The Federal Reserve: A New History

Published by EH.Net (August 2023).

Robert Hetzel. The Federal Reserve: A New History. Chicago: University of Chicago Press, 2023. 696 pp. $45 (hardcover), ISBN: 978-0226821658.

Reviewed for EH.Net by Michael D Bordo, Rutgers University.

Robert Hetzel has written an ambitious history of Federal Reserve monetary policy since the establishment of the Federal Reserve System in 1913. The book follows an illustrious narrative tradition going back to Milton Friedman and Anna Schwartz’s A Monetary History of the United States:1867 to 1960 (1963) and Allan Meltzer’s A History of the Federal Reserve (2005, 2010). But unlike the earlier books it is based on the modern macroeconomic theory first pioneered by Robert Lucas (1972) and an analytical approach to monetary policy developed since the 1980s at the Federal Reserve Bank of Richmond, where Hetzel was a senior researcher and advisor for five decades.

The author uses the narrative approach of Friedman and Schwartz (1963) and Romer and Romer (2004), which views the history of business cycles under the Fed as semi-controlled experiments. He compares the performance of the Fed in its use of its policy tools to stabilize the business cycle (maintaining both price stability and real output at full potential) across all cycles since establishment of the Fed.

His analysis is based on two sets of modern tools developed by researchers connected with the Richmond Fed. The first is the microeconomic analysis of the connection between Fed monetary policy and the money market via the demand and supply of borrowed and non-borrowed reserves (“the plumbing of monetary policy”) developed by Marvin Goodfriend and others in Cook and LaRoche (1993). The second is the macroeconomic New Keynesian model under rational expectations and the assumption of sticky price setting developed by Marvin Goodfriend and Robert King (1997), which models the strategies required to match the Fed’s real policy rate (the federal funds rate) to Knut Wicksell’s natural rate of interest (further developed by Michael Woodford 2000).

Hetzel’s analytical framework provides a modern perspective to the Modern Quantity Theory of Money framework followed by Friedman and Schwartz (1963) and Meltzer (2005, 2010). Unlike those books, here the model framework is front and center, instead of subtly intertwined with the narrative and buried in footnotes. Hetzel also comparatively downplays the role of monetary aggregates in the Fed’s monetary policy making. An implication of this approach is that a reader who is not familiar with the post-Lucas macro tradition may have difficulty reading this book.

The author divides his narrative of Fed history into three separate regimes. First is the early pre-World War II Fed, embedded in the gold standard and real bills traditions inherited from the nineteenth century. This was followed by the post-World War II regime (1951-1979), which began under Chairman William McChesney Martin who employed a countercyclical policy based on a reaction function referred to as LAW (Leaning Against the Wind) with tradeoffs. Hetzel refers to the third regime (1979 to 2006) associated with Paul Volcker and Alan Greenspan as LAW with Credibility.

The Early Fed

The Federal Reserve Act of 1913 was based on two principles: the gold standard under which the role of a central bank was to use its discount rate to maintain gold convertibility. With free capital mobility the domestic interest rate was determined by the world interest rate and a central bank only had limited ability to pursue domestic objectives (Bordo and MacDonald 2005). Under the real bills doctrine the Fed could use its discount rate to buy and sell eligible (self-liquidating) commercial paper (real bills) and to eschew operations in speculative assets on the belief that speculation would lead to asset price booms, then to inflation in goods and services, followed by an asset price bust, deflation and depression. According to the real bills doctrine were the Fed to only operate in real bills there would never be a surplus or shortage of money (credit) and the economy would always be in balance.

Hetzel posits that the early Fed should be viewed as the first modern central bank to be on a fiat money standard, that the Fed was not constrained by its adherence to the gold standard, unlike the pre-World War I central banks of Europe. This was because the U.S. was a large relatively closed economy, and the Fed could easily sterilize gold flows by offsetting open market operations. According to him, the key failure of the interwar Fed was that it did not learn to base its policies on a reaction function, whereby the Fed would gear changes in its policy rate on deviations from price stability and real economic potential. Instead, it mistakenly based its policy on the real bills doctrine and seemed to view its sole function as preventing speculative excesses.

The author’s primarily closed economy approach could be challenged by extensive evidence that the international capital markets under the interwar gold exchange standard were as efficient as pre-1914 (Bordo and MacDonald 2002) and hence that the U.S. was influenced by international monetary forces. Indeed, the well-known global gold standard approach of Jacques Rueff, Robert Mundell and Barry Eichengreen is totally absent. At the very least, the U.S. was a large open economy with imperfect capital mobility, as argued by Bordo, Choudhri and Schwartz (2002), and the Fed followed a managed gold standard, as earlier argued by Friedman and Schwartz.

In the Hetzel story, as has been argued earlier by Brunner and Meltzer (1968), Wheelock (1992), and Meltzer (2005), the Fed’s real bills approach led it to begin a tight money policy beginning in early 1928 to stem the Wall Street boom that had begun in 1926. This led to the Great Contraction of 1929 to 1933. Moreover, unlike Friedman and Schwartz, Meltzer (2005) and Bernanke (1983), the author views the entirety of the Great Contraction as due to the Fed’s tight monetary policies as explained via the mechanics of the Richmond Fed plumbing model. Unlike his predecessors, Hetzel downplays the role of the four U.S. banking panics from 1930 to 1933 as the key reason the Great Contraction was so severe and protracted. He is especially critical of Ben Bernanke’s (1983) thesis that the banking panics led to the collapse of financial intermediation (which later led to the development of the credit channel of monetary policy). At the very least, further empirical evidence that confronts the voluminous international historical literature that suggests that financial crises, controlling for other factors, can both cause recessions and make them worse (for a survey see Bordo and Meissner 2016) would be most helpful to back this controversial position. This is particularly so in the face of a moderate rise in policy interest rates before 1929 and a massive decline in the money supply that did not occur until the banking panics began.

The LAW with Tradeoffs

The author views the Federal Reserve Treasury Accord of February 1951 as a watershed in Fed policymaking. He is highly complementary of Chairman Martin’s adoption of the reaction function approach to monetary policymaking. Henceforth the Fed would adjust its policy rate, via its Free Reserves indicator, to offset business cycle shocks. Hetzel provides compelling narrative and empirical evidence that this new approach greatly improved both real and nominal performance compared to the interwar era. However, he argues that because the Fed waited for inflation to rise before commencing its tightening in the upswing of the business cycle, its exit policies would always be too late. This agrees with both the earlier Friedman and Schwartz and Meltzer approaches (see Bordo and Landon Lane 2013 and Bordo and Levy 2022).

Martin’s success was short lived, ending with the Great Inflation, which began on his watch in 1965. In agreement with Meltzer (2010). Hetzel attributes the Great Inflation to President Lyndon Baines Johnson’s fiscal shocks of the Vietnam War and the Great Society leading to pressure on the Fed to accommodate the fiscal deficit, as well as the ascendency of Keynesian doctrines in both the Administration and the Fed. The Keynesian approach emphasized maintaining full employment (at 4%) and the view that the Fed could exploit the Philips curve tradeoff of lower unemployment at the expense of higher inflation on the grounds that the benefits of lower unemployment outweighed the costs of higher inflation as argued by Samuelson and Solow (1960).

Chairman Martin was succeeded by Arthur Burns, who believed that inflation was driven primarily by cost-push forces and not by the Fed’s expansionary monetary policy. His solution to inflation was wage and price controls. Burns was also strongly influenced by pressure from President Richard Nixon not to pursue tight monetary policy, which could lead to a recession and prevent Nixon’s reelection chances in 1972. Hetzel, in sympathy with the articles in Bordo and Orphanides (2013), describes the ratcheting up of inflation and inflationary expectations through the 1970s under Burns and his successor William Miller, neither of whom tightened monetary policy enough, over concern of rising unemployment, to break the back of inflationary expectations. Again, the author ignores the rest of the world and the possible role that Nixon’s abandonment in August 1971 of the gold peg of the dollar under the Bretton Woods system could have played in the de-anchoring of inflationary expectations.

The LAW-with-Credibility Fed

Hetzel sees the Volcker shock of 1979 as another watershed in Fed monetary policy making. Paul Volcker, with the backing of President Ronald Reagan, was able to tighten monetary policy sufficiently to break the back of inflationary expectations and inflation but at the expense of two very serious recessions. Volcker is praised for creating a regime of credibility for low inflation. His mantle was taken in 1987 by Alan Greenspan, who cemented credibility by preemptively tightening in the inflation scare of 1994. Hetzel nicely describes how Greenspan used the bond market – which quicky incorporated expectations of future inflation – as its intermediate target. The author praises the Volcker-Greenspan regime for creating the Great Moderation of low and stable inflation and good real economic performance from the mid 1980s to the early 2000s. He views this period as being so successful because the Fed followed rule-like policies, with its reaction function operating close to that of the Taylor rule (1993).

As for the Global Financial Crisis (GFC) of 2007-2008 that ended the Great Moderation, the author attributes it entirely to the policies of Greenspan’s and later Ben Bernanke’s (who succeeded Greenspan as chair in 2006) Fed, which kept its policy rate too high so as to fend off a temporary run-up in commodity prices in 2006-2008. Hetzel attributes these wholesale price pressures primarily to the integration of China into the WTO. He downplays the role that low interest rates played before 2000 in fueling the housing boom, as argued by Taylor (2007). He also downplays the role of the subprime mortgage induced collapse of credit market intermediation in causing the GFC, in contrast to the view of the Federal Reserve under Bernanke. He is highly critical of the Fed’s deployment of numerous lender of last resort facilities to shore up the financial system, which he refers to as credit policies — a form of fiscal policy involving the picking of winners and losers — leading to resource misallocation, moral hazard, and a threat to the Fed’s independence. Like his interpretation of the Great Contraction, his contrarian view of the Fed’s lender of last resort policies in the GFC could use more empirical evidence. As with the Great Contraction of 1929-1944, it is difficult to attribute a deep downturn solely to a previously, modestly tight stance of monetary policy.

The author also has a contrarian view of the slow recovery following the GFC. Unlike the consensus view, he regards Fed Chairman Janet Yellen’s policies after 2012 as a successful continuation of the Volcker Greenspan doctrine in producing good real and nominal performance. He is highly critical of the FAIT (Flexible Average Inflation Targeting) policy strategy enacted by Chairman Jerome Powell in 2019. It was adopted under the belief that the Fed had been unable with its existing quantitative easing and forward guidance strategy, to reach its 2% inflation target during the recovery from the Great Recession. Under the FAIT strategy the Fed would allow inflation to temporarily overshoot its 2% inflation target to push unemployment low enough to employ disadvantaged groups in society. The risk of a more permanent inflation overshoot would not be problematic under the new strategy because of the assumption that inflation would always be credibly anchored at the 2 % target. Hetzel convincingly argues that FAIT was one of the key factors leading to an increase in the outbreak and persistence of high inflation from 2021 to 2023.

The author is also critical of the financial market rescue policies adopted by the Powell Fed in the spring of 2020 as unnecessary in the face of natural market forces, which by themselves would have led to a quick recovery from the pandemic induced shutdown of the economy. The quick decline in credit market spreads after the Fed intervened in the corporate and municipal bond markets, in his view, had little to do with the Fed’s actions. Again, empirical analysis may suggest an alternative conclusion (Bordo and Duca 2022).

In the concluding chapters, Hetzel makes the case for the Fed to follow more rule-like policies along the lines suggested by Goodfriend King (1997). He posits that the Fed should gear its real federal funds rate to the Wicksellian natural rate of interest. He also recommends a return to the preemptive strategies of the Volcker-Greenspan era and an abandonment of FAIT.

Robert Hetzel’s book is a very important contribution to the literature on the history of U.S. monetary policy. His application of modern macro analysis provides a new approach to the subtleties of Fed policy making. His contrarian views on the causes of the Great Recession and the Global Financial Crisis provide a challenge for future research. In my view this book should be read by monetary policy makers and serious students of the Federal Reserve.

References

Ben Bernanke (1983) “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.” American Economic Review, Vol. 73 (June): 257-276.

Michael D Bordo and Ronald MacDonald (2005) “Interest Rate Interactions in the Classical Gold Standard, 1880-1914: Was There Any Monetary Independence?” Journal of Monetary Economics, Vol. 82, No. 2: 307-327.

Michael D Bordo, Ehsan Choudhri, and Anna J Schwartz (2002) “Was Expansionary Monetary Policy Feasible During the Great Contraction?” Explorations in Economic History, Vol. 39, No. 1 (January),: 1-28,

Michael D Bordo and Ronald MacDonald (2003) “The Interwar Gold Exchange Standard: Credibility and Monetary Independence.” Journal of International Money and Finance, Vol. 22, No. 1 (February): 1-32.

Michael Bordo and John Landon Lane (2013) “Exits from Recession: The U.S. Experience 1920-2007.” In Vincent Reinhart, ed., No Way Out: Persistent Government Interventions in the Great Contraction. Washington DC: American Enterprise Institute.

Michael D Bordo and Athanasios Orphanides (2013) The Great Inflation: The Rebirth of Modern Central Banking. Chicago: University of Chicago Press for the NBER.

Michael D Bordo and Christopher Meissner (2016) “Fiscal Crises and Financial Crises.” In John B. Taylor and Harald Uhlig, eds., North Holland Handbook of Macroeconomics. North Holland Publishers.

Michael D Bordo and John Duca (2022) “An Overview of the Fed’s New Credit Policy Tools and Their Cushioning Effect on the Covid-19 Recession.” Journal of Government and Economics, Vol. 3, Issue C.

Michael D Bordo and Mickey Levy (2023) The Fed’s Monetary Policy Exit Once Again Behind the Curve.” In Michael D Bordo, John H. Cochrane, and John B. Taylor, eds., How Monetary Policy Got behind the Curve—and How to Get Back. Stanford: Hoover Institution Press.

Karl Brunner and Allan Meltzer (1968) “What Did We Learn from the Monetary Experience of the United States in the Great Depression?” Canadian Journal of Economics, Vol. 1, No. 2 (May): 334-348.

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Marvin Goodfriend and Robert King (1997) “The New Neoclassical Synthesis.” In Ben S. Bernanke and Julio Rottemberg, eds., NBER Macroeconomics Annual 1997, Vol. 12. Cambridge: MIT Press.

Robert E. Lucas, Jr. (1972) “Expectations and the Neutrality of Money.” In Robert E. Lucas, Jr. and Thomas J. Sargent, eds., Studies in Business Cycle Theory. Cambridge: MIT Press.

Allan Meltzer (2005) A History of the Federal Reserve. Volume 1: 1913-1951. Chicago: University of Chicago Press.

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Christina and David Romer (2004) “A New Measure of Monetary Shocks: Derivation and Implications.” American Economic Review, Vol. 94, No. 4 (September): 1055-1084.

Paul A. Samuelson and Robert M. Solow (1960) “Analytic Aspects of Anti-Inflation Policy.” American Economic Review, Vol. 50, No. 2 (May): 177-194.

John B. Taylor (1993) “Discretion Versus Policy Rules in Practice.” Carnegie Rochester Conference Series on Public Policy, Vol. 39: 195-214. Amsterdam: North Holland.

John B. Taylor (2007) “Housing and Monetary Policy.” Federal Reserve Bank of Kansas City Jackson Hole Economic Symposium. August.

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Michael D Bordo is a Board of Governors Professor of Economics and a Distinguished Professor of Economics at Rutgers University. He is currently working on a book project with Ned Prescott, “Federal Reserve Structure, Economic Ideas, and Monetary and Financial Policy,” as well as several projects in monetary history.

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