Episode 16 - The Punch Bowl
An episode dedicated to Fall! And to be more specific an important phrase in the Centralverse about the overarching, high level goal of all central banks. The phrase is part of one of the most important metaphors in finance.
Welcome to The Bankster Podcast. I’m your host, Alexander Bagehot, and this is Episode 16 - The Punch Bowl. Every episode we dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse. Now the Centralverse is the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support.
The seasons are changing here in the midwest of the United States where I live and work. The wind is getting colder and although we still have beautiful days, they are fewer and farther between. But one thing that really brightens up my spirits when it’s cold outside is a nice warm mug of cider. Growing up my Grandmother called her special recipe Wassail. I’m a few thousand miles away from my grandma these days, but last week my work began serving hot cider at lunch time and at all of the big meetings. It’s not my grandma’s but it’s still good! As I was sipping my 9th mug of cider this past week I was reminded of a classic Centralverse phrase that has come up a few times recently in the news cycle. That is if you’ve been able to see past the political mayhem that fills the airwaves.
The phrase is “the punch bowl”. It’s a metaphor that dates back more than 60 years concerning the job of central banks. So in the spirit of the Fall season I’m going to focus this episode on what Punch has to do with central banks and businesses around the world. As usual, I’ll start off by explaining what the phrase means and why it’s used. Then I’ll follow up with the history behind where it came from. So if you’re close to your grandma’s house, get yourself some Wassail, and enjoy the episode! You’re going to be hearing this phrase a lot in the coming months.
The Punch Bowl
If you were to ask most economic professors, business journalists, or even central bankers what the goal of the Federal Reserve is their answer would almost certainly include some reference to the dual mandate. As we’ve discussed in past episodes the official goals, known as the dual mandate, of the Federal Reserve, as set out in the law that created the central bank, include maximizing employment and keeping inflation at a healthy, low, positive level. There a lot of different ways to measure these goals and we’ve mentioned them in earlier episodes and we’ll explore different facets of them in future episodes. However, although this might be the answer most in the industry would give, I would argue that there’s a higher goal that actually came first. And that is to keep the overall economy healthy and mitigate the damage done by natural economic downturns. Or another interpretation of this higher level goal might be - to spur on the economy when it is doing poorly and slow down the economy when it is overheating.
It’s from this second interpretation that the metaphor of the punch bowl is used. So imagine the scene. You’re asked to host a party for a group of economists. Sounds like the making of one exciting party, am I right? Well, probably not. So the party gets going and it’s a bit boring. So, as the host, what do you do to liven up the party? You put out a spiked punch bowl and hope these economists loosen up and enjoy the party. Well, if time goes by, the economists indulge in the punch, and the party starts to get a little too exciting, you as the host may decide, “Ok, that’s enough encouragement. Time for me to take away the punch bowl.” Then as the effects of the contents of the punch bowl begin to wear out the party may calm down slightly. You can imagine using this punch bowl, hoping to keep the party fun without letting it get out of control.
So that’s the punch bowl metaphor. But how does it apply to the high level goal of central banking? Well, let’s start by breaking down the pieces of the metaphor. The party represents the economy. All of the people attending the party are participants in the economy, which means business, governments, banks, and individuals like you and me. And like at any party there are some people with more popularity and have more influence on what happens at the party. The host of the party is the central bank. And finally, the punch bowl is the money supply.
The central bank can increase the amount of money in the system to encourage the economy to grow faster, or they can take away money from the system to slow the economy down. The danger of an economy that is getting overheated is inflation, and the danger of an economy that is slowing down is more unemployment. Both of these situations are bad, just like a boring party is bad, but so is a party that is out of control.
Now let’s bring this metaphor into the real world. You can imagine that the US housing market was the coolest kid at the economy party of 2003, 04’, 05’, 06’, and 2007. The Federal Reserve began to slowly remove the punch bowl of low interest rates as the party got more and more exciting. In this example many have argued that this punch bowl of low interest rates had been left out for far too long - but that’s an argument for another episode. If you can remember in 2007 and early 2008 the economy just about died. Seeing that the party was dying the Federal Reserve lowered interest rates, increasing the amount of money in the system, hoping to get the economy moving again. When that didn’t appear to be enough to get the economy back on its feet the Federal Reserve turned to all sorts of other measures including: Quantitative Easing, buying long term bonds, saving large insurance institutions and investment banks, among other things. In the metaphor it’s like they not only brought back the punch bowl, refilled to the brim, but they also brought a piñata, a clown, and a bouncy castle.
Unfortunately, the economy was slow in recovering. It took many more years than expected to get back to pre-recession levels of employment and growth. To this day many of the extreme measures taken by the Federal Reserve have been removed from the system. Quantitative Easing has ended. The Fed no longer expands the quantity of long term bonds it’s holding. However, the very low interest rates remain. In the metaphor this is like saying the clown has gone home and the blow up castle is put away, but the punch bowl is still being refilled to the rim.
Over the next few weeks and months there is going to be a lot of talk of “Taking away the punch bowl.” And now you will know that those arguing for a removal of the punch bowl are suggesting that the Federal Reserve should lighten their stimulus of the economy and increase interest rates. Listen for the phrase in the news and write in and let me know when you hear it!
Now it’s time to wind the clocks back and learn about the origins of this impressive and enduring metaphor.
Origins of the Punch Bowl
William Martin was the 9th Chairman of the Federal Reserve System. He served as Chairman from 1951 to 1970 - longer than any other person before or since. He came into the position at an exceptionally important time period for the central bank. If you remember, in Episode 7 - Independence Part I I told the incredible story of the Treasury/Fed accord. Although the idea of an independent central bank was important to the founders of the Federal Reserve, in practice, for the first 40 years or so of its history the President of the United States had a heavy influence on the decisions of the Federal Reserve’s policy setting committee.
Martin’s immediate predecessors, Mariner Eccles and Thomas McCabe, had fought a long and hard battle to secure the central bank’s independence. And Martin had been an active participant on the other side in President Truman’s Treasury Department. So when the President had an opportunity to appoint the next Fed Chair at the end of McCabe’s term he selected Martin, hoping that Martin would give back significant control of the central bank to the White House. But in this case, the President was sorely disappointed. Martin held strong to the importance of the central bank’s independence. If you’re interested in learning more about this amazing story go back to Episode 7 and listen to how the Fed finally secured true independence from the government.
So this sets the stage for who William Martin is and some background on his entry into the most important position at the Federal Reserve. Over the next 20 years he would play a pivotal role in many important decisions. But today the focus is on one comment he made at the conclusion of one speech. Now onto the actual origins of the punch bowl.
As you’ve learned throughout the podcast, speeches by leaders of the Centralverse are some of the most important policy tools a central bank has. Some speeches stand out as especially memorable and leave their mark on the current economy and leave a lasting impression on the Centralverse in general. William Martin delivered one such speech nearly 61 years ago to the day. On October 19th, 1955, in the regal Waldorf Astoria, Chairman Martin gave a speech to the New York Group of the Investment Bankers Association of America.
He began his speech by describing a hopeful vision for the new post Great Depression, post World Wars America. He continued, “It seems rather striking that one of the ideas now firmly imbedded in our articles of material faith, the concept of governmental responsibility for moderating economic gyrations, is almost entirely a product of our own Twentieth Century.” So he’s saying that somehow in the first half of the 1900’s the idea that the government should take a more active role in preventing economic collapses was born and grew quickly to the point where it was widely accepted.
He explains it this way, “This concept, which is steadily being brought into sharper focus, has evolved from general reaction to a succession of material crises heavy in human hardship. It grew from mass desperation and demand for protection from economic disasters beyond individual control.”
He continues: “The Federal Reserve System, which I have the honor to represent, was our earliest institutional response to such a demand. It emerged out of the urgent need to prevent recurrences of such disasters as the money panic of 1907, and out of the thought that the Government had a definite responsibility to prevent financial crises and should utilize all its powers to do so. Accordingly, 42 years ago Congress entrusted to the Federal Reserve System responsibility for managing the money supply.”
For most of the rest of the speech Martin speaks to the impact of the business cycle on those that live it and those whose job it is to watch over it. He raises that never truly answerable question, “How much government intervention is the right amount to keep the economy in check, yet without hindering its natural growth?” He muses over this and other questions for a few pages and then ends his speech with the ever more famous quote about the role of the central bank in this economy.
“The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”
This quote, and the underlying metaphor, have been used for decades and decades and remains as one of the most important in all of central banking history. Next time somebody asks you about the Federal Reserve, try using this metaphor as an example. It has it’s flaws, as all metaphors do, but I think you’ll find it holds pretty strong at an introductory level.
So to review: The party is the economy. The host of the party is the central bank. The people at the party are businesses, banks, and consumers like you and me. And the punch bowl is the money supply. When the economy needs a boost the Federal Reserve brings out the punch bowl and that helps get the party going - or in other words, they increase the money supply which gets the economy moving again. When the economy gets too exciting, and inflation is in danger of overrunning, the Fed can increase interest rates and “remove the punch bowl”.
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Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to my Chairman William Martin, for holding strong to Independence and for giving us the great Punch Bowl metaphor. And to everybody else, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!