jep.27.4.full - Economic Perspectives Fall 2013 Volume 27 Number 4 Ben S Bernanke A Century of US Central Banking Goals Frameworks Accountability

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Unformatted text preview: Economic Perspectives Fall 2013, Volume 27, Number 4 Ben S. Bernanke, “A Century of US Central Banking: Goals, Frameworks, Accountability” Ricardo Reis, “Central Bank Design” Gary Gorton and Andrew Metrick, “The Federal Reserve and Panic Prevention: The Roles of Financial Regulation and Lender of Last Resort” Julio J. Rotemberg, “Shifts in US Federal Reserve Goals and Tactics for Monetary Policy: A Role for Penitence?” Barry Eichengreen, “Does the Federal Reserve Care about the Rest of the World?” Martin Feldstein, “An Interview with Paul Volcker” Articles Recommendations for Further Reading • Correction • Correspondence • Notes Economic Perspectives A journal of the American Economic Association Volume 27, Number 4 Nico Voigtländer and Hans-Joachim Voth, “Gifts of Mars: Warfare and Europe’s Early Rise to Riches” Benjamin Marx, Thomas Stoker, and Tavneet Suri, “The Economics of Slums in the Developing World” The Journal of Fall 2013 Economics and Moral Virtues Michael J. Sandel, “Market Reasoning as Moral Reasoning: Why Economists Should Re-engage with Political Philosophy” Luigino Bruni and Robert Sugden, “Reclaiming Virtue Ethics for Economics” Perspectives Symposia The First 100 Years of the Federal Reserve The Journal of Economic The Journal of Fall 2013 The Journal of Economic Perspectives A journal of the American Economic Association Editor David H. Autor, Massachusetts Institute of Technology Co-editors Chang-Tai Hsieh, University of Chicago Ulrike Malmendier, University of California at Berkeley Associate Editors Katherine Baicker, Harvard University Benjamin G. Edelman, Harvard University Raymond Fisman, Columbia University Gordon Hanson, University of California at San Diego Anil K Kashyap, University of Chicago Adam Looney, Brookings Institution David McKenzie, World Bank Kerry Smith, Arizona State University Chad Syverson, University of Chicago Christopher Udry, Yale University Managing Editor Timothy Taylor Assistant Editor Ann Norman Editorial offices: Journal of Economic Perspectives American Economic Association Publications 2403 Sidney St., #260 Pittsburgh, PA 15203 email: [email protected] The Journal of Economic Perspectives gratefully acknowledges the support of Macalester College. Registered in the US Patent and Trademark Office (®). Copyright © 2013 by the American Economic Association; All Rights Reserved. Composed by American Economic Association Publications, Pittsburgh, Pennsylvania, USA Printed by R. R. Donnelley Company, Jefferson City, Missouri, 65109, USA No responsibility for the views expressed by the authors in this journal is assumed by the editors or by the American Economic Association. THE JOURNAL OF ECONOMIC PERSPECTIVES (ISSN 0895-3309), Fall 2013, Vol. 27, No. 4. The JEP is published quarterly (February, May, August, November) by the American Economic Association, 2014 Broadway, Suite 305, Nashville, TN 37203-2418. Annual dues for regular membership are $20.00, $30.00, or $40.00 depending on income; for an additional $15.00, you can receive this journal in print. E-reader versions are free. For details and further information on the AEA go to . Periodicals postage paid at Nashville, TN, and at additional mailing offices. POSTMASTER: Send address changes to the Journal of Economic Perspectives, 2014 Broadway, Suite 305, Nashville, TN 37203. Printed in the U.S.A. The Journal of Economic Perspectives Contents Volume 27 • Number 4 • Fall 2013 Symposia The First 100 Years of the Federal Reserve Ben S. Bernanke, “A Century of US Central Banking: Goals, Frameworks, Accountability” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Ricardo Reis, “Central Bank Design” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Gary Gorton and Andrew Metrick, “The Federal Reserve and Panic Prevention: The Roles of Financial Regulation and Lender of Last Resort” . . . . . . 45 Julio J. Rotemberg, “Shifts in US Federal Reserve Goals and Tactics for Monetary Policy: A Role for Penitence?” . . . . . . . . . . . . . . . . . . . . . . . . . 65 Barry Eichengreen, “Does the Federal Reserve Care about the Rest of the World?” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 Martin Feldstein, “An Interview with Paul Volcker” . . . . . . . . . . . . . . . . . . . . . . . 105 Economics and Moral Virtues Michael J. Sandel, “Market Reasoning as Moral Reasoning: Why Economists Should Re-engage with Political Philosophy” . . . . . . . . . . . . . . . . . . . . 121 Luigino Bruni and Robert Sugden, “Reclaiming Virtue Ethics for Economics” 141 Articles Nico Voigtländer and Hans-Joachim Voth, “Gifts of Mars: Warfare and Europe’s Early Rise to Riches” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 Benjamin Marx, Thomas Stoker, and Tavneet Suri, “The Economics of Slums in the Developing World” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187 Features Timothy Taylor, “Recommendations for Further Reading” . . . . . . . . . . . . . . . . . 211 James Poterba, Steven Venti, and David Wise “Correction: The Composition and Drawdown of Wealth in Retirement” . . . . . . . . . . . . . . . . . . . . . . . . . . . 219 “Correspondence: Patents and the Dissemination of Inventions”: Dean Alderucci and William J. Baumol, with Michele Boldrin and David K. Levine . . 223 Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227 Statement of Purpose The Journal of Economic Perspectives attempts to fill a gap between the general interest press and most other academic economics journals. The journal aims to publish articles that will serve several goals: to synthesize and integrate lessons learned from active lines of economic research; to provide economic analysis of public policy issues; to encourage cross-fertilization of ideas among the fields of economics; to offer readers an accessible source for state-of-the-art economic thinking; to suggest directions for future research; to provide insights and readings for classroom use; and to address issues relating to the economics profession. Articles appearing in the journal are normally solicited by the editors and associate editors. Proposals for topics and authors should be directed to the journal office, at the address inside the front cover. Policy on Data Availability It is the policy of the Journal of Economic Perspectives to publish papers only if the data used in the analysis are clearly and precisely documented and are readily available to any researcher for purposes of replication. Details of the computations sufficient to permit replication must be provided. The Editor should be notified at the time of submission if the data used in a paper are proprietary or if, for some other reason, the above requirements cannot be met. Policy on Disclosure Authors of articles appearing in the Journal of Economic Perspectives are expected to disclose any potential conflicts of interest that may arise from their consulting activities, financial interests, or other nonacademic activities. Journal of Economic Perspectives Advisory Board Tim Besley, London School of Economics Olivier Blanchard, International Monetary Fund Elizabeth Hoffman, Iowa State University Christopher Jencks, Harvard University David Leonhardt, The New York Times Carmen Reinhart, Peterson Institute John Roemer, Yale University Howard Rosenthal, New York University Journal of Economic Perspectives—Volume 27, Number 4—Fall 2013—Pages 3–16 A Century of US Central Banking: Goals, Frameworks, Accountability Ben S. Bernanke S everal key episodes in the 100-year history of the Federal Reserve have been referred to in various contexts with the adjective “Great” attached to them: the Great Experiment of the Federal Reserve’s founding, the Great Depression, the Great Inflation and subsequent disinflation, the Great Moderation, and the recent Great Recession. Here, I’ll use this sequence of “Great” episodes to discuss the evolution over the past 100 years of three key aspects of Federal Reserve policymaking: the goals of policy, the policy framework, and accountability and communication. The changes over time in these three areas provide a useful perspective, I believe, on how the role and functioning of the Federal Reserve have changed since its founding in 1913, as well as some lessons for the present and for the future. The Great Experiment The original goal of the Great Experiment that was the founding of the Fed was the preservation of financial stability. In the words of one of the authors of the Federal Reserve Act, Robert Latham Owen (1919, p. 24), the Federal Reserve was Ben S. Bernanke is Chairman of the Board of Governors of the Federal Reserve System, Washington, DC. ■ doi=10.1257/jep.27.4.3 4 Journal of Economic Perspectives established to “provide a means by which periodic panics which shake the American Republic and do it enormous injury shall be stopped.”1 At the time, the standard view of financial panics was that they were triggered when the needs of business and agriculture for liquid funds outstripped the available supply — as when seasonal plantings or shipments of crops had to be financed, for example— and that panics were further exacerbated by the incentives of banks and private individuals to hoard liquidity during such times (Warburg 1914). The new institution was intended to relieve such strains by providing an “elastic” currency: that is, by providing liquidity as needed to individual member banks through the discount window. Commercial banks, in turn, would then be able to accommodate their customers. Interestingly, although congressional advocates hoped the creation of the Fed would help prevent future panics, they did not fully embrace the idea that the Fed should help end ongoing panics by serving as lender of last resort, as had been famously recommended by the British economist and writer Walter Bagehot (1873 [1897]), the source of the classic dictum that central banks should address panics by lending freely at a penalty rate (see also Willis 1923, p. 1407; Carlson and Wheelock 2012; Bordo and Wheelock 2013). Instead, legislators imposed limits on the Federal Reserve’s ability to lend in response to panics, for example, by denying nonmember banks access to the discount window and by restricting the types of collateral that the Fed could accept.2 Soon after the Federal Reserve was founded in 1913, its mission shifted to supporting the war effort and then to managing the unwinding of that support. The year 1923 was thus one of the first in which the Federal Reserve confronted normal peacetime financial conditions, and it took the opportunity to articulate its views on the appropriate conduct of policy in such conditions in the Tenth Annual Report of the Federal Reserve Board (Board of Governors 1924). The framework that the Federal Reserve employed in these early years to promote financial stability reflected in large measure the fact that the United States was on the gold standard as well as the influence of the so-called “real bills” doctrine.3 1 A 1929 book review by the financial editor of the New York Times, making reference both to the idea of a “great experiment” and to the broad responsibilities for financial stability of the new central bank, observed: “The Federal Reserve System has from the first necessarily been a great experiment, bound to adjust its general policies to the requirements of such novel and varying situations as should arise in the course of our financial history and which could not possibly be foreseen” (Noyes 1929). To be sure, the US Treasury carried out some central banking functions before the creation of the Federal Reserve, and the First and Second Banks of the United States represented early attempts to establish a central bank. By 1913, however, it had been about 75 years since the latter institution had ceased fulfilling that purpose. Moreover, the Federal Reserve operated somewhat differently from the prior institutions, as well as from existing central banks abroad, and thus its creation amounted to an experiment. 2 The collateral acceptable to be pledged to the discount window has been expanded significantly over time; in particular, various pieces of banking legislation in the early 1930s enabled the Federal Reserve to make advances to member banks so long as the loans were “secured to the satisfaction” of the Federal Reserve Bank extending the loan. The Monetary Control Act of 1980 gave all depository institutions access to the discount window. 3 Humphrey (1982) discusses the historical evolution of the real bills doctrine. He notes that, in its simplest form, the doctrine contends that banks should lend against short-term commercial paper Ben S. Bernanke 5 In the real bills doctrine, the Federal Reserve saw its function as meeting the needs of business for liquidity— consistent with the idea of providing an elastic currency— with the ultimate goal of supporting financial and economic stability. When business activity was increasing, the Federal Reserve would seek to accommodate the need for credit by supplying liquidity to banks; when business was contracting and less credit was needed, the Fed would then reduce the liquidity in the system. The policy framework of the Fed’s early years has been much criticized in retrospect. Economic historians have pointed out that, under the real bills doctrine, the Fed increased the money supply precisely at those times at which business activity and upward pressures on prices were strongest; that is, monetary policy was procyclical. Thus, the Fed’s actions tended to increase rather than decrease the volatility in economic activity and prices (Friedman and Schwartz 1963; Humphrey 1982; Meltzer 2003). As noted, the Federal Reserve pursued its real bills approach in the context of the gold standard. In the 1920s, Federal Reserve notes were redeemable in gold on demand, and the Fed was required to maintain a gold reserve equal to 40 percent of outstanding notes. In principle, the gold standard should limit discretion by monetary policymakers, but in practice US monetary policy did not appear to be greatly constrained in the years after the Fed’s founding. Indeed, the large size of the US economy, together with the use of market interventions that prevented inflows and outflows of gold from being fully translated into changes in the domestic money supply, gave the Federal Reserve considerable scope during the 1920s to conduct monetary policy according to the real bills doctrine without much hindrance from the gold standard.4 I’ve discussed the original mandate and early policy framework of the Federal Reserve. What about its accountability to the public? When the Federal Reserve was established, the question of whether it should be a private or a public institution was highly contentious. The compromise solution created a hybrid Federal Reserve System. The system was headed by a federally appointed Board of Governors, which initially included the Secretary of the Treasury and the Comptroller of the Currency. However, the 12 regional Reserve Banks were placed under a mixture of public and private oversight, including board members drawn from the private sector, and they associated with real business transactions (as opposed to other activities such as speculative investment). According to this doctrine, central banks should expand the money supply to facilitate this type of bank lending, by buying commercial paper from banks or accepting as collateral banks’ holdings of such paper. Thus, the doctrine implies that the money supply should expand and contract along with business activity. 4 Specifically, the Fed was able to sterilize the effects of gold flows on the domestic money supply through open market operations —the purchase and sale of government securities in the open market. Initially, the Fed’s main tools were the quantity of its lending through the discount window and the interest rate at which it lent — the discount rate. Open market operations were “discovered” when, to generate earnings to finance its operations, the Federal Reserve began in the 1920s to purchase government securities. Fed officials soon found that these operations affected the supply and cost of bank reserves and, consequently, the terms on which banks extended credit to their customers. Subsequently, of course, open market operations became a principal monetary policy tool, one that allowed the Fed to interact with the broader financial markets, not only with banks (Strong 1926). 6 Journal of Economic Perspectives were given considerable scope to make policy decisions that applied to their own districts. For example, Reserve Banks were permitted during this time to set their own discount rates, subject to a minimum set by the Board of Governors. While the founders of the Federal Reserve hoped that this new institution would provide financial and hence economic stability, the policy framework and the institutional structure would prove inadequate to the challenges the Fed would soon face. The Great Depression The Great Depression was the Federal Reserve’s most difficult test. Tragically, the Fed failed to meet its mandate to maintain financial stability. In particular, although the Fed provided substantial liquidity to the financial system following the 1929 stock market crash, its response to the subsequent banking panics of the 1930s was limited at best; the widespread bank failures and the collapse in money and credit that ensued were major sources of the economic downturn. Bagehot’s dictum to lend freely at a penalty rate in the face of panic appeared to have few adherents at the Federal Reserve of that era (Friedman and Schwartz 1963). Economists have also identified a number of instances from the late 1920s to the early 1930s when Federal Reserve officials, in the face of the sharp economic contraction and financial upheaval, either tightened monetary policy or chose inaction. Some historians trace these policy mistakes to the early death in 1928 of Benjamin Strong, Governor of the Federal Reserve Bank of New York, which left the decentralized system without an effective leader (for example, Friedman and Schwartz 1963, chapter 7). This hypothesis, whether valid or not, raises the interesting question of what intellectual framework an effective leader would have drawn on at the time to develop and justify a more activist monetary policy. The degree to which the gold standard actually constrained US monetary policy during the early 1930s is debated; but, in any case, the gold standard philosophy clearly did not encourage the sort of highly expansionary policies that were needed.5 The same can be said for the real bills doctrine, which apparently led policymakers to conclude, on the basis of low nominal interest rates and low borrowings from the Fed, that monetary policy was appropriately supportive and that further actions would be fruitless (Meltzer 2003; Romer and Romer 2013). Historians have also noted the prevalence at the time of yet another counterproductive doctrine: the so-called “liquidationist view” that depressions perform a necessary cleansing function (as discussed, for 5 The US commitment to the gold standard might have constrained policy if looser monetary conditions, by encouraging capital outflows and a higher demand for imports, induced sufficient gold outflows to threaten the gold backing of the dollar (Eichengreen 1992). Wicker (1965) and Temin (1989) suggest that US policymakers in the early 1930s indeed felt constrained by the gold standard. In contrast, Hsieh and Romer (2006), as well as Bordo, Choudhri, and Schwartz (2002), focus on the short-lived monetary expansion in 1932 as evidence against the idea that the gold standard imposed important constrain...
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