A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The early experience of the Federal Reserve induced it to abandon, or modify, the principles underlying the act. As noted, the international gold standard ended when the war started. War finance conflicted with the penalty rate, so the Federal Reserve abandoned it. Political concerns and mistaken policies prevented return to a penalty rate. And the more thoughtful among the early leaders began to question the central tenets of the real bills doctrine.

  4. Carter Glass was a Virginia country newspaper publisher. He was elected to the House from Virginia in 1902 and served as chairman of the Banking Committee from 1914 to 1918. In 1918 he replaced William G. McAdoo as secretary of the treasury. In 1920 he was appointed, then elected, to the Senate, where he served until 1946.

  Wartime experience and the postwar boom, recession, inflation, and deflation convinced many that a passive strategy was inappropriate. Less than a decade after it was established, the Federal Reserve began to search for a more active approach.

  THE FOUNDERS’ RATIONALE

  The House report on the Glass bill accepted that centralization of banking resources is the “root of the central banking argument” but concluded that in a country as large as the United States “equally good results can be obtained” by several federations.5 The report makes it clear that the House Banking Committee expected the regional reserve banks to function cooperatively but independently and to achieve the advantages of central banking without acquiring the monopoly powers of a single central bank. The striking feature of the report, however, is the extent to which the congressmen who approved it viewed the proposed system as a large association of banks able by pooling gold reserves to take better advantage than the individual national banks of the note issuing and discounting privileges that the national banks possessed. In addition to providing a new bank of issue, Congress made sure that the act improved the procedures for issuing notes by both broadening the definition of acceptable collateral and removing government bonds from the list of acceptable collateral.

  Virtually every discussion of banking reform commented on the frequency and severity of United States banking crises. The desire to reduce the frequency and severity of crises—five in the previous thirty years—is a main point of agreement in all the reform plans. All proposals recognized that a central bank could serve as lender of last resort in a banking crisis.

  5. See 63d Cong., 1st sess., September 9, 1913, H. Rept. 69, in Krooss 1969, 3:2275–2342. The quotations are from Krooss 1969, 3:2284. Some of the passion aroused by the different views can be judged from the reference to the work of the National Monetary Commission. The commission’s work is described as costly, lacking in originality, of historical interest only, and with no value for or direct bearing on legislative issues (Krooss 1969, 3:2280–81). Although Glass claimed credit for the final bill, much of the substance had been worked out earlier by Nelson Aldrich based on proposals made by Paul Warburg, a partner in Kuhn, Loeb and Company. Also, Glass gave no credit to Senator Robert Owen (Oklahoma), chairman of the Senate Banking Committee (Friedman and Schwartz 1963; Chernow 1993). Warburg (1930, 2:238) found five main differences between the Aldrich bill and the Owen-Glass bill. The most important of these concerned the greater role of the federal government in the Owen-Glass bill and the provision allowing each reserve bank to set its own discount rate. Owen-Glass also prescribed the size of reserve requirement ratios, a matter left to the central bankers in the Aldrich plan. The act specified that two members of the board were to come from banking and finance. The principal difference between the Glass-Owen and Aldrich proposals is the size and power of the Federal Reserve Board. The Aldrich plan called for a single central bank with fifteen branches and a board with forty-five members.

  Since there was no established lender of last resort under the National Banking Act, banks attempted to protect themselves against runs or currency demands by holding gold or currency reserves.6 If all banks sought to increase their gold holdings simultaneously, short-term interest rose as high as 100 percent annually. To reduce the demand for gold, clearinghouse associations or groups of bankers pooled resources to provide payment facilities during periods of stress. Such private facilities had to assume the risk of defaults. A central bank that pooled reserves and lent during a panic would provide “elasticity” at lower cost. Hence bankers were eager to shift responsibility for maintaining the payments and clearing mechanism to a central bank, and there was wide support for this reform.

  A second meaning of elasticity referred to seasonal fluctuations. Proponents expected a central bank to reduce seasonal fluctuations in interest rates, principally during the autumn marketing of the harvest. Under the prevailing system, interest rates rose and the dollar appreciated within the gold points when foreigners borrowed and purchased dollars to buy grain. New York banks sold holdings of British bills to smooth the seasonal fluctuation in exchange rates, but large seasonal swings remained until after the Federal Reserve was established (Warburg 1930; Myers 1931; Miron 1986).

  The two types of inelasticity had a common source. The National Banking Act tied note issues to government bonds. Hence if banks expanded up to the limit set by the note issue, note issues could not expand further in response to seasonal or cyclical demands. A central bank empowered to discount real bills would remove this inelasticity and finance the crop movement. Currency would be more elastic.7 John U. Calkins, later governor of the Federal Reserve Bank of San Francisco, subsequently stated the contemporary view of the relation between elasticity and real bills: “Probably the most important effect of the Federal Reserve Act was to set up the machinery necessary to provide elastic currency; elastic in that it would be based on self-liquidating credit instruments arising out of the production and distribution of commodities. An obligation of the United States does not represent a transaction of this character. . . to the extent such obligations back the currency such currency is fiat currency” (Federal Reserve Governors Conference, May 1922, 143–44 [hereafter cited as Governors Conference]).

  6. In the panic of 1907, call money rates in New York reached a 100 percent annual rate on October 24. There were no offers earlier in the day at 60 percent (Tallman and Moen 1990, 8). J. P. Morgan and others organized loans to the stock exchange, and on October 26 the Clearinghouse Association began to issue certificates. The certificates served principally as a means of settlement between banks, releasing gold and currency for use by the public. Other currency substitutes were also introduced (9–10). Tallman and Moen (1995) point to an important difference between New York and Chicago during the panic of 1907. The Chicago clearinghouse treated trusts similar to banks and permitted them to be members of the clearinghouse. New York did not. When concerns arose about the safety of depositors at Knickerbocker Trust, the New York clearinghouse did not have much information about, or responsibility for, payments drawn on Knickerbocker. Chicago did not experience failures, but New York did. Although there was no lender of last resort, this experience suggests how anticipations or uncertainty about the payments function can induce bank runs and failures. The experience also points up the importance of defining financial institutions broadly at a time of panic.

  Authority to discount real bills was seen by many at the time as the main improvement of the new legislation.8 Many bankers shared Paul M. Warburg’s view that the Federal Reserve could prevent wide swings in interest rates without risking inflation if it purchased real bills.9 Reliance on real bills also freed the credit system from dependence on the call money market and thus on credit to stock exchange brokers and dealers who financed their positions in that market. Leading economists such as A. Piatt Andrew, H. Parker Willis, J. Laurence Laughlin, and Horace White also advocated the real bills doctrine.10 These economists believed that credit would be adjusted to the needs of trade if banks invested in commercial and agricultural loans and avoided bonds, real estate, call money, and other speculative assets (Mints 1945, 206–7).

  7. The outright prohibition against government securities as backing
or collateral for note issue was written into the Federal Reserve Act. Paradoxically, the Glass-Steagall Act of February 1932 temporarily removed the restriction as a means of encouraging expansion of the note issue and preventing bank runs during the Great Depression. It was never restored. In June 1945 the use of government securities as collateral became permanent. See chapter 5.

  8. Attempts to include deposit insurance in the Senate bill failed in the House. Glass opposed these efforts, and they were removed in conference (Glass 1927, 208–9). United States economic history would have been very different had the provision been in place after 1930.

  9. Warburg was a New York banker who had taken a strong interest in central banking. He was born in Germany into a family of German-Jewish bankers, so he was familiar with practices abroad. After the 1907–8 crisis, he discussed his views with Senator Nelson Aldrich and subsequently took a leading role in drafting the Aldrich plan. One of his major contributions was to convince Aldrich that the problem of elasticity was not primarily a problem of providing currency. He saw the need for a discount bank to provide reserves seasonally and cyclically. He repeated this point many times. See Warburg 1930, vol. 2. He also worked with the House and Senate committees that drafted the Federal Reserve Act and served a four-year term from 1914 to 1918 (vice chairman in 1916–18) as a member of the first Federal Reserve Board. He was not reappointed during World War I, allegedly because of his German origin and his close ties to German bankers (Chernow 1993, 44). In the 1920s he served as an influential member of the Federal Advisory Council.

  10. Of these, the most important in practice was Willis. Willis collaborated with Glass, served on his staff at the House Banking Committee, and drafted much of the act. Later he served as secretary of the organizing committee and as secretary of the Federal Reserve Board. In later years he was highly critical of the way the System developed and made his views known as editor of a leading business paper, the Commercial and Financial Chronicle.

  Mints (1945, 251–53) adds three additional benefits the founders expected the Federal Reserve to bring. First, bank reserves, mainly gold reserves, would be pooled and therefore available for lending when needed. Second, a bill market would replace the call money market, as in London. The call money market provided credit based on stock exchange collateral and hence depended on a speculative asset. The bill market depended on real bills, particularly bills arising from the financing of foreign trade. Third, improvement in the check clearing system would reduce the number of banks charging fees for clearing checks. The Federal Reserve instituted collection at par at the reserve banks but did not, initially, make par collection a condition of membership.

  Section 15 of the Glass bill (section 14 of the act), titled “Open Market Operations,” authorized the Federal Reserve banks to engage in such operations in any of the assets acceptable as collateral for rediscounts and to purchase and sell gold and government bonds. The House report on the Glass bill noted that the purpose of open market operations was to enable the “Federal Reserve banks to make their rate of discount effective in the general market at those times and under those conditions when rediscounts were slack and when therefore there might have been accumulation of funds in the Reserve banks without any motive on the part of member banks to apply for rediscounts or perhaps with a strong motive on their part not to do so” (Krooss 1969, 3:2317–18). The Senate report saw open market operations as a means of developing a market for bills, thereby reducing the variability of rates, the risk premium, and the average level of market rates.11

  11. Glass (1927, 90) records that H. Parker Willis, his chief adviser, proposed open market operations. Willis was later highly critical of the use of open market operations as the principal policy tool. The perceived tie between open market operations and discount rates was so close that authority for setting discount rates is in (the same) section 14 of the act. The Senate committee could not agree and issued two separate reports. One report refers to open market operations as one of the main benefits of the bill. The source of the gain is the development of a market for bills and not the power to affect market rates of interest and expand or contract the monetary base. See 63d Cong., 1st sess., November 22, 1913, S. Rept. 133, in Krooss 1969, 3:2377–2416. The discussion of open market operations is on 2398–2400. On 2395 the report discusses the stability of interest rates and notes that in 1907 interest rates had been highly variable using the following figures for money rates in selected months of 1907:

  The extreme variability of rates may explain the great concern in the Senate report with reducing the variability of market rates. However, the report anticipates that there will be “a comparatively stable rate of interest upon a lower basis than heretofore, because the element of hazard of panic and of financial stringency will be removed by the proposed system” (2395).

  None of the reports discusses the effect of changes in money on prices or pays much attention to problems of inflation or deflation. The effects of money on prices were not unknown to Congress. Silver agitators had pressed the point during the deflation of the seventies and eighties. The lengthy report of the Jones Commission (1877) had discussed the issue and concluded that an inconvertible paper money was subject to government control and should be allowed to expand with population so as to keep the price level constant.12 The quantity of gold or convertible currency, on the other hand, could not “be greater than such an amount as may be requisite to maintain the prices. . . at a substantial parity with the prices of all other countries using the same kind of money” (Krooss 1969, 3:1866).13 Yet none of this found its way into the act or influenced the reports of the House or Senate committee on the amended Glass bill.14

  A principal reason for the omission is the Gold Standard Act of 1900 that legally established the gold standard as the United States monetary standard. The United States was thought to be part of the international gold standard that determined the stocks of money and the price levels in all member countries. However, after the start of the European war but before the effective beginning of the Federal Reserve System, all the principal gold standard countries suspended the gold standard. It was never reestablished in its prewar form.

  12. The proposal is, of course, similar to Henry Thornton’s. Krooss (1969, 3:1798–1911) reprints the report of the chairman of the Senate Monetary Commission (45th Cong., 1st sess., March 1877, S. Doc. 703). The report offers, as a sideline, a monetary explanation of history and points out that from the end of the Roman Empire to the fifteenth century, the stock of money in the (former) empire shrank from $1.8 billion to $200 million. It asserts a large effect of the decline in money and prices: “The crumbling of institutions kept even step and pace with the shrinkage in the stock of money and the falling of prices. All other attendant circumstances than these last have occurred in other historical periods unaccompanied and unfollowed by any such mighty disasters. It is a suggestive coincidence that the first glimmer of light only came with the invention of bills of exchange and paper substitutes, through which the scanty stock of the precious metals was increased in efficiency” (3:1863). Other periods are interpreted in a similar way. However, the report does not argue for inflation but generally favors stable prices.

  13. The following was written before Irving Fisher’s analysis of interest rates: “Equally fanciful and erroneous is the proposition that the rates of interest for money can be lowered by increasing its quantity. . . . [T]he rates for the use of loanable capital depend upon . . . the current rates of business profits . . . and the fiscal policies [sic] of governments. . . . In truth, increasing the amount of money tends indirectly to raise the rate of interest by stimulating business activity, while decreasing the amount of money reduces the rate of interest by checking enterprises and thereby curtailing the demand for loans” (3:1866–67; italics added). The report did not, however, distinguish anticipated from actual price changes, as Thornton had done.

  14. There was a general belief, however, that centralization of reserves and deve
lopment of a money market would reduce interest rates and make rates more uniform within the country. This was expected to contribute to economic development (U.S. Treasury Department 1915, 12; Warburg 1930).

  The intent of the legislation was very different from the way the System evolved. The original conception was of a relatively passive system. The price level would be controlled mainly by gold movements and changes in foreign exchange. Seasonal and cyclical movements in demand for credit would increase or reduce demand for rediscounts at Federal Reserve banks. Much of this activity, it was believed, would take the form of changes in the volume of rediscounts of bills of exchange or acceptances initiated by banks. The Federal Reserve would not be entirely passive, however. Its active role, like that of the Bank of England, would consist mainly of raising or lowering the discount rate in ordinary times and providing emergency credit to prevent or respond to a financial panic. The discount rate would be a penalty rate, so in ordinary times bankers would keep discounts to a minimum.