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A Cautionary History of US Monetary Tightening

BERKELEY – 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.

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.