[PEN-L:28405] Re: Re: The D word surfaces

[Bill Lear <rael@xxxxxxxxxx>]

On Tuesday, July 23, 2002 at 18:58:14 (-0400) Doug Henwood writes:
>Devine, James wrote:
>
>>I'd have to look again at this, but the Fed often has let the
>>discount rate follow the market -- and market rates were clearly
>>falling. According to Friedman & Schwartz, market rates may have
>>fallen more than the discount rate: "Though discount rates fell
>>absolutely [before Oct. 1930], it probably rose relative to the
>>relevant market interest rates, namely, those on short-term
>>securities with essentially zero risk of default." (_The Great
>>Contraction_, p. 45.)
>
>Of course, Friedman wants to blame the depression on the Fed, since
>it couldn't have been the result of anything intrinsic to capitalism.
>It had to be bad state policy - stupid Fed and Smoot-Hawley.

     ... in the  United States the fear of the  Member Banks lest they
     should be  unable to cover their  expenses is an  obstacle to the
     adoption of a wholehearted cheap money policy.

     --- J. M. Keynes, September 1932

This quote from Keynes is found in "Monetary Policy, Loan Liquidation,
and Industrial Conflict: The Federal Reserve and the Open Market
Operations of 1932" by Gerald Epstein and Thomas Ferguson, in
Ferguson's *Golden Rule*.  According to Epstein and Ferguson:

     In  the summer  of 1929,  output and  employment in  the American
     economy  began falling.   After the  stock market  crash  in late
     October,  the  decline  turned  into  a  catastrophic  rout.   By
     mid-1930, the United States, along with many other countries, was
     clearly sliding  into deep  depression.  Yet the  Federal Reserve
     System, widely trumpeted  in the 1920s as the  final guarantor of
     financial  stability,  did  very   little  to  offset  what  soon
     developed into the greatest deflation in American history.

     For  two long  years the  Fed  maintained its  posture of  Jovian
     indifference.  On occasion the  New York Fed promoted very modest
     increases in liquidity; discount  rates were lowered and flurries
     of open market purchases occurred, but nothing more.

They note that in spring of 1932 the Fed "came to life" after passage
of the Glass-Steagall Act and worked to infuse cash into the Reserve's
member banks.  However, this policy was short-lived and by the summer
of 1932, the Fed "effectively abandoned the new policy".

The thrust of the essay is to "highlight the potentially disastrous
consequences of one of the Fed's most basic structural
characteristics: its dual responsibility for both the health of the
member banks and the welfare of the economy as a whole."  Before
launching into this effort, Epstein and Ferguson briefly review and
critique standard accounts, including that of Milton Friedman and Anna
Schwartz.  Of this account, they point out:

     Friedman and Schwartz's account  of the making of monetary policy
     in   this   period   ...   emphasizes   domestic   concerns   and
     underestimates  the role  international  economic considerations,
     especially  a  concern  for  protection  of the  gold  stock  and
     maintenance of the gold standard,  played in the making of policy
     throughout  most of  the period  of  1929 to  1932 ....  although
     Friedman and Schwartz are correct  in claiming the passage of the
     Glass-Steagall Act of early  1932 temporarily alleviated the free
     gold problem for the Federal  Reserve System as a whole, they are
     mistaken in dismissing both gold and the international economy as
     constraints thereafter.

     To see  how the international  economy affected Fed  policy after
     the Glass-Steagall Act of 1932, however, it is necessary to break
     with the  tradition of  analyzing the Fed's  actions in  terms of
     their effects on broad categories,  such as the total gold stock,
     the balance of  payments, or the national income.   One must look
     in detail at the microeconomics of the banking sector to identify
     how  various  actions  of   the  Fed  potentially  affected  bank
     profitability  at  different   points  in  time.   If,  following
     Stigler, Posner,  and other recent  analysts of the  symbiosis of
     regulator  and  regulated, one  gathers  evidence  on the  policy
     preferences  of private  bankers and  their interaction  with the
     regulators, we find  a ready answer to our  ... central questions
     about the Fed's open market program of 1932.

I won't reveal the details of why the Fed "largely sat on its hands as
the entire American financial structure collapsed", largely because of
time constraints and tired fingers, but I think the analysis is quite
stimulating.


Bill