Mitchel Y. Abolafia - Stewards of the Market: How the Federal Reserve Made Sense of the Financial Crisis

Of course, the big developments since our last meeting were in financial markets. We seem to be repeatedly surprised with the depth and duration of the deterioration in these markets; and the financial fallout from developments in the subprime markets, which I now perceive to be spreading beyond that sector, is a source of appreciable angst.

FOMC TRANSCRIPT, AUGUST 7, 2007, 31

I was thinking that Edward R. Murrow said that anybody who isnt confused really doesnt understand the situation [laughter]. Im confused, and I dont understand the situation.

FOMC TRANSCRIPT, DECEMBER 11, 2007, 60

We are in uncharted waters, but we are groping our way forward.

FOMC TRANSCRIPT, DECEMBER 1516, 2008, 198

Surprise. Confusion. Groping forward. These are the reactions of policymakers at the Federal Reserve in the midst of dealing with the financial crisis of 2008. They are frank acknowledgments of the difficulty involved in the interpretation of a breach in the fabric of accustomed expectations. They reflect the vulnerable sentiments of colleagues addressing each other. These colleagues share a responsibility, not only to understand the breach, but to mitigate its consequences. The surprise, confusion, and groping toward an interpretation can be described as sensemaking, a term that refers to the moment when people, in this case policymakers, ask the question, Whats going on here? This moment occurred repeatedly over the course of the financial crisis when Federal Reserve (the Fed) policymakers were confronted by unexpected and often ambiguous circumstances.

It is rare that we catch sight of policymakers in the midst of sensemaking. Such deliberations usually occur beyond the public gaze. An unusual opportunity is afforded by the existence of verbatim transcripts of policy meetings that include all seven of the governors of the Federal Reserve and the twelve presidents of its regional Reserve Banks. The policymakers meet every six weeks to search out shifts in the economy and to adjust the supply of money and credit consistent with the Feds mandated goals of price stability and maximizing employment. As such, the Federal Open Market Committee (FOMC) is designed for collective sensemaking. During a crisis, the urgency of that sensemaking is magnified. The existence of the transcripts allows us to map the changing content of sensemaking to see how the policymakers understanding of events evolved and to examine their changing justifications for actions taken and not taken.

Sensemaking during the crisis did not occur in a vacuum. It was a social process. The policymakers not only received volumes of data and analysis from their staffs, they also met with business leaders, they read private-sector analyses of the situation, and, of course, they influenced each other.

In the ensuing analysis, my purpose is to understand the Feds unfolding interpretation of the financial crisis. In this sense, analytic discretion (sensemaking) was the default option.

Current research suggests that Fed policy adhered more closely in recent years to a neo-Keynesian framework but not a formal model.

The mechanism for control of the money supply has changed over the course of US history. This change has generally been in the direction of increased government control over the market for money, but it has not been without conflict. There has always been a tension between the appropriate functions of the market and the state. Farmers, merchants, bankers, and political parties representing their interests have contested the appropriate means and degree of control by the state. The conflict over control of monetary policy can be divided into three stages: market-based control, bureaucratic control, and technocratic control. A short digression into history will orient our understanding of the Feds response to the financial crisis.

Market-Based Control. The Constitution of the United States, when written in 1787, gave the federal government the power to coin money and regulate the value thereof. Such legal tender could be used to pay off all obligations. This system was considered self-regulating in that the supply of currency in the economy would not grow without an increase in the supply of the precious metal on which it was based. As such, the Founders contemplated no other regulatory device. But the Constitution was better designed to maintain political stability than economic stability, and economic interests were rarely content to rely solely on the benefits of self-regulation.

The supply of precious metals was not a reliable source of economic stability. The monetary history of the nineteenth century is one of severe dislocation wrought by the bank panics of the 1830s, 1870s, and 1890s, when depositors lost confidence in the banks ability to deliver their cash. The money supply, tied to the supply of gold, was not flexible enough to meet spikes in demand, such as those triggered by droughts and floods. Large numbers of businesses failed and individual savings were wiped out in runs on the banks. Political conflict over how the currency should be valued was nearly continuous.

Bureaucratic Control. The Panic of 1907, in which J. P. Morgan famously tried to mobilize the urgently needed monetary liquidity, provided the critical incentive needed for the creation of a central bank. Morgan announced that he could no longer be expected to rescue the banking system in a panic. Reform-minded businessmen and bankers designed a central bank that would allow them to build their firms while avoiding unmanageable panics. In the final legislation, enacted in 1913, a system of eight to twelve regional Reserve Banks was to be created and run by the regional bankers, overseen by a board of governors in Washington. Although the degree of banker control was to erode over the course of the twentieth century, the long efforts of the banking community paid off with the creation of a central bank that could furnish an elastic currency that could be expanded when needed, thereby creating enhanced financial stability.