A commenter named Marcus Nunes just sent me one of the most chilling quotations I have ever read, and it was from the minutes of a Fed meeting. But first a bit of background. In October 2008 the Fed made the same mistake as in early 1937; they put into effect regulations that increased the demand for bank reserves, just at the moment we were entering a recession. The 1937 action was actually more justifiable, because the recession was not yet visible. In both cases many economists made a logical error. In 1937 they assumed that higher reserve requirements wouldn’t be a problem because banks had lots of excess reserves—forgetting that they held ERs for a reason. In 2008 most economists focused on interest rates as the indicator of monetary policy, not expectations of future policy actions. The interest on reserves (IOR) program did not immediately raise rates, but did prevent them from immediately falling to zero. Much worse, it made future QE much less effective, as markets understood that any future increases in the monetary base would now be held as excess reserves.
Now the Fed is considering eliminating IOR as a way of stimulating the economy. Of course if they do that, it will be an implicit admission that the October 2008 action was contractionary in effect, and it will go down in the history books as an even worse mistake than the 1937 RR increase. Will the Fed be willing to “lose face” and admit its error?
My wife tells me that the Chinese don’t like to lose face. I assure her that we don’t have that problem here, Americans have no difficulty in admitting their mistakes and moving on. But the quotation that Marcus sent me has caused me to re-evaluate my view of Americans. Could the Fed really put losing face ahead of the well-being of hundreds of millions of Americans, many without jobs? It seems unthinkable, almost unimaginably cruel, but the following excerpt suggests that it did happen in 1937. Read it and then I’ll explain why. By the way, the opening and closing passage are from a paper by Orphanides.
On May 1, 1937, the final leg of the tightening was completed. With that in place, excess reserves fell back to levels as low as had not been seen since several years earlier (Figure 4). May 1937 also marked the peak of the incomplete expansion from the Great Depression of 1929-1932. The economy promptly returned to recession. Though the extent of the sharp decline in activity was not immediately evident, by Fall it became fully clear to the Committee that the economy was thrown back to a severe recession, once again. The following evaluation of the situation by Williams at the November 1937 meeting is informative, both for offering a frank admission that the FOMC apparently wished for a slowdown to occur and also for outlining the case that the recession, nonetheless, had nothing to do with the monetary tightening that preceded it. Particularly enlightening is the reasoning offered by Williams as to why a reversal of the earlier tightening action would be ill advised.
“We all know how it developed. There was a feeling last spring that things were going pretty fast … we had about six months of incipient boom conditions with rapid rise of prices, price and wage spirals and forward buying and you will recall that last spring there were dangers of a run-away situation which would bring the recovery prematurely to a close. We all felt, as a result of that, that some recession was desirable … We have had continued ease of money all through the depression. We have never had a recovery like that. It follows from that that we can’t count upon a policy of monetary ease as a major corrective. … In response to an inquiry by Mr. Davis as to how the increase in reserve requirements has been in the picture, Mr. Williams stated that it was not the cause but rather the occasion for the change. … It is a coincidence in time. … If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted. (FOMC Meeting, November 29, 1937. Transcript of notes taken on the statement by Mr. Williams.)”
The Federal Reserve made every effort to build a convincing case that the cause of the 1937 downturn could be more than accounted for by factors other than the monetary tightening and that policy action by the rest of the government and not by the Federal Reserve were needed to restore prosperity.
I suppose someone will say that Williams is denying that the RR increase caused the 1937 depression. Yes, he’s denying it, but you’d have to be even more naive than me (and that’s a pretty bad insult by the way) to believe he is sincere:
1. He admits that the policy was intended to be contractionary, indeed intended to cause a “recession.”
2. By November 1937 it was clear that the “recession” was becoming a depression.
3. They are discussing lowering RRs as an expansionary device.
4. Later on when the depression got worse (in 1938) they did lower RRs.
Let’s put him on the couch:
“We all felt, as a result of that, that some recession was desirable”
I.e., it wasn’t just my fault, we all felt that way.
If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn.
Do I even need to comment?
It makes a bad record and confused thinking.
Yes, we mustn’t let the public become “confused.”
I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression
A depression can’t be happening now, because that would mean I was wrong.
I would rather not muddy the record with action that might be misinterpreted
Muddy the record, or muddy my reputation?
A depression did occur, as NGDP fell roughly 5%. To give you an idea of just how bad it was, the largest yearly decrease since then was only 1.7%. BTW, that occurred in 2009, just after the Fed started the IOR.
Although I am generally a non-interventionist, for some strange reason I supported the Iraq War. (Actually 6 or 7 reasons, none of which seem very good today.) Sometimes in conversation I will mention how the Iraq War was a mistake, and people will say “But I thought you supported the war.” And I think to myself, “Yes, and your point is . . . “ Sometimes you just have to bite the bullet, admit your mistake, and move on.
I’ve led a sheltered life. I wasn’t in the room when Nixon conferred with his advisers after Watergate, or Kennedy met with his legal team after Chappaquiddick. So I am pretty naive about people. This transcript was a real eye-opener for me.
You probably think that I’m getting ready to accuse the Fed of being evil if they don’t get rid of the IOR. I’m afraid my naivete is so deeply ingrained that within days I’ll again be assuming they are well-intentioned civil servants doing the best they can. You guys are free to draw your own conclusions.