Kareken and Wallace models take
government policy as exogenous. Appreciating the problem of banking regulation requires making government policy endogenous in ways that recognize
the incentives that confront government policy makers as time and chance
unfold.
The good and bad aspects of deposit insurance isolated by the Diamond
and Dybvig and Kareken and Wallace models, respectively, present a tension
about how the government should administer deposit insurance and lender of
last resort functions. At least informally, the dilemma has long been recognized. Bagehot said that in normal times the Bank of England should act in
a way that convinces other banks not to expect to be bailed out when they
experience adverse portfolio shocks; but nevertheless that when banks are
threatened by a run, the Bank of England should lend freely to other banks,
albeit while charging a high rate of interest and requiring good collateral.
Bagehot warned that this policy might not work. Indeed, under rational
expectations it cannot work because it is not coherent intertemporally.
At the time that Northern Rock failed in 2007, Lawrence Summers chided
Governor Mervyn King of the Bank of England with the advice that ‘now
is not the time to bring out the moral hazard police’. Summers’s advice is
both correct, according to a pure Diamond and Dybvig view, and incorrect,
according to a pure Kareken and Wallace view that would make you ask ‘if not
now, when?’ When a run threatens, government authorities face incentives
that will make them choose to follow through on the painful policies needed
to confirm the ‘preservative apprehensions’ on the part of banks’ creditors
23
that would stop banks from taking on too much risk. Such intertemporal
conflicts among the things preferred by a benevolent government are called
time-consistency problems.29
5.4
A model with good and bad aspects of bank bailouts
Keister (2010) extends the Diamond and Dybvig model to characterize a
time-inconsistency problem inherent in sustaining government policies that
alter the vulnerability of the economy to runs while also changing banks’
choices about liquidity.30 He does this by augmenting the model to include
a government that uses taxes to finance a public good and occasionally to
bail out depositors.31 The model is set up so that bailouts are part of an
efficient government policy both ex ante and ex post, though the generosity
and distribution of the bailouts differ across those two timing protocols. The
ex ante efficient policy (designed at time 0 before people realize whether they
want to consume early or late and see a sunspot variable that may trigger
runs) involves a level and distribution rule for government bailouts together
29
That prospective actions that ex ante seem desirable to government functionaries also
seem suboptimal ex post is at the heart of the predicament of designing deposit insurance
and lender of last resort policies. Bagehot (1920, pp. 100-101) identified the problem:
“A panic, in a word, is a species of neuralgia, and according to the rules of science you
must not starve it. The holders of the cash reserve must be ready not only to keep it
for their own liabilities, but to advance it most freely for the liabilities of others. They
must lend to merchants, to minor bankers, to “this man and that man” whenever the
security is good. In wild periods of alarm, one failure makes many, and the best way to
prevent the derivative failures is to arrest the primary failure which causes them.” But
“If the banks are bad, they will certainly continue bad and will probably become worse
if the Government sustains and encourages them. The cardinal maxim is that any aid to
a present bad bank is the surest mode of preventing the establishment of a future good
bank. Bagehot (1920, pp. 51-52).
30
See Allen and Gale (2007, ch. 7) for a welfare analysis of alternative proposals for
regulating bank portfolios.
31
At time 0, the government taxes private agents, carries the proceeds over without
depreciation into period 1, which it then uses either to purchase a public good or bail
out depositors facing losses. The public good is valued by both early and late consumers.
There is a sunspot variable s taking on two values s1 , s2 with known positive probabilities
that potentially induces late consumers to withdraw early when s = s2 .
24
with illiquid bank portfolios. (Here the degree of illiquidity is defined as the
ratio of short term liabilities to short term assets. The bank is illiquid when
this ratio exceeds 1.) An ex post efficient government policy (designed at time
1 after people realize their types and observe the sunspot variable) involves
larger bailouts as well as a distribution of bailouts across banks and depositors
that distorts ex ante incentives. The basic problem is that if they were to
anticipate that the government would carry out the ex post optimal rule for
distributing bailouts to depositors, intermediaries would choose portfolios
that are more illiquid than the ex ante efficient ones, an adverse outcome
that Keister uses to frame the time inconsistency problem confronting policy
makers in this environment. It is important to note that Keister’s analysis
does not rationalize a no-bailout policy. He shows that relative to the ex ante
efficient policy, an arbitrary ex ante policy of no bailouts expands the region
of the parameter space for which the economy is vulnerable to runs that
are associated with inefficient outcomes. Keister (2010) uses this finding
to capture the adverse destabilizing effects of a no-bailout policy. Keister
constructs a tax on banks’ illiquidity that together with the ex post optimal
bailout policy implements the ex ante optimum.
5.5
Related approaches
Stern and Feldman (2004) explore other ways of characterizing and coping
with the incentive problem confronting government agents that is provoked
by the tension between ex post good (arresting contagion) and ex ante bad
(provoking excess risk-taking) aspects of deposit insurance and other lenderof-last resort activities. These writings take us into the realms of political
economy and sustainable government plans.
The analysis of Stern and Feldman addresses the time-consistency problem by focusing attention on ways to rearrange the interests and choice menus
available to voters and government policy makers that can make it in their
interests to follow through with policies designed to ameliorate the excessive
25
risk-taking that government creditor insurance policies promote. Their perspective is that what has thus far impeded protecting ourselves against both
contagion and efficient risk-taking is a set of incentive problems confronting
not just banks and their creditors but also the elected officials and other
government officers with the authority to insure creditors and act as lenders
of last resort. Stern and Feldman were inspired to apply lessons we have
learned in coping with the time inconsistency problem created by temporarily exploitable trade-offs between inflation and unemployment. Accordingly,
they seek government programs and appointment procedures that will give
government agents the incentives to execute policies that will attenuate excessive risk-taking at tax payer expense.
6
Concluding remarks: what is a real bill?
This paper has cited formal models that interpret Adam Smith’s ‘real bills’
as safe evidences of private indebtedness and the wedges that the real bills
doctrine aims to eradicate as being wedges between risk-free rates of return
faced by different people. We have seen that analogous efficiency-versusstability issues arise when we ask whether financial intermediaries should be
allowed to transform maturities and risks to help complete missing insurance
and lending markets. Rate of return wedges and the associated inefficiencies
are tell-tale signs of equilibria in models with incomplete markets. Expanded
intermediation can reduce those wedges. Should banks and other intermediaries be allowed to improve efficiency by offering products that rely on
statistical averaging and censoring to transform bundles of risky assets of
various durations into less risky assets that can back short-term risk-free deposits? Whether financial institutions should be allowed to purchase or to
create such wedge reducing, efficiency improving assets and use them to back
putatively risk-free liabilities raises questions about proper policies toward
public lenders of last resort and suppliers of deposit insurance.
26
I began by quoting words from Milton Friedman that asserted the importance of properly regulating monetary arrangements. I conclude by quoting
troubling words that express a fear that in the U.S. we have not yet figured
out where to draw lines properly.
. . . some central structural issues have not yet been satisfactorily
addressed.
A large concern is the residue of moral hazard from the extensive
and successful efforts of central banks and governments to rescue
large failing and potentially failing financial institutions. The
long-established safety net undergirding the stability of commercial banks deposit insurance and lender of last resort facilities
has been both reinforced and extended in a series of ad hoc decisions to support investment banks, mortgage providers and the
worlds largest insurance company. In the process, managements,
creditors and to some extent stockholders of these non-banks have
been protected.
The phrase too big to fail has entered into our everyday vocabulary. It carries the implication that really large, complex and
highly interconnected financial institutions can count on public
support at critical times. . . . Beyond the emotion, the result is to
provide those institutions with a competitive advantage in their
financing, in their size and in their ability to take and absorb
risks.
As things stand, the consequence will be to enhance incentives
to risk-taking and leverage, with the implication of an even more
fragile financial system. We need to find more effective fail-safe
arrangements.
Paul Volcker (2010)
27
A
Bagehot: ideal versus practical banking
regimes
Walter Bagehot (1920) described the features of the mid 19th century British
money market that rendered it vulnerable to recurrent panics and that virtually forced the Bank of England to be the lender of last resort. Bagehot
made it clear that he did not like the existing British banking system and
the advantages and responsibilities that the Bank of England had acquired
as owner of a preponderance of England’s reserves and through its special
relationships with the government. Bagehot said that what he called a ‘natural’ competitive banking system without a ‘central’ bank would be better.
Bagehot (1920, p. 98):
Nothing can be truer in theory than the economical principle that
banking is a trade, and only a trade; and nothing can be more
surely established by a larger experience than that a Government
which interferes with any trade injures that trade. The best thing
undeniably that a Government can do with the Money Market is
to let it take care of itself.
Bagehot (1920, p. 103) thought that a system of competitive banks would
ordinarily be immune to breakdowns and would not need a lender of last
resort.
Under a good system of banking a great collapse, except from
rebellion or invasion, would probably not happen. A large number
of banks each feeling that its credit was at stake in keeping a good
reserve probably would keep one; if any one did not, it would be
criticised constantly, and would soon lose its standing, and in the
end disappear.
But Bagehot said that this ideal system was not practical for late 19th century Britain. He described Britain as having evolved through a long process
28
of political and economic improvisations to reach a system of banking arrangements that a good theorist could criticize but that a pragmatist must
acknowledge was invulnerable to proposals for reform.32 “Thus our one reserve system of banking was not deliberately founded upon definite reasons;
it was the gradual consequence of many singular events and of an accumulation of legal privileges on a single bank which has now been altered and
which no one would now defend.” Bagehot (1920, p. 97) Centralizing the
entire banking system’s reserves with the bank of England made the system
more unstable than the ‘natural’ competitive system that Bagehot preferred.
“And this system has plain and grave evils. 1st. Because being created by
State aid it is more likely than a natural system to require State help.” Bagehot (1920, p. 105) “The English Government not only created this singular
system but it proceeded to impair it and demoralise all the public opinion respecting it.” This happened when by requiring the Bank of England
to suspend convertibility of its notes into specie, “[Mr. Pitt] removed the
preservative apprehension which is the best security of all banks.” Bagehot
(1920, p. 106) (italics added)
B
Real Bills in the Federal Reserve Act
The real bills doctrine was written into the Federal Reserve Act of 1913 and
taken seriously by early Federal Reserve Boards. Thus,
. . . any Federal reserve bank may discount notes, drafts, and bills
of exchange arising out of actual commercial transactions; that
is, notes, drafts, and bills of exchange issued or drawn for agricul32
“Credit is a power which may grow but cannot be constructed. Those who live under
a great and firm system of credit must consider that if they break up that one they will
never see another, for it will take years upon years to make a successor to it. On this
account I do not suggest that we should return to a natural or many reserve system of
banking. I should only incur useless ridicule if I did suggest it.” (Bagehot (1920, p. 68))
So much for mechanism design.
29
tural, industrial, or commercial purposes . . . Nothing in this Act
contained shall be construed to prohibit such notes, drafts, and
bills of exchange, secured by staple agricultural products or other
goods, wares, or merchandise from being eligible for such discount; but such definition shall not include notes, drafts, or bills
covering merely investments or issued or drawn for the purpose
of carrying or trading in stocks, bonds, or other investment securities, except bonds and notes of the Government of the United
States. Notes, drafts, and bills admitted to discount under the
terms of this paragraph must have a maturity at the time of discount of not more than ninety days . . .
Federal Reserve Act, 1913. section 13, paragraph 2
From the Annual Report of the Federal Reserve Board in 1923 we have:
[T]here will be little danger that the credit created and contributed by the Federal reserve banks will be in excessive volume
if restricted to productive uses. Board of Governors (1923, p. 34)
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35
Bank Failures and Output During the Great Depression
Jeffrey Miron
Department of Economics, Harvard University and the Cato Institute
Natalia Rigol
Department of Economics, M.I.T.
April, 2012
Abstract
In response to the Financial Crisis of 2008, macroeconomic policymakers employed a range of
tools designed to prevent failures of large, complex financial institutions (“banks”). The Treasury and the
Fed justified these actions by arguing that bank failures exacerbate output declines, rather than just
reflecting output losses that have already occurred. This view is consistent with economic models based
on credit market imperfections, but it is an empirical question as to whether the feedback from failures to
output losses is substantial.
This paper examines evidence on the relation between bank failures and output losses by reconsidering the findings in Bernanke (1983) on the relation between bank failures and output during the
Great Depression. Our analysis provides little indication that bank failures exerted a substantial or
sustained impact on output during this period.
We thank Jaron Cordero for superb research assistance. John Lapp, Randall Parker, Greg Mankiw, Tom
Sargent, Kate Waldock and participants at the Wake Forest conference “The Federal Reserve Was a Bad
Idea” provided helpful comments on an earlier draft.
1
I. Introduction
In response to the Financial Crisis of 2008, macroeconomic policymakers employed a range tools
designed to prevent failure of large, complex, financial institutions (“banks”).1 Most importantly, the
Treasury injected capital directly into banks, and the Fed expanded its balance sheet by roughly $1.3
trillion. The Federal Financing Housing Administration also placed Fannie Mae and Freddie Mac into
conservatorship, and the Treasury injected $100 billion of capital in each agency.
The Treasury and the Fed justified these actions by appealing to the claim that bank failures
contribute to output declines, rather than just reflecting output losses that have already occurred. This
proposition is defensible from certain theoretical perspectives (e.g., Bernanke and Gertler 1985), and
some prior empirical work appears to support the proposition (e.g., Bernanke (1983), Bernanke and James
(1991)). Economists as a group supported the Fed and Treasury policies, mainly from concern that
widespread bank failures would exacerbate the recession. A few even speculated that failure to take these
actions would risk another Great Depression.
Yet government support of failing banks has costs, whether or not this support dampens
recessions. Most importantly, moral hazard generated by the prospect of bailouts can distort lending and
investment decisions toward excessively risky projects or sectors. More broadly, the prospect of bailouts
might increase uncertainty, delay appropriate adjustments as banks wait for policymakers to decide
whether and whom to bail out, generate strategic actions by banks seeking to profit from bailouts, or
reward politically connected banks rather than systemically crucial ones.
In assessing the wisdom of bailouts, therefore, it is important to know whether the feedback from
bank failures to output is substantial or modest. If failures have a large impact on output, bailouts are
1
Some of the financial institutions targeted by these actions were not banks per se, but we use the term
bank throughout for ease of presentation.
2
potentially desirable even if they generate their own costs. If failures have a modest impact on output,
that case is harder to make.
This paper examines evidence on the relation between bank failures and output by reconsidering
the findings in Bernanke (1983), which appear to show that bank failures had a substantial impact on
output during the Great Depression. We argue that data for the interwar period provide little indication
that bank failures exert a substantial or sustained impact on output. This conclusion is partially just a
statement that determining whether failures cause or reflect output losses is difficult because convincing
instruments for bank failures are not available. But it is also a statement that even under the most
generous identifying assumption, the impact of failures during the Great Depression does not appear to
have been large or persistent.
II: Bank Failures and Output During the Great Depression
In attempting to understand the Great Depression, Bernanke (1983) argues that the Friedman and
Schwartz (1963) monetary explanation is incomplete because theoretical models of money cannot easily
explain the protracted non-neutrality necessary to account for the length of the downturn from 1929-1933.
Further, Bernanke suggests that the declines in money were not sufficient to explain the magnitude of the
fall in output over the same period.
Bernanke therefore proposes that bank failures had a non-monetary effect on the real economy
through credit rationing, since failures made credit scarcer for borrowing firms. In his view, banks act as
low-cost credit intermediaries who collect money from lenders and evaluate the risk of borrowers. The
non-trivial and costly-to-replicate service that the banking system provides is to differentiate between
good and bad borrowers. Bank failures therefore decrease intermediation capital, raise the cost of loans,
and reduce output because alternative sources of credit intermediation cannot arise quickly or in sufficient
quantity after banks fail.2
2
Following Fisher (1933), Bernanke also argues that debt deflation in the 1930s decreased the net worth
of both borrowers and banks, destroying intermediaries and available credit.
3
Bernanke’s Empirical Strategy
To quantify the importance of monetary versus non-monetary factors in generating the output
declines of 1929-33, Bernanke estimates the equation
yt = a(L) yt-1 + b(L) (mt – t-1mt) + c(L) DBANKSt + d(L) DFAILSt + et
where
yt
is the log growth rate of monthly industrial production;
mt- t-1mt
is the growth rate of growth of M1 less the predicted growth rate;
DBANKSt
is the first difference of real deposits of failing banks;
DFAILSt
is the first difference of real liabilities of failing businesses.
Bernanke creates the monetary surprises as residuals from a regression of the growth rate of M1 on four
lags of the growth rate of industrial production, wholesale prices, and M1 itself (Bernanke 1983, p. 268).
Bernanke also estimates a version of Equation (1) in which he replaces the money surprises with price
surprises, defined analogously.
Under the null hypothesis that bank and business failures play no independent role in the
propagation of output, DBANKS and DFAILS should not enter Equation (1). Instead, the only impact of
bank failures should occur via their impact on the money stock, consistent with the Friedman and
Schwartz view that monetary shocks generated the lion’s share of the output declines during the
downturn. In this case, the monetary surprise variable, mt-
t-1mt,
should be sufficient to explain the
behavior of output.
Overview of the Data
Before examining estimates of Equation (1), we consider plots of the raw data. Figure 1 displays
the log of monthly industrial production along with the real value of deposits in failed banks for
Bernanke’s sample period, 1921:1 – 1941:2. Figure 2 shows these same data for 1928-1936 to facilitate
4
closer examination of the timing. These graphs suggests three conclusions about the relation between
output and failures.
At the broad brush level, an impact of bank failures on output does not leap from the graph.
Industrial production fluctuated significantly during parts of the interwar period that experienced minimal
bank failures. Industrial production declined by 31.6 percent, over a span of fifteen months, from the
cyclical peak in July, 1929 to the first wave of bank failures in November, 1930. That magnitude decline
– which equaled almost half the overall drop – makes it plausible that bank failures were partly a response
to adverse economic conditions, whether or not failures contributed to output losses.
At a more detailed level, these data are consistent with the view that failures reduce output, since
in November, 1930, October, 1931, and March, 1933, a reduction in output (relative to trend) occurs
simultaneously with a spike in failures. The output declines in these periods were not by themselves
enormous, and failures do not look as those they had a persistent impact on output, but some correlation is
apparent.
The graphs also suggest that one particular observation – the bank holiday in March, 1933,
declared by President Franklin Roosevelt on March 6th – might play a substantial role in driving the
correlation between failures and output declines. The real value of deposit liabilities of suspended banks
in March, 1933 was eight times higher than the second largest value in the sample, October, 1931.
As it turns out, our conclusions based on the regressions presented below are consistent with the
impressions provided by this graphical examination. We will end up concluding that failures plausibly
have some impact on output, but this impact is sensitive to the identifying assumption about timing, not
especially large or persistent, and somewhat sensitive to exclusion of the bank holiday from the sample.
Regression Results
5
Table 1 presents our replication of the results from Bernanke’s 1983 paper (Table 2, Equations
(1) - (4)).3 Our estimates are close but not identical to those reported in Bernanke. 4
The coefficients on the contemporaneous money or price surprises are positive and significant,
consistent with the Friedman and Schwartz view that money played a role in the propagation of the
Depression. The lagged monetary or price surprises are not significant.
The coefficients on the contemporaneous and lagged values of the liabilities of failed banks are
both negative and significant or nearly significant, especially the contemporaneous values. This is the
crucial result in Bernanke’s paper; it suggests that even after controlling for the impact of bank failures on
the stock of money, bank failures played an additional, non-monetary role in generating the output
declines of the 1929-1933 period. The coefficients on the business liabilities variables are also negative
and significant, consistent with Bernanke’s hypothesis.
These results are thus consistent with Bernanke’s conclusions. We now examine whether these
results are robust to certain specification issues.
The Bank Holiday
As Bernanke notes and Figures 1-2 illustrate, bank failures were unusually high in March, 1933.
It is not obvious whether to include this observation in the regressions, since the mechanism by which
banks closed during this episode (an economy-wide, government-imposed shutdown) was not identical to
the standard mechanism. We take no position on this for now and instead examine alternative empirical
approaches to dealing with this observation.
Bernanke’s reported results include the March, 1933 data. Bernanke notes that he tried an
alternate specification in which he scaled this observation to 15% of its reported value (p.270), and that
3
Bernanke’s results utilize OLS standard errors. We have examined standard errors corrected for autocorrelation, but these have minor effects on the results. We therefore report OLS standard errors to ease
comparison with Bernanke’s original results.
4
We have expended considerable effort in the attempt to fully reconcile our estimates with Bernanke’s estimates, so
far without success. Bernanke is not 100% explicit about his sample periods, but no plausible choice yields exactly
his results. It is possible that data revisions explain the discrepancies, but it is not obvious why such old data would
have been revised. We continue to examine this issue.
6
under this modification, the bank failure coefficient retains high significance. We obtain the same result
with our data; this approach to handling the March, 1933 observation does not produce a material change
in Bernanke’s results; see Table 2, columns (1) - (2).
We reconsider this issue by reporting regressions that drop March, 1933 from the sample
entirely.5 Columns (3)-(4) of Table 2 show the results. In this specification, the bank and business failure
variables still enter negatively, consistent with Bernanke’s hypothesis, but the coefficients are less
statistically significant. Thus, exclusion of the Bank Holiday does not reverse Bernanke’s results but it
weakens them somewhat.
It is not obvious whether results that exclude the bank holiday are more or less informative than
those that include this observation. On the one hand, the number of failures and the quantity of deposits
involved was enormous in March, 1933. This might mean this observation is most relevant to episodes
like the recent crisis in which many large banks appeared to be at risk of failure. On the other hand, the
exact nature of these suspensions differed from those arising “endogenously,” since those during the
holiday were nationwide, applied to all banks, and were imposed by government decree.
Identification
A crucial issue in interpreting Bernanke’s results is whether causation runs mainly from bank
failures to output or from output to bank failures. Bernanke recognizes this issue and explains why he
believes that his regressions measure the impact of failures on output, rather than the reverse, but we do
not find his reasoning persuasive. Bernanke states,
To conclude that the observed correlations support the theory outlined in this paper requires an
additional assumption, that failures of banks and commercial firms are not caused by
(anticipations) of future changes in output. To the extent that, say, bank runs are caused by the
receipt of bad news about next month’s industrial production, the fact that bank failures tend to
lead production declines does not prove that the bank problems are helping to cause the decline
(p.271).
5
These regressions also drop additional observations because of the lag structure of the regression.
7
We find this description of the identifying assumption confusing. Bernanke seems to suggest that his
equation suffers from simultaneous equations bias only if anticipations of future output declines can
increase bank failures. But as his regressions are specified, they are subject to such bias so long as
current output declines can affect current failures.
The ideal way to resolve this issue is to instrument for contemporaneous bank failures, but we are
not aware of convincing instruments.
An alternative approach is to assume it takes at least a month for bank failures to disrupt credit
intermediation and thereby lower output. Under this assumption, any contemporaneous relation between
output and failures is assumed to represent the impact of output on failures. We can then determine the
effects of failures on output by excluding contemporaneous failures from the regressions. At a minimum,
it seems reasonable to consider this specification.
Table 3 presents the results.
In these regressions, bank failures have no predictive power for
output; indeed, the coefficients on bank failures imply that failures predict increases in output. Thus, if the
identifying assumption implicit in Table 3 is correct, these data and this specification provide no evidence
(indeed, contradict) the view that bank failures cause output declines.
Whether this identifying assumption is convincing is impossible to say on a priori grounds. Thus,
it is not correct to interpret Table 3 as showing that Bernanke’s conclusions are invalid. But the Table 3
results do show that under an alternate and plausible identifying assumption, the interwar data do not
support these conclusions.
The Magnitude of the Effects
A different issue in the assessment of Bernanke’s conclusions is the quantitative importance of
bank failures in contributing to declines in output, whatever identifying assumption one makes. The raw
data examined above did not seem to suggest a large impact, but we reconsider this issue based on the
estimated regressions reported in Table 1. Thus, we return to Bernanke’s identifying assumption that all
8
of the contemporaneous correlation between output and failures reflects the influence of failures on
output.
Figure 3 displays forecasts of the log of industrial production, along with the actual values, based
on estimates of Equation (1) that include or exclude the bank and business failure variables. The forecasts
begin in July, 1929.6 To construct these forecasts, we proceed as follows. First, we generate the fitted
values for the growth rate of industrial production from the relevant equation. Second, we set the
forecasted log of industrial production in the first forecast month equal to the log of industrial production
in the last month of the non-forecast period plus the predicted growth rate from that period to the first
forecast period. Third, for all subsequent months, we set the forecasted log of industrial production equal
to the forecasted log of industrial production for the previous month plus the forecast growth rate.
In the figure, the solid line shows actual industrial production; the short-dashed line shows
forecasts based on the purely monetary model; and the long-dashed line shows forecasts based on this
model augmented with Bernanke’s additional variables.
The figure suggests that Bernanke’s credit variables have minimal impact on the ability of such
regressions to explain the decline in output from its peak in 1929 to the trough in 1933. The purely
monetary equation does a reasonable job; it gets the direction of most ups and downs correct, and it
explains a non-trivial percentage of the decline in output. The equation augmented with the failure
variables, however, does hardly any better. Thus, even under Bernanke’s identifying assumption, in which
credit variables are statistically significant determinants of output growth, they are not quantitatively
important determinants of that growth.
III. Discussion
The results we have presented, by themselves, shed light on our understanding of the Great
Depression. As Bernanke confirmed, monetary factors do indeed appear to have played a major role in the
downturn, consistent with the work of Friedman and Schwartz. But the main avenue through which bank
6
We obtain similar results if we begin the forecasts in July, 1930.
9
failures mattered seems to have been through their impact on the money supply, rather than via a credit
intermediation channel.
Our results do not deal directly with whether bank failures during the recent financial crisis would
have generated a far deeper or longer recession than occurred, had the Treasury and Fed not taken the
actions that forestalled these failures. This is because the two episodes differed in important respects.
Perhaps most significantly, bank failures during the Great Depression consisted mainly of large numbers
of small banks; bank failures during the recent episode would plausibly have involved small numbers of
large, highly interconnected banks. Thus our results shed little direct light over whether Too-Big-to-Fail
concerns were valid.
To the extent U.S. experience during the Great Depression – and especially the view that bank
failures play a significant, independent role during that period – formed the intellectual foundation for
Treasury and Fed actions, however, our results suggest a hint of caution. If the Great Depression does not
constitute evidence for Too-Big-to-Fail, then what historical episodes do provide that evidence? We leave
that
question
for
another
day.
10
References
Bernanke, Ben (1983), “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great
Depression,” American Economic Review, 73(3), 257-76.
Bernanke, Ben and Mark Gertler (1987), “Banking in General Equilibrium,” in New Approaches to
Monetary Economics, W. Barnett and K. Singleton, eds., New York: Cambridge University Press.
Bernanke, Ben and Harold James (1991), “The Gold Standard, Deflation, and Financial Crisis in the
Great Depression: An International Comparison,” in R. G. Hubbard, ed., Financial Markets and
Financial Crises, Chicago: University of Chicago Press.
Fisher, Irving (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, 1, 337-57.
Friedman, Milton and Anna J. Schwarz (1963), A Monetary History of the United States, 1867-1960,
New York: National Bureau of Economic Research.
11
Table 1: Our Replications
VARIABLES
IPt-1
IPt-2
Moneyt
Moneyt-1
Moneyt-2
Moneyt-3
(1)
Equation 1
(2)
Equation 2
(3)
Equation 3
(4)
Equation 4
0.621***
(10.13)
-0.117*
(-1.936)
0.439***
(3.705)
0.100
(0.828)
0.0532
(0.442)
0.151
(1.259)
0.554***
(9.037)
-0.0593
(-1.002)
0.619***
(9.814)
-0.133**
(-2.171)
0.249**
(2.165)
0.0554
(0.487)
0.149
(1.297)
0.148
(1.321)
0.612***
(9.667)
-0.0826
(-1.340)
Pricet
0.552***
(4.968)
0.476***
(4.094)
0.154
(1.308)
-0.147
(-1.249)
Pricet-1
Pricet-2
Pricet-3
DBANKSt
Constant
0.00153
(0.947)
0.00167
(1.088)
-0.000390***
(-5.909)
-0.000197***
(-2.860)
-0.00491**
(-2.369)
-0.00429**
(-2.054)
0.00217
(1.409)
Standard Error
Observations
0.0263
268
0.0250
268
0.0237
244
DBANKSt-1
DFAILSt
DFAILSt-1
0.568***
(4.323)
0.196
(1.431)
-0.0303
(-0.223)
-0.213
(-1.595)
-0.000378***
(-6.132)
-0.000182***
(-2.819)
-0.00360*
(-1.762)
-0.00289
(-1.402)
0.00202
(1.355)
0.0230
244
12
Table 2: Bank Holiday: Omitting and Scaling March 1933
VARIABLES
IPt-1
IPt-2
Moneyt
Moneyt-1
Moneyt-2
Moneyt-3
DBANKSt
(1)
Scaled Eq. 3
(2)
Scaled Eq. 4
(3)
Omitted Eq. 3
(4)
Omitted Eq. 4
0.618***
(9.808)
-0.132**
(-2.164)
0.249**
(2.169)
0.0563
(0.496)
0.150
(1.308)
0.150
(1.338)
-0.000461***
(-5.944)
-0.000234***
(-2.892)
-0.00484**
(-2.339)
-0.00433**
(-2.073)
0.611***
(9.660)
-0.0824
(-1.336)
0.504***
(7.770)
-0.0294
(-0.467)
0.313***
(2.820)
0.126
(1.114)
0.227**
(2.047)
0.266**
(2.377)
-0.000890**
(-2.083)
-0.000536
(-1.256)
-0.00212
(-1.014)
-0.00301
(-1.435)
0.517***
(7.814)
0.0109
(0.169)
Constant
0.00217
(1.411)
-0.000444***
(-6.138)
-0.000215***
(-2.838)
-0.00353*
(-1.732)
-0.00292
(-1.420)
0.566***
(4.308)
0.196
(1.427)
-0.0282
(-0.208)
-0.211
(-1.581)
0.00203
(1.356)
Observations
244
244
DBANKSt-1
DFAILSt
DFAILSt-1
Pricet
Pricet-1
Pricet-2
Pricet-3
0.00223
(1.525)
-0.000526
(-1.215)
-0.000323
(-0.744)
-0.00271
(-1.290)
-0.00272
(-1.295)
0.447***
(3.271)
0.215
(1.528)
0.00565
(0.0403)
-0.134
(-0.957)
0.00211
(1.434)
235
235
13
Table 3: Identification: Excluding Contemporaneous Bank Failures
VARIABLES
IPt-1
IPt-2
Moneyt
Moneyt-1
Moneyt-2
Moneyt-3
(1)
Eq. 3
(2)
Eq. 4
(3)
Eq. 3
(4)
Eq. 4
0.647***
(9.600)
-0.140**
(-2.128)
0.440***
(3.703)
0.0550
(0.451)
0.00397
(0.0330)
0.139
(1.156)
0.607***
(8.940)
-0.0946
(-1.428)
0.665***
(9.623)
-0.137**
(-2.077)
0.431***
(3.626)
0.0886
(0.715)
0.0188
(0.155)
0.0993
(0.805)
0.630***
(9.084)
-0.0948
(-1.431)
Pricet
1.94e-05
(0.312)
-0.00222
(-1.036)
0.662***
(4.795)
0.305**
(2.085)
0.0916
(0.635)
-0.192
(-1.341)
1.62e-05
(0.270)
-0.000904
(-0.431)
Constant
0.00213
(1.289)
Observations
244
Pricet-1
Pricet-2
Pricet-3
DBANKSt-1
DFAILSt-1
0.00216
(1.343)
8.14e-05
(1.073)
-0.00217
(-0.966)
0.000106
(1.449)
-0.000109
(-0.0483)
0.00203
(1.230)
0.655***
(4.750)
0.321**
(2.186)
0.0981
(0.673)
-0.168
(-1.167)
7.80e-05
(1.093)
-0.000586
(-0.265)
0.000109
(1.599)
0.000903
(0.409)
0.00207
(1.286)
244
244
244
DBANKSt-2
DFAILSt-2
14
Deposits of Failed Banks
0
1.2
1000
2000
3000
Industrial Production (ln)
1.4 1.6 1.8
2
2.2
2.4
4000
1.2
0
4000
3000
2000
1000
2
1.8
1.6
1.4
1.2
2.4
2.2
Industrial
Jan1919
Sep1924
July1930
Apr1936
Dec1941
Date
I.P.
Deposits
Figure
000
(ln)1: of
Industrial
Production
Failed Banks
Production
(ln)
and Deposits of Failed Banks (1919-1942)
Jan1919
Sep1924
July1930
Apr1936
Dec1941
Date
I.P. (ln)
Deposits of Failed Banks
Figure 1: Industrial Production and Deposits of Failed Banks (1919-1942)
15
1000
0
Jan1928
June1929
I.P. (ln)
Dec1930
Date
June1932
Dec1933
Deposits of Failed Banks
Figure 2: Industrial Production and Deposits of Failed Banks (1928-1934)
16
Deposits of Failed Banks
3000
2000
1.8
1.6
1.4
1.2
Industrial Production (ln)
2
4000
1ndustrial
0
4000
3000
2000
I1000
2
1.8
1.6
1.4
1.2
Industrial
Jan1928
June1929
Dec1930
June1932
Dec1933
Date
I.P.
Deposits
Figure
000
(ln)2: of
Industrial
Production
Failed Banks
Production
(ln)
and Deposits of Failed Banks (1928-1934)
2.5
2.1
1.7
1.3
Industrial Production (ln)
2.5
2.1
1.7
1.3
Industrial
Jan1921
Apr1926
July1931
Oct1936
Dec1941
Date
Actual
Forecasted
Figure
3:
I.P.Dynamic
Production
From Equation
Simulation
(ln) 3
1 of Industrial Production (Beginning January 1929)
Jan1921
Apr1926
July1931
Oct1936
Dec1941
Date
Actual I.P.
Forecasted From Equation 3
Forecasted From Equation 1
Figure 3: Dynamic Simulation of Industrial Production (Beginning January 1929)
17
Has the Fed Been a Failure?
George Selgin*
Department of Economics
Terry College of Business
University of Georgia
Athens, GA 30602
[email protected]
William D. Lastrapes
Department of Economics
Terry College of Business
University of Georgia
Athens, GA 30602
[email protected]
Lawrence H. White
Department of Economics
George Mason University
Fairfax, VA 22030
[email protected]
November 9, 2010
Revised: December 1, 2010
JEL Classifications: E30, E42, E52, E58
*Corresponding author. We thank David Boaz, Don Boudreaux, Tyler Cowen,
Christopher Hanes, Jeff Hummel, Arnold Kling, Jerry O‘Driscoll, Scott Sumner,
Alex Tabarrok, Dick Timberlake, Randy Wright, and numerous blog commentators,
for their helpful suggestions, while absolving them of all responsibility for our
paper‘s arguments and conclusions.
Electronic copy available at: http://ssrn.com/abstract=1713755
ABSTRACT
As the one-hundredth anniversary of the 1913 Federal Reserve Act
approaches, we assess whether the nation‘s experiment with the Federal Reserve
has been a success or a failure. Drawing on a wide range of recent empirical
research, we find the following: (1) The Fed‘s full history (1914 to present) has been
characterized by more rather than fewer symptoms of monetary and macroeconomic
instability than the decades leading to the Fed‘s establishment. (2) While the Fed‘s
performance has undoubtedly improved since World War II, even its postwar
performance has not clearly surpassed that of its undoubtedly flawed predecessor,
the National Banking system, before World War I. (3) Some proposed alternative
arrangements might plausibly do better than the Fed as presently constituted. We
conclude that the need for a systematic exploration of alternatives to the
established monetary system is as pressing today as it was a century ago.
1
Electronic copy available at: http://ssrn.com/abstract=1713755
“No major institution in the U.S. has so poor a record of performance over so
long a period, yet so high a public reputation.” Milton Friedman (1988).
I. Introduction
In the aftermath of the Panic of 1907 the U.S. Congress appointed a National
Monetary Commission. In 1910 the Commission published a shelf-full of studies
evaluating the problems of the post-bellum National Banking system and exploring
alternative regimes. A few years later Congress passed the Federal Reserve Act.
Today, in the aftermath of the Panic of 2007, and as the one-hundredth
birthday of the Federal Reserve System approaches, it seems appropriate to once
again take stock of our monetary system. Has our experiment with the Federal
Reserve been a success or a failure? Does the Fed‘s track record during its history
merit celebration, or should Congress consider replacing it with something else? Is
it time for a new National Monetary Commission?
The Federal Reserve has, by all accounts, been one of the world‘s more
responsible and successful central banks. But this tells us nothing about its
absolute performance. To what extent has the Fed succeeded or failed in
accomplishing its official mission? Has it ameliorated to a substantial degree those
symptoms of monetary and financial instability that caused it to be established in
the first place? Has it at least outperformed the system that it replaced? Has it
learned to do better over time?
We address these questions by surveying available research bearing upon
them. The broad conclusions we reach based upon that research are that (1) the full
Fed period has been characterized by more rather than fewer symptoms of
monetary and macroeconomic instability than the decades leading to the Fed‘s
establishment; (2) while the Fed‘s performance has undoubtedly improved since
World War II, even its postwar performance has not clearly surpassed that of its
(undoubtedly flawed) predecessor; and (3) alternative arrangements exist that
might do better than the presently constituted Fed has done. These findings do not
prove that any particular alternative to the Fed would in fact have delivered
1
superior outcomes: to reach such a conclusion would require a counterfactual
exercise too ambitious to fall within the scope of what is intended as a preliminary
survey. The findings do, however, suggest that the need for a systematic
exploration of alternatives to the established monetary system, involving the
necessary counterfactual exercises, is no less pressing today than it was a century
ago.
As far as we know the present study is the first attempt at an overall
assessment of the Fed‘s record informed by academic research.1 Our conclusions
draw importantly on recent research findings, which have dramatically revised
economists‘ indicators of macroeconomic performance, especially for the pre-Federal
Reserve period. We do not, of course, expect the conclusions we draw from this
research to be uncontroversial, much less definitive. On the contrary: we merely
hope to supply prima facie grounds for a more systematic stock-taking.
In evaluating the Federal Reserve System‘s record in monetary policy, we
leave aside its role as a regulator of commercial banks. Adding an evaluation of the
latter would double an already large task. It would confront us with the problem of
distinguishing areas where the Fed has been responsible for rule-making from those
in which it has simply been the rule-enforcing agent of Congress. It would also
raise the thorny problem of disentangling the Fed‘s influence from that of other
regulators, because every bank the Fed regulates also answers to the FDIC and a
chartering agency. Monetary policy, by contrast, is the Fed‘s responsibility alone.2
Although Martin Feldstein (2010, p. 134) recognizes that ―[t]he recent financial crises, the
widespread losses of personal wealth, and the severe economic downturn have raised questions about
the appropriate powers of the Federal Reserve and its ability to exercise those powers effectively,‖
and goes on to ask whether and in what ways the Fed‘s powers ought to be altered, his conclusion
that the Fed ―should remain the primary public institution in the financial sector‖ (ibid., p. 135)
rests, not on an actual review of the Fed‘s overall record, but on his unsubstantiated belief that,
although the Fed ―has made many mistakes in the near century since its creation in 1913…it has
learned from its past mistakes and contributed to the ongoing strength of the American economy.‖
2 Blinder (2010) argues that, given the premise that the Fed as presently constituted will continue to
be responsible for conducting U.S. monetary policy, it ought also to have its role as a supervisor of
―systematically important‖ financial institutions preserved and even strengthened. Goodhart and
Schoenmaker (1995) review various arguments for and against divorcing bank regulation from
monetary control.
1
2
II. The Fed’s Mission
According to the preamble to the original Federal Reserve Act of 1913, the
Federal Reserve System was created ―to furnish an elastic currency, to afford means
of rediscounting commercial paper, to establish a more effective supervision of
banking in the United States, and for other purposes.‖ In 1977 the original Act
was amended to reflect the abandonment of the gold standard some years before,
and the corresponding increase in the Fed‘s responsibility for achieving
macroeconomic stability. The amended Act makes it the Fed‘s duty to ―maintain
long-run growth of the monetary and credit aggregates commensurate with the
economy's long run potential to increase production, so as to promote effectively the
goals of maximum employment, stable prices, and moderate long-term interest
rates.‖ On its website the Board of Governors adds that the Fed also contributes to
―better economic performance by acting to contain financial disruptions and
preventing their spread outside the financial sector.‖
These stated objectives suggest criteria by which to assess the Fed‘s
performance, namely, the relative extent of pre- and post-Federal Reserve Act price
level changes, pre- and post-Federal Reserve Act output fluctuations and business
recessions, and pre-and post-Federal Reserve Act financial crises. For reasons
already given, we don‘t attempt to address the Fed‘s success at bank supervision.
III. Inflation
The Fed has failed conspicuously in one respect: far from achieving long-run
price stability, it has allowed the purchasing power of the U.S. dollar, which was
hardly different on the eve of the Fed‘s creation from what it had been at the time of
the dollar‘s establishment as the official U.S. monetary unit, to fall dramatically. A
consumer basket selling for $100 in 1790 cost only slightly more, at $108, than its
(admittedly very rough) equivalent in 1913. But thereafter the price soared,
reaching $2422 in 2008 (Officer and Williamson 2009). As the first panel of Figure
1 shows, most of the decline in the dollar‘s purchasing power has taken place since
3
1970, when the gold standard no longer placed any limits on the Fed‘s powers of
monetary control.
The highest annual rates of inflation since the Civil War also occurred under
the Fed‘s watch. The high rates of 1973-5 and 1978-80 are the most notorious,
though authorities disagree concerning the extent to which Fed policy was to blame
for them.3 Yet those inflation rates, in the low ‗teens, were modest compared to
annual rates recorded between 1917 and 1920, which varied from just below 15% to
18%, with annualized rates for some quarters occasionally approaching 40% (see
Figure 1, third panel). Significantly, both of the major post-Federal Reserve Act
episodes of inflation coincided with relaxations of gold-standard based constraints
on the Fed‘s money creating abilities, consisting of a temporary gold export embargo
from September 1917 through June 1919 and the permanent closing of the Fed‘s
gold window in 1971.4
Although the costs of price level instability are hard to assess, the reduced
stability of prices under the Fed‘s tenure has certainly not been costless. As the
Board of Governors itself has observed (Board of Governors, 2009),
[s]table prices in the long run are a precondition for maximum sustainable
output growth and employment as well as moderate long-term interest rates.
When prices are stable and believed to remain so, the prices of goods,
services, materials, and labor are undistorted by inflation and serve as
clearer signals and guides to the efficient allocation of resources … .
Moreover, stable prices foster saving and capital formation, because when the
Because these were episodes not merely of inflation but of stagflation, they are frequently said to
have depended crucially on adverse aggregate supply shocks triggered by OPEC oil price increases.
This ―traditional‖ explanation has, however, been cogently challenged by Robert Barsky and Lutz
Kilian (2001) (see also Ireland 1999 and Chappell and McGregor 2004), who concludes ―that in
substantial part the Great Stagflation of the 1970s could have been avoided, had the Fed not
permitted major monetary expansions in the early 1970.‖ Blinder and Rudd (2008) have in turn
written in defense of the ―traditional‖ perspective.
4 World War II was also a period of substantial inflation, though this fact is somewhat obscured by
standard (BLS) statistics, which do not fully correct for the presence of price controls. Friedman and
Schwartz (1982, p. 106) place the cumulative distortion in the wartime Net National Product deflator
at 9.4%, while Rockoff and Mills (1987, pp. 201-3) place it between that value and 4.8%.
3
4
risk of erosion of asset values resulting from inflation—and the need to guard
against such losses—are minimized, households are encouraged to save more
and businesses are encouraged to invest more.
More specifically, as Ben Bernanke (2006, p. 2) observed in a lecture several
years ago, besides reducing the costs of holding money, stable prices
allow people to rely on the dollar as a measure of value when making longterm contracts, engaging in long-term planning, or borrowing or lending for
long period. As economist Martin Feldstein has frequently pointed out, price
stability also permits tax laws, accounting rules, and the like to be expressed
in dollar terms without being subject to distortions arising from fluctuations
in the value of money.
Feldstein (1997) had in fact reckoned the recurring welfare cost of a steady inflation
rate of just 2%—costs stemming solely from the adverse effect of inflation on the
real net return to saving—at about 1% of GNP.5
As Bernanke‘s remarks suggest, unpredictable changes in the price level have
greater costs than predictable changes. Benjamin Klein (1975) observed that,
although the standard deviation of the rate of inflation was only a third as large
between 1956 and 1972 as it had been from 1880 to 1915, inflation had also become
much more persistent. The price level had consequently become less rather than
more predictable since the Fed‘s establishment. Robert Barsky (1987) reported in
the same vein that, while quarterly U.S. inflation could be described as a whitenoise process from 1870-1913, it was positively serially correlated from 1919 to 1938
and from 1947 to 1959 (when the Fed was constrained by some form of gold
Lucas (2000), in contrast, put the annual real income gain from reducing inflation from 10% to zero
at slightly below 1 percent of GNP. The difference stems from Lucas‘s having considered inflation‘s
effect on money demand only, while overlooking its influence on effective tax rates, which play an
important part in Feldstein‘s analysis. Leijonhufvud (1981) and Horwitz (2003) discuss costs of
inflation, including those of ―coping‖ with high inflation environments and those connected to
inflation‘s tendency to distort relative prices, that elude measurement and are for that reason
overlooked by both Feldstein and Lucas.
5
5
standard), and has since become a random walk. These findings suggest that, as
the Fed gained greater control over long-run price level movements, those
movements became increasingly difficult to forecast.
Our own estimates from an ARMA (1,1) model yield conclusions similar to
Klein‘s. Although the standard deviation of inflation was greater before the Fed‘s
establishment than it has been since World War II, the postwar inflation process
includes a large (that is, above 0.9) autoregressive component, whereas that
component was small and negative before 1915 (see Table 1).6 Relatively small
postwar inflation-rate innovations have consequently been associated with
relatively large steady-state changes in the price level (see Figure 2). A GARCH
(1,1) model of the errors from the ARMA model accordingly reveals a stark
difference between the conditional variance of the inflation process before and since
the Fed‘s establishment, with almost no persistence in the variance of inflation
prior the Fed‘s establishment, and a very high degree of persistence afterwards, and
especially since the closing of the Fed‘s gold window (Table 1, second panel).7
Lastly, by treating six-year rolling standard deviations for quarterly inflation and
price-level series as proxies for the uncertainty associated with each, we confirm
Klein‘s finding that, while the rate of inflation has tended to become more
predictable as inflation has become more persistent, forecasting future price levels
has generally become more difficult, with the degree of difficulty increasing with the
These findings are based on Balke and Gordon‘s (1986) quarterly GNP deflator estimates spliced to
the Department of Commerce deflator series in the fourth quarter of 1946. Hanes (1999) argues that
pre-Fed deflator estimates understate somewhat the serial correlation of pre-Fed inflation, while
overstating the volatility of pre-Fed inflation, owing to their disproportionate reliance upon
(relatively pro-cyclical) prices of ―less-processed‖ goods.
7 The coefficient on the ARCH(1) term for the pre-Fed period is not significantly different from zero.
In the event that it is indeed zero, the GARCH(1) coefficient is not identified.
Although Cogley and Sargent (2002) and several other researchers reported a decline in the
persistence of inflation coinciding with the beginning of the Great Moderation, Pivetta and Reis
(2007, p. 1354), using a more flexible, non-linear Bayesian model of inflation dynamics and several
different measures of persistence, find ―no evidence of a change in [inflation] persistence in the
United States‖ since 1965, save for ―a possible short-lived change during the 1982-1983 period.‖
6
6
forecast horizon (Figure 3). The conditional variances implied by the GARCH model
are shown in Figure 4.8
The last panel of Figure 4 makes it especially easy to appreciate why
corporate securities of very long (e.g. 100-year) maturities, which were common in
decades just prior to the passage of the Federal Reserve Act, have become much less
common since. To the extent that its policies discouraged the issuance of longerterm corporate debt, the Fed can hardly be credited with achieving ―moderate longterm interest rates.‖9
IV. Deflation
While it has failed to prevent inflation, the Fed has also largely succeeded,
since the Great Depression, in eliminating deflation, which was a common
occurrence under the pre-Fed, post Civil War U.S. monetary system. Between 1870
and 1896, for example, U.S. prices fell 37%, or at an average annual rate of 1.2%
(Bordo et al. 2004, and Figure 1, panel 2).
The postwar eradication of deflation would count among the Fed‘s
achievements were deflation always a bad thing. But is it? Many economists
appear to assume so. But a contrasting view, supported by a number of recent
studies, holds that deflation may be either harmful or benign depending on its
underlying cause. Harmful deflation—the sort that goes hand-in-hand with
depression—results from a contraction in overall spending or aggregate demand for
goods in a world of sticky prices. As people try to rebuild their money balances they
Concerning the difficulty of forecasting inflation in recent years especially see Stock and Watson
(2007).
9 For more recent and international evidence of the negative effect of inflation on firm debt maturity
see Demirgüç-Kunt and Maksimovic (1999). As one might expect, the post-1983 ―Great Moderation‖
(discussed further below) revitalized some previously moribund markets for very long term corporate
debt. Thus Disney‘s 1993 ―Sleeping Beauty Bonds‖ became the first 100-year bonds to be issued
since 1954. The more recent decline in U.S. Treasury bond yields has also added to the
attractiveness of very long-term corporate debt. Indeed, on August 24, 2010, Norfolk Southern
managed to sell $250 million worth of century bonds bearing a record low yield of just 5.95 percent,
despite the risks involved. Still many investors remained skeptical. As one portfolio manager
opined (Financial Times August 24, 2010), ―You are giving a company money for a long period of
time with no ability to foresee the conditions in that period of time and for a very low interest rate.‖
8
7
spend less of their income on goods. Slack demand gives rise to unsold inventories,
discouraging production as it depresses equilibrium prices. Benign deflation, by
contrast, is driven by improvements in aggregate supply—that is, by general
reductions in unit production costs—which allow more goods to be produced from
any given quantity of factors and which are therefore much more likely to be
quickly and fully reflected in corresponding adjustments to actual (and not just
equilibrium) prices.10
Historically, benign deflation has been the far more common type. Surveying
the 20th-century experience of 17 countries, including the United States, Atkeson
and Kehoe (2004, p. 99) find ―many more periods of deflation with reasonable
growth than with depression, and many more periods of depression with inflation
than with deflation.‖ Indeed, they conclude ―that the only episode in which there is
evidence of a link between deflation and depression is the Great Depression (19291934).‖ This finding stands in stark contrast with the more common view
exemplified by Ben Bernanke‘s (2002a) assertion, in a speech aimed at justifying
the Fed‘s low post-2001 funds target, that ―Deflation is in almost all cases a side
effect of a collapse in aggregate demand—a drop in spending so severe that
producers must cut prices on an ongoing basis in order to find buyers.‖
Atkeson and Kehoe‘s arresting conclusion depends on their having looked at
inflation and output growth statistics averaged across five-year time intervals and
over a sample of 17 countries. There have in fact been other 20th-century instances
in which deflation coincided with recession or depression in individual countries
over shorter time intervals. In the U.S. this was certainly the case, for example,
during the intervals 1919-1921, 1937-1938, 1948-1949 (Bordo and Filardo 2005, pp.
814-19), and, most recently, 2008-2009. It remains true, nonetheless, that taking
both 19th and 20th-century experience into account, it is, as Bordo and Filardo (ibid.,
Selgin (1997) presents informal arguments for permitting benign (productivity-driven) deflation,
while Edge, Laubach, and Williams (2007), Schmidt-Grohé and Uribe 2007, and Entekhabi (2008)
offer formal arguments. For the history of thought regarding benign deflation see Selgin (1996).
10
8
p. 834) observe, ―abundantly clear that deflation need not be associated with
recessions, depressions, and other unpleasant conditions.‖
Although the classical gold standard made deflation far more common before
the Fed‘s establishment than afterwards, episodes of ―bad‖ deflation were actually
less common under that regime than they were during the Fed‘s first decades (ibid.,
p. 823). Benign deflation was the rule: downward price level trends, like that of
1873-1896, mainly reflected strong growth in aggregate supply. Occasional
financial panics did, however, give rise to brief episodes of bad deflation. We take
up below the question of whether the Fed has succeeded in mitigating such panics.11
Taking these findings into account, the Fed‘s record with respect to deflation
does not appear to compensate for its failure to contain inflation. It has, on the one
hand, practically extinguished the benign sort of deflation, replacing it with
persistent inflation that masks the true progress of productivity. On the other
hand, it bears some responsibility for several of the most severe episodes of harmful
deflation in U.S. history.
V. Volatility of Output and Unemployment
If the Fed has not used its powers of monetary control to avoid undesirable
changes in the price level, has it at least succeeded in stabilizing real output? Few
claim that it did so during the interwar period, which was by all accounts the most
turbulent in U.S. economic experience.12 In fact, according to the standard
(Kuznets-Kendrick) historical GNP series, thanks to that turbulent interval the
cyclical volatility of real output (as measured by the standard deviation of GNP
from its Hodrick-Prescott filter trend) has been somewhat greater throughout the
full Fed sample period than it was during the pre-Fed (1869-1914) period.
The predominance of benign over harmful deflation appears to have been still more marked in the
UK and Germany, owing perhaps to those countries‘ less crisis-prone banking systems (Bordo, Lane,
and Redish 2003).
12 On the volatility of macroeconomic series during the interwar period see especially Miron (1989),
who, comparing the quarter centuries before and after the Fed‘s founding, finds that stock prices,
inflation, and the growth rate of output all became considerably more volatile, while average growth
declined, and concludes that ―the deterioration of the performance of the economy after 1914 can be
attributed directly to the actions of the Fed.‖
11
9
The same data also support the common claim (e.g. Burns 1960; Bailey 1978;
De Long and Summers 1986; Taylor 1986) that the Fed has made output
considerably more stable since WWII than it was before 1914 (Table 2, row 1 and
Figure 5, first panel). Christina Romer‘s (1986a, 1989, 2009) influential work has,
however, cast doubt even on this more attenuated claim. According to her, the
Kuznets-Kendrick pre-1929 real GNP estimates overstate the volatility of pre-Fed
output relative to that of later periods, in part because they are based on fewer
component series than later estimates and because they conflate nominal and real
values, but mainly because the real component series are almost exclusively for
commodities, the output of which is generally much more volatile than that of other
kinds of output. From 1947 to 1985, for example, commodity output as a whole was
about two and a third times more volatile than real GNP.
According to Romer‘s own pre-1929 GNP series, which relies on statistical
estimates of the relationship between total and commodity output movements
(instead of Kuznets‘ naïve one-to-one assumption), the cyclical volatility of output
prior to the Fed‘s establishment was actually lower than it has been throughout the
full (1915-2009) Fed era (Table 2, row 2 and Figure 5, second panel). More
surprisingly, pre-Fed (1869-1914) volatility (as measured by the standard
deviations of output from its H-P trend) was also lower than post-World War II
volatility, though the difference is slight.13
Complementary revisions of historical unemployment data by Romer (1986b)
and J.R. Vernon (1994a), displayed here in Figure 6, likewise suggest that the post1948 stabilization of unemployment apparent in Lebergott‘s (1964) standard series
is an artifact of the data. Because Vernon‘s revised unemployment series is based
on the Balke-Gordon (1986) real GNP series, which is more volatile than Romer‘s
GNP series, and because his series includes the relatively volatile 1870s, Vernon
By looking at standard deviations of output after applying the Hodrick Prescott filter, rather than
simply looking at the standard deviation of the growth rate of output, we allow for gradual changes
in the sustainable or ―potential‖ growth rate of real output, and thereby hope to come closer to
isolating fluctuations in output traceable to monetary disturbances. Concerning the general merits
of the Hedrick-Prescott filter relative to other devices for isolating the cyclical component of GNP
and GDP time series see Baxter and King (1999).
13
10
finds a somewhat larger difference between 19th century and postwar
unemployment volatility than that reported by Romer. Nevertheless he finds that
his estimates ―indicate depressions for the 1870s and 1890s which are appreciably
less severe than the depressions perceived for these periods by economists such as
Schumpeter and Lebergott‖ (ibid., p. 707).
Romer‘s revisions have themselves been challenged by others, however,
including Zarnowitz (1992, pp. 77-79) and Balke and Gordon (1989).14 The lastnamed authors used direct measures of construction, transportation, and
communication sector output during the pre-Fed era, along with improved
consumer price estimates, to construct their own historic GNP series. According to
this series, the standard deviation of real GNP from its H-P trend for 1869 to 1914
is 4.27%, which differs little from the standard–series value of 5.10%. Balke and
Gordon‘s findings thus appear to vindicate the traditional (pre-Romer) view (Table
2, row 3, and Figure 5, third panel).
More recent work helps to resolve the contradictory findings of Romer on one
hand and Balke and Gordon on the other. Rather than rely on conventional
aggregation procedures to construct historic (pre-1929) real GDP estimates, Ritschl,
Sarferaz and Uebele (2008) employ ―dynamic factor analysis‖ to uncover a latent
common factor capturing the co-movements in 53 time series that have been
consistently reported since 1867. According to their benchmark model, which
assumes that the coefficients (―factor loadings‖) relating individual series to the
latent factor are constant, there was in fact ―no change in postwar volatility relative
to the prewar [that is, pre-World War I] period‖ (ibid., p. 7). Allowing instead for
Although Zarnowitz (1992, p. 78) agrees that, because they are based on ―cyclically sensitive‖
series, the standard (Kuznets-Kendricks) GNP estimates ―exaggerate the fluctuations in the
economy at large,‖ he claims that, in deriving her own estimates by ―simply imposing recent patterns
on the old data,‖ Romer ―precludes any possibility of stabilization, thus making her conclusion
inevitable and prejudging the issue in question.‖ Rhode and Sutch (2006, p. 15) repeat the same
criticism. But Romer‘s method does not rule out the possibility of stabilization any more than that
used in deriving the standard series does: both approaches take for granted a constant ratio of
commodity output volatility to general output volatility. The difference is that, while Romer
estimates the constant, Kuznets implicitly assumed a value of one. That Romer‘s estimate
necessarily reflects postwar structural relationships hardly renders her approach more restrictive
than, much less inferior to, Kuznets‘s.
14
11
time-varying factor loadings (and hence for gradual structural change), Ritschl et al.
find that post-WWII volatility was a third greater than pre-Fed volatility (ibid., p.
29, Table 1). These findings reinforce Romer‘s conclusions.15 But Ritschl et al. are
also able to reproduce Balke and Gordon‘s postwar moderation using a common
factor based on their non-agricultural real time series only, which resemble the
series Balke and Gordon rely upon for their GNP estimates. Here again, the
moderation vanishes if factor loadings are allowed to vary. Balke and Gordon‘s
finding of a substantial reduction in post-WWII output volatility relative to pre-Fed
volatility thus appears to depend on their focus on industrial output and implicit
assumption that the relative importance of different components of that output
hasn‘t changed.
Even if one accepts the Balke-Gordon GNP estimates, it does not follow that
the Fed deserves credit for (belatedly) stabilizing real output. It may be that
aggregate supply shocks, the real effects of which monetary policy is unable to
neutralize, were relatively more important before 1914 than they have been since
World War II. The effects of this reduced role for supply shocks might then be
misinterpreted as evidence of the Fed‘s success in limiting output variations by
stabilizing aggregate demand.
Using the Balke-Gorden output series, John Keating and John Nye (1998)
estimate a bivariate vector autoregression (VAR) model of inflation and output
growth for the U.S. over the periods 1869 to 1913 and 1950 to 1994. They then
identify aggregate demand and supply shocks by assuming, in the manner of
Blanchard and Quah (1989), that supply shocks alone have permanent real effects,
which allows them to decompose the variance of output into separate supply- and
demand-shock components. Doing so they find that aggregate supply shocks were
of overwhelming importance in the earlier period, accounting for 95% of real
output‘s conditional forecast error variance at all horizons (Keating and Nye, Table
3, p. 246). During the post-World War II period, in contrast, the fraction of output‘s
The findings are, as one might expect, robust to the exclusion of nominal time series from the
study.
15
12
forecast error variance attributable to supply shocks has been just 5% at a one-year
horizon, rising to only 68% after a full decade (ibid., Table 2, p. 240).
Keating and Nye (1998) themselves, however, question the validity of these
findings because, according to their identification scheme, a positive pre-Fed
―supply‖ shock causes the price level to increase rather than to decline. But this
seemingly ―perverse‖ comovement may simply reflect the tendency, under the
international gold standard regime, for supply shocks involving exportable
commodities, such as cotton, to translate into enhanced exports and thus into
increased gold inflows (see Davis, Hanes, and Rhode 2009). A more recent study by
Michael Bordo and Angela Redish (2004) allows for this possibility by extending the
Keating-Nye model to include a measure of the pre-Fed money stock and by
assuming that the price level is uninfluenced in the long run by either aggregate
supply or aggregate demand shocks at the national level—an assumption consistent
with the workings of the international gold standard. According to their estimates,
which again rely upon Balke and Gordon‘s quarterly output data, aggregate supply
shocks accounted for 89% of pre-Fed output variance at a one-year horizon and for
almost 80% of such variance after ten years. These findings differ little from
Keating and Nye‘s for the pre-Fed period.
Bordo and Redish examine the pre-Fed era only, and so do not offer a
consistent comparison of it with the post-World War II era. To arrive at such a
comparison, while shedding further light on the Fed‘s contribution to postwar
stability, we constructed a VAR model allowing for four distinct macroeconomic
shocks—to aggregate supply, the IS schedule, money demand, and the money
supply—which are identified using different and plausible identifying restrictions
for the pre-Fed and post-World War II sample periods. Using this model (and
relying once again on the Balke-Gordon GNP estimates) we find that aggregate
supply shocks account for between 81 and 86 percent of the forecast error variance
of pre-Fed output up to a three-year horizon, as opposed to less than 42% of the
13
variance after World War II (Table 3).16 In terms familiar from recent discussions
of the causes of the post-1983 ―Great Moderation‖ in output volatility (discussed
below), our findings suggest that the post-WWII period taken as a whole enjoyed
better ―luck‖ than the pre-Fed period.
Our model also shows no clear improvement after World War II in the
dynamic response of output to aggregate demand shocks. Whereas one might expect
the Fed, in its role as output stabilizer, to tighten the money supply in the face of
positive IS (spending) shocks and to expand it in response to positive shocks to
money demand, the response functions we estimate indicate instead that the Fed
has tended to expand the money stock in response to IS shocks, causing larger and
more persistent deviations of output from its ―natural‖ level than would have
occurred in response to similar shocks during the pre-Fed period (Figure 7, lefthand-side panels). At the same time, the Fed was less effective than the classical
gold standard had been in expanding the money supply in response to
unpredictable reductions in money‘s velocity.
Fiscal stabilizers, whether ―automatic‖ or deliberately aimed at combating
downturns, are also likely to have contributed to reduced output volatility since the
Fed‘s establishment, when state and federal government expenditures combined
constituted but a fifth as large a share of GDP as they did just before the recent
burst of stimulus spending (Figure 8). Thus DeLong and Summers (1986) claim
that the decline in U.S. output volatility between World War II and the early 1980s
was due not to improved monetary policy but to the stabilizing influence of
progressive taxation and countercyclical entitlements. Subsequent research (e.g.
Gali 1994; Fatas and Mihov 2001; Andres, Domenech and Fatas 2008; and Mohanty
and Zampolli 2009) documents a pronounced (though not necessarily linear)
relationship between government size and the volatility of real output. According to
For details see Lastrapes and Selgin (2010). Numerous other studies employing a variety of
identification schemes, also find that demand shocks have been of overwhelming importance during
the post-World War II period. See for example, Blanchard and Watson (1986), Blanchard and Quah
(1989), Hartley and Whitt (2003), Ireland (2004), and Cover, Enders, and Hueng (2006). A notable
exception is Gali (1992) who, using a combination of short- and long-run identifying restrictions,
finds that supply shocks were more important. None of these studies examines the pre-Fed period.
16
14
Mohanty and Zampoli, a 10% increase in the government‘s share of GDP was
associated with a 21% overall decline in cyclical output volatility for 20 OECD
countries during 1970-1984.17
Fiscal stabilizers appear, on the other hand, to have played no significant
part in the post-1984 decline in output volatility (as well as in both the average rate
and the volatility of inflation) known as the ―Great Moderation.‖ Consequently that
episode seems especially likely to reflect a genuine if belated improvement in the
conduct of monetary policy. We next turn to research concerning that possibility.
VI. The “Great Moderation”
The beginning of Paul Volcker‘s second term as Fed Chairman coincided
with a dramatic decline in the volatility of real output that lasted through the
Greenspan era. Annual real GDP growth, for example, was less than half as
volatile from 1984 to 2007 as it was from 1959 to 1983. The inflation rate, having
been reduced to lower single digits, also became considerably less volatile. Many,
including Blinder (1998), Romer (1999), Sargent (1999) and Bernanke (2004), have
regarded this ―Great Moderation‖ of inflation and real output as evidence of a
substantial improvement in the Fed‘s conduct of monetary policy—a turn to what
Blinder (1998, p. 49) terms ―enlightened discretion.‖18 Bernanke, conceding that
the high inflation in the 1970s and early 1980s was largely due to excessive
monetary expansion aimed at trying to maintain a below-natural rate of
unemployment, argues similarly that Fed authorities learned over the course of
that episode that they could not exploit a stable Phillips curve, while Romer (1999,
p. 43) claims that after the early 1980s the Fed ―had a steadier hand on the
macroeconomic tiller‖ (Romer 1999, p. 43).
While government size is generally negatively correlated with the volatility of output growth, it
also appears to be negatively correlated with output growth itself. Thus Afonso and Furceri (2008)
find, based on estimates for the period 1970-2004, that for the OECD countries a one percentage
point increase of the share of government expenditure to total GDP was associated with a .12
percentage point decline in real per capita growth. To this extent at least automatic stabilizers
appear to be a poor substitute for a well-working monetary regime.
18 See also Clarida, Gali, and Gertler (2000).
17
15
The ―enlightened discretion‖ view has, however, been challenged by
statistical studies pointing to moderating forces other than improved monetary
policy.19 A study by Stock and Watson (2002, p. 200; see also idem. 2005) attributes
between 75% and 90% of the Great Moderation in U.S. output volatility to ―good
luck in the form of smaller economic disturbances‖ rather than improved monetary
policy. Subsequent research has likewise tended to downplay the contribution of
improved monetary policy, either by lending support to the ―good luck‖ hypothesis
or by attributing the Great Moderation to financial innovations, an enhanced
―buffer stock‖ role for manufacturing inventories, an increase in the importance of
the service sector relative to that of manufacturing, a change in the age composition
of the U.S. population, and other sorts of structural change.20 As usual, there are
exceptions, prominent among which is the study of Gali and Gambetti (2009), which
finds that improved monetary policy, consisting of an increased emphasis on
inflation targeting in setting the federal funds target, did play an important part in
the Great Moderation.
Most authorities do attribute the substantial decline in both the mean rate of
inflation and in inflation volatility since the early 1980s to improved monetary
policy. Yet even here the contribution of enlightened monetary policy may be less
than it appears to be: according to Barro and Gordon‘s (1983) theory of monetary
policy in the presence of a time-inconsistent temptation to improve current-period
real outcomes using surprise inflation, the higher the natural rate of
unemployment, the greater the inflationary bias in the conduct of monetary policy,
Bernanke himself offered his thesis as a plausible conjecture only, without attempting to test it
against alternatives.
20 See, among many other works on the topic, McConnell and Perez-Quiros (2000), Ahmed, Levin,
and Wilson (2004), Alcala and Sancho (2004), Irvine and Schuh (2005), Dynan, Elmendorf, and
Sichel (2006), Sims and Zha (2006), Arias, Hansen, and Ohanian (2007), Leduc and Sill (2007), Davis
and Kahn (2008), Jaimovich and Siu (2009), Liu, Waggoner, and Zha (2009), Fernández-Vallaverde,
Guerrón-Quintana, and Rubio-Ramirez (2010), and Moro (2010). Besides attributing the Great
Moderation to a ―fantastic concatenation of [positive output] shocks‖ rather than to improved policy
the last of these studies reaches the more startling conclusions that ―there is not much evidence of a
difference in monetary policy among Burns, Miller, and Greenspan,‖ and that, had Greenspan been
in command in 70s, a somewhat greater rate of inflation would have been observed (ibid., pp. 4 and
33).
19
16
other things equal. According to Ireland (1999) and to Chappell and McGregor
(2004), both the actual course of inflation in the 1970s and afterwards and the
arguments on which the FOMC based its decisions conform to the predictions of the
theory of time-inconsistent monetary policy.21
In the presence of supply shocks, moreover, the time-inconsistency
framework implies that higher inflation will be accompanied by a more marked
―stabilization bias,‖ and hence by greater inflation volatility. Richard Dennis
(2003; see also Dennis and Söderström 2006) explains:
to damp the inflationary effect of the adverse supply shock, central bankers
have to raise interest rates more today, generating more unemployment than
they would if they could commit themselves to implement the tight policy
that they promised. In this scenario, the effect of the time-inconsistency is
called stabilization bias because the time-inconsistency affects the central
banker's ability to stabilize inflation expectations and hence stabilize
inflation itself. The stabilization bias adds to inflation's variability, making
inflation more difficult for households, firms, and the central bank, to predict.
As Chappell and McGregor observe (2004, pp. 249-50), to the extent that the
Great Moderation conforms with the predictions of the theory of time inconsistency,
that moderation supplies no grounds for complacency about the Fed:
According to King and Morley‘s (2007) recent estimates, the natural rate of unemployment, having
peaked at over 9% in 1983, fell to less than half that level by 2000. Earlier estimates of the natural
rate show a similar pattern, though with smaller amplitude.
The argument summarized here is complemented by that of Orphanides and Williams (2005)
and Primiceri (2006) to the effect that a combination of a heavy emphasis on activist employment
stabilization and mistakenly low estimates of the natural rate of unemployment informed monetary
policy decisions that led to double digit inflation in the 70s and early 80s. In the later 80s, in
contrast, the natural unemployment rate was overestimated or at least no longer underestimated.
See also Surico (2008). Of course these arguments don‘t by themselves rule out the possibility of
negative cyclical movements in inflation that are independent of changes to the natural rate of
unemployment, such as are likely to accompany a financial crisis like the recent one.
21
17
Policy-makers may have greater appreciation for the importance of
maintaining price stability, but the fundamental institutions by which
monetary policy decisions are made have not changed, nor has the broader
political environment. Shocks similar to those that emerged in the 1970s
could do so again. While Blinder (1997) would comfort us with the argument
that the time inconsistency problem is no longer relevant, a more
troublesome interpretation is possible. The current time-consistent
equilibrium is more pleasant than the one prevailing in the 1970s, not just
because the Fed is more enlightened, but also because of a fortunate
confluence of exogenous and political forces.
Recent experience has, of course, made it all too evident that prior reports of
the passing of macroeconomic instability were premature. According to Todd
Clarke (2009, p. 5) statistics gathered since the outbreak of the subprime crisis
reveal ―a partial or complete reversal of the Great Moderation in many sections of
the U.S. economy‖ (ibid., p. 7). Clarke himself, in what amounts to the flip-side of
the Stock-Watson view, characterizes the reversal as a ―period of very bad luck,‖
asserting (ibid, p. 25) that ―once the crisis subsides … improved monetary policy
that occurred in years past should ensure that low volatility is the norm‖ (ibid., p.
27; compare Canarella et al. 2010). Those who believe, in contrast, that ―luck‖ was
no less important a factor in the moderation as it has been in the recent reversal, or
who (like Taylor 2009a) see the subprime crisis itself as a byproduct of irresponsible
Fed policy, are unlikely to share Clarke‘s optimism.
VII. Frequency and Duration of Recessions
Some of the hazards involved in attempting to compare pre- and post-Federal
Reserve Act measures of real volatility can be avoided by instead looking at the
frequency and duration of business cycles. Doing so, Francis Diebold and Glenn
Rudebusch (1992, pp. 993-4) observe, ―largely requires only a qualitative sense of
18
the direction of general business activity‖ while also allowing one to draw on
indicators apart from those used to construct measures of aggregate output.
The conventional (NBER) business cycle chronology suggests that
contractions have been both substantially less frequent and substantially shorter on
average, while expansions have been substantially longer on average, since World
War II than they were prior to the Fed‘s establishment. Because it is based on
aggregate series that avoid the excessive volatility of conventional pre-Fed output
measures (Romer 1994, p. 582 n.28), and because it only classifies contractions of
some minimum duration and amplitude as business cycles, the chronology does in
fact avoid some of the dangers involved in comparing pre-Fed and post-WWII
output volatility.
The NBER‘s chronology has nonetheless been faulted for seriously
exaggerating both the frequency and the duration of pre-Fed cycles and for thereby
exaggerating the Fed‘s contribution to economic stability. According to Christina
Romer (ibid., p. 575), whereas the NBER‘s post-1927 cycle reference dates are
derived using data in levels, those for before 1927 are based on detrended data.
This difference alone, Romer notes, results in a systematic overstatement of both
the frequency and the duration of early contractions compared to modern ones.22
The NBER‘s pre-1927 indexes of economic activity, upon which its pre-Fed
chronology depends, are also based in part on various nominal time series which
(for reasons considered above) are a further source of bias (ibid., p. 582; also Watson
1994).
Using both the Fed‘s and an adjusted version of her and Jeffrey Miron‘s
indexes of industrial production (Miron and Romer 1990), Romer arrives at a new
set of reference dates that ―radically alter one‘s view of changes in the duration of
contractions and expansions over time‖ (ibid., p. 601). According to this new
Decades before Romer, George W. Cloos (1963, p. 14) observed, in the course of a considerably
more trenchant evaluation of the NBER‘s business cycle dating methods, ―that the gross national
product and the Federal Reserve Board‘s industrial production index are usable measures of general
business activity and that peaks and troughs in these series are to be preferred to the Bureau‘s
peaks and troughs.‖
22
19
chronology, although contractions were indeed somewhat more frequent before the
Fed‘s establishment than after World War II (though not, it bears noting, more
frequent than in the full Federal Reserve sample period), they were also almost
three months shorter on average, and no more severe. Recoveries were also faster,
with an average time from trough to previous peak of 7.7 months, as compared to
10.6 months. Allowing for the recent, 18-month-long contraction further
strengthens these conclusions. And while the new dates still suggest that
expansions have lasted longer since World War II than before 1914, that difference,
besides depending mainly on one exceptionally long expansion during the 1960s
(ibid., p. 603), is also much less substantial than is suggested by the NBER‘s dates.
Because the Miron and Romer industrial production series begins in 1884,
Romer does not attempt to revise earlier business cycle dates. That project has,
however, been undertaken more recently by Joseph Davis (2006) who, using his own
annual series for U.S. industrial production for 1796 to 1915 (Davis 2004), finds no
discernible difference at all between the frequency and average duration of
recessions after World War II and their frequency and average duration throughout
the full National Banking era. Besides suggesting that the NBER‘s recessions of
1869-70, 1887-88, 1890-91, and 1899-1900 should be reclassified as growth cycles
(that is, periods of modest growth interrupting more pronounced expansions)
Davis‘s chronology goes further than Romer‘s in revising the record concerning the
length of genuine pre-Fed contractions, in part because it goes further in
distinguishing negative output growth from falling prices. The change is most
glaringly illustrated by the case of the recession of 1873. According to NBER‘s
chronology, that recession lasted from October 1873 to May 1879, making it by far
the longest recession in U.S. history, and therefore an important contributor to the
conclusion that recessions have become shorter since the Fed‘s establishment.
According to Davis‘s chronology, in contrast, the 1873 recession lasted only two
years, or just six months longer than the subprime contraction.23
Some experts go even further than the NBER in confusing deflation with depression. For example,
FRB Dallas President Richard Fisher refers during a February 2009 CSPAN interview to the ―long
23
20
In comparing pre- and post-Federal Reserve Act business cycles we have
again tended to set aside the interwar period, as if allowing for a long interval
during which the Fed had yet to discover its sea legs. Nevertheless the Fed‘s
interwar record, and especially its record during the Great Depression, cannot be
overlooked altogether in a study purporting to assess its overall performance. And
that record was, by most modern accounts, abysmal. The truth of Friedman and
Schwartz‘s (1963, pp. 299ff.) thesis that overly restrictive Fed policies were
responsible for the ―Great Contraction‖ of the early 1930s is now widely accepted
(e.g. Bernanke 2002b; Christiano, Motto, and Rostagno 2003), as is their claim that
the Fed interfered with recovery by doubling minimum bank reserve requirements
between August 1936 and May 1937. Romer (1992) has shown, furthermore, that
although monetary growth was, despite the Fed‘s interference, the factor most
responsible for such recovery as did take place between 1933 and 1942, that growth
was based, not on any expansionary moves on the part of the Fed, but on gold
inflows from abroad prompted first by the devaluation of the dollar and then by
increasing European political instability.24
Some economic historians, most notably Barry Eichengreen (1992), have
blamed the Great Depression in the United States on the gold standard rather than
on the Fed‘s misuse of its discretion, claiming that the Fed had to refrain from
further monetary expansion in order to maintain the gold standard. But Elmus
Wicker (1996, pp. 161-2) finds that gold outflows played only a minor role in the
banking panics that were the proximate cause of the monetary collapse of 19301933, while Bordo, Choudri, and Schwartz (2002) show that, even had there been
perfect capital mobility (which was far from being the case), open market purchases
on a scale capable of having prevented that collapse would not have led to gold
outflows large enough to pose a threat to convertibility. Hsieh and Romer (2006),
depression‖ of 1873-1896 (http://www.c-span.org/Watch/watch.aspx?ProgramId=Economy-A-40471).
Concerning the myth of a ―Great Depression‖ of 1873 to 1896 see Shields (1969) and, for Great
Britain, Saul (1969).
24 According to Robert Higgs (2009), despite the gold inflows of the ‗30s and unprecedented wartime
government expenditures the U.S. private economy did not fully recover from the Great Depression
until after World War II.
21
finally, draw on both statistical and narrative evidence to examine and ultimately
reject the specific hypothesis that the Fed was compelled to refrain from
expansionary policies out of fear that expansion would provoke a speculative attack
on the dollar. Instead, they conclude (ibid., p. 142), ―the American Great Depression
was largely the result of inept policy, not the inevitable consequence of a flawed
international monetary system.‖25
VIII. Banking Panics
If the Fed has not reduced the overall frequency or average duration of
recessions, can it nonetheless be credited with reducing the frequency of banking
panics and hence of the more severe recessions that tend to go along with such
panics? A conventional view holds that the Fed did indeed make panics less
common by eliminating the currency shortages and associated credit crunches that
were notorious features of previous panics; and Jeffrey Miron‘s research (1986)
appears to support this view by showing how, in its early years at least, the Fed did
away with the seasonal tightening of the money market, and consequent spiking
interest rates, that characterized the pre-Fed era.
However, more recent and consistent accounts of the incidence of banking
panics suggest that the Fed did not actually reduce their frequency. Andrew Jalil
(2009) concludes, on the basis of one such new reckoning, ―that contrary to the
conventional wisdom, there is no evidence of a decline in the frequency of panics
during the first fifteen years of the existence of the Federal Reserve‖ (ibid., p. 3).
That is, there was no reduction between 1914 and 1930, and hence none until the
conclusion of the national bank holiday toward mid March of 1933. Jali‘s findings
agree with Elmus Wicker‘s conclusion, based on his comprehensive analyses of
financial crises between the Civil War and World War II (Wicker 1996, 2000), that
previous assessments had exaggerated the frequency of pre-Fed banking panics by
In particular, the 1930s Fed has been faulted for having regarded low nominal interest rates and
high bank excess reserves as proof that money was sufficiently easy (Wheelock 1989). Scott Sumner
(2009) argues that the Fed repeated the same mistake in 2008.
25
22
counting among them episodes in ―money market stringency coupled with a sharp
break in stock prices‖ or collective action by the New York Clearinghouse but no
widespread bank runs or failures‖ (ibid. 2000, p. xii). In fact, Wicker states,
there were no more than three major banking panics between 1873 and 1907
[inclusive], and two incipient banking panics in 1884 and 1890. Twelve years
elapsed between the panic of 1861 and the panic of 1873, twenty years
between the panics of 1873 and 1893, and fourteen years between 1893 and
1907: three banking panics in half a century! And in only one of the three,
1893, did the number of bank suspensions match those of the Great
Depression (ibid.)
In contrast, Wicker (1996) elsewhere reports, the first three years of the Great
Depression alone witnessed five major banking panics. No genuine post-1913
reduction in banking panics, or in total bank suspensions, took place until after the
national bank holiday of March 1933; and credit for that reduction belongs, not to
the Fed, but to the RFC (which purchased $1.1 billion in preferred stock from some
6500 banks between March 1933 and May 1934) and, starting on January 1, 1934,
deposit insurance (Figure 8). ―As the RFC and FDIC became more important to
stabilizing the banking system,‖ financial historian Robert Lynn Fuller (2009, p.
535) observes, ―the Federal Reserve Bank [sic] became less so…because its primary
purpose—to provide liquidity to the system—had become irrelevant in a system
awash in liquidity.‖26
Besides supplying a more accurate account of the frequency of banking panics
before and after the Fed, Jalil‘s chronology of panics allows him to revise the record
concerning the bearing of panics on the severity and duration of recessions.
Whereas DeLong and Summers (1986), employing their own series for the incidence
of panics between 1890 and 1910, conclude that banking panics played only a small
Having been obliged to borrow $3 million from the Fed to meet their legal reserve requirements in
February 1932, the Fed‘s member banks afterwards equipped themselves with ample excess
reserves: even on the eve of the national bank holiday they held reserves equal to 112.8 percent of
requirements (Fuller 2009, p. 540).
26
23
part in the pre-Fed business cycle, Jalil (2009, p. 34) finds that they were a
―significant source of economic instability.‖ Nearly half of all business cycle
downturns before World War II involved panics, and those that did tended to be
both substantially more severe and longer-lasting than those that didn‘t: between
1866 and 1914, recessions involving major banking panics were on average almost
three times as deep, with recoveries on average taking almost three times as long,
as those without major panics (ibid., p. 35).27 This evidence suggests that, by
serving to eliminate banking panics, deposit insurance also served, for a time at
least, to reduce the frequency of severe recessions. This fact in turn points to the
need for a further, downward reassessment of the Fed‘s post-1933 contribution to
economic stabilization.
Finally, those banking panics and accompanying, severe recessions that did
occur before 1914 were not inescapable consequences of the absence of a central
bank. Instead, according to Wicker (2000, p. xiii) and Eugene White (1993), among
others, banking panics both then and afterwards were fundamentally due to
misguided regulations, including laws prohibiting both statewide and interstate
branch banking. Besides limiting opportunities for diversification, legal barriers to
branch banking, together with the reserve requirement stipulations of National
Banking Act, encouraged interior banks to count balances with city correspondents
as cash reserves. The consequent ―pyramiding‖ of reserves in New York, combined
with inflexible minimum reserve requirements and the ―inelasticity‖ of the stock of
national bank notes (which had to be more than fully backed by increasingly
expensive government bonds, and which could not be expanded or retired quickly
even once the necessary bonds had been purchased owing to delays in working
through the Office of the Comptroller of the Currency) all contributed to frequent
The precise figures are: average percentage decline in output, 12.3% for recessions involving
major panics, 4.5% otherwise; average length of recovery, 2.7 years for recessions involving major
panics, 1 year otherwise. The length of recovery is the interval from the trough of the recession to
recovery of the pre-downturn peak.
27
24
episodes of money market stringency, some of which resulted in numerous bank
suspensions, if not in full-blown panics.
Other nations‘ experience illuminates the role that misguided regulations,
including those responsible for the highly fragmented structure of the U.S. banking
industry, played in making the U.S. system uniquely vulnerable to panics. Michael
Bordo (1986) reports that, among half a dozen western countries he surveyed (the
others being the U.K., Sweden, Germany, France, and Canada), the U.S. alone
experienced banking crises; and Charles Calomiris (2000, chap. 1), also drawing on
international evidence, attributes the different incidence of panics to differences in
banking industry organization.
Given its proximity to and economic integration with the U.S., Canada‘s
experience is especially revealing. Unlike the U.S., which had almost 2000 (mainly
unit) banks in 1870, and almost 25,000 banks on the eve of the Great Depression,
Canada never had more than several dozen banks, almost all with extensive branch
networks. Between 1830 and 1914 (when Canada‘s entry into WWI led to a run on
gold anticipating suspension of the gold standard), Canada experienced few bank
failures and no bank runs. It also had no bank failures at all during the Great
Depression, and for that reason experienced a much less severe contraction of
money and credit than the U.S. did. Although the latter outcome may have
depended on government forbearance and implicit guarantees which, according to
Kryznowski and Roberts (1993), made it possible for many Canadian banks to stay
open despite being technically insolvent for at least part of the Great Depression
period,28 the fact remains that Canada was able to avoid banking panics without
resort to either a central bank or explicit insurance.29
Kryznowski and Roberts (1993) claim that nine out of Canada‘s ten banks were insolvent on a
market-value basis for most of the 1930s. Wagster (2009), in contrast, concludes based on a different
approach they were insolvent only during 1932 and 1933.
29 The Bank of Canada was established in 1935, not in response to the prior crisis but, according to
Bordo and Redish (1987), to appease an increasingly powerful inflationist lobby.
Canadian banks‘ relative freedom from restrictions on their ability to issue banknotes also
contributed to their capacity to accommodate exceptional demands for currency. In the U.S., in
contrast, national banks were unable to issue notes at all after 1935, and were severely limited in
their ability to do so before the onset of the Great Depression. State bank notes had been subject to
28
25
IX. Last-Resort Lending
That the Federal Reserve System was not the only solution to pre-Fed
banking panics, that it may in fact have been inferior to deregulatory reforms aimed
at allowing the U.S. banking and currency system to develop along stronger,
Canadian lines, and that credit for the absence of panics after 1933 mainly belongs
not to the Fed but to deposit insurance, doesn‘t rule out the possibility that the Fed
has occasionally contributed to financial stability by serving as a lender of last
resort (LOLR).
The traditional view of the lender of last resort role derives from Walter
Bagehot (1873). In Bagehot‘s view a LOLR is a second-best remedy for a banking
system weakened by legal restrictions, including those awarding monopoly
privileges to favored banks (first-best to Bagehot was a minimally restricted and
hence stronger system like Scotland‘s).30 The LOLR can help prevent financial
panics, without creating serious moral hazard, by supporting illiquid but not
insolvent banks. Bagehot‘s classical rules for last-resort lending instructed the
Bank of England to extend credit ―freely and vigorously,‖ but only to borrowers that
passed a solvency test (Bagehot‘s was posting ―good banking securities‖ as
collateral), and only at a higher-than-normal rate of interest. As Brain Madigan,
Director of the Federal Reserve‘s Division of Monetary Affairs, has noted,
―Bagehot‘s dictum can be viewed as having a sound foundation in microeconomics‖:
Specifically, lending only to sound institutions and lending only against good
collateral sharpen firms‘ incentives to invest prudently in order to remain
solvent. And lending only at a penalty rate preserves the incentive for
borrowers to obtain market funding when it is available rather than seeking
recourse to the central bank (Madigan 2009, p. 1).
a prohibitive tax since 1866. Concerning the politics behind the decision to suppress state bank
notes, and the economic consequences of that decision, see Selgin (2000).
30 Why, then, did Bagehot recommend that the Bank of England serve as a LOLR instead of
recommending removal of its monopoly privileges? Because, as he put it at the close of Lombard
Street (1873, p. 329), ―I am quite sure that it is of no manner of use proposing to alter [the Bank of
England‘s constitution]. ... You might as well, or better, try to alter the English monarchy and
substitute a republic.‖
26
In Bagehot‘s day the solvency requirement was intended to protect the thenprivate Bank of England‘s shareholders from losing money on last-resort loans.
Today it serves to protect taxpayers from exposure to public central bank losses.
Judged from a Bagehotian perspective, how well has the Fed performed its
LOLR duties? According to Thomas Humphrey (2010), a former Federal Reserve
economist and an authority on classical LOLR doctrine, it has performed them very
badly indeed, honoring the classical doctrine ―more in the breach than in the
observance‖ (ibid., p. 22). While Humphrey does identify episodes, including the
October 1987 stock market crash, the approach of Y2K, and (in some respects) the
aftermath of 9/11, in which the Fed seems to have followed Bagehot‘s advice, he
notes that this has not been its usual practice.31
During the Great Depression, for example, the Fed departed from Bagehot‘s
doctrine first by failing to lend to many solvent but illiquid banks, and later (in
1936-7) by deliberately reducing solvent banks‘ supply of liquid free reserves (ibid.,
p. 23). Since then, it has tended to err in the opposite direction, by extending credit
to insolvent institutions. The Fed made large discount window loans to both
Franklin National and Continental Illinois before their spectacular failures in 1974
and 1984, respectively; and between January 1985 and May 1991 it routinely
offered extended credit to banks that supervisory agencies considered in imminent
danger of failing. Ninety percent of these borrowing banks failed soon afterwards
(United States House of Representatives 1991; Schwartz 1992).
During the subprime crisis, Humphrey observes, the Fed ―deviated from the
classical model in so many ways as to make a mockery of the notion that it is a
LOLR‖ (Humphrey 2010, p. 1). It did so by knowingly accepting ―toxic‖ assets, most
notably mortgage-backed securities, as loan collateral, or by purchasing them
outright without subjecting them to ―haircuts‖ proportionate to the risk involved,
31Some
would add the New York Fed‘s rescue of the Bank of New York following its November 1985
computer glitch. We instead classify this as overnight ―adjustment‖ lending, reserving the term ―last
resort‖ for more extended lending. Concerning the Fed‘s last-resort lending operations after 9/11,
Lacker (2004, p. 956) notes that, while these generally conformed to classical requirements, the Fed
extended discount window credit at below market rates.
27
and by supplying funds directly to firms understood to be insolvent (ibid, pp. 24-28;
see also Feldstein 2010, pp. 136-7).32 As the two panels of Figure 10 show, until
September 2008 the Fed also sterilized its direct lending operations through
offsetting Fed sales of Treasury securities, in effect transferring some $250 billion
in liquid funds from presumably solvent firms to potentially insolvent ones—a
strategy precisely opposite Bagehot‘s, and one that tended to spread rather than to
contain financial distress (Thornton 2009a, 2009b; also Hetzel 2009 and Wheelock
2010, p. 96). This strategy may ultimately have harmed even the struggling
enterprises it was supposed to favor, for according to Daniel Thornton (2009b, p. 2),
if instead of attempting to reallocate credit the Fed had responded to the financial
crisis by significantly increasing the total amount of credit available to the market,
―the failures of Bear Stearns, Lehman Brothers, and AIG may have been avoided
and, so too, the need for TARP.‖ Moreover, according to several authorities, it was
thanks to TARP itself, or rather to the gloom-and-doom warnings Ben Bernanke
issued in his effort to secure the passage of TARP, that ―[a] relatively modest
contraction of economic activity due to … the deflation of house prices became the
Great Recession‖ (Goodfriend 2010, p. 18; also Taylor 2009a, pp. 25-30).
In September 2008 the Fed at last turned from sterilized to unsterilized
lending, and on such a scale as resulted in a doubling of the monetary base over the
course of the ensuing year. At the same time, however, it began paying interest on
excess reserves, thereby increasing the demand for such reserves, while also
arranging to have the Treasury sell supplemental bills and deposit the proceeds in a
special account. Thanks in part to these special measures bank lending, nominal
The insolvent firms included Citigroup and AIG. The way was paved toward the recent departures
from Bagehot‘s ―sound security‖ requirement for last-resort lending by a 1999 change in section 16 of
the Federal Reserve Act, which allowed the Fed to receive as collateral any assets it deemed
―satisfactory.‖ The change was originally intended to provide for emergency lending in connection
with Y2K, for which it proved unnecessary.
32
28
GDP, and the CPI, instead of responding positively to the doubling of the monetary
base, plummeted (Figure 11).33
Finally, rather than pursue a consistent policy—a less emphasized but not
less important component of Bagehot‘s advice—the Fed unsettled markets by
protecting the creditors of some insolvent firms (Bear Stearns) while allowing
others (Lehman Brothers) to suffer default. Former Fed Chairman Paul Volcker
(2008, p. 2) remarked, in the aftermath of the Fed‘s support (via its wholly owned
subsidiary Maiden Lane I) of J.P. Morgan Chase‘s purchase of Bear Stearns, that
the Fed had stretched ―the time honored central bank mantra in time of crisis—
‗lend freely at high rates against good collateral‘—to the point of no return.‖
The Fed has been increasingly inclined to lend to insolvent banks in part
because creditworthy ones have been increasingly able to secure funding in private
wholesale markets. As Stephen Cecchetti and Titi Disyata (2010) observe, under
modern circumstances ―a bank that is unable to raise funds in the market must,
almost by definition, lack access to good security for collateralized loans.‖ Prior to
the recent crisis, the development of a well-organized interbank market ready to
lend to solvent banks led many economists (Friedman 1960, pp. 50-51; Goodfriend
and King 1988; Kaufman 1991; Schwartz 1992; Lacker 2004, p. 956ff.) to declare
the Fed‘s discount window obsolete and to recommend that it be shut for good,
leaving the Fed with no lender of last resort responsibility save that of maintaining
system-wide liquidity by means of open market operations, while relying upon
private intermediaries to distribute liquid funds in accordance with Bagehot‘s
precepts. Notwithstanding Cecchetti and Disyatat‘s (2010, p. 12) claim that ―a
systemic event almost surely requires lending at an effectively subsidized
rate…while taking collateral of suspect quality,‖ open-market operations have in
Keister and McAndrews (2009), while conceding that both the unprecedented growth in banks‘
excess reserve holdings and the related collapse of the money multiplier were consequences of the
Fed‘s October 2008 ―policy initiatives,‖ including its decision to begin paying interest on reserves,
also insist that ―concerns about high levels of reserves are largely unwarranted‖ on the grounds that
the reserve buildup ―says little or nothing about the programs‘ effects on bank lending or on the
economy more broadly.‖ Perhaps: but bank lending and nominal GDP data do say something about
the programs‘ broader effects, and what they say is that, taken together, the programs were in fact
severely contractionary.
33
29
fact proven capable of preserving market liquidity even following such major
financial shocks as the failure of the Penn Central Railroad, the stock market crash
of October 1987, the Russian default of 1998, Y2K, and the 9/11 terrorist attacks.34
The subprime crisis has, however, led many experts to conclude that it is
Bagehot‘s precepts, rather than direct central bank lending to troubled firms, that
have become obsolete. Some justify recent departures from Bagehot‘s rules, or at
least from strict reliance on open-market operations, on the grounds that the crisis
was one in which the wholesale lending market itself was crippled, so that even
solvent intermediaries could not count on staying liquid had the Fed supplied
liquidity through open market operations alone. ―With financial institutions
unwilling to lend to one another,‖ argues Kenneth Kuttner (2008, p. 2; compare
Kroszner and Melick 2010, pp. 4-5), ―the Fed had no choice but to step in and lend
to institutions in need of cash.‖ Years before the crisis Mark Flannery and George
Kaufman (1996, p. 821) made the case in greater detail:
The discount window‘s unique value arises when disarray
strikes private financial markets. If lenders cannot confidently assess
other firms‘ conditions, they may rationally withdraw from the
interbank loan market, leaving solvent but illiquid firms unable to
fund themselves. …In response to this sort of financial crisis,
government may need to do more than assure adequate liquidity
through open market operations. Broad, short-term [N.B.] discount
window lending, unsecured and at (perhaps) subsidized rates, may
constitute the least-cost means of resolving some types of widespread
financial uncertainties.
In the Penn Central case, the Fed was prepared to supply discount window loans if necessary, and
even invoked the 1932 clause allowing it to lend to non-bank institutions so as to be able to lend to
Penn Central itself. But it did not actually make any last-resort loans (Calomiris 1994). In that of
the 9/11 attacks, the Fed supplied $38 billion in overnight credit to banks on the day of the attacks
because the Fed had not anticipated any need for open market operations. But in subsequent days
the open-market desk made up the deficiency, and discount window borrowing returned to more-orless normal levels (Lacker 2004).
34
30
But even when ordinary open-market market operations appear insufficient,
it doesn‘t follow that direct Fed lending, let alone lending at subsidized rates to
presumably insolvent firms, is necessary. Instead, the scope of Fed liquidity
provision can be broadened by relaxing its traditional ―Treasuries only‖ policy for
open-market operations to allow for occasional purchases of some or all of the
private securities it deems acceptable as collateral for discount window loans.35
Willem Buiter and Anne Sibert (2008) argue that such a modification of the Fed‘s
open-market policy—what they term a ―market maker of last resort‖ policy—would
have sufficed to re-liquify nonbank capital markets, and primary dealers especially,
while heeding both Bagehot‘s principles and the stipulations of the Federal Reserve
Act. It would also have avoided any need for the TAF, the TSLF, special purchase
vehicles, and other such ―complicated method[s] of providing liquidity‖ that
unnecessarily exposed the Fed ―to the temptation to politicize its selection of
recipients of its credit‖ (Bordo 2009, p. 118) while compromising its independence
(Thornton, Hubbard, and Scott 2009; Bordo 2010; Goodfriend 2010).36
Even the potential failure of financial institutions deemed ―systematically
important‖ doesn‘t necessarily warrant departures from classical LOLR precepts.
Consider the case of Continental Illinois, the first rescue to be defended on the
grounds that certain financial enterprises are ―too big to fail.‖ Although the FDIC
claimed, in the course of Congressional hearings following the rescue, that the
holding company‘s failure would have exposed 179 small banks to a high risk of
Strictly speaking, the Fed‘s open-market policy has been one of ―Treasuries and gold and foreign
exchange only.‖ As David Marshall (2002) explains, Fed officials at one time preferred to confine its
open market operations to private securities, including bankers‘ and trade acceptances and private
bills of exchange, owing in part to their fear that extensive government debt holdings would
compromise the Fed‘s independence. In fact the Fed first began purchasing substantial quantities of
Treasury securities on the open market in response to pressure from the Treasury following U.S.
entry into World War I. The ―Treasuries only‖ policy dates from the 1930s. For further details see
Marshall (ibid) and Small and Clouse (2005).
36 According to Buiter (2010), private security purchases conducted by means of reverse Dutch
auctions would guarantee purchase prices reflecting illiquid securities‘ fundamental values but
sufficiently ―punitive‖ to guard against both moral hazard and excessive Fed exposure to credit risk.
Cecchetti and Disyatat (2010), in contrast, claim that ―liquidity support will often be, and probably
should be, provided at a subsidized rate when it involves a liquid asset where a market price cannot
be found.‖
35
31
failure, subsequent assessments by the House Banking Committee and the GAO
placed the number of exposed banks at just 28. A still later study by George
Kaufman (1990, p. 8) found that only two banks would have lost more than half of
their capital. The 1990 failure of Drexel Burnham Lambert had no systemic
consequences, and there is no evidence, also according to Kaufman (2000, p. 236),
that the failure of Long Term Capital Management eight years later ―would have
brought down any large bank if the Fed had provided liquidity during the
unwinding period through open market operations‖ while also backing the
counterparties‘ unwinding plan.
During the subprime crisis financial enterprises far larger than either
Continental or Drexel Lambert either failed or were threatened with failure. Yet
there are doubts concerning whether even these cases posed systemic risks that
could only be contained by direct support of the firms in question. When it was
placed into FDIC receivership in September 2008, Washington Mutual was five
times larger, on an inflation-adjusted basis, than Continental Illinois at the time of
its failure. Still the FDIC was able, after wiping out its shareholders and most of its
secured bondholders, to sell it to J.P. Morgan Chase without either inconveniencing
its customers or disrupting financial markets (Tarr 2010).37
Or consider Lehman Brothers. It was one of the largest dealers in credit
default swaps [CDSs]. Peter Wallison (2009a, p. 6; see also Tarr 2010) nevertheless
found ―no indication that any financial institution became troubled or failed‖
because of its failure.38 Wallison explains:
Continental Illinois failed with $40 billion in assets, equivalent to $85 billion in 2008 dollars, as
compared to the $307 billion in assets of Washington Mutual and $812 billion of Wachovia when
those firms were resolved. Likewise, Drexel Burnham Lambert had $3.5 billion in assets in 1990, or
the equivalent of $6 billion in 2008 dollars, while the assets of Lehman Brothers at the time of its
failure amounted to $639 billion.
38 As Tarr (2009, p. 5) notes, the same conclusion was reached by the international Senior
Supervisory Group (SSG), which reported as well that the failures of Fannie May and Freddie Mac
―were managed in an orderly fashion, with no major operational disruptions or liquidity problems.‖
On the success of chapter 11 as a means for resolving Lehman Brothers see Whalen (2009).
37
32
Lehman‘s inability to meet its obligations did not result in the ―contagion‖
that is the hallmark of systemic risk. No bank or any other Lehman
counterparty seems to have been injured in any major respect by Lehman‘s
failure, although of course losses occurred… . Although there were media
reports that AIG had to be rescued shortly after Lehman‘s failure because it
had been exposed excessively to Lehman through credit default swaps
(CDSs), these were inaccurate. When all the CDSs on Lehman were settled
about a month later, AIG‘s exposure turned out to be only $6.2 million.
Moreover, although Lehman was one of the largest players in the CDS
market, all its CDS obligations were settled without incident.
Wallison‘s statement should be amended to allow for the fact that on the
Tuesday following Lehman‘s Monday bankruptcy filing, the Reserve Primary
money-market mutual fund, having written off its large holdings of unsecured
Lehman paper (and having lacked sponsors capable of making up for the loss), had
to reduce its share price below the pledged $1 level to 97 cents. Reserve Primary‘s
―breaking the buck‖ led to several days of large redemptions from other (especially
institutional) prime money-market funds, and thereby to a sharp drop in the
demand for commercial paper. Significantly, government money-market funds,
including Treasury-only funds, experienced inflows; and it is possible that the
redemptions would have subsided on their own as it became clear that most funds
would remain able to meet all redemption requests at $1 per share. The Treasury
nevertheless intervened on Friday to guarantee all money-market share prices at
$1.39
In deciding not to rescue Lehman Brothers, the Fed abided by the classical
rules of last-resort lending. It earlier chose, on the other hand, to rescue the
creditors of Bear Stearns by paying about $30 billion for the firm‘s worst assets so
According to Baba, McCauley, and Ramaswamy (2009, p. 76), although they benefitted from
neither the U.S. Treasury guarantee or the Fed‘s money market fund liquidity facility established on
the same day, ―European–domiciled dollar MMFs generally experienced runs not much worse than
those on similar US prime institutions with the same manager.‖
39
33
that J. P. Morgan Chase would purchase the firm and assume its debts. Later it
also chose to rescue AIG. On what grounds did it determine that Bear Stearns and
AIG were ―too big to fail,‖ while Lehman Brothers was not?40 Bear Stearns, like
Lehman Brothers, was an investment bank, and AIG was an insurance company
and CDS issuer. Both firms had played highly risky strategies and were caught
out. Neither was a commercial bank involved in retail payments, and neither
performed functions that couldn‘t have been performed just as well by other private
firms. Creditors and counterparties stood to lose, but it isn‘t clear that many of the
numerous broker-dealers and hedge funds that did business with Bear Stearns
would not have survived its default or that the failure of some of them would have
had extensive knock-on effects. In fact, the Fed has never explained the precise
nature of the ―systemic risk‖ justifying its intervention in these instances. Nor has
it ever made public its criteria for determining which failures posed a systemic
threat that could not be handled in classical fashion.
The Fed‘s departures from classical doctrine also do not seem to have been
very effective in achieving its short-run objective. The rescue of Bear Stearns did
not keep Lehman or AIG from toppling. Instead, it appears to have encouraged
those firms to leverage up further by persuading reassured creditors to lend to them
even more cheaply. In any event, the Fed‘s actions did not suffice to substantially
improve conditions in the money market. The root of the problem was not a lack of
liquidity but of solvency. As Kuttner (2008, p. 7) and many others have observed,
―no amount of liquidity will revive lending so long as financial institutions lack
sufficient capital.‖
The Fed‘s unprecedented violations of classical LOLR doctrine during the
recent crisis threaten ultimately to further undermine financial stability both by
impeding its ability to conduct ordinary monetary policy and by contributing to the
moral hazard problem. Regarding the former problem Kuttner (ibid., p. 12) writes,
Wallison (2009b, p. 3) writes that although Goldman Sachs was AIG‘s largest CDS counterparty,
with contracts valued at $12.9 billion, a spokesman for Goldman declared that, had AIG been
allowed to fail, the consequences for Goldman ―would have been negligible.‖
40
34
Saddling the Fed with bailout duties obscures its core objectives,
unnecessarily linking monetary policy to the rescue of failing institutions.
Moreover…loan losses could compromise the Fed‘s independence and thus
weaken its commitment to price stability in the future.
In light of such considerations it would be better, according to Kuttner, ―to return to
Bagehot‘s narrower conception of the LOLR function, and turn over to the Treasury
the responsibility for the rescue of troubled institutions, as this inevitably involves
a significant contingent commitment of public funds.‖
But the most important costs that must be set against any possible short-run
gains from Fed departures from classical LOLR doctrine consist of the moral hazard
problems caused by such departures, including the problem of zombie institutions
gambling for recovery. As Kaufman (2000, p. 237) puts it: ―there is little more costly
and disruptive to the economy than liquid insolvent banks that are permitted to
continue to operate.‖ It is a common misconception to think that imposing losses on
management and shareholders, while shielding counterparties and creditors, is
enough to contain moral hazard. So long as bank creditors can expect high returns
on the upside, with implicit government guarantees against losses on the downside,
they will lend too cheaply to risky poorly diversified banks, making overly high
leverage (thin capital) an attractive strategy. Normal market discipline against
risk-taking is thus significantly undermined (see Roberts 2010). Already by 2002,
according to one estimate (Walter and Weinberg 2002), more than 60% of all U.S.
financial institution liabilities, including all those of the 21 largest bank holding
companies, were either explicitly or implicitly guaranteed. Overly risky financial
practices were a predictable consequence. As Charles Calomiris (2009a) observes,
the extraordinary risks taken by managers of large financial firms between 2003
and 2007 were the result, not of ―random mass insanity‖ but of moral hazard
resulting in large part from the Fed‘s willingness—implicit in previous practice—to
depart from classical last-resort lending rules to rescue creditors of failed firms.
35
Likewise, according to Buiter (2010, p. 599), although unorthodox Fed
programs may have succeeded in enhancing market liquidity during 2007 and 2008,
some, including the TAF, the TSLF, the PDCF, the opening of the discount window
to Fannie and Freddie, and the rescue of Bear Stearns, appear ―to have been
designed to maximize bad incentives for future reckless lending and borrowing by
the institutions affected by them.‖41 Far from being an unquestionably worthwhile
departure from classical last-resort lending rules, the unprecedented granting of
support to insolvent firms during the subprime crisis may well prove the most
serious of all failures of the Federal Reserve System.42
X. Alternatives to the Fed, Past and Present
Our review of the Fed‘s performance raises two very distinct questions: (1)
might the United States have done better than to have established the Fed in 1914,
and (2) might it do better than to retain it today? While the first question is of
interest to economic historians, the second should be of interest to policymakers.
The questions are distinct because the choice context has changed. One
major change is that the gold standard is no longer in effect. Under the gold
standard, the scarcity of the ultimate redemption medium was a natural rather
than a contrived scarcity. The responsibilities originally assigned to the Fed did not
need to include, and in fact did not include, that of managing the stock of money or
the price level. The gold standard ―automatically‖ managed those variables under a
regime of unrestricted convertibility of banknotes and deposits into gold. The Fed‘s
principal assignments were to maintain the unrestricted convertibility of its own
liabilities and to avoid panics that threatened the convertibility of commercial bank
liabilities.
As of April 2009, the combined value of Treasury, FDIC, and Fed capital infusions and guarantees
extended in connection with the subprime crisis was $4 trillion (Tarr 2009, p. 3).
42See also Brewer and Jagtiani 2009. The FDIC Improvement Act of 1991 endeavored to limit the
problem of excessive guarantees, including excessive Fed lending to insolvent banks, by amending
the Federal Reserve Act through inclusion of a new rule (10B) penalizing the Fed for making all save
very short-term loans to undercapitalized banks. However, an exception was made for banks
judged TBTF. In mid-2008, however, banks being operated by the FDIC were exempted from the
rule, largely defeating its purpose.
41
36
Consequently it is relatively easy to identify viable alternatives to the
adoption of the Federal Reserve Act in 1913. At a minimum, the continuation of
the status quo was an option. In light of the severe Great Contraction of the early
1930s under the Fed‘s watch, worse than any of the pre-Fed panics, Friedman and
Schwartz (1963, pp. 168-172 and 693-4) argued that continuing the pre-Fed status
quo would have had better results. Under the pre-1908 status quo panic
management was handled by commercial bank clearinghouse associations. The
clearinghouses lent additional bank reserves into existence, met public demand for
currency by issuing more, and when necessary coordinated suspensions of
convertibility to prevent systemic contraction (Timberlake 1993, pp. 198-213).
According to Elmus Wicker (2000, pp. 128-9), a ―purely voluntary association of New
York banks that recognized its responsibility for the maintenance of banking
stability was a feasible solution to the bank panic problem.‖ In particular, Wicker
maintains, the Gilded Age might have been rendered entirely panic-free had the
1873 recommendations of New York Clearing House Association, as contained in
the so-called ―Coe Report‖ recommending that Congress formally grant the New
York Clearing House Association authority to oversee the efficient allocation of
member banks‘ reserves during crisis.
Congress did in fact implement a reform along the lines suggested by the Coe
Report in the shape of the 1908 Aldrich Vreeland Act, which assigned the issue of
emergency currency, which was illegal for clearinghouses but clearly helpful, to
official National Currency Associations that could lawfully do what the
clearinghouses had been doing without legal authority. The system of emergency
currency issue by National Currency Associations had one test, when the onset of
the First World War incited a sharp demand for currency in 1914 before the Fed
was up and running, and it passed the test well (Silber 2007).
An alternative, deregulatory alternative to a central bank also received
serious attention in the decades prior to the passage of the Federal Reserve Act.
This was a plan endorsed by the American Bankers Association at its 1894
convention in Baltimore and henceforth known as ―the Baltimore Plan.‖ The
37
Baltimore Plan basically viewed the panic-free and less-regulated Canadian
banking system as a model (Eugene White 1983, pp. 83-90; Bordo, Redish, and
Rockoff 1996; Calomiris 2000, ch. 1). Under a system devised to sell government
bonds during the Civil War, federally chartered (―National‖) banks were required to
hold backing for their notes in the form of federal bonds. The backing requirement
increasingly constrained the issue of notes as the eligible bonds became increasingly
scarce. (State-chartered banks were prevented from issuing notes by a prohibitive
federal tax.) Reformers for good reason viewed this requirement as the source of
the notorious secular and seasonal ―inelasticity‖ of the National Bank currency
(Noyes 1910; Smith 1936). Under the Baltimore Plan, federally chartered banks
would have been allowed to back their note liabilities with ordinary bank assets, a
reform that some proponents called ―asset currency.‖
The Baltimore Plan was blocked in the political arena by the power of a
vested interest, the small bank lobby. Asset currency reformers worried that a
surfeit of currency might arise if the existing restrictions on note-issue were lifted
without any accompanying system for drawing excess currency out of circulation.
They observed that Canada‘s nationwide-branched banks were an efficient notecollection system, and so favored not only Canadian-style deregulation of note-issue
but also deregulation of bank branching. They failed to overcome the political clout
of the small bankers who were determined to block branch banking (Eugene White
1983, pp. 85-89; Selgin and White 1994).
Coming up with alternatives to the Fed today takes more imagination.
Assuming that there is no political prospect of replacing the fiat dollar with a return
to the gold standard or other commodity money system, for the dollar to retain its
value some public institution must keep fiat base money sufficiently scarce. In this
respect at least, our finding that the Fed has failed does not by itself indicate that it
would be practical to entirely dispense with some sort of public monetary authority.
But neither does it indicate that the only avenues for improvement are marginal
revisions to Fed operating procedures or additions to its powers. On the contrary,
the Fed‘s poor record calls for seriously contemplating a genuine change of regime.
38
In particular it strengthens the case for pre-commitment to a policy rule that would
constrain the discretionary powers that the Fed has used so ineffectively. Whether
implementing such a new regime should be called ―ending the Fed‖ is an
unimportant question about labels.
A detailed blueprint or assessment of any particular policy rule would be out
of place here, but it is useful to sketch some alternatives that merit consideration,
to underscore the point that the Fed as presently constituted carries an opportunity
cost.43
XI. Contemporary Alternatives to Discretionary Monetary Policy
The general case for a monetary rule is well known. Milton Friedman (1961)
and Robert E. Lucas, Jr. (1976) argued empirically and theoretically that the Fed
lacks the informational advantage over private agents that it would need to outforecast them and improve their welfare through activist policy. Finn Kydland and
Edward Prescott (1977) made the point that even a well-informed and benevolent
central bank is weakened by lack of pre-commitment when the public in forming its
inflation expectations takes into account the central bank‘s temptation to use
surprise inflation to improve the economy‘s unemployment or real output. At the
most philosophical or jurisprudential level, the case for a constitutional constraint
on monetary policy-makers derives from the general case for ―the rule of law rather
than rule by authorities.‖ The rule of law means constraints against arbitrary
governance so that citizens can know what to expect from their government (White
2010). John Taylor (2009b, p. 6) writes: ―More generally, government should set
clear rules of the game, stop changing them during the game, and enforce them.
The rules do not have to be perfect, but the rule of law is essential.‖
In suggesting alternatives to the Fed that ―merit consideration,‖ we deliberately exclude proposals
that would merely transfer powers of discretionary monetary control from the Fed to Congress. Like
Blinder (2010, p. 126) and many others, we believe that an independent central bank is likely to
produce superior macroeconomic performance than one under Congressional influence. We disagree,
on the other hand, with Professor Blinder‘s suggestion that, because he wants to ―End the Fed,‖
Congressman Ron Paul must not appreciate the advantages of an independent central bank over a
dependent one.
43
39
XI.1. Commodity standards
Based on its long history, the gold standard warrant consideration as an
alternative to discretionary central banking.44 Dismissals of the gold standard as a
viable option have often been based on flawed assessments of its past performance
(see Kydland and Wynn 2002, pp. 7-9). The instability in the U.S. financial system
during the pre-Fed period was due to serious flaws in the U.S. bank regulatory
system rather than to the gold standard. Indeed, the Federal Reserve Act, which
retained the gold standard, was predicated on this view. Canada adhered to a gold
standard during the same period, but with a differently regulated banking system
experienced no such instability.
Perhaps the leading indictment of the gold standard today is Barry
Eichengreen and Peter Temin‘s (2000) charge that it was ―a key element—if not the
key element—in the collapse of the world economy‖ at the outset of the Great
Depression. Here it is important to distinguish a classical gold standard from the
structurally flawed interwar gold exchange standard. The latter was created by
European governments to assist their misguided (and ultimately futile) attempts to
restore prewar gold parties despite having pushed up prices dramatically by use of
printing-press finance during wartime suspensions of gold redeemability. The
massive deflation that became unavoidable when France ceased to play along with
the precarious postwar arrangement (Johnson 1997; Irwin 2010) was not a failing of
the classical gold standard. Neither were postwar exchange controls or ―beggar thy
neighbor‖ trade policies.45
It is an automatic system like the classical gold standard that is worth
reconsidering, certainly not the interwar system. The classical gold standard did
We forgo the opportunity to discuss proposals for multi-commodity standards, which have the
disadvantage of being untried and less well understood.
44
As one Bank of England official (H.R. Siepmann) observed in a 1927 memorandum, referring
obliquely to the Bank of France‘s policies, ―If one country decides to revert to the [classical] Gold
Standard, it may lay claim to more gold than there is any reason to expect the gold centre to have
held in reserve against legitimate Gold Exchange Standard demands. What is then endangered is
not merely the working of the Gold Exchange Standard, but the Gold Standard itself. Such a violent
contraction may be provoked that gold will be brought into disrepute as a standard of value‖
(Johnson 1997, p. 133). This is, in fact, precisely what happened.
45
40
not depend on central bank cooperation—indeed many leading participants did not
even have central banks—so it was less vulnerable to defection by any particular
central bank, and therefore more credible, than the interwar arrangement (Obstfeld
and Taylor 2003). Although Eichengreen and Temin (2000) acknowledge the
benefits of the prewar gold standard, they never explain why it was necessary to
abandon the gold standard altogether rather than to simply allow for one-time
devaluations by the countries that had suspended and inflated.
A second indictment of the gold standard derives from fear of secular
deflation. We noted above the importance of distinguishing benign from harmful
deflation, while also observing that the secular deflation that characterized much of
the classical gold standard period was benign, accompanying vigorous real growth.
It is true that spokesmen for the interests of farmers complained about secular
deflation. They appear to have believed, mistakenly, that overall deflation was
lowering their real or relative incomes, as though nominal rather than the real
factors were lowering the prices of what they sold realative to the prices of what
they bought. Or they were seeking a bit of unexpected inflation to reduce ex post
the real value of the debts they had incurred in farm mechanization. Their
complaints reflected misperception or special-interest pleading rather than any
genuine harm being done by a benign deflation (Beckworth 2007).
A third and long-standing objection to a gold standard by economists—the
main reason Keynes famously called it a ―barbarous relic‖—is that it needlessly
incurs resource costs in extracting and storing valuable metal for monetary use. A
fiat standard can in principle replicate a gold standard‘s price-level stability
without any such resource costs (Friedman 1953). In practice, however, fiat
standards have not replicated gold‘s price-level stability (Kydland and Wynne 2002,
p. 1). Nor, ironically, have they even lowered resource costs. The inflation rates of
postwar fiat standards have by themselves imposed estimated deadweight costs
greater than the reasonably estimated resource costs of a gold standard (White
1999, pp. 48-49). Meanwhile, the public has accumulated gold coins and bullion as
inflation hedges, adding more gold to private reserves than central banks have sold
41
from official reserves. The real price of gold is much higher today than it was under
the classical gold standard, encouraging the expansion of gold mining (Figure 12).
Thus the resource costs of gold extraction and storage for asset-holding purposes
have risen since the world‘s departure from the gold standard.
At least three serious problems do confront any proposal to return to a gold
standard. The first is choosing a gold definition of the dollar that avoids
transitional inflation or deflation (see White 2004). The second is securing a
credible commitment to gold. As James Hamilton has remarked,―[i]f a government
can go on a gold standard, it can go off, and historically countries have done exactly
that all the time. The fact that speculators know this means that any currency
adhering to a gold standard (or, in more modern times, a fixed exchange rate) may
be subject to a speculative attack‖ (Hamilton 2005). Hamilton (1988) has argued
that a drop in the credibility of governments‘ commitment to fixed parities, leading
to a speculative rise in the demand for gold, contributed to the international
deflation of the early 1930s. To remove the threat of speculative attack may require
the further reform of moving currency redemption commitments out of monopolistic
and legally immune (hence non-credible) central banks and returning them, as in
the pre-Fed era, to competing private issuers constrained by enforceable contracts
and reputational pressures (Selgin and White 2005).
The third problem, which argues against any nation‘s unilateral return to
gold, is that a principal virtue of the classical gold standard was its status as an
international standard. A single nation‘s return to gold would not reestablish a
global currency area, and would achieve only a relatively limited reduction in the
speculative demand for gold as an inflation hedge. As it would also fail to
substantially increase the transactions demand for gold, it could not be expected to
make the relative price of gold as stable as it was under the classical system (White
2008). To provide considerably greater stability than the present fiat-dollar regime,
42
a revived U.S. gold standard would probably need to be part of a broader
international revival.46
XI.2 Rule-bound fiat standards
Given that the postwar fiat standards managed by discretionary central
banks have generally failed to deliver the long-run price stability that was delivered
by the gold standard, Kydland and Wynne (2002, p. 1) ask whether a better fiat
regime is possible. They note that the ―hard pegs‖ of dollarization or currency
boards have proven successful at delivering more stable nominal environments in
countries that have adopted them. But, they naturally ask, ―What about the large
country, the ‗peggee‘? What rule or regime can a large country such as the United
States … adopt to guarantee long-term price stability?‖
A well known and very simple type of monetary rule is a fixed growth path
for M2, as advocated by Milton Friedman in the 1960s. It is arguably no longer
appropriate in the current environment where the velocity of M2 (or any other
monetary aggregate) is no longer stable. A number of more sophisticated rules that
accommodate unstable velocity have been more widely discussed in recent years.
(1) A Taylor Rule, which continuously updates the fed funds target according
to fixed formula based on measured departures of inflation and real output from
specified norms, can be viewed as a description of Fed policy over the recent past,
with notable exceptions. The exceptions, the departures from the fitted Taylor
Rule, appear to have been harmful (Taylor 2009a). A fed funds rate well below the
Taylor-Rule path for an extended period fosters an asset bubble; a rate too high
precipitates a recession. A firm commitment to a fully specified Taylor-type rule
could helpfully constrain monetary policy.
Although prospects for any such revival can only be judged remote, World Bank President Robert
Zoellick (2010) recently prompted renewed discussion of the merits of such a move by arguing that
proponents of a new Bretton-Woods type world monetary system (―Bretton Woods II) should consider
using the price of gold ―as an international reference point of market expectations about inflation,
deflation and future currency values.‖ Zoellick added that ―Although textbooks may view gold as the
old money, markets are using gold as an alternative monetary asset today."
46
43
(2) A McCallum Rule is similar to a Taylor Rule, except that the monetary
base (rather than the fed funds rate) is the instrument, and feedback comes from
base velocity growth and nominal income growth. A McCallum Rule amounts to a
type of nominal-income rule, with the corrective policy response to nominal income
above or below its target level fully specified in terms of adjustment to monetary
base growth. McCallum‘s (2000) simulation study claims that adhering to the rule
would have improved the economy‘s macroeconomic performance over the actual
performance under the Fed‘s discretionary policy-making.
(3) Scott Sumner (1989 and 2006; also Jackson and Sumner 2006) and Kevin
Dowd (1995) have each proposed constraining monetary policy to a nominal income
target. In contrast to McCallum‘s backward-looking feedback from observations on
realized nominal income, they propose forward-looking feedback from the expected
level of nominal income implied by futures markets indicators.
(4) Toward the end of his career Milton Friedman (1984) proposed simply
freezing the monetary base, and—reminiscent of the Canadian alternative in
1913—allowing seasonal and cyclical variations in the demand for currency relative
to income (variations in velocity‘s inverse) to be met by private note-issue.
XII. Contemporary Alternatives to a Public Lender of Last Resort
An important argument for retaining a discretionary central bank is that as a
lender of last resort the central bank can helpfully forestall panics or liquidity crises
in the commercial banking system. In the usual understanding, a lender of last
resort injects new bank reserves whenever a critical insufficiency of reserves would
otherwise arise. To evaluate the argument we need to ask why the banking system
might face insufficient reserves. Harry Johnson (1973, p. 97) pointed out that
commercial bankers should be presumed capable of optimizing their reserve
holdings:
At least in the presence of a well-developed capital market, and on the
assumption of intelligent and responsible monetary management by
44
the central bank, the commercial banks should be able to manage their
reserve positions without the need for the central bank to function as
―lender of last resort.‖
Johnson‘s ―well-developed capital market‖ refers to the fact that a U.S.
commercial bank with low reserves due to random outflows can quickly replenish its
reserves by borrowing overnight in the fed funds market. His ―assumption of
intelligent and responsible monetary management by the central bank‖ means
assuming that the central bank has not sharply reduced the monetary base and
thereby the total of available bank reserves. (The possibility of a crisis due to
contractionary central bank policy itself hardly justifies having a central bank.)
Under those conditions, a critical shortage of reserves in the banking system as a
whole implies an unexpected spike in the demand for reserve money, presumably
due either to banks raising their desired reserve ratios or to the public draining
reserves from the banking system.
A spike in demand for reserve money, left untreated, implies the shrinkage of
the money multiplier and thus of the broader monetary aggregates. What is called
the ―lender of last resort‖ can thus be viewed as an aspect of a central bank‘s remit
under a fiat standard to prevent the money stock from unexpectedly shrinking,
though one also directed at preserving the flow of bank credit by preventing solvent
financial firms from failing for want of adequate liquidity. A central bank with a
target for M1 or M2 automatically injects base money as the money multiplier
shrinks. A central bank pre-committed to a Taylor Rule or a nominal income target
does likewise.
A central bank in a modern financial system can readily make the necessary
reserve injections through open market purchases of securities. For reasons
considered above, it need not and generally should not make loans to particular
institutions, for the sake of avoiding moral hazard and favoritism. A central bank‘s
readiness to lend to troubled or otherwise favored banks, providing explicit or
implicit central bank bailout guarantees, promotes bad banking.
45
Jeffrey Lacker (2007) reminds us that nineteenth-century writers, like
Walter Bagehot who famously urged the Bank of England to lend to other banks in
times of credit stringency, ―wrote at a time when lending really was the only way
the central bank provided liquidity.‖ He continues:
Indeed, when the Fed was founded in 1913, discount window lending
was envisioned as the primary means of providing reserves to the
banking system. Today, the Fed's primary means of supplying reserves
is through open-market operations, which is how the federal funds rate
is kept at the target rate. In fact the effect of discount window loans on
the overall supply of liquidity is automatically offset, or "sterilized," to
avoid pushing the federal funds rate below the target. So it is
important to distinguish carefully a central bank's monetary policy
function of regulating the total supply of reserves from central bank
credit policy, which reallocates reserves among banks.
Given a monetary policy rule that automatically injects reserves to counteract an
incipient monetary contraction, and especially allowing for occasional (but
presumably rare) departures from a ―Treasuries only‖ open-market policy, there is
no need for a lender (as opposed to a ―market maker‖) of last resort. That is, the
Fed‘s discount window can be closed without impeding its role of maintaining
financial system liquidity. A case for keeping the discount window open would have
to be made on the (unpromising) grounds that the Fed should intervene in the
allocation of reserves among banks, or should use the window to lend cheaply (or
purchase assets at above-market prices) to inject capital into banks on the brink of
insolvency.
Historical evidence indicates that official discount-window lending is not
necessary to avoid banking panics, scrambles for liquidity characterized by
contagious runs on solvent institutions. Panics have been a problem almost
exclusively in countries where avoidable legal restrictions have weakened banks
46
(Selgin 1989; Benston and Kaufman 1995). The United States in the late 19th to
early 20th century is the prime example of a legislatively weakened and relatively
panic-prone system. Even in that system, clearinghouse associations limited the
damage done by panics by organizing liquidity-sharing and liquidity-creation
arrangements, including temporary resort to clearinghouse ―loan‖ certificates, and,
if necessary, by arranging for a suspension or ―restriction‖ of payments (Timberlake
1993, pp. 207-9; Dwyer and Gilbert 1989).47 Bagehot himself, as we noted
previously, did not see any need for a lender of last resort in a structurally sound
banking and currency system—though for him this meant a system in which
currency was not fiat money and was not supplied monopolistically.
Central bank lending that, contra Bagehot, puts insolvent institutions on life
support can be replaced by policies for promptly resolving financial institution
insolvencies. In recent years such proposals as expedited bankruptcy and ―living
wills,‖ possibly requiring that losses be borne by holders of subordinated debt or
―contingent capital certificates,‖ have been widely discussed (Board of Governors
1999; Calomiris 2009b; Flannery 2009). Outright bailouts, on ―too big to fail‖
grounds, can be left to the Treasury. As Kuttner (2008, p. 12) observes:
Saddling the Fed with bailout duties obscures its core objectives,
unnecessarily linking monetary policy to the rescue of failing
institutions… . In view of these concerns, it would be desirable to
return to Bagehot‘s narrower conception of the LOLR function, and
turn over to the Treasury the responsibility for the rescue of troubled
institutions, as this inevitably involves a significant contingent
commitment of public funds.
The option of suspending payments can also be a contractual feature of banking contracts, as it
was in the case of early Scottish banknotes bearing a so-called ―option-clause.‖ Concerning those, see
Gherity (1995) and Selgin and White (1997). On the potential incentive-compatibility of contractual
suspension arrangements--that is, their ability to rule-out panic-based runs—see Gorton (1985).
Although in Diamond and Dybvig‘s (1983) model and later studies based on it, including Ennis and
Keister (2009), suspension is suboptimal because it entails some disruption of optimal consumption,
this conclusion depends on the unrealistic assumption that people cannot shop using (suspended)
bank liabilities (Selgin 1993).
47
47
Such a reform, Kuttner adds (ibid., p. 13), would simplify the implementation of
monetary policy by avoiding bailout-based changes to the supply of bank reserves,
while reducing the risk of higher inflation or reduced Fed independence. 48
XIII. Conclusion
Available research does not support the view that the Federal Reserve
System has lived up to its original promise. Early in its career, it presided over
both the most severe inflation and the most severe (demand-induced) deflations in
post-Civil War U.S. history. Since then, it has tended to err on the side of inflation,
allowing the purchasing power of the U.S. dollar to deteriorate considerably. That
deterioration has not been compensated for, to any substantial degree, by enhanced
stability of real output. Although some early studies suggested otherwise, recent
work suggests that there has been no substantial overall improvement in the
volatility of real output since the end of World War II compared to before World
War I. Although a genuine improvement did occur during the sub-period known as
the ―Great Moderation,‖ that improvement, besides having been temporary, appears
to have been due mainly to factors other than improved monetary policy. Finally,
the Fed cannot be credited with having reduced the frequency of banking panics or
with having wielded its last-resort lending powers responsibly. In short, the
Federal Reserve System, as presently constituted, is no more worthy of being
regarded as the last word in monetary management than the National Currency
System it replaced almost a century ago.
The Fed‘s record suggests that its problems go well beyond those of having
lacked good administrators, and that the only real hope for a better monetary
system lies in regime change. What sort of change is a question beyond the scope of
this paper, which has only indicated some possibilities. We hope that it will also
encourage further research exploring those alternatives‘ capacity to contribute to a
genuinely improved monetary system.
48
See also Repullo (2000) and commentators.
48
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66
1880
1890
1900
1910
1920
1930
1940
1950
1960
Inflation (log difference, annualized)
Price level (natural log)
Price level (1972:I = 100)
1970
1980
1990
2000
2010
Notes: GNP deflator (Balke and Gordon 1986 series spliced to Department of Commerce series in 1946:IV). Vertical lines indicate the founding
of the Fed, the end of World War II, and the effective end of the gold standard in the US.
-0.40
-0.30
-0.20
-0.10
-0.00
0.10
0.20
0.30
0.40
0.50
2.50
3.00
3.50
4.00
4.50
5.00
5.50
6.00
6.50
0
50
100
150
200
250
300
350
400
450
Figure 1: Quarterly US price level and inflation rate, 1875 to 2010.
5
Pre-Fed
10
15
25
Quarters
Post-WWII
20
Post-Fed
30
35
40
45
Post-1971
Notes: Impulse responses as a function of forecast horizon, implied by the ARMA coefficient estimates in Table 1.
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.35
Figure 2: Price level response to standard deviation inflation shock, various subperiods.
1890
1890
1900
1900
1910
1910
1920
1920
1930
1930
1950
1940
1950
Price level
1940
Inflation
1960
1960
1970
1970
1980
1980
1990
1990
2000
2000
2010
2010
Notes: 6-year rolling standard deviations of the quarterly inflation rate and the price level, using data shown in Figure 1.
0.00
0.05
0.10
0.15
0.20
0.25
0.30
0.00
0.05
0.10
0.15
0.20
0.25
0.30
Figure 3: Price level and inflation uncertainty.
0.6
0.5
0.4
0.3
0.2
0.1
0.0
0.6
0.5
0.4
0.3
0.2
0.1
0.0
2.00
1.75
1.50
1.25
1.00
0.75
2.00
1.75
1.50
1.25
1.00
0.75
2.75
2.50
2.25
2.00
1.75
1.50
2.75
2.50
2.25
2.00
1.75
1.50
1950
1950
1950
1960
1955 1960
1955 1960
1955
1975
1980
1985
1965 1970 1975
1980 1985
100 year horizon
1980 1985
30 year horizon
1970
1965 1970 1975
1965
1995
2000
1990 1995 2000
1990 1995 2000
1990
2010
2005 2010
2005 2010
2005
Notes: Fitted values at various horizons of conditional variance of the price level as implied by coefficient estimates in Table 1.
3.00
3.00
1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914
3.25
3.25
100 year horizon
2.25
2.25
1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914
2.50
2.50
30 year horizon
0.7
0.7
1875 1878 1881 1884 1887 1890 1893 1896 1899 1902 1905 1908 1911 1914
0.8
0.8
5 year horizon
0.9
5 year horizon
0.9
Post-WWII
Pre-Fed
Figure 4: Conditional variances of the price level forecast errors, various horizons.
1870
1870
1870
1880
1880
1880
1890
1890
1890
1900
1900
1900
1910
1910
1910
1920
1920
1920
1940
1940
1930
1940
Balke and Gordon
1930
Romer
1930
Standard
1950
1950
1950
1960
1960
1960
1970
1970
1970
1980
1980
1980
1990
1990
1990
2000
2000
2000
Notes: See table 2 for series definitions and sources. Shaded area is deviation from trend, where trend is measured using Hodrick-Prescott
filter.
-0.20
-0.15
-0.10
-0.05
-0.00
0.05
0.10
0.15
0.20
0.25
-0.20
-0.15
-0.10
-0.05
-0.00
0.05
0.10
0.15
0.20
0.25
-0.20
-0.15
-0.10
-0.05
-0.00
0.05
0.10
0.15
0.20
0.25
Figure 5: Percentage deviations of real GNP from trend.
1870
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
Notes: Source – 1869-99 (Vernon 1994), 1899-1930 (Romer 1986, adjusted series), 1931-40 (Coen 1973, adjusted series), 1941-2009 (BLS).
Dashed lines indicate sub-period sample means.
0.0
2.5
5.0
7.5
10.0
12.5
15.0
17.5
20.0
22.5
Figure 6: US unemployment rate, 1869 to 2009.
5
10
15
20
-0.006
-0.006
10
15
-0.010
10
15
20
5
Post-WWII
Pre-fed
10
15
20
Response of money to money demand shock
5
Post-WWII
Pre-fed
Response of output to money demand shock
Notes: Responses to an unanticipated increase in the IS curve (aggregate spending) and to an unanticipated increase in the demand for real
money balances, as a function of forecast horizon in quarter. See Lastrapes and Selgin (2010).
5
-0.005
-0.005
-0.010
0.000
0.000
Pre-fed
0.005
0.010
0.010
0.005
0.015
0.015
Post-WWII
0.020
0.020
20
-0.004
-0.004
Response of money to IS shock
-0.002
-0.002
0.000
0.000
Pre-fed
0.002
0.002
0.004
0.006
0.006
Post-WWII
0.008
0.008
0.004
0.010
0.010
Response of output to IS shock
Figure 7: Dynamic responses of output and money to aggregate demand shocks, Pre-Fed and Post-WWII.
1910
1920
Federal
1930
1940
1960
1970
State and local
1950
1980
Total
1990
2000
Notes: Federal spending is federal net outlays from the Office of Management and Budget (as reported by the St. Louis Federal Reserve
Database) State and local expenditures are from usgovernmentspending.com.
0.0
0.1
0.2
0.3
0.4
0.5
0.6
Figure 8: Annual federal, state and local spending relative to GDP, 1902 to 2009.
1900
1905
1910
1915
1920
1925
1930
1935
1940
1945
1950
1955
Notes: Sources: Banking and Monetary Statistics 1914-1941, Board of Governors of the Federal Reserve System; All Bank Statistics 1896-1955;
Annual Report of the Comptroller of the Currency, December 3, 1917, Vol. 1.
0
5
10
15
20
25
30
Figure 9: US bank failures as percentage of all banks, 1896 to 1955.
Other
2008
Reserve balances
Currency
2009
2009
Supp. Treasury
Federal Reserve liabilities
Direct lending
2008
2007
Open market
2007
Federal Reserve credit
Other
Monetary base
Total
2010
Total
2010
Notes: Weekly data. ‘Open market’ includes all securities held outright, including mortgage-backed securities, plus repurchase agreements.
‘Direct lending’ includes term auction credit, all other loans, and all net portfolio holdings of the Fed’s special investment vehicles. Source: St.
Louis Federal Reserve Data base.
0
500
1000
1500
2000
2500
0
500
1000
1500
2000
2500
Figure 10: Federal Reserve Credit and components, monetary base and excess reserves, 2007 to 2010.
2000
2001
2002
Notes: Quarterly data, year-to-year growth rates.
-0.04
-0.02
0.00
0.02
0.04
0.06
0.08
2004
Nominal GDP
2003
2005
2007
GDP Deflator
2006
2008
Figure 11: Nominal GDP growth and inflation, 2000 to 2010.
2009
2010
1870
1880
1890
1900
mean = 389.71
1910
1920
1930
1940
mean = 243.38
1950
1960
1970
1980
1990
2000
mean = 521.83
Notes: Annual average gold price based on London P.M. fix relative to the GNP deflator. Source for gold prices: data from 1861 to 1899 are
from Global Financial Data, average of high and low; data from 1900 to 2009 are from Global Insight.
0
200
400
600
800
1000
1200
1400
Figure 12: Real price of gold, 1861 to 2009.
Table 1: Characteristics of quarterly inflation.
Sample statistics
1875-1914 1947-2010
mean
standard deviation
autocorrelation, 1 lag
autocorrelation, 2 lags
autocorrelation, 3 lags
autocorrelation, 4 lags
autocorrelation, 5 lags
autocorrelation, 6 lags
autocorrelation, 7 lags
autocorrelation, 8 lags
autocorrelation, 9 lags
autocorrelation, 10 lags
autocorrelation, 11 lags
autocorrelation, 12 lags
-0.05%
8.33%
0.18
-0.16
0.01
-0.03
-0.04
-0.01
0.06
0.10
0.06
0.01
0.10
0.13
3.39%
2.54%
0.80
0.72
0.65
0.54
0.49
0.42
0.38
0.41
0.39
0.45
0.43
0.43
1915-2010
1971-2010
3.16%
6.78%
0.70
0.43
0.29
0.26
0.19
0.11
0.05
0.02
0.01
0.09
0.16
0.16
3.84%
2.51%
0.89
0.84
0.81
0.78
0.71
0.69
0.62
0.60
0.57
0.56
0.54
0.52
Coefficients from ARMA(1,1)-GARCH(1,1) model
constant
AR(1)
MA(1)
constant in variance
ARCH(1)
GARCH(1)
Conditional variance (5yr)
Conditional variance (30yr)
Conditional variance (100yr)
0.008
-0.467
0.689
0.00026
0.049
–
0.350
0.843
1.530
0.0015
0.9372
-0.4530
0.000006
0.260
0.714
0.230
1.135
2.263
0.0002
0.9078
-0.3705
0.000005
0.351
0.695
–
–
–
0.0009
0.9567
-0.4616
0.000002
0.1128
0.8531
–
–
–
Notes: Inflation is quarterly log difference of the price level, adjusted to an annual rate, using the data
described in Figure 1.
5.064
2.664
4.270
1869-1914
(1)
5.764
5.716
6.291
9.323
9.224
10.195
2.554
2.554
2.773
1915-2009 1915-1946 1947-2009
(2)
(3)
(4)
1.706
1.706
1.696
1.138
2.145
1.473
1.841
3.463
2.388
1984-2009
ratio
ratio
(5) (2)/(1) (3)/(1)
0.504
0.959
0.649
ratio
(4)/(1)
0.337
0.640
0.397
ratio
(5)/(1)
Notes: Trend is measured using the Hodrick-Prescott filter. ‘Standard’ series, 1869-1929: original Kuznets series, with adjustments by Gallman
and Kendrick (see Rhode and Sutch, 2006, p. 3-12). ‘Romer’ series, 1869-1929: real GNP from Romer (1989, Table 2). ‘Standard’ and ‘Romer’
series, 1929-2009: spliced to real GNP (Bureau of Economic Analysis of the Department of Commerce, taken from Federal Reserve Bank of
St. Louis Database). ‘Balke-Gordon’ series, 1869-1983: real GNP from Balke and Gordon (1986, Appendix B, Table 1); 1984-2009: spliced to
BEA real GNP. All data available from the Historical Statistics of the United States, Millennial Edition On-line, 2006.
Standard
Romer
Balke-Gordon
Series
Table 2: Output volatility (percentage standard deviation from trend), alternative GNP estimates.
Table 3: Contribution of aggregate supply shocks to output forecast error variance.
horizon (quarters)
Pre-Fed
Post-WWII
1
2
3
4
5
6
7
8
81.1373
83.0815
85.7569
86.5508
86.3244
86.3275
86.5984
86.8482
36.2475
35.2230
41.2518
46.4824
51.7597
56.7460
60.9029
64.2719
12
88.9045
72.8033
16
90.7820
77.4053
20
91.8888
80.4573
24
92.7255
82.7308
Notes: Source – Lastrapes and Selgin (2010).
Comments on
“Has The Fed Been a Failure”
by
George Selgin, William D. Lastrapes, and Lawrence White
Written by Doug Pearce, however he was not able to attend and deliver these comments at the
conference.
While I learned a lot reading this paper, as someone interested in
monetary policy, I found this paper to be depressing. It is a wideranging review of many strands of the literature (18 pages of
references) with the following conclusions:
a. Macro-economic performance seems worse post-Fed than pre-Fed
even if the Great Depression is omitted
b. The Great Moderation was largely luck rather than at least partially
due to better monetary policy
c. The Fed has not been successful in reducing the frequency of bank
panics and has often misused the discount window
d. There are alternatives to the currently-constituted Fed that are likely
to perform better
How do they reach these conclusions?
Macro performance
1. The price level has certainly not been a stationary series (stable price
level) and the Fed has allowed persistent inflation particularly after
1970.
- while many economists would view the last 25 years of
inflation as satisfactory, the authors refer to Feldstein’s calculation that
even steady 2% inflation is costly due to nominal contracting
- Later in the paper the authors suggest that a steady deflation
rate would be fine but do not explain why this would not also lead to
misallocations under nominal contracting
2. Starting perhaps with Christina Romer’s work, some estimates of
economic activity indicate that real output under the Fed is no less
variable than pre-Fed. This is an area of the literature that is clearly
controversial. Dick Sylla’s paper for this conference, for example,
reaches the opposite conclusion.
3. Even if one accepts the data that suggest less volatility post WWII,
this might be due to relatively fewer supply shocks. If there are
relatively more aggregate demand shocks than aggregate supply
shocks, the Fed should have been able to lower the volatility of output
since presumably monetary policy is aimed at countering demand
shocks. They report that several studies, using some variant of the
Blanchard-Quah approach, find that demand shocks were more
prevalent post WWII. Their own empirical work, based on an
unreported 4-variable VAR, finds similar results and, in addition, finds
evidence of pro-cyclic monetary policy.
Because the details of their model is not specified in the paper, it
is hard to evaluate their results. They appear to find that the Fed
targeted interest rates since “IS shocks” cause the money supply to rise
but this seems contradicted by the finding that the money supply did
not respond much to money demand shocks. Can constant coefficient
VARs reflect what is going on if monetary policy is changing over the
period?
4. The paper reviews recent work that finds no evidence that banking
panics were less frequent after the Fed was established. Criticisms of
the Fed’s discount policy run from a lack of appropriate lending in the
Great Depression a la Friedman and Schwartz to inappropriate lending
to insolvent institutions contrary to the usual interpretation of the
Bagehot prescription – however see Richard Anderson (St Louis Fed,
Economic Synopsis, no. (7), 2009 for an interpretation of Bagehot more
favorable to the Fed’s action.
I am less convinced that unlimited branching could replace the discount
window. The Canadian experience in the 1930s may be instructive but
remember that there were few Canadian banks because of the strict
restrictions on entry. It took a special act of parliament to get a charter.
With modern communications, it seems to me that all branches could
have runs at the same time and that a lender of last resort would still
be needed.
With respect to the Penn Central case, the paper gives the impression
that the Fed did little to prevent a collapse of the commercial paper
market. I did not get that impression from the Calomiris paper. The Fed
did assure banks that they would lend through the discount window if
banks needed to borrow to then lend to corporations which could not
roll over their commercial paper. Discount lending to large banks did
rise. The Fed also removed the interest-rate ceiling on large CDs and
substantial funds then flowed into banks, reducing the need to borrow
at the discount window. No other company defaulted on its
commercial paper.
In Meltzer’s history of the Fed, he sees the FDICIA of 1991 as the right
approach to discount lending but that it was not enforced. Can we
make the rules of discount lending clear and can we enforce them?
5. The paper suggests that, if the gold standard cannot be substituted
for the Fed due to commitment and international cooperation issues,
we need more rule-based policies. Any target policy such as the Taylor
Rule has to be concerned with real time measurements, particularly
measures of the GDP gap.
It seems to me difficult to separate time-inconsistency stories from
poor measures of the gap. The time inconsistency literature assumes
that the Fed would like to push GDP above its natural rate level – due
to distortions from the tax system etc. – by creating surprise inflation.
Ireland and others suggest that this can explain the Great Inflation.
How do we separate this from the story of Orphanides and others that
the Fed thought that the natural rate of output was higher than it
turned out to be? If, as Friedman argued (AER, March 1968), we are
unlikely to measure the natural rate accurately then a simpler Taylortype rule that targets inflation seems preferable.
Comments on Selgin, Lastrapes and White – Delivered by Robert
Whaples
When John Wood and I began planning for this conference, at the top of
my wish list was a paper that does exactly what this paper does – asks
what are the key criteria by which one could decide whether or not the
Fed has done a good job or a bad one, and then looks closely,
quantitatively at the historical record to see how the Fed’s record stacks
up to alternative arrangements, especially the previous regime.
Answering the “was the Federal Reserve a bad idea” question is
inherently hard because there are many criteria to grade it on, because
economic measurement is difficult, and especially because determining
cause and effect is very difficult – we don’t have multiple historical
records to compare, so ceteris isn’t paribus.
The case against the Fed begins by noting that prices have been much
less stable since its creation. This is potentially damning but another,
perhaps more realistic benchmark for comparison is how price stability
in the U.S. under the Fed has compared with price stability in other
countries. Here our record looks worse than a few but better than most.
A root cause of the modern era’s continued bouts of inflation and even
hyperinflation seems to be the move to fiat money. Has any fiat money
regime in history maintained price stability for extended periods of time?
Does the Fed deserve the blame for inflation or does the move to fiat
money? Didn’t the Fed, perhaps tragically, play a role in America’s
decision to stick with commodity-based money longer than other
countries during the Great Depression?
Should the U.S. return to the gold standard? The strongest consensus in
the hundreds of questions I’ve asked economists in formal surveys over
the years comes on this question. When Ann Mari May and I asked this
question in 2008, only 3 percent agreed with the idea that the U.S.
should return to the gold standard.
On the issue of price stability, the paper seems to imply that the optimal
inflation rate is 0 percent. I’m not convinced, contra the citation of
Feldstein, that low inflation has substantial costs that outweigh its
benefits. When I surveyed a random sample of economists a few years
ago, the consensus was that the Fed should aim for a low level of
inflation, around 2 percent, as some other central banks explicitly do.
I’m skeptical that we learn a lot by looking at pre- and post-Fed trends in
the unemployment rate. Vernon’s unemployment series begins in 1869
when the agricultural work force made up a little more than half of the
labor market. By 1920, when the Fed was getting on its feet, agriculture
made up only about one quarter of the labor force. It was considerably
harder for farmers, most of them self-employed or sharecroppers, to
become unemployed than it was for wage employees. Thus, an
unemployment rate around 10% in the late 1800s has a much different
meaning than an unemployment rate of 10% toward the middle of the
20th century. Moreover, the official unemployment rate estimates of the
1930s are subject to Darby’s criticism that they count many government
employees – those on relief work – as unemployed. Robert Margo’s
micro-analysis of labor markets in the late 1930s, lends support to
Darby’s contention.
Finally, the most damning charge against the Fed appears to be,
following Friedman and Schwartz, that its policy missteps helped turn
the Recession of 1929 into the Great Depression, a depression that
wasted countless resources and human lives and which permanently
altered American institutions – many say for the worse. The vast
majority of economic historians have come to accept the position that
the Fed helped cause the Great Depression. When I surveyed them in
the 1990s, only about a quarter of them disagreed with the statement that,
quoting Friedman and Schwartz, “throughout the contractionary period
of the Great Depression, the Federal Reserve had ample powers to cut
short the process of monetary deflation and banking collapse. Proper
action would have eased the severity of the contraction and very likely
would have brought it to an end at a much earlier date.” So, perhaps the
most important question we should ask is: what would the Great
Depression era have looked like without a Fed, with one of the
alternative counterfactual monetary regimes?
US Growth and Stability with and without a Central Bank
Richard Sylla
New York University
Abstract:
US history provides an interesting case study of a country that had a central bank
in its early decades, then abandoned the institution for eight decades, and then brought
the central bank back in 1914. The historiography of early US central banking is mostly
political; here there is an attempt to make it more economic and financial, and to relate it
to the later Federal Reserve history. The paper is also an initial foray into the issue of
what difference the presence of a central made for US economic growth and financial
stability.
Prepared for “The Federal Reserve was a Bad Idea” conference at Wake Forest
University, February 11-12, 2011. Draft of February 2, 2011. Richard Sylla is Henry
Kaufman Professor of the History of Financial Institutions and Markets, and Professor of
Economics, Stern School of Business, New York University, 44 W. 4th St., Suite 8-65,
New York, NY 10012, USA. Telephone: 212 998-0869. Fax: 212 995-4218. Email:
[email protected]. Some material here draws on a shorter paper, “What price did the
USA pay for abandoning its central bank in 1836,” in J. Morilla et al., Homenaje a
Gabriel Tortella: Las Claves del Desarrollo Economico y Social (Madrid, 2010), 684-93.
1
US Growth and Stability with and without a Central Bank
That Banks furnish temptations to overtrading … must mean that by affording additional aids to mercantile enterprise, they induce the merchant sometimes to adventure beyond the prudent and salutary point. But the very statement of the thing shows that the subject of the charge is an occasional ill, incident to a general good…. If the abuses of a beneficial thing are to determine its condemnation, there is scarcely a source of public prosperity which will not be speedily closed. In every case, the evil is to be compared with the good; and in the present case such a comparison will issue in this, that the new and increased energies derived to commercial enterprise from the aid of banks are a source of general profit and advantage, which greatly outweigh the partial ills of the overtrading of a few individuals at particular times, or of numbers in particular conjunctures. Alexander Hamilton, Report on a National Bank, Dec. 1790 I
The first US Congress under the Constitution established a central bank or
national bank, the Bank of the United States (BUS), in 1791. Apart from the period 1811
to 1816, the new nation had the BUS at the center of its financial system from 1791 to
1836. The first version of the BUS failed to obtain a renewal of its twenty-year charter in
1811. Then chaotic US finances experienced during the War of 1812 made renewal of
the BUS an early item of congressional business after the war ended in 1815. Hence, in
1816, the second BUS, an enlarged version of the first, received a federal charter for
twenty years.
In 1832, President Andrew Jackson vetoed Congress’s bill to re-charter the
second version of the BUS, and its backers in Congress could not obtain the
supermajority of congressional votes to override Jackson’s veto. The second BUS,
weakened by the withdrawal of US government balances starting in 1833, ceased to be a
national bank in 1836, although it continued to operate as a large state bank with a new
2
charter from the state of Pennsylvania. Both the first and second BUS had their
headquarters in Philadelphia, Pennsylvania, and operated branches throughout the USA.
From 1836 until 1914, when Congress’s third version of a central bank, the
Federal Reserve System (the Fed), began operating, the USA was without a central bank.
The Fed, in effect the third BUS, continues to operate to this day, and it currently enjoys
considerable prestige in the global financial system, although perhaps less in 2011 than
was the case half a decade ago because of the financial crisis of 2007-2009.
During the eight decades, 1834-1914, when the USA was without a central bank,
much of modern central banking theory and practice became established in other leading
nations in the world economy. In the years leading up to 1914, Congress drew heavily on
the experiences of other nations with central banking when it fashioned the legislation
creating the Fed The early US experience, while not ignored, played little role in the
deliberations that led to the Fed.
These are some of the basic facts of the checkered history of US central banking.
They raise some questions. How did the new country come to have a central bank so
early in its history? If the early USA had one of the world’s first central banks up to
1836, and then abandoned it only to bring it back in 1913, there must have been reasons.
Why did the USA abandon central banking for nearly eight decades? Why did it then reestablish a central bank? What price, if any, did it pay for not having a central bank in
that long interim? How did economic growth and financial stability compare between the
two eras of when the USA had central banks and the eight decades when it lacked such
an institution?
II
3
Congress founded the first Bank of the United States in 1791on the
recommendation of Alexander Hamilton, the first US Secretary of the Treasury. It was
not a new idea for Hamilton. As a young lieutenant colonel in General George
Washington’s Continental Army during the American War of Independence, Hamilton in
1781 had recommended a national bank to Robert Morris. Morris had just been
appointed Congress’s Superintendent of Finance, and was charged with bringing some
order to the chaotic finances of the American revolutionaries. In April 1781, six months
before participating in the decisive battle of Yorktown, Hamilton told Morris that the
USA needed a national bank and provided him with a fairly detailed draft charter for one.
Among other things, he wrote:
The tendency of a national bank is to increase public and private credit.
The former gives power to the state for the protection of its rights and interests,
and the latter facilitates and extends the operations of commerce among
individuals. Industry is increased, commodities are multiplied, agriculture and
manufactures flourish, and herein consist the true wealth and prosperity of a state.
Most commercial nations have found it necessary to institute banks and
they have proved to be the happiest engines that ever were invented for advancing
trade. Venice, Genoa, Hamburg, Holland and England are examples of their
utility. They owe their riches, commerce and the figure they have made at
different periods in a great degree to this source. Great Britain is indebted for the
immense efforts she has been able to make in so many illustrious and successful
4
wars essentially to that vast fabric of credit raised on this foundation. Tis by this
alone she menaces our independence.1
This is a rather remarkable statement from a young army officer 230 years ago,
particularly when one realizes that neither the West Indies where Hamilton was born and
raised, nor the British North American colonies where he went as a teenager, nor the
emerging USA of 1781 had any banks at all. Hamilton was both precocious and on his
way to becoming the most advanced economic thinker in eighteenth-century America.
Exactly how he came to have so much knowledge of economic and financial history, and
so many insights into the financial bases of economic growth and political power are still
open questions. Like others in the founding generation, Hamilton had a college
education in the classics that included ancient and modern political theories, and he had
read works of David Hume, Malachy Postletwayt’s Universal Dictionary of Trade and
Commerce (a compendium of factual information mostly about Europe), and (at some
point but perhaps not by 1781) Adam Smith’s Wealth of Nations.2 He had an ability to
grasp historical evidence and draw correct conclusions from the limited amount of it
available to him while he served as an army officer from 1776 to 1781. In the late
eighteenth century, Hamilton developed a greater appreciation than others did of the
financial development-political power nexus and the finance-economic growth nexus.
After the passage of more than two centuries, these connections are now much clearer
than they were in Hamilton’s time. Hume and Smith, for example, had quite negative
1
“To Robert Morris, April 30, 1781,” in H.C. Syrett, ed., The Papers of Alexander Hamilton, vol. II, pp.
604-35.
2
Hamilton’s celebrated Report on Manufactures (1791) is in part an extended and critical commentary on
Smith’s seminal work.
5
views of national debts, whereas Hamilton could see them as potential national blessings
because they fostered state power and financial development. And both British writers
had deep reservations about the utility of business corporations, whereas Hamilton
thought the advantages of the corporate form were so obvious that governments ought to
encourage its usage and spread.
A decade after recommending a national bank to Morris, Hamilton as Treasury
Secretary got his bank. He wanted it to stimulate economic growth, as he had deduced
such a bank would do, but more immediately he needed the Bank of the United States as
a source of loans to the new US government to protect its rights and interests. In another
part of his grand plan to modernize US finances and the American economy, Hamilton
had undertaken to fund the US revolutionary war debts at par and pay interest on them in
hard money starting in 1791. The problem was that the US government’s revenues were
far from sufficient to do that. Ordinary tax revenues would not be large enough to
operate the government and pay interest on the debt until 1793 or 1794. So Hamilton had
to borrow to meet the new US government’s obligations in its first years. He did so
extensively, from the few state-chartered banks that had arisen by early 1790s, from
foreign (mostly Dutch) bankers, and especially from the new Bank of the United States.
The BUS was an innovative institution. Capitalized at $10 million, it was much
larger than any of the few other corporations that existed in the new country. The US
government took a 20 percent ownership stake, purchased with a loan from the bank, and
private investors subscribed for the other 80 percent. The investors could pay for up to
three-fourths of their stock by tendering the new US debt securities arising from
Hamilton’s national debt restructuring. By design the BUS supported the national debt,
6
and the national debt in turn supported the capitalization of the BUS. Along with the
new national debt securities, BUS stock was freely traded in the securities markets that
sprung up in US cities as a result of Hamilton’s policies, and a majority of BUS shares
had moved into the hands of foreign investors by the early nineteenth century. Foreign
ownership, although it brought welcome European capital to the USA, would become a
political problem for the first BUS and for its successor, the second BUS.
The BUS had a monopoly of federally chartered banking; no other bank would be
chartered by Congress to compete with it in fulfilling the US government’s banking
needs. But nothing in its charter granted it a monopoly of corporate banking. States
retained the right to charter banking corporations. Many of them, prompted by the
example of BUS federal charter, did so.3 There were only 3 state banks in 1790, but 20
by 1795. There would be more than a hundred such state banks by 1811, and several
hundred by the early 1830s.
Hamilton’s charter for the BUS allowed the bank to open branches wherever it
chose. The first BUS had 9 of them; the second BUS would have 25, one in nearly every
state. The USA thus had interstate banking via the Banks of the United States during its
early decades. That disappeared after Jackson’s veto of the second BUS’s re-chartering
by Congress in the 1830s. Interstate banking would reappear in the USA a century and a
half later, with substitutes such as correspondent banking filling in for it during the
interim.
In contrast, the Bank of England, founded a century before the BUS, was a
corporation entirely owned by private investors. It was the British government’s bank,
3
See Howard Bodenhorn, “Federal and State Commercial Banking Policy in the Federalist Era and
Beyond,” in D. A. Irwin and R. Sylla, eds., Founding Choices: American Economic Policy in the 1790s
(2011), Chap. 5, 151-76.
7
but its banking monopoly was far stronger than that of the BUS. Until 1825, no other
joint stock banks were allowed in England and Wales. Early in the eighteenth century, to
solidify its monopoly of corporate banking the Bank of England had secured legislation
from the English Parliament decreeing that all other banks had to be unlimited-liability
partnerships with no more than 6 partners. By 1825, in contrast, the USA had more than
300 limited-liability state banking corporations. Unlike the BUS, the Bank of England
did not have any branches until 1825, when the British government allowed it to open
branches as compensation for ending the 6-partner rule that had protected its corporate
monopoly. All of the capital of the Bank of England consisted of UK national debt, but
only part of the initial capital of the BUS was US national debt, and much of that was
quickly liquidated to fund more profitable lending to the private sector. The first BUS by
the mid 1790s even pressured the US government to reduce its large loan balances so that
it could engage in more private lending. In 1830, 60 percent of the assets of the second
BUS consisted of loans to the private sector, as compared to less than an eighth of the
assets of the Bank of England.4
Was the BUS a central bank? Because the term ‘central bank’ came much later in
time, this question is often asked, and the answer to it usually depends on semantics. If
one defines a central bank in terms of all the major functions of today’s central banks, it
is easy to render a “no” answer to the question. But because the BUS was the federal
government’s bank, it was usually a creditor of many state banks, whose notes were paid
in to the government in tax collections and then deposited in the BUS. Holding the notes
of state banks gave the BUS the power to restrain, or not restrain, the credit expansion of
state banks by varying the speed of returning their notes to them. There is evidence
4
Sylla, “Comparing the UK and US Financial Systems.”
8
indicating that the first BUS did this, and it is a central banking function. The evidence is
substantial that the second BUS did it, especially when Nicholas Biddle, perhaps the
world’s first self-conscious central banker, headed it starting in 1823. Moreover, during
financial stringencies and individual state bank embarrassments, the BUS often would
intervene in “lender of last resort” fashion, exhibiting another central banking function.
Perhaps it did so at the behest of the Treasury Secretary, a finding that has led one scholar
of the BUS to contend that in the early USA, the Treasury Secretary was the central
banker and the BUS was the agent used to implement central banking interventions.5
Whatever the details, the facts that the BUS used its powers to restrain, or not restrain,
state banks, and to act on occasion as a lender of last resort, doing both in the interest of
financial and macroeconomic stability, argue that it performed essential central banking
functions. The BUS was a central bank, before the term entered the lexicon. It is less
clear that the Bank of England in the early nineteenth century thought or acted as if it
had any such central banking responsibilities.
III
More than likely, it was the exercise of central banking functions that got both
versions of the BUS into political trouble. Economically, both were meritorious
economic institutions most of the time.
The biggest mistakes of the two BUSs came early in their histories. When the
first BUS opened at the end of 1791, it expanded its credit too quickly, fueling a
speculative bubble that popped in March 1792.6 During this panic of 1792, Hamilton
5
6
Cowen, Origins and Economic Impact of the First Bank.
Ibid.
9
came to the rescue, acting as a central banker in a variety of actions that included
liquidity injections, fostering co-operation between securities dealers and banks to ease
the liquidity crisis, and requesting banks to continue lending to merchants owing federal
taxes with guarantees that the Treasury would refrain from drawing down the proceeds of
the tax payments.7
The second Bank in its first years 1817-18 also expanded credit somewhat
recklessly, and then it became an instrument of the Treasury in contracting credit after the
inflation of the War of 1812, when there was no central bank and American banks outside
of New England in 1814 suspended convertibility of their liabilities into specie. The
contraction led to a second US panic in 1819, for which the BUS was widely blamed
even though it was merely executing Treasury policy aimed at restoring convertibility of
bank money to specie.8 This is an early example of what became common later in time,
namely politicians conveniently letting the central bank serve as a scapegoat for the
consequences of their own actions.
Nonetheless, during the first period of US central banking from 1791 to 1836
(excepting the years 1811-1816 when there was no central bank), the economy of the
USA expanded at high modern rates with little long-term price inflation. US rates of
economic growth were than those of any other country, as will be discussed later in this
essay. Some might attribute the favorable inflation experience to the USA being most of
the time during these years on a specie standard. Historically, commitments to specie
standards often restrained inflation. But we have to recognize that central banks during
periods of specie-standard commitments were instruments that helped to maintain the
7
8
Sylla, Wright, and Cowen, “Alexander Hamilton, Central Banker.”
Timberlake, Monetary Policy in the United States.
10
commitment by restraining excessive credit expansions that might have threatened it.
The Banks of the United States did this.
Credit restraint in an economy growing as rapidly as did the young United States
often was not appreciated by entrepreneurs and bankers. In the US case, there was no
shortage of entrepreneurs. The banks that wanted to finance them were state-chartered
banks. Many of the latter resented the restraints imposed on occasion by the central
bank, as would many entrepreneurs seeking financing. In the uniquely democratic
politics of the young American republic, both groups had more political clout than they
would have had in other countries.
State banks in particular had much to gain from getting rid of the central bank.
They would get rid of a regulator that restrained their credit expansions. They would get
rid of a competitor—the Banks of the United States, which as noted earlier, engaged in
extensive private-sector lending while also acting as the US government’s banker. And
with the BUS gone the state banks would gain the federal government’s banking
business, since the government had to keep its money somewhere and make payments by
drawing on its balances.
Of course, state banks in 1811 and 1832 could not say they wanted to get rid of
the Bank of the United States for these reasons. That would have seemed self-serving.
Instead, they and politicians beholden to them came up with other, loftier sounding
reasons for getting rid of the central banks. In 1811 and again in 1832, anti-BUS
politicians raised the issue of the constitutionality of the two central banks. Hamilton had
thought he had put the issue to rest in his famous 1791 opinion on the constitutionality of
the BUS, which led Washington to sign into law Congress’s bill to charter it. The US
11
Supreme Court likewise thought it had put the issue to rest in the famous case,
McCulloch v. Maryland, decided in 1819. In that case, the Chief Justice of the US, John
Marshall, drew on Hamilton’s 1791 opinion to affirm the Bank’s constitutionality and
deny the state of Maryland’s right to tax it out of existence. Maryland had tried to do just
that in order to improve the competitive position of Maryland’s own state-chartered
banks. State banks and state politicians also raised the specter of “monopoly” in their
campaigns against the BUS. This may be one of the first instances, but certainly not the
last, of weaker competitors trying to rein in or get rid of a stronger one by charging it
with being a monopolist.
If there were real economic problems with either BUS, democratic-republican
politics could easily have remedied them with new provisions in new charters. These
were offered, for example by Albert Gallatin, Treasury Secretary in 1811. Gallatin told
Congress:
It does not seem necessary to advert to the particular objections made
against the present charter, as these may easily be obviated by proper alterations….
The capital may be extended, and more equally distributed; new stockholders may
be substituted to the foreigners, … and any other modifications which may be
thought expedient, may be introduced, without interrupting the operations of the
institution now in force, and without disturbing all the commercial concerns of the
country.9
9
Clarke and Hall, Legislative and Documentary History of the Bank of the United States, p. 301. Italics
added for emphasis.
12
Secretary Gallatin’s reasonable proposals fell on deaf ears. Nothing else better shows
that anti-BUS bankers and politicians were determined to get rid of the BUS if they
could. They wanted no central bank, not a better one.
This was known at the time. It is not a later discovery. In the Senate debates in
1811, Senator Crawford of Georgia, a BUS supporter, asked and answered a question
about why many congressmen and the states they represented were against a new charter
for the BUS:
And sir, what is the inducement of these great states, to put down the Bank
of the United States? Their avarice, combined with the love of domination. They
have erected banks, in many of which they hold stock to a considerable amount,
and they wish to compel the United States to use their banks as places of deposit
for their public moneys, by which they expect to increase their dividends. And in
the banks in which they [the state governments] hold no stock, many of the
individual members of their Legislatures are stockholders, and no doubt were
influenced to give instructions [to their congressional delegations] by motives of
sheer avarice.10
Despite Hamilton, despite Gallatin, despite Madison who had initially opposed
the BUS in 1791 and then supported its renewal as president in 1811 and 1816, despite
Senator Crawford, and despite Chief Justice Marshall, President Andrew Jackson would
repeat all of the old 1811 charges in his 1832 veto message. He and the people around
him wanted no central bank, not a better one, because they saw that to be in their political
and economic self-interest.
10
Ibid., p. 310.
13
A political-economy analysis of the fate of the two Banks of the United States
thus shows that their vulnerabilities were political, not economic. But did the
disappearance of formal central banking for reasons of political economy have any
economic consequences?11
IV
How might the disappearance of an independent central bank affect an economy?
If, as Hamilton said in 1781, “the tendency of a national bank is to increase public and
private credit,” then getting rid of such an institution ought to damage public and private
credit. Is there any evidence of this in the US case?
There is. It can be seen in analyses of interest rates and debt yields, both between
the USA and the UK and within the USA at different times. During the first decade of
nineteenth century, when the first BUS was in operation, yields of US government 3%
bonds averaged 5.06%, and in the UK, where the already venerable Bank of England held
sway, British 3% consol yields averaged 4.80%. The average spread was 26 basis points.
The first BUS went out of existence (entered liquidation) in 1811. And the
second BUS did not begin to operate until 1817. In the decade 1810-19, US 3 yields
averaged 5.14%, and UK consol 3s averaged 4.57%. The average spread of US over UK
widened to 57 basis points, more than twice what it was in the previous decade.
In the next decade, 1820-29, the heyday of the second BUS whose future became
more doubtful when Jackson became president in 1829, US 3% yields were 3.76%, and
11
The argument of this section is hardly new. As noted in the text, Senator Crawford used it in 1811. It is
amplified in Bray Hammond, Banks and Politics in America (1957), one of the great books on US
economic history.
14
UK consol 3s average yields were 3.72%. The average spread of US over UK had
narrowed to a mere 4 basis points.
In the early 1830s, the entire US national debt was retired, making comparisons of
government bond yields in the two countries problematic if not impossible. In the same
period, Jackson successfully vetoed the re-charter of the second BUS in 1832 and
withdrew US government deposits from the BUS starting in 1833. The bank ceased
operating under its federal charter in 1836. When long-term US government debt
securities reappeared in 1842, their yield spreads over British consols were 217 basis
points from 1841 to 1849, 107 basis points during the 1850s, and 207 basis points during
the 1860s, the decade that saw the American Civil War.12
The US-UK yield spreads of the 1840s, 1850s, and 1860s were far wider than
they had been when the two BUSs existed. The yield spread patterns of US over UK debt
instruments thus appear to support Hamilton’s contention that national/central banks
increased public credit. If we assume that capital markets were integrated across public
and private securities, which most likely is a valid assumption, then the yield-spread
evidence also would support his theory that such institutions increased private credit.
Another US interest rate series, that for debt issues of New England state and
local governments, has an advantage of continuity that is lacking for US federal debt with
its hiatus in the 1830s when it briefly disappeared. During the 1820s, New England
municipals had an average spread of 105 basis points over UK consols. In the 1830s,
when the second BUS lost its charter, the spread widened to 155 basis points. It widened
further in the 1840s and 1850s to an average of 176 and 190 basis points, respectively.13
12
13
The US and UK bond yield data here are taken from Homer and Sylla, History of Interest Rates.
Ibid.
15
The New England municipal yield spreads over UK consols imply that “country
risk” increased for the USA after it got rid of its central bank. Foreign investors who
bought many of the US federal and municipal debt issues demanded higher yield spreads
on these securities compared to what they could get at home, and higher spreads than
they had required when the USA had a central bank.
Country risk for the USA, of course, might have increased for reasons other than
Andrew Jackson’s banking policies. The US fought a war with Mexico in the years
1846-1848, and there were rising political tensions in the USA over the issue of slavery,
for example, before the Civil War of 1861-65.
On the other hand, both the New England municipal and US federal securities
data already cited have another implication. Before Jackson’s 1832 veto of the central
bank, New England municipals had market yields higher than those of US federal bonds.
When US federal securities reappeared in the 1840s, however, New England municipal
yields were lower than yields on US government debt. What could explain this reversal?
A valid answer could be that a government that did away with a central bank designed in
part to lend it money when it needed to borrow should have expected such a reaction
from domestic and foreign investors after it so weakened its financial position and
credibility. There is ample evidence to support this answer. Barings, the noted British
merchant bank that had been deeply involved for three decades in American finance,
witnessed the antics of the Jackson administration and trimmed its exposure to the USA
in the early 1830s.14
The yield spread averages discussed are suggestive, but they lack precision as to
when the damage to US financial credibility occurred. Greater precision is obtained by
14
See Peter E. Austin, Baring Brothers and the Birth of Modern Finance, Chaps. 3-5.
16
political scientist Rose Razaghian in a paper providing structural-break and multivariate
regression analyses for a detailed series of US government bond yields.15 She finds a
structural break toward higher yields at the time the first BUS failed to be re-chartered in
1811—“yields increased by 68 basis points after September 18, 1811.” When the second
BUS appeared in 1817, she finds a structural break toward lower yields on US debt
securities—shortly after the second BUS began operating there was a structural break
dated March 18, 1817 and “the yield fell considerably by 117 basis points.” Shortly after
Jackson vetoed the second BUS re-charter bill on July 10,1832, she finds a structural
break toward much higher yields dated August 8, 1832, when “yields increased by 80
basis points.”16
Razaghian’s multivariate regression analysis, designed to control for a host of
factors that might have influenced government debt yields, reinforces the structural-break
analysis:
The coefficients for both FirstBank and SecondBank are negative and significant.
Specifically, during operation of the first Bank, the yield on government securities
declined by 65 basis points. Given an average yield of 5.56% during this period,
this translated into an almost 12% decrease in the yield. The impact of the second
Bank was even more pronounced driving down yields by 115 basis points, which
amounted to a 21% decrease from the average yield.17
15
Rose Razaghian, “Political Institutions and Sovereign Debt: Establishing Financial Credibility in the
United States, 1789-1860.” Working paper, 2004.
16
Razaghian, p. 26.
17
Razaghian, p. 30.
17
Razaghian also analyzed the impact of the Independent Treasury system,
Congress’s 1840s substitute for a central bank. Structural-break analysis was
complicated by the fact that the Independent Treasury system was authorized on August
6, 1846, not long after the Mexican-American War began on May 13 of that year. Two
structural-break points in mid and late 1846 were followed by increased yields. On the
other hand, by comparing yields during three years before and three years after the war,
Razaghian found that yields declined modestly in the latter period, by less than they had
declined under the first and second BUS regimes. So the Independent Treasury may have
been better than nothing. In Razaghian’s multivariate regression analysis, however, the
Independent Treasury variable had an insignificant effect on yields.18 Congress’s
substitute for a central bank thus appears to have been less effective or ineffective in
lowering nineteenth-century US bond yields than either of the first two central banks it
had authorized.
It thus seems evident that one price Americans paid for abolishing their central
bank, both in 1811 and 1836, was a higher cost of credit, absolutely and in comparison
with what borrowers across the Atlantic paid. Were there other costs? Did higher costs
of credit have an impact on economic growth? On economic and financial stability?
V
Standard economic models would predict that higher borrowing costs would tend
to reduced capital formation and economic growth. But the latest and most detailed data
on US economic growth going back to 1790, compiled by Officer and Williamson,
appear to provide no support for lower growth after the central bank was defrocked in the
18
Razaghian, pp. 27, 30.
18
1830s.19 These data indicate that the USA grew at high modern rates from the beginning.
US real GDP per capita, a common measure of economic growth that standardizes for
population and price-level changes, grew at a rate of 1.41percent per year from 1790 to
1833 (a peak year and also the year Jackson’s policies began to weaken the central bank’s
effectiveness; it is useful to compare growth rates peak-to-peak, and I do so here
whenever it is possible), and at 1.50 percent per year from 1833 to 1913, the period of US
history without a central bank.
Those who doubt the wisdom of central banking might find such a comparison
comforting since it shows that US growth was slightly greater in the period without a
central bank than in the period before Jackson ended the BUS as a central bank. Less
comforting for them is that peak to peak US growth from 1913, the year Congress passed
the Federal Reserve Act, to 2007, before the latest financial crisis, was 2.11 percent per
year, substantially higher than in either of the two previous periods. Because economic
historians studying long-term growth typically find patterns of gradual acceleration in
growth rates, perhaps the surprising aspect of the US data is how modest was the
acceleration of US growth between the periods 1790-1833 and 1833-1913. The
acceleration of growth after 1913 was much more substantial. Perhaps the absence of a
central bank after the mid 1830s had the effect of muting what otherwise might have been
a more robust acceleration of US long-term growth.
Officer and Williamson also provide a comparable series for the UK, although it
is annual only from 1830 to the present, with benchmarks for 1759 and 1801. According
to this series, real GDP per person in the UK grew 0.18 percent per year from 1759 to
1801, and also 0.18 percent from 1801 to 1831. If these data are approximately correct,
19
Officer and Williamson. "Annualized Growth Rate and Graphs of Various Historical Economic Series”
19
all the stories about the great breakthroughs of the first industrial revolution appear to be
just that and no more, at least as far as UK growth before the 1830s is concerned. UK
growth appears to have been negligible. An alternative rendering is somewhat more
favorable for the pre 1831 period. Nicholas Crafts estimates that UK GDP per capita
accelerated from 0.35 percent per year during 1781-1801, to 0. 52 percent per year during
1801-1831.20 From 1831 to 1913, the UK grew at 1.13% per year, roughly 0.4 percent
less than the US rate in this period. From 1913 to 2007, the UK rate is 1.68 percent,
again about 0.4 percent below the US rate in the same years.
From these data, it is evident that the USA almost always grew at higher rates
than did the UK. The difference is roughly 0.4 percent per year since the 1830s. In the
early nineteenth century, the difference was much greater; from the 1790s to the 1830s,
the US grew roughly a full percentage point per year faster than the UK. The underlying
data also indicate that, converting sterling to dollars at prevailing exchange rates, the
USA had essentially equaled the UK in real per capita GDP by the 1830s, a finding
similar to that of some scholars, and disputed by still others.21
The only extended period in which the USA did not grow significantly faster than
the UK was during the four decades from the 1830s to the 1870s. Although the
difference is minimal, the UK actually grew faster from its peak in 1831 to its peak in
1875, 1.39 percent per year, than the US did from its 1833 peak to its peak in 1873,
which was 1.35 percent per year. At the beginning of this period the US abandoned its
central bank, and at its end the US was just beginning to exert more federal control over
20
Crafts, “British Economic Growth, 1700-1850.”
See Sylla, “Comparing the UK and US Financial Systems, 1790-1830.” In The Origin and Development
of Financial Markets and Institutions, From the Seventeenth Century to the Present, J. Atack and L. Neal,
eds.
21
20
the country’s banking system as a result of the Civil War National Bank legislation. In
the UK more or less the opposite happened in these decades, as the Bank of England
under the prodding of Walter Bagehot and others transformed itself from just a very large
banking corporation into a model central bank in the era when England became the
workshop of the world.
Since the USA could only equal the UK in economic growth during the period
from the 1830s to the 1870s, whereas it grew significantly faster than the UK in all other
periods of its history, it is arguable that the USA did pay a price in terms of economic
growth for abolishing its central bank in the 1830s. In terms of its own economic growth,
the fact that the US grew substantially faster in the nine decades of the Federal Reserve
era than it did in the previous eight decades without a central bank would appear to
reinforce the argument.
VI
Why might the USA have grown relatively slower after it abolished it first central
bank, compared both to the UK and to its own twentieth-century growth performance
after it reinstated a central bank in 1914? Based on the above discussion of interest rates
and yields on debt instruments, there is an obvious answer: The USA had a relatively
higher cost of capital when it was without a central bank, compared both to the UK and to
the period when it had a central bank. A higher cost of capital probably meant that there
was less capital investment, less capital formation, and less economic than there might
otherwise have been.
21
Can we quantify what the difference might have been? That calls for a
counterfactual: How much faster would US economic growth have been if the lower cost
of capital associated with having a central bank had been there during the eight decades
from 1833 to 1913? Recall from the previous section that the Officer-Williamson series
indicates that the real per capita GDP grew about 1.4 percent per year in the period 17901833, and 2.1 percent per year during 1913-2007. If, as many students of historical
economic growth maintain, one should expect to find—and often does find—that growth
accelerates gradually as economies transition from pre-modern to modern ones, then one
might have expected a US growth rate from 1833 to 1913 to be somewhere in the middle
of its range before 1833 and after 1913. The middle of that range of 1.4 to 2.1 is 1.75
percent per year. Actual US growth from 1833 to 1913 was 1.5 percent per year, a
difference of -0.25 percent from what might have occurred in the counterfactual scenario
with the USA having a central bank from 1833 to 1913.
Over an extended period, a small difference of a quarter percent per year in
growth rates can make a significant difference in end results. According to Officer and
Williamson, US real GDP per person (in 2005 dollars) was $1874 in 1833 and $6167 in
1913. If, however, growth had been at 1.75 percent per year of the 80 years instead of
1.5 percent, real GDP per person would have been $7497 in 1913. It would have been 22
percent greater than it actually was. Another way of assessing the difference is to ask
how long it took after 1913 for US real GDP per person to reach $7497. That level was
reached by 1926. Such is the power of compound interest that the US may have set back
its growth by 13 years by not having a central bank from 1833 to 1913. And on average
we might be 22 percent richer today than we actually are.
22
What is the explanation of the higher capital costs the USA had to endure during
the eight decades it decided to abandon its central bank? Greater financial and
macroeconomic instability could be an answer because investors are likely to demand a
higher return and invest less in economies that are unstable. As a rough index of
instability, consider the incidence of financial crises. Table 1 gives the dates of financial
crises in the US and the UK from a variety of sources, but mostly from Kindleberger and
Aliber, Manias, Panics, and Crashes. The USA had 16 crises by this reckoning, and the
UK 15. But the timing is often different between the two.
Looking only at the US, there were 8 crises during the 140 years (1791-1833,
1914-2010) when the country had an effective central bank, and 8 in the 80 years (18331913) when it did not. Financial crises were more frequent, one every 10 years on
average, when there was no central bank than the one every 18 years on average when
there was such an institution.
Looking at the UK, the difference is even more striking. Forrest Capie (2009),
the official historian of the Bank of England, says that institution did not master the art of
central banking until the 1860s. Prior to that time it was merely, and slowly, learning
how to be a central bank. While it was learning, from 1792 to 1865, there were 9 crises,
one about every 8 years on average. From 1866 to 2010 there were 6 UK crises, one
every 24 years. In the UK case crises were three times as frequent before the Bank of
England became a central bank than they were after it became one.
Comparing the two countries, the early period is interesting because the USA
arguably had better central banks in the two BUSs than did the UK in the Bank of
England. While the two BUSs were present, there were two crises in 46 years, or one in
23
23 years. The UK had 7 crises in that period, or one every 6 years. The greater
frequency of crises in the UK perhaps explains why the yield spreads between the USA, a
capital importer, and the UK, a capital exporter, were substantially narrower than they
were in the decades after the USA got rid of its central bank.
Reinhart and Rogoff provide a list of the dates of banking crises in the two
countries that differs somewhat from the list of financial crises in Table 1.22 But the
results are similar. By their reckoning, the USA had 16 banking crises and the UK 14.
While it had its central banks, the USA had 6 crises in 140 years, or one every 23 years;
in the eight decades without a central bank the USA had 10 banking crises, or one every 8
years. Banking crises were nearly three times more frequent on average when there was
no central bank. In the UK case, banking crises were roughly twice as frequent when the
Bank of England was learning how to be a central bank than they were after it became
one.
The evidence on the incidence of financial crises appears to provide strong
support for the idea that central banks are good institutions. But why? Clearly the
presence of a central bank does not eliminate crises. It just makes them considerably less
frequent. How does a central bank do that? The answer must be that it uses its powers to
prevent crises that might have happened. It can do that by managing credit expansions
and contractions so that speculative bubbles and their collapses happen less frequently,
and by providing lender-of-last-resort aids to illiquid institutions and markets.
In the US case there are numerous examples of this scattered across two plus
centuries. Hamilton in the US crisis of 1792, which occurred just as the BUS was getting
started, acted as a central banker so effectively that the crisis passed quickly and did so
22
Reinhart and Rogoff, This Time is Different (2009), Appendix A.4.1.
24
little economic damage that most historians ignore it.23 Nicholas Biddle, president of the
second BUS, acted similarly in 1825, among other occasions, to prevent a major crisis
that had erupted in the UK from spreading to the USA.24 Before the Federal Reserve
opened its doors in late 1914, its first chairman, Treasury Secretary W. G. McAdoo,
intervened as a central banker to prevent a financial crisis that threatened to engulf the
USA when World War I broke out in Europe.25 In our own time, the Federal Reserve
under Chairman Alan Greenspan injected liquidity at the time of the stock market crash
of 1987, the Russia/Long –Term Capital Management crisis of 1998, the collapse of the
dot.com bubble in 2000, and the September 11, 2001, terrorist attacks to stave off
financial crises that might have happened.
VII
The evidence from history, while not overwhelming, seems pretty strong. Central
banks have their uses. The Federal Reserve was not a bad idea.
23
Sylla et al., “Alexander Hamilton, Central Banker.”
See T. P. Govan, Nicholas Biddle (1959).
25
W. L. Silber, When Washington Shut Down Wall Street (2007).
24
25
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United States, 1832.
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1791-1797, 2000.
Crafts, Nicholas. “British Economic Growth, 1700-1850: Some Difficulties of
Interpretation.” Explorations in Economic History 24 (July 1987), 245-68.
Govan, T. P., Nicholas Biddle: Nationalist and Public Banker, 1786-1844 (1959).
Hamilton, Alexander, The Papers of Alexander Hamilton, H. C. Syrett, ed., 27 vols.,
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Hammond, B., Banks and Politics in America, from the Revolution to the Civil War,
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26
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1790s (2011).
Kindleberger, C. P., and R. Aliber. Manias, Panics, and Crashes: A History of Financial
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Various Historical Economic Series," MeasuringWorth, 2011.
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to the Present, J. Atack and L. Neal, eds. (2009)
27
Sylla, R., R. E. Wright, and D. J. Cowen, “Alexander Hamilton, Central Banker: Crisis
Management and the Lender of Last Resort in the US Panic of 1792,” Business
History Review 83 (Spring 2009), 61-86.
Timberlake, R. H., Monetary Policy in the United States, 1993.
Wicker, E. Banking Panics of the Gilded Age (2000).
28
Table 1. Financial Crises in the US and UK, 1790-2010
US
UK
1792
1819
1793
1797
1810
1815-16
1819
1825
1836
1837
1839*
1857
1847
1857
1866
1873
1884*
1890*
1893
1907
1921
1929-33
1973-75
1979
1890
1921
1931
1973-75
1982
1982-87
2007-09
2007-09
Source: Kindleberger and Aliber, Manias, Panics, and Crashes (5th ed., 2005),
Appendix A, with additional US crises not noted by Kindleberger, but noted by
Sprague, History of Crises under the National Banking System (1910) and Wicker,
Banking Panics of the Gilded Age (2000) designated by *. Capie (2009) notes that
some consider the UK to have had financial crises in 1878, 1890, 1914, and 1931, two
of which dates appear above, but contends that these were true financial crises.
29
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Comments on “US Growth and Stability with and
without a Central Bank” by Richard Sylla
Sandeep Mazumder
Wake Forest University
February 2011
1
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Overview of Paper
Overview of Paper
In this paper, Sylla poses and addresses four main questions concerning
the history of the central bank in the United States:
1
How did the newly independent United States have a central bank
so early in its history?
2
Why did the US abandon its central bank from 1833-1913?
3
What price did the US pay for not having a central bank in those
eight decades, and therefore why did the US re-establish a central
bank?
4
Can we say anything about economic growth and financial stability
if we compare US history in the periods with and without a central
bank?
2
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
1. Early Central Bank
1) How did the newly independent United States have a central bank so
early in its history?
Alexander Hamilton (at that time the US Treasury Secretary) in 1781
recommended to Robert Morris (Congress’ Superintendent of Finance)
that a central bank be created in order to “increase public and private
credit.”
Simultaneously Hamilton suggested that trade would greatly be enhanced
by the setting up of a central bank
Sylla argues in this paper that the central bank in the US (at that time
the Bank of the United States) was imperative as a source of loans to the
government, thereby enabling them to protect its rights and interests. Eg,
financing of US revolutionary war
A strength of this paper was how the question of whether the BUS was
really a central bank at all is addressed: Sylla argues that the BUS had
the power to restrain (or not) credit expansion in the US, so it is hard to
argue against it being a central bank
3
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
2. Abandoning the Central Bank
2) Why did the US abandon its central bank from 1833-1913?
Credit was expanded too quickly leading to a speculate bubble that
peaked in 1792. The second version of the BUS also over-expanded credit
in its first years (1817-18). The resulting Treasury-inspired credit
contraction led to a panic in 1819, for which the BUS was largely blamed
A strong part of this paper is where Sylla argues that there’s more to the
story than this: the central bank wasn’t disbanded purely due to mistakes
made in extending lines of credit. State banks actually had large
incentives to do away with the central bank:
◦ The state banks could get rid of the regulator and no longer have
restrictions on how much they could expand credit
◦ And state banks could gain the federal government’s banking
business
In other words, the central bank in the US was brought down for political
not economic reasons, according to Sylla’s arguments in this paper
4
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
3. The Cost of Not Having a Central Bank
3) What price did the US pay for not having a central bank in those eight
decades, and therefore why did the US re-establish a central bank?
Since this paper argues that a central bank facilitates the increase in
public and private credit, the natural consequence of the abolition of the
central bank is that public and private credit must be damaged
Sylla examines the spread between US and UK government bond yields to
see if there is evidence for this argument. He finds that this spread
increased greatly from the 1800s to the 1860s, providing evidence that
the US’ ability to create credit was greatly reduced by the lack of a
central bank
However Sylla does well to acknowledge that this increasing spread
cannot be solely attributed to the abandoning of the central bank:
country risk existed as well, such as from the war with Mexico, and the
political tensions that arose from slavery before the Civil War
5
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
4. Growth With and Without a Central Bank
4) Can we say anything about economic growth and financial stability if
we compare US history in the periods with and without a central bank?
Theory tells us that higher borrowing costs that arise without a central
bank will lead to reduced capital accumulation and therefore lower
economic growth
The data that Sylla presents points towards the US growing at a faster
rate with a central bank than without a central bank
For instance, from 1790 to 1833 US real GDP per capita grew at an
average annual rate of 1.41% per year
However in the period without a central bank (1833-1913), this growth
rate was 1.50% per year
6
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
4. Growth With and Without a Central Bank
Though this rate is actually higher than the previous period, Sylla
argues that this century was one where the United States ought to
have been growing at high rates
Indeed from 1913-2007, the time period with the Federal Reserve as
the central bank, this growth rate was substantially higher at 2.11%
per year
In other words, Sylla suggests that the eight decades without a
central bank had the effect of dampening US real GDP growth
This is further backed up by the fact that only period in which the
US did not grow significantly faster than Britain was in the four
decades from the 1830s to the 1870s (i.e. when there was no
central bank)
7
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
4. Growth With and Without a Central Bank
To predict what US growth might have been from 1833-1913 if a
central bank had been in operation, Sylla suggests that 1.75% is a
counterfactual growth rate that we can use: one that is much
higher than what actually existed
Additionally Sylla discusses the history of US central banks and the
frequency of financial crises:
◦ In the US for the 140 years that a central bank was in place,
only 8 crises occurred, while in the 80 years without a central
bank 8 crises occurred
◦ Therefore not only is growth hampered by the absence of a
central bank, but financial crises become much more frequent
8
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Conclusion
Sylla’s Conclusion
Overall Sylla presents some very convincing arguments in this paper
and he concludes that central banks are vital in making crises less
frequent.
They also allow credit expansions and contractions to occur in
smooth fashion, which ultimately has a positive effect on a
country’s rate of economic growth
Thus the conclusion of the paper is:
“The Federal Reserve was not a bad idea.”
9
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Comments
Comments:
Overall this paper was well thought-out and well presented
In particular, the details and nuances of some of history of central banks
in the United States were insightful. I certainly learned a lot!
The strengths of the paper lie specifically in the discussion of how the
central bank operated in the country in the context of the political
situation and time period in question
For instance, the comparing the BUS with the Federal Reserve is not an
apples-to-apples comparison, and Sylla skillfully outlines why this is the
case
10
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Criticisms
Criticisms: three specific instances were the arguments need to be more
developed
1 Sylla points out that from the 1830s to 1870s (when there was no US
central bank) Britain grew faster:
◦ However comparing British growth from 1831-1875 and US growth
from 1833-1873, we see that British real GDP per capita grew at a
rate of 0.04% per more than US real GDP per capita
◦ This begs the question: is this a statistically significant difference?
◦ Or can we discard this number as inconsequential?
11
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Criticisms
2 Sylla takes the US growth rate of 1.4% per year from 1790-1833 and the
growth rate of 2.1% per year from 1913-2007 to compute his
counterfactual growth rate of 1.75% per year from 1833-1913
◦ This is unlikely to be an adequate way of computing counterfactual
growth rates
◦ It is based purely on the mean of the two numbers that we have,
which in itself ignores the number of years within each time period
◦ A more sophisticated approach that estimates a growth equation
first, and then uses such a model to compute static or dynamic
forecasts would be a more satisfying way of computing a
counterfactual growth series
12
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Criticisms
3 The point made about the frequency of financial crises was an excellent
point, but this idea is crying out for an analysis of the severity of the
financial crises that occurred both with and without a central bank
◦ If the 8 financial crises that occurred from 1833-1913 (no central
bank) were much less severe than the 8 crises that occurred under
the operation of a central bank, then maybe we wouldn’t care as
much about this frequency result?
13
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Possible Extensions
Possible Extensions: these points aside, I believe the growth section
warrants development along the following two dimensions:
1
Data
◦ Sylla uses averages computed from the Officer and Williamson
(2011) data set, without utilizing the time series to its fullest extent
◦ Data going back this far is not always to obtain, but it does exist
14
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Possible Extensions
15
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Possible Extensions
◦ Clearly there is more to these data than simple sample averages can tell us
◦ Which brings me to my second point
16
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Possible Extensions
2
Isolating the Impact of the Central Bank on Growth
◦ The paper completely ignores other factors that affected US growth
in the nineteenth and early twentieth centuries
◦ I agree that the existence or nonexistence of a central bank
potentially plays a role in shaping what growth could or could not
be, but in the absence of a serious regression analysis we cannot
really make conclusions about this one way or the other
◦ In other words, we are more than likely either overstating or
understating the impact that the central bank has on growth since
we have not controlled for other crucial factors that were also
important at the same time
17
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Possible Extensions
Some examples from the literature of other factors that need to be
considered at the same time as the existence of a central bank:
◦ Irwin (2001) argues that late nineteenth century growth in the US hinged
crucially on population expansion and capital accumulation, which in turn
was negatively affected by tariffs
◦ Broadberry and Irwin (2006) argue that UK growth was higher than US
growth in the mid-nineteenth century due to higher aggregate labor
productivity (as opposed to the lack of a central bank)
◦ Indeed, Irwin (2003) asserts that US growth increased after 1910 due to
an abundance in iron and steel that enabled a sharp increase in the export
of US manufactured goods (therefore growth is possibly not due to the
Federal Reserve but due to other factors)
18
Comments on “US Growth and Stability with and without a Central Bank” by Richard Sylla
Possible Extensions
While Sylla’s paper does not necessarily argue that the above points
did not affect growth, unless we compare these factors
simultaneously with central bank existence, there’s no way for us to
really know if the Federal Reserve has had a positive or negative
impact on US growth
This is the main aspect in which this paper needs to be developed,
but if the claims of the paper withstand such tests then this piece of
research has the potential to be an important finding in the
argument in favor of the Federal Reserve
19
Comments on “US Growth and Stability with and without a Central Bank” by
Richard Sylla
Sandeep Mazumder
In this paper, Sylla poses and addresses five main questions concerning the history of the
central bank in the United States:
1. How did the newly independent United States have a central bank so early in its
history?
2. Why did the US abandon its central bank from 1833-1913?
3. Why after this period did the US reestablish a central bank?
4. What price did the US pay for not having a central bank in those eight decades?
5. Can we say anything about economic growth and financial stability if we compare
US history in the periods with and without a central bank?
Before examining potential improvements and/or extensions that could be made to this
paper, let us consider the answers that Sylla posits to the above four (combining 3 and 4
into one question) questions
1. How did the newly independent United States have a central bank so early in its
history?
 Alexander Hamilton (at that time the US Treasury Secretary) in 1781
recommended to Robert Morris (Congress‟ Superintendent of Finance)
that a central bank be created in order to “increase public and private
credit.”
 Simultaneously Hamilton suggested that trade would greatly be enhanced
by the setting up of a central bank
 The example that Hamilton modeled this notion from was Great Britain
who he noted as being “indebted” for their success to their own central
bank
 Indeed he noted that “tis by this alone she (Britain) menaces our
independence.”
 Sylla clearly admires the ideas set forth by Hamilton in his
recommendation for a central bank and argues that Hamilton was ahead of
his time when it came to thinking about the interaction that the financial
sector has with politics and economics
 But more to the point, Sylla argues in this paper that the central bank in
the US (at that time the Bank of the United States) was imperative as a
source of loans to the government, thereby enabling them to protect its
rights and interests.
 One example of such interest was the financing of the US revolutionary
war
 A particular strength of this paper when addressing the creation of the
Bank of the United States was to ask the question: was this really a central
bank at all?
1
o If we use the benchmark of modern central banks, Sylla argues,
then surely the BUS cannot be considered a central bank
o However Sylla is quite correct in saying that the BUS was the
federal government‟s bank, and thus was a creditor of many state
banks. Therefore it had the power to restrain (or conversely not
restrain) the credit expansion of banks by manipulating the rate in
which notes were returned to them
o In other words, the BUS by all accounts can be considered to be
the United States‟ first central bank
2. Why did the US abandon its central bank from 1833-1913?
 Credit was expanded too quickly when the BUS first opened in 1791,
leading to a speculate bubble that peaked in 1792
 The second version of the BUS also over-expanded credit in its first years
(1817-18)
 Thereafter the BUS became the Treasury‟s tool for contracting credit after
the inflation caused by the War of 1812
 This credit contraction led to a US panic in 1819, for which the BUS
received the brunt of the public‟s blame
 A strong part of this paper is where Sylla argues that there‟s more to the
story than this: the central bank wasn‟t disbanded purely due to mistakes
made in extending lines of credit
 State banks actually had large incentives to do away with the central bank:
o The state banks could get rid of the regulator and no longer have
restrictions on how much they could expand credit
o And state banks could gain the federal government‟s banking
business
 In other words, the central bank in the US was brought down for political
not economic reasons, according to Sylla‟s arguments in this paper
3 & 4. Why after this period did the US reestablish a central bank? In other words,
what price did the US pay for not having a central bank in those eight decades?
 Since this paper argues that a central bank facilitates the increase in public
and private credit, the natural consequence of the abolition of the central
bank is that public and private credit must be damaged
 Sylla examines the spread between US and UK government bond yield to
see if there is evidence for this argument
 He finds that this spread went from 26 basis points in the first decade of
the 19th century to 57 basis points from 1810-19
 In the decades of the 1840s, 1850s, and 1860s the spread continued to
widen, providing evidence that the US‟ ability to create credit was greatly
reduced by the lack of a central bank
 Although Sylla astutely acknowledges that this increasing spread cannot
be solely attributed to the abandoning of the central bank: country risk
2
existed as well, such as from the war with Mexico, and the political
tensions that arose from slavery before the Civil War
5. Can we say anything about economic growth and financial stability if we compare
US history in the periods with and without a central bank?
 Theory tells us that higher borrowing costs that arise without a central
bank will lead to reduced capital accumulation and therefore lower
economic growth
 The data that Sylla presents points towards the US growing at a faster rate
with a central bank than without a central bank
 For instance, from 1790 to 1833 US real GDP per capita grew at an
average annual rate of 1.41% per year (based on Officer and Williamson
(2011) data)
 However in the period without a central bank (1833-1913), this growth
rate was 1.50% per year
 Though this rate is actually higher than the previous period, Sylla argues
that this century was one where the United States ought to have been
growing at high rates
 Indeed from 1913-2007, the time period with the Federal Reserve as the
central bank, this growth rate was substantially higher at 2.11% per year
 In other words, Sylla suggest that the eight decades without a central bank
had the effect of dampening US real GDP growth
 This is further backed up by the fact that only period in which the US did
not grow significantly faster than Britain was in the four decades from the
1830s to the 1870s
 To predict what US growth might have been from 1833-1913 if a central
bank had been in operation, Sylla suggests that 1.75% is a counterfactual
growth rate that we can use; one that is much higher than what actually
existed
 The final piece of evidence that Sylla presents with regards to the history
of US central banks is the frequency of financial crises.
 In the US for the 140 years that a central bank was in place, only 8 crises
occurred, while in the 80 years without a central bank 8 crises occurred
 Therefore not only is growth hampered by the absence of a central bank,
but financial crises become much more frequent
Sylla‟s Conclusion:
 Overall Sylla presents some very convincing arguments in this paper and he
concludes that central banks are vital in making crises less frequent.
 They also allow credit expansions and contractions to occur in smooth fashion,
that ultimately has a positive effect on a country‟s rate of economic growth
 Thus the conclusion of the paper is “The Federal Reserve was not a bad idea.”
Comments:
 Overall this paper was well thought-out and well presented
3





In particular, the details and nuances of some of history of central banks in the
United States was insightful. I certainly learned a lot!
The strengths of the paper lie specifically in the discussion of how the central
bank operated in the country in the context of the political situation and time
period in question
For instance, the comparing the BUS with the Federal Reserve is not an apples-toapples comparison, and Sylla skillfully outlines why this is the case
In several places, Sylla alludes to the political interferences that hampered the
central bank
This idea of „central bank independence‟ I believe was a little underdeveloped in
the paper, particularly given the large literature that argues how the effectiveness
of central banks is directly tied to the credibility of monetary policymakers. This
is something that can be strengthened in one or two areas in the paper
Criticisms:
 The main place where the paper was a little weak was its argument that US
growth would have been much higher if a central bank had existed from 18131933
 This argument is highly intriguing—indeed it is the premise of the entire paper—
but needs to be much more thorough
 Three specific instances were the arguments need to be more developed:
 Sylla points out that from the 1830s to 1870s (when there was no US
central bank) Britain grow faster. However comparing British growth
from 1831-1875 and US growth from 1833-1873, we see that British real
GDP per capita grew at a rate of 0.04% per more than US real GDP per
capita
 This begs the question: is this a statistically significant difference?
 Or can we discard this number as inconsequential?
 Sylla takes the US growth rate of 1.4% per year from 1790-1833 and the
growth rate of 2.1% per year from 1913-2007 to compute his
counterfactual growth rate of 1.75% per year from 1833-1913
 This clearly is not an adequate way of computing counterfactual
growth rates
 It is based purely on the mean of the two numbers that we have,
which in itself ignores the number of years within each time period
 A more sophisticated approach that estimates a growth equation
first would be a more satisfying way of computing a counterfactual
growth series
 The point made about the frequency of financial crises was an excellent
point, but this idea is screaming for an analysis of the severity of the
financial crises that occurred both with and without a central bank
 If the 8 financial crises that occurred from 1833-1913 were much
less severe than the 8 crises that occurred under the operation of a
central bank, then maybe we wouldn‟t care as much about this
frequency result?
4
Extensions:
 These points aside, I believe the growth section warrants extension along the
following two dimensions:
1. Data
 Sylla uses averages computed from the Officer and Williamson
(2011) data, without utilizing the time series in its fullest extent
 Data going back this far is not always to obtain, but it does
exist…show diagrams
 Clearly these more to these data than simple sample averages can
tell us
 Which brings me to my second point
2. Isolating the Impact of a Central Bank on Growth
 The paper completely ignores other factors that affected US
growth in the nineteenth and early twentieth centuries
 I agree that the existence of nonexistence of a central bank plays a
role in shaping what growth could or could not be, but in the
absence of a serious regression analysis we cannot really make
conclusions about this one way or the other
 In other words, we are more than likely either overstating or
understating the impact that the central bank has on growth since
we have not controlled for other crucial factors that were also
important at the same time
 Some examples from the literature of other factors that need to be
considered at the same time as the existence of a central bank:
 Irwin (2001) argues that late nineteenth century growth in
the US hinged crucially on population expansion and
capital accumulation, which in turn was negatively affected
by tariffs
 Broadberry and Irwin (2006) argue that UK growth was
higher than US growth in the mid-nineteenth century due to
higher aggregate labor productivity (as opposed to the lack
of a central bank)
 Indeed, Irwin (2003) asserts that US growth increased after
1910 due to an abundance in iron and steel that enabled a
sharp increase in the export of US manufactured goods.
 While Sylla‟s paper does not necessarily argue that the above
points did not affect growth, unless we compare these factors
simultaneously with central bank existence, there‟s no way for us
to really know if the Federal Reserve has had a positive or negative
impact on US growth
 This is the main aspect in which this paper needs to be developed,
but if the claims of the paper withstand such tests then this piece of
research has the potential to be an important finding in the
argument in favor of the Federal Reserve
5
jw FRBadIdea/ITtoFR
1/8/11
A COMPARISON OF THE INDEPENDENT TREASURY AND THE
FEDERAL RESERVE AS CONGRESS’S AGENTS FOR ‘THE
REGULATION OF THE CURRENCY’
John H. Wood
Wake Forest University
The Congress shall have Power … To coin Money, regulate the
Value thereof, and of foreign Coin, and fix the Standard of Weights and
Measures.
U.S. Constitution, Art. 1, Sec. 8.
Abstract
The principal monetary authority, or agent of Congress’s money power,
between 1846 and 1914, was the U.S. Treasury Department, closely
monitored by Congress. It was succeeded in this role by the more
independent Federal Reserve. The Great Depression of 1929-33 may
have been worsened by the increase in monetary policy’s independence
of Congress.
Which produces better policy: close congressional oversight,
including debates over controversial actions, of the monetary
authority, or an expert independent agency outside Congress’s
attention? Experience of the Independent Treasury of 1846-1913
and the Federal Reserve System since 1913, allow at least partial
answers.
The principal short-term influence on the monetary base in the
decades before the creation of the Federal Reserve System was the
U.S. Treasury. Government was smaller than today, but Treasury
receipts and spending exerted substantial effects on money and the
financial markets. Congress sought to modify these effects by the
Independent Treasury Act of 1846, which directed the Treasury to
receive and pay funds with as little as possible to do with banks – a
course that reinforced Treasury disturbances to the monetary base.
The story of the Independent Treasury in Section 1 is one of
Treasury secretaries bending or breaking the law, subject to
monitoring by Congress, in the interests of the money markets.
Section 2 is concerned with the replacement of the
Treasury/Congress’s control of money by an independent expert
agency. I deal primarily with the Federal Reserve’s first twenty
years. It was controlled by the Executive during and after World
War I for the purpose of monetizing the deficit. After the severe
fluctuations associated with the Federal Reserve’s release from the
support of government bond prices in 1920 and its tight-money
response to inflation, Congress criticized the Executive’s influence
and reaffirmed the Federal Reserve’s independence in 1922, which it
enjoyed until the coming of the New Deal in 1933.
Section 3 outlines a model in which monetary policy is
determined by the influence on governance and utilities of Congress,
the Executive, and the monetary authority. The model is checked
against natural experiments arising from shocks to the governance of
policy.
The last section speculates on the effects of the replacement of
the Independent Treasury by the Federal Reserve, especially during
the Great Depression. The independence of the latter expert agency
from congressional oversight had important effects on the general
welfare.
1
1. The Independent Treasury, 1846-1913
Be it enacted …, Sec. 6. That the treasurer of the United States …
and all public officers of whatsoever character … are hereby required
to keep safely, without loaning, using, depositing in banks, or
exchanging for other funds than as allowed by this act, all the public
money collected by them … till the same is ordered by the proper
department or officer of the Government to be transferred or paid
out….
Sec. 18. That on January 1, 1847, and thereafter, all duties, taxes,
sales of public lands, debts, and sums of money accruing or becoming
due to the United States … shall be paid in gold and silver coin only, or
in treasury notes ….
Sec. 19. That on April 1, 1847, and thereafter, every officer or
agent engaged in making disbursements on account of the United States
… shall make all payments in gold and silver coin, or in treasury notes
if the creditor agree to receive said notes …
The Independent Treasury Act, August 6, 1846.1
Origins. President Andrew Jackson’s decision in 1833 to transfer the
government’s deposits from the Bank of the United States to statechartered commercial banks turned the Treasury’s depository choices
into a political football.2 The 1836 Act to Regulate the Deposits of
Public Money, which directed that they be distributed among the
states “in proportion to their respective representation in the Senate
and House of Representatives of the United States” did not prevent
active bank lobbying for deposits.3 Charges that “pet banks” were
the benefactors of political favoritism, along with losses from bank
failures, led Congress to require the Treasury to secure its money in
its own, “sub-treasury,” vaults.
The “independent Treasury” was opposed by Daniel Webster in
the Senate because
The use of money is in the exchange. It is designed to circulate,
not to be hoarded. All the Government should have to do with it is to
receive it today, that it may pay it away tomorrow. It should not
receive it before it needs it, and it should part with it as soon as it owes
it. To keep it – that is, to detain it, to hold it back from general use, to
hoard it, is a conception belonging to barbarous times and barbarous
Governments (Congressional Globe, 25th Cong., 2nd sess., app., pp.
634-35).
The Independent Treasury bill was passed in 1840 but repealed the
next year by the Whig Congress in preparation for a third national
bank, which, however, was vetoed by President Tyler. The
Independent Treasury was reestablished in 1846, and managed the
government’s cash until the Federal Reserve became its fiscal agent.
The Whigs and then the Republicans, supported by most economists,
continued to prefer a national bank, but were unable to overcome the
suspicions of big government and financial interests entertained by
the party of Jefferson and Jackson until it changed course under
Woodrow Wilson.
The Treasury and the money markets. “The relations between the
treasury and the money market [,which]under the most favorable
conditions require skillful management” (Myers 1931, p. 353), were
subjected by the Independent Treasury to additional shocks from
federal budgets and the Treasury’s cash collection and payment
procedures. Seasonal movements in net Treasury receipts absorbed
reserves in active times such as the autumnal crop movements. The
fiscal surpluses common to peace had longer-term deflationary
effects. During the two decades of falling prices preceding 1896,
Treasury balances rose from $51 million to $258 million, significant
amounts compared with the average monetary base of $1 billion.
“A strict interpretation of the law … was difficult to maintain in
the face of the market’s need and it was gradually relaxed” (Myers
1931, p. 355). The Treasury often supplied funds to the financial
markets under stress by early interest payments, debt redemptions,
and the use of banks as government depositories -- equivalent to the
later open-market operations and direct bank lending by the Federal
Reserve. Both institutions were dependent on, and interested in, the
strength and stability of financial institutions and markets.
2
The first Secretary of the Independent Treasury, Robert Walker
(1845-49), promised that the system would give “stability to
[business] operations, and insure them, to a great extent, against
those fluctuations, expansions, and contractions of the currency so
prejudicial to their interests.” It avoided the “ruinous” expansions
and revulsions of bank paper compounded by the national bank
favored by the Whigs (CG, 29th Cong., 1st sess., app., p. 13; 2nd sess., p.
10). Democratic secretaries had a special reason for assisting
financial stability.
Congressmen understood the Treasury’s influence on monetary
conditions. The Whig W.S. Miller warned that the Secretary of the
Treasury would have great capacity for mischief in the new system
because he “will hold in his hands the destinies of the trading
community.” He saw the Treasury’s ability to issue notes as a
particularly disturbing influence. Senator Thomas Hart Benton
complained that its power to issue notes made the Treasury a bank of
issue (CG, 29th Cong., 1st sess., p. 1115).
This was not all bad, Chairman R.T.M. Hunter of the Senate
Committee on Finance, said ten years later. The issuance notes
during the 1857 recession promised to “relieve the community more
… than any other mode in which we can borrow money.” Because
the notes served as bank reserves, “We offer incidentally to the
merchant and to the banks a great advantage in Treasury paper of
this sort, which is equivalent to specie” (CG, 35th Cong., 1st sess., pp.
96-97).
Secretary James Guthrie had reported in the summer of 1853 that
… the amount still continuing to accumulate in the Treasury,
apprehensions were entertained that a contraction of discounts by the
city banks of New York would result, … and … might have an
injurious influence on financial and commercial operations. With a
view, therefore, to give public assurance that money would not be
permitted to accumulate in the Treasury, a public offer was made on the
30th of July to redeem … the sum of $5 million of the loans of 1847 and
1848. (CG, 33rd Cong., 2d sess., app., p. 250)
Guthrie justified actions such as this in the 1856 Treasury Annual
Report by calling attention to the uncertainties that destroy
… confidence, and with it credit, inducing the hoarding of the precious
metals, the withdrawal of deposits, the return of bank notes for
redemption, the consequent stagnation of commerce in all its channels
and operations, the reduction of prices and wages with inability to
purchase and pay, bank suspensions and general insolvency…. The
independent treasury, when over-trading takes place, gradually fills its
vaults, withdraws the deposits, and, pressing the banks, the merchants
and the dealers, exercises that temperate and timely control which
serves to secure the fortunes of individuals and preserve the general
prosperity. (pp. 31-32)
Secretary Howell Cobb carried Guthrie’s activism into the panic of
1857 until the Treasury’s gold and silver balance, further depleted by
the budget’s turn to deficit, neared the $6,000,000 regarded as a
minimum. Cobb defended his halt to debt purchases in the 1857
Treasury Report:
There are many persons who seem to think that it is the duty of the
Government to provide relief in all cases of trouble and distress ... and
their necessities, not their judgments, force them to the conclusion that
the Government not only can, but ought to relieve them. (pp. 11-12)
Treasury interventions, overseen by a Congress that took its
monetary responsibilities seriously, continued to the end of life of the
Independent Treasury. The similar Treasury and Fed responses to
influences on the monetary base are depicted in Figures 1 and 2.
Meanwhile, it is worth looking at the relations of Congress and
the Treasury during the post-Civil War resumption of the gold
standard, which we will see differed significantly from those
between Congress and the Federal Reserve a half-century later.
The post-Civil War resumption. War spending and deficits induced
runs on gold and suspensions of convertibility by banks and the
Treasury at the end of 1861. Four-fifths of Civil War government
spending was financed by debt, one-fifth of which was non-
3
convertible currency -- the famous “greenbacks” – and the dollar
price of gold doubled between 1861 and 1864. The prices of goods
in general rose seventy-five percent (Figure 3). The resumption of
dollar convertibility at its pre-war value would require a substantial
deflation.
Three approaches were considered. Some groups, including the
Greenback Party, opposed deflation. These overlapped with the
silver interests that later took the lead in the fight against the gold
standard. Congress at first took the opposite view, and in December
1865, a House resolution stating “the necessity for a contraction of
the currency with a view to as early a resumption of specie payment
as the business interests of the country would permit” passed by a
vote of 144-6. This suited Secretary of the Treasury Hugh
McCulloch, whose “chief aim [was] to provide the means to
discharge the claims upon the Treasury at the earliest date
practicable, and to institute measures to bring the country gradually
back to the specie basis, a departure from which … is no less
damaging and demoralizing to the people than expensive to the
Government.”4
However the “resolution soon proved not to reflect the real
sentiment of the people” (Dewey 1922, p. 335). The secretary had
set about his task too energetically to suit most people. He was
denounced as an impractical and dangerous theorist who expected to
achieve specie payments by a ‘few legislative whereases and be it
enacteds’, while American industry was paralyzed by the deflation
and uncertainty resulting from his “species of experiment,” to take a
sampling of letters to Congress.5
In April 1866, Congress restricted retirements to $10 million a
month the next six months and $4 million a month thereafter.
McCulloch protested. “He thought the limit could be doubled
“without injuriously affecting legitimate business…. There is a great
adaptability in the business of the United States, and it will easily
accommodate itself to any policy which the Government may adopt”
(Treasury Annual Report 1865; Krooss, 1969, pp. 1467-68).
McCulloch proceeded as rapidly as he was allowed, and had cut
greenbacks almost in half when in February 1868 Congress froze
them at the amount then in circulation -- $347 million. Republican
leader James G. Blaine wrote of the pressures on Congress:
Mr. McCulloch, in trying to enforce the policy of contraction
represented an apparently consistent theory in finance; but the great host
of debtors who did not wish their obligations to be made more onerous
and the great host of creditors who did not desire that their debtors
should be embarrassed and possibly rendered unable to liquidate united
on the practical side of the question and aroused public opinion against
the course of the Treasury Department. In the end, outside of banking
and financial centers, there was a strong and persistent demand for
repeal of the Contraction Act. [A]lthough it might be admitted that the
entire nation would be benefited by the ultimate result, the people knew
that the process would bring embarrassment to vast numbers and would
reduce not a few to bankruptcy and ruin.
James G. Blaine, Twenty Years of Congress, p. 328.
The middle way advocated by John Sherman, chairman of the
Senate Finance Committee – that resumption should occur naturally
and gradually, without restriction, by letting the country grow into
the stock of currency – became, with fits and starts, the official
policy. “Unofficially, procrastination became the norm; and after a
few years many congressmen were paying only lip service to the
resumption ideal” (Timberlake 1993, p. 91).
So much for long-term goals. The Treasury’s short-term
behavior took up where it had left off before the war, that is, usually
if irregularly inclined to assist the money market. President Grant’s
first secretary, George Boutwell (1869-73) engaged in open-market
purchases, especially in the autumn, and in October 1872 stretched
the law to reissue $5,000,000 of the retired greenbacks. “Where but
in the Treasury Department can the power for increasing and
decreasing the currency be reposed? I form the conclusion that the
circulation of the banks should be fixed and limited, and that the
power to change the volume of circulation within limits established
4
by law, should remain in the Treasury Department” (TAR 1872, p.
xxii).
Two important lessons of the discussion so far will be helpful in
comparing the Independent Treasury and the Federal Reserve. The
19th –century populace, Congress, and usually the Treasury
recognized the importance of the money supply – like the populace
and parts of Congress but unlike the Federal Reserve in the 1930s;
and the monetary rules vs. discretion debate was alive in the 19th
century.
Boutwell’s policy was debated, but Congress took no action. He
continued to defend his actions in the Senate, which he entered upon
leaving the Treasury. His use of the greenback reserve was
… in its effect … substantially what is done by the Government of
Great Britain through the Bank of England. The Secretary furnished
temporary relief…. Clothed with authority by law, [he] could not sit
silent and inactive while ruin was blasting the prospects of many and
creating the most serious apprehensions in all parts of the country. It
was a great responsibility; but it is a responsibility which must be taken
by men who are clothed with the authority. (Congressional Record, 43d
Cong., 1st sess., app., p. 19)
Boutwell, responded to Senator Carl Schurz’s charge that his was a
“do-nothing policy” as far as resumption was concerned by saying
that his opinions the last “five years have been the opinions of the
people of this country. Moreover, these opinions have been
illustrated in a policy which was alike the policy of the legislative
and executive branches of the government” (p. 17).
“In fact,” Timberlake (1993, p. 101) observed, “Congress had
not intended either to grant discretion to the secretary in the use of
the ‘reserve’ or to deny it…. The issue had simply been
overlooked…. Congress could have promptly settled the issue with a
simple act specifying its norms of policy, but it left the issue
unresolved. Undoubtedly it was a case of ‘leave it alone and maybe
nothing will happen’. Nevertheless, in doing nothing Congress by
implication sanctioned the secretary’s discretion over the greenback
‘reserve’.”
Sherman chided his colleagues for their gestures to resumption
while allowing money to increase and the gold premium to continue
(CR, 43d Cong., 1st sess., p. 700). It had fallen from 100 percent at
the end of the war to 11 percent in October 1870, but remained near
that point for six years.
Congress did not adopt a more rigorous policy until after the
1874 elections in which the Democrats won control of the House and
gained several seats in the Senate. The Republican majority of the
lame-duck Congress believed their loss had been caused by the
Democrats’ exploitation of the conflicts between the GOP’s hardand soft-money wings, and in the interest of party unity, looking
toward the 1876 elections, arranged a compromise. The Resumption
Act of January 1875 removed the limit on National Bank notes,
which especially helped the soft-money southern and western
regions that felt short-changed. In an offsetting-appeal to
conservatives, it was made the duty of the Treasury to redeem
greenbacks at the rate of eighty percent of increases in national bank
notes. Finally, the date of full resumption of Treasury liabilities for
specie was set for January 1, 1879 (Krooss 1969, pp 1684-85).
The Act was received with a mixture of indifference and
skepticism. Financial writers were unclear whether it was
inflationary or deflationary, and thought its purposes purely political.
A resumption date had been set, but they saw nothing in the Act to
bring it about. It was a mere wish, a futile gesture that only created
four more years of uncertainty (Unger 1964, pp. 260-62; Timberlake
1993, pp. 110-12).
The dedicated resumptionist Schurz asked whether some of the
notes redeemed by the Treasury would be reissued, as in the past.
Sherman answered that he would leave the interpretation of
“redeem” to future Congresses, when greenbacks were down to the
target $300 million. “The case that is put … may never arise…. But
if there is any doubt upon that question, I leave every Senator to
5
construe the law for himself; and if there is a doubt about it, I say it
is not wise as practical men dealing with practical affairs, seeking to
accomplish a result, to introduce into this bill a controversy which
will prevent that unity that is necessary to carry out the good that is
contained in this bill.” The hard-money Democratic Senator Allen
Thurman complained that “it is very difficult to find what is in [the
bill]. We know that there is a great deal of omission but the least
possible amount of commission that ever I have seen in a great
public measure” (CR 43d Cong., 2nd sess., pp. 196-97).
Sherman’s unwillingness to try to control future actions
resembled Prime Minister Robert Peel’s opposition to the suggestion
that the 1844 law tying the Bank of England’s notes to its gold
should include a provision for relaxation in the event of crisis.
My confidence is unshaken that we are taking all the precautions which
legislation can prudently take in against the recurrence of a monetary
crisis. It may occur in spite of our precautions, and if it does, and if it
be necessary to assume a grave responsibility for the purpose of
meeting it, I dare say men will be found willing to assume such a
responsibility. I would rather trust to this than impair the efficiency
and probable success of those measures by which one hopes to control
evil tendencies in the beginning, and to diminish the risk that
extraordinary measures may be necessary. (Wood 2005, p. 98)
They had different motives – Sherman’s the common political
avoidance of conflicts over details, and Peel’s the avoidance of time
inconsistency (the promise of assistance guarantees its necessity,
Samuel Jones Loyd [1844] had warned), but both saw the advantages
(political or economic) of trusting the discretion of future decisionmakers.
Opponents were unable to get the two-thirds majority necessary
to override the inevitable Republican presidential veto, and the
measure remained on the books until, to the surprise of many, it was
implemented as written. The plan proved more restrictive than had
been thought. Although the $80 reduction in greenbacks for every
$100 increase in national bank notes sounded inflationary, it forced a
contraction because the greenbacks were high-powered money.
This, possibly reinforced by the market’s confidence in its success,
and the good luck of a favorable trade balance and inflows of gold
associated with bad harvests in Europe and good harvests in the
United States, enabled resumption on schedule (Friedman and
Schwartz 1963, pp. 79-85; Carter 2006, tab. Ee1-21).
The resumption of 1865-79 was the longest and (possibly as a
result) the least painful of those that ended the wartime suspensions
of the gold standard in Britain and the United States the last two
centuries (The others were the Napoleonic Wars, the War of 1812,
and World War I). Nature was generally allowed to take its course.
Congress and the Treasury by and large waited for the economy to
grow into the money stock. History – including Wesley Mitchell’s
Business Cycles (p. 45), NBER indicators, and Willard Thorp’s
Annals (p. 67) -- has labeled most of this period recessionary, which
accords with the traditional association of deflation and depression.
In fact, output fell perceptively only in 1874, and grew at an average
annual rate of 4.4 percent -- 4.5 percent during the so-called long
recession of 1873-79 (Carter 2006, tab. Ca9).
The question remains: why did resumption take so long? The
answer seems to be that the electorate – acting through Congress -was involved in the decision, and important groups were disposed to
moderation. They, like the British businessmen and economists of
the 1920s, desired resumption sometime, but not at the price of
present pain (Moggridge 1969). No one with the self-assurance and
influence of David Ricardo (after 1813 in Britain), William
Crawford (Secretary of the Treasury 1816-25), or Montagu Norman
(Governor of the Bank of England, 1920-44) was at hand to force a
hard-money policy (Wood 2000). Furthermore – and this may be the
most important reason – there was no “expert” third party following
the Civil War, no central bank, at hand whom the politicians could
assign to administer the medicine.
This was the era of what the young Woodrow Wilson (1885)
called Congressional Government.6 “The checks and balances which
6
once obtained,” he wrote, “are no longer effective.” The federal
courts were under the appointive power of Congress, and the
Supreme Court had declared its reluctance “to interfere with the
political discretion of either Congress or the President.” The
President’s cabinet had been made “humble servants” of Congress.
In line with its British heritage, Congress in the course of exercising
its power of the purse expected the Secretary of the Treasury to be its
agent.
Speaking for the Morrison resolution that prescribed the
Treasury’s cash (see below), Senator James Beck reminded his
colleagues that whereas the laws creating the other executive
departments enjoined their secretaries to advise and act under the
direction of the president, the Secretary of the Treasury was required
“to make report and give information to either branch of the
Legislature … and generally to perform all such services relative to
the finances as he shall be directed to perform…. We with the
Secretary of the Treasury manage the purse; the president and the
other secretaries control the sword” (CR, 49th Cong., 1st sess., p. 7675).
Late 19th century Congresses exercised their constitutional
authority over the currency directly. They did not pass it on to an
expert agency independent of congressional appropriations. In the
previous American resumption a strong secretary had been able to
use the national bank. “The Bank supplied the machinery, the
secretary supplied the brains” (Hammond 1957, p. 249), and the
Bank got the blame. The Bank of England similarly got most of the
blame for the disasters associated with the returns to gold in 1819
and 1925. Consequently, the Bank’s powers were pulled back while
the governments of the day survived (Wood 2005, pp. 47-59, 28093)7.
Between 1865 and 1879, however, the legislators were directly
accountable for the currency. The political cost of imposing pain has
been given as a reason for divorcing the politicians from money. On
the other hand, devotion to the ideal monetary theory of the day
carries costs of its own. “Wasn’t it Lord Melbourne who said that
‘No statesman ever does anything really foolish except on
principle’“? Keynes asked in reference to the government’s
determination to defend the pound in 1930 (Writings xx, p. 379)
Discretionary money management. A central bank? The Independent
Treasury was intended to keep the Government’s money from banks.
But in the 1880s, as in the 1850s, the Treasury had a greater reserve
than seemed necessary and its secretaries were sensitive to the
money market. There was no legal reserve or special redemption
fund, although “by tradition public sentiment adopted $100,000,000
as the line of demarcation between safety and danger” (Dewey 1922,
p. 441). Some took advantage of an 1861 amendment “to allow the
Secretary of the Treasury to deposit any of the moneys obtained on
any of the loans now authorized by law … in such solvent speciepaying banks as he may select” (Krooss 1969, p. 1174). The
amendment was irrelevant during the war suspension, but Secretary
Charles Fairchild (1887-89), who “always considered the needs of
banks,” used it to justify an expansion of Treasury bank deposits
from $13 million to $54 million (Taus 1943, pp. 81-82).
The Commercial and Financial Chronicle noted: “The time was
when our banks provided beforehand for the fall trade and so
trimmed their sails through the summer months to avert a storm by
preparing themselves for the crop demand. Of late years they have
looked to the Treasury wholly and have gone through the summer
trenching on their reserves regardless of any increased drain sure to
come later on” (Taus, 1943, p. 88). Sometimes they were
disappointed. Secretary William Windom (1889-91), “a strict
observer of the letter of the Law of 1846” (Taus 1943, p. 82),
“believed that the policy of depositing public money in banks was
wholly unjustifiable,” and cut the Treasury bank deposits to $21
million.
Congressmen complained of excessive sums in Treasury vaults
that might be applied to the debt to save interest expenses, and the
Appropriation Act of 1881 gave the Treasury discretion to redeem
7
Government debt. But balances remained high, and rose during the
Cleveland administration (1885-89), which desired a “prudent”
reserve.8 In 1886, those wanting easier money secured House and
Senate agreement to the Morrison resolution that called on the
Treasury to apply its “surplus or balance … over $100,000,000 … to
the payment of the interest-bearing indebtedness of the United
States” at a maximum rate of $10,000,000 a month.9 Congressman
A.J. Warner quoted Lord Overstone -- “In adopting a paper
circulation we must unavoidably depend for a maintenance of its due
value upon the adoption of a strict and judicious rule for the
regulation of its amount” -- and asked why it was necessary to
“hoard $228,000,000 in the Treasury of the United States? Is it to
purchase the favor of Wall Street and the banks? If so it is altogether
too dear a price” (CR, 49th Cong., 1st sess., pp. 6884, 6887).
Senator Beck argued that it was Congress’s responsibility to
direct the Secretary to relieve him of temptation and political
embarrassment. Congressman Nelson Dingley, on the other hand,
objected to Congress’s interference “with a question which
exclusively pertains to administration. This is the first attempt, I
think, in the history of this Government to determine by a legislative
resolution what should be the working balance of the Treasury…. No
cast-iron rule can be laid down on a matter of this kind.”
Conservatives got a contingency balance of $20,000,000 in the
resolution, and authority for the secretary to suspend debt purchases
in emergencies. Congressman Benjamin Butterworth believed the
secretary’s discretion was “indispensable to the maintenance of the
national credit,” and called the Treasury reserve “the ballast which
keeps our monetary ship steady as she moves through the sea of
financial troubles which constantly threaten” (CR, 49th Cong., 1st
sess., pp. 7675, 6937, and 7998).
The rising silver interests posed a threat to sound money. The
Bland-Allison Act of 1878 instructed the Treasury to buy $2 to $4
million of silver a month. Actual purchases were close to the lower
limit, but the Sherman Silver Purchase Act of 1890, enabled by the
growing political power of the West, required purchases of 4.5
million ounces of silver a month with Treasury notes issued for the
purpose and redeemable in gold or silver coin.10 The new policy
coincided with falls in exports and Government receipts. Both
contributed to gold exports – the first through the balance of trade
and the second by depressing investor confidence in the country’s
ability or desire to remain on the gold standard.
There was panic in June 1893, and President Grover Cleveland
called a special session of Congress to repeal the Silver Purchase Act
with its author’s concurrence. Sherman’s defense of his earlier
action is interesting. He had used his influence, he reminded the
Senate, for the lesser of the two evils then available: limited silver
purchases rather than free silver coinage. Furthermore, the Act was
not inappropriate to the circumstances of its time.
Sir, “give the devil his due.” The law of 1890 may have many
faults, but I stand by it yet, and I will defend it, not as a permanent
public policy, not as a measure that I take any pride in, because I yielded
to the necessity of granting relief, but I do say that the beneficial effects
that flowed from the passage of the law were infinitely greater … than
the loss we have suffered in the fall in the price of silver. Without it, in
1891 and 1892 we would have met difficulties that would have
staggered us much more than the passing breeze of the hour …. The
immediate result of the measure was to increase our currency, and thus
relieve our people from the panic then imminent, similar to that which
we now suffer. The very men who now denounce from Wall Street this
compromise were shouting “Hallelujah!” for their escape by it from free
coinage (CR, 53rd Cong., 1st sess., pp. ).
But times had changed. The Act had caused money and trade to fall
as fears of devaluation led to gold hoards. Now the right course was
to restore confidence in the currency.
Sound money was not assured until later in the decade, after
rising gold production reversed the fall in prices and William
McKinley defeated William Jennings Bryan in the presidential
8
election of 1896. The country formally turned from bimetallism to
gold in the Gold Standard Act of 1900, which declared:
That the dollar consisting of twenty-five and eight-tenths grains of
gold nine-tenths fine … shall be the standard unit of value, and all
forms of money issued or coined by the United States shall be
maintained at a parity of value with this standard, and it shall be the
duty of the Secretary of the Treasury to maintain such parity.
The Treasury would issue and redeem notes for gold, a task that
elsewhere was performed by central banks, and the Act provided that
a reserve fund of $150,000,000 in gold coin and bullion was to be
“set apart in the Treasury.” If the “fund shall at any time fall below
$100,000,000, then it shall be [the secretary’s] duty to restore the
same to the maximum sum of $150,000,000 by borrowing money on
the credit of the United States,” specifically by issuing bonds “to be
payable, principal and interest, in gold coin of the present standard
value….”
Monetary policy continued along the same lines in the 20th
century, although it was distinguished by more explanation – one
might say “greater transparency” – by secretaries and less debate in
Congress. Friedman and Schwartz (1963, p. 149) wrote that the
Treasury’s “central-banking activities … were being converted from
emergency measures to a fairly regular and predictable operating
function.” Andrew (1907) called Secretary Leslie Shaw’s (19021907) policy of serving “the money market as an ever-present help in
time of trouble [was] characterized by innovations and stretching of
his constitutional powers such as ordinarily an administrative official
only makes as a last resort in moments of helpless and unforeseen
catastrophe.” Patton (1907), however, saw in Shaw’s policy simply
a continuation of the Treasury’s “function of regulating the money
market of the country.”
When financial journalists and academic economists condemned
his actions as autocratic and primarily for the relief of “a ring of
powerful Wall Street speculators,” Shaw answered: “It has been the
fixed policy of the Treasury Department for more than half a century
to anticipate monetary stringencies, and so far as possible prevent
panics,” which he likened to pestilences.11
The Treasury was not free of congressional criticism, although
the small amount suggested the majority’s assent.12 Shaw evidently
“stayed within the proper tolerances” (Timberlake 1993, p. 197).
The Republican party controlled both Houses of Congress from 1895
to 1911 (the presidency 1897-1913). The friend of banks and sound
money, Nelson Aldrich, was chairman of the Senate Finance
Committee from 1898 to 1911. These groups had stakes in the
existing monetary standard, and no doubt approved Treasury efforts
to make it work smoothly.
In 1907-1908, Congress adopted several measures “which
expressly sanctioned certain actions of Mr. Shaw. The collateral
required of depository banks was to be left to the discretion of the
Secretary of the Treasury. No longer was the Treasury forbidden to
deposit customs receipts in national depositories. Government funds
could now be placed in properly qualified national banks [and] no
reserve need be held against deposits of public money” (Taus 1943,
pp. 119-20). In addition, the Aldrich-Vreeland Act of 1908 reacted to
the 1907 panic by authorizing the formation of bank groups with
powers to issue “emergency currency” under the administration of
the Secretary of the Treasury. These powers were applied by
Wilson’s Treasury Secretary William McAdoo during the crisis of
August-October 1914 (Taus 1943, pp. 129-30, 139-42).
These and other amendments “which permit the use of the banks
for practically all the business of the Government, have … virtually
abolished the [Independent Treasury] system,” David Kinley (1910,
pp. 206-207) wrote in one of the studies commissioned by the
National Monetary Commission created by the Aldrich-Vreeland Act
of 1908 to “inquire into and report to Congress … what changes are
9
necessary or desirable in the monetary system of the United States or
in the laws relating to banking and currency.” “It has been repealed
piecemeal. The fact that it has been so repealed, that step by step the
separation of the Treasury and the banks has been done away with by
special legislation, is the best of evidence that this separation was felt
to be injurious to the business of the country. The formal repeal of
the law now would be largely perfunctory.”
The effectiveness of the Treasury as a central bank is difficult to
judge. It may have moderated financial movements. Certainly it
tried. Shifts of funds to banks in years of pressure, especially 1907,
were large. On the other hand, although the first decade of the new
century was more prosperous than the depressed 1890s, there is little
evidence of improved financial stability. There were as many panics
in the later decade as the earlier, and no lessening of seasonal
fluctuations in interest rates.13
Secretary Shaw suggested that these would be corrected by more
powers for the Treasury. It the Secretary “were given $100,000,000
to be deposited with the banks or withdrawn as he might deem
expedient, and if in addition he were clothed with authority over the
reserves of the several banks, with power to contract the nationalbank circulation at pleasure, in my judgment no panic as
distinguished from industrial stagnation could threaten either the
United States or Europe that he could not avert” (TAR 1906, p. 49).
Powers such as these, and more, would be given to the next
monetary authority.
2. The Federal Reserve System, 1913-32.
An act to provide for the establishment of Federal Reserve banks,
to furnish an elastic currency, to afford means of rediscounting
commercial paper, to establish a more effective supervision of banking
in the United States, and for other purposes.
Preamble, Federal Reserve Act, Dec. 23, 1913.
Organization and powers. The Federal Reserve Act was adopted for
several reasons and with many compromises, but this paper is limited
to its influence on – or rather dominance of -- the monetary base
(high-powered money).14 The main operating arm of the System
consisted of twelve Federal Reserve Banks, from Boston to San
Francisco, with powers that included the “discount [of] notes, drafts,
and bills of exchange arising out of actual commercial transactions,”
buying and selling U.S. securities, and “To establish …, subject to
review and determination of the Federal Reserve Board, rates of
discount to be charged by the Federal Reserve Bank for each class of
paper, which shall be fixed with a view of accommodating
commerce and business” (Sec. 13-14). The deposits and notes so
created were limited by reserves of gold and lawful money of at least
35 percent against the former and gold of at least 40 percent against
the latter (Sec. 16). Fed credit was further constrained by the gold
standard, which was explicitly retained. “Nothing in this Act …
shall be construed to repeal the parity provisions in” the Gold
Standard Act of 1900 pertaining to “the standard of value … of all
forms of money issued or coined by the United States” (Sec. 26).
The stock of Federal Reserve Banks was owned by their member
commercial banks, which with the business community made up the
majorities of the boards of directors (Sec. 4).15 The Federal Reserve
Board, located in Washington, D.C., consisted of seven members, of
whom five were appointed for ten-year terms by the President of the
United States subject to the advice and consent of the Senate, plus
the Secretary of the Treasury and the Comptroller of the Currency as
members ex officio. At least two of the five appointed members
10
were to be “experienced in banking and finance” (Sec. 10).16 The
Board was authorized “To exercise general supervision over said
Federal Reserve Banks” (Sec. 11), a provision that was continuously
disputed as the groups struggled for power.
Early performance. The Act specified the objectives of these great
powers to print money as an “elastic currency” and the
“accommodation of commerce and business,” which the Fed quickly
pursued. Its first Annual Report (1914) argued that its duty was “not
to await emergencies but by anticipation, to do what it can to prevent
them.”
So … if, at any time, commerce, industry or agriculture are, in the
opinion of the Federal Reserve Board, burdened unduly with excessive
interest charges, it will be the clear and imperative duty of the Reserve
Board acting through the discount rate and open market powers, to
secure a wider diffusion of credit facilities at reasonable rates.
Included in this approach was elimination of the wide seasonal
fluctuations in interest rates, replaced by a strong seasonal in Fed
credit (Miron 1986). This continued the stabilization procedures of
the Independent Treasury, which its greater powers enabled the Fed
to expand. Table 1 shows the Fed’s greater responses (0.95
compared with 0.88) to “other” influences on the monetary base, as
well as higher correlation. The Fed’s positive response to real GNP
was consistent with an “elastic currency” and the “accommodation of
business.”
The Fed’s monetary policy was soon chosen by the
administration’s desire for finance of the war effort. Fed credit (plus
its gold, giving approximate high-powered money) jumped (in
billions) from $2380 in 1916 to $5360 at the end of 1918, as money
and prices (see Figure 3) soared. There was a respite in early 1919,
before the expansion of credit resumed, reaching $6090 in October
1920.17
In a preview of the events following World War II, the Fed
considered anti-inflationary rate increases as early as January 1919.
However, the Treasury was in the midst of converting short-term to
long-term debt, and told the Fed that the “failure” of the
government’s loan would be disastrous for the country.” An
assistant secretary wrote that the Treasury was “honor bound” to
avoid the infliction of capital losses on the patriotic citizens who had
financed the war effort (Wood 2005, p. 174).
The Fed was released from the obligation to support Treasury
bonds, and raised rates at the end of 1919. Although the economy
peaked in January 1920, the Fed raised rates again in June 1920. Its
credit fell to $4655 in August 1922. This period saw the sharpest
rise and fall of prices in American history. The Chairman of the
Board justified the Fed’s failure to lower rates in Spring 1920 by the
fear of gold losses due to deflations abroad (Harding 1925, pp. 16566).
A joint congressional committee held hearings on this episode
and issued a scathing report (1922). It is our opinion “that a policy
of restriction of loans and discounts by advances in the discount rates
of the Federal reserve banks could and should have been adopted in
the early part of 1919, notwithstanding the difficulties which the
Treasury Department anticipated in floating the Victory loan if such
a policy were adopted. [H]ad such a policy been adopted in 1919 the
difficulties, hardships, and losses which occurred in 1920-21 as a
result of the process of deflation and liquidation would have been
diminished” (p. 12).
This extraordinary period of “expansion, extravagance, and
speculation, the like of which has never before been seen in this
country or perhaps in the world,” and the devastating reaction, were
caused by Federal reserve policies, which, the committee recognized,
were subordinated to the Treasury’s credit requirements.18
Congress had not interfered with the Fed before, and this report
reinforced its own reluctance, as well as the Executive’s (Havrilesky
1993, pp. 45-46, 87-89). There were critics in Congress, but none
came close to attracting enough support to influence the Fed by
legislation or otherwise.19 President Calvin Coolidge dismissed
11
Secretary of Commerce Herbert Hoover’s (1952, pp. 9, 11)
complaints about easy money with the statement that the Fed had
been set up as an independent agency, and “we had no right to
interfere.” The closely monitored monetary agent with limited
powers existing before 1914 had been succeeded by an independent
authority with, in the circumstances, virtually unlimited powers.
The Great Depression.
Does the board maintain that there is no emergency existing at this
time?
Cong. A.J. Sabath, CR, 71st Cong., 3rd sess., Jan. 19, 1931, p. 2619.20
American money and prices had been able to double between 1914
and 1920 without endangering the gold standard because of inflows
of gold for safety and purchases of war materials. The gold reserve
rose from (in billions at year end) $1.2 in 1914 to $2.7 in 1918, $3.5
in 1922, and near $4 from 1924 until revaluation in 1934.
The Federal Reserve achieved price stability between 1921 and
1929 by means of what may be called the monetary base rule
depicted in Figure 3. It sterilized gold inflows and other influences
on the base (Wood 2005, p. 185).
Alternatively, its policy may be described as what was later
called the free-reserves rule as the Fed’s discount rate responded to
the borrowing of money market banks from the Fed (Meltzer 2003,
pp. 161-65). “One of the best guides,” the head of the New York
Reserve Bank, Benjamin Strong, said, was “the amount of borrowing
by member banks in principal center.” For example, “Our
experience has shown that when New York City banks are
borrowing in the neighborhood of $100 million or more, then there is
some real pressure for reducing loans, and money rates tend to be
markedly higher than the discount rate” (Chandler 1958, p. 240).
These practices constituted “a record of fundamental consistency
and harmony with no sharp breaks in either the logic or interpretation
of monetary policy” between 1922 and 1933 (Wicker 1969; also
Wheelock 1991; Wood 2009, pp. 164-68), Table 1 shows that the
Fed was easier in the Great Depression, although not enough to
offset the public’s increased demand for currency.
Unfortunately, relations between the Fed’s actions and the
system changed in 1929, and there was no information or incentive
mechanism in place to induce an adjustment in monetary policy.
The Fed failed to take account of the dependence of bank borrowing
on economic activity (Meigs 1962, p. 87; Meltzer 2003, p. 312;
Wheelock 1990). Money and prices fell by a third between 1929 and
1933, more than 10,000, or 40% of banks, failed, and not even an
unemployment rate of 25% called forth an expansionary monetary
policy.
The Fed failed to understand the system for which it was
responsible, and the great distance from the costs of its mistakes
prevented it from reacting to the problems of the victims. The new
institution constituted a huge agency problem that will be discussed
below.
The Fed had responded quickly and vigorously to the stock crash
in October 1929, buying $132 million of government securities, so
that there were no panic increases in money rates as in past crises.
After crashing from 299 on Saturday to 212 on Tuesday, the Dow
Jones Industrial Average rallied to 230 at Tuesday’s close and 274
on Thursday. The Board’s approval was grudging, but the New
York Fed kept up security purchases until the Spring, when, in the
view of the Board, there was “no evidence of money not being
available to business on reasonable terms, and no reason to believe
that further reductions in rates will help to revive business. Further
ease in money would probably result in further increasing
speculative activity” (Wood 2005, p. 199). After a brief recovery in
January, industrial production fell 13% between February and
August. The Dow recovered to 294 in April 1930 before falling to
40 in July 1932.
It is said that economists rediscovered money in the 1960s, but
the man on the street never doubted its importance. More than fifty
bills to increase the money supply were introduced into the 72nd
12
Congress (1931-33) (Krooss 1969, pp. 2661-62). The Goldsborough
bill authorized and directed the Fed “to take all available steps to
raise the present deflated wholesale commodity level of prices as
speedily as possible to the level existing before the present deflation,
and afterwards to … maintain such wholesale commodity of prices.”
The bill expanded those available means by broadening the Fed’s
open-market operations and giving it the authority to revalue the
dollar by changing its gold content (Krooss 1969, pp. 2675-82 ).21 A
modified bill passed the House 289-60 but became an empty
resolution in the Senate.
During hearings on the Goldsborough bill, Mississippi
Congressman Thomas Jefferson Busby urged the Fed “to cooperate
with Congress, and launch out and shake off some of its fears about
what might happen” if it tried to stop the de
flation. In view of the large gold reserve, “I can not understand
… the Federal Reserve Board taking such hesitant … attitudes
toward tackling the economic depression with which we are
overwhelmed.” The head of the New York Fed replied:
Mr. Harrison -- But you have got to remember one thing, Mr.
Congressman. There is always difficulty about the mechanics and the
speed with which we operate. First of all, it is not always easy, over a
certain number of days, to buy as many Government securities as you
might want. They are most popular investments and they are
sometimes hard to get, and without completely disorganizing the
market you sometimes cannot purchase them as rapidly as you want
them.
… you run the risk, if you go too fast, of flooding the market or the
banks with excess reserves faster than they can use them, or faster than
is wise for them to use them. The proper and orderly operation of the
open market, I think, is to create a volume of excess reserves gradually,
gradually increasing them, and keeping it up constantly, and not have
periods when you have got excess reserves one week and none another
week (pp. 494-95).
3. Congress, its agents, and monetary policy
Policy can be considered a game involving legislators, the executive,
and bureaucratic agents. It includes the initial delegation of
objectives and authority, and procedures for oversight and control.
The actions of political and bureaucratic officials throughout this
process jointly determine policy (Calvert et.al. 1989)
There is a large literature on the optimal formation of agencies as
functions of the possibilities of oversight and the distributions of
power and rewards among political branches, the bureaucracy, and
special interests.22 This paper does not address these political
conflicts and compromises behind the Fed’s constitution,23 but rather
accepts its initial appearance as an independent agency whose
policies were determined by its own preferences.
Over time, however, the Fed’s governance was subjected to
shocks and consequent shifts in policy that depended on the
preferences of those in control. Those shocks and policy changes are
depicted in Figure 4. Figure 4a suggests three influences on
monetary policy: the president, Congress, and the monetary authority
(IT or FR), with utilities P(D), C(w), and IT(m) and FR(m), where D
indicates the president’s desire to finance/monetize deficits at least
cost, w indicates the electorate’s welfare (employment, growth, and
inflation) to which Congress is sensitive, and m indicates the
monetary authorities’ interests in the stability of the money markets.
Policy is conducted by the monetary authority, and in general may be
affected by the utilities of all tor any hree groups, the arrows
indicating presidential and congressional influences on the monetary
authority’s policy.
Heavy lines and boxes identify dominant influences on policy.
For example, Figure 4b implies that monetary policy was governed
by the president’s goal of debt monetization during the Civil War
and World War I.
We saw in Section 2 that monetary policy was affected by both
Congress and the IT during 1864-1913, as suggested by Figure 4c.
13
The Treasury was particularly interested in the money markets, but it
was monitored by Congress and therefore also acted in favor of
general economic stability and progress during the resumption of
1864-79 and afterward. The dashed line means that presidents
periodically influenced monetary policy, such as Grant’s 1874 veto
of a bill increasing the currency, Cleveland’s response to the panic of
1893, and Roosevelt’s support of Secretary Shaw.
These years correspond – closely in some sub-periods – to the
period after World War II, when congressional committees
monitored the FR on an increasingly formal basis, often demanding
specific goals, and the executive periodically pressured the FR (such
as during the Vietnam War). A significant difference from before
1914 is that since World War II executive pressures have
predominantly been on the side of monetary ease (Havrilesky 1993,
pp. 29-80). 24
The 1922-32 period of an independent central bank corresponds
with Figure 4d, and may best be discussed in connection with the
counterfactual question considered in the next section.
4. What if the Independent Treasury had not been replaced by
the Federal Reserve?
We must recognize at the outset that the FR was not established in
isolation. It was a product of the progressive era of reform that also
yielded anti-trust laws, prohibition, women’s suffrage, the income
tax, the Federal Trade Commission, and the Food and Drug
Administration. It is difficult to imagine that the government’s
control of the currency would not have increased even without the
FR. We have seen that the IT’s powers had been expanding. The
notion that sound money was the first duty of the monetary
authorities regardless of economic conditions was on its last legs. It
is ironic that the more powerful authority created in 1913 was less
active than its predecessor when it was needed most – during the
Great Depression.
Before getting into that problem we should consider the
problems faced by the FR initially which would also have
confounded the IT. Both institutions were confronted with inflation
at the ends of the Civil War and World War I. We have seen that the
IT undertook to restore the price level and resume the gold standard
with as few adverse real effects as could be managed, over the
lengthy period 1864-1879. The FR, on the other hand, pursued no
such policy, and was under no pressure to do so because the gold
standard had not been suspended. The gold of the United States had
actually increased because of the greater foreign inflation – even
though the world’s monetary gold stock had declined relative to
world prices, and gold production fell because of its higher costs.
The FR sought stable prices during the 1920s, and was
successful until the end of that decade (Figure 3). It is unlikely that
the IT would have behaved differently. Why force deflation when
the gold value of the currency has been maintained?
However, when things went wrong -- when prices fell and
unemployment rose in the Great Depression – the pressures for
action were less for the FR than the IT. We saw Congress’s
pressures on the IT during the resumption of 1864-79. We also saw
Congress’s decision to affirm the FR’s independence after 1922.
Popular agitations for anti-deflation measures after 1929 were less
effective than after 1864.
A common explanation of the Fed’s inaction was its fear of
losing gold and so violating the required gold/FR-note ratio
(Timberlake 1993, pp. 269-70); to which might be added the FR’s
focus (as explained to Congressman Busby) on the money markets.
Some congressmen were willing to devalue the dollar or abandon the
gold standard altogether if necessary to stop the fall in prices.
However, they could not get a majority at least partly because of the
established principle of FR independence. Acceptable performance
(from the principal’s point of view) by an agent requires either the
same preferences as the principal or monitoring of the former by the
latter, as before but not after 1913.
14
This was not true everywhere. Almost ninety percent of the
countries that had resumed the gold standard at the prewar par in the
1920s abandoned convertibility before the U.S. devalued in 1933,
several with Britain in 1931. In most cases, their prices stopped
falling and their economies turned up before the U.S..25 In nearly all
these countries, monetary policy and the gold value of the currency
were government (not simply central bank) matters. Central bank
independence has not always been good.
In summary, the background after 1913 (the progressive
movement and America’s maintenance of the gold standard despite
the war inflation) would probably have elicited behavior from the IT
similar to that seen from the FR. On the other hand, the FR’s
continued monetary ease after the war had not been realized by the
IT; nor therefore severe contractions like that of 1920-21. So the
exacerbation of fluctuations by the FR, compared with that which
would probably occurred under the IT, was very great from the
beginning. It is not surprising that the Executive pressured a thirdparty (the FR) to undertake a potentially politically costly (in the
long-run) policy for short-run (low interest rate) benefits that it had
not performed itself (the IT). The already greater freedom of the FR
than the IT from congressional monitoring, and therefore from the
pain of unemployment, was reinforced by this episode for the period
from 1922 through the Great Depression.
…………………….
15
Table 1. Monetary Authority Reaction Functions
Indep. Treasury, 1879:1-1914:3 Federal Reserve, 1914:4-1932:4
Coefficient
t-statistics
Coefficient
t-statistics
2.59
7.49
2.89
4.71
dHo
-0.88
-5.96
-0.95
-46.79
dGDP(%)
-0.06
-0.63
0.52
3.08
-0.002
-1.18
0.01
1.46
0.002
0.37
-0.001
-1.37
3.32
2.60
Constant
dCPR
Fiscal surplus
Great depress. dummy
AR(1)
0.45
5.46
R2
0.55
0.98
F
230.63
388.39
Notes: Estimation by instrumental variables using lagged values of dHo, real GDP growth, and change
in commercial paper rate. Quarterly dummies and electoral variables not reported.
dHo is “other” influences on high-powered money to which the monetary authorities respond:
dH = (dG +dN –S) +dT = dHo +dT, respectively changes (relative to previous high-powered money)
in high-powered money, monetary gold, and national bank notes secured by U.S. bonds, the budget
surplus, and monetary authority discretion (dependent variable, dT).
Sources: Treasury Annual Reports through 1917 then Federal Reserve Board Banking and
Monetary Statistics (1943). Heckelman and Wood (2005).
16
17
18
19
Figure 4. Influences on monetary policy, 1861-1932
(a) General
P(D)
C(w)
IT(m),
FR(m)
(b) Monetization of debt, Civil War and World War I
P(D)
IT(m),
FR(m)
C(w)
20
(c) IT 1864-1913, including resumption 1864-79
P(D)
IT(m)
C(w)
(d) Independent central bank 1922-32
P(D)
F(m)
C(w)
21
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ENDNOTES
1
Krooss, 1969, pp. 1163-73.
2
The “Bank war” and Jackson’s veto of the renewal of the federal charter of
the Bank of the United States are discussed in Catterall (1902), Hammond
(1957), and Temin (1969).
3
Section 13 (Krooss 1969, p. 972).
4
Banker’s Magazine, April 1865, p. 783; as quoted in Unger, 1964, p. 41.
5
To Pennsylvania Congressman Thaddeus Stevens and Maine Senator
William Fessenden, Jan. 1866 (Unger 1959).
6
Written while a graduate student at Johns Hopkins University. The
quotations are from the “Introductory” chapter.
7
The Bank’s monopolistic privileges were curtailed in the 1820s while the
Tories survived to 1830. The Conservative party lost power briefly in 1929
but was dominant from 1931 to 1945, while the Bank of England’s power
over monetary policy was lost to the government of the day.
8
Cleveland’s first Treasury Secretary, Daniel Manning (1885-87), wrote
Congressman Frank Hiscock that it would not be “prudent” to reduce the
Treasury balance (Timberlake, 1993, p. 154).
9
Introduced July 13, 1886, by Chairman William Morrison of the House
Ways and Means Committee.
10
Six states were admitted to the Union in 1889-90. See Krooss (1969, pp.
1917-18, 1952-60) for these acts and the repeal of the latter.
11
Address to the American Bankers’ Association, 1905 (Timberlake, 1993,
p. 192).
12
Congressional criticisms were primarily charges of favoritism in the
Treasury’s choice of depository banks. For example, see Secretary of the
Treasury, “A reply to the inquiry included in the House resolution dated
Jan. 4, 1900, relating to the transactions of the Treasury Department with
certain banks,” 56th Cong., 1st sess., House doc. 264, and debates in the
23
House, CR, pp. 656-67, 912-20, and 1269-72. These complaints had little
support in Congress notwithstanding the critical tone of Andrew (1907).
13
See Miron (1986) for panics. For interest rates, the average annual
difference between the high and low monthly average stock exchange call
loan rate was 7.40 percent during 1900-1910 compared with 4.90 during
1890-99. (Federal Reserve Board 1943, p. 448).
Senator Carter Glass, “the father of the Federal Reserve,” who had steered
the Federal Reserve Act through the House of Representatives, accused the
Fed of departing from Congress’s intentions by forcing uniform discount
rates on Federal Reserve Banks and permitting the rapid rise in brokers’
loans during the stock boom of the late 1920s. He proposed bills to raise
bank reserve requirements and tax speculative transactions (Wall Street J.,
June 8, 1928; Feb. 5, 1929; June 1, 1929).
14
The Act benefited money market banks with reliable access to cheap
money from a non-competitor (competition from the commercial Banks of
the United States had helped their rejection), permission to engage in the
finance of international trade, lower reserve requirements, and an agency to
encourage price cooperation. Smaller banks generally opposed the System,
and they were bought off by requiring only National Banks to become
member banks of the Federal Reserve System. Virtually all state-chartered
banks – 70 percent of all commercial banks and 50 percent of deposits in
June 1916 – remained outside the System (Kolko 1963, pp. 99. 217-54;
Wood 2009, pp. 105-110; Federal Reserve Board 1943, pp. 20-22)
15
The nine directors of each Federal Reserve Banks included three of each
of class A (chosen by the stock-holding banks), B (businessmen), and C
(designated by the Federal Reserve Board).
16
One each of the initial appointees were for terms of two, four, six, eight,
and ten years.
17
The Fed might have accommodated the Treasury in any case, but as
Chairman Harding (1925, p. 123) of the Federal Reserve Board wrote, it
could have been forced by the executive to do its bidding by the Overman
Act, which authorized the president during and for six months after the war
“to make such redistribution of functions among executive agencies as he
may deem necessary,” including from the Fed to the Treasury.
18
This episode is discussed by Friedman and Schwartz (1963, pp. 226-39);
Chandler (1958, pp. 139-60), and Reed (1922, pp. 298-315)
Unsuccessful in directing the Fed, Congress encouraged it to be more
active by expanding its lending powers in the first Glass-Steagall Act
(1932).
20
Sabath’s letter to the Federal Reserve Board, entered into the record,
included: “the Federal reserve system was established for the purpose,
among others, of creating an agency from which member banks can obtain
credit for seasonal or emergency needs. Does the Board maintain ….?”
21
This was Irving Fisher’s (1911, pp. 331-32) compensated dollar,
22
For example, Calvert, McCubbins, and Weingast (1989), Bawn (1997),
Macey (1992), and Lupia (2001).
23
Discussed in Jeong, Miller, and Sobel (2008), Kolko (1963, pp. 217-54),
and Wood (2009, pp. 100-110)
24
Havrilesky discusses the influences of Congress and the executive, where
the FR’s submission to one depends on its support from the other.
25
Those resuming convertibility at prewar pars were the Netherlands,
Switzerland, Denmark, Norway, Sweden, U.K., Egypt, India, Australia, N.
Zealand, Mexico, Argentina, and Uruguay. Canada never suspended. All
but the first two left gold between 1929 and 1931. Countries of the Western
Hemisphere continued to fall with the U.S., while the others turned up after
their suspensions (Mitchell 2007abc).
……………………
19
Some congressmen urged the Fed to maintain the high agricultural prices
inherited from the war during the House Banking and Currency
Committee’s Stabilization hearings of 1926 and 1928; Wood 2005, p. 188).
24