speeches · April 23, 2003
Speech
William Poole · President
The Fed’s Role in Maintaining Financial Stability
UniversityofCentralArkansas
Conway,Arkansas
April24,2003
I’m delighted to be here to speak at the theoperationofthefinancialsystem.Iaskthis
University of Central Arkansas. I’m gradu- basicquestion:Whatsortsoffinancialinstability
ally making way around the state to the arethedirectresponsibilityoftheFederalReserve
various campuses; perhaps over the next Systemandwhatsortsaretheresponsibilityof
few years I’ll manage to speak at all the other othersorsimplyaconsequenceofthebehavior
ArkansascampusesI’venotyetvisited.Ihopeso. ofhighlycompetitivemarkets?Inparticular,itis
Ihavealong-standinginterestinunderstand- amistaketoassumethateveryfinancialproblem
inghowandwhyfinancialmarketssometimes isevidenceofapolicyfailure,orrequiresapolicy
becomedysfunctional.WhenIfirststartedstudy- response.
ingeconomics,inthelate1950s,thesubject Beforeproceeding,Iwanttoemphasizethat
seemedtobeaspecialtopicineconomichistory. theviewsIexpressherearemineanddonot
Andthatremainedmyviewthroughgraduate necessarilyreflectofficialpositionsoftheFederal
school.AboutthetimeIbeganmyfirstuniversity ReserveSystem.Ithankmycolleaguesatthe
appointment,in1963,financialmarketsbeganto FederalReserveBankofSt.Louisfortheirassis-
becomelessstable.Theissuesintheearly1960s, tanceandcomments,especiallyAltonGilbert,
forthemostpart,centeredonthegoldstandard DavidWheelock,MarkVaughan,andBill
andinstabilitiesintheBrettonWoodssystemof Emmons.Iretainfullresponsibilityforerrors.
fixedexchangerates.Butbeforetoomanymore
yearshadpassed,boutsofinstabilitybeganto
appearinthedomesticfinancialmarkets. FEDERAL RESERVE
Occasionalepisodesoffinancialinstability
RESPONSIBILITIES
seemnowtobethenorm,andindeedinrecent
yearsoperationofournation’sfinancialsystem TheFederalReservehasthreemainrespon-
hasbeensubjecttosubstantialshocks.Apartial sibilities.Oneistocontributetomaximumsus-
listwouldincludethesuddenstockmarketcrash tainableeconomicgrowthbymaintaininglow
of1987andtheslow-motioncrashstartingin andstableinflation,orpricestabilityforshort.
early2000.Thelistwouldalsoincludethefinan- Thesecondisregulationandsupervisionofbanks
cialmarketdisruptioninthefallof1998,after andtheirholdingcompaniestocontributetosta-
RussiadefaultedonitsbondobligationsandLong- bilityofthebankingsystem.Thethirdisprovision
TermCapitalManagementexperiencedsevere ofpaymentsservicesincludingdistributionof
pressuresthatbroughtthefirmtothebrinkof currency,clearingofpaperchecks,andelectronic
disorderlycollapse.Andwhocanforgetthesevere paymentsservices.Successinthesethreeareas
stressinthepaymentssysteminthehoursand contributesto,butdoesnotguarantee,stability
daysfollowingthe9/11terroristattacksinNew ofoutputandemployment.Successcertainly
YorkandWashington? doesnotguaranteestabilityofpricesinfinancial
Mypurposethiseveningistoaddresstherole markets,aswehaveseenfromtheperformance
oftheFederalReserveinmaintainingstabilityin ofthestockmarketinrecentyears.Despitethis
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FINANCIALMARKETS
fact,itisalsotruethatFedfailuretoachieveits ofdepositorsranontheirbankstowithdrawcur-
goalshasahighprobabilityofdestabilizingprices rency.Overtimebanksdevelopedwelldefined
infinancialmarkets. mechanismsfordealingwithsuchbankruns
whileavoidingdisruptioninthepaymentssystem.
Thesemechanisms,whichwerecoordinatedby
SELECTIVE HISTORY OF theclearinghousesthroughwhichbankscleared
checks,includedlendingcurrencytosomeof
FINANCIAL PROBLEMS
thebanksundergreatestpressurefromdepositor
ThebestwayIcancommunicatewhatit runsandissuingtemporarycertificatesthatmem-
meanstopreservefinancialstabilityistodescribe bersoftheclearinghousescoulduseforsettlement
eventsduringseveralperiodsinournation’shis- amongthemselves.
torywhenthenationwasnotabletomaintain Duringsomeoftheseperiodsofbankruns,
financialstability.Ifsomeoftheseexamplesseem bankswereabletomeetthedemandsoftheir
oldandoutofdate,thatisbecausewemustuse depositorsforcurrency,thusavoidingdisruptions
suchexamplestoexploretheimportanceofprice inthepaymentssystem.Duringotherperiods,
stabilitygiventhatthenationhasenjoyedlowand however,theseprivateremediesforbankruns
stableinflationformostofthelast20years. werenoteffectiveinpreservingtheoperationof
Ibeginwiththefallof1907,thelastepisode thepaymentssystem.During1873and1893,
ofamajorbreakdowninournation’sbanking membersoftheclearinghouseinNewYorkCity
systempriortotheformationoftheFederal respondedtorunsbytemporarilyrefusingtopay
Reserve.Bankingproblemsinthefallof1907 currencytotheirdepositorsondemand.
wereacatalystforstimulatingchangeintherole Theseperiodsofsuspensionofcurrencypay-
ofourgovernmentintheoperationofthenational mentsinvolvedmajordisruptionsinthepayments
financialsystem.TheUnitedStatesdidnothave systemofthenationbecauseatthetimemuch
acentralbankatthattime—theFederalReserve commerceinvolvedpaymentwithcurrency.Itis
beganoperationsin1914—anddidnothavefed- importanttorealize,however,thatdisruptionin
eraldepositinsurance,whichwasestablishedin thefinancialsystemwouldhavebeenworsein
the1930s.Withnofederaldepositinsurance, 1873and1893ifbankshadnotsuspendedcur-
thewillingnessofpeopletoholdbankdeposits rencypaymentstodepositors.Runsonbankscre-
dependedontheirconfidenceinthestrengthof atedakindofimplosionofthebankingsystem,
thebanks. asbanksattemptedtoquicklyselltheirassetsto
NewYorkCitywasthenation’sfinancial obtainthecurrencydemandedbytheirdepositors.
center,asitremainstothisday.Themostimpor- Suspensionofcurrencypaymentsstoppedthe
tantstockexchangeinthenationwaslocatedin implosionofthebankingsystem.Eventhough
NewYorkCity,andtheuninterruptedoperation bankswereabletoresumecurrencypayments
ofthestockexchangedependedonshort-term todepositorswithinaboutamonthofthesus-
loanstostockbrokersbybankslocatedinNew pensionsin1873and1893,theseperiodsofsus-
YorkCity.Businesseslocatedthroughoutthe pensionofcurrencypaymentscreatedmajor
nationsettledtransactionsamongthemselves disruptionsineconomicactivityintheUnited
withdraftsdrawnuponbankslocatedinNew States.
YorkCity.Disruptionstotheoperationofthe Nowconsidertheexperienceof1907.Econ-
banksinNewYorkCitycreateddisruptionsin omicactivitypeakedinMay1907.Inthefall,
thenation’spaymentssystem. eventsuniqueto1907ledtoarunonamajor
Priorto1907,therehadbeenaseriesof trustcompanyinNewYorkCitythatwasnota
episodesinwhichadversedevelopmentsunder- memberoftheclearinghouse.Membersofthe
minedtheconfidenceofthepublicinthefinancial clearinghousedecidedtowithholdaidfromthe
strengthofbanks.Atthesetimes,largenumbers trustcompany.Thatdecisionappearstohavebeen
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TheFed’sRoleinMaintainingFinancialStability
anunwiseone,asfailureofthetrustcompany debtincreasedinrealterms.Forexample,ahouse-
triggeredrunsonmembersoftheclearinghouse. holdthathadtakenoutamortgageinthe1920s
Whentheprivateremedieswerenoteffectivefor mightbeunabletomakethemortgagepayments
copingwiththedepositorruns,membersofthe aswagesfell,evenassumingthatthehomeowner
clearinghousedecidedtosuspendcurrencypay- remainedemployed.Ofcourse,manybecame
mentstotheirdepositors. unemployed.Eventuallymanybusinessesand
Asin1873and1893,thesuspensionofcur- householdsdefaultedontheirdebtobligations,
rencypaymentsinthefallof1907stoppedfurther underminingthesolvencyoftheircreditorsand
reductionsinbankassets,butatthecostofamajor theconfidenceofdepositorsinthefinancial
disruptioninthepaymentssystemthataggravated strengthoftheirbanks.
theeconomicrecessionthathadstartedinMay TheU.S.bankingsystemexperiencedaseries
1907.Thisepisodeandmanyothersdemonstrate ofdepositorrunsduringtheearly1930s.The
clearlytheconnectionbetweenbankingstability FederalReservefailedtooffsetthereservesthat
andstabilityofoutputandemployment. bankslostthroughcurrencywithdrawalsbytheir
Thepoliticalbacklashfromthe1907bank- depositors.Banksnolongeremployedtheirpre-
ingpaniceventuallyledtotheformationofthe Fedprivateremediesforruns,becausethey
FederalReserveSystemin1914.Thefoundersof expectedtheFederalReservetodealwithruns.
theFederalReservebelievedthatanimportant Thiswasaperiodofpolicydrift;neitherthe
functionofthenewcentralbankwastoprovide FederalReservenorthebanksthemselvesacted
currencytobankstomeettemporaryincreases tohalttheimplosionofthebankingsystem.
incurrencydemandbybankcustomers.TheFed Pressureonthebanksbecamesogreatthatin
providedassistancebymakingloanstomember March1933,shortlyafterhisinauguration,
banksthroughtheFed’sdiscountwindow. PresidentRooseveltdeclaredabankingholiday
TheUnitedStatesexperiencedseveralminor fortheentirenation.Everybankinthenation
recessionsinthe1920s,butnogeneralizedfinan- wasclosedforatleastafewdays.Government
cialproblems.ItappearedthattheFederalReserve authoritiespermittedbankstoresumeoperations
wasworkingasintended.Butthen,inOctober astheycertifiedthebankstobeinsoundfinancial
1929,thestockmarketcrashed.Thecrashwasa condition.Customersofthousandsofbanksthat
majorshocktotheU.S.financialsystem,butitdid didnotresumeoperationhadtheirbankdeposits
notitselfnecessarilyleadtotheGreatDepression. frozenuntilthefailedbankswereliquidated.
OneviewoftheonsetoftheGreatDepression Thedisruptionintheoperationofthepay-
assignsmuchoftheblametotheFederalReserve mentssysteminMarch1933wasgreaterthan
System,whichfailedinitsmandatetomaintain duringtheearlierperiodsofsuspensionofcur-
pricestabilityandasoundbankingsystem.The rencypayments.Duringtheperiodsofsuspension
FederalReservepermittedthemoneysupplyto ofcurrencypayments,bankshadremainedin
fallsharplyduringtheearly1930s,leadingto operationandprocessedpaymentsinitiatedby
sharplyfallingpricesofgoods,services,and theirdepositorsintheformofchecks.Inshort,
wages.Theconsumerpriceindexdeclinedabout in1933,theFederalReservepresidedoverthe
25percentbetween1929and1933.Thisexperi- largestbankingcrisisinthehistoryoftheUnited
encewithdeflation,aswelltheJapaneseexperi- States.Thenation’sresponsewastoestablisha
enceinthe1990s,demonstratesconclusively systemoffederaldepositinsurance,tomake
thatamajordeflationisextremelydamagingto bankingpanicslesslikelyinthefuture.
bankingstabilityandeconomicactivity. The1930sillustratethedamagethatdeflation
Businessesandhouseholdsthathadborrowed cancreateinaneconomy;the1970s,theperiod
fundsinthe1920spriortotheonsetofdeflation oftheGreatInflation,illustratesthedamageof
in1930didnothavesufficientcashflowtomeet highinflation.Theinflationbegantotakerootin
theirdebtobligations.Aspricesandwagesfell, 1965,slowlyatfirst.Then,theentiredecadeof
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FINANCIALMARKETS
the1970swasaperiodofrelativelyhighU.S. TheepisodesoftheGreatDepressionandthe
inflation.Thelowestyear-over-yearpercentage endoftheGreatInflationshowclearlythedamage
changeintheconsumerpriceindexwas3.3per- fromanunexpecteddeclineintherateofinfla-
centin1972,andeventhatperformancewasan tion.Inthefirstcase,inflationwentfromabout
artificialresultofwage-pricecontrolsthatcould zerotoroughly–10percentperyear;inthesec-
notbesustainedinthelongrun.Theinflationrate ondcase,inflationwentfromroughly10percent
roseeveryyearfrom1976,whentheinflation toroughly4percentperyear.Inflationitself
ratewas5.8percent,to1980,whentheinflation causesmanydifficulties;thelessonistoavoid
ratewas13.5percent. inflationinthefirstplace,toavoidboththeprob-
Risinginflationduringthe1970shadadverse lemsfrominflationandfromitsending.
effectsonthefinancialsystemforseveralreasons. Therelativelylargegapbetweenlong-term
Whereasdeflationintheearly1930sdamaged interestratesandtheinflationrateduringmuch
borrowersbyincreasingtherealvalueofdebt, ofthe1980smaybeinterpretedasanindicator
oftheinflationaryexpectationsofinvestors.Along
inflationinthe1970sdamagedlendersbydecreas-
periodofrelativelylowinflationwasnecessary
ingtherealvalueofdebt.Loansnegotiatedwhile
toconvinceinvestorsthattheeconomywouldnot
inflationwasrelativelylowinthe1950sandearly
repeattheinflationaryexperienceofthe1970s.
1960swererepaidindollarswithlowerpur-
Whileexperienceofthe1930sillustratesthe
chasingpower,thusunderminingthefinancial
adverseeffectsofdeflationontheoperationof
strengthoflenders.
ournation’sfinancialsystem,theexperienceof
Afterapersistentriseintheinflationratefor
the1970sand1980sillustratesthedamagethat
severalyears,businessesandhouseholdsbegan
canresultfromapersistentriseintherateofinfla-
toborrowonthebasisofexpectationsthathigh
tionfollowedbyanabruptslowingofinflation.
inflationrateswouldcontinueindefinitely.Inter-
Savingsandloansassociations(S&Ls)were
estratesthatborrowerswouldhaveconsidered
especiallyvulnerabletorisingandthenfalling
extremelyhighafewyearsearlierappearedmore
inflationinthe1970sand1980s.Forseveral
acceptableinlightoftheirexpectationofcontin-
decades,theseorganizationshadremainedprof-
uedhighinflation.
itablewhileassumingagreatdealofinterestrate
Therateofinflationdeclinedsharplyduring
risk.TheriskarosewhenS&Lsattractedfunds
theearly1980safteranaggressivetighteningof
intheformofshort-termdepositsprovidedby
monetarypolicyinlate1979.Theconsumerprice
householdsandlentfundsintheformoflong-
index,whichrose13.5percentin1980,increased
term,fixed-rateresidentialmortgages.TheS&Ls
only3.2percentin1982.Thisabruptslowingof
werevulnerabletosharpincreasesinmarket
inflationputfinancialpressureonthebusinesses
interestrates;asratesroseduringthe1970s,S&Ls
andhouseholdsthathadborrowedatrelatively
hadtoincreasedepositratesbutwerestuckwith
highinterestratesinanticipationofcontinuing
thelowerratesonlong-termmortgagesissuedin
highinflation.Ofcourse,somebusinessesand
earlieryears.Bythetimethegovernmentgot
householdscouldrefinancetheirdebtasinterest aroundtodealingwiththeproblemofthebank-
ratesdeclinedduringthe1980s,butnotallcould ruptS&Ls,thecosttothetaxpayerswasabout
becausetheywerelockedintolong-termobliga- $150billion.
tions.Perhapsreflectingexpectationsthatinflation WhiletheproblemsoftheS&Lscreateda
wouldriseonceagain,long-terminterestrates messforthegovernmenttoresolve,itdidnot
declinedmuchmoreslowlythandidtherateof causeabreakdownintheoperationofthepay-
inflation.Theinterestrateon10-yearTreasury mentssystem,becausethepubliccontinuedto
securitiespeakedat15.3percentinSeptember havefaithinfederaldepositinsurance.Wemust
1981andremainedabove10percentuntil gobackto1933tofindanexampleofabreakdown
November1985. intheoperationofournation’spaymentsystem.
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TheFed’sRoleinMaintainingFinancialStability
AlthoughtheFederalReservedidnotregulate andnewtechnologies.TheFed’sresponsibility
theS&Ls,lessonsfromthatunhappyexperience istomaintainasteadygeneralpriceleveland
werenotlostonbankingregulatorsandCongress. nottotakeapositionontheappropriatenessof
Congressactedtostrengthenregulationofdeposi- individualprices.Wehaveampleevidencethat
toryinstitutionsintheFederalDepositInsurance stockpricescanfluctuatesubstantiallyeven
CorporationImprovementActof1991. whilethegenerallevelofgoodspricesisstable.
Avoidinginflationarydisturbancestoeconomic
activityandtofinancialmarketsisamajor
SCORE CARD ON CONDITIONS achievementofthelast20yearsorso.
FOR FINANCIAL STABILITY AsI’venoted,theU.S.economyinrecent
yearshasexperiencedfinancialshocksthathad
IstheFedachievingitsobjectivesofmoder-
thepotentialtobecomemuchmoreserious.I’ve
ateinflationandfinancialstrengthforthe
emphasizedthattheFedplaysacriticalrolein
nation’sbankingindustry?Since1992,theyear-
maintainingfinancialstabilitythroughitspolicies
over-yearpercentagechangeintheconsumer
topromotepricestability.Thebaselinecondition
priceindexhasbeenwithinarangebetween1.5
ofpricestabilitymakesitmuchmorelikelythat
percentand3.5percent.Excludingthevolatile
marketresponsestoshockswillnotcumulateto
foodandenergycomponentoftheCPI,therange
largerandmoregeneralproblems.
hasbeenbetween2.1and3.3percent.Thispat-
Thereisanotherpartofthestory,though,that
ternofinflationratesdoesnothavethekindsof
Ihavenotemphasizedsofar.ThatpartistheFed’s
adverseimpactsonthestabilityofthefinancial
roleinrespondingtoanyparticularshockinwhat-
systemthatweobservedinmanyearlieryears.
everwayisappropriatetodealwiththeshock.For
Inaddition,variousmeasuresindicatethat
example,thecollapseoftheTwinTowerson9/11
thebankingindustryisinrelativelystrongfinan-
ledtotheunavoidableclosureoftheNewYork
cialcondition.Iwillciteonemeasure,theratio
StockExchangeandthegovernmentsecurities
ofequitytototalassetsforallbanks.Thisratio,
markets.Thephysicalclearingprocessforpay-
whichwas6.4percentin1990,was8.5percent
mentswasdamaged,whichmeantthatbanksand
in1998,andhasrisenfurtherto9.2percentin
firmswithbillscomingduecouldnotinfactmake
2002.Thestrengthofthebankingsystemwasan
thepayments,eventhoughtheyhadamplefunds.
importantsourceofstabilityinthefallof1998,
Forexample,howdoIgethomefromtheairport
afterRussiadefaultedonitsbonds.Thatstrength
ifI’mrelyingontheATMtogetcashtopaythe
hasalsobeenimportantinlimitingtheextentof
taxidriver,andfindthattheATMisbroken?The
therecessionof2001andhelpingtosustainthe
fundsareinmyaccount,butIcan’tgettothem.
economyinthefaceofthelargedeclineinthe
equitymarkets. Becausethepaymentssystemforlargedollar
Finally,duringrecentyearstheFederal electronictransferswasbrokenon9/11,those
Reservehasimplementedapolicyofensuring relyingonreceivingfundstomaketheirownpay-
thatdefaultbyoneormorebanksthatareinvolved mentscouldnotobtainthefundstheywereowed.
intheoperationofsystemsforsettlementoffinan- TheFedlentmassiveamountsoffundssothese
cialtransactionswouldnotdisruptthesettlement paymentscouldbemade.TheFed’sactionswere
oftransactionsbythesesystems.TheFedacted tunedtotherealitiesoftheparticularproblem.
vigorouslytomaintainoperationofthepayments So,theFed’sresponsibilityistwo-fold:First,
systemfollowingtheterroristattacksof9/11,and tomaintainthesolidbaseofpricestabilityand,
hassincestrengtheneditsprocessesfurther. second,torespondasneededtooffsettheeffects
Inanentrepreneurial,marketeconomybusi- ofshockswhentheyoccur.TheFedhasnoway
nessesandhouseholdsareguidedbypricesignals topreventallshocks,butitcanlimitthecollateral
andexpectationsofprofitsfromnewmarkets damagethatwouldotherwiseflowfromthem.
5
FINANCIALMARKETS
ThenationisfortunatethattheFederal
Reserveisgenerallyeffectiveinminimizing
collateraldamagefromunpredictableshocks.
Minimizing,though,isnotthesamethingas
eliminating.Animportantitemofunfinished
businessistoexaminechangesingovernment
policyandmarketpracticethatmightreducethe
likelihoodandseverityofshocksinthefirstplace.
Butthatisthesubjectofanotherlectureanother
day.Indeed,thesubjectissolargethatitdeserves
severallecturesonseveraldays.
6
Cite this document
APA
William Poole (2003, April 23). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20030424_poole
BibTeX
@misc{wtfs_speech_20030424_poole,
author = {William Poole},
title = {Speech},
year = {2003},
month = {Apr},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/speech_20030424_poole},
note = {Retrieved via When the Fed Speaks corpus}
}