Scott Sumner  

It's hard to teach a central bank new tricks

They Scare Me... Henderson on Deaton...

How did the Fed do during its first 100 years? For a deeper look at this question, you should read Selgin, Lastrapes and White. Here I'll take a very broad overview, and look at a few key themes.

In my view, the Fed has committed three major policy errors: the Great Depression, the Great Inflation and the Great Recession. Fed officials such as Ben Bernanke have acknowledged that the Fed was to blame for the first two, but we'll have to wait a few decades before we get a widely accepted view of the third failure.

All three major policy failures have something in common---the Fed was faced with a policy environment that was completely unanticipated when the Fed was first created. And in each case they proved unable to quickly adapt to that new and unforeseen environment. In the first two cases they did eventually adapt, and I hope and expect they will eventually adapt one again.

Here are the three unforeseen policy environments:

1. The Fed was created in 1913, right before WWI. Soon after, the war pushed the value of gold dramatically lower, as European powers sold off gold to finance military spending. After the war, many European countries took some time to return to gold. During that period the value of gold remained artificially depressed. The Fed did not know how to adapt to a world where the value of gold was artificially depressed, and likely to rise sharply as things returned to "normal." (Recall that a rising value of gold was deflationary under a gold standard.)

Federal Reserve2.jpg

2. The Fed was created during a period where it was assumed that the price of gold would remain stable. It was stable at $20.67 and ounce up to 1933, and then at $35 an ounce from 1934 to April 1968. But then the free market price of gold in Europe began rising above $35/oz. In a sense, 1968 is the year the US transited from a commodity money regime (with temporary periods of suspension) to a pure fiat regime, where the expected rate of inflation is not anchored by a commodity price peg. At first, the Fed proved unable to operate a fiat money regime. Eventually they learned how to control inflation (the Taylor Principle.)

3. The Fed had traditionally relied on interest rate targeting as a means of steering monetary policy. When nominal rates hit zero in late 2008, the Fed proved unable to adapt to the new environment. They sharply undershot their implicit aggregate demand targets. Once again, I believe they will eventually learn to adapt to this new environment. In this recent post I point out that there are signs the Fed is considering the market monetarist proposal for negative interest on bank reserves. I hope and expect that the Fed will eventually adopt other ideas, such as level targeting and NGDP targeting.

In Europe the unforeseen problems were slightly different. Unlike in the US, the ECB did not face the zero bound problem during 2008-12. Instead they faced several other unanticipated problems. In 2010 and 2011, it turned out that the policy that was likely to produce on target inflation in the eurozone would not even come close to producing macroeconomic stability. In addition, the "one-size-fits-all" problem turned out to be far more severe than the founders of the ECB had anticipated. And you could add that they also didn't foresee the risk of sovereign debt default in multiple countries, creating contagion risk.

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COMMENTS (7 to date)
E. Harding writes:

Like the White House, the Eccles Building is not as large as it appears in the photos. I saw it from the road.

Also, it was easy to not forsee the EZ sovereign debt crisis, given that the market valued German and Greek debt the same way as late as 2009.

Larry writes:

A few questions:

What does the next crisis look like?

Will it take as long to emerge as this one?

Obviously, we haven't returned to the Great Moderation mode. Will that require new monetary policies?

Daublin writes:

"All three major policy failures have something in common---the Fed was faced with a policy environment that was completely unanticipated when the Fed was first created. And in each case they proved unable to quickly adapt to that new and unforeseen environment."

That is an awesome quote.

It beautifully encapsulates the major weakness of a government-run organization. Such organizations gradually find a stable way to do things and then do the same exact thing for year after year. When circumstances change, though, they tend to go on doing the same thing and have a hard time adapting.

The same thing came to mind a few weeks ago when I was thinking over California's problems with its water supply. The public utilities do just fine so long as things are normal, but as soon as you have an outlier year, they don't know what to do, and they aren't allowed to change things up even if they did have an idea.

B Cole writes:

All true. But I think QE as sustained conventional central bank policy is next. Or should be.

Most economists are uncomfortable with the idea. The Economist magazine says that when major central banks, such as the People's Bank of China, were adding to their reserves, they were in essence conducting QE.

And when the socialists and warmongers in Washington DC figure out that QE is a good idea, then it could become a bad idea....

Dave writes:

In case 1 the price of gold was depressed.
In case 2 gold was stable. Those two timelines overlap ... so you need to clarify.

An unstated conclusion of your post is the the Fed cannot (or at least does not) anticipate problems, which has implications.

Scott Sumner writes:

E. Harding, Good point.

Larry, I believe that crises are almost impossible to predict. Those successful in the past mostly got lucky.

Just to be clear I am thinking of asset price collapses. One can certainly predict that bad economic policies will lead to bad outcomes, but in that case the asset prices will already reflect that bearish view, even before the fall in RGDP arrives.

Daublin, Yes, California is an excellent analogy.

Ben, I still think either level targeting or NGDP targeting would be more powerful.

Dave, Not the price of gold, the value of gold was depressed. Yes, the value of gold again become depressed in the late 1960s, but in this case the government responded by letting the nominal price rise, rather than restoring its value through deflation.

michael pettengill writes:

The period from 2007 to the present is the era of the Fed trying to push string.

You can see the effect of pushing string in the velocity of money according to fred:

The velocity of M2 and MZM have never been calculated to be lower by the Fed, and M1V has not been this leaving the gold standard, and has been on a long trend down that has never been seen before.

The demands of the rich are for high capital gains which requires high profits which ends up with trillions in cash that can't be spent building capital because it will cause massive capital losses. See WalMart shares in response to the reports of the cash being paid to labor to build capital assets - building capital assets is driving down the shares that represent the "value" of the capital assets. But hey, too much capital will mean no monopoly profits on capital in excess and that will crater share prices. If WalMart becomes like Amazon in spending all revenue paying labor to build more capital assets then all retailers will be forced to pay workers to build more capital assets and in the end there will be excess capital assets and too much productive capacity that prices will be forced to marginal labor costs with zero profits and returns on capital equal to zero which is the returns on cash.

That means, if you have cash and assets, you can not spend the cash or you destroy the wealth in the inflated prices of the assets you own.

This is seen in the lower and lower velocity.

And the flood of cash is increased by the decay in public assets from cutting taxes, like the implicit tax cut on transportation that has reduced investment in highways and bridges by 40% over the past two decades, even as more and more assets have reached end-of-design-life.

How can the Fed fight the public and private policy that drives 10% returns when returns to cash are 0% and spending cash will destroy wealth by cratering asset prices by eliminating the monopoly needed for 10% returns?

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