A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The rest of the memo was defensive, aimed at preventing reorganization and a shift of power to the Board. The memo claims that the Federal Reserve had shown its effectiveness in financing World War I and in acting promptly in the recessions of 1924 and 1927. None of the existing central banks used credit or monetary control to stabilize prices, prevent booms or depressions, or hasten recovery; therefore the System should be credited for its successes and could not be blamed for the depression. Further, the Federal Reserve Act limited the Federal Reserve’s mandate to “accommodat[e] the needs of industry, commerce and agriculture” (ibid., 4). The Thomas amendment removed that restriction, so there is “no lack of power or of central banking machinery for carrying out whatever monetary and credit policies the Government may deem desirable for the promotion of recovery” (6; emphasis added).

  114. In addition to Harrison, the committee included two former governors of the Reserve Board, Black and Young, Norris (Philadelphia), two representatives of the Cleveland bank, and G. J. Schaller, who had replaced James McDougal at Chicago. The only Board member was J. J. Thomas, recently arrived as vice governor of the Board. Its advisers, Emanuel Goldenweiser and John H. Williams, were responsible for the drafting. Most members of the committee had participated actively in policymaking during the depression, so the committee was almost certain to find lack of power, not errors, as the reason for the System’s failures.

  115. An early draft drew a strong response from George James, a member of the Board (1923–36), who was not a committee member. Describing the drift as “one man’s offhand opinion,” James criticized most severely neglect of “investment speculation on the part of member banks. In my humble opinion this very factor was one of the major causes of the recent banking difficulties” (memo James to Board, Board of Governors File, box 142, October 2, 1934).

  The principal conclusion: System reorganization would not solve the problem of how to manage credit control policy. The memo proposed a broad study of banking, monetary, credit, and organizational changes. In October the committee reduced the scope of possible changes. The defensive tone and substance remained until the final report.

  The preliminary report (October) located the “basic problem” in the quality of bank credit extended: “This lack of quality has been due to conflicting jurisdiction, to laxity of laws, to lack of uniformity . . . in supervision, and . . . to lack of skill and vision in [bank] management” (Preliminary Report of the Committee on Legislative Program, Board of Governors File, box 142, October 16, 1934, 1). There is not a word about Federal Reserve failures or inaction: “The depression which began in 1929 continued to develop notwithstanding the great volume of credit made available to the banks through open market operations by the Federal Reserve banks” (2).116

  Perhaps reflecting the realities of the time, the final report made a brief reference to a new theme: the Federal Reserve banks have a responsibility to adjust their policies to “the need for expansion or restraint as conditions dictate” (Report, System Committee on the Legislative Program, Board of Governors File, box 142, December 17, 1934, 2). The report immediately shifted away, locating the main defects not in System failures to respond to economic conditions or bank failures, but in the “quality of bank assets and the soundness of banks” (ibid.). It failed to recognize that “quality” and “soundness” depend to a considerable extent on what happens to the economy.

  The report proposed improved supervision and regulation, to be achieved by unifying examinations and supervision under the reserve banks and by subjecting all banks to unified standards.117 The deposit insurance law required all insured banks to join the Federal Reserve System by July 1937. The report wanted this provision retained, but it was dropped.

  The most important change proposed in the report called for increased authority to raise and lower reserve requirement ratios. Under the existing power, in section 19 of the act, changes required approval of the president and declaration of an emergency. The committee proposed giving that authority to the Board. It also endorsed a staff proposal to make reserve requirements depend on both deposit turnover (velocity) and volume (ibid., 18).

  116. The section on credit control concludes: “The record of the System shows that it has always functioned in the spirit of its constitution as an institution vested with the public interest” (Preliminary Report of the Committee on Legislative Program, Board of Governors File, box 142, October 16, 1934, 5).

  117. Unification of examination standards was not achieved until 1938. The report showed awareness of moral hazard. It recommended that liquidation of failed banks take place “before the equity has been absorbed,” but it made no proposal about how this could be done or how to avoid dissipation of the assets of failed or failing banks.

  The final report removed from the earlier draft the Board’s defense of its policy from 1929 to 1933: “The Federal Reserve System has undertaken bolder and more extensive experiments in credit control than have ever been carried out by any other banking or Governmental authority” (Preliminary Report, Board of Governors File, box 142, October 16, 1934, 9). Failures and depression had occurred, of course, but not because of Federal Reserve failures. The problem was expansion of speculative credit, over which the Federal Reserve had more control after 1933. However, “sound banking is possible only under sound economic conditions. In the presence of profound national and international maladjustments that developed during the decade after the war, no banking system could function effectively” (10).118 The report does not mention that some reserve banks refused to participate or that the Board did not force recalcitrant reserve banks to pool the gold stock by discounting for participating banks.

  Currie’s Treasury Proposal

  Most of the work of Viner’s committee at the Treasury reflected Currie’s views.119 Currie expanded the recommendations in his book (Currie 1968). The responsibility of the Federal Reserve, Currie wrote, is to control the quantity of money, not the quality of credit. The Federal Reserve Act took the opposite approach through its reliance on the real bills (commercial loan) doctrine.120

  118. The preliminary report ignores the dispute between New York and Washington in October 1929, when New York acted independently, and the subsequent criticism by Young and the Board. See chapter 4. “The Federal Reserve promptly cushioned the decline [in stock prices] by promptly . . . buying securities on a large scale. During the depression it purchased . . . in unparalleled volume and thereby enabled the member banks not only to meet the drain of currency. . . . [but] to reduce their indebtedness to the Reserve banks to negligible proportions” (Preliminary Report, Board of Governors File, box 142, October 16, 1934, 8). The last statement shows the continuing influence of Riefler-Burgess views.

  119. Currie had studied at the London School of Economics before receiving a Ph.D. at Harvard. At Harvard, he met Ralph Hawtrey, a visiting professor who had done pathbreaking work in monetary economics, emphasizing the role of money in cyclical fluctuations. Currie’s work (1968) blamed the Federal Reserve for the depth and severity of the depression, anticipating the later critiques by Warburton (1948) and Friedman and Schwartz (1963). See Sandilands 1990, Laidler 1993, and Brunner 1968.

  120. “By and large the concern of the banking authorities in this country has been with the composition of bank assets” (Currie 1968, 35). Currie pointed out that, probably because it was difficult to do, the Federal Reserve had never defined “productive credit” (39).

  Currie concluded that “there exists no valid theoretical justification for the Commercial Loan Theory of Banking” (ibid., 39). “The drastic contraction of money from 1929 to 1932 can in large part be attributed to the failure of the reserve administration to appreciate the significance of changes in the supply of money” (44). And he added: “It is generally held that the reserve administration strove energetically to bring about expansion throughout the depression but that the contraction continued despite its efforts. Actually the reserve administration’s policy was one of
almost complete passivity and quiescence” (147).

  To remedy these failures and control the money stock, Currie proposed 100 percent reserves against demand deposits and no reserve requirements for other deposits. The gold standard and open market operations would control the volume of reserves and deposits. Banks could expand or contract lending relative to money by bidding for time deposits.

  Control of money was vested in a five-person board appointed by the president and confirmed by the Senate. Its charge was to maintain business stability, not to “accommodate commerce and business.” It would have discretionary authority to alter gold reserves, within limits consistent with maintenance of the gold standard.

  Currie expanded these proposals in his recommendations to Morgenthau mainly by adding detail and working out the transition to 100 percent reserves against demand deposits. One issue discussed at length was whether the Federal Reserve Board (called the Federal Monetary Authority) should be responsible to the administration. Currie recognized the possible inflationary consequences of this arrangement, but he chose political control under a general congressional mandate that set objectives. He suggested removing the secretary of the treasury from the Board.121 Eccles took Currie onto the Board’s staff as assistant director of research. Currie’s main task initially was staff work leading to the 1935 act.

  The Banking Act in Congress

  The bill that was sent to Congress in February 1935 contained three sections. Roosevelt recognized that the proposed changes in the Federal Reserve Act calling for creation of a central bank, with headquarters in Washington, would not be popular with most bankers, many populists, and those who wanted to nationalize banking. He joined the Eccles-Currie proposals (title 2) to two other pieces of legislation. Title 1 liberalized FDIC assessments and required all member banks to join the deposit insurance fund.122 Title 3 changed a section of the Banking Act of 1933 that required bank officers to resign if they had not repaid all loans to their banks by July 1. Title 3 extended the time limit for repayment, made technical adjustments to the Federal Reserve Act, and made permanent the use of government securities as collateral for the note issue. Thus Roosevelt put together a provision that many bankers wanted for personal reasons, and permanent deposit insurance, popular with Congress and the public, with a proposal that many disliked very much (Hyman 1976, 171).123

  121. The Board would consist of experts who would publish quarterly reports containing diagnosis of current conditions, expectations about future trends, “an account of its current policy which not only explains why it is being pursued but also what it hopes to accomplish thereby” (Currie 1968, 215). This proposal anticipated the decisions in New Zealand, Sweden, Britain, and elsewhere in the 1990s when central banks in these countries adopted inflation targets. It took many years before central banks surrendered enough secrecy to provide information about their current and prospective activities.

  The House passed the bill almost as it had been submitted. The vote was 271 to 110. Eccles testified on ten days, presenting the proposal and responding to questions. Unlike Currie, he described the 1928–29 experience as a “speculative orgy,” perhaps to appeal to Congress. The aim of the proposed legislation was both to control speculation and to “promote stability of employment and business.” The latter was a decisive shift in goals, certain to be unpopular with Glass (House Committee on Banking and Currency 1935, 180).

  To meet this new goal the Federal Reserve needed reorganization and new powers. Eccles emphasized four changes proposed in the bill: (1) subject the head of each reserve bank to approval by the Board, make the Board’s governor the head, and eliminate the office of reserve bank chairman;124 (2) vest control of open market operations in a five-person committee consisting of three Board members and two reserve bank governors; (3) transfer authority to specify eligible paper from the reserve banks to the Board; and (4) further liberalize provisions relating to real estate

  122. The 1934 FDIC law provided permanent deposit insurance on July 1, 1935, up to $10,000, 75 percent insurance for accounts between $10,000 and $50,000, and 50 percent above $50,000. Title 1 limited insurance to $5,000. Title 1 also gave the FDIC power to restrict entry. Warburton (1966, xiii) explains that the premium for deposit insurance, 0.083 percent, was set to cover depositors’ losses from bank failures except in deep depression of the 1870s, 1890s, and early 1930s.

  123. Morgenthau saw the bill as a means of wresting control of monetary policy from bankers. Roosevelt shared this view. In October 1933 he said: “Some members of the banking fraternity . . . do not want to make loans to industry. They are in a sullen frame of mind hoping by remaining sullen to . . . force our hands” (quoted in Blum 1959, 343). See the earlier reference to Chase National Bank and Harrison’s discussion with Winthrop Aldrich, its chairman. Morgenthau and Roosevelt saw this opposition of New York banks and large insurance companies as the dominant influence on the open market committee and the New York reserve bank (343).

  124. The title of governor is not written into the Federal Reserve Act. The reserve bank directors created the position and gave the title to the banks’ top officials.

  lending. The last provision was included to attract bankers’ support by increasing their opportunities at a time of relatively small loan demand.125

  The proposed control of open market operations did not fully satisfy Eccles. In his testimony he went beyond his bill, asking the committee to remove the two reserve bank governors, eliminate the committee, and make the Board alone responsible for open market operations. A committee of five reserve bank governors would have a consultative or advisory role only.126

  In the course of more than two hundred pages of testimony, Eccles both explained and defended sections of the proposed bill and offered his explanation of the causes of the depression and the path to recovery. The questions show the principal concerns of opponents and supporters, and Eccles’s arguments give a preview of the policies he followed and advocated during the rest of the decade. The committee members expressed their fears of deficits and debt burdens that return again and again in the next sixty years. Many of the comments about debt and deficits would be repeated unchanged in the 1980s and 1990s.

  congressional concerns Eccles chaired a committee, consisting mainly of Board staff, that prepared the bill without consultation or discussion with the reserve banks. The proposal then went to an Interdepartmental Loan Committee, chaired by Morgenthau, with representatives of other government agencies: “The Board was not asked to approve it. The Board was kept advised of the legislation” (Blum 1959, 352–53).

  This method of drafting raised concern about the shift in power that the bill proposed. Repeatedly Eccles was asked about the dangers of consolidating power over discount rates, reserve requirements, and open market operations in a single agency, appointed by the president and subject to political control. Congressmen expressed concern about the potential for inflation and the use of monetary expansion by the executive branch to influence elections. And the old issue of regional autonomy remained (366–67). Eccles responded that “monetary policy is a national matter, and it cannot be dealt with regionally without having such situations as we have had in the past” (367).

  125. Other provisions of title 2 reduced terms for reserve bank directors to six years, raised salaries and provided pensions for future members of the Board, repealed collateral requirements for Federal Reserve notes (extending the 1932 Glass-Steagall provisions), expanded authority to raise or lower reserve requirements, and made other technical changes (House Committee on Banking and Currency 1935, 185).

  126. The House had already adopted this plan, but Eccles’s testimony angered Morgenthau. He distrusted the Federal Reserve Board, in part because of its unwillingness to further reduce interest rates in 1934 (Blum 1959, 346–47). They “lacked courage” (348). Glass tried to use the opportunity to get Morgenthau to withdraw support, but after talking to Roosevelt, Morgenthau decided to support government ownership of the reserve
banks and the principle of placing the open market committee under the Board’s control. He did not endorse a specific compromise because Roosevelt had not yet made a decision (349). Throughout the spring Roosevelt was cautious about endorsing title 2. At one point he led Glass to believe that he did not care about title 2 (347, 349).

  the role of monetary policy The colloquy with House members shows that Eccles knew the legislation was a long step away from the Glass-Wilson reserve system and toward a modern central bank with responsibility for economic stability. That step was not taken for many years, however. The main reason is that the Treasury held a commanding position during the 1930s and 1940s. Eccles’s beliefs about monetary policy and his framework for analyzing the economy also played a role.

  Eccles held a Keynesian view long before that view became dominant among academics and central bankers. Mixed with that view were vestiges of older ideas about underconsumption, overinvestment, borrowing, speculation, and income distribution. Eccles repeated many times, in the hearings and elsewhere, that the depression was due in part to inequality in income distribution. One of the fullest statements of this belief is: “One of the principal troubles or difficulties that brought about the depression was not the shortage in the supply of money altogether, but it was due in part to the inequitable distribution of income which contributed to the speculative situation in the security markets and to an expansion of productive capacity out of relationship to the ability of the people of the country to consume under the existing distribution of income” (House Committee on Banking and Currency 1935, 405).