President Wilson was proud of his achievement.
It provides a currency which expands as it is needed and contracts when it is not needed, a currency which comes into existence in response to the call of every man who can show a going business and a concrete basis for extending credit to him, however obscure or prominent he may be, however big or little his business transactions. More than that, the power to direct this system of credits is put into the hands of a public board of disinterested officers of the Government itself who can make no money out of anything they do in connection with it. No group of bankers anywhere can get control; not one part of the country can concentrate the advantages and conveniences of the system upon itself for its own selfish advantage. (Wilson as quoted in Kettl 1986, 22)
LAW AND PRACTICE
President Wilson’s compromise resolved the immediate political conflicts and established an institution, but it left major economic and organizational issues unresolved. The structure of the new system did not concentrate decision-making authority and responsibility. A struggle for power and control broke out early and continued until resolved by the Banking Act of 1935.
2. Wicker (2000) shows that perceptive writers understood the need for a lender of last resort by the 1860s, but attempts by the New York clearinghouse to provide the service often failed because of the conflict between the collective interest in system stability and the members’ individual concerns for the safety of their own institutions.
Although the Federal Reserve was an independent agency from the start, in practice two political appointees—the secretary of the treasury and the comptroller of the currency—served as ex officio members of its board, with the secretary as board chairman.3 Before the 1930s, treasury secretaries rarely participated actively.
The 1935 act resolved this organizational anomaly by removing the secretary and the comptroller from the Federal Reserve Board. By that time the secretary took an active part in monetary policy and often influenced decisions. The legal change did not change the locus of decision-making power. The Treasury retained its strong influence until 1951.
The 1913 legislation did not ensure that the new system would respond to crises better than the old. On the recommendation of the officers, or on their own initiative, the directors of individual reserve banks could decide not to participate in System operations. The officers who headed the reserve banks were mainly bankers, the same types of individuals that had run banks or clearinghouses in the past. A change of location to the reserve banks was not enough to ensure that concern for financial stability would outweigh other interests. Some did not recognize that the lender of last resort had to place the interests of the financial system above the interests of the individual reserve banks.
Institutions both shape the society of which they are part and adapt to the dominant views in that society. Although the Federal Reserve was independent of the day-to-day political process, the public, acting through its representatives, could insist on structural changes or, without formally changing structures, demand that the Federal Reserve undertake new responsibilities or give up old ones. No institution can be independent of this pressure for change.
In the 1920s the reserve banks learned to coordinate actions that affected interest rates and the stocks of money and credit. A committee, led by the New York reserve bank, took responsibility for securities purchases and sales. The reserve banks adopted a formula for allocating the System’s portfolio among the reserve banks. The reserve banks retained the right to reject participation.
The committee was an informal, extralegal arrangement. The Board, acting in its supervisory role, had to approve purchases and sales. The line between supervision and decision making was never clear, so the procedures irritated some Board members and became a source of friction. Friction increased as open market operations became the principal policy instrument.
3. The comptroller is a Treasury official responsible for regulating banks with national charters.
The Banking Act of 1935 resolved this conflict also. Board members became members of the Federal Open Market Committee for the first time and held seven of the twelve seats and chairmanship of the committee. New York lost its leadership role. The New York bank did not regain a permanent seat on the committee until 1942. Since that time, the president of the New York bank has served as the committee’s vice chairman.
The 1935 act permanently shifted the locus of power to the Board. The Federal Reserve became a central bank. The twelve regional reserve banks lost their semiautonomous status and much of their original independence.
The history of the Federal Reserve is in part the story of how social, political, economic, and technological changes affected the institution. The Federal Reserve began operations not in the heyday of the gold standard but near its end. At the time, acceptance of the standard by bankers, economists, leading businessmen, and others, at home and abroad, was so great that the standard seemed to many the social manifestation of a natural order. The standard did not work in the smooth, orderly way that its proponents imagined, but it provided an internationally acceptable means of payment and store of value (Bordo and Schwartz 1984). Debts were settled and payments made without conflict. The movement of gold balances and their effect on domestic prices gave the standard the automaticity for which it is famous.
The gold standard required countries to use monetary policy to keep exchange rates fixed and thus to allow prices, output, and employment to vary as required by the movements of gold and the country’s exchange rate. Debtor countries had to pay their obligations in gold even if the price of gold rose relative to commodity prices, and creditors had to accept gold in settlement if commodity prices rose relative to the price of gold. Exporters and importers had reasonable certainty about the payments they would make or receive, since the rate of inflation remained bounded except in wartime, when the standard did not operate.
Efforts at international monetary coordination in the 1920s and 1930s foundered on the conflict between a fixed exchange rate and goals for inflation or employment. The Federal Reserve worked actively to restore the international gold standard in the 1920s, first in Germany, than in Britain, France, Holland, Poland, and elsewhere. It sought to maintain domestic price stability also. The two goals were incompatible once other countries fixed their currencies to gold. Coordination could not resolve the conflict. In the end, the Federal Reserve failed to achieve either its domestic or its international goal.
Again in the 1930s, Britain, France, and the United States renewed efforts to coordinate exchange rate policy. The new approach, known as the Tripartite Agreement, failed also. Countries would not subordinate domestic policy to the exchange rate goal.
The lesson drawn from these experiences by policymakers in Washington, London, and elsewhere was that previous attempts lacked effective mechanisms for enforcing coordination while achieving price stability. In 1944 the Bretton Woods Agreement sought to retain exchange rate stability as a goal of economic policy and to reconcile external and internal monetary stability. The agreement had fixed but adjustable rates in place of the rigid exchange rates under the gold standard. Countries did not have to reduce their price level to remove external imbalances. They could respond to permanent changes in competitive position by devaluing and could borrow from a central facility, the International Monetary Fund (IMF), when facing cyclical or temporary balance of payments deficits. The Fund would lend balance of payments surpluses to countries in deficit. In the early postwar years to 1951, the Fund did little. Most countries had wartime exchange controls and inconvertible currencies.
The Bretton Woods system of fixed but adjustable exchange rates, like the interwar gold exchange standard, tried to supplement the stock of gold by using foreign exchange—dollars and pounds—as reserve currencies. The two differed fundamentally. The stock of gold grew slowly; the stocks of dollars and pounds could grow without limit. Member countries accepted an obligation to treat the two alike. In practice this meant
they had to accept inflation or appreciate their exchange rate.
The new system recognized a lasting change in beliefs about the responsibilities of government. As the population moved from rural to urban areas and from agriculture to manufacturing and service industries, governments assumed new responsibilities for social welfare and economic stabilization. The public in many countries would not accept the level of unemployment, deflation, or inflation needed to maintain the exchange rate. Adjusting the exchange rate seemed to be a less costly solution in 1944. At first the IMF had to approve exchange rate changes, but this restriction was not enforced.
President Wilson wanted the Federal Reserve to remain independent of government. Except for wartime and postwar subservience to the Treasury, independence developed in the early years and continued through the Harding, Coolidge, and Hoover administrations.
President Roosevelt and his treasury secretary, Henry Morgenthau, believed that the reserve banks represented bankers, many of whom opposed the president’s programs. Devaluation of the dollar in 1934 gave the Treasury the financial resources to affect interest rates by buying securities, and it did so. Also, the Treasury sterilized and desterilized gold, affecting the rate at which monetary aggregates rose.
The Federal Reserve chairman, Marriner S. Eccles, expressed concern about the Treasury’s actions but felt powerless to prevent them. And faced with relatively large gold inflows, he wanted to prevent inflation. Equally, he believed that at the interest rates prevailing during the 1930s, monetary policy could do little to stimulate expansion.
The head of the fiscal authority favored an activist monetary policy. The head of the monetary authority proposed more activist fiscal policies. Secretary Morgenthau wanted interest rates to remain low so that he could finance peacetime deficits and much larger wartime deficits. Monetary policy had the important role in his scheme of keeping market rates from rising. Eccles wanted larger budget deficits during the depression and large surpluses after the war.
Eccles, like Morgenthau, did not respect Federal Reserve independence. Although he disliked Treasury interference in monetary matters, he did little to prevent it. He advised and testified on a broad range of government policies including budget, tax, and housing policy. At times he opposed Morgenthau’s policies, and on one occasion he proposed an excess profits tax that differed from administration policy.
A most unusual breach of independence occurred in January 1951 when the entire open market committee met in President Truman’s office. The president and Secretary John Snyder wanted the Federal Reserve to maintain the long-term interest rate on Treasury bonds at the wartime peg. The president did not ask for a commitment, and the committee did not offer one. Nevertheless, meeting the president in the White House to discuss monetary policy was a long way from the tradition of independence that President Wilson had tried to foster.
IDEAS AND DECISIONS
A history of the Federal Reserve is a history of the decisions made and the ideas that prompted them. The chapters that follow allow the participants to explain their actions, and the reasons for them, in their own words. These decisions produced very different results: a steep postwar recession in 1920–21, a period of stability in the 1920s followed by the Great Depression of the 1930s and, much later, the Great Inflation of the 1970s.
The men who made these decisions were not chicane or evil. They did not directly seek the outcomes that their decisions helped to bring about. They did not fail to stop the depression because they liked the outcome and wanted it to continue. They acted as they did because of the beliefs they held about their responsibilities and about the way their actions affected the economy. Much of this history is about their reasons and their reasoning—what it was and how it changed in response to events and new ideas.
Men and women interpret events using the theories or beliefs they learned earlier. The beliefs or theories that guided the Federal Reserve were mostly mainstream beliefs at the time they were held. Individual leaders influenced decisions most effectively by introducing new or different ideas or new interpretations. Benjamin Strong in the 1920s recognized the need to replace the gold standard rules and the commercial loan theory, on which the founders based the Federal Reserve Act. Marriner Eccles believed monetary policy could do nothing in the 1930s when short-term interest rates were low, so he did nothing to lift the economy from the depression. Later he believed that the Federal Reserve did not have the political support to use general monetary policy to prevent inflation after World War II. He proposed selective credit controls to substitute for higher interest rates and slower money growth.
Individuals matter most when they are able to lead others to act in ways that do not fit comfortably within the prevailing orthodoxy. Strong led the Federal Reserve to support Britain’s return to the gold standard in 1924–25. In 1927 he lowered interest rates and expanded money to help Britain maintain the gold standard. Allan Sproul led the Federal Reserve toward independence from the Treasury in 1950–51.
These and other episodes show that leadership was important at times. Events of this kind are rare. Most policy decisions and actions apply a framework or theory based on prevailing beliefs.
This volume starts with the founding of the Federal Reserve in December 1913 and ends with the Treasury–Federal Reserve Accord in March 1951. In many respects the accord marks the beginning of a larger, and greatly changed, institution. In 1913 the United States was an emerging economy. Great Britain was the financial power and the center of the international financial system. Approximately 30 percent of the labor force worked in agriculture. By 1951 only 11 percent remained in agriculture (U.S. Department of Commerce 1966, 178–79). The United States had become the financial leader, the dominant economy, and the technological and managerial leader as well.
In 1913 the London market financed most United States exports. Since the exports included mainly agricultural products, there was a large seasonal demand for financing in the fall, so interest rates rose each fall. United States bankers wanted to replace London bankers. They believed they were at a disadvantage, since they could not discount export credits at a central bank. Politicians wanted to reduce the seasonal fluctuation in interest rates. A bank that could expand credit and reduce interest rates seasonally satisfied both groups.
Seasonal credit expansion was not the only reason for establishing the Federal Reserve. Recessions in 1893–94, 1895–97, 1899–1900, 1902–4, 1907–8, and 1910–12 averaged nineteen months, according to the National Bureau of Economic Research. In all, there were 113 months of recession from December 1895 to January 1912—55 percent of the time. Several of the recessions were severe. Financial panics, interest rates temporarily at an annual rate of 100 percent or more, financial failures, and bankruptcies were much too frequent. Other countries had a lender of last resort to ameliorate financial crises or even prevent them. The series of crises and financial panics increased support for creation of a new institution.
In the 1920s the Federal Reserve received credit for improving economic performance. It eliminated both the seasonal and the extreme changes in interest rates characteristic of financial panics. Although the economy continued to experience relatively large cyclical fluctuations and many banks failed, old-style financial panics did not return in the three recessions from 1920 through 1927.
THE ECONOMY 1913–51
In first quarter 1951, real GNP was nearly three times greater than at the start of System operations in 1914, a compound annual growth rate of 2.8 percent. Growth was far from uniform. Chart 1.1 shows the many cyclical swings. Quarterly values of annual GNP growth range from 20 percent to –20 percent, associated with war and the Great Depression, but many years show changes of 10 percent or more.
Stable growth was not part of the Federal Reserve’s formal mandate in the early years. Most of the System’s leadership would have denied any responsibility for economic activity or employment.
Chart 1.1 shows the main events and experiences tha
t shaped the Federal Reserve and were shaped by it. Two postwar contractions followed the two wartime expansions. The three and a half years of contraction from 1929 to 1933 stand out, as do the recovery following devaluation of the dollar against gold in 1933–34 and the wartime expansions from 1941 to 1945.
Also, the price level in first quarter 1951 was approximately three times its early 1914 value. Prices rose at a compound annual rate of 2.8 percent a year. As chart 1.2 shows, wartime inflations contributed greatly to the average rate of change, so the average for the period is misleading. In both world wars, the Federal Reserve issued money, as required to support the Treasury’s interest rate policy. After increasing in response to gold inflows from 1914 to 1917, the price level fluctuated widely from 1917 to 1939 around a constant value. The price level was approximately the same in 1939 as in 1917, before the United States participated as a combatant in World War I. The price level then doubled between 1940 and 1951,a more than 6 percent annual rate of increase. Most of the increase occurred during World War II, but part of it appears after the war, when price controls ended.
A History of the Federal Reserve, Volume 1 Page 2
