A History of the Federal Reserve, Volume 2 (97 page)

When all the dust settles, the ultimate reason for the rejection by the FOMC of either measure of the monetary base as an operating instrument or target for monetary policy is the fourth conclusion above, namely that such an operating instrument would produce intolerable interest rate fluctuations. This is the historical basis of objections by the Federal Reserve to any monetary aggregate that has been proposed as a target or operating instrument for monetary policy. The substantive basis for this position is extremely weak. The experience with the New Operating Procedures in 1979–82 is typically cited as support. However, the experience of 1979–80 is contaminated by (1) the uncertainty of market participants (and perhaps also Federal Reserve officials) in the fall of 1979 about exactly how the New Operating Procedures would be implemented and (2) the credit controls fiasco in the spring of 1980. Analysis of the experience in 1981 and 1982 under the New Operating Procedures suggests that interest rate variability during this period was no greater than prior to 1979 or subsequent to 1982.

TEN

Past Problems and Future Opportunities

Don’t try tricks, don’t try to be too clever; keep steady, keep committed to your mandate, even in exceptional circumstances; say as much as you can about what you are going to do: announce a “strategy”; don’t be dogmatic, but follow a policy which is always in line with your strategy. (Issing, 2003)

Otmar Issing, a distinguished central banker, showed in his years spent guiding the European Central Bank how to operate successfully in the space between rules and discretion. He rejected both commitment to a fixed rule and no rule at all. He called it rule-like behavior. Central banks’ policy should announce and implement a clear strategy that market participants understand and from which they can predict central bank responses. In the normal course of events, it should follow that strategy.

Central banks operate in an uncertain world. They have lender-of-last-resort responsibility in addition to their macroeconomic responsibility. Serving as lender of last resort requires departing from the normal operating rule or strategy. To prevent liquidity problems from becoming crises, the central bank must not follow a fixed strategy. The rule for crises should be known in advance, as Bagehot (1873) first stated clearly. It then becomes part of rule-like behavior.

The Federal Reserve’s authority is delegated; the U.S. Constitution gives Congress the power over money. In 1913 Congress chose to appoint an agent to carry out these tasks. It granted independence, but it always retained the right to withdraw or restrict it. Members of the Board of Governors hesitate to act in ways that arouse public and congressional ire. This alone makes the Federal Reserve a political as well as an economic institution and weakens independence, as the preceding chapters show.

Political pressures also come, at times, from the administration. The Federal Reserve is not part of the administration, but its actions affect the degree of public support that an administration receives. The modern public holds the administration responsible for the state of the economy and its current and expected well-being. The administration can not sanction the Federal Reserve. Public complaints are usually counterproductive. There is a gap between responsibility and authority. The administration and Congress are held responsible for economic shortcomings; most people are unaware that the shortcomings often result from Federal Reserve actions and decisions.

A central bank is better able to resist political pressures if it has public support. The German Bundesbank and the Swiss National Bank established firm reputations as opponents of inflation that earned the respect and support of their countrymen. One way to gain and hold support is to operate in a known and predictable way, as Issing prescribed at the head of this chapter. Being successful is important.

Federal Reserve history has two major crises—the Great Depression of the 1930s, and the Great Inflation of the 1960s and 1970s and subsequent 1980s disinflation. Together these events occupy more than thirty years of the seventy-three-year history to 1986 considered in these volumes. The years of relatively stable growth and low inflation were many fewer until recently; 1923 to 1928 and 1952 to 1964 stand out. From the end of the Great Inflation to 2007, the United States experienced three of its longest expansions interrupted by relatively mild, brief recessions. Federal Reserve policy contributed to the change sometimes called “the great moderation.” This chapter looks at some major past errors and some changes that contributed to better outcomes. Then it suggests some further changes, many of which FOMC members proposed on occasion.

The two principal sources of policy errors resulted from political interferences or pressure and mistaken beliefs. Volume 1 of the history made the case for mistaken beliefs or incorrect theory—mainly the real bills doctrine as a decisive cause of the failure to take effective action to limit, prevent, and end the Great Depression. A different set of beliefs and failure to resist political pressures caused the Federal Reserve to start and continue the Great Inflation. To end high inflation, Paul Volcker made two major changes. He increased Federal Reserve independence, and he gave greater weight to reducing inflation and permitted the unemployment rate and interest rates to rise as required to control inflation.
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1. Federal Reserve officials in the 1970s often gave concern about interest rate changes as a reason for failure to control money growth. This may have been a statement about perceived
political constraints or a complaint that inflation could not be controlled when government ran budget deficits. Perhaps both. Some recognized also that they failed to develop a mediumterm strategy or the means of implementing it.

At its founding in 1913–14, the Federal Reserve was a system of semiautonomous regional banks with a supervisory board in Washington.
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This arrangement was a compromise that reconciled populist fears that bankers would run the new system for their benefit with bankers’ fears that the political authorities would run it for theirs. The compromise set off a struggle for control mainly between the Board in Washington and the New York reserve bank. Autonomy contributed to the Federal Reserve’s failure in the early 1930s. The Banking Acts of 1933 and especially 1935 greatly reduced Reserve bank autonomy, greatly reduced the role of the bank’s outside directors, and centralized control in Washington. The Banking Act of 1935 created the legal structure of the central bank that remains today.

The Board remained under the guidance of the Treasury from 1934 to 1951. It did not begin to exercise control until after the 1951 Accord. In the early years of the Martin era, 1951–54, the System agreed to the changes necessary to consolidate the Board’s control and weaken the authority of the banks, especially New York.

External events made inevitable this change from a semi-autonomous system of banks to a central bank. In 1913, the United States was emerging as one of several world or regional powers. Financial markets had not consolidated. It was possible to have interest rates set regionally. London was the global center of finance, and European powers such as Britain, France, and Germany struggled for international dominance. Existence of the Federal Reserve created a national market in the United States that later brought regional interest rates closer together.

Occasionally, members of Congress question the role of the reserve bank presidents as members of FOMC, the presence of member bank directors on the boards of the reserve banks, and the fact that reserve bank presidents vote on national monetary policy but are not confirmed by the Senate. The usual response to comments of this kind stresses the importance of local information in interpreting national policy and the value of having different opinions voiced at FOMC meetings. The Federal Reserve has not committed to a single analytic model. At times, differences in approach gradually changed policy analysis and operations. Examples are the emphasis the St. Louis bank president gave to money growth and the Minneapolis bank gave to rational expectations. Also, the presidents and
their staff use anecdotal information acquired in discussions with local leaders to modify their forecasts or judgments.

2. McAfee (2004, 29) wrote, “Our formal legislated structure still describes 12 unaffiliated specialized national banks run by their directors.” He points out that practice strayed far from original intent and legislation.

In a country as large and diverse as the United States, differences in interpretation of events and their future implications are both inevitable and useful. If the members of FOMC accepted a precise model or a common rule, regional and analytic differences would be of lesser importance. That has not happened and is unlikely. The advantages of having the regional banks express differences of opinion should not be forsaken. Mark Willes, an effective and outspoken member of FOMC as president of the Minneapolis bank, emphasized the importance of independent research departments at the reserve banks as a major source of strength in the system (Willes, 1992, 8). Also, St. Louis, aided at times by Richmond and San Francisco, was an early proponent of an effective anti-inflation policy. President Ford (Atlanta) raised pertinent issues at many meetings in the 1980s, and Presidents Stern and Hoenig urged an end to too big to fail.

By 1950, and in the years that followed, the United States was a superpower of unparalleled strength. It proposed and brought to fruition an international order built upon the International Monetary Fund, the General Agreement on Tariffs and Trade, the World Bank, and, in the political sphere, the United Nations. The central financial markets had moved to New York or developed there. Monetary actions by the Federal Reserve influenced conditions at home and abroad. The original design would not have survived in the new conditions.

The Federal Reserve in 1951 was not well equipped to manage either the domestic or the international economy. Congress had approved the Employment Act of 1946 and the Bretton Woods Enabling Act of 1944. The former committed the government to preventing a return of the Great Depression by promising “maximum employment and purchasing power” but did not define either. The latter tied the dollar to gold and made the dollar the central currency in the international monetary system. No one mentioned that a central bank could not expect to realize both commitments unless it maintained low inflation or price stability.

The Federal Reserve resolved the conflict by accepting domestic concerns as its responsibility. The Banking Act of 1933 had restricted its international role; the Treasury took responsibility, although it relied on Federal Reserve members and staff for advice, recommendations, and assistance in financing currency support operations.

Volume 2, books 1 and 2, summarizes the main developments and actions in the years 1951 to 1986. It considers three main topics: the relation of Federal Reserve policy to monetary theory; the independence of the Federal Reserve; and inflation and disinflation. The Federal Reserve
made many errors, as the text notes. Some of the principal errors reflected prevailing beliefs in the academic profession and elsewhere in society. These contributed to the weakening of independence and the persistence of inflation.

In addition to its two central banking functions—monetary policy and lender of last resort—the Federal Reserve regulates and supervises financial institutions. During the years discussed in this volume, there were several banking regulators. The Comptroller of the Currency, part of the Treasury, supervised and examined national banks. In the early 1960s, the Comptroller pushed deregulation, putting pressure on an often reluctant Federal Reserve to follow.

Regulations are often written by lawyers who approach problems and crises by introducing new prohibitions and restrictions. They have been slow to recognize that markets often respond to regulation by innovating to circumvent the regulation. Government securities funds and money market funds circumvented restrictions on rules that prohibited small buyers from purchasing Treasury bills and certificates of deposit that paid market interest rates. Protection of large banks as “too big to fail” encouraged mergers and giantism. One justification for deposit rate regulation was protection of thrift institutions that lent on home mortgages. This was a costly error. Markets developed money market funds to circumvent ceiling rates at banks and thrift institutions. Inflation and regulation combined to eliminate most thrift institutions and to force removal of most interest rate restrictions. Taxpayers paid between $120 and $150 billion to cover the losses of failed thrift institutions.

Central bankers spent several years developing risk-based standards. This raised the cost to banks of risky loans. In the current, internationally competitive, open financial system, to circumvent regulation banks removed risky assets from their balance sheets. Risk did not disappear. Risk shifted from the regulated, supervised, and monitored banks to many places. We learn where the risks have moved when failures arise. This policy is inconsistent with a proper lender-of-last-resort function. More regulation cannot solve this problem. Risky assets will gravitate to less regulated markets and institutions.

Time will pass before lawyers recognize that they must rely more on incentives and less on regulations that prohibit or require action. Market discipline—which often means failures—is a costly way to teach prudent and effective risk management. The principal alternative is effective internationally agreed incentives. Experience with recent efforts to agree on common rules for risk management that create incentives for stabilizing behavior suggest two major impediments. Lawyers have a large role in
regulation; they emphasize command and control. Devising incentives for stability in a global economy is a challenge that economists have not accepted.
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