Faith in the Fed- my last word

by on November 21, 2010 at 5:29 pm in Economics, History | Permalink

In his response to my critique, Tyler calls the Federal Reserve the "saviour institution," a most un-Tyler like phrase although consistent with his earlier plea that all will be well if we just put our faith in the Fed.

Clearly, I am less of a true-believer than Tyler but lets turn from faith based argument towards substantive matters.

I said the case for the Fed is weak, Tyler responds that the case for free banking is weak–this is not a rebuttal.  The point is more than rhetorical since there are many alternatives to the Fed as we know it, Scott Sumner has relentlessly made the case for nominal-GDP targeting (with futures markets), Kotlikoff makes the case for limited purpose banking, Tyler and Randy Kroszner once made the case for a similar idea, mutual fund banking (Tyler is less favorable today), Selgin and White make the case for free banking, and of course there are also commodity standards such as a gold standard and the BFH system (e.g. see this piece by Bill Woolsey). Since the case for the Fed is weak, I see work on all these alternative institutions as important and valuable.

In the 1970s and 1980s there was a large literature on rules versus discretion at the Fed, that literature faded out with the great moderation. The great moderation today looks more like a combination of luck and structural change rather than discretionary wisdom.  The Selgin, Lastrapes, White paper can be read as an argument to put greater weight on rules.

Tyler argues (but compare here) that "Many of the Fed's most serious mistakes are sins of omission, not commission…" and then he seems to argue (it's not entirely clear) that alternative institutions are all omission and thus cannot do better.  The rules versus discretion debate shows us the falsity of this conjunction.  As Sumner has repeatedly reminded us a nominal GDP rule would have required more action not less. Moreover, it's quite possible that other alternative institutions such as free banking would also do better on avoiding sins of omission as well as commission.

Tyler says:

It takes a good deal of imagination to believe that the Fed's periodic overreaches outweigh the benefits it provides through countercyclicality.

If this were correct the benefits of the Fed in reducing variability would be obvious in the data. The benefits are not obvious in the data, why not? I see several possibilities.

1) As Milton Friedman showed, once we take into account lags and uncertainty it's quite easy to see how counter-cyclical monetary policy can backfire even when the case for monetary policy is strong.

2) As I suggested above, it could also be that alternative institutions performed about as well on counter-cyclicality as the Fed.  

3) It could also be that counter-cyclical monetary policy is not as important as we think. Tyler has argued strongly that the current recession is majority structural (e.g. here, here, here) and thus that neither monetary nor fiscal policy is very effective.  If a lot of recessions are structural then monetary institutions of any kind might not matter that much.

Millian November 21, 2010 at 2:10 pm

So Tyler now has to defend a specific monetary policy, not just the institutions, against practically all alternatives? We call that "moving the goalposts" over here, after the ball has been kicked no less.

Tyler Cowen November 21, 2010 at 2:20 pm

By the way people, Alex and I more frequently had back-and-forth debates in the early days of MR. You can try the archives, I recall one being about school vouchers. Oddly, the WSJ complained, in print, that we were doing this.

Bill November 21, 2010 at 2:40 pm

Tyler puts his comments below the fold and Alex above the fold. A little more assertive for Alex, or perhaps the assertiveness is from Alex having to be more defensive of a bad argument.

We're lucky the Mesopotamian cultures dropped iron for their currency, as that store of wealth would have been a poor choice of an item of scarcity; we look curiously on the Spanish invasions of Latin America which boosted world supplies of gold, (omg, we must therefore have been more wealthy, right); we wonder how a product which was plundered from church monestaries or by invading armies came to be a fictional measure of anything, ironically, other than the power of the state to invade and capture or hold or tax. The King, other than invading others and stealing their currency, didn't do anything to earn it.

But, then, currency is all belief anyway, isn't it. You believe those ones and zeroes displayed on your monitor from your bank account balance, afterall, mean something, don't they and that they are in your account? Or are they or do they. Ultimately, it's trust that 1's and zeros are "at the bank" when in fact they never are, they're lent out to someone else.

Currency is only a medium and mediator of exchange.

Bottom Line: If we have nothing to sell that others want, it doesn't matter a tiddley squeeck because eventually we will fail regardless of an initial currency position from any type of medium of exchange.

And, that's the irony here: all this talk for something that will never happen, while our competitiveness, our willingness to engage in real discussion about real things, is frittered away by discussing some 19th century relic and 19th century panics and busts.

Last I checked we're in the 21st Century.

Matthew C. November 21, 2010 at 4:26 pm

I'd love for Tyler to justify the Fed buying crap mortgage paper (1.5 trillion dollars of it) and the rest of the Fed / Treasury bailouts of the imprudent on the backs of everyone else. And why isn't the Fed restructuring the defunct zombie banks (B of A, Citi, JP Morgan Chase) so we can have a real recovery?

dave November 21, 2010 at 4:41 pm

Bill,

It is relevant because our system of currency is so distorted that it has catastrophic impacts on our real economies ability to produce goods. Those ones and zeroes are the measuring sticks people use to make economic decisions about what to produce and who will consume that production. If the ruler is broken, you can't build anything correctly.

Sleazy P. Martini November 21, 2010 at 5:18 pm

josh,

Exactly. Tyler is so concerned with maintaining his impeccable mainstream credentials that he's willing to put forth obviously

stupid and embarrassing arguments. That Alex is far from the best guy to debate him on this issue, yet easily mops the floor

with him, shows just how low Tyler has sunk.

George Selgin November 21, 2010 at 5:44 pm

For the record, a few Fed "sins of commission," off the top of my head:

WWI inflation (much worse than the 70s)
'25-'28 "help the BofE stem gold drains" easy money/stock bubble (there is non-Austrian support for this)
'36-7 doubling of reserve requirements depression-within-depression
WWII: inflation disguised by OPA controls; Fed plays handmaiden to Treasury until '53 Treasury Accord
late '60s-mid '70s Vietnam inflation (so much for Accord)
'80-'82 Volcker disinflation causes '82 recession (perhaps unavoidable given need to stop inflation)
'80s and '90s: TBTF invented and reinforced with Conti and LTCM bailouts–both quite unjustified according to later evidence.
post-2001 easy money
October 2009 interest on reserves when bank lending is drying up.

That, once again, is off the top of my head.

George Selgin November 21, 2010 at 6:04 pm

"It is clear that something has smoothed inflation volatility since about the time the Fed opened shop."

Yes indeed; and that something is a change in the inflation data. The pre-Fed data is based on commodity prices rather than broader price data used to construct the CPI or GDP deflator since then. The additional volatility is mostly if not entirely a statistical artifact due to this difference. We mention this fact (and related stuff) in our paper. Our source on this matter is Chris Hanes, who has studid the data in question in great detail.

I hope that persons chiming in for the Fed will please read our paper to see whether in fact the conventional facts they are tempted to report are not convincingly rebutted there. Of course we woudn't have bothered writing it if we had not been aware that much of what people "know" about how the Fed made things better just ain't so.

Bill November 21, 2010 at 6:26 pm

George, To repeat one of the other Wiki cites, here are the number of financial crises before and after the Fed:

19th century

Danish state bankruptcy of 1813

Panic of 1819 – pervasive USA economic recession w/ bank failures; culmination of U.S.'s 1st boom-to-bust economic cycle

Panic of 1825 – pervasive British economic recession in which many British banks failed, & Bank of England nearly failed

Panic of 1837 – pervasive USA economic recession w/ bank failures; a 5 yr depression ensued

Panic of 1847 – a collapse of British financial markets associated with the end of the 1840s railroad boom.

Panic of 1857 – pervasive USA economic recession w/ bank failures

1866: Overend Gurney crisis – comprised the Panic of 1866 (primarily British)

Panic of 1873 – pervasive USA economic recession w/ bank failures, known then as the 5 yr Great Depression & now as the Long Depression

Panic of 1884

Panic of 1890

Panic of 1893 – a panic in the United States marked by the collapse of railroad overbuilding and shaky railroad financing which set off a series of bank failures

Australian banking crisis of 1893

Panic of 1896 – an acute economic depression in the United States precipitated by a drop in silver reserves and market concerns on the effects it would have on the gold standard

[edit] 20th century

Panic of 1901 – limited to crashing of the New York Stock Exchange

Panic of 1907 – pervasive USA economic recession w/ bank failures

Panic of 1910–1911

1910 – Shanghai rubber stock market crisis

Wall Street Crash of 1929, followed by the Great Depression – the largest and most important economic depression in the 20th century

1973 – 1973 oil crisis – oil prices soared, causing the 1973–1974 stock market crash

Secondary banking crisis of 1973–1975 – United Kingdom

1980s – Latin American debt crisis – beginning in Mexico in 1982 with the Mexican Weekend

Bank stock crisis (Israel 1983)

1987 – Black Monday (1987) – the largest one-day percentage decline in stock market history

1989–91 – United States Savings & Loan crisis

1990 – Japanese asset price bubble collapsed

early 1990s – Scandinavian banking crisis: Swedish banking crisis, Finnish banking crisis of 1990s

1992–93 – Black Wednesday – speculative attacks on currencies in the European Exchange Rate Mechanism

1994–95 – 1994 economic crisis in Mexico – speculative attack and default on Mexican debt

1997–98 – 1997 Asian Financial Crisis – devaluations and banking crises across Asia

1998 Russian financial crisis

[edit] 21st century

2001 – Bursting of dot-com bubble – speculations concerning internet companies crashed

2007–10 – Financial crisis of 2007–2010, followed by the late 2000s recession and the 2010 European sovereign debt crisis

Fewer after than before the creation of the Fed in 1913 (even if you argue the Fed was acting like a Fed during the depression, which it was not), not even controlling for the complexity of the economies.

Here's a link: http://www.marginalrevolution.com/marginalrevolut

Ah, the wisdom of crowds.

jorod November 21, 2010 at 7:10 pm

And forget about inflation..look at the amount of debt out there and the underlying assets. If the RE market doesn't come back soon, there are a lot of lenders that will go under. Artificially low rates defeat the purpose of prices/rates that act as a natural brake on debt creation.

Jeffrey Horn November 21, 2010 at 7:55 pm

Alex, did you consider the role the Fed could make in the current deflationary episode when making your last argument, point 3 above?

Even if the Fed can't fix structural issues, 1) couldn't it still provide price stability in the face of deflation following structural re-adjustment, and 2) *shouldn't* it?

J Thomas November 22, 2010 at 3:00 am

"Ask yourself: do we want a money system that is reliable, and is central banking or free banking more likely to provide that?"

Neither is reliable. Both are based on banking.

So if you believe that the economy is a series of dice throws, it is only a matter of time until you get a black-swan event which will make the system fail. If you instead believe in cause-and-effect models, most of them will give catastrophes quicker. The banks will collectively do things that promote catastrophe. Or the government will do disastrous things that require the central bank to correct, and each time it gets harder to correct until the system fails. Etc.

What would you have to believe, to think that banking systems are not basicly designed to fail occasionally? Wouldn't we be better off with a design that's fundamentally different?

George Selgin November 22, 2010 at 3:17 am

Bill, I'm perfectly aware of the crises that you list. But I can't see what most of them have to do with the question whether the Fed has succeeded in its mission or not. (The Fed can hardly be said to have been responsible for ending crisis in other countries.) And Andy is right to note that the cessation of U.S. crises after '33 was not the Fed's doing but that of the FDIC and (between March '33 and January '34) the RFC.

Andrew November 22, 2010 at 4:58 am

My last word: The solution is working on the mechanics, Mark-to-Market, bankruptcy, etc, you know, rule of law stuff. QE is just goofing around. It's not the end of the world (this time) but it's not going down the road that leads to solutions.

Also, The Fed has benefitted from the growth in credit. They will not benefit from the contraction. But maybe we'll say the past few and coming bubbles should be seen as examples of not having a Fed ;)

JohnP November 22, 2010 at 5:49 am

Thank you both for discussing this! I'm looking forward to exploring the links.

Bas November 22, 2010 at 6:15 am

Faith in the Fed does not equal faith in central banking in general. The fact that your rather myopic discussion does not even address this issue is quite typical: Americans, even American economists, have developed quite a blind spot for the unique position of the dollar as the dominant global currency.

Yet this single fact crucially changes the way a central bank functions, because it alters the consequences of monetary policies in a number of ways. Most importantly, global dollar dominance largely removes the kind of 'natural' constraints inflation imposes on monetary policy elsewhere in the world.

The lack of technical limits to monetary policy ensures the Fed could never become a technocratic, inflation targeting institution in the mould of the ECB. Instead, the Fed will be tempted to encroach again and again on the domain of politics, to the point where monetary and fiscal policy become almost indistinguishable.

That's one reason why Cowen's argument concerning the allegedly beneficial countercyclicality of Fed policy rings false. An unconstrained central bank like the Fed seldom has any incentive to remove the punch bowl when the party gets started. Just as it cannot refrain from 'countercyclically' filling it to the brim when everyone is already passed out.

Discussing the pros and cons of central banking while referring exclusively to the Fed is a rather obvious category mistake.

Bill November 22, 2010 at 7:58 am

And, all I ask is that you read a paper by a Professor who has written books on US financial panics, and has written a new paper on the current financial crisis, comparing it to previous ones.

I admit to being an uniformed plaigarist and using some of his comments on this and previous crises to critique George's paper,

so, MR readers: take up the challenge. Read both papers and form your own opinion.

Here is the link to Prof. Wicker's paper: http://mpra.ub.uni-muenchen.de/21839/1/MPRA_paper

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