Cautionary histories of US monetary tightening

Brad Delong has a piece on the same.

He actually questions the famous Volcker episode which created its own problems:

The US Federal Reserve has embarked on an effort to tighten monetary policy four times in the past four decades. On every one of these occasions, the effort triggered processes that reduced employment and output far more than the Fed’s staff had anticipated. As the Fed prepares to tighten monetary policy once again, an examination of this history – and of the current state of the economy – suggests that the United States is about to enter dangerous territory.

Between 1979 and 1982, then-Fed Chair Paul Volcker changed the authorities’ approach to monetary policy. His expectation was that by controlling the amount of money in circulation, the Fed could bring about larger reductions in inflation with smaller increases in idle capacity and unemployment than what traditional Keynesian models predicted.

Unfortunately for the Fed – and for the American economy – the Keynesian models turned out to be accurate; their forecasts of the costs of disinflation were dead on. Furthermore, this period of monetary tightening had unexpected consequences; financial institutions like Citicorp found that only regulatory forbearance saved them from having to declare bankruptcy, and much of Latin America was plunged into a depression that lasted more than five years.

We are told of a very different version of Volcker history. It is easily one of the most celebrated (if not the most) episode of monetary history where a central bank curbed inflation due to tight policy. So much so, it has become the benchmark for anything in monetary policy. We are also told how Volcker episode was finally a victory of monetarism over years of evil Keynesian policies since 1945. But here Prof Delong says the final outcome of declining economic activity was a victory of Keynesian models! Economics is all over the place as so many interpretations are there. We need to know econ history and from many different perspective as there is no single narrative.

He points to further episodes:

Then, between 1988 and 1990, another round of monetary tightening under Alan Greenspan ravaged the balance sheets of the country’s savings and loan associations, which were overleveraged, undercapitalized, and already struggling to survive. To prevent the subsequent recession from worsening, the federal government was forced to bail out insolvent institutions. State governments were on the hook, too: Texas spent the equivalent of three months of total state income to rescue its S&Ls and their depositors.

Between 1993 and 1994, Greenspan once again reined in monetary policy, only to be surprised by the impact that small amounts of tightening could have on the prices of long-term assets and companies’ borrowing costs. Fortunately, he was willing to reverse his decision and cut the tightening cycle short (over the protests of many on the policy-setting Federal Open Markets Committee) – a move that prevented the US economy from slipping back into recession.

The most recent episode – between 2004 and 2007 – was the most devastating of the four. Neither Greenspan nor his successor, Ben Bernanke, understood how fragile the housing market and the financial system had become after a long period of under-regulation. These twin mistakes – deregulation, followed by misguided monetary-policy tightening – continue to gnaw at the US economy today. 

So, it seems most monetary tightening episodes since 1980s have had their undesired consequences as well.

The tightening cycle upon which the Fed now seems set to embark comes at a delicate time for the economy. The US unemployment rate may seem to hint at the risk of rising inflation, but the employment-to-population ratio continues to signal an economy in deep distress. Indeed, wage patterns suggest that this ratio, not the unemployment rate, is the better indicator of slack in the economy – and nobody ten years ago would have interpreted today’s employment-to-population ratio as a justification for monetary tightening.

Indeed, not even the Fed seems convinced that the economy faces imminent danger of overheating. Inflation in the US is not just lower than the Fed’s long-term target; it is expected to stay that way for at least the next three years. And the Fed’s change in policy comes at a time when its own economists believe that US fiscal policy is inappropriately restrictive.

Meanwhile, given the fragility – and interconnectedness – of the global economy, tightening monetary policy in the US could have negative impacts abroad (with consequent blowback at home), especially given the instability in China and economic malaise in Europe.

The author thinks one reason why Fed might be moving to rate hike is because of pressure of banks:

It is tempting to conclude that the Fed’s eagerness to tighten monetary policy – despite unfavorable historical precedents and ongoing economic uncertainty – is driven by commercial banks with excessive influence in official policymaking. After all, commercial banks’ business model works only when the banks can earn (via passive and relatively safe long-term investments) at least 3% a year more than they pay depositors. And that is possible only if US Treasury rates are higher than they are now.

If this is true, it would reflect a failure by bankers to understand their industry’s material interests. What would most benefit commercial banks is not an immediate increase in interest rates, but a monetary policy that contributes to ensuring that the economy is capable of supporting higher interest rates in the future. If history is any guide, tightening monetary policy in the near term will only lead to further economic turbulence, followed by a rapid retreat to low interest rates. Embarking on that path should be a cause of concern for everyone.

Not sure about this. Banks are made the scapegoats for thinking on both sides. Low rates also mean treasury profits continue for banks. This idea of higher rates imply banks keep treasuries till maturity which is not true. Higher rates are likely to hit banks portfolios..

Macro narratives all over the place..


2 Responses to “Cautionary histories of US monetary tightening”

  1. Anantha Nageswaran Says:

    You have written on the Project Syndicate article by Dani Rodrik. You have noted the Stiglitz argument against Fed tightening. You have cited Bradford de Long here on the undesired consequences of monetary tightening. You also lament that macro narratives are all over the place. Then, on Sept. 18, you had cited other posts from Mises.ORG on the Fed’s inaction.

    Volcker tightened for different reasons. Not just to wring out inflation form the system but to restore the primacy of the US dollar, to show the pesky Europeans their place, to tame oil, to tame American banks and to tame Latin American borrowers. He succeeded spectacularly. Either Mr. De Long is unaware of them or he is naive or he thinks we are naive.

    Macro, by nature, will be all over the place. You should have seen that point come through well in the piece by Dani Rodrik. There is no one grand, unified theory of everything in macro. Counterfactuals are impossible and theories are points of departure and not descriptors of reality, because other things are not constant but constantly changing.

    That is what makes macro interesting, intellectually attractive and hence makes arguments both endless and inconclusive.

  2. Amol Agrawal Says:

    It is not just Rodrik but others as well who have made these points. I keep pointing to such articles just to highlight not to take macro too seriously. It used to be fascinating but is more irritating now.

    On Volcker, depends on how you look at it. It were the American lenders who had lent heavily to Latin America in the name of how foreign capital can benefit the region. But most of the ill-effects of Volcker tightening was borne by Latin Americans and not American bankers. There should have been some balancing act.

    Unfortunately, this is how all these stories play out eventually wherever you look at. Financial capitalism is really amazing in its consistency that way. But still we make huge noise around its importance. It is actually all these guys who write on global finance who think us to be naive.

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