Wednesday, November 26, 2014

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.

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    1. CommentedRoss Clem

      Was it monetary policy in the 1930s that fueled U.S. recovery from the depression or the WWII?

    2. Portrait of Pingfan Hong

      CommentedPingfan Hong

      After the ECB launched the outright monetary transaction (OMT) programme in September 2012, there is no much difference between the ECB and the US Fed their monetary approaches any more.

    3. CommentedProcyon Mukherjee

      Robert Solow's note on Federal Reserve (How to save American Finance) that was written on 8th April opens up new thought on the challenges of excessive supply when the last dollars of financial activity absorbs more resources while doing precious little in improving either productivity or efficiency. This marginal efficiency issue has always been downplayed as the quantum increase in trading activity masks this. Trade is hardly an avenue for sustainable changes to happen in the economy.

    4. CommentedProcyon Mukherjee

      I fully agree with Barry that the abuse of Monetary History is rampant in the cognitive dissonance that abounds around the continuation of an ultra loose monetary policy for extended periods of time; current historicity seem to suggest with the help of data that the impact is transitory in form of constructive and sustainable demand/job creation engine while its influence to make bubbles in certain classes of assets has been confirmatory. Barry’s reference to prior periods as old as 1920 or 1930 has very little significance given the excessive financialization that we are avowed in current times.

    5. CommentedGerald Silverberg

      Or there is a third alternative, that in a balance-sheet recession, monetary policy is largely ineffectual ("pushing on a string"). It was only fiscal policy (massive infrastructure and armaments expenditures), naturally with supporting credit expansion, that brought countries out of the Great Depression one by one after leaving the Gold Standard and suspending/repudiating international debts.

      But Eichengreen's point is well taken - that Europe's obsession with the German hyperinflation of 1923 is misplaced and puzzling, and that the proper analogy is with the disastrous Brüning austerity emergency decrees and Austrian Creditanstalt bank run of 1931.

      You can vote for candidates for the 'Creditanstalt' Brüning and Mellon Memorial Prizes at

    6. Portrait of Michael Heller

      CommentedMichael Heller

      Barry: You’ve moved the dates around a fraction, but basically you are the umpteenth person to say the 1920s and 1930s are terribly relevant to the situation today. I doubt that. Just look around you. Does it still look like 90 years ago? I don’t think so. The variables are completely different, and the juxtaposition or inter-causality of the variables is similarly utterly different. I stifle a yawn before suggesting that it might be far more useful to get to grips with the underlying logical reasoning contained within the raging debates among classic masters of economic theory either side of the 1930s, who have no parallel today (evidence here). Max Weber, Joseph Schumpeter, Friedrich Hayek, James Buchanan, to mention only five if one includes Keynes. Your certainty, along with the certainty of the predominant media-savvy economist-intellectuals, seems so entirely shaped by Keynes that I simply cannot take seriously your historical analogies. If your analogies had any value at all they could not avoid drawing attention to the raging differences of opinion that fundamentally shaped the policy processes of the day 90 years ago. Instead you yourself have succumbed to the simplistic dichotomies of history’s straw man analogies. For this reason I conclude that yours, on this particular occasion, have no practical value in the present day. They are empty not only of Schumpeter but of logic and theory.

        CommentedRobert Lunn

        Michael-it sure does not remind me of the 1930's. His "tale of two central banks" should be questioned on the premise. The ECB has engaged and promoted aggressive carry trade options bringing down rates on the periphery. They are also starting from a different level of intervention. (Cost of the safety net for example.) My point is the results of the activity by both banks should be examined.
        If measured by the impact on the average person, the Fed loses hands down.