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July 17, 1997

WEA CONFERENCE - Seattle, Washington
July 10-12,1997

Chapter 4 of Allan’study of the Fed covers the period 1923-1929. It has several themes
and issues that bear on h o w w e think about other periods.
I’ discuss five issues:
1. International Issue:
inconsistency between price levels in United States and Europe and the desire
on both sides of the Atlantic to return to 1914 gold price parities.
2. Inflation diagnosis issue:
disparity between goods prices and asset prices.
3. M o n e y diagnosis issue:
disparate behavior of broad and narrow measures of money.
4. Theoretical issue:
Riefler-Burgess vs. real bills doctrine.
5. Understanding issue:
O M O and inflation
I w o n ’discuss other issues:
1. Improved credibility thesis
2. Favorable productivity surprise thesis

1. International Issue

In the decade from 1914 to 1924, the United Kingdom had experienced
considerably more inflation on balance then the United States or France. Nevertheless,
all three countries wanted to return to their respective 1914 gold prices. That is
equivalent to returning to the 1914 exchange rates between the dollar, the pound Sterling
and the French franc.

But, since the Sterling prices of internationally traded goods had risen
considerably more on balance than the dollar or French Franc prices of those same goods,
to return to 1914 parities would mean either the dollar and French Franc prices had to rise
or Sterling prices had to fall.

Given the objectives of the respective countries, gold flowed out of the United
Kingdom and into the United States. Ordinarily, that would have simultaneously reduced
the price level in the United Kingdom and raised the price level in the United States.
Allan argues that the Federal Reserve sterilized the gold inflow into the United States, in
effect forcing all the adjustment on the British, which meant substantial deflation.

M y guess is that Allan does not believe the United States should have accepted
the full inflationary implications of the gold inflow, but, rather, i was simply wrong on
both sides of the Atlantic to attempt to return to 1914 gold prices.


this, he argues, was the predominant cause of the crash of 1929 and the
subsequent Great Contraction.


2. Inflation Diagnosis Issue

Allan argues that at least by 1926 the Federal Reserve was pursuing a deflationary
policy, as evidenced by the falling PPI and CPI:


he documents that at least some members of the Federal Reserve
Board of Governors viewed the stance of policy as inflationary, as
evidenced by rising equity and other asset prices.


implicit in part of the chapter is that if monetary policy had been less
restrictive, then earnings expectations could have been realized and the
crash of 1929 avoided.


some in the Federal Reserve (as well as Friedman & Schwartz) argue
that the crash became unavoidable after excessively expansionary
central bank credit growth had permitted an equity market bubble that
could not be sustained.


Friedman & Schwartz are not clear on either their diagnosis or their
prescription when they state that policy before 1929 was “ easy to
break the speculative boom, yet too tight to promote healthy economic

3. Money Diagnosis Issue

Monetary base grew slowly (1926-1928).

- Narrow money fell or grew even more slowly.

Broad money grew more rapidly.


In other words,

narrow money multiplier fell, while


broad money multiplier rose, and what was happening to the demand for
central bank money is not clear.

Cagan and Friedman/Schwartz treated the public’and commercial bank’behavior —
shifting from high reserve transaction liabilities to low or no reserve time deposits —as
though i was an exogenous event that raised the broad money multiplier, while reducing
the narrow money multiplier, and thereby


expanding broad money growth faster than people really wanted to hold
(excess supply) while at the same time contracting narrow money (excess
demand?), and I’ not sure what they thought was happening to demand for
base money.

Allan suggests that the interest rate policies pursued by Federal Reserve Banks —(raising
opportunity costs of holding high reserve transactions liabilities induced the banks to
adopt practices to “
encourage depositors to shift from [demand to time], (footnote 185,
page 171) —reducing average reserve requirement ratio and permitting bank assets to rise
relative to M o n e y growth.”
This sounds like commercial banks had to find ways to economize on holdings of
base m o n e y because the growth of supply was restricted -- excess demand for base
But, if bank policies and technologies were operating like sweep accounts today
[Cagan, Friedman/Schwartz], then the demand for central bank money was falling, -­
even slower growth of monetary base was excess supply.

This gets at the heart of central banking.


4. T h e Theoretical Issue
Which, as documented by Allan, is different than either of the interpretations of M
growth, because neither the view held by the Board of Governors nor the Reserve Banks
relied on money as an indicator.
Board of Governors was sold on the “ bills doctrine”
and felt central bank
credit could and should be used only to finance real economic activity such as plant and
equipment and working capital. If so limited, there could be neither an excess supply of
nor excess demand for currency, so the purchasing power would be stable.

Allan documents that the Board of Governors criticized Federal Reserve Banks
for [perhaps naively and inadvertently] financing equity market speculations - and
therefore risking inflation.

The Reserve Bank response [especially N e w York and Benjamin Strong] was that
cutting edge” monetary policy was commercial bank “
reluctance to borrow”
FRBs; then, commercial banks contracted earning assets to pay off borrowings restraining economy.

5. Understanding Issue

what causes inflation, or


h o w is price level stability maintained

Allan documents some Federal Reserve officials stating:
that: O M O have nothing to do with rate of inflation.
that: money growth has nothing to do with interest rates.
that: legislation should N O T ('1926') mandate price stability because that
would mean the Federal Reserve Banks would be required to
stabilize the prices of specific commodities such as cotton!


In fact, their testimony against proposed legislation requiring stabilization of the
purchasing power of the dollar is similar to arguments economists would use today to
argue that wage and price controls are harmful to the economy.

Other Issues

Reserve Bank’desire to buy (or reluctance to sell) securities for
earnings reasons


View of some that what the Federal Reserve Banks did was unrelated
to the quantify of money.


Keynes praise of Federal Reserve policies from 1923-1928.


Arrogance: Governor Miller re: Ben Strong [p. 79]


Carter Glass (great structure in spite of ignorance about monetary