St. Louis Discussion Club
Thursday, April 10, 2003
Roger W. Garrison

Boom, Bust, and the Federal Reserve: 
Are There Parallels to the 1920s?

I'd like to begin with a few autobiographical remarks—not because I think you ought to know all about me but rather to tie my discussion of the parallels mentioned in my title to the monetary wisdom that prevailed for a brief period some twenty years ago. My approach also allows a few ironies to emerge from the discussion.

Some thirty-five years ago, I was an undergraduate in engineering just down the road at Rolla, Missouri and was in the last graduating class that had the option of buying a class ring that said Missouri School of Mines rather than University of Missouri at Rolla. I opted for the MSM ring because of the solid reputation the School of Mines had in applied mathematics and analytical methods generally and in my own field of electrical engineering. 

My class was also one of several in that era that had to deal with the military draft. I opted for a commission in the Air Force, which kept me out of the Army and, as things turned out, kept me in the contiguous 48 during the Vietnam War. I became a military systems engineer, specializing in electronic countermeasures. At the end of my tour, which pretty much coincided with the end of the war, there was a glut in the market for engineering—hitting especially hard the aerodynamic and electrical engineers. My live options were to stay in warfare electronics, going to work for a defense contractor, or to get out of engineering.

Eventually, and in a sequence of decisions, I effectively opted out of engineering. Just how I opted into the field of economics could take some explaining. But to make that long story short, I won't tell it—except to say that I earned a masters degree in economics just up the river from here at UMKC and spend the better part of two years at the Kansas City Federal Reserve bank, eventually continuing my graduate studies at the University of Virginia. 

Virginia's economics department in the mid seventies was in decline. Jim Buchanan and Gordon Tullock had left. Warren Nutter had fallen ill, and the few others to whom UVA owed its good reputation (for its adherence to the principles of classical liberalism) were on the political outs. The department was beginning to turn towards mathematical economics—though not as much so as was the general trend in those years. In the field of macroeconomics, there wasn't much sympathy for Keynesianism, except in the first-semester core course. That course was taught by a visiting professor who was so inept as to make Keynes's ideas monumentally unappealing, despite his trying to do just the opposite. In those years, monetarism and its offshoots (new classicism and rational expectations) were considered to be the mainstream and the cutting edge of monetary theory.

I begin with this autobiographical sketch to make two points. First, although I have a strong mathematical background, I have little or no inclination to take a mathematical approach to economics. I learned the mathematical tools separately from the substantive content of economics, a training sequences that keeps the math in perspective—which, in many cases, is to say that it keeps the math at bay. In monetary economics, what often matters most are the institutional arrangements, which can limit the policymaker's options and in some cases can all-but-guarantee that pro-active policy will do more harm than good.

Second, I can use the simple truths of monetarism that I learned at UVA as well as the so-called monetarist experiment of the early 1980s as a benchmark for making contrasts both backward in time (to the 1920s) and forward in time (to the 1990s). Let me see if I can state those monetarist truths in a way that is understandable and that works to my own advantage in comparing the most recent economic expansion to the one that occurred three-quarters of a century ago.

SIMPLE TRUTH #1 (which usually goes unstated): Under suitably designed monetary institutions, a magnitude known as THE money supply is discernible. I'm oversimplifying a bit here because there were always several magnitudes (M1, M2, M3, etc.) that had a claim on our attention. However, the most basic M, which is the simply the total of coin, currency and checking-account balances, had a special claim on our attention, as I'll make clear shortly. M1 was the M to watch. And I might mention that the other Ms all moved in the same direction and at about the same rate as M1—which meant that theoretical results were robust with respect to the money-supply definition.

SIMPLE TRUTH #2. People hold a small part of their wealth in the form of money. Their willingness to do so, that is, their demand for money, doesn't change much over time, Hence, with a given level of economic output, there is a strong quantitative relationship between the quantity of money in the economy and the general level of prices. Demonstrating the relative constancy of money demand empirically—for many different countries and for many different time periods—is Milton Friedman's legacy to monetary economics. Showing that money demand is stable yields the conclusion that monetary disturbances come from the supply side of the money market—or, more pointedly, from the Federal Reserve. Friedman's empirical research underlies his celebrated statement: "Inflation is always and everywhere a monetary phenomenon." That is, any sustained rise in the price level is a direct reflection of a prior growth in the money supply. The word "prior" here should get some emphasis. The lag, long and variable as described by Friedman, was thought to be somewhere between 18 and 30 months.

SIMPLE TRUTH #3. For an economy that enjoys real economic growth of, say, 2-3 percent over the long run, a steady increase in the money supply of that same 2-3 percent will prevent both inflation and deflation. The monetarists express this simple truth mathematically using the equation MV=PQ—an equation that also once served as the license plate number on Friedman's Cadillac Eldorado. Again, I may be accused of oversimplification, since I haven't allowed for some slow secular change in the demand for money. But whether simplistic or just simple, this was Friedman's monetary rule. Attempts to enhance the economy's performance by varying the rate of monetary growth in order to offset perceived variation in other magnitudes—the demand for money or the level of employment—is more likely to degrade the economy's performance than to improve it. (By the way, if 2-3 percent seems too imprecise to constitute a rule, let me invite you to consider an alternative rule articulated by Richard Timberlake, a monetarist-emeritus at the University of Georgia. He adds precision by expressing the rule to the nearest hundredth of a percent. Allowing for a very mild inflation, Professor Timberlake would have the Federal Reserve increase the money supply at the rate of 3.65 percent each year—except for leap years, when the rate should be adjusted upward to 3.66 percent!)

The so-called monetarist experiment doesn't quite live up to its name, a point that Professor Timberlake never tires of making. (I append the "so-called" in his honor.) If the early 1980s actually belonged to the monetarists, you should expect that I would be able to indicate just what monetary rule the Federal Reserve settled on and just how they stuck to it during the experiment. The truth is that the Federal Reserved simply adopted Monetarist operating procedures—but without committing to some long-run monetary rule. 

Let me explain.

The Fed has its influence on the supply side of the market for bank reserves, which get swapped around among commercial banks, the borrowing banks paying interest (the federal funds rate) to the lending banks. And with the reserve requirement set by the Fed, the volume of checking-account money becomes some multiple of the reserves. The Fed can sweeten the pool of reserves until it achieves some particular federal funds rate. This is called interest-rate targeting. Or it can sweeten the pool of reserves until it achieves a certain magnitude for, say, M1. This is called money-supply targeting. But it can't do both. It can target the federal funds rate and let M1 be what it will, or it can target M1 and let the federal funds rate rise or fall to its market clearing level.

At the end of the 1970s, when both the inflation rate and the federal funds rate were in the double-digit range, the Fed abandoned interest rate targeting in favor of money-supply targeting. This was the essence of the so-called monetarist experiment. For the first few years of the 1980s, the Fed, under the leadership of Paul Volcker, formulated and implemented policy in terms of money supply targets—though it never actually committed itself to a Friedmanesque monetary rule. The Fed would report periodically on its performance and intentions. It would explain why it had overshot its most recent money-supply target and then set a new target, starting, of course, from a base that was already—and chronically—off the mark on the high side. The phenomenon was known as base drift. Incentives to inflate—whether to accommodate Treasury borrowing or to stimulate the economy—were always stronger than the incentive actually to hit the most recently announced money-supply target.

Money growth rates during those years were erratic and, on average, too high, a summary judgment that Milton Friedman made at every opportunity. My own point in this retrospective is a different one. It is noteworthy now—but went without saying at the time—that the Fed could actually specify a target. Never mind, for the moment, that it almost never hit the target. It did, at least, actually have one to shoot at. Explaining how a money supply target could be readily specified entails what I've called the irony of monetarism. Dating from the mid-1930s banking reforms, banks were prohibited from paying interest on checking accounts. Checking-account money, in effect, was subject to an interest-rate ceiling set at zero percent. As a matter of legislative decree, then, a bank account could be either checkable (a demand deposit) or interest-bearing (a savings deposit) but not both. Regulation Q, as it was called, created something close to a black-and-white distinction between money and nonmoney. 

So, here is the irony. According to the monetarists, markets work best without government-imposed regulations-without price floors or price ceilings, for instance. But a smoothly functioning economy does require price-level stability, which requires a monetary rule, which requires a crisply defined money supply, which requires an interest-rate ceiling of zero percent on checking-account money. 

Take away the ceiling and there goes the crispness of distinction between money and nonmoney; there goes the discernable target, there goes even the possibility of a monetary rule. And coincident with the so called monetarist experiment itself was the phasing out of Regulation Q. Finally, now, we can do a comparison of the money-supply targeting of the early Volcker Fed with monetary policies that predate the bank reforms that gave us Regulation Q and that postdate the phasing out of this little piece of intervention. 

During the early years of the Federal Reserve, the focus was on credit market conditions, which is to say, on interest rates. Little attention was paid to the money supply. Throughout the roaring '20s and even into the depressing '30s, the money supply was simply allowed to do what it would as the Federal Reserve set about meeting the needs of trade-needs that were high during the expansion and low during the contraction. 

Leland Yeager, a monetarist emeritus at Auburn University and refugee from the University of Virginia, tells a story that he picked up years ago from an associate of Irving Fisher. Fisher was a pre-Friedman monetarist, who did much to keep the quantity theory of money alive in the early decades of the twentieth century. He watched the modest monetary growth and relatively stable prices during the '20s with great satisfaction, declaring that we had achieved a new plateau of prosperity. He watched the money supply shrink in the early '30s with great alarm. At one point, circa 1931, he confronted Eugene Meyer, the Alan Greenspan of his day, and pressed the issue directly: "Aren't you a little concerned about what's happening to the money supply?" Governor Meyer paused and then replied, "Oh, I don't know. What is happening to the money supply"? Manipulating interest rates, meeting the needs of trade, and keeping score in the then ongoing power struggle between the Federal Reserve Board and the New York Federal Reserve Bank all had higher priority than monitoring changes in the money supply. (By the way, dealing with gold also got a lot of attention, too. While paying lip service to the principles of the gold standard, the Fed kept the gold standard from working by sterilizing gold flows—keeping inflows of gold from increasing the money supply and keeping outflows from reducing it. Federal Reserve policymakers favored the gold standard only if all central banks played by the rules of the game—as if using gold as money were actually some kind of a game.)

Yeager's story about Eugene Meyer has its parallel in modern times. Not long ago, during one of Alan Greenspan's appearances on Capitol Hill, he was asked a question that had a distinct monetarist flavor to it. Greenspan's own concerns were about perceived productivity gains and the consequent potential for easing credit conditions without refueling the fires of inflation. He responded to the monetarist question in a forlorn tone: "We don't know what money is, anymore." The sound bite was picked up by Jay Leno and drew more than a few guffaws from the Tonight Show audience. "I don't know who should be running this country's central bank," Leno quipped, "but surely it should be someone who does know what money is." 

In the absence of Regulation Q, the distinction between checkable accounts and interest-bearing accounts, was hopelessly blurred. In recent years other institutional and technological factors have only added to the blur. Now, the different measures of money move at different rates and sometimes in opposite directions. M1 has become almost meaningless, and the relationship between bank reserves and some of the other measures is difficult if not impossible to pin down. Money supply targeting is simply not a option that the Federal Reserve has anymore. It has no plausible basis for specifying a particular money-supply target, and little hope of actually hitting it. Further, dating to about 1982, the demand for money—tracked as velocity in the monetarists' equation of exchange, a variable shown to be stable in earlier years, had become unstable. Even hitting a money-supply target, then, would not have straightforward implications about the price level. Interest-rate targeting has become the default-mode operating procedure. And there seems to be no turning back.

And so we have it: In the '20s and '30s, the Federal Reserved manipulated credit market conditions with an eye to the needs of trade and without much attention to the money supply; In the '90s and into the 21st century, the Federal Reserve has manipulated credit conditions with an eye to productivity gains and without much attention to the money supply. The parallels are pretty strong. (I might mention here that the term "needs of trade" was common among proponents of the real bills doctrine—which is widely understood today as the real bills fallacy. In my judgment, a similar fallacy is involved in Greenspan's reasoning that is based on perceived productivity gains. An unusually high level of measured productivity in interest-sensitive industries is more likely the effect of prior monetary ease rather than a justification for further ease.)

The parallels get stronger when we consider what actually happened to the price level during the '20s and during the '90s. In both decades the inflation rate was low by historical standards. The price level was virtually constant during the '20s, it rose at a rate somewhat less than 3 percent during the 1990s. Inflation cannot be seen as a problem in its own right in either episode. 

I've already identified one irony of monetarism. We're now in a position to identify another one. During the episode that we call the monetarist experiment, roughly 1979-1982, money growth, which was strong and very erratic, gave us an inflation rate in the high single digits (We should acknowledge, though, that this was an improvement over the low double-digit inflation that characterized the end of the Carter administration.) By contrast, during the '20s and again during the '90, the inflation rate was nil or very low, despite the Federal Reserve's inattention to the money supply. And so we have our second irony: When the Fed tried—though arguably not in earnest—to hit a well defined money-supply target, it failed. But when it didn't or couldn't identify a relevant money-supply target, it succeeded in managing its affairs in a way that, willy nilly, kept inflation at historically low levels.

Ironies, it turns out, come in threes. A third irony linking the '20s with the '30s is the most worrisome one. Whether achievable through money-supply targeting or not, a constant price level has always been taken by the monetarists as the hallmark of macroeconomic stability. The hallmark-status of price-level constancy is not argued for by Friedman but simply taken for granted on the basis of a perceived tradition and near-consensus in the profession. Significantly, economists critical of monetarism have argued against price-level constancy as a policy objective. Austrian economist F. A. Hayek, who spent some time in the United States in the early '20s, identified the consequences of Federal Reserve policy as "artificial price-level stability," a term that could only be puzzling to monetarists.

So, what is artificial about price-level stability? In answering this question, we see still more parallels between the '20s and the '90s. Real economic growth was substantial in both decades. in the early decade, much of the increased output came in the forms of automobiles, household appliances (made viable by electrification), and processed foods. In the recent decade, the growth was in the forms of computer hardware and software, internet-based businesses, and just-in-time inventory management. In any period characterized by real economic growth, output prices tend to fall in those sectors that account for the growth—with the result that the overall price level edges downward. If more goods are traded against an unchanged number of dollars, the average unit price must be lower. This obvious and unlamentable consequence fails to materialize only if the central bank increases the number of dollars to keep pace with the increase in output. It is true, of course, that growth-induced deflation coupled with money-induced inflation can have the net result of price-level constancy.

Following the early work of Ludwig von Mises, F. A. Hayek realized that additions to the money supply came into the economy through credit markets and hence impinged directly on interest rates. This injection effect had consequences of its own quite apart from countering the deflation that would otherwise occur. Absent monetary expansion, the interest rate will adjust itself to the behavior of savers and borrowers. This is the rate that has long been called the natural rate of interest. It's the rate that governs the economy's investment sector, keeping investment undertakings in line with the saving that will see them through to completion. It's the rate that keeps the economy's growth rate in line with the trade-offs we all make between consuming now and saving for the future. Credit markets governed by the natural rate of interest are a strict pre-requisite, according to Hayek, to sustainable economic growth.

The Austrian economists, and particularly Mises and Hayek, realized that an artificially low rate of interest would set the stage for unsustainable economic growth. With easy money and cheap credit, more investment projects would be undertaken than could possibly be completed. A credit-induced artificial boom would lead, inevitably, to a bust. This is the Austrian theory of the business cycle. I like to make the distinction between the consequences of increased saving and the consequences of increased money: A saving-induced increase in investment will play itself out as economic growth. A money-induced increase in investment will not play itself out but rather will do itself in. The economy will suffer a boom-bust sequence and the Federal Reserve will have created the very sort of instability that it hoped a constant price level would somehow prevent. 

Monetarists are unattuned to the real consequences of holding the interest rate below its natural level. Allan Meltzer just published the first volume of his History of the Federal Reserve (Chicago: University of Chicago Press, 2003). This book runs 800 pages and covers only the first 37 years of the Fed's 90-years existence. The foreword is written by Alan Greenspan. Comprehensive as Meltzer's treatment is, he gives no hint that the interest rate plays a role in keeping investment in line with saving and hence governing the economy's growth rate or that cheap credit can get investment out of line with saving and set the economy off on an unsustainable growth path. (On a more positive note, Jerry Jordon, recently retired president of the Cleveland Federal Reserve Bank, has wondered out loud if allowing prices to fall in the face of increased output might allow the price system to operate more efficiently. He has even cited Hayek on the point. But actually implementing this productivity norm, as it has come to be called, has never been given serious consideration by the Federal Reserve.) 

And so we have our third and final irony: In circumstances of substantial real economic growth, a constant or slowly rising price level can create the illusion of economic stability, even though the monetary policy essential for maintaining this artificial constancy sets the economy onto a growth path that cannot be sustained. By according hallmark status to price level constancy, the monetarists have blinded generations of economists to the hazards of easy money. The New Economy of the '90s, like the New Plateau of Prosperity of the '20s, was a bust waiting to happen.

Let me conclude with a brief survey of the state of debate in the Federal Reserve today.

Judging from recent speeches by Federal Reserve Board Member Ben Bernanke, the conflict in policy debates these days is between the "inflation hawks" and the "growth hawks." The inflation hawks want to fight inflation; the growth hawks want to stimulate growth. Bernanke, who himself is something of a "deflation hawk," advocates "inflation targeting," a scheme that supposedly can achieve everyone's goals. I'm prepared to reject all such targets and declare myself a "natural-rate hawk." That is, I believe that the rate of interest should be determined by the impersonal forces in the market place and not by the various hawks within the Federal Reserve all shooting at targets they can hardly identify and are unlikely to hit.

Thank you for your attentiveness.