55
American Economic Review: Papers & Proceedings 2013, 103(3): 55–60
http://dx.doi.org/10.1257/aer.103.3.55
The hundredth anniversary of the founding of
the Federal Reserve is a natural time to reect
on the record of US monetary policy. It is widely
agreed that this record is far from perfect, and
that there have been some major failures of mon-
etary policy over the past century. Our thesis is
that overly pessimistic views about the power of
monetary policy have been a critical source of
these failures.
There is little doubt that the opposite prob-
lem—an overinated belief in the power of mon-
etary policy—has also contributed to important
policy errors. Most famously, policymakers in
the mid-1960s believed that they faced a long-
run ination-unemployment trade-off, and thus
that monetary policy could move the economy
to a sustained path of very low unemployment
and low ination. This belief led them to pursue
highly expansionary policy, starting the econ-
omy down the road to the ination of the 1970s
(for example, Romer and Romer 2002 and
Primiceri 2006). The record of such errors has
led some to argue that perhaps the most impor-
tant attribute of a successful central banker is
humility (for example, Booth 2012).
In this paper, we present evidence that an
unduly pessimistic view of what monetary
policy can accomplish has been a more impor-
tant source of policy errors and poor outcomes
over the history of the Federal Reserve. At vari-
ous times in the 1930s, faced with the Great
Depression, Federal Reserve ofcials believed
that the power of monetary policy to combat the
downturn or stimulate recovery was minimal. In
The Most Dangerous Idea in Federal Reserve History:
Monetary Policy Doesn’t Matter
†
By C D. R  D H. R*
* C. Romer: Department of Economics, University of
California, Berkeley, CA 94720 (e-mail: cromer@econ.
berkeley.edu); D. Romer: Department of Economics,
University of California, Berkeley, CA 94720 (e-mail:
[email protected].edu). We thank Donald Kohn for
helpful comments.
†
To view additional materials, and author disclosure
statement(s),visit the article page at
http://dx.doi.org/10.1257/aer.103.3.55.
both the mid- and late 1970s, faced with high
ination, policymakers believed that monetary
policy could not reduce ination at any reason-
able cost. And there is evidence that in the past
few years, faced with high unemployment and a
weak recovery, monetary policymakers believed
that policy was relatively weak and potentially
costly. In each episode, these beliefs led to a
marked passivity in policymaking.
The next three sections discuss the link
between pessimistic beliefs and policy inaction
in the 1930s, the 1970s, and the past few years,
respectively. The nal section concludes by
arguing that being a good central banker appears
to require a balance of humility and hubris.
I. The 1930s
The most signicant error in the history of the
Federal Reserve surely occurred in 1929–1933,
when the money stock fell 26 percent, the price
level declined 25 percent, and output decreased
27 percent. There is vast evidence that an overly
pessimistic assessment of the power of mone-
tary policy to combat the downturn was a criti-
cal source of this error (Friedman and Schwartz
1963; Meltzer 2003; and many others). Many
Federal Reserve ofcials believed that expan-
sionary policy would not be effective and that it
might involve substantial costs. The result was
inaction in the face of the largest downturn in
American history.
One early episode showing monetary policy-
makers’ pessimism about what they could
accomplish occurred in the summer of 1930,
when the Federal Reserve Bank of New York
proposed expansionary actions. New York’s pro-
posal was opposed by most of the other Federal
Reserve banks, and so little was done.
The opponents of expansion proffered two
main arguments that it would be ineffective.
First, and crucially, the main indicators of
the stance of policy that they used—nominal
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interest rates, banks’ excess reserves, and bor-
rowing from the Federal Reserve—implied
that policy was already highly expansionary.
They therefore thought that monetary policy
had done all it could. For example, one oppo-
nent argued, “With credit cheap and redundant
we do not believe that business recovery will be
accelerated by making credit cheaper and more
redundant.”
1
Another referred to “the fruitless-
ness and unwisdom of attempting to depress
still further the abnormally low interest rates
now prevailing.” Second, they believed that the
cause of the downturn was not monetary but lay
in excesses in the 1920s, and thus that the down-
turn could not be solved by monetary policy.
One policymaker said,
The consequences of … an economic debauch
are inevitable. We are now suffering them.
Can they be corrected or removed by
cheap money? We do not believe that they
can. …
[T]here is no short cut or panacea for
the rectication of existing conditions.
Policymakers also saw two costs to expan-
sion, related to the two reasons they viewed
expansion as unproductive. First, they believed
that an expansion that had little impact would
damage their credibility, and so make later
expansion less effective. As one put it,
[With] an abundance of funds in the market, … it
should be the policy of the Federal Reserve
System to maintain a position of strength, in
readiness to meet future demands, as and when
they arise, rather than to put reserve funds into
the market when not needed.
Second, they feared that expansion could trigger
renewed speculation and ination. For example,
one bank governor said, “Cheap money is a
stimulant, … but a headache will follow if the
dose is large enough, and persisted in. It encour-
ages over-borrowing.”
These beliefs prevented signicant action
not just in 1930, but throughout the downturn.
Consider, for example, the decision to end a brief
period of expansionary open-market operations
in 1932. Hsieh and Romer (2006, pp.169–72)
1
The sources for all the quotations and data used in the
paper are given in the online Appendix.
document the reasons that George Harrison
(governor of the Federal Reserve Bank of New
York, and one of the architects of the program)
gave for the decision:
When the gures of member bank reserves are
sufciently high … , we shall probably have
done our part. If the commercial banks can’t or
don’t use the credit which we provide, that is
another problem.
It was thought best … not to use our ammu-
nition until the chances of effective response
from the banking and business community
would favor the success of our undertaking.
These ideas persisted into the recovery. For
example, the expression that at some point fur-
ther monetary easing is ineffective because “one
cannot push a string” appears to have originated
in Congressional testimony in 1935 by Marriner
Eccles, the governor (that is, head) of the Federal
Reserve Board. Similarly, in 1937, the Federal
Open Market Committee (FOMC) believed that
“the existing volume of excess reserves and of
supplies of private capital is abundant at this
time at low rates,” and therefore that “effective
action to meet and overcome the present busi-
ness recession should be taken outside the eld
of the System’s various monetary powers.”
In addition, the view that monetary expansion
could lead to ination even when the economy
was far below capacity took on special impor-
tance in the mid-1930s. Policymakers were con-
cerned that expansion “might well add unwise
stimulus to the ination of prices” and that “a
further increase in excess reserves of member
banks might give added impetus to existing
inationary tendencies.”
Consistent with these beliefs, the Federal
Reserve was largely passive in the recovery, just
as it had been during the downturn. The mone-
tary base rose rapidly during much of this period,
but the increases were almost entirely the result
of gold inows and the Treasury’s decision not
to sterilize them, rather than of Federal Reserve
actions.
The Federal Reserve’s major policy initia-
tive in this period—the doubling of reserve
requirements in 1936–1937 and working with
the Treasury to sterilize gold inows at the
same time—was motivated by fear of ination
in a still-depressed economy. Policymakers
VOL. 103 NO. 3
57
the most dangerous idea in federal reserve history
believed that banks’ excess reserves could “cre-
ate an injurious credit expansion,” and therefore
“decided to lock up this part of the present vol-
ume of member bank reserves as a measure of
prevention.”
2
II. The 1970s
Another major failure of Federal Reserve
policy occurred in the late 1960s and the 1970s,
when ination rose erratically from low levels to
near 10 percent. In two parts of this era, Federal
Reserve ofcials believed that ination was very
unresponsive to economic slack, and thus that
monetary policy was an extremely ineffective
way to ght it.
3
The rst part of the era when this view pre-
vailed was roughly from 1971 to 1973. After
ination failed to fall in the mild recession of
1969–1970, Federal Reserve chairman Arthur
Burns and other policymakers concluded not
that the natural rate was higher than they had
previously believed, but that ination was
almost impervious to high unemployment.
Federal Reserve documents record that in June
1971, Burns expressed the view that:
[O]f late one found that at a time when unem-
ployment was increasing prices continued to
advance at an undiminished pace and wages
rose at an increasing pace. …
In his judgment a much higher rate of
unemployment produced by monetary policy
would not moderate [wage-cost] pressures
appreciably.
In July, he testied that “even a long stretch of
high and rising unemployment may not sufce
to check the inationary process.”
As discussed by Romer and Romer (2002),
these views led the Federal Reserve to not use
2
Of course, the pessimistic views we have described
were not the only source of the policy failures in the 1930s.
Meltzer and Friedman and Schwartz show how views about
the proper role of monetary policy, including the importance
of defending the gold standard and of meeting credit demand
rather than promoting macroeconomic stability, had impor-
tant effects on policy. In addition, Friedman and Schwartz
document how the fractured power structure of the Federal
Reserve in the rst part of the decade favored inaction over
action.
3
Nelson (2005) documents similar beliefs in the United
Kingdom in this era.
conventional monetary policy to combat ina-
tion. For example, in May 1971, the economist
making the ofcial staff presentation to the
FOMC said,
The question is whether monetary policy could
or should do anything to combat a persist-
ing residual rate of ination … . The answer,
I think, is negative. … It seems to me that we
should regard continuing cost increases as
a structural problem not amenable to macro-
economic measures.
The belief that monetary policy would not be
effective in controlling ination caused policy-
makers to advocate incomes policies, such as
wage and price controls, instead. For example,
in June 1971, Burns testied,
[A] substantial increase of unemployment has
failed to check the rapidity of wage advances
or to moderate appreciably the rise of the gen-
eral price level.
With increasing conviction, I have there-
fore come to believe that our Nation must
supplement monetary and scal policy with
specic policies to moderate wage and price
increases.
At the FOMC meeting the same month, Burns’s
views were summarized as:
He thought the Administration had been much
too slow to recognize the need for an effec-
tive incomes policy. He had urged that action
be taken in that area and intended to continue
doing so.
The second part of the 1970s when beliefs
about the ineffectiveness of policy were preva-
lent occurred under the chairmanship of G.
William Miller in 1978 and 1979. Shortly after
becoming chairman, Miller testied,
Our attempts to restrain ination by using con-
ventional stabilization techniques have been
less than satisfactory. Three years of high
unemployment and underutilized capital stock
have been costly in terms both of lost produc-
tion and of the denial to many of the dignity
that comes from holding a productive job.
Yet, despite this period of substantial slack in
the economy, we still have a serious ination
problem.
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AEA PAPERS AND PROCEEDINGS
Other policymakers held similar views. For
example, in May 1979, Governor Henry Wallich,
generally regarded as one of the most antiina-
tionary FOMC members, said, “We also have
evidence that ination in the American economy
is much less variable than it is in other countries
and is, therefore, much harder to bring down.”
And at Miller’s nal meeting in July 1979, the
staff presentation stated, “we expect that rising
unemployment will do little to damp ination,”
and that “[f]or monetary policy alone there seems
to be little in the way of policy options which
would yield substantially improved results dur-
ing the next year or two.” During the discussion,
the economist in charge of the presentation listed
several reasons that “we wouldn’t expect to get
the same price response from very weak mar-
kets” as had occurred just a few years before.
This humility about their powers again caused
monetary policymakers to not pursue antiina-
tionary policy, but instead to continue to stimu-
late the economy (Romer and Romer 2002).
Miller testied in March 1979, “Real interest
rates … still appear to remain low by histori-
cal standards and thus continue to facilitate an
expansion of overall demands.”
These views also led monetary policymakers
to again advocate nonmonetary steps to combat
ination. At his rst FOMC meeting in March
1978, Miller argued that monetary policy was
not the best way to ght ination, saying that
if the administration did not “take some more
believable steps in ghting ination … , ination
is going to be left to the Federal Reserve and
that’s going to be bad news.” The ofcial sum-
mary of the meeting said, “It was noted that an
effective program to reduce the rate of ination
had to extend beyond monetary policy.” That
same month, Miller testied that conventional
policies “need to be complemented by programs
designed to enhance competition and to correct
structural problems.”
Thus, in both the 1930s and the 1970s, undue
pessimism about what monetary policy could do
led to Federal Reserve inaction and highly unde-
sirable economic outcomes.
III. The Past Few Years
The last several years have been another time
of dismal macroeconomic performance. The
economy suffered its largest postwar recession
in 2007–2009. Since then, unemployment has
remained very high and has consistently been
projected to remain so for years. And in contrast
to the 1970s and early 1980s—but similar to the
1930s—the high unemployment has occurred at
a time of low ination, with core ination and
the Federal Reserve’s ination forecasts gener-
ally below its ination target.
It is clearly too soon to reach rm conclu-
sions about recent monetary policy. Much of
the record of policymakers’ thinking is not yet
available. More importantly, there has not been
enough time to condently assess what monetary
policy could and could not have accomplished.
Nonetheless, it seems hard to assign pes-
simism about the power of monetary policy a
large role in the crisis itself. Before the crisis,
monetary policymakers appear to have believed
that they would be able to largely counteract the
macroeconomic effects of a large fall in house
prices. And during the crisis, they believed they
had the ability to prevent a collapse of the nan-
cial system and acted aggressively to do so.
There are, however, intriguing parallels
between policymakers’ beliefs in the period
from roughly the end of the recession to the
latter half of 2012 and beliefs in the 1930s and
1970s. Monetary policymakers in each period
have to some extent believed that their tools
were not very effective and potentially costly.
In the recent period, the strongest views of this
type have been among some of the presidents
of the regional Federal Reserve banks. Indeed,
at times some have expressed views similar to
ones from the 1930s. For example, one argued
against additional action on the grounds that,
“Why would the Fed provision to shovel bil-
lions in additional liquidity into the economy’s
boiler when so much is presently lying fallow?”
Another argued that “a zero-rate policy increases
the risk of misallocating real resources, creating
a new set of imbalances or possibly a new set
of bubbles.” A third argued that “the supply of
bank reserves is already large enough to support
the economic recovery,” and that “further mon-
etary stimulus runs the risk of raising ination
in a way that threatens the stability of ination
expectations.”
In addition, some bank presidents have attrib-
uted high unemployment to structural prob-
lems and have therefore doubted the ability of
monetary policy to reduce it without triggering
ination. For example, one stated, “Most of the
existing unemployment represents mismatch
VOL. 103 NO. 3
59
the most dangerous idea in federal reserve history
that is not readily amenable to monetary policy.”
Another said:
You can’t change the carpenter into a nurse
easily … . Eventually … [p]eople will be re-
trained and they’ll nd jobs in other indus-
tries. But monetary policy can’t retrain people.
Monetary policy can’t x those problems.
Among the leading gures on the FOMC—
chairman Ben Bernanke, vice-chair Janet
Yellen, and president of the Federal Reserve
Bank of New York William Dudley—the view
that monetary policy tools are not very effective
and potentially costly has been milder and more
nuanced, relative both to the views described
above and to those in the 1930s and 1970s.
Nonetheless, there is evidence that it has been
present. It appears to have had two key elements.
One is that the power of the tools is limited.
The language that these monetary policy makers
have used to describe what their tools could
accomplish has consistently been measured.
In October 2012, for example, Bernanke said
that “we expect our policies to provide mean-
ingful help to the economy,” but that “mon-
etary policy is not a panacea” for “tackl[ing],”
among other things, “the near-term shortfall
in aggregate demand.” Similarly, in November
2011, after identifying “a dearth of aggregate
demand,” Yellen also said that “monetary pol-
icy is not a panacea.” The same month, Dudley
said, “although a stimulative monetary policy is
essential for recovery, it may not be sufcient.”
The second element has been the belief
that the tools involve costs. Probably the most
explicit statement of this view was made by
Bernanke in August 2012. He listed four poten-
tial costs to nontraditional policies: they “could
impair the functioning of securities markets,”
“reduce public condence in the Fed’s ability
to exit smoothly from its accommodative poli-
cies,” create “risks to nancial stability,” and
cause “the possibility that the Federal Reserve
could incur nancial losses.”
4
Similarly, Dudley
said in November 2011 that nontraditional tools
4
Bernanke’s conclusion was that “the costs of nontra-
ditional tools, when considered carefully, appear manage-
able”; and, as we discuss below, his speech came shortly
before a decision by the FOMC to use the tools more force-
fully. Nonetheless, the speech provides an unusually clear
discussion of the costs that policymakers perceived.
entail “costs as well as … benets,” and went on
to detail the costs he perceived.
Policymakers have been explicit that these
considerations have muted their policy response.
In October 2012, Bernanke said that “the Federal
Reserve has generally employed a high hurdle
for using” nontraditional tools. In April 2012,
Yellen said, “The FOMC’s unconventional pol-
icy actions … , in my judgment, have not entirely
compensated for the zero-bound constraint.”
These statements are consistent with the fact
that Federal Reserve policy in recent years has
been less aggressive than some analysts have
urged (for example, Gagnon 2009).
Another parallel with the earlier periods—
particularly the 1970s—is that concern about the
effectiveness of their tools has led monetary pol-
icymakers to advocate nonmonetary measures.
In September 2012, after saying that monetary
policy “is not a panacea” for addressing tight
nancial conditions and high unemployment,
Bernanke said, “We’re looking for policymakers
in other areas to do their part.” Using very similar
language in November 2011, Yellen elaborated
on her view that monetary policy alone could
not solve an aggregate demand shortfall by say-
ing that “it is essential for other policymakers
to also do their part.” And in January 2012, the
Federal Reserve sent Congressional leaders an
unsolicited white paper discussing “current con-
ditions and policy considerations” concerning
the housing market and housing policy.
Thus, concern about the power of policy
has limited the Federal Reserve’s response to
the very weak economy. Whether that concern
has reected unwarranted pessimism or a wise
assessment will not be known for many years,
if ever.
Two pieces of evidence, however, are at least
suggestive of unwarranted pessimism. The rst
is the analogy to the Depression. Then, as in the
past few years, nominal interest rates were very
low, and many attributed poor economic condi-
tions to a speculative boom and bust rather than
to monetary causes. Yet the modern consensus is
that the beliefs that monetary expansion would
be ineffective and potentially costly were mis-
taken. Second, the Federal Reserve’s decision
in September 2012 that it was appropriate to
use its tools more aggressively, even though its
economic outlook had improved since the previ-
ous meetings, suggests that policymakers may
now think they had been underestimating the
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AEA PAPERS AND PROCEEDINGS
effectiveness of the tools, or overestimating their
costs.
5
But both pieces of evidence are clearly
far from denitive.
IV. Conclusion
The view that hubris can cause central bank-
ers to do great harm clearly has an important ele-
ment of truth. A belief that monetary policy can
achieve something it cannot—such as stable low
ination together with below-normal unemploy-
ment—can lead to the pursuit of reckless poli-
cies that do considerable damage.
But the hundred years of Federal Reserve
history show that humility can also cause large
harms. In the 1930s, excessive pessimism about
the power of monetary policy and about its
potential costs caused monetary policymak-
ers to do little to combat the Great Depression
or promote recovery. In critical periods in the
1970s, undue pessimism about the potential of
contractionary monetary policy to reduce ina-
tion led policymakers to do little to rein in the
Great Ination. We have stressed that it is too
soon to reach conclusions about recent develop-
ments. But, faced with persistent high unem-
ployment and below-target ination, beliefs
that the benets of expansion are small and the
costs potentially large appear to have led mon-
etary policymakers to eschew more aggressive
expansionary policy in much of 2010 and 2011.
In hindsight, these beliefs may be judged too
pessimistic.
The approaches of two largely success-
ful Federal Reserve chairmen—William
McChesney Martin and Paul Volcker—also sug-
gest that the value of humility in a central banker
may be overstated. Both came into ofce believ-
ing that monetary policy could accomplish a
great deal, and both used policy aggressively. For
example, Volcker undertook a highly successful
disination program because, as he stated at his
conrmation hearings, “I don’t think we have
any substitute for seeking an answer to our prob-
lems in the context of monetary discipline.”
5
For example, the Summary of Economic Projections in
September 2012, when the FOMC decided to make greater
use of the tools, involved a considerably lower level of
unemployment, and a similar rate of decline in unemploy-
ment and a similar path for ination, than the projections
in November 2011, when it decided to take no substantial
new action.
One possible conclusion is that central bank-
ers should have a balance of humility and hubris.
They need a sound knowledge of both the limita-
tions and the powers of monetary policy. That is,
the most important characteristic to look for in
central bankers is not their inherent optimism or
pessimism about the effectiveness of monetary
policy, but rather their understanding of how the
economy works and the possible contributions
of policy.
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