Crisis Management at the Fed—Past and Present

After the Federal Reserve introduced its new approach to monetary policy at the end of August, Fed officials recognized that there is no “exact science” for applying the new inflation benchmarks. As the Fed continues to focus more on unemployment than inflation, it’s worth looking back and recognizing that such policies have never followed an “exact science.”

When trying to evaluate our current economic situation, many people might suggest looking to the 2008 crisis or Japan’s monetary experience in the last two decades. But the Second World War and our recovery from it presents a better opportunity for us to see where history rhymes and where it does not. Two particular similarities stand out: The role of the Fed and the inadequacy of aggregate metrics like price indices to capture the real economic situation.

During the war, large parts of the population lost their traditional employment; this is the case now too; entire sectors closed down and others were reoriented toward war efforts; today, education and leisure sectors are shuttered, while tech now helps us work from home, stream entertainment, and manage home deliveries. The mobility of people between countries and international trade diminished drastically; we see this today, too. Then and now, massive wealth was destroyed, stock markets plunged, and governments spent and borrowed massively to finance literal and figurative war efforts. Once we take these similarities into account, the policy options seem clearer.  

The Fed and Public Debt

The Federal Reserve played a new, non-monetary role during WWII. For nine years, until 1951, the Fed was the agency of the Treasury. The Fed’s goal was to prevent the default of government bonds in light of the vast amounts of defense spending. This goal had nothing to do with central banks’ usual ones: managing interest on reserves, liquidity management, and being the lender of last resort to the financial sector and banks. Instead, it served the government’s fiscal policy. Marriner Eccles, the Chairman of the Fed during WWII, stated repeatedly that taxes could not finance the war effort, and the “very heavy deficit financing required large purchases of government securities,” which was possible only by keeping interest rates low and stable. While neither the Fed nor the European Central Bank makes this explicit, this is exactly what they have been doing during our current crisis.

The similarities in global conditions are striking: No other governments had then or have now the credibility of the US government; During both WWII and this “war,” demand for private borrowing was drastically reduced around the world; There was a massive centralization of powers to reallocate resources, without taking prices into account. The view was that unless the Fed co-ordinates with the Treasury to prevent default, it would prolong the war—the military one then, the epidemic one now—with devastating impact on the country’s prosperity, employment, and compensations.  

In 1951, the Fed’s Board of Governors debated with President Truman about whether, in light of the Korean War, to continue the “unrestrained sale of Government securities to the Fed” and keep interest rates low, as a 1951 Memorandum put it. The Fed believed this could not be done without bringing about inflation, which would threaten the war effort and increase the risk of default. The Memorandum stated that, “As governors of the Federal Reserve System, it is our duty to present to Congress the urgent necessity that we be freed to use our powers to combat further erosion of the purchasing power of the American dollar . . . essential to maintain investor confidence in the Government credit . . . [and] assure investors in Government securities that the purchasing power of the principal and interest of their investments will be maintained.” 

With the end of WWII and the relaxation of widespread price controls, the risk of default diminished, the move of brains and capital around the world increased, and borrowing increased—all of which heightened the risk of inflation. The Fed stopped being an agency of the Treasury and dedicated itself to anti-inflationary policies and sustaining stable exchange rates. As our current crisis evolves and eventually comes to an end, the Fed should also transition back to its primary purposes.

During wars, the goal is to win as quickly as possible and with as few casualties as possible—this mirrors our “war” against the epidemic, too, as the goal is to diminish fatalities and severe illness: Consider the lockdowns, extreme mitigation measures, massive economic stimulus, the single-minded mandate for what hospitals could do, and the rapid investment in medical technology. Taxes could not finance the WWII spending. Borrowing at stable and low rates was necessary. Such policies become feasible as the mobility of people and capital across borders was drastically impaired, the society dedicated itself to the war effort by buying “victory” bonds and reducing borrowing and spending, and the velocity of monetary aggregates declined significantly. And since the government had to quickly reallocate people and resources for the war effort, both production and prices came under control, price indices losing much of their meaning—just as they are today. 

 Price Indices and Governing by Aggregate Numbers

Simon Kuznets, the architect of aggregate statistics during and after WWII, admitted that “it was impossible to construct a price index of products that would span both prewar and war years.” During wars, “market prices” and aggregates do not guide policies concerning the allocation of people and resources: The US had some 16 million serve in the military during WWII, and Washington mandated what to produce, where, and at what price. Winning the war quickly, with as few casualties as possible required immediate, speedy decisions: backward-looking aggregate statistics were of no consequence.  

The fact that the official statistics from price indices showed no inflation during and immediately after WWII, in spite of the Federal Reserve’s accumulation of Treasury Bonds, is not surprising: By June 1943, the Office of Price Administration (OPA) had set up 200 Industry Advisory Committees in charge of controlling prices. Governments banned producing cars and refrigerators, with those companies producing tanks and other armaments instead. Food staples were rationed, though traded in black markets. The OPA eventually dropped new automobiles from the index; it drastically reduced the weight applied to gasoline, and by 1943 it also dropped refrigerators, radios, and other goods from the index. The official numbers showed inflation until 1949 and deflation during 1949 and 1950 (with monetary velocity rising). But given the price controls, nobody knows how much was sheer statistical fiction. 

After the war, societies recovered from far more drastic shut-downs, destruction, and high national debts than what we are experiencing now.

The above policies bear similarity to the present situation, too. It was headline news when GDP dropped by an annualized 32.9 percent last quarter. The actual drop for the quarter, however, was only 9.5 percent—and this negative number in fact disguised good news: In this virus-war, hospitals had to reallocate resources to deal with Covid-19, to the exclusion of many other services. The bad quarterly number disguised the good news that part of the drop was due to a significant decline in revenues of the health sector as the drastic reallocation of beds, equipment, and staff was not needed. But it indicated that the health sector could recover by once again treating non-Covid patients—once they were allowed to do so as we moved from “war-against-the virus” to a more normal existence. Annualizing a number that gave us only a snapshot of a highly unusual point in time is a foolish way to gauge the health of the economy.

Price indices are similarly unreliable now: Whereas prices of transportation, entertainment, and restaurants diminished, and people spent far less on them, their weight in the calculation of the CPI did not change. The Bureau of Labor Statistics (BLS), which is in charge of calculating the CPI, made no adjustments and announced that new weights will be used in the January 2022 indices only. The index, therefore, is more of a calculation of prices as they would be if we were in normal times. It’s unclear what such a calculation reflects.  With the weights unadjusted, all these components of the index—showing prices dropping—measure some “deflation.” But since the weights have in fact dropped drastically in consumers’ baskets, the actual deflation is much smaller—if there is deflation at all.

We also know that customers have been buying other goods and services at a much higher rate—video streaming services and home deliveries of food, for example. Yet these weights were not adjusted either. 

Also, since March, the BLS grounded its 400 data-collection specialists, who are now supposed to find out about thousands of prices by phone or the Internet. But the data collectors were instructed not to contact establishments by phone when it would cause an undue burden. These establishments include hospitals, physicians’ offices, grocery stores, department stores, and restaurants.  

Evaluating the “housing equivalent” component in the CPI is even more problematic. According to the National Multifamily Housing Council, 69 percent of apartment tenants had paid their monthly rent by April 5, down from 81 percent the previous month. Thirty-nine states have announced some form of eviction moratorium. Such policies amount to a reduction in housing costs, implying more uncertainty about inflationary measures (housing, transportation, and recreation represent roughly 60 percent in the CPI). When I asked BLS how they are dealing with this problem, the answer was “rent collection is a challenge we are continuing to review and address on an ongoing basis.”

Finally, the unemployment statistics are equally uncertain: by one measure, unemployment stands at about 16.3 million; by another, it is nearly double this number, the latter including all those who receive federal monthly benefits. As pointed out above, peacetime and wartime indices become hardly comparable: God and the Devil are in the details, and such details offer better guidance on policies than miscalculated, incomprehensible aggregates.    

Lessons to Learn

What, then, can guide fiscal and monetary policies to speed up recovery as we move toward “peacetime” after fighting this “virus war”? The example of our recovery from WWII can help guide us.

First, recall the reason for the 1951 agreement between the Fed and Treasury—the need to prioritize the stability of the US dollar and prevent inflation. Other countries also demonstrate the importance of a stable currency after wars. Consider Germany after WWII: 20 percent of all its housing was destroyed. Food production per capita in 1947 was half of what it had been in 1938. Industrial output in 1947 was one-third of its 1938 level, and a large percentage of Germany’s working-age men had died. The currency had no value: in fact, it stopped circulating and black markets thrived. 

But in 1948, Ludwig Erhard stabilized the currency, abolished price controls and regulations, and lowered taxes drastically (before these reforms, the highest marginal tax rate was 95 percent). The “German miracle” started, also supported until 1961 by millions of well-trained yet penniless immigrants escaping Communism.

Similar patterns were repeated in Israel after the 1973 Yom Kippur war, though after far less destruction. By the early 1980s, Israel’s centralized economy was in tatters, with inflation in three digits (445% in 1985). Drastic monetary stabilization and deregulation followed, and by the late 1980s, Israel benefitted from one million Russian immigrants, a 20 percent addition to its population, a third of whom were scientists and engineers. The “start-up nation” was on its way.

These events were in sharp contrast to policies after WWI, when Europe and the US mismanaged their monetary and fiscal policies, and entered into disastrous international treaties, the Treaty of Versailles being the most prominent. The post-WWII West avoided these blunders with the Bretton Woods agreement to stabilize exchange rates, recognizing that stability of contracts are at the core of commercial societies, with the US managing better international relations, and benefiting from an inflow of brains from around the world.

Societies recovered from far more drastic shut-downs, destruction, and high national debts than what we are experiencing now. Preventing inflation, stabilizing exchange rates, deepening financial markets, de-centralizing decision-making (as opposed to relying on misleading aggregate data), have been some of the keys to faster recoveries. 

Of course, populations were younger then; religion, families, and communities were disciplining factors; societies were united to rebuild after the wars; there was no extensive welfare culture; and immigrants swam or sank. Today, there are protests in the cities; the US appears Balkanized; the media has become intensely opinionated and partisan, with the separation of facts and fiction now requiring much skepticism and intense due diligence. The Internet, once expected to bring about “information revolution,” has brought about equal measures of “disinformation.”  

Yet the US remains a magnet for talents ready to vote with their feet; the US dollar is still the world’s reserve currency (gold’s warning sign of rising by 30 percent to above $2000 notwithstanding); and the US is still expected to correct institutional flaws faster than other countries. There is still reason for optimism.