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Central Banks Enter Age of Improvisation

Author: Benn Steil, Senior Fellow and Director of International Economics
January 18, 2010
Financial News


Many observers in Washington, not least of which Fed Chairman Ben Bernanke, are mesmerized by parallels between today and the 1930s.  Yet the parallels between the earlier boom years of this new millennium and the 1920s are actually far more compelling.

The monetary policy responses to the 1929 and 2008 crashes could not have been more different, with the former followed by tightening and the latter by a shift into overdrive.  Yet the policy stances during the pre-crash roaring twenties and noughties were - not coincidentally - extremely similar.

During the 1920s, the Fed was not, in contrast to popular mythology, mechanically following the dictates of the gold standard.  Far from it.  Fed officials made explicit the fact that they were pursuing a policy they called price stabilization - like today's inflation targeting, but without the upward drift.  Yet to stabilize the wholesale prices the Fed was targeting in the 1920s (wholesale prices being where the data were) in the face of enormous downward pressure from rapid technological advance, "it was necessary to force enormous quantities of bank credit into the economic system as an offsetting factor," observed American economists C.A. Phillips, T.F. McManus, and R.W. Nelson, eight years after the '29 crash.  Thus "the great American 'stabilisation' of 1922-1929," concluded British economist D.H. Robertson three years after the crash, "was really a vast attempt to de-stabilise the value of money in terms of human effort by means of a colossal programme of investment in buildings, motor car plants, etc. . . . which no human ingenuity could have managed to direct indefinitely on sound and balanced lines."

One result was eerily similar to our house mania 80 years later: "a constructional boom of previously unheard-of dimensions.  A real estate boom developed, first in Florida," reported Phillips, McManus, and Nelson, "but soon was transferred to the urban real estate market on a nation-wide scale."

Yet a few weeks ago, in a widely reported speech to the American Economic Association, Chairman Bernanke insisted that "the best response to the housing bubble would have been regulatory, not monetary." This in spite of "evidence that monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 contributed to the boom in the housing market," according to research from European Central Bank economists Frank Smets and Marek Jarocinski.

The parallels with the 1920s are unmistakable, and the message clear: effective monetary policy must regulate the credit cycle.  But this message has unfortunately been warped in our day into the idea that it should instead "target asset prices" - a notion which at any given point in time is subject to the compelling criticism, levelled by Alan Greenspan and others, that monetary authorities can know neither which specific asset prices to target nor what the specific target prices should be.  But targeting asset prices is a very different proposition from controlling metrics of broad private credit growth, even though such growth certainly affects asset prices.

In fact, the famous 1977 amendment to the Federal Reserve Act which directed the board of governors to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" also directed it to "maintain long run growth of monetary and credit aggregates" so as to achieve those goals.  After quoting this requirement in a 2006 speech, Chairman Bernanke, a long-time champion of inflation targeting, went on to enumerate the problems of identifying appropriate monetary aggregates to target while not even mentioning credit aggregates.

Many would argue that human ingenuity is simply not capable of properly regulating a vast economy's flow of credit - any more than it is capable of wisely targeting asset prices or price indexes.  I have great sympathy with this view.  But this brings us to Alan Greenspan's observation in 2005 congressional testimony that "as long as you have fiat currency, which is a statutory issue, a central bank properly functioning will endeavor to, in many cases, replicate what a gold standard would itself generate".  This is an important riposte, however unintended, to Chairman Bernanke's protestations that the housing bubble was the fault of bad regulation, and not monetary policy, and that the U.S. current account imbalance is the fault of a "global savings glut", and not monetary policy.  Under a true classical gold standard, when the U.S. sends a dollar to China, China would have to redeem it for U.S. gold.  A fall in the U.S. gold stock would necessitate a rise in U.S. interest rates, which would reduce credit growth, reduce prices, and reduce the trade deficit.  In other words, the bubbles and imbalances which marked the past decade were features of a monetary regime which did not replicate a gold standard - and which in fact continues to allow gold prices to soar.

Strikingly, as we begin to emerge from the worst economic crisis since the 1930s, there is less consensus today on what monetary policy should do going forward than there has been for at least 20 years.  As in the era after the collapse of the gold standard in the 1920s, central banking is entering an age of improvisation.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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