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The Use and Abuse of Monetary History

BERKELEY – Imagine two central banks. One is hyperactive, responding aggressively to events. While it certainly cannot be accused of ignoring current developments, its policies are widely criticized as storing up problems for the future.

The other central bank is unflappable. It remains calm in the face of events, seeking at all cost to avoid doing anything that might be construed as encouraging excessive risk-taking or creating even a whiff of inflation.

What I have just described is no mere hypothetical, of course. It is, in fact, a capsule depiction of the United States Federal Reserve and the European Central Bank.

One popular explanation for the two banks’ different approaches is that they stem from their societies’ respective historical experiences. The banks’ institutional personalities reflect the role of collective memory in shaping how officials conceptualize the problems that they face.

The Great Depression of the 1930’s, when the Fed stood idly by as the economy collapsed, is the molding event seared into the consciousness of every American central banker. As a result, the Fed responds aggressively when it perceives even a limited risk of another depression.

By contrast, the defining event shaping European monetary policy is the hyperinflation of the 1920’s, filtered through the experience of the 1970’s and 1980’s, when central banks were enlisted once again to finance budget deficits – and again with inflationary consequences. Indeed, delegating national monetary policies to a Europe-wide central bank was intended to solve precisely this problem.

It is not only in central banking, of course, that we see the role of historical experience in shaping policymaking. President Lyndon Johnson, when deciding to escalate US intervention in Vietnam, drew an analogy with Munich, when the failure to respond to Hitler’s aggression had catastrophic consequences. A quarter-century later, President George H.W. Bush, considering how best to roll back Iraq’s invasion of Kuwait, drew an analogy with Vietnam, where the absence of an exit strategy had caused US forces to get bogged down.

But a key conclusion of research on foreign policy is that decision-makers all too often fail to test their analogies for “fitness.” They fail to ask whether there is, in fact, a close correspondence between historical circumstances and current facts. They invoke specific analogies not so much because they resemble current conditions, but because they are seared into the public’s consciousness. As a result, analogical reasoning both shapes and distorts policy. It misleads decision-makers, as it did both Johnson and Bush.

The same dangers arise for monetary policy. For the Fed, it is important to ask whether the 1930’s, when its premature policy tightening precipitated a double-dip recession, really is the best historical analogy to consider when contemplating how to time the exit from its current accommodating stance. Certainly, the Great Depression is not the only alternative on offer.

The Fed might also consider policy in 1924-1927, when low interest rates fueled stock-market and real-estate bubbles, or 2003-2005, when interest rates were held down in the face of serious financial imbalances. At a minimum, the Fed might develop a “portfolio” of analogies, test them for fitness, and distill their lessons, as President John F. Kennedy famously did when weighing his options during the Cuban missile crisis in 1962.

Similarly, the ECB might consider not only how monetary accommodation allowed governments to run large budget deficits in the 1920’s, but also how central bankers’ failure to respond to the financial crisis of the 1930’s fed political extremism and undermined support for responsible government. Again, rigorous analysis requires testing these historical analogies for fitness with current circumstances.

Anyone who does so will find it hard to defend the ECB and its stubborn inaction in the face of events. There is exactly zero evidence in Europe today that inflation is just around the corner. And, if current European governments are not committed to austerity and fiscal consolidation, then which governments are?

When I consider the European economy, the ECB’s failure to provide more monetary support for economic growth appears to be directly analogous to Europe’s disastrous monetary policies in the 1930’s. The political consequences could be similarly devastating. Europeans should ponder why the inflationary 1920’s, rather than the politically catastrophic 1930’s, have become the historical lodestar for current monetary policy.

On the other hand, when I contemplate the US economy, I conclude that recovery from the Great Depression, and not 1924-1927 or 2003-2005, is the episode that most closely resembles current circumstances. Only in the 1930’s were interest rates near zero. Only in the 1930’s was the economy digging itself out from a major financial crisis.

Then again, perhaps it is to be expected that I find the analogy with the 1930’s compelling. That was the defining episode for American monetary policy. And I am, after all, an American.