Federal Reserve documents 3 page

Otto and Lenka settled first in Bari, a coastal city in southern Italy, where Anna’s brother, Victor, was born in 1944. After the war, the family moved to Grottaferrata, a little town on the outskirts of Rome, where Anna was born in 1956. Following a crackdown by the Italian authorities on illegal immigrants, they immigrated to the United States while Anna was still a baby. The Friedmanns settled in Denver, where they had relatives.

Neither of Anna’s parents graduated from high school. Nevertheless, education was paramount in the Friedmann household. Victor would graduate from Harvard, earn a master’s degree at MIT, and become a petroleum engineer. Anna would attend Wellesley on a full scholarship, but only after Victor assured her parents that it was a top-flight school even though it admitted only girls. She majored in chemistry for her parents, but her true love was Latin American literature. She would introduce me to the writings of Gabriel Garcнa Mбrquez and Jorge Luis Borges.

I proposed to Anna two months after our blind date. We were married on May 29, 1978, at Temple Israel in Boston, three days after Anna’s graduation. We honeymooned in Italy, visiting the Fried-manns’ home in Grottaferrata and meeting people Anna’s parents and brother had known when they lived there. Our first home together was a small, roach-infested apartment in a six-story tan-and-brown brick apartment building three blocks from Harvard Square. My National Science Foundation grant had run out,

and we lived on my teaching assistant stipend and what Anna earned working as a receptionist in an optometrist’s office in Harvard Square. For entertainment, we budgeted $5 a week to play pinball together at a place across the street from our apartment.

As I worked to complete my thesis, I applied for teaching positions and was offered assistant professorships at Harvard, Stanford, and Princeton, among others. Anna, meanwhile, was accepted into several master’s programs in Spanish literature. We agreed on Stanford.

During the summer before my job and Anna’s program began, Anna and I shared a house near the Stanford campus with a graduate school friend, Jeremy Bulow. To help pay the rent, we invited Mark Gertler, an acquaintance of Jeremy’s, to join us. Mark had earned his doctorate at Stanford a year earlier and had arranged to spend the summer there working on his research. Mark and I both were excited about beginning our careers and we found that we had many common interests. We talked for hours. It was the start of a long and fruitful collaboration and friendship.

My first challenge at Stanford was teaching. My position was in the Graduate School of Business rather than the economics department. At twenty-five, I was younger than many of the students, who had returned to school after several years spent working. They were skeptical of my youth and inexperience, probably rightly so. Often they were paying their own way and were looking for a good return on their tuition dollars. I had been trained largely in theoretical economics but I quickly learned to tie my lectures to things the students ultimately wanted to do. I asked them, for example, to analyze the economic policies of emerging-market countries and to think through the implications for investing or starting a business in those countries. The experience helped me approach economics in a more applied way. And I found that I was good at explaining things.

AFTER READING FRIEDMAN and Schwartz at MIT, I had become a Great Depression buff in the way that other people are Civil War buffs, reading not only about the economics of the period but about the politics, sociology, and history as well. But the essential question—the Holy Grail of macroeconomics, I

would call it—was why the Depression happened, and why it was so long and deep. (It was basically the same question I had asked my grandmother as a boy in Charlotte.) Before Friedman and Schwartz, the prevailing view—based on John Kenneth Galbraith’s 1954 book The Great Crash, 1929—was that the Depression was triggered by the speculative excesses of the 1920s and the ensuing stock market crash. Friedman and Schwartz showed that the collapse of the money supply in the early 1930s, rather than the Great Crash, was the more important cause of the Depression. The sharp decline in the money supply hurt the economy primarily by inducing a severe deflation (falling wages and prices). Prices in the United States fell by nearly 10 percent per year in 1931 and 1932. This violent deflation in turn led households and firms to postpone purchases and capital investments in anticipation of lower prices later, depressing demand and output. Moreover, the international gold standard, which created a monetary link among countries tied to gold, spread America’s deflation and depression abroad.

Friedman and Schwartz’s perspective was eye-opening, but I wondered whether the collapse of the money supply and the ensuing deflation, as severe as it was, could by itself explain the depth and length of the Depression. Unemployment in the United States soared to 25 percent in 1933, from less than 5 percent before the 1929 crash. It did not fall below 10 percent until the eve of the U.S. entry into World War II, even though the deflation occurred mostly prior to 1933. It seemed to me that the lack of credit after the collapse of the banking system had to have played a significant role in the slump as well. More than 9,700 of the nation’s 25,000 banks failed between 1929 and 1933.

The notion that the failure of more than a third of the nation’s banks in a five-year span would impede credit flows and damage the economy seems unremarkable today, but my first paper on the subject was greeted with skepticism at conferences and seminars. Many economists at the time saw the financial system as a “veil”—basically an accounting system that kept track of who owned what, not something that had significant independent effects on the economy. Surely, they argued, if a company’s bank goes out of business the company will find financing somewhere else.

But, in reality, finding alternative financing may not be so easy. The collapse of a bank, resulting in the effective destruction of its accumulated experience, information, and network of relationships, can be very costly for the communities and businesses it serves. Multiply that damage by more than 9,700 bank failures and you can readily understand why the disruption of credit helps explain the severity of the Depression. It took some time to publish my paper, but finally, in June 1983, it appeared as the lead article in the American Economic Review, the profession’s most prestigious journal.

A later paper, which I wrote with Princeton historian Harold James, supported my interpretation of the Depression in an international context. We looked at the experience of twenty-two countries during the Depression and found, basically, that two factors dictated the severity of the economic downturn in each country. The first was the length of time the country stuck with the gold standard. (Countries that abandoned gold earlier were able to allow their money supplies to grow and thereby escape deflation.) That finding was in keeping with Friedman and Schwartz’s emphasis on the money supply. The second

factor was the severity of the country’s banking crisis, consistent with my view of the importance of credit as well as money.

Through much of the 1980s and 1990s, Gertler and I (later joined by one of his students, Simon Gilchrist, now of Boston University) worked on analyzing how problems in the financial system can exacerbate economic downturns. We identified a phenomenon we called “the financial accelerator.” The basic idea is that recessions tend to gum up the flow of credit, which in turn makes the recession worse. During a recession, banks lend more cautiously as their losses mount, while borrowers become less creditworthy as their finances deteriorate. More cautious banks and less creditworthy borrowers mean that credit flows less freely, impeding household purchases and business investments. These declines in spending exacerbate the recession.

More generally, our work underscored the importance of a healthy financial system for the economy. For example, it implied that recessions are worse when households and businesses start with high debt levels, as falling income and profits make it more difficult for borrowers to pay their existing debts or to borrow more. Likewise, if a country’s banking system is in bad shape at the outset of a recession, the downturn will likely be worse. In extreme cases like the Depression, a banking collapse can help create a prolonged economic slump.

The financial accelerator theory also helps explain why deflation is so harmful, in addition to the tendency of households and firms to defer purchases. If wages and prices are falling, or even if they are growing at unexpectedly slow rates, borrowers’ incomes may not grow quickly enough to allow them to keep up with their loan payments. Borrowers under pressure to make loan payments will naturally reduce other types of spending, and their weaker financial conditions will make it harder for them to obtain additional credit. The deflation of the 1930s led to widespread bankruptcies and defaults, gravely worsening an already bad situation.

My reading and research impressed on me some enduring lessons of the Depression for central bankers and other policymakers. First, in periods of recession, deflation, or both, monetary policy should be forcefully deployed to restore full employment and normal levels of inflation. Second, policymakers must act decisively to preserve financial stability and normal flows of credit.

A more general lesson from the Depression is that policymakers confronted with extraordinary circumstances must be prepared to think outside the box, defying orthodoxy if necessary. Franklin Roosevelt, who took office in 1933, exemplified this by experimenting boldly in the face of an apparently intractable slump. Some of his experiments failed, such as the National Industrial Recovery Act of 1933, which tried to stop price declines by reducing competition in industry. But others proved crucial for recovery. Most notably, FDR defied the orthodoxy of his time by abandoning the gold standard in a series of steps in 1933. With the money supply no longer constrained by the amount of gold held by the government, deflation stopped almost immediately. Roosevelt also quelled the raging financial crisis by temporarily shutting down the nation’s banks (a bank holiday), permitting only those judged sound to

reopen, and by pushing legislation establishing federal deposit insurance. These measures brought intense criticism from orthodox economists and conservative business leaders. And they were indeed experiments. But, collectively, they worked.

AS MY SIXTH YEAR at Stanford approached, I began to think about my career options. Junior faculty generally either were awarded lifetime tenure after six years or moved on. The administration had let me know that my prospects were good. But on a visit to Stanford, Hugo Sonnenschein, an economist who was then provost at Princeton, urged me to consider joining Princeton’s faculty instead. Alan Blinder, the best-known macroeconomist at Princeton, called as well. At Stanford, I had been promoted from assistant professor to associate professor without tenure in 1983. Now both Stanford and Princeton were offering me full professorships at age thirty-one.

Professionally, I liked both places, but Anna much preferred Princeton. Six years earlier, we had both been eager for a change from the Cambridge and Wellesley scene, and for the chance to live in California. Our son, Joel, had been born in December 1982, and Anna saw the leafy environs of Princeton as more conducive to family life. I was fine with the choice.

And so, in 1985, we moved across the country to Rocky Hill, New Jersey, a historic village of about seven hundred people four miles north of the Princeton campus. We bought a two-story colonial with a big yard and delighted in the view of an apple tree, a fig tree, and a huge rhododendron from the screened-in porch. It seemed as if all of the families on the block had children. They roamed from yard to yard. Our daughter, Alyssa, was born in June 1986. David and Christina Romer, junior economic faculty members at Princeton, lived a block from us and also were expecting.

After six years in Rocky Hill we moved to a larger house in Montgomery Township, about eight miles north of campus. We weren’t alone. Families with children were pouring into the township, which was fast changing from a farming area into an exurb of New York City. The township’s schools, which also served Rocky Hill, would soon be overwhelmed by rising enrollments. Anna and I were both educators (by then she was teaching Spanish at the private Princeton Day School), and we both strongly believed all children deserved a quality education. Our own kids attended public schools. Anna, who was more plugged into the network of local parents than I was, persuaded me to run for the school board—or as she would put it later, “I made him run.”

I was elected, twice, and served six grueling years. A constant battle raged between the newcomers to the township, like us, who wanted more and better schools, and the longtime residents, who worried about the cost. I observed more than once that two of the things people cared most about were the welfare of their children and minimizing their taxes, and here was a case where these values directly conflicted. In 2000, my last year on the board, I provided the tie-breaking fifth vote in favor of asking voters to approve a bond issue that would raise property taxes to pay for new schools. Five years later, a brand-new high school opened its doors. By then, Anna and I had moved to Washington, and both Joel and Alyssa were in

college.

MY RESEARCH INTERESTS continued to evolve at Princeton, influenced by new colleagues and by ideas percolating in the profession. I was beginning to focus more on monetary policy—how it works, how to measure whether policy is tight or easy, how to estimate the effects on the economy of a change in policy. My interest in monetary policy led me to accept various advisory roles with three regional Federal Reserve Banks (in Boston, Philadelphia, and New York) and to make visits and presentations at the Board of Governors—the Federal Reserve’s headquarters—in Washington.

I knew that the process of making monetary policy could itself be quite complex. In most central banks around the world, policy decisions are made by committees, whose members must analyze a wide range of economic information. And it’s not enough for committee members to agree on a policy: The policy decisions and their rationales must also be clearly communicated, including to the legislature (typically, the body responsible for overseeing the central bank) and to participants in financial markets (because the effects of monetary policy decisions depend crucially on how interest rates and asset prices respond). Policymaking is more likely to be consistent and communication effective when both are underpinned by a coherent intellectual framework. I found myself becoming increasingly interested in the policy frameworks that central banks use, and in how those frameworks might be improved. In 1992, jointly with Frederic “Rick” Mishkin of Columbia University, I completed a series of case studies of the frameworks used by six major central banks. Mishkin and I had overlapped in graduate school and found that we had similar interests, including a fascination with financial crises and the Great Depression. Rick was brash, with strong opinions, and sometimes outrageously funny, in contrast with the calm and understated Mark Gertler.

One especially promising framework for making monetary policy, inflation targeting, was still very new when Mishkin and I began working together. Simply put, an inflation-targeting central bank publicly commits to achieving a particular inflation rate, say 2 percent, over a particular time horizon, say one to two years.

A central bank can’t achieve low and stable inflation by mere declaration, of course. It has to back its words with actions by adjusting monetary policy—usually by raising or lowering a benchmark interest rate—as needed to hit the inflation target over its stated time horizon. If a central bank can’t do what it says it will do, having an official target won’t help much. Nevertheless, announcing an inflation target instills discipline and accountability, because it forces policymakers either to hit their target or to offer a credible explanation for why they missed. Indeed, frequent public communication—both prospective, about the central bank’s goals and plans for achieving them, and retrospective, about past performance— is a key element of most inflation-targeting strategies. New Zealand’s central bank was the pioneer of inflation targeting, starting in 1990. Canada followed in 1991, and then Great Britain, Sweden, Australia, Chile, Israel, and others. Ultimately, several dozen countries, both advanced and emerging-market

economies, would adopt the approach.

In follow-up work in 1997, Mishkin and I looked at the experience of the early adopters and asked whether the United States could benefit from inflation targeting. The question was controversial because the Federal Reserve had long valued its discretion to respond flexibly to economic developments without the constraint of an announced target. As critics of inflation targeting pointed out, under the chairmanships of Paul Volcker and Alan Greenspan, the Federal Reserve had employed its discretion to good effect, bringing inflation down from a peak of 13.5 percent in 1980 to around 2 percent by the late 1990s.

Mishkin and I nevertheless argued that inflation targeting would improve U.S. monetary policy. For one, setting a permanent inflation target would create an institutional commitment to continuing the Volcker and Greenspan policies that had lowered and stabilized inflation, while producing two long economic expansions during the 1980s and 1990s. Just as important, from our perspective, the increased transparency that accompanies inflation targeting would, by shaping market expectations of the path of future interest rates, help the Fed to better achieve its objectives. In contrast, less transparent policies would keep markets guessing unnecessarily.

In other papers, I argued that inflation targeting helped not only countries with high inflation but also those, such as Japan, with the opposite problem of deflation. Japan in the 1990s had experienced a “lost decade” (which eventually became two lost decades) of alternating subpar growth and outright economic contraction. The country had plenty of problems, including slow population growth and an aging workforce, inefficiencies in agriculture and the service sector, and troubled banks. Nevertheless, it seemed to me that the deflation that followed the collapse of Japanese stock and real estate markets in the early 1990s surely was a major reason that Japan went from being one of the most dynamic economies in the world to being perhaps the most sluggish advanced economy.

In a 1999 paper, I suggested that inflation targeting not only could have helped prevent Japan from tipping into deflation (by inducing the Bank of Japan, Japan’s central bank, to react more quickly to falling inflation), it was also part of the cure for getting out of deflation. By then, the Bank of Japan had moved short-term interest rates down to zero and had pledged to keep rates at zero “until deflationary concerns subside.” With prices still falling, Japan needed even easier monetary policy, but its policymakers repeatedly asserted that because interest rates cannot be lower than zero, they had done all they could. I disagreed. First, I suggested, instead of continuing to hold out the vague promise about deflationary concerns subsiding, the Bank of Japan should try to shift the public’s inflation expectations by setting an explicit target for inflation.† Second, I noted that, even with the short-term interest rate at zero, Japan had other tools to stimulate the economy, such as buying large quantities of financial assets—a suggestion also made by Milton Friedman.

My diagnosis of the Japanese situation was right, I think. Indeed, the Bank of Japan would adopt my suggestions some fourteen years later. However, the tone of my remarks was sometimes harsh. At a conference in Boston in January 2000, I had started by asking whether Japanese officials were suffering

from “self-induced paralysis,” accused them of having “hidden behind minor institutional or technical difficulties in order to avoid taking action,” criticized them for “confused or inconsistent” responses to helpful suggestions from academics such as myself, and concluded by blaming them for an unwillingness to experiment. “Perhaps it’s time for some Rooseveltian resolve in Japan,” I pontificated. Years later, having endured withering, motive-impugning criticism from politicians, editorial pages, and even fellow economists, I found myself wishing I had dialed back my earlier rhetoric. In 2011, in response to a question from a Japanese newspaper correspondent, I confessed, “I’m a little bit more sympathetic to central bankers now than I was ten years ago.”

IN 1996, I WAS asked to serve as chairman of the Princeton economics department, a position I would hold for six years. Being chair carried prestige and some ability to set the department agenda, but not much in the way of actual authority. Important matters were decided by consensus of the faculty, with considerable input from the university administration. I joked later that I was responsible for major policy decisions, such as whether to serve doughnuts or bagels at the department coffee hour. Faculty hiring and tenure decisions generated the most heat. Professors often pushed for colleagues they believed shared their own views or who would strengthen their subfield within the department. I quickly learned that trying to resolve disputes by fiat didn’t work in a crowd of strong-minded people with high regard for themselves. I had to consult, and listen, and listen some more. Once people had an opportunity to express their concerns they would often be satisfied, if not happy.

As my time as department chair wound down, I was looking forward to shedding administrative duties and spending more time on professional pursuits and writing. I had recently taken on two positions that would give me greater scope to influence the course of research in monetary economics. In 2000, I was named director of the monetary economics program at the National Bureau of Economic Research (a nonprofit organization headquartered in Cambridge, Massachusetts), and a year later I was selected to be editor of the American Economic Review. I had started writing a book about the Depression that I hoped would appeal to a broad audience. I had 120 pages and a title, Age of Delusion: How Politicians and Central Bankers Created the Great Depression.

Early in 2002, a phone rang outside my office in the economics department. It was Glenn Hubbard, a Columbia University professor on leave and serving as chairman of President Bush’s Council of Economic Advisers. “Will you take the call?” a secretary asked.

* Three decades later, Harvard’s facebook would inspire student Mark Zuckerberg to create the online social network of the same name.

† In my paper I suggested a temporary inflation target of 3 to 4 percent. I suggested the higher rate because years of deflation had resulted in a level of prices much lower than borrowers had expected when they took out longer-term loans, implying much higher debt burdens than borrowers had anticipated. Higher than normal inflation for a while would offset the effects of protracted deflation. What was key to my argument, however, was not the numerical value of the target but that a specific target be announced.

CHAPTER 3

Governor

Glenn asked a simple question: Would I be interested in coming to Washington to talk with the president about possibly serving on the Federal Reserve Board?

It was not a question that I had anticipated. I had studied monetary policy and the Federal Reserve for years, but mostly from the outside. Frankly, I had never expected to be part of the institution and contributing to policy decisions.

I thought about Glenn’s offer and discussed it with Anna. It was a big decision for both of us. For me, professionally, it would mean several years away from research and teaching just as I was finishing up my time as department chairman. And it might mean stepping down as editor of the American Economic Review only a year after taking the position. Going to Washington would also entail family sacrifices. Itwouldn’t be fair to ask Anna and Alyssa to move with me—Alyssa was still in high school—so I would have to live in D.C. and commute to New Jersey on weekends. Joel, at nineteen, was attending Simon’s Rock College in Great Barrington, Massachusetts.

But a stint at the Federal Reserve Board would allow me to see the process of policymaking from inside one of the country’s most powerful institutions. I was interested in all of the work of the Board, including the regulation and supervision of banks. The big attraction, however, was the chance to be involved in U.S. monetary policy. I had studied monetary economics and monetary history my entire professional career. What good was economics as a discipline, I asked myself, if it’s not used to improve policymaking and thereby make people better off? The nation was still recovering from the shock of the 9/11 attacks—our next-door neighbor, a good friend, had died in the World Trade Center—and I knew that many people were going to be called on to serve the country. Public service at the Federal Reserve

was hardly on par with what soldiers and first responders endure, but at least I could hope to contribute. With Anna’s assent, I called Glenn back and told him that I was interested.

I HAD READ extensively about the history and function of the Federal Reserve in the course of my research. It represented the fourth attempt by the United States to create a central bank, depending on how you count. Before the ratification of the Constitution, the congressionally chartered but privately owned Bank of North America (1782–1791) served as a de facto central bank. It was followed by the First Bank of the United States (1791–1811), initiated by Treasury secretary Alexander Hamilton over the bitter opposition of Secretary of State Thomas Jefferson and James Madison. Its twenty-year charter lapsed amid pervasive popular distrust of financiers and big banks. Next came the Second Bank of the United States (1816– 1836). Congress voted to extend the charter of the Second Bank, but President Andrew Jackson—the exemplar of populist antagonism to the bank—vetoed the extension in 1832, and Congress did not try again.

Despite not having a central bank, the United States established a national currency—the greenback— in 1862, eventually replacing a system in which private state-chartered banks issued their own currency. And in 1873, the country returned to the gold standard, which had been suspended during the Civil War.

Still, the absence of a central bank in the United States after 1836 had serious drawbacks. Most obviously, the country had no public institution that could respond to the recurring bank runs and financial panics that buffeted the economy, including major panics in 1837, 1857, 1873, 1893, and 1907, as well as many minor episodes.

Indeed, the final and ultimately successful attempt at creating a central bank, led by President Woodrow Wilson in 1913, was motivated by the Panic of 1907. Beginning in October 1907, runs by depositors in New York City, and the failure of a large financial firm called the Knickerbocker Trust, contributed to a sharp decline in stock prices and a significant recession. In the absence of a central bank, a private consortium led by the legendary financier J. Pierpont Morgan worked to end the panic, extending loans to institutions experiencing runs, examining their books, and reassuring the public. That a private citizen could act where the government could not was an embarrassment. In response, Congress in 1908 created a National Monetary Commission to study whether and how a central bank could be established for the United States. Legislative proposals appeared before Wilson took office.

Date: 2016-04-22; view: 690