Sunday, July 12, 2015

Two History Lessons for Janet Yellen

On the eve of Fed Chair Janet Yellen’s semi-annual monetary policy testimony to the Congress I think it is appropriate to discuss two lessons from history that are appropriate for today. First there is a great deal of concern about the impact of the Fed moving off of its zero interest rate policy out of fear that it would trigger financial instability in the global economy that could blow back to the U.S.. One lesson from history suggests that giving international concerns priority over domestic concerns is fraught with unintended consequences.

For example in July of 1927 New York Fed President Benjamin Strong summoned the heads of the central banks of the U.K., France and Germany for a meeting to discuss fissures that were developing in the international gold standard, the sustainability of continued lending to Germany and most important the need to maintain Sterling at its new parity. Instead of focusing on the domestic economy which was recovering very smartly from the 1926 slowdown, the Fed yielded to international pressure and lowered the discount rate from 4.0% to 3.5%. Strong realized there was a risk of creating a stock market bubble by noting to Deputy Bank of France Director Charles Rist that the contemplated rate cut would be “coup de whisky” for the stock market. It was a risk he was willing to take and from then on the stock market went hyperbolic to create blow-off of 1929. As we noted in an earlier post despite all of the cries from Wall Street to keep rates low, Janet Yellen was not put on this earth to be the fairy godmother of the stock market.

Our second lesson concerns the myth of 1937 which blames the economic collapse of that year on a tightening of monetary and fiscal policy. Professor Douglas A. Irwin of Dartmouth convincingly debunks that myth with his “Gold Sterilization and the Recession of 1937-38” in the December 2012 issue of Financial History Review.  ( To Irwin it was not the doubling of reserve requirements by the Fed or the fiscal tightening by President Roosevelt, but rather it was the Treasury gold sterilization policy that began in December 1936 and lasted into February of 1938 that triggered the downturn. From 1934-36 the monetary base fueled by huge inflows of gold increased at 17% annual rate. Fearing speculative capital inflows, the so called “hot money,” the Roosevelt Administration elected to sterilize the inflow of gold. With that growth in the monetary base came to a complete halt. It was gold sterilization, not the nonbinding increase in reserve requirements that caused the recession.

The lessons here are that Janet Yellen should worry less about the international effects of monetary policy and the myth of 1937. She should instead focus on the domestic economy with a 5.3% unemployment rate that appears to be on a 3% growth path with prices rising toward the Fed’s 2% target.

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