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“Fed greatly destabilized the U.S. economy”

As the European crisis just gets worse and worse I am reminded by what a clever man once said – he is that clever man Ben Bernanke in 2004:

“Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability. The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies. Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.”

I wonder what he is thinking of his colleagues in the ECB and about his own responsibilities today.

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Please listen to Nicholas Craft!

Professor Nicholas Craft as written a report for the British think tank Centre Forum on “Delivering growth while reducing deficits: lessons from the 1930s”. The report is an excellent overview of the British experience during the 1930s, where monetary easing through exchange rate depreciation combined with fiscal tightening delivered results that certainly should be of interest to today’s policy makers.

If you are the lazy type then you can just read the conclusion:

“The 1930s offers important lessons for today’s policymakers. At that time, the UK was attempting fiscal consolidation with interest rates at the lower bound but devised a policy package that took the economy out of a double-dip recession and into a strong recovery. The way this was achieved was through monetary rather than fiscal stimulus.

The key to recovery both in the UK and the United States in the 1930s was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further. In the UK, the ‘cheap money’ policy put in place in 1932 provided an important offset to the deflationary impact of fiscal consolidation that had pushed the economy into a double-dip recession in that year.

If economic recovery falters in 2012, it may be necessary to go beyond further quantitative easing as practised hitherto. It is important to recognize that at that point there would be an alternative to fiscal stimulus which might be preferable given the weak state of public finances. The key requirement would be to reduce real interest rates by raising inflationary expectations.

At that point, inflation targeting as currently practised in the UK would no longer be appropriate. A possible reform would be to adopt a price level target which commits the MPC to increase the price level by a significant amount, say 15 per cent, over four years. In the 1930s, the Treasury succeeded in developing a clear and credible policy to raise prices. It maybe necessary to adopt a similar strategy in the near future.

It would be attractive if this kind of monetary stimulus worked, as in the 1930s, through encouraging housebuilding. This suggests that an important complementary policy reform would be to liberalize the planning restrictions which make it most unlikely that we will ever see the private sector again build 293000 houses in a year as happened in 1934/5.”

If I have any reservations against Craft’s views then it is the focus on real interest rates in the monetary transmission mechanism. I think that is a far to narrow description of the transmission mechanism in which I think interest rates plays a rather minor role. See my previous comment on the transmission mechanism.

That minor issue aside Craft provides some very insightful comments on the 1930s and the present crisis and  I hope some European policy makers would read Craft’s report…

I got this reference from David Glasner who also has written a comment on Craft’s report.

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