We all know how it developed.
Matt Yglesias has a post describing how Hjalmar Schacht cleaned up after not one but two monetary policy disasters:
I was reading recently in Hjalmar Schacht’s biography Confessions of the Old Wizard (thanks to Brad DeLong for getting me a copy) and part of what’s so incredible about it are that Schacht’s two great achievements””the Weimar-era whipping of hyperinflation and the Nazi-era whipping of deflation””were both so easy. The both involved, in essence, simply deciding that the central bank actually wanted to solve the problem.
. . .
The institutional and psychological problem here turns out to be really severe. If the Federal Reserve Open Market Committee were to take strong action at its next meeting and put the United States on a path to rapid catch-up growth, all that would do is serve to vindicate the position of the Fed’s critics that it’s been screwing up for years now. Rather than looking like geniuses for solving the problem, they would look like idiots for having let it fester so long. By contrast, if you were to appoint an entirely new team then their reputational incentives would point in the direction of fixing the problem as soon as possible.
This reminded me 1936-37, when the Fed made the mistake of doubling reserve requirements. Late in the year the economy slumped badly, and it was clear that the decision had been a mistake. At the November FOMC meeting they discussed the possibility of reversing the decision:
“We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. … In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)”
This is one of the most chilling statements I have ever read. The opening sentence is the sort of thing juvenile delinquents say to each other when their prank has gone horribly awry, and they are nervously working on a joint alibi. An incredible effort at denial runs all through the piece. First he admits that they raised reserve requirements because “some recession was desirable.” Then he claims it was just a “coincidence in time” that the downturn followed the reserve requirement increase, even though the express purpose of the increase was to cause a “recession.” Then he claims that if they reverse their decision it will look like the previous decision had caused the recession. Then he said that a depression can’t be happening, because there is no good reason for a depression. Well it was happening, unemployment rose to almost 20% in 1938. In the end, they decided to stick with the high reserve requirements throughout the rest of 1937. Reading that quotation one can almost see the perspiration on Mr. Williams’ forehead.
In a recent comment section a Fed employee named Claudia Sahm took me to task for some intemperate remarks I made about the Fed. I think her criticism was valid. I should not throw around terms like “criminally negligent.” I don’t doubt that the vast majority of Fed employees are well-meaning. Maybe all of them are. But Matt’s piece reminds me that human psychology is very complex. We often don’t know why we do things. Why am I blogging? Is it the valiant crusade I’d like to believe I’m engaged in, or am I just fooling myself? (As Robin Hanson would presumably argue.) Suppose Ben Bernanke had been at Princeton for the past 5 years. Now suddenly the Fed chairman is “promoted” to Secretary of the Treasury, and replaced with Bernanke. (As G. William Miller was replaced mid-term with Volcker.) What would happen next? My guess is that Bernanke would immediately set out implementing some of the bold policies that he recommended the Japanese adopt back in 2003.
In 2008 the Fed did what the consensus of economists thought they should be doing. If we could go back in time to the meeting right after Lehman failed, most economists would now say the Fed should slash interest rates sharply (they actually left them unchanged.) If John Taylor is appointed Fed chairman in 2014, and if aggregate demand is still quite depressed, I very much doubt he’d adopt the tightening of monetary policy that many on the right are now calling for.
Update: Speaking of Robin Hanson, his new post relates to his very issue. And I also enjoyed this recent post:
For example, to impose punishments bigger than lifetime exile, beat them a bit first.
Some worry about variation in how much people dislike exile. But there is also variation in how much people dislike fines, prison, torture, and public humiliation. The best way to reduce punishment variation is probably to bundle together many kinds of punishment. Maybe fine them some, beat them a little, humiliate them a bit, and then exile them for a while.
In 2006 the US spent $69 billion on corrections, and 2.3 million adults were incarcerated at year-end 2009. A state prisoner cost an average of $24,000 per year in 2005 (source). Why waste all that money?!
Not so much the ideas, but the way they are expressed. Only an economist can write like that!
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21. December 2011 at 18:33
I remember being “shocked” when I found that quote. And its true that when a Central Bank puts its mind to “do it” they usually are successful. After several idiotic experiences that included price freezes, outright confiscation, among other “unorthodox” experiments, all under the excuse that Brazil´s inflation was of the inertial variety, which made MP useless, in June 1994 inflation was 50% (on that month) and in July it was only 3.5% and by September it was less than 2%!
And as the late Rudi Dornbusch said in 1996 about the Plan that did that: “The plan is brilliant, only doubtful because of the fact that it defeated inflation without fiscal austerity. It´s a unique experience!”
21. December 2011 at 18:38
And the Arnold Kling quote that David Levey sent us nicely describes how the “protection racket” works:
The Fed was very successful at bailing out large financial institutions. It was a failure at maintaining nominal GDP growth. You would think that this would make the Fed highly vulnerable politically. However, the political right protects the Fed by raising false alarms about inflation, thereby arguing for monetary policy to be tighter, not looser. And the political left protects the Fed by insisting that things would have been much worse without the bank bailouts and by insisting that we are in a liquidity trap.
21. December 2011 at 19:05
Scott: Robin Hanson’s para is repeated: it makes “one of the most chilling statement’s” read a little oddly.
21. December 2011 at 19:16
Marcus, Yes, thanks for sending me that. And amusing Dornbusch quotation.
Lorenzo. Thanks, I deleted it. I always seem to have trouble with computers.
21. December 2011 at 21:10
Quite ironic that the final word on Bernanke’s career now depends on whether or not he can find a way to “save face.” So much for Asian cultures being the only ones concerned with shame.
22. December 2011 at 02:47
It would be interesting to read more about Hjalmar Schacht and what really happened in 1923 and the early nazi years. I think I’ve read somewhere that the central bank lent money to currency speculators who were aggressively selling marks against francs, pounds, dollars etc, practically destroying their own currency and enriching their banker friends at the same time. Unbelievable if it’s true.
22. December 2011 at 04:56
Scott,
It has been argued that doubling of the reserve requirements in 37′ had no real impact on the banks. Douglas Erwin makes the argument that banks had very large reserves at the time, and that in effect the increased requirements were “not binding.” Sterilizing the currency had a greater impact on the tightening of monetary policy. http://www.dartmouth.edu/~dirwin/1937.pdf
22. December 2011 at 05:18
I am not a student of the Great Depression…a gap in my economics training…and yet one who I greatly respect once told me “history does not repeat itself.” While it is instructive to read transcripts from 1937, this is 2011. The world is different, news flies around faster and even if today’s Fed should be more transparent…it is vastly more open and informed than the one in the Depression. My gut tells me that Ben Bernanke does not view his job as a popularity contest. He was derided as Helicopter Ben early on and now he can’t even vacation in El Paso. I have to believe that the actions of the FOMC are driven by their beliefs about how the economy works and the current (and expected) state of the economy. Critique them on those metrics (which you often do) and leave the psycho analysis for the psychologists (economists do not have a comparative advantage in everything).
P.S. One quick disclaimer, since my name and work affiliation mentioned in public always get my antsy. I comment here with my personal opinions. All official views are on the Board’s website: http://www.federalreserve.gov/ My day job is to analyze and forecast consumer expenditures, which is just one small input to monetary policy.
P.S.S. As usual, I disagree with Hanson’s analysis, particularly when it wanders into gender differences. I was chided a bit by some economist friends for nudging you to use less inflammatory words. Two female economists reminded me yesterday that there seem to be big payoffs to being a ‘jerk’ in economics, so it’s silly to ask an economist to be nice.
22. December 2011 at 06:42
Shane, Good point.
Mattias, That’s an episode I don’t know much about.
nanute, You can make an argument either way, although of course even if you are right that would help poor Mr. Williams. His name will live in infamy. Gold sterilization also may have played a role, but the argument is essentially the same as for reserve requirements, so it’s pretty hard to make one argument and not the other. I happen to think private gold hoarding was much more important than either reserve requirements or sterilization.
Claudia, Looking at psychology is part of the bloggers job. I do blogging, not news reporting. As you know Ben Bernanke’s public comments on this crisis literally make no sense. One half the time he suggests the Fed’s not out of ammo and it’s done all it should to boost AD. The other half the time he suggests we’ve got a massive demand problem on our hands but the Fed can’t solve it alone. I’m not given 1 hour to cross-examine him at press conferences (and our reporters either don’t know how or don’t have the time to pin him down), so all I can do is guess as to what he really believes. The only thing I know for sure is that his real beliefs are not what he’s saying publicly, because he’s too smart for that. My views on monetary economics are very close to Bernanke’s views. He was my first choice to be Fed chairmen. Something strange is going on, but I just don’t know what it is. Maybe he can’t convince his colleagues.
You said;
“I was chided a bit by some economist friends for nudging you to use less inflammatory words. Two female economists reminded me yesterday that there seem to be big payoffs to being a ‘jerk’ in economics, so it’s silly to ask an economist to be nice.”
I’m not sure if I should thank your friends or yell at them!
Seriously, they are wrong about me. I’m being a jerk out of stupidity combined with emotion, not because I think it would get me noticed. But I can’t blame them for thinking otherwise, as they don’t know me personally.
And finally, your comment that the Fed is now more transparent has no bearing on this post. I am talking about motives, conscious or unconscious. Transparency has no bearing on that issue.
I do understand that your views here aren’t meant to suggest official Fed views.
And finally, since you brought up Hanson and gender differences; are female economists more likely to view highly argumentative economists as “jerks?” My guess is the answer is yes.
22. December 2011 at 07:05
The posting of that memo is hardly chilling. At the time that was not the only opinion nor does it accurately reflect all the thinking on the matter or what was actually happening in the real world. You might have case to make, only that memo just does not provide any empirical evidence. It is literally some guy shooting off his armchair opinion at one point in time.Did Doubling Reserve Requirements Cause the Recession of 1937-1938? A Microeconomic Approach
“In 1936-37, the Federal Reserve doubled the reserve requirements imposed on member banks. Ever since, the question of whether the doubling of reserve requirements increased reserve demand and produced a contraction of money and credit, and thereby helped to cause the recession of 1937-1938, has been a matter of controversy. Using microeconomic data to gauge the fundamental reserve demands of Fed member banks, we find that despite being doubled, reserve requirements were not binding on bank reserve demand in 1936 and 1937, and therefore could not have produced a significant contraction in the money multiplier. To the extent that increases in reserve demand occurred from 1935 to 1937, they reflected fundamental changes in the determinants of reserve demand and not changes in reserve requirements.”
22. December 2011 at 07:07
A good primer on the Weimar inflation for those who don’t comprehend German is Adam Fergusson’s “When Money Dies.” Originally published in 1975, it was reprinted in 2010 by United States Public Affaris, a member of the Perseus Books Group. Chapter 13 discusses the policies of Dr. Schacht when he arrived on the scene.
22. December 2011 at 07:58
[…] Scott Sumner discusses the 1937 “cover-up” episode: This reminded me 1936-37, when the Fed made the mistake of doubling reserve requirements. Late in the year the economy slumped badly, and it was clear that the decision had been a mistake. At the November FOMC meeting they discussed the possibility of reversing the decision: […]
22. December 2011 at 08:12
I am even beginning to suspect that some academics and pundits, rather than being proven wrong, would prefer the Fed never go whole hog into Market Monetarism.
What if the Fed tries Market Monetarism and it works?
All the braying about tight money, and discipline, all the pompous pettifogging, the gold fever, the sense of moral superiority, the rants about inflation being theft—all would be exposed and proven as useless and destructive posturing.
BTW, Carpe Diem (Mark Perry) ran a chart yesterday showing industrial output by various nations for the last 30 years. China has exploded, and it now globe leader. The USA grew nicely. Since 1995, industrial output in Japan has contracted by about 20 percent. The yen has soared.
A strong yen (tight money) is suffocating Japan. But they whipped inflation.
If you apply leeches to an anemic, it hurts the patient but feels good to the doctor. The stern medicine must work, by purging the patient of bad blood.
22. December 2011 at 09:29
You will notice that I did not call you or any other economist a “jerk” in my comment…remember I was waxing poetic the other day on civility in public discourse. Of course, the Chairman of the Federal Reserve cannot just run his mouth in public…people (and more importantly markets) parse his words very carefully. They even notice words coming from Fed economists (hence my antsy response). As a blogger you can say anything you want about anything with little chance of losing your job (yes I am little jealous)…but this is not a luxury of someone who works at the Fed.
On your quip about female economists, I am often bemused by Hanson and some other male bloggers (I tend to follow econ blogs) when they wander into the realm of female behavior and thinking. I do think women, on average, tend to be a little more circumspect about what they know and don’t know. Sure less confidence has its downsides (especially in competitive pursuits) but it has advantages in collaborative endeavors. It’s too colloquial to call over-confident, all-knowing persons ‘jerks’ and it’s incorrect to say it’s a gender-specific or time-invariant or profession-specific trait. I am not always nice either.
22. December 2011 at 10:27
“only economists can write like that”. You don’t. I don’t think I have ever heard you say anything any where near so cold and callous (and juvenile). Maybe you are not a big enough jerk to be a successful economist. Thank goodness!
23. December 2011 at 07:08
Chandler, You missed the point, I’m not claiming the reserve requirement increase caused the recession. I happen to think it was only a minor factor. I’m claiming it was put into effect to cause a recession.
Thanks Stephan.
Ben, Good point, although falling population is part of the Japanese story.
Claudia, The fact that Fed employees are afraid to speak their mind is one reason why it is such a dysfunctional institution. No one would interpret your opinions to be official Fed policy; they should be encouraging public dissent.
I agree about jerkiness not being a gender specific trait, and indeed I did not suggest it was. I’ve also know jerks of both genders.
23. December 2011 at 07:15
RobbL, What’s interesting about economists like Hanson is how they cut through all comfy the fictions in our society. They are willing to sound cold and cruel even when they aren’t being any more cold and cruel than anyone else. They just tend to be more honest.
How’s this for a chilling, cold, and cruel punishment. Take a proud, independent man who yearns to be free and throw him in a 8 by 10 prison cell and let him stay there for 30 years. I find it hard to imagine anything more barbaric. Yet as far as I know all 535 people in Congress support this policy.
We even throw people in prison for taking pain killers for back pain.
10. August 2012 at 06:53
[…] 1. We know that in the past the Fed has done great harm to the country. And we know from the Fed minutes that at times they’ve done this knowingly. They’ve refused to change course after a bad decision for fear of losing face. They’ve admitted as much. […]