Great Depression

Just Vote NO

On Tuesday, July 21, the Senate Banking Committee will vote on whether to support Dr. Judy Shelton’s nomination to join the Board of Governors of the Federal Reserve System. Accordingly, we are re-posting our July 2019 commentary in which we outlined our strong opposition to Dr. Shelton’s candidacy.

In our view, over the past year, the case against Dr. Shelton has strengthened. The Federal Reserve’s speedy and decisive response to the COVID pandemic is a key reason that the U.S. financial system has steadied and the economy quickly began to recover from the worst shock since the 1930s. Had the United States been operating on a gold standard, as Dr. Shelton has long advocated, these Fed actions would not have been feasible.

Indeed, under a gold standard, instead of easing forcefully and committing to sustained accommodation, the central bank would have been obliged to tighten policy in an effort to resist the 19-percent rise of the gold price since the end of 2019. Just as it did in the Great Depression, this policy would have led us down a path of financial crisis and economic disaster (see our earlier posts here and here).

We hope that the Senate Banking Committee will vote down Dr. Shelton’s candidacy and send a determined message that unambiguously backs the Federal Reserve’s commitment to use every means at its disposal―zero interest rates, large-scale asset purchases, and broad lending programs―to restore economic prosperity and maintain price stability. Barring outright rejection, the Committee should at least move to hold an additional hearing on this nomination, as the Committee minority has proposed….

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Some Unpleasant Gold Bug Arithmetic

Most people care far more about the prices of things they purchase—food, housing, health care, and the like—than the price of gold. Not coincidentally, professional economists display a remarkably explicit consensus against forcing the central bank to adopt a policy that fixes the price of gold.

Yet, there are still powerful people who think that the United States would benefit if the central bank’s sole purpose were to restore a gold standard. With the nomination of gold standard advocate Judy Shelton to be a Governor of the Federal Reserve, we feel compelled to take these views seriously. So, here goes.

Several years ago, we emphasized that a gold standard is incredibly unstable. In this post, we address the mechanics of how the U.S. central bank would run the system. In our view, it is incumbent on any gold standard advocate to answer a series of practical questions: What gold price are they proposing? How much gold would the Federal Reserve have to acquire and hold to make the scheme credible? Will the Fed be able to lend to banks and operate as a lender of last resort?

Our answers highlight the operational challenges. Since the Fed initially would commit to holding a particular dollar value (that is, the product of price and quantity) of gold, we need to consider price and quantity together. With the smallest balance sheet we can imagine, our best guess is that the Fed initially would have to triple its gold holdings, driving the price of gold up by two thirds (to about $2,600 per ounce). Then, to maintain the gold standard, the Fed would still need to purchase one-third of world gold production each year. Without gold holdings over and above this minimum, the Fed would not be able to lend at all, much less without limit as it can under a pure fiat money standard….

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Protecting the Federal Reserve

Last week, President Trump tweeted his intention to nominate Dr. Judy Shelton to the Board of Governors of the Federal Reserve System. In our view, Dr. Shelton fails to meet the criteria that we previously articulated for membership on the Board. We hope that the Senate will block her nomination.

Our opposition arises from four observations. First, Dr. Shelton’s approach to monetary policy appears to be partisan and opportunistic, posing a threat to Fed independence. Second, for many years, Dr. Shelton argued for replacing the Federal Reserve’s inflation-targeting regime with a gold standard, along with a global fixed-exchange rate regime. In our view, this too would seriously undermine the welfare of nearly all Americans. Third, should Dr. Shelton become a member of the Board, there is a chance that she could become its Chair following Chairman Powell’s term: making her Chair would seriously undermine Fed independence. Finally, Dr. Shelton has proposed eliminating the Fed’s key tool (in a world of abundant reserves) for controlling interest rates—the payment of interest on reserves….

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Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

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Ten Years After Bear

Ten years ago this week, the run on Bear Stearns kicked off the second of three phases of the Great Financial Crisis (GFC) of 2007-2009. In an earlier post, we argued that the crisis began in earnest on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime mortgage debt. In that first phase of the crisis, the financial strains reflected a scramble for liquidity combined with doubts about the capital adequacy of a widening circle of intermediaries.

In responding to the run on Bear, the Federal Reserve transformed itself into a modern version of Bagehot’s lender of last resort (LOLR) directed at managing a pure liquidity crisis (see, for example, Madigan). Consequently, in the second phase of the GFC—in the period between Bear’s March 14 rescue and the September 15 failure of Lehman—the persistence of financial strains was, in our view, primarily an emerging solvency crisis. In the third phase, following Lehman’s collapse, the focus necessarily turned to recapitalization of the financial system—far beyond the role (or authority) of any LOLR.

In this post, we trace the evolution of the Federal Reserve during the period between Paribas and Bear, as it became a Bagehot LOLR. This sets the stage for a future analysis of the solvency issues that threatened to convert the GFC into another Great Depression.

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Why a gold standard is a very bad idea

The extraordinary monetary easing engineered by central banks in the aftermath of the 2007-09 financial crisis has fueled criticism of discretionary policy that has taken two forms. The first calls for the Federal Reserve to develop a policy rule and to assess policy relative to a specified reference rule. The second aims for a return to the gold standard (see here and here) to promote price and financial stability. We wrote about policy rules recently. In this post, we explain why a restoration of the gold standard is a profoundly bad idea.

Let’s start with the key conceptual issues. In his 2012 lecture Origins and Mission of the Federal Reserve, then-Federal Reserve Board Chair Ben Bernanke identifies four fundamental problems with the gold standard:...

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Inflation and Fiscal Policy

Why is it proving so difficult to raise inflation? For generations after World War II, this was not something that worried economists. Yet, today, even as central banks lower policy rates close to zero (or below) and expand their balance sheets beyond what anyone previously imagined possible (see chart), inflation remains stubbornly below target in most of the advanced world.

Nowhere is this problem more profound than in Japan, where mild deflation was the norm for nearly two decades and where inflation still remains well shy of the Bank of Japan’s 2% target. Even as monetary policymakers expanded the central bank’s balance sheet by nearly one-third of GDP and nudged its policy rate slightly below zero, consumer price inflation (as measured by our preferred trend measure, the 10% trimmed mean) has slipped from 0.9% to 0.1% over the two years to July 2016...

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Central Banks and Systematic Risks

Modern economies are built by businesses that take risk. As Edison’s defense suggests, successful risk-takers need scope to experiment without distraction. Economies lacking institutions to support risk-taking are prone to stagnation.

By securing economic and financial stability, central banks play a key role in promoting the risk-taking that is fundamental to innovation and capital formation. On rare occasions, it is officials’  bold willingness to do “whatever it takes” that does the job. More often, it is a series of moderate, gradual actions. Yet, even then, the understanding that the central bank has the broad capacity to act—and, when necessary, to do so without limit—is a key factor underpinning the stability of the system...

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Unconventional monetary policy through the Fed's rear-view mirror

On December 16, the Federal Open Market Committee is poised to hike interest rates, putting an end to the near-zero interest rate policy that began in December 2008. So, it’s natural to step back and ask what this episode has taught us about monetary policy at the near-zero lower bound for nominal interest rates. This is not merely some academic exercise. The euro area and Japan are still constrained by the zero bound. And, in this era of low inflation and low potential growth, policy rates in advanced economies are likely to hit that lower bound again (see, for example, here). How the Fed and other central banks respond when that happens will depend on the lessons drawn from recent experience...

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Monetary Policy: A Lesson Learned

The Federal Open Market Committee (FOMC) recently ended another round of large-scale asset purchases, so now is a good opportunity to take stock of what Fed policy has achieved since the peak of the financial crisis in fall 2008.

Back in 2002, then-Governor Ben Bernanke gave a speech entitled “Deflation: Making Sure "It" Doesn't Happen Here.” His message was that the experience of the 1930s taught us the importance of using aggressive monetary accommodation to avoid deflation. As Chairman of the Federal Reserve Board during the financial crisis of 2007-2009, Bernanke and his colleagues took actions that their 1930s predecessors had not. The result was a Great Recession, not another Great Depression...

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