Monetary Lessons Learned (And Ignored)

Has the Federal Reserve’s monetary stimulus since 2008 been a failure? Many observers of the economic scene think so, and the evidence, they argue, is overwhelming. The U.S. economy, after all, remains plagued with sluggish growth, high unemployment and dim prospects for something more anytime soon. On its face, this looks like damning evidence. But this is a misreading of what monetary policy has accomplished, or more precisely: what it’s kept from happening.

It’s certainly reasonable to argue that without the Fed’s extraordinary accommodative monetary policy in recent years the economy would be even weaker than it is. Keep in mind too that some economists—Scott Sumner, for instance—assert that even with nominal rates at zero, the Fed continues to run a tight monetary policy. In any case, there are inflation hawks who believe the opposite and that the central bank has erred dramatically on the side of easy money since 2008 and that this easing has been a complete and utter failure. But that’s like claiming that spraying water on a burning house, and limiting the damage to the upper floors, was a waste of time because it didn’t save the entire structure.
Does any one really think that if the Fed had not acted as it has in recent years that the economy would be stronger? Well, yes, there are quite a few folks who push this line. But based on what evidence? Was there a time in history when a comparable blow to the body economic hit and the Fed was more hawkish? Yes, there was, but the outcome wasn’t encouraging.
We know that the Fed’s idle monetary hands in the early 1930s enabled a recession to deteriorate into a Great Depression. And, yes, the fact that the U.S. was on the gold standard was a contributing factor, as many studies have shown over the years. Barry Eichengreen and Peter Temin summed up the problem succinctly a few years ago when they wrote:

The gold-standard mentality and the institutions it supported limited the ability of governments and central banks to respond to adversity; they led to the adoption
of policies that made economic conditions worse instead of better. In response to
balance-of-payments deficits and gold losses, governments could only restrict credit
with the goal of reducing domestic prices and costs until international balance was

Christina Romer speaks for many economists when she echoes the point in a 2009 speech:

In the 1930s, the collapse of production and wealth led to bankruptcies and the disappearance of nearly half of American financial institutions. This, in turn, had two devastating consequences: a collapse of the money supply, as stressed by Milton Friedman and Anna Schwartz, and a collapse in lending, as stressed by Ben Bernanke.

She goes on to remind:

The United States was on a gold standard throughout the Depression. Part of the explanation for why the Federal Reserve did so little to counter the financial panics and economic decline was that it was fighting to defend the gold standard and maintain the prevailing fixed exchange rate.13

The more you study economic history, the more you understand that the only reasonable response to a massive financial crisis that triggers a deep recession is satisfying the public’s surging demand for liquidity. If you fail on that front, deflation is the inevitable consequence, at which point the game is lost. It’s really a no brainer. The footnotes in Romer’s speech is a good start if you’re looking for details and formal analysis.
Meanwhile, none of this should be surprising at this point. Well before the Great Depression, Walter Bagehot explained why a lender of last resort is essential at times. The lesson has been established and re-established many times over the decades, but the lesson continues to fall on deaf ears in some circles.
Don’t misunderstand: I’m not arguing that the Fed’s policy in recent years has been perfect. Far from it. And, yes, there’s a price tag to keeping a recession from turning into something worse. But there are no free lunches in economics, and so it’s always a question of risk-reward tradeoffs. As such, quite a bit of the Bernanke bashing represents a misreading of economic history’s lessons, as Greg Mankiw recently argued.
The critics counter that Bernanke’s Fed has done too much and that the monetary overreach is hurting the recovery. But the lessons of history beg to differ. Indeed, Fed critics on the other side of this debate say that the central bank still isn’t doing enough. Passive monetary tightening, despite nominal rates at zero, was and remains the problem, according to David Beckworth and others.
But this is economics and even lessons of crises long ago don’t fully resonate. Perhaps that’s the nature of the dismal science, but it’s distressing just the same. And to the extent it keeps policy ineffective, it comes with a heavy cost in the real world.
Granted, the Fed’s role is primarily one of preventing a financial crisis from turning into a depression. That falls well short of expecting the central bank to engineer robust growth, although the likes of Sumner and Beckworth think that if the Fed had been more proactive in preventing nominal GDP from slipping in the first place, we’d be in better shape now. Maybe, but we’ll never really know since we can’t replay history with an alternative scenario.
What is clear, or at least what seems clear to this observer, is that the Fed can at least keep the economy from a full meltdown when the forces of contraction surge to unusually potent levels. By that standard, QE1, QE2 and related monetary efforts have been successful. Successful, but forever controversial.