The Fed’s response to COVID-19 through the lens of history

The lessons from history never exactly repeat themselves, but they often rhyme. The Federal Reserve can learn important lessons from the pandemic of 1918, the Great Contraction of 1929-33, World War II and the Great Financial Crisis (GFC) of 2007-2008. The Fed must avoid repeating the mistakes of the past.

The key lesson from the 1918 pandemic is that absent a mandatory government lockdown, the COVID-19 recession would have been much less severe but likely deadlier. The key lesson from the Great Contraction of the 1930s is the importance of the Fed acting as a Lender of Last Resort (LOLR) and stabilizer of the macro economy. The key lesson from World War II is that once the present emergency ends, the Fed must unwind its status as LOLR and its expansionary monetary policies to prevent undesired high inflation. The GFC teaches the Fed that it must plan the exit strategy to unwind its emergency facilities and not allow them to become part of its normal set of policies. 

The pandemic of 1918-1919 killed upwards of 50 million people worldwide, including 675,000 in the U.S., highlighted by a spike in the fall 1919 when U.S. troops returned from World War I. The highest mortality rate was among working-age people between the ages of 20 and 40. No cures or vaccines were made available.  

The pandemic led to a mild recession with a sharp temporary drop in industrial production but a speedy bounce back. There was no increase in unemployment. Municipalities required non-pharmaceutical interventions such as facemasks and school and church closings, but there were no mandated lockdowns. The Fed was engaged in accommodating the Treasury’s financing of World War I and did not respond to the pandemic.

The structure of the economy was different than today, with far less urbanization, more primary and secondary production and fewer services. The demands of World War I offset the negative shocks to the labor force and consumption from the pandemic. 

The Great Contraction of 1929-33 involved a 35 percent collapse in real GDP, 10 percent per-year deflation and human devastation stemming from persistently high unemployment that lasted for a decade. It was generated by totally misguided monetary policy. Federal Reserve policy caused the initial downturn in 1929 with its tight policies in the late 1920s to stem the Wall Street boom. The Fed then ignored its mandate as LOLR and failed to mitigate four serious banking panics from 1930-33 that contributed to debt deflation and widespread bankruptcies. The strikingly passive Fed then interrupted the economic recovery by mistakenly doubling bank reserve requirements, precipitating the recession of 1937-1938. The eventual economic recovery was facilitated by Treasury actions in leaving the gold standard and devaluing the dollar.

World War II required unprecedented deficit spending and massive government intervention to marshal resources for the war effort. The Fed became subservient to the Treasury’s deficit financing and pegged interest rates. The inflationary impact was somewhat suppressed by wage and price controls. After the war, the Treasury pressured the Fed to continue its bond price pegs and accommodative monetary policy, fearing the reoccurrence of recession. Instead, the economy boomed, and once wage and price controls were removed, inflation averaged 15 percent per year from 1945 to 1948. The Fed finally regained its independence to fight inflation with an accord with the Treasury in 1951. 

During the GFC of 2007-2008, Fed Chairman Ben Bernanke, as a student of the Great Depression, implemented emergency LOLR policies. Alternative liquidity facilities and quantitative easing, including purchases of mortgage-backed securities, helped ease financial market dysfunctions, although the Fed’s perception that the financial market faced a liquidity crisis and not an insolvency crisis delayed its response. The financial crisis finally ended with the imposition of stress tests of the major commercial banks.

Many of the Fed’s LOLR credit policies involved picking winners and losers, a form of fiscal policy that provided rewards for risky behavior. This threatened the Fed’s independence. Long after the economy had recovered, the Fed continued its emergency quantitative easing and a credit policy of purchasing mortgage-backed securities. Along with forward guidance, the Fed’s Quantitative Easting (QE) had only a limited effect in speeding up the recovery from the GFC. Quantitative Easing was hindered by paying interest on excess reserves, and the Fed’s balance sheet strategy was the source of poor communications. 

The COVID-19 pandemic and government shutdown contraction seemed like the Great Contraction of the 1930s on steroids and now may be ending just as quickly. Meanwhile, the Fed continues to implement an expansive array of LOLR facilities, including purchasing corporate and municipal bonds, and direct business lending, a practice that centuries of central banking history shows is fraught with peril. The Fed’s credit and fiscal policies clearly threaten its independence and heighten moral hazard. The Fed’s expansionary monetary policy (along with the fiscal stimulus) is supporting the economic recovery. But this policy comes with high political and economic risks if it generates significant inflation (above the Fed’s 2 percent target) in the not-too-distant future.

The Fed needs to establish a transparent and systematic strategy for unwinding its LOLR facilities and adjusting its monetary policy to foster its goals of maximum employment and price stability and to maintain operational independence and credibility. It should be guided by the lessons of these past crises. 

Michael D. Bordo is a Board of Governors Professor of Economics at Rutgers University and a distinguished visiting fellow at the Hoover Institution.