Volatile Times and Persistent
Conceptual Errors:
U.S. Monetary Policy 1914-1951
Charles W. Calomiris
Columbia Business School and NBER
Atlanta Fed Jekyll Island Conference
November 2010
Central Questions
• What did the Fed try to do, why, and how?
• What effects did Fed monetary policy have?
• Why did it take so long to correct errors in
monetary policy?
• What do we learn from this experience about
how central banks learn?
– Importance of initial conditions (beliefs about policy;
unique US circumstances required original thinking)
– Importance of environment (especially, volatility of
WWI, roaring twenties, Great Depression, WWII,
which made it hard to identify policy errors)
What Did the Fed Try to Do, Why, and How?
• Goal: Provide an “elastic” currency, which was expected to
resolve problems of peculiar US tendency for banking
panics, which was related to unusually high seasonal swings
in interest rates (under unit banking, cotton crop, etc.). And
do so without centralizing power, without promoting
bubbles and without threatening gold standard. NOT
expecting (or desiring) to prevent cycles or bank failures.
• Why? Historical experience of 1873-1907. Panics occurred
at seasonal and cyclical times of high banking system
leverage (peaks) when liabilities of failed businesses spiked
and stock market fell (Calomiris and Gorton 1991). Stable
reserve ratios would reduce systemic liquidity risk.
• How: Real bills doctrine, decentralized system of 12
districts (‘til 1935) lending reserves on loans as collateral,
balance of power among government, banks, others.
Real Bills Doctrine
• Provide liquidity to accommodate loan demand variation
based on fundamentals (which will allow banks to keep
their loan-to-reserves stable, and will thus smooth seasonal
and cyclical fluctuations in interest rates).
• To do so, focus on lending against “self-liquidating”
commercial bills that finance goods in transit.
• Avoid fueling bubbles by avoiding accommodation of real
estate or stock market lending.
=> (1) Riefler-Burgess framework’s focus on borrowed
reserves and nominal interest rates to gauge needs of
market, (2) promote use of real bills as collateral, (3)
discourage use of Fed discount window to promote nonreal bills based lending, and (4) lend at a “penalty” rate
(real bills limits and penalty rate were abandoned with
WWI need to support government).
Figure 1
The Loan Market with and without the Fed
Loan Supply
(without Fed)
Real
Loan
Interest
Rate
Loan Supply
(with Fed)
High Loan
Demand
Average Loan
Demand
Low Loan
Demand
Real Quantity of Loans
Problems with Real Bills Policy
• Accommodates demand shifts for loans assuming
that they are based on fundamentals, and is thus
pro-cyclical in effect (no nominal anchor)
• Focuses on nominal interest rate and does not
take account of real interest rate changes due to
expected inflation changes.
• Does not take into account loan-supply shocks.
• The latter two are especially relevant for
explaining the monetary implosion of the Great
Depression.
Figure 2
Loan Supply Contraction and Rising Real Loan Rates
During the Depression
Loan Supply (1932)
Real
Loan
Interest
Rate
Loan Supply (1931)
Loan Supply (1929)
Loan Demand (1929)
Loan Demand (1931)
Loan Demand (1932)
Real Quantity of Loans
Why Did It Take So Long To Correct Errors?
• Fed didn’t expect to end recessions.
• Beliefs about its limited power to spur economy, and
misinterpretations of loan and money supply collapses
as demand-side collapses.
• Money illusion by Fed policy makers.
• Volatility of environment: WWI; technology changes in
1920s, alongside deep structural changes in financial
sector, transport, communications, stock market boom
and bust, and gold standard resumption; Great
Depression shocks and New Deal policies; and WW II.
This volatility was not conducive to identifying errors in
thinking about policy. Priors were not revised.
Identifying Policy Influences Is Hard
• This statement is true even in retrospect.
• Some key issues about the effects of monetary policy during the
interwar period remain highly controversial; identifying them
and adapting policy in real time was challenging.
• To illustrate that point, consider some of the major continuing
controversies.
– Was 1928-29stock market boom a bubble? (My view: Perhaps not.)
– Was the Fed constrained by the gold standard, and if so when and
why? (My view: In a few months in late 1931 there were justifiable
concerns about the risk of a run on the dollar; otherwise no.)
– Were waves of bank failures in 1930 and early 1931 national panics
or reflecting fundamental insolvency? (My view: No.)
– Was the Fed constrained by a “liquidity trap”? (My view: No.)
– Did the Reserve Requirement Increases of 1936-1937 Cause the
Recession of 1937-1938? (My view: No.)
The Fed’s Success Story: Seasonal Smoothing
• Seasonal variation in the level of interest rates and the
ratio of loans to reserves became much smoother after
the founding of the Fed.
• Seasonality of interest rate volatility and stock returns
volatility were also reduced.
• These findings by Miron and Bernstein et al. suggest
that accommodating seasonal demand did reduce
seasonal liquidity risk.
• It is possible that the observed success in seasonal
smoothing reinforced adherence to the Riefler-Burgess
framework, and thereby contributed to cyclical policy
failures.
Politics and the Fed
• Changes in policy did not only reflect economic
considerations. The Fed was constrained by force
majeure.
• WWI and WWII: monetary policy independence
has limits.
• 1935 Act: Consolidation of power at Board, and
reduction of power of Fed (also note ESF, silver,
targeting of gold price).
• The Accord of 1951: reflects expansion of Fed’s
balance sheet, which allows it to credibly
threaten a contraction.
Lessons for Today: (1) Learning Is Slow When
You Need It Most
• Volatile times can make learning and accountability
hard. Likely false views are harder to discredit
• Is it obvious that TBTF bailouts were a good idea, and
that related policies were appropriate in implementing
them?
• Is it obvious which parts of TARP/TALF/etc. were
properly designed?
• Is it obvious whether QE II is now warranted?
• If not, even if all these were bad ideas or badly done,
policy makers will not learn easily or be held
accountable for their errors as much as they should be.
Lessons for Today: (2) New Institutions
Create, Not Just Resolve, Big Problems
• The creation of the Fed was a response to the
panic-ridden national banking era. Perhaps a
better response would have been branch
banking, which would have permitted the
creation of a central bank that could have learned
from other countries’ histories better.
• We solved the problem of seasonal smoothing
and disruptive national banking era liquidity risk,
but with a mistaken policy approach that gave us
the much greater banking and economic distress
of the Great Depression.
Lessons for Today: (3) What Will Be Political
Fallout of Current Reforms
• Major political shocks (WWI, the Great
Depression, and WWII) matter for monetary
policy over and above their economic
consequences: all caused major changes in the
structure and operations of the Fed, with lasting
consequences.
• Will Dodd-Frank further politicize the Fed?
• What will be the consequences for long-term
price stability and regulatory efficiency?