Selgin, Lastrapes and White on “Has the Fed been a Failure?”

George A. Selgin and his co-authors have a working paper here on the history of the US Federal Reserve:

George A. Selgin, William D. Lastrapes and Lawrence H. White, 2010. “Has the Fed Been a Failure?” Cato Working Paper no. 2 (November 9).

This working paper is forthcoming in the Journal of Macroeconomics, so the definitive version is not yet available.

While the paper is clearly an important contribution, and is a useful study worth reading, it is not by any means an attempt to gauge the success of a modern Keynesian system of macroeconomic management, full employment, and effective financial sector regulation. This is a paper judging the success of the Federal Reserve in the full period of its existence. The earlier part of that period (1913–1934) was much more like the 19th century in terms of fiscal policy and financial regulation, than the post-1945 period.

I also have a number of problems with the work of Selgin, Lastrapes and White (henceforth Selgin et al.), as follows:

(1) Merely focussing on a central bank seems a limited test of the superiority of modern macroeconomic interventions and Keynesian management of an economy. Moreover, just focusing on the US also ignores evidence from other nations. One conclusion of this paper – that the Fed existed during the worst deflationary output collapse in American history (Selgin et al. 2010: 9) – is no surprise. The Great Depression was the result of severe government failures to provide macroeconomic stability, principally fiscal and GNP stabilisation, and measures to stop banking sector collapse.

(2) Selgin et al. (2010: 10) state:

“According to Romer’s … pre-1929 GNP series, which relies on statistical estimates of the relationship between total and commodity output movements (instead of Kuznets’ naïve one-to-one assumption), the cyclical volatility of output prior to the Fed’s establishment was actually lower than it has been throughout the full (1915–2009) Fed era (Table 2, row 2 and Figure 5, second panel). More surprisingly, pre-Fed (1869–1914) volatility (as measured by the standard deviations of output from its H-P trend) was also lower than post-World War II volatility, though the difference is slight. (Selgin et al. 2010: 10)

Yet it appears to me that comparing the full 1915–2009 period with 1869–1914 is misleading. Why? Because it conflates three periods of distinct government macroeconomic policy from 1915 to 2009:

(1) the pre-1934 period in which modern Keynesian fiscal policy did not exist. This period was essentially like policy in the late 19th century.

(2) the 1946–1970s period of Keynesian economics.

(3) The post 1979–2009 neoliberal macroeconomic period, with its obsession with inflation targeting, and abandonment of full employment Keynesian fiscal policy (from about 1989 in the US).

Period (1) saw the Great Depression, so it is obvious this distorts the data when it is lumped in with periods (2) and (3). A proper gauge of the superiority of period (2) requires looking at the data between about 1947–1973.

Furthermore, although the “… pre-Fed (1869–1914) volatility (as measured by the standard deviations of output from its H-P trend) was also lower than post-World War II volatility” according to Romer’s data, even Selgin et al. admit that the difference is slight. And even that comparison is distorted by the 1979–2009 neoliberal period.

Moreover, as is well known, the whole subject of accurate estimates of pre-1914 US GNP is plagued with problems, as even Selgin et al. (2010: 10) admit:

“Romer’s revisions have themselves been challenged by others, however, including Zarnowitz (1992, pp. 77-79) and Balke and Gordon (1989). The last-named authors used direct measures of construction, transportation, and communication sector output during the pre-Fed era, along with improved consumer price estimates, to construct their own historic GNP series. According to this series, the standard deviation of real GNP from its H-P trend for 1869 to 1914 is 4.27%, which differs little from the standard–series value of 5.10%. Balke and Gordon’s findings thus appear to vindicate the traditional (pre-Romer) view … .” (Selgin et al. 2010: 11).

Balke and Gordon (1989) do not support Romer’s findings, and provide support for the view that pre-1914 output volatility was worse than the post-1945 period.

(3) Selgin et al. (2010: 14–15) – rather surprisingly – come to a conclusion that supports the Keynesian case:

“Fiscal stabilizers, whether automatic or deliberately aimed at combating downturns, are also likely to have contributed to reduced output volatility since the Fed’s establishment, when state and federal government expenditures combined constituted but a fifth as large a share of GDP as they did just before the recent burst of stimulus spending (Figure 8). Thus DeLong and Summers (1986) claim that the decline in U.S. output volatility between World War II and the early 1980s was due not to improved monetary policy but to the stabilizing influence of progressive taxation and countercyclical entitlements. Subsequent research … documents a pronounced (though not necessarily linear) relationship between government size and the volatility of real output. According to Mohanty and Zampoli, a 10% increase in the government’s share of GDP was associated with a 21% overall decline in cyclical output volatility for 20 OECD countries during 1970–1984. (Selgin et al. 2010: 14–15).

(4) Selgin et al. (2010: 23) find that “no genuine post-1913 reduction in banking panics, or in total bank suspensions, took place until after the national bank holiday of March 1933.” They further find that it was the Reconstruction Finance Corporation (RFC) and Federal Deposit Insurance Corporation (FDIC) that were the primary policy measures contributing to banking stability. That doesn’t surprise me.

(5) Selgin et al. (2010: 25) declare that the US banking panics of the 19th century were caused by “misguided regulations, including those responsible for the highly fragmented structure of the U.S. banking industry, played in making the U.S. system uniquely vulnerable to panics.” This might be true to some extent. Only the most irrational person would contend that regulation can never do harm. Regulation might be poorly designed and have bad effects. But good regulation is quite different.

Selgin et al. (2010: 25) further cite the work of Bordo (1986), who found that the UK, Sweden, Germany, France, and Canada were largely free from the type of banking panics that the US suffered in this period (1870–1933).

What it is left unsaid is that, while Britain was not subject to the degree of financial instability and banking panics that the US experienced, the UK had a central bank during the 19th century, the Bank of England (the second oldest central bank in the world). The German Empire (which was created in 1871) had a central bank called the Reichsbank, which existed from 1876 until 1945. Was Germany’s comparative financial sector stability related to the actions of the Reichsbank? Sweden is in fact home to the world’s oldest central bank, the Riksbank, which began in 1668 as a private bank, and from the 19th century was the major credit institution and issuer of bank-notes in Sweden. France also had a central bank from the 18th century, the Banque de France, which was established by Napoleon Bonaparte in 1800.

Selgin et al. (2010: 25) appeal to Canada to prove their point:

“… Canada’s experience is especially revealing. Unlike the U.S., which had almost 2000 (mainly unit) banks in 1870, and almost 25,000 banks on the eve of the Great Depression, Canada never had more than several dozen banks, almost all with extensive branch networks. Between 1830 and 1914 (when Canada’s entry into WWI led to a run on gold anticipating suspension of the gold standard), Canada experienced few bank failures and no bank runs. It also had no bank failures at all during the Great Depression, and for that reason experienced a much less severe contraction of money and credit than the U.S. did. Although the latter outcome may have depended on government forbearance and implicit guarantees which, according to Kryznowski and Roberts (1993), made it possible for many Canadian banks to stay open despite being technically insolvent for at least part of the Great Depression period, the fact remains that Canada was able to avoid banking panics without resort to either a central bank or explicit insurance. (Selgin et al. 2010: 25).

Yet the citation of Kryznowski and Roberts (1993) requires that it was government intervention and implicit guarantees that provided banking stability for Canada during the Great Depression. Moreover, while the modern Canadian central bank – the Bank of Canada – did not exist until 1935, the Bank of Montreal appears to have functioned as a de facto central bank for Canada from the 1860s until 1935. This doesn’t support Selgin et al.’s case.

Bordo (1986) finds that the UK, Sweden, Germany, France, and Canada had a degree of banking stability from 1870 to 1933 that the US lacked. Yet all those nations had official central banks or de facto central banks in this period. What conclusion does that suggest? I submit to you it is not the conclusion of Selgin et al.

I would also like to point out that Selgin et al.’s graph (figure 9: “US bank failures as percentage of all banks, 1896 to 1955”) shows that modern financial sector regulation from 1934 appears to have minimised bank failures to zero or at least to an insignificant level compared to the pre-1934 system.

BIBLIOGRAPHY

Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92.

Bordo, M. D. 1986. “Financial Crises, Banking Crises, Stock Market Crashes and the Money Supply: Some International Evidence, 1870–1933,” in F. Capie and G. E. Wood (eds.), Financial Crises and the World Banking System, MacMillan, London. 190–248.

Davis, J. H. 2004. “An Annual Index of U.S. Industrial Production, 1790–1915,” Quarterly Journal of Economics 119.4: 1177–1215.

Davis, J. H. 2006. “An Improved Annual Chronology of U.S. Business Cycles since the 1790s,” Journal of Economic History 66.1: 103–121.

Kryznowski, L. and G. S. Roberts. 1993. “Canadian Bank Insolvency, 1922–1940,” Journal of Money, Credit, and Banking 25.3: 361–376.

Romer, C. D. 1986. “Spurious Volatility in Historical Unemployment Data,” Journal of Political Economy 94: 1–37.

Romer, C. D. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869–1908,” Journal of Political Economy 97.1: 1–37.

Selgin, G. A., Lastrapes, W. D. and L. H. White, 2010. “Has the Fed Been a Failure?” Cato Working Paper no. 2 (November 9).

Zarnowitz, V. 1992. Business Cycles: Theory, History, Indicators, and Forecasting, University of Chicago Press, Chicago.

The “Dreaded” Post Keynesians?

In my various readings of the blogs that I find interesting, I just came across these remarks (that I seem to have missed) by George Selgin on the Free Banking blog referring to the debate that I recently had with Selgin here in the comments section of my blog on the Keynes versus Hayek LSE debate:

“At Social Democracy a post-Keynesian blogger who styles himself ‘Lord Keynes’ similarly misinterpreted my ‘liquidationist’ stand, inviting what became a long exchange with me there that was interesting in part because by engaging in it I learned that trying to argue with a dreaded Post-Keynesian can after all be a lot more rewarding, as well as a lot more pleasant, than trying to argue with many Rothbardians!
George Selgin, “The Keynesians Answer Back,” August 5th, 2011.

I did indeed make an error in my original post on Selgin’s position, but I was happy to correct it. And it was a pleasant surprise to find that Selgin’s position on the bailouts was one that a Post Keynesian could readily agree with. In actual fact, debating Selgin was a pleasure, and so much more rewarding than the blathering nonsense that one normally encounters from Rothbardian anarcho-capitalists.

But Selgin refers to the “dreaded” Post-Keynesians? Why “dreaded”?

It has long been known that the radical subjectivist wing of the Austrians and the Post Keynesians have ideas in common. In fact, the Austrian moderate subjectivists O’Driscoll and Rizzo tried to reach out to Post Keynesians in their book The Economics of Time and Ignorance with this comment:

“[i]t is evident that there is much more common ground between post-Keynesian subjectivism and Austrian subjectivism …. the possibilities for mutually advantageous interchange seem significant” (The Economics of Time and Ignorance, Oxford, UK, 1985, p. 9).

The “possibilities for mutually advantageous interchange” seem real to me, but there is so much mutual hostility from both sides that dialogue rarely comes to anything, mainly because Austrian economics is hijacked by the Rothbardian cult.

But I would like to think that the Austrians and Post Keynesians can learn from each other, even if obstacles remain. Ludwig Lachmann seems to be an Austrian whose work should be seriously examined by Post Keynesians.

Another point is that aspects of the Austrian/libertarian critique of Roosevelt’s New Deal, particularly those of Robert Higgs, are quite reasonable in some ways, especially since Keynes himself was also critical of the New Deal. There was undoubtedly some degree of “regime uncertainty” caused by the unprecedented interventions of Roosevelt’s New Deal which had never been seen before in America. When Keynes visited America in 1934, he saw first hand something that would confirm Higg’s view:

“[sc. Keynes] acknowledged that some aspects of the New Deal had created a crisis of confidence in the business community, but turned this into an argument that the government should increase its emergency expenditure to $400m. a month, while trying to reassure business that ‘they know the worst’ and discontinuing some aspects of the objectionable policies of the National Recovery Administration.” (Skidelsky 1992: 508).

The truth is that certain aspects of the New Deal had little if anything to do with Keynesianism. The New Deal came out of different ideas and types of thinking, and one of these was the sort of American corporatism/cartelism that even Herbert Hoover had supported to some extent. The solution to Roosevelt’s troubles was simply stopping his anti-business rhetoric and ending many of his counterproductive programs, and concentrating on fiscal stimulus, just as Keynes advised.

BIBLIOGRAPHY

Skidelsky, R. J. A. 1992. John Maynard Keynes: The Economist as Saviour, 1920–1937 (vol. 2), Macmillan, London.

Selgin on Fractional Reserve Banking

George Selgin explains his views on fractional reserve banking (FRB) in this interview:

“RF: Do you consider fractional reserve banking inherently problematic? Does free banking require a commodity standard so private banks don’t issue too much currency? ....

Selgin: .... As for fractional reserve banking, I think it’s a wonderful institution and that it’s crazy to argue that we need to get rid of it to have a stable monetary regime. Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on its fraudulent nature or inherent instability are, frankly, making poor arguments. I don’t think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment ….

That’s quite unlike the situation you have when you have a monopoly bank of issue. Even in the presence of a gold standard, when the privileged banks’ IOUs are themselves claims to gold, a monopoly bank of issue can expect other banks to treat its paper notes and its deposit credits, which are close substitutes, as reserve assets — that is, to treat them as if they were gold themselves. As a result of that tendency, which exists only because the recipient banks are deprived of the right to issue their own paper currency, the less privileged banks become dependent on the monopoly currency provider and, therefore treat its notes as reserve money. Now that monopoly bank has the power to generate more reserves for the whole system and it, in turn, is free of the discipline of the clearing mechanism. That’s where central banks’ power comes from. This is what allows central banks to promote a general overexpansion of credit and inflation. What I just described is exactly the sort of thing that triggered many of the financial crises of the 19th century.”
Stephen Slivinski, “Interview, George Selgin,” Federal Reserve Bank of Richmond, Winter 2009.

It is certainly true that, in the face of rising demand for money, 19th-century nations created credit and paper money in increasing amounts:

“[the] reconciliation of high rates of economic growth with exchange-rate and gold-price stability [in the 19th century] was made possible … by the rapid growth and proper management of bank money, and could hardly have been achieved under the purely, or predominantly, metallic systems of money creation characteristic of the previous centuries. Finally, the term ‘gold standard’ could hardly be applied to the period as a whole, in view of the overwhelming dominance of silver during its first decades, and of bank money during the latter ones. All in all, the nineteenth century could be far more accurately described as the century of an emerging and growing credit-money standard, and of the euthanasia of gold and silver moneys, rather than as the century of the gold standard.” (Triffin 1985: 153).

Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%. Thus growth rates in the 19th century were only sustained by a massive expansion of credit money, and what economic growth that did occur was not achieved under the type of “pure” gold standard that existed in previous centuries.

But Selgin gets his history wrong in one important respect.

Now, having admitted that FRB is a highly useful institution for fostering investment, Selgin opposes central banks as promoting “general overexpansion of credit and inflation” and causing financial crises. Yet America had no central bank for most of the 19th century, and financial crises hit that nation regularly. By contrast, Britain had the Bank of England in the 19th century and was not subject to financial crises as severely and frequently as America. In the UK, between 1866 and 1914, there were no serious financial crises, and “Baring Crisis” of 1890 was in fact dealt with by the Bank of England (Wood 2005: 112):

“During the gold standard years Britain suffered no major financial crises in which the stability of its financial system was threatened; the maturation of a Bank of England conscious of its lender-of-last-resort responsibilities, together with a banking system composed of large banks with countrywide branch networks, limiting the scope for crisis. The United States, in contrast, possessed no central bank, and its financial system was characterized by a large number of geographically restricted unit banks and periodic surges of bank failures” (Bayoumi et al. 1996: 9).

In response to this, free banking proponents like Selgin will probably complain that the US “free banking” period was not really free at all, because of state regulations, such as those that restricted branch banking in the US. But that does not refute the contention that a lender-of-last-resort central bank in the US could have prevented many of these liquidity crises, despite the weakness of branch banking. And it certainly won’t fly in the case of Australia in the 19th century, where there was minimal regulation which was mostly ignored anyway, and where there was no central bank. Australia suffered a devastating property bubble in the 1880s and financial crisis in the 1890s, followed by depression (Hickson and Turner 2002).

Selgin also ignores the role that financial regulation can play in directing the flow of credit and preventing asset bubbles. We largely eliminated serious asset bubbles and financial crises in the West after 1945 with a system of effective financial regulation, until the neoliberal era deregulation (late 1970s onwards). With Keynesian macroeconomic management and financial regulation, the post-WWII era was the golden age of capitalism (1945–1973), with superior real GDP growth and real wage growth and low unemployment.


BIBLIOGRAPHY

Bayoumi, T., Eichengreen, B. and M. P. Taylor, 1996. “Modern perspectives on the gold standard: Introduction,” in T. Bayoumi, B. Eichengreen, and M. P. Taylor (eds), 1996. Modern Perspectives on the Gold Standard, Cambridge University Press, Cambridge. 3–16.

Hickson, C. R. and J. D. Turner, 2002. “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review 9: 147–167.

Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–16

Wood, J. H. 2005. A History of Central Banking in Great Britain and the United States, Cambridge University Press, Cambridge and New York.