III.1 Setting the scene
This chapter uses econometric and traditional historical methods to look at the US monetary union in three distinct phases of its history: the period from 1880 to 1913, when the United States had a currency union but no central bank; the period from 1914 to 1943, when the newly created Federal Reserve had to meet a number of unexpected and diﬃcult challenges; and the postwar era, during which the Federal Funds rate emerged as a dominant monetary instrument. At least since Mundell (1961) economists have recognized that monetary policy will normally be easier to formulate for a monetary union when all regions are experiencing the same kind of shock than when diﬀerent regions are experiencing diﬀerent kinds of shocks. If all regions, for example, are experiencing a housing boom that the monetary authority regards as dangerous, then the monetary authority may well choose a contractionary policy to combat the boom. Many monetary economists, of course, would recommend that the monetary authority ignore short-term shocks and instead focus on maintaining long-run price stability. Clearly, however, dealing with a situation in which all regions are experiencing the same type of housing boom, the case we refer to as a symmetric shock, will be easier than dealing with a situation in which one region is experiencing a housing boom while other regions are not, the situation we refer to as an asymmetric shock. If the monetary authority raised interest rates throughout the monetary union in order to slow the rise in housing prices in the one region experiencing a boom it might aggravate economic conditions in other regions. Here we will explore US monetary history to see whether in fact asymmetric shocks have
been a problem, whether the problem of asymmetric shocks has grown or diminished over time, and how the United States has coped with the problem of asymmetric shocks. We also discuss the evolution of banking regulation and its impact on the integration of capital markets throughout the period. Finally, we draw some lessons from the US experience for Europe. We will try to identify regional shocks by looking at regional bank lending rates. These
are the right rates to use because they reﬂect the actual conditions facing borrowers and lenders in each region of the United States. We will work with four regions: the Northeast, the Plains, the South and the West.1 Figure 9.1 shows the basic bank lending rates in our four regions for the period 1880-2002. As you can see, there are a number of occasions in which rates diverge, presumably due to underlying shifts in the supply of or demand for bank loans. There is a clear tendency over the long run for the rates to converge, but even in recent decades, when the regional bank lending rates move closely together, there are periods of a year or more when the rates diverge. To identify the locus of the shocks hitting the US economy we estimate a VAR model,
described in the next section. In subsequent sections we compare the pattern of shocks
uncovered by our econometric model with the shocks identiﬁed in traditional narrative histories of the American monetary system. For the most part our two sources reinforce each other: When our econometric model identiﬁes a major shock we usually ﬁnd a convincing story in the traditional literature, and vice versa. In a few cases our econometric results identify regional shocks that have not received much attention in the traditional literature, and suggest the need for further research. In each case separately our attributions of particular interest rate shocks to particular
events have to be considered tentative conjectures. It would take a great deal of digging to trace out the links that we hypothesize between, say, regional banking panics and regional bank lending rates. The cases do, however, add up and suggest that our identiﬁcation of shocks makes sense. In the end, it is clear that the US economy was struck repeatedly by both symmetric shocks –
shocks hitting the core and the periphery – and by asymmetric shocks – shocks hitting only the core or the periphery, or opposed shocks hitting the core and the periphery. It is the latter pattern that creates the most diﬃcult problem for an activist monetary policy agenda. It also appears that the problem of asymmetric shocks diminished in the postwar era.