The Fed's Repetitive Ineptitude Is Uncanny
On Friday, March 12, 1937, Treasury Secretary Henry Morgenthau, Jr., summoned Federal Reserve Board Chairman Marriner Eccles to his office for an impromptu meeting. Summoned might be too strong a word but historical accounts on both sides suggest that the conversation was not really a choice. In the Great Depression era, which at that time was still in effect though by then it had occurred to some policymakers it was finally over, the Federal Reserve had lost a great deal of its agency. It was hard to argue against the proposition given the events starting in late 1929. The institution was, after all, created for the express purpose of currency elasticity and yet the nation not even two decades after the Fed's founding was in the midst of continued economic pain after perhaps the greatest of all its panics.
The immediate topic of discussion that day between Eccles and Morgenthau was the government bond market. It had that week experienced rather severe disruption after having been in a variable selling mood ever since the prior December. Economic and financial circumstances being what they were at the time, the Treasury Secretary was more than a little concerned about any financial disruption no matter where it had or was to occur.
According to Chairman Eccles, Secretary Morgenthau was rather adamant that the Fed use its Open Market Desk to prevent the newly issued 2.5% bonds from trading at all below par. That, he pressed, would be a very bad signal. Eccles countered that specific authority in the case of that specific bond was lacking at FRBNY, which conducted the operations of the Open Market Desk; to achieve at least a partial effort directed at what the Treasury Secretary desired would require special authorization.
A non-scheduled meeting was called for the next day, a Saturday no less, indicating both the relative flow of "order" as well as the gravity with which the situation was taken. There was no uniform consensus about Morgenthau's request; indeed, the informal count of Board members showed the majority quite against the idea. Having believed, first, that the Depression was nearing an end they wanted to pursue what we call today "normalization" in financial markets as it was occurring, they believed, in the real economy. If that meant some disruption in government bond prices, then so be it.
FRBNY President George L. Harrison was against any action at all, as were many of the other branch presidents. From the March 15, 1937, FOMC transcript for the meeting:
"During the discussion which followed there appeared to be general agreement that the drop in prices in the bond market was in the nature of a natural adjustment which was due primarily to non-monetary causes. Mr. Burgess [manager of the System Open Market Account] stated that the selling on the market Friday appeared to come to a considerable extent form dealers who were reducing holdings of bonds acquired as a result of the March 15 financing, although selling orders were also coming in from all parts of the country."
The Fed would not under any circumstances peg the government bond market or any specific security, that much was specified by Chairman Eccles in his meeting with Morgenthau. And though there was a great deal of resistance on the matter, in the end it was Eccles almost alone who carried the discussion. It was decided in that very Washington way that the Fed would only seek to maintain "order" in markets but allow them to go where they may. It sounds entirely reasonable but the whole point of what constitutes "order" and what instead counts as "disorder" is not truly a factor fit for such centralization.
This verdict was delivered to Treasury right then and there; the transcript records that at 11:55 am that Saturday, "the members of the executive committee and Messrs. Morrill, Goldenweiser and Burgess went to the office of the Secretary of the Treasury where they met with the Secretary, Mr. Wayne C. Taylor, Assistant Secretary of the Treasury, Mr. D. W. Bell, Acting Director of the Budget, Mr. Archie Lochhead, Technical Assistant in the Secretary's office, Mr. George C. Haas, Director of Research and Statistics of the Treasury Department, and other members of the staff of the Treasury." It was not, apparently, well received as Morgenthau and his staff immediately "withdrew" and returned later to demand (my word) a more concrete proposal about what the Fed was going to do "to counteract the firming of long-term interest rates which he [Morgenthau] felt was attributable solely to Federal Reserve action."
That was what the whole matter truly was about, as the growing disruption in government bonds was effect to "some" other cause. The Fed was steadfast, or it seemed, in its view that it was the natural progress of recovery but the Treasury Secretary (and likely the position of the FDR administration) could not help but notice the most obvious correlation. The Fed had voted to change the reserve requirement in 1936 and announced it publicly that July. The first increase took place already in August 1936 with a second two-step addition to happen on March 1, 1937, and then again on May 1. From Treasury's perspective, it was hard to dismiss the timing of the start to rising interest rates overall (and not just government bonds) but really and specifically the second policy change that barely two weeks thereafter had seen such bond market furor as to require frenzied perhaps heated backroom policy discussions at high tempo on a spring Saturday.
A full FOMC meeting was called for the following Monday and in it Fed Staff Chief Economist E. A. Goldenweiser proclaimed yet again that recovery was entrenched, widespread and sustainable.
"Mr. Goldenweiser said that the basic economic situation was good, that recovery was definitely under way with a very rapid rise in business activity in December, a slight recession in January and February due chiefly to labor troubles and floods, and a resumption of the upward trend in the latter part of February and early part of March. He pointed out that recovery was not confined to the United States but that conditions were fairly good in most of the large countries and that France, in spite of her financial difficulties, was experiencing a decided economic up turn."
In the technical memorandum written to justify the policy of increasing the reserve requirement, published in the 1937 Annual Report, the Fed wrote that it was "a precautionary measure to prevent an uncontrollable expansion of credit in the future." It was Goldenweiser who provided, it seems, a great deal of the justification for this stance, as he had been appointed Chief economist while still serving as the Board's director of research (as Milton Friedman and Anna Schwarz actually point out in their book A Monetary History). At the January 1937 FOMC meeting, Goldenweiser re-iterated the policy determination toward causation that, "the most effective time for action to prevent the development of unsound and speculative conditions is in the early stages of such a movement when the situation is still susceptible to control..."
The Fed had been founded only in 1913 but not even three decades in this was no currency elasticity function - matching market demand for whatever a central bank could or might supply. The central bank was now in its own habit of determining what was and what was not "real" or "good" or "beneficial." The Fed was absolutely sure the economy was heading for full recovery; the "market" was not. The central planners carried the argument.
At the conclusion of the emergency (though it was never called that) Saturday meeting, the FOMC proposed for full vote the following Monday only slight changes in the maturities of what securities the Open Market Desk would be authorized to purchase, and some additional authority to permit $25 million in "fluctuations" of holdings between weekly statement dates "as may be desirable for the practical administration of the account." Additional emergency authority was also added that allowed a further $250 million increase or decrease in government bond holdings in the Open Market Account "in the event of an emergency." Eccles related to Morgenthau that on that last point there would be consultation with Treasury about the ongoing health and overall state of the government bond market. It was a compromise that satisfied no one, but left everyone with no other alternative.
The Treasury, of course, was not powerless beyond any implicit authority over Fed behavior. The Department could have acted within its own authority in the gold market or to use the "stabilization fund" but either of those actions would have had the effect of increasing excess reserves and thus would be in direct contradiction to stated, published, and active Federal Reserve policy. Any kind of inconsistency in that sense would likely have been devastating so no matter how much Morgenthau blamed the Fed he wasn't going to undertake political suicide.
There was, of course, no disagreement about the state of bank reserves. Everyone could easily observe them and their plenty. But nobody, it seems, could agree on exactly what they meant for the recovery or financial markets. The Fed's position, again, was that their very existence, though non-economic in nature (gold inflows since the trough and almost exclusively via foreign government accounts), were an immediate danger in that as the recovery proceeded beyond some trigger threshold those formerly idle reserves would turn to inflationary fuel very quickly. Obviously, policymakers believed that whatever might have such effect was immediately at hand, worrying far more about monetary-driven "overheating."
The actual constitution of those reserves were quite another matter, but one that did not concern the Board. As Goldenweiser noted again at the March 15 meeting, "the present supply of money is large and is concentrated in the financial centers and in the hands of people holding it for investment gives strength to the investment market, that reactions in the securities market were the result of psychological factors rather than fundamental economic changes, and that, while they were to be expected under existing conditions, they should not cause the System particular concern." This was demonstrably false.
In January 1937, just before the first step of the second increase in reserve requirements went into effect, at a meeting of the bank directors of the New York Fed branch they discussed the topic of reserve distribution. The New York banks were increasingly concerned about potential disruptions in national monetary flow due to the uneven nature of bank reserve allocations. NYC banks were at the top of the nation's banking pyramid as central reserve city banks, which meant a special function in a special place of operating the actual payment system that is the first and primary role of money (medium of exchange). As central reserve city banks, they were funded with deposits from banks in reserve cities (correspondent balances) which were in large part funded by correspondent deposits from country banks. Like a tree, the country banks were the leaves, the reserve city banks the big branches, and the central reserve city banks the trunk.
This was an ancient arrangement (in American financial terms, anyway) that placed central reserve city banks as the pivot between the monetary system and financial system (asset and money markets). Because of their locations in money centers, especially NYC, they could funnel their holdings of correspondent balances into various financial markets, from government bonds to stocks (call money). It was this very weakness (bottleneck) that caused so much destruction starting in late 1929.
By 1937, however, though the aggregate holding of excess reserves was large there existed an imbalance or concentration outside of the central reserve city banks further down the correspondent network. Smaller country banks especially had taken to holding large balances as one lesson derived from the massive waves of bank runs, the last of which had occurred just four years before. They were gun shy; and why wouldn't they have been? Holding great excess reserves in a correspondent balance was at least one measure of liquidity while attempting to offset the serious inefficiency of doing so. That was the allure of the central reserve city banks and their correspondent offerings, meaning that because they could generate financial returns in financial markets they could pay significant interest on correspondences. Given the very low interest rate environment of that time (this being one reason for that), even reserve city banks were hard pressed not to deliver their excess "liquidity" in this fashion.
When the change in reserve requirement was first discussed in 1935, the central reserve city banks sensed what was coming. But their argument was to no avail; the economists were certain the recovery was in place and that excess reserves being so plentiful would make any market deviation or disruption a temporary or "transitory" ruggedness on the road to normalization. When FRBNY's directors met in January 1937, they already had experience of the first half of the reserve requirement change and were intent on being heard for what they were already observing. The reserve requirement would hit them twice and on "both" sides each time; once for their own liabilities and then again in the form of correspondent withdrawals as banks further down the correspondent system were forced to adjust their own balance sheets.
The flow of reserves being so unevenly presented, the NYC banks were proven correct, as was Treasury Secretary Morgenthau. In a matter of just months the Great Depression would become "greater" in what was one of the largest cyclical declines in our history. Contributing to the magnitude was a shocking credit crunch that appears as a huge reduction in liquidity radiating from especially NYC outward. The whole cycle is mostly forgotten as it has been subsumed as an extension of the prior crash into one whole Great Depression. It has only been recent events that seem to have performed a limited rediscovery of that part of the 1930's.
The similarities are absolutely striking, then as now. The magnitudes, of course, are different but overall it is fascinating in how there are so many processes or imbalances that have repeated. First and foremost, despite the huge crash at the front, the recoveries that followed both were "somehow" lackluster. They were an advance, to be sure, but neither actually came close to closing the economic hole created by each's opening act. We see exactly the same disparity in the current "cycle", where the Great Recession delivered the same asymmetry collapse to recovery; far too much of the former and not nearly enough of the latter. In both cases, Great Depression as Great Recession, the recoveries were insufficient despite tremendous inflows or "monetary" expansion. And in both, it was that count that convinced the Fed in very different eras the risks were more inflation and overheating than not.
Mr. Goldenweiser's March 1937 economic summation would fit right at home in any current FOMC discussion. And yet, then as now, there are and have been any number of warnings about why that would be pure folly. Money supply is not liquidity, and in actual economic circumstances it is flow that determines health not the centralized assumptions of central planners who view their own opinions and determinations as far superior to anything else.
As Milton Friedman and Anna Schwarz write in admonishing specifically Harrison, even after the economy started to turn in the summer of 1937 he and the others in his court, "regarded assertions to the contrary by economic analysts outside the System as simply ill-informed..." We won't be privy to what Ben Bernanke or Janet Yellen have been saying in similar regards of their own policy discussions these past few years, but what we already know publicly is exactly the same. At first this current "unexpected" weakness was all "transitory" but now it is to be treated as just weakness without any significance. "Global turmoil" is just some big mystery.
If there is a difference between this point in mid-cycle and that in the middle of the Great Depression, it is that the cycle in 1937 developed very quickly and though devastating passed in relatively short order (as does any cycle). This one, however, is something altogether different as it presents itself as a slowdown that just won't stop slowing down. Even secular stagnation, which was an academic attempt to describe the slowdown as slow but steady growth and thus entirely concerning but benign, has been increasingly cast aside as what we find now is neither recession nor stagnation but instead slow but steady contraction.
That state of affairs had been predicted, more or less, by market activity going back years. There were the events of 2011 that acted as the final nails in the eurodollar coffin; the events of 2013 well before the word "taper" which led only to bond market (and currency) turmoil very much like what I described above in late 1936 and early 1937. Bearishness and collapsing curves have been a constant feature of credit and funding since November 20, 2013. And there was gold.
Economists, in particular, could not contain themselves over the crash (actually two) in gold in April 2013. They found it a sign from orthodox heaven that all the monetary efforts of four QE's had finally paid off, and it was only to be recovery from there on. Felix Salmon at Reuters wrote of the happy collapse of the "fear bubble" and his utter delight in it, "As a result, the falling price of gold is more important than simply being an opportunity for schadenfreude around the likes of Glenn Beck or John Paulson or Zero Hedge." It was none of those things; the gold crash was a "dollar" warning and maybe the most deafening before the "rising dollar", and it, too, wasn't heeded because economists always see themselves and their work as successful. I wrote last year:
"So much happy emotion was never really much of a ‘stimulant', of course, but the negative factors on ‘dollar' circulation were very real. In many ways, the collapse in gold presaged this latest stage or leg in the collapse of the global "dollar", eurodollars in particular, which starts to account for the economic behavior these past few years as well. Gold, then, since early 2008 has been telling us a lot about the tendency of the eurodollar standard toward outright imbalance and dysfunction. That is a condition that is not in any way conducive for a global recovery, which is one big reason why, despite orthodox giddiness over gold prices, it never came."
It is absolutely astounding that the nation's deputized monetary agency, private in ownership though it may be, still has not the slightest competency over money and monetary affairs such that it would repeat almost exactly the mistaken interpretations and tendencies first made eighty years ago. Progress is slow within bureaucracies, to be sure, but this is all uncanny. Economists have never much liked markets and politicians even less, but the combination of those two here into the Federal Reserve's modern existence is an unending string of ineptitude from one side to the other - and all of it still contained within its supposed core function. It's not just that they don't get money, they also have no idea how money actually relates to real economic function. It's why we got the continued Great Depression, why they were being "laughed at" in the 1960's, and why we now have a slowdown all over the world that will not stop; and one policymakers cannot deny quick enough despite market concurrence yet again. In 1937 there were just a few warnings before it all fell apart again; since 2013, we have seen a steady diet of them in only increasing intensity, and all met with the familiar refrain of "nothing to see here." If "they really don't know what they are doing" should be the institutional motto, "nothing to see here" surely places as its first subheading.
This repetition and consistency of ineptness suggests the most basic problem is not just the various theories guiding each Fed incarnation, but the entire centralized system itself. It just doesn't work, it never really has, and there is even less now to suggest at some point it ever will.