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Once Bitten, Twice Shy: Rethinking the Federal Reserve’S Independence and Monetary Policy in the U.S

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Once Bitten, Twice Shy: Rethinking the Federal Reserve’S Independence and Monetary Policy in the U.S ONCE BITTEN, TWICE SHY: RETHINKING THE FEDERAL RESERVE’S INDEPENDENCE AND MONETARY POLICY IN THE U.S. by Niveditha Prabakaran B.S. Mathematics-Economics, B.A. Politics and Philosophy School of Arts and Sciences 2011 Submitted to the Undergraduate Faculty of School of Arts and Sciences in partial fulfillment of the requirements for the degree of Bachelor of Philosophy University of Pittsburgh 2011 UNIVERSITY OF PITTSBURGH SCHOOL OF ARTS AND SCIENCES This thesis was presented by Niveditha Prabakaran It was defended on April 20, 2011 and approved by Steven Husted, Professor, Economics, University of Pittsburgh Thomas Rawski, Professor, Economics, University of Pittsburgh James Burnham, Professor, School of Business, Duquesne University Thesis Director: Werner Troesken, Professor, Economics, University of Pittsburgh ii ONCE BITTEN, TWICE SHY: RETHINKING THE FEDERAL RESERVE’S INDEPENDENCE AND MONETARY POLICY IN THE U.S. Niveditha Prabakaran, B.Phil University of Pittsburgh, 2011 Copyright © by Niveditha Prabakaran 2011 iii Once Bitten, Twice shy: Rethinking the Federal Reserve’s Independence and Monetary Policy in the U.S. Niveditha Prabakaran, B.Phil University of Pittsburgh, 2011 It is widely believed that the Federal Reserve played a central role in bringing about the biggest catastrophe in American history—the Great Depression. The literature is extensive in seeking to provide an explanation for the Federal Reserve’s policy errors. This paper offers a new interpretation on why such an event occurred by studying a heretofore-unexamined landmark court case. In 1928, a private citizen filed suit against the Federal Reserve Bank of New York for increasing discount rates; he sough a court injunction that would force the Federal Reserve to decrease rates. The courts found in the System’s favor. In 1929, he appealed the case, which was dismissed due to a failure in enjoining the Federal Reserve Board as an indispensible party. The judge during the time further wrote an opinion, in which he clarified that the Board rather than the Banks had true authority within the Federal Reserve System. This paper looks at how these two decisions affected Federal Reserve policy between 1929-1933. It argues that the de- politicization of the Federal Reserve coupled with implicit judicial sanction allowed it to act on its flawed ideology without fear of political recrimination. The paper also examines the impact of the Great Depression on the Federal Reserve’s independence today. iv TABLE OF CONTENTS PREFACE .................................................................................................................................. VII 1.0 INTRODUCTION .............................................................................................................. 1 2.0 THE FEDERAL RESERVE’S CONSTITUTIONALITY ............................................. 7 3.0 THE TRIALS AND TRIBULATIONS OF A YOUNG FED ....................................... 15 4.0 THE LEAD-UP TO THE STOCK MARKET CRASH ............................................... 23 5.0 PLUNGING INTO THE GREAT DEPRESSION ........................................................ 35 6.0 A THOUGHT EXPERIMENT ....................................................................................... 43 7.0 THE DEARTH OF CENTRAL BANK INDEPENDENCE IN THE U.S. .................. 47 8.0 CONCLUSION ................................................................................................................. 58 APPENDIX A ............................................................................................................................... 63 APPENDIX B ............................................................................................................................... 66 BIBLIOGRAPHY ........................................................................................................................ 68 v LIST OF FIGURES Figure 1: Historical Real GDP in the U.S. (logged) from 1790 to Present .................................... 2 Figure 2: Central Bank Independence and Average Inflation (from Alesina and Summers [1993]) ... 49 Figure 3: Inflation Rates in the U.S. from 1900 to present .......................................................... 51 Figure 4: Real GDP in the U.S. from 1900 to present (logged) ................................................... 52 vi PREFACE To my committee, Dr. Burnham, Dr. Husted and Dr. Rawski, and especially to my advisor Dr. Troesken, I would like to thank all of you for your patience, support and guidance in helping me complete this Bachelor of Philosophy. I would not have found this interesting case and fascinating legal history without my advisor, whose class I was fortuitous enough to take. Additionally, I would like to thank my family and friends; this thesis would not have been possible without their relentless encouragement and unwavering belief in me. They accompanied me to coffee shops, libraries and other venues and put up with me during my most stressful times, and for that I shall always be beholden to them. Finally, I would like to thank the faculty and administration at the Honors College. This work would not have been possible without their guidance, especially during my formative years at the University of Pittsburgh. They truly enriched my undergraduate experience. Dedication To the late Dean of the Honors College, G. Alec Stewart a.k.a “Doc.” Doc, thank you for entering my life when you did; you changed my thinking for the better. I am grateful to have known you and very much missed your presence this last year at Pitt. vii 1.0 INTRODUCTION “Ours is a land rich in resources...filled with millions of happy homes; blessed with comfort and opportunity... In no nation are the fruits of accomplishment more secure… I have no fears for the future of our country. It is bright with hope.” ~Herbert Hoover, Inaugural Address, March 4, 1929, Washington D.C.1 The above quote from President Hoover’s Inaugural Address was recorded seven months before the stock market crash that would rock the U.S. economy; by the end of his term in 1932, the United States would have been plunged into a depression that left one in every four unemployed and significantly reduced the nation’s wealth. From the experience of a “higher degree of comfort and security than ever existed before in the history of the world,” the United States entered a severe depression of a magnitude never experienced by the U.S. economy before or since.2 The graph on the following page shows the U.S. real GDP; one can see the clean, log- linear relationship of GDP, except for the period between 1929 and 1933. Between the peak in 1929 and the trough in 1933, real GDP had declined by about 37%. 1 Hoover, Herbert. Inaugural Address. Washington, D.C. 4 March 1929. <http://www.hooverassociation.org/hoover/ speeches/inaugural_address.php> 2 Ibid. 3 Friedman, Milton and Anna J. Schwartz. A Monetary History of the United States, 1867 to 1960. Princeton: 1 U.S. Real GDP (1790 to 2010) 7.5 7.25 7 6.75 6.5 6.25 6 5.75 5.5 Logged GDP 5.25 5 4.75 4.5 4.25 4 3.75 3.5 1790 1805 1820 1835 1850 1865 1880 1895 1910 1925 1940 1955 1970 1985 2000 In Years Figure 1: Historical Real GDP in the U.S. (logged) from 1790 to Present Data from: Johnston, Louis and Samuel H. Williamson, "What Was the U.S. GDP Then?" MeasuringWorth, 2010. <http://www.measuringworth.org/usgdp/>. 2 The literature on explanations for this calamity is extensive; the standard argument holds that money supply played a central role in exacerbating the magnitude of the recession. According to Friedman and Schwartz (1971), the Federal Reserve System (referred to as the “Fed” from here on), which had been entrusted with the authority to mitigate financial turmoil and ensure economic prosperity, actually caused the historically unprecedented contraction, which they call “a tragic testimonial to the importance of monetary forces.”3 Whether external factors forced the recession or it occurred because of the Fed’s policies, it is nonetheless widely accepted today that the Fed’s erroneous policy significantly worsened the recession, especially in its failure to fulfill its role as the lender of last resort. This has led to extensive research into the reasons for the Fed’s policy failures. In their book A Monetary History of the United States, 1867 to 1960, Friedman and Schwartz (1971) argue that the death of Governor Strong of the Federal Reserve Bank of New York in 1928 left a power vacuum within the Fed because Harrison, who replaced strong in 1928, was not a dominant personality and was unable to lead the Fed during its time of need. This resulted in a shift of power to the Board, which did not have traditions of strong leadership. They contend that this lack of leadership prevented the Fed from taking decisive and prompt action, as it had done in the 1920s under Strong; thus, policy from 1929-1933 was “passive, defensive, [and] hesitant” and ultimately, ineffective.4 In A History of the Federal Reserve, Volume 1: 1913-1951, Meltzer (2003) argues that Strong’s death would not have been changed the outcome of policy during this time because by 1930, the rest of the reserve banks and the Board blamed the speculation of 1928-29 on what 3 Friedman, Milton and Anna J. Schwartz. A Monetary History of the United States, 1867 to 1960. Princeton: Princeton University Press, 1971. p. 300 4 Ibid., p. 411 3 they viewed as Strong’s over-expansionary policy in 1924-27. Meltzer contends that this diminished the New York Bank’s standing during policy-making
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