Response to Tyler on the Fed

Tyler's Case for the Fed (see below) has solidified my judgment that the case for the Fed is surprisingly weak.  I will draw out some of Tyler's comments.

I view 1929-1932 as a better illustration of "a world without a Fed" than "a world with a Fed," even though of course we had a Fed then.

I have learnt that the best response to this kind of reasoning is to say "please pass the nam tok, Tyrone" and move on. Be forewarned.

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

It's wrong to evaluate a big institution like the Fed by assuming a world in which everything else is exactly the same, except for the Fed's absence. Tyler does a lot of this in his post but I am not enamored of this style of reasoning. This is why we need pre and post-Fed history.  Pre and post-comparisons are one of the few methods we have for understanding how entirely different institutional structures perform in equilibrium (looking at countries without a central bank is another possibility). Pre and post-comparisons have all kinds of problems, since other things are changing, but the facts do at least put some constraints on imagination.

By the way, as the Miron paper I linked to shows, comparing just the 25 years before and after the Fed (even if you exclude GD) also suggests that the Fed reduced stability.

Tyler says the Fed has been getting better. Ok, but that also illustrates the weakness of Tyler's approach. After 100 years we would have expected alternative institutions to have also gotten better.

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

Tyler gives us his informed opinion but it's long on opinion and short on information. Would it be possible to be more vague?  "Improvements"? Compared to what? Compared to the Fed in the 1970s?  Unknown magnitude? As I said, Tyler's case for the Fed leaves me more solidified in my judgment that the case is weak. I will let the Straussians ponder that more.

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.

I agree with this entirely.  Governments want central banks because they help to fuel war. Historically, this is why central banks were created. 

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;

Like the points Tyler makes in the beginning of his post about who does or does not support deposit insurance this is sociology, irrelevant to the fundamental question of evaluation.

Moreover, as I pointed out earlier the case for "independent" central banks is also weak; central banks are always politicized, only the interest groups change.


Alex, Yesterday you began the discussion with what you described as an excellent review of economic literature in a Cato working paper arguing that the Fed is either unnecessary or minimally helpful. According to one of the authors, the paper relied on work by a Professor Wicker who studied the depression, and wondered what he said as a person who studied bank panics of the past.

Here is a current paper comparing the current situation to the past and his comments on the Fed, intervention of a lender of last resort, private interbank mechanisms (which failed in previous crises and in this one as well), and the role of the Fed in today's world v. the world without a Fed.

Here is the link and quotes from a recent paper by Wicker on the current financial crises:

1. "In stark contrast to the seventy five years of relative banking stability was the

sixty years of banking instability between 1873 and 1933: four major banking crises in

1873, 1893, 1907, and 1914 and three banking panics in 1930 and 1931. And then there

was the complete collapse of the banking system in March 1933. What, indeed, is

anomalous is that the U.S. established a central bank, the Federal Reserve System, in

1913 in part to prevent a recurrence of the national banking era crises and yet the worst

banking crises occurred in 1930 and 1931. The banking acts of 1933 and of 1935 and the

Securities and Exchange Act of 1934 were designed to prevent a recurrence of the

banking panics of the Great Depression. The legislation had been successful in

preventing banking panics like those that occurred during the Great Depression." (p. 3)

The paper goes on to say that the financial crisis today is different than the Great Depression because of larger institutions, greater interconnected to off bank entities, and more.

2. "The Banking Acts of 1935 created the Federal Deposit Insurance Corporation

(FDIC) with the authority to guarantee within bounds bank deposits. Depositor

confidence would respond if the FDIC was credible. And there have been no national or

regional banking panics of this type since 1935. We can conclude that type one systemic

risk has been successfully managed without recurrence of destabilizing bank runs." (p. 31).

3. He is advocating for more regulation, not less, nor for the elimnation of the Federal Reserve: "Type two systemic risk is a different matter. It was late in coming to prominence [in the current financial crisis, ed.], and we are still identifying and learning to respond to it much less managing it. But it

was already clear that managing systemic risk required enlarged responsibilities for the

Federal Reserve System and a new regulatory framework for keeping track of derivativetrading (e.g., a clearing house or an exchange, or both, and some means to measure

volume of contracts outstanding). It may also be necessary to reduce the aggregate size

of megabanks (LCFIs). It is too early to know which path bank regulatory reform will

follow. More must be revealed about the nature of systemic risk arising from the ‘too big

to fail’ doctrine applied to large complex financial intermediaries. This kind of systemic

risk reflects counterparty risk – that is, the risk of making transactions with other banks.

This is a loss of confidence between banks (and other intermediaries). But also type two

systemic risk implies that the credit exposures between intermediaries may be large

enough such that the failure of one institution may threaten insolvency of one or more

LFCIs....Recent experience suggests that substantial regulatory reform is

necessary." (p31-32)

4. And, the risks to the system today are higher, and letting banks fail without increasing liquidity will create systemic risks:

"What we have learned about banking crises in the US since the Civil War is how

they differed from the current financial crisis, but it is more important to recognize that

the “old school” remedies for those banking crises are not the relevant cure for the

current crisis. Bagehot’s rules need some updating. That does not mean, however, that

the central bank refrain from injecting liquidity to forestall a loss of depositor confidence.

Rather, we suggest that in the presence of “too big to fail” policies, managing type two

systemic risk requires a new research agenda. Our understanding of type two systemic

risk – interconnectedness and the transmission of insolvency -- is still in the early stage.

And evidence to support the type two systemic risk hypothesis must await the availability

of bank records (how insolvent were the LCFIs and LCNFIs?).

Our brief review of the panics of the National banking Era and the Great

Depression supports our general description of type one systemic risk. In the current

crisis, there has been no general shock to depositor confidence, no widespread bank runs,

no increase in hoarding, and no decline in measured money stock. There was, however, a

tremendous shock to confidence in structured financial products and securitized assets

more generally. The collapse of the housing bubble was a shock to the solvency of

certain large, complex non-depository financial institutions (LCNFIs) in the central

money market (New York City) as well as some outside NYC. In the current

crisis systemic risk has been magnified by the existence of megabanks with more

sophisticated and complex interconnections. Fear of negative spillovers from a mega

bank failure generates motives to forestall failure. The insolvency or threatened

insolvency of a megabank has given rise to a new doctrine "too big to fail" or another

way of putting it - excessive systemic risk. The old doctrine that we described earlier --"

let insolvent banks fail" prevailed during the national banking era and the Great

Depression. Restoring bank solvency today requires a markedly different solution for

restoring liquidity." (p. 38-39)

Agree. Tyler said a lot of things without actually saying anything at all.

Addendum: It seems to me that in a way we have one huge monopoly bank, the federal reserve. It is the source of all money but it does not do a real good job of watch over its' money to ensure that it is not corrupted.

Alex, I am not sure if it was your intention, but this exchange has raised your status, relative to Tyler's.

" Governments want central banks because they help to fuel war. Historically, this is why central banks were created." What war were we fighting when the Fed was created?

Pre- and post-comparisons are worthless in this context. The Fed may have technically existed in the Great Depression, but it had no clue how to conduct monetary policy. All one needs to do is compare the recent financial crisis to the Great Depression to see the value of a modern, well run central bank.

"All one needs to do is compare the recent financial crisis to the Great Depression to see the value of a modern, well run central bank."

The fact that Fed apologists can make no better claim in defending the Fed's recent performance than to observe that things haven't been as bad as they were in '33 is itself quite remarkable. Must we have a crisis even worse than that of the 30s before they are prepared to concede that we ought to try and improve upon our "modern, well run central bank"?

What are some "[industrial democracies] without a central bank" for us to look at?

Present company excluded, it's funny when people who didn't know what was going to happen and don't know what is happening can predict the alternate reality that things would have been so much worse except for one thing that is different is the central has improved.

I disagree that it doesn't follow to compare those crises because the onset of the Great Depression was characterized by a lack of action from the Federal Reserve.

Tyler is right!

tedm, you could certainly perform an analysis on that basis, but it would be irrelevant. The opportunity cost of ending the Fed is not losing the influence of the 1930's Fed, it's losing the influence of today's Fed.

George Selgin, I don't know who Joseph Davis is but that is absolutely preposterous. More than 1/3 of the nation's banks failed in the panic of 1837. I've seen sources that say unemployment was still 14% 3 years after the Panic of 1873.

Actually, you do not have to compare anything to the 19th century panics if you look at a non-responsive Fed in the 1930's as the equivalent of no Fed at all.

But, we have already done a natural experiment: in this last crisis, no large bank was lending to any other bank up until the Fed intervened. (Oh, forgot about Warren Buffett.) And, in addition, the largest banks were the ones most at risk, so who was going to lend to them in this moment of crisis. I've got it: Let's invent a counterfactual world with even bigger banks who are unleveraged to lend to them. Yeah.

And then we can also look at the non-bank banks--they lived in the unregulated world. The Fed didn't regulate them. CIT? GE Capital. Insurance companies. Do you have any faint memory of what happened in this market? Do you recall any programs that the Fed instituted that provided liquidity to the non-bank banks?

I now understand what the word counterfactual means. It means counter facts.

You might want to look at the economic historian Wicker's paper on the comparison of the 19th century panics to today.

He discusses it in detail:

Hint: Systemic risk is different today than it was in the 19th century. Read about it for yourself, though, as he compares various panics of the past to today's crisis.


So your understanding of FED action during the GD is that they did nothing? If so, how do you square that with the common narrative that they contracted the money supply?

Ryan, I think you are reading into my statement that the Fed did nothing more than I said, but if you want me to say they knowingly contracted the money supply, I wouldn't be comfortable with that, although I would be with one that said they adopted the wrong (raising interest rates) and ineffective policies, and that people learn from history and experience, or why else did the Fed flood the market with liquidity in 2008. Up until the 1960's the predominant view was that the Fed had played a passive role in monetary policy during the the depression. Schartz and Friedman argued that the Fed did not keep the supply of money constant or act as the lender of last resort. So if your criticism is that the Fed should have acted as the Fed or lender of last resort, I don't know how that squares with your position that we would be better off without the Fed.

As for the Fed and the Great Depression, what was it doing during the time of 1923 to 1929?


"Present company excluded, it's funny when people who didn't know what was going to happen and don't know what is happening can predict the alternate reality that things would have been so much worse except for one thing that is different is the central has improved."

Well said!

"So if your criticism is that the Fed should have acted as the Fed or lender of last resort, I don't know how that squares with your position that we would be better off without the Fed."

This is neither my criticism or my contention. My point was simply that the FED did indeed exist during the GD, and did indeed undertake certain monetary policies. Contrasting the policies then to those of today only serves as a comparison of central bank policy vs central bank policy. Neither event serves as an indicator of what performance would have looked like under a free banking system. At least some have suggested looking at the wildcat banking systems; while that system had its own unique set of issues, one could at least make a better case for it approximating a free system.

Likewise, I don't deign to know how a free banking system might have dealt with either the GD or recent recession, but I'm quite certain neither the GD or 07 recession inform on that matter.

"Look at the non-bank bank system during this crisis. That was the "free banking system." It wasn't regulated by the Fed at the time of the crisis. What happened?"

Having written a few things about free banking, I think I'm qualified to speak concerning what it is and what it isn't; and what Bill is talking about here certainly isn't free banking. (Free banks aren't propped up by implicit government guarantees, for one thing.) Perhaps once he's gotten around to reading the paper he's been criticizing here, he can turn to reading some of the literature on free banking.

Look at the non-bank bank system during this crisis. That was the "free banking system." It wasn't regulated by the Fed at the time of the crisis. What happened?

You know what happened. Credit froze up, and the Fed had to intervene to help GE Capital and others.

No. Put it this way. When you have a cat, it affects even the mice the cat does not catch.

The behavior of institutions that arose partly to avoid Fed intervention, does not reflect how institutions would behave without the Fed.

George, You say that non-bank banks are propped up with implicit government guarantees.

Any source for that?

And, if you say that it is implicit because if the non-bank banks failed, we would bail them out, then you could also argue that the "free" banks, if they failed, we would probably bail them out for the same reason.

That would probably be implicit too.

So, the Fed fulfilled the role of lender of last resort, at least a little.

What do they want, a cookie?

Andrew, Also, thank you for the first Wicker citation which led to others which support the Fed. Stand up and take a bow.

Lou said

"The housing bubble was impacted by regulatory decisions that had nothing to do with the Fed."

Sorry, no. The Fed set the regulatory rules for mortgage origination and servicing through its rulemaking powers under the Truth in Lending Act (TILA). Also, the Fed was part of the inter-agency prudential regulators that set safety and soundness rules for banking institutions (part of the FFIEC). Also, the Fed was the BHC-level regulator for the financial derivatives activities in the trading arms of Citi, BofA,... (but not AIG). Also, the Fed (and the SEC) had their regulators within Lehman during almost all of 2008.

P.S. I am not a Fed critic. Ex ante, the Fed staff honestly believed that it was better to use monetary policy to clean up a popped housing bubble than to head one off. Ex post, that position looks like a mistake. That period gets coded as "The Fed existed," unless the researcher wants to throw out the entire record and rely entirely on theory - which is fine if you want to go that route. Just don't screw with the historical record just because you disagree with agency decisions ex-post.


J Thomas: "The behavior of institutions that arose partly to avoid Fed intervention, does not reflect how institutions would behave without the Fed."

First, I disagree. The space the non-bank banks occupied involved the same market as banks--they both gave loans and competed for the same customer. I could go to a bank for inventory financing, and also get it from GE Capital. Non-bank banks were and are competitors of banks. To use your analogy, they are all mice, competing for the same cheese; therefore, they should also be regulated as Volcker has argued.

I agree completely. If you regulate banks but don't regulate other businesses that do the same things, one or the other of them will tend to get outcompeted -- depending on whether the regulation aids or detracts from survival. If it's worth regulating banks, do it to everything that plays the role of banks. If it isn't worth regulating banks, then stop.

I say that non-bank actors living in an environment that's dominated by the Fed are not a good model for non-bank actors living in a Fedless environment. They will not behave the same at all.

Second, the logic of the argument doesn't hold. No denial of the statement that non-bank banks, not subject to regulation, did not go with a request for a handout, claiming that if they could not raise money in the market, their hostages--sorry, customers--would be injured if they could not get access to the Fed.

Did you add an extra negative there, or leave one out? Of course they asked for handouts. Why wouldn't they? What did they have to lose?

If there was no Fed they would be asking for handouts from whatever institution could hand them handouts. Why do they ask for money from the central bank? Same as Willy Sutton. "Because that's where the money is."

First, Long Term Capital Management. Should have been allowed to go bankrupt.
A key gov't job in a market system is to Enforce Contracts, including, under Rule of Law, creating a reasonable amount of justice when one side FAILS to fulfill their contractual obligations.
Not having bankruptcy law available and usable for LTCM was a gov't failure -- not preparing one after the 1998 bailout is inexcusable.

I do believe that the USA financial system would have been better without a Fed (Alex is right!)-- but even more firmly believe this cannot be proven, and that the political desire to have influence over an institution with the power of the Fed will dominate any Ron Paul ideal of a Free Banking world (Tyler's conclusion is the 99.9% probable result for the next 20 years). Heck, we are unlikely to even take the baby step of allowing competing currencies.

Besides allowing war by the gov't, the Fed also pretty much insures that the super-rich can stay that way, and socialize any Big Losses that their risky behavior creates, rather than lose it en masse.

Because the Fed is gov't, it learns more slowly then the rich would learn w/o the Fed. If we, the people, are gonna be stuck with a Fed, we MR folk would be more productive to push for overall better monetary policy. But economists can't even agree on what the definition of money is, much less the optimal policy.

CPI inflation measures aren't considered clear facts about inflation, either, there is a not-well defined money to be controlled by the Fed to maintain a not fully defined inflation/ price level.

Even with a Fed, we need better bankruptcy laws to allow the Big Banks to go belly up. We need better rating agencies, perhaps to be expanded as more insurance, too, and if we can't have Free Rating agencies, which we don't have now, it's silly to believe in Free Banking. (Even without reading the article in favor of it.)

An obvious PR problem is that the relaxation of prior banking restrictions, "freeing up the banks", certainly did contribute to the current crisis. To actually de-regulate will require taking specific steps, but with respect to the Fed, I'm not reading here much in the way of "small steps toward a much better world".

So Alex, Tyler, what policy changes do you actually recommend? Whether or not you believe the case for a Fed is weak, what laws should be changed now?

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