The Federal Reserve-Then & Now (1)

The Federal Reserve: 

Then and Now 

Roger W. Garrison

Roger W. Garrison is associate professor of economics at Auburn University. 

He wishes to thank James Barth, Jeffrey Friedman, and Sven Thommesen for 

their helpful comments on an earlier version of this paper. 

The Review ofAustrian Economics Vo1.8, No. 1(1994): 3-19 

ISSN 0889-3047

A good friend of mine has two sons who, in their youth, were unusually mischievous. On one occasion, when my friend had just replenished his liquor supply in preparation for a cocktail party that evening, his sons decided that a liquor cabinet was a pretty good substitute for a chemistry set. They broke the seals and poured from one bottle directly into the next: scotch into rum; rum into gin; gin into scotch. And they added a little creme de menthe all around. When their father discovered the deed (not in time to save the evening guests from some innovative cocktails), he issued punishment in the form of reduced allowances and increased yard duties. The two boys accepted the punishment gracefully and promised never to do that again. 'You know," my friend told me, "I believe them. They'll never do that again. The next time, it'll be something else." 

And so it is with the Federal Reserve. Mischievous by its very nature, it rarely does the very same thing twice. Fed-watchers, always looking for a precise pattern in monetary aggregates, hoping to get an exact fix on the Federal Reserve's modus operundi, are almost sure to be disappointed. The enduring capacity of the Federal Reserve to exert a powerful influence on the course of economic events derives importantly from its adaptability. New trends in fiscal policy and modifications in the regulatory environment can change the nature and significance of Federal Reserve actions in ways that are difficult to perceive until after the fact. 

In recent years, difficulties in perceiving just how the Federal Reserve is affecting the course of the economy have translated into doubts that the Federal Reserve has a significant effect-doubts even that money has much to do with the cyclical variation of employment and output. So-called real theories of the business cycle account for each departure from trend-line growth in terms of some real shock to the economy-which typically means a change in technology or in resource availability.' In turn, the focus on macroeconomically significant real shocks, which are relatively few and far between in comparison to monetary shocks, has caused many modern macroeconomists to believe that business cycles themselves are far less troubling than was once thought. To similar effect, the increasing reliance on an analytical framework that' reduces all macroeconomic phenomena to considerations of aggregate demand and aggregate supply has led textbook writers to emphasize the temporariness of cyclical variation rather than the pervasive discoordination and painful recovery that characterize boom and Such treatments of cyclical variations and of the relationship between monetary and fiscal policy are fundamentally flawed. 

While important changes in the fiscal and institutional environment underlie the comparison between the Federal Reserve then (1920s-1930s) and the Federal Reserve now (1980s- 

1990s), the Federal Reserve's power to create money must figure importantly in the accounts of both periods. Understanding just how, though, requires an analysis that makes use of a level of aggregation much lower than that of conventional macroeconomics.  Rather than causing the economy harm, minor changes in the economy's output are understood to be a consequence of an efficient market coping with minor (macroeconomically speaking) changes in underlying realities. (In this context, the Great Depression is seen as something of an 'outliern not well accounted for by this or any other theory of the business cycle.)  

From Textbook Macroeconomics to Macroeconomic Realities

Macroeconomic policy is conventionally divided into two categories: monetary policy, which is formulated and implemented by the Federal Reserve, and fiscal policy, which is the net effect of the many spending and taxing decisions made by Congress. Macroeconomic textbooks typically introduce monetary and fiscal policies in separate chapters and then deal with the interplay between the two by constructing multi-quadrant graphs in 

which the money supply, government spending, and the level of taxation, each represented in separate quadrants, have a combined economywide effect on the rate of interest and the level of income. 

There is a certain logic to this policy decomposition. Inflating, spending, and taxing in the conventional macroeconomic frame-work have their own separate short-run effects on the interest rate and income level: expansionary monetary policy causes incomes to rise and interest rates to fall; expansionary fiscal policy (increased government spending or decreased taxation) causes both incomes and interest rates to rise. The effect of coordinated monetary and fiscal policy is simply the sum of the individual effects. Economic expansion driven by both the Federal Reserve and the federal budget, for instance, has a double-barreled effect on the level of income while leaving the rate of interest unchanged.

Yet the relevance of such textbook treatments of policy hinges on several critical assumptions. By expanding the money supply, policymakers intend to affect output and employment rather than prices and wages. Any hopes for these intended real effects-as opposed to purely nominal effects-must be based on the assumption that prices and wages are somehow stuck above their market-clearing levels at the outset of the expansion and that the new money lent at lower interest rates is used only to mobilize other- wise idle resources. If, instead, pre-expansion prices and wages are fully adjusted to their market-clearing levels, then the effects of monetary expansion are only temporary. In the long run, real incomes return to their pre-expansion levels as prices and wages adjust upward; real interest rates return to their pre-expansion levels as rising prices and wages build an inflationary premium into the structure of nominal interest rates. Similarly, expansionary fiscal policy, which increases real rates of interest, has only a temporary effect on incomes under conditions of flexible prices and wages. These assumptions and qualifications are acknowledged-though sometimes cryptically-in most modern macroeconomic textbooks. 

But these treatments employ an exceedingly high level of aggregation, whereby "income" summarily measures both the total output produced in exchange for that income and the spending power capable of buying that output. This aggregation causes the phrase "temporary effects of fiscal and monetary policy" to seem innocuous or benign, seriously understating the actual effects of policy. The conventional wisdom is that policy in the 

form of such "stimulus packages" may temporarily push the activities of producing, earning, and spending beyond levels that can be sustained. At worst, the dynamics of policy-induced 

changes in macroeconomic magnitudes give scope for political chicanery as incumbent administrations resort to fiscal and monetary stimulants just prior to election.

According to an increasingly common view, cyclical movements in income and output-whether attributable to policy actions or to real factors-are considered harmful only in that the timing of consumption is slightly less than optimal. This assessment allows for a quantitative estimate of the welfare loss due to temporal suboptimality of approximately one tenth of one percent of total consumption-which translates into about $8.50 per 

person per year. Disaggregating the economy's investment sector into policy-relevant patterns of investment, however, reveals that the temporary effects are not so benign. The scope for harm caused by monetary and fiscal stimulants can instead be seen in 

terms of unsustainable changes in the pattern of investment. Even if the spending power of income earners equals total output in aggregate terms, a systematic, policy-induced mismatch between decisions in the investment sector and the underlying preferences of consumers and wealth holders can lead to severe economic downturns and painful recoveries. 

By carefully identifying the relevant aspects of investment patterns in different cyclical episodes, we can identify both theme and variation in the story of boom and bust. We can find both similarities and differences, for instance, in comparing the experience of the 1920s and 1930s with that of the 1980s and 1990s. Further, we can show that the prolonged succession of policy-induced "temporary" effects, which has fundamentally changed the relationship between fiscal and monetary policy, has had permanent effects on the health of the economy. 

Variation on a Theme 

How strong are the parallels between the boom of the 1920s and 

the boom of the 1980s? How similar are the economic circum- 

stances of the early 1990s to those of the early 1930s? 

It may be tempting to try to account for our current 

macroeconomic plight by retelling the story of the interwar 

experience, changing only the dates and a few minor details. But 

the story doesn't fit that well. Credit conditions as judged by real 

rates of interest were relatively tight during the 1980s in com- 

parison to credit conditions during the 1920s. And although the 

overall monetary expansion was actually greater in the more 

recent episode, the patterns of monetary growth in the two 

periods differs importantly. In the 1920s, the money growth 

rate peaked near the end of the decade as the Federal Reserve 

attempted with increasing resolve to keep the boom going; in the 

1980s, the peak growth rate of M1 came at mid-decade, after 

which monetary growth fell to low single digits while the bull 

market continued. Adjusting the story by replacing the conven- 

tional money or credit aggregates with more narrow ones, such as 

the monetary base, or with broader ones, such as the Divisia index, 

does little to improve the fit. And given the intense Fed-watching in 

recent decades, it would in fact be surprising to learn that the 

Federal Reserve had nonetheless ignited and sustained an arti- 

ficial boom for several years by simply repeating its misdeeds 

of the 1920s. There is, after all, a kernel of truth in the notion 

of "rational expectations"-as recognized by Ludwig von Mises 

years before that term achieved currency in macroeconomic 

thought. 

Parallels can be found not in the strict sense of a replay but 

in the broader sense of variation on a thenie. The story requires 

a recasting of the characters and some major changes in the plot. 

The Federal Reserve no longer plays the lead; it plays instead an 

indispensable supporting role. Banking legislation and fiscal 

policy are more central to the storyline. In accounts of both 

periods,. however, we can say that unprecedented conditions al- 

lowed an artificial boom to go unchecked for a significant period 

of time. Unprecedented in the 1920s was a strong central bank 

bent on stimulating growth in a peacetime economy. Unprece- 

dented in the 1980s was a banking industry operating in a 

dramatically altered regulatory environment and a federal gov- 

ernment running deficits measured in the hundreds of billions. 

Interest rates in the recent episode play an important role not 

so much because of considerations of time discount but because 

of considerations of risk. During the 1920s, the low time discount 

signaled by artificially depressed interest rates did not accurately 

reflect people's. actual willingness to save; during the 1980s, the 

low risk premiums built into interest rates did not accurately 

reflect people's actual willingness to accept the risks of increas- 

ingly speculative investments-much less the additional risks 

attributable to the government's irresponsible fiscal policy. The 

boom of the 1980s was no less artificial, however, than the one in 

the 1920s. To see why, we shall have to shift our focus from the 

easy money provided by the Federal Reserve in the 1920s to the 

risk-free securities provided by the Treasury in the 1980s. But 

first let us highlight aspects of the 1920s that have identifiable 

counterparts in the 1980s. 

The Federal Reserve played a leading role in the dramatic 

boom of the 1920s (and the bust of the 1930s). Artificially cheap 

credit provided by the Federal Reserve underlay the economic 

expansion that lasted through mid-1929. This credit expansion, 

in- an economic environment largely devoid of Fed-watchers, 

drove a wedge between saving and investment. Guided by low 

rates .of interest, investment outstripped saving in aggregate 

terms, and-more importantly-investment projects were exces- 

sively long-term. As the boom proceeded, low interest rates lured 

capital into relatively time-consuming production processes. 

That is, the timing of the output of these production processes 

was skewed toward the future in comparison to the intertemporal 

pattern of demand for output. While the intertemporal distortion 

of output is the essence of so-called real business cycle theory, it 

is only a symptom, in the view presented here, of a pervasive 

distortion in the economy's capital structure. The economywide 

inconsistencies-attributable to Federal Reserve policy-be- 

tween investment decisions of the business community and the 

time preferences of consumers made the bust inevitable. The 

recovery, hampered by policies aimed at re-igniting the boom, 

consisted of extensive capital liquidation and a general intertem- 

poral restructuring of capital. 

Modern textbook treatments of the recent economic boom in 

comparison to the interwar boom hinge on a sharp distinction 

between monetary and fiscal policy. The earlier boom was driven 

by monetary policy; the later one by fiscal policy. It is true that 

the 1920s were characterized by (relatively) tight fiscal policy and 

loose monetary policy as each is conventionally measured, and 

that the 1980s saw a reversal in the relative strengths of the two 

policy alternatives. But the strict dichotomization between fiscal 

and monetary policy is badly overdrawn. In the 1980s, the signifi- 

cance of fiscal policy lay not in its augmentation of aggregate 

demand but in the private-sector risks and uncertainties that 

were attributable to chronic and dramatic federal budget deficits. 

This shift in focus directs attention to the Federal Reserve's 

critical supporting role throughout the decade and to the banking 

legislation at its beginning. 

While irresponsible fiscal policy created additional risks and 

uncertainties to be born by the private sector, the Federal Reserve 

in its capacity to monetize Treasury debt kept the risk premium 

off Treasury securities. Further, while extensive changes in the 

regulatory environment faced by the banking industry led banks 

to take on increasingly riskier portfolios, the Federal Reserve in 

its capacity of lender of last resort-together with policies of the 

Federal Deposit Insurance Corporation (FDIC)-kept the risk 

premium off bank securities and minimized the worries of the 

banks' depositors. Although the story of the 1980s is institution- 

ally complex, the general nature of the problems in the private 

sector is relatively simple. The regulatory and policy environ- 

ment led the business community to take on risks that were 

systematically out of line with the risk preferences of private 

wealth holders. This systematic discrepancy between risks un- 

dertaken and risk preferences, which provides the thematic 

link to the interwar episode, justifies the claim that the 1980s 

boom was artificial and that the bust was inevitable. 

Deficit-Induced Uncertainties 

It is not difficult to demonstrate that chronic and dramatic 

federal budget deficits create uncertainties in the private sec- 

tor.' A numerical example can serve to illustrate. Suppose the 

government's anticipated rate of spending over the next several 

years is a trillion dollars per year and that it anticipates collect- 

ing $800 billion per year in tax revenues. The difference, the 

anticipated annual deficit, of $200 billion represents yet-to-be- 

funded government spending. The business community understands that the government 

will appropriate a trillion dollars worth of resources each year. 

Tax codes stipulate the particular targets of eighty percent of 

the government's appropriation activities. Production plans 

can be made in the light of these codified taxing procedures. But 

there can be no plans that effectively take into account the other 

twenty percent, the anticipated deficit. In effect, the government is 

putting the private sector: "We are planning on appropriating 

another $200 billion worth of resources, but we are not saying 

just how, just when, and just whose." 

The government may continue issuing new Treasury bills 

while holding the line on the money supply. This would mean 

continued strains on credit markets, real rates of interest higher 

than they otherwise would be, and continued trade deficits as the 

Treasury sells those bills both at home and abroad. Alternatively, 

the government may rely more heavily on money creation. The 

Federal Reserve may begin buying Treasury bills at an acceler- 

ated rate. This process of debt monetization would take the 

pressure off credit markets and strengthen export markets. It 

would reduce the real rate of interest (temporarily) but would build 

an inflation premium into the entire structure of interest rates. As 

still another alternative, the government may institute new taxes 

of some kind or raise tax rates in some yet-to-be-specified way. In 

the meantime, a $200-billion cloud of "intent to appropriate in 

some unspecified way" looms large over the private sector. 

There is no effective hedge against uncertainty of this kind. 

There are no probabilistic answers to the question ofjust how the 

government will appropriate the additional resources. Should 

long-term capital be shifted out of export industries because of 

the currently high foreign-trade deficit and correspondingly weak 

export markets? Or should it be kept in place by anticipations of--or 

hopes for-a change in fiscal strategy? Should long-term financial 

commitments be based on the current credit conditions or on the 

contingency of some unknown likelihood that the Treasury will 

borrow more heavily in domestic as opposed to foreign credit mar- 

kets? Should land, durable assets, and even inventories be bought 

or sold at prices that reflect current inflation rate? Or should 

such transactions reflect accelerating inflation based upon some 

guess about the extent and timing of debt monetization? 

Although the government's borrowing at irresponsibly high 

levels adds to the riskiness of private-sector activities, none of these 

risks are born by the holders of Treasury securities. This discrep- 

ancy between risk created and risk assumed can be directly attrib- 

uted to the Federal Reserve in its capacity to monetize Treasury 

debt. Overextended borrowers in the private sector must pay a 

substantial default-risk premium in order to continue borrow- 

ing. Even overextended municipalities pay a default-risk pre- 

mium as their bonds are downgraded by bond-rating agencies. 

The power to tax alone is not enough to protect municipal bond- 

holders against default. But the interest rate paid by the federal 

treasury contains no default-risk premium at all. The. Federal 

Reserve stands ready to monetize the Treasury's debt in circum- 

stances that otherwise would require an outright default. It is true, 

of course, that actual monetization imposes costs in the form of 

price distortions and a general price inflation, but these costs are 

imposed on the economy in general-not just the holders of Treas- 

ury securities. Since a "monetization risk," unlike a default risk, is 

born by holders and non-holders alike, there is no monetization- 

risk premium-separate from the economywide inflation pre- 

mium-built into the nominal yield on Treasury securities. The very 

potential for debt monetization is what breaks the link between 

fiscal irresponsibility and some corresponding risk premium. 

The Federal Reserve, then, plays a critical supporting role in 

the pursuance of fiscal policy. Relieving the holders of Treasury 

securities of any risk burden increases the attractiveness of those 

securities and thus eliminates what would otherwise be a binding 

market constraint on further Treasury issues. The increasing 

significance of potential debt monetization suggests that the 

magnitude of the Federal Reserve's influence is not to be detected 

in actual movements of monetary aggregates. The mere fact that 

the Federal Reserve stands ready to monetize debt gives the 

Treasury a much longer leash than it would otherwise have.