Arnold Kling  

Speaking of the Fed...

Bad Argument for the Fed... Two Strains of Conservatism...

George Selgin, William D. Lastrapes, and Lawrence H. White have a long paper comparing economic performance before and after the Fed was created. They make a strong case that performance has not improved.

I think this history is well worth reviewing. Just as most people casually assume that Roosevelt did a heckuva job during the Great Depression, most people casually assume that the Fed has done a heckuva job with its responsibilities. Do not be surprised if data fail to support such casual assumptions. On the other hand, do not be surprised if people prefer to hold onto their faith in Roosevelt and in the Fed.

On the other hand, my main comment on the paper is that many other structural changes have occurred since 1907. The composition of output has shifted. The structure of production has become more roundabout. We cannot treat the 19th century as a control and the 20th century as an experiment, with only one variable (the Fed) different between the two.

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COMMENTS (9 to date)
mick writes:

America became the world's leading industrial power by 1910, before the wars and contrary to popular history. This was indeed the dark ages of the capital G Gold Standard and almost non existent regulations.

Hyena writes:

There's also the matter of purchasing and appropriating the entire country for a pittance.

George Selgin writes:

While the structure of the U.S. economy has certainly changed, it isn't clear that it has changed in a manner that can excuse the Fed's failure to achieve a substantial overall improvement in post-WWII stability compared to pre-1914 stability. For example, the increase in the relative share of services and corresponding decline in agriculture would not be expected to bring greater instability.

The one structural change that certainly should make a (predictable) difference is growth in government spending. But theory says that it should make things more rather than less stable. We do talk about this.

Bill Lastrapes and I have a paper in progress that attempts a full-blown counterfactual exercise, that is, that controls more systematically for structural change in assessing the Fed's contribution to macroeconomic stability.

Joe Cushing writes:

People tend to believe whatever we were tought as childreen. If you want people to believe the truth about Roosevelt, you need to get them the message before the public schools teach them that the new deal and big government saved us from depression--and that Hover was a do nothing.

B.B. writes:

This is like Obama keep blaming Bush so he doesn't have to take responsibility for his own failures.

Let's go blame the Fed for the Great Depression? Why not? It is convenient for gold bugs who want a pure gold standard with no central bank. (Hello Rand Paul and Ron Paul.)

But what is there are some inconvenient facts? The US was on the gold standard until 1933. The deflationary impulse of the gold standard pushed the world into deflation and depresson. Every coountry started to recover as soon as they left the gold standard, including the US.

The lesson of the Great Depression is not abolish the Fed but abolish the gold standard.

For evidence, I recommend reading Temin, Eichenbaum, Thompson, and a careful reading of Friedman and Schwartz.

Yes, the Fed made mistakes in the early-1930s even in a gold standard context. So did everyone else.

Harold Demsetz described the "utopian fallacy": compare the messy world of history comingled with fallible men with an idealized hypothetical alternative which never existed. Utopia always looks better...on paper, whether it is Communism or free banking with a gold standard.

fundamentalist writes:

Great paper! Thanks for the link.

Michael Jordan writes:

Something that everyone seems to dance around without actually saying is that the Fed is a private institution. They have one interest in their minds - lining their pockets. The only incentive they have to even consider helping the country in general out is so that they don't, figuratively speaking, kill the goose that lays their golden eggs.

It would seem that they might be able to see the wisdom of "the better they do, the more we make," but for whatever reason, they choose to manipulate the economy through interest rates and other borrowing costs in the fashion that it is running now. It is rather like the old General Store situation. For those that do not know the picture: On some of the plantations in the south the plantation would have a store set up. The prices would be exorbitant, but since most of the slaves didn't have transportation, they did not have much choice but to shop there. But the store did offer credit, which, due to the exorbitant prices, the slaves had no choice but to avail themselves of in order to survive. They were effectively trapped.

So at this juncture, not much has changed with the exception of the date and the number of people involved.

suo Marte writes:

Clearly, our friend B.B. has not read Meltzer's History of the Federal Reserve...

Acknowledging the fact the Federal Reserve DID cause the Great Depression has nothing to do w/ "gold bugs" - it's about learning from the past to inform us for the future.

Why do so many have a difficult time admitting an institution they know so little about is responsible for the greatest economic calamity in US history?

The US CLAIMED to follow a gold EXCHANGE standard in 1933 (this was NOT the same classical gold standard followed before WWI). Again, clearly our friend B.B. has not read Meltzer (nor H Clark Johnson for that matter...)

Is it "Eichenbaum"? Or perhaps "Barry Eichengreen"? Eliminating the gold standard as Eichengreen says simply throws the baby out w/ the bath water.

Again, as painstakingly proven: the classical gold standard & the gold EXCHANGE standard, were NOT the problem. Rather, Govts didn't follow the rules necessary for these monetary mechanisms to work correctly.

Same reason Bretton Woods failed - Govts do NOT follow the rules they establish for themselves when these rules no longer serve their best interest. Why is this so difficult for some to comprehend?

One more time for B.B.'s benefit:

1. England overvalued its currency relative to gold

2. France undervalued its currency relative to gold; refused to keep foreign currency as reserves & most importantly STERILIZED gold inflows to maintain domestic price levels.

3. The US Federal Reserve (led by the NY Branch) manipulated discount rates between 1925-27 in an effort to stem the gold flow from England to the US - to help England maintain its incorrect gold EXCHANGE parity ratio. The US Federal Reserve, like France, STERILIZED gold inflows contrary to the workings of the gold EXCHANGE standard. And the Federal Reserve mistakenly used a version of the Real Bills Doctrine as indicators (after the 1929 stock crash) for its monetary policy; they incorrectly thought their policy was accomodative when in reality it was tight. Their thinking was driven by the Real Bills Doctrine.

4. It's simply incorrect to say "every coountry started to recover as soon as they left the gold standard". Perhaps B.B. should consult the BLS re: US unemployment rates in 1933 when FDR removed the US from the gold EXCHANGE standard w/ unemployment rates in 1937 - four years later?

5. During crisis, suspending gold convertability was standard operating procedure during the CLASSICAL gold standard of the 19th Century. Me thinks B.B.'s not heard of Thornton or even Bagehot...

Ignorance is bliss - indeed!

ps - Thank you Selgin, Lastrapes & White for an excellent paper.

suo Marte writes:

Clearly my previous post was a bit over the top & detracting from the point I was attempting to make. My apology to B.B. Let's give it another go, shall we?


Meltzer's recent & definitive “History of the Federal Reserve” has much to teach us re: the Federal Reserve’s few successes, its many failures and the true role played by the much maligned gold exchange standard w/ respect to the causes of the Great Depression:

1. When England returned to the gold exchange standard after WWI its currency was knowingly overvalued relative to gold by Churchill’s Govt.

2. France’s Govt, on the other hand, knowingly undervalued its currency relative to gold, refused to keep foreign currency as reserves & most importantly sterilized gold inflows to maintain domestic price levels. Like England, all of these actions by France were contrary to the rules of the gold exchange standard.

3. The US Federal Reserve (led by the NY branch) lowered discount rates in 1925 & again in 1927 in an effort to stem the gold flow from England to the US to help England maintain its incorrect gold exchange ratio. Moreover, the US Federal Reserve, like France, knowingly sterilized gold inflows to the US contrary to the gold exchange standard rules.

4. After the 1929 crash it was this sterilization of gold inflows by the US Federal Reserve, guided by the central bank’s incorrect adherence to the Real Bills Doctrine (i.e. the “Riefler-Burgess framework”), that caused the Great Depression. Specifically, by concentrating on bank reserves above the legal minimum necessary to cover deposits for setting NOMINAL interest rates; instead of concentrating on the quantity of money, available credit and general economic conditions on inflation-adjusted REAL interest rates the Federal Reserve focused on exactly the wrong signals for determining "loose" and "tight" monetary policy. As Meltzer makes clear on pg 401 of Vol 1: “If the US had followed the rules, the money stock would have expanded by 14.6% from August 1929 to June 1930” and “... an expansive monetary policy would have prevented at least some of the deflation and recession, so falling prices and fears of collapse would have been absent. The world would have been spared much of what followed."

5. The facts do not support the notion that leaving the gold exchange standard immediately solved the problem. Simply compare the US unemployment rate in 1933 when FDR removed the US from the gold exchange standard to the unemployment rate in 1937 - four years later.

6. Besides, as the Bank of England demonstrated on more than one occasion during the 19th Century, the classical gold standard operating procedure calls for the suspension of gold convertibility during crisis. This was explained by Thornton, Bagehot, and others.

Meltzer proves the gold exchange standard (& the classical gold standard for that matter) did not cause the Great Depression. Blaming the gold exchange standard as Eichengreen does simply throws the baby out w/ the bath water.
Rather, the Great Depression was caused by Govts & their central banks by expressly not following the rules necessary for the gold exchange monetary mechanism to work correctly. Govt failure to follow the rules also explains why Bretton Woods failed. The simple fact is Govts do not follow international monetary rules they establish for themselves (for very long) when these rules no longer serve Govt’s primary short-term interest – remaining in power.

Why do so many have a difficult time admitting the Federal Reserve, an institution they know so little about, is responsible for the greatest economic calamity in US history?

Thank you Selgin, Lastrapes & White for an excellent paper.


Again, I apologize to B.B. for my previous post.


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