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.BIBLIOGRAPHY
(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.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.
(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).
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.
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.