About Federal ReserveHow the Federal Reserve got to be? Monetary policy is the most flexible economic policy tool of government, and possibly its most potent one as well. The experience of the 1920s and 1930s revealed a deep mistrust of monetary policy, and perhaps to a greater extent, of central bankers. Governments yearned for some form of stability, after decades of large fluctuations in the price level and in other major macroeconomic aggregates. Martin Mayer describes it in his book and says “Despite general dissatisfaction with the Feds performance in the last years of the 1920s boom and the first years of the depression, the restive Democratic Congress could not imagine another device to do the money job.
A very eminent group of University of Chicago economists (headed by Frank Knight, Henry Simons, Aaron Director, Sen. Paul Douglas, and Albert Hart) had submitted a detailed scheme to nationalize the Federal Reserve Banks and convert all commercial banks to institutions that could accept demand deposits only subject to a 100 percent reserve requirement, as the only safe way to organize government deposit insui-ance. 24 They got a respectful hearing from Agriculture Secretary Henry Wallace, who urged the scheme on Roosevelt, but neither the president nor the Congress wanted to upset this applecart when so many people were selling apples (p.
77)While fiscal policy would dominate the scene as the principal tool of policy, three concurrent forces lead to a shift back to the view that the central bank must occupy a central place in the implementation of economic policy. First, exchange rate stability is an illusion and must of necessity come in conflict with domestic objectives that diverge across countries.
Second, the growth of trade and of capital mobility leads to international imbalances that are exacerbated by artificial attempts to maintain exchange rate regimes ill suited to such an environment. Third, fiscal policy is slow to act and is increasingly an inept instrument for attaining particular economic objectives. This is especially true in a world of high-frequency data. The impression is sometimes given that what has changed, in the 1990s especially, is the greater recognition of the importance of price stability. Nothing could be further from the truth.
Economists and policy makers long ago felt that monetary policy was about delivering low and stable inflation rates. “It may be assumed that the whole of the economic world is agreed upon the desirability of securing some degree of stability in the general level of prices. Martin Mayer describes this situation and says, “Among the oddities of the 1990s has been the rise of a school of thought holding that there is no systemic risk n finance—that the markets will rebalance quickly if only governments will permit the foxes of economic growth to eat the lame ducks of unwisely sunk costs.
Central banks, in this theory have fostered a culture of ‘pseudo-systemic risk” to puff up their own importance. Writing in 1995, when the emerging markets were booming, Anna Schwarz and colleagues wrote that, “investors will shun entities where they perceive uncompensated risk and flock to entities with more inviting returns”. Emerging stock markets are an example Two yea later, the collapse of these market & coupled with the collapse of the currencies of the countries where they were situated, plunged much of Asia and some of South America into the worst depression since the 1930s.