Many economists take for granted that the Federal Reserve has contributed positively to economic stabilization in the U.S. In 1960, for example, economist Arthur Burns noted that the Federal Reserve had fulfilled its promise by helping to “ease the transition from the expanding to the contracting phase of business cycles.” [1] More recently, Harvard professor Martin Feldstein noted that the Fed “[h]as learned from its past mistakes and contributed to the ongoing strength of the American economy.” [2] The conventional wisdom is that the Fed has, in fact, helped to tame business cycles and to reduce volatility in key macroeconomic variables.
A close look at the evidence, though, suggests that this view should be reconsidered. For instance, several studies suggest that data deficiencies cause key pre-Fed-era data series to appear more volatile than their post-World War II counterparts. Despite the conventional view, there is evidence that the Fed has not been as effective as once thought in accomplishing its stabilization goals, and even some evidence that the Fed era has had more economic instability than the pre-Fed era. This Backgrounder highlights these research findings and argues that the apparent postwar stabilization is largely the result of incomplete prewar data.
General Data Problems Most modern macro-level data, as well as the procedures for compiling the data, did not exist before the Great Depression. The economists who began compiling these data series in the 1920s and the 1930s did the best they could to estimate data from earlier time periods, and they clearly understood that their approximations were rife with potential errors. For the most part, however, their warnings have gone unheeded, as the conventional view that business cycles have been tamed solidified.
Despite this conventional belief, surprisingly few comprehensive academic studies exist that assess the Federal Reserve’s overall performance since its founding in 1913, in part because the Fed’s mission and methods have changed substantially during that time. One such study, published in 2012 by George Selgin, William Lastrapes, and Lawrence White, examines nearly every component of the Fed’s mission. The study includes original empirical research and also provides numerous citations to academic research that more narrowly focuses on key portions of the Fed’s operations. [3] This Backgrounder relies heavily on those citations to highlight the Fed’s impact on business cycles, output, and unemployment. [4]
Another problem with comparing economic performance in the pre– and post–Federal Reserve eras is that three anomalous events occurred soon after the Fed was created in 1913. World War I, the Great Depression, and World War II produced major disruptions to the world’s economies throughout roughly the next 30 years. As a result, many economic studies exclude the interwar years, in order to avoid these somewhat unique economic conditions. Nonetheless, the Federal Reserve did exist during this time period, so several studies also include the interwar years. Whenever possible, this Backgrounder presents data comparisons with and without the interwar period.
Has the Fed Tamed the Business Cycle? The term “business cycle” describes the pattern of fluctuations—expansions and contractions—in economic activity over time. Periods of expansion are measured from the bottom (trough) of the previous cycle to the top (peak) of the next cycle. Contractionary periods, on the other hand, are measured from peak to trough. The official U.S. business cycle dates are provided by the National Bureau of Economic Research (NBER), a nonprofit research organization consisting mostly of academic economists. These dates, starting with 1854, were first compiled during the Great Depression.
The official dates show that economic expansions have become longer, and also that economic contractions have become both shorter and less frequent in the post-World War II era than before the creation of the Fed. Many economists have attributed this improvement to “better” economic stabilization policies employed in the postwar era, including those implemented by the Federal Reserve. Research published in the late 1980s and early 1990s, however, suggests that such conclusions should be tempered because of problems with the prewar data. [5]
One contribution of this research was to simply remind people that the economists who compiled the NBER dates during the Depression provided us with a major caveat. The 1946 NBER publication Measuring Business Cycles, a highly detailed description of the NBER’s original methodology, states:
This is not to say that the reference dates must remain in their present state of rough approximation. Most of them were originally fixed in something of a hurry; revisions have been confined mainly to large and conspicuous errors, and no revision has been made for several years. Surely, the time is ripe for a thorough review that would take account of extensive new statistical materials, and of the knowledge gained about business cycles and the mechanics of setting reference dates since the present chronology was worked out. [6] The revisions were never made because NBER economists were diverted from that task in service of World War II-related economic problems. [7] Furthermore, recent research makes it clear that “the NBER reference dates for the cycles before 1927 were chosen long before the modern procedures described in Measuring Business Cycles were established.” [8] In other words, the methods used to date the pre-World War II cycles are different from those used to date the postwar cycles. Statistically, the key problem is that the pre-1927 NBER dates are based on de-trended data while the post-1927 dates are derived using data that include a trend. [9]
Properly accounting for this difference alters the NBER prewar dates and challenges the conventional wisdom that recessions have become shorter in the postwar period. The evidence suggests that the data used to derive the official NBER dates systematically biases the NBER’s pre-World War II cycles so that they appear more severe, in several ways, than they really were. Alternative dates show that many of the “new prewar peaks are several months later than the NBER peaks and many of the new troughs are several months earlier.” [10] The study’s main findings can be summarized as follows:
- The official NBER dates show a dramatic decline in the length of contractions over time. The new dates, though, show that the average length of recessionary periods in the post-World War II period is slightly longer than the average for recessions that occurred prior to World War I.
- The new dates suggest that the average loss of economic output is similar in the post-World War II era relative to the typical loss prior to World War I. However, the length of time it took for the economy to return to its previous peak level was nearly three months shorter in the pre-World War I period.
The new dates confirm that recessions were indeed more frequent in the pre-World War I era relative to the post-World War II time frame. When, instead, the entire Federal Reserve period is compared to the full pre-Fed period, the frequency of recessions did not decrease. Still, even when the interwar period is excluded, the new dates suggest that economic contractions were shorter and recoveries were faster in the pre-Fed era than previously believed. [11] The study’s author concluded:
Thus, the changes in recessions revealed by the new chronology do not show an obvious improvement in business cycles over time. Although the time separating contractions has become longer between the pre–World War I and postwar eras, recessions themselves have not on average become shorter, less severe, or less persistent over time. [12] One possible caveat is that these results are related to data starting in 1884, thus leaving out a large portion of the post–Civil War period. Other published research, however, has addressed the full post–Civil War time frame and is largely consistent with the earlier results. The updated work finds no discernible difference between either the frequency or average duration of contractions before World War I versus after World War II. [13]
In fact, the newer research suggests that the NBER should reclassify four recessionary periods during the late 19th century as growth periods. [14] More generally, this study reports shorter recessionary periods between the Civil War and World War I. For example, the NBER dates show a recession lasting from October 1873 to May 1879, by far the longest recession in the nation’s history. The newer research, however, suggests the 1873 recession lasted only two years.
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