What is the case for the Fed?

by on November 18, 2010 at 7:10 am in Economics, History | Permalink

Alex asks this question.  I am not so enamored of the pre- and post-Fed macroeconomic comparisons.  Presumably the Fed advocate also favors deposit insurance and active exercise of the lender of last resort function.  Furthermore most Fed advocates today do not want a gold standard, in part because it ties the hands of the Fed in a crisis.  I view 1929-1932 as a better illustration of the workings of "a world without a Fed" than "a world with a Fed," even though of course we had a Fed then.  If you take the relevant division to be "before and after WWII," the Fed looks pretty good.

It's also the case that the 19th century had much less interconnected leverage than today's world (not only because of the absence of a Fed) and that agricultural productivity was a much bigger determinant of overall volatility.

I see the historical ledger as follows:

1. The Fed made 1979-1982, and the 1970s in general, much worse than they had to be, and for no good reason.  Count that as a strike against the Fed.

2. The Fed made the recent crisis much better than it otherwise would have been.  Without a Fed, we would have experienced something akin to a Great Depression, including a frozen payments system.

2b. If you wish to give the recent crisis an anti-Fed spin, you can argue that if previous bailouts had not occurred, we might have avoided the high levels of leverage circa 2006 and thus avoided such a major crash.  We would have had one or two big recessions earlier on, however.  More to the point, I believe that Congress would have done earlier bailouts; after all, that is what just happened in Ireland and TARP was Congress in any case.  What is the point of going that route?  People think of the gold standard as fetters on the Fed, but I think of the Fed as an excuse for Congress to step back.  Consult the wisdom of Garett Jones.

3. A "real Fed" would have made 1929-1932 much better than it was.  In my view this #3 more than cancels out #2b.  It is unrealistic to ask for a perfect or even a very good Fed, but it is not unrealistic or utopian to advocate "a Fed better than the 1929 Fed" and indeed we've had that ever since 1937.

4. In the 1950s, 1960s, 1980s, and 1990s, I see the Fed as bringing improvements, of unknown magnitude.

5. Historically central banks have been essential in helping nations fight major wars.  The world's preeminent military power simply will have a Fed, for the same reason that it has lots of nuclear weapons.

6. More generally, both Fed and Treasury are usually, in relative terms, voices of economic reason within government, even if they're not everything you wish them to be.  It is arguably counterproductive to lower their status.  Currently, the relevant alternative is a totally politicized Fed, not no Fed at all; see #5.

Addendum: Bryan Caplan offers relevant comment.

1 liberalarts November 18, 2010 at 3:22 am

2b is an especially good point. Anti Fed sentiment, by the way, is very shallow. I am pretty sure that the vast majority of Americans –including the minority who spout negatives about the Fed– know virtually nothing about what the Fed does. Without a doubt, though, the existence of the Fed has reduced congressional and executive activism in the last two years, as well as during both terms of George W. Bush.

2 Bill November 18, 2010 at 3:40 am

If you have to accept that there may need to be a lender of last resort in some circumstances–because banks are unwilling to lend to other banks (ala last crisis), because of assymetrical information, because of shocks (ala Europe right now, or Mexico, or LTCM)

–then acting without a lender of last resort or an entity capable of suddenly adding liquidity–means the following:

1. Institutions that are very large will not be able to fulfill that role in a time of crisis (look at all the major banks during the last crisis–were they willing to lend to each other?) or only a few can, and then only partially (Warren Buffet??, the Kochs?)

2. The lender of last resort–if it is not your government–could be and likely would be another government,

Like China.

It's your choice.

3 George Selgin November 18, 2010 at 3:42 am

"If you take the relevant division to be "before and after WWII," the Fed looks pretty good."

But our paper does take that division, for the most part; and still we conclude that the Fed doesn't look so good.

The paper also has a long section eveluating the Fed's performance as a LOLR.

I do appreciate arguments to the effect that a major power is bound to have a Fed, or something like it, to finance wars etc. But (most) economists insist on claiming that the Fed and central banks generally are not merely inevitable but the best possible means for administering nations' money supplies. It is that claim that the paper disputes. And I'm far from certain that, if economists changed their tune on this score–if they ceased to make dubious claims concerning the general macroeconomic benefits of central banks–that even major democratic governments could continue to saddle their nations with destabilizing arrangements for the sake of having access to emergency revenues.

4 gorianin November 18, 2010 at 3:59 am

"More to the point, I believe that Congress would have done earlier bailouts; after all, that is what just happened in Ireland and TARP was Congress in any case."

Do you believe the political tool as USA congress is capable of fast unpopular action?
You are joking, right? The reason, US congress makes sense is the fact is not so political, it is one of the few institution in US that can have longer then four years plans and goals.

5 J Thomas November 18, 2010 at 4:16 am

I think a more practical question is what should the Fed's mandate look like? Employment and price stability, or just price stability? I don't know the answer to that one…

Isn't the Fed an organization of bankers, run by bankers for bankers?

If somebody decided that employment should be an end rather than just a means for the Fed, what could they do to make it so?

Perhaps your question is not a practical one after all.

6 DK November 18, 2010 at 4:29 am

questions from a loyal reader:
1. what were the mistakes in the 70's? i was a kid then, I remember my parents' emotions but not the Fed's role.
2. what made the post-WWII period different? it is perhaps just that the US was the strongest global power, and thus in control of its economic destiny in a way other countries weren't, and a way we won't be in the next 50 years?

7 josh November 18, 2010 at 4:58 am

Tyler,

You have made an ass of u and me.

8 Roland November 18, 2010 at 5:00 am

My take from F & S (its early, memory is imperfect)is that there were critical deficiencies of institutional design present in 1929 that were fixed later. In particular, it was not actually a central federal bank but rather a decentralized network subject to too many veto points..

9 George Selgin November 18, 2010 at 5:25 am

"Agricultural volatility in the 19th Century makes the Fed look worse. Also consider the inflationary effects of the gold rush."

I don't get part 1 of this sentence at all. Surely the relatively volatility of agriculture make the Fed look better since agriculture's share has declined over time. (Chris Hanes has some good stuff bearing on this.)

As for the inflationary effects of the gold rush: try finding them in the available statistics. You will see a tiny blip at most–nothing to compare to what happened in the 70s, let alone during WWI. In fact, I suspect that the overall inflation rate in the gold-rush period (define it however you like) was not substantially greater than the average post-1913 rate.

10 a November 18, 2010 at 5:32 am

If the Fed had taken a hands-off attitude and let LTCM fail miserably in 98, then none of the subsequent problems with leverage would have happened. Several IBs would have suffered huge losses, everyone would have learned the true meaning of risk, and most would have behaved much much better. After LTCM it was understood by all the IBs that you didn't have to take counterpart risk in a systemic crisis seriously. That implied all that followed. It's that simple.

Moral hazard matters. What the Fed did in 98 (and later) came back to haunt it, and all of us, a decade later. And you can be sure that what the Fed did this time, by again ignoring moral hazard, will again come back to haunt it.

11 ladderFF November 18, 2010 at 6:00 am

Can someone flesh out #5?

12 Lee Kelly November 18, 2010 at 6:20 am

Tyler said: 2. The Fed made the recent crisis much better than it otherwise would have been. Without a Fed, we would have experienced something akin to a Great Depression, including a frozen payments system.

Really? In the absence of the Fed, private institutions would arise to provide interbank clearinghouse services (even deposit insurance and lender of last resort roles). Private money issuers would have responded to the increased demand for money with a greater supply. The housing bubble would probably not have been as severe in the first place were it not for the Fed's easy monetary policy in the 2002-2006 period.

If we abolished the U.S. Postal Service, then would all mail and package delivery cease? No. If we abolished the Fed, would no private institutions offer similar services and would the money supply be unchanging? No. I'd bet my socks that with a full on free banking system, NGDP would not have dropped sharply in 2008.

13 Master of None November 18, 2010 at 7:39 am

"It seems others above have made similar points."

Including yourself in 2.b.

But, when you say "We would have had one or two big recessions earlier on, however" I think that is an important point.

If we're going to have a financial crisis-related every 5 years or so, as Jamie Dimon has said, we should at least have it FAIRLY. The Fed has proven itself a tool to create unfairness in our economic system, and this is destructive. It's the "moralism" argument from Interfluidity.

Congress is a separate, related, issue, but the "Fed or not" argument should be made in the context of the political system that we have.

14 Bill November 18, 2010 at 1:09 pm

Philo, Re your comment: 'In general, an all-wise regulator would make things as good as they can possibly be; but that observation contributes nothing toward evaluating real-world regulators.'

Perhaps the regulator was not so all wise. It was administering the Austrian solution to the patient: let it burn out. Being a regulator doesn't make you wise, by any means, but you can learn something once you are burned on what not to do in the future and what to do differently.

In addition, one economic historian maintains that the Fed did not believe it to be in its powers to do some things under the 1913 Act, so you also have to control for both changes in regulatory authority and even the understanding of one's own authority when you make this statement across different periods.

15 Troy Camplin November 18, 2010 at 2:34 pm

Um, what about the fact that the Fed caused the bubble that caused the Great Recession (and the one that caused the Great Depression)? Surely that counts against it. I'm guessing these sorts of things couldn't happen under free banking (and didn't where it was tried).

16 anonymous November 18, 2010 at 6:41 pm


The Fed made 1979-1982 […] much worse than [it] had to be, and for no good reason. Count that as a strike against the Fed.

Wait, what?

You condemn in equal measure the Fed policy of Paul Volcker and the very different Fed policy of Burns and Miller in the high-inflation Seventies? Really?

If not, then it is careless phrasing to conflate the two.

If so, then surely there is material for a separate post here, given that received wisdom has practically canonized Volcker for breaking the back of inflation and ushering in two decades of prosperity and stock market utopia.

That wasn't an offhand remark in passing, that was a drive-by! Don't leave us hanging…

17 MichaelM November 18, 2010 at 7:38 pm

"In the absence of X private institutions would arise…."

A central theme of the stories in the Great Book of Libertarian Fairy Tales.

As a matter of fact, clearinghouses were performing exactly this role in the years prior to the adoption of the Federal Reserve Act. Part of the reason the recession following the Panic of 1907 was relatively shallow was the clearinghouses acting as lenders of last resort, issuing scrip in order to buffer the reserves of fragile banks.

18 Bill November 19, 2010 at 9:33 am

MichaelM, Re you comment: 'As a matter of fact, clearinghouses were performing exactly this role in the years prior to the adoption of the Federal Reserve Act. Part of the reason the recession following the Panic of 1907 was relatively shallow was the clearinghouses acting as lenders of last resort, issuing scrip in order to buffer the reserves of fragile banks.'

What facts do you have to support that statement?

It is contrary to economic history and false.

Here is a summary of Prof Wickers work on this subject of clearinghouses working. If you dispute this, please put some evidence in the record

"In Banking Panics of the Gilded Age, Elmus Wicker shows that with one notable exception (the Panic of 1873), the New York Clearinghouse was unsuccessful in dealing with financial panics and contagion. (NYCH was a bank clearinghouse, not a derivatives clearinghouse, but there are important similarities. Most importantly, NYCH had the ability to mutualize some risks.) Wicker argues that conflicts between heterogeneous members were the main impediment in dealing with panics. Although mutualization of risks would have mitigated panic (because the banks collectively were more likely to be solvent than any individual bank), mutualization transferred wealth from the stronger banks to the weaker ones. The inability to overcome this distributive conflict stymied the ability of the NYCH to respond to crises in an effective way."

If you dispute this, please put some evidence in the record, and I will respond with some additional quotes.

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