Although dedicated Fed watchers long saw it coming, the big news from Jackson Hole is that the Fed now has a new monetary policy strategy—the crowning achievement of the much-ballyhooed review of its “Strategy, Tools, and Communications” it launched in early 2019. It’s called “average inflation targeting,” and chances are that if you’re reading this you’re wondering (1) what the heck it means and (2) what, if any, difference it will make.

Don’t feel bad. More than a few seasoned monetary economists have been asking themselves the same questions, myself included. Having come up with some answers, I thought to share them with you, together with my reasons for concluding, first, that the new strategy isn’t likely to improve things; and, second, that the Fed has missed a chance to adopt a different strategy that really would work better.

Falling Short

The best way to understand average inflation targeting (henceforth, AIT) is to first understand what the Fed was up to before Powell’s announcement. That requires knowing both what it intended to do and what it did in fact.

Concerning what the Fed intended to do, starting in late January 2012, and until quite recently, it was committed to stabilizing inflation “at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures.” Doing that, Fed officials concluded, would serve to keep the public’s “longer-term inflation expectations firmly anchored,” presumably at the same, 2 percent level.

So much for intentions. As the following chart makes clear, what the Fed did in fact, albeit unintentionally, was allow inflation to frequently fall well below its target level:

That the Fed routinely fell short of its inflation target doesn’t mean that it simply tossed the target aside. On the contrary: to judge from market participants’ own inflation expectations, as reflected in the TIPS spread, the Fed generally adjusted its policy stance in a manner consistent with achieving its 2 percent inflation going forward. Its calculations only proved mistaken after the fact. As the next chart shows, the one clear exception to this occurred in December 2015, when the Fed raised its rate target for the first time since the 2008 crisis, when the expected 5‑year forward inflation rate was well below target. That decision appears, by the way, to have been due more the Fed’s decision to prematurely begin raising the fed funds rate to an overestimated “normal” value, than to any naïve Phillips Curve reasoning. (See this Twitter thread.)

Many Misses are as Good as a Mile

If the Fed was (almost) always setting its policy stance so as to keep the expected inflation rate close to 2 percent, what more could one ask of it? Plenty, actually. That becomes clear once one distinguishes between the path of the expected rate of inflation on one hand, and that of the actual price level on the other. To take a simple case, suppose that the Fed has a 2 percent inflation rate target, and that at each FOMC meeting it sets that target where it thinks it needs to be to get the price level to increase by 2 percent over the coming years. Suppose also that the public agrees with the Fed’s decision, so that the expected inflation rate at each rate setting is also 2 percent. If all goes according to plan, the price level will never veer from its 2 percent path.

But suppose that the economy experiences a series of unexpected shocks that put downward pressure on prices. These could be either negative demand (velocity) shocks or positive supply shocks. Suppose as well that those shocks aren’t matched by corresponding shocks of the opposite sort. The Fed, in other words, faces a “run” of negative price level surprises. In that case, although it continues to set its rates at levels calculated to keep the forward-looking inflation rate at its 2 percent target, the ex-post or “backward-looking” inflation rate will be persistently below that target; and the longer that run continues, the larger will be the gap between actual and intended inflation. The chart below, with the price level (P) as its vertical axis, and time as its horizontal axis, shows the case where each of three adverse demand shocks, occurring at the dates marked by horizontal grey lines, causes a downward shift of the price-level from its original target path, represented by the dashed blue line, where the slope (π) of that line represents the Fed’s 2 percent inflation target. After each shock, prices once again rise at the Fed’s target rate (red lines). Consequently, the ex-post inflation rate, represented by the slope of the dashed green line, is 1.5 percent, or 50 basis points below the targeted rate represented by the slope of the dashed blue line. Although future shocks might shift prices higher, offsetting this undershooting, there’s no reason to suppose that they’re bound to do so.

Average is (Sometimes) Over

The upshot of all this is that steering monetary policy differs from steering a car in at least one crucial respect, namely, that whereas you can keep a car on course without ever glancing at the rear-view mirror, an inflation-targeting central bank that only looks ahead can end up badly off course. A still better analogy would be with setting a ship’s course: getting the right bearing (compass direction) is seldom enough. As a ship gets buffeted by winds and currents, adjustments have to be made to compensate for drift.

Such adjustments are what Average Inflation Targeting is all about. In the abstract, the idea couldn’t be simpler: to set its course going forward, the Fed takes account of how far it has drifted off course in the past. That means aiming for an inflation rate below its long-run target whenever it finds that inflation has drifted above that target, and aiming for a rate above its long-run target whenever it finds inflation has drifted off course in the opposite direction. Put in practice today, AIT would mean setting a course for above-target inflation, to make up for the below-target inflation the Fed has allowed in the past.

So much for the abstract theory. Translating it into practice is where things get tricky, as there are all sorts of ways for doing so, each with its own advantages and disadvantages.

The most obvious choice that has to be made concerns how far backwards the Fed should look. After all, an “average” has to be an average taken over a certain number of observations. Will the Fed achieve an average rate of inflation equal to its long-run target over a span of two years? Three? A decade? How far back will it look in setting its future course, and how long will it allow itself to take to make up for any past drift?

Such choices are especially fraught when AIT first goes into effect, for it’s precisely then that the time choices are likely to matter most. A long interval of strictly forward-looking policy has allowed the price level to drift far from its originally-targeted path. The further back the Fed chooses to look now, the greater the adjustments it may have to make, and (because these adjustments are likely to take time) the longer its overall averaging window must be. The less far it looks, the less its new policy will differ from strict (that is, strictly forward-looking) inflation targeting (SIT). Either way, it may prove difficult for the Fed to convince the public that anything has changed.

Catching Powell’s Drift

So, what precise approach to AIT does the Fed have in mind? The disappointing answer is… no precise approach at all! “In seeking to achieve inflation that averages 2 percent over time,” Powell said in his Jackson Hole speech, “we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting.”

In other words, just about anything is possible. The Fed might even go on with its SIT strategy (assuming that’s what the Fed has been up to), since (as Stephen Cecchetti and Kermit Schoenholz explain) SIT amounts to a special version of AIT with a trivially short “averaging window.” Or it could allow the inflation rate to wander either well above or well below its long-run target, restrained only by a vague promise to rein it in “eventually.” In short, to return to our nautical analogy, it’s not clear that the Fed has done anything other than grant itself more leeway.

“In theory,” Norbert Michel writes,

making up for past misses is a good thing, but the flexible nature of this new policy makes it very difficult to know exactly what the Fed will do as economic conditions unfold. …It is also rather disappointing because, after basically a decade of being unable to hit its inflation target, the Fed has essentially broadened its definition in a way that ensures it can’t miss.

Can’t miss, that is, even if it keeps doing just what it’s been doing all along—or worse. As Tim Duy observes in his own, trenchant critique of the Fed’s new strategy, because it allows the Fed to miss its inflation target “by an unspecified magnitude for an unspecified period of time,” the Fed’s open-ended version of AIT “has unanchored policy expectations by creating uncertainty around what it means to meet its inflation target,” leaving market participants at sea “until further guidance is provided.”

Inflation Expectations and the ZLB

That almost anything is possible with the Fed’s particular version of AIT doesn’t mean that AIT couldn’t possibly improve things. According to its champions, if implemented correctly, AIT could help the Fed overcome the “Zero Lower Bound” (or ZLB) problem. That problem arises when the Fed’s policy rates are already at or very close to zero, and negative rates aren’t an option. If inflation is still too low or unemployment is still too high, or both things are true (as has been the case recently), the ideal policy rate is presumably somewhere below zero. Yet the Fed can’t go there. Instead it’s “stuck” at the ZLB.

How might AIT help? The explanation has to do with the fact that, other things equal, any increase in the expected rate of inflation lowers “real” (inflation-adjusted) interest rates. It follows that an increase in expected inflation amounts to an easing of monetary policy even when the Fed’s policy rate is stuck at zero. AIT might offer a built-in solution to the ZLB problem, because any initial over-tightening leads to a corresponding upward adjustment in inflation expectations, and hence to a lowering of anticipated real interest rates, which serves as an effective alternative to lower nominal rates.

Whether this potential advantage of AIT will be of any use in practice is another matter. In their November 2019 Peterson Institute Policy Brief, David Reitschneider and David Wilcox observe that, even with a relatively aggressive form of AIT, the flatness of the present-day Phillips Curve means that, after a bout of undershooting, getting back to a targeted average inflation rate may instead be more a matter of time than of any substantial inflation overshooting. And the time required could well be more than a decade. Consequently the ability of AIT to relax the ZLB constraint will depend not only on the strictness of the AIT rule but on the public’s willingness to believe that the FOMC will stick to that rule “for many, many years into the future—a debatable proposition.”

An Incredible Commitment

If AIT has potential advantages, it also suffers from at least one serious drawback. That drawback becomes evident when, instead of having to make up for a period of below-target inflation, the Fed has to do the opposite.

Suppose, for instance, that several unexpected, positive demand shocks drive the inflation rate to 3 percent for a time. Eventually the shocks cease, and the rate returns to 2 percent. Under AIT, that return doesn’t suffice: the Fed has to tighten further, so as to drive the inflation rate below 2 percent long enough to get the price level back to its original, 2 percent path. But the correction comes at the cost of a temporary reduction of employment and output, which both the public and the government are bound to resent. “Imagine the Fed Chair,” Brookings’ David Wessel writes, “explaining at a press conference that the Fed was going to raise interest rates and increase unemployment to compensate for a period at which inflation was too high and unemployment too low.”

In their previously mentioned Policy Brief, Reitschneider and Wilcox supply an example of how AIT might have led to exactly the sort of impasse Wessel describes had the Fed resorted to it in the past. Had the Fed pursued an aggressive 5‑year AIT strategy during the mid 2000s, based on headline Personal Consumption Expenditure (PCE) inflation, Reitschneider and Wilcox calculate that the oil shock that took place then would have compelled it to keep “the federal funds rate near 8 percent even as the housing market collapse, financial stress intensified, and the economy slipped into recession.”

Faced with stiff-enough opposition, the Fed might fail to carry out some or all of a needed correction, undermining the credibility of its policy commitment. Because the Fed’s efforts to make up for excessively low inflation are less likely to meet with similar opposition, the result could be an “asymmetrical” average inflation targeting strategy that allows the price level path to drift upwards. In that case, even if the Fed starts out with a clearly-specified AIT rule, its reluctance to stick with it will cause the long-run inflation rate to exceed the Fed’s target, while making the future course of the price level just as unpredictable as it is under strict inflation targeting.

And a Missed Opportunity

AIT is only one of several alternatives to conventional inflation targeting the Fed claims to have considered during its review. Another is nominal GDP level targeting (NGDPLT), which seeks to keep total spending on final goods, rather than the PCE index, on a fixed upward trend. Although the Fed hasn’t made public its reasons for favoring AIT over NGDPLT, it may have been won over by arguments Lars Svensson makes in a paper he presented at the June 2019 Chicago Fed conference. So far as I’m aware, Svensson’s was the only paper addressing these choices to be featured in the course of the Fed Listens events.

Last October, I pointed to what I consider to be several serious shortcomings of Svensson’s arguments. Here I wish to compare it to AIT, to see how they would differ in practice, and whether either offers any clear advantage over the other. To simplify the comparison, I’ll consider price-level targeting (PLT), which as we’ve seen is but a strict version of AIT. Because NGDPLT and PLT involve identical responses to demand shocks, to compare the policies and decide which is best, we only need to consider how each would have the Fed respond to positive or negative supply innovations, including both shocks to the (“natural”) level of output and changes in its growth rate relative to some past trend.

For one-time (level) supply shocks, the answer to the question is very simple: whereas PLT has the Fed fully and rapidly make up for any deviation from a given price-level trajectory, whether it stems from a demand or supply shock, NGDPLT does not call for it to make up for deviations stemming from supply shocks. Instead, so far as one-time supply shocks are concerned, NGDPLT resembles strict inflation targeting (SIT) in letting bygones be bygones.

For growth rate changes, the answer is distinct, but analogous. Whereas PLT calls for monetary easing to counter what would otherwise be an altered inflation rate, NGDPLT once again calls for no change in the Fed’s stance. Instead, it allows the inflation rate to increase when the output growth rate declines, and to decline when the output growth rate increases.

So, which is better, PLT or NGDPLT? Let’s first consider their relative merits as means for addressing output level shocks. In an article assessing price-level targeting, George Kahn offers an implicit comparison:

The major cost of a price-level target comes from supply shocks—shocks such as an increase in oil prices that push the price level up and cause output to fall. Under a price-level target, these shocks would lead the central bank to tighten policy to extinguish the impact of the shock on the price level. This, in turn, would further exacerbate the decline in output. In contrast, an inflation-targeting central bank would “forgive—and forget” shocks to the price level. The result would be a permanent shift in the price-level path, but with less short-run inflation and output volatility. Thus, a price-level target could lead to greater variability in inflation and output over the short run compared with an inflation target.

Bearing in mind that, so far as supply shocks are concerned, NGDPLT is equivalent to SIT, Kahn’s assessment amounts to a verdict in favor of NGDPLT: an oil shock like that of 2007, which would have proven so disastrous to an average inflation targeting Fed, would have posed far less of a challenge to one committed to NGDPLT. Because it mimics PLT’s response to demand shocks, and SIT’s response to supply shocks, NGDPLT succeeds in doing better than either.

NGDPLT may be said to offer a similar advantage in the case of output growth rate innovations. But here it also has a further advantage, namely, a superior ability to assist the Fed in steering clear of the ZLB. To understand why, consider that the zero lower bound has become binding chiefly owing to a secular decline in the real neutral interest rate. And that decline is largely due to a declining rate of productivity growth. Given some fixed target long-run inflation rate, and assuming that by the Fed’s strategy, whatever it is, keeps the expected rate of inflation roughly equal to that target rate, the neutral nominal interest rate will also decline as productivity growth declines. The lower that neutral nominal rate, the greater the risk that the Fed finds itself stuck at the ZLB.

Now consider: under AIT, the long-run inflation target is independent of both the real neutral rate, and the productivity growth rate that informs it. Under NGDPLT, in contrast, the (implicit) inflation target varies inversely with any change in the rate of productivity growth, and so will expected inflation once the change is recognized. Consequently, a reduction in the growth rate of output that lowers the real neutral rate need not lower the long-run, nominal neutral rates. NGDPLT thus reduces the risk that future reductions in productivity growth will cause the ZLB to bind more often.

To conclude: after frequently falling-short of its inflation target, the Fed now promises to make up for it, by switching to average inflation targeting. Whether the new strategy does any good remains to be seen. But even if it does, by choosing AIT over NGDPLT, the Fed has missed yet another mark. Here’s to hoping that, some day, it makes up for that miss as well.


[Cross-posted from Alt‑M.org]

“Without Roosevelt’s intervention, the economic recovery that lasted from 1933 to 1937 would have been weaker and shorter—-not unlike our own recovery after the Great Recession.” (David Weiman, “Imagining a World without the New Deal,” The Washington Post, August 12th, 2011.)

***

In the previous installment to this series, I showed how the U.S. economy owed most of the recovery it experienced between 1933 and 1937 to an onrush of “hot money” from Europe that revived aggregate spending. I also explained how that hot money owed its warmth, not to any steps FDR took in the U.S., but to the martial maneuverings of Benito Mussolini and Adolph Hitler.

In today’s post I plan to show that the 1933–37 recovery fell far short of reversing the collapse the U.S. economy suffered between 1929 and 1933, and that this disappointing outcome was the result of New Deal policies aimed at boosting wage rates. The resulting higher wage rates prevented the revival of spending from sponsoring a corresponding revival of employment.

A Disappointing Recovery

Although any sort of recovery would have been welcome after the disastrous Great Contraction, the recovery between March 1933 and May 1937 was disappointing in several respects. Most obviously, it didn’t last. Instead, a depression followed it that, though short lived, was severe enough to reverse most of the previous years’ gains. And although, as the chart below shows, industrial production eventually caught up to, and even slightly surpassed, its 1929 level, it remained far below the trend to which a full recovery would have returned it.

But the biggest disappointment was the persistence of high unemployment. Most of the gain in output was due to remarkable post-1933 gains in total factor productivity rather than increased employment. The unemployment rate as conventionally measured (with workers in government relief programs counted as unemployed) stayed obstinately above 15 percent until 1936, and was still above 10 percent in the late summer of 1937. It then rose sharply again as the new depression took hold. To put these numbers in perspective, between April and September 1929, the highest recorded unemployment rate was just above 2 percent.

Writing of the situation as of 1935, Ellis Hawley, a sympathetic critic of the New Deal, observes (pp. 131–2) that the gains achieved up to then “were hardly reasons for jubilation”:

Over ten and a half million workers were still unemployed, approximately twenty million people were still dependent upon relief, basic industries were still operating at little more than half their capacity, and the real income of the average family was still thirteen percent below that of 1929.

Why didn’t all that gold flowing in from Europe translate into large employment gains? One reason was banks’ inclination to accumulate excess reserves after the bank holiday, which reduced the inflows’ contribution to broad money growth: banks could either use new reserves to support increased lending or security purchases, or they could simply hold on to them. To the extent that they accumulated reserves, as gold reserves grew, the money stock would grow less than proportionately. As the chart below shows, for most of the period before 1936, and especially until the start of 1935, banks accumulated excess reserves almost as quickly as the Fed acquired gold. So the money stock grew at a relatively modest (but hardly trivial) rate. Total spending likewise grew less rapidly, and contributed less to recovery, than it might otherwise have.

The Wages Puzzle

Yet the extent of demand growth was hardly so limited as to account for the persistence of double-digit unemployment. By 1937, as the next chart shows, nominal GNP was almost 70 percent above its 1933 level, and just 30 percent below its 1929 level. So why didn’t employment increase correspondingly? The reason is that, instead of serving to pay going wage rates to a larger number of workers, a substantial part of the increase in spending was offset by higher wage rates: instead of using their increased earnings to hire more workers, employers were using them, or a big chunk of them, to give raises to their existing workers. The chart’s purple line, showing manufacturing workers’ hourly earnings, shows how those earnings rose sharply after mid-1933. In two years they’d risen 35 percent, and they would go on rising until the middle of the “Roosevelt Depression.”[1]

To anyone unfamiliar with the government policies of the period, this pattern of hourly wage changes should seem, not just perplexing, but perverse: how could wage rates rise sharply while more than a fifth of the labor force was out of work? With so many workers desperately seeking jobs, and most plants operating at well below capacity, why would manufacturers, confronted with the choice of either giving their workers a raise, or hiring more workers at going wage rates, if not for less, not make the second choice?

The answer isn’t to be found among the laws of supply and demand. But it can be found easily enough among the laws passed by the Roosevelt administration. As economic historian Christopher Hanes observes in a recent, excellent paper on the topic, those laws supply

an obvious explanation. Starting in 1933 the Roosevelt administration adopted “New Deal” labor policies embodied in the National Industrial Recovery Act (NIRA), which established the National Recovery Administration (NRA) codes, and the 1935 National Labor Relations Act (NLRA or Wagner Act). NRA codes boosted nominal wage rates, and imposed “labor standards” such as overtime premium pay, by regulatory fiat. Both the NIRA and the NLRA promoted formation of labor unions and strengthened workers’ bargaining power over employers. These policies could boost prices, as well as wages, as they gave an extraordinary boost to labor costs of production.

The N.I.R.A.

Although the March bank holiday brought the banking crisis to an end and ended the Great Contraction, the economy that emerged from it was in dire straits, with over a quarter of its workers unemployed. The demand for some further government action, Ellis Hawley writes, (p. 53), “was overwhelming.” The Roosevelt administration’s first response to this demand was the Agricultural Adjustment Act of May 10th, 1933. Its second, passed five weeks later, was the National Industrial Recovery Act (NIRA). The NIRA was to be the New Deal’s centerpiece. It was, FDR declared, “the most important and far-reaching legislation ever enacted by the American Congress.”

The NIRA consisted of three parts or “titles.” Title II established the PWA (Public Works Administration) and assigned it a budget of $3.3 billion. Title III contained various miscellaneous provisions, including one transferring the RFC’s public works activities to the PWA. Title I, which most concerns us, addressed “Industrial Recovery.” It provided for the establishment of industry “codes of fair competition.” Among other things, the codes were supposed to assure adequate working conditions, set maximum working hours and minimum ordinary and overtime wage rates, and affirm workers’ right to engage in collective bargaining. Businesses operating under approved codes were to be exempt from federal antitrust laws. Four days after the NIRA was passed the National Recovery Administration (NRA) was established to see to the codes’ development and enforcement.

Establishing minimum wage rates had in fact been the original aim of what became the NIRA. Like many people, FDR believed that higher wage rates would translate into an overall increase in workers’ “purchasing power,” which, by enabling them to spend more, would in turn promote recovery. He therefore asked Labor Secretary Frances Perkins to suggest amendments to Hugo Black’s “Thirty Hours” bill, a measure first introduced in 1932 that the Senate had passed in April, that would provide for minimum wage rates. At the time, Perkins says in her memoir (p. 197), FDR’s “mind was as innocent as a child’s of any such program as the NRA.” Eventually FDR decided to offer a substitute for Black’s bill instead of amending it. The result was a scheme in which industrial and trade associations would come up with codes establishing minimum wage rates and other working conditions that all firms in an industry would have to meet. Industries that abided by approved codes would be exempt from antitrust laws that would otherwise have prohibited them from colluding.

In practice the NRA worked out far differently than Perkins and other champions of higher wages intended. Although Advisory Boards featuring consumer as well as labor representatives took part in the code-writing process, industry representatives paid little heed to them. Instead they took advantage of both the code-writing opportunity and the suspension of antitrust laws to regulate product prices and output so as to turn formerly competitive (albeit imperfectly competitive) industries into so many cartels. Although the codes did provide for minimum wage rates, and although actual wage rates in some cases were set even higher than those minimums, they often were written so that, if wage rates rose, product prices would rise just as much.

“In practice,” Hawley observes (pp. 33–4), “the NRA became a mechanism that conflicting groups sought to use for their own ends, and agency that was unable to define and enforce a consistent line of policy.” The result disappointed practically everyone, including the businessmen who hoped to profit by dominating the code-writing boards. Before it was over even FDR himself couldn’t help admitting, albeit only privately (to Frances Perkins), that “the whole thing is a mess” (Robert McElvaine, The Great Depression, p. 162).

The High-Wages Fallacy

Considering that verdict, it should not be surprising to discover that William Randolph Hearst had a point when he quipped that NRA really stood for “No Recovery Allowed.” The NRA codes themselves did nothing to boost aggregate spending, which was the real key to recovery. Instead they only prevented the increased spending that did occur from boosting total employment. And so far as this outcome is concerned, the codes failed not because they veered from their original purpose, but because they did just what they were supposed to do!

Of course the misuse of industry codes to establish and enforce monopoly prices itself contributed to unemployment, because monopoly prices meant less output, which, other things equal, meant less demand for labor. But it was mainly by boosting wage rates, just as they were meant to, that the codes undermined the employment-generating capacity of increased spending, by reducing the number of jobs any given level of spending could support.

Before we explore the magnitude of the codes’ unintended consequences, I’d better explain why their champions thought they’d have just the opposite effect, and why they were so tragically mistaken.

The belief that compelling firms to increase their workers’ wage rates would promote recovery, or the “high-wage doctrine,” had its roots in the “underconsumption” theory of depression, which reached its peak of popularity during the 1920s. According to that theory, depressions happened when workers collectively weren’t paid enough to buy the output their employers produced. The problem, Hartley Withers wrote in 1914 (Poverty and Waste, p. 83, my emphasis), was that while it might be obvious enough to business owners “that the workers of other industries should be better paid,” because that would allow them to spend more, few were willing to increase their own workers’ wage rates. Instead “every company or firm would naturally wait for others to begin” (ibid., p. 84). Government action might be needed to overcome this free-rider problem.

The severe though short-lived depression of 1920–1921 led to a surge in the high-wage doctrine’s popularity, by convincing many that the sharp (perhaps 20 percent) decline in wage rates during it was not merely a symptom of a collapse in total spending, and certainly not a way of restoring employment, but an aggravating cause of the collapse. Thanks to that episode, and to William Foster and Waddill Catching’s 1927 book, Business Without a Buyer, which popularized the high-wage doctrine, by the time the Great Depression started, the doctrine was conventional wisdom. Hoover and Roosevelt may have disagreed about many things, but both of them subscribed to it. The difference between them was that, while Hoover merely tried to persuade businessmen to resist cutting their workers’ wage rates, FDR compelled firms to abide by the NRA’s codes: besides risking criminal prosecution and fines of up to $500 per violation, firms that failed to follow the codes could have their business licenses revoked—the business equivalent of the death penalty.

Had the high-wage doctrine been sound, that difference would have been a good thing. But it wasn’t. Instead, as Jason Taylor and I pointed out some years ago, the doctrine rested on the confusion of “wage rates,” meaning the amount businesses paid for any given quantity of labor, with total wages paid (or the “wage bill”), meaning the total amount businesses spent on labor. That the same term, “wages,” could refer to either of these very different things, contributed to that confusion. While it’s obviously true that, holding product prices constant, raising workers’ total wages also increases their “purchasing power,” allowing them to spend more, it doesn’t follow that compelling businesses to pay higher wage rates will have that effect, because firms might respond by scaling-back employment. What’s more, during a depression, when firms are making few if any profits, this is likely to be the only way they can afford to pay higher wage rates. In that case, the only way to have higher wage rates without sacrificing employment is to somehow see to it that total spending goes up before wage rates do so. But doing that calls for expansionary monetary or fiscal policy.

In short, although higher wage rates and increased employment can be results of increased spending, mandating higher wage rates doesn’t itself generally serve to increase spending. And if it doesn’t increase spending, it’s likely to lead to less unemployment. The graph below, in which LS is the labor supply schedule, illustrates this last point. It shows how, taking product prices as given, as wage rates rise, so does the quantity of labor supplied. LD represents firms’ demand for labor, which is a function of their earnings. N* and w* are the market-clearing level of employment and the market-clearing money wage rate, respectively. Unless LD changes, firms have only so much revenue they can devote to paying workers. Consequently, imposing a minimum wage rate, w’, above w*, causes employment to decline from N* to N’.

By the same token, when aggregate spending does grow, as it did after 1933 thanks to all that hot money, employers can take advantage of the growth to either increase wage rates or employ more workers. But the more they do the first, the less they can do the second. In the next graph, LD*, w*, and N* represent pre- Great Depression levels of labor demand, wage rates, and employment, while LD⁰, w⁰, and N⁰ represent their levels after the Great Contraction. After that, hot-money fueled spending growth raised the demand for labor back toward ND*. On its own, that increase would eventually have restored employment to N*, while also raising w back to w*. But imposing beforehand a mandatory minimum wage (w’ once again) limits the potential gain in employment to N’.

Keynes on the NIRA

Because underconsumptionist theories superficially resemble Keynes’s theory attributing depressions to a lack of spending, some have been tempted to treat Title 1 of the NIRA as an application of Keynes’s ideas. Frances Perkins, for one, claimed that by setting minimum wage rates, the NIRA “constituted an effective demonstration of the theories which John Maynard Keynes had been preaching and urging.” But that was hardly Keynes’s own view. In his famous December 1933 open letter to FDR in the New York Times, he criticized the theory that boosting wage rates (among other “prime costs”) would raise workers’ purchasing power in much the same terms as I have:

Now there are indications that two technical fallacies may have affected the policy of your administration. The first relates to the part played in recovery by rising prices. Rising prices are to be welcomed because they are usually a symptom of rising output and employment. When more purchasing power is spent, one expects rising output at rising prices. [Therefore] it is essential to ensure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turn-over. But there is much less to be said in favour of rising prices, if they are brought about at the expense of rising output. Some debtors may be helped, but the national recovery as a whole will be retarded. Thus rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.

Keynes went on to say that, while he approved of the NIRA’s attempts to achieve a more equal distribution of incomes “in principle,” he also considered it a mistake to treat higher prices as an end in itself: “The stimulation of output by increasing aggregate purchasing power is the right way to get prices up; and not the other way round.” And the most reliable way to get purchasing power up was through “governmental expenditure which is financed by Loans and not by taxing present incomes,” that is, by deficit spending:

The set-back which American recovery experienced this autumn was the predictable consequence of the failure of your administration to organise any material increase in new Loan expenditure during your first six months of office.

Keynes wrote so, it bears recalling, a month before the dollar was devalued, and well before “hot money” started to pour into the U.S. from Europe, supplying the basis for an increase in U.S. consumers’ purchasing power far greater than that achieved by FDR’s fiscal policies.

Code Blues

So much for the theory. But just how well do the facts fit it? Very well, actually.

First, concerning the codes, these were of two sorts: approved NIRA codes developed for and by representatives of specific industries, and a “blanket code,” adopted in late July, 1933, that firms had to abide by until their industries’ NIRA codes were approved. The vast majority of employers—Henry Ford was a notorious exception—agreed to take part in the program, earning the right to display the NRA’s blue eagle attesting to the fact that they were “doing their part” to end the depression.

All of the codes prevented wage rate cuts and set minimum wage rates; but they also tended to raise the wage rates of non-minimum wage workers, while raising rates for all workers indirectly by mandating across-the-board cuts in individual employees’ weekly hours, while forbidding cuts in their total pay. “From June 1933 to June 1934,” Frances Perkins writes (p. 208), “the average hourly earnings in manufacturing increased thirty-one per cent. The downward spiral of hourly earnings was checked and an upward spiral was set in motion.”

But what about employment? According to Jason Taylor’s estimates, it was only by virtue of the blanket code’s “work sharing” provision that the codes succeeded at all in scaling-back unemployment. Although it compelled firms to spread work among more workers, the blanket code actually caused aggregate hours worked to decline by over 9 percent. Yet that was nothing compared to what the NIRA codes did: once firms adopted them, they tended to hire less labor. Other things equal (again, according to Taylor’s estimates), although the blanket code by itself would have created 1.34 million new jobs, albeit only by work sharing, the NIRA codes would have destroyed almost as many. Together both sets of codes might have reduced workers’ aggregate hours by as much as one third—a calamitous figure. Fortunately, Taylor observes, other things weren’t equal. Instead, fiscal and (especially) monetary stimulus “offset much, but not all, of the negative effect that cartelization and high wage rates had on aggregate hours worked.”

After carefully studying the timing and extent of post-1933 wage rate increases beyond those consistent with underlying growth in spending, Christopher Hanes concludes that between them, the NRA codes and increased union activity (encouraged first by the NRA, and then by the Wagner Act), offer “a plausible and complete explanation” for them (emphasis in original).

The Wagner Act

Hanes also shows that the timing of the period’s “anomalous” wage rate movements is not consistent with the alternative hypothesis, proposed in a 2008 paper by Gauti Eggertsson, that wage rates rose in response to policy changes, such as the dollar’s devaluation, that “raised the expected long-run future price level.”

Eggertsson’s view is especially hard to square with what took place between November 1936 and October 1937. During that time, both the Fed and the Treasury adopted anti-inflation policies that ought to have reduced the public’s future price level expectations. Yet wage rates rose substantially above levels consistent with current spending. Here’s a chart showing Hanes’s hourly earnings series (note that it differs somewhat from the FRED series shown in a previous chart) and unemployment. The vertical lines mark the dates of Fed reserve-requirement increases (black) and the start of the Treasury’s gold sterilization program (gold):

The NIRA also can’t explain those wage hikes: it ceased to exist, except as a minor bureau devoted to publishing economic reports, when the Supreme Court declared it unconstitutional on May 27th, 1935. However, the Wagner or National Labor Relations Act passed two months later does explain them. Besides continuing many of the NIRA’s labor provisions, the Wagner Act and the NLRB (National Labor Relations Board), its enforcement agency, substantially strengthened workers’ right to form unions and engage in strikes. Thanks mainly to them, Harold Cole and Lee Ohanian report, both the share of unionized workers and the number of strikes they held doubled between 1935 and 1939. And because the NLRB was able for a time to force them to rehire workers they’d fired for taking part in sit-down strikes, those strikes tended to be very effective.[2]

Hanes shows that the nominal wage rate hikes of 1936–7 coincided perfectly with “a wave of union organization and strikes” that followed the passage of the Wagner Act. It took the “Roosevelt Depression” to put a stop to them, which it did only by setting output and unemployment back to where they’d been just before the dollar was devalued. I plan to discuss the causes of that sad episode in a later post.

Great Expectations?

In his influential 2008 paper, “Great Expectations and the End of the Great Depression,” Gauti Eggertsson uses a New Keynesian modeling framework to argue that various New Deal policies, such as the bank holiday and devaluation of the dollar, helped to promote recovery not simply by boosting prices and wages but by boosting the expected rate of inflation. By doing so, Eggertsson argues, those policies eased monetary policy by lowering the real policy rate, even or especially when the nominal policy rate was at its “zero lower bound.” Elsewhere, Eggertsson observes that the opposite could happen as well, as it did in 1937, following the Treasury’s late-December 1936 decision to start sterilizing gold inflows.


But if strikes or NRA codes are effective in boosting nominal wage rates, why shouldn’t they themselves have boosted inflation expectations, thereby lowering real interest rates and stimulating employment and output?

In a 2012 paper, “Was the New Deal Contractionary?” Eggertsson claims that strikes and wage codes did in fact promote recovery this way. Codes and strikes could, he suggests, be just as effective in boosting inflation expectations as expansionary monetary or fiscal policies. And, no matter what policy achieves them, “higher inflation expectations decrease real interest rates and thereby stimulate demand. Expectations of similar policy in the future increase demand further by increasing expectations about future income.” Thus Eggertsson arrives at the seemingly paradoxical conclusion that “policies that reduce the natural level of output [can] increase actual output.”

It’s as clever a defense of the NIRA and NLRB as has yet been put forward—clever enough to have won over some very smart economists, including Miles Kimball. But with all due respect to them and to Eggertsson himself, I believe Eggertsson here pushes his compelling 2008 argument a step too far. In particular, I believe that his attempt to treat NRA codes and such supply-restricting policy measures as having consequences similar to those of demand-expanding ones rests upon the false premise that any policy that raises the present and expected future level of prices also raises “expectations about future income.”

In a response to Kimball, Scott Sumner hits the nail on the head: Why, he asks, isn’t it always safe to assume that higher inflation expectations are expansionary? “The simple answer,” he says,

is that looking at inflation expectations is reasoning from a price change. Thus if inflation rises due to a positive AD shock (more NGDP) then both prices and output will rise in the short run. But if NGDP is unchanged, then higher inflation leads to lower output. That’s why supply shocks are contractionary.

The New Keynesian models are simply wrong. The role played by inflation expectations in NK models should be played by NGDP growth expectations. Switching to NGDP allows us to avoid reasoning from a price change, and avoiding mistakes like the claim that adverse supply shocks can be expansionary.

Companies do not care about inflation expectations; they care about total revenue expectations—which are tied in to NGDP growth.

Workers, by the same token, don’t necessarily care about wage rate expectations; they care about their expected future earnings, which are also tied to NGDP (aggregate spending) growth. When wage rates are expected to go up only because codes or strikes force them up, a rational, representative member of the labor force has no reason to expect to earn more. That’s one possible outcome, to be sure. But so is a higher probability of being unemployed. In the final analysis, Eggertsson’s clever argument turns out to be but a high-tech version of that highly-destructive old fallacy, the high-wage doctrine. In the original, workers only had to insist on higher wage rates, regardless of the state of aggregate spending, to make themselves better off. In Eggertsson’s version, they need only anticipate higher future wage rates to do so.

Alternatively, one might fault Eggertsson for treating the natural (“efficient”) interest rate as varying in response to what he calls a “preference shock” only, and not in response to changes to the actual and expected natural level of output. In contrast, it is generally understood (p. 12 and surrounding) that “if the average household becomes more optimistic regarding future [real income] growth rates, this will lead to an increase in the natural interest rate,” and that if households expect real income growth to decline, the natural real interest rate will decline as well.

But if a leftward-shift in aggregate supply, stemming from the establishment of NIRA codes, is allowed to both raise the expected inflation rate and lower the natural (or efficient) real rate of interest, one can no longer conclude that the codes will serve to reduce the gap between the efficient real rate and the real policy rate. It follows that Eggertsson’s story would only make sense if a representative household in the 1930s was rational enough to revise its inflation expectations upwards in response to the passage of the NIRA, but not rational enough to reduce its anticipated real earnings by a corresponding amount.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold
• Part 8: The NRA

_______________________

[1] As Christopher Hanes explains (p. 21), because “hourly earnings” can change as a result of increased overtime pay or workers shifting from lower to higher wage-rate jobs, movements in that measure give only an approximate indication of movements in average hourly wage rates. Unfortunately the only wage rate index available for the Great Depression period stops in 1935. Up to that point, however, the two measures do appear to move together.

[2] In their highly influential paper, Cole and Ohanian develop a general equilibrium model of the bargaining process between firms and workers. They then derive predicted paths for real wage rates for both cartel and competitive versions of the model, and conclude that the cartel version accounts well for the actual pattern of New Deal wage-rate changes. So far this is all consistent with the general thrust of this post. However, an important difference between my own perspective and Cole and Ohanian’s is that while they blame New Deal programs for boosting real wage rates, I hold that they mainly did harm by raising nominal wage rates: for any given level of aggregate demand and corresponding revenues, the number of labor hours firms can afford declines as hourly wage rates increase, regardless of how output prices behave. And, as Barro and Grossman explained back in 1971, it is in fact perfectly possible to have high unemployment despite the fact that real wage rates are at their competitive general equilibrium levels, provided that nominal wages rates and prices are both set at excessively high levels.

[Cross-posted from Alt‑M.org]

“In 1934, the government price of gold was increased to $35 per ounce, effectively increasing the gold on the Federal Reserve’s balance sheets by 69 percent. This increase in assets allowed the Federal Reserve to further inflate the money supply.” (“FDR takes United States off gold standard,” His​to​ry​.com, November 24, 2009.)

As I pointed out several installments ago, the recovery that followed FDR’s assumption of office was fueled almost exclusively by growth in the Federal Reserve’s gold holdings. As the following FRED chart shows, those holdings almost tripled during the four years following the nationwide bank holiday, allowing the M2 money stock to concurrently grow to 150 percent of its pre-holiday level. The result was a “Great Expansion” of real GNP that more than offset the “Great Contraction” of the preceding three years.

Today I’ll discuss the causes of the gold inflow that fueled the post-1933 recovery, and especially the part played by FDR’s decision to devalue the dollar. I hope to convince you that, although devaluation certainly helped, it was neither the only nor the most important reason why the U.S. monetary system, having shut-down on account of a gold shortage, soon found itself once again awash with precious metal.

Unto Caesar

Before we turn to consider what devaluation itself did or didn’t accomplish, I’d like add a bit more to what I said in my post on the bank holiday, which (among other things) addressed the pre-devaluation steps that got gold flowing into the Fed, not from overseas, but from American hoards. One of those steps consisted of telegrams the Federal Reserve Board sent to each of the 12 Federal Reserve banks on March 8th, requesting that they

prepare and forward to the Board as soon as possible after Mar. 13 1933, as complete a list as can be made from information you are able to obtain, of the names and addresses of all persons who have withdrawn gold from your bank or a member bank in your district since Feb. 1 1933, and who have not redeposited in a bank on or before Mar. 13 1933.

The Fed banks in turn asked their members to assist them by supplying “the names and addresses of persons who on or after Feb. 1 1933, have withdrawn gold coin or gold certificates from your bank and who have not, to your knowledge, redeposited the same in a bank on or before Mar. 13 1933,” together with “a separate list containing similar information, so far as available, regarding withdrawals of gold coin and gold certificates from your bank prior to Feb. 1, 1933.”

As The New York Times reported later that same day, these requests were made in response to direct instructions from FDR, who was anticipating the passage, on March 9th, of the Emergency Banking Act. Among its other provisions, that act would grant him the authority to prohibit the “export, hoarding, melting, or ear-marking of gold or silver coin or bullion… by any person within the United States or any place subject to the jurisdiction thereof.” It also stipulated that anyone who violated the prohibition might

be fined not more than $10,000, or, if a natural person, may be imprisoned for not more than ten years, or both; and any officer, director, or agent of any corporation who knowingly participates in such violation may be punished by a like fine, imprisonment, or both.

Considering these circumstances, it’s hardly surprising that bankers complied with the Fed’s requests, and that many of the hoarders whose names they’d divulged to the Fed rushed to redeposit coin and bullion. According to the March 10, 1933 New York Times,

repentant hoarders displayed a good deal of agitation, but they were received courteously by the guards of the reserve bank, and came out with an evident air of relief when they had disposed of their dangerous treasure.

When that Times report came out, $65 million in gold had already been returned to the Fed. By the end of the month, after the deadline for preparing and forwarding lists of gold hoarders was extended to March 27,th, the Fed’s gold reserves were up to $625 million, as compared to just $365 million on inauguration day.

But the government wasn’t through reining-in hoarded gold. On April 5th, Roosevelt issued Executive Order 6102, “forbidding the hoarding of gold coin, gold bullion, and gold certificates.” What had until then been a mere threat now became reality: those who still hadn’t surrendered hoarded gold or gold certificates now had until May 1st to return all but $100 worth of coins (excepting collectible coins and gold for non-monetary uses) to the Fed or face either or both of the stiff penalties allowed for by the Emergency Banking Act. On April 28th, FDR issued another Executive Order (No. 6260), calling for anyone who still possessed gold coin, gold bullion, or gold certificates, to file a return within 45 days with Internal Revenue Bureau documenting what they possessed, for whom, where, and what for. Finally, in a step worthy of Scrooge himself, the government revoked the $100 gold coin exemption three days after Christmas, forcing children to trade those shiny coins Santa put in their Christmas stockings for the Treasury’s paper certificates! But it only took until May 10th for the total value of gold coin and certificates returned to the Fed to reach $770 million—a sum roughly corresponding to the amount American’s had hoarded between the start of the year and the start of the national bank holiday.

Having corralled most of the nation’s gold back into the Fed’s coffers, Roosevelt then made sure it could no longer escape abroad. On April 20th, he issued another Executive Order (No. 6111) indefinitely continuing the restrictions on international gold transactions he’d imposed on March 10th (Executive Order No. 6073) and otherwise prohibiting “the earmarking for foreign account and the export of gold coin, gold bullion or gold certificates from the United States or any place subject to the jurisdiction thereof” except when licensed to do so by the Treasury Secretary. Finally, the same April 28th Executive Order that called for those possessing gold to report their holdings to the Internal Revenue Bureau spelled-out the special circumstances under which gold export licenses might be granted.

The Road to Devaluation

With most American gold safely ensconced in the Fed’s vaults, and strict limits placed on gold exports, the Great Contraction was over. But as we’ve seen, recovery from that contraction would take place only once the gold that had fled the U.S. during the depression started flowing back to it.

FDR eventually encouraged that return flow by reducing the dollar’s official gold content. But by the time he did so, gold’s market price had already risen to a level roughly corresponding to that change. FDR first let it rise on its own by letting the dollar float on April 19th, 1933. But when stock and commodity prices started sagging again in July, he decided to have the government intervene to deliberately boost gold’s market (London) price. The result, which FDR unveiled during his fourth fireside chat of October 22nd, was the controversial gold purchase program, aimed at deliberately regulating gold’s market price by having the RFC purchase it at prices set daily by FDR and his Treasury Secretary. From then onward the dollar’s depreciation became a deliberate object of policy, informed by George Warren’s controversial theory that a depreciating dollar would go hand-in-hand with a proportional rise in commodity prices. FDR hoped to reduce the dollar’s gold value enough to fulfill his long-standing promise to get commodity prices back to their mid-1920s level, and to do so before he settled on a new gold dollar.

So the dollar fell. Yet until January 31st, when its gold content was officially and permanently reduced from 25.8 to 15 5/21 grains of gold nine-tenths fine, the dollar’s depreciation did little to spur growth in either the U.S. gold stock or broader money measures. Instead—and despite increased world gold output—between March 1933 and the end of January 1934 the U.S. monetary gold stock shrank slightly, while M2 grew by little more than 2 percent—hardly enough to fuel a recovery. Real GNP, which had risen sharply during the weeks following the bank holiday, dropped just as sharply after July.

In contrast, as the next FRED chart shows, the new year would see more or less steady growth in all three measures, with the gold stock rising especially rapidly (note the different index scales on the figure; the one for gold is on the left) and M2 and real GNP growing at more modest but almost identical rates. These trends continued through 1935, 1936, and the first quarter of 1937.

Why was the dollar’s de facto devaluation between April 1933 and January 1934 less effective in luring gold back to the U.S., and in promoting money growth and recovery, than the de jure devaluation that followed? As Scott Sumner explains in The Midas Paradox (p. 238), with most former gold bloc currencies still fixed to gold, the RFC’s gold purchases could only raise gold’s market price by depressing other gold bloc nations’ price levels. Because the purchases themselves did nothing to raise U.S. prices, the terms of trade stayed unchanged. As the London Times reported on November 17th,

So far as [FDR’s] campaign has gone at present, it has had less effect in raising prices in America than in depressing prices and checking recovery in the rest of the world. It must moreover, continue to exert a deflationary influence until there is some plain indication of the level to which President Roosevelt intends to drive the dollar (quoted in ibid, p. 251).

In his famous December 1933 open letter to the New York Times, Keynes offered a further explanation for the gold purchase program’s failure to draw gold to the U.S. “The recent gyrations of the dollar,” he said, “have looked to me more like a gold standard on the booze than the ideal managed currency of my dreams.” They presumably looked that way to others as well. Here, from the 1934 Federal Reserve Board Annual Report, is a chart showing what they looked like to a Frenchman:

A drunken gold standard, Keynes argued, bred uncertainty, which favored neither foreign trade nor foreign investment. “In the field of gold-devaluation and exchange policy,” he concluded,

the time has come when uncertainty should be ended. This game of blind man’s bluff with exchange speculators serves no useful purpose and is extremely undignified. It upsets confidence, hinders business decisions, occupies the public attention in a measure far exceeding its real importance, and is responsible both for the irritation and for a certain lack of respect which exists abroad.

One tangible consequence of this lack of respect was a flight from the dollar. On November 18th the New York Times reported that $1 billion in American capital fled via sterling into gold, including some purchased on the open market “for private American accounts” (Sumner, p. 252n28). Clearly, if devaluation was going to aid recovery, it would have to be devaluation of the sober sort.

Yet even the drunken dollar may have accomplished something. Whatever Keynes and Frenchmen might think of it, the bulls of Chicago and Wall Street were at first keen on the dollar’s wobbly descent: much as George Warren predicted they would, stocks and commodities soared as soon as FDR let the dollar float; and for a while they kept on rising as the dollar fell. According to Sumner (Midas Paradox, pp. 197–8), who himself refers to the well-known articles of Peter Temin and Barry Wigmore (1990) and Gauti Eggertsson (2008), instead of rising in response to money growth, those exceptionally sensitive prices rose in anticipation of such growth, because they led traders to expect “a dramatic change [in] the future path of monetary policy.” Like the bank holiday, which started the process of recovery by quelling expectations of further deflation, and the April 19th prohibition of gold ownership, which succeeded in raising inflation expectations above zero, FDR’s gold purchase program did some good by further boosting inflation expectations.

In fact the RFC’s gold purchases were almost certainly too small to have mattered in themselves. Instead it was the government’s daily gold price settings that suggested to traders that it was testing the waters and would soon announce a permanent plunge. Traders’ reactions in turn supplied FDR with valuable information concerning just how high the dollar’s gold price would have to go to accomplish his goal of raising commodity prices to their 1925 level—too high, apparently, for when he finally devalued the dollar, commodity prices were still well below their 1925 level.

Still, it’s hard to resist the conclusion that, all things considered, FDR’s gold-buying program was a costly waste of time. It didn’t raise commodity prices as much as FDR had hoped it would; and whatever it did accomplish might have been accomplished sooner, and with much less turmoil, if instead of playing cat and mouse with speculators for four months, he’d taken advantage of the Thomas Amendment to throw the devaluation switch in October, if not before.

Gold Rush

As Sumner notes (p. 269), once the dollar was formally devalued, “gold flows continued to influence U.S. monetary policy, perhaps even more so than prior to 1933.” And as we’ve seen, so far as the U.S. was concerned, those flows were positive, persistent, and prodigious: between January 31st, 1934 and May 1st, 1939, the U.S. gold stock rose from $6,829 million to $15,795 million. The money stock rose with it, as did bank lending and investment, but they rose less than the Fed’s gold reserves did because the nation’s still-traumatized banks thought it wise to accumulate large cushions of excess reserves.

Why did the U.S. gold stock grow so rapidly after 1933? There were several reasons, not all of which had to do with the dollar’s devaluation. The most obvious reason was devaluation’s immediate effect on the dollar value of existing U.S. gold holdings, which rose at once by $2.8 billion. That didn’t mean, however, that the Federal Reserve’s gold holdings increased that much. In fact, for a while they didn’t increase at all, because the devaluation took place after the Fed swapped all its gold for the Treasury’s dollar-denominated gold certificates. The $2.8 billion paper profit from devaluation therefore went straight to the Treasury. Of that gain, $2 billion was used to establish the Treasury’s Exchange Stabilization Fund, while the rest, together with another $200 million in accumulated RFC gold purchases, went into the Treasury’s general Fed account. So long as the Treasury didn’t spend it, its windfall did nothing to promote growth in the U.S. money stock. But as the Treasury disbursed funds from its Fed account, member banks’ reserve balances increased by the same amount.

Because it cheapened the dollar, devaluation also altered the balance of trade, encouraging exports while discouraging imports. This change accounted for over a third of the $1,217 million in gold imports during 1934. Afterwards it typically accounted for much less. 1938, however, proved a banner year: during it, net U.S. merchandise exports alone drew in $1,133 million in gold—more than in any year since 1921.[1]

More aggressive gold mining, itself a consequence of both the dollar’s devaluation and that of other gold-bloc currencies, also increased U.S. gold reserves for several years, to the tune of about $1 billion each year.

Hot Money

But the most important source of new gold by far was foreign capital, vast amounts of which began pouring into the United States from the start of 1934, dominating the balance of U.S. international payments from then until the end of the decade. The inflow of foreign capital contributed $4,396 million to the U.S. gold stock between 1934 and 1938, or three times the amount added by net trade receipts. And it would contribute a lot more after that.

Although the start of this capital inflow roughly coincided with the dollar’s devaluation, the inflow had little to do with that step. Devaluation did matter for several weeks: by stabilizing the dollar’s gold value, it prompted the return of foreign capital that had taken flight when FDR started tinkering with gold’s price. After that, foreign capital came to the U.S. because the situation in Europe itself was becoming more and more precarious. War clouds, which began gathering there when Hitler became Germany’s chancellor in January 1933, thickened rapidly when he became its Fuhrer in August 1934.

From then onward, a steady stream of capital flowed in from Europe, with larger waves set off by each new European crisis. The first wave followed Hitler’s March 16th, 1935 announcement that he planned to rearm Germany. By May, Eric Rauchway writes (The Money Makers, p. 121), the French were “changing a billion francs a day into gold” to ship overseas. “All the steamers scheduled to depart France were loaded with the stuff.” As if the Nazi threat itself weren’t enough, the French also worried that “at any moment the government might devalue the franc, embargo gold, or institute exchange controls.” Italy’s invasion of Ethiopia (Abyssinia) that October started a second wave. Other waves followed the foreign exchange crisis brought about by Germany’s rearmament (August and September 1936), the Munich crisis (September 1938), Germany’s occupation of Prague (April 1939), the Nazi-Soviet pact (August 1939), Germany’s invasion of Poland (September 1939), and the first rumors of an impending invasion of France (November 1939). Perhaps surprisingly, European capital didn’t fly to the States following the Anschluss of March 12th, 1938. But that was so only because that the invasion took place while the U.S. was having its own crisis: the severe “Roosevelt Recession.”

These huge capital inflows weren’t just unconnected to the dollar’s devaluation: they had nothing to do with any New Deal policy. Indeed, far from seeking to attract capital from abroad, or welcoming it as it flew in, FDR and his Treasury team became increasingly worried that what they disparagingly called “hot money” would lead to unwanted… inflation! At last, in the late summer of 1936, they decided to do something about it. As I’ll explain in a later post, it was mainly owing to that decision that the promising recovery of 1933–1937 gave way to the aforementioned Roosevelt Recession, which undid a large share of the preceding years’ gains.

But if capital inflows were responsible for most of those gains, and if those inflows were neither planned nor encouraged by the Roosevelt administration, they can’t be included among the New Deal’s accomplishments. Frank Steindl makes the point more starkly: “without Adolf Hitler to spawn a capital flight to the United States,” he says, “virtually no U.S. recovery would have occurred before 1941.” Of course we owe Hitler no thanks for helping us to all that capital—which he did at Europe’s, and eventually the entire world’s, expense. But we can’t thank FDR for it, either.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday
• Part 7: FDR and Gold

__________________

[1] These and other details reported here about sources of U.S. gold inflows are mostly taken from Amos Taylor’s article, “Capital Movements in the United States Balance of Payments,” in the May, 1939 Survey of Current Business, pp. 12–14.

[Cross-posted from Alt‑M.org]

“The Lights Go Out in Lebanon as Financial Collapse Accelerates,” declared a recent headline in The Washington Post. The headline refers specifically to worsening power outages but more generally to Lebanon’s ongoing “economic implosion.” This breakdown is due in large part to chaos in Lebanon’s monetary and banking systems. Since October 2019 the Lebanese pound (also called the lira) has lost more than 80 percent of its value on the black market, with USD1 most recently trading around LBP8100. There is a black market because, although the Banque du Liban (the Lebanese central bank) continues to declare an official exchange rate of LBP1507.5 per USD, that rate is now available only to importers of a few favored goods.[1]

The peg became unsustainable, as pegged exchange rates invariably do, when the central bank created more money than was consistent with preserving parity between the purchasing power of its currency and that of the US dollar at the pegged rate. Instead of tightening when necessary to stop an outflow of dollar reserves, the Banque du Liban after 2016 began desperately to borrow from Lebanon’s commercial banks (at high interest rates) the dollars it needed to maintain the semblance of a peg. The commercial banks attracted dollars by passing those high rates on to depositors who presumably hoped to cash out before a devaluation came. The scheme, called “financial engineering” by Riad Salameh, long-time head of the Banque du Liban, devolved into Ponzi finance, racking up an estimated $40 billion in losses.

There are legal exchange houses in Beirut at which the dollar could recently be purchased for LBP3850, but residents may buy only small amounts there, creating a dollar shortage at that rate. Around 75 percent of bank deposits are in US dollars, but commercial banks since October have refused to redeem their dollar deposits in dollars (with remarkable legal impunity), allowing only conversion to LBP at the 3850 rate.

In June, Lebanon’s annualized inflation rate topped 50%. Imported goods’ prices have risen at a much faster rate with the depreciation of the pound.

The monetary chaos is not unrelated to Lebanon’s sovereign debt fiasco. Its ratio of sovereign debt to GDP is the world’s third highest (after Japan and Greece), above 150 percent and climbing with the annual budget deficit running 11.4 percent of GDP in 2019. In March 2020, the government defaulted on its external dollar debt. Behind this fiscal crisis is the tangled history of a state built on clientelism (legislative seats are apportioned among the major religious communities) and fueled by widespread corruption.

Is there a way back to a sane monetary system? Full dollarization offers a reform that has proven practical and effective in Ecuador and elsewhere.

Types of Dollarization

“Dollarization” means the transition from using a domestic fiat currency to using an external currency, typically the US dollar, as the monetary standard. Lebanon has long had extensive popular or unofficial dollarization, as seen in the popularity of dollar deposits. Popular dollarization spreads as the inflation rate in local currency rises. But an end to the current chaos in Lebanon requires full or official dollarization: a discrete event in which the national government adopts the external currency and shuts down the local currency.

Official dollarization usually follows unofficial dollarization. In Ecuador, for example, as the inflation rate in sucres rose ever higher in 1998–99, Ecuadoran households and firms one by one put themselves on a US dollar standard. They shifted savings into dollars. They posted prices in dollars, even when accepting payment in local currency, so that they didn’t have to reprice every day. Everyone followed the exchange rate daily. Sellers of high-ticket items wanted to be paid in dollars. Eventually every grocery shop wanted to be paid in dollars. Private sector wages began being paid in dollars. The driving force of this process is simple: people prefer to be paid in, and to hold, a money of relatively stable purchasing power to a rapidly depreciating money.

Lebanon is in the midst of the same process. Sellers of high-ticket and imported items want to be paid in dollars, which means that key transactions are blocked by the shortage of legal dollars created by the exchange-rate controls and freezing of dollar deposits.

By unofficially dollarizing their saving and spending and accounting, people dislodge their deteriorating official currency and spontaneously establish a de facto US dollar standard. A national government that relies on money-printing for revenue typically responds as the Lebanese government has, erecting an array of legal barriers to slow spontaneous dollarization. These legal restrictions put the government at odds with the citizens it is supposed to serve. Beirut’s popular street protests—leaving the central bank building adorned with graffiti—are testimony to the conflict. (“Protesters on the streets, who once revered Salameh’s ability to steer the financial system through bouts of unrest, now daub graffiti on the walls of the central bank,” reported Reuters in November.)

In January 2000, Ecuador’s government stopped fighting the people’s choice and officially switched to the dollar. One motivation was that nominal tax revenues in its own currency were not keeping up with inflation, reducing the government’s revenue in real terms. The government of Lebanon may yet respond to the same motivation. Official dollarization is the next step for Lebanon if it wants a better and less chaotic currency.

Official dollarization has a successful track record where it has been tried: Panama has held to its dollarized economy since 1904; the Turks and Caicos Islands since 1969; Ecuador since 2000; and El Salvador since 2001. Dollarization is so popular in Ecuador that even the left-wing government of Rafael Correa (2007–17), who complained that it was a “straitjacket,” dared not end it.

Benefits of official dollarization

Why does official dollarization succeed? Most simply, with prices in dollars and no local currency in circulation, the national government can no longer print money to pay its bills. The prices of traded goods, and of goods and services generally, are constrained by prices in the US and other dollar-using countries. Dollars will flow out if local prices exceed prices elsewhere. The local inflation rate is thus constrained by the US inflation rate. Before official dollarization, Ecuador in 1970–99 suffered a 28% average annual inflation rate. The rate rose into hyperinflation (> 50% per month) toward the end of 1999. Ecuador officially dollarized its economy in January of 2000. Since 2004, Ecuador’s inflation rate has averaged 3.1% per year.

Official dollarization benefits the public because it means that holding money is no longer taxed heavily. People no longer need to spend time and resources delaying payouts, speeding up collections, and keeping depreciating local currency balances low by making frequent trips to the currency exchange market. Prices of goods and services become less noisy, more informative, and more reliable, which enables longer-term household and business planning.

By reducing risk surrounding the future purchasing power of money, official dollarization makes interest rates lower and less noisy, both in nominal and in real terms. The reduced long-term risk opens a market for long-term loans. In Latin America most home mortgages in local pesos run only 5 years and then need to be rolled over at current rates. In the dollarized economy of Panama, however, 30-year fixed-rate mortgages are available. Although dollar loans are already available in Lebanon, it is risky to lend dollars to a borrower whose income is in Lebanese pounds, because devaluation makes the borrower unable to repay. With official dollarization, devaluation risk disappears for importers and exporters, which is very important for a small, trade-reliant nation like Lebanon.

Official dollarization also shields the currency, and therefore the private economy to a great extent, from government fiscal chaos. Even if the government defaults, as Ecuador did in 2008, and as Lebanon did in March, companies can still go about their business. A government teetering on the brink of insolvency can no longer resort to rapid money printing, with its results of high inflation and devaluation, to tax its citizens. It no longer has reason to impose financial and trade restrictions. When it has its own currency to print, by contrast, as economist John Cochrane put it, “the government’s problems infect the rest of the economy.”

Finally, official dollarization reduces instability in commercial banking. As the example of Panama shows, the Lebanese banks can call upon the Federal Reserve Bank of New York for supplies of fresh Federal Reserve Notes, and upon major New York commercial banks for standby lines of credit. With official dollarization the Banque du Liban would no longer conduct monetary policy. It could no longer drain banks of their dollar liquidity via “financial engineering,” turning the financial system into a Ponzi scheme. In Ecuador, the hyperinflation of the local currency caused a banking crisis, but within a few years following dollarization the commercial banks became stable and prudently run, and have remained so.

Of course, official dollarization is not enough to cure all economic problems. It does not guarantee that the government will keep tax rates moderate, balance the budget, stop doling out favors to clients, root out corruption, obey the rule of law, allow free trade, or welcome foreign investment.

It may be a blow to nationalist pride to give up a national currency that once was internationally respected. But living in the past is an expensive indulgence. Lebanese citizens should consider the words of an Argentine advocate for dollarization—and former head of the Argentine central bank—Pedro Pou: “We do not suggest that each country should produce every possible good. We are happy with the idea that we should import automobiles or TV sets from the more efficient producers; why should we not apply the same logic to money?”[2]

We can expect opposition to official dollarization in Lebanon from central bankers and their advisers, who sincerely think that they can do a better job of expertly steering the economy—despite all evidence to the contrary. We can expect it from politicians who think that the Banque du Liban’s power to print money can still benefit them personally. Never mind the Lebanese people clearly voting with their wallets and pocketbooks in favor of the dollar. Such policymakers either fail to think about dollarization as the market verdict resulting from choices of individual families and firms, or they simply don’t believe that those choices deserve respect. They think about the monetary system only as a tool to be engineered and manipulated by expert policymakers and analysts (presumably themselves).

How might Lebanon implement official dollarization?

The first step for Lebanon is to eliminate its dollar shortage by eliminating exchange-rate fixing and dollar rationing. The government need only dismantle legal barriers to buying and selling dollars at a market-determined price, to importing and exporting dollars in unrestricted quantities, and the dollar shortage will end. It should also let contracts that call for payment in dollars be specifically enforced in dollars, i.e. not allow debtors or renters to swindle creditors or landlords by forcing acceptance of payment in lira at the obsolete official rate. Let the public freely express its preferences regarding currencies.

The second step is to pass legislation to officially dollarize, converting taxation and government expenditure to the dollar and setting a path for the retirement of the lira. The examples of Ecuador and El Salvador can be studied with advantage. They recommend declaring a one-time conversion at the freed market rate (which will presumably be below the current black-market rate), and having the Banque of Lebanon redeem its lira liabilities with dollars at that rate.

There is a complication: It isn’t clear that the Banque du Liban has sufficient assets to retire its pound liabilities. It may be insolvent when its assets, especially sovereign bonds, are valued at market prices. The Lebanese government says that the central bank has lost about $50 billion. For his part, Mr. Salameh disputes that figure and claims that the bank has a positive net worth, but the Banque du Liban hasn’t produced a credible balance sheet to show its solvency. In any case, the bank is owned by the government. Accordingly, the Association of Banks in Lebanon in May called on the government to sell off enough state assets to repay the Banque du Liban’s borrowings from the commercial banks, in order to enable the banks to make depositors whole. The same proposal can be extended if necessary to redeem the Banque du Liban’s lira banknote liabilities with dollars.

Once the lira is retired, the Banque du Liban will be removed from monetary policy decision-making. If it continues to exist, its role can be refocused to that of supervising and auditing the commercial banks.

Would a currency board make more sense?

A currency board works in jurisdictions where the authorities can be trusted to play strictly by the rules. It has worked just fine in Hong Kong, where so far China has kept its hands off the Hong Kong Monetary Authority. It has the advantage, where it works, of yielding a bit of income to the government from the interest earned on the USD Treasury Bills held as reserve assets. Of course, that interest is next to zero today and probably will be for years to come. So the choice between dollarization and a currency board comes down to whether the Lebanese people trust their government to play strictly by the rules and resist the temptation to grab the pot of money sitting at the currency board.

Argentina’s example warns us of the dangers of a government cheating on an unorthodox currency board. In 1991 the Argentine central bank created a new peso, fixed to the US dollar at 1:1, and was supposed to keep at least 100% backing in USD assets. But the government compelled it to buy the dollar-denominated debt of the Argentine government, which traded below par value due to the risk of default. Thus the central bank began lending to the government and became under-reserved on a mark-to-market basis. There was a run against the peso for dollars, and the system broke its promise to buy back all the pesos at 1:1. (Worse still, the Argentine government took control of all dollar deposits in commercial banks and repaid them 1:1 in pesos simultaneous with devaluation, so it repaid only about 30 cents on the dollar.)

Outright dollarization, by contrast, eliminates the lira and with it any threat of devaluation and forced conversion of onshore dollar deposits into lira. It is not impossible to undo official dollarization, but it is impossible to undo it so suddenly, and much harder to undo even gradually.

What about a Bitcoin standard?

Some Lebanese already hold Bitcoin, and they should enjoy complete freedom to do so. Others save by accumulating gold. But few will find Bitcoin or gold currently suitable as an everyday medium of exchange. In contrast to dollars, hardly any sellers of goods and services inside the country accept payment in BTC or gold. (A 2019 Coindesk article on “How Lebanon’s Economic Crisis Highlights Bitcoin’s Limitations” mentions only a single retailer, a car dealer in Beirut, offering to accept Bitcoin.) The purchasing power of Bitcoin remains much too volatile for an everyday medium of exchange. It is imprudent to hold in Bitcoin the part of your monthly paycheck with which you plan to pay your rent, given the risk of Bitcoin’s value falling 10% or more before the rent is due.

A small country on a Bitcoin or gold standard would have dramatically volatile exchange rates against the rest of the world. A dollar standard, by contrast, eliminates exchange rate volatility against the world’s dominant medium of international trade.

Conclusion

The US dollar is not a perfect currency. But it needn’t be perfect to provide a vast improvement over Lebanon’s chaotic status quo. Annual inflation of 2 percent is far better than 50 percent. A free currency market is far better than one with price controls and discriminatory rationing. Full dollarization offers the best hope for turning the lights back on in Lebanon.

_________________

[1] This essay contains the gist of my remarks made via Zoom to an audience in Lebanon on Saturday, 18 June 2020. My thanks to Forrest Partovi and Jalal Hasbini respectively for arranging the event and for leading the discussion.

[2]Pedro Pou, “Is Globalization Really to Blame?” In J. S. Little and G. P. Olivei (eds.) Rethinking the International Monetary System (Boston: Federal Reserve Bank of Boston, 2000).

[Cross-posted from Alt‑M.org]

“The public plainly showed that it recovered from the fear and hysteria which characterized the last few days before the banking holiday was proclaimed.” (The New York Times, March 14th, 1933.)

During the opening days of March, 1933, the U.S. economy resembled a stricken body slowly bleeding out, its organs failing one by one. The Federal Reserve System was hemorrhaging gold, and entire state banking systems were shutting down one after another. If the economy was to survive and recover, FDR had first to staunch the bleeding, and then to arrange for a transfusion. Here I explain how he managed the first of these steps.

Panic at the Fed

Before we consider how FDR managed to end the nationwide banking crisis that broke out on the eve of his inauguration, let’s recall just how that crisis came about. It began with the official closing of Michigan’s banks in mid-February, 1933. Michigan’s decision led other states to start declaring holidays as well. In the meantime, fear of an impending devaluation led to both foreign and domestic runs on the dollar. Together these events set the stage for FDR’s declaration of a nationwide bank holiday on March 6th, two days after taking office.

So much for the barest facts. In Drifting Toward Mayhem, his superb but underappreciated history of the depression-era banking crises, historian Robert Lynn Fuller supplies many crucial details. Perhaps the most striking of these is that “hysteria” didn’t take hold of bank depositors until after state governments everywhere began shutting-down or limiting withdrawals from banks. Until then it was mainly commercial bankers and (most importantly) Federal Reserve officials who went into panic mode.[1]

During the “wave of fear” that immediately followed Michigan’s crisis, Fuller says, “the public remained mostly calm. …[D]epositors did not rush to their banks to withdraw cash.” Instead, the wave got started by bankers and state politicians who mostly reacted not to actual depositor runs but to “each other’s anxiety about what might happen.” The governors of Tennessee and Maryland followed Michigan’s example by declaring their own bank holidays, while those of 17 other states allowed their banks to limit depositors’ cash withdrawals. Unfortunately such responses only gave bankers elsewhere more reason to panic, by denying them access to correspondent balances that often made up a substantial share of their liquid reserves, or by making them fear they might lose access to those balances at any moment. The ensuing scramble for funds upped the pressure on governors who hadn’t yet done so to relieve the pressure on their banks.

As holidays and restrictions multiplied, ordinary bank depositors were bound to join the fray, not because they went berserk, but because they also feared being frozen out of their own accounts. Thus when crowds gathered to withdraw their savings from a bank, as they did in Newark, New Jersey on March 2nd, when they lined-up in front of the Howard Savings Institution, they did so, not because they feared it might be broke, but because they believed that New Jersey’s governor was about to declare a holiday that would put their savings out of reach. Fear of local holidays thus joined the growing fear that FDR would suspend gold payments to inspire people to get their money out of banks that were often not only solvent but understood to be so by those who ran on them.

Once one allows for such (perfectly rational) fears of both state bank holidays and devaluation, there isn’t much need, after all, for any appeal to depositor hysteria. This doesn’t mean that depositors never mistook sound banks for unsound ones during those months, and it certainly doesn’t mean that there were no unsound banks left after those around Detroit went belly-up. But it does cast doubt on the view that depositors had come to generally suspect their banks of being broke.[2]

No Holiday for Hoover

As we saw in the last installment, it was the run on the dollar, and especially foreigners’ part in it, that ultimately led the federal government to shut down the entire U.S. banking system. Although that run harmed commercial banks, it was less of an immediate threat to most of them than to the Federal Reserve System itself, and the New York Fed in particular, for it was a run out of dollars of all kinds and into gold, where that gold was most kept at the New York Fed. The final, fatal blow to the nation’s banks came when the “wave of fear” engulfed New York Fed officials who, Fuller writes (p. 397), “reacted against future expectations of actions by European central bankers, who acted on their own worries about the future of the dollar under President Roosevelt.”

It was those officials rather than ordinary bankers who first urged President Hoover to declare a nationwide bank holiday. When that attempt failed, they resolved to get New York State Governor Lehman to declare a state bank holiday. Because state governments lacked the authority to take action on the Fed’s behalf, they asked the New York Clearing House Association to join them in making the request. Because the Clearing House banks were themselves in remarkably good condition, and had no desire for a holiday, it did so only with considerable reluctance. Once New York’s banks were shut down, it was clear that all the still-open commercial banks in the rest of the country would soon have to close. Fed officials informed other state governors accordingly so that, by the time of FDR’s inauguration, state bank holidays had been declared almost everywhere. Most of the banks that were still open stayed so in defiance of state officials’ orders, presumably because they felt capable of weathering the storm.[3]

Yet the crisis still wasn’t over. While widespread state bank holidays stopped runs on ordinary banks, so far as the Fed was concerned, they were only a stopgap: although the holidays ended the drain of gold from the Fed to U.S. banks and their customers, they couldn’t stop foreign central banks from cashing their dollars in for gold. Only a national bank holiday declared by federal authorities could do that. The point deserves emphasis: the national bank holiday was needed not for ordinary banks’ sake but to keep the Fed from being forced off the gold standard. [4]

Why, in that case, hadn’t Hoover declared such a holiday when the New York Fed first urged him to, or even before then? Why did he leave it to FDR, allowing the Fed to lose that much more gold, and also allowing panic to damage more sound banks until state holidays finally shut almost all of them down? It wasn’t that Hoover was a cold-blooded Social Darwinist who “wanted to keep banks open and failing from panic until the weak banks had all collapsed,” as Eric Rauchway (Winter War, p. 199) claims. Hoover may have been pusillanimous; but he was by no means “inhumane” (ibid.). His problem wasn’t a lack of compassion but legal scruples; and those scruples were themselves not at all groundless, for while it was clear that no state governor could legally shut down the Fed, it was far from certain that he himself could do it legally.

It appears that Hoover’s advisors first contemplated using the authority of the 1917 Trading with the Enemy Act (as amended in 1918) to suspend or restrict the Fed’s gold payments in January 1932. Though nothing came of the idea then, by mid-February, 1933, when Michigan closed its banks, officials at both the Fed and the Treasury were urging Hoover to make use of it. Walter Wyatt, the Fed Board’s general counsel, went so far as to draft a resolution for the purpose. Hoover was eventually persuaded enough to consult both Carter Glass and William Mitchell, his Attorney General, about it. But both, and Mitchell in particular, doubted the plan could withstand a legal challenge unless the Democrat-controlled Congress gave it its ex post facto concurrence. Just what the consequences of a finding that the holiday was illegal would have been is far from clear. But Ogden Mills, Hoover’s Treasury Secretary, thought it would be “fatal” (Awalt 1969, p. 358).

So Hoover hesitated. Over the coming days, as the monetary system crumbled around him, he made various attempts to persuade FDR to publicly support his resolution, and to otherwise secure Congress’s backing. To shorten a long story that flatters neither of its main protagonists, between them Hoover’s haughtily ham-handed approaches to FDR, and the fact that FDR had little politically to gain by cooperating with him, ruled-out any hope that Hoover’s effort would succeed. Hoover accused FDR of wanting to blacken his reputation at the nation’s expense. FDR in turn wondered why Hoover couldn’t muster-up the pluck to close the banks without his help. Each had a point; and both therefore deserve some blame for the fact that a national bank holiday wasn’t declared until two days after FDR became president.[5]

His Finest Week

Regardless of how it fell to FDR to put it into effect, the national bank holiday that began on March 6th and ultimately ended on the 13th was to be among the greatest achievements, if not the greatest single achievement, of his first term in office. Yet the holiday was much less a New Deal achievement, and much more one for which the Hoover administration deserves credit, than is generally appreciated. Although FDR took the lead and played his part brilliantly, his performance was based on a script much of which had been prepared while Hoover was still president, or by Hoover Treasury officials who stayed on to help FDR’s still very green team orchestrate the closing and reopening of the nation’s banks.

To realize just how much Hoover’s men contributed, it helps to first review the timing of the holiday and public events surrounding it. FDR was sworn in on the afternoon of March 4th, a Saturday. Thirty-six hours later, at 1 A.M. on Monday the 6th, citing the authority granted him by the 1917 Trading with the Enemy Act, he issued his proclamation closing the banks and prohibiting any export or sale of gold until March 9th. On the evening of the 9th, at the end of an emergency joint session, Congress passed the Emergency Banking Act, retroactively amending the Trading with the Enemy Act so it could be used not just during a war but “during any other period of national emergency declared by the President.” Later that same evening FDR signed an executive order, dated Friday, March 10th, extending the bank holiday until March 13th but continuing the moratorium on gold exports indefinitely. Finally, on March 12th, he gave his first and most famous fireside chat, explaining what had taken place and the procedure by which sound banks would begin reopening in stages starting the next day.

We’ve already seen how the idea of using the Trading with the Enemy Act to close the nation’s banks and suspend gold payments had first been considered by Fed officials in 1932 and proposed to Hoover well before FDR took office. FDR’s proclamation of the 9th was also one Hoover’s Attorney General had prepared for his signature, with some advice from Fed officials, several days before. Several of the five Titles of the Emergency Banking Act had also been drafted before—in some cases months before—FDR took office, and some outgoing Hoover officials spent inauguration day helping to draft the rest. One of them—Treasury Secretary Ogden Mills—came up with the plan that, with minor modifications, was used to reopen the banks. Finally, apart from astute rhetorical changes made by FDR himself, the text for FDR’s famous fireside chat was drafted by Hoover’s Treasury Undersecretary, Arthur Ballantine. Nor is it likely that the incoming administration could have managed without all this help. On the contrary: FDR’s own team, including William Woodin, his Treasury Secretary, came to Washington with no similar plans of their own, and were accordingly grateful for the help.

Under the circumstances, it seems only fair to conclude that, although chronologically speaking the national bank holiday, the steps taken during it, and the reopening of the banks that followed, all belong to the New Deal, which must therefore be credited for any part they played in the recovery, Hoover’s “old Deal” also deserves some of that credit.

Confidence Tricks

Whoever may deserve credit for it, the fact remains that the nationwide banking holiday marked the turning point of the Great Depression. With it the “Great Contraction” that began in 1929 came to an end. And afterwards, as the banks reopened, a recovery began that would continue, with fits and starts, until the summer of 1937. That recovery wouldn’t have been possible had the public not been convinced not only to quit withdrawing money from their banks but to start putting it back into them.

Conventional wisdom attributes this amazing revival of trust in the banking system to Roosevelt’s confidence-inspiring “chat,” and especially to the public’s willingness to take him at his word when he promised that banks would reopen only once they were determined to be sound. According to this view, depositors no longer had to judge for themselves whether an open bank might fail, and so had no need to hesitate to place their life savings with it.

It’s a pleasant story. But it’s hardly plausible. Though FDR’s words were certainly encouraging, and may have assuaged some depositors’ concerns, they could hardly have won over the many sophisticated bank customers who knew perfectly well that there weren’t enough bank examiners around to thoroughly go through thousands of banks’ books, with less than a week at their disposal, to determine which ones were solvent. The situation that confronted bank examiners in the New York Fed district was presumably not unique. As Barry Wigmore (1987, p. 752) reports, they complained that it wasn’t “humanly possible…to appraise with accuracy” the banks they’d been asked to appraise.[6] More importantly, neither FDR’s remarks nor any proof of commercial banks’ soundness could quell the fears of devaluation that informed the biggest run of all—namely, that by foreigners, and foreign central banks especially, to convert dollars into gold. It was, once again, that run, rather than any general loss of faith in the country’s surviving commercial banks, that had been the final straw that made a federal banking holiday necessary in the first place.

Yet within three days from the end of the national banking holiday, thousands of banks had been licensed to reopen, including more than three-quarters of the 5,916 national banks closed by proclamation. And their customers did not rush to withdraw the money still left in them. What, then, was the real key to the reopenings’ success? William Silber claims that it consisted of steps that amounted to a full if only implicit guarantee of deposits in reopened banks. First, among its other provisions, the Emergency Banking Act allowed Federal Reserve Notes to be backed, not only by gold, commercial paper, and U.S. government securities, but by any “notes, drafts, bills of exchange, or bankers’ acceptances”—that is, by just about any Federal Reserve bank assets. Second, in his fireside chat, FDR promised that new currency was “being sent out by the Bureau of Engraving and Printing to every part of the country,” so that “banks that reopen will be able to meet every legitimate call.” He in turn had his Treasury Secretary promise to indemnify the 12 Federal Reserve banks for any losses they incurred in fulfilling his commitment to the public. This arrangement, Silber says, amounted to a 100-percent deposit guarantee—that is, a guarantee far more complete than the one that took effect when the FDIC began insuring deposits the following January.

But Silber’s argument isn’t the whole story. Like arguments that credit FDR’s soothing words or people’s naive confidence in bank examiners for restoring depositors confidence, it overlooks the fact that many depositors had never distrusted their banks in the first place: if they took their money out, it was because they feared either that the dollar would soon be devalued or that state authorities were about to make their accounts inaccessible. For banks that had not been suspected of being unsound before the national holiday, no new guarantees were needed.

The nine large banks of the New York Clearing House Association were a case in point. With one notable exception, they were, despite everything, in remarkably solid condition when Governor Lehman closed them; and it’s for that reason that their examiners, for all their carping about lacking time for proper audits, approved all but the one for reopening on March 13th—the day the nationwide holiday ended.[7] Nor were New York’s banks unique: more than half of the 15,000-odd national, state and private banks closed en masse by state authorities, representing 90 percent of closed bank assets, were judged perfectly safe and ready to open that week on the basis of perfunctory assessments that mainly reflected the general understanding, shared by savvy depositors and regulators alike, that the banks in question had never been in any danger of failing. The remaining, closed banks were another matter; but these were opened, if at all, only after steps were taken to assure their solvency, whether by bolstering their capital or otherwise.

But what about gold? So long as devaluation fears persisted, how could people be induced to hold either bank deposits or paper dollars instead of gold itself? They had, first of all, to be prevented from withdrawing any more gold from their banks. This much had been largely accomplished by FDR’s March 6th bank holiday proclamation, which among other things provided that no “banking institution or branch shall pay out, export, earmark, or permit the withdrawal or transfer in any manner or by any device whatsoever, of any gold or silver coin or bullion or currency or take any other action which might facilitate the hoarding thereof.” Although FDR’s subsequent proclamation of March 10th announced that the banks would begin reopening on March 13th, the same proclamation continued the suspension of gold dealings indefinitely. The domestic run on gold that played so large a part in the banking troubles of the last several weeks would never trouble U.S. banks, or the Fed, again.

This leaves but a single conundrum. For people didn’t just quit exchanging paper dollars for gold. Many also hastened to return gold they’d been hoarding, and did so well before the notorious April 5th, 1933 Executive Order (No. 6102) prohibiting gold ownership outright. By May the Federal Reserve System had recovered more gold than it had lost since the start of February. Yet devaluation, far from having become unlikely, was daily becoming more likely than ever.

Why, then, were Americans seen literally lining up to hand their gold back to the Fed on March 9th, before their banks had even reopened? Eric Rauchway (The Money Makers, p. 52) claims that they were glad to take advantage of the governments’ offer to take “a great burden from them…by accepting their gold for safe paper money,” as if they hadn’t always had the option of holding paper dollars instead of gold, and as if gold were not “safer” than nominal paper equivalents that everyone expected to see devalued!

Evidently Professor Rauchway was either unaware of, or chose not to draw attention to, a more obvious reason why gold started flowing back into the Fed, to wit: that on Wednesday, March 8th, just before all those long lines formed, the Federal Reserve Board announced that the Fed banks had compiled lists of those “unpatriotic” persons who had withdrawn gold from the system during the preceding weeks, and that it planned to have the press publish them if they didn’t bring the gold back at once (Fuller, p. 465). At least one Fed bank—Philadelphia’s—also threatened to refuse to supply currency to member banks that didn’t help it identify such unpatriotic citizens. According to Fuller “This tack served its purpose.” That Friday alone $200 million in gold coin and bullion came back. Soon Fed officials were able to report that they now had all the gold backing they needed for their notes, so that the requirement no longer had to be suspended. Whatever FDR’s fireside chat accomplished, it can’t be credited with this gold inflow, most obviously because the gold started coming back before the chat, but also because FDR offered no assurance against devaluation, fear of which had prompted gold hoarding in the first place.

***

Intimidation was all well and good for getting Americans to bring their gold back to the Fed. But it couldn’t do a thing about any of the gold that had escaped abroad. Getting that gold, or at least some of it, to come back, would take different measures. Just what those measures were, and how they worked, will be the subject of our next installment.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises
• Part 6: The National Banking Holiday

___________________

[1] Fuller’s book is, unfortunately, out of print. So is Phantom of Fear, a latter book by him, dealing with the 1933 crisis only, which I wasn’t able to consult in writing this post.

[2] According to the Commercial and Financial Chronicle for April 8th, 1933, while foreigners’ fear that the U.S. would be forced off the gold standard was the proximate cause of heavy gold losses the Federal Reserve Bank of New York suffered during the first days of March, and on Friday, March 3rd especially, those losses were in turn “largely responsible for the domestic distrust which came concurrently and so greatly added to the home propensity to hoard.” Based on a painstaking econometric study of the role of fundamentals versus panic-based withdrawals in depression-era banking crises, Calomiris and Mason (2003) find the crisis that began in January 1933 was the only one in which a nationwide “panic” appears to have played an important role. However, they note that what their model identifies as a “panic” effect may actually be fear of devaluation that the Chronicle refers to. That Calomiris and Mason also find some evidence of a nationwide “panic” in the fall of 1931, when Britain’s suspension of the gold standard also inspired a run on the dollar, lends further credence to this possibility. (The month of October 1931 witnessed 522 bank suspension—a record that held until March 1933.) Calomiris and Mason don’t mention the possibility that fear of state bank holidays may also have contributed to the 1933 crisis.

[3] Fuller (Drifting, chapter 12) refers to numerous examples of such banks.

[4] Although state governors technically lacked the authority to close national (as opposed to state-chartered or private) banks, that problem had been separately dealt by a February, 25th Joint Resolution allowing the Comptroller of the Currency to “exercise to such extent as he deems advisable with respect to any national banking association any powers which the State officials having supervision of State banks, savings banks and/​or trust companies.”

[5] Concerning the Hoover-FDR stalemate, see Fuller chapter 13, Susan Kennedy, The Banking Crisis of 1933, pp. 135–151; and Jonathan Alter, The Defining Moment, chapter 26. Because Alter’s book is generally very sympathetic to FDR, his conclusion (p. 181) that “it is hard to avoid the conclusion that he intentionally allowed the economy to sink lower so that he could enter the presidency in a more dramatic fashion” is especially telling.

[6] In a very interesting working paper of which I became aware only after this essay was nearly complete, Peter Conti-Brown and Sean H. Vanatta argue that, despite their limited numbers and the short period of time available to them, the bank examiners’ efforts were actually crucial to the bank holiday’s success, because in identifying and refusing to open unsound banks, they gave credibility to FDR’s claim that reopened ones were indeed “sound.” I agree that the bank examiners played a more important role than is often recognized; and Conti-Brown and Vanatta argue this much compellingly. I suspect nonetheless that they exaggerate the extent to which the public had lost confidence in banks closed by state holidays rather than because examiners concluded that they were financially unsound. There were, no doubt, depositors who needed to be reassured before returning to such banks. But there were also many who never doubted that their banks were sound. That many proved to be sound in fact made examiners’ task less fraught than it might have been otherwise. Their task was nonetheless delicate, for it fell on them to limit the Treasury’s exposure to losses it might otherwise have incurred by having promised to indemnify the Fed for any loss it incurred in guaranteeing the deposits of reopened banks.

[7] The lone exception, Harriman National Bank, went into receivership in October 1933. Joseph Harriman, its chairman and former president, had by then been arraigned for fraud, for which he was found guilty and sentenced to several years in prison in 1934.

[Cross-posted from Alt‑M.org]

Today, when we speak of ways to fight recessions, two options inevitably take pride of place: expansionary Fed policy (meaning lower interest rates or more asset purchases or both) and expansionary fiscal policy (more government spending or lower taxes or both).

But if you’ve been keeping up with this series, you’ll know that, although the U.S. economy rebounded between March 1933 and early 1937, neither expansionary fiscal policy nor Fed actions of the sort we count on today deserve much credit for that rebound. Instead, the Treasury and the Fed played only bit parts, while the spotlight shone on FDR and his virtuoso gambol with gold.

FDR’s handling of gold helped the U.S. economy recover from the Great Depression in part by getting the precious metal to flow into it, countering the persistent effects of a previous gold drain. That drain led to a nationwide banking crisis that brought the U.S. economy to its knees just before FDR took office. Before I can explain how, and to what extent, FDR’s gold policies contributed to the recovery, we must step back in time to consider the causes of the banking crisis, including the part gold played in it.

A Weak Banking System

To understand how the world’s largest economy ended up shutting-down its entire banking system, one must first be aware of a long-standing defect of that system and of how it led, first to the proliferation of small and under-diversified banks, and then to as many bank failures.

That crucial defect, which dates to the earliest days of banking in this country, and which afflicted the vast majority of banks in the years leading to the depression, was “unit” banking. A unit bank is one that does business only from its headquarters, instead of also conducting it at branches set up elsewhere in the same state, if not in other states. Although branch banking is now the rule, for most of U.S. history it was the exception. In 1920, branching was altogether prohibited in 18 states; in most other places it was allowed on a limited basis only. Until as late as the 1980s, branching across state boundaries was virtually unknown.

Even before World War I, the combination of unit banking laws and low regulatory capital requirements in many state banking laws (the minimum capital requirements of nationally-chartered banks tended to be higher) had resulted in a banking system consisting mainly of large numbers of very small banks. Because the U.S. was then a predominantly rural nation (not until 1920 would more Americans live in cities than in the countryside), and farm output made up about 25 percent of total private GDP, most of these banks served rural communities, whose business was farming. Their fortunes were therefore necessarily bound up with those of the farmers they served, which often turned on the profitability of a small number of crops, if not of a single crop. The opportunities for diversification of unit banks in larger towns and cities were also limited, though not so severely.

Unit banking made U.S. banks highly vulnerable to major economic shocks. So it’s hardly surprising that occasional panics, like those of 1884, 1893, and 1907, witnessed clusters of bank failures, including though not always limited to failures of rural banks. But between them the 1907 panic and World War I made matters much worse, by encouraging the creation of many new banks of the weakest sort, setting the stage for unprecedented bank fatalities.

The change brought by the Panic of 1907 consisted of deposit insurance schemes set up in eight states (Oklahoma, Kansas, Nebraska, Texas, Mississippi, South Dakota, North Dakota, and Washington) between then and 1917. According to David Wheelock, the premiums banks paid in these systems were small in comparison with, but otherwise unrelated to, the riskiness of their loans and other investments. Insurance therefore subsidized risky banks in states that adopted it.

The Great Farm Boom and Bust

But WWI would indirectly do even greater harm to the banking system. Because the war shut-down many European farms, and troops needed to be fed, crop and livestock prices rose sharply, encouraging U.S. farmers and ranchers to extend their acreage. Then, when the U.S. entered the war, the Agricultural Extension service egged farmers on further with a vigorous campaign aimed at getting them to contribute to the war effort by farming more intensively with the help of tractors and new methods of pest and weed control. More new banks popped up in turn to finance farmers’ purchases of land and tractors and other inputs using credit secured by mortgages. Between them, subsidized deposit insurance and the WWI farm boom caused the number of banks to more than double, from 12,427 in 1900 to 30,291 by 1920. Bank lending to farmers itself doubled between the start of the War and 1920.

After the war, crop prices fell as sharply as they’d risen during it (see the chart below, reproduced from an article by Joe Belongia and Alton Gilbert), triggering a farm crisis that was to ruin many farmers over the course of the next decade, often bringing their banks down with them.

In 1921 alone, over 500 banks failed, topping the previous record reached during the Panic of 1893. The 1921 failures coincided with the general, severe depression of that year. But while most industries recovered quickly from the depression (and did so with little help from either the Fed or the Treasury), agriculture and banking didn’t. Instead, as the next chart (H/T “Lord Keynes”) shows, bank failures mounted, with almost twice as many banks failing in 1926 as had failed in 1921. By the end of the decade 5,411 banks had failed, over 80 percent of them rural. Sure enough, four-fifths of the failures were in states that altogether prohibited branch banking, and failure rates were higher, other things equal, in states with deposit insurance than in those without it. Nor did those state deposit insurance schemes spare depositors from losses: every one of them failed during the 1920s, and every one of those failures save that of Texas’s guarantee fund left depositors with losses.

Still another chart (from a very good paper by Lee Alton, Wayne Grove, and David Wheelock) shows the predominance of rural banks among those that failed:

Depression-Era Changes

After the 1929 crash, rural banks kept on failing. But their ranks were joined by increasing numbers of urban banks, especially during a series of banking crises culminating in the systemic crisis of early March 1933.

Until that final crisis, fundamentals—that is, poorly performing bank loans and investments, as opposed to panicking depositors—continued to account for most bank closings, including some spectacular ones. One difference was that prices for securities and other assets banks either owned outright or held as collateral against loans now declined as precipitously as crop prices had declined after the war, putting more urban banks in jeopardy, including some larger ones. These included a chain of banks owned by Caldwell and Company in Tennessee and some surrounding southern states, which failed in November 1930, and the New York-based Bank of United States, which when it collapsed a month later was the largest U.S. commercial bank to fail up to that time.[1]

Nor did falling crop and livestock prices cease to take their toll. In October 1932, not quite a year after Rogers Caldwell’s banks went under, a dozen Nevada banks owned by George Wingfield found themselves in hot water thanks to depressed livestock prices. The twist was that those banks were the source of more than 75 percent of Nevada’s bank credit. On October 31st, after loans from the Reconstruction Finance Corporation proved insufficient to save Wingfield’s banks, Nevada governor Fred Balzar decided to buy time for them by declaring a twelve-day bank holiday that was eventually extended until December 18th. Wingfield’s banks were ultimately saved by merging them, with the help of some supporting loans, to form the Bank of Nevada. But by then Balzar’s holiday idea had itself become a scourge to bankers that was about to engulf every bank in the country.

Going for the Gold

Bank holidays, starting with Nevada’s, were only the most notorious manifestation of a new factor that had come to join bank fundamentals as an important cause of banking troubles: fear.

The first wave of fear to wash over U.S. banks came not from panicking depositors but from Europe, where it was set in motion by the Bank of England’s decision to suspend gold payments. That decision caused other European central banks, and those of Belgium and France especially, to withdraw gold from the United States to bolster their own reserves. By the end of October, the U.S. gold stock had shrunk by $320 million. According to Susan Kennedy (p. 30), “The rush from abroad to convert dollar balances into gold frightened American depositors,” causing them to start hoarding gold themselves. By November 7th they’d withdrawn another $500 million in gold. The withdrawals put that much extra stress on an already badly strained banking system. During October alone another 522 banks, with almost half a billion in deposits, failed.

President Hoover countered these developments with an anti-hoarding campaign and by establishing the National Credit Corporation on October 17th. When the NCC—a voluntary, banker-funded and operated credit pool—proved inadequate, he encouraged Congress to pass the Reconstruction Finance Corporation Act, which he signed on January 22nd, 1932.[2] By the start of March 1932, the government-funded RFC had made a thousand loans, mostly to banks and trust companies, and they seemed to help: only 46 banks failed that month, compared to 342 in January.

In the meantime, however, domestic and foreign gold withdrawals reached the point of making Treasury Secretary Ogden Mills declare, on February 7th, 1932, that the country was within two weeks of having to either default on its foreign obligations or violate the Fed’s gold reserve requirements. It was this close call that inspired the passage, on February 27th, of the first Glass-Steagall Act, allowing Federal Reserve notes to be backed by Treasury securities instead of either commercial paper or gold. Unfortunately, badly needed structural reforms, including a plan to ease barriers to branch banking, which was tenaciously fought for by Carter Glass but just as doggedly opposed by Henry Steagall, failed to make it into law.

Despite the lack of fundamental reform, and thanks in part to the RFC’s emergency loans, the banking situation calmed down that spring. By late spring it seemed to some that the worst might be over. In New England especially, economic conditions were improving; and commodity, stock, and output figures started moving up. Gold even started coming back into the banks’ coffers. Hoover began to hope his policies would be vindicated after all, cinching his reelection.

But things didn’t turn out that way, in part because the presidential campaign itself ended up rekindling depositors’ fears.

Campaign of Fear

The false dawn ended abruptly that June when Chicago and surrounding towns suffered another wave of bank failures, though one still confined to insolvent banks. Late summer brought another lull, but that also proved misleading. New England’s example wasn’t followed elsewhere. Instead, conditions worsened. By the fall not only Nevada’s banks but banks everywhere faced new runs that caused them to rein-in their lending. As Susan Kennedy (Banking Crises, p. 131) notes, although at first the runs’ targets were still mostly rural banks, runs on metropolitan banks became increasingly common.

For all his efforts to shore up ailing banks and all his preaching about the importance of confidence, Herbert Hoover unwittingly contributed to banks’ troubles by sowing seeds of suspicion. He did so, first of all, during an October 4, 1932 campaign speech in Des Moines, when he revealed how close the country had come that February to defaulting on its gold payments. As Scott Sumner explains in The Midas Paradox (pp. 141–2), although Hoover had hoped to rack-up kudos for having saved the situation, he merely succeeded in raising new doubts concerning the state of the U.S. gold stock: within days, the dollar had fallen sharply against other gold-standard currencies, and was said by the New York Times to appear “feeble and delicate.” Having been repeatedly assured until then that the dollar was rock solid, depositors now had reason to distrust such assurances. Because of this, Paul Einzig (quoted in ibid., p. 142n19) observed, when a run on the dollar started some months later, “no official reassuring statement was able to restore confidence.”

If in Des Moines Hoover unintentionally undermined voter’s confidence in his own government, both there and elsewhere he very deliberately tried to undermine their confidence in his opponent, declaring (among other things) that he planned to tinker with the gold standard. As we’ll see, when FDR finally resorted to it, devaluation would help to bring gold rushing back into the U.S. monetary system. But devaluation is one thing; the prospect of devaluation is quite another: if people, at home or abroad, anticipate the reduction of a currency’s gold content, to avoid a capital loss they’ll want to trade their paper notes, deposits and securities denominated in that currency for gold itself. So the more who believed Hoover’s lurid account of FDR’s plans, the more banks and the dollar suffered.

Yet FDR did little to assuage their fears. In fact, as he told his own staff, he had no idea whether the country could stay on the gold standard, and he wished to avoid committing himself to it for that reason. But he could hardly declare that he was not committed to it—not without guaranteeing a crisis. So he mostly left it to others, including Carter Glass, to deny Hoover’s charges; and when he did reply himself he did so obliquely, as when, in a November 4th speech at the Brooklyn Academy of Music, he accused Hoover of conjuring up a “rubber dollars” bogeyman. During the interregnum FDR, pressed more and more, said less and less. As inauguration day approached, the exchanges again turned against the dollar. “Uncertainty over Roosevelt’s plans for the dollar,” Sumner says (p. 181), “was most responsible for this change in sentiment.”

Panic in Detroit

Faith in the dollar could only weaken so much before it broke; and several developments in early 1933 hastened that breaking point’s arrival. The first serious blow came on January 6th, when Congress’s decision to name banks that received RFC assistance “exposed even saved banks to heavy withdrawals by frightened depositors” (Kennedy, p. 132). Then, in early February, runs on some New Orleans banks caused Huey Long to declare that the state would take two days holiday to commemorate the United States’ decision to sever diplomatic ties with Germany sixteen years earlier. More serious still was the Detroit banking crisis. Detroit was a one-industry town, whose banks were mostly owned by just two companies: the Guardian Detroit Union Group, comprising 31 banks, and the 40-bank Detroit Bankers Company. By the start of 1933 several of these banks, including the Guardian Group’s Union Guardian Trust Company, were in trouble, both because automobile sales had collapsed and because their holding companies had been squeezing fat dividends from them.

Come mid-January it was clear that Union Guardian Trust couldn’t survive without help, which it tried to get from the RFC. But the RFC couldn’t lend it enough on the collateral it had to offer. All hopes now rested on the possibility of further local support, including Henry Ford’s agreement to “freeze” his $7.5 million deposit with the Trust, in effect reducing its current liabilities by a like amount. Alas for Detroit, Ford not only refused to go along, but threatened to cash in his firm’s deposit at Detroit’s First National Bank—the Detroit Banking Group’s flagship. When failed pleas from RFC and other regulatory authorities, and ultimately from Herbert Hoover himself, made it clear that Ford wasn’t bluffing, only two options remained: either Michigan could declare a bank holiday, as Nevada and Louisiana had done, or upon reopening for business the next day most of its banks would fail. At last, in the small hours of Valentine’s Day, Comstock declared a holiday.

Although it gave Michigan’s own bankers a breathing spell, Comstock’s declaration was bad news for bankers elsewhere: fearing that their own governors might follow Comstock’s example, depositors in other states rushed to withdraw their money. Their prophecies were self-fulfilling. State banking systems started shutting-down one after another, like so many dominoes toppling: New Jersey on February 20th; Maryland and Ohio on the 25th, and a dozen other states before March 2nd. By the 3rd, another two dozen states had shut their banks down.

A Run on the Dollar

Yet those holidays weren’t themselves the last straw. What finally precipitated the national bank holiday was not a general loss of confidence in the nation’s commercial banks but the growing conviction, both at home and overseas, that the gold standard’s days were numbered.

Several developments informed that conviction, including an attempt, in January, to provide for devaluation in the (ultimately doomed) Glass-Steagall bill that was then being considered. The most upsetting of these happened in the second week of February, when word got out that Carter Glass had refused to serve as FDR’s Secretary of the Treasury because FDR would not promise not to devalue the dollar. Pressed about his intentions, FDR became more taciturn than ever. Soon a full-fledged run on the dollar had begun. By its end, $1.8 billion in paper currency had been withdrawn from the banks, of which almost a third—$563 million—was afterwards presented to the Fed for payment in gold. Before long the Federal Reserve Bank of New York, where most of the nation’s gold was kept, had lost so much gold that it had to suspend its gold-reserve requirement.

As I’ve explained elsewhere, it was not commercial bankers but the leaders of the New York Fed

who first pleaded for a national bank holiday, and who were relieved when New York State Governor Herbert Lehman declared a state banking holiday that anticipated the national one. The significance of this becomes all the more apparent when one considers that officials at several of New York’s biggest banks, fearing such a holiday would damage their banks’ reputations, argued against it, telling Lehman that they’d “rather stay open and take their beating.”

Those New York banks were actually well-prepared to withstand a beating that February. They joined the New York Fed in asking Lehman to declare a holiday only because George Harrison, its governor, asked them to do so to keep the public from realizing that the Fed itself had its back against the wall. Once Lehman agreed, officials at the other Fed banks began urging the governors of states in their districts that had not yet declared holidays to do so. When FDR took office on March 4th, most of the banks in the country had temporarily closed.

No System-wide Gold Shortage

Paradoxically, although a shortage of gold at the New York Fed was the proximate cause of the national bank holiday, the Federal Reserve System was never short of gold. Instead, as the next FRED chart shows, at its nadir, the Fed banks’ gold stock (red line) was worth almost $3 billion, or almost 55 percent (green line) of its combined note and member bank deposit liabilities (blue line). As against that the law required only two-thirds of that amount.[3] In other words, when the New York Fed pled for the holiday that eventually shut down the entire U.S. banking system, the Fed banks still had $1 billion in gold to spare.[4]

“It is difficult to imagine a more shocking indictment of U.S. monetary policy,” Scott Sumner says (Midas Paradox, p. 149), “than the fact that on the day FDR took the United States off the gold standard it still held over 37 percent of the word’s gold stock.” It is indeed. But how could it have happened? The sadly prosaic answer is that the Federal Reserve System failed. The System failed first of all by not taking advantage of its statutory power to temporarily relax the Fed banks’ high gold reserve requirements. When, the day after FDR had declared a nationwide holiday, Senator Glass asked Governor Harrison why the New York Fed asked for a holiday when it still held substantial amounts of gold, he received the perfectly unsatisfactory answer that, had it not done so, it would eventually have run out!

The Fed banks also failed by not cooperating with one another. Officials at the Chicago Fed in particular pointedly refused to help their New York counterparts by buying or re-discounting some of the New York Fed’s securities. Not only didn’t they help: at one point they threatened to stage a run of their own on the beleaguered New York bank![5]

***

Although this series is mainly concerned with the New Deal, and specifically with its contribution to ending the Great Depression, no account of that contribution would be complete without a discussion of FDR’s handling of the national bank holiday and his consequent dethroning of the gold standard. But to properly assess those, we’ve had to review the events leading to the nationwide banking crisis. As we’ve seen, although he was not yet president, FDR could not help being part of that story. Soon he’d play a much bigger and very different part, as the man who promised to reverse the tide he had himself inadvertently helped to set in motion.

Continue Reading The New Deal and Recovery:

• Intro
• Part 1: The Record
• Part 2: Inventing the New Deal
• Part 3: The Fiscal Stimulus Myth
• Part 4: FDR’s Fed
• Part 5: The Banking Crises

__________________

[1] Just how close to insolvency the Bank of United States was at the time of its failure on December 11th, 1930, is controversial. Surveying the relevant literature and evidence, Paul Trescott concludes that although the bank “was not seriously insolvent at the time of its closing,” its “condition was deteriorating rapidly.” Trescott’s conclusion is at least consistent with Ted Temzelides’ observation that upon being liquidated it “paid off 83.5 percent of its liabilities” despite having “had to liquidate a large fraction of its assets under unfavorable conditions.”

[2] As James Olson observes, by establishing the RFC, Hoover took “an extraordinary step forward in the history of American public policy. Indeed, the tragedy of Hoover’s reputation lies in the comparison historians have made between the Republican president and those presidents who followed him. Hoover becomes a landmark figure in the history of American politics when one compares him with his predecessors. In 1931, for the first time, an American President had admitted that the federal government was responsible for maintaining the economic welfare of the nation, for controlling the operation of the business cycle.”

[3] Each Fed bank had to maintain a gold reserve equal to at least 40 percent of its outstanding Federal Reserve notes, plus a reserve of either gold or greenbacks equal to at least 35 percent of its members’ deposits.

[4] In case you wonder, the previous two low points in the Fed’s gold holdings coincide with the foreign drain on gold that followed Great Britain’s abandonment of the gold standard on September 22, 1931, and the Chicago banking panic of June 1932.

[5] Several economists have argued that the Fed need never have suspended gold payments, and that it might have avoided doing so even as it pursued more expansionary monetary policies that could have averted the Great Contraction. Although the possibility is of immense interest, it falls beyond the scope of our topic. See, however, Bordo, Choudhri, and Schwartz (2002) and Hisieh and Romer (2006), and Sumner’s discussion of these, in The Midas Paradox (pp. 148–56). A more recent study by Garo Garabedian and Rebecca Stuart concludes that, although more extensive Fed asset purchases during 1932 would have gone far toward achieving an earlier end to the U.S. depression, they would also have forced the U.S. off the gold standard sometime that year.

[Cross-posted from Alt‑M.org]

Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress appropriated $454 billion to the Treasury’s Exchange Stabilization Fund (ESF) to backstop emergency lending facilities known as “special purpose vehicles” (SPVs).[1] With the Treasury backstop, the Fed has the potential to lend a maximum of $4.5 trillion to fund the SPVs, which hold the assets off the Fed’s balance sheet—including emergency lending to corporations, small and medium-sized businesses, municipalities, and states (see Torres). In April, the Fed announced plans to lend nine SPVs up to $2.3 trillion to boost the economy (see Timiraos and Fed’s Press Release). However, the Fed has only provided about 6 percent of that amount (see Cox). All of the SPVs have now been activated (see Condon).

Although the Fed’s new lending powers were intended to counter the U.S. economic collapse following the government-ordered lockdown to combat the pandemic, they risk giving the Fed a permanent footprint in private credit markets. In this article, I focus on the consequences of the Fed’s entry into the corporate credit market, with the establishment of the Primary and Secondary Market Corporate Credit Facilities (CCFs).[2]

The Primary Market CCF, which opened on June 29, is designed to buy newly issued bonds, while the Secondary Market CCF began buying ETFs specializing in corporate debt on May 12 and began purchasing individual corporate bonds (including both investment-grade and high-yield bonds) after June 15. The later are “fallen angels”—that is, bonds of firms that were investment grade prior to March 23, but are now rated as junk bonds. The Primary Market CCF is backed by $50 billion from the Treasury’s ESF, while the Secondary Market CCF is backed by $25 billion. As of June 24, the Secondary Market CCF’s asset purchases only amounted to $8.7 billion (see Condon). The following section examines the objectives and operation of the Secondary Market CCF; the Primary Market CCP has yet to buy any bonds.[3]

Objectives and Operation of the Secondary Market Corporate Credit Facility (SMCCF)

Instead of Congress directly providing credit to the corporate sector via fiscal policy, the decision was made to let the Fed do the heavy lifting via the CARES Act and Section 13(3) of the Federal Reserve Act. The “Investment Management Agreement” for the SMCCF set out the objectives for the facility while the “Credit Agreement” established the procedures for operating the program.

Objectives of the SMCCF

According to the Investment Management Agreement, the objectives of the SMCCF, including its relation to the Primary Market CCF, are as follows:

The [Corporate Credit] Facility is designed to achieve three objectives: (1) to provide broad support for secondary credit markets to facilitate orderly and timely risk transfer; (2) to support primary issuance for solvent borrowers at borrowing rates that are well aligned with the secondary market reflecting more normalized levels; and (3) to reduce the incidence and severity of market dysfunction, fire sales, and indiscriminate liquidation [p. 41, emphasis added].

Investment and Credit Agreements

The procedures for establishing the SMCCF, as described in the investment and credit agreements, are the following:

1. The Secretary of the Treasury first approves the SPV.
2. The Fed’s Board of Governors (not the Federal Open Market Committee) then establishes the Secondary Market CCF.
3. The New York Fed sets up a limited liability company in Delaware—the “Corporate Credit Facilities LLC.”
4. The LLC’s obligations to the New York Fed (“as lender”) are spelled out in the Credit Agreement: Loans are to be “secured by all the assets” of the LLC; the asset manager, BlackRock Financial Markets Advisory, “shall not exercise such authority with any purpose or design of favoring or discriminating against any sector of the economy or region of the country”; and the New York Fed imposes investment guidelines to ensure the objectives of the SPV are implemented by the investment manager.
5. The CCFs are to be terminated by September 30, 2020, unless otherwise instructed by the Board of Governors and the Treasury.

This is a detailed process with numerous legal documents and compliance requirements intended to prevent BlackRock from unfairly benefiting from its management role. The following paragraph from the Investment Management Agreement, Section 8.4, “Effective Internal Controls,” is illustrative of the complex relationship between the New York Fed and BlackRock:

The Manager shall provide to the FRBNY the System and Organization Control 1 (“SOC 1”)-Type II reports of the Manager and its Affiliates with respect to their respective operations and controls relevant to the performance of services under this Agreement, which reports have been prepared by an accredited independent auditor in accordance with the American Institute of Certified Public Accountants’ Statement on Standards for Attestation Engagements (SSAE No. 18) and International Standards of Attestation Engagements No. 3402, or successor standard report (“SOC 1 Reports”). The Manager shall provide SOC 1 Reports to the FRBNY at least annually. If the Manager’s SOC 1 Report covers a period other than a calendar year, the Manager shall also provide the FRBNY a letter signed by a responsible officer of the Manager attesting for the period of time from the end of the period covered by the SOC 1 Report through the calendar year in which that end date occurs (the “bridge period”) that (i) there have been no material changes to the tested controls during the bridge period; (ii) the control objectives remain in place; and (iii) the description of the services and related internal controls in the SOC 1 Report continues to be substantially accurate [p. 10, sec. 8.4.2].

In addition to strict compliance requirements, the Investment Management Agreement establishes a “Fee Schedule and Payment Procedure” (Exhibit D) that prohibits BlackRock (or any future manager) from receiving management fees when buying for its accounts under the program.[4] Nevertheless, BlackRock has already benefited by the strong uptick in the corporate ETF and bond markets stemming from the announcement effects of the CCF program. When the Fed first announced the SPV for corporate credit, the bond market saw a surge in demand for corporate debt: bond prices rose while yields fell. In response, the search for yield led to greater demand for junk bonds as well as stocks, pushing those asset prices up. Companies that were already highly levered became more so (see Wirz).

How the SMCCF Decides How Many Bonds or ETFs to Buy Each Day

The New York Fed provides a detailed description of how the SMCCF decides how many bonds or ETFs to buy on a daily basis. The language is precise and presented in the New York Fed’s “Frequently Asked Questions” (FAQs) bulletin:

The pace of purchases is based on a percentage of average daily volumes in the respective markets. The percentage to be purchased each day is based upon an array of measures of corporate bond market functioning, the rate of change of such measures, and other indicators. Measures of corporate bond market functioning include, but are not limited to, transaction cost estimates, bid-ask spreads, credit curve shape, spread levels and volatility, trading volumes, and dealer inventories. With respect to ETF purchases, ETF-specific measures such as premium or discount to net asset value (“NAV”) and creation/​redemption volumes are considered. With respect to bond purchases, the results of SMCCF and PMCCF operations, demand in the PMCCF, PMCCF share of new issuance, and pricing and amounts of new issuance are considered.

If the measures used to size daily purchases indicate sustained improvement in market functioning, to levels at or near those prevailing prior to the COVID-19 dislocation, SMCCF purchases are expected to slow notably and, in some cases, could pause entirely. If those measures subsequently indicate deterioration in market functioning, however, SMCCF purchases would be expected to increase.

It is important to note the emphasis on “market functioning.” One of the Fed’s main arguments for intervening in the corporate credit market is the presumption that markets malfunction in the face of great uncertainty, like that caused by the pandemic. Yet it is normal for credit spreads and volatility to increase in the face of rising uncertainty (see Hetzel, p. 3).[5] Market participants have an incentive to collect information quickly and to factor it into their investment decisions. When faced with a pandemic and government lockdown of the economy, investors will reassess credit risks, which will show up in widening yield spreads. When central banks pursue policies that underprice risk, they distort relative yields, weaken the corrective forces of free markets, and misallocate scarce capital. Credit allocation is politicized and the “moral hazard” of mispricing risk is revealed—that is, when risk is underpriced by central banks, the demand for risky assets, such as “fallen angels,” increases. Highly indebted corporations take on more debt and risk insolvency.

Fed’s Justification for Entering the Corporate Credit Market

When the Fed announced its decision to create the Corporate Credit Facilities LLC on March 23, it justified that historic decision by arguing that central bank action was necessary to revive sagging corporate credit markets in the wake of the COVID-19 pandemic and the government’s lockdown of the economy. Private lenders faced great uncertainty in early March and were dumping their bond holdings, including investment-grade corporate bonds and ETFs. [see Wirz] As Fed Chairman Jerome Powell noted, “Investors fled from any kind of risk and … market[s] stopped functioning.”

This “market failure” narrative was also aired by Fed Vice Chairman Randal Quarles in a recent speech at the Exchequer Club in Washington:

The first phase of the impact of the COVID event on the financial system was the market turmoil we experienced in March. This was the result of severe uncertainty triggering major re-pricing and volatility in global financial markets, disrupting the flow of credit to the economy. We saw many examples of a “dash for cash,” with firms drawing down their lines of credit with banks, and the indiscriminate sale of assets by investors in order to obtain liquidity.

Likewise, Daleep Singh, executive vice president and head of the Markets Group at the New York Fed, argued that the role of the Fed during a crisis is “to make sure the financial system is functioning”—and to ensure that credit is provided to “particular parts of the economy that aren’t really getting a near-term benefit from Treasury market stabilizing” (in Hetzel, p. 14, emphasis added).

When Chairman Powell and his Board of Governors announced the new program aimed at restarting corporate debt markets via direct and indirect purchases of bonds and syndicated loans, their hope was to stabilize debt markets, aid large corporations, and stimulate employment and output. In particular, they wanted to create a strong demand for corporate bonds—even before any loans were made to the Corporate Credit Facilities (see Smialek).[6] With that aim in mind, Quarles remarked:

The authorities worked together to address the problem through a combination of monetary, fiscal, and regulatory measures. These interventions [which included the SPVs set up by the Fed and Treasury] led to rapid improvements in financial markets. Credit spreads have narrowed for both investment-grade and high-yield bonds, markets are functioning in an orderly manner, and credit provision to the economy has held up.

Powell would agree. On May 29, at an online forum at Princeton, he stated: “Even before we actually began lending, [markets] start[ed] to work again. There’s a confidence factor.” Private investors rushed back into the market, and even highly indebted firms like Boeing and Ford were able to secure funds (Boeing borrowed $22 billion in April and Ford $8 billion). Yields on investment-grade bonds fell and investors increased their demand for higher-yielding junk bonds (see Wirz).[7]

The Fed has been careful not to target individual firms in its corporate lending: It has bought ETFs tracking a broad portfolio of bonds and created its own index to guide its purchases of bonds on the secondary market.[8] Nevertheless, its intrusion in the corporate credit market affects the allocation of credit and supports bond prices and lowers yields below the true credit and default risks. More importantly, by promising to use its firepower to support both large investment-grade corporate debt and distressed firms, the Fed has created the expectation that it can price risk better than private markets and is needed to ensure that the corporate credit market functions smoothly. Yet, as Robert Hetzel, who spent more than 40 years as an economist at the Richmond Fed, notes: there was no market failure—spreads reflected investors’ expectations regarding the pandemic and how fast businesses would recover. In times of uncertainty, credit and default risks increase and should be reflected in yields (see Hetzel, p. 12).

Hetzel (p. 19) argues that the Fed’s justification for intervening in corporate credit markets rests on a false presumption—namely, that “financial markets ceased to function in mid-March, but were revived by the announcement of 13 (3) programs.” His narrative is that “markets continued to function” and that “the Fed played a key role in that continued functioning. However, its role was the traditional one of supplying ample reserves, not allocating credit.” That is why he calls the Fed’s intervention in credit markets “strikingly revolutionary” (p. 14).

Reasons for Keeping the Fed Out of the Corporate Credit Market

The close link between the Treasury and Wall Street—and the authority the Treasury secretary has in implementing the corporate credit program—endanger Fed independence. For that reason alone, having the Fed intervene in the corporate credit market is a bad idea. Other reasons for keeping the Fed out of the corporate credit market are:

1. The Fed is ill-equipped to engage in corporate lending. The New York Fed has long engaged in open market operations, but now must oversee a complex SPV to buy corporate bonds, ETFs, and syndicated loans. Doing so requires more resources and staff time—at a high opportunity cost. Hiring BlackRock as a manager and coordinating with the Treasury adds more layers of bureaucracy. It also opens the Fed to politicization as monetary and fiscal policy merge. Consequently, the market allocation system for corporate credit is tainted.
2. The Fed should be a “Monetary Authority” not a “National Investment Authority.” The Fed has tried to avoid picking winners and losers in making decisions about how to allocate credit. However, when it extends credit to “fallen angels,” buys ETFs that hold bonds of Apple and other profitable companies, and selects weights for its Broad Market Index, it is difficult to be fully neutral. The Fed’s discretionary powers are increased and its monetary authority diminished by a loss of independence.[9] The Fed should focus on its monetary responsibility to provide temporary liquidity to banks that are solvent and let Congress engage in spending decisions to support the private sector, which was shut down by the government to fight the pandemic.
3. Private competitive markets, not the Fed or Treasury, should be setting the terms and price of corporate credit to avoid politicization of investment decisions and misallocation of credit. When the Fed effectively subsidizes highly levered companies, by allowing them “to borrow at interest rates that are not reflective of their true risks” (Kocherlakota), it is a movement toward market socialism and a danger to market liberalism.
4. When companies can borrow at rates that don’t fully reflect the risks involved, the moral hazard problem can become serious—leading to even more risky investments and “zombie” corporations kept alive by “cheap” credit. This process saps funds from more profitable enterprises, slows economic growth, and reduces economic freedom.
5. Capital markets by their very nature discriminate to steer capital and credit to its most productive uses. Although BlackRock is prohibited from discriminating “against any sector of the economy or region of the country,” that constraint could destroy, rather than create, societal wealth.
6. The Fed’s role should be to provide a stable currency and keep nominal GDP on a stable path, not to engage in credit and fiscal policy, or to peg rates at near zero to support asset prices and create a pseudo-wealth effect. Placing a wall between fiscal and monetary policy is essential for the Fed’s independence and credibility.[10]

Congress could have placed the Treasury in charge of the SPVs for emergency lending and left the Fed free to focus on monetary policy and not intervene in credit markets or conduct fiscal policy. Although the Fed has moved slowly in using its firepower to purchase corporate debt—as well as in establishing its Main Street Lending Program and Municipal Liquidity Facility—there will be increasing political pressure to expand its footprint in those credit markets. Indeed, once started on the path of employing the central bank to extend credit to businesses, states, and municipalities, it will be difficult to reverse course. Market participants now expect the Fed to support an array of asset prices and any deviation from that policy is bound to have dire consequences. Normalization will therefore be more difficult. Hetzel is correct in arguing that, “If the Fed is going to forswear intervention in credit markets …, it will have to abandon its historic aversion to commitment and rules.” (p. 23).

The Fed’s Credibility and Independence Depend on Adopting a Monetary Rule that Limits the Scope of Monetary Policy

Since the global financial crisis and the pandemic, the Fed’s emergency lending powers have grown by leaps and bounds. Its balance sheet has gone from about $900 billion before the financial crisis to more than $7 trillion today. Its emergency lending authority has expanded dramatically as well, with a score of new SPVs and the power to leverage the Treasury’s $454 billion appropriation from Congress to as much as $4.5 trillion.

Now is the time for the Fed and Congress to think about the future of monetary policy and the steps needed to normalize Fed policy so that, when the pandemic ends, plans will be in place to ensure monetary stability and robust private credit markets.

First and foremost, Congress and the Fed need to consider moving toward a rules-based monetary system, such as one that ensures a steady growth path for nominal GDP. Forward guidance based on a sound monetary rule would be superior to “dot plots” and date-driven policy.

Congress and the Fed must recognize the limits of monetary policy. The Fed can determine the path of nominal income, but it can’t permanently increase wealth or real economic growth. Monetary policy should be divorced from credit policy and fiscal policy, which means depoliticizing the Fed. Private markets, not the Fed, should allocate credit. Lending directly to the Treasury—which is what happens when the Fed lends to an SPV—is “a dangerous and inappropriate action for any central bank,” according to Bill Nelson, chief economist at the Bank Policy Institute.[11]

In 2001, J. Alfred Broaddus and Marvin Goodfriend, officials at the Federal Reserve Bank of Richmond, wrote:

We assert two closely related principles. First, the Fed’s asset acquisitions should respect the integrity of the fiscal policymaking process by minimizing the Fed’s involvement in allocating credit across sectors of the economy. Second, assets should be chosen to minimize the risk that political entanglements might undermine the Fed’s independence and the effectiveness of monetary policy.

That is still wise advice in thinking about the use of Section 13(3) lending.

The Fed also needs to rethink the floor operating system, get rid of interest on excess reserves, and return to a corridor system—so that the stance of monetary policy is once again linked to the size of the Fed’s balance sheet (see Selgin, Plosser, Hetzel). Interest rates must be able to move freely and respond to market forces, not be rigged by government actions, either by the Fed or Treasury.[12]

This does not mean the Fed should do nothing, only that it should limit its actions to what is consistent with sound monetary policy and not try to engineer private credit markets or push up asset prices.

Conclusion

The Fed’s intervention in the corporate credit market is a risky venture. With the pandemic, the Fed has drifted into the fiscal space and is engaging in credit policy rather than pure monetary policy. Allocating credit to corporations—as well as to small and medium-sized businesses and municipalities—has taken the Fed far afield from its traditional role as lender of last resort to illiquid banks. Exiting from the current emergency programs may not be easy from a political standpoint. The longer they last, the more the Fed will be entangled with the Treasury and lose much of its independence.

Independence will be more secure—and monetary policy more predictable—the more limited the Fed’s powers are and the more guidance that is provided by a rules-based regime than by pure discretion in a fiat money world.

**********

[1] The ESF was created to provide an “orderly” system of exchange rates, not to take equity positions in SPVs (see Congressional Research Service).

[2] This article is based on my remarks at the Western Economic Association International’s virtual conference, June 29, 2020, and builds on earlier work (see Dorn and Dorn).

[3] For a detailed description of the Primary and Secondary Market Corporate Credit Facilities, see “FAQs: Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility.” Unlike the Secondary Market facility, the Primary Market CCF requires that firms opt into the program. But few firms are expected to do so because the requirements are steep: corporations wanting the facility to purchase newly issued debt must be unable to secure “adequate credit” elsewhere; their debt must be investment grade or have a relatively high junk bond rating if downgraded after March 22, and the firm must be solvent (see Smialek).

[4] “The Manager [BlackRock] shall not charge the Company [SMCCF] for, and the Company will have no obligation to pay, fees to the Manager relating to the Company’s holdings of ETFs” (Investment Management Agreement, p. 54, Exhibit D). See also “Terms of Assignment for BlackRock.”

[5] References to Hetzel in this article come from the draft of his paper dated June 25, 2020, which was circulated for a panel at the Western Economic Association International’s virtual conference on June 29. The paper, “Covid-19 and the Fed’s Credit Policy,” is forthcoming as a Mercatus Center Working Paper.

[6] “The Secondary Market Corporate Credit Facility (SMCCF) was established to support credit to large employers by providing liquidity for outstanding corporate bonds.”

[7] It is difficult to determine the exact impact of the Fed’s announcement of the Primary and Secondary Market Corporate Credit Facilities, because the Fed also announced large-scale purchases of Treasuries. For other compounding factors, see Hetzel: “There is … no way to isolate the announcement effect of the Fed’s credit programs from the Fed’s monetary policy actions and from the fiscal policies in the CARES Act” (p. 12).

[8] The New York Fed reported on June 15 that its rate of purchases of outstanding corporate bonds, using its Broad Market Index, will depend on selected indicators of market functioning. In particular, the Secondary Market CCF would increase purchases “if those measures … indicate a deterioration in market functioning” (see Timiraos). The index is made up of nearly 800 eligible firms, with the highest weights given to Toyota Motor Credit, Volkswagen Group America, Daimler Finance, AT&T, and Apple (see Smialek, Cox, and Chappatta).

[9] Lev Menand distinguishes between a monetary authority and an investment authority: “Whereas a monetary authority strives to manage the money supply in a neutral way that encourages sustainable economic growth and price stability, an investment authority is necessarily non-neutral. Its investments affect relative prices and make some projects more attractive and cheaper to finance and other projects more expensive and difficult to finance” (p. 25).

[10] Broaddus and Goodfriend point out that the Federal Reserve’s exemption from the appropriations process means it “should avoid, to the fullest extent possible, taking actions that can properly be regarded as within the province of fiscal policy and the fiscal authorities.” They favor a Treasuries-only policy because it “leaves all the fiscal decisions to Congress and the Treasury and hence does not infringe on their fiscal policy prerogatives.” In contrast, “when the Fed extends credit to private or other public entities, … it is allocating credit to particular borrowers, and therefore taking a fiscal action and invading the territory of the fiscal authorities.” The authors recognize that, “in principle, the Fed could consider purchasing and maintaining a ‘neutral’ portfolio of non-Treasury financial assets mirroring the aggregate outstanding stock of financial assets in some way.” However, they believe that “defining and maintaining such neutrality in practice … would be exceedingly difficult if not impossible, especially in the short run.”

[11] When the assets and liabilities of the Fed are consolidated with those of the CCF LLC, “the loan from the FRBNY to CCF LLC is eliminated” (see “Factors Affecting Federal Reserve Balances of Depository Institutions”).

[12] Moving to yield curve control would be a move in the wrong direction (see Dorn). Pegging the price of government debt is not a panacea for real economic growth; it only allows for the growth of government and the demise of freedom.

[Cross-posted from Alt‑M.org]