After the Tears We'll Be Laughing At the Fed
Edwin Dale was a reporter and public official with a lengthy track record of respect from all sides. He wrote for the New York Times from 1955 until 1977, participating in his early days through the Times' Washington Bureau in the great inflation debates of the 1950's. Those were of themselves narrower recognition that the classical economy once thought immutable might be giving up to new strands of function and development. He eventually moved on to government work, becoming the Budget Office's spokesman under David Stockman in Reagan's administration. When he died in May 1999, his New York Times obituary leaves little doubt as to his reputation. Former Fed Chair Paul Volcker is quoted as saying, "It was pretty wild and woolly when I was Chairman of the Federal Reserve, and he was a voice of calm, common sense during that period."
What first brought economics to a young reporter was the recession of 1957-58. In an article titled Basic Inquiry Into A Baffling Inflation, Dale noted perhaps for the first time in a widespread media format deep divisions among economists about the economic context of the middle 1950's; and those that would ultimately lead to that recession. At issue was that puzzling background: the government was in surplus, monetary policy believed appropriately tight and all fraught with what he called "substantial" excess capacity. All of those factors should have conspired toward "deflation" not rising consumer prices.
It would not be the first time Mr. Dale would note great and heavy discrepancies between settled economic thought and the inability of that philosophy to explain, let alone control, the world around it. In another New York Times article, this one published on February 2, 1969, Dale would wade into what would turn out a monumentally conclusive turn in economic history. Under the headline Laughing At the Fed, Dale wrote that "our" central bank had become a direct and stinging object of derision around the world.
"There are many ‘in-groups' in this world, each with its own set of private jokes. In the monetary in-group, which just might have the prosperity of us all at stake, the biggest "yok" in town is the nation's central bank, the Federal Reserve System. Banks are laughing at it. Economists are laughing at it. Businessmen - getting loans like crazy - are probably laughing at it. Congressmen are not in the in-group. They are just frustrated and puzzled by it."
It wasn't just the Fed, either, as Dale noted that provocation was similar in London. Thus, the central banks at the world's two remaining co-reserve currencies, those only left convertible to gold, were not performing well. The reason seemed rather obvious to Dale, as again economists at the Fed were more considered of their peculiar minutiae than the first great tremor of what would become the full Great Inflation.
"The Federal Reserve, it often seems, hurls thunderbolts and nothing happens. It raises the discount rate and it furiously buys and sells Treasury bills. It watches such arcane things as the Federal funds rate and net borrowed reserves and the bank credit proxy. It tells the world solemnly that, by golly, it means business in stopping inflation. It doesn' t know how, to be sure. As King Lear said, ‘I will have such revenges on you that all the world shall-- I will do such things--what they are yet I know not; but they shall be the terrors of the earth.'"
That last part, placing monetary policy under homage to Shakespearean tragedy, got noticed; and why shouldn't it have. In the benefit of hindsight we see Dale was plainly right to do so, as the Fed plunged not just itself into madness but took the rest of the global economy and financial system with it.
Boston Fed President Frank Morris read Dale's article and took it on himself to answer the charge. We know this because it is included in the FOMC Memorandum of Discussion (MOD) for the February 4, 1969, meeting. Shocking as it may sound to a policymaker, the banks within the Boston area, or at least those Morris saw fit to call upon, all told him unequivocally that nobody was laughing at the Fed. Well.
Morris would prove himself what convention would now term as a "dove." Under the Chairmanship of Volcker in the late 1970's, it was Morris who would become something of the leading dissenter against the "tight money" policies, those dubbed the "Volcker minority." If nothing else, Morris was remarkably consistent as that would be his position throughout his tenure. In 1969, however, the implications were revolutionary.
The specific issue in the early months of 1969 was the eurodollar. Inflationary circumstances had arisen since 1965, but by the middle of 1968 they were reaching, still, past what were thought settled limits. In monetary terms, Regulation Q subjected banks to a rate ceiling above which they could not offer to pay on deposits. With inflationary pressures, deposit rates were across-the-board at their ceiling. In a closed system, as was envisioned during the Great Depression when these regulations were written, having in mind that depression and the predicate crash that preceded it, rate ceilings are exactly that. However, in the late 1960's there was this new thing, this eurodollar, that provided a dollar outlet for banking resources.
Primarily non-banks, mostly large corporations but some wealthy individuals, took advantage of the eurodollar format. Regulation Q didn't apply to banks outside the United States - how could it? But what was peculiar was that these banks operating in Europe (Frankfurt, Zurich, Paris, but mostly London) were doing so in dollars. It should be emphasized at this point that nobody then quite knew where eurodollars had come from; we still have no idea. The rumors that persisted were that they were the workaround creation of the Soviet Union and Eastern bloc nations forced to trade with dollars but highly reluctant to cycle them back to American banks (onshore) lest they become subject to US government ire and then restriction.
Instead, so the story goes, dollar balances were placed with European banks in European cities to at least mitigate the political dangers tangential to trade finance. This was the later 1950's, the same time as economists were wondering what happened to "inflation."
There were, obviously, other factors involved in the ascent of the eurodollar. That included the necessities of trade finance itself, both as a general trend of that age and specifically the collapse of sterling. The Suez crisis, in particular, left sterling in even more of a precarious position in global trade, which was no small matter. Sterling still dominated a huge bloc of global geography in trade terms, so with its increasing instability and the inability of the Bank of England to respond to all that there was necessarily an opening. Since banks in London were already in London financing trade in sterling, the abrupt appearance of the eurodollar for whatever reason was in some ways fortuitous in timing. They could just swap dollar merchant trade for former sterling merchant trade.
The reason for that flexibility is that global trade finance isn't so much "store of value" money but "medium of exchange" money. Companies in India, for example, weren't (aren't) interested in attaining sterling or dollars for their possession but only so far as sterling or dollars would mediate trade across different systems. If exporting, the Indian business could convert easily whatever payment currency might be coming back into rupees; if importing, the business would convert rupees into sterling or dollars to be further converted into whatever currency of the ultimate destination of the goods.
Dollar trading, eurodollar more specifically, however was especially advantaged by its lack of regulation and rules. There were no reserve requirements but more so than lack of government rulemaking there was no need for reserves properly understood as currency. Again, global trade did not require payment in physical Federal Reserve Notes at each node of a transaction, only the method and systemic capacity to bring together disparate financial and currency regimes under a common standard. The dollars as eurodollars remained almost exclusively creatures of bank finance, never really leaking out into the real economy or real world. All that happened organically, even if you believe the Soviets started it.
Because of that bright efficiency, the eurodollar market itself became rather large before the Federal Reserve even knew it existed. This is not surprising, the same thing happened in federal funds; or at least the federal funds market had experienced tremendous growth throughout the 1950's but it wasn't until 1959 that the Fed finally undertook a 3-year study to understand it, and until 1964 before the central bank began publishing more primitive statistics including the now-familiar federal funds rate agglomeration. What happened with inflation, again?
With eurodollars operating on such efficient terms, eurodollar banks could at every turn outcompete money markets in New York. By 1968, that was amplified as Regulation Q prevented domestic banks from even closely contending with eurodollars; there started a very large "flow" of deposits from New York to (largely) London in the form of large time deposits. While that might have provided some probative and positive evidence of the direct manner of monetary policy restraint, to increasing unease and disgust the FOMC found that New York City banks were in large part simply "borrowing them back." In other words, deposits flowed outside the US to eurodollars, US bank subs overseas would borrow them there and then lend them back to their head offices in New York.
In many cases, it was far easier than even that; there wouldn't even need to be any bank customer leaving the bank at all. The transactions could all take place physically in NYC, where, as Milton Friedman astutely observed in 1971, the "bookkeeper's pen" could by itself accomplish the round trip entirely; all that were necessary were compliant accounting rules. For monetary policy, this was anathema; eurodollars were laughing at the Fed.
For banks in the Boston region, they might not have hooted in direct contact with Frank Morris, but the larger of those under his assumed authority were doing it in fact. In many ways, however, it was the smaller of the nation's banks that demonstrated the revolution about where all this was going. The February 1969 FOMC MOD also notes a peculiar change in the function (and habit) of domestic bank reserves themselves.
"These funds [deposit outflows] were then channeled through the Euro-dollar market to the largest banks, with an actual basic reserve surplus developing in New York City banks last week and a record level of borrowing by country banks. These twin developments had the result of taking some of the pressure off the Federal funds market as the most aggressive bidders had less urgent needs and country banks made greater use of the discount window. This in turn helps explain last week's anomaly of the highest level of net borrowed reserves in 16 years and a relatively comfortable Federal funds market."
The act and practice of borrowed reserves, though qualified in terms of meeting regulatory reserve requirements, had been officially discouraged since the 1950's. Regulatory policy wanted banks to meet their liquidity constraints more so with internal resources rather than the regular practice of hitting up the Discount Window as banks had done throughout the 1920's. The federal funds market had developed as an alternate to the Discount Window for these borrowed reserves, but that 1959 Federal Reserve study in the market claimed that it was mainly used for intermittent practice rather than a stable source of reserve funding. The study did, however, note that those banks who were "chronic" borrowers at the Discount Window had become through the 1950's similarly "chronic" buyers of federal funds.
The break in funding regimes in 1968 and 1969 opened those doors wide. There were now methods by which banks could use wholesale techniques to mitigate outside constraints, including monetary policy and regulations. But these were not symmetrical; wholesale dynamics greatly favored the larger banks that could, ostensibly, use their size and special knowledge to broker funding markets both onshore and off. The conduits for these wholesale flows (including repo) would be the biggest banks most willing to shed traditional formats. This is what gave us the S&L crisis of the 1980's (so much for Volcker stability), as many smaller banks and even thrifts sought to emulate what these large commercial banks figured out in the late 1960's.
For monetary policy itself, the implications are just as stark. With banking no longer as directly responsive to policy since the very idea of reserves is no longer so settled, those arcane proxies Edwin Dale contemporarily derided, the FOMC simply needed to try that much harder to accomplish its intended goals (dubious as those might have been to begin with). In other words, if the FOMC felt it needed to do X in money markets, now with eurodollars and federal funds (and repos) reaching broadly in terms of borrowed reserves, they had to twice or three times X to achieve their desired correlations. This wasn't the main reason for the stop-go policy of the 1960's and 1970's that produced the Great Inflation, but it was certainly a compelling factor.
More so, however, it tells us a lot about monetary policy's abilities in the first place. Commanding interest rates is not a simple task; in many ways it is exactly the thunder of King Lear or, as might have it in the period since 2007, King Canute commanding the tides. From the perspective of policymakers, they are almost gods (just listen to Bernanke, even to this day); from the rest of the world, the view obviously changes by circumstances.
That would seem to afford a lot of concurrence with the circularity of history itself; which suggests more than a little too much deference to monetary policy in all contexts. It was Paul Volcker that set the current frame for the Federal Reserve, and it has seemingly determined to undo that goodwill with more and more effort as time passes. In 1992, Alan Greenspan's Fed pushed the federal funds target down to 3%. That occurred during the first of the "jobless recoveries" that are now "somehow" commonplace in the business cycle. At the next juncture, it was a floor of 1% by the middle of 2003. Save the housing bubble, we might not have known there was much recovery at all during the middle 2000's.
None of that was bulwark against the Great Recession and Panic of 2008. There was King Canute Bernanke telling us repeatedly and with growing emphasis that no worries should ever develop even after housing turned in 2006 - he would simply command the federal funds rate to whatever proper setting. When he testified before Congress in March 2007 that subprime was "contained" I have no doubt he meant it in the exact same way that Frank Morris was convinced that his Boston banks took his policy just as serious. What that testimony did, however, was reveal the shocking lack of depth to Bernanke's perceptions (a full examination of why is here).
So in broad and general terms, we find that central banks all around the world have turned to increasingly absurd ways with which to make monetary policy find their intended depth; and still they never do. The things that have happened in the past few years would have in 2006 been judged utterly insane. We may have become far too desensitized by now, but if you told Bernanke that the Bank of Japan would be buying corporate debt at negative yields, as it did just this week, and that it wasn't so outlandish to assume that the Fed might follow, he and everyone else would have dismissed you outright as insane. It no longer is.
If this year turns out the way it is already shaping up, can you really not imagine Janet Yellen (or her successor, assuming she doesn't survive the growing debacle) doing the same as the Bank of Japan? There has already been a steady growth of stories and rumors, all emanating carefully from that policy corridor, of intellectual flirtations with negative interest rates. Not only that, the FOMC in June 2003, just as Greenspan was achieving his "ultra-low", ridiculed the Bank of Japan for its first two (of ten or eleven, depending on how you count) QE's - only to follow them almost exactly just five years later.
Central bank measures have, again, become increasingly absurd; everywhere they have been so has been only further deprived of true and sustainable economic growth. I won't waste your time here revisiting the subject of this "recovery" as there is no longer any point to reciting the catalog of woe. The reconciliation of this disparity is simply reputation alone. Volcker's goodwill still lingers in the institutional sense even if Greenspan as "maestro" has more and more rotted. It is all the more frustrating that such reputation was given in the first place, unearned as it really was.
Central planning never works and the episode of 1969 demonstrates exactly why; bureaucracies cannot cope with dynamic conditions. When faced with those, bureaucracies instead react hostilely (if not in outright denial), searching for a way to induce or maintain stasis and sclerosis so that control and power become the dominant goal in religious proportions. There is no more dynamic surface than banking, especially banking freed from the strictures of money.
Thus, the more dynamic that seeps out or leaks into function beyond the self-narrowed gaze and limited apprehension of the central bank, the more absurd lengths the central bank must take to project, even if only to itself, its domination on only its own terms. Last month, the current incarnation of the FOMC took once more to the federal funds rate even though there is nobody there because that is what they do and that is what shall rule. This drastic misplacement was apparent before the first QE or the first FOMC vote on ZIRP; it was all right there in at least March 2007, Bernanke seated in front of Congress full of self-righteous arrogance. That, too, had become something of a quasi-currency. The more he expressed what was just plain wrong but couched in the soothing tones of Volcker-type confidence, the more the world just bought it - and headed right over the cliff.
Because of that inertia and apathy, we are all headed back toward "laughing at the Fed." There will be a great many more tears before that is accomplished, but such is, I think, human nature. It should have been 2009 (I plead once more for everyone to simply read the FOMC transcripts from 2008) but the cycle of history was apparently not yet ready to swing back in the truly healing direction. The Fed has never been what has been made out of it, a fact that is revealed only intermittently to wide enough audience. Let us hope this turns out as quickly as possible one of those times.