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Leadership at Federal Reserve

In chapter 6 of their 1963 classic, A Monetary History of the United States, 1867-1960, Milton Friedman and Anna Jacobson Schwartz argue that the tragic consequences of the Great Contraction of 1929-1933 could have been averted with a strong leadership at the helm of the Federal Reserve. The article turns this observation on its head and asks: If there is a strong leadership at the helm of the financial system, is there any assurance that there will be no crisis in the system, or if any crisis is brewing, will a strong leadership succeed in nipping it in the bud? It tests this in the light of what has been happening in Wall Street since the mid-1990s.

PERSPECTIVEEconomic & Political Weekly EPW march 21, 2009 vol xliv no 1237Leadership at Federal ReserveD N Ghoshnothing could be skipped, not even a single footnote. Context and Issue As the authors survey the period, the issue worrying them throughout is: could not the Federal Reserve have stemmed the severity of the Depression if it had under-stood and exercised the role expected of it? Apart from a critical review of the many facets of the role and functioning of the Federal Reserve, what has come under microscope is the responsibility of persons at the helm of affairs. Before we come to the gist of the assessment, it may be useful to set out the major landmarks in the evolution of the Great Depression. The first landmark is October 1929, the month in which the bull market crashed. For four years preceding this, from Octo-ber 1925 itself, speculation was raising its ugly head in Wall Street, but the Federal Reserve was undecided on how to cool stock market speculation. The two wings of the Federal Reserve held two different views: Washington was in favour of direct pressure without raising discount rates, whereas New York, led by Benjamin Strong, a long-time commercial banker, held that it would be of no avail unless New York was authorised to refuse loans at the discount window for banks carrying credits that were financing speculation. The issue remained unresolved; the Board stuck to the view that while suppression of speculation was highly important, raising the discount rate would stifle the flow of credit for productive purposes; instead, it suggested the use of direct pressure. The differences hinged on the question whether the stream of speculative finance is sepa-rable and distinct from the stream of finance for productive activities and whether any monetary intervention can touch one without impacting on the other. Strangely, even as this to and fro debate on what would be the best way of conduct-ing the assault on speculation continued, the bubble burst with disastrous conse-quences for the economy.The second landmark was the onset of the First Banking Crisis in October 1930. The stock market crash changed the at-mosphere within which businessmen and In chapter 6 of their 1963 classic, A Monetary History of the United States, 1867-1960, Milton Friedman and Anna Jacobson Schwartz argue that the tragic consequences of the Great Contraction of 1929-1933 could have been averted with a strong leadership at the helm of the Federal Reserve. The article turns this observation on its head and asks: If there is a strong leadership at the helm of the financial system, is there any assurance that there will be no crisis in the system, or if any crisis is brewing, will a strong leadership succeed in nipping it in the bud? It tests this in the light of what has been happening in Wall Street since the mid-1990s.D N Ghosh ( is the chairman of ICRA.The publication of the A Monetary History of the United States, 1867-1960 in 1963 was a central sensa-tion among monetary and economic histo-rians. At a time when aggregate demand management, the core of the Keynesian revolution, was the conventional wisdom, Milton Friedman and Anna Jacobson Schwartz, through this classic of theirs, stirred up a hornet’s nest, provoking acri-monious monetarist-Keynesian debates. While these continued to rage, the success of the deflationary monetary policies in the 1960s and 1970s brought about a balance in economic and monetary policymaking: along with Keynesian demand manage-ment, the authorities came to accept over the 1960s and the 1970s, that money mat-ters, and that central banks have to keep a watchful eye on the behaviour of money and the stance of their credit policy. Classics are to be revered, not read. Thanks to the Princeton University, we now have easy access through this volume to chapter six of the A Monetary History that addresses the issues concerning the role of the Federal Reserve during the Great Depression. Adding value to this re-markable volume1 is a new preface by Anna Schwartz, a new introduction by Peter Bernstein, and the remarks of Ben Bernanke, made on the occasion of Milton Friedman’s 90th birthday. Readers are also fortunate to find, reproduced here, the incisive comments of Albert Hettinger, the Director of National Bureau of Eco-nomic Research, made at the time when the manuscript of theA Monetary History was submitted for publication. In Peter Bernstein’s words, it is “a sparkling story of tragedy… of confusion, uncertainty, and raw ignorance… infighting among mem-bers of the Federal Reserve Board and the Presidents of Banks” becoming “a routine pastime”. Reading it after a lapse of nearly 40 years, at a time when a raging financial crisis is threatening to shake capitalism to its roots, I found it unputdownable;
PERSPECTIVEEconomic & Political Weekly EPW march 21, 2009 vol xliv no 1239The authors sum up the lesson in the concluding sentences of the volume:It happens that a liquidity crisis in a unit fractional reserve banking system is precise-ly the kind of event that can trigger – and has often triggered – a chain reaction. And economic collapse has often the character of a cumulative process. Let it go beyond a cer-tain point, and it will tend for a time to gain strength from its own development as its effects spread and return to intensify the process of collapse. Because no great strength would be required to hold back the rock that starts the landslide, it does not follow that the landslide will not be of major proportions (Italics added).The tragic consequences could have been averted, the authors argue, with a strong leadership. With the passing away of Benjamin Strong in October 1928, the dominating figure in policymaking in New York Bank, the operating arm of the Board, there was a shift of power from the New York Federal Reserve to the Board of Governors of the Federal Reserve at Washington. Friedman and Schwartz consider this change as critical. Benjamin Strong’s successor Harrison tried his best to carry on with Strong’s policy, but he was overruled. The members of the Board in Washington saw themselves primarily as a supervisory and review body; their attitude was that it was not the job of the Federal Reserve to stimulate business by making money artificially cheap in periods of depression or dear inperiods of boom, but merely to adapt itself to conditions as it found them. In situations like this, what makes the dif-ference is the presence of one or more outstanding individuals willing to assume responsibility and leadership. Strong leadership was absent; that could have put an end to the drift and indecision and saved the system. Leader as Saviour?Towards the end, after detailing the story of the tragedy, the authors draw the fol-lowing observation: “It is a defect of the financial system that it was susceptible to crises resolvable only with such leader-ship”. One can turn this observation on its head and ask: If there is a strong leader-ship at the head of the financial system, is there any assurance that there will be no crisis in the system, or if any crisis is brewing, a strong leadership will succeed in nipping it in the bud? Can we test this in the light of what has been happening in Wall Street since the mid-1990s? Unlike what had happened at the time of the Great Contraction, there was no leader-ship vacuum at the Federal Reserve at this time. On the contrary, it was fortunate to have been blessed throughout the period with a strong leadership in Alan Green-span. Yet, we had two bubbles; the second one has now developed into a global economic and financial crisis.The Federal Reserve, under Greenspan’s undisputed leadership, was guided by a market fundamentalist approach. The Efficient Market Hypothesis of Eugene Fama along with the influence of ideas of complete rationality as the dominant feature of economic systems had come to become conventional wisdom, not to be lightly challenged. Looking back, this new orthodoxy underpinned much of the malaise of today. The persistence of asset bubbles over a long period of time, involv-ing the most closely regulated entities, namely, banks; grossly overpaid senior ex-ecutives who took bad decisions guided by the sole motivation of keeping profits (and hence their bonuses) up, not allowing considerations of solvency and prudence to influence their judgment and thus causing the eventual ruin of their charges; and an apparent hands-off team of regula-tors who were reluctant to use the autho-rity vested in them by law and did not see their obligation to do so – it is this approach by a strong leader, and not any absence of strong headship, that was responsible for the build-up of two successive crises.Let us take an overview of the first crisis. The controversy over the role of the Federal Reserve in the face of what appears to be speculation in asset prices had a second incarnation during this cri-sis. In the 1920s, as we have discussed above, there was unanimity that specula-tion had to be curbed, but opinions dif-fered as to the correct method to be de-ployed. Greenspan had a different philo-sophical approach: it was not the business of the Federal Reserve to control specula-tion in asset prices. Let us recall the scene in the early 1990s. For many, the sustained buoyancy of Wall Street was the expres-sion of a new renaissance of American capitalism: technology stocks were domi-nating the market at inexplicable levels, far above their fair values. An analyst at Phillips and Drew estimated that 15 technology stocks were valued at more than the entireUS market a decade ago. More worrying was the rationalisation of such valuations; a book, authored by Glassman and Hasset, decried the writings of “bubblogists” asserting that the market continued to be undervalued and that a forward looking model for valuing stocks had to be devised to replace the old P/E model that stood repudiated by the past two decades of market history. Arthur Levitt decried the behaviour of the market as the “culture of gamesmanship”; even Greenspan’s “irrational exuberance” speech in December 1996 did not cool the market. The Dow Jones was then at 6,437; when he spoke two and half years later at the central bankers meet (at Jackson Hole in August 1999), the index was about 5,000 points higher. Interest rate increas-es from time to time had little impact. Asset bubbles may have responded to monetary policy adjustments if liquidity had been squeezed early enough. The bubble ultimately burst. What is the quality of leadership that comes out of this episode? On the one hand, the policy of non-interference seemed to send out a signal that market participants had to behave responsibly, or otherwise they would be digging their own graves. On the other hand, the midnight intervention following the Long-Term Capital Manage-ment (LTCM) debacle sent out a different kind of signal: let the market function as it chooses; the principle of “moral hazard” has been given a decent burial. The market developed a touching belief that if there be any crisis in Wall Street, Greenspan would be the great saviour, even for those who were speculating in the market at a highly geared level with bank funds. Certainly Greenspan behaved as a strong leader, deciding to do what he considered best, but many started worrying where he was leading us to.The second episode was of a different genre. Early in the new millennium, as the world’s leading financiers surveyed the wreckage of the global technology boom and the resulting crash of the stock market, they must have marvelled at the
PERSPECTIVEmarch 21, 2009 vol xliv no 12 EPW Economic & Political Weekly40resilience of their own financial system. Despite the heavy losses in telecommuni-cations and the collapse of large compa-nies such as Enron and Parmalat in other sectors, no big financial institution had run into financial difficulty. This, bank-ers and regulators argued, as many might recall, was because banks had been ex-tensively using techniques such as securi-tisation and creation of derivative instru-ments to pass on risks that they would have otherwise held in their books. This approach, dubbed as the “originate and distribute” model, was widely hailed as one that had transformed the banking industry into a less risky and more profit-able business. As it turned out, these claims proved to be nothing more than empty boasts. Bruised by stock market losses, Ameri-cans started buying houses in a big way. Massive house mortgage loans were being extended to non-creditworthy persons – those who did not have the inherent capa-bility to honour their repayment commit-ments. The financial sector, including commercial banks, created these assets on the expectation that property prices would continue to go up. Having created these assets, they shook these off their books to duck the requirement of having to make higher capital provisions. These loans were transformed into securitised assets, which investment bankers, backed by lines of credit from the same commercial banks, sold all over the globe. The easy credit policy created an age of leverage. Total public and private debt in the US rose from about 155% of gross domestic pro-duct in the early 1980s to something like 356% by the middle of 2008. With average household debt rising from about 75% ofannual disposable income in 1990 to nearly 130%, a large proportion of American households got submerged under the accumulated debt. The financial sector’s debt grew even faster. According to one recent estimate, the total leverage ratios (on and off book assets and expo-sure divided by tangible equity) for the two largest US banks were 88:1 for Citibank and 134:1 for Bank of America (Niall Ferguson,Financial Times, 19 December 2008). At a time when this high, and clearly unsustainable, leverage was building up, investment in housing continued to be encouraged. Even as things went wild, Greenspan dismissed those who warned that a new bubble was emerging; it was just a little “froth” in a few areas. This time, as at the time of the equity bubble, the mistake was not only to set interest rates too low, but to also stand back even as wildly imprudent policies were being openly pursued by mortgage lenders. The US had endured financial crises before with little or no effect on the real economy, for example in 1987 and 1998, but these were autonomous financial crises with little connection to the underlying US economy. The present financial crisis is different. It is defined by the bursting of two bubbles – in housing and in the credit markets – bubbles that were deeply interconnected. Two questions come up. First, if the banks were getting more and more involved in risky lending, should not the regulators have intervened? If the originators of loans were generating risky assets and investors were packag-ing these into securitised products and then selling these products to investors all over the globe, were not the regula-tors getting concerned about systemic risk, that a few defaults could well trig-ger a chain reaction on a global level? Second, is there any point in blaming the innovators for having come up with the new financial instruments? If the wide-spread use of these instruments had the potential of exponentially increasing the risks in the financial systems all over the globe, should not the authorities have stepped in to limit and supervise strictly the use of such financial instruments? In particular, the Federal Reserve, as the regulator in the US, which has the largest number of investment banks that created and distributed these products, will have to bear the primary responsibility. Secu-ritised products distribute the risks, but cannot wash away the original sin at the primary lending level, which in this case were the strictly regulated banking and mortgage institutions. Widespread con-cerns were being voiced by several experts that the extensive use of these instruments needed to be strictly super-vised. The Federal Reserve did not how-ever appear worried; it kept its hands off and continued to believe that the market would correct distortions, if any.The conjuncture of circumstances that have led to the current crisis is different from what had led to the Great Contrac-tion of the 1930s. But would we be far too wrong to say, as we survey the wreckage, that, as in the earlier case, in this one too, it has turned out to be a “story of great tragedy” (to quote Peter Bernstein again), somewhat in the nature of Greek drama, in which the protagonist is found to have always carried the seeds of his own de-struction. After the bloodbath is over, we would in all probability look afresh at the role and responsibility of the central banks of the leading countries. Certainly central banks should have strong leaders, as Friedman and Schwartz would have us believe, but as national economies are now more integrated than ever before, strong central bank leadership, by itself, at the national level would prove unequal to the task of countering the kind of crisis we are facing today. There has to be an improved macro prudential supervision at the global level; coordination at the G-8 (orG-20) level is no substitute for that. In a fundamental sense, in the global context, the voices from countries that are directly affected by the decisions taken by the financial systems the western nations run, regulate and supervise are never heard. The rich western nations, with the mantle of global leadership they have thrust upon them-selves and who are collectively responsi-ble for this mess, are yet to get their acts together and arrest the global meltdown. As the huge financial losses caused by the financial crisis forcefully show, macro- financial stability is a public good that canbe effectively secured and managed today only through the establishment of appropriate institutions at the global level. To remove this institutional deficit, we need strong political leadership at the international level. While all these are being debatedad nauseam at all forums, drift and indecision continue. Note1 The Great Contraction 1929-1933 by Milton Fried-man and Anna Jacobson Schwartz, with a New Preface by Anna Jacobson Schwartz and aNew Introduction by Peter L Bernstein (Princeton: Prin-ceton University Press), 2008; pp xxxii + 265.

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