Why this article?
This article is a direct follow-up to WTF 1, in which I discussed the origins of the Federal Reserve. There was a need at the time to introduce some stability in the banking system. The formation of the Fed did that. From 1913 – the year of its formation – to the Great Depression years of 1929-1933, the system did have the desired effect. The banking system was much more stable. In fact, credit was freely available after the First World War. This newfound availability of credit in the economy was largely responsible for the “Roaring 20s” in the US. This was a period of great economic expansion and significant increases in standards of living.
The Roaring 20s ended badly. Too much credit never ends well, as we learned again many decades later. Over-leverage combined with a confluence of other factors led to the Great Depression. I’ll discuss them below. By the end of it, policymakers realized that the Fed’s mandate was not sufficient. It was updated over the next few years. It had to be.
Fast-forward to the 1970s, the US Economy faced another challenge. This time it was fueled by a post-WWII economic regime that drove up the general level of prices and ultimately caused high levels of unemployment. The Fed had to adapt again. Thanks to then Chairman Paul Volcker, it did.
And then a few decades later came the Great Recession of 2008. I remember this vividly. In fact, it was then that I started reading up on the Great Depression. Some of the parallels were eerie. Again, the Fed had to innovate. But this time Chairman Bernanke had a full arsenal of lessons from the previous two crises to stop the Great Recession from becoming another Great Depression.
The point is that the Fed had to adapt and evolve over the years. What we have today is not a perfect system, but it is the product of decades of collective experience. You can substitute the word “experience” with the word “mistakes”. But the institution has learnt from them. That institutional memory is the reason why you and I are reasonably confident that our dollar will have roughly the same purchasing power in 2020 as it does today.
The Great Depression: Deflation Shock
The Great Depression lasted about 4 years from 1929 to 1933 and was the greatest economic crisis the US has ever faced. The Fed was still young at this point having been formed in 1913. As I mentioned in WTF 1, the Fed was formed as a reaction to the all-too-common occurrences of bank-runs and credit crunches in the American Heartland. The Fed was set up to be the “lender of last resort”. But this wasn’t enough.
The Great Depression was kick-started with a stock-market crash in 1929. From peak-to-trough, the stock market in the US dropped by 85%! This started a domino effect that ultimately led to unemployment rates of about 25%, fueled by massive contraction of credit, production and exports. Everything that could go wrong seemed to go wrong. It still amazes me that economists still disagree about the exact causes of the Great Depression. But then again, no two economists ever agree on anything. Based on my readings, here’s what I’ve gathered about the rough plotline of the Great Depression:
- The stock market boomed in the 20’s in no small part due to easy margin credit. Thanks to a more stable and trustworthy banking system, this was possible.
- The Fed raises the Fed Funds rate because money supply in the economy was exceeding the Fed’s limits.
- Margin money dried up around the same time that the stock bubble burst. Whether the Fed’s policy caused the stock bubble to burst is unclear. But it certainly exacerbated the situation.
- As margin money was called, banks which lent money to stockbrokers faced a slew of no shows. Suddenly, reserves shrank.
- Because of their losses due to non-paying stockbrokers, banks were reticent to lend any reserves to other sectors in the real economy – the importers of commodities in particular.
- This decrease in imports caused a reciprocal decrease in American exports across many industries.
- Adding to that pain was the seemingly non-sensical trade tariff war imposed by President Hoover via the Smoot-Hawley Act.
- General level of spending dropped because money supply dropped.
- In the meantime, news of the stock market crash and the banking-crunch in New York reached the American heartland. In fact, many regular folks (who had invested in equities for the first time in their lives) had seen their portfolios evaporate.
- People began losing confidence in banks. They had seen this movie before. They didn’t quite understand how the Federal Reserve System would make banks more stable.
- People began withdrawing funds from banks. Money supply contracted at a rapid pace.
- At this point the Fed started lowering rates and buying US Treasury bonds in the open market to shore up liquidity. But maybe it was too late.
- What made matters worse was this: Only about 2 out of every 3 banks in the US was part of the Federal Reserve System. They had access to the Fed in emergencies. The rest still didn’t.
- It was a vicious loop: the stock market crash affected bank liquidity, which affected credit to other industries, which affected peoples’ perception of the economy, which caused bank runs, which made all of the above worse.
- The Fed lowered rates to nearly Zero but the problem now was Deflation – falling prices. Prices were falling because there was a marked lack of demand. People were being stingy because jobs were insecure, and credit had dried up.
- Falling prices sounds good. But it’s bad for borrowers. Imagine a businessman who borrowed $100,000 to start a factory. When he borrowed the money, he may have assumed a certain price level and profit margin at which he can sell his product. If that price level drops and his profit margin drops, the interest on that $100,000 loan suddenly looks more ominous. Economists call this the “Real Interest Rate”, which equals the nominal interest rate minus Inflation. Since Deflation is negative Inflation, it acts as an extra layer of obligation. The next step, of course, is default, if the “Real” interest rate gets too high.
- Defaults went up. Credit dried up even more. Lather, Rinse, Repeat.
- The Fed – as a lender of last resort – was ineffective in quelling this vicious loop.
The plotline above is an approximation. The reality was more convoluted. But there was a vicious loop of lack of credit in the economy fueling lack of spending further fueling layoffs and bank runs. You might ask: why didn’t the Fed do more to stop these bank runs by lending to these troubled banks? Good question. Legendary economist Milton Friedman asked the same question in his seminal work: A Monetary History of the United States.
Friedman argued that the Fed messed up by not focusing maniacally on Money Supply. In his view, if money supply was increased appropriately – via open market transactions – the Fed would have arrested the loop before it became too vicious. Admittedly, I haven’t read Friedman’s book. But critics of the book argue that Friedman missed one important point: The Gold Standard. I’ll come back to this. But first…
The main lessons for the Fed from the Great Depression were:
- Make sure most banks in the country are part of the Federal Reserve System. Otherwise, bank run contagions are hard to contain.
- Make sure that Commercial Banks – responsible for Savings and Loans – are not allowed to lend to speculative traders. The Glass-Steagall Act was a worthy response to this problem. It emphatically demarcated the difference between Commercial Banks and Investment Banks.
- Make sure the Money Supply is adequate enough to fight DEFLATION. Falling prices or even expectations of falling prices are:
- Symptoms of lack of credit in the economy.
- Symptoms of weak demand.
- Probably BOTH.
- Lead to unemployment.
The last lesson was the biggest one. It was the beginning of a new way of thinking – from Lender of Last Resort to ensuring that Money Supply in the overall economy kept up with Economic Growth. But in the Great Depression, the Gold Standard was an impediment to carrying out this duty.
The not-so-golden Gold Standard.
The Gold Standard was a remnant of the past. It was an international agreement that mandated major currencies to peg to the supply of Gold. This never made sense to me. What does the supply of Gold have to do with the real economy – the willingness and effort of people to produce goods and services?
But the Gold Standard was in place during the Great Depression. And the Federal Reserve, in charge of the quantity of money in the system, was beholden to it. Unless they acquired a lot of gold through the open market or through more mining, they couldn’t increase the level of money supply in the economy. Their hands were tied. It seems Friedman didn’t give this point much credence. And it seems to me that the Fed could have done more (as Friedman suggested) if it wasn’t beholden to the Gold Standard.
This point wasn’t lost on the Fed at the time. Nor was it lost on the FDR Administration. In 1934, FDR signed into law The Gold Reserve Act of 1934, which mandated:
- The Fed hand over all Gold Reserves to the US Treasury.
- Gold exports from the US to be banned.
- Banks prohibited from converting cash to gold.
- Raise the “exchange rate” to $35 a troy ounce of gold from about $24.
All these actions drastically increased the supply of Gold in the US. The Fed now had a much freer hand to increase money supply. Credit markets were restored. Lending resumed. Firms started producing. Deflation was stemmed. Unemployment was stemmed. The vicious loop that set the US (and Global) economy into a downward spiral slowly but surely transformed into a virtuous loop. The US economy expanded at a healthy rate right up until the Second World War. While the Gold Standard was weakened by the FDR Administration, it took another 4 decades for the US to finally get rid of it.
The 70s Show: The Great Inflation
Before the 70s happened, a bunch of elite economists from 40-odd countries gathered in Bretton Woods, New Hampshire, right after World War II to discuss a new, stable Global Monetary System. Among the attendees was legendary economist John Maynard Keynes, who represented Great Britain. He advocated a Global Clearing House for Banks with a Global Reserve Currency. Remember how we discussed in WTF 1 that the Fed performs the role of a clearinghouse for inter-bank transactions. Keynes’s US counterpart – Harry Dexter White – didn’t buy into it. He envisioned a greater role of the US Dollar – to make it the Reserve Currency of the world. White won. The Bretton Woods agreement declared the US Dollar was to be pegged to Gold at that FDR price of $35/ounce; and every other currency to be pegged to the US Dollar. The US Dollar thus became the de facto Reserve Currency of the world.
It took just a couple of decades for the Bretton Woods agreement to break down. A few things conspired:
- The amount of US Dollars in the economy far outpaced the proportional amount of Gold. The US Dollar was clearly overvalued.
- The Vietnam War and President Lyndon Johnson’s social programs (massive government spending) exacerbated the situation because it pumped in a lot of money.
- Since World War II, American exports to Europe and Japan kept growing, thereby increasing their need for USD over a couple of decades. Foreign countries liked to hold their reserves in USD because it was the de facto Reserve Currency of the world.
- Too many US dollars were sloshing around. But the USD was supposed to be tethered to Gold. The supply of Gold was – as expected – growing slowly.
- At one point in the late 1960s, there were about $50 billion in foreign reserves of USD compared to just about $10 billion in gold reserves at Fort Knox.
- The world was worried that the USD was highly overvalued, just by virtue of being the world’s de facto reserve currency.
- At the same time, trade balances in the world were shifting. Until the mid 60s, most of Europe and Japan were huge importers of US goods. Now many of these countries, after having rebuilt their economies, were competitive exporters. Their demand for US goods also shrank. This put huge pressure on the US trade deficit.
- The demand for US Dollars decreased because exports from those regions increased. Many other countries wanted to convert their USD to Gold.
- Traders in the FX market also thought that the US would have to devalue the currency because there just wasn’t enough Gold to back it up.
- This prompted “Gold Runs”, in which people started trading in US Dollars for Gold.
- This devalued the US Dollar any way.
The entire gamut of conspiring factors was summarized by economist Robert Triffin in what is now known as the Triffin Dilemma. Here’s how he summarized the dilemma:
“If the United States stopped running balance of payments deficits, the international community would lose its largest source of additions to reserves. The resulting shortage of liquidity could pull the world economy into a contractionary spiral, leading to instability.”
“If U.S. deficits continued, a steady stream of dollars would continue to fuel world economic growth. However, excessive U.S. deficits (dollar glut) would erode confidence in the value of the U.S. dollar. Without confidence in the dollar, it would no longer be accepted as the world's reserve currency. The fixed exchange rate system could break down, leading to instability.”
I dumbed it down for myself and this is how I saw the problem: To be the world’s reserve currency AND be a credible domestic currency created all sorts of problems for Fiscal and Monetary Policy in the US. It was a crazy idea to expect the US (or any country) to craft economic policy that fosters economic growth both at home and abroad. At the heart of this problem was the Gold Standard – an arbitrary “index”, a relic of the Middle Ages, that had nothing to do with production and consumption in the real economy.
In 1965, inflation in the US was at about 1%. Very low. By the end of the 60s, it had reached about 6%. The increase was largely blamed on Keynesian spending by the Johnson government on social programs and the Vietnam War. The prevalent thinking in economic policy in that era was driven by something called the Phillips Curve.
The Phillips Curve suggested that Inflation and Unemployment have an inverse relationship. To reduce unemployment, inflation must be tolerated. Both fiscal and monetary policy took this seriously. I don’t know for sure, but it appears to me that the Phillips Curve gained credence because of the experience of the Great Depression. During those years, unemployment and DEFLATION went hand-in-hand. So, anecdotally, the Phillips Curve made sense. The big fiscal spending programs in the 1950s and 60s caused inflation but it was tolerated by the Fed. Why? 2 reasons:
- The Phillips Curve was taken seriously…
- While the Fed was supposed to maintain and environment that fostered “Full Employment” and “Stable Prices”, the former took precedence…because, well, Phillips Curve.
Add to this the issue of the Gold Standard and the burden of being the Reserve Currency, the Fed wasn’t ready to act on Inflation at all. Money Supply was in full flow to ensure full employment at home and maintain its reserve currency status abroad.
But by the time the early 70s rolled around, something wasn’t working. Prices were rising. But so was Unemployment. The Phillips Curve was breaking down. President Nixon and his team of economic advisors realized this. He was already facing inflation at home because of expansionary fiscal and monetary policy that wasn’t afraid of inflation. But unemployment was rising because there were cost pressures which squeezed profit margins of businesses. Given the choice between solving the problem of Inflation or Unemployment, Nixon’s political calculus chose to tackle Unemployment.
As election season was approaching, Nixon did something shocking in 1971. It was literally called the “Nixon Shock”. Here’s what he did:
- Put a 90-day freeze on Wage reductions and Price increases.
- Cease USD for Gold exchange.
- Impose a 10% tariff on imports to stem the flow of dollars abroad.
Essentially, he pulled out of Bretton Woods – the Fixed Exchange Rate system that pegged the US Dollar to Gold and other currencies to the US Dollar. His motivation, in this particular order was:
- Decreasing Unemployment.
- Stopping runs on the US Dollar.
- Allow the Fed to keep its easy monetary policy intact.
What happened? With the wage and price controls, the Nixon administration did curb inflation for some time. But along the way, the Fixed Exchange Rate system basically collapsed. The US was effectively off the gold standard. The Floating rate of the US Dollar dropped drastically against other currencies. Imports became much more expensive. Once the series of 90-day wage and price freezes ended, prices shot back up. Around the same time, as luck would have it, there was the Arab Oil Embargo.
Thus, began the period of The Great Inflation.
Paul Volcker: The Great Disinflation
So far, the Fed was limited by 2 flawed economic constructs:
- The Gold Standard/Bretton Woods.
- The Phillips Curve.
While Nixon and team essentially ended the Gold Standard era, it took a serious economist to get rid of the Phillips Curve. Up until now, the Fed was influenced heavily by the Great Depression. Unemployment was their key metric because it was perfectly compatible with fiscal policy and the politics of any President. But Volcker, who was appointed Chairman of the Fed by President Jimmy Carter in 1979, took a totally new angle.
By 1979, the Fed had failed twice in the public’s eyes:
- In containing the bank-runs during the Great Depression, which led to Deflation and Unemployment.
- In containing Inflation in the 70s, leading to Unemployment.
The Fed’s first lesson was about Deflation. This time around, it was about Inflation. The Phillips Curve suggestion that Inflation and Unemployment are inversely related was proved wrong. It seems obvious now but the key to debunking the Phillips Curve was to point out 2 different kinds of inflation. There is a “Demand Pull” inflation and a “Cost Push” inflation. The former is more about increases in aggregate spending causing increases in prices. The latter is about input costs increasing, which forces businesses to raise prices. Demand-pull inflation is a symptom of a strong economy. Cost-push inflation is not. The 70s was about cost-push inflation – a type of inflation that the Phillips Curve didn’t worry about.
Volcker, armed with the observations and theories of Milton Friedman, posited that while the Phillips Curve may work for a short period of time, it breaks down over a longer timeframe. Volcker surmised that easy credit in the economy may cause people to hire more workers, increase wages and aggregate spending in the short term. But once price levels keep rising, demand-pull inflation morphs into cost-push inflation, eventually leading businesses to lay off workers in order to protect their profit margins.
Volcker popularized another significant Economics construct: the credibility of the Fed. What he saw in the 70s, in the time leading up to his Chairmanship, was that inflation begets inflation. When people have doubts about the ability of the Fed to maintain price stability, they expect inflation. When they expect inflation, they tend to front-load their consumption. That causes more inflation. And then it can balloon out of proportion. But this sort of “looting” mentality wouldn’t exist if the Fed had credibility to keep prices stable.
So far, the Fed’s priority was Full Employment. Volcker changed that. He argued that the Fed’s priority – by far – should be Price Stability. Full Employment was important but without Price Stability and Credibility, Full Employment was not achievable. Volcker set out on a massive war against Inflation in the 1980s. And he won.
Volcker focused on adjusting Bank Reserves to influence interest rates. He reduced money supply in the economy to cause an increase in interest rates. He was willing to sacrifice some more unemployment temporarily with the sole purpose of fighting inflation. And that’s what happened. Initially, his interest rate increases caused some credit shortage and some more layoffs. But eventually, prices stopped rising because of a further slowdown of demand. Once inflation was much lower, businesses found the environment much more predictable. Their profit margins, and expectations of it, were much more predictable. Hiring resumed. There was a newfound belief that the Fed could tame inflation. Volcker took about 5 years to tame inflation and, amazingly, he was given a free reign by both the Carter and Reagan administrations. His thinking panned out to be effective and gave the Fed a level of credibility it still enjoys.
Ready for The Great Recession.
I won’t go into detail about the 2008-2009 financial crisis because it’s a fairly recent occurrence and lot has been written about it. But it occurred to me, as I was doing my research, that the evolution of the Fed over almost 100 years made it ready to fight the greatest recession since the Great Depression. Here’s that evolution, in short:
- Lender of Last Resort to…
- Fighting Deflation to…
- Focusing almost entirely on Full Employment to
- Focusing almost entirely on Inflation.
Each stage in the evolution was influenced by their experience in fighting real economic challenges. By the time 2008 rolled around, they had done all of the above. The 2008 Crises was similar to the Great Depression in one significant way: Both were triggered by massive leverage-fueled speculation. In the Great Depression, stockbrokers borrowed to fund speculative stock trades. In the 2008 crises, investment banks created products that allowed people with bad credit to buy humongous homes. In the latter crisis, tranches of these over-leveraged products also made it to peoples’ Savings Accounts and Commercial Bank Balance Sheets under the garb of AAA-rated securities. It was a domino-effect waiting to happen. And it did. But this time, the Fed was smarter and more credible.
Almost serendipitously, the Fed was chaired by Ben Bernanke, who had spent his entire academic career studying the Great Depression and – specifically – the role of the Fed in the Great Depression. His training had imprinted in his brain that:
- The Fed had to be prepared to be the lender of last resort.
- They had to fight Deflation with whatever means necessary.
- Once that fight was over, the focus had to return – maniacally – onto checking Inflation.
This started the final chapter in the evolution of the Fed so far. In the 2008 crisis, the Fed employed some new methods because the scope of the crisis demanded it. Bernanke’s primary focus was to revive the credit markets and foster an environment of lending again so as to avoid Deflation. He was hell-bent on not repeating the mistakes of the Fed during the Great Depression. To do this, he had to go outside the Fed’s comfort zone and buy not just US Treasury securities to encourage more lending in the real economy, but also to buy more “exotic” securities like Mortgage Backed Securities to keep interest rates low for homebuyers. This operation – known as Quantitative Easing – lasted several years. The Fed’s Balance Sheet ballooned, which concerned a lot of die-hard “Monetarists” that it would lead to crazy inflation. It didn’t happen.
Since the 2008 crisis, inflation has never crossed the threshold level of 2%. Quantitative Easing has essentially ended and we’re now in the longest economic expansion since the 1990s. Inflation is under control. Deflation is not a risk. The Fed still has a somewhat archaic dual mandate of:
- Price Stability
- Full Employment
This dual mandate still smacks of the now defunct Phillips Curve. In my view, it should be reduced to Price Stability. Full Employment, it seems to me, is a side-effect of that. If the Fed has its Credibility intact, and business expect inflation to be under control, they will produce, hire workers, pay good wages and create more income for aggregate demand to grow. One big assumption in that statement is that the Fiscal side of economic policy is rational and pro-growth. As we’re seeing now, with the Tariffs and Trade Wars, we can’t count on rationality and politics to mix. The Fed, now under Chairman Powell, can only do what it must – keep Inflation AND Deflation in check by whatever means necessary. If that includes, reacting to bad Fiscal Policy, then so be it. That is what we’re seeing now.
- How the Fed does what it does – tools it uses to ensure Price Stability and Full Employment.
- Do we need the Fed at all anymore? Are Cryptocurrencies or the Modern Monetary Theory better alternatives?