Patrick Sullivan left me the following comment:

[Read] what Alan Greenspan did in October 1987. He was on an airplane to Dallas on ‘Black Monday’ when the stock market began to plummet. On arrival he made a few phone calls, and early the next day the Fed issued a statement;

‘The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system.’

It followed up that statement with substantial open market purchases over the next days and weeks. I.e. it created more money. And Fed officials began a round of telephone calls to banks, reminding them they were in the business of lending that money.

American liberals argue that institutions like the Fed rescue the economy from a deeply unstable capitalist system. Libertarians are skeptical of the activism and worry that it just stores up more trouble for the future. But what if they are both wrong? What if the Fed rescues the economy by doing nothing? Here’s a graph of the monetary base from 1985 to 2003:

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If you look closely you’ll see two spikes where the Fed injected liquidity. One occurred at the end of 1999, as the Y2K issue led to fears that ATMs would not work on January 1, 2000. Liquidity was again injected for a very brief period after 9/11. But these are special cases, where even many libertarian economists would recognize the value of some temporary liquidity.

Notice, however, that the Fed didn’t do anything significant in 1987, which saw a stock market crash almost identical to the 1929 crash (both saw a gradual decline of 20% to 25% over 6 weeks, followed by a sharp decline of 20% to 25% over one or two days.) If they did a few open market operations, they were nothing out of the ordinary. The base did not show any unusual moves around the time of the crash (at least using bi-weekly data, perhaps money was injected for a few days and then withdrawn.)

The standard view of 1987 is that Alan Greenspan wanted to avoid the mistakes of 1929. This time the Fed would heroically ease money, and rescue the economy. That’s what the Fed would like us to believe. But where is all this extra money?

How about interest rates? Did the Fed avoid the mistakes of 1929 by slashing interest rates, unlike after 1929? What do you think?

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Again, I don’t see anything dramatic in 1987, just a fed funds rate fluctuating between 6% and 7%.

Actually it was the 1929 Fed that heroically cut interest rates, immediately after the stock market crash, and then again and again in 1930:

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This doesn’t make any sense. Is the standard view that Greenspan avoided the mistakes of 1929 totally wrong? No, that view is exactly right, but only if you accept my claim that the monetary base and the fed funds rate tell us NOTHING about the stance of monetary policy. In 1987 Greenspan made it clear that the Fed would do whatever it takes to keep AD growth at an adequate level. (He didn’t use those exact words, but that was the essence of his message.) In contrast, in 1929 Fed officials were actually trying to implement a tight money policy, to “pop” the stock market bubble. There were not committed to stable growth in AD, indeed they barely knew what it was.

This is what Nick Rowe calls the “Chuck Norris effect.” Show enough determination and you don’t need to act.

If the base and interest rates are not reliable indicators, then what is? I’d argue for expected NGDP growth. By that metric there was probably almost no change in monetary policy; NGDP kept chugging along at a decent rate for another 3 years, before we experienced a mild recession in 1990-91. And then another decade long boom, and another mild recession.

With sound monetary policy the Fed is not called upon to rescue the economy with wild and crazy actions like massive QE and unconventional asset purchases. And you need not fear imbalances building up, because NGDP growth stays stable. Both the liberals and libertarians are wrong. In 1987 Greenspan did not rescue the economy, nor did he store up future problems by bailing it out with lots of money printing. He did almost nothing other than keep on doing what he was already doing, and it worked. If the Fed had adopted 5% NGDPLT in 2007, there would have been no Great Recession, and yet it would have looked like the Fed did far less than they actually did. Interest rates would not have fallen to zero, and there would have been no QE. (In fairness, we would have suffered mild “stagflation,” slow growth and above 2% inflation.)

PS. In contrast, the 1998 rescue of LTCM was a big mistake, as was Bear Stearns. These actions created moral hazard that came back to bite us when Lehman was able to borrow huge sums from investors that assumed it too was “too big to fail.” Bailouts are not the Fed’s job, stable NGDP growth is.

PPS. Ironically it is those periods where Fed policy fails that it looks the most active by the now-discredited interest rate/monetary base measures. It looks like it’s valiantly trying to boost the economy (or stop inflation with high rates), but just doesn’t have enough “ooomph.” Actually, the aggressive interest rates changes and/or QE reflect the condition of the economy, an economy way off track due to previous Fed policy errors.