THE CHOICE OF A MONETARY POLICY FRAMEWORK:LESSONS FROM THE 1920S Thomas M. Humphrey Anyone who studies the early history of the Federal Reserve is boundto notice a singular curiosity. In the 1920s andearly 1930s, when U.S. goldholdingswere sufficiently large to relax the constraint of the international goldstandardandpermitdomesticcontrol of the money stock andprice level, the Feddeliberatelyshunnedthe best empirical policy framework that mainstream monetary science hadto offer. An Overview The Quantity Theory Developedby Irving Fisher andother U.S. quantity theorists, this framework was the outcome of an evolution in numerical measure- ment that hadbeen occurring in monetary economics since the early years of the 1900s. Although somewhat crudeandunsophisticatedby today’s standards, the quantity theory framework had by the mid- 1920s progressedto the point where, statistically andanalytically, it was state of the art in policy analysis. Its constituent variables, all expressedin a form amenable to empirical measurement, hadbeen fittedwith relevant dataseries. It boastedthe ability to establish empirical causality between certain variables at cyclical andsecular Cato Journal, Vol. 21, No. 2 (Fall 2001). Copyright © Cato Institute. Al rights reserved. Thomas M. Humphrey is a Vice President and Economist at the Federal Reserve Bank of Richmond. He thanks Bob Hetzel, Judy Klein, and Mary Morgan for their constant encour- agement, constructive criticism, andexpert help in correcting errors, omissions, andinconsis- tencies. He is also indebted to James Dorn, William Gavin, David Hammes, Roger Sandilands, Anna Schwartz, Ellis Tallman, andRichardTimberlake for helpful comments. This article grew out of andoverlaps a companion piece, “Quantity Theory andNeeds-of-TradeMeasurements andIndicatorsfor Monetary Policymakers in the 1920s,” forthcoming in “The Age of Economic Measurement,” supplement to History of Political Economy (vol. 33). This article does not necessarily represent the views of the Federal Reserve System or the Federal Reserve Bank of Richmond. 285 CATO JOURNAL frequencies. It hadsurvivedrigorous testing, by the standardsof the time, for accuracy andusefulness. Most of all, as the basis of a co- herent andwell workedout monetary theory of the cycle, it claimed to predictthe effects of Fedmonetary policy on output andprices in both the short run and the long. Here, ready-made, seemed to be the answer to a central banker’s prayers. Here was a framework the Fed coulduse to conductpolicy andto stabilize the economy. Yet the Fedrefusedto have anything to dowith this framework and its components. Insteadof concentrating on the money stock, the price level, andother indicatorsfeaturedin the quantity theory, the Fedfocusedon such measures as the level of market interest rates, the volume of member bank borrowing, andthe type andamount of commercial paper eligible for rediscount at the central bank. Why wouldthe Fed,seemingly in needof reliable andaccurate gauges of the quantity andvalue of money, eschew them andthe framework featuring them? Why wouldit denyitself the opportunity to take advantage of the improved empirical knowledge—and poten- tial policy advances stemming therefrom—embodied in the quantity theory andits associatedmonetary approach to the tradecycle? A Passive Fed The answer, of course, was that the quantity theory framework was incompatible with the type of institution createdby the FederalRe- serve Act of 1913. Far from being the activist, ambitious, price-level- stabilizing central bank envisionedin the quantity theory, the Fedwas instead a passive, decentralized, noninterventionist system of 12 semi- autonomous but cooperating regional Reserve Banks designed to ac- commodate automatically all productive (nonspeculative) business demands for credit and money over the cycle. The 1913 act expressly stated as much. Reserve Banks, it declared, exist for the purpose of “accommodating commerce and business,” a purpose they fulfill by “furnishing an elastic currency” and “affording a means of rediscount- ing commercial paper.” Accommodation and regional autonomy were the watchwords. The act said nothing about stabilization as a policy goal or about a single central agency chargedwith the dutyof achiev- ing that goal. Nevertheless, by the mid-1920s there were voices—some inside the Federal Reserve System, but most outside—claiming that the Fed shouldhave learnedthat stabilization rather than accommodationwas its overridingtask andthat certain statistical measures andindicators were available to help it accomplish that task. Accordingly, these same voices advocated that the original Federal Reserve Act be amended to 286 THE CHOICE OF A MONETARY POLICY FRAMEWORK make price stability the chief responsibility of the System andthat power be given to a single central authority to unify, coordinate, and synchronize the policy actions of the individual Reserve Banks. But the Fedrejectedthese suggestions andclung to the notions that accommodation was its duty and that the proffered quantity theoretic measures were irrelevant to the discharge of that duty. The result was that the Fedspurnedthe quantity theory or monetary- approach-to-the-business-cycle framework for an entirely different one instead. Composed of the real bills or needs-of-trade doctrine (also known as the commercial loan theory of banking), that frame- work hadnonmonetary forces drivingthe price level just as it had output and the needs of commerce determining the money stock. The Real Bills Doctrine Since the doctrine taught (1) that money created by loans to fi- nance real production rather than speculation has no influence on prices, (2) that causality runs from prices andoutput to money rather than vice versa as in the quantity theory, and(3) that Reserve Banks in no way possess control over money, there was no reason for the Fedto accept a theory asserting the opposite. 1 Indeed, as previously noted,throughout the 1920s officials andeconomists locatedat the FederalReserve Boardandcertain regional Fedbanks went out of their way to reject the quantity theory approach to the business cycle andits notion that the price level andreal output couldandshouldbe stabilizedthrough money stock control. The initial phase of the Great Depression starkly revealedthe consequences of the Fed’s choice of policy frameworks. That episode put the rival frameworks to the test. The quantity theory framework passedthe test with flying colors. Its indicators—moneystock, price level, andreal rates of interest—correctly signaledthat monetary policy was extraordinarily restrictive and likely to precipitate a con- traction. The real bills doctrine, on the other hand, failed the test. Its indi- cators—member bank borrowing andnominal market rates of inter- est—signaled, wrongly, that policy was remarkably easy so that the Fed had already done all it could do to stop the slump. Guided by these indicators,the Feddidnothingto arrest andreverse the mon- etary contraction that was pushing the economy into depression. 1Conversely, there was every reason for Fed officials to endorse a doctrine that implied that their policies, being passive andautomatic, couldnever be the cause of inflation or defla- tion. Such a doctrine promised to exonerate the officials from blame for these phenomena andperhaps accounts for its appeal to them. 287 CATO JOURNAL Indeed, far from being alarmed by the monetary contraction, the Fedsaw it as precisely what the real bills doctrineprescribedin an environment of falling output andemployment. Accordingto the doctrine, the slumping levels of those variables meant that less money andcreditwere requiredto finance them. Likewise, the price defla- tion accompanying the slump was interpretedas indicatingnot that money andcreditwere tight, but rather that the speculative excesses of the stock market boom of 1928–29 were being purgedfrom the economy. In brief, real bills indicators were telling the Fed early in the depression that it was doing the right thing and that its policy was sound. In actuality, however, the opposite was true, and real bills indicators were leading the Fed astray. Those indicators, although accurate andprecise, nevertheless wreakedhavoc because they were embodied in a framework instructing policymakers to let money and credit vary procyclically rather than countercyclically. The Importance of Comparing Rival Theories and Indicators The story of the rival theories andtheir constituent policy indica- tors is instructive for at least four reasons. First, it illustrates how different statistical gauges can yield conflicting policy signals. Second, it indicates that theory necessarily precedes measurement in the sense that central bankers must have an analytical framework in place before they can determine the relevant indicator variables to mea- sure. Third, it reveals the corollary proposition that policymakers observe only what they are predisposed to see; that is, it shows that their chosen analytical framework dictates the very indicators to which they will respond. Finally, it indicates that theories superficially similar in some respects can differ fundamentally in others. In the case of the quantity theory andthe real bills doctrine,while both recognizedthat money stock growth in excess of output growth might be inflationary, they disagreed over the cause. The quantity theory attributedinflation to the resulting excess aggregate spending,but the real bills doctrineattributedit to the wrong kindof spending— namely, spending for speculative,