The Fed's Dismal Record

0:00Thanks everybody. It's a pleasure to be here. Thank you, Doug, for that very kind introduction and thanks to the Mises Institute and its chair, Lew Rockwell, for the opportunity it gave me to speak to all of you today about a very important subject. I want to explain a little bit the background behind the topic I've chosen today. As Doug mentioned, I wrote a book not very long ago, published a book that I'd worked on for quite a long time. And, you know, after a project like that, you feel exhausted for a while. It really takes a lot out of you. And so I've been in that state for some time and recently I was fishing around for a kind of easy project to kind of ease myself back into the research mode with.

0:49And that's why I decided to write a paper asking the question, has the Fed been a failure? But as you might be able to see, it's kind of a long paper, right? Because for most of you, I might have just had one word and none would have been done, and you would have said, Well, I'm convinced and that would have been the end of it. But here I have a somewhat different audience in mind and a different overall objective than to merely declare the Fed a failure or affirm that it's a failure. And the purpose is to ask the question whether there is need to consider, That is rather to convince economists that there isn't as much need today to look for some radical alternatives to the Federal Reserve system as there was need a hundred centuries ago to look for alternatives and alternative to the then existing national currency system that had been in place for about 50 years since the Civil War.

2:10You may know, perhaps, that it was in 1910, in fact, that the National Monetary Commission reported on alternatives to the established U.S. monetary system of that day. In other words, it was exactly a century ago. The commission's report consisted of a shelf of volumes examining alternative monetary systems, their history and so on. The Commission was a stacked deck. The whole point of it by then was to conclude that yes, we needed something like a central bank. But the general idea of examining existing alternatives or possible alternatives, that was a good idea.

2:55And it was motivated by the fact that there had been a series of relatively serious, well, I can't say relatively anymore, and the serious financial crises leading up to the commission's report. And it was generally understood that that system, that is the system that prevailed for money and banking between the Civil War and 1910 was, after all, not working very well. Well, today I believe we have enough reason to ask the same questions about the Fed's performance. And what I seek to do in my paper and what I wish to do here, though I don't think it's quite as difficult in this context, is to make the case that the Federal Reserve has been no less successful in solving this country's monetary and financial problems than the previous system, that is, the system it replaced was successful at solving those problems.

4:00That is, the Fed has not even improved on the system it was supposed to replace. Also to make my project a little more challenging, perhaps, I want to make this case using evidence and arguments from prominent mainstream economists. I will not appeal even once today to works by Austrian economists or other known critics of the Federal Reserve system. On the contrary, I'm going to make the case that the Fed has been a flop, using only arguments to be found in mainstream outlets, professional economics journals by prominent economists, many of whom do not consider themselves at all critics of the Fed. Indeed, I'll even quote some testimony and argument from prominent Federal Reserve authorities themselves in in Making My Case.

4:55And in this way, I hope to convince not so much people like all of you who are reasonably open-minded, intelligent, and incredulous when it comes to conventional wisdom, but economists who you may have gathered from some of the other talks this weekend can be rather dim-witted people who need to have lots of evidence before they can start to see something is plain to see to almost any other kind of human being. Now, I want to start out by noting what the Fed claims its own mission to be so that we can judge it by its own standards. That is, we only have to ask whether the Fed has done what it says it's supposed to do.

5:45Here is a statement of the Fed's mission from the Humphrey-Hawkins amendments to the Federal Reserve Act Act, which is what governs the Fed's operations today, and you see that it says that its purpose is, quote, to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. Further, from the Federal Reserve Board's website, we read that the Fed has the additional purpose of containing financial disruptions and preventing their are spread outside the financial sector. So that gives us a fairly straightforward set of criterion by which to evaluate the Fed's performance. We can ask, how good a job has it done stabilizing prices?

6:32How good a job has it done stabilizing output? How good a job has it done preventing banking crises? And finally, how good a job has it done acting as a lender of last resort in connection with such crises. These seem to be the relevant points worth looking at. Now, I want to, before beginning my evaluation, let's look at what the Federal Reserve authorities themselves have to say about the importance of stable prices, about how costly it can be not to have stable prices. Here is a quote from the Board of Governors again. I'll read it for the sake especially of those of you way in the back. Stable prices in the long run are a precondition for maximum sustainable output growth and employment, as well as moderate long-term interest rates.

7:26When prices are stable and believed to remain so, the prices of goods, services, materials and labor are undistorted by inflation inflation and serve as clearer signals and guides to the efficient allocation of resources. Moreover, stable prices foster saving and capital formation because when the risk of erosion of asset values resulting from inflation and the need to guard against such losses are minimized, households are encouraged to save more and businesses are encouraged to invest more. This is the Fed's own statement. And here is a further statement by Fed Chairman Ben Bernanke from a few years ago. Quote, stable prices allow people to rely on the dollar as a measure of value when making long-term contracts, engaging in long-term planning or borrowing or lending for a long period.

8:20As economist Martin Feldstein has frequently pointed out, price stability also permits tax laws, accounting rules and the like to be expressed in dollar terms without being being subject to distortions arising from fluctuations in the value of money. By the way, the same fellow, Feldstein, estimated that the losses to the public from tax distortion effects alone of inflation of 2% inflation relative to zero amounted to 1% of the nation's GDP. And that's only a small part of the cost of inflation. All right then, we see that all people at the Fed are in agreement that stable prices are very important.

9:06This is a chart of the consumer price index. I'm not questioning standard measures of the value of money. For this, again, I want this to be an imminent criticism. I don't want to rely on anything that most economists would find controversial. $100 in 1790, that is at the beginning of the Republic, was worth the same amount as $108 in 1913. And as you can tell from the chart, you could pick pretty much any figure from before 1913, and it would almost have the same value as the 1913 figure. So $100 is worth $108 in 1913. $108 in 1913, however, was the equivalent of about $2,500 today.

10:01Moreover, if you were to examine this chart more closely, you'd see another pattern, and that pattern is simply this, that the greater the Federal Reserve's command over the money Supply, the less the Fed has been constrained itself by the gold standard in particular, which was done away with only in stages starting in the 30s and ending in the 70s, early 70s, the more the price, more rapidly the price level has tended to rise, the more the dollar has lost purchasing power. And that suggests, of course, that there is after all no coincidence in the fact that the dollar has lost value since the Fed has been in charge and the more the Fed is in charge, the more the dollar loses value.

10:50Now, Bernanke and the other, Bernanke statement and others also point to the instability of the price level and not just the stable rate of inflation as something to be avoided. Let's look at the inflation rate since 1914. One of the things that everybody knows is that we had very bad inflation in the 70s. Very bad, double digit. But it was mostly the low teens, those double digits. What a lot of people don't know is the Fed did not wait nearly that long to use its powers of monetary control to cause severe inflation, indeed, the worst peacetime inflation in history. It did so within a few years of its establishment.

11:35Between 1916 and 1920, The inflation rate bounced around between 15 and 20% on an annual basis with some monthly rates, annually adjusted, of 25%. And by the way, it did that in part because although it didn't suspend the gold standard during World War I, there were some restrictions on gold exports. There was an embargo that restricted gold exports. So here again, the extent of the inflation is directly related to the extent to which the Fed is free to do whatever it wants in managing the money supply.

12:22Now some boring statistics, but I won't go into the details of what's behind them. Suffice to say that if you're concerned about the unpredictability of the price level, then One way to gauge that is by just trying to fit price level movements into a statistical model. Well, if you do that, you find the following results. This was actually done by an economist who published the results in, I think the AER, but a prominent journal. Basically before the Fed, inflation is a quote, white noise process. That basically means it just fluctuates nicely around zero with the tendency to revert to zero.

13:08But as the Fed gains control of the money supply, the process generating inflation starts to include important components of drift until since 1960 or relatively, or since the time when the Fed began to break the last of the links to the gold standard, inflation has become a random walk. That is to say, pretty much unpredictable. and that's when the costs of inflation become the greatest. So that's inflation. Now, some mainstream economists might be tempted to say, well, all right, the Fed has caused inflation. We all know that the price level has risen a lot under its administration of money.

13:55But after all, it has eradicated deflation and we know that deflation is a scourge to be avoided at all costs. However, even according to some recent work by mainstream economists, it's not the case that deflation is always bad. On the contrary, there are two kinds of deflation, you might say, good and bad, and I will hasten to say, actually deflation per se is never bad. It's a response to a relative shortage of money compared to goods and it's sometimes the best possible response. But let's just allow though that less controversially, deflation can be caused either by a shrinkage of the demand for goods by people spending less or by a change in supply.

14:49Conventionally, again, conventionally, bad deflation happens when demand shrinks, right? People are spending less and so the prices of goods will tend to fall. If for any reason prices can't fall right away, there can be a short run period or perhaps not such a short run period when you have unsold goods and unemployment because labor also can be unsold. That's what happened notoriously in the Great Depression. I'm not denying the boom bust part of that story, but the other part was FDR preventing Declining prices from falling through the National Recovery Administration and that made the depression last much longer. But prices may fall simply because goods are being produced more efficiently. So there are more goods being sold, their unit costs of production are declining and the decline in price that follows with constant demand or spending is a reflection of declining goods prices.

15:45All right. Well, let's get back to the question, has the Fed at least made up for some of the inflation it's caused through its service of eradicating deflation? And the answer is, what the Fed has done is to eliminate all the good deflation, but it also has uniquely contributed to the only known episode of severe bad inflation in modern history. Here is a quote from an article from the American Economic Review a few years ago by the authors Atkinson and Kehoe. A broad historical look, they conclude, finds many more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation. Moreover, the same authors find that, and this is surveying many countries, not just the US, the only episode in the 20th century of bad deflation was the Great Depression.

16:44And of course, the Fed was in charge then. If you go back to the 19th century, the conclusions are the same. There was, in that case, there was plenty of deflation. It was quite common to have deflation in the, at least for fairly long spans of time, I'm sorry, I don't mean to show you that yet, in the 19th century, but most of the deflation, in fact practically all of it was good deflation, it was relatively little bad deflation. So once again, the Fed caused bad inflation, it caused bad deflation, it got rid of only one thing, good deflation. So that's two wrongs and no rights.

17:29Let's talk about stability of output. Let's talk about that for a bit. It used to be thought that the Fed had stabilized output and also employment substantially or rather that it had done so since World War II. By the way, most comparisons, including my own, of the Fed's performance with the performance of the monetary arrangement that preceded it, are comparisons of pre-World War I performance, right, pre-Fed, and post-World War II. We leave out the interwar period, including the and the Great Depression. Why? Well, as everyone knows, that was practice. And so, if we do that, of course, and can still make a case that the Fed has not made things better, we have a very strong case indeed. Because everyone agrees, there has been no period of more severe or economic volatility, unemployment or almost any other bad you can imagine apart from inflation at least than the 1930s or the interwar period generally because it was another fairly severe but short-lived crisis in 1920-21 and then there was inflation of course in the early, in the World War I period itself.

18:56All right, well, it turns out that the estimates of volatility that used to be relied upon for output came from an economist named Kuznets and they were based on unpublished output figures, GNP figures he'd come up with before World War I. Why did Kuznets never publish and so on. In fact, in order to construct these figures, he had to make a very bold assumption, namely that the volatility of pre-World War I GNP was tracking that of commodity output.

19:43In other words, the total output was as volatile as commodity output. Well, we know that that's just hardly ever true. Since the second World War, when we have accurate statistics for both total and commodity output, we see that total output is only 60% as volatile as commodity output. So, treating, guessing, or estimating total Capital Output for Before World War I Using Commodity Money Output as a Guide Gives You Very Exaggerated Measures of Pre-World War I Volatility. Well, an economist who's been mentioned in this conference, Christina Romer, who is of course head of the Council of Economic Advisors, did a study where she revised the volatility figures to correct this bias that Kuznets figures contained.

20:43And these are the results. And what you can see is that for industrial production, the period before 1914 involves volatility that's somewhat greater than after World War II, but not substantially. This is measured by standard deviation, right? For GNP, it's 3 versus 2.5. Again, not remarkably worse. For commodity output, it's very similar, 5.2 to 4.9. And and Unemployment, again, slightly worse, but not much. This is leaving the Great Depression period, the crisis of 21 and 20 out of the story. If you include those, of course the volatility was much greater at that time, the Fed's overall performance is obviously worse.

21:30But indeed, even if you don't, oh, I thought I had a quote from Romer.

21:38Let me read, I'm sorry, This isn't made into the slideshow, but let me read Romer's own conclusion on this, right? This is from the head of the present Council of Economic Advisers. Let's take me a moment here. Oh, well, I can't find it. You're just going to have to take my word for it. She actually says, oh, I know, it's coming up. It's coming up in connection with Recessions, pardon me, we'll get to it. One more thing about volatility though, right, about how much output fluctuates.

22:28It's very important to realize that when we're really, if we're really wanting to evaluate monetary systems, what we're concerned about isn't the overall instability or variability of output, it's the contribution of monetary changes to that variability. that is the component or the portion of the variability that you can trace to fluctuations in money supply and spending. Because of course, output can vary owing to so-called supply shocks or supply innovations over which monetary authorities have no control and which monetary policy really shouldn't try to eliminate. These are non-monetary fluctuations.

23:13Well, here again are some fancy statistics and I won't trouble you to explain how they're derived, but these are two sets of estimates of the forecast error variances attributable to supply shocks, that is supply innovations before 1914 and after World War II. The bigger the share you can blame on supply innovations, the less monetary policy is responsible, the less it's the fault of the monetary system. Well, by one set of estimates, and we need to look at the short horizons, don't ask why, but it's almost 100% is demand, is supply innovations before World War I.

24:02In other words, it's not the monetary system, it's harvest failures and such. Whereas after, the figures from the same study are more like, well, from one of them, like 5%. Another study reports a figure of about 89% supply-induced fluctuations in output. If you take these figures into account, then the story ends up being something like this, that although output fluctuates a little more after World War II than it did before World War I, The monetary component of output fluctuations, the extent to which it's due to a poorly behaved monetary system, is much larger after World War II than before World War I.

24:53Does that make sense? Okay. So, now let's talk about business cycles. Since measuring output is so tricky, especially before World War I, it may be safer to focus on looking at the number and duration of recessions, without asking how deep they were, which requires having good measures of output and such. So did the Fed at least succeed in reducing the frequency or severity, sorry, the frequency or duration of recessions? Well, according to the old NBER statistics, there were many more recessions before World War I and they lasted longer, a lot longer than they have since. The only problem is if you look at how the NBER was measuring recessions before for World War I, how it estimated their existence and length, well, let me put it this way, I'm going to try to be as polite as I can, the only way they could have been more unscientific about it would have been if they had been using sheep on trails. It's really a joke.

26:07One of the many things they did wrong was to treat deflation, that is, falling prices as proof of depression, and as Doug French explained very well, this introduces a very, A recession is when there's less goods being produced, not when goods are getting cheaper. And just correcting for that, as recent scholars have done, for example, there's that 1873 recession or depression that Doug was talking about. Five years long according to the NBER and only two years according to a more recent study. I'm running out of time, so let me just suffice to say, and here's where I can quote Christina Romer, Christina Romer, Recessions have not become noticeably shorter over time. The average length of recessions is actually one month longer in the post-World War II era than in the pre-World War I era.

26:59There is also no obvious change in the distribution of the length of recessions between the pre-war and post-war eras. Christina Romer, Chairman of the President's Council of Economic Advisors, Note the date of the publication. Where's my red? I can't see it, can you? There it is. 1999, okay? Guess what happens if you update this? The conclusion gets what, stronger? Yeah, you bet. Okay, very quickly, right? I don't know, I don't see a five minute signal, but I bet I'll get it pretty soon. Banking panics. It used to be assumed that we had a lot more banking panics before the Fed than now, But a recent study by a graduate of the University of California, Berkeley, that famous headquarters of free market thought, or at least it looks so, has found that if instead of relying on exaggerated newspaper accounts, you look at the real evidence and define banking panics consistently, there's hardly any improvement until after 1930.

28:04In fact, he writes, contrary to the conventional wisdom, there is no evidence of a decline in the frequency of panics during the first 15 years of the existence of the Federal Reserve. Now there's another important date. There's no reduction until 1930. Well, of course, they were in a panic in 1930. So there's really no reduction until 1934. Why is there a reduction afterwards? It's all because of deposit insurance. Look, I hate deposit insurance more than anyone else in the world perhaps, but what stopped conventional panics was that for a long time and not the Fed. So the Fed can't get credit for having stopped conventional banking panics. Finally, well, I was going to talk more about the lender of last resort and all that.

28:50Let me just say very briefly on that subject that the conventional view of the lender of of Last Resort, which is considered to be the enlightened view by almost all authorities, comes from Walter Badgett, who explained it back in 1873 in his book Lombard Street, whereby the way he said, it would be better not to have a central bank at all, if you could avoid it. But accepting that the Bank of England was there to stay, he wrote that central banks in a crisis should lend freely at penalty rates on good security. The Fed has practically never done it and for example it was a house study between conducted for the years 1985 to 1991 90 percent of the banks that received extended Fed credits during that period failed soon afterwards and most of the others were in danger of failing in the recent crisis the Fed has violated Badget's rules more flagrantly than ever as you know it is engaged on in so-called lender of last resort lending to an extent never before seen but whereas

29:57Badget would have it land only to sound solvent institutions maintaining the liquidity of the solvent firms not so as not to have them go under with the insolvent ones and let the insolvent firms fail what the Fed did in the The recent crisis was to, of course, extend vast amounts of credit to institutions that were known to be insolvent. At the same time, until October 2008, it sterilized those loans, which meant it sold securities in the open market to withdraw liquidity from the rest of the economy. Listen to what I'm saying. It took liquidity from the solvent firms to give to the insolvent firms.

30:43This is turning badger on his head. And it, of course, didn't do any good. I could say more about this, but I think I really need to draw to a close. I will give you just a hint, just a little hint, if I can find my little thing that I've been holding, of the...oops, that's not it. It's a magic trick. I've made it go away. I'll have to learn how to do this again for some party. I'll give you a hint of what my conclusions are regarding what we should do about all this. But that's all I really have time for today. Thanks very much.