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The Taylor Rule: Is It a Useful
Guide to Understanding
Monetary Policy?
Robert L. Hetzel


ore than anyone else in the decade of the 1990s, John Taylor spurred
research into the nature of the monetary policy pursued by the Federal Reserve System. Taylor has advanced a simple and intuitive
reason for why the Fed has done a better job of controlling inflation since the
early 1980s: It has raised the funds rate more aggressively in response to inflation. This article suggests a different perspective. The question should be how
the Fed prevents inflation from arising in the first place, not how vigorously it
responds to observed inflation.



Indisputably, the behavior of inflation improved in the 1980s under the leadership of Paul Volcker as chairman of the FOMC (Federal Open Market Committee) of the Federal Reserve System. John Taylor attributes the improved
behavior of inflation to the Fed’s increased aggressiveness in responding to realized inflation. Specifically, Taylor (1993, 1998, 1999a) argues that the FOMC
sets an interest rate target based on the observed behavior of inflation and the
amount of excess capacity in the economy. According to Taylor, before 1979,
the FOMC raised the funds rate less than one-for-one with increases in inflation.
After 1979, it raised the funds rate more than one-for-one with inflation.
Taylor presented his analysis to encourage discussion of how to move from
discretion to explicit rules in the formulation of policy. His work advanced the
cause of thinking about monetary policy as a systematic strategy by distilling

I received extremely helpful criticism from Michael Dotsey, Andreas Hornstein, Athanasios
Orphanides, and Alexander Wolman. The ideas expressed in this paper are those of the author
and do not necessarily reflect those of the Federal Reserve Bank of Richmond or the Federal
Reserve System.

Federal Reserve Bank of Richmond Economic Quarterly Volume 86/2 Spring 2000



Federal Reserve Bank of Richmond Economic Quarterly

systematic behavior from actual FOMC behavior. That is, he advanced a rule
for monetary policy that was both prescriptive and descriptive. The policymaker
could adopt Taylor’s proposed rule as a systematization of what had worked
in practice rather than as an ideal based solely on an abstract model of the
Taylor deduced his rule from the observed behavior of the FOMC by
emphasizing two aspects of that behavior. First, the FOMC uses a short-term
interest rate as its policy instrument. Second, it sets its interest rate peg (the
funds rate) based on the observed behavior of the economy. In the words of
former FOMC chairman William McChesney Martin, the FOMC follows a
policy of “leaning against the wind.” It raises its interest rate peg when economic activity is “strong” and inflation undesirably “high,” and conversely. In
a broad sense, any characterization of monetary policy will possess the flavor
of a Taylor rule.
For all these reasons, Taylor has stimulated much useful research on monetary policy. Furthermore, more than anyone else, he has conveyed the professional consensus in economics that policymakers should conduct policy
with explicit, quantitative objectives and a clear strategy for achieving those



Taylor (1993) showed that the following formula (now known as the Taylor
rule) with gπ and gx equal to .5 predicts the funds rate reasonably well over
the period 1987 through 1992:
it = 2 + πt + gπ (πt − π ∗ ) + gx xt .


The funds rate is it . The constant term, 2, is the assumed long-run average
of the real rate of interest. The prior four-quarter inflation rate is πt and the
FOMC’s inflation target is π ∗ . The output gap, xt , is the percentage deviation of
real GDP from a trend line measuring potential output. Taylor assumes that the
FOMC’s inflation target has remained unchanged at 2 percent. Taylor (1999)
also contends that over time monetary policy has improved because the FOMC
has responded more vigorously to deviations of inflation from this 2 percent
value by increasing the magnitude of the coefficient gπ on the inflation term
(πt − π ∗ ).
Taylor (1999b) illustrates the last point with the following model:
xt = −ϕ(it − πt − r) + ut


πt = πt−1 + λxt−1 + et


it = g0 + gπ πt + gx xt


R. L. Hetzel: The Taylor Rule


The variables are as defined above, except that πt is current period inflation
and r is the long-run average real rate of interest. The parameters ϕ and λ are
positive. The shocks ut and et are serially uncorrelated with zero mean.
Equation (2) is an IS function, which relates the output gap to the real
rate of interest. Equation (3) is a Phillips curve, which relates inflation to the
output gap. Equation (4) is the reaction function of the central bank, which
takes the form of a Taylor rule. The trend inflation rate depends upon the target
the central bank sets for inflation, which comes from its joint selection of gπ
and g0 in (4).
Taylor attributes the inflation of the 1960s and ’70s to an inadequate response by the Fed to observed inflation. Inflation arose in this period because
of dynamic instability caused by gπ < 1. Specifically, a positive inflation shock
(et > 0) exacerbated inflation by lowering the real rate of interest (it −πt ). Taylor
(1999b, p. 664) writes, “This relationship between the stability of inflation and
the size of the interest rate coefficient in the policy rule is a basic prediction
of monetary models used for policy evaluation research.”



What problems arise in identifying the systematic part of monetary policy,
especially the part that has led to better control of inflation since the early
1980s? To begin, the FOMC does not specify explicit numerical objectives
or an explicit strategy for achieving such objectives. Members of the Federal
Reserve have typically emphasized the discretionary aspects of monetary policy
rather than the systematic aspects. (Gramley [1970] is a prototypical example.)
What the economist sees is only the correlations between economic activity and
the funds rate that emerge out of the policy process. In order to characterize
monetary policy, the economist must infer both the FOMC’s objectives and its
Even if one assumes that a functional form like the Taylor rule successfully
predicts the behavior of the funds rate, what has one learned about the behavior
of the FOMC? Unfortunately, the answer is “nothing” unless one has solved the
identification (simultaneous equations bias) problem. One must determine that
the functional form is a structural rather than a reduced form relationship. The
former is a behavioral relationship that explains how the FOMC alters its policy
instrument in response to the behavior of macroeconomic variables. In contrast,
a reduced form is an amalgam of structural relationships embodying both the
behavior of the FOMC and the public. To estimate a structural relationship,
one needs two kinds of information: knowledge of the proper functional form
to estimate and a model that allows for the separation of the response of the
FOMC to the behavior of the public from the response of the public to the
behavior of the FOMC (see Bernanke and Blinder [1992]).


Federal Reserve Bank of Richmond Economic Quarterly

In practice, this approach is too demanding. As a simpler alternative,
economists attempting to characterize actual FOMC behavior posit a plausible policy rule consistent with the observed correlations between the funds
rate and economic activity. They then posit a model and ascertain whether the
combination of the policy rule and model predicts observed economic activity,
especially inflation. That is, they test the rule and the model jointly by observing
whether the combination offers a useful analytical framework for understanding
monetary policy. As is the case with the more demanding procedure, one must
still use a model.
This way of testing the usefulness of the Taylor rule has to date generated
useful debate. However, it has not settled any fundamental issues. Economists
who use the Taylor rule almost always opt for a particular class of models.
The Taylor rule highlights an output gap and observed inflation. Consequently,
the rule fits naturally with activist models in which the central bank controls
inflation by manipulating an output gap. This article raises questions about
whether a combination of the Taylor rule with such models offers a useful
explanation for the historical behavior of inflation in the United States.
Real Control Models
Economists use the Taylor rule most commonly in models that embody what I
term a “real control” view of inflation. (Below, I also use the term “activist.”)
In such models, the central bank controls inflation through manipulation of the
output gap (the amount of unutilized resources in the economy) in response to
exogenous inflation shocks. Because the Taylor rule highlights the response of
the central bank to the output gap and realized inflation, the rule fits well with
such models. Taylor (1999b) lists papers performing simulations with these
models and the Taylor rule.
Ball (1999), Svensson (1999), and Rudebusch and Svensson (1999) are
examples of “backward-looking” models of the above sort in that the output
gap and inflation depend on their own past values. The model of the economy
shown below in equations (5) and (6), from Clarida, Gali, and Gertler (1999),
is a “forward-looking” example. Equation (5), an aggregate demand or IS relationship, relates the contemporaneous output gap, xt , to the expected future
output gap, the real rate of interest, [it − Et πt+1 ], and a shock gt . Equation (6),
a Phillips curve, relates inflation to expected future inflation, the output gap,
and a shock ut .
xt = −ϕ[it − Et πt+1 ] + Et xt+1 + gt


πt = λxt + βEt πt+1 + ut


The Taylor rule and the real control models referred to above will rise or
fall together. If together they provide a useful description of U.S. experience,

R. L. Hetzel: The Taylor Rule


then a Taylor rule embodying an aggressive response to inflation will work
well for central banks. How satisfactory are these models? They embody two
primary assumptions.
The first assumption is that the price level is a nonmonetary phenomenon.1
Inflation arises from shocks exogenous to the central bank. The central bank
can control inflation if it responds vigorously to these shocks, but it does not
create inflation. The assertion that the above models treat the price level as a
nonmonetary phenomenon requires fuller explanation. The models allow the
central bank to control inflation. They also incorporate a Phillips curve that
does not permit the central bank to affect output through sustained changes
in the level of the inflation rate. In this sense, they exhibit long-run monetary
The statement that the price level is a monetary, as opposed to a nonmonetary, phenomenon is more than an affirmation that the central bank can control
inflation and that in the long run money is neutral. It implies that inflation
possesses a single cause: excess money creation by the central bank. Control
of the price level centers on the central bank’s control over the process of
creating and destroying money rather than on its manipulation of the amount
of unemployed resources in the economy.
Nonmonetary models of inflation treat the price level as an atheoretical
phenomenon. There is no single explanation for inflation, but instead a taxonomy of the different varieties of inflation. The primary classes in this taxonomy
are demand-pull, cost-push, and expectational inflation. Economists who consider inflation a nonmonetary phenomenon use the empirical correlations of
the Phillips curve as a structural relationship in their model simulations. The
Phillips curve gives operational content to demand-pull inflation, which becomes the inflation predicted by the output gap (xt ). Additional inflation (the
error term ut in (6)) is either expectational or cost-push.2
1 The only reference in Clarida, Gali, and Gertler (1999, p. 1685) to money is in the context
of whether money is a suitable intermediate target, that is, whether the public’s demand for money
is stable and interest inelastic. Over the postwar period until 1981, M1 demand was stable and
interest inelastic. The authors refer to the introduction of NOW accounts nationwide in 1981 that
changed the character of M1 demand. In their words, “the aggregates went haywire.” However,
they ignore the more fundamental issue of whether inflation is a monetary phenomenon.
The Clarida et al. (1999) paper places monetary policy in an optimal control framework.
Based on knowledge of the structure of the economy, the central bank sets an interest rate target to
offset exogenous shocks. As long as the central bank sets the interest rate target optimally, money
creation and destruction (the central bank itself) is not a source of disturbances. The applicability
of the model then is limited to periods when the central bank pursued an optimal monetary policy.
For historical investigation of monetary policy, its use would appear to be limited.
2 Clarida, Gali, and Gertler (1999, p. 1667) state that the output gap measures “movements
in marginal costs associated with variation in excess demand. The shock ut+i , which we refer [to]
as ‘cost push,’ captures anything else that might affect expected marginal costs. We allow for the
cost push shock to enable the model to generate variation in inflation that arises independently
of movement in excess demand, as appears present in the data.”


Federal Reserve Bank of Richmond Economic Quarterly

The second assumption is that the central bank can systematically control
the real rate of interest in a way that allows it to manipulate fluctuations in excess capacity. That is, the central bank can follow a systematic monetary policy
that moves actual output relative to potential output in a predictable way. With
the Taylor rule, the central bank responds directly to realized inflation, as one
would expect when cost-push shocks drive inflation. The central bank controls
inflation by systematically varying the output gap. The key parameter is the
sacrifice ratio, the inverse of λ, in the Phillips curve. Rudebusch and Svensson
(1999, p. 209) note that both their small model and the Board’s larger MPS
model possess a sacrifice ratio somewhat above 3. Specifically, a decline in the
inflation rate of 1 percentage point requires the output gap to be negative by 1
percentage point for 3.3 years.
In these models, the structural character of the relationship between inflation and excess capacity offers the policymaker a trade-off between the
variability of inflation and output. The policymaker can reduce the variability
of output by increasing the variability of inflation. In this sense, real control
models are activist.3
Assessing Real Control Models
Again, most economists who use the Taylor rule to explain U.S. monetary
policy use real control models that embody two assumptions. First, inflation is
a nonmonetary phenomenon. Second, the central bank can pursue a monetary
policy that allows it to manipulate real variables (the real rate of interest and
excess capacity) in a systematic fashion. Both assumptions are controversial.
Because policymakers like to see themselves as fighting inflation rather
than creating it, they generally find congenial the first assumption. However,
a brief overview of the U.S. historical experience suggests that this view of
inflation has served policymakers poorly.4
William McChesney Martin was FOMC chairman from 1951 through early
1970. He was fiercely antagonistic to inflation and maintained near-price stability until the end of 1965. At that time inflation began to rise and remained
high through 1971. Martin and other policymakers blamed the inflation on the
rise in the government deficit produced by the Vietnam War and Great Society
programs. In terms of equations (5) and (6) above, they attributed inflation to
an aggregate demand shock (gt > 0).
3 Some economists define an activist policy as a rule for which the central bank alters its
interest rate peg in response to variations in real economic activity. However, this definition is
too general to be useful. An interest rate instrument inevitably requires the central bank to take
account of the way fluctuations in real economic activity affect the real rate of interest. The term
“activist” most usefully refers to models in which the policymaker can supersede the working of
the price system to diminish the variability of real output.
4 Goodfriend and King (1997), Goodfriend (1997), Hetzel (1998), and Hafer and Wheelock
(2000) describe the pre-1980 views held by policymakers.

R. L. Hetzel: The Taylor Rule


If the price level is a nonmonetary phenomenon, monetary policy is only
one policy instrument available for dealing with demand-pull (aggregatedemand) inflation. Fiscal policy is another. Chairman Martin helped convince
Congress to pass an income tax surcharge in June 1968 that turned a deficit
equal to 3 percent of GNP into a small surplus. Policymakers chose a restrictive
fiscal policy over a restrictive monetary policy to limit the rise in interest rates.
However, despite widespread predictions to the contrary, neither the economy
nor inflation slowed. Continued high money growth trumped restrictive fiscal
Arthur Burns was FOMC chairman from early 1970 until early 1978.
Like Martin, he had a visceral dislike for inflation. Prior to becoming FOMC
chairman, Burns (1957) had viewed inflation primarily as an expectational
phenomenon made possible by the economic security offered to individuals by
the welfare state. Upon becoming chairman, he came to see inflation as driven
by cost-push pressures emanating from demands by labor for wage increases
(ut > 0 in (6)).
On August 15, 1971, President Nixon announced the price and wage controls desired by Chairman Burns (Hetzel 1998). The controls did in fact restrain
the rise in labor costs. Nonetheless, inflation surged in early 1973. This time
Burns blamed the inflation on special factors, especially bad agricultural harvests and oil price increases. When those relative price increases ceased, however, inflation still continued. Burns (1979) ended his term as FOMC chairman
by returning to his original belief that inflation was primarily an expectational
phenomenon (in (6), Et πt+1 > 0 arises independently of monetary policy).
That view dominated policymakers’ views until Paul Volcker became FOMC
chairman in August 1979.
From the perspective of inflation as a monetary phenomenon, only the
central bank can control inflation. If the central bank uses an interest rate as
its policy instrument, it must achieve two tasks to ensure the monetary control
necessary to control inflation. First, the central bank must stabilize expected
inflation at a level equal to its inflation target. Otherwise, movements in its
nominal interest rate target translate only unreliably into movements in the real
rate. Second, the central bank must move its interest rate target responsively to
changes in real output growth to track the economy’s equilibrium real interest
rate. In that way, the central bank sets its interest rate target to avoid monetary
emissions and absorptions that force undesired changes in the price level.5
5 Such a policy approximates a rule for steady, moderate growth in money if the demand
by the public for real money balances is stable and relatively interest inelastic. Regardless of
whether such a condition holds, from this quantity theory perspective, the control of inflation
by the central bank is more aptly characterized in terms of monetary control than in terms of
control of the extent of the economy’s unemployed resources. The central bank controls inflation
by tracking (not controlling) the equilibrium real rate of interest, thereby avoiding undesired
monetary emissions and absorptions that require changes in the price level.


Federal Reserve Bank of Richmond Economic Quarterly

In contrast, from the perspective of inflation as a nonmonetary phenomenon, monetary policy is not necessarily the socially optimal instrument for
controlling inflation. For the control of demand-pull inflation, fiscal policy
can work without the side effects produced by high interest rates on interestsensitive sectors of the economy, like housing. With cost-push or expectational
inflation, monetary policy is not the socially optimal instrument. The socially
optimal way to deal with such inflation is for the government to intervene
directly in the individual markets that are causing the inflation rather than to
raise the unemployment rate.
Both monetary and nonmonetary views of inflation allow for central bank
control of inflation. If the central bank accepts sole responsibility for the control of inflation, empirical observation will not allow economists to distinguish
whether inflation is a monetary or nonmonetary phenomenon. However, the
change in the political and intellectual environment in the early 1960s produced an experiment capable of discriminating between these two views. Their
differing policy implications become important when society sees the control
of inflation as costly, that is, when society sees λ of (6) as low. That happened
in the ’60s.
President Eisenhower had made the control of inflation a top priority of his
administration. Moreover, he was philosophically opposed to direct intervention by government in private decisionmaking. (See Saulnier [1991], especially
Chapter III.) As a result, he had to rely on the indirect control of inflation
through monetary policy.
The change of presidential administration in 1961 and the altered social environment of the ’60s made direct intervention by government in the economy
to control inflation politically attractive. At the same time, the appearance of
the Solow-Samuelson (1960) Phillips curve promised a guide for distinguishing demand-pull from cost-push inflation. When the output gap was negative
and, consequently, demand-pull inflation was in check, the central bank could
pursue an expansionary monetary policy. Inflation beyond that predicted by
excess capacity was of the cost-push or expectational variety. Government
should deal with it through direct intervention. In fact, in the ’60s and ’70s,
to deal with perceived cost-push inflation, the government made regular use of
the moral suasion of public announcements, wage and price guideposts, direct
intervention in wage and price decisions, and actual controls.
The attempt to discriminate between demand-pull and cost-push or expectational inflation and to design policies of inflation control accordingly failed.
After 1979, the Federal Reserve assumed sole responsibility for inflation. A
simple interpretation of this failed experiment is that inflation is a monetary
phenomenon. The central bank alone determines and controls inflation.
The assumption that inflation is a monetary phenomenon also provides an
explanation of the temporal relationship between money growth and inflation.
Friedman (1989, p. 31) estimated that two years typically elapse between a

R. L. Hetzel: The Taylor Rule


monetary acceleration and the ensuing initial rise in inflation. The issue is not,
as Taylor phrased it, whether the Fed responded vigorously enough to realized
inflation, but why the Fed created the inflation in the first place.6
Furthermore, direct evidence for cost-push shocks is weak. By a cost-push
shock, economists mean a change in a relative price that affects the absolute
price level. Economists frequently cite as examples increases in the price of
oil, real wages, and commodity prices, especially of food. However, unless the
central bank makes money creation depend upon relative prices, there is no
theoretical basis for such an explanation of inflation. If a central bank were
to follow such a policy for money creation, the problem would be with its
procedures for monetary control rather than its weak response to inflation when
it did appear.7
Although some economists cite the two oil price shocks of the ’70s as costpush shocks, the evidence that these events caused the inflation of the period
is problematic. For the United States, monetary policy had been expansionary
well before the oil price shocks. The fact that inflation already had risen significantly before the shocks implies that monetary policy created the inflation
(Hutchison 1991). Hetzel (1998) disentangles the effect of an expansionary
monetary policy and the oil price increases on inflation by looking at Japan,
which did not pursue an expansionary monetary policy before the second oil
price shock. Although Japan imported all of its energy, it did not experience
significant inflation after the second oil price rise.
Also, direct evidence for expectational inflation is lacking. Clarida, Gali,
and Gertler (2000) argue that a low response coefficient on the inflation term in
the Taylor rule can explain the high, variable inflation of the pre-1980 period.
Specifically, a response coefficient of less than one will “lead to indeterminacy
of the equilibrium and raise the possibility of fluctuations in output and inflation around their steady state values that result from self-fulfilling revisions in
expectations” (Clarida, Gali, and Gertler 2000, Sec. IV B). Chari and Christiano
(1998) also argue that the pre-1980 inflation was expectational. In their words,
the economy fell into “expectation traps.”
According to this latter view, the Fed ratified the high rate of inflation
expected by the public to avoid depressing economic activity. However, an
6 Keynes (1923, p. 148) in A Tract on Monetary Reform cites Hawtrey (Monetary Reconstruction) approvingly: “If we wait until a price movement is actually afoot before applying
remedial measures, we may be too late. ‘It is not the past rise in prices but the future rise that
has to be counteracted.’ ” (italics in original)
7 Ball and Mankiw (1995, p. 161) argue that “[A]ggregate inflation depends upon the distribution of relative-price changes.” They dismiss Milton Friedman’s criticism of relative-price
(cost-push) theories of inflation with the contention that the latter’s “analysis implicitly assumes
that nominal prices are perfectly flexible” (p. 162). The argument is a red herring. Certainly, the
relative price changes produced by events particular to individual markets can show through to
the price level. However, if the central bank does not accommodate such changes in the price
level with money creation, in time they must disappear.


Federal Reserve Bank of Richmond Economic Quarterly

explanation that makes the public’s expectations the driving force behind inflation conflicts with a wide variety of evidence that the public was slow to
raise its expectations in response to higher inflation. Survey data on expected
inflation show that expectations lagged actual inflation throughout the ’70s.
(See the discussion below in Section 4a.)
The second assumption of real control models is that the central bank exercises predictable control over real variables. Because the central bank controls
only a nominal variable (monetary base creation), it must be able to exploit
the nominal-real correlations of the Phillips curve to control real variables
in a systematic fashion. Friedman (1968) and Phelps (1970) challenged this
assumption in their formulation of the natural rate hypothesis, where they
assumed that the correlations between excess capacity (the unemployment rate)
and inflation summarized in Phillips curves arise from unanticipated monetary
shocks. Lucas (1973) and Sargent and Wallace (1975) in their natural raterational expectations extension of the natural rate hypothesis argued the policy
ineffectiveness proposition. According to this proposition, the predictable part
of any monetary policy rule would not affect real variables. Consistently implemented, a Taylor rule would disappoint in its ability to control the variability
of real output.8
Can the FOMC Make the Concept of an Output Gap Operational?
An additional assumption of the Taylor rule and the activist models that give
the rule content is that the concept of an output gap is operational. That is, the
central bank possesses a reliable estimate of the amount of unutilized resources
in the economy. However, that assumption is problematic. There are references
to the output gap in FOMC discussions before 1980. Much later, during the
Clinton administration, many policymakers referred to the concept. The members of the Council of Economic Advisors and the Clinton appointees to the
Board of Governors used the Taylor rule as a cross-check and relied on the idea
of an output gap. However, based on my knowledge of the historical record, I
believe that the FOMC from late 1979 through 1992 did not take actions based
on an estimate of the output gap.
8 Rudebusch

and Svensson (1999, p. 208) argue that the empirical correlations of the Phillips
curve represent a structural relationship that the central bank can exploit systematically (the Lucas
critique does not apply) because of their stability over time.
The Samuelson-Solow (1960) Phillips curve used in models in the ’60s and ’70s related
inflation to excess capacity. Its inverse correlations disappeared with the sustained high inflation
of the ’70s. The correlations that remained were between changes in inflation and excess capacity
(or the difference between the unemployment rate and the NAIRU: the nonaccelerating inflation
rate of unemployment).
Lucas (1973) and Friedman (1976, Chapter 12, “Wage Determination and Unemployment”)
employed the logic of the rational expectations-natural rate hypothesis to argue that these latter
correlations would also disappear if the Fed ever pursued a policy of lowering excess capacity
(unemployment) by regularly raising the rate of inflation.

R. L. Hetzel: The Taylor Rule


Because economists disagree on a theoretical construct for the output gap,
there is no accepted guide for making the concept operational. In practice,
economists have estimated the output gap as the percentage difference between
contemporaneous output and a trend line fitted to past output. Unfortunately,
due to data revisions, the estimate for contemporaneous output changes, often
considerably, as time passes. Furthermore, not until many years have passed
are economists likely to agree on how to fit a trend line measuring potential
output. Together, these factors create enormous uncertainty about the true value
of the output gap.
Croushore and Stark (1999), Orphanides (1998-03, 1999), and Runkle
(1998) point out the resulting problems for making a Taylor rule operational.
Orphanides and van Norden (1999, p. 24) concluded:
[T]he reliability of output gap estimates in real time tends to be quite low.
Different methods give widely different estimates of the output gap in real
time and often do not even agree on the sign of the gap. The standard error
of the revisions is of the same order of magnitude as the standard error of the
output gap.

Kozicki (1999) calculated the funds rate targets implied by Taylor rules
using alternative plausible real-time measures of the output gap and inflation.
She found the range of implied values for the funds rate target to be extremely
wide. Kozicki (1999, p. 25) concluded, “Taylor-type rules are likely to be of
limited use to policymakers facing real-time decisions.” Orphanides (1998-03,
p.3) found that one-quarter-ahead forecasts of the funds rate based naively on
a continuation of the existing funds rate were more accurate than the forecasts
from a Taylor rule implemented with contemporaneously available data.
It is instructive to look at the reliability of estimates of the output gap over
the period when an activist policy focused attention on that variable. Over the
period 1966Q1 to 1979Q4, real-time estimates of the output gap (measured by
the Council of Economic Advisers) averaged −4.5 percent. However, using
the data available as of 1994Q4 yields an estimate of the output gap over this
period of 1.6 percent.9 That is, the average difference in the contemporaneous
estimates of the output gap and the estimate made later is 6.1 percentage points.
One can interpret monetary policy under Chairman Volcker as the abandonment of a policy rule incorporating the spirit of the Taylor rule. In the earlier
period, the FOMC formulated monetary policy based on control of the output
gap and on a direct response to inflation. That policy earned the appellation
“stop-go,” although “go-stop” would have been more apt. In the go phase,
monetary policymakers attempted to eliminate a perceived negative output gap
with expansionary monetary policy. In the stop phase, they had to create a
negative output gap to eliminate the inflation they had created in the go phase.
9 Athanasios

Orphanides kindly supplied these figures.


Federal Reserve Bank of Richmond Economic Quarterly

Activist stabilization policy promised to mitigate cyclical fluctuations by
controlling the variability of the output gap. Furthermore, based on empirical
estimates of the Phillips curve, such policy promised that the resulting output
gaps would yield only modest inflation. In its actual implementation, however,
activist policy foundered on the difficulty of making the concept of an output
gap operational and on the long lags in the effects of actions undertaken to
control the perceived level of idle resources. As Milton Friedman (1960, p. 88)
argued, responding directly to realized inflation destabilized the economy.
Under Chairman Volcker, the FOMC stopped trying to identify the amount
of unemployed resources in the economy. Instead of trying to maintain output
at an estimated potential level (or maintain the unemployment rate at its fullemployment level), the FOMC began to move the funds rate whenever real
output appeared to grow faster than its sustainable rate (Mehra 2000b). That is,
the FOMC retained a sense of the slope of the trend line measuring potential
output, but stopped trying to estimate its level.
Orphanides’ Critique of the Taylor Rule
Athanasios Orphanides (1999, p. 41) has attacked the Taylor rule for its unrealistic demand that policymakers possess reliable information on the output gap:
The recent resurrection of interest in policy activism through rules that rely
on accurate knowledge of the economy’s ‘full employment potential’ must be
recognized for the danger it embodies. Much like during the 1970s, insufficient
attention appears to have been paid to the informational limitations inherent
in such activist policies.

Orphanides simulates a model that would permit an activist monetary policy
if the policymaker had reliable information on potential output. In particular,
the model is in the spirit of the activist model of Rudebusch and Svensson
(1999). In such a model, the policymaker can take advantage of the backwardlooking expectations of the public to vary systematically the real rate of interest.
Changes in the real rate of interest affect the output gap with a lag. In turn,
changes in the output gap affect inflation with a lag. Using this model and
characterizing monetary policy with a Taylor rule, Orphanides explains the
inflation of the ’60s and ’70s as resulting from overly pessimistic contemporaneous estimates of the output gap. Because Orphanides accepts the empirical
correlations of Phillips curves as structural, his criticism of activist stabilization
policy stops short of the more sweeping criticisms contained in the natural raterational expectations critique summarized above.
Economists who accept Orphanides’ demonstration that real-time estimates
of the output gap are unreliable but favor Taylor rules conclude that the central bank should respond primarily to observed misses of inflation from target
(Orphanides et al. 1999). However, if the central bank is credible, unintentional
expansionary monetary policy actions would appear initially as increases in

R. L. Hetzel: The Taylor Rule


output and only belatedly as increases in inflation. The long lag in the impact
of expansionary monetary policy on inflation would then cause this monetary
policy to destabilize the economy.
Monetary policy has been a success since the early 1980s. There is then
much at stake in the debate over how to characterize it. If one can characterize it
with a Taylor rule embedded in an activist model, then monetary policy should
be used actively to stabilize the economy. The Fed could have avoided the
inflation of the ’70s while still pursuing an activist policy if it had adjusted the
parameters of its rule and implemented it more cautiously. The alternative is that
the inflation of the ’70s derived from a fundamental misunderstanding of the
nature of inflation and the inevitable failure of activist policy. The improvement
in monetary policy came from the abandonment of activist monetary policy.



John Taylor laid out a normative research agenda: the formulation of a monetary
policy rule that will stabilize the economy. This section criticizes the Taylor rule
literature that has attempted to derive an optimal rule from empirical estimation.
Choosing the Estimation Period
To begin, because the FOMC uses an interest rate as its instrument, an optimal
rule describes how the interest rate responds in a way that offsets the effects of
real shocks that push output away from its potential value. An optimal rule then
characterizes the optimal behavior of the price system. Empirical estimation of
such a rule requires estimation over a period when the central bank responded
optimally to real shocks and did not itself create nominal demand shocks.
In this spirit, Taylor compares policy rules estimated over periods of relative
instability and stability of inflation.
This procedure raises difficult issues, however. Economists use 1980 as
a dividing line between policies that failed to stabilize inflation and policies
that stabilized inflation. They then typically use that year as a dividing line
for estimating “bad” and “good” reaction functions. Even so, the Fed gained
credibility much later than 1980. A rule implemented over a period like the
’80s when the Fed did not possess credibility will not necessarily constitute
an optimal rule. Such a rule may differ from the optimal rule implemented
when the Fed possesses credibility. From this perspective, 1980 is not a good
dividing line.
To see this point, note the undesirability of estimating an optimal rule over
a period when the central bank had to suppress inflation. From a quantity theory
perspective, the central bank created the inflation, not the private sector. That is,
one should look for an optimal rule over a period when the central bank did not


Federal Reserve Bank of Richmond Economic Quarterly

have to correct its own past mistakes.10 Similarly, one should not estimate over
a period when the central bank had to “correct” the expectational behavior of
the public. It is true that the FOMC largely stabilized the inflation rate starting
in 1983; however, it only gradually gained credibility for an objective of price
stability. As Goodfriend (1993) documents, because the Fed lacked credibility,
it had to respond to “inflation scares.”
Interpreting the Estimated Coefficient on Inflation
The key result that emerged in the empirical estimation of Taylor rules is the
rise over time in the coefficient estimating the Fed’s reaction to inflation. Taylor attributes the improved control of inflation to this rise. However, such an
inference is questionable. If the central bank is credible and stabilizes inflation,
then the correlation between realized inflation and expected future inflation will
be zero. Fluctuations in inflation will occur randomly around the central bank’s
target, but those fluctuations will not alter the public’s expectation of future
inflation. The latter is the relevant variable for the behavior of interest rates.
Consider again Taylor’s (1999b) model expressed in equations (2), (3), and
(4). A more realistic model will determine the real rate of interest as the difference between the interest rate and expected inflation, not realized inflation, πt .
Assume a positive inflation shock, et > 0. If, as Taylor assumes, such shocks
are serially uncorrelated, expected future inflation will remain unchanged and
so will the equilibrium rate of interest. The transitory rise in inflation will
redistribute income between parties who had entered into nominal contracts,
but that is water under the bridge. The market and the central bank should not
respond to realized inflation. The policy parameter gπ should be zero.
How then can one explain the increase over time in Taylor-rule regressions of the estimated value of gπ , the parameter that is supposed to capture
the response of the central bank to inflation? Does the rise over time in the
coefficient estimated on the inflation term reflect an independent change in
the FOMC’s behavior deriving from a more aggressive response to inflation?
Alternatively, does the rise reflect a response of the FOMC to a change in
the public’s behavior that derives from a loss of Fed credibility? A historical
review will clarify the issues.
The monetary history of the United States is one of moving from a commodity standard to that of pure fiat money. One would then expect that over
time, as the public adapted to the change in regime, the value of the correlation between the interest rate and inflation would rise. Imagine a commodity
10 Taylor (1993) originally estimated his rule over the period 1987 to 1992. However, during
that period FOMC actions produced a reduction in inflation. The FOMC had brought the inflation
rate down to 4 percent in 1983. Faced with the strains of a worldwide banking crisis and recession,
it stabilized inflation at that level. By the end of the decade, the FOMC moved to a soft-landing
strategy to continue the process of restoring price stability.

R. L. Hetzel: The Taylor Rule


standard in which the price level is stationary. In this case, a positive inflation
rate will imply a subsequent negative inflation rate. The correlation between
inflation and the interest rate will be negative.
In contrast, imagine a fiat money standard where changes in the inflation
rate are a random walk. Now, the contemporaneous inflation rate is the best
predictor of future inflation. The inflation premium in the interest rate will be
equal to observed inflation. The emergence of a positive correlation between
inflation and the interest rate will reflect the change in the way the public
forecasts inflation based on past inflation. The increase in the correlation over
time reflects a loss of credibility, not a more aggressive policy of controlling
Until the mid-1960s, the public could retain the way it had formed its
expectation of future inflation under a commodity standard. Until then, a pure
fiat money regime with no institutional constraints on the level of inflation was
still a historical novelty (Friedman 1986). At this time, the Fed’s rejection of
the constraints imposed by the Bretton Woods system and its attempt to make
the economy grow along an unrealistically high path for potential output caused
the inflation rate to begin to wander.11
As McCallum (1994, Figure 1) shows, over the period from mid-1955 to
1980, inflation went from being a low-order autoregressive process to being
nearly a random walk. The public did adapt to this change in the behavior of
inflation. Friedman and Schwartz (1970, p. 631) found that interest rates began
to incorporate a Fisher effect (inflation premium) starting in the mid-1960s.
However, the public learned only slowly.
The fact that bondholders continued to suffer losses throughout the 1970s
is evidence that learning proceeded slowly. Until the beginning of the 1980s,
inflation regularly exceeded the forecasts of inflation made by the public and
by economists (see Darin and Hetzel [1994], Sec. 4 and Croushore and Stark
[1996]). One reason the public adapted slowly to the change in the monetary
regime was the association of the large increases in inflation in the ’60s and
’70s with the unusual events of the Vietnam War and oil price shocks. By 1979,
however, the public came to see inflation as a nonstationary process. Indeed,
the resulting turmoil that belief caused for bond markets provided one impetus
to the change in Fed procedures in 1979 (Hetzel 1986). Paul Volcker and later
Alan Greenspan made Fed credibility into the nominal anchor lost in going off
the gold standard.

11 The

last time the FOMC raised the level of short-term interest rates to offset a balance of
payments deficit and gold outflows was in November 1964.


Federal Reserve Bank of Richmond Economic Quarterly

Estimation Bias
Consider a specific example of how the change over time in the way the public
has forecast inflation can raise empirical estimates of the response of the funds
rate to inflation. Clarida, Gali, and Gertler (2000) estimate a forward-looking
Taylor rule:
i∗ = a + gπ (E[πt+1 | Ωt ] − π ∗ ) + gx E[xt+1 | Ωt ]


it = (1 − ρ)i∗ + ρit−1 + νt


The variable i∗ is an implied funds rate target. According to (7), the FOMC
determines i∗ as the sum of a constant term a and responses to the miss of
forecast inflation from its targeted value and to a forecast of the output gap.
The FOMC forms these forecasts based on available information Ωt . E is the
expectations operator. According to (8), the FOMC smoothes the actual funds
rate, it , by setting it equal to a weighted average of the implied target and last
period’s actual target. (νt is a random policy shock.)
Clarida, Gali, and Gertler (2000) estimate (7) and (8) through an instrumental variables procedure. Specifically, they use as a proxy for E[πt+1 | Ωt ]
predicted values derived from a regression of future quarterly inflation, πt+1 ,
on four quarterly lags of past inflation as well as other lagged variables. (The
time subscript one on inflation indicates one year or four quarters in the future.)
Empirical estimation shows a rise in the value of gπ over time. However, this
result may derive from a change in the way the public formed its expectation
of inflation in response to a change in the monetary regime.
The central bank cannot set its interest rate target in a way that ignores
the public’s expectation of inflation. Therefore, the dependent variable of (7),
the interest rate target, will on average contain an inflation premium that reflects the public’s true measure of expected inflation. A problem arises if the
right-hand variable used to proxy for the central bank’s forecast of inflation,
E[πt+1 | Ωt ], is a biased measure of the public’s expected inflation. If that case,
the coefficient estimated for gπ will also be biased.12
Consider first use of observed inflation as a proxy for E[πt+1 | Ωt ]. In a
world of incomplete credibility, the public will form its measure of expected
inflation based in part on the observed value of inflation, not exclusively on
12 Presumably, the central bank varies its policy instrument so that at some appropriate
future horizon its inflation forecast always equals π ∗ . That is, the term (E[πt+1 | Ωt ] − π ∗ ) in
(7) will always equal zero. What one wants is the central bank’s inflation forecast conditional
on no change in its instrument. In the absence of such forecasts, one must use some proxy. The
proxy that economists use typically depends upon the observed behavior of inflation. The problem
comes because the public’s expectation of inflation was not completely determined by π ∗ . Then
the proxy used for expected inflation will be related to the inflation premium the public puts into
the interest rate, which affects the behavior of it and i∗ . However, that relationship can change
over time in a way that biases empirical estimates of gπ .

R. L. Hetzel: The Taylor Rule


the central bank’s objective π ∗ . As explained above, in the pre-1980 period,
the public’s expectation of future inflation rose with observed inflation, but less
than one for one. In the post-1980 period, it rose one for one. In a regression
of (7) and (8), that fact will bias downward the coefficient estimated for gπ in
the earlier period.13
Consider next a two-stage estimation procedure that uses as an instrument
for expected inflation the forecasted value from a regression of inflation on its
own past values. Again, as explained above, the sum of the weights in such a
regression rose over time and approached one in 1980 with the change in the
character of the monetary regime. This rise in the sum of estimated coefficients
captures the change in the inflation rate from a stationary to a nonstationary
series. However, the public only gradually accepted this change as the normal
state of affairs. Consequently, the problem identified above arose. In the pre1980 period, the public’s expectation of inflation and the interest rate rose in
line with rises in this proxy for E[πt+1 | Ωt ], but less than one for one. That
fact biases downward the coefficient estimated for gπ . However, by the 1980s,
that bias disappears.14
A different kind of estimation bias arises because of the difficulty in finding
instruments that are orthogonal to the shocks in a Taylor rule regression. Clarida, Gali, and Gertler (2000) conduct their estimation subject to the following
orthogonality condition, which comes from combining (7) and (8) and some
algebra involving adding and subtracting actual inflation in period t + k, πt,k ,
and the actual output gap in period t + q, xt,q :
E{[it − (1 − ρ)a − (1 − ρ)gπ πt,k − (1 − ρ)gx xt,q − ρit−1 ]zt } = 0.


The term in brackets measures the difference between the actual interest rate
target and an estimate of it from (7) and (8). The authors assume that this term
is orthogonal to the instruments, which include lagged inflation and the lagged
output gap.
Evaluating the plausibility of this last assumption requires some knowledge
of monetary history. After 1980, periodic “inflation scares” caused the FOMC
to raise sharply its interest rate peg (see Hetzel [1986], Goodfriend [1993], and
13 The problem is analogous to the one identified by Sargent (1971) in tests of the natural
rate hypothesis using regressions with lagged inflation rates as a proxy for expected inflation.
(See also Woodford 1999, p. 43.)
14 My reading of the pre-1980 historical record is that the FOMC did increase its funds rate
target in line with increases in the inflation rate that it and the public expected. The problem was
that both the FOMC and the public underpredicted inflation because of the novelty of an activist
monetary regime. Both the FOMC and the public knew when monetary policy was expansionary.
However, they underestimated the inflationary consequences. The FOMC believed that an expansionary policy would primarily affect output growth rather than inflation when the output gap was
negative. Because most policymakers believed inflation was a nonmonetary phenomenon, they
ignored the warning signs coming from high rates of money growth.


Federal Reserve Bank of Richmond Economic Quarterly

Mehra [1999, 2000a]). It follows that the policy rule (7) omits a variable—the
FOMC’s assessment of its credibility. Specifically, when the rate of growth
of real output rose, financial markets became concerned that inflation would
revive. Bond rates rose and the FOMC raised the funds rate to demonstrate its
determination to prevent a rise in inflation. To capture this effect, (10) adds
a credibility variable, INFSCt , to (7). That variable is correlated with output
growth and the output gap, xt :
i∗ = a + gπ (E[πt+1 | Ωt ] − π ∗ ) + gx E[xt+1 | Ωt ] + INFSCt .


The aggressive response of the FOMC in raising the funds rate during
an inflation scare would generate a positive error in a regression using (7),
but not (10). Persistence of the initial shock causing the high output growth
would then produce a correlation between the contemporaneous error and the
instrumental variables zt , which include lagged real output. This correlation
biases the estimation results. In sum, an instrumental variables procedure does
not solve the omitted variables problem.
Are the Long-run Real Rate and Inflation Target Constant?
Problems arise in the estimation of a Taylor rule if the long-run real rate of
interest is not constant. The Taylor rule attributes the historically high value
of the real funds rate starting in 1980 to the excess of inflation over a 2 percent inflation target. (From 1980 through 1990, the real commercial paper rate
shown in Figure 2 is 4.7 percent, well above the assumed 2 percent long-run
average.15 ) That is, the FOMC supposedly kept the real funds rate higher than
its long-run average because inflation was above target. However, the 2 percent
figure for the FOMC’s inflation target does not derive from internal FOMC
documents. It could simply be an ad hoc way of getting a higher prediction
for the funds rate by artificially creating a positive miss of an inflation target.
A low inflation target compensates for an unrealistically low estimate of the
long-run average real rate of interest.
In addition, the assumption that the FOMC’s objective for inflation remained unchanged during the period from 1965 through 1981 when inflation
rose is implausible. In the pre-1980 period, the FOMC tried to determine
whether inflation was demand-pull, cost-push, or expectational in origin. It
tended to accommodate changes in inflation perceived as cost-push or expectational rather than demand-pull. The inflation rate acceptable to the FOMC then
rose as actual inflation rose.
15 The

Appendix explains the measure of the real rate of interest. It is the difference between
the interest rate on commercial paper observed at the time of FOMC meetings and the inflation
forecast made at the same time by the staff of the Board of Governors. (This series is available
only through 1994 because of the five-year lag in the release of Board staff inflation forecasts.)

R. L. Hetzel: The Taylor Rule




Regression equation (11) embodies the Taylor rule. Equation (12) collects the
actual inflation terms πt , and (13) rewrites (12) with k1 + k2 = 1. Equation (14)
combines the constant term and the inflation target term under the assumption
that the inflation target and the weight the central bank assigns to it do not
change (k4 = k0 + k2 πt∗ ).
i∗ = c0 + πt + c1 (πt − πt∗ ) + c2 xt + µt


i∗ = c0 + (1 + c1 )πt − c1 πt∗ + c2 xt + µt


i∗ = k0 + k1 πt + k2 πt∗ + k3 xt + µt


i∗ = k4 + k1 πt + k3 xt + µt


The wide popularity of the Taylor rule derives from its presumed ability to
predict the actual behavior of the funds rate. This section extends the work of
Croushore and Stark (1999), Kozicki (1999), Orphanides (1998-03), and Runkle
(1998) by examining how well a Taylor rule predicts the funds rate using data
available to the FOMC at the time of its meetings. (The Empirical Appendix
explains the data.) Figure 1 shows the value of the funds rate benchmark that
came out of FOMC meetings and the value predicted by regression equations
possessing the functional form (14).16 The regressions used to generate the
predictions shown in Figure 1 are estimated separately for the periods November 1965 through July 1979, August 1979 through July 1987, and August 1987
through May 1999. The last two periods correspond, respectively, to the tenures
of Paul Volcker and Alan Greenspan as FOMC chairman.17
The fit shown in Figure 1 is not particularly close. For the period November 1965 through July 1979, the standard error of estimate of the appendix
16 See the discussion in Section A of the Empirical Appendix for an explanation of the
construction of the series label “funds rate benchmark.”
17 I do not compare the funds rate with predictions from a Taylor rule assumed to be different
from what the FOMC actually used. Taylor (1999, section 7.4) performs this exercise as a test of
the superiority of a hypothetical Taylor rule. However, predictions derived from inserting historical
data into a hypothetical rule make no sense. If the hypothetical rule had been implemented, it
would have produced different macroeconomic outcomes, and one should use those outcomes to
test the rule. That exercise requires a model. (See McCallum [1987, 1988] for an example.)
The logic of the Taylor (1999a) experiment appears to be as follows. One can look at a period when inflation was undesirably high. Then, one FOMC meeting at a time, one can construct
the funds rate implied by the hypothetical rule and historical data. If the implied funds rate is
uniformly higher than the actual, one can argue that the hypothetical rule would have produced
a more restrictive monetary policy and, therefore, would have been better. However, a similar
exercise would be to take the following as a rule: Keep the funds rate 5 percentage points above
its historically observed maximum value. That hypothetical rule would also be unambiguously
more restrictive. But one has no way of knowing whether it would have been better than actual
policy without model simulations.


Federal Reserve Bank of Richmond Economic Quarterly

regression (1) predicting the funds rate is 1.6. For the period August 1979
through July 1987, the value is 2.1 (appendix regression (2)). For August 1987
through May 1999, it is .76 (appendix regression (3)).
Judd and Rudebusch (1998) estimate the Taylor rule with a lagged value
of the funds rate. They argue that such a term reflects interest rate smoothing
by the FOMC. The appendix estimates Taylor rule regressions that include a
lagged value of the funds rate. The output gap and inflation terms add little
predictive power beyond that offered by the lagged value of the funds. In the
pre-Volcker period, the regression basically implies that the FOMC sets the
funds rate equal to its prior value. For the Volcker period, the standard error
of estimate is 1.44 and for the Greenspan period, .24. Even in the Greenspan
period, the prediction error seems rather large as the .24 value is basically the
same magnitude as the 25-basis-point change the FOMC generally uses when
it changes the funds rate.18
Can the Taylor Rule Explain Inflation?
This section finds that the actual real rate of interest has generally been high
when evaluated in the context of a Taylor rule. It is then puzzling that inflation
persisted above the FOMC’s presumed 2-percent target for so long.
Below, I construct a measure of disinflationary pressure. It is the difference
between the real rate of interest and a Taylor-rule benchmark value that should
maintain inflation at its prevailing level. I construct this benchmark measure under the assumption that the FOMC actually used the Taylor rule in implementing
monetary policy. Furthermore, I construct it using the data contemporaneously
available to the FOMC at the time of its meetings. Observations correspond to
FOMC meetings.
The solid line of Figure 2 plots the short-term real rate of interest. The
dashed line is the benchmark value measuring neutral monetary policy.19 I make
use of the following intuitive interpretation of how the Taylor rule specifies how
the FOMC sets the real funds rate implicit in its funds rate benchmark. It sets
18 For the Volcker and Greenspan periods, the standard deviations of the first differences of
the funds rate benchmarks are, respectively, 1.6 and .29, only slightly higher than the standard
errors of estimate from the regressions that include the lagged interest rate targets as regressors.
One can think of these standard deviations as measuring the predictive ability of a naive forecast
that assumes the contemporaneous value equals the prior value. The Taylor rule part of the
regression then adds very little information beyond what the lagged interest rate target adds.
19 The output gap proxy used to generate this benchmark is only partially satisfactory, especially for the pre-1979 period. As Orphanides (1999) has emphasized, in the ’60s and ’70s,
policymakers typically used a measure of the output gap derived from a trend line for potential
output that was unrealistically high. The effect on Figure 2 of using a more realistic contemporaneous (pessimistic) estimate of the output gap would be to make the FOMC appear more hawkish
on inflation by showing the real rate of interest to be significantly higher relative to the neutral
benchmark level.

R. L. Hetzel: The Taylor Rule


Figure 1 The Funds Rate Benchmark and Its Taylor Rule Predictions

Notes: The dashed line is the within-sample predicted values of regressions (1), (2), and (3) in
the Appendix. Observations correspond to FOMC meetings, whose number per year has declined.
See Appendix for discussion of the series “Fed Funds Rate Benchmark.” Tick marks indicate last
observation of the year.

this implicit real rate as the sum of three components: 1) the long-run average
real rate, assumed constant at 2 percent; 2) a cyclical component, assumed
equal to half the output gap, .5xt ; and 3) an amount to correct for misses of the
inflation target, .5(πt − π ∗ ). The benchmark value measuring neutral monetary
policy is the sum of the first two components: the long-run average real rate and
the cyclical component of the real rate. In periods when the real rate exceeds
the benchmark, inflation should fall, and conversely.
Over the entire period shown in Figure 2, the real rate of interest usually
exceeded or equaled the neutral benchmark level. That is, the FOMC was
setting the real rate implicit in the funds rate at a level designed to lower
inflation. The major exception was the period from 1977 through 1979. Since
1980, the real rate has also generally exceeded the presumed long-run average
real rate of 2 percent. Given the willingness of the FOMC to maintain disinflationary real rates of interest on average, it is hard to explain why inflation
fell to its targeted value of 2 percent only in 1997.20
20 From

1983 through 1991, CPI inflation generally exceeded its assumed target by 2 to 3
percentage points. From 1992 until early 1997, the excess was about 1 percentage point.


Federal Reserve Bank of Richmond Economic Quarterly

Figure 2 The Real Rate of Interest and Its Neutral Benchmark Value

Notes: The real rate of interest is the real commercial paper rate calculated as described in the
Appendix. The neutral benchmark values are the sum of the Taylor rule components: 2 + .5xt ,
with xt an output gap. Observations correspond to FOMC meetings. Tick marks indicate last
observation of the year.

Figure 3 plots quarterly averages of the difference between the dashed and
solid lines of Figure 2, that is, the neutral benchmark minus the real rate of
interest. A rise in the real rate relative to the benchmark produces a fall in this
measure of the stance of monetary policy. Figure 3 also plots quarterly observations of the difference between subsequently realized four-quarter (personal
consumption expenditures) inflation and the prior four-quarter inflation rate.
Negative values indicate that the inflation rate is falling. Falls in the solid line
(an increase in the degree of monetary restriction) below zero should produce
negative values of the dashed line (falls in inflation). Over the entire period
shown, as measured here, monetary policy is generally disinflationary (the solid
line is generally negative). However, inflation remained above 2 percent until
early 1997.
Over the period 1965Q4 through 1979Q4, the correlation between the two
lines is almost zero (.06). Inflation does fall starting in 1971 after a prolonged
monetary tightening. However, that fall may have occurred chiefly because of
the price controls instituted in August 1971. The Taylor rule fails to predict the
disinflation starting in 1975. Although there is a professional consensus that

R. L. Hetzel: The Taylor Rule


Figure 3 Monetary Restrictiveness and Changes in the Inflation Rate

Notes: The solid line is quarterly averages of the observations of the dashed line minus the solid
line of Figure 2. The dashed line is the change in (personal consumption expenditure) inflation
measured as the average of the contemporaneous and future 3 quarters values minus the average
of the contemporaneous and past 3 quarter values. Tick marks indicate fourth quarter.

monetary policy was highly contractionary after summer 1974, the Taylor rule
does not unambiguously identify that tightness.
The correlation between the two lines of Figure 3 rises to .62 over the
period 1980Q1 to 1999Q1. However, the correlation derives primarily from a
single episode of monetary stringency—the Volcker disinflation. The message
is little more than that the FOMC can reduce inflation through a sharp rise in
the funds rate. Inflation rises after 1986 even though the Taylor rule indicates
that monetary policy is disinflationary.
Cost-push shocks could explain the failure of “high” interest rates to produce falling inflation. A high real rate of interest relative to the Taylor rule
neutral benchmark could then be associated with rising rather than falling inflation. However, if this assumption is correct, one would expect to see the
level of inflation positively correlated with the real rate of interest. That is,
causation goes from inflation to the real rate rather than vice versa.
Figure 4 shows the real rate of interest and the inflation rate. It fails to reveal a consistent positive relationship. For example, contrary to the Taylor rule,
the real rate of interest is somewhat higher in 1969–1970 than in 1973–1974, yet


Federal Reserve Bank of Richmond Economic Quarterly

Figure 4 Real Interest Rate and Inflation

Notes: The real interest rate is the monthly observation of the short-term real commercial paper
rate. The series after 1978 differs from that of Figure 2 in that a monthly series is constructed
using inflation forecasts from DRI. Inflation is the monthly annualized growth rate of the CPI.
Tick marks indicate December.

the inflation rate is considerably higher in the latter period. In 1984–1985 the
real rate is higher than in 1988–1989, yet the inflation rate is somewhat lower.



This article criticizes two assumptions of the Taylor rule literature. First, the
use of the Taylor rule in activist models with cost-push shocks is a good guide
for the monetary policymaker. Second, the FOMC has done a better job since
1980 of controlling inflation because it became more aggressive in responding
to realized inflation.

R. L. Hetzel: The Taylor Rule


The Appendix summarizes the estimation of Taylor rules for three periods:
the pre-Volcker period (November 1965–July 1979), the Volcker period (August
1979–July 1987), and the Greenspan period through to the near present (August
1987–May 1999). Section A explains the use of contemporaneously available
data. Section B presents the regressions. Section C explains the construction
of the series on the real rate of interest.
A. Data Used to Estimate the Taylor Rule
The observations correspond to FOMC meetings, which are monthly through
1978 and 8 per year thereafter (11 in 1980). If there were two meetings in
a month, I have used the first one. For the December 1965 through October
1970 meetings, the funds rate benchmark is the actual average value in the
first full statement week following the FOMC meeting. For the November
1970 through September 1979 meetings, the funds rate benchmark is the initial
value set by the FOMC. It comes from the Board of Governors staff document
called the Bluebook (“Monetary Policy Alternatives”) and FOMC Memoranda
of Discussion.
For the February 1980 through October 1981 meetings, the funds rate
benchmark is the actual average value in the first full statement week following the FOMC meeting with the following exceptions: November 1979,
January 1980, May 1980, May 1981, and July 1981. For these meetings and
for the meetings from November 1981 through December 1993, the funds rate
benchmark is the value the Desk “anticipated” would prevail subsequent to the
FOMC meeting as reported in the New York Fed memorandum “Open Market
Operations and Securities Market Developments.” From 1994 on, the funds
rate benchmark is the figure publicly announced after the FOMC meeting.
One should keep in mind that the FOMC did not use the funds rate as its
policy instrument consistently over this period. In the ’60s, it used a complex
of money market conditions, chiefly the short-term Treasury bill rate. In the
’70s it did set a funds rate target. From October 1979 until fall 1982, it set
a target for nonborrowed reserves. Thereafter, until February 1994, it set a
“reserve-position” target for banks approximated by borrowed reserves. Along
with the level of the discount rate, the value of borrowed reserves determined
the level of the short-term interest rate.
The important point to keep in mind is that there are two distinct kinds
of policy instruments: reserve aggregates and money market conditions. With
the former, the Fed sets a reserve aggregate like the monetary base or total
bank reserves and the marketplace determines the level of short-term interest
rates. With the latter, the Fed sets a short-term money market rate of interest


Federal Reserve Bank of Richmond Economic Quarterly

and supplies whatever reserves are necessary to defend that rate of interest.
In practice, the Fed has at times implemented this latter procedure directly by
setting an interest rate peg. At other times, it has controlled the short-term
interest rate indirectly. For example, it has set the discount rate and a value for
reserves that banks borrow through the discount window (see Cook [1989] and
Hetzel [1982]). The Fed has always operated using money market conditions
as its policy instrument. The funds rate benchmark series described above is a
general measure of the money market conditions intended by the FOMC.
Data for calculating values of inflation πt and the output gap xt come from
the Board of Governors staff document called the Greenbook (“Current Economic and Financial Conditions, Part 1”) and from the Federal Reserve Bank of
Philadelphia Real Time Data Set (Croushore and Stark 1999). The contemporaneously available data series for each FOMC meeting derives from splicing
Greenbook data with the contemporaneously available longer data set from
the appropriate Philadelphia Fed Real Time Data series. πt is a four-quarter
average of annualized quarterly percentage changes in the implicit nominal
output deflator (GNP before 1992 and GDP thereafter).
I call the values of inflation and the output gap calculated as described
below “actual” values because they rely primarily on actually available data
rather than on forecasts of the future made by the Board staff. If the FOMC
meeting was in the first or second month of the quarter, the four lagged inflation
values averaged to calculate πt begin with the quarter prior to the quarter of
the FOMC meeting. If the FOMC meeting was in the last month of the quarter,
the four lagged values begin with the contemporaneous quarter.
The output gap xt is the percentage difference between current real output
and trend real output (real GNP before 1992 and real GDP thereafter). Trend
real output is the value of a trend line fitted through the past 40 quarters of
data available at the time of the FOMC meeting. If the meeting was in the first
or second month of the quarter, the value used for current real output is for
the quarter prior to the quarter in which the FOMC meeting occurred. If the
FOMC meeting was in the last month of the quarter, current real output is for
the contemporaneous quarter.
I also experimented with “predicted” values of inflation and the output gap
that relied more heavily on forecasts of the future made by the Board staff.
If the FOMC meeting was in the first or second month of the quarter, the
four lagged inflation values used to calculate average inflation begin with
the contemporaneous quarter’s predicted value. If the FOMC meeting was
in the last month of the quarter, the four lagged values begin with the succeeding quarter’s predicted value. If the FOMC meeting was in the first or second
month of the quarter, the value of current real output used in calculating the
output gap is quarterly real output predicted for the contemporaneous quarter.
If the FOMC meeting was in the last month of the quarter, current real output
is the succeeding quarter’s predicted value.

R. L. Hetzel: The Taylor Rule


The inflation target is π ∗ . Taylor arbitrarily assumes it is constant at 2
percent. However, if that is the case, the Taylor rule predicts that the real rate
should move in line with the level of the inflation rate. Figure 4, which shows
the real rate of interest and the inflation rate, fails to reveal such a consistent
relationship. I therefore attempted to infer a target from FOMC documents and
As a proxy, I use the inflation forecast from the Greenbook made for the
quarter that was most distant in the future (usually three to four quarters into
the future in the ’70s and eight quarters thereafter). After November 1979, I
use as an additional proxy the midpoint of the central tendency range of fourth
quarter to fourth quarter inflation predicted by FOMC members and presented
by the FOMC chairman at the most recent February or July Humphrey Hawkins
Hearings preceding the pertinent FOMC meeting.
Although these latter figures are forecasts, forecasting inflation is not like
forecasting the weather. The FOMC controls inflation over some appropriately
long forecast horizon. Both the Board staff and FOMC members make their
forecasts contingent on the monetary policy they consider desirable. The forecasts then reflect the outcomes the Board staff and the FOMC members consider
acceptable. In that sense, these “forecasts” are acceptable benchmark values.
That is, the participants in the formulation of monetary policy assumed they
would behave in a way that brought their forecast of inflation into agreement
with these benchmarks for inflation.
Inclusion of such a term, however, did not yield satisfactory results. For
example, it often entered with the wrong sign. The results reported below drop
this term. The regressions adopt the assumption of the empirical Taylor rule
literature that the FOMC’s inflation target is constant and is captured by the
constant term of the regression equation.
B. Estimated Taylor Rules
Regression (1) fits a Taylor rule from December 1965 to July 1979. It uses
the “predicted” series for inflation and the output gap described above. The
standard error of estimate of the regression fitted with the “actual” series was
slightly higher.
i∗ = 3.0 + .69πt + .21xt + µt
(8.6) (11.0) (5.1)
Date: 11/65 to 7/79

R = .43

SEE = 1.6

DW = .11

DoF = 157

(The absolute value of the t-statistic is in parentheses. R is the corrected
R-squared statistic. SEE is the standard error of estimate. DW is the DurbinWatson statistic. DoF is degrees of freedom.)
Below, I report regression equations for the Volcker and Greenspan periods.
For the Volcker period, the fit of the regressions using actual and predicted data


Federal Reserve Bank of Richmond Economic Quarterly

is basically the same. For this period, I report the regression estimated with
predicted data. For the Greenspan period, I use the actual inflation and output
gap data as they yield a somewhat lower standard error of estimate.
Regression equation (2) is for the Volcker period.
i∗ = 4.1 + 1.16πt + .14xt + µt
Date: 8/79 to 7/87

R = .66


SEE = 2.1


DW = .59

DoF = 63

Regression equation (3) is for the Greenspan period.
i∗ = 1.5 + 1.56πt + .62xt + µt
Date: 8/87 to 5/99

R = .82


SEE = .76


DW = .42

DoF = 92

As emphasized by Taylor, the estimated coefficients on the inflation terms rise
over time.
Regressions (4) and (5) add a lagged value of the funds rate for the Volcker
and Greenspan periods, respectively. The regression for the pre-Volcker period
is uninformative in that it implies that the FOMC sets the funds rate equal to
its prior value.

i∗ = .87 + .43πt + .12xt + .69i∗ + µt
(1.5) (3.7)
Date: 8/79 to 7/87

R = .85


SEE = 1.44

DW = 1.6

DoF = 62

i∗ = .20 + .22πt + .13xt + .86i∗ + µt
(2.3) (4.1)
Date: 8/87 to 5/99

R = .98


SEE = .24


DW = 1.8

DoF = 91


R. L. Hetzel: The Taylor Rule


C. The Real Rate of Interest
The following explains the real rate of interest used in Figure 2. It is the commercial paper rate minus predicted inflation. The commercial paper rate more
closely approximates the funds rate than the Treasury bill rate. Over the period
November 1965 through July 1979, the pre-Volcker period, the commercial
paper rate used to construct the real rate averaged 6.6 percent, while the actual
value of the funds rate averaged 6.5 percent. Reflecting its riskless and liquid
character, the short-term Treasury bill rate averaged only 5.9 percent.
The commercial paper rate used to construct the real rate is recorded on
the date of the Greenbook publication. Until 1970, the paper rate is the 4–
6 month rate. Thereafter, it is either the 3-month or 6-month rate depending
upon whether the interval from the Greenbook date to the end of the succeeding
quarter is closer to 3 or 6 months. Predicted inflation is for the implicit price
deflator through July 1992, the fixed-weight deflator through March 1996, and
the GDP chain-weighted price index thereafter. Predicted inflation is a weighted
average for the quarter in which the Greenbook was published and the succeeding quarter with the weights varying with the number of days remaining in the
contemporaneous quarter after the Greenbook date and the number of days
in the succeeding quarter. For a full discussion of this series, see Darin and
Hetzel (1995).

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. Prosperity Without Inflation. New York: Fordham Press, 1957.
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83 (Winter 1997), pp. 1–22.

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S. Bernanke and Julio Rotemberg, eds., NBER Macroeconomics Annual
1997. Cambridge, Mass.: MIT Press, 1997.
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National Income, and Stabilization Policy. Homewood, IL: Richard D.
Irwin, 1970.
Granger, C. W. J., and P. Newbold. “Spurious Regressions in Econometrics,”
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Hafer, R. W., and David C. Wheelock. “The Rise and Fall of Monetary Policy
Rules: A Case Study of the Monetarist Rule,” Federal Reserve Bank of
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Hetzel, Robert L. “Japanese Monetary Policy: A Quantity Theory Perspective,”
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1999), pp. 1–25.
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of the Money Supply in 1980,” Journal of Money, Credit, and Banking,
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1997,” Federal Reserve Bank of San Francisco Economic Review, 1998,
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Kozicki, Sharon. “How Useful Are Taylor Rules for Monetary Policy?” Federal
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of Governors of the Federal Reserve System, May 1999.
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of Governors of the Federal Reserve System Finance and Economics
Discussion Series, 1998-03.
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in Real Time,” Board of Governors of the Federal Reserve System, August
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the Design of Monetary Policy,” Federal Reserve Board, Washington D.C.,
August 1999.
Phelps, Edmund S. “Money Wage Dynamics and Labor Market Equilibrium,”
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How the Asian Crisis
Affected the World
Economy: A General
Equilibrium Perspective
Xinshen Diao, Wenli Li, and Erinc Yeldan


t has been more than two years since the financial crisis first broke out in
East Asia in the summer of 1997. Now that much of the dust has settled,
it is clear that the world economy was far from being mired in a global
slump.1 Furthermore, although the growth in the crisis-afflicted countries and
other emerging market economies did slow quite significantly, growth was
sustained in North America and Western Europe. Indeed, growth accelerated
in some cases.2
Until very recently, the conventional view was rather pessimistic. Observers
feared that the economic stress that had begun in Southeast Asia would worsen
and spread. For the world economy as a whole, as well as for key industrial
countries, growth was expected to be slower, risks higher, and flows of capital
further dislocated. Even in the United States, a country that, for most of its
history, has shrugged off economic turmoil abroad, there was a fair amount
of nervousness. Many economists forecasted much slower growth rates for the
next few years (see among others, DRI forecasts) in light of the intensity of
Xinshen Diao: Trade and Macroeconomics Division, International Food Policy Research
Institute. Wenli Li: Research Department, Federal Reserve Bank of Richmond. Erinc Yeldan:
Department of Economics, Bilkent University, Ankara, Turkey. We would like to thank Bob
Hetzel, Ned Prescott, and Roy Webb for their comments. The views expressed in this article
are those of the authors; they do not represent the views of the Federal Reserve Bank of
Richmond or the Federal Reserve System.
1 According to “World Economic Outlook” (December 1998 and May 1999), annual percentage changes from a year earlier for world output are 4.3, 4.2, 2.5 and 2.3 for 1996, 1997,
1998, and 1999 respectively. The average growth rate for world output between 1990 and 1999
is 3.4 percent.
2 Figure 1 depicts the change of GDP in selected Asian countries, while Figure 2 contrasts the
behavior of GDP over the same period in major industrial economies. Source: “World Economic
Outlook and International Capital Markets Interim Assessment,” IMF, December 1998.

Federal Reserve Bank of Richmond Economic Quarterly Volume 86/2 Spring 2000



Federal Reserve Bank of Richmond Economic Quarterly

Figure 1 Selected Asian Economies: Real GDP Growth

Source: IMF, International Financial Statistics

Figure 2 Selected Industrial Economies: Real GDP Growth

Source: IMF, International Financial Statistics

X. Diao, W. Li, and E. Yeldan: Asian Crisis


the Asian crisis and the distinct possibility that it could spread worldwide.
The puzzling question that naturally arises is, “Why didn’t the whole world
economy enter a slump?”
In this article, we attempt to answer this question from a general equilibrium perspective. The strategy here is to use a standard growth model
augmented with multi-region and multi-production sectors to analyze how a
set of real shocks hitting crisis countries affects the world economy as well
as economies in different regions. These shocks, as will become clear later,
are identified by recent research on the causes of the crisis. The mechanism
that connects regions and that transmits shocks across them consists of two
links: commodity trade and capital flows. Our analysis shows that much of
the fear of a global recession spreading to industrial economies was not well
grounded. Moreover, the burden of adjustment to the crisis was uneven across
regions. The developing countries bore the brunt of this adjustment, suffering
declines in economic activities. By contrast, industrial countries escaped largely
unscathed. The impact the crisis had on them was small and even positive in
its initial stages.
This article does not attempt to explain the crisis and its causes. Rather it
measures, with the aid of a general equilibrium model of real trade and capital
flows, the spillover effects of the crisis on the other regions of the world.
Surprisingly, while various explanations of the East Asian financial crisis have
been advanced, little effort has been devoted to analyzing its effects on the
world economy. More is the pity, for the importance of such an analysis is
great and indeed goes beyond what we conduct in this article. The results here
suggest that policy actions that have generally been viewed as responsible for
the robust growth of industrialized nations in the face of the financial crisis may
not matter much after all. These actions include monetary policies adopted by
industrial countries. They also include the stabilization and reform package that
Asian crisis countries implemented at the insistence of the IMF. In other words,
it could well be that many common concerns were overstated and not based
on careful economic analysis.



While there is little consensus on the definite causes of the crisis, there is
now evidence that the region’s economies had been confronting a deteriorating
macroeconomic environment since the early 1990s (see, e.g., Krugman [1998],
Radelet and Sachs [1998], Flood and Marion [1998], Corsetti et al. [1998],
Chang [1999], and Whitt [1999]. A description shared by many is that given
by Chang [1999]).
Several countries in the region experienced a real appreciation in their
currencies during the 1990s and by 1997 had sustained sizable current account


Federal Reserve Bank of Richmond Economic Quarterly

deficits. These deficits were mostly financed through short-term foreign borrowing. Foreign portfolio and direct investment, attracted by the region’s record
economic growth for more than two decades, had also occurred. The growth
rate of exports and industrial output in crisis countries, on the other hand,
slowed substantially during the same period. This trend was largely the result
of the weak Japanese import demand combined with disinflationary aggregate
demand policies in most Asian economies.
The rapid inflow of capital and the slowing of growth unveiled a host of
inherent structural problems in the region’s financial systems. These problems
included (1) lack of competition, supervision, and regulation of the financial
sector, and (2) heavy government intervention in credit allocation. Under these
conditions, financial intermediaries whose liabilities were guaranteed by the
respective governments naturally posed a serious problem of moral hazard in
which government guarantees subsidized and induced increased risk-taking,
and resulted in excessive borrowing and lending, mostly from abroad.
The essence of the crisis was a huge, sudden reversal of capital flows that
was a manifestation of private investors attempting to liquidate their claims
brought on by a lack of confidence in the countries’ financial systems. Accustomed to large-scale capital inflows, the sudden turnaround in flows was
an enormous shock to the Asian economies. Moreover, with a dramatic depreciation in the real value of their currencies and high domestic interest rates,
domestic credit conditions tightened, which led to a rapid rise in non-performing
loans and a sudden loss of bank capital. The resulting collapse of domestic bank
capital added to the contraction by further restricting bank lending. The result
was the abandonment of planned investments by some firms and the curtailing
of production activities by others. Accompanying the decline in current income
and diminished expectations of future income, the consumption demand fell.
All of the crisis countries experienced a collapse in GDP growth in 1998.



The crisis affected the rest of the world, not only through the international financial system, but also through international commodity trade and capital mobility.
Since one region’s imports are another’s exports, the decline in imports of crisis
countries, agriculture for example, can cause agricultural exporting countries
to experience a decrease in their exports, and hence a fall in farm receipts.
The higher the ratio of agricultural exports to total production, the larger the
negative effects are likely to be.
A decline in the prices of internationally traded inputs tends to lower production cost, thus affecting the competitiveness of various sectors depending
on the intensity of the use of these inputs in production. Offsetting the decline
in intermediate input cost is the cost of purely domestic resources, such as

X. Diao, W. Li, and E. Yeldan: Asian Crisis


labor, that are not traded internationally. The cost of these resources may rise
due to the expansion of production at home.
Another effect of the crisis is through capital markets. Capital leaving
crisis countries will flow into non-crisis countries, putting downward pressure
on interest rates there. The reduced domestic interest rates will in turn stimulate
investment and thus growth in the domestic capital stock. Sectors that experienced increased capital formation, either directly or indirectly from these flows,
will respond by increasing their demand for other resources whose productivity
is increased by growth in capital stock. Thus, the growth in capital stock can,
by increasing the demand for labor and associated inputs, also contribute to the
bidding up of the prices of purely domestic or non-traded resources and further
raise the cost of production.
Effects of the Asian crisis on the world economy depend, in the long run,
on three factors: the extent to which pre-crisis expectations of long-run returns
to capital were grossly in error; the likelihood that the crisis will spread to
other regions; and post-crisis policies of crisis-ridden economies.



We formalize the argument presented above, and estimate the spillover effects of the crisis on other regions of the world economy in this section. Our
model, employed in the following paragraphs, belongs to the family of multisector, multiregion, computable general equilibrium setups. These frameworks
are used widely to analyze the impact of global trade liberalization and structural adjustment programs. Our model, which draws in many ways upon recent
contributions by McKibbin (1993), Mercenier and Sampaio de Souza (1994),
Mercenier and Yeldan (1997), and Diao and Somwaru (2000), incorporates considerable detail on sectoral output, consumption, and trade flows—both bilateral
and global.3 The model excludes financial market phenomena that capture effects such as investor confidence. Nevertheless, as will be demonstrated later,
the model and the assumed shocks that disturb it account for most of the falls
in investment, output, and terms of trade observed in the Asian countries. One
does not need to revert to less well-defined concepts as “financial contagion,”
“financial fragility,” and so on to explain the real effects of the Asian crisis.
Our scheme is to model the inherent structural problem of crisis economies
as overinvestment in certain sectors. The outbreak of the crisis and its subsequent development are modeled as an impulse and response mechanism.
The impulse takes the form of an adverse shock to sectoral total factor
3 Noland, Robinson, and Wang (1999) uses a similar but static computable general equilibrium framework to analyze the impact of the Asian Financial Crisis on the world economy under
the assumption that Japan and/or China depreciate their currencies.


Federal Reserve Bank of Richmond Economic Quarterly

productivity and to the risk premium associated with investment in these sectors. For example, a negative shock means that productivity falls and the risk
premium rises. Such an increase in risk premium can be due to either policy
changes that eliminate governmental benefits to firms or impair the collateral
firms could offer to potential investors.
The Asian financial crisis has also had serious negative effects on aggregate
employment of resources. Many firms throughout the region went bankrupt,
and the rate of labor unemployment rose. Instead of specifying increased unemployment or closed factories, however, we allowed all resources to remain
employed but reduced their efficiency, thereby generating the same fall in output. The magnitude of these shocks is described in more detail below as we
analyze different scenarios.
To begin then, the closed world economy is divided into three open-trading
regions: developing economies, developed economies, and crisis economies. We
will specify countries in each region in the next section. There are four production sectors in each region, and they each produce a single aggregate commodity. These sectors include (1) agriculture and food processes (agriculture);
(2) mineral, materials, and intermediates (intermediaries); (3) manufacturing;
and (4) services.
Within each region, a representative consumer makes joint decisions on
consumption and savings. Similarly, on the supply side, a representative producer in each sector makes production and investment decisions simultaneously.
The model also incorporates multilateral trade and capital flows among the
regions. Commodities produced for domestic markets are assumed imperfect
substitutes for those imported from abroad. The price of a good imported by
a region, therefore, is not necessarily the same as the price of the same good
produced at home or exported to other regions. A detailed description of the
model is as follows.
Producers within each sector of a region are aggregated into a representative firm. A firm makes production and investment decisions to maximize its
intertemporal profits. In doing so, the firm chooses levels of labor and intermediate inputs every period, taking as given prices of outputs, the wage rate,
prices of intermediate inputs, and the stock of capital. Outputs are either sold
in the domestic market or exported to foreign markets.
Firms are owned by a representative household or consumer, and investment is financed by the household’s domestic saving and international borrowing. At each period, firms’ profits, divn,i,t —equivalent to the gross revenue
minus labor costs, intermediate input costs, and investment costs—are distributed to the household. Investment raises the stock of capital but there exist
capital adjustment costs. Investment goods are purchased from other sectors,

X. Diao, W. Li, and E. Yeldan: Asian Crisis


as well as from firms’ outputs. Investment goods can also be imported from
abroad. Formally, a firm’s problem can be described as follows:


{In,i,t ,Ln,i,t ,ITDn,j ,i,t ,...,ITDn,j ,i,t }

Vn,i =

Rn,i,t divn,i,t



Xn,i,t = f (Ln,i,t , Kn,i,t , ITDn,j1 ,i,t , ..., ITDn,jJ ,i,t ),


Kn,i,t+1 = (1 − δn,i )Kn,i,t + In,i,t ,
where divn,i,t ≡ Pn,i,t Xn,i,t −



PCn,j,t ITDn,j,i,t −wn,t Ln,i,t −PIn,i,t In,i,t (1+φn,i Kn,i,t );


Vn,i is the value of firm i in region n in the first period; Rn,i,t = Πts=1 1+r is the
discount factor for future returns; Xn,i,t is the final output; Pn,i,t is the price of the
output; Ln,i,t , Kn,i,t , and ITDn,j,i,t are, respectively, labor, capital, and intermediate
inputs in the production of Xn,i,t ; wn,t is the wage rate; PCn,j,t is the price of the
intermediate input used by firm i in the production of Xn,i,t ; In,i,t is the quantity
of new capital equipment built through investments at time t; PIn,i,t is the price
of the investment good; δn,i is the capital depreciation rate; and φn,i Kn,i,t is the
adjustment cost per unit of capital investment.
Due to the presence of adjustment cost on capital, marginal products of
capital differ across sectors resulting in unequal, though optimal, rates of investments. Furthermore, once investment becomes realized as fixed physical
capital, it cannot be reinvested in other sectors, especially in other assets such
as foreign bonds. There also exists other regional risk factors associated with
investment. We model such risk by adding a risk premium on the interest rate
faced by firms. That is, in each region, firms face an interest rate defined as
rn,t = (1 + πn,t )rt ,


where πn,t is the risk premium for firms and is defined as an exogenous variable in the model, and rt is the riskless interest rate facing the world. For our
purposes, we assume the riskless interest rate prevails in developed economies.
A Cobb-Douglas production function relates the output of new capital
equipments with the inputs in the form of sectoral goods. These inputs can
be either produced domestically or imported. Hence, PIn,i,t can be written as a
function of composite prices:

PIn,i,t = An,i Πj PCn,j,t ,


where An,i is the efficient coefficient for investment, PCn,j,t is the price of the
composite good, 0 < dn,i,j < 1 and j dn,i,j = 1.


Federal Reserve Bank of Richmond Economic Quarterly

In each region a representative household owns labor and financial assets, including the equity in domestic firms and foreign bonds. The household allocates
income to consumption and savings to maximize lifetime utility:




U(TCn,t )


subject to the following budget constraint:
SAVn,t = wn,t Ln,t + TIn,t + divn,t + rt Bn,t−1 − PTCn,t TCn,t ,


where ρ is the positive rate of time preference, TCn,t is the aggregate consumption at time t, SAVn,t is the household saving, Bn,t−1 is the stock of foreign
assets, rt Bn,t−1 is the interest earned from ownership of foreign bonds, PTCn,t
is the consumer price index, and TIn,t is the lump-sum transfer of government
revenues from taxes and tariffs. We assume no government saving-investment
behavior. The government spends all its tax revenues either on consumption or
as transfers to the household. TCn,t , the instantaneous consumption, is generated
from the consumption of final goods by maximizing a Cobb-Douglas function:

TCn,t = Πi cn,i,t ,


Σi PCn,i,t cn,i,t = PTCn,t TCn,t ,


subject to

where cn,i,t is the final consumption for good i and consumption shares bn,i
satisfy 0 < bn,i < 1, and Σi bn,i = 1.
World Commodity Markets and Capital Flows
International trade flows are tracked by their origin and destination. The variable Mn,s,i,t represents the trade flow of commodity i from region n to s at time
t and is endogenous in the model.
When a country’s current consumption plus its investments exceeds its current domestic income, the country experiences a trade deficit in which imports
exceed exports. If the reverse is true, the country experiences a trade surplus, or
an excess in exports over imports. If the country does not own enough foreign
assets to offset a deficit, the trade deficit has to be financed by international borrowing (i.e., SAVn,t is negative). Once international borrowing occurs, foreign
capital flows into the country. The current period’s foreign borrowing becomes
a net debt burden that either increases the country’s total outstanding debt or
reduces its foreign assets, i.e.,




(PWn,s,i,t Mn,s,i,t − PWs,n,i,t Ms,n,i,t ),

FBn,t =


X. Diao, W. Li, and E. Yeldan: Asian Crisis
Bn,t+1 = (1 + rt )Bn,t + FBn,t ,


where FBn,t is the foreign trade deficit of region n, PWn,s,i,t is the world price
of commodity i from region n to s at time t, and Bn,t is the foreign debt. A
negative FBn,t implies trade surplus for region n, while a negative Bn,t is foreign
assets for n.
We define a region’s real exchange rate as a ratio of the region’s consumer
price index over the same index for the region of developed economies, i.e.,
the consumer price index for developed economies is chosen as a numeraire.4
Movements in a region’s real exchange rate reflect changes in the price level
relative to that of developed economies. These movements do not capture any
changes in the region’s exchange rate policy or policies for financial or monetary sectors.
Government Policies
Government policy instruments include import tariffs, indirect taxes imposed
on production processes, and sales taxes on final consumption.5 Our main purpose here is to suggest how the effects of government interventions and weak
financial systems might lead to overinvestment in financially dubious projects
within crisis-ridden economies. Information necessary to address these matters,
however, is not available in a quantifiable form in the original database. For,
as discussed earlier, such government intervention has often taken the form of
implicit insurance that is equivalent to a stock of contingent public liabilities
reflected neither by data on debt nor on the deficit until contingent liabilities
become actual ones, that is, until the crisis occurred. Even though there were
differences in the specifics of the governments’ policies to enable firms to
expand their investment, they all led to the same outcome: excessive concentration of investments in certain key sectors of the economy. For these reasons,
we introduce an “investment subsidy policy” to capture the basic features of
government interventions in firms’ investment strategies. The subsidy, granted
only for manufacturing firms with no comparable provisions for the other three
sectors,6 is designed to lower firms’ capital installation (adjustment) costs as
4 This

price index is the average of consumption good prices weighted by their base year
levels of consumption.
5 Further information about these instruments along with their initial levels are included
in the database used for conducting the calibration. See Global Trade Analysis Project (GTAP)
Database, version 3, in McDougall (1997).
6 In Korea, excess investments and associated profitability problems were concentrated in
the manufacturing sector, whereas in other countries, such as Thailand, the focus was on the
real estate sector (Huh 1997). Data availability limits our analysis to the case of subsidy to the
manufacturing sector. Since the manufacturing sector is more export-oriented, this arrangement
allows for a higher probabilty that the crisis will be propagated to the rest of the world. Therefore,
our analysis can be viewed as a worst-case scenario from the viewpoint of non-crisis economies.


Federal Reserve Bank of Richmond Economic Quarterly

well as to put a ceiling on the interest rate they face. We assume that the investment subsidy is financed by a lump-sum tax on (or a lowered government
transfer to) the household.
More formally, let sn,i,t be the subsidy rate on the capital installation
cost, and γn,i,t be the difference in percentage between the market interest
rate and government’s interest ceiling. Then the capital adjustment cost function is redefined for the manufacturing sector of crisis-ridden economies as

(1 − sn,i,t )φn,i Kn,i,t and equation (3.4) becomes

rn,i,t = (1 + πn,t )(1 − γn,i,t )rt ,


where sn,i,t and γn,i,t are positive for manufacturing and zero for the other three
sectors in crisis economies.
Equilibrium requires that at each time period three conditions hold. First, in
each region, the demand for production factors equal their supply. Second,
the world total demand for each sectoral good equals its total supply. Third,
aggregate household savings equal zero. In the steady state equilibrium, the
following constraints must also be satisfied for each region:
rn = rss ,
rss =


Ii,ss = δi Ki,ss ,
FBss + rss Bss = 0.
Readers can find more details of the model, including Euler equations used
to solve the model and a glossary of variables, in the appendix of our working
paper, “Challenges and Choices in Post-Crisis East-Asia: Simulations of Investment Policy Reform in an Intertemporal, Global Model” (Federal Reserve
Bank of Richmond Working Paper 98-7).



In their recent paper, Corsetti, Pesenti, and Roubini (1998) undertake an extensive analysis of the macroeconomic environment and financial system of
crisis-ridden economies. Shunning a purely financial panic explanation, they
conclude that common domestic and international shocks hit several East Asian
economies in the 1996–1997 period. Our simulation pursues this line of argument. Because we lack a full-fledged theory on financial-real economy linkages,
however, we directly implement the real, or nonmonetary, consequences of the

X. Diao, W. Li, and E. Yeldan: Asian Crisis


crisis on investment patterns. We do so by shocking the model (that is, by increasing the risk premium and the difficulty of undertaking capital investment in
the region) to simulate the investment contraction. The actual crisis produces
currency depreciation as well as increases in domestic interest rates, prices,
unemployment, and bankruptcy rates in the affected countries. Such outcomes
are likely to cause investment to fall and economic growth to slow. Since
the intertemporal general equilibrium is a real or nonmonetary phenomenon in
which variables expressed as nominal or monetary magnitudes, including currency exchange rates and many financial assets, are not explicitly recognized, it
cannot capture directly the effects of currency depreciation on world financial
and asset markets.7
Our list of crisis economies includes a number of Asian countries (Indonesia, Korea, the Philippines, Thailand, Malaysia, Singapore, Hong Kong,
and Taiwan), two Latin American countries (Brazil and Argentina), and one
European country (Russia) to better capture the later development of the crisis.
The developed region includes EU countries, the United States, Canada, Australia, New Zealand, and Japan. The remaining countries are in the group of
developing nations.
Tables 1 and 2 summarize the trade flows for the three regions across the
agriculture, intermediaries, manufacturing, and services sectors. Crisis economies import chiefly from developed economies. Other developing economies
import from crisis and developed economies. Finally, developed economies
import agriculture, intermediary goods, and services from both crisis and other
developing economies, but import manufacturing goods mostly from the former. Crisis economies share with other developing economies a similar trade
structure in the sense that they export most of their commodities to developed
economies in all sectors except manufacturing. Developed economies export to
both crisis and other developing economies.
Our model employs investment subsidy to reduce the cost of capital adjustment. It also uses a ceiling on interest rates to reduce the risk of investment in
the manufacturing sector. For our baseline solution, we choose the subsidy rate
that produces a total subsidy equal to 2.2 percent of total investment. Similarly,
we choose an interest rate ceiling that results in manufacturing firms facing a
rate 30 percent lower than the market rate of crisis economies. The subsidies
are received only by firms investing in the manufacturing sector and they are set
equivalent to 40 percent of the capital adjustment costs of this sector.8 The rest
7 However, the apparatus allows us to introduce the concept of real exchange rate as the
ratio of domestic versus foreign commodity baskets. See Obstfeld and Rogoff (1996, Ch. 4) for
an analytical exposure.
8 According to Dalla and Khatkhate (1995)’s calculation, the interest subsidy involved in
policy loans in Korea amounted to over 1 percent of GNP and 6.2 percent of government expenditure in 1991; the cumulative subsidy during 1981–1991 amounted to 2 trillion won per


Federal Reserve Bank of Richmond Economic Quarterly

Table 1 Share of Imports by Region and Sector
Imp. Region

Exp. Region























Table 2 Share of Exports by Region and Sector
Exp. Region

Imp. Region























of the model is calibrated to the 1995 Global Trade Analysis Project (GTAP)
Database (see footnote 4) under the assumption that the initial current account
is in balance for each region. That is, each region’s initial current account is
assumed to be “sustainable” and consistent with its initial interest rate.

Baseline Scenario
In our baseline simulation, we proceed as follows. For the first three years,
we exogenously raise the value of the region’s risk premium, πn,t , in Equation
(3.12) and reduce the technological coefficient, An,i , in the sectoral investment
functions in equation (3.5) for crisis-ridden countries. Then, for the following
three years, we slowly lower the risk premium and raise An,i to its original
level. The shocks are chosen so that simulated changes in output in the crisis
economies match, during the first seven years, that of the actual changes in
these regions in the years 1997, 1998, and 1999 and the IMF projection for
these countries for the years 2000–2003 (“World Economic Outlook and International Capital Markets Interim Assessment,” International Monetary Fund,

X. Diao, W. Li, and E. Yeldan: Asian Crisis


December 1998).9 The comparison of simulated and actual results, as well as
the IMF projections, is in Figure 3. The simulation results for other variables
and for the other two regions are summarized in Figures 4–6.
Outcomes of the simulation closely track both the development of the
crisis and the IMF’s projections. GDP in crisis countries decreases with a fall
in investment. With the depreciation of the crisis area’s real exchange rate, the
price of traded goods increases relative to the price of goods domestically produced and consumed. Exports increase, imports decrease, and the trade balance
improves. A trade surplus together with a low level of investment produces a
current account surplus for these crisis economies.
The model also depicts the simulated effects of the crisis on the world
economy as well as on the other countries. As can be seen in Figure 4, world
GDP falls by 0.47 percent in the first year of the simulation. GDP falls 0.23
percent in developing economies but rises slightly (0.02 percent) in the developed region in the first year. Growth further slowed for all three regions in the
second year and started to recover beginning in the third year. These effects
are mainly the results of corresponding changes in the levels of international
commodity trade and capital mobility.10
The counterpart of the decline in commodity imports of crisis economies
is a corresponding fall in the exports of non-crisis regions. In the simulation, exports fall by 5–8 percent in developed economies and 1–2 percent
in developing economies during the first two years after the crisis. Since
exports as a percentage of total output are smaller in developed economies
(11.7 percent) than in developing economies (19.2 percent), it follows that
the same degree of export decline has a relatively smaller impact on GDP of
developed economies. Moreover, the export decline in developed economies
stems from decreased demand, especially for manufacturing and services of
crisis economies and other developing economies. Conversely, the export fall
experienced by developing economies stems mainly from competitive pressure exerted by crisis economies who have a trade structure similar to their
developing country counterparts. Although the simulation produced a depreciation in the real exchange rate in developing economies, it was relatively

9 The growth rate for the crisis-ridden region is a weighted (by GDP) average of the growth
rates of each country in the region minus their average growth rate from 1990–1996. These
numbers correspond to the percentage changes in GDP from the steady state reported from the
10 According to IMF (“World Economic Outlook,” 1999), the change of growth rates in
world output (detrended by a 3.4 percentage average growth rate for world output from 1990 to
1999) are 0.78, −0.914, and −0.114 percent for 1997, 1998, and 1999 respectively. The weighted
(by their GDP) change of GDP growth rates for Canada, the United Kingdom, France, Germany,
and the United States (detrended by their respective average growth rates from 1990 to 1999) are
0.16, 0.051, and −0.21 percent for 1997, 1998, and 1999 respectively. Although our simulation
does not match the exact numbers, it does reproduce the qualitative patterns.


Federal Reserve Bank of Richmond Economic Quarterly

Figure 3 GDP Changes in Crisis Hit Economy


insignificant compared with the depreciation in crisis economies. Since exchange rate depreciation tends to spur exports by making them less expensive,
we find that exports in developing economies decrease, but at a slower rate than
in developed economies. Conversely, imports for both developed economies and
other developing economies increased, with the rate of increase being higher
for developed economies. These numbers from our simulation are broadly consistent with the actual ones. Among the five developed economies discussed
earlier (Canada, the United Kingdom, France, Germany, and the United States),
all of them experienced substantial increase in their imports (year by year) between 1997 and 1999. Only the United Kingdom and the United States had
large drops in their exports. The other countries experienced an increase in their
exports; however, the increase in their exports was outpaced by a corresponding increase in their imports. For the five crisis economies (Korea, Malaysia,
the Philippines, Thailand, and Indonesia), all except Malaysia experienced a
substantial decline in imports in 1997 and 1998. And, except for Korea and
Indonesia in 1998, all experienced a large increase in their exports.
The decrease in exports and increase in imports in developed economies
produced a trade balance deficit that was financed by large capital inflow into
these economies. This inflow, when transformed into an increase in capital
stock, raises the production potential, hence GDP, of developed economies.
The developing economies, however, do not benefit from such capital inflows

X. Diao, W. Li, and E. Yeldan: Asian Crisis


Figure 4a The Impact of the Crisis on World Economy

and investment falls initially and only rises slightly after that. With a negative
change, or appreciation, in its real exchange rate, its GDP falls slightly. Given
that developed economies account for about 70 percent of world GDP and


Federal Reserve Bank of Richmond Economic Quarterly

Figure 4b The Impact of the Crisis on World Economy

that the crisis does not affect them much, the world GDP only falls by 0.47
percent in the first year of the simulation, even though the crisis economies
and developing economies register GDP falls of 3 and 0.23 percent.

X. Diao, W. Li, and E. Yeldan: Asian Crisis


Figure 5a Sectoral Effects of the Crisis: Crisis Hit Economy

Figure 5 documents sectoral export and import changes for each region for
the first six years following the crisis. We observe that, for crisis economies,
exports rise and imports fall during the first two years in all four sectors. By the
third year, exports in all four sectors have reversed their signs and are showing
negative percentage changes. Imports in intermediate goods and manufacturing
have also reversed their signs and become positive, though it takes longer for
imports in agriculture and service to recover. For other developing countries,
exports decline in all four sectors in the first two years, then recover starting
from the third year. Except for the first year in manufacturing, imports have
increased. In developed economies, exports decline in all four sectors, more
so in manufacturing and service, in the first two years. This decline in exports
is a result of the decreased import demand of crisis economies, a decreased
demand that more than offsets the increased import demand coming from other
developing economies.
Figure 6 depicts changes in bilateral trade flows between crisis-ridden
economies and the other two economies. Following the crisis, the real exchange rate depreciation in crisis-ridden regions causes, by cheapening the


Federal Reserve Bank of Richmond Economic Quarterly

Figure 5b Sectoral Effects of the Crisis: Other Developing Economy

region’s exports while rendering its imports dearer, a fall in its imports and rise
in its exports. Since one region’s imports are another’s exports, the developed
region’s exports of manufactured goods and services suffer a fall both from the
reduced import demand of the crisis-ridden region and the competitive effect
of that region’s increased exports, which displace, or crowd out, the exports of
the developed region.
Alternative Scenarios
In our simulation of the baseline scenario, we attempted to replicate both (1) the
development or unfolding of the crisis and (2) the most recent IMF projections.
One may argue that these events and projections already take into account policy actions mentioned earlier. Therefore, it is not surprising that, by matching
growth rates of crisis countries to these numbers, we saw little or no impact on
the world economy and its constituent industrial economies. Put another way,
had it not been for the policy considerations, growth rates for crisis economies
would have been slower and thus the effects of the crisis on the world and
industrial economies larger. For example, concerns were manifest that the crisis

X. Diao, W. Li, and E. Yeldan: Asian Crisis


Figure 5c Sectoral Effects of the Crisis: Developed Economy

would, by enhancing investment risk in two ways, divert investment away from
emerging markets. First was the risk that the crisis would, through contagion,
generate additional crises. Second was the risk that the crisis may, by raising
public fear, make potential investors more risk-averse than they were before.
Both types of risk would inhibit investment in emerging markets. Consequently,
we construct two alternative scenarios to account for possible implications of
this risk.
Scenario One
In scenario one, we disturb, or shock, the crisis-ridden region’s risk premium so
that GDP declines in the region are consistent with the IMF projection back in
October 1998 (“World Economic Outlook,” International Monetary Fund, October 1998).11 It takes about ten years for the GDP in the crisis-ridden region
to completely recover. We find that the pattern of changes in investment, GDP,
decline in GDP for the crisis hit region was projected to be −3.6, −6.4, and −4.3
respectively for the first three years.
11 The


Federal Reserve Bank of Richmond Economic Quarterly

Figure 6a The Impact of the Crisis on the Bilateral Trade between
Crisis Hit Region and Other Regions

X. Diao, W. Li, and E. Yeldan: Asian Crisis
Figure 6b The Impact of the Crisis on the Bilateral Trade between
Crisis Hit Region and Other Regions



Federal Reserve Bank of Richmond Economic Quarterly

current account, exports, imports, and the real exchange rate are the same as
baseline simulation results, but the magnitude is bigger. The world GDP drops
0.64 percent the first year, 1.32 percent the second year, and 0.31 percent the
third year. GDP in the other developing region declines for two consecutive
years (−0.30 and −0.29 percent), while GDP in the developed region increases
slightly in the first year (0.01 percent), decreases for the next year, and begins
to recover in the third year (−0.002 and 0.035 percent, respectively). Capital
flows going from the crisis-ridden region to the other developing region and
the developed region are more severe. In particular, countries in the developed
region show large capital account deficits.
Scenario Two
In scenario two, we consider the policy reforms undertaken by crisis economies
during the period. In particular, we eliminate the government’s investment subsidy and remove the ceiling interest rate in the manufacturing sector. Of course,
without an explicit banking sector, the model cannot capture all effects of a
change in the government’s investment policy, especially the effects of government intervention in the banking system. Note, however, that even though
the model lacks an explicit banking system, it maintains an effective financial
capital market economy in a theoretically consistent framework.
It is obvious that the investment-subsidy policy distorts firms’ investment
decisions and thus leads to overinvestment in manufacturing and possibly
underinvestment in other sectors, such as services. It follows that removing
such policy distortions would lower manufacturing investment and increase
investment allocated in the other sectors. Eliminating the investment subsidy
to manufacturing also affects the trade structure of the crisis-prone region as
investors now require a higher premium to hold assets of manufacturing firms.
In the crisis-ridden region, GDP also worsens for the first few years compared
with its counterpart in the baseline scenario.12 For countries in the developed
region, GDP again was not affected much—the growth rate was 0.01 percent
for the first year, −0.08 percent for the second year, and 0.32 percent for the
third year—although its current account deficits declined further. Moreover,
the simulated investment policy reform conducted by the crisis-ridden region
generates relatively modest aggregate effects in the short and medium run.
The main reason is that the expected gains from the investment policy reform
take the form of enhancement to economic efficiency, i.e., gains in productivity
growth. Our model cannot capture such endogenous gain, however, as it is based
on neoclassical growth theory in which productivity growth is exogenous. In
actual policy setting, one may encounter many other forms of distortions in
12 For

the crisis hit economies, GDP declined 3.6, 6.8, and 3.3 percent for the first three
years, and 2.5 percent for the fifth year.

X. Diao, W. Li, and E. Yeldan: Asian Crisis


industrial policies, in banking systems, or in capital markets of crisis-ridden
economies. We would expect once countries implemented such essential reforms, adjustments in their economies as well as in the entire world would be
much larger than they are in our simulations.
In summary, our simulation analysis indicates that the crisis reduced
GDP in developing economies, but raised GDP in developed economies.
Furthermore, the crisis had a larger effect on developing than on developed
economies. Capital flows from crisis economies to non-crisis economies, developing and developed, caused capital account deficits in both regions, more
so in the developed region.



The preceding paragraphs have investigated the impact of the East Asian Crisis on the world economy with the aid of an intertemporal general equilibrium
model. Admittedly our model is incomplete; it contains no monetary or financial sectors. Still, despite the absence of a full-fledged model of real-financial
linked theoretical apparatus, we were able to estimate the real effects of the
crisis by examining its consequences on investment demand. Our simulation
results, conducted under three reasonable scenarios, revealed that the crisis had
by far the largest negative impact on other developing economies. The impact
on industrial economies, on the other hand, is generally small and even positive
initially. Our analysis suggests that the fear of a “global slump” was not well
founded. The corollary is that policy actions associated with the “recovery” of
the world economy may not have mattered at all, since there was no global
slump from which to recover.

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Corsetti, Giancarlo, Paolo Pesenti, and Nouriel Roubini. “What Caused the East
Asian Currency and Financial Crisis?,” Japan and the World Economy,
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Benjamin Strong, the
Federal Reserve, and the
Limits to Interwar American
Part I: Intellectual Profile of a
Central Banker
Priscilla Roberts


his essay on Benjamin Strong, the first governor of the Federal Reserve
Bank of New York (1914–1928), evolved from the author’s research on
the development of an American internationalist tradition during and
largely in consequence of the First World War. Viewing Strong’s activities in
the broader context of the world view and diplomatic preferences of the educated East Coast establishment, a foreign policy elite to which Strong belonged
and most of whose norms he accepted, greatly illuminates his broader motivations and the interwar relationship between finance and overall international
diplomacy. Strong’s work for international stabilization also provides revealing
insight into the limits of American internationalism during the 1920s and the
degree to which, in both finance and diplomacy, the interwar years represented a
transitional period between the restricted pre-1914 American world role and the
far more sophisticated assumptions which would guide United States policies
in the aftermath of the Second World War.
Strong’s career as governor encompassed 15 years of rapid domestic and
international change. The outbreak of the First World War just a few weeks

This article is based on a paper presented as part of the seminar series at the Federal Reserve
Bank of Richmond. The author, Priscilla Roberts, is Lecturer in History and Director of the
Centre of American Studies, University of Hong Kong. The article benefited greatly from
the comments of Robert Hetzel, Marvin Goodfriend, and Roy H. Webb. Thanks are due to
all for so generously sharing their time and expertise. The views expressed are the author’s
and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve

Federal Reserve Bank of Richmond Economic Quarterly Volume 86/2 Spring 2000



Federal Reserve Bank of Richmond Economic Quarterly

after he became governor in 1914 greatly enhanced the economic position
of the United States. American manufacturers, financed by American bankers,
provided much of the materiel essential to the Allied war effort, causing a flood
of gold into the United States and tipping the international balance of trade and
payments heavily in favor of the United States. When the war ended in 1918,
European nations’ ability to undertake postwar reconstruction depended upon
the extent to which they could tap into the accumulated American capital reserves. During the war the U.S. economy boomed but American prices soared.
Once fighting ended in late 1918, a short but intense recession occurred in
1920–1921, the product of a combination of the cessation of wartime orders
and the Federal Reserve Board’s efforts to end inflation by raising interest
rates. After 1922, for most of the decade the American economy boomed,
enjoying both real growth and price stability and generating the surplus funds
necessary to enable Americans to invest heavily overseas. In the mid-1920s,
private American loans financed both the return of most European countries
to the gold standard and a wide array of European government and business
enterprises. The American stock market slump of October 1929 marked the end
of this prosperity. It precipitated a range of interlocking domestic and international economic difficulties whose constantly intensifying destructive synergy
led to the worldwide Great Depression, the impact of which persisted until the
late 1930s. The Federal Reserve System’s inability to cope with the crisis led
directly to the Banking Act of 1935, which greatly enhanced the powers of the
Washington-based central Federal Reserve Board while diminishing those of
the constituent regional Federal Reserve Banks.



It is worth remembering that Strong was merely one individual in a group of
prominent interwar American figures who were committed to what they termed
“internationalist” policies and who often worked closely together to this end.
This foreign policy elite generally favored expanding their country’s international diplomatic and economic role. Its members usually supported American
intervention against Germany in the First World War and U.S. participation
in an international organization to maintain peace and in efforts to facilitate
Europe’s postwar economic recovery. Many also endorsed international arms
limitation and some an American guarantee of France’s security against a potential future German attack. There was a strong Anglophile element to their
thinking: Most believed that an Anglo-American alliance, formal or informal,
and Anglo-American diplomatic and economic cooperation would be fundamental to any acceptable postwar settlement.1
1 On

this outlook, see Priscilla Roberts, “The First World War and the Emergence of American Atlanticism 1914–20,” Diplomacy and Statecraft 5:3 (November 1994), 569–619; idem, “The

P. Roberts: Intellectual Profile of a Central Banker


Insights drawn from more traditional diplomatic history, as opposed to
economic history, can help to illuminate some of Strong’s policy choices, suggesting that his financial activities can only be fully understood when viewed
in the overall context of contemporaneous broad internationalist developments
within the United States. In particular, his profound sympathy for the Allies
during the First World War, his support for American assistance to the Allied
cause, and his belief that Anglo-American cooperation, economic and otherwise, must provide the foundation of the postwar international order, were far
from unique. This outlook was shared not only by most in the New York financial community, the Morgan partners, for example, but also by the majority
of the American East Coast elite, such as Theodore Roosevelt, his secretary of
state, Elihu Root, Root’s protege Henry L. Stimson, and numerous others.
The Anglo-American emphasis of the First World War and the 1920s seems
to have derived, in large part, from the broadly Anglo-Saxonist views of the
late-nineteenth- and early-twentieth-century U.S. upper crust. Roosevelt and
the circle around him subscribed to Mahanist views that American security and
the Monroe Doctrine had always depended upon Britain’s goodwill and the
consequent tacit protection that the British fleet afforded against the depredations of other European powers.2 The Anglo-Saxonist movement reached its
apogee in the years around the turn of the century. Throughout the nineteenth
century, especially from the 1880s onwards, historians and political theorists,
such as the British Edward August Freeman, John Mitchell Kemble, and John
Richard Green, and their American counterparts, James K. Hosmer, Herbert
Baxter Adams, John W. Burgess, and the even more influential Reverend
Josiah Strong, John Fiske, and Mahan himself, disseminated and popularized
the belief that the Anglo-Saxon race, in effect the British and Americans, was
uniquely capable of self-government and had evolved the best and most democratic institutions to date.3 In addition, many admired the British Empire as an
Anglo-American Theme: American Visions of an Atlantic Alliance, 1914–1933,” Diplomatic
History 21:3 (Summer 1997), 333–64.
2 See Alfred T. Mahan, The Interest of America in Sea Power, Present and Future (Boston:
Little Brown, 1897), esp. 27, 49–51, 107–34, 189–90, 257–59; idem, The Interest of America in
International Conditions (Boston: Little Brown, 1910), esp. 35–124, 155–85; idem, Lessons of
the War With Spain (Boston: Little Brown, 1899), 289–98; Robert Seager, Alfred Thayer Mahan:
The Man and His Letters (Annapolis: Naval Institute Press, 1977), 148–49, 225–26, 268–69, 522–
25; Howard K. Beale, Theodore Roosevelt and the Rise of America to World Power (Baltimore:
Johns Hopkins University Press, 1956), 144–45; William C. Widenor, Henry Cabot Lodge and the
Search for an American Foreign Policy (Berkeley: University of California Press, 1980), 87–91,
149, 158–59; Kenton J. Clymer, John Hay: The Gentleman in Politics (Ann Arbor: University of
Michigan Press, 1975), 125–29.
3 The origins of this tradition are covered in Reginald Horsman, Race and Manifest Destiny:
The Origins of American Racial Anglo-Saxonism (Cambridge, MA: Harvard University Press,
1981). For its later development, see Stuart Anderson, Race and Rapprochement: Anglo-Saxonism
and Anglo-American Relations, 1895–1904 (Rutherford, NJ: Fairleigh Dickinson University Press,
1981); Beale, Theodore Roosevelt, 41–47; David S. Healy, US Expansionism: The Imperialist


Federal Reserve Bank of Richmond Economic Quarterly

example of enlightened government.4 Prominent British statesmen, for their
part, were eager to welcome the United States into the imperialist club as a
fellow Anglo-Saxon power which would, they hoped, be an ally. Conscious of
their own isolation vis-` -vis the new European powers, especially the increasa
ingly assertive Wilhelmine Germany, they hoped that the United States and
Britain might establish at least a de facto alliance.5
This viewpoint informed Strong’s own Manichaean interpretation of the
war as a global struggle between the forces of good and evil. It was reinforced
by Strong’s personal ties with Britain, and given added ideological underpinning
by the belief that Britain and the United States shared a common Anglo-Saxon
heritage, one incomparably superior to that of any other nation. On the outbreak of the First World War, every indication is that Strong’s sympathies were
automatically and unhesitatingly pro-Ally, and that he was determined to do
all in his power to assist the Allies. This sentiment was entirely typical of the
social circles in which he moved.6 It also had a major impact upon his conduct
of wartime and postwar Federal Reserve business, predisposing him to close
cooperation with Britain and to a world view to which intimate Anglo-American
collaboration was fundamental.
The prominence of international considerations in Strong’s policymaking
should also be perceived as part of the broad outlook of the New York financial community, and as one aspect of the development since the late nineteenth
century of a sense that the United States was a world power, which should
both behave and be treated as one. One important goal of the Federal Reserve
System’s founders, particularly those New York bankers who were among its
most prominent architects, was to provide the United States with a central
banking system which would enable their country to fulfill its potential as an
international financial power. Throughout the First World War and the 1920s,

Urge in the 1890s (Madison: University of Wisconsin Press, 1970), 13–16, 29–33, 123–24, l38–
42; Richard Hofstadter, Social Darwinism in American Thought, rev. ed. (Boston: Beacon Press,
1955), 170–84; Michael H. Hunt, Ideology and US Foreign Policy (New Haven: Yale University
Press, 1986); Bradford Perkins, The Great Rapprochement: England and the United States, 1895–
1914 (New York: Atheneum, 1968), 74–83.
4 See Roberts, “The First World War,” 592. See also Robert E. Osgood, Ideals and SelfInterest in America’s Foreign Relations: The Great Transformation of the Twentieth Century
(Chicago: Chicago University Press, 1953), 66–70; Hofstadter, Social Darwinism, 179–84; Beale,
Theodore Roosevelt, chs. 1–2; Healy, US Expansionism, 33, 38–39, 114, 122–25, 129–37; Hunt,
Ideology and US Foreign Policy, 79–81.
5 See Anderson, Race and Rapprochement, 86–94, 112–29; Beale, Theodore Roosevelt, 96–
96, 139–40; David Dimbleby and David Reynolds, An Ocean Apart: The Relationship Between
Britain and America in the Twentieth Century (London: Hodder and Stoughton, 1988), 40–41;
Osgood, Ideals and Self-Interest, 58–59; Perkins, Great Rapprochement, 51–53, 65–67; D. C.
Watt, Personalities and Policies: Studies in the Formulation of British Foreign Policy in the
Twentieth Century (London: Longmans, 1965), 28–30.
6 For a broader exploration of this outlook, see Roberts, “The Anglo-American Theme,”

P. Roberts: Intellectual Profile of a Central Banker


Strong and other leading New York bankers perceived the System primarily in
this light, as part of America’s mechanisms for dealing with the outside world.
Although their numbers were relatively small, they were highly influential.
They included some of the brightest up-and-coming young men from the top
East Coast banks. Among them were Henry P. Davison of J. P. Morgan and
Company, the intellectual Paul M. Warburg of Kuhn, Loeb and Company, and
Frank A. Vanderlip of the National City Bank of New York, not to mention
Strong himself and his colleague Fred I. Kent of the Morgan-associated Bankers
Trust Company. In the early twentieth century all these institutions had substantial international interests and plans to enhance them. For the U.S. finance
system, which until late in the nineteenth century had looked to Europe to
provide capital, their activities represented a new departure.7
From this perspective, the creation and operation of the Federal Reserve
System were an integral part of the increasingly assertive U.S. policies which
characterized the early part of the century. The United States flexed its military
muscles in the Venezuela crisis and the Spanish-American War, as it sent the
Great White Fleet around the world, acquired the Philippines, administered
the customs of several Latin American countries, participated in international
arbitration conferences, helped to settle the Russo-Japanese War, intervened
in Mexico, and ultimately developed the plans which would eventually result
in the League of Nations. In this sense, it seems highly significant that as
a young man Strong was one of a coterie of youthful diplomats, journalists,
financiers, and military men, whose shared belief that the United States must
assume a much greater world role than in the past brought them together in a
small, exclusive private club, often termed “the Family,” at 1718 H Street in
Washington, D.C.8
It can also be argued that, as with a number of other American internationalists among his contemporaries, Strong’s passionate devotion to internationalism
and to European economic reconstruction fulfilled certain personal needs of his
own. He was a man who needed a purpose, even a mission, in life. Shortly
before his death, Strong wrote: “All of my experience of life (and sometimes
it grips me hard) convinces me that nowhere can one get better guides than
from the teachings of Christ and [Abraham] Lincoln. . . . Maybe it’s this point
of view which gives me more joy when salaries are raised than when the
discount rate is.”9 Indeed, to some degree his internationalist activities served
as a near-religious faith for him. In the United States, Strong was perhaps the

7 See Lawrence Broz, The International Origins of the Federal Reserve System (Ithaca:
Cornell University Press, 1997).
8 See A. J. Bacevich, “Family Matters: American Civilian and Military Elites in the Progressive Era,” Armed Forces and Society 8 (Spring 1982), 405–18.
9 Strong to Walter T. Stewart, July 6, 1928, File 1117.2, Benjamin Strong Papers, Federal
Reserve Bank of New York, New York.


Federal Reserve Bank of Richmond Economic Quarterly

most dedicated advocate of Europe’s recovery, and it became a cause to which
he literally devoted his life. Perhaps for personal reasons, Strong virtually drove
himself to death in the service of the Federal Reserve System and European
reconstruction. After the suicide of his first wife and his divorce from her
successor in 1916, by all appearances Strong’s only interest in life became
his work. Shortly after his second marriage ended, Strong suffered the first of
a recurrent series of bouts of tuberculosis brought on by overwork, a malady
whose associated complications ultimately killed him. Even when confined to a
Colorado or Arizona sanatorium, supposedly recuperating, he habitually wrote
lengthy letters to associates on every aspect of Federal Reserve policy. The
“determination” to finish the “job” of European reconstruction was perhaps the
only thing keeping him alive. In 1928 Strong recounted his doctor’s reaction
when he learned of his patient’s decision to retire as governor, a choice which
seems to have been precipitated by his relationship with a much younger opera
singer, whom he intended to marry:
His advice was to quit as soon as possible and do it with as little effort as
possible. But he was not satisfied with that advice until he knew my plans,
as he feared that after a few months, inactivity might be worse than the work
would be after a long rest. He feels I need an anchor and naturally thought
of an occupation. . . . He feels that for five years past and longer I have been
kept alive only by my determination to keep alive until a job was finished,
once I let go that idea I would crack.10

It was perhaps not entirely surprising that shortly afterwards Strong died, still
supposing that the task of European economic reconstruction had been successfully completed.



Strong was unquestionably a major force in the post-World War I economic
reconstruction of Europe. During the 1920s, credits extended by the New York
Federal Reserve Bank to the Bank of England, the Banque de France, the
Reichsbank, and other central banks, underpinned the restoration of the gold
standard throughout most of Western Europe. This was an endeavor in which
Strong worked closely with the New York financial community, especially
the preeminent investment bank, J. P. Morgan and Company. Once a country
had made the commitment to return to the gold standard and had undertaken
the preparatory fiscal work of balancing budgets, cutting expenditures, and,
in general, observing orthodox economic principles, the Morgan banking firm
generally handled the American portion of loans to European governments,
10 Strong to Stewart, July 26, 1928, ibid.; on Strong’s temperament, see also Lester V.
Chandler, Benjamin Strong: Central Banker (Washington, DC: Brookings Institution, 1958),
1–2, 47–53.

P. Roberts: Intellectual Profile of a Central Banker


facilities intended to finance stabilization and thereby, it was hoped, promote
economic recovery from the ravages of war. On occasion the New York Federal
Reserve Bank also furnished credits to central banks in countries undertaking
stabilization measures. These undertakings were by no means purely American
in character, though the war had so diminished the ability of Europe’s central
bankers to orchestrate such endeavors and of private bankers to float the associated loans that the Europeans required American assistance to do so. The 1920s
return to the gold standard was choreographed by a concert of central bankers,
an enterprise in which Strong and the Morgan partners were closely associated
with the Bank of England, the Banque de France, the Reichsbank, and the central banks of Austria, the Netherlands, Italy, and Belgium, as well as with those
countries’ leading private bankers. Biographies of Montagu Norman have also
drawn attention to the close friendship that existed between him and Strong and
their joint commitment to restore the gold standard in Europe and so implement
a return to the international financial normalcy of the prewar years.11 Norman
was very conscious that Britain’s loss of financial stature because of the war
meant that, to accomplish postwar economic reconstruction, Europe “need[ed]
the active cooperation of our friends in the United States,” the Federal Reserve
and private bankers whose financial participation and assistance was a sine qua
non for the success of all such schemes.12
During the First World War, disputes among New York bankers over the
impact which Federal Reserve policies might have upon the outcome of the
European war led to fierce debates within the System. In the 1920s, by contrast, much of the New York financial community essentially shared a common
outlook as to the desirability of accomplishing Europe’s financial rehabilitation.
While those investment bankers with German ties found the Morgan firm and
its allies moved too slowly for their liking in providing loans to finance German
recovery, they differed over timing rather than over fundamentals.13 At least
11 On

these endeavors, see Richard Hemmig Meyer, Bankers’ Diplomacy: Monetary Stabilization in the Twenties (New York: Columbia University Press, 1970); Stephen V. O. Clarke,
Central Bank Cooperation 1924–31 (New York: Federal Reserve Bank of New York, 1967);
Chandler, Benjamin Strong, chs. 6–11; R. S. Sayer, The Bank of England, 1891–1944, 3 vols.
(Cambridge: Cambridge University Press, 1976), Vol. 1, chs. 7, 8, 15; Sir Henry Clay, Lord
Norman (London: Macmillan, 1957), chs. 5, 6; Andrew Boyle, Montagu Norman (New York:
Weybright and Talley, 1967), chs. 7, 8; Barry Eichengreen, Golden Fetters: The Gold Standard
and the Great Depression 1919–1939 (New York: Oxford University Press, 1992), chs. 4–7.
12 Quotation from Norman to G. Vissering, November 16, 1921, File G3/177, Bank of England Archives, London; see also, for example, Norman to W. H. Clegg, October 13, 25, December
17, 1921, ibid.; Norman to V. Moll, February 6, 1922, ibid.; Norman to Baron Havenstein, June
23, 1922, File G3/178, ibid.
13 See Roberts, “The American ‘Eastern Establishment’ and World War I: The Emergence
of a Foreign Policy Tradition” (Ph.D. diss., Cambridge University, 1981), 530–36. Initially the
National City Bank of New York, the largest United States commercial bank, was far less wedded
to European recovery and currency stabilization than the investment banks, declining to participate in the Austrian stabilization loan of 1923 and querying the 1925 Federal Reserve line of


Federal Reserve Bank of Richmond Economic Quarterly

in part, Strong’s dominance of the Federal Reserve System during the 1920s
reflected the fact that the New York financial constituency was firmly united
behind him, another indication of the manner in which, despite the attempts of
the System’s founders to prevent any one region attaining such influence, New
York was able to prevail on most important issues.
The roots of Strong’s policies during the 1920s can be traced back at least
to the First World War. Strong became governor of the Federal Reserve Bank
of New York almost concurrently with the outbreak of war in Europe. Like
other New York bankers, Strong perceived the war as providing an opportunity
to expand America’s international financial role, to allow New York to become a center which could aspire to rival London’s preeminent position. One
field of opportunity for the United States was the development of a market
in commercial paper, or bankers’ acceptances, previously a London monopoly.
The new Federal Reserve Act permitted the Federal Reserve Banks to buy, or
rediscount, such paper.14 A second was the potential for U.S. banks to play a far
greater role in international finance than ever before, floating loans which would
likewise once have been left to the London market. Strong eagerly promoted
the development of American acceptance financing, welcoming the manner in
which the war facilitated the growth of a U.S. acceptance market.15
On several wartime trips to London, Strong developed far closer ties than
before with British bankers—including those in the Bank of England—and
explored the possibilities of obtaining for the United States a decidedly more
substantial share of international financing. Even before the United States intervened in the First World War, Strong perceived that after the war Europe
would desperately require capital for reconstruction, and that his country would
possess the only substantial reservoir thereof.16 Some American bankers,
credit which the Bank of England negotiated to support Britain’s return to gold. Later in the
decade, however, the National City overinvested in foreign loans, particularly German bonds,
and suffered severe losses in the subsequent European financial crash. Ibid., 537–39; Silvano A.
Wueschner, Charting Twentieth-Century Monetary Policy: Herbert Hoover and Benjamin Strong,
1917–1927 (Westport, CT: Greenwood Press, 1999), 65–67, 72, 88–89; Harold van B. Cleveland
and Thomas F. Huertas, Citibank 1812–1970 (Cambridge, MA: Harvard University Press, 1985),
145–50, 167–68.
14 See James Livingston, Origins of the Federal Reserve System: Money, Class, and Corporate Capitalism, 1890–1913 (Ithaca: Cornell University Press, 1986), 202–03; Burton I. Kaufman,
Efficiency and Expansion: Foreign Trade Organization in the Wilson Administration, 1913–1921
(Westport, CT: Greenwood, 1974), 30, 76; Carl P. Parrini, Heir to Empire: United States Economic
Diplomacy, 1916–1923 (Pittsburgh: University of Pittsburgh Press, 1969) 103–04; Broz, International Origins, 142–159; Clyde William Phelps, The Foreign Expansion of American Banks:
American Branch Banking Abroad (New York: Ronald Press Company, 1927), 104–11.
15 Strong to Paul M. Warburg, August 5, September 10, 1915, Box 12, Paul M. Warburg
Papers, Yale University Library, New Haven, CT; Chandler, Benjamin Strong, 83–96; Priscilla
Roberts, “‘Quis Custodiet Ipsos Custodes?’: The Federal Reserve System’s Founding Fathers and
Allied Finance in the First World War,” Business History Review 73:4 (Winter 1998), 585–620.
16 Strong to Fred I. Kent, July 10, 1915, U. S. Senate, 74 Cong., 2d Sess., Hearings Before the
Committee Investigating the Munitions Industry, 40 vols. (Washington, DC: Government Printing

P. Roberts: Intellectual Profile of a Central Banker


particularly the Morgan partners, consciously discountenanced predictions of
postwar American commercial and financial predominance.17 Strong carefully
emphasized that his country’s financiers hoped not to shoulder aside their British
counterparts, but to enter into a partnership with them. He told Norman: “I do
hope that you and other sensible and friendly people in London do not attach
too much importance to the vain-glorious boasting of the American press about
these financial developments.”18 Even so, in a speech in March 1916, Strong—
though sweetening the pill by emphasizing his own complete support for the
Allied cause—told prominent London bankers:
[T]his war might entail tremendous sacrifices upon the English people, including the bankers, and if it involved the surrender of some part of the world[’]s
banking to New York, at least we believed that it would be surrendered upon
fair terms, on fair competitions [sic], and that some of us felt that if this great
sacrifice had to be made, England, which had established the standard of
commercial honor and integrity throughout the world, would rather relinquish
this great trust into the hands of those who spoke their own language and who
believed in the same institutions, and had, I hoped, the same high ideals of
honor and integrity.19

While some British financiers, including the officials of the Bank of England,
Sir Felix Schuster of the Union of London and Smith’s Bank, the partners of
Morgan Grenfell and Company, J. P. Morgan and Company’s sister firm, and
Sir Charles Addis of the Hong Kong and Shanghai Banking Corporation, were
prepared to welcome or at least—in return for access to U.S. funds—tolerate
American cooperation, others were less sanguine.20 Yet few British bankers
were likely to welcome wholeheartedly any diminution of their own country’s
financial predominance. Not unsympathetically, Strong recounted that, when he
visited Britain in 1916, Sir Edward Holden, chairman of the London City and
Midland Bank, “made an address at the Manchester Chamber of Commerce in
which he referred to efforts of American bankers to undermine Lombard Street’s
Office, 1934–36), 30:9527; Strong, diary, March 28, 1916, File 1000.2, Benjamin Strong Papers,
Federal Reserve Bank of New York.
17 See, for example, Thomas W. Lamont, address before Cosmopolitan Club, March 31,
1915, 29–30, File 144-20, Thomas W. Lamont Papers, Baker Library, Harvard Business School,
Boston, MA; Lamont, “Financial Illusions of the War,” 209–11, ibid.; Dwight W. Morrow, “Address delivered at New York State Bankers Association Dinner,” January 7, 1916, “Speech to
Commercial Club,” November 9, 1916, Speeches File, Dwight W. Morrow Papers, Robert Frost
Library, Amherst College, Amherst, MA. Strong congratulated Morrow on the first of these
speeches. See Strong to Morrow, January 16, 1916, File Bankers Association, New York State,
18 Strong to Norman, March 22, 1917, File 1116.1, Strong Papers.
19 Strong, diary, March 10, 1916, reporting speech at London Clearing Banks dinner,
File 1000.2, ibid.; cf. Strong to Alexander Mackenzie, July 1, September 17, 1915, File
1112.5, ibid.; Strong to Sir Edward Holden, April 19, 1917, File 1112.3, ibid.
20 Strong, diary, March 6–8, 10, 13, 21, 22, 23, 1916, File 1000.2, ibid.


Federal Reserve Bank of Richmond Economic Quarterly

supremacy and he was so overcome by the mere thought that the old man broke
down and wept.”21 Strong’s policies towards Britain rather neatly exemplify the
Anglo-American relationship of “competitive cooperation,” which the historian
David Reynolds perceives as characterizing the immediate pre-World War II
Yet, even as Strong pursued an enhanced financial position for his country,
he also implemented policies that might be perceived as assisting Britain and
the other Allies at the expense of the United States. It is hard to exaggerate
the depth of Strong’s commitment to the Allies. Like many others of the East
Coast upper-crust elite, those Anglophiles whom Henry F. May has termed
the “custodians of culture,” Strong perceived the First World War as a global
struggle between the forces of good and evil, Prussianism, Kaiserism, and
autocracy against democracy, freedom, civilization, and Christianity.23 Even
before American intervention, he identified himself almost completely with the
Allied cause. Publicly explaining the meaning of the war in 1917, Strong stated:
Four hundred years ago [sic] the Anglo-Saxon race received the first great bill
of rights upon which their personal liberties are founded, when King John of
England signed the great Magna Charta at Runnymede. For two hundred and
fifty years that race in England has been engaged in building up constitutional
government. It was the beginning, the foundation of our personal liberties;
the foundation of the liberties of the English-speaking peoples throughout the
world. It was bequeathed to us one hundred and fifty years ago by Great
Britain, and for substantially four hundred years we English-speaking people,
and those from other countries whom we have adopted, have been developing
our institutions based upon that foundation of constitutional law. For forty
years, since the war between Prussia and France, a military autocracy in Germany, filled with lust for power, has been building up a great military structure,
on an entirely different theory of personal or autocratic government, and now
they have come into conflict—so the question is, which is going to win?
That is the greatest problem the human race has ever faced—constitutional
government against personally organized military government, with the Kaiser
at its head.24

Strong’s support for the Allied cause was slightly less fervent than that of many
of his associates, for example the members of the Morgan firm. The Morgan
21 Strong

to James Brown, September 4, 1916, Munitions Hearings, 31:9937.
David Reynolds, The Creation of the Anglo-American Alliance, 1937–1941 (Chapel
Hill: University of North Carolina Press, 1981).
23 See Henry F. May, The End of American Innocence: A Study of the First Years of Our
Own Time, 1912–1917 (New York: Oxford University Press, 1959), 363–37; Roberts, “The First
World War,” 575–56; idem, “The Anglo-American Theme,” 338–30.
24 See Strong, “The Sale of Liberty Bonds,” address to the Four-Minute Men, New
York City, October 1, 1917, in Strong, Interpretations of Federal Reserve Policy in the
Speeches and Writings of Benjamin Strong, ed. W. Randolph Burgess (New York: Harper &
Row, 1930), 41.
22 See

P. Roberts: Intellectual Profile of a Central Banker


partners, to whom he had always been extremely close, and whom he would
probably have joined had they not persuaded him to take the Federal Reserve
position instead, financed and handled most of the Allied war purchases in the
United States.25 Like the Morgan partners, well before American intervention
Strong was determined to do all he could to help the Allies. To this end, he
pushed for interpretations of the new Federal Reserve System’s regulations that
would assist the Allies in their increasingly desperate quest to obtain American
financing for the war purchases which were vital to their ability to continue
fighting the war. In doing so, Strong at least temporarily undercut the development of a New York acceptance market. By permitting repeated extensions
of commercial credits against Allied war purchases, he effectively converted
these securities into medium-term unsecured loans to the Allied powers, which
absorbed most of the capital that would otherwise have been available to finance
genuine acceptances.26 Strong was also one of those bankers who supported
the extension of American loans and credits to the Allies. In addition, in 1916
he negotiated correspondent relationships for the New York Federal Reserve
Bank with the Bank of England and the Banque de France, one purpose of
which was to facilitate the Allies’ American fund-raising.27
Strong’s efforts to assist the Allies involved him in lengthy and fiercely
contested battles with another major figure in the Federal Reserve System, the
New York banker Paul M. Warburg. The intellectual Warburg was perhaps
Strong’s closest friend; the two men had been allies in the struggle to create
the Federal Reserve System, and Warburg was one of those who persuaded him
to accept the position of governor. The German-born Warburg himself became
a vice-governor of the Federal Reserve Board, and probably its strongest voice.

25 On the Morgan firm’s wartime role, see “Memorandum Relative to Financing by J. P. Morgan & Co. during the World War,” no date, File 213-7, Lamont Papers; Kathleen Burk, Britain,
America, and the Sinews of War, 1914–1918 (Boston: Allen Unwin, 1985), chs. 1–5; idem, Morgan Grenfell 1838–1988: The Biography of a Merchant Bank (Oxford: Oxford University Press,
1989), 103–34; Vincent P. Carosso, Investment Banking in America: A History (Cambridge, MA:
Harvard University Press 1970), 204–07; Ron Chernow, The House of Morgan: An American
Banking Dynasty and the Rise of Modern Finance (New York: Atlantic Monthly Press, 1990),
ch. 10; Edward M. Lamont, Ambassador from Wall Street: The Story of Thomas W. Lamont,
J. P. Morgan’s Chief Executive (Lanham, MD: Madison Books, 1994), 67–85; Harold Nicolson,
Dwight Morrow (New York: Harcourt Brace, 1935), 172–93; Roberts, “The American ‘Eastern
Establishment’ and World War I,” 247–61.
26 See Roberts, “ ‘Quis Custodiet Ipsos Custodes?,’ ” 592–617.
27 See Roberts, “ ‘Quis Custodiet Ipsos Custodes?,’ ” 605–06; Chandler, Benjamin Strong,
93–98; Paul P. Abrahams, “The Foreign Expansion of American Finance and Its Relationship to
the Foreign Economic Policies of the United States” (Ph.D. diss., University of Wisconsin, 1967),
82–83; Sayers, Bank of England, 1:93. For details of these negotiations, see Strong diary and
letters during European trip of 1916, File 1000.2, Strong Papers; Munitions Hearings, 27:8239–
8252; exhibits 2354–2395, ibid., 8428–8455; File Federal Reserve Board–Bank of England 1915–
1918, Box 329, 74 Cong., 2nd Sess., U.S. Sen., Papers of the Special Committee Investigating
the Munitions Industry, Record Group 46, National Archives, Washington, DC.


Federal Reserve Bank of Richmond Economic Quarterly

Until American intervention in April 1917, he and Strong waged a persistent
battle as to whether Federal Reserve regulations should be framed and interpreted in such a way as to facilitate the Allies’ ability to finance their war
purchases in the American market. Perhaps not surprisingly, while both men
couched their arguments in terms of the best interests of the United States,
Strong invariably favored courses which would assist the Allies while Warburg, though more neutral and pacifist than pro-German, supported measures
which would encourage the Allies to consider a negotiated peace settlement.
Initially, Strong was victorious; then, in late 1916 it seemed that Warburg and
his allies on the Federal Reserve Board, W. P. G. Harding, its chairman, and
Adolph C. Miller, a fellow governor, had finally triumphed, thanks to assistance
from President Woodrow Wilson. Shortly afterwards German determination to
wage unlimited submarine warfare on the United States impelled an American
declaration of war, and the whole issue became moot. Even so, it demonstrated
the manner in which noneconomic considerations, particularly sympathies for
one or another European country, could affect the judgment of figures within
the Federal Reserve System.28
To some degree this long-running debate prefigured Strong’s continuing
pattern of behavior during most of the 1920s, when he habitually gave international considerations a high priority. As early as 1916, Strong supported
postwar “disarmament” and “a formal, definite understanding between all the
great nations, including the United States, that differences between nations will
be settled without force and that settlement, if necessary, will be imposed upon
parties to disputes by a combination of the neutrals.”29 Moreover, he hoped
that this would rest upon a foundation of Anglo-Franco-American cooperation
and understanding, though he feared that for political reasons any such alliance
would have to remain informal.30 In negotiating the correspondent relationship
with the Bank of England, he told Lord Cunliffe, its governor, that he favored
such an arrangement not simply for commercial reasons, but also because he
“believed . . . that the world’s future very largely depends upon the character
of the understandings between your people and ours.”31
Whereas many pro-Ally Americans tended to believe that any lasting peace
settlement must be contingent on a conclusive Allied victory, in late 1916
Strong endorsed Woodrow Wilson’s attempts to bring about a negotiated peace

28 See

Roberts, “‘Quis Custodiet Ipsos Custodes?,”’ 585–620.

29 Strong

to Warburg, December 15, 1916, File 211.3, Strong Papers; see also Strong to
Warburg, November 17, 1916, ibid., Strong, diary, March 28, 1916, File 1000.2, ibid.; Strong to
James Bryce, October 23, 1916, File 1111.3, ibid.
30 Strong, diary, March 28, 1916, File 1000.2, ibid.; Strong to Bryce, October 23, 1916, File
1111.3, ibid.
31 Strong

to Cunliffe, December 3, 1918, File 1115.1, ibid.

P. Roberts: Intellectual Profile of a Central Banker


settlement, provided that American influence was employed to win peace terms
favorable to the Allies.32 Even before this, he had opposed a punitive peace settlement, arguing that “when the war stops—it should actually STOP,” whereas
the imposition of harsh economic terms upon Germany would effectively continue hostilities through nonmilitary channels and “lead to a renewal of the
very conditions which gave rise to the present war.”33 He warned his British
friend Lord Bryce, a former ambassador to the United States, that his country,
while willing in principle to participate in the postwar international settlement,
might well refuse to guarantee “peace arrangements in which was consciously
planted the germ of later strife.” In addition, he told Bryce, British attempts
to subjugate Germany economically might lend added force to the contentions
of those Americans who advocated commercial competition with Britain, and
that such policies would in any case be unworthy of England’s distinguished
and honorable diplomatic record.34
Strong was indeed concerned by proposals that the British and French
developed at the Paris Economic Conference of June 1916, which appeared
to envisage a protectionist trading bloc of the Allied nations. The meeting’s
recommendations included the postwar prohibition of trade with former enemy
states, the elimination of enemy firms in Allied countries, the common pooling
of the Allies’ natural resources, their cooperative purchase of raw materials
not otherwise available, restrictions on former enemy powers’ shipping, and
measures to encourage mutual trade among the former Allies.35 Although the
British contended that such an Allied economic bloc would be aimed only at
their quondam enemies, not at the United States, Strong warned British friends
that such commercially discriminatory measures would severely impede the
achievement of any type of postwar Anglo-American entente or cooperation.
He believed that if the United States “avoided trouble with Germany and kept
out of the war” such measures, although supposedly intended merely as antiGerman, “would inevitably be directed to some extent against us.” A free
trader, he also feared that proposals such as those advanced at the Paris Economic Conference gave added weight to the arguments of those Americans
who supported protective tariffs, export trade combinations, “and other similar
projects, all possibly proper enough as weapons of defence, but which will,
I hope, not be required in order to face a world which has armed itself with

32 Strong to Bryce, January 12, 1917, File 1111.3, ibid.; see also Strong to J. H. Treman,
December 21, 1916, File 333.221, ibid. Somewhat erroneously, Strong believed that the German
leaders were willing, even eager, to make peace. Strong to W. P. G. Harding, November 20, 1916,
Munitions Hearings, 31:9674.
33 Strong, diary, March 9, 1916, File 1000.2, Strong Papers.
34 Strong to Bryce, October 23, 1916, File 1111.3, ibid.
35 See Parrini, Heir to Empire, 15–17; Gerd Hardach, The First World War, 1914–1918
(London: Penguin, 1977), 237–41; Kaufman, Efficiency and Expansion, 166–75.


Federal Reserve Bank of Richmond Economic Quarterly

every political contrivance for a commercial strife to be carried to the point of
Strong’s attitude towards European reconstruction was thus moderate and
pragmatic, but he never doubted that the United States should participate in
this enterprise. From before American intervention until his death, Strong remained dedicated to the cause of facilitating European recovery. Inevitably, one
consequence of this would be a great increase in U.S. international financial
activities, a development consonant with Strong’s long-time interest in building
up the United States as a world economic power. After American intervention,
he stated publicly, repeating his utterances while his country was still neutral,
that the United States would possess the only large resources of postwar capital
available to finance Europe’s economic recovery.37
When the war ended, Strong continued to state the case for the provision
of American capital to finance European recovery, both as immediate longdated credit for food and raw materials to tide Europe over the impending
winter of 1919–1920, and longer-term loans and investment capital to facilitate
economic redevelopment. Like many leading American bankers, at the end of
the war Strong believed that economic reconstruction was far more vital to the
restoration of European stability than the settlement of political questions. As
he had earlier, Strong opposed a Carthaginian peace, supporting the imposition
of a relatively moderate, rather than harshly retributive, reparations settlement
on Germany. He also supported the reduction or even cancellation of the war
debts that the Allies owed the United States.38 He called for speedy ratification
of the Treaty of Versailles, even if some of its terms were imperfect, on the
grounds that until this took place the maintenance of a technical state of war
with Germany would reinforce American businessmen’s prevailing uncertainty
as to European conditions, discouraging private American investment in Europe. He also hoped that after ratification the League of Nations machinery
would provide some of the administrative infrastructure needed to accomplish
economic reconstruction and solve such problems as German reparations and
Allied war debts.
In the long term, Strong hoped for extensive American private investment
in Europe, which he believed should be predicated upon European governments’ return to strict financial discipline, balanced budgets, governmental
economy, currency stabilization, minimal state intervention, and the removal

36 Strong,

“Interview with Lord Kitchener,” March 24, 1916, File 1000.2, Strong Papers;
Strong, diary, March 28, 1916, ibid.; Strong to Bryce, October 23, 1916, File 1111.3, ibid.
37 Strong, “An Appeal to Buy Bonds,” address at mass meeting at the Metropolitan Opera
House, New York City, September 27, 1918, in Interpretations, 53.
38 See Strong, “Memoranda,” on inter-Allied debts and reparations, Strong to Leffingwell,
July 31, 1919, Strong, “Memorandum,” August 30, 1919, Strong, diary, September 13, 1919, all
in File 1000.3, Strong Papers.

P. Roberts: Intellectual Profile of a Central Banker


of preferential tariff barriers. In the short term, Strong argued, the American
government should be prepared to extend some credits to European businessmen and governments, to tide them over their immediate difficulties.39 Strong
even expected the U.S. government to write off some such assistance, telling
Russell C. Leffingwell, the Under Secretary of the Treasury who later became
a leading Morgan partner, that “a part of the problem can be dealt with on a
business basis and a part of it must be dealt with on an eleemosynary basis.”40
In 1919 several American bankers to whom Strong was close, including
his old friend Paul Warburg and Fred I. Kent, the president of the Bankers
Trust Company, together with leading British and Dutch financiers, were instrumental in drafting the Amsterdam Memorial, signed by J. P. Morgan, Jr.,
as well as many leading European and American statesmen, bankers, and industrialists. This international petition called for the extension of large-scale
American credits and loans to European governments and businesses, lenient
intergovernmental debt settlements, a reparations assessment relatively generous to Germany, and a readiness on the part of both Americans and Europeans
to make sacrifices for these ends. Strong firmly approved of the Memorial’s
prescriptions, although he declined to sign it, on the grounds that “my relations with our treasury department [are] of such an intimate character that I
feared the possibility of its being misunderstood and causing embarrassment
which would, of course, have done harm rather than help the effort.”41 The
Amsterdam Memorial led the League of Nations in December 1920 to endorse
the ter Meulen plan, named after a Dutch banker, which called for European
governments to issue bonds that could be used to guarantee private credits to
finance Europe’s recovery. Although he had some reservations as to the degree
of statism this undertaking involved, Strong suggested that American bankers
might participate if their own government was prepared to take “an active and
official part in the plans for European reconstruction.”42
As early as 1921 Strong was eager to cooperate with other central banks
to devise schemes to facilitate Europe’s economic recovery, probably through
a variety of private credits guaranteed by European governments. At this
time Charles Evans Hughes, the Secretary of State, refused to permit him to

39 Strong to Leffingwell, July 31, August 21, 30, 1919, Strong, “Memorandum,” August 30,
1919, Strong to Harding, September 11, 1919, File 1000.3, Strong Papers; Strong to Norman,
March 20, 1920, File 1116.1, ibid.
40 Strong to Leffingwell, July 31, 1919, File 1000.3, ibid.
41 Strong to G. Vissering, March 29, 1920, File 1150.0, ibid.; for the drafts and text of the
memorial and much correspondence among its supporters, see the materials in Box 17, Warburg
Papers; the Warburg Memorial Collection, Boxes 18 and 19, Record Group 56, Records of the
Department of the Treasury, National Archives II, College Park, MD; and Boxes 20 and 22,
Robert H. Brand Papers, Bodleian Library, Oxford, England.
42 Strong to Hoover, June 9, 1921, quoted in Wueschner, Charting Twentieth-Century Monetary Policy, 27.


Federal Reserve Bank of Richmond Economic Quarterly

undertake such activities.43 Strong also continued to urge Anglo-American financial and economic cooperation in promoting European economic recovery.44
He remained anxious that financial and commercial rivalries should not disrupt
Anglo-American harmony. Noting Britain’s eagerness to attract American credit
and investment capital, Strong suggested to Lord Cunliffe, Montagu Norman’s
predecessor as governor of the Bank of England, that “if this problem is approached in a friendly and cooperative spirit they [the British] are the one
nation in the world to which credit will be freely given here, because, after all,
it is the English businessman and banker that we trust.”45 Writing to Norman
the same day, Strong stated: “I believe the greatest difficulty comes from a fear
on the part of your London bankers of the [Sir Edward] Holden [chairman of
the London City and Midland Bank] type that we are going to encroach upon
the English banking preserves. Frankly, I don’t see how it can be avoided for a
time because when the period of unsettlement is over we are going to have the
reserve of banking in this country and it is bound to find an outlet.”46 Writing
in 1920 to an official of the New York Federal Reserve Bank, Strong stated
that their institution “should always have it in mind” that its policies could
adversely affect the British. “By this I do not mean to suggest that our policy
should be shaped with regard to their interests, but rather that when our policy
does appear to impose hardship upon them, the least we can do with such an
intimate association is to keep them advised and give them some explanation
of the reasons for our course.”47
As Strong’s words suggest, and as the 1920s would demonstrate, however
fervent his personal commitment to internationalism, the parameters within
which he and the Federal Reserve System operated imposed distinct restrictions
upon the degree to which he could make European recovery and stabilization
his first priority. He could not ignore political pressures, internecine sectional
disputes among American bankers and within the Federal Reserve System, and
the domestic demands of the U.S. economy. Strong was also firmly wedded to
orthodox, pre-Keynesian economic tenets rooted in the thinking of the prewar
era. His policies in the decade after the war would demonstrate both the ambitious scope of internationalist central banking objectives in the United States
and the de facto obstacles to their attainment.
43 See

Wueschner, Charting Twentieth-Century Monetary Policy, 27–32.
to Russell C. Leffingwell, July 31, 1919, File 1000.3, Strong Papers; Strong to
Montagu Norman, November 22, 1918, February 5, May 21, 1919, File 1116.1, ibid., Strong to
Lord Cokayne, May 23, 1919, File 1115.2, ibid.
45 Strong to Cunliffe, February 5, 1919, File 1115.1, ibid.
46 Strong to Norman, February 1919, File 1116.1, ibid.; cf. Strong to Norman, November
22, 1918, May 2, 1919, ibid.; Strong to Cunliffe, December 3, 1918, Cunliffe to Strong, January
5, 1919, File 1115.1, ibid.; Strong to Leffingwell, July 25, 31, 1919, Strong, diary, July 28, 1919,
File 1000.3, ibid.
47 Strong to Pierre Jay, March 30, 1920, File 320.113, ibid.
44 Strong

Benjamin Strong, the
Federal Reserve, and the
Limits to Interwar American
Part II: Strong and the
Federal Reserve System in
the 1920s
Priscilla Roberts



Controversial in life, the dominating figure of Benjamin Strong, first governor
of the Federal Reserve Bank of New York, continues to precipitate debate
long after his death in 1928. “There are,” intoned former President Herbert
Hoover, “crimes far worse than murder for which men should be reviled and
punished.”1 Perhaps slightly biased by the fact that the Great Depression had
ruined his presidency, he was referring to what he perceived as deficiencies in
Federal Reserve policy during the 1920s. In particular, Hoover believed that the
United States Federal Reserve System, most of whose members he unkindly
characterized as “mediocrities,” had been overly influenced by the priorities of
its dominant figure, Benjamin Strong. Describing Strong as “a mental annex to

This article is based on a paper presented as part of the seminar series at the Federal Reserve
Bank of Richmond. The author, Priscilla Roberts, is Lecturer in History and Director of the
Centre of American Studies, University of Hong Kong. The article benefited greatly from
the comments of Robert Hetzel, Marvin Goodfriend, and Roy H. Webb. Thanks are due to
all for so generously sharing their time and expertise. The views expressed are the author’s
and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve
1 See

Herbert Hoover, The Memoirs of Herbert Hoover, Volume III: The Great Depression
1929–1941 (New York: Macmillan, 1941), 14.

Federal Reserve Bank of Richmond Economic Quarterly Volume 86/2 Spring 2000



Federal Reserve Bank of Richmond Economic Quarterly

Europe,” Hoover laid much of the blame for the stock market crash of 1929
and the subsequent Great Depression on the governor’s deep commitment to
facilitating Europe’s economic recovery from the damage done by the First
World War. During the 1920s, the majority of Europe’s governments, led by
Great Britain, returned to the gold standard. Britain’s insistence on doing so
at what Hoover termed a “fictitious rate” of $4.86 to the pound sterling, in
his opinion far too high, and Strong’s acquiescence in these policies, in turn
led Strong to expand American credit by keeping American discount rates
relatively low and manipulating the Reserve System’s open market operations.
The rationale for this was that keeping interest rates lower in the United States
than in Britain eased pressures on sterling and enabled the Bank of England,
whose governor, Montagu Norman, was Strong’s closest friend, to maintain an
overvalued pound. Hoover ascribed Strong’s policies to what he viewed as the
malign persuasions of Norman and other central bankers, especially Hjalmar
Schacht of the Reichsbank and Charles Rist of the Bank of France. He believed that due to Strong’s unwise predilections, from the mid-1920s onward
the United States experienced credit inflation, which fuelled the stock market
bubble that collapsed in the Great Crash of 1929. Although Hoover suggested
that other economic weaknesses, including a “weak banking system” and the
low purchasing power of farmers and white-collar employees, contributed to
this, he argued that imprudent Federal Reserve policies bore the primary responsibility for the crash and the Depression.2
Hoover was not alone among Strong’s contemporaries in expressing the
view that Strong’s efforts to aid Britain’s return to the gold standard laid the
foundation for the Depression by triggering stock market speculation. At the
onset of the Great Depression, Russell C. Leffingwell, a leading partner in the
investment bank J. P. Morgan and Company, agreed with those who condemned
Strong’s policies and ascribed to them at least some responsibility for the boom
and final crash of that decade’s second half. Leffingwell did so even though
Strong had close ties to the Morgan banking firm, which had provided much
of the financing for European nations’ stabilization efforts.3
Within the Federal Reserve System, Strong’s rate policies of the mid-1920s
also provoked substantial regional opposition, particularly from midwestern and
agricultural elements, who generally endorsed Hoover’s subsequent analysis.4
It is generally accepted that in 1924 Strong engineered low interest rates in the
United States, which by making the dollar and sterling respectively less and
more attractive to investors drove up the foreign exchange value of the British
2 Ibid.,

2–15, quotations from 8 and 9.
to Lamont, August 29, 1931, File 102-15, Thomas W. Lamont Papers, Baker
Library, Harvard Business School, Boston, MA; cf. Leffingwell to Lamont, March 8, 1929, File
102-13, ibid.; Leffingwell to Lamont, May 29, 1929, File 103-14, ibid.
4 See note 10, below.
3 Leffingwell

P. Roberts: Strong and the Federal Reserve System


currency and facilitated Britain’s return to the gold standard.5 The records not
only of Strong’s correspondence with Montagu Norman, but also the Bank
of England’s files on relations with the Federal Reserve Bank of New York,
reveal how closely British and American bankers kept in touch on their respective discount rates.6 Throughout the 1920s, two of the Federal Reserve
Board’s directors, Adolph C. Miller, a professional economist, and Charles S.
Hamlin, perennially disapproved of the degree to which they believed Strong
subordinated domestic to international considerations; indeed, they and Strong
had generally disagreed over Federal Reserve policies ever since all three men
joined the System in 1914.7 In 1925 Hoover, then Secretary of Commerce
and in the early 1920s an ally of Strong’s in the quest to bring about European
economic recovery, also demonstrated great reservations toward Strong’s policy
of reducing United States rates in order to facilitate Britain’s return to gold at
its prewar parity, and worked behind the scenes to precipitate congressional
questioning of its wisdom.8
The issue of government control over foreign loans also brought Strong—
and other New York bankers—into direct conflict with the Secretary of Commerce, clashes which probably contributed to Hoover’s later antagonism towards Strong. Indeed, one consequence of their disputes was that after mid-1922
the two men, once fairly close collaborators, ended their formerly extensive
correspondence, generally communicated through intermediaries, and only met
on one subsequent occasion, in November 1923.9 Hoover believed that the U.S.
government should have the final say as to whether a foreign loan was in the
national interest, and demanded that American bankers obtain preapproval of
5 Strong

to Andrew Mellon, May 27, 1924, File Gold (Miscellaneous), 1922–1925, Box 86,
Record Group 56, Records of the Department of the Treasury, National Archives II, College Park,
MD; Lester V. Chandler, Benjamin Strong: Central Banker (Washington, DC: Brookings Institution, 1958), 241–46, 300–07; Stephen V. O. Clarke, Central Bank Cooperation 1924–1931 (New
York: Federal Reserve Bank of New York, 1967), 85–96; Milton Friedman and Anna Jacobson
Schwartz, A Monetary History of the United States 1867–1960 (Princeton: Princeton University
Press, 1963), 282–284, 288; Elmus R. Wicker, Federal Reserve Monetary Policy 1917–1933
(New York: Random House, 1966), 80, 89–90; R. S. Sayers, The Bank of England, 1891–1944,
3 vols. (Cambridge: Cambridge University Press, 1976), I:139–40; Sir Henry Clay, Lord Norman
(London: Macmillan, 1967), 140–44; Boyle, Montagu Norman (New York: Weybright and Talley,
1967), 183–84; Silvano A. Wueschner, Charting Twentieth-Century Monetary Policy: Herbert
Hoover and Benjamin Strong, 1917–1927 (Westport, CT: Greenwood Press, 1999), 57, 75–85;
Barry Eichengreen, Golden Fetters: The Gold Standard and the Great Depression 1919–1939
(New York: Oxford University Press, 1992), 191–92.
6 See correspondence in Series OV31 and OV32, Bank of England Archives, London;
Strong’s extensive correspondence with Norman, Files 1116.1–1116.8, Benjamin Strong Papers,
Federal Reserve Bank of New York, New York.
7 See Chandler, Benjamin Strong, 44–45 and pass.; Donald F. Kettl, Leadership at the Fed
(New Haven: Yale University Press, 1986), 24–25, 33–35; Wueschner, Charting Twentieth-Century
Monetary Policy, esp. 71, note 99, and chs. 4 ff.
8 See Wueschner, Charting Twentieth-Century Monetary Policy, 77, 84, 90–104.
9 Ibid., 42, 104.


Federal Reserve Bank of Richmond Economic Quarterly

all such loans from the Department of Commerce. He was also eager to demand
that the proceeds of American loans should be spent on American products.
Like most of his fellow bankers, Strong opposed all such restrictions, viewing them as an undesirable extension of government supervision over aspects
of the economy that should be left to the free market. In correspondence with
Hoover and others, Strong expressed his views at length. The outcome was that
American bankers found themselves obliged to notify the State Department of
all foreign issues; the department could and sometimes did object to them on
grounds of the national interest, but Hoover’s attempts to force borrowers to
spend the proceeds in the United States failed.10
The most notorious episode of monetary ease, however, occurred in July
and August 1927, when Strong, though alarmed by the American market’s
speculative and inflationary tendencies, nonetheless forced through the Federal
Reserve System a decrease in the discount rate from 4 to 3 percent. This
move relieved the excessive pressures to which the initial level of American
interest rates was subjecting the dangerously shaky pound. In July 1927 the
central bankers of Great Britain, the United States, France, and Germany had
met on Long Island in the United States to discuss means of strengthening
Britain’s gold reserves and the general European currency situation. Strong’s
reduction of discount rates and purchase of L 12 million of sterling, for which
he paid the Bank of England in gold, appear to have been the direct result of
this conference. Indeed, according to Charles Rist, one of the French bankers
who attended, Strong said that the American authorities would reduce discount
rates as “un petit coup de whisky for the stock exchange.”11 Strong pushed this
reduction through the Federal Reserve System despite strong opposition not
just from Miller, but also from James McDougal, the governor of the Chicago
Federal Reserve Bank, who represented Midwestern bankers who generally

10 Strong, diary, August 6, 1919, File 1000.3, Strong Papers; Strong to S. Parker Gilbert,
May 23, 1921, File 012.5, ibid.; Strong to Gilbert, June 2, 1921, File Federal Reserve Board
1921, Box 70, Record Group 56, National Archives II; Strong to Charles Evans Hughes, April
14, 1922, File 800.51/312, Record Group 59, Records of the Department of State, National
Archives II, College Park, MD; memorandum by Strong, attached to Hoover to Hughes, April
29, 1922, 800.51/316, ibid.; Gilbert to Strong, October 18, 1925, enclosing Gilbert to Secretary
of State, October 16, 1925, and Gilbert to Garrard B. Winston, October 18, 1925, Strong to
Gilbert, November 7, 1925, File 1012.1, Strong Papers; Chandler, Benjamin Strong, 265–66; Carl
P. Parrini, Heir to Empire: United States Economic Diplomacy, 1916–1923 (Pittsburgh: University
of Pittsburgh Press, 1969), 188–94; Michael J. Hogan, Informal Entente: The Private Structure
of Cooperation in Anglo-American Economic Diplomacy 1918–1928 (Columbia, MO: University
of Missouri Press, 1977), 98, 100; Herbert Hoover, The Hoover Memoirs, Vol. 2 The Cabinet
and the Presidency 1920–1933 (London: Hollis and Carter, 1952), 85–91; Wueschner, Charting
Twentieth-Century Monetary Policy, 33–35, 38–42.
11 See Chandler, Benjamin Strong, 375–77; Clarke, Central Bank Cooperation, 123–24; Sayers, Bank of England, 1:336–345; Clay, Lord Norman, 236–37; Boyle, Montagu Norman, 231;
Eichengreen, Golden Fetters, 212–13; Wueschner, Charting Twentieth-Century Monetary Policy,
137–39. Rist’s recollection of Strong’s remark is quoted in Sayers, Bank of England, 1:340.

P. Roberts: Strong and the Federal Reserve System


did not share New York’s preoccupation with international financial markets.
Indeed, the Chicago Bank only reduced its rates when the Federal Reserve
Board ordered it to do so.12
In a confidential memorandum written shortly afterwards for use at a meeting of the Federal Advisory Council, Strong specifically denied that his close
relationship with the Bank of England had affected his policy choice on this
issue. The rate reduction had, he claimed, facilitated European purchases of
America’s “marginal production of export goods,” the market for which would
disappear should European currencies collapse. He also cited, as he had on
numerous earlier occasions since the First World War, the menace of domestic
American inflation were Europe to ship over excessive amounts of gold.13 Yet
Frank Altschul, a leading partner in the New York branch of the multinational
investment bank Lazard Freres, told Emile Moreau, the governor of the Bank of
France, “that the reasons given by Mr. Strong as justification for the reduction
in the discount rate are being taken seriously by no one, and that everyone in
the United States is convinced that Mr. Strong wanted to aid Mr. Norman by
supporting the pound.”14 Other correspondence in Strong’s own files suggests
that he was giving priority to international conditions rather than to American
exporters’ needs. Writing to Norman, who praised his handling of the affair as
“masterly,” Strong described the rate reduction as “our year[’]s contribution to



Since the 1930s, economic historians have focused on Strong’s central role
in setting early Federal Reserve policies; the likely relationship between these
policies to the Great Depression; the possibility that, had he lived, Strong might
have averted the slump; and Strong’s involvement in international economic
12 Strong’s own version is given in Strong, “The Chicago Rate Controversy,” September 11,
1927, File 320.121, Strong Papers. Accounts may also be found in Chandler, Benjamin Strong,
438–55; Clarke, Central Bank Cooperation, 124–34; Wicker, Federal Reserve Monetary Policy,
106–16; Wicker, “Federal Reserve Monetary Policy,” 336–37; Friedman and Schwartz, Monetary
History, 288–89; Sayers, Bank of England, 1:340–341; Clay, Lord Norman, 237; Boyle, Montagu
Norman, 231; John Kenneth Galbraith, The Great Crash 1929, reprint ed. (Boston: Houghton
Mifflin, 1997), 55; Eichengreen, Golden Fetters, 211–14; Wueschner, Charting Twentieth-Century
Monetary Policy, 136–37, 140–45.
13 Strong, “The Chicago Rate Controversy,” September 11, 1927, File 321.121, Strong
14 See Emile Moreau, The Golden Franc: Memoirs of a Governor of the Bank of France:
The Stabilization of the Franc (1926–1928) (Boulder, CO: Westview Press, 1991), 343, diary
entry for August 24, 1927.
15 Strong to Norman, August 9, 1927, Norman to Strong, August 11, 1927, File 1116.7,
Strong Papers.


Federal Reserve Bank of Richmond Economic Quarterly

affairs, especially central banks’ efforts during the 1920s to restore international
currency stability.
Several historians have suggested that Strong’s economic policies during
the 1920s were fundamentally sound and that, had he survived, he might well
have taken more decisive action than did his successors in the Federal Reserve
System to deal with the slump that developed into the Great Depression. In their
Monetary History of the United States, Milton Friedman and Anna Schwartz
argue that the root cause of the Great Depression was the Federal Reserve
System’s “great contraction” of money in the late 1920s and the early 1930s.
Indeed, they even suggest that the term ‘Great Contraction’ should replace the
traditional nomenclature of ‘Great Depression.’ Friedman and Schwartz undermine one of Hoover’s major arguments when they point out that the 1920s
were a period of minimal inflation when the monetary expansion failed even
to match the growth in national income. They agree with Hoover, however, in
ascribing to Strong a dominating position within the System, certainly that of
first among equals. In their view, “foreign considerations were rarely important
in determining the policies followed but were cited as additional justification
for policies adopted primarily on domestic grounds whenever foreign and domestic considerations happened to coincide.”16 Moreover, one of the major
problems affecting Federal Reserve monetary policy was that after Strong’s
death in 1928, the System suffered a year of stasis, since a “dispute [over
raising the discount rate] between the [Federal Reserve] Board and the New
York Bank largely paralyzed monetary policy during almost the whole of the
important year 1929.” While tensions between the Board and the member banks
had always existed, “So long as Benjamin Strong was alive, his unquestioned
preeminence kept the struggle submerged. . . . Strong’s death in October 1928,
preceded by a few months of inactivity, triggered a phase of overt conflict.”
Although Friedman and Schwartz attribute the onset of the Depression to the
collapse of the banking system, they also believe that Strong’s absence was a
major reason for the inadequate Federal Reserve response.17
Lester V. Chandler largely agrees with Friedman and Schwartz, arguing as
they do that by raising interest rates and contracting money and credit in the late
1920s, the Federal Reserve System initiated the deflationary monetary policy
that led to the Great Depression. As the Depression developed, the System
only half-heartedly relaxed its monetary stringency. As a result, between 1929
and 1932 the money supply effectively fell by almost 25 percent and thereby
created a vicious spiral of continuous intensification of the Great Depression’s
effects. For most of 1929, inconclusive battle was joined within the Federal
16 See Friedman and Schwartz, Monetary History, chs. 5, 6, 7, quotation from 269; Milton
Friedman, “Real and Pseudo Gold Standards,” Journal of Law and Economics 5:1 (October 1961),
17 Quotations from Friedman and Schwartz, Monetary History, 255.

P. Roberts: Strong and the Federal Reserve System


Reserve System as to whether commercial paper resulting from the financing of
“speculative” transactions should be eligible for discount, with several members
of the Board, notably the two long-time directors Adolph Miller and Charles
Hamlin, arguing that ruling it ineligible would discourage stock speculation.
According to Chandler, then, in the early 1930s the Fed radically failed to meet
the needs of the economy, thereby helping to precipitate the greatest contraction
in United States history.18 The popular historian John Brooks suggests that, had
Strong “been given another year of life, his full attention would surely have
focused on the American situation and his firm hand might have done much to
set things to rights in time.”19 Although Chandler rather hedges his bets, the
final pages of his biography of Strong seem to endorse this viewpoint, as does
an article by the economist Robert L. Hetzel.20
Historical debate still continues as to whether Strong’s concern to facilitate
European economic recovery compromised the American economy and, in particular, led him to subordinate United States monetary policies to the demands
of European reconstruction. Chandler, Strong’s sole biographer to date, tends
to favor this approach.21 The economist John Kenneth Galbraith, by contrast,
goes so far as to describe as “formidable nonsense” the view that Strong’s
1927 determination to lower discount rates in the United States was “an act
of generous but ill-advised internationalism” that ultimately caused the Great
An assessment minimizing the impact of Strong’s death is given in work
by Meltzer and Karl Brunner, Silvano Wueschner, and Elmus R. Wicker. While
stressing different economic factors, they alike tend to downplay the role of
Strong. Wicker argues that consistent policies were followed throughout the
1920s, both before and after Strong’s demise, and that changes in gold flows
and international monetary relations were primarily responsible both for the
Federal Reserve’s successes during the greater part of the 1920s and for its
failure to respond adequately to the Great Depression.23 Brunner and Meltzer
emphasize the Federal Reserve System’s continuing reluctance to make substantial open market purchases, with the resulting constriction upon the money

18 See Lester V. Chandler, America’s Greatest Depression 1929–1941 (New York: Harper &
Row, 1970), chs. 5 and 7; cf. Friedman, “Real and Pseudo Gold Standards,” 70–72.
19 See John Brooks, Once in Golconda: A True Drama of Wall Street 1920–1938 (New York:
Harper & Row, 1969), 98–99.
20 See Chandler, Benjamin Strong, 457 ff; Robert L. Hetzel, “The Rules versus Discretion
Debate over Monetary Policy in the 1920s,” Federal Reserve Bank of Richmond Economic Review
71 (November/December 1985), 3–14.
21 See Chandler, Benjamin Strong.
22 See Galbraith, Great Crash, 9, 11.
23 See Elmus R. Wicker, “Federal Reserve Monetary Policy, 1922–33: A Reinterpretation,”
Journal of Political Economy, 73:4 (August 1965), 325–43; idem, Federal Reserve Monetary


Federal Reserve Bank of Richmond Economic Quarterly

supply, as the primary factor; again, they suggest that these policies were similar
to those the Federal Reserve System had followed throughout the 1920s, and
that it was their timing, not the inherent wisdom of the protagonists, that made
their impact so disparate.24
Elmus R. Wicker and Silvano A. Wueschner defend Strong against charges
that his policies neglected U.S. interests, yet question the thesis that he would
have been successful in combating the Great Depression. Wicker suggests that
Strong had a sophisticated appreciation of the importance of international factors to the U.S. economy, and that, far from being “quixotic,” his policies were
inspired by a prudent concern for his own country’s interests. Wicker also
argues that Strong’s fundamental commitment to the gold standard precluded
any likelihood that he would have done better than his successors in countering
the Great Depression.25
Wueschner’s recent study Charting Twentieth-Century Monetary Policy
likewise portrays Strong as the representative of New York financial interests,
and his support for European stabilization and Britain’s return to gold as “required if the involvement of the American banking community in international
finance and debt settlements was to yield the current and future returns that it
gave promise of yielding.” He also confesses himself skeptical that, had Strong
not died, he would have provided vigorous and successful leadership in the
subsequent financial crisis.26 Wueschner not only draws attention to Strong’s
dominating personality but also illuminates those conflicts that arose between
Strong and New York financial forces on the one hand and agricultural, interior interests within the United States, and those between Strong and Herbert
Hoover, then Secretary of Commerce. Wueschner brings out the manner in
which disputes among Board members, including Adolph C. Miller as well as
Hoover and Strong, over the primacy of domestic or international considerations
in the setting of Federal Reserve policy, continued from the time of the First
World War throughout the 1920s and culminated in the famous 1927–1928
debates over Federal Reserve discount policy. He pays particular attention to
the close relationship between Strong and Norman. He also makes it clear that
the National City Bank, New York’s largest commercial bank, did not ascribe
the same primacy to international recovery as did Strong and the Morgan investment banking interests with whom he was closely associated. Wueschner
argues that internecine Federal Reserve System policy disputes “contributed

24 See

Karl Brunner and Allan H. Meltzer, “What Did We Learn from the Monetary Experience of the United States in the Great Depression?” Canadian Journal of Economics 1 (1968),
334–48, reprinted in Allan H. Meltzer, Money, Credit and Policy (Aldershot: Edward Elgar Publishing, 1995), 104–18.
25 See Wicker, “Federal Reserve Monetary Policy, 1922-33,” 325–43; idem, Federal Reserve
Monetary Policy.
26 See Wueschner, Charting Twentieth-Century Monetary Policy, 161.

P. Roberts: Strong and the Federal Reserve System


in some degree to the inability of the system to develop a coherent Federal
Reserve policy that could provide the regulatory instrumentality that the nation
Yet another respected historian goes so far as to ascribe at least part of the
responsibility for the Great Depression and Europe’s financial collapse in the
early 1930s to Strong’s dominating figure. Barry Eichengreen’s massive recent
work Golden Fetters argues forcefully that the overall strategy of European
interwar reconstruction was misguided and that its reliance on the restoration
of the gold standard created an unduly rigid economic system which itself
precipitated the Great Depression and was then unable to remedy the situation. Eichengreen, one of Strong’s most severe critics, suggests that the deep
commitment of Strong, Norman, and other international bankers to returning
the pound, the mark, and European currencies to the gold standard at overly
high parities, which they were then forced to maintain at all costs, including
deflationary policies, had the effect of undercutting Europe’s postwar recovery.
Not only did Strong and his fellows help through their policies to precipitate the
Great Depression, but their continuing attachment to gold acted as a straitjacket
confining economic and fiscal policies within narrow bounds that effectively
precluded expansionist options. Eichengreen draws attention to the inflexibility
that was one result of the gold standard and to the manner in which bankers’
desire to protect their national currencies’ convertibility into gold at almost any
cost drastically limited the options available to them when responding to the
crisis. He argues that in 1927 Strong’s narrow reliance on the gold standard,
which emphasized the financial predominance of the United States—the possessor of by far the greatest holdings of gold in the world—as opposed to a
broader-based gold-exchange standard, which would have permitted the use of
both foreign exchange reserves and gold to back national currencies, exacerbated nascent international economic problems. Eichengreen also implies that
in 1928 Strong might well have been more daring in reducing discount rates in
the United States and that the Federal Reserve System’s later reluctance to do
so, its determination to force “liquidation” of all assets, greatly enhanced the
Great Depression’s severity and severely affected European countries. At the
same time, Eichengreen points out that to adopt any other course might well
have been more difficult for Strong in the post-1928 period, since whereas
before that time there was relatively little conflict or incompatibility between
the System’s domestic and international objectives, at least where American
interest rates were concerned, after 1928 this was no longer the case.28
Peter Temin lays much of the responsibility for the crisis upon the Great
War and its impact on the international monetary system. Like Eichengreen,

27 Ibid.,
28 See

quotation from 130.
Eichengreen, Golden Fetters, esp. chs. 4–10.


Federal Reserve Bank of Richmond Economic Quarterly

he suggests that the international gold standard itself was one of the major
factors underlying and reinforcing the Great Depression, since “the conditions
that had sustained it before the war no longer existed.”29 Temin agrees with
Wicker that Strong’s fundamental commitment to the gold standard precluded
any likelihood that he would have done better than his successors in countering the Great Depression.30 Charles P. Kindleberger even questions the image
of Strong as a dominating figure who set a clear objective, referring to the
“Hamlet-like indecision” of his policies toward stock market speculation in
1927 and 1928.31



Whatever historians’ specific opinions of Strong’s policies, he is clearly a figure whom students of pre-1930 Federal Reserve policies cannot ignore. This
essay does not propose to answer the fundamentally irresoluble question of
whether, had he lived, Strong might have prevented the Great Depression. It
does, however, address the issue of the degree to which Strong’s internationalist predilections influenced him in setting domestic monetary policy. Overall,
it seems that while international considerations undoubtedly ranked high in
Strong’s order of priorities, clearly defined limitations restricted his commitment to assisting Europe, and these boundaries broadly reflected the nature of
and constraints upon American internationalism in the interwar period.
For Strong, European reconstruction was not simply a policy but a cause,
almost a religious faith. In 1927 he told Norman:
Long ago I had reason to ponder the question whether I would allow discouragements to dissuade me from favoring a constructive attitude toward
reconstruction abroad. There have been many and serious ones, at times, and
many reasons, as well as temptations to quit and let the old world solve its
own problems.
Considering everything, (and that included personal satisfaction and the
like) I decided to allow no discouragements to alter our position. It has at
times involved serious risks to my own position and prestige in the System
and the country.32

According to Hoover’s bitter post-presidential charges, Strong recklessly placed
the interests of the international financial system ahead of United States domestic concerns. In practice, the picture was more complex, reflecting the distinct
29 See Peter Temin, Lessons from the Great Depression (Cambridge, MA: MIT Press, 1989),
quotation from 25.
30 Ibid., 34–35.
31 See Charles P. Kindleberger, Essays in History: Financial, Economic, Personal (Ann
Arbor: University of Michigan Press, 1999), 13.
32 Strong to Norman, August 9, 1927, File 1116.7, Strong Papers.

P. Roberts: Strong and the Federal Reserve System


boundaries of Strong’s commitment to European recovery and the limitations
that broadly characterized the outlook of most contemporary internationalists,
bankers among them, as well as the influence of political constraints. These, in
turn, illuminate the significant differences that generally distinguished interwar
American internationalism from the variety that prevailed after the Second
World War.
There is no reason to doubt that Strong believed his work for European
currency stabilization also promoted the best interests of the United States. He
argued frequently that uncertain exchange rates, especially when the dollar was
at a premium against other currencies, made it difficult for American exporters
to price their goods competitively.33 As he had done during the war, on numerous later occasions Strong also stressed the importance of preventing an influx
of gold into the United States and consequent domestic inflation; to avoid this,
Strong argued, Americans should make loans to Europe, pursue lenient debt
policies, and accept European imports.34
Neither Strong nor his friend Norman appears ever to have questioned the
parities at which they stabilized first the mark and then sterling; rather, they
accepted that returning the pound to gold at prewar exchange rates was likely
to require British deflation and American efforts to use lower United States
interest rates to alleviate pressures on sterling. In 1931 Leffingwell wrote to
Thomas W. Lamont, a fellow Morgan partner:
You will remember that when Monty [Norman] came over to discuss with us
plans for the return to the gold standard, I asked him whether it was politically
possible for the Bank of England to raise the bank rate from time to time to
defend her gold and to complete the operation. He assured me that it was.
He was mistaken about this. The general strike soon followed and instead of
Monty’s defending the gold standard and completing the deflation on classical
lines by making money dearer in England, he called upon Ben to defend it

33 Strong to Junnosuke Inouye, August 29, 1921, File 1330.1, ibid.; Strong to William Hailey,
October 24, 1921, File 1112.5, ibid.; Strong to Herbert Hoover, April 22, 1922, File 013.1, ibid.;
Strong to Mellon, May 27, 1924, File Gold (Miscellaneous) 1922–1925, Box 86, Record Group
56, National Archives II; Strong, “The Chicago Rate Controversy,” September 11, 1927, File
320.121, Strong Papers; memorandum written by Strong, December 25, 1924, included in “Open
Market Hearings,” extract from Strong’s testimony before a Hearing of the House Committee
on Banking and Currency, April 1926, in Strong, Interpretations of Federal Reserve Policy in
the Speeches and Writings of Benjamin Strong, ed. W. Randolph Burgess (New York: Harper
& Row, 1930), 256–61; Strong, “Credit Arrangement with the Bank of England,” extract from
his testimony before the House Committee on Banking and Currency, April 1926, ibid., 275–90;
Chandler, Benjamin Strong, 266–68.
34 Strong to Hoover, April 22, 1922, File 013.1, Strong Papers; Strong to Mellon, May
27, 1924, File Gold (Miscellaneous) 1922–1925, Box 85, Record Group 56, National Archives
II; Strong, “The Reconstruction of World Finance,” address before executive council, American
Bankers Association, October 3, 1922, in Interpretations, 146–47; Strong, “Prices and Price
Control,” unpublished article prepared by him in April 1923, ibid., 231–34.


Federal Reserve Bank of Richmond Economic Quarterly
by making it cheaper in America. This Ben did for Monty consistently and
persistently, and successfully until the return of France to the gold standard
in 1927 and her adoption of a definite deflation policy. This seemed to make
it necessary for Ben to adopt an active (instead of passive) inflation policy
in the latter part of that year. Ben’s long illness in 1928, and the stupidity
and stubborness [sic] of the Washington Federal Reserve Board in 1929, left
the inflation policy uncorrected until it was too late to correct it without the
disaster of September and October 1929.35

It should be noted that, Leffingwell’s ex post facto criticisms notwithstanding, in 1925 the Morgan firm had enthusiastically endorsed and provided a
credit facility to back Britain’s return to gold. Despite Leffingwell’s effective
condemnation of Strong’s policies as inflationary, there is substantial evidence
to suggest that, in practice, Strong was generally cautious in assisting with
European recovery. Leffingwell’s implicit suggestion that, had Strong survived,
Federal Reserve discount rate policies in 1928 would have followed a different
path can perhaps be viewed as a lefthanded tribute to Strong’s predominating
concern to protect his own country’s interests.
Leffingwell’s assertions as to Strong’s easy money policy notwithstanding,
Strong often seems to have placed American domestic interests above those
of the international financial system. Most notably, he was never prepared to
permit the vast quantities of gold that accrued in the United States during the
First World War and for most of the 1920s to trigger domestic inflation within
the United States, despite the fact that such policies would have greatly eased
the burdens which European nations faced in resuming the gold standard. As
early as July 1915, Strong went so far as to state that the enormous quantity
of gold with which the Allies had paid for many of their war supplies was
“deposited with us in trust until the tide turns when we probably will have to
let some part of it go to Europe.”36 In the interim, Strong made every effort to
ensure that the influx of gold did not encourage domestic inflation, even though
the consequent price differential between the United States and Europe would
have greatly facilitated the ability of European nations to export to the United
States and hence would have hastened their economic recovery.
By preference, if no other considerations intervened, in the immediate postwar period Strong was largely wedded to economic orthodoxy, and tended to
take a fairly hawkish and conservative line on raising the discount rate to damp
down inflationary and speculative tendencies. His policies therefore reflected
a delicate balancing act between international and domestic priorities. Just
35 Leffingwell to Lamont, August 29, 1931, File 102-15, Lamont Papers; cf. Leffingwell
to Lamont, March 8, 1929, File 102-13, ibid.; Leffingwell to Lamont, May 29, 1929, enclosing
Leffingwell to Edward C. Grenfell, May 29, 1929, File 103-14, ibid.
36 Strong to Fred I. Kent, July 10, 1915, U.S. Senate, 74 Cong., 2d Sess., Hearings Before the
Committee Investigating the Munitions Industry, 40 vols. (Washington, DC: Government Printing
Office, 1934–36), 30:9527; Strong, diary, March 28, 1916, File 1000.2, Strong Papers.

P. Roberts: Strong and the Federal Reserve System


after the First World War, Strong was eager to raise discount rates, advocating
stringent monetary policies designed to drive down the soaring wartime cost
of living. His friend Russell Leffingwell, then Under Secretary of the Treasury,
initially opposed this anti-inflationary policy, probably largely because it would
drive up the interest rates on Treasury certificates, thereby making government
financing more expensive. In a classic example of bureaucratic politics, the
Treasury’s primary preoccupation was to reduce and eventually pay off the
high national debt that had accumulated during the war years. Carter Glass,
the Democratic politician who became Treasury Secretary in late 1918, may
also have feared the impact of higher increased rates and consequent deflation
on the outcome of the approaching presidential election. Early in 1920, after a
lengthy and sometimes heated dispute which nonetheless left their mutual respect for each other undiminished, Leffingwell joined Strong after the Treasury
had issued the Liberty bonds to finance long term the outstanding government
debt. The two men also sought to check increasing stock market speculation.37
A side effect of higher American interest rates was that the dollar rose
against other currencies, so that prospective European borrowers found the
cost of both American goods and the capital needed to finance economic recovery had risen. European debtors of the United States whose obligations were
denominated in dollars also faced increased payments. Intensifying European
misery, the financial assistance which Strong and others had earlier urged the
American government to provide for European relief and reconstruction never
materialized. Federal Reserve rates were by no means the only factor which
contributed to the American recession of 1920–1921; tighter fiscal policy and
the cessation of most war-related government orders in mid-1919 were also
significant, but deflationary rate policies magnified their impact. Still, by December 1920 a visit to London had led Strong to fear the high rate policy had

37 Strong

to Leffingwell, February 6, 28, December 19, 1919, Leffingwell to Strong, February 6, October 8, 1919, File 012.4, Strong Papers; Leffingwell, “Memorandum Concerning
Strong’s Confidential Letter of December 19, 1919,” May 4, 1920, Leffingwell to Charles A.
Morss, May 14, 1920, Letterbook 43b, Russell C. Leffingwell Letterbooks, Manuscripts Division,
Library of Congress, Washington, DC; numerous other memoranda in the Leffingwell letterbooks
for this period, copies of which are usually also in the File Federal Reserve Banks—Discount
Rates (Policy Letters) 1918–1920, Box 66, Record Group 56, National Archives II; Rixey Smith
and Norman Beasley, Carter Glass: A Biography (New York: Longmans Green & Co., 1939),
182–85; Chandler, Benjamin Strong, 148–69; Wicker, Federal Reserve Monetary Policy, 33–
45; Friedman and Schwartz, Monetary History, 221–31; Wueschner, Charting Twentieth-Century
Monetary Policy, 10–17. Leffingwell himself retrospectively minimized the significance of this
debate, pointing out that those “trivial variations of rates” Strong suggested would not “have
been an appreciable factor towards the control of inflation.” He suggested, moreover, that once
the Treasury had decided that a genuine inflationary problem existed, it took the initiative in
early 1920 in raising discount rates to 6 percent. It was perhaps not entirely coincidental that
the Treasury decision to do so coincided with Glass’s departure. Leffingwell to S. Parker Gilbert,
March 1, 1922, File Federal Reserve Banks—Discount Rates (Policy Letters) 1922, Box 66,
Record Group 56, National Archives II.


Federal Reserve Bank of Richmond Economic Quarterly

been carried to the point at which the high price of American capital was endangering the prospects for European recovery, and he was prepared to recommend
a decrease in rates. Although for some months afterward American domestic
conditions caused him to retreat from this suggestion and leave discount rates
as they were, in autumn 1921 the Federal Reserve System adopted, possibly—
though this is uncertain—on Strong’s suggestion, what he described as “a rather
aggressive program towards easing up money conditions, not entirely in our
own interest but somewhat in the interest of world recovery.”38
Over time Strong’s commitment to European recovery apparently intensified appreciably, but limits remained. Most significantly, Strong was not
prepared to countenance major price inflation in the United States even to
facilitate Britain’s return to gold. Eichengreen has suggested that a major factor
undercutting Britain’s return to gold was the Federal Reserve System’s policy of
“sterilizing” gold imports, i.e., through sales of government securities reducing
the money supply by the amount of the additional gold received. By preventing
inflation in the United States, which such gold shipments would otherwise have
precipitated, these policies made it almost impossible for European countries
suffering from a balance of payments deficit to reverse the process, as their own
products became cheaper. Had Strong been prepared to countenance inflation
in the United States, the price differential between the two countries would
have shrunk, making it unnecessary for Britain to adopt such stringent and
deflationary monetary policies in the quest to return to gold.39
Even though by the mid-1920s this situation had persisted for ten years,
Strong may still have regarded—or at least found it convenient to regard—the
American gold stockpile as a temporary phenomenon, soon to be liquidated
by the vast upsurge in U.S. loans and investments in Europe that began in
1923 and which he believed Britain’s return to gold would further encourage.
(Like most international bankers, he expected subsequent European recovery
to generate increased European exports to the United States.)40 Moreover, in
fairness to Strong, in 1924 he suggested to Andrew Mellon, the Secretary of
the Treasury, that to facilitate Britain’s return to gold, it would be necessary
to have “some small advance in prices here and possibly some small decline

38 Strong

to Federal Reserve Bank, New York, December 12, 1920 (not sent), File 1000.4,
Strong Papers; quotation from Strong to William Hailey, October 24, 1921, File 1111.2, ibid.;
Strong to Norman, June 27, July 5, November 1, 1921, File 1116.2, ibid.; Chandler, Benjamin Strong, 174–177; Friedman and Schwartz, Monetary History, 234–35; Wueschner, Charting
Twentieth-Century Monetary Policy, 17–21; Friedman, “Real and Pseudo Gold Standards,” 67–68.
39 See Eichengreen, Golden Fetters, esp. 203–07; Chandler, Benjamin Strong, esp. 282–303;
Friedman, “Real and Pseudo Gold Standards,” 69–70.
40 Such policies were entirely compatible with central banking theories that, when gold was
valued at a fixed price, short-term gold policy could be used to pursue other objectives, such as
maintaining stable interest rates or prices. See Marvin Goodfriend, “Central Banking Under the
Gold Standard,” Carnegie-Rochester Conference Series on Public Policy 29 (1988), 85–124.

P. Roberts: Strong and the Federal Reserve System


in their [British] prices. . . . The burden of this readjustment must fall more
largely upon us than upon them.”41
Yet, after making all such allowances, Strong undoubtedly had taboos he
would not contemplate breaking, of which countenancing excessive domestic inflation was probably the most pronounced. His reaction to the British
economist John Maynard Keynes’s mere mention of American policies of “demonetizing gold and locking it up in Washington” was instructive. To Carl
Snyder, head of the New York Reserve Bank’s research division, Strong tetchily
complained that Keynes
must think we are indeed very stupid people. If we are going to permit this
gold, which does its initial damage the minute it arrives here, to do further
damage by permitting it to become the basis of a great inflation, he and
others of his stripe are consciously or unconsciously looking to this country
to indulge in a great inflation for their benefit. We are not going to do it if it
can be helped and if they would be sensible enough to get their own houses
in order and manage their own damn currency in a sensible, civilized fashion,
they would shortly be able to come over here and get the gold they need to
present a respectable monetary face to the world. I am thoroughly tired and
impatient of the ravings of these inflationists who want us to play the part
of cat’s paw and pull their chestnuts out of the fire when they haven’t the
courage to do it themselves.42

Not only Strong but many of his American and European compeers were familiar with the economic writings of Keynes, notably A Tract on Monetary Reform
(1923) and the more polemical The Economic Consequences of Mr. Churchill
(1925), which suggested that their gold standard and monetary goals were
logically incompatible. Keynes specifically opposed sterling’s return to gold at
the $4.86 parity Norman favored and which, to Norman and many other British
officials, was not negotiable. To them, this valuation was not merely an economic goal but a matter of national honor, a symbolic reaffirmation of Britain’s
prestige and a public demonstration that the country had regained its pre-1914
international position. In the 1920s Keynes, by contrast, remained an economic
maverick whom financial authorities, while admitting his brilliance, regarded
with considerable suspicion. His fondness for public controversy and invective, most evident in the publication of The Economic Consequences of the
Peace (1919) with its stinging attacks on Woodrow Wilson, led many British
and American bankers to consider him somewhat unstable, while the views
expressed therein led him to be labeled undesirably “pro-German” for some
41 Strong

to Mellon, May 27, 1924, File Gold (Miscellaneous), 1922–1925, Box 86, Record
Group 56, National Archives II; cf. Chandler, Benjamin Strong, 283.
42 Strong to Carl Snyder, February 4, 1924, File 320.454, Strong Papers.
43 See Robert Skidelsky, John Maynard Keynes, Volume 2: The Economist as Saviour 1920–
1937 (London: Penguin Press, 1994), 189; Hession. This view of Keynes as pro-German pervades


Federal Reserve Bank of Richmond Economic Quarterly

When Norman sent him a copy of Keynes’s Tract on Monetary Reform,
Strong commented “that some of his conclusions are thoroughly unwarranted
and show a great lack of knowledge of American affairs and of the Federal
Reserve System.” Of Keynes himself, he wrote, “I have a great respect for his
ability and the freshness and versatility of his mind, but I am much afraid of
some of his more erratic ideas, which impressed me as being the product of
a vivid imagination without very much practical experience.”44 “Mr. Keynes
seems to have rather overdone himself,” Norman dismissively responded, “a
fact which perhaps comes from his trying to combine the position of financial
mentor to this and other countries with that of a high-class speculator (by
which I mean one whose sole object is to buy stocks when they are cheap
and sell them when they are dear).”45 Other American bankers shared their
skepticism. “Keynes is always perverse, Puckish,” Leffingwell wrote in 1931.
“He attacks anything sound or established or generally accepted, partly for
the fun of it, partly for the purpose of stimulating debate. In doing so he is
utterly irresponsible. He doesn’t care how much harm he does in giving aid
and comfort to the enemies of sound finance.”46 In rejecting Keynes’s views,
Strong, Norman, and their compeers simply reflected the conventional wisdom
of their day.47
Two factors help to account for Strong’s reluctance to take major risks to
facilitate Europe’s return to the gold standard. The first was that, like most
international bankers of his time, he believed implicitly in the orthodox economic principles of the gold standard, balanced budgets, and stable prices.
It is worth noting that Norman, who as a fellow central banker of similarly
orthodox economic views likewise detested inflation, found this perspective
entirely acceptable and apparently never suggested to his colleague that the
United States should tolerate greater inflation, accepting this state of affairs
as the price it must pay if European currencies were to return to gold.48 For
the correspondence for the early 1920s between the editors of Foreign Affairs, Archibald Cary
Coolidge and Hamilton Fish Armstrong. Archibald Cary Coolidge Files, Boxes 17–20, Hamilton
Fish Armstrong Papers, Mudd Manuscripts Library, Princeton University, Princeton, NJ.
44 Strong to Norman, January 4, 1924, File 1116.4, Strong Papers.
45 Norman to Strong, January 30, 1924, ibid.
46 Leffingwell to Lamont, August 29, 1931, File 103-15, Lamont Papers. By 1945, however,
Leffingwell had gained greater respect for Keynes, stating that he was “not popular over here, but
he knows his facts and his economics better than anyone else.” Leffingwell to Lamont, September
13, 1945, File 104-5, ibid.
47 On the limitations of American economic thinking at this time, see also Chandler, America’s Greatest Depression, 111–14.
48 Despite his own opposition to Britain’s return to gold at pre-1914 parities, Keynes simultaneously expressed apprehension that the United States might jettison its existing policy of
accepting gold which it would “maintain . . . at a fixed value” and instead “be overwhelmed by the
impetuosity of a cheap money campaign,” one which would lead the United States to release all
its gold simultaneously, with drastic effects on the international monetary system. John Maynard
Keynes, A Tract on Monetary Reform (London: Macmillan, 1923), 169, 175–76.

P. Roberts: Strong and the Federal Reserve System


the majority of British and American international bankers and economists
in the 1920s, Strong included, their formative years had fallen in the prewar
period, when—as Eichengreen demonstrates—the self-regulating international
gold standard worked better than in any period before or since.49 They looked
back to that time as a norm whose restoration—including return to gold at
prewar parities—was the goal they sought to attain. In this sense they endorsed
the presidential campaign slogan of Warren G. Harding in 1920 for a “return to
normalcy.” It is also worth noting that the profound admiration American international financiers felt for the British financial system made it almost impossible
for them to appreciate how weak the British economic position was and how
detrimentally the First World War had affected Britain. Notwithstanding some
domestic British opposition, both Strong and Norman appear to have taken it
as a sine qua non that sterling must return to gold at the prewar parity.50
In Strong’s defense one should also note that even had he been prepared to
acquiesce in far greater U.S. price inflation than occurred in the 1920s, political
pressures might well have prevented him implementing such policies. Economic
policy is, like politics, the art of the possible. Memories of the inflation and
subsequent deflation of the 1917–1921 period helped to ensure that during the
1920s the maintenance of stable prices and the need to avoid either excessive
inflation or deflation became a major political concern and was viewed as a
primary objective of the Federal Reserve System. (Memories of these previous
monetary policies and their political and economic consequences may also
have been another reason why, in the late 1920s, the Federal Reserve System
hesitated to act decisively in either raising or reducing rates.) Despite Strong’s
oft expressed belief that central bankers should remain immune from political
pressures, in practice, as Wueschner has pointed out, he was highly sensitive to
political considerations.51 Although Strong doggedly resisted attempts to pass
legislation demanding that the Federal Reserve System employ rate policy and
open market operations to ensure price stability, preferring that Federal Reserve
officials should be allowed to use their discretion in attaining this objective, it
was a goal he broadly shared.52 Publicly and in correspondence with Norman
he frequently stressed the importance of maintaining price stability.53 In this,
he reflected the views of most central bankers.
Even more broadly, internal political developments throughout Europe
jeopardized central bankers’ interwar efforts to return to gold. Eichengreen
49 See

Eichengreen, Golden Fetters, ch. 1.
e.g., Strong to Norman, June 3, July 9, 1924, Norman to Strong, June 16, October
16, 1924, File 1116.4, Strong Papers.
51 See Wueschner, Charting Twentieth-Century Monetary Policy, xvi, 21, 36–37, 44–45, 50,
52 Ibid., 54, 79, 119–20; Chandler, Benjamin Strong, 199–204; Hetzel, “Rules Versus Discretion Debate,” 7–11, 14.
53 See Kindleberger, Essays in History, 12.
50 See,


Federal Reserve Bank of Richmond Economic Quarterly

plausibly argues that in the 1920s the commitment to defend the international
gold standard in difficult times encountered new obstacles in many nations, not
just the United States, in the form of domestic policy objectives that interfered
with the honoring of the commitment. One major reason was that the post-World
War I broadening of the franchise in most European countries due to the spread
of universal suffrage had made it far more difficult than before for governments
and central bankers to resist electoral pressures for increased social spending
and the reduction of interest rates, regardless of such policies’ impact upon
the international monetary system.54 French monetary policies appear to give
some confirmation to this thesis. Throughout the 1920s and 1930s, the French
were far less committed than any other major European nation to maintaining
the international gold standard system. Although they finally returned to gold
in 1927, they did so—to the regret of Emile Moreau, the governor of the
Banque de France—below pre-1914 parities, which effectively subjected the
pound to additional deflationary pressures. (Revealingly, Strong showed little
interest in the precise par value of the franc.)55 For much of the Great Depression, French actions, including not only a gold sterilization but, ironically,
a tenacious attachment to gold several years after most other countries had
abandoned it, continued to compromise the international financial system and
efforts to coordinate economic policies, just as French fiscal policies in the
early 1920s rejected the balanced budget norms which international financiers
demanded. The effective secession of a leading European country from gold
standard norms made it commensurately more difficult for others to continue
to observe them.56 Increasingly, countries pursued their own national economic
priorities even if the priorities conflicted with efforts to implement coordinated
transnational financial cooperation.

54 See

Eichengreen, Golden Fetters. Early in his career, the distinguished historian Paul M.
Kennedy likewise drew attention to the degree to which the extension of the franchise in earlytwentieth-century Britain vastly increased the political constituency for increased social welfare
spending, if necessary at the expense of defense budgets. Paul M. Kennedy, The Realities Behind
Diplomacy: Background Influences on British External Policy, 1865–1980 (London: George Allen
& Unwin, 1981) 47–51, 236–40.
55 Melvyn P. Leffler, The Elusive Quest: America’s Pursuit of European Stability and French
Security, 1919–1933 (Chapel Hill: University of North Carolina Press, 1979), 166.
56 Ibid., chs. 4–8; H. Clark Johnson, Gold, France, and the Great Depression, 1919–1932
(New Haven: Yale University Press, 1997); Eichengreen, Golden Fetters, esp. chs. 8–10; Prefaces
by Milton Friedman, Stephen D. Stoller and Trevor Roberts, and Jacques Rueff to Moreau, Golden
Franc, x–xxi, 1–10; Charles P. Kindleberger, A Financial History of Western Europe, 2nd ed. (New
York: Oxford University Press, 1993), ch. 19; Friedman, “Real and Pseudo Gold Standards,” 70.
On French budgetary policies in the early 1920s, see also Stephen D. Schuker, The End of French
Predominance In Europe (Chapel Hill: University of North Carolina Press, 1973).

P. Roberts: Strong and the Federal Reserve System




Just before he died, Strong felt that the reconstruction of Europe was virtually
completed and his policies had been successful.57 Other leading bankers shared
this view. During World War II, his sometime critic Leffingwell reflected, “As I
look back over the 1920’s it seems to me that the job we did in the reconstruction of currencies all over the world was a good one.” Expanding this theme,
18 months later he added:
[T]he British war debt settlement of 1922 or 1923 and gold resumption of
1925 . . . gave hope to the human race which did not altogether disappear
until in 1931 the Hawley-Smoot tariff, the veto of the German-Austrian customs union, the failure of Credit Anstalt, Hoover’s panicky defense of his
moratorium, and the May and Macmillan reports pulled the plug.58

Such optimistic views notwithstanding, between the wars Federal Reserve policies towards European recovery shared the prevailing weaknesses of broader
American internationalism, revealing the half-hearted nature of the post-1918
U.S. assumption of a greater world role. Charles P. Kindleberger suggests that
between the wars one of the major international economic structural problems
was the fact that, while Britain was no longer strong enough to play the role of
international economic hegemon, the United States was not prepared to assume
the associated burdens and responsibilities of the role it inherited.59 Warren I.
Cohen has described this period as one of “empire without tears,” when the
United States wished to enjoy the benefits of international influence at the
lowest cost possible, refusing to bind itself to commitments overseas or make
the sacrifices almost inherent in a world hegemonic position.60 The diplomatic
historian Melvyn P. Leffler has pointed out that post-World War I American
foreign policymakers were subjected to various conflicting and often inconsistent demands, including among others domestic political pressures and calls
for fiscal economy at home, which decidedly limited the extent to which U.S.
officials were prepared to make concessions to Europeans on such economic
issues as war debts, reparations, or trade and tariffs, as well as exchange rates.61
57 Strong

to Owen D. Young, August 17, 1928, File 320.122, Strong Papers.
to Lamont, April 4, 1940, File 103-22, Lamont Papers; Leffingwell to
Lamont, October 10, 1941, File 106-11, ibid.; also Leffingwell to Lamont, September 11,
1940, File 103-23, ibid.
59 See Charles P. Kindleberger, The World in Depression, 1929–1939 (Berkeley: University
of California Press, 1973), 25–29; idem., Essays in History, 45–46.
60 See Warren I. Cohen, Empire Without Tears: America’s Foreign Relations, 1921–1933
(New York: Knopf, 1987).
61 See Melvyn P. Leffler, “Political Isolationism, Economic Expansionism or Diplomatic Realism? American Policy toward Western Europe 1921–1933,” Perspectives in American History 8
(1974), 428–30; idem., “The Origins of Republican War Debt Policy, 1921–1923: A Case Study in
the Applicability of the Open Door Interpretation,” Journal of American History 59:4 (December
1972), 585–601.
58 Leffingwell


Federal Reserve Bank of Richmond Economic Quarterly

Numerous other historians, among them Frank Costigliola, Joan Hoff Wilson, and John Braeman, have drawn attention to the tentative, unsystematic,
and often contradictory character of American international thinking between
the wars, the profound hesitancy with which presidential administrations in the
1920s recognized any American responsibility whatever for managing the international economic and political system, and the degree to which the United
States preferred to rely upon the unilateralist policies Wilson terms “independent internationalism.”62 In this context, Strong’s determination neither to
abandon prewar European currency parities nor to demand economic sacrifices of the United States in support of them epitomizes the halfhearted and
hesitant nature of his country’s overall interwar international outlook. The
Federal Reserve System’s own development trajectory closely paralleled the
broader pattern of the evolution of the United States as a world power. Mira
Wilkins rightly reminds us that between the wars the U.S. government deliberately eschewed formal involvement in European recovery and points out
“how new to world finance New York was” and how ill-equipped the inexperienced existing economic institutions were to handle the new international
financial challenges.63 Viewed from this perspective, Strong’s efforts to facilitate European interwar economic recovery represented a remarkable departure,
especially when one recalls that the Federal Reserve System had only existed
since 1913. To paraphrase Samuel Johnson, their significance was not merely
that they were flawed, but that they were made at all. If Strong was no more
enlightened than his contemporaries, this was because he was a man of his
times. A product of the late Victorian era who fundamentally embraced that
period’s economic norms, he lacked, unlike the brilliant but often exasperating
Keynes, the visionary ability to construct a new paradigm of political economy.
Paradoxically, the very failure of Strong and his American and European
peers and their principles to provide lasting solutions to international economic
difficulties between the wars was high among the factors impelling American
officials, when reconstructing the post-1945 world, to follow guidelines very
different from those followed in the 1930s. By the end of the Second World War,
the U.S. government was prepared to play the leading part in this enterprise;
moreover, European nations were then far more dependent economically upon
the United States than they had been in the 1920s, which greatly facilitated
62 See Joan Hoff Wilson, American Business and Foreign Policy, 1920–1933 (Lexington:
University of Kentucky Press, 1971); John Braeman, “Power and Diplomacy: The 1920s Revisited,” Review of Politics 44:3 (July 1982), 423–469; Frank Costigliola, Awkward Dominion:
American Political, Economic, and Cultural Relations with Europe, 1919–1933 (Ithaca: Cornell
University Press, 1984).
63 See Mira Wilkins, “Cosmopolitan finance in the 1920s: New York’s emergence as an
international financial centre,“ in The State, the Financial System, and Economic Modernization,
eds. Richard Sylla, Richard Tilly, and Gabriel Tortella (Cambridge: Cambridge University Press,
1999), 283; cf. Chandler, America’s Greatest Depression, 112–14.

P. Roberts: Strong and the Federal Reserve System


American attempts to induce them to cooperate with American-led reconstruction efforts. At that time, the United States insisted upon fixing exchange rates
at economically viable levels, and Treasury officials were prepared to accept an
outflow of excess gold from the United States in payment for European exports.
More broadly, the impact of the Great Depression and the Second World War
impelled the United States to play the role of international political, not just
economic, hegemon, establishing a range of American-led institutions intended
to implement world recovery and stability, including the United Nations, the
International Bank for Reconstruction and Development, and the International
Monetary Fund. Moreover, when these proved insufficient, the United States
quickly instituted supplementary measures, including the Marshall Plan, NATO,
individual loans to particular countries, and assorted military and economic
international aid programs.
Within the Federal Reserve System itself, Strong’s dominance of the System and the acrimony this often generated ultimately helped to bring reform.
An institution that could be so susceptible to domination by a single individual,
albeit one of great determination and ability, had inherent structural problems.
The general dissatisfaction non-East Coast bankers expressed over New York’s
predominance in the System might in any case have precipitated demands for
Federal Reserve reform. Yet it was above all the System’s failure to cope with
the crisis of the Great Depression that fueled the pressures leading to the 1935
Banking Act’s overhaul of the Federal Reserve System. The primary purpose
of the Federal Reserve System had been to prevent or at least alleviate the panics and depressions of the pre-1913 period. The operation of Murphy’s Law
ensured that, by the cruel workings of chance, Strong’s disappearance from the
System coincided with the period in which the System came under far greater
stress than ever before. Given the emphasis its founders had originally placed
on decentralizing power within the System, it may well be that the difficulties
of the 1920s and the Great Depression were experiences necessary to enable
the System’s reform.
In his memoirs, Herbert Hoover blamed Benjamin Strong’s internationalism for the Depression. According to Hoover and other critics of Strong such
as Adolph Miller, the dominating governor of the Federal Reserve Board in
Washington, Strong’s “easy money” policies designed to assist Britain’s return
to the gold standard produced a speculative rise in stock prices on the New
York Stock Exchange. The inevitable bursting of that speculative bubble led
to the Great Depression. But this picture hardly fits the Benjamin Strong who,
in his support of the fateful decision in 1928 to raise interest rates and force a
monetary contraction to bring down stock prices, was an economic nationalist.
High interest rates in the United States pulled capital out of Europe and forced
monetary deflation there and elsewhere. The international gold standard that
Strong had labored so hard to create became an engine of worldwide deflation.


Federal Reserve Bank of Richmond Economic Quarterly

The truth of the matter is that Strong, in his support of the rate hikes and
monetary contraction, was only adhering to the commonly accepted real-bills
views of his time. According to these views, central banks should thwart the
speculative extension of credit to prevent increases in asset prices that would
ultimately collapse and lead to deflation and depression. If Strong was guilty in
holding these views, then so too was the entire banking community, commercial
and central. The lesson is clear. Instead of looking for a single individual to
blame for causing the Great Depression, it is surely more enlightening and productive to recognize the flaws in the views underlying the policies that produced
that catastrophic episode. Such recognition is part of a broader understanding
of how America’s shift from isolationism to internationalism after World War
II promoted the more peaceful and prosperous world of the second half of the
twentieth century.