The other part of the Fed’s responsibility is to be lender of last resort. And once again, the Fed did not read its mandate. It responded inadequately to the bank runs, essentially allowing a tremendous decline in the banking system as many banks failed. And as a result, bank failures swept the country. A very large fraction of the nation’s banks failed; almost ten thousand banks failed in the 1930s. That continued until deposit insurance was created in 1934. Now, why did the Fed not act more aggressively as lender of last resort? Why didn’t it lend to these failing banks? Well, in some cases, the banks were really insolvent. There was not much that could be done to save them. They had made loans in agricultural areas and their loans were all going bad because of the crisis in the agricultural sector. But part of it was the Fed appeared, at least to some extent, to agree with the liquidationist theory, which said that there was too much credit; the country was overbanked; let the system contract; that was the healthy thing to do. But unfortunately, that was not the right prescription.
In 1933, Franklin Roosevelt came to power. Roosevelt had a mandate to do something about the Depression. He took a variety of actions; he was very experimental. Some of those actions were quite unsuccessful. For example, something called the National Recovery Act tried to fight deflation by requiring firms to keep their prices high. But that was not going to help without a bigger money supply. So a lot of things Roosevelt tried did not work, but he did two things that I would argue did a lot to offset the problems the Fed created. The first was the establishment of deposit insurance, the FDIC, in 1934. After that, if you were an ordinary depositor and the bank failed, you still got your money back and therefore there was no incentive to run on the banks. And in fact, once deposit insurance was established, we went from literally thousands of bank failures annually to zero. It was an incredibly effective policy. The other thing FDR did was he abandoned the gold standard. And by abandoning the gold standard, he allowed monetary policy to be released and allowed expansion of the money supply, which ended the deflation and led to a powerful short-term rebound in 1933 and 1934. So the two most successful things that Roosevelt did were essentially offsetting the problems that the Fed created or at least exacerbated by not fulfilling its responsibilities.
So, what are the policy lessons? It was a global depression that had many causes, and the whole story requires you to look at the whole international system. But policy errors in the United States, as well as abroad, did play an important role. And in particular, the Federal Reserve failed in this first challenge in both parts of its mission. It did not use monetary policy aggressively to prevent deflation and the collapse in the economy, so it failed in its economic stability function. And it did not adequately perform its function as lender of last resort, allowing many bank failures and a resulting contraction in credit and also in the money supply. So the Fed did not fulfill its mission in that respect. These are key lessons, and we want to keep these in mind as we consider how the Fed responded to the 2008–2009 financial crisis.
STUDENT: You mentioned the tightening of monetary policy in 1928 and 1929 to stem stock market speculation. Do you think that the Federal Reserve should have taken different actions, such as increasing margin requirements, to stem the speculation or was it wrong for them to take any action at all against the bubble?
CHAIRMAN BERNANKE: That is a good question. The Fed was very concerned about the stock market and believed that it was excessively priced, and there was evidence for that. But they attacked it solely by raising interest rates without paying attention to the effect on the economy. So they wanted to bring down the stock market by raising interest rates, and of course they succeeded! But raising interest rates had major side effects on the economy as well. So, yes, we have learned that asset price bubbles are dangerous and we want to address them if possible, but when you can address them through financial regulatory approaches, that is usually a more pinpoint approach than just raising interest rates for everything. So margin requirements are at least looking at the variety of practices. There were a lot of very risky practices by brokers in the 1920s; it was the equivalent of day traders. Every paper boy had a hot tip for you and there were not many checks and balances on trading, who can make a trade, what margin requirements were, and so on. I think the first line of attack should have been more focused on bank lending, on financial regulation, and on the functioning of the exchanges.
STUDENT: I have a question on the gold standard. Given everything we know about monetary policy now and about the modern economy, why is there still some argument for returning to the gold standard, and is it even possible?
CHAIRMAN BERNANKE: The argument has two parts. One is the desire to maintain “the value of the dollar,” that is, to have very long-term price stability. The argument is that paper money is inherently inflationary, but if we had a gold standard we would not have inflation. As I said, that is true to some extent over long periods of time. But on a year-to-year basis it is not true, and so looking at history is helpful there. The other reason advocates want to see a return to the gold standard, I think, is that it removes discretion: it does not allow the central bank to respond with monetary policy, for example to booms and busts, and the advocates of the gold standard say it is better not to give that flexibility to a central bank.
I think, though, that the gold standard would not be feasible for both practical reasons and policy reasons. On the practical side, it is just a simple fact that there is not enough gold to meet the needs of a global gold standard, and obtaining that much gold would cost a lot. But more fundamentally, the world has changed. The reason the Bank of England could maintain the gold standard even though it had very little gold reserves was that everybody knew that the Bank’s first, second, third, and fourth priorities were staying on the gold standard and that it had no interest in any other policy objective. But once there was concern that the Bank of England might not be fully committed, then there was a speculative attack that drove it off gold. Now, economic historians argue that after World War I, labor movements became much stronger and there was a lot more concern about unemployment. Before the nineteenth century people did not even measure unemployment, and after World War I you began to get much more attention to unemployment and business cycles. So in the modern world, commitment to the gold standard would mean swearing that under no circumstances, no matter how bad unemployment got, would we do anything about it using monetary policy. And if investors had 1 percent doubt that we would follow that promise, then they would have an incentive to bring their cash and take out gold, and it would be a self-fulfilling prophecy. We have seen that problem with various kinds of fixed exchange rates that have come under attack during the financial crisis. So I understand the impulse, but if you look at history you will see that the gold standard did not work very well, and it worked particularly poorly after World War I. Indeed, there is evidence that the gold standard was one of the main reasons the Depression was so deep and long. And a striking fact is that countries that left the gold standard early and gave themselves flexibility on monetary policy recovered much more quickly than the countries that stayed on gold to the bitter end.
STUDENT: You mentioned that President Roosevelt used deposit insurance to help end bank runs and also abandoned the gold standard to help end deflation. I believe that in 1936 and 1937, up until 1941, we had a double dip and the recession went on. As you have said, today we are sort of out of the recession. What things do you think we need to be careful of—things that possibly were mistakes made in the Great Depression that we should avoid today?
CHAIRMAN BERNANKE: Right, it is not generally appreciated that the Great Depression actually was two recessions. There was a very sharp recession in 1929 to 1933; from 1933 to 1937, there was actually a decent amount of growth and the stock market recovered some; but in 1937 to 1938, there was a second recession that was not quite as serious as the first one but was still serious. There is a lot of controversy about it, but one view that was advanced early on was
that the second recession came from a premature tightening of monetary and fiscal policy. In 1937 and 1938, Roosevelt was under a lot of pressure to reduce budget deficits and tighten fiscal policy. The Fed, worried about inflation, tightened monetary policy. I do not want to claim it is that simple—a lot was happening—but the early interpretation was that the reversal in policy was premature, which prevented the recovery from proceeding faster. If you accept that traditional interpretation, you need to be attentive to where the economy is and not move too quickly to reverse the policies that are helping the recovery.
STUDENT: Based on a few of the graphs we saw today and other historical trends, it seems that after an economic slump, recovery often takes five or more years, as represented by the Great Depression and the oil crisis in the 1970s. Do you think it is common for unemployment to remain at high levels until sometimes a half decade after an economic slump, and that criticisms are often premature? And how do you address these concerns in a political environment where short-term fixes rule the day?
CHAIRMAN BERNANKE: Well, the Depression was an extraordinary event. There were many serious declines in economic activity in the nineteenth century, but nothing quite as deep or as long as the Great Depression. The high unemployment that lasted from 1929 until basically World War II was unusual. So we should not conclude that was a normal state of affairs. Now, more generally, some research suggests that following a financial crisis it may take longer for the economy to recover because you need to restore the health of the financial system. Some argue that may be one reason this most recent recovery is not proceeding faster than it is. But I think it is still an open question and there is a lot of discussion about that research. So no, it is not always the case. If you look at recessions in the postwar period in the United States, you see that recoveries very frequently take only a couple of years—recessions are typically followed by a faster recovery. What may be different about this episode—and again this is a subject of debate—is that, unlike the other recessions in the postwar period, this one was related to and triggered by a global financial crisis, and that may be why it is already taking longer for the economy to recover.
STUDENT: Since you said depressions are global recessions, shouldn’t there be more global cooperation and shouldn’t central banks have a uniform type of fix they cooperate on, instead of every country turning to its own fix?
CHAIRMAN BERNANKE: The Fed and the central banks did cooperate, and continue to cooperate. One of the problems in the Depression was the bad feelings left over from World War I. In the nineteenth century there was a reasonable amount of cooperation among central banks, but in the 1920s, Germany was facing having to pay reparations, and France, England, and the United States were all bickering about war debts, and so the politics was quite bad internationally and that impeded cooperation among the central banks. Also, international central bank cooperation is probably even more important when you have fixed exchange rates. In the 1920s, you had fixed exchange rates because of the gold standard; that meant that monetary policy in one country affected everybody. That was certainly a case for more coordination, but it did not happen. At least today we have flexible exchange rates, which can adjust and tend to insulate other countries from the effects of monetary policy in a given country, so that reduces the need for coordination somewhat—but there is still, I think, a need for coordination.
1 The Bank of England was not set up from scratch as a full-fledged central bank; it was originally a private institution that acquired some of the functions of a central bank, such as issuing money and serving as lender of last resort. But over time, central banks became essentially government institutions, as they all are today.
2 Notice, by the way, how many of the little black dots are to the right. In 1914, most of the economic activity in the United States was in the eastern part of the country. Now, of course, economic activity is much more evenly spread across the country but the Federal Reserve banks are in the same locations as in 1914.
LECTURE 2
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The Federal Reserve after World War II
It is very helpful to put the recent crisis and the ongoing recovery into historical context. As we go along, I want to make sure you keep your eyes on the ball, that is, the two basic missions of a central bank. The first is maintaining macroeconomic stability: maintaining stable growth and keeping inflation low and stable. The principal policy tool for maintaining macroeconomic stability is monetary policy. In normal times, the Fed and other central banks use open market operations—purchases and sales of securities in markets—to move interest rates up or down, and in doing so try to create a more stable macroeconomic environment.
The second part of a central bank’s mission is maintaining financial stability. Central banks are focused on trying to ensure that the financial system functions properly, and in particular, they want to prevent, if possible, and if not, to mitigate the effects of a financial crisis or a financial panic. I talked last time about the lender of last resort function, the notion that in a financial panic, a central bank should follow Bagehot’s rule of lending freely against good collateral at a penalty rate, and by providing short-term credit to financial institutions, a central bank can halt or reduce a run or a panic and the accompanying damage to the financial system and the economy.
But let’s talk a little bit about history. We left off at World War II, which ended the Depression and led to a sharp drop in unemployment as people were put to work building munitions and serving on the home front. One of the aspects of wars that economists pay attention to is how they get financed. Normally, wars are financed very substantially by borrowing. During World War II, the U.S. national debt increased quite substantially to pay for the war. And the Fed, in cooperation with the Treasury, used its ability to manage interest rates to keep interest rates low, so as to make it cheaper for the government to finance World War II. So that was the role of the Fed during the war.
After the war ended, the debt was still there. The government was still worried about paying the interest on the national debt, which was at a very high level, and so there was considerable pressure on the Fed to keep interest rates low even after the war. But that had the drawback that, if one keeps interest rates low even as an economy is growing and recovering, one risks overheating the economy and triggering inflation. By 1951, the Fed was very concerned about inflation prospects in the United States. After a series of complex negotiations, the Treasury agreed to let the Fed set interest rates independently, as needed, to achieve economic stability. That agreement, called the Fed–Treasury Accord of 1951, was very important because it was the first clear acknowledgment by the government that the Federal Reserve should be allowed to operate independently. Today, around the world there is a very strong consensus that central banks that operate independently will deliver better results than those that are dominated by the government. In particular, a central bank that is independent can ignore short-term political pressures, for example, to pump up the economy before an election, and in doing so, it can take a much longer perspective and get better results. The evidence for this is quite strong. As a result, major central banks around the world are typically independent, which means that they make their decisions irrespective of short-term political pressures.
In the 1950s and the 1960s, the Fed’s primary concern was macroeconomic stability. Monetary policy during that period was relatively simple because the economy was growing. As after World War I, the U.S. economy was dominant after World War II. The fears about a renewed Depression had not come true. As a result, a lot of growth was occurring. The Fed tried to follow what is called a “lean against the wind” monetary policy, which means that when the economy is growing quickly (or too quickly), the Fed tightens to try to restrain overheating, and when the economy is growing more slowly, the Fed lowers interest rates and creates some expansionary stimulus in order to avoid a recession. William McChesney Martin, who was chairman of the Federal Reserve from 1951 to 1970,
was very attentive to the risks of inflation. He said, “Inflation is a thief in the night.” He tried through this “lean against the wind” policy to keep inflation and growth stable. The 1950s were perhaps more tumultuous than you might think, with a serious war in Korea and a couple of recessions during that decade. Nevertheless, it was basically a productive and prosperous decade as the economy went back to civilian operations after the end of World War II.
The Federal Reserve and the Financial Crisis Page 3