A History of the Federal Reserve, Volume 1
Page 10
The currency school did not respond to the banking school arguments correctly or even uniformly. Some argued that the currency to deposit ratio was approximately constant, so control of currency issues meant control of money. Others argued that deposits could not be controlled because of substitution. Still others contended that the velocity of deposits was much lower than the velocity of currency and that the velocity of bills of exchange was lowest of all.
Improved understanding of the reasons for the failure of the currency principle had to await Fisher and Keynes. Fisher argued that the currency principle worked badly because currency was a poor indicator of monetary expansion and inflation. According to Fisher (1920, chap. 4), bank loans and bank deposits increased much more than currency during the early stages of the expansion. In his notation, M' (deposits) rose relative to M (currency) following an inflow of gold or other source of base money. Later in the expansion, consumer expenditures increased and the ratio of currency to deposits rose. This rise forced fractional reserve banks, operating under gold standard rules, to surrender reserves. Faced with a loss of reserves, the banks raised loan rates, called loans, and reduced deposits. By redistributing the monetary base between reserves and currency, the rise in the currency ratio reduced the circulating medium, M + M', or in current terminology, reduced money, currency and deposits. The reduction in money brought the expansion to an end and started the contraction.
Fisher’s explanation links short-term changes to the long-term value. The key element in his explanation of cycles is that businesses, banks, and households failed to anticipate promptly the inflation caused by monetary expansion. A central bank operating on the currency principle (or gold standard rules) would always react too slowly to prevent inflation. Since currency increased for a time by less than the inflow of gold, the central bank did not increase the discount rate or take action to slow the monetary expansion. As a result, commercial banks expanded deposits and loans by more than the amount consistent with the given gold stock and the long-run average ratio of currency to deposits. Inflation was under way before currency increased relative to gold. Changes in money and credit were therefore procyclical.
Fisher was one of the first to emphasize that differences in the timing of cyclical changes in the stocks of currency and deposits caused the currency ratio to fluctuate around its long-run trend. Others commented on the fluctuations but failed to see that they were systematic, not random events. However, Fisher did not draw the implications for central bank policy of adherence to the currency principle. This was done by Keynes, in rather picturesque language.48
Most nineteenth-century writers not only failed to analyze the timing and proximate causes of changes in money but did not consider the failures of monetary policy as a main cause of fluctuations in output. Neither the fluctuations under Palmer’s rule nor the series of crises under the act of 1844 stimulated anyone to analyze the relation of the Bank of England’s policy to interest rates, output, prices, and specie flows. A few writers in the currency school accused the bank of overexpanding its discounts in 1844, but they did not follow the charge far enough to see the conflict with the currency principle. Had they considered the implications of their argument, they would have been forced to recognize that a central bank should keep control of both uses of the monetary base—reserves and currency—not currency alone. Almost certainly, some would have recognized that the way to control the uses was to control the total sources. Again, this point was not recognized until John Maynard Keynes’s Treatise on Money (1930, 2:225–26).
48. “For in the event of an inflation developing, the note issue is in modern conditions the latest phenomenon in point of time to exhibit symptoms of the disorder which is at work in the economic system. To attempt to maintain monetary health by regulating the volume of the note issue is like attempting to maintain physical health by ordering a drastic operation or amputation after the affliction has run its full course and mortification is setting in. For, generally speaking, the note-issue will not expand—for reasons other than increase in the volume of employment—until the inflationary influences have had time to raise the money-rates of remuneration of the factors of production” (Keynes 1930, 2:273, 2:264).
Thomas Tooke, testifying before Parliament in 1832, anticipated Marriner Eccles’s “pushing on a string.”49 Wood (1939, 48) summarizes a part of his statement: “An increased issue of notes might only swell the note reserves of the London bankers or be deposited by them in the Bank.” Samuel Gurney, a leading banker of the period, testified that if there was an abundance of notes, extra notes would remain in the tills of the bankers, the “natural depository” of surplus notes. If there were ample means for speculation, mere idle funds would not encourage speculation (54).
William Blake argued in 1823 that inflation was caused by fiscal policy (government purchases) financed by new debt issues. The debt issues activated previously idle balances, that is, increased velocity. And Lord Lauderdale blamed the contraction before 1820 on the government’s budget surplus. A surplus reduced “effectual demand,” so production declined. Lauderdale wanted the government to replace the war expenditures that ended in 1815 with expenditures on public works (Viner 1965, 192–94).50
CONCLUSION
Every complete theory of the monetary system must provide answers to a number of related questions. What is the monetary standard, and what are the source components of the monetary base? Why do the source components expand and contract? Which items are included as uses of the monetary base? If the uses of the base consist of more than one item, what effect does the substitution of one item for another produce on the monetary system? By what means and to what end should the government or a central bank seek to control the base? What are the short- and longer-term consequences of a change in the base on the stock of means of payment? What are the short- and longer-term consequences of changes in the means of payment on prices, output, employment, and balance of payments? What, if any, is the feedback from the changes in prices and real variables to the source components of the base?
49. Eccles’s statement is in the congressional hearings before the Banking Act of 1935. See , House Committee on Banking and Currency 1935, 321. Asked what would happen if the Federal Reserve printed currency and paid off debt, Eccles replied, “The currency would increase the reserves of the banking system . . . but the currency would immediately go into the banks and from the banks into the Federal Reserve banks—and you would have—additional excess reserves.”
50. Some, of course, recognized that among all the arguments, there were none that showed an increase in money would not raise prices. See Wood’s discussion of Thomas Attwood (1939, 52–53). Attwood wrote of a depression: “Let them [the public] be glutted with money. They will then seek prosperity and the prosperity of the country will return.” Attwood elsewhere recognized that an unanticipated fall in prices redistributed wealth and intensified depression because prices did not all fall at a uniform rate. Like Thornton, Attwood noted that wages were slow to fall and used this observation to explain unemployment of labor.
In practice, there have been three distinct types of answers. One, following Thornton, stresses the relation of the base to the stock of money, the effects of money on economic activity, prices, balance of payments, and specie flows or exchange rates. A second approach, following Ricardo, puts aside questions of the relation of the base to the stock of money or means of payment and avoids analyzing the effects of substituting one means of payment for another. For the purposes of analysis, money and the base are identical or proportional. In both of these approaches, the monetary base stands at the bottom of a pyramid. Substitution of one type of credit instrument for another is of secondary importance, or no importance at all, once the determinants of the base and the stock of money have been specified and the relation between the two analyzed or dismissed. Corresponding to each set of tastes, state of technology, and anticipation of the future, the economy has a real rate of return at which
the public willingly holds the stocks of money and real capital. The variety of claims and debts cancel each other out and affect the solution only to the extent that they represent changes in taste or technology, and then only as much as any other change in taste or technology. Corresponding to the real rate of interest, there is a market rate that differs from the real rate by the anticipated rate of price change. When anticipated and actual rates of price change remain equal, the economy reaches and remains in long-run equilibrium.
A third approach looks at the credit system as one that issues a variety of claims and debts that substitute for money or more generally for means of payment. In this approach, money lacks fundamental importance in the explanation of price and output changes or specie flows. Credit, interest rates, or more recently “flows of funds” become the main indicators of the state of the credit markets. The banking school developed this notion, if such a loose and amorphous collection of ideas can be described as “developed.”
Each of the three types of monetary analysis was known in the nineteenth century, and for a time each had a dominant influence on the development of central banking theory and practice. But in the end the banking school view became the established view among bankers and central bankers and was challenged by only a few economists. When the Aldrich Commission in the United States received the testimony of leading bankers and experts on central banking in 1912, the members heard very little about the effects of changes in money on domestic economies and a great deal about the “needs of trade,” “self-regulating productive credit,” and the use of the discount rate to stop an outflow of gold.
They learned, too, about the role of the Bank of England in smoothing the money market to eliminate seasonal fluctuations and its practice, well established by the 1840s, of offsetting the effects of Treasury operations on interest rates. These policies focused attention on short-term market interest rates and were the forerunner of so-called defensive open market operations. Among the by-products of the focus on short-term changes was the increased frequency of discount rate changes and, considerably more important, the belief or opinion that such operations were a main responsibility of central banks.
The promising analysis started by Henry Thornton recognized that money was neutral in the long run but not in the short run. Thornton’s work opened the way to a careful analysis of the differences between central banks and intermediaries, between money and credit, between real and nominal rates of interest, between relative and absolute price changes, and between permanent and transitory changes. He recognized the errors in the real bills doctrine. Later Irving Fisher revived and added to the understanding of these issues, but, like Thornton’s, his work did not influence central bankers until the Great Inflation of the 1970s.
Walter Bagehot did not have a theoretical framework to match Thornton’s. He understood, however, the importance of a lender of last resort. And he emphasized the importance of precommitment by the central bank and of following precommitment with action.
The Federal Reserve’s approach to policy originated in the Bank of England’s nineteenth-century practices and the partially developed theory or framework that the practices attempted to apply. By the end of that century, discussions of central banking confused credit and money, used money market variables as indicators of monetary policy, and denied or cast doubt on the ability of a central bank to induce short-term changes in output or employment by monetary means. Although stabilization of prices and employment was mentioned as a goal of monetary policy in the literature of the early and late nineteenth century, virtually every discussion of the policy of the period concluded that monetary policy was guided by the state of the reserves, not by output, employment, or economic stability.
three
In the Beginning, 1914 to 1922
On December 23, 1913, Congress approved the Federal Reserve Act. Final passage came after several lengthy disputes and many pages of testimony favoring and opposing a central bank. More than thirty volumes of research reported on the findings of the National Monetary Commission.1 Despite the intense discussions, detailed investigation of financial systems that preceded the act, and the number of alternative bills drafted, considered, and dismissed, the act says very little about the broader purposes of the legislation. The title talks of furnishing an elastic currency, affording means of rediscounting commercial paper, and improving the supervision of banking; the act speaks of setting discount rates “with a view of accommodating commerce and business” but mentions no other objectives.
Omission of a broad statement of purpose or policy objective was not an oversight. The act represented a compromise between many different groups that had very different purposes in mind. At one extreme were the proponents of a single central bank, owned by the commercial banks and run by bankers. The group favoring this alternative looked to the European central banks as a model, particularly the Bank of England. Many of the group’s members were bankers or “practical” men, which often meant in the context of the time that they had some idea of the services that central banks rendered to banks but less understanding of the longer-run consequences of central bank operations. They wanted the central bank to damp fluctuations in market interest rates, particularly those caused by the seasonal demand for currency and the financing of crop harvests, and to encourage the development of a broad national market in commercial paper and bills of exchange patterned on the London market. One of their principal aims was to increase the seasonal response, or elasticity, of the note issue by eliminating the provisions of the National Banking Act that tied the amount of currency to the stock of government bonds.2 They believed firmly that a central bank could reduce panics by serving as lender of last resort in periods of distress. The record of the Bank of England in the previous fifty years reassured them that their beliefs were well founded.
1. The commission was created by act of Congress following the 1907–8 recession that produced more than 240 bank suspensions (Board of Governors of the Federal Reserve System 1943, table 66, 283).
At the opposite extreme were those who opposed a central bank of any kind. The main economic content of their argument was that a central bank is a monopoly, but they did not oppose monopoly as such. They feared or claimed that the monopoly would be run for the benefit of the bankers, particularly J. P. Morgan and other New York bankers. Instead of proposals to avoid a “bankers’ monopoly” they produced evidence of concentration, interlocking directorates, and control of financial institutions, railroads, and other enterprises in hearings before the Pujo Committee and in that committee’s final report.3 However, the Pujo report made few recommendations, was silent on the main issues involved in the discussions of banking reform, and had greater influence on the designers of the Federal Trade Commission than on the designers of the Federal Reserve System.
Proponents and opponents of a central bank clashed over the recommendations of the National Monetary Commission. Legislation drafted at the end of the Taft administration in 1912 embodied many of the principles proposed by the commission. The chairman of the commission, Senator Nelson Aldrich, was a New York Republican. His plan, the Aldrich plan, was unacceptable to the Democrats and opposed in their platform for the 1912 election. They objected much more to the organization of the system and the centralization of power in the hands of the larger banks than to the chartering of a bank to discount commercial paper and issue currency not tied to government securities.
The 1912 election shifted control of Congress to the Democrats. Many Democrats were willing to accept a central bank only if it was under political control. Some members wanted semi-independent regional banks. A month after his election, President-Elect Wilson met with Carter Glass, the new chairman of the House Committee on Banking and Currency. Wilson proposed a mixture of private and public control (Glass 1927, 81–82).4 His legislative proposal to Congress, on June 23, 1913, included that recommendation and urged that control “be vested in the Government itself, so that the banks may be the
instruments not the masters of business and of individual enterprise and initiative.” The final structure included Wilson’s compromise—a politically appointed Federal Reserve Board in Washington and regional banks in principal centers, run by bankers, with no clear division of authority between the two. As part of the compromise, Wilson proposed a Federal Advisory Council consisting of bankers, appointed by the reserve banks, to serve as advisers to the Board. As with the First Bank and Second Bank of the United States, Congress did not want to grant a permanent charter, so the initial charter was for twenty years. Permanence was not granted until the McFadden Act of 1927.
2. Government bonds were used as collateral or security for national banknotes, the principal currency or note issue under the 1863 National Bank Act. As the government debt declined, pressure to reduce the note issue rose. The Federal Reserve Act initially removed this tie by eliminating government securities as collateral for Federal Reserve notes.
3. Arsene P. Pujo was chairman of the House Committee on Banking and Currency. See 62d Cong., 3d sess., February 28, 1913, H. Rept. 1593, in Krooss 1969, 3:2143–95.
In its early years the Federal Reserve faced three major challenges. First, an unanticipated war brought a large increase in gold and removed the gold standard as the monetary system of the developed world. The Federal Reserve had a small portfolio, so it had no means of controlling the resulting inflation, even if it wished to sterilize the inflow. Second, the compromises that enabled a majority to support passage of the act shifted the argument over government or private control without resolving it. In the System’s early years, frequent conflicts broke out between the reserve banks and the Board as both sides struggled to gain control. Third, the intent of the principal proponents was not realized. They expected to create an institution capable of preventing inflation, responding to banking crises, and financing exports of grain, cotton, and other primary products. Instead they created a largely passive bank, dependent on revenues from member bank discounts but with limited influence over the volume of discounts. The real bills doctrine left the initiative to commercial banks. The Federal Reserve’s main channel of influence—the discount rate—was a penalty rate. But raising interest rates was unpopular and provoked concerns about bankers’ domination of the economy.