Full text of Economic Quarterly (Federal Reserve Bank of Richmond) : Second Quarter 2013, Vol. 99, No. 2

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Economic Quarterly— Volume 99, Number 2— Second Quarter 2013— Pages 83–116

The Monetarist-Keynesian
Debate and the Phillips
Curve: Lessons from the
Great In ation
Robert L. Hetzel

A

chievement of consensus over the cause of cyclical ‡uctuations
in the economy and the nature of in‡ation has foundered on
the impossibility of running the controlled experiments that
isolate a single cause from the multiple forces that impact the economy. In this respect, the period from the mid-1960s through the end
of the 1970s (the Great In‡ation) is important in that the characterization of monetary policy— the economists’proxy for an experiment—
was unusually clear.1 Monetary policy was activist in that the Federal
Reserve pursued both unemployment and in‡ation objectives in a way
shaped by the assumed tradeo¤s of the Phillips curve.2 The experience of the Great In‡ation did produce enduring changes, especially
the assumption of responsibility by central banks for the control of
in‡ation without recourse to wage and price controls. However, the
The author gratefully acknowledges helpful comments from Thomas Lubik,
Andrew Owen, Felipe Schwartzman, and Alex Wolman. The views expressed
in this article are those of the author and do not necessarily re‡ect those of
the Federal Reserve Bank of Richmond or the Federal Reserve System. E-mail:
robert.hetzel@rich.frb.org.
1
Much of the commentary in this article summarizes work by Hetzel (1998; 2008a,
Chs. 5–12, 22–25; 2012, Ch. 8; and 2013a).
2
Over time, economists who urge an activist policy aimed at achieving an optimal
mix of low in‡ation and low unemployment or an optimal tradeo¤ in the variability
of these variables have altered the character of the empirical correlations between in‡ation and unemployment to which they attribute structural signi…cance. Until the end of
the 1970s, the period relevant for the discussion here, most commonly, they emphasized
the correlation between in‡ation and the unemployment rate. Subsequently, they have
emphasized the correlation between the di¤erence in the unemployment rate and a reference value often termed the NAIRU (non-accelerating in‡ation rate of unemployment)
and the change in the rate of in‡ation.

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di¢ culty of isolating the impact of policy from other forces, especially
in‡ation shocks, has limited the conclusions that economists draw from
this experience.
In the 1960s, and well into the 1970s, an unusual degree of professional consensus existed. This Keynesian consensus emerged out of
two dramatically contrasting episodes. The persistence of high unemployment in the decade of the 1930s (the Great Depression) appeared
to demonstrate the weak equilibrating properties of the price system.
In contrast, the low unemployment during World War II appeared to
demonstrate the usefulness of …scal policy in managing aggregate demand in order to maintain employment at its full employment level.
Supported by this intellectual consensus during the Great In‡ation,
policy attempted to stabilize unemployment at a lower level than had
prevailed over most of the post-War era. The activist policy pursued
in order to achieve this objective engendered the monetarist-Keynesian
debate, which centered on whether policymakers could and should base
policy on the observed in‡ation-unemployment relationship captured
by the empirical correlations of the Phillips curve.
Section 1 o¤ers a broad overview of the methodology economists
use for learning from historical experience— whose antecedents lie in
the Friedman-Cowles Commission debate of the early 1950s. Section 2
summarizes the way in which the contemporaneous understanding of
the Phillips curve shaped monetary policy in the 1970s. Sections 3 and
4, respectively, contrast Keynesian and monetarist views on the Phillips
curve and the resulting disagreement over the desirability of an activist
monetary policy. Section 5 explains the way in which the SamuelsonSolow interpretation of the Phillips curve embodying an inverse relationship between in‡ation and unemployment supported the policy of
aggregate-demand management in the Great In‡ation. Section 6 reviews the challenge made by Milton Friedman to the Samuelson-Solow
interpretation of the Phillips curve. In a way analogous to the contrasting experiences of the Great Depression and World War II, Sections 7
and 8 summarize how the contrasting experiences of the Great In‡ation and the Volcker-Greenspan era changed the prevailing Keynesian
intellectual consensus. The article concludes, in Sections 9 and 10, with
some speculation on the course of the current debate over the causes
of the Great Recession, which began in earnest in 2008.

R. L. Hetzel: Lessons from the Great In ation
1.

85

FRIEDMAN AND THE COWLES COMMISSION
ECONOMISTS: COMPLEMENTARY
ADVERSARIES

In the late 1940s, the University of Chicago and the University of Cambridge assembled perhaps the greatest collection of intellectual brilliance the economics profession will ever see. They provided much
of the impetus involved in changing economics from its then dominant institutionalist character to the neoclassical character now considered mainstream. Along with the mathematical formalization of
Keynes’s (1936) book (The General Theory of Employment, Interest
and Money), in Hicks (1937) the methodology developed by the economists of the Cowles Commission laid out the general framework for
construction of models of the economy and highlighted the econometric issues of identi…cation of structural equations from the reduced-form
correlations found in the data.3 In his essay “The Methodology of Positive Economics,” Friedman ([1953a] 1953) criticized the identi…cation
strategy of the Cowles Commission with its reliance on a priori assumptions about which variables could be excluded in the estimation of the
equations comprising a model of the economy.4
Friedman argued that many alternative models would …t a set of
macroeconomic time series equally well.5 As a consequence, goodness
of …t for a given body of data would not distinguish between models.
Hypothesis testing requires the elucidation of contrasting implications
of alternative models. Those contrasting implications then should be
taken to data sets not available to the economist at the time of building
the model. Most notably, testing required that models not only …t the
existing data but also that they yield implications about the future.6
Understanding the context of Friedman’s 1953 essay helps to elucidate the statements it contains about hypothesis testing. At the end of
the 1940s, there was an e¤ort to test the marginal foundation of neoclassical economics by examining its “realism,” for example, through
surveys asking the managers of …rms whether they choose price and
3
The Cowles Commission pioneered the representation of the economy by a system of stochastic di¤erence equations. As expressed by Tjalling Koopmans (1947, 167),
the Cowles Commission’s members worked on empirical estimation based on recognition
of the fact that “the mere observation of regularities in the interrelations of variables
. . . does not permit us to recognize or to identify behavior equations among such regularities.” The general approach of giving the behavioral equations that represent the
economy a microeconomic foundation shapes the research agenda of macroeconomics.
4
Sims (1980) talked about “incredible” identifying restrictions of the large-scale
econometrics models spawned by the Keynesian attempt to give empirical content to
the Cowles Commission agenda.
5
See Chari, Kehoe, and McGrattan (2009) for a similar statement.
6
For a restatement, see Friedman and Schwartz (1991).

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Federal Reserve Bank of Richmond Economic Quarterly

output based on a marginal cost schedule. The then-dominant institutionalist school questioned the realism of marginal cost pricing.
Friedman argued that the theoretical assumptions of neoclassical models were a necessary abstraction required in order to yield refutable
implications.7 The relevant test of a model is its predictive ability.
Because of its complexity, a “realistic” model would always a¤ord a
rationalization of the data but the economist could not distinguish between …tting a model to the data and testing its validity.
Beyond the simpli…cation entailed by the theoretical abstraction
necessary to compare the implications of a model to the data in a way
capable of refuting rather than rationalizing the model, it is necessary to separate exogenous from endogenous variables. The ideal is
the controlled experiment of the physical sciences. A test of the competing hypotheses that guide the formulation of alternative models is
then simpli…ed because of the assignment of causality made possible by
the controlled experiment. Applied to economics, the Friedman strategy was to relate both the evolution of central bank procedures and
episodes of signi…cant departures from those procedures to changes in
the political and intellectual environment unrelated to the operation of
the price system. This diversity of central bank behavior serves as a
semi-controlled experiment informative for disentangling causation in
the historical association between real and monetary instability.
The spirit of the Friedman approach to testing models involves, as
a …rst step, speci…cation of the alternatives. At this stage, models can
be superior along two dimensions. First, some may be better microfounded than others. Second, some may explain a more challenging
set of empirical phenomena. That is, they are more resistant to …tting
time series through data mining. The ideal is to proceed along two parallel, inter-related paths: model building and the isolation of “robust”
correlations.
The search for robust correlations requires searching across time
and across countries in pursuit of persistent relationships. In the context of monetary models of the business cycle, correlations between
monetary and real instability that survive this diversity of experience
are as close as one can come to a controlled experiment. The diversity
of experience limits the possibility of some nonmonetary cause common to all episodes producing the correlation between monetary and
real instability. The discipline of looking at the entire set of historical experiences rather than isolating individual episodes favorable to
one hypothesis, in this case, the monetary nonneutrality explanation
7
Of course, they also impose the discipline of constrained optimization that households and …rms undertake all available trades that improve their welfare (markets clear).

R. L. Hetzel: Lessons from the Great In ation

87

of the business cycle, reveals whether real instability arises in contexts of monetary stability as well as in contexts of extreme monetary
instability.
Speci…cally, the economist looks for event studies, that is, episodes
in which he (she) has some information particular to the time period
about the nature of causation. Because of the impossibility of controlling for extraneous forces in particular episodes, the ideal is one where
metastudies generalize across a wide variety of historical event studies.
In particular, do monetary-real correlations appear in a su¢ ciently wide
variety of historical episodes so that the only common element in the
episodes is likely to be the behavior of the central bank? Correlations
that persist across time and place and come tagged with information
of central bank behavior unrelated to the stabilizing operation of the
price system then become the “stylized facts”that discipline the choice
of frictions to incorporate into models.8
The challenge is to run a horse race among models that potentially
selects the one that is likely to o¤er better predictions out-of-sample.
Although alternative models can di¤er in the adequacy of their microfoundations, the Friedman emphasis is on the assumption that each
model builder knows the data and will select a combination of model
and data that support his (her) model. By itself, neither model …t nor
economic theory is adequate to identify the true structural equations.
One central element in model selection is to discipline the horse race
through identi…cation of policy using a variety of historical information
rather than representing policy by a general functional form with free
parameters the estimation of which will necessarily aid the …t of any
model.
To make the discussion more speci…c, a correlation common to all
recessions is central bank behavior that imparts inertia to reductions in
interest rates while the economy weakens. For central banks concerned
with the behavior of the external value of their currency, this behavior
is associated with countries going onto the gold standard or a peg with
a foreign currency at a parity that overvalues the domestic currency
(requires a reduction of the real terms of trade through de‡ation). For
the other cases, this behavior is associated with a concern to lower
in‡ation or asset prices considered arti…cially elevated by speculation.
These episodes come tagged with information that the behavior of the
central bank does not arise out of a systematic reaction function related
8
One problem in macroeconomics is the practical di¢ culty of generalizing from the
vast literature on historical episodes that are potentially useful as event studies. This
di¢ culty makes it harder to reach agreement in monetary economics over the “stylized”
facts a model should explain. In contrast, new mathematical techniques useful in model
construction are more readily incorporated into mainstream models.

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Federal Reserve Bank of Richmond Economic Quarterly

to the ongoing behavior of the economy. Monetarists point to such a
correlation as robust.
In monetary economics, the horses in these races divide into three
basic classes. In the Keynesian tradition, cyclical ‡uctuations arise
from real shocks in the form of discrete shifts in the degree of investor
optimism and pessimism about the future large enough to overwhelm
the stabilizing properties of the price system and, by extension, to overwhelm the monetary stimulus presumed evidenced by cyclically low
interest rates. In the quantity theory tradition, cyclical ‡uctuations
arise from central bank behavior that frustrates the working of the
price system through monetary shocks that require changes in individual relative prices to reach, on average, a new price level in a way uncoordinated by a common set of expectations. In the real-business-cycle
tradition, cyclical ‡uctuations arise from productivity shocks passed on
to the real economy through a well-functioning price system devoid of
monetary nonneutralities and nominal price stickiness. Of course, only
the …rst two horses contended in the debate during the Great In‡ation.

2.

THE CENTRAL ROLE OF THE PHILLIPS CURVE
DURING THE GREAT INFLATION

The Phillips curve is a set of empirical observations showing an inverse
relationship between the behavior of in‡ation and unemployment. At
the heart of the activist policy pursued during the Great In‡ation was
the belief in an “exploitable” Phillips curve, that is, a Phillips curve
allowing the policymaker to trade o¤ between the achievement of unemployment and in‡ation objectives. The monetarist-Keynesian debate
turned, to a signi…cant extent, on the issue of whether the empirical
correlations of the Phillips curve represented a structural relationship
that would allow policymakers to trade o¤ between their pursuit of the
two variables, with predictable consequences.9
Speci…cally, during periods of economic recovery from a cyclical
trough when in‡ation had fallen and the unemployment rate was above
normal and thus unemployment had become the main concern, policymakers assumed that monetary policy could be expansionary without
9
During the Great In‡ation, monetary policymakers eschewed the language of
tradeo¤s. As a result, discussions within the Federal Open Market Committee (FOMC)
never explicitly employed the conceptual framework of the Phillips curve. Moreover,
FOMC discussion followed the packaging for the public of policy actions as individual
actions, each of which was defensible in a common sense way in the context of the
contemporaneous behavior of the economy and the resulting relative priority assigned
to achieving unemployment and in‡ation objectives. As a result, both the systematic
character of monetary policy and the conceptual framework generating that policy have
to be inferred by economists.

R. L. Hetzel: Lessons from the Great In ation

89

exacerbating in‡ation. That is, a ‡at Phillips curve would allow a
reduction in unemployment to its full employment level with little increase in in‡ation. In the aftermath, in the advanced stages of economic
recovery when a reduction in unemployment and an increase in in‡ation turned in‡ation into the main concern, policymakers assumed that
monetary policy could be restrictive by creating a moderate, socially
acceptable increase in unemployment. That is, a moderate but sustained increase in unemployment above its full employment level acting
through a downward-sloping Phillips curve would lower in‡ation at an
acceptable social cost in terms of unemployment. In a way given by the
sacri…ce ratio embedded in the Phillips curve, monetary policy could
engineer the required number of man-years of excess unemployment—
the so-called soft landing— through an extended but moderate increase
in unemployment above its full employment level.
This common understanding of the nature of the Phillips curve
and activist policy rested on two basic assumptions. First, in‡ation is
a nonmonetary phenomenon. That is, in‡ation springs from a variety
of real factors rather than from the failure of the central bank to control
money creation. One reason that the Great In‡ation is an interesting
laboratory for economists was the existence of a monetary aggregate
(M1) that provided a good measure of the stance (stimulative or contractionary) of monetary policy due to the interest-insensitive nature
of real money demand and a stable, albeit lagged, relationship with
nominal expenditure. However, the assumption that money responded
passively to the various real forces that determine the combined total of
real aggregate expenditure and in‡ation (nominal aggregate expenditure) removed money from consideration as a useful policy instrument.
It was the real character of in‡ation that made the Phillips curve, rather
than money, into the relevant predictor of in‡ation.
The second basic assumption was that policymakers understood
the structure of the real economy su¢ ciently well to pursue an unemployment objective. They knew the level of unemployment consistent
with full employment, by consensus, taken to be 4 percent. The excess
of unemployment over this full employment level measured the amount
of idle workers desiring productive employment. Also, policymakers
could forecast the behavior of the economy based on their choice of
policy su¢ ciently well to exploit the tradeo¤s of the Phillips curve.
They could lower excess unemployment through stimulative monetary
policy at an acceptable cost in terms of in‡ation. Analogously, when
the unemployment rate became an intermediate objective of policy central for lowering in‡ation rather than an objective in itself and policy
was restrictive, they could manage in‡ation with an acceptable cost
measured in terms of extended excess unemployment.

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3.

Federal Reserve Bank of Richmond Economic Quarterly

AN OVERVIEW OF TRADITIONAL
KEYNESIAN VIEWS

As described in The General Theory, swings in investor sentiment,
which Keynes termed animal spirits, drove the business cycle. Adjustment to these swings in sentiment occurred through changes in output
unmitigated by the operation of the price system. Keynes …xed nominal prices by assuming rigid wage rates and by taking the price level
as an institutional datum. The resulting framework served as a clarion
call for government action to counter recession. It did so by challenging the prevailing view that the de‡ation and recession following the
bursting of an asset bubble required an extended period of rectifying
accumulated imbalances (Hetzel 1985; 2012, Ch. 3).
In Keynes’s framework, the exogeneity of ‡uctuations in investment captured the assumption that irrational swings from optimism
to pessimism about the future overwhelm the ability of the stabilizing
properties of the price system. That is, in recession, no decline in the
real interest rate is su¢ cient in order to redistribute demand from the
future to the present to maintain aggregate demand equal to potential
output. In response to an exogenous decline in investment, output has
to decline. Otherwise, given the exogenous decline in investment, the
full employment level of saving would exceed investment. A decline
in output is necessary to reduce saving in line with a lower level of
investment.
However, a given decline in output decreases saving by only a fractional amount because of a marginal propensity to consume out of
income (output) greater than zero. The required reduction in saving
must occur through a decline in output (income) that is a multiple
of the decline in investment. As captured by the Keynesian multiplier, exogenous swings in investment translate into shifts in output in
a mechanical way based on the inverse of the marginal propensity to
save (one minus the marginal propensity to consume). The optimism
in Keynes’s message came from the implication that the government
could o¤set the excessive private saving that arose at full employment
through public dissaving, that is, through de…cit spending. With social
saving (government dissaving plus private saving) at the full employment level, output need not fall in order to equate private saving to a
lower level of exogenous investment.
At a deeper level, the issue is why an increased desire to save
(transfer resources to the future) in order to guard against a future
that has become darker and more uncertain does not translate into increased investment but instead requires a decline in output. That desire is frustrated on two levels. The ability of …nancial intermediation
to transfer resources from savers to investors with opportunities for

R. L. Hetzel: Lessons from the Great In ation

91

productive investment breaks down.10 Also, the nominal rigidity of
wages and prices frustrates the desire to save for the future through an
increased work e¤ort. Without the management of aggregate demand
by government through de…cit spending, output and employment can
fall short of potential output over extended, perhaps inde…nite, periods.
Keynesians believed that the central bank should target the behavior of the unemployment rate (the amount of idle resources in the
economy due to the weak ability of the price system to maintain full
employment and the full utilization of resources). The central bank
should pursue this real objective subject to the constraint imposed by
the acceptable level of in‡ation. The central role of the Phillips curve
derived from the assumption that it o¤ered policymakers a practical
way of estimating the cost in terms of in‡ation incurred by the pursuit
of the full employment objective. Similarly, in response to in‡ation
shocks, the Phillips curve allowed policymakers to predict the cost in
terms of excess unemployment of mitigating the in‡ation produced by
the in‡ation shock.

4.

AN OVERVIEW OF MONETARIST (QUANTITY
THEORY) VIEWS

Monetarism, as formulated by Milton Friedman, challenged the activist
monetary policy pursued during the Great In‡ation and the Keynesian
consensus that supported it. Monetarists believed that the central
bank should concentrate on the control of money creation with the
objective of price stability. This monetary objective would turn over
to the price system the exclusive responsibility for the determination of
real variables like the unemployment rate.11 The following elucidates
the central role played by the need for monetary control.
Although central banks use the interest rate as their instrument,
their uniqueness comes from monopoly control over the monetary base
(bank reserves and currency). Because the monetary base is the medium
used to e¤ect …nality of payment in transactions for whatever instruments possess the property of a medium of exchange (broad money or
simply money here), the control of money creation requires the control
of the monetary base. It follows that the interest rate rule the central
10
A liquidity trap (the willingness of the public to hold whatever amount of money
the central bank creates) vitiates the e¤ectiveness of monetary policy as opposed to …scal
policy.
11
The intensity shown by Keynesians in the monetarist-Keynesian debate came
from the fear that a central bank policy organized around monetary control would lead
to a rule for controlling money that left the determination of real variables to the operation of the price system.

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Federal Reserve Bank of Richmond Economic Quarterly

bank follows must provide for that control. The following elucidates
the discipline imposed on that rule.
Money serves three functions. It is a numeraire, a store of value,
and a medium of exchange. In order to serve its function as a numeraire,
the money price of goods (the number of dollars that exchange for a
representative basket of goods consumed by households) must evolve
predictably. The simplest case is that of price stability. In its function
as a numeraire, money has a public good aspect. Although …rms set
prices in terms of dollars, they only intend to set a relative price (the
rate of exchange of their product with other products). There is then
an advantage to all …rms that set dollar prices for multiple periods in
setting the dollar price for their product based on the same assumption
about the future price level. An assumption of rational expectations
is that the central bank can organize this coordination by following a
rule that causes the price level to evolve predictably.12 In the sense of
Hayek (1945), a stable numeraire is one element in allowing the price
system to economize on the information that households and …rms need
in order to make decisions.
Money also serves as a medium of exchange. To e¤ect transactions,
the public desires to hold a well-de…ned amount of purchasing power
(the nominal quantity of money multiplied by the goods price of money,
the inverse of the price level). To prevent an unpredictable evolution of
the price level that vitiates the role of money as a numeraire, the central
bank must cause nominal money to grow in line with the real demand
for money consistent with growth in potential output plus transitory
demands. Even if central banks do not have money targets and even if
money does not serve to forecast economic activity, monetary stability
requires that central bank procedures control money creation.13
A monetary-control characterization of policy follows if the price
level is a monetary phenomenon in the strong form in the sense that
there is no structural (predictable) relationship between real variables
like unemployment and nominal variables like nominal money and the
monetary base, the variable over which the central bank exercises
12
The assumption is not true in any literal sense in that the evolution of the monetary standard since the breakdown of the gold standard has been one of learning. However, it possesses the powerful implication that if the central bank behaves in a credible,
consistent way, its rule will discipline the way in which markets forecast in‡ation.
13
Like any abstraction, one has to give empirical content to the variable “money.”
In principle, one would like a measure of the transactions (liquidity) services yielded by
di¤erent assets, such as contained in a Divisia aggregate (Barnett 1982). A complicating
factor is that, since 1994, the Federal Reserve Board has not measured the extent to
which banks “sweep” deposits o¤ their balance sheets in order to avoid the tax imposed
by non-interest-bearing reserve requirements. Monetary aggregates like M1 are therefore
likely mismeasured.

R. L. Hetzel: Lessons from the Great In ation

93

ultimate control. Two implications follow from the absence of a structural relationship between money and real variables. First, the central
bank must provide a nominal anchor. Because the welfare of individuals depends on real variables (physical quantities and relative prices),
nothing in their behavior gives money a well-de…ned value in exchange
for goods by limiting its quantity. The intrinsic worthlessness of money
requires the central bank to follow a rule that limits the nominal quantity of money.
The second implication of the absence of a structural relationship
between money and real variables is that in order to provide for monetary and real stability, the central bank must turn over the determination of real variables to market forces. In this sense, in order to provide
for monetary stability, the central bank must avoid “price …xing” by
interfering with the operation of the price system. Equivalently, given
that central bankers use an interest rate as their policy instrument, in
order to provide for monetary and real stability, monetary policy procedures must entail moving the nominal interest rate so that the resulting
real interest rate tracks the natural interest rate.14 Speci…cally, central
banks must allow market forces to determine the real interest rate and,
by extension, other real variables like the unemployment rate.15
The control of trend in‡ation then comes from the way in which the
central bank’s rule creates a stable nominal expectational environment
that shapes the way in which …rms in the “sticky”price sector set prices
for multiple periods rather than through manipulation of an output
gap based on Phillips curve tradeo¤s. A critical facet of the monetarist
assumption that the price system works well in the absence of monetary
disorder is rational expectations.16 Speci…cally, when …rms set a dollar
price for their product for multiple periods, they take into account the
way in which future changes in the price level will a¤ect the relative
price of their product. The assumption of rational expectations implies
that if the central bank behaves in a predictable and credible way, …rms
collectively will coordinate these relative-price maintaining changes in
14
In the context of the New Keynesian model, the natural rate is the real interest
rate that would obtain in the absence of any nominal rigidity in prices. The counterpart
in the writings of Milton Friedman is the assumption that the price system gives real
variables well-de…ned (natural) values when actual and expected in‡ation are equal.
15
This Wicksellian view contrasts with the Keynesian view in which multiple
sources of price stickiness exist, say, in the setting of wages and product prices. In
principle, if the central bank possessed su¢ cient knowledge of the economy, it could
follow a rule that managed real aggregate demand by controlling the real interest rate
in order to trade o¤ optimally between in‡ation and both employment and output gaps.
See the Appendix.
16
This assumption is not in Milton Friedman’s formulation of the quantity theory.
It …rst appears in the mathematical formulation of monetarist ideas in Lucas ([1972]
1981).

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Federal Reserve Bank of Richmond Economic Quarterly

dollar prices on the central bank’s in‡ation target. The self-interest of
…rms in setting their markup of price over marginal cost optimally over
time causes them to use information e¢ ciently about the nature of the
monetary regime.
Individually, …rms set relative prices based on marginal cost. The
central bank’s rule separates the determination of the price level from
the determination of relative prices (at cyclical and lower frequencies).
As a consequence of following a rule that causes the real interest rate
to track the natural interest rate (the real rate determined by market
forces), the central bank allows the price system to determine real variables and allows the price system to keep real output ‡uctuating around
its potential level.17 As a consequence of its interest rate target, the
central bank then allows nominal money to grow over time in line with
the real money demand associated with growth in potential output.
The interest rate target also allows changes in money to accommodate
transitory changes in money demand and whatever in‡ation occurs as
a consequence of the central bank’s in‡ation target. In this way, the
rule causes nominal money to grow over time in a way that does not
require unanticipated changes in the price level in order to bring real
money into line with real money demand.
The central bank can control trend in‡ation— no less and (just as
important) no more. In order to avoid destabilizing economic activity,
it should allow transitory noise to pass through into the price level.
In the passage containing the famous “long and variable lags” phrase,
Friedman (1960, 86–8) argued that the power of the central bank was
limited to the ability to control trend in‡ation. Any attempt to manage
the behavior of the real economy or to smooth transitory ‡uctuations in
in‡ation would in practice destabilize the economy due to policymakers’lack of knowledge of the structure of the economy. The following
summarizes the experiment with aggregate demand management in the
decade and a half after mid-1965.18

5.

THE VAST EXPERIMENT OF PAUL SAMUELSON
AND ROBERT SOLOW

In The General Theory, Keynes assumed that with excess capacity in
the economy increases in aggregate demand would raise output. Only
17
As noted above, Keynesians point to the low rates of interest in recession as
evidence of the impotence of monetary policy. Monetarists point to the inertia central
banks put into the interest rate when the economy weakens and the associated monetary
deceleration. A low interest rate in recession implies only that the public is pessimistic
about the future.
18
For other accounts, see Hetzel (2008a, 2013a) and King (2008).

R. L. Hetzel: Lessons from the Great In ation

95

at full employment would increases in aggregate demand appear as
price rises.19 Given the general consensus that emerged after World
War II that a 4 percent or lower unemployment rate represented full
employment, an unemployment rate above 4 percent implied the existence of idle workers— workers who wanted to work at the prevailing
wage rate but could not …nd work. Aggregate demand management
should then be able to push the unemployment rate down at least to
4 percent without in‡ation. In the language of the time, demand-pull
in‡ation would not be a problem.
The contest for the presidency between John F. Kennedy and
Richard Nixon in 1960 initiated a national debate over the use of
aggregate-demand management to lower the unemployment rate to 4
percent or lower. Kennedy’s economic advisers wanted to pursue an activist policy of aggregate demand management. Politically, the chief obstacle to adoption of such a policy with its deliberate de…cits was fear of
in‡ation. The Kennedy Council of Economic Advisers needed a model
that would predict the in‡ation rate associated with the reduced unemployment rate presumed to follow from a policy of aggregate-demand
management. The Samuelson-Solow ([1960] 1966) interpretation of the
empirical correlations of the Phillips curve provided those predictions.
Consistent with the Keynesian temper of the time, Paul
Samuelson and Robert Solow o¤ered an interpretation of the Phillips
curve based on the premise that in‡ation is a real phenomenon rather
than a monetary phenomenon. As a real phenomenon, there is no single explanation for in‡ation. The Keynesian taxonomy of the causes of
in‡ation contained two kingdoms. Aggregate-demand (demand-pull)
in‡ation arises from a high level of aggregate demand that stresses the
rate of resource utilization. Cost-push in‡ation arises from increases in
relative prices particular to individual markets that pass through permanently to the price level. A wage-price spiral could turn cost-push
in‡ation into sustained in‡ation.
For the years 1861 to 1957 for Great Britain, A. W. Phillips (1958)
demonstrated the existence of an inverse relationship between the rate
of change of money wages and the unemployment rate. In 1960,
Samuelson and Solow ([1960] 1966, 1,347) presented a graph of the
same variables for the United States. Collectively, the observations in
the Samuelson-Solow graph did not exhibit any particular pattern. The
two economists argued, however, that the inverse relationship found by
19
See Keynes ([1936] 1973, 300–1). He referred to the in‡ation that would arise
as the economy approached full employment as “bottleneck” in‡ation. Before full employment, cost-push in‡ation could occur caused by “the psychology of workers and by
the policies of employers and trade unions.”

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Phillips appeared in two periods: 1900–30 (omitting World War I),
and 1946–58. The Phillips curve had, however, shifted up in the latter
period.20
Samuelson and Solow ([1960] 1966, 1,348) assumed that the empirical Phillips curve they identi…ed was “a reversible supply curve for
labor along which an aggregate demand curve slides.. . . [M]ovements
along the curve might be dubbed standard demand-pull, and shifts
of the curve might represent the institutional changes on which costpush theories rest.” They believed that the Phillips curve o¤ered an
exploitable tradeo¤. Breit and Ransom (1982, 128) quoted Solow:
I remember that Paul Samuelson asked me when we were looking
at the diagrams for the …rst time, “Does that look like a reversible
relationship to you?” What he meant was, “Do you really think the
economy can move back and forth along a curve like that?” And
I answered, “Yeah, I’m inclined to believe it,” and Paul said, “Me
too.”

The upward shift in the post-World War II period in the empirical Phillips curve, however, created a conundrum for Samuelson and
Solow over what unemployment rate to recommend as a national objective. Their graphical analysis indicated that the unemployment rate
consistent with price stability (zero in‡ation) was 5.5 percent. That
unemployment rate was unacceptable to them. Samuelson and Solow
([1960] 1966, 1,351) referred to a 3 percent unemployment rate as a
“nonperfectionist’s goal” and adopted it as their reference point for
full employment.
The issue of what in‡ation rate would arise if aggregate-demand
management lowered the unemployment rate to 3 percent then depended on whether the Phillips curve had shifted upward because of
cost-push in‡ation. If not, then price stability would require an unemployment rate of 5.5 percent. Because the data did not themselves
reveal whether the market power of large corporations and unions had
pushed up the empirical Phillips curve of the 1950s, Samuelson and
Solow ([1960] 1966, 1,350) concluded that only the “vast experiment”
of targeting 3 percent unemployment could determine whether their
empirically estimated Phillips curve had been pushed up by cost-push
in‡ation. With the objective of 3 percent unemployment achieved with
aggregate-demand management, in the absence of cost-push in‡ation,
prices should be stable. If cost-push in‡ation did arise, government
20
Samuelson and Solow ([1960] 1966) translated the Phillips curve of Phillips (1958)
into the more familiar Phillips curve with in‡ation on the vertical axis by lowering nominal wage growth by an assumed rate of growth of labor productivity.

R. L. Hetzel: Lessons from the Great In ation

97

programs to deal with the market power of large corporations and
unions could make price stability with full employment possible.
Samuelson and Solow ([1960] 1966, 1,347 and 1,352) accepted the
possibility that an increase in in‡ationary expectations could have
caused what they conjectured to be cost-push in‡ation. However, they
assumed that a policy to reverse that increase in in‡ationary expectations would likely entail a prolonged, socially unacceptable period of
high unemployment.
The apparent shift in our Phillips curve might be attributed by
some economists to the new market power of trade-unions. Thus,
it is conceivable that after they [policymakers] had produced a lowpressure economy [an economy with price stability], the believers
in demand-pull might be disappointed in the short run; i.e., prices
might continue to rise even though unemployment was considerable.
Nevertheless, it might be that the low-pressure demand would so act
upon wage and other expectations as to shift the curve downward
in the longer run— so that over a decade, the economy might enjoy
higher employment with price stability than our present-day estimate
would indicate. [italics added]

Samuelson and Solow warned of the social cost of maintaining the
5.5 percent unemployment rate necessary to deliver price stability if
indeed in‡ation was of the cost-push variety. Samuelson and Solow
([1960] 1966, 1,352 and 1,353) wrote that such a “low-pressure economy
might build up within itself over the years larger and larger amounts
of structural unemployment” leading to “class warfare and social con‡ict.” “[D]irect wage and price controls” were a way “to lessen the
degree of disharmony between full employment and price stability.”
What happened to make a reality the “vast experiment” envisaged by Samuelson and Solow? In the Eisenhower administration, the
Keynesian policy prescription of aggregate-demand management exercised no practical in‡uence because of concern for balanced budgets
and for the balance of payments and gold out‡ows. In the 1962 Economic Report of the President, President Kennedy did set 4 percent
as a national goal for the unemployment rate accompanied by wage
“guideposts”in order to control cost-push in‡ation (Hetzel 2008a, Ch.
6). However, in the context of the Bretton Woods system, Kennedy
was unwilling to risk a dollar crisis (a run on the dollar) given the
international tension associated with the Cuban missile crisis and the
Berlin Wall (Hetzel 2008a, Ch. 7). For that reason, policy remained
dominated by the conservative Treasury.
Starting with the 1964 tax cut, enacted in the Johnson administration following the fall 1963 assassination of Kennedy, the political

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Federal Reserve Bank of Richmond Economic Quarterly

temper turned activist. President Johnson, with roots in the tradition of Texas populism, simply disliked “high” interest rates. More
important, the country split in response to the Vietnam War and the
emergence of a militant civil rights movement. “Low” unemployment
o¤ered a social balm. At the same time, Keynesian economists pro¤ered
the promise of full employment, taken to be 4 percent unemployment,
at an acceptable cost in terms of in‡ation. That promise came from a
Keynesian interpretation of the Phillips curve.
With the 1964 tax cut, the political system became hostile to increases in interest rates. Congressmen argued that any such increases
would thwart the will of the political system to lower the unemployment
rate as evidenced by the tax cut. William McChesney Martin, chairman
of the FOMC, also had to deal with an increasingly Keynesian Board
of Governors. In response, he worked with Treasury Secretary Henry
H. Fowler to get an income tax surcharge that would eliminate the
de…cit and, hopefully, remove the need for increases in interest rates.
However, the temporizing that e¤ort entailed in raising interest rates
in response to strong economic growth and declining unemployment
caused money growth to surge. By the end of the 1960s, 6 percent in‡ation had replaced the price stability (1 percent consumer price index
[CPI] in‡ation) of the start of the decade (Hetzel 2008a, Ch. 7).
Arthur Burns replaced William McChesney Martin as chairman of
the FOMC in February 1970. Burns was willing to implement an expansionary monetary policy under the condition that President Nixon
would impose wage controls in order to control in‡ation (Hetzel 1998,
2008a). Burns got those controls in August 1971. The United States
also got the “vast experiment” envisaged by Samuelson and Solow: a
policy of aggregate demand management intended to create a low unemployment rate accompanied by price controls to restrain cost-push
in‡ation.
Over time, the Phillips curve that Samuelson and Solow identi…ed
for the United States shifted. Stockman (1996, 906 and 904) shows the
Phillips curve for consecutive time periods. After a noisy start from
1950 to 1959, the curve exhibited a negative slope in the 1960s. It then
shifted up from 1970 to 1973 and then again in 1974 to 1983. The
curve shifted down after 1986. Initially, both Keynesian economists
and policymakers interpreted the upward shift in the 1970s as evidence
of cost-push in‡ation.

R. L. Hetzel: Lessons from the Great In ation
6.

99

AN EXPECTATIONS-ADJUSTED PHILLIPS
CURVE: FRIEDMAN'S CHALLENGE TO
SAMUELSON-SOLOW

In their challenge to the Keynesian consensus in favor of an activist
monetary policy, Friedman and Schwartz (1963a) organized the data on
money and the business cycle using the National Bureau of Economic
Research methodology of leading, coincident, and lagging indicators.
The historical narrative in Friedman and Schwartz (1963b) associated
changes in the behavior of money (changes in a step function …tted
to money growth rates) to behavior of the central bank adventitious
to the working of the price system. This procedure isolated changes in
nominal money arising independently of changes in real money demand.
Friedman then used these temporal relationships to forecast both the
cyclical behavior of the economy and the rising in‡ation during the
Great In‡ation.
Friedman and Meiselman (1963) also published an article showing that money, but not investment, predicted nominal output. The
Keynesian assumption was that velocity would adjust in order to make
whatever amount of money existed compatible with a level of nominal output independently determined by real forces. This variability
in velocity should have limited the predictive power of money. The response by Ando and Modigliani (1965) provided an impetus to the construction of large-scale macroeconomic models as a way of measuring
the impact of changes in investment based on structural relationships
rather than the reduced-form relationships of Friedman and Meiselman.
Keynesians believed that such models would allow forecasts of the evolution of the economy under alternative policies. The intention was to
enable an activist policy to improve on the working of the price system, which the Keynesian consensus assumed worked only poorly to
maintain the full employment of resources.
Friedman challenged the feasibility of such models. Friedman (1960)
argued that “long and variable lags” inherent in the impact of discretionary policy actions could destabilize the economy. In his presidential address to the American Economic Association, Friedman ([1968]
1969) argued that economists lacked the knowledge required to construct proxies for resource slack (underutilization of resources). The
large-scale econometric models required to implement an activist monetary policy necessitated measures of these output gaps. Moreover, any
attempt to use monetary policy to control the behavior of a real variable like unemployment in a systematic, predictable way would cause
the assumed structural equations of these models to change in unpredictable ways.

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Speci…cally, Friedman ([1968] 1969) criticized the idea of an exploitable Phillips curve tradeo¤ between in‡ation and unemployment.21
Friedman’s criticism reiterated his belief in the monetary rather than
the real nature of in‡ation. The correlation between nominal and real
variables at cyclical frequencies arises from monetary nonneutrality due
to monetary disturbances.22 Any systematic attempt by the central
bank to lower unemployment through in‡ation would founder on the
e¤ort of the public to forecast in‡ation in order to set relative prices
optimally. The Phillips curve would then be vertical. This proposition
came to be known as the natural rate hypothesis.23
This formulation of the natural rate hypothesis derived its predictive content from the distinction between anticipated and unanticipated changes in in‡ation. Friedman expressed that distinction in the
“expectations-adjusted” Phillips curve. That is, variation in the unemployment rate is related not to variation in the in‡ation rate, but to
variation in the in‡ation rate relative to the in‡ation rate expected by
the public. Surprise changes in in‡ation can cause actual and expected
prices to diverge and thus a¤ect real variables. The short-run nonneutrality of money then corresponded to the interval of time required for
the public to adjust its expectations in response to a higher in‡ation
rate.
Friedman predicted that an attempt by the Fed to peg the unemployment rate at a level less than the natural rate (the value consistent
with equality between actual and expected in‡ation) would require increased in‡ation. He argued that the level of the Phillips curve would
shift upward as the public’s expectation of in‡ation rose (see Humphrey
[1986]). Friedman also assumed that the public formed its expectation of in‡ation based on the past behavior of in‡ation (adaptive
21

See, also, Friedman (1977).
While prices set in terms of dollars economize on the bookkeeping required to
record relative prices, they only serve that purpose adequately in a monetary environment in which the evolution of the price level is predictable. There is then no “illusion”
(confusion) about the relative price corresponding to a dollar price.
23
Economists continue to divide over the issue of whether the central bank can
exploit a Phillips curve relationship in order to mitigate large ‡uctuations in unemployment due to aggregate-demand shocks by increasing ‡uctuations in in‡ation. The
converse case is that of mitigating large ‡uctuations in in‡ation due to in‡ation shocks
by increasing ‡uctuations in an output gap. Goodfriend and King (1997) exposit the
New Keynesian model in the monetarist spirit. The New Keynesian model as exposited
by Clarida, Gali, and Gertler (1999) incorporates the assumption that the central bank
can exploit a Phillips curve tradeo¤ in order to mitigate the e¤ects on output of a
real shock such as a markup or aggregate demand shock provided it follows a rule that
commits it to returning in‡ation to a long-run target. The Clarida, Gali, and Gertler
(1999) argument, however, does not address the issue of whether the central bank possesses the requisite knowledge of the structure of the economy (Friedman [1951] 1953;
1960). See the Appendix for skeptical comments on how well economists can estimate
the structural coe¢ cients of the New Keynesian Phillips curve.
22

R. L. Hetzel: Lessons from the Great In ation

101

expectations). The lag with which expectations adjusted to higher in‡ation could then explain the correlation between high (rising) in‡ation
and low unemployment.
Friedman’s formulation of the expectations-augmented Phillips
curve, however, raised the theoretical possibility of long-run monetary
nonneutrality. It appeared that the central bank could maintain the
lower level of unemployment with ever-rising rates of in‡ation (the accelerationist hypothesis). For monetarists, the problem with that implication was that money was not necessarily neutral even in the long
run in its in‡uence on real variables (provided of course the central
bank was willing to tolerate ever higher rates of in‡ation). As with
the original Phillips curve, there appeared to be no unique equilibrium
level of unemployment.
An answer to that problem led Robert Lucas to incorporate John
Muth’s idea of rational expectations into macroeconomics. Lucas
([1972] 1981) used the island paradigm employed by search models
as a metaphor for incomplete information. He also imposed “rational expectations” in which the expectations of individuals are formed
consistently with the structure of the economy and with the monetary
policy followed by the central bank. Individuals on an island would
alter output over confusion between a change in the overall island-wide
price level and the relative price of their product. Within this model,
Lucas stated the monetary neutrality proposition in a way that avoided
the paradox of a central bank able to a¤ect real output through systematic variation in the rate of in‡ation. The central bank could not
permanently lower the unemployment rate through an ever-increasing
in‡ation rate because the public would come to anticipate its actions
and set prices in order to o¤set them. Such models incorporated what
economists called the natural-rate/rational-expectations hypothesis.
Friedman had o¤ered an explanation for the inverse correlations of
the Phillips curve that predicted the disappearance of those correlations
in response to sustained in‡ation. The stag‡ation of the United States
in the 1970s supported that prediction. In reference to the SamuelsonSolow Phillips curve, Lucas and Sargent ([1978] 1981, 303) talked about
“econometric failure on a grand scale.”Lucas ([1973] 1981) argued that
even the short-run tradeo¤ would tend to disappear as the variability
of in‡ation increased.
Modigliani and Papademos (1975) o¤ered the counterattack to the
Friedman-Lucas critique. They pointed out that one could eliminate
the empirically observed shifts in the Phillips curve by using …rstdi¤erences of in‡ation. They then related …rst-di¤erences in in‡ation
to the di¤erence in the unemployment rate and a benchmark value
they termed the NIRU for “nonin‡ationary rate of unemployment.”

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Federal Reserve Bank of Richmond Economic Quarterly

The NIRU (later called NAIRU for nonaccelerating in‡ation rate of
unemployment) is the value of the unemployment rate for which in‡ation remains at its past value.24 In practice, the estimated NAIRU is
close to a slowly moving average of the past value of the unemployment
rate.25
NAIRU models of in‡ation allowed for a long-run vertical Phillips
curve. Apart from this assumption, however, they are in the tradition
of the Samuelson-Solow Phillips curve. Originally, Keynesians adopted
the Phillips curve because it supplied a connection between their IS-LM
models, which were speci…ed entirely for real variables, and in‡ation.
The Phillips curve was an empirical relationship, not a theoretical one.
It speci…ed a relationship going from a real variable, unemployment,
to a nominal variable, the rate of change of nominal wages (prices).26
In NAIRU regressions, the unemployment rate relative to the NAIRU
is the independent variable and in‡ation is the dependent variable.
The central bank still possesses the ability to alter the rate of in‡ation
through systematic control of a real variable, unemployment.
Keynesian economists argued that a Phillips curve with in‡ation in
…rst di¤erences represented a structural relationship that the central
bank could use to smooth ‡uctuations in output around potential by
imparting inverse ‡uctuations to changes in in‡ation.27 The converse
proposition came to be known as “‡exible in‡ation targeting.”That is,
the central bank can eliminate an overshoot of in‡ation from target,
24
Modigliani and Papademos suggested the archetypal NAIRU regression with in‡ation as the dependent variable and the unemployment rate and lagged in‡ation rates
as independent variables. Estimation by constraining the coe¢ cients on the lagged in‡ation terms to equal one allows calculation of the NAIRU. When in‡ation remains
constant, the expectation of lagged in‡ation, given by the distributed lag of the in‡ation terms, equals the actual in‡ation rate. Consequently, the left-hand side variable
(in‡ation) equals the right-hand side variable, expected in‡ation. The NAIRU then is
the (negative) value of the constant term. That is, one solves the regression equation
for the unemployment rate at which in‡ation equals expected in‡ation. Sargent ([1971]
1981) initiated a critique of this way of measuring expected in‡ation. In NAIRU regressions, the coe¢ cients on the right-hand side of lagged in‡ation terms do not vary with
changes in monetary policy. As a result, there is an inherent inertia in the expectations
formation of the public that allows the policymaker to exploit a short-run Phillips curve
tradeo¤.
25
King, Stock, and Watson (1995, 10) have found that “estimates of the NAIRU
were very imprecise.” Consistent with the monetarist hypothesis that monetary instability produces the inverse correlations of the Phillips curve, Dotsey, Fujita, and Stark
(2011) found that the negative slope of the Phillips curve comes from recessions.
26
The rationale for treating empirically estimated Phillips curves as structural derives from a generalization to the behavior of the price level of the way in which positive
excess demand in individual markets produces relative price increases.
27
King and Watson (1994) found a relationship between in‡ation and unemployment at business cycle frequencies, although not over lower frequency (trend) horizons.
Their …nding that in‡ation does not Granger cause (predict) unemployment, however,
is not supportive of the idea that the central bank can manipulate in‡ation to control
unemployment.

R. L. Hetzel: Lessons from the Great In ation

103

say, from an in‡ation shock, by raising the unemployment rate above
its NAIRU value in a controlled way. The cost in terms of excess
unemployment is given by the sacri…ce ratio: the number of man-years
of unemployment in excess of NAIRU the central bank must engineer
to lower the in‡ation rate 1 percentage point.28

7.

THE FIRST HALF OF THE SAMUELSON-SOLOW
VAST EXPERIMENT

As noted above, the Phillips curve shifted upward in the 1970s. For
example, in the 1950s, the unemployment rate among men 25 years and
older averaged 3.5 percent. In the 1970s, it averaged 3.6 percent. In
the 1950s, in‡ation (average, annualized monthly growth rates of CPI
in‡ation) averaged 2.3 percent. In the 1970s, however, that …gure rose
to 7.5 percent. Similarly, annualized CPI in‡ation averaged over the
…rst six months of 1964 was 0.85 percent while unemployment averaged
5.3 percent over this period. That …gure was just slightly less than the
5.5 percent …gure Samuelson and Solow had estimated as consistent
with price stability. In contrast, for the 12-month period ending July
1971 (preceding the introduction of wage and price controls in August
1971), annualized monthly CPI in‡ation averaged 4.4 percent, while
the unemployment rate averaged 5.8 percent.
In each case, the higher rate of in‡ation did not lower unemployment. Keynesians, however, attributed these upward shifts in in‡ation
and the Phillips curve to cost-push shocks. In contrast, monetarists attributed them to shifts in expected in‡ation that frustrated the attempt
to lower unemployment through aggregate-demand policies.
In 1970, 6 percent in‡ation accompanied 6 percent unemployment.
Consistent with the prevailing Keynesian consensus, all but a minority of economists, mainly restricted to Chicago, Minneapolis, and the
St. Louis Fed, interpreted the advent of this stag‡ation as a re‡ection
of cost-push pressures that raised the level of the Phillips curve. In
1971, the Nixon administration turned to wage and price controls to
restrain this presumed cost-push in‡ation and thus make way for an
28
For example, David Stockton (Board of Governors of the Federal Reserve System
1989, 12) told the FOMC: “The sacri…ce ratio is arrived at by dividing the amount of
disin‡ation during a particular time period— measured in percentage points— into the
cost of that disin‡ation— measured as the cumulative di¤erence over the period between
the actual unemployment rate and the natural rate of unemployment. Thus, it is a
measure of the amount of excess unemployment over a year’s time associated with each
one percentage point decline in the in‡ation rate.”
The sta¤ reported that during the three post-Korean War disin‡ations, the sacri…ce
ratio was at or somewhat above 2. The exception was the period of price controls
imposed in 1971.

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Federal Reserve Bank of Richmond Economic Quarterly

expansionary monetary policy. Although those controls ended in 1974,
the Carter administration resorted to various forms of incomes policies
(see Hetzel [2008a, Chs. 8, 10, and 11]). These active attempts to control real output growth and unemployment while using incomes policies
to control cost-push in‡ation created the experiment that Samuelson
and Solow had talked about. The results contradicted the Keynesian
assumption that policymakers could use aggregate-demand management in order to control real variables like unemployment in a systematic way and with a predictable cost in terms of in‡ation.
In the 1970s, Keynesian economists could see that supply shocks
and a wage-price spiral drove in‡ation. The implication of rational
expectations that a credible rule for monetary policy would shape the
in‡ationary expectations of the public conformably with that rule appeared like an abstraction devoid of real-world relevance. It followed
that a monetary policy objective of price stability that failed to accommodate in‡ation from nonmonetary causes would produce high unemployment. The following quotation from Paul Samuelson ([1979] 1986,
972) is representative of the times (see, also, Hetzel [2008a, Ch. 22]):
Today’s in‡ation is chronic. Its roots are deep in the very nature of
the welfare state. [Establishment of price stability through monetary
policy would require] abolishing the humane society [and would]
reimpose inequality and su¤ering not tolerated under democracy. A
fascist political state would be required to impose such a regime
and preserve it. Short of a military junta that imprisons trade
union activists and terrorizes intellectuals, this solution to in‡ation
is unrealistic— and, to most of us, undesirable.

Samuelson’s statement re‡ected the 1960s and 1970s Keynesian
consensus that the behavior of the price level was determined by nonmonetary forces either having to do with real aggregate demand (demand pull) or with characteristics related to the lack of competitive
markets such as the market power of large corporations and unions
(cost push) (see, for example, Samuelson [1967]). The activist policy
of aggregate-demand management combined with incomes policies of
various degrees re‡ected this belief.29
On the international stage, Keynesian policy prescriptions played
out in countries that pegged their exchange rates to the dollar as part
of the Bretton Woods system. As re‡ected in the Keynesian spirit of
the time, countries with pegged exchange rates also followed policies of
aggregate-demand management intended to maintain full employment
29
The term “incomes policies” refers to any government intervention into the wage
and price setting of the private sector. Wage and price controls are an extreme version.

R. L. Hetzel: Lessons from the Great In ation

105

(see Capie [2010] for the United Kingdom case). As Friedman ([1953b]
1953) had predicted, these countries had to resort to capital controls as
well as wage and price controls in order to reconcile an exchange rate
peg with an unwillingness to allow their internal price levels to adjust
in order to vary the real terms of trade to achieve balance of payments
equilibrium. In 1973, the Bretton Woods system of pegged exchange
rates collapsed (Hetzel 2008a, Ch. 9).
By the end of the 1970s, the experiment with activist monetary
policy concluded with double-digit in‡ation accompanied by cyclical
instability. However, as noted above, despite the unusual clarity about
policy, extraneous forces always prevent these episodes from o¤ering the
kind of certitude as a controlled experiment in the physical sciences.
The issue remains whether activist monetary policy produced this result or whether a series of adverse in‡ation shocks overwhelmed the
stabilizing properties of activist policy.30 Velde (2004) characterized
the issue as one of bad hand (in‡ation shocks) or bad play (destabilizing monetary policy). In early 1979, the United States could have
continued the experiment with activist monetary policy reinforced by
a return to wage and price controls. However, a change in the political
landscape with the election of Ronald Reagan as president, combined
with the way in which individuals occasionally change the course of
events in the form of Paul Volcker as FOMC chairman, gave the United
States a very di¤erent kind of monetary experiment.31

8.

THE SECOND PART OF THE VAST
EXPERIMENT

The back-to-back experience of the Great Depression with World War
II created the Keynesian consensus. The back-to-back experience in
the 1970s of an activist policy directed toward maintaining low, stable
unemployment and the policy in the 1980s and 1990s of restoring price
stability through restoring nominal expectational stability ‡ipped the
professional consensus. The profession came to see in‡ation as a monetary phenomenon. Also, countries realized that if they were to control
their own price levels, they had to abandon …xed exchange rates in
favor of ‡oating exchange rates in order to gain control over money
30
Gordon (1985) and Sims and Zha (2006) emphasized the importance of in‡ation
shocks. Sims and Zha (2006, 54) argued that “the di¤erences among [monetary policy] regimes are not large enough to account for the rise, then decline, in in‡ation of
the 1970s and 1980s.” Blinder (1987, 133) wrote: “The fact is that, the Lucas critique
notwithstanding, the Phillips curve, once modi…ed to allow for supply shocks . . . has
been one of the best-behaved empirical regularities in macroeconomics. . . .”
31
On the political economy of the late 1970s, see Hetzel (2008a, Ch. 12).

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Federal Reserve Bank of Richmond Economic Quarterly

creation. Having ‡oated their exchange rates, countries realized that
they had to leave the control of in‡ation to the central bank.
The second part of the “vast experiment” was then the e¤ort by
the Volcker and Greenspan FOMCs to restore the nominal expectational stability lost in the preceding stop-go era (Hetzel 2008b). The
Volcker-Greenspan FOMCs discarded the idea of measuring the level
of idle resources (the output gap). Instead, they moved the funds rate
in a persistent way designed to counter sustained changes in the rate
of resource utilization. That is, they removed the measurement error
inherent in trying to measure the level of idle resources by focusing on
changes in the degree of resource utilization (Orphanides and Williams
2002). Given the desire to restore credibility in instances of sustained
increases in the rate of resource utilization, the Fed watched bond markets for evidence that the “bond market vigilantes”were satis…ed that
increases in the funds rate would cumulate to a su¢ cient degree in order to prevent a revival of in‡ation. In response to in‡ation scares, the
FOMC raised the funds rate more aggressively (Goodfriend 1993).
The willingness of the FOMC to move the funds rate in a sustained
way made it clear to markets that it had abandoned the prior practice of inferring the thrust of monetary policy from a “high” or “low”
level of short-term interest rates. That is, the FOMC did not back o¤
from changes in the funds rate when the funds rate reached a “high”
or “low” level. These procedures, termed “lean-against-the-wind with
credibility” by Hetzel (2008a), removed the cyclical inertia from interest rates (see Hetzel [2008a, Chs. 14, 15, 21, and 22]). Equivalently,
the discipline they imposed in removing cyclical inertia from funds rate
changes prevented attempts to use Phillips curve tradeo¤s to achieve
macroeconomic objectives.
The demonstration that the Fed could maintain low, stable in‡ation
without incurring the cost of recurrent bouts of high unemployment
weakened the Keynesian consensus. The economics profession became
receptive to replacement of the IS-LM model with what would become,
in time, the New Keynesian model. In the Great In‡ation, Keynesians
had ‡eshed out the IS-LM model with explanations of in‡ation that
turned on a wage-price spiral propelled by expectations of in‡ation
untethered by monetary policy. They also assumed the existence of
negative output gaps persisting over many years arising from the weak
equilibrating properties of the price system. The New Keynesian model
challenged the self-evident descriptive realism of such assumptions with
incorporation of rational expectations and an inner real-business-cycle
core in which the price system worked well to maintain macroeconomic
equilibrium.

R. L. Hetzel: Lessons from the Great In ation

107

The traditional Keynesian Phillips curve with in‡ation generated
by the momentum of lagged in‡ation and an output gap measured as
cyclical deviations of output from a smooth trend ceded place to the
New Keynesian Phillips curve. The forward-looking agents posited by
the New Keynesian model base their behavior not only on the current
policy actions of the central bank but also on the way in which the central bank’s systematic behavior shapes the policy actions it takes in the
future in response to incoming data on the economy. As a result, contemporaneous in‡ation (current price-setting behavior) depends on the
expectation of future in‡ation, which depends on the rule the central
bank implements.

9.

THE GREAT DEBATE WILL CONTINUE

The recent Great Recession has weakened the New Keynesian consensus described above, at least in the Goodfriend-King (1997) version in
which the optimal policy for the central bank is to stabilize the price
level and thereby allow the real-business-cycle core of the economy
to control the behavior of the real economy. To a signi…cant extent,
both popular and much professional commentary have reverted to the
historical “default option” for explanations of the business cycle— the
“imbalances” model (Hetzel 2012, Ch. 2). The business cycle is selfgenerating because imbalances accumulate during periods of expansion.
At some point, the extent of maladjustments cumulates to the point at
which a correction becomes inevitable. The economy must then endure
a period of purging of the economic body.
In …nancial markets, these imbalances appear as credit cycles. In
periods of economic expansion, investors become overly optimistic about
the future. They take on debt and push asset prices to levels not supported by the underlying productive capacity of the assets. Inevitably,
these asset bubbles burst. Investors …nd themselves with too much
debt. A long, painful process of deleveraging ensues in which economic
activity is depressed. When this process works its way out, recovery
can begin. Once again, the process of swings in investor sentiment from
unfounded optimism to unfounded pessimism begins. Commentary in
this vein on the Great Recession has focused on an asset bubble in the
housing market made possible by expansionary monetary policy in the
years preceding 2008.
In order to move beyond the “descriptive reality” of these age-old
explanations of the business cycle based on the correlation that in economic booms asset prices rise and debt increases while in recessions
asset prices decline and debt declines, one needs a model and plausible exogenous shocks. The Keynesian model with its swings in animal

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spirits among investors that overwhelm the stabilizing properties of the
price system was an attempt to construct such a model. In the spirit
of this article, how will economists test the imbalances hypothesis or
Keynesian versions of it against the monetarist hypothesis that highlights as the precipitating factor in recessions central bank interference
with the operation of the price system?
To recapitulate the discussion of methodology of Section 1, there
will be a multitude of models assuming di¤erent shocks and di¤erent structures of the economy and frictions that can explain historical
time series and, a fortiori, particular events like the Great Recession.
It is thus improbable that economists will ever reach consensus over
the cause of a particular recession. However, scholarly debate will return to the pattern of asking how well a particular recession like the
Great Recession …ts into one of the alternative frameworks that explain the recurrent phenomenon of cyclical ‡uctuations. Economists
will continue running horse races among models based on the entire
historical record. Using models based on microeconomic foundations,
they will ask whether the implications of the model adequately explain
correlations in the entire historical record that are robust in that the
correlations persist over time and across countries, that is, in a variety
of circumstances. The latter characteristic is the social sciences version
of the controlled experiment in the physical sciences.
Consider the correlation between monetary and real instability.
The monetarist hypothesis is that, to a signi…cant degree, causation
runs from monetary to real instability. In the world of Milton
Friedman, prior to 1981, given the existence of a monetary aggregate
(M1), which was interest insensitive and stably related to nominal output (GDP), the robust correlation was that monetary decelerations
preceded business cycle peaks. Furthermore, the central bank behavior that accompanied those monetary decelerations plausibly produced
changes in nominal money originating independently of changes in real
money demand. The robustness of this generalization across countries and across time reduces the possibility that it re‡ects causation
produced by some third variable so that real instability arises independently of monetary instability. Of course, no controlled experiment
produced these correlations. The hypothesis that monetary instability
produces real instability has to be put into a form in which it yields
testable predictions about the future.
Because of the disappearance since 1981 of a monetary aggregate
like M1 that is useful as a predictor of nominal GDP, it is necessary to
refocus the search for robust correlations based on the monetarist hypothesis that monetary disorder originates in central bank interference
with the operation of the price system. Reformulated in this spirit,

R. L. Hetzel: Lessons from the Great In ation

109

the monetarist hypothesis receives support from the continuance of the
central bank behavior associated with the monetary decelerations preceding business cycle peaks in the pre-1981 period.
What is this central bank behavior? In the post-World War II period, when the Fed became concerned about in‡ation, it …rst raised
interest rates and then, out of a concern not to exacerbate in‡ationary expectations, introduced inertia into the downward adjustment of
interest rates when the economy weakened (Hetzel 2012, Ch. 8).32 Although the Fed did not employ the language of tradeo¤s, these attempts
to exploit a Phillips curve relationship by allowing a negative output
gap to develop have constituted a reliable leading indicator of recession
(Romer and Romer 1989; Hetzel 2008a, Chs. 23–25; Hetzel 2012, Chs.
6–8). The same empirical regularity existed in the pre-World War II
period, but the Fed raised rates and then introduced inertia into the
downward adjustment of interest rates while the economy weakened
not out of concern for in‡ation but out of concern that the level of
asset prices re‡ected a speculative asset bubble.
Hetzel (2009, 2012, 2013b) argues that the Great Recession …ts
into this monetarist characterization of central bank behavior associated with recessions. The persistent in‡ation shock that began in
summer 2004 intensi…ed in summer 2008 and pushed headline in‡ation
well above core in‡ation and central bank in‡ation targets. That in‡ation shock created a moderate recession by dampening growth of real
disposable income. Moderate recession turned into severe recession
in summer 2008 when central banks either raised interest rates (the
European Central Bank) or left them unchanged as economic activity
weakened (the Fed). The attempt to create a negative output gap to
bend in‡ation down mirrored the stop phases of the earlier stop-go
monetary policy.

10.

TESTING THEORIES OF THE BUSINESS CYCLE

In the absence of consensus within the economics profession over the
causes of the business cycle, popular commentary …lls the void with
explanations based on descriptive reality. That verbiage is inevitable
given the importance of phenomena like cyclical ‡uctuations in unemployment. However, economists do possess a methodology for learning
and will make progress in understanding the causes of the business
32
The exceptions are especially important for evaluating robust correlations. Prior
to the April 1960 business cycle peak, the FOMC raised rates and then maintained
them despite a weakening economy out of a concern not for in‡ation but rather out of
concern for a de…cit in international payments and gold out‡ows (Hetzel 1996; 2008a,
52–5).

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Federal Reserve Bank of Richmond Economic Quarterly

cycle. In this respect, the stumbling, painful, and ongoing process
of the central bank learning how to manage the …at money regime
that replaced the earlier commodity standards remains a still underinvestigated source of the semi-controlled experiments required to extract causation from correlation.

APPENDIX:

RECENT WORK ON THE PHILLIPS CURVE

Little in the work on the New Keynesian Phillips curve (NKPC) challenges the Friedman assertion that policymakers lack su¢ cient information about the structure of the economy in order to implement an
activist monetary policy. As summarized by Hornstein (2008), the results of empirical estimation of the NKPC o¤er little useful information
for the policymaker interested in exploiting a Phillips curve tradeo¤.
For example, Hornstein (2008, 305) comments:
Nason and Smith [2008] also discuss the …nding that the estimated
coe¢ cient on marginal cost tends to be small and barely signi…cant.
This is bad news for the NKPC as a model of in‡ation and for
monetary policy.

The coe¢ cient on real marginal cost referred to summarizes the
real-nominal interaction implied by the nominal price stickiness in the
New Keynesian model. As implied in the above quotation, econometric
estimation provides no practical guidance for monetary policy procedures based on Phillips curve tradeo¤s.
Hornstein elucidates the reasons for this lack of guidance in his discussion of Schorfeide (2008). Estimation of the NKPC through singleequation methods founders on the seemingly technical but fundamental
issue of the lack of plausible instruments useful for forecasting in‡ation,
while at the same time being unrelated to the other variables in the
Phillips curve and macroeconomic shocks. Everything in macroeconomics is endogenously determined. The alternative is to treat the
elements in the NKPC, like real marginal cost, as “latent variables,”
that is, variables not observable but constructed from the equations
of a complete model. The problem then is that di¤erent models yield
di¤erent measures and there is no consensus on the true model (the
model useful for the analysis of policy).
Given a model with a NKPC, Schmitt-Grohé and Uribe (2008) conduct a normative exercise evaluating di¤erent monetary policy rules.

R. L. Hetzel: Lessons from the Great In ation

111

However, as Hornstein (2008, 307) notes, with “no agreement on how
substantial nominal rigidities are” it is hard to know how useful such
exercises are for policy. For example, the authors make use of a Taylor
rule, which assumes that the central bank can respond directly to misses
in its in‡ation target without destabilizing the economy. In actual practice, the assumption is that in response to such a miss, the central bank
can create a controlled negative output gap (increase …rms’markups in
order to eliminate the miss). The whole issue then reemerges of whether
central banks can control in‡ation through exploiting a Phillips curve
tradeo¤. The Lucas-Friedman contention that attempts by the central bank to exploit real-nominal relationships destabilize the economy
remains a live issue.
The econometric di¢ culties highlighted by Hornstein (2008) turn
ultimately on the issue of identi…cation, both of shocks and of structural
relationships. That fact suggests that in future research the profession
should revive the monetarist identi…cation scheme implicit in the work
of King (2008), who uses historical narrative to isolate the monetary
policy experiments conducted by the regime changes of central banks
(see, also, Hetzel [2008a, 2012]).

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Economic Quarterly— Volume 99, Number 2— Second Quarter 2013— Pages 117–141

Federal Reserve Interdistrict
Settlement
Alexander L. Wolman

T

he Interdistrict Settlement Account (ISA) is used to keep track
of movements in assets and liabilities across Federal Reserve
Banks within the Federal Reserve System. To the extent that
the independent …nancial status of individual Federal Reserve Banks is
meaningful, the ISA is the means by which each Bank grants credit to
the other Banks in the System. Even if one views …nancial independence as more apparent than real, the behavior of individual Reserve
Bank balance sheet components, including ISA, can shed light on ongoing …nancial developments in the economy. This article provides an
introduction to the ISA and traces the behavior of ISA and some other
components of Reserve Bank balance sheets during the Great Recession and the …nancial crisis. In addition, it provides some speculative
discussion of how Reserve Bank balance sheets could be informative
about economic conditions as the Fed exits from unconventional monetary policy.
The ISA may seem like an obscure topic. However, in 2012 the European debt crisis led to much discussion of the TARGET2
system, which is— loosely— Europe’s analogue to the combination of
ISA and the Fedwire funds transfer system (see Cecchetti, McCauley,
and McGuire [2012], Whelan [2012], and the references therein). Discussions about TARGET2 often included comparisons— some of them
shaky— to ISA, drawing attention to the fact that there were few sources
available describing ISA to the lay public.1 In attempting to help …ll
The author is grateful to Ceci Adams for her patient explanations of ISA accounting,
and to Huberto Ennis, Peter Garber, Bob Hetzel, J.P. Koning, Marisa Reed, Karl
Rhodes, and John Weinberg for comments and discussions. The views in this article
are the author’s. They do not represent the views of the Federal Reserve Bank of
Richmond or the Federal Reserve System. E-mail: alexander.wolman@rich.frb.org.
1
Lubik and Rhodes (2012) provide a concise summary of ISA in their essay on
TARGET2. Koning (2012) provides a more detailed discussion of ISA, including a

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Federal Reserve Bank of Richmond Economic Quarterly

that void, this article also discusses two important ways in which ISA
di¤ers from TARGET2.
Monetary policy in the United States is implemented primarily by
the Federal Reserve Bank of New York. For example, the securities purchases that comprise the Federal Open Market Committee’s (FOMC)
large-scale asset purchase programs (LSAPs) are conducted by the New
York Fed. However, securities purchased by the New York Fed are apportioned the same day to all 12 Federal Reserve Banks, and there is
an annual rebalancing of Federal Reserve Bank balance sheets. Both
the apportionment and rebalancing involve use of the ISA, and in recent years these have been main drivers of the ISA. As such we provide
a relatively detailed discussion of both topics. Apportionment assures
that all 12 Federal Reserve Banks are e¤ectively equal stakeholders in
monetary policy operations; the New York Fed simply acts as agent
for the other 11 Banks. Rebalancing, in turn, assures that over time
the securities are held by Reserve Banks in rough proportion to the
liabilities that have been issued by those Reserve Banks.
There is one authoritative source for the ISA, the Federal Reserve’s
Financial Accounting Manual (FAM). While the FAM is publicly available, it is written for users and not for the interested public. This
article is not a substitute for the FAM, but should provide an accessible introduction to the ISA for readers without the time or inclination
to delve into the FAM. In that context, it is important to stress that
the language and terminology used here con‡ict at times with the language used in the FAM. Note in particular that ISA balances will be
referred to throughout as an asset that can enter with a positive or
negative sign on Federal Reserve Bank balance sheets; this is the same
convention used in the Federal Reserve Board’s H.4.1 release, which is
the source for most of the data used in the article.

1.

THE INTERDISTRICT SETTLEMENT ACCOUNT:
OVERVIEW AND EXAMPLES

Each of the 12 Federal Reserve Banks has its own balance sheet. The
assets on a Federal Reserve Bank’s balance sheet currently consist primarily of securities allocated to the bank by the New York Fed. The
liabilities consist mainly of Federal Reserve notes in circulation (paper
currency) and reserve accounts of banks located in the Reserve District.
Many transactions that a¤ect a Reserve Bank’s balance sheet involve
only the Reserve Bank and a commercial bank. For example, if a
history of clearing and settlement across Federal Reserve Banks. Eichengreen, Mehl,
and Chitu (2013) also discuss that history— see Section 2.

A. L. Wolman: Federal Reserve Interdistrict Settlement

119

Table 1 T-Accounts for Commercial Banks, Check Clearing
Example
Paying Commercial Bank (“Bank A”)
Assets
Liabilities
$1 million, Reserve account
$1 million, customer deposits
(at Richmond Fed)
Receiving Commercial Bank (“Bank B”)
Assets
Liabilities
+$1 million, Reserve account
+$1 million, customer deposits
(at Atlanta Fed)

commercial bank withdraws currency from the Federal Reserve Bank
of Richmond, there is an increase in the Richmond Fed’s net Federal
Reserve notes outstanding, and an o¤setting decrease in reserves (denoted “other deposits held by depository institutions” on the balance
sheet as represented by the H.4.1 release); and if the Richmond Fed
makes a discount window loan to a commercial bank (necessarily in its
district), then there is an increase in the Richmond Fed’s loan assets,
and an increase in its reserve liabilities. Other transactions, however,
a¤ect the balance sheets of more than one Federal Reserve Bank. The
ISA is a line item on the asset side of each Federal Reserve Bank’s
balance sheet that is used to account for transactions across Federal
Reserve Banks. It can be negative or positive for a single Reserve
Bank and always sums to zero across the 12 Reserve Banks.2
The ISA can be best understood through examples of di¤erent types
of transactions. Transactions that are initiated by commercial banks
are relatively easy to explain, whereas transactions that are undertaken
by the Federal Reserve Bank of New York as part of the Fed’s monetary
or credit policy implementation are more complicated and will lead us
into the discussion of allocation/apportionment in the next section. For
each example, we will provide both a verbal discussion and a summary
using T-accounts.
Consider …rst a stylized situation where customers of a commercial
bank in the Fifth Federal Reserve District (Richmond) write checks to
customers of a commercial bank in the Sixth Federal Reserve District
(Atlanta) in the net amount of $1 million. The paying commercial
bank will see its reserve account at the Richmond Fed (an asset on
2

The current system for accommodating de…cits and surpluses across Federal Reserve Districts dates back to 1975. See Eichengreen, Mehl, and Chitu (2013) for a description and analysis of the pre-1975 system, focusing on the period from 1913 to 1960.

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Federal Reserve Bank of Richmond Economic Quarterly

Table 2 T-Accounts for Federal Reserve Banks, Check
Clearing Example
Paying Federal Reserve Bank (Richmond)
Assets
Liabilities
$1 million, ISA balances
$1 million, Bank A reserve account
Receiving Federal Reserve Bank (Atlanta)
Assets
Liabilities
+$1 million, ISA balances
+$1 million, Bank B reserve account

the commercial bank’s balance sheet) reduced by $1 million, and it
will see its customers’deposits (a liability) reduced by $1 million. The
receiving commercial bank will see corresponding increases in its reserve account at the Atlanta Fed and in its customers’deposits. Just
as both commercial banks have balanced changes in assets and liabilities, so do both Federal Reserve Banks. The Richmond Fed’s reserve
account liabilities decrease by $1 million, the Atlanta Fed’s reserve account liabilities increase by $1 million, and the o¤setting changes on
the asset side of the Reserve Banks’balance sheets occur through the
ISA. Because the Richmond Fed is e¤ectively making a payment to
the Atlanta Fed, its ISA balance (an asset) falls by $1 million, and the
Atlanta Fed’s ISA balance rises by $1 million. Tables 1 and 2 show the
relevant T-accounts. If ISA did not exist, there are two possibilities for
how to account for this transaction (ignoring legal issues). One possibility is that securities or other assets could be transferred from the
Richmond Fed to the Atlanta Fed.3 Alternatively, the balance sheets
of the Federal Reserve Banks could be consolidated, so that the transaction would simply involve a relabeling of accounts with the single
Federal Reserve Bank. We will not go through these alternatives for
the other examples below, but the reader should keep in mind that
similar reasoning applies.
Next, consider delivery of $1 million of new currency (bills) to the
Federal Reserve Bank of New York (for example), where the new currency is designated as issued by the Federal Reserve Bank of San Francisco.4 In this case, the Federal Reserve Bank of San Francisco’s
3
Eichengreen, Mehl, and Chitu (2013) discuss how, before 1975, instead of ISA
there was a combination of settlement through transfer of gold certi…cates (to be discussed below) and discretionary “mutual assistance” among Reserve Banks.
4
All currency is designated as issued by one of the 12 Federal Reserve Banks, and
is marked with the corresponding district number and letter. As this example suggests,
however, currency does not necessarily enter circulation in the district through which it
is o¢ cially issued.

A. L. Wolman: Federal Reserve Interdistrict Settlement

121

Table 3 T-Accounts for Federal Reserve Banks, New
Currency Example
Federal Reserve Bank of San Francisco
Assets
Liabilities
+$1 million, ISA balances +$1 million, Federal Reserve Notes outstanding
Federal Reserve Bank of New York
Assets
Liabilities
$1 million, ISA balances
$1 million, Notes held by Federal Reserve Banks

liabilities increase by $1 million (“Federal Reserve notes outstanding”
on the H.4.1 release) and the Federal Reserve Bank of New York’s liabilities decrease by $1 million (“Notes held by Federal Reserve Banks”
on the H.4.1).5 Of course, both Banks must have an o¤setting balance
sheet change, and these involve the ISA: The San Francisco Fed’s ISA
balance increases by $1 million, and the New York Fed’s ISA balance
decreases by $1 million. The T-accounts are trivial in this case, shown
in Table 3. In e¤ect, the New York Fed is purchasing currency from
the San Francisco Fed using its ISA account.
We move now to transactions related to the implementation of monetary or credit policy. These transactions are typically initiated by the
Federal Reserve Bank of New York, and thus at …rst only impact the
New York Fed’s balance sheet.6 However, according to the policies set
forth in the FAM, the associated balance sheet changes are apportioned
on a daily basis to all 12 Federal Reserve Banks.
Consider …rst a typical asset purchase that a¤ects the domestic
portfolio of the System Open Market Account (SOMA). The Fed’s
ongoing large-scale asset purchases fall into this category, so we will
use a speci…c example of one of these purchases. On December 27,
2012, the Federal Reserve Bank of New York purchased $4.614 billion
of Treasury securities from the primary dealers who serve as trading
counterparties with the New York Fed.7 These purchases settled on
5
“Notes held by Federal Reserve Banks” appears on the liability side of each Federal Reserve Bank’s balance sheet. However, on the liability side it is deducted from the
value of Federal Reserve notes outstanding. Thus, if a Reserve Bank has $10 billion in
notes outstanding, and holds $100 million of notes in its vaults, then its consolidated
liability for these items is $9.9 billion.
6
Some forms of credit policy, for example the Term Auction Facility, initially hit
all the Reserve Bank balance sheets, to the extent that commercial banks in all 12
Districts borrow at the auction. In contrast, the Maiden Lane facilities involved only
the New York Fed’s balance sheet.
7
A complete list of purchases is available at www.newyorkfed.org/
markets/pomo/display/index.cfm.

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Table 4 SOMA Portfolio Allocation Percentages

District
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
System Total

Domestic
2012
2011
2:429
2:459
56:065
46:504
3:306
3:426
2:542
2:701
7:117
11:549
6:029
7:434
5:548
5:939
1:563
1:893
0:909
1:537
2:009
2:660
3:885
3:955
8:596
9:944
100
100

Foreign
2012
3:506
32:258
8:674
7:393
20:685
5:718
2:668
0:818
0:408
0:995
1:602
15:277
100

2011
3:456
28:963
9:686
7:418
20:505
5:731
2:534
0:815
3:089
0:900
1:515
15:388
100

December 28, which means that on December 28 the Federal Reserve
Bank of New York’s securities holdings (an asset) increased by $4.614
billion. The primary dealers were paid for these securities by credits
to their accounts in reserve-holding banks; thus, the New York Fed’s
reserve liabilities increased by $4.614 billion.8 Subsequently, but still
on December 28, the $4.614 billion increase in securities holdings was
apportioned to all 12 Federal Reserve Banks according to the percentages listed in the second column of Table 4. How those percentages are
determined will be discussed in detail in the next section; the procedure is complicated, but loosely it tends to assign higher percentages to
Reserve Banks with a higher percentage of currency outstanding and
deposit liabilities. The reduction in the New York Fed’s securities holdings and the increases in the other Reserve Banks’securities holdings
were o¤set by increases in New York’s ISA balance and decreases in
the other Banks’ISA balances. Again, it is as if the other 11 Federal
Reserve Banks purchased securities from the New York Fed using their
ISA accounts. Table 5 puts this example in T-account form, for the
New York Fed and the Richmond Fed. New York has two steps; in
the …rst step it receives all the securities, and in the second step it
apportions 43.935 percent of the securities to the other 11 Banks. In
the apportionment step, 7.117 percent of the securities are apportioned
to Richmond.
8
In principle, a primary dealer’s deposit account could be with a bank located
outside the New York Federal Reserve District. In this case ISA would be involved in
the initial transaction. For simplicity we assume that the primary dealer’s bank has a
reserve account with the New York Fed.

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Table 5 T-Accounts for Federal Reserve Banks, Asset
Purchase Example

Step 1
Step 2
Step 3

Federal Reserve Bank of New York
Assets
Liabilities
+$4.614 billion securities
+$4.614 billion commercial bank
deposits (reserves)
$2.027 billion securities
—
+$2.027 ISA balances
—
Federal Reserve Bank of Richmond
Assets
Liabilities
+$328 million securities
—
$328 million ISA balances
—

A similar process occurs for foreign-currency denominated assets in
the SOMA portfolio, but the apportionment uses percentages based on
member bank capital in each district. Apportionment will be discussed
in more detail below. An example of a foreign-currency denominated
transaction occurred the week of August 15, 2012, when the European
Central Bank (ECB) drew on its swap line with the Federal Reserve
Bank of New York by $7 billion; the swap line allows the ECB to lend
dollars to European banks, creating dollar reserves in the process.9 The
New York Fed’s assets increased by $7 billion, in the form of holdings
of Euros in an account at the ECB; its liabilities also increased by $7
billion, in the form of increased deposits, corresponding to deposits
in U.S. commercial banks held by the European banks that borrowed
dollars from the ECB. The same day that the swap drawdown occurred,
the $7 billion increase in foreign currency holdings was apportioned to
all 12 Federal Reserve Banks according to the percentages listed in
the fourth column of Table 4. The reduction in the New York Fed’s
foreign currency holdings and the increases in the other Reserve Banks’
foreign currency holdings were balanced by increases in New York’s ISA
balance and decreases in the other Banks’ ISA balances. Again, this
example is summarized in T-account form for New York and Richmond,
in Table 6.
9

Data on swap line drawdowns are available at www.newyorkfed.org/
markets/fxswap/fxswap_recent.cfm, and a detailed explanation of the swap facility is provided at www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm.

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Table 6 T-Accounts for Federal Reserve Banks, Foreign
Currency Swap Example

Step 1
Step 2
Step 3

Federal Reserve Bank of New York
Assets
Liabilities
+$7 billion Euros at ECB
+$7 billion commercial bank
deposits (reserves)
$4.742 billion Euros at ECB
—
+$4.742 billion ISA balances
—
Federal Reserve Bank of Richmond
Assets
Liabilities
+$1.448 billion Euros at ECB
—
$1.448 billion ISA balances
—

2.

ALLOCATION OF SOMA TRANSACTIONS AND
ANNUAL REBALANCING

Table 4 listed the percentages according to which foreign and domestic
SOMA transactions were allocated to the 12 Reserve Banks in 2011
and 2012. These percentages are updated annually through a process
that re‡ects ISA balances over the year and the composition across
Districts of currency outstanding (for the domestic portfolio) and the
composition across Districts of member bank capital (for the foreign
portfolio). New York has by far the highest allocation percentage for
both the foreign and domestic portfolios, but the percentages for the
other 11 Banks varied widely in 2012, from a low of 0.41 percent of the
foreign portfolio for the Minneapolis Fed, to a high of 20.69 percent
of the foreign portfolio for the Richmond Fed. The remainder of this
section describes how the percentages are determined. An important
element of the domestic portfolio rebalancing is that it also involves
an approximate “settling” of ISA balances. In contrast, the foreign
portfolio rebalancing generates ISA transactions as an outcome, but
they do not drive the process.

Domestic Portfolio
In April of each year, the 12 Reserve Banks’allocation percentages for
the domestic SOMA portfolio are updated. We will use a hypothetical example for the Federal Reserve Bank of Richmond to explain how
the process works. Before going into the details, we need to introduce
the gold certi…cate account, an item on the asset side of each Federal
Reserve Bank’s balance sheet. The gold certi…cate account is a carryover from the time that the United States was on a gold standard.

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125

Today, the Systemwide gold certi…cate account corresponds to the value
of gold held by the U.S. Treasury. While the gold certi…cate account
plays a role in the process described below, in no way do the Treasury’s
gold holdings restrict the quantity of currency or bank reserves that the
Federal Reserve can issue.
1. Denote Richmond’s average daily ISA balance for the preceding
12 months by B, and recall that we follow the H.4.1 release
and put ISA on the asset side of the balance sheet. In the …rst
step, the ISA balance is reduced by B, and there is an o¤setting
increase of B in the Richmond Bank’s gold certi…cate account. If
B is negative, then the ISA balance rises and the gold certi…cate
account falls in this step.10
2. Denote the Systemwide ratio of the gold certi…cate account to
the value of Federal Reserve notes by :11 Denote the corresponding ratio for the Richmond Bank by R . In the second
step, Richmond’s gold certi…cate account is adjusted upward or
downward— as appropriate— to equate the new R to : The o¤setting balance sheet entry is a decrease or increase in Richmond’s holdings of the domestic SOMA portfolio.
3. Denote the new ratio of Richmond’s domestic SOMA portfolio
holdings to the total domestic SOMA portfolio by : Until the
following April, Richmond’s allocation of the domestic SOMA
portfolio will be given by :
The rebalancing process is undeniably complicated. However, some
intuition can be gained by thinking about a hypothetical case where
the allocation of securities purchases is always quickly accompanied by
matching reserve ‡ows. Each time the New York Fed purchases securities, an identical quantity of reserve liabilities is created, typically on
the balance sheet of the New York Fed. A fraction of the securities
are quickly allocated to the Richmond Fed. If reserves of the same
magnitude then ‡ow from the New York Fed to the Richmond Fed,
there will be o¤setting ISA transactions. If this occurs for every securities purchase, then in step 1 above there will be zero average ISA
balance, and the only adjustment in April would occur because of di¤erent growth in Richmond Federal Reserve notes than in the System as a
whole. This example makes clear that it is primarily the combination of
10
As described in the Appendix, it is possible for the gold certi…cate account to
become negative in step 1. But any negative balance would be reversed in step 2.
11
The Systemwide value of the gold certi…cate account has not changed since 2006.

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Table 7 Currency and Reserves by District (April 10, 2013),
and SOMA Domestic Allocations for 2012
District
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
System Total

Currency (%)
3:33
37:70
3:31
4:34
7:30
12:37
6:75
2:61
1:67
2:66
6:96
11:01
100

Reserves (%)
1:64
67:07
2:01
1:10
4:85
2:96
3:72
0:79
0:53
1:26
2:71
11:35
100

SOMA (%)
2:43
56:07
3:31
2:54
7:12
6:03
5:55
1:56
0:91
2:01
3:89
8:60
100

di¤erential growth in reserves and currency that leads to changes in a
Reserve Bank’s allocation percentage for the domestic portfolio.
To further illustrate the relationship between a Reserve Bank’s
share of liabilities and its allocation percentage, Table 7 lists each
Bank’s share of total reserves (“other deposits”) and net Federal Reserve notes outstanding on April 10, 2013, together with the 2012
SOMA domestic allocation percentages from Table 4. For every Reserve Bank except San Francisco, the SOMA percentage lies between
the Reserve Bank’s share of currency and its share of reserves. As we
have seen, in any given year the allocation is a complicated function
of past history, ISA over the prior 12 months, and the distribution of
Federal Reserve notes. However, the table shows that the distribution
of currency (Federal Reserve notes) and reserves together are generally
a good approximation to the SOMA allocation.
Finally, an important thing to note about the annual rebalancing
process is that it generally does not result in a Reserve Bank’s ISA
balance moving to zero. This would only happen if the Reserve Bank’s
ISA balance on the day of rebalancing were equal to its average balance
over the prior 12 months.

Foreign Portfolio
The annual foreign portfolio allocation percentages are determined in
January, rather than April. As with the domestic portfolio, a onetime adjustment takes place to bring the account balances across Reserve Banks in line with the new percentages. However, whereas the

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127

domestic allocations are determined by a complicated process involving
prior-year ISA balances and the distribution of Federal Reserve notes,
the foreign allocations derive in a simple way from the distribution of
Reserve Bank capital. Each Reserve Bank has capital and surplus,
based on the capital of the member banks in the respective Federal Reserve District (see Section 5 of the Federal Reserve Act for the details).
Again, we will use a hypothetical example for the Federal Reserve Bank
of Richmond to explain the annual process for determining the new foreign allocation and for reconciling the foreign portfolio.
Denote the Richmond Fed’s share of the SOMA foreign portfolio
by 0 : Denote the Richmond Fed’s share of Systemwide capital and
surplus by : For the next year, changes to the SOMA foreign portfolio
will be allocated to the Richmond Fed according to the ratio . There
is also a one-time rebalancing, to equate Richmond’s foreign portfolio
share to its capital share. If the capital share is greater than the foreign
portfolio share ( > 0 ), then the foreign portfolio is increased to make
the new share, call it 1 ; equal to : And if < 0 ; then Richmond’s
foreign portfolio balance is decreased so that 1 = : In the former
case, the increase in Richmond’s foreign portfolio balance is o¤set by
a decrease in Richmond’s ISA balance. Likewise, if < 0 ; there is an
o¤setting increase in Richmond’s ISA balance. E¤ectively, Richmond
is buying (or selling) shares in the SOMA foreign portfolio using its
ISA balances.
Referring to columns 4 and 5 of Table 4, the di¤erential allocation
percentages among Reserve Banks for the foreign portfolio simply re‡ect di¤erent levels of capital of the member banks in each district.
The Richmond Fed has a relatively large allocation percentage for the
foreign portfolio because Bank of America, one of the four largest banks
in the country, is a member bank located in the Richmond District.
If one is tracking Reserve Bank ISA balances, the annual adjustments in January and April are signi…cant for two reasons. First, to
the extent that there were persistently large ISA balances over the
prior year, say because of signi…cant changes in the size of the domestic SOMA portfolio, the April rebalancing would lead to large one-time
ISA ‡ows.12 Second, to the extent there are signi…cant changes in the
size of the overall SOMA portfolio over the coming year, say because of
asset purchases or sales, or swap line drawdowns, the new percentages
will a¤ect the ISA ‡ows as the portfolio grows or shrinks.
12
The foreign portfolio rebalancing in January would lead to large ISA ‡ows if
there were a sharp divergence between Reserve Banks’ capital shares and their foreign
portfolio shares. In order for this to happen, there would have had to be large changes
in capital shares over the course of the year, presumably because of banking industry
restructuring.

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Federal Reserve Bank of Richmond Economic Quarterly

Comparison to TARGET2
The European Monetary Union has a similar character to the United
States from a monetary perspective, in that it is composed of a system
of central banks that together administer a single currency. Just as
the ISA provides, and measures, a form of credit among Federal Reserve Banks, the TARGET2 system in Europe provides, and measures,
a form of credit among the national central banks in Europe.13 Because there is a wealth of literature describing how TARGET2 works
in the Eurosystem, we will not go into any detail on that topic here,
instead focusing on two important di¤erences between TARGET2 and
the ISA. One di¤erence involves how the systems work, and it has received signi…cant attention already.14 The other di¤erence involves the
interpretation of TARGET2 versus ISA balances, which has received
less attention.
A key operational di¤erence between TARGET2 and the ISA involves rebalancing. In the Eurosystem, there is no regular administrative process corresponding to the Federal Reserve System’s April ISA
rebalancing. In principle then, it is possible for TARGET2 balances
among countries in the European Monetary Union to grow arbitrarily
large in absolute value. In practice, the European sovereign debt crisis was associated with persistently large positive TARGET2 balances
for Germany, Netherlands, Luxembourg, and Finland, and persistently
large negative TARGET2 balances for Ireland, Portugal, Greece, Spain,
and Italy. However, since late 2012, the absolute level of TARGET2
balances has been declining in most of these countries.15
As we will see below, the ongoing increase in the Federal Reserve
System’s balance sheet, together with the limited tendency for reserve
balances to ‡ow from New York to the other Districts, means that without the annual rebalancing, New York— like the …rst group of European
countries listed above— would have a persistently increasing ISA balance. Would such a scenario create the same uproar in the United
States that it has created in Europe? Likely not, because (i) Federal
Reserve Districts do not correspond to national, or even state borders, and (ii) the (hypothetical) accumulation of ISA balances in New
York is associated with the fact that New York is a …nancial center,
rather than with an especially strong economy in the New York Federal
13
We say “a form of credit” because the national central banks and Federal Reserve
Banks are only pseudo-independent of each other.
14
See the references mentioned in the Introduction.
15
For several of the national central banks, TARGET2 balances are easily accessible
through the banks’ o¢ cial websites. The website www.eurocrisismonitor.com provides
updated time series of all TARGET2 balances.

A. L. Wolman: Federal Reserve Interdistrict Settlement

129

Reserve District. In fact, as Eichengreen, Mehl, and Chitu (2013) discuss, prior to 1975 annual rebalancing did not take place among Federal
Reserve Banks. In principle, there was instead daily settlement across
regional banks using gold certi…cates, but in practice “interdistrict accommodation operations” took place and balances did build up over
time. Eichengreen, Mehl, and Chitu (2013, 4) argue that the build
up of these balances “did not excite experts or the American public,
nor in most cases did they trigger insurmountable tensions between
regions.”16
The second important di¤erence between ISA and TARGET2 arises
from the di¤erent degrees of …nancial integration within Europe and
the United States. One element— albeit a relatively recent one— of
the highly integrated U.S. …nancial system is the prominent role of
interstate bank branching. Interstate bank branching and its corollary
interdistrict bank branching mean that some bank deposits are located
in a Federal Reserve District that is di¤erent than the one where the
reserves backing that deposit are held. Because the location of reserves
may not coincide with the residence of depositors, ISA ‡ows may give
misleading information about underlying …nancial ‡ows.
Consider again the check clearing example from Table 1. Suppose JPMorgan Chase customers in Ohio write checks for $1 million
to Bank of America customers in California. These transactions represent a transfer of bank deposits from residents of the Cleveland Federal
Reserve District to residents of the San Francisco Federal Reserve District. However, JPMorgan Chase’s reserve account is held with the
Federal Reserve Bank of New York, and Bank of America’s reserve account is held with the Federal Reserve Bank of Richmond. Based on
ISA balances then, one would incorrectly interpret the transactions as
representing a transfer of liquid assets from the New York District to
the Richmond District.
In practice, the fraction of deposits with the property just described
is quite large. For example, on June 30, 2013, JPMorgan Chase had
customer deposits of $950 billion, but less than half of those deposits
were held at branches within the New York Federal Reserve District.
Or consider Bank of America, with customer deposits of $1.02 trillion,
more than 45 percent of which were held in just four states outside the
Richmond district: California ($241 billion), Florida ($81 billion), New
York ($62 billion), and Texas ($82 billion).17 These examples are much
16
It should be noted as well that earlier (im)balances did tend to be driven by differential economic activity across regions, as opposed to FOMC-directed securities purchases or swap line drawdowns.
17
The numbers in this paragraph are taken from the FDIC’s Summary of Deposits
website, www2.fdic.gov/sod/.

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Federal Reserve Bank of Richmond Economic Quarterly

less prevalent in Europe: For the most part, transfers of deposits from
a bank in Germany to a bank in Finland, for example, would represent
transfers of deposits from German residents to Finnish residents.

3.

INTERDISTRICT FLOWS DURING AND AFTER
THE GREAT RECESSION

We turn now to actual data on ISA and other aspects of Reserve Bank
balance sheets, concentrating on the post-2007 period. ISA behavior
underwent a marked change after 2007 as a result of the Fed’s credit
programs, asset purchases, and swap lines with foreign central banks.
After describing some of the more notable aspects of that behavior,
we then suggest one way in which ISA behavior could provide useful
information about the state of the economy as the Fed begins its exit
from unconventional monetary policy.

Unconventional Monetary Policy and the ISA
Prior to September 2008, the balance sheets of the 12 Federal Reserve
Banks grew at a fairly steady rate, mainly re‡ecting growth in currency
demand as the economy grew. Secular growth does not necessarily imply changes in ISA balances, and both the volatility and absolute level
of Reserve Bank ISA balances were low over this period. During the autumn of 2008, the Federal Reserve began paying interest on reserves at
near market rates and lowered its Fed Funds rate target to near zero.
Either one of these actions on its own would have severely reduced
banks’incentive to economize on reserve holdings— previously a small
fraction of currency outstanding. Simultaneously, and in a process that
continues today, the Fed embarked on a series of credit expansion and
asset purchase programs that dramatically increased the quantity of
bank reserves: As of December 25, 2013, the aggregate level of reserves
stood at $2.5 trillion, more than 239 times the level in early September
2008.18 As described in Section 1, the asset purchases and central bank
liquidity swaps that have generated much of this increase necessarily
involve ISA transactions because the initial balance sheet increase at
the New York Fed is subsequently allocated to the other 11 Banks.
Thus, ISA balances at the 12 Reserve Banks behaved very di¤erently
after September 2008 than they had previously. In the remainder of
18

See Keister and McAndrews (2009) and Ennis and Wolman (2012) for additional
details on the behavior of bank reserves and the Federal Reserve System’s balance sheet
more generally.

A. L. Wolman: Federal Reserve Interdistrict Settlement

131

Figure 1 Selected Components of Consolidated Federal
Reserve Bank Balance Sheets

this section we discuss ISA behavior in the post-September 2008 period,
concentrating on the Richmond and New York Banks.
Figure 1 displays four of the main components of the consolidated
12 Federal Reserve Bank balance sheets. Currency and reserves, which
are liabilities to the Fed (hence denoted by an “L” in the legend), are
plotted as the dashed orange and black lines, and the asset categories
securities and swaps (hence “A”in the legend) are plotted as the solid
blue and red lines. The …gure re‡ects the discussion in the previous
paragraph: In “normal times” securities grew steadily, hand in hand
with currency. Once the large balance sheet expansions began in 2008,
the dramatic increases in swaps and then securities were re‡ected in
the growth of reserves, with currency remaining on a relatively stable
upward trend.
For the same time period, Figure 2 plots ISA balances for the New
York and Richmond Federal Reserve Banks, as well as the mean absolute value of ISA balances across all 12 Reserve Banks. There are
several notable features of this …gure. As stated above, before 2008,
when currency and securities were growing steadily and reserves were

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Federal Reserve Bank of Richmond Economic Quarterly

Figure 2 Interdistrict Settlement Account

low, both the level and volatility of ISA balances were low relative
to their later behavior; this applies to Richmond, New York, and the
entire System as re‡ected in the mean absolute value. That said, the
swings in New York’s ISA balance were large relative to the other Banks
(compare the black line in Figure 2 to the red solid and blue dashed
lines).
In a typical year before 2008, the New York Fed would be purchasing securities at a steady rate, and then immediately “selling” a
signi…cant fraction of those securities to the other 11 Banks, in exchange
for ISA balances. This would tend to make New York’s ISA balance
increase over the course of the year ending in April, when the annual
rebalancing of the domestic SOMA portfolio occurs. However, a close
look at Figure 2 reveals that New York’s ISA balance was just as likely
to be decreasing over the year to April. The explanation may lie in the
behavior of reserve balances: When the New York Fed purchases securities, the initial increase in reserves generally occurs in the accounts of
banks in the New York District because the securities are sold by primary dealers, whose commercial bank accounts tend to be with New
York banks. Over time, however (prior to 2008), the newly created

A. L. Wolman: Federal Reserve Interdistrict Settlement

133

reserves would spread out across the System, roughly in proportion to
economic activity, and be converted to currency. If the spreading out
occurred before the conversion to currency, then it would involve an
increase in ISA balances for other Banks and a decrease for New York,
to o¤set New York’s lower reserve account liabilities and other Banks’
higher reserve account liabilities. Overall, ISA balances were low and
stable at the other 11 Banks because, to a …rst approximation, the
other 11 Banks were simply o¤setting New York’s ‡uctuations, with
percentages similar to those in Table 4 (recall that the percentages are
updated annually).
Beginning in September 2008, just as the size and composition of
the consolidated Federal Reserve Banks’balance sheet began to change
dramatically, so did the behavior of ISA balances. This occurred at the
New York Fed as well as the other Reserve Banks. From the end of 1999
through September 10, 2008, the New York Fed’s average absolute ISA
balance was $17.1 billion; from September 17, 2008, through the end
of 2013, New York’s absolute ISA balance averaged $141.2 billion. For
all Federal Reserve Banks, the corresponding increase was from $4.5
billion to $35.2 billion.19
While the entire post-2008 period has been characterized by high
and volatile ISA balances, the behavior of New York and Richmond’s
ISA balances relative to the rest of the System divides into …ve distinct
phases. In phase 1, from September 2008 through March 2009, New
York’s ISA balance rose and fell dramatically, and Richmond moved in
opposite directions with somewhat smaller swings. Phase 1 is mainly
accounted for by the behavior of swap lines. Swap line drawdowns
increased from $62 billion on September 17, 2008, to their peak of $583
billion on December 10, and then by March 11, 2009, had fallen to
$314 billion. As swap drawdowns rose and fell, New York’s ISA balance
would naturally rise and fall (Richmond’s would fall and rise). In phase
2, roughly from March through the end of 2009, both New York and
Richmond’s ISA balances were increasing. For New York, this was due
to the …rst round of LSAPs, and for Richmond it seems to have been
due to an increase in deposits (reserves) that was quite large relative
to other Banks (see Figure 4). Both Richmond and New York’s ISA
balances were relatively stable throughout 2010, apart from a large
decrease for Richmond with the annual rebalancing of the domestic
SOMA portfolio in April; because of Richmond’s large average balance
19
The calculation for all 12 Banks is as follows: First, calculate the weekly mean
absolute balance across Banks, then average that balance across time to arrive at $4.5
billion and $35.2 billion for the two periods.

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over the previous 12 months, the 2010 rebalancing involved reducing
Richmond’s ISA balance by approximately $175 billion.20
During phase 3, which lasted from late 2010 through the April 2012
domestic SOMA rebalancing, ISA balances in Richmond and New York
were driven by the increase in reserves from the second LSAP program.
The typical pattern associated with securities purchases occurred: New
York’s ISA balance increased as it allocated the newly purchased securities across the System, and Richmond’s ISA balance decreased as
it “purchased”securities from New York. These asset purchases ended
in the middle of 2011, and ISA balances were relatively stable until the
April 2012 rebalancing. At that time there was a large reallocation of
securities from Richmond to New York, with a corresponding decrease
in New York’s ISA balance and an increase in Richmond’s ISA balance;
e¤ectively, New York was purchasing back a similar but not identical
quantity of securities from Richmond.
Regarding phase 3, there has been some speculation among commentators that rebalancing did not occur in April 2011. As evidence in
favor of this view, Koning (2012) notes that while the New York Fed
had an average ISA balance of around $147 billion over the previous 12
months, there is no evidence in the H.4.1 data of a similar-sized ISA
decrease in April 2011. However, Koning also notes that the discrepancy may be a result of the inherent limitations in weekly data. In
fact, this latter view is correct. Rebalancing did occur as usual, as can
be con…rmed by looking at the behavior of securities on the New York
Fed’s balance sheet.
Figure 3 zooms in on the behavior of the New York Fed’s ISA and
securities holdings, from April 2010 through June 2011. The three vertical lines in the …gure represent April 6, April 13, and April 20, 2011.
As described in Section 2, the annual domestic portfolio rebalancing
for a Bank with positive ISA balance over the past year involves a decrease in its ISA balance and an equal-sized increase in its securities
holding; the Bank is e¤ectively purchasing securities with its ISA balance. Although New York’s ISA did not display an unusual decrease
in April 2011, its securities holdings did increase by $150 billion from
April 13 to April 20. Securities were increasing steadily during that
period because of the second LSAP program, but the rate of increase
was nowhere close to $150 billion per week. The only plausible explanation for the $150 billion increase in securities is the annual rebalancing, which Koning indeed calculates ought to have been close to $150
20

The number in the text is approximate because it is based on the weekly H.4
data, which incorporate all factors that a¤ected the ISA during the week that settlement
occurred.

A. L. Wolman: Federal Reserve Interdistrict Settlement

135

Figure 3 New York: ISA and Securities around April 2011

billion. The ISA change is not visible in the weekly data because it was
partially o¤set by other factors unrelated to the rebalancing.
Phase 4, from April 2012 until late 2012, was characterized by
declining ISA balances in both Richmond and New York. During this
period, aggregate reserves were relatively stable (Figure 4), but deposit liabilities in both Richmond and New York were declining, with
the o¤set coming from ISA balances. Evidently reserves were ‡owing
out of Richmond and New York to the other Districts. Finally, phase
5 corresponds to the ongoing third LSAP program. New York’s ISA
balance has increased markedly from allocating the new securities purchases, and Richmond’s balance has generally been declining since the
last SOMA rebalancing in April 2013.

ISA Fluctuations as a Potential Signal for
Monetary Policy
In comparing TARGET2 to ISA, we noted that the prevalence of interdistrict branching in the United States meant that ISA behavior was
unable to provide the kind of information about cross-region

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Federal Reserve Bank of Richmond Economic Quarterly

Figure 4 Deposits (Reserves)

payment ‡ows that TARGET2 can provide. However, it should be
clear from the example we used to make that point that ISA behavior
does provide some information about payment ‡ows across institutions.
At the weekly level, only net ‡ows across Federal Reserve Districts are
captured, so ‡ows across institutions within the same Federal Reserve
District are missed entirely. Nonetheless, there may be some value in
the information that is captured by ISA.
Starting in December 2013, the Federal Reserve began to reduce
the pace of securities purchases in its third LSAP program. Assuming
that the economic recovery continues, the tapering of asset purchases
is likely to be the …rst stage in an exit from unconventional monetary
policy, where the later stages will involve an increase in the federal
funds rate target and a reduction in the Federal Reserve’s securities
holdings. Ennis and Wolman (2010, 2012) have argued that the large
quantity of reserves outstanding makes it especially important that the
Fed not fall behind the curve in raising its target for the federal funds
rate. The …nancial ‡ows represented by ISA ‡uctuations may provide
one useful signal about the right time to raise that target.

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137

Figure 5 Summary Statistic for Dispersion of ISA Changes

Informally, the idea is that if monetary policy were to fall behind
the curve we would eventually expect to see in‡ation, but the in‡ation
would likely be preceded by more rapid turnover of the monetary base
(in particular, bank reserves). That increase in turnover would in turn
be re‡ected in an increase in volatility of ISA balances. Figure 5 plots
one measure of this volatility, from 2008 through 2013. For each Reserve Bank, we calculated the absolute valuable of the weekly change
in the Bank’s ISA balance, from the H.4.1 report. Then, for each week,
we calculated the standard deviation of these changes across the 12
Banks. The jagged line in Figure 5 is the time series for this standard
deviation, and the grey horizontal line is the mean over the period from
January 2008 through December 2013. There are no surprises in Figure
5, given what we already know from the previous …gures. In September
2009 there was a discrete upward shift in the dispersion measure, but
since that time the series’ behavior has been relatively steady, apart
from spikes at the April rebalancing in 2010 and 2012. In the scenario
where ISA behavior signals that it may be time for interest rates to
rise, we would see an upward shift in the dispersion measure.

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Federal Reserve Bank of Richmond Economic Quarterly

Anyone can track the dispersion measure in Figure 5, simply by
downloading data from the Federal Reserve’s website. As such, it may
provide a useful way for the interested public to track monetary conditions. Policymakers themselves have access to the daily reserve balances of every …nancial institution with an account at a Federal Reserve
Bank. They can therefore construct a more granular version of Figure
5, which begins with the absolute daily change in reserve balances for
each account-holding institution, instead of the absolute weekly change
in ISA balances for each Reserve Bank.

4.

CONCLUSION

The massive expansion of the Federal Reserve System’s balance sheet
since 2008 has been accompanied by a notable increase in payment ‡ows
across Federal Reserve Districts. These payment ‡ows are measured by
the Federal Reserve’s Interdistrict Settlement Account (ISA), much as
‡uctuations in TARGET2 balances measure payment ‡ows across national central banks within the Eurosystem. There is, however, an
important di¤erence in the mechanics of the two systems; annual rebalancing occurs in the United States but not in Europe. In addition,
because the U.S. banking system is highly integrated across regions,
there are limits to the kind of information about payment ‡ows that
can be conveyed by ISA data.
Although the post-crisis period comprises several distinct phases
of ISA behavior, as described in Section 3, the overall trend has been
one in which the FOMC’s asset purchase programs have tended to
increase ISA balances (an asset) as well as deposit liabilities on the
New York Fed’s balance sheet. Absent the annual rebalancing process,
described in Section 2, rough calculations suggest that New York’s ISA
balance would have risen to approximately $800 billion by the end
of 2013, assuming that it started at zero at the beginning of 1999.
Going forward however, as the asset purchase programs are eventually
reversed, we should expect the behavior of ISA balances at New York
and the other Banks to reverse as well. As long as the quantity of bank
reserves remains large, the behavior of ISA balances may turn out to
be a useful indicator of when the time has come for the fed funds target
to rise.

A. L. Wolman: Federal Reserve Interdistrict Settlement

APPENDIX:

139

FORMAL DESCRIPTION OF ISA SETTLEMENT

What follows is a more formal statement of the process described in
Section 2, for annual settlement of ISA using the domestic SOMA
portfolio.
1. (a) Denote Richmond’s average ISA balance for the preceding
12 months by BR , and recall that we follow H.4.1 and put
ISA on the asset side. In the …rst step, the ISA balance is
reduced by BR , and there is an o¤setting increase of BR in
the Richmond Bank’s asset item, “gold certi…cate account.”
If BR is negative, then the ISA balance rises and the gold
certi…cate account falls in this step.
(b) Denote the Systemwide ratio of the gold certi…cate account
to the value of Federal Reserve notes by : Denote the corresponding ratio for the Richmond Bank by R . In the second
step, Richmond’s gold certi…cate account is adjusted upward
or downward— as appropriate— to equate the new R to :
The o¤setting balance sheet entry is a decrease or increase
in Richmond’s holdings of the domestic SOMA portfolio.
(c) Denote the new ratio of Richmond’s domestic SOMA portfolio holdings to the total domestic SOMA portfolio by :
Until the following April, Richmond’s allocation of the domestic SOMA portfolio will be given by :
(d) Given
IR;0 =
BR =
IR;1 =
GR;0 =
GR;1 =
GR;2 =
G=
N=
NR =
SR;0 =
SR;1 =
S=
R =

Richmond’s initial ISA balance
Richmond’s average ISA balance
Richmond’s new ISA balance
Richmond’s initial gold certi…cate account
Richmond’s “intermediate” gold certi…cate account
Richmond’s new gold certi…cate account
System’s gold certi…cate account
System’s Federal Reserve notes
Richmond’s Federal Reserve notes outstanding
Richmond’s initial SOMA holdings
Richmond’s new SOMA holdings
System’s SOMA holdings
Richmond’s new SOMA allocation percentage

i. In step a, we have IR;1 = IR;0 BR and GR;1 = GR;0 +BR :
G
NR GR;1 and
ii. In step b, we have GR;2 = GR;1 + N
SR;1 = SR;0 (GR;2 GR;1 ) :
iii. Thus, for step c, R = SR;1 =S:
iv. Note that GR;1 is completely arti…cial. For an instant, a
bank’s gold certi…cate account could go highly negative

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Federal Reserve Bank of Richmond Economic Quarterly
or could go higher than the System’s total, though at
every instance the total across Banks does sum to the System’s total. We can rewrite the process without GR;1 as
G
G
GR;2 = N
NR and SR;1 = SR;0
(GR;0 + BR ) .
N NR
This makes it clear that Richmond’s gold certi…cate account only changes to the extent that either (i) the System’s ratio of gold certi…cate account to notes changes,
or (ii) Richmond’s notes quantity changes. And, Richmond’s SOMA changes if (i) Richmond’s gold certi…cate
account changes, or (ii), more importantly in practice, if
Richmond’s ISA balance averaged something other than
zero over the previous 12 months.

REFERENCES
Board of Governors of the Federal Reserve System. 2014. “Factors
A¤ecting Reserve Balances. Federal Reserve Statistical Release
H.4.1.” Available at www.federalreserve.gov/releases/h41/.
Board of Governors of the Federal Reserve System. 2014. Financial Accounting Manual for Federal Reserve Banks. Available at
www.federalreserve.gov/monetarypolicy/…les/BST…naccountingmanual.pdf.
Cecchetti, Stephen G., Robert N. McCauley, and Patrick M.
McGuire. 2012. “Interpreting TARGET2 balances.” BIS Working
Papers No. 393. Available at www.bis.org/publ/work393.pdf.
Eichengreen, Barry, Arnaud Mehl, and Livia Chitu. 2013. “Mutual
Assistance between Federal Reserve Banks, 1913–1960 as
Prolegomena to the TARGET2 Debate.” Manuscript.
Ennis, Huberto M., and Alexander L. Wolman. 2010. “Excess
Reserves and the New Challenges for Monetary Policy.” Federal
Reserve Bank of Richmond Economic Brief 10-03.
Ennis, Huberto M., and Alexander L. Wolman. 2012. “Large Excess
Reserves in the U.S.: A View from the Cross-Section of Banks.”
Federal Reserve Bank of Richmond Working Paper No. 12-05.
Keister, Todd, and James McAndrews. 2009. “Why Are Banks
Holding So Many Excess Reserves?” Federal Reserve Bank of New
York Current Issues in Economics and Finance 15 (December).

A. L. Wolman: Federal Reserve Interdistrict Settlement

141

Koning, J.P. 2012. “The Idiot’s Guide to the Federal Reserve
Interdistrict Settlement Account.” Available at
http://jpkoning.blogspot.ca/2012/02/idiots-guide-to-federalreserve.html.
Lubik, Thomas A., and Karl Rhodes. 2012. “TARGET2: Symptom,
Not Cause, of Eurozone Woes.” Federal Reserve Bank of
Richmond Economic Brief 12-08.
Whelan, Karl. 2012. “TARGET2 and Central Bank Balance Sheets.”
Available at www.karlwhelan.com/Papers/
T2Paper-March2013.pdf.

Economic Quarterly— Volume 99, Number 2— Second Quarter 2013— Pages 143–162

Too Big to Manage? Two
Book Reviews
Edward Simpson Prescott

R

oddy Boyd’s Fatal Risk: A Cautionary Tale of AIG’s Corporate
Suicide and Greg Farrell’s Crash of the Titans: Greed, Hubris
and the Fall of Merrill Lynch and the Near Collapse of Bank of
America are interesting and informative books about two of the large
…nancial …rms that got into trouble and played an important role in the
recent …nancial crisis. American International Group (AIG) was bailed
out by the Federal Reserve and the federal government while Merrill
Lynch almost certainly would have failed if it had not been acquired
by Bank of America over that tumultuous weekend in which Lehman
Brothers failed.
Both books cover, from the perspectives of these two …rms, the
events leading up to and during the …nancial panic of the autumn of
2008. The descriptions are useful and entertaining, but there are many
other books on the …nancial crises that cover these events too. What
these two books do provide that many other books do not is a window
into how these two large …rms were run, how they grew leading up
to the crisis, and what decisions were made or not made that got the
…rms into trouble. What I want to do in this review is to use the books’
analyses of AIG and Merrill Lynch to give some insight into how large
…nancial institutions are run, their risks, why some of them failed in
the recent crisis, and the implications for too-big-to-fail policy.1
The author would like to thank Arantxa Jarque, Sam Marshall, David Price, and
John Weinberg for helpful comments. The views expressed in this article do not
necessarily represent the views of the Federal Reserve Bank of Richmond or the
Federal Reserve System. E-mail: edward.prescott@rich.frb.org.
1

Farrell’s book covers much more than the buildup of risk that led to Merrill’s
near failure. It is also about John Thain’s unsuccessful attempt to keep Merrill Lynch
independent, its sale to Bank of America, and the ensuing after e¤ects. It also discusses
Bank of America, including some of its history. Because my interest in this review
is limits on a person’s ability to manage large …nancial …rms, I won’t discuss these
parts of the book. Furthermore, in my mind, the history of Bank of America— and its

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Federal Reserve Bank of Richmond Economic Quarterly

Both authors put the role of the CEO at the center of their stories. Boyd argues that AIG collapsed because the high-energy, aggressive Hank Greenberg built a …rm with risks that his successor, Martin
Sullivan, could not manage when he took over in 2005. Farrell argues
that Merrill Lynch lost its independence because the ambitious, distant
Stan O’Neal ripped up the old “Mother Merrill” culture when he took
over in 2002. Like any good story, both books discuss the personalities of these leaders, their humble roots, how they interacted— or in
some cases did not interact— with their subordinates, and how these
character ‡aws contributed to the ending of their …rms. These Shakespearean elements make for a good tragedy and, indeed, are essential
to the story, but the focus on individuals runs the risk of hiding the real
lesson of both books. In my view, both stories are ultimately about
the limits of a leader’s span of control, that is, the scope and scale
of people and activities that a person can e¤ectively manage. Both
books provide evidence that these …rms were so large, leveraged, and
complicated that mistakes by leadership were fatal when the mortgage
market declined. What is not addressed in either book, however, is the
equally important lesson of why these two …rms were able to grow to
become so large, leveraged, and complicated in the …rst place. Later
in this article, I will argue that the answer to that question lies in 40
years of federal policy of bailing out large …nancial …rms.

1.

AMERICAN INTERNATIONAL GROUP

When American International Group (AIG) was bailed out by the federal government in September 2008, it was a $1 trillion company with an
astonishing reach. It operated worldwide, had a huge number of counterparties, and, in addition to supplying traditional insurance products
like life insurance and property and casualty insurance, it leased aircraft, provided asset management services, sold annuities, insured stable value funds in pension plans, and was active in capital markets. It
was involved in so many parts of the economy that it is not hard to see
why it was viewed as too big to fail.
Boyd tells a convincing story about how AIG got to this point.
He gives some background on the unusual history of AIG, but spends
much of the book discussing Maurice “Hank”Greenberg, its CEO until
Queen City neighbor Wachovia— is really the story of the end of legal and regulatory
restrictions on interstate and intrastate bank branching and the ensuing scramble among
banks to be the “winner” in the acquisition game. For a book with more history of these
two banks (as well as that of a third bank, the conservatively run “old” Wachovia), that
gives some idea of why Charlotte of all places ended up as the second most important
banking center in the United States, see Rick Rothacker’s Banktown.

E. S. Prescott: Too Big to Manage? Two Book Reviews

145

2005, and the growth of the …nancial products group, AIGFP. This unit
issued the credit default swaps (CDS) that, along with losses in AIG’s
securities lending unit, were the main causes of AIG’s collapse.
AIGFP was set up in 1987 as a joint venture with Howard Sosin,
a former academic and a trader with Drexel Burnham Lambert. The
vision of AIGFP was to use the AAA rating of AIG to fund derivative
transactions, like interest rate swaps, at a lower cost than its competitors, and for most of its years, AIGFP seemed to do this very well.2
Boyd describes what AIGFP did, but he spends a lot of time talking
about its leaders. He describes Sosin’s strong-willed personality and
his con‡icts with Greenberg. He also covers the succeeding years after Sosin was forced out in 1993, when AIGFP was …rst run by the
calm Minnesotan Tom Savage and then, starting in 2001, by the hard
charging, intimidating Joseph Cassano.
The AIGFP transactions that did so much damage to AIG were
part of its CDS portfolio, and actually only a small portion it. A CDS
is essentially an insurance contract written on the performance of some
asset. AIGFP started providing CDS in 1998. These CDS were initially
written on corporate debt, but over time AIGFP expanded the pool of
assets it insured to include bank loans and, starting in 2004, collateralized debt obligations (CDO). A CDO is a security that receives cash
from a trust that holds a bundle of loans, …xed-income securities, or
other assets. From 2004 until the end of 2005, the CDOs that AIGFP
insured included subprime mortgage-backed securities. Some of these
CDS contained credit swap annexes that required AIG to post collateral
if the value of the referenced security dropped in value. Downgrades to
the referenced securities, as well as to AIG as a whole in 2008, required
AIG to post large amounts of cash as collateral that it did not have in
September 2008. The liquidity problems from these collateral calls and
losses on its securities lending portfolio were the two most signi…cant
causes of its collapse.
The portion of AIGFP’s CDS portfolio that caused so much trouble
for AIG was, as mentioned earlier, proportionally small. As of September 2008, AIG insured about $360 billion of assets with CDS and only
$55 billion of that was on CDOs that contained subprime mortgage
securities (Congressional Oversight Panel 2010, 24). It was these latter
CDOs that caused most of the losses and, furthermore, these losses
came from just 125 of AIGFP’s approximately 44,000 derivative contracts. Indeed, as pro…table as AIGFP was, it was never that big a
2

Using AIG’s AAA rating to generate low-cost funding seems to have been a strategy of AIG’s. That was one of the reasons, for example, that AIG bought the aircraft
leasing business ILFC (Boyd 2011, 66).

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Federal Reserve Bank of Richmond Economic Quarterly

percentage of AIG’s income. For example, the Congressional Oversight
Panel (2010, 23) reports that in 2006, AIGFP provided only about 7
percent of AIG’s operating income.3
To understand how AIG got to the point where a relatively small
portion of the …rm could bring the rest of it down, it is necessary to
understand something about AIG’s history and the dominating role
played in it by Hank Greenberg.
AIG was a very unusual company. It was founded by Cornelius
Vander Starr in Shanghai in 1919. Starr ran the company until he
appointed Greenberg as his successor in 1968. Under Greenberg, the
company grew dramatically.4 It expanded its insurance business and,
in 1987, it entered capital markets through its joint venture with Sosin.
It also had a very unusual long-term incentive scheme in which Greenberg would dole out shares of the Starr company— a byproduct of the
corporate reorganization of AIG that he undertook when he …rst ran
the company— that he also controlled, to loyal employees once they
reached age 65. The promise of this long-term payout, which seems
similar to the old investment banking partnership model, tied employees to AIG and gave them strong incentives to work hard and be loyal
to the …rm.
Boyd makes clear that much of the growth of AIG was due to the
ambition and energy of Greenberg. The central role that Greenberg
played in AIG is re‡ected in this description of Greenberg’s management style (Boyd 2011, 132–3):
All people who discuss Greenberg and his tenure at AIG eventually
mention the beehive of his o¢ ce. People came and went, orders were
delivered— often in under one minute— and more people ‡ow in and
more orders are laid out....It was common for a division chief, earning
well into seven …gures, to be sitting in a chair next to the CFO as
Greenberg sat behind his desk on the phone listening to someone
from Tokyo while carrying on (possibly) related conversations with
the division chief and CFO. Often, these conversations were truly
material as to corporate strategy and direction.

The picture that one gets of AIG is that it was a somewhat decentralized organization, with an entrepreneurial culture, but in which
there was e¤ective corporate oversight in the form of Greenberg. Boyd
gives a story about how Greenberg watched positions that, for as large
a company as AIG, are relatively small (Boyd 2011, 75):
3

The highest percentage it reached was about 12 percent in 2002.
Greenberg resigned as CEO in 2005. This means that over an 86-year period, the
…rm only had two leaders.
4

E. S. Prescott: Too Big to Manage? Two Book Reviews

147

On many occasions, Davis and Rubin [two of the leaders of AIG
Trading] had gotten called out of meetings, ‡agged down on vacations,
interrupted in the middle of a big trade, and ordered to defend a
certain position then on the books. The rub was that most every
time it was the tail end of some big trade they were squaring away
with a large customer and were in the process of selling. On a few
occasions, they had made the mistake of attempting to reason with
Greenberg, something to the e¤ect of, “Hank, this is a $5 million
position in yen futures/gold forwards/natural gas options. It’s really
liquid and pretty minimal in the scope of-”
[Greenberg replying] “Hedge it, reinsure it, or there are consequences.”

Boyd also writes (2011, 63):
But any analysis of AIG’s risk management begins and ends with
Greenberg. Like a brilliant professor with a cluttered o¢ ce, he
knew where everything was and what it all meant. He was the risk
management terminus, the ultimate arbiter of what was and was not
acceptable. The problem was not that it didn’t work, but that it
worked so well. A generation of AIG employees learned to measure
the risk they took so that it would be congruent with what Hank
would tolerate. Investors and analysts happily assumed that a system
like that would be in place forever more.
It wouldn’t be.

Boyd’s view is that this dependence on Greenberg was AIG’s weakness. If he were to leave and a lesser mortal stepped in his place, the
system would break down, and this is what he argues happened when
Martin Sullivan replaced Greenberg.
One of the most extraordinary things about how AIG lost
Greenberg was the way it happened. Despite Greenberg turning 80
years old in 2005, he did not become ill or simply decide to retire. Instead, he was forced to leave because of the actions of Eliot Spitzer,
the politically ambitious New York attorney general.
In the aftermath of the Enron accounting scandals, the political
environment had shifted toward more aggressive enforcement of accounting violations. Based on several reinsurance transactions in 2000
that were of a questionable accounting nature, Spitzer went after AIG
hard. Boyd’s view is that Spitzer’s legal case was not that strong, that
he aggressively used leaks to the media to frame public opinion at the
expense of the rule of law, and that he was driven by his political ambitions. Regardless of the merits of Spitzer’s case, the end result was
that Greenberg was forced out in February 2005 as head of AIG and
replaced with Martin Sullivan. Partially because of the scandals, AIG

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Federal Reserve Bank of Richmond Economic Quarterly

lost its coveted AAA rating. Furthermore, the attention of the Board
of Directors and senior leadership was so focused on dealing with the
legal risks from settlements with the attorney general and regulators
that they were distracted from dealing with more traditional sources
of risk.
It is after Greenberg left that AIGFP and Securities Lending made
the decisions that got AIG into trouble. AIG kept writing CDS through
the end of 2005 after Greenberg left in February of that year and even
after AIG was downgraded from its AAA rating.5 Furthermore, the
increase in risk taken by the securities lending program started in the
winter of 2005, also after Greenberg had left. AIG’s securities lending
program took the investment-grade securities that its various insurance
subsidiaries owned and then lent them out for cash collateral. They
then took this cash and, rather than lend it against safe securities like
short-term Treasury securities, they lent it against risky securities such
as subprime mortgage-backed securities.6 Not only did the value of
these securities drop, but they created liquidity risks because the cash
lenders demanded their cash back and AIG was forced to sell these
long-term securities precisely when mortgage markets were collapsing
and becoming more illiquid.
Greenberg claims that once AIG was downgraded in early 2005,
he would have stopped insuring the CDOs if he was still at the helm
(Congressional Oversight Panel 2010, 27). Whether this is true is, of
course, impossible to know. One distinction between the two regimes,
however, is that under the Sullivan regime, there is evidence that AIG’s
senior management was unaware of the risks that AIGFP was actually
taking. The collateral calls on AIG in the autumn of 2008 were based
on contractual terms in annexes to the CDS contracts. Amazingly,
corporate headquarters seems to have been unaware of the existence
of these annexes (Boyd 2011, 325). This suggests that there were serious problems in AIG’s controls and reporting systems. Indeed, the
Congressional Oversight Panel (2010, 28) reports that AIG’s auditor,
PricewaterhouseCoopers, noted that in 2007 there were material weaknesses with the valuation of the CDS written by AIGFP on super senior
CDO securities.
5
Not all of the CDO risk can be attributed to these latter CDS. The CDOs that
AIGFP insured had a feature called dynamic asset management (Congressional Oversight
Panel 2010, 24), which means there is a collateral manager who replaces collateral as
it is paid o¤ according to the CDOs investment rules. Consequently, CDOs insured
prior to Greenberg’s departure would still have picked up some of the worst vintages of
subprime loans that were made in 2006 and 2007.
6
For example, in July 2007, one AIG unit discovered that 80 percent of its $540
million investment was really backed by mortgage-backed securities that could be considered subprime (Boyd 2011, 248).

E. S. Prescott: Too Big to Manage? Two Book Reviews

149

Boyd points out some other weaknesses in AIG’s information systems, such as the inability to get up-to-date …nancial information for
AIG’s units (Boyd 2011, 174), that suggest this was a more pervasive problem. The picture that one gets of AIG as a company is that
the management information systems had some big weaknesses, but
Greenberg’s instincts and deep knowledge of the company compensated
for these gaps. When Greenberg was forced to leave, this knowledge
was lost and his replacement, Sullivan, was left with a company that
was so big and complex that it had hidden risks.

2.

MERRILL LYNCH

From 2002 to September 2007, E. Stanley O’Neal was the CEO of
Merrill Lynch. He was hired in 1987 and quickly rose through the ranks.
He became president in 2001 and acted decisively to …rst manage the
operations of the …rm after the terrorist attacks of September 11, 2001,
and then to greatly reduce sta¤ that was no longer needed because of
the end of the tech boom. Partly because of his performance in this
period, he was promoted to CEO in 2002, forcing out the previous
CEO, David Komansky.
O’Neal greatly changed Merrill Lynch in both its strategic focus and
its culture. Historically, the strength and focus of Merrill Lynch was its
vast network of …nancial advisers— “the thundering herd”— who gave
…nancial advice to Main Street America. Until O’Neal, Merrill’s CEOs
had been promoted from this line of business.7 However, in the late
1990s, capital market and trading activities were growing relative to the
…nancial advice business and were considered to be more promising. As
CEO, O’Neal took this mandate and greatly expanded it.8 The other
dramatic change that O’Neal made to Merrill Lynch was to end its
paternalistic culture of taking care of its employees. This culture gave
the …rm the nickname “Mother Merrill”and it meant, in practice, that
mediocre performers were sometimes protected. When O’Neal reduced
7
O’Neal actually ran wealth management for a short period of time before being
promoted, but most of his career at Merrill was spent in other areas.
8
For reporting purposes, Merrill broke its activities into two lines of business. The
formal names of these businesses change over time, but one line of business consists
mainly of wealth management and the other consists of capital market activities, like
trading, as well as investment banking services, e.g., merger and acquisition advice. In
1998, the wealth management business had net revenues of $11.3 billion while the trading/investment banking line of business had net revenues of only $6.5 billion. By 2006,
the proportional importance of the two units had almost reversed. The wealth management business had net revenues of $12.1 billion, while the trading/investment banking
business, which includes the …xed-income, commodities, and currencies unit discussed
later, had net revenues of $18.9 billion. (Source: Merrill Lynch Annual Reports 1998,
2006.)

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Federal Reserve Bank of Richmond Economic Quarterly

sta¤, he did so dramatically by laying o¤ 22,000 people, or nearly 30
percent of the …rm’s employees.
Farrell’s view is that in destroying this old culture, which he thinks
did need to be replaced or at least altered, O’Neal destroyed some of
the important checks on risk-taking that had existed at the …rm. First,
paternalistic cultures tend to be more risk averse. Second, as part of
the layo¤s, he eliminated many executives who were associated with the
old regime or were a potential threat to him and replaced them with
a younger, more diverse group that was loyal to him (Farrell 2010,
89). What arose in its place was a culture missing strong independent
executives willing to challenge O’Neal on decisions. Farrell believes it
was these conditions that allowed for the decisions that caused Merrill
Lynch’s problems.
Merrill Lynch’s biggest problems came from its …xed-income, commodities, and currencies, or FICC, line of business. One part of this
business was to underwrite, or create, CDOs. A CDO underwriter
buys the …xed-income securities that go into the CDO and structures
the securities.
By 2004, Merrill Lynch was the largest underwriter of CDOs
(Barnett-Hart 2009). As the housing boom grew, the volume of CDOs
grew and many of them included mortgages, particularly subprime
ones. Like many of the other investment banks, Merrill Lynch bought
a subprime originator, First Franklin, in 2006 to vertically integrate
the supply of mortgages.
A signi…cant risk for a CDO underwriting …rm is that it will not
be able to sell all the CDOs it creates or, if it can’t even put the CDO
together, the assets that it bought in the …rst place. This was what
happened to Merrill Lynch. In late 2006 and the …rst half of 2007,
as most everyone else was getting out of this business, they kept underwriting CDOs. In the …rst half of 2007, Merrill underwrote $34
billion in CDOs, most of which ended up on its balance sheet because
investors had stopped buying them (Farrell 2010, 18). Furthermore,
these CDOs were backed by particularly risky collateral, namely, subprime loans made at the peak of the boom as well as risky tranches
from other CDOs.
It was these positions that contributed the most to Merrill’s troubles. At the end of the second quarter of 2007, before the write downs
started, Merrill Lynch had a balance sheet of slightly over $1 trillion,
and, like the other investment banks, it was highly leveraged, so it only
had equity capital of $42 billion.9 Amazingly, these CDO holdings
9

Source: Merrill Lynch 10-Q, second quarter 2007.

E. S. Prescott: Too Big to Manage? Two Book Reviews

151

performed so poorly that they lost most of their value over the next
year, which wiped out much of this capital. (Merrill did raise capital
over this period and had earnings in some other parts of the …rm, which
o¤set some of these losses.)10 As Farrell (2010, 34) puts it,
Merrill Lynch had just violated the cardinal rule of every …nancial
institution on Wall Street, which holds that no one business unit
should ever be given enough leeway to sink the entire …rm.

To put this in perspective, in 2006 FICC’s revenue net of interest
expense was about $7.5 billion, which was about 22 percent of Merrill’s
total revenue (Merrill Lynch 2007 annual report). Furthermore, FICC
not only underwrote CDOs, but also traded in currencies, commodities,
and other …xed-income securities, so the 22 percent upper bound is
probably far from the actual amount.
Farrell ties this disastrous buildup in risk to the hiring decisions
made by O’Neal and one of his chief lieutenants, Ahmass Fakahany.
In 2006, when FICC was created as a separate unit within the trading
group, the head of sales and trading, Dow Kim, had to decide who
would head it. Kim’s …rst choice was an internal candidate named Je¤
Kronthal who had experience with mortgage-backed securities, understood risk, and had been at Merrill Lynch since 1989. Furthermore,
he had recently become cautious about the real estate market (Farrell
2010, 24). Kim’s second choice was Jack DiMaio, an outsider, who
had run a hedge fund and, as a consequence of that experience, understood risk. Unfortunately, neither O’Neal nor Fakahany (to whom Kim
reported) wanted Kronthal or DiMaio. Instead, they wanted Osman
Semerci, whom they had pegged as a rising star at Merrill. Kim was
reluctant to hire him because of his lack of experience in risk but did
what his bosses wanted (Farrell 2010, 25).
Semerci’s background was in sales. He started in Merrill in retail
and moved to institutional sales and did very well at that. However, he
did not have much experience with risk and Farrell describes his promotion, with some hyperbole, as “[taking a] salesman with the instinct
of a riverboat gambler and making him general manager of the casino”
(Farrell 2010, 25). One month after Semerci took over in July 2006,
Kronthal, along with a group of experienced traders, was …red.
10
Merrill’s 2007 and 2008 10-Ks give more details on FICC’s losses. Over this twoyear period, they wrote down their CDOs by $26.9 billion, wrote down U.S. subprime
mortgages by $14.0 billion, adjusted the value of their hedges down by $13.0 billion,
and wrote down subprime securities by $7.2 billion. The total was $61.1 billion over
this two-year period.

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Federal Reserve Bank of Richmond Economic Quarterly

Ostensibly, the buildup of Merrill’s CDO exposure was due to a bad
hiring decision, but this would not be the …rst time a corporate CEO
hired the wrong person for a job. What is particularly troubling is that
outside of FICC, the rest of Merrill seemed unaware of the size of the
CDO position. Farrell does not provide the details on what the risk
management, accounting, and other control functions in the …rm were
measuring with respect to the CDOs, but several stories he reports
suggest that these systems were lacking.
Particularly illuminating were the di¢ culties that several high-up
executives faced in determining just how much CDO exposure FICC
built up under Semerci. At a July 2007 board meeting, Laurence Tosi,
who was the chief operating o¢ cer of global markets and investment
banking (which FICC was part of), learned that FICC had accumulated $31 billion of CDOs on its balance sheet, yet claimed they had
minimal mortgage exposure. He was skeptical (Farrell 2010, 17–18)
and tried to …gure out just how much risk FICC really had (Farrell
2010, 16).11 Furthermore, at about the same time a former risk executive named John Breit started his own attempt to …gure out the true
exposure after hearing about it from some junior quantitative analysts
at a conference. Farrell describes the di¢ culties they faced in tracking
down the exposures, mainly because the information was tightly controlled by Semerci and his sta¤ was afraid of talk to non-FICC sta¤
about these matters.
Farrell puts the positions that Semerci built up as the proximate
cause of Merrill’s failure and he believes that O’Neal did not realize
how much CDO exposure was building up.12 Nevertheless, he blames
O’Neal and Fakahany for Merrill’s troubles because they pushed for
Semerci’s promotion and, more importantly, O’Neal fostered a culture
that eviscerated some of the checks that existed under the old Mother
Merrill culture, which might have prevented Semerci’s promotion and
him from building up the large CDO exposure.
11

Some of FICC’s risk would not have shown up in accounting numbers because
it was hedged. In order to sell AAA CDO securities, Merrill had traditionally bought
protection from AIGFP that made the securities more appealing to investors. However,
AIG stopped providing this service on subprime-backed securities in late 2005. Consequently, by 2007 Merrill was holding on to the AAA portions and hedged them by
buying insurance from the monoline insurers. The monoline insurers were pretty thinly
capitalized, and, given the nature of their business, couldn’t really provide much insurance against big aggregate shocks, so these hedges were not that useful and later were
written down in value.
12
McLean and Nocera (2010) also believe that O’Neal was unaware of the size of
the exposure. Furthermore, they think Kim, who left Merrill in May 2007, was unaware
of it as well (McLean and Nocera 2010, 314).

E. S. Prescott: Too Big to Manage? Two Book Reviews
3.

153

SPAN OF CONTROL AND TOO BIG TO MANAGE

Despite AIG being primarily an insurance company and Merrill Lynch
being primarily an investment bank, they had several features in common. First, both were very large and complex. At the end of 2006,
AIG had $979 billion in assets, and Merrill had $841 billion in assets.
Second, both were highly leveraged. At the end of 2006, AIG’s leverage
ratio was nearly 10, while Merrill’s was nearly 22. Third, both got into
trouble mainly from the actions of one or two units within their …rm.
Fourth, and this is the major thesis of the authors, neither …rm’s CEO
had a good system in place for preventing the buildup of risk, or even
recognizing it, in portions of their …rm.
In the span of control model used in economics to study the size
of …rms (e.g., Lucas [1978]), managers di¤er in their ability to manage
people and other resources. The more capable the manager is, the more
people and activities he can e¤ectively manage. If the market allocates
resources to managers e¢ ciently, then each manager or CEO of a …rm
gets the right amount of inputs. But if for some reason the market
does not do this e¢ ciently, then the CEO and his management team
get the wrong amount.13
What seemed to happen in the case of Merrill and AIG is that they
got too much capital and became too large to e¤ectively manage. In
AIG’s case, the “system”for controlling risk was so dependent on Hank
Greenberg that when he was forced to leave, it stopped working. His
successors were left with a very large, complex organization in which a
proportionally small but complex part was able to take enough risk to
sink the organization. Similarly, while the Merrill collapse looks to be
due to a bad hiring decision, it should not be forgotten that Merrill was
a $1 trillion …rm, and there was a lot more going on than just the CDO
underwriting activities of FICC. For a …rm of that size, a $30 billion
exposure is a relatively small percentage of the balance sheet. The fatal
mistake was to develop a corporate culture that did not recognize how
risky that line of business could be and then allowing a risk-taker to
run it.
There are other examples where the failure of one small part of a
…nancial …rm caused it to fail. One such famous case was the failure
of Barings Bank in 1995. Barings failed because a single trader named
Nick Leeson was able to use his control over back o¢ ce functions to
hide enormous bets that he took on the Japanese and Singaporean
exchanges— bets that ultimately failed (Kuprianov 1995).
13
The Appendix contains a span of control model where too-big-to-fail policies lead
…nancial …rms to become ine¢ ciently big.

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Federal Reserve Bank of Richmond Economic Quarterly

The lack of a proper control environment at Barings is an example of a management failure, though by recent standards Barings was
neither a particularly large nor a particularly complicated …rm. However, one bank whose troubles can be tied to growing too large was
UBS. UBS made a strategic decision to expand its …xed-income business in 2005 near the end of the mortgage boom. However, as the
UBS Shareholder’s report (2008) documents, pricing of internal funding encouraged the accumulation of AAA-related CDO positions. One
division would originate these CDOs and another division would buy
them. Risk measurement did not fully pick up exposures, partly because they relied on the ratings, but also because information systems
reported net (inclusive of hedges that turned out to be too small or not
very good) rather than gross exposures.14 The report concludes that
senior management did not intend to take a lot of risk, but instead
were unaware of how much risk the bank was really exposed to. Partly
because of these losses, UBS was later bailed out by the Swiss National
Bank.
Where the two books have a limitation is that there is a lack of
detail about the risk management and other information systems used
by the two companies. There are bits and pieces of evidence that
suggest neither …rm’s systems were up to the task, but what could
really cement this conclusion would be an in-depth analysis by someone
with unfettered access to insiders and management reporting systems,
like was done by UBS.15 Then we would have a better sense of how
much of the risk that was taken was due to inadequate measurement
systems, how much was due to conscious risk-taking, and how much
was just bad luck. Both authors had to work with what they could
determine from public sources, as well as whoever was willing to talk
with them, often o¤ the record, so this criticism is not directed at them.
While these weaknesses in internal risk management and management information systems are important to investigate, it needs to be
recognized that any system will eventually fail. What the AIG, Merrill Lynch, and UBS cases demonstrate is that diversi…cation does not
14
The poor quality of internal information seems to have been a problem at numerous large …nancial …rms during this crisis. Kirsten Grind’s book The Lost Bank: The
Story of Washington Mutual details the rise and fall of this huge West Coast thrift. She
reports that in its rapid accumulation of other banks and thrifts, Washington Mutual,
by 2004, ended up with 12 di¤erent mortgage information systems and did not consolidate them, partially because its mortgage business was doing so well (Grind 2012,
99). Furthermore, when the market started to turn, the lack of attention to integrating
data systems made it di¢ cult for Washington Mutual to track the characteristics of its
mortgage portfolio (Grind 2012, 165). So much for technological economies of scale in
banking!
15
The Congressional Oversight Panel (2010) report has some information along
these lines for AIG.

E. S. Prescott: Too Big to Manage? Two Book Reviews

155

always reduce risk for a …nancial …rm. As the scope of a …rm’s activities
grow, these activities become harder to evaluate and control. If losses
from a particular activity can be large enough to sink the …rm and the
other activities of the …rm can’t function on their own, then failure of
a single part of a …rm can be disastrous. For …nancial …rms that are
highly leveraged and dependent on short-term debt, mistakes by management make this possibility even more likely. If a …rm is involved in
too many activities, then more diversi…cation is really less.

4.

TOO BIG TO FAIL AND TOO BIG TO MANAGE

So what might have led these two …rms (and others) to get so large
and complicated? Why might they have grown to exceed their managers’ span of control? Some of it was certainly the housing boom.
Most …nancial institutions did well in this period, so it was easy to
grow. Nevertheless, another important factor at work, which neither
author discusses, is that both …rms were large enough that they could
reasonably be considered to be too big to fail. This meant that their
creditors could monitor them less carefully and charge less to lend to
them. As a consequence, both …rms could get larger and more complex
than they would have otherwise. Indeed, Greenberg’s strategy was to
use the funding advantage that came with AIG’s AAA rating to fund
AIGFP’s positions at a lower cost than its competitors, and that is one
reason this unit, and others, could enter into so many transactions and
grow.
The de…ning characteristic of U.S. …nancial regulatory actions over
the last 40 years has been to intervene to prevent failures of large …nancial …rms and to bail out short-term creditors of banks. The origins of
this policy can be found in Sprague (1986), who describes a succession
of bailouts made by the Federal Deposit Insurance Corporation (FDIC)
from the early 1970s through the mid-1980s.16 The …rst large one was
Bank of Commonwealth, a $1.2 billion bank in Detroit. The next large
one was of First Pennsylvania in 1980, a $9 billion bank that made a
disastrous interest rate bet.17 Finally, in 1984 there was the big bailout
at the time, Continental Illinois, which is when the term “too big to
fail” spread widely in public discourse.
16

For an excellent book on too big to fail, see Stern and Feldman (2009).
A large bank that was almost bailed out in 1983 was Sea…rst, a $9 billion bank
in Seattle that was heavily exposed to Penn Square, a bank that failed in 1982. Sprague
(1986) reports that a $250 million loan from the FDIC was prepared and ready to be
made in case Sea…rst could not …nd a buyer. Fortunately for the FDIC, Bank of America
bought the bank at the last minute.
17

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Federal Reserve Bank of Richmond Economic Quarterly

Continental Illinois was a $30 billion bank that was mainly funded
by uninsured deposits in the wholesale market. Furthermore, it had
an extensive network of correspondents and counterparties. When
Continental Illinois got into trouble, its wholesale lenders started pulling
their money out. Bank regulators were so worried about the contagion e¤ects of its failure that the Federal Reserve made extensive
discount window loans that allowed uninsured depositors to withdraw
their money and the FDIC took partial ownership.
As Hetzel (1991, 2012) documents, Continental Illinois was not the
only bank for which Federal Reserve discount window lending was used
to prevent a sudden failure. It was also used in the periods leading up
to the failures of Franklin National in 1974 and the National Bank of
Washington in 1990 and, in both cases, the emergency lending gave
uninsured depositors time to get much of their money out of the bank
before it failed. While there are exceptions, in general uninsured depositors rarely lose money in a bank failure.
While any doubts about whether nonbank …nancial …rms like AIG
or Merrill Lynch were too big to fail were erased by the …nancial crisis,
what did creditors think before the crisis when these …rms were growing? Did they think that they would they receive the same treatment
as a bank in trouble? Based on the precedents discussed above, there
are good reasons to think that they would have. Merrill Lynch funded
its holdings of mortgage-backed securities by using short-term repo
markets, which are essentially short-term loans and a bit like deposits.
Failure in the repo market would be very disruptive. AIG’s credit default swaps were held by many counterparties and some of them might
have failed if AIG had failed, much like many correspondents and other
banks might have failed if Continental Illinois had failed. Finally, there
are precedents for …nancial regulators to intervene at nonbank …nancial …rms and in …nancial markets. For example, when the hedge fund
Long-Term Capital Management failed in 1998, the New York Fed put
its creditors together— mainly the large commercial banks and investment banks— so that they would agree to put capital into the fund and
avoid rapidly liquidating its assets. In 1987, when the stock market
dramatically dropped, many broker-dealers were close to failing, but
regulators pressured banks to lend to them to keep them functioning.18
It is well recognized that the safety net can encourage risk-taking,
as in the infamous “gambling for resurrection”that some of the savings
18
An extremely high fraction of …nancial liabilities are explicitly or implicitly
backed by the federal government. Marshall, Pellerin, and Walter (2013) estimate that,
as of the end of 2011, 57 percent of …nancial liabilities in the United States are explicitly
or implicitly backed by the federal government.

E. S. Prescott: Too Big to Manage? Two Book Reviews

157

and loans engaged in during the 1980s (see White [1991]). Sprague’s
description of how both Bank of Commonwealth and First Pennsylvania
bought long-term securities, betting that interest rates would fall (but
instead rose), seems to …t this description (Sprague 1986, 86).
But there is a second, indirect way in which the safety net encourages risk. Both AIG and Merrill Lynch seemed to have gotten too big
and complicated for what their management could handle.19 Now, in
a sense, these two mechanisms are one and the same. After all, consciously becoming large and complicated is a way to become riskier,
but knowingly taking a risky bet seems to have some di¤erences from
stumbling into a risky bet. My reading of the books is that both authors believe that the CEOs were unaware of just how much risk their
…rms were exposed to. They were too removed from the activities
on the ground to understand the risks, while the enormous pro…ts of
the mortgage boom years masked some of the signals that might have
warned them earlier about what was really going on.

5.

CONCLUSION

Both books contain many other interesting insights into AIG, Merrill
Lynch, other …rms, and …nancial markets. Boyd’s description of the history of AIG, with its international origins and Greenberg’s connections
to world leaders, makes one wonder about the political economy of the
insurance business, while AIG’s use of shares in Starr as a long-term
incentive is worth knowing more about, particularly with the move in
bank regulation toward pushing banks to use more deferred compensation. Similarly, Farrell describes the unusually powerful role played
at Bank of America by its human resources department and, as a former …nancial reporter (he used to work for the Financial Times), he
has special insight into how information makes its way to the public.
For example, he makes it quite clear that executives at large …nancial
…rms are just as willing as Washington o¢ cials to strategically leak
information to reporters.
While reading the books, the emphasis on Greenberg and O’Neal
makes it tempting to look at the failure of both …rms solely as failures of
their CEOs. But behind both stories are really two important themes
that transcend any individual. The …rst is that 40 years of bailing out
…nancial …rms and short-term creditors led us to the point where some
…nancial …rms are encouraged to get too leveraged, too complex, and
19

For a description of the traditional risk-shifting model used to study bank risktaking, see Prescott (2001). For a simple model of an alternative way in which the
safety net increases risk, and which is along the lines of this review, see the Appendix.

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Federal Reserve Bank of Richmond Economic Quarterly

too big for their own, or anyone else’s, good. The second theme is that
there are plenty of …nancial activities that can develop large exposures
to risk and, when one of these fails, the losses can be so large that they
are catastrophic and bring down the rest of the …rm.
Where the two books excel is that they demonstrate how dangerous
a bad decision can be in a large, leveraged, complex …nancial …rm. A
managerial mistake, either intentional or unintentional, can bring down
a …nancial …rm. If the …rm is small, then such a mistake will likely
cause failure, but the consequences won’t be that severe. Put all of
these activities into one …rm and the same mistake will be less likely to
cause a failure, but if a big enough mistake happens, the consequences
will be a whole lot worse.

APPENDIX
This appendix works through a basic span of control model that formalizes the idea expressed in this review that large …nancial …rms can
get so large that they are riskier than is socially optimal. The model
is a version of Lucas (1978) in which managers of varying talent levels
manage capital.20 The model can be used to characterize industries in
which the size distribution is skewed to the right, that is, there are a
few large …rms and lots of small …rms, which is the pattern in many
industries and increasingly so in …nancial intermediation. The better
a manager is, the more capital he manages. However, we add government bailouts that lower the cost of capital to large banks. As a
consequence, the most talented managers manage a bigger bank than
is socially optimal.
There is a cumulative distribution function, H(t), of individuals
with managerial talent t. An individual may either be a manager or a
worker. A manager rents capital, k, and tries to produce output.21 A
manager is successful with probability f (t; k). If successful, he produces
tg(k), and if he is not successful, he produces zero. We assume that g(k)
is increasing and concave in k and that f (t; k) is linear and decreasing
20
The model is also related to Ennis and Malek (2005), who develop a model of a
large number of ex ante identical banks, each of which chooses its size and risk. Deposit
insurance and too-big-to-fail policies encourage each bank to get ine¢ ciently large and
take on an ine¢ ciently high amount of risk.
21
Capital here is simply the funds invested in the …rm. To keep the model simple,
all the invested funds are treated like debt.

E. S. Prescott: Too Big to Manage? Two Book Reviews

159

in k. The linearity is a strong assumption, but greatly facilitates the
analysis. We also assume that f (t; k)g(k) is increasing and concave in
k for the range of capital relevant for this problem. This assumption
ensures that the banks are in the region of capital where getting bigger
still increases expected revenue.
The rental rate on capital equals its expected return; its risk-free
rental rate is r. If an individual becomes a worker, his income is w.
Both w and r are exogenous. Finally, each individual maximizes his
expected income.
We model too-big-to-fail banks by assuming that if one of these
banks fails, the owners of its capital are repaid their principal and still
receive their interest. For simplicity, we assume that all banks with
managerial talent t
tb are too big to fail, which means they only
have to pay out the risk-free rate, r, when they are successful.22 We
also assume that all people with talent t tb …nd it worthwhile to be
managers; this way there will be banks that are not too big to fail and
others that are. The decision for too-big-to-fail managers is how much
capital to rent. They solve
max f (t; k)(tg(k)
k

rk):

A linear equation times a concave function is concave, so this equation
is concave and the …rst-order condition is necessary and su¢ cient for
characterizing an optimum. It is
f2 (t; k)tg(k) + f (t; k)tg 0 (k) = f2 (t; k)rk + f (t; k)r:

(1)

For a manager who is not too big to fail, that is, t < tb , the interest
rate that he pays is r=f (t; k), which re‡ects the probability that the
owners of the capital might not get it back. His objective function is
max f (t; k)tg(k)
k

rk:

The …rst-order condition is
f2 (t; k)tg(k) + f (t; k)tg 0 (k) = r:

(2)

Let k (t) be the optimal amount of rental capital for a t < tb
individual. A person with this level of talent will be a manager if
f (t; k (t))tg(k (t))

rk (t)

w:

It is straightforward to show that @k@t(t) > 0 and that a manager’s
pro…ts are increasing in t. Therefore, there is a marginal manager, tz ,
22

The more natural alternative is to make the too-big-to-fail cuto¤ depend on the
amount of capital a bank manages, but that complicates the analysis because it creates
a discrete choice for some banks of whether to exceed the too-big-to-fail threshold.

160

Federal Reserve Bank of Richmond Economic Quarterly

who is indi¤erent between being a worker and a manager. People sort
into jobs according to the following rule
t < tz
! workers
tz t < tb ! manages a bank that can fail
t tb
! manages a too-big-to-fail bank:
The distortion in this economy is that capital for too-big-to-fail
banks is subsidized. Not surprisingly, this means that these banks get
ine¢ ciently large. To see this, compare (1) with (2) for a …xed level
of k. The former equation characterizes the amount of capital chosen
by a bank with the too-big-to-fail subsidy, and the second equation
characterizes the capital without the subsidy. The left-hand side of
these two equations are identical and, by assumption, decreasing in k.
Furthermore, comparing the right-hand sides of these two equations,
observe that f2 (t; k)rk + f (t; k)r < r. Consequently, a k that satis…es
(1) is more than a k that satis…es (2).
Too-big-to-fail banks are ine¢ ciently big, and they fail more often
than they would without the subsidy. Interestingly, in the debate about
the quantitative e¤ects of too big to fail, the spread in interest rates
of bonds between the largest banks and small (but still large) banks is
sometimes used to measure the size of the subsidy. In this model, this
spread does not measure the subsidy, since the subsidy is the di¤erence
in the interest rate that would have been paid by the too-big-to-fail
bank if it could fail and the risk-free rate. Furthermore, in the absence
of the subsidy, the too-big-to-fail bank would be smaller, fail less frequently, and be more productive. Measuring the interest spread does
not measure these e¤ects either.
Decisions by managers with tz
t < tb are not a¤ected by the
subsidy. Neither the size of a non-too-big-to-fail bank is a¤ected nor
who is the marginal manager because r and w are exogenous. This
would not be true if r and w were endogenous.23
In this model, one solution to the distortion is a tax on …rm size, or
in a more general model, a tax on the insured liabilities of the too-bigto-fail banks. One proposal discussed in policy circles for getting rid
of too big to fail is to cap bank size. In this model, that would mean
capping the banks to the size corresponding to the largest non-too-bigto-fail bank. This would, of course, eliminate too big to fail, but as this
model makes clear, it would do so at a cost, possibly a substantial one.
In particular, the most productive banks— the ones run by the high
23
In all likelihood, the general equilibrium e¤ects need not be trivial. The subsidized capital moves capital through the banking system, which could lead to overinvestment. This in turn would a¤ect the capital-labor ratio and, thus, r and w.

E. S. Prescott: Too Big to Manage? Two Book Reviews

161

talent managers— would be arti…cially small, thus reducing banking
sector productivity.

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Meltdown: An Empirical Analysis. Cambridge, Mass.: Harvard
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Boyd, Roddy. 2011. Fatal Risk: A Cautionary Tale of AIG’s
Corporate Suicide. Hoboken, N.J.: John Wiley & Sons, Inc.
Congressional Oversight Panel. 2010. “The AIG Rescue, Its Impact
on Markets, and the Government’s Exit Strategy.” June Oversight
Report. Washington, D.C.: U.S. Government Printing O¢ ce
(June 10).
Ennis, Huberto M., and H. S. Malek. 2005. “Bank Risk of Failure and
the Too-Big-to-Fail Policy.” Federal Reserve Bank of Richmond
Economic Quarterly 91 (Spring): 21–44.
Farrell, Greg. 2010. Crash of the Titans: Greed, Hubris, the Fall of
Merrill Lynch, and the Near-Collapse of Bank of America. New
York: Crown Business.
Grind, Kristen. 2012. The Lost Bank: The Story of Washington
Mutual, The Biggest Bank Failure in American History. New
York: Simon & Schuster.
Hetzel, Robert L. 1991. “Too Big to Fail: Origins, Consequences, and
Outlook.” Federal Reserve Bank of Richmond Economic Review
77 (November): 3–15.
Hetzel, Robert L. 2012. The Great Recession: Market Failure or
Policy Failure? New York: Cambridge University Press.
Kuprianov, Anatoli. 1995. “Derivatives Debacles: Case Studies of
Large Losses in Derivatives Markets.” Federal Reserve Bank of
Richmond Economic Quarterly 81 (Fall): 1–39.
Lucas, Robert E., Jr. 1978. “On the Size Distribution of Business
Firms.” Bell Journal of Economics 9 (Autumn): 508–23.

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Marshall, Elizabeth, Sabrina R. Pellerin, and John R. Walter. 2013.
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