The Historical Performance of the Federal Reserve: The Importance of Rules
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The Historical Performance of the Federal Reserve: The Importance of Rules
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| ISBN-13: | 9780817922146 |
|---|---|
| Publisher: | Hoover Institution Press |
| Publication date: | 06/01/2019 |
| Edition description: | None |
| Pages: | 648 |
| Product dimensions: | 6.00(w) x 9.00(h) x 1.90(d) |
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CHAPTER 1
Rules versus Discretion
A Perennial Theme in Monetary Economics MICHAEL D. BORDO
Introduction
THE DEBATE OVER RULES versus discretion has been ongoing in monetary economics for over two centuries. The question is, Should a free society allow well-intentioned, even wise, individuals to run monetary policy, or should it be guided by simple and well-understood (automatic) rules? The debate has evolved in its context and theoretical framework over the years, but the main theme is the same.
We survey the issues from the classical debate between the Bullionists and the anti-Bullionists and then the Currency School versus the Banking School in early nineteenth-century England; to the operation of the gold standard convertibility rule in its various manifestations from the mid-nineteenth century until 1971; to the mid-twentieth-century perspective of the Chicago School: Henry Simons and Milton Friedman; to the late twentieth-century perspective that came from the literature on rational expectations and time inconsistency; and to the current discussion on interest rate instrument rules and the Taylor rule.
The Classical Debate; the Bullionists and antiBullionists; the Currency School versus the Banking School
During the Napoleonic Wars from 1793 to 1815 there was a significant run-up in inflation and depreciation of the pound on the foreign exchanges following the suspension of specie convertibility in 1797. The Bank of England requested the suspension because it was unable to maintain convertibility according to its charter and also finance government expenditures by the purchase of Exchequer (Treasury) bills at a low interest rate (Bordo and White 1990). The Bank of England's note issue expanded as the intensity of the conflict reached its climax, so that by 1810 prices were rising close to 10 percent per year. During this period there was a debate between some of the leading economic thinkers of the time over the causes of the inflation (Viner 1937). The Bullionists, led by David Ricardo and Henry Thornton, attributed the rise in prices and the decline in sterling to excessive note issue by the Bank of England. The anti-Bullionists, Thomas Tooke and James Fullarton, attributed the inflation to nonmonetary causes, including harvest failures and the ongoing remittances to British allies on the Continent (Bordo and Schwartz 1980). The Bullion Report of 1810, largely drafted by David Ricardo, blamed the Bank for overissuing its notes. As a solution, Ricardo proposed that the Bank follow a simple rule: the Bank should always maintain specie convertibility, that is, it should peg the price of sterling in terms of specie at the official rate of 3 pounds, 17 shillings, and 10 ½ pence per ounce of gold and allow its note issue to fluctuate automatically with the Bank's gold reserves. In the case of a balance of payments (trade) deficit, the Bank's gold reserves would decline, and the Bank would reduce its note issue. The opposite would occur with a balance of payments (trade) surplus. The rule, in a sense, would stabilize the purchasing power of gold in terms of other goods and services (Laidler 2002).
Specie convertibility at the original parity was restored in 1821, and the Bank returned to its peacetime role. A second debate began in the 1820s between the successors of the Bullionists, the Currency School (McClelland, Lord Overstone, Longfield, Norman, and Torrens), and the successors to the anti-Bullionists, the Banking School (Tooke, Fullarton, J. S. Mill). The Currency School writers focused on the issue of how the Bank could maintain price stability with a mixed currency system (specie and bank notes). They argued that the Bank should follow the Currency principle, that is, the money supply should behave exactly as it would under a pure specie standard. Thus a gold inflow should lead to a one-to-one increase in the total currency and the opposite for a gold outflow. This principle led to the adoption of Palmer's rule (1827), named after Horsely Palmer, a governor of the Bank of England. Palmer posited that the Bank should keep its security portfolio constant and keep its gold reserves at one-third of its total liabilities. This would allow the Bank's note issue to vary directly with gold flows into and out of the Bank.
The Banking School criticized Palmer's rule and the Currency principle for omitting deposits at the Bank of England and the country banks for not accounting for movements in the velocity of circulation. They also defined money as currency plus deposits, whereas the Currency School defined it as simply currency (coins plus bank notes).
The Banking School argued that the money supply was endogenous and was determined according to the real bills doctrine by the needs of trade. If the Bank discounted only real commercial bills, reflecting the state of the economy, there never would be too much or too little money in circulation. An increase in the note issue by the Bank would always return via the operation of the price-specie flow mechanism and by the Law of Reflux (Schwartz 2008a).
Another critique of the Bank's sole pursuit of the Currency principle was the problem of internal drains, or commercial bank runs in the face of financial distress. The demands for liquidity would reduce the Bank's gold reserves, and via the Currency principle would lead the Bank to tighten monetary policy, thus aggravating the financial crisis. The Banking School believed that discretionary policy was needed to deal with liquidity drains. Serious banking panics in 1825, 1836, and 1839 led to the call for major reform of the Bank of England.
Reform came in the Bank Charter Act of 1844, which divided the Bank into the Issue Department and the Banking Department. The Issue Department would follow the Currency principle. Its balance sheet consisted of a fixed fiduciary note issue of 14 million pounds, and then every additional pound would vary with gold flows into and out of the Bank's reserves. The Banking Department was set up on commercial banking lines. The Bank would accept deposits from commercial banks and other financial intermediaries, and private individuals and would make loans at the discount rate (Bank rate) at rates slightly above the market rate. The Banking Department had reserves of the Fiduciary note issue and some gold.
Although the Bank was following rules-based policy, it was unable to deal with several very serious banking panics in 1847, 1857, and 1866. The problem was that the Banking Department did not have adequate reserves to freely provide liquidity to the financial system in the face of a panic. On several occasions the Bank avoided suspending convertibility by requesting a Treasury letter (a temporary suspension of the Bank's charter), which allowed it to expand the fiduciary note issue as needed. As it turned out, just the news of the issue of the Treasury letter was sufficient to allay the panic in 1847 (Dornbusch and Frenkel 1984) and later in 1866. Another problem with the Bank of England's handling of financial crises was that it attached greater importance to the well-being of its shareholders than to the public in general. In several banking panics (1825, 1847, and 1866), the Bank, concerned over its profitability, acted too late to provide liquidity to the general money market (Schwartz 1986). This led Walter Bagehot, editor of the Economist, to state his Responsibility Doctrine urging the Bank, which was privately owned but had a public charter, to put the public's interest first. In his classic book Lombard Street (1873), Bagehot also formulated rules for a lender of last resort: in the face of an internal drain (banking panic), lend freely; in the face of an external drain (a currency crisis), lend at a high rate; and in the face of both, lend freely at a high rate.
In the years after 1844 the Bank developed a set of "rules of thumb" to operate as a central bank under the classical gold standard in a world of free capital mobility (Bordo and Schenk 2017). The rules of the game required the Bank to use its discount rate to accommodate gold flows. Thus in the face of a balance of payments deficit and a gold outflow, the Bank was supposed to raise the Bank rate both to encourage a capital inflow and to depress aggregate demand to reduce the demand for imports (raise the balance of trade). In the face of a balance of payment surplus, the Bank was supposed to lower the Bank rate and encourage capital to leave and stimulate the economy to increase the demand for imports (reduce the balance of trade) (Bordo 1984).
The gold standard convertibility rule prevailed until the collapse of the classical gold standard at the outbreak of World War I in 1914. Following the rule meant that countries would subsume domestic stability concerns to maintaining the fixed gold parity. The rule followed was a contingency rule under which the monetary authority would maintain the fixed gold price except in the event of a major emergency, such as a war when convertibility could be suspended and the central bank could expand its note issue to raise seigniorage, and the fiscal authorities could run large deficits to smooth taxes (Bordo and Kydland 1995).
The gold standard rule was successful in the sense that it was associated with stable exchange rates and long-run price stability, and its macro performance was better than it had been in the interwar period (Bordo 1981). However, many contemporary economists were critical of the gold standard because it was associated with short-run price level instability and frequent recessions.
The price level exhibited long swings of low deflation (twenty years) followed by long swings of low inflation (twenty years). These swings in the price level reflected the operation of the commodity theory of money (Barro 1979), whereby long-run price stability (also known as mean reversion) in the price level was brought about by changes in gold production and shifts between monetary and nonmonetary uses of gold in response to changes in the price level affecting the real price of gold. Thus in periods of deflation, falling prices raised the real price of gold (assuming that monetary authorities fixed the nominal price). This led to increased gold production and occasional gold discoveries, in addition to a shift from nonmonetary to monetary uses of gold, which led to an increase in the world monetary gold stock and then rising prices. The opposite occurred in periods of inflation.
Contemporary economists posited that alternative variations of the gold standard rule could produce price stability (Bordo 1984). W. S. Jevons (1884) discussed stabilizing a price index. Alfred Marshall (1926) preferred symmetalism — basing the monetary standard on a mixture of gold and silver whose value would remain constant with changes in the relative supplies of the two metals. Irving Fisher (1920) developed the compensated dollar, whereby the monetary authorities would change the official price of gold to offset movements in a price index. His proposal was, in essence, a price-level rule. Indeed, in the 1920s his scheme was incorporated in two acts of Congress, which were never passed but which would have required the Federal Reserve to follow a price-level rule (Bordo, Ditmar, and Gavin 2008).
The classical gold standard broke down at the start of World War I. Only the United States maintained the gold dollar peg (although the United States imposed a gold embargo from April 1917 to April 1919). After the war many major belligerents wanted to return to the prewar gold standard at the original parities according to the gold standard contingent rule. Most of these countries came out of World War I with very high rates of inflation and unprecedented levels of outstanding national debt, making resumption a daunting task. The United Kingdom returned to gold at the original parity in 1925, but it did so at the expense of high unemployment (Keynes 1925). France was unable to resume at the original parity because of its high debt and unstable polity (Bordo and Hautcoeur 2007). Germany and other former Central Powers ran hyperinflations. They all restored gold at greatly devalued parities.
The interwar gold standard created at the Genoa Conference in 1922 was a gold exchange standard in which members held both gold and foreign exchange as reserves. The United Kingdom and the United States as center countries backed their currencies with gold. The interwar gold exchange standard lasted only six years. It lacked the credibility of the prewar standard, as most countries were unwilling to let the gold convertibility rule dominate their needs for domestic stability. It also was plagued by maladjustment in the face of disequilibrium parities and nominal rigidities (Meltzer 2003). It collapsed in 1931.
The last vestige of the gold standard rule was the Bretton Woods system established at the international monetary conference in New Hampshire in 1944. Under Bretton Woods, the United States as center country would peg its dollar to gold at $35 per ounce while other countries would peg their currencies in terms of dollars. Unlike the gold standard, the Bretton Woods system was an adjustable peg system whereby members could change their parities in the face of a fundamental disequilibrium brought about, for example, by a supply shock that changed the real exchange rate. Bretton Woods also had capital controls. Like the interwar gold exchange standard, the Bretton Woods system, which had some of the flaws of the Gold Exchange Standard, broke down between 1968 and 1971. A key problem was that the basic rules of the system were not followed. The United States as center country inflated its currency after 1965. Other countries also broke the rules by not allowing the adjustment mechanism to work in the sense that surplus countries like Germany did not allow their money supplies to expand, and deficit countries like the United Kingdom did not allow adjustment through deflation (Bordo 1993).
Rules versus Authorities in the Twentieth Century
The Federal Reserve was founded in 1913 to be the central bank for the United States. The Federal Reserve Act was in part based on concepts from the Currency School versus Banking School debate and the history of the Bank of England (Meltzer 2003, chap. 2). From the Currency School the Fed inherited the convertibility rule of the gold standard. From the Banking School the Fed inherited both the real bills doctrine and the institution of a lender of last resort to allay banking panics.
By the time the Federal Reserve opened its doors for business in November 1914, most of the belligerents in World War I had left the gold standard, and when the United States entered the war in April 1917, an embargo on gold exports was imposed for two years. The Federal Reserve became an engine of inflation financing the government's fiscal deficits. The gold standard became operational after the war, but in the 1920s the Fed prevented the adjustment mechanism from working by sterilizing gold inflows and preventing the money supply from rising. This policy contributed to the global imbalances that eventually led to the breakdown of the interwar gold exchange standard (Friedman and Schwartz 1963; Irwin 2010).
The real bills doctrine guided the Fed's action in the first two decades of its operation, and according to Friedman and Schwartz (1963) and Meltzer (2003), contributed to some serious policy errors, including the recession of 1920–1921, the Wall Street stock market boom and crash in the 1920s, and the banking panics of the Great Contraction. Indeed, Milton Friedman (1960), following Henry Simons (1936), was highly critical of the independent Federal Reserve for following flawed discretionary policies.
In a seminal article "Rules versus Authorities in Monetary Policy," Henry Simons (1936) made the case for the Federal Reserve to follow rules rather than discretion. Simons posited that in a liberal order (a free society and free market economy), central bank discretion would lead to uncertainty, which would prevent relative prices and markets from operating efficiently, thus contributing to economic instability. He believed that a simple legislated monetary rule would remove the uncertainty of leaving policy decisions to central bank officials. Simons considered a number of possible rules. His first choice was to have a fixed money supply. If prices were flexible, it would lead to deflation as productivity advance would lead to real economic growth. He had reservations with this rule because of measurement issues in determining which monetary aggregate to use; these include: the presence of price rigidities and financial innovation and the development of money substitutes, which would shift velocity. However, he argued that 100 percent Reserve banking could solve the problem of money substitutes (shadow banking). In his scheme commercial banks would become public utilities that just managed the payments system (Friedman 1967; Rockoff 2015). The financial intermediation function of banks would be done by investment banks. Simons also considered tying the money supply to the fiscal deficit and having monetary policy run by the Treasury. Maintaining a balanced budget would also keep the money supply stable.
(Continues…)
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Table of Contents
Foreword John B. Taylor ix
Introduction/Overview xiii
Part 1 Theoretical Perspectives 1
1 Rules versus Discretion: A Perennial Theme in Monetary Economics Michael D. Bordo 3
2 The Importance of Stable Money: Theory and Evidence Michael D. Bordo Anna J. Schwartz 29
Part 2 Empirical Evidence 51
3 Monetary Policy Regimes and Economic Performance: The Historical Record Michael D. Bordo Anna J. Schwartz 53
4 Introduction to "The Great Inflation: The Rebirth of Modern Central Banking" Michael D. Bordo Athanasios Orphanides 167
Part 3 Monetary Policy Performance 187
5 Exits from Recessions: The US Experience, 1920-2007 Michael D. Bordo John S. Landon-Lane 189
6 Deep Recessions, Fast Recoveries, and Financial Crises: Evidence from the American Record Michael D. Bordo Joseph G. Haubrich 267
7 Credit Crises, Money and Contractions: An Historical View Michael D. Bordo Joseph G. Haubrich 267
8 Three Great American Disinflations Michael D. Bordo Christopher Erceg Andrew Levin Ryan Michaels 309
9 Aggregate Price Shocks and Financial Instability: A Historical Analysis Michael D. Bordo Michael Dueker David Wheelock 353
10 Does Expansionary Monetary Policy Cause Asset Price Booms? Some Historical and Empirical Evidence Michael D. Bordo John Landon-Lane 387
Part 4 Monetary History 445
11 The History of Monetary Policy Michael D. Bordo 447
12 The Banking Panics in the United States in the 1930s: Some Lessons for Today Michael D. Bordo John Landon-Lane 463
13 Could Stable Money Have Averted the Great Contraction? Michael D. Bordo Ehsan U. Choudhri Anna J. Schwartz 495
14 Was Expansionary Monetary Policy Feasible during the Great Contraction? An Examination of the Gold Standard Constraint Michael D. Bordo Ehsan U. Choudhri Anna J. Schwartz 527
15 Could the United States Have Had a Better Central Bank? An Historical Counterfactual Speculation Michael D. Bordo 565
About the Author 595
Index 599