A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  Glass was exultant after the hearings ended. He told Harrison, “I have them badly whipped both in the subcommittee and in the big committee” (Harrison Papers, Telephone Conversation with Senator Glass, file 2021.0, June 15, 1935). The subcommittee had voted to put off discussion of title 2 for a week, so Glass hoped to pass only titles 1 and 3 to meet the July 1 deadline for bankers to repay their loans and continue deposit insurance. He planned to amend title 2 “to make it objectionable to the administration” (ibid., 1).141

  Both tactics failed. Pressed by Roosevelt, Chairman Steagall insisted on a compromise, prepared by Eccles and Goldsborough, that extended title 1 for two months. The Senate accepted many of Glass’s amendments, but the House did not, so the issue moved to a conference committee.142

  The final bill was again a compromise between concerns about banker or political control. Congress accepted many of the changes Eccles proposed, but not in the form he had suggested. The Board gained power and influence over policy and appointments at the reserve banks; however, Glass managed to get representation by the reserve banks on the new open market committee and authority for directors to choose a reserve bank’s officers, subject to Board approval.143

  139. Hamlin’s argument for keeping the secretary on the Board stressed the need for cooperation and coordination of fiscal and monetary actions, a theme much discussed in the early postwar years (Senate Committee on Banking and Currency 1935, 949).

  140. Eccles (1951, 206) is critical of this argument and fails to recognize that he had made a similar argument in response to Senator Couzens’s question. A list of some principal witnesses is on 205–6.

  141. Glass does not seem to have noticed that Eccles’s testimony, defending the bill and its purposes, had changed opinions in the press and the public. The Washington Post, owned by Eugene Meyer, and the New York Times, both influential, changed from opposition to support. Eccles was the subject of favorable articles in leading magazines (Hyman 1976, 181–82).

  142. Glass’s bill tried to prevent the executive branch from controlling the System. It required the Federal Reserve to report to Congress on open market operations, required a supermajority of five governors to change reserve requirement ratios, limited Board members to a single term, and required four members from one party and three from another.

  Morgenthau supported the final bill because he anticipated large budget deficits and wanted to share responsibility for any future debacle that deficit finance might cause. Above all, he wanted a Board with power to keep interest rates low. He wrote in his diary: “I have been hoping and have not mentioned it to a soul that the Federal Reserve Board would be given additional powers and created more or less as a monetary authority so that they and the Treasury can share the responsibility and possibly help us in case we get into a financial jam” (Blum 1959, 352).144

  The Act

  The act changed the open market committee from a committee of twelve reserve bank governors to seven Board members and five members chosen by reserve bank directors.145 The head of the bank had the title president, not governor, and was not ex officio a member of the open market committee. Reserve bank directors appointed the presidents and first vice presidents for five-year terms, with approval of the Board of Governors. As before, the Board set salaries. The act replaced the full-time office of chairman and Federal Reserve agent with a part-time chairman.146

  As before, the president appointed members of the Board of Governors, subject to Senate confirmation. The act reduced the size of the Board from eight to seven members, holding office for staggered fourteen-year terms beginning March 1, 1936, and removed the secretary of the treasury and the comptroller of the currency.147 The chairman and vice chairman (formerly governor and vice governor) received four-year terms in those offices and fourteen-year terms as board members (or the remaining years of an unexpired term). No one could be appointed to more than one fourteen-year term.148

  143. Subsequently, the new bylaws of the Federal Open Market Committee barred the presidents from divulging FOMC decisions to their directors.

  144. Morgenthau continued along this line, citing his power over the present Board as stemming not from his seat on the Board but from the use of the Exchange Stabilization Fund “plus the many other funds I have at my disposal. . . . [T]his power has kept the open market committee in line and afraid of me” (Blum 1959, 352).

  145. Section 205 of the 1935 act specified that the five presidents would be chosen from restricted groups as follows: Boston and New York; Philadelphia and Cleveland; Chicago and St. Louis; Richmond, Atlanta, and Dallas; Minneapolis, Kansas City, and San Francisco. Each year, a committee of directors met to choose the representative. The act did not require rotation among the reserve banks. Harrison was chosen from 1936 to 1940, with Boston’s president always as alternate. Beginning in 1942, New York gained a permanent seat as vice chairman of the committee; Chicago alternated with Cleveland, and the remaining nine banks rotated within three triplets. New York’s first vice president serves as the New York alternate.

  146. The 1913 act intended the chairman and Federal Reserve agent to be the main contact with the Board. The position of governor is not mentioned in the act. Practice evolved so that the governor became the chief executive. The 1935 act recognized practice. Directors of reserve banks continued to receive $20 per meeting they attended plus travel (if over fifty miles), plus $10 per diem for expenses.

  Accommodating commerce and business remained in the act, but the new law weakened the role of real bills by adding “with regard to the general credit situation of the country.” Eccles did not get his choice of phrasing, but Glass could not keep unchanged the wording in the 1913 act. More important was the change in the definition of eligibility. Under the 1935 act, the Board could define eligibility as broadly as it wished. Although the real bills doctrine lived on, it no longer had the force of law behind it. This was a major step in the evolution of the System.

  The Board also gained authority to change required reserve ratios up to twice the prevailing ratio by majority vote. Eccles lost the unlimited authority that he requested and Glass opposed. The act eased restrictions on mortgage loans by member banks. Reserve banks were required to vote on discount rates every two weeks; as before, changes required approval of the Board.

  Eccles had tried to replace requirements for geographical representation on the Board with a vague reference to education and experience. Glass’s views prevailed, so the bill retained the original restrictions.149

  The bill passed on August 19, and the president signed it on August 23. Glass took credit for the final bill, as he had for the 1913 bill (Eccles 1951, 221). In fact, the compromise gave Eccles many of the changes he wanted. Glass lost on the shift of power to the Board, the diminished powers of the regional reserve banks, and the weakened role of the real bills doctrine. The 1935 Act permitted the Federal Reserve to become a central bank, but the major changes in practice came only after World War II and the Korean War.150

  147. Morgenthau agreed to the removal of the secretary but was piqued when he learned that the comptroller, his subordinate, would remain (Hyman 1976, 187). Glass favored removal of the secretary because he believed that, as secretary, he had too much influence after World War I.

  148. The salary increased from $12,000 to $15,000 a year, more than $190,000 in 2001 dollars. The rule for service left either Miller or Hamlin, who had served since 1914, eligible for the fourteen-year term beginning in 1936. The other could receive a twelve-year term. Eccles persuaded Roosevelt not to reappoint either. Hamlin was given a staff position as special counsel, and Miller was given responsibility for supervising construction of the new Board of Governors building (Hyman 1976, 198). The building was financed from the Board’s “profits” and by assessments on the reserve banks.

  149. In the 1960s and after, several presidents bypassed sectional restrictions by appointing governors based on their birthplace, even if they had not lived there for twenty years or more
.

  OTHER PROPOSED CHANGES

  Although pleased by the increased power granted by the Banking Act, Eccles was not satisfied with the extent of the Board’s powers. He pressed Roosevelt to support legislation forcing all banks to become members of the Federal Reserve System. His reasoning is similar to claims made repeatedly by other Federal Reserve chairmen: the Reserve System “cannot function efficiently or effectively in the national interest as long as half of the banks are in it and the other half out. . . . [O]ne half. . . is free to negate management in the national interest” (Eccles 1951, 267–68; memo to President Roosevelt November 12, 1936, quoted in Hyman 1976, 275–76). Eccles wanted all banks with deposit insurance to be members of the Federal Reserve System and all bank examination and regulation to be under the Federal Reserve’s control. Also, he wanted bank examiners to vary examination standards over the cycle in harmony with monetary policy, a result that could be achieved only if the Federal Reserve controlled the examinations.

  Eccles greatly overstated his case. More than 50 percent of the banks were not members, as he said, but their share of deposits was down to 15 percent in 1936 from 27 percent in 1928 and nearly 17 percent in 1933. Bank failures in the depression, and the bank holiday, had eliminated many of the small, weak, mainly nonmember banks. New lending powers had encouraged growth in the number of state bank members and national banks. Table 6.3 shows these data for selected dates in the 1930s.

  The proposal requiring membership, coming soon after the first increase in required reserve ratios, probably reflects Eccles’s concern that the higher ratios would reduce Federal Reserve membership by increasing cost. This argument is more plausible than the argument Eccles—and subsequent chairmen—used. Contrary to their claims, control of money and bank credit or an interest rate does not require universal membership in the Federal Reserve System. There is no valid argument to this effect and no evidence that control changed after all banks became subject to reserve requirements in the 1980s.

  150. The act also required the Board and the open market committee to keep a complete record of all action taken, the reasons for the action, and the votes. The record had to be published annually in the Board’s report. Miller (1936, 11) describes this as a major innovation for central banking. He thought it would improve the reasoning given for votes.

  Examination Standards

  Roosevelt did not endorse Eccles’s proposal for Federal Reserve control of bank examination, but Eccles did not give up. He tried several more times to persuade Roosevelt to endorse his program. Finally, as part of a program to end the 1937–38 recession, Roosevelt endorsed unification and liberalization of bank examination policies in a message to Congress on April 14, 1938 (Hyman 1976, 247; Eccles 1951, 272).151 Roosevelt then asked Morgenthau to establish a committee of federal and state banking agencies to agree on a more liberal bank examination policy.

  All the banking agencies, except the Federal Reserve, quickly agreed on revision of examination procedures and a common set of standards. The National Association of State Bank Examiners accepted the changes. Eccles continued to argue over some technical details. What most disturbed him, perhaps, was that the new standards had been agreed to without legislation. Consolidation of all examination under the Federal Reserve would not be necessary, and he would not get countercyclical examination standards. Adding to Eccles’s problem was strong support for the revision by the American Bankers Association and the financial press, and his own political blunder.152 Morgenthau gave him an ultimatum: agree to the committee’s recommendations or he would go to the president without Federal Reserve agreement. Eccles agreed, and the standards were issued.153

  151. Many of the same arguments about examination standards as a cause of recession or slow recovery reappeared in Federal Reserve and administration statements in 1991–92. Eccles’s argument seems rather naive despite his experience in government. He compared the banking authority he wanted to create to the Interstate Commerce Commission—“a single, strong, independent, nonpolitical, but public body . . . that would make decisions free from the political winds” (Eccles 1951, 270).

  152. Eccles made the mistake of complaining about “faulty examination procedures” in a long letter to Senator Arthur Vandenberg (Michigan), a potential rival to Roosevelt in the 1940 election. The letter urged countercyclical examination standards. Vandenberg published it in the Congressional Record and made it public. Eccles’s criticism of administration banking policy, with the clear implication that it delayed the recovery, infuriated Morgenthau (Blum 1959, 430–31; Eccles 1951, 275–77).

  The new standards allowed banks to invest in nonmarketable bonds issued by small corporations and reduced the size of the mandatory write-off of slow and doubtful loans. The standards used average value over several months in place of current market value to judge soundness of marketable assets. This moved away from mark-to-market accounting and increased examiner’s discretion.

  Eccles did not give up. A few months later he told Roosevelt that he would resign at the end of his term, February 1940, unless the Board of Governors gained new powers “to do the work expected of it” (Eccles 1951, 279). Knowing Roosevelt’s reluctance to take up the membership issue, Eccles recommended that the president ask Congress to study the issue and draft legislation. Congress appropriated $25,000 for this purpose, one-fourth the amount Eccles had suggested. The matter died when the war in Europe shifted attention toward preparation for war. Eccles never realized this objective, nor did other chairmen who pursued it.

  Nationalizing the Reserve Banks

  Proposals to nationalize the reserve banks by having the government repurchase all outstanding shares continued after passage of the 1935 Banking Act. In May 1937 Congressman Wright Patman (Texas), who later chaired the House Banking Committee, proposed legislation that attracted 151 cosponsors. The legislation transferred ownership of the reserve banks to the government, returned the treasury secretary and the comptroller to the Board, and added the chairman of the FDIC and twelve members, one from each district. The enlarged Board would serve as the Federal Open Market Committee (FOMC). The bill also required the Federal Reserve to stabilize and maintain the purchasing power of money and gave all members of the FDIC the rights and privileges of member banks. At the time, the consumer price index was about 80 percent of its 1926 level. The act required the Federal Reserve to keep the price level within 2 percent of its 1926 value. Once again, some members urged price stabilization and a price level target.

  The Board’s staff dismissed the last proposal as unrealistic and impractical (Board of Governors File, box 141, undated). The reasons they gave show some change of views. The staff no longer denied that the price level depends on money, but it recognized both monetary and nonmonetary causes of price changes. For example, a crop failure or taxes may raise prices. Also, there was no satisfactory measure of the price level. Index numbers differ.

  153. Eccles’s version claims that Morgenthau adjusted the recommendations to meet Eccles’s requirements (Eccles 1951, 276).

  The staff concluded that the Patman bill mistook ownership for control. The banks owned stock in the reserve banks but did not control the System. All the net earnings of the reserve banks after dividends of 6 percent went into a surplus fund. The excess was paid to the Treasury (or had been used for other purposes, e.g., to establish the FDIC). Congress could allocate the surplus, so it had final control.154

  Raising Prices

  The 1937–38 recession renewed proposals to raise the price level and thereafter keep it stable. Congressman Goldsborough again offered legislation to require the Federal Reserve to restore wholesale prices to the 1921–29 average. Other legislation (Board of Governors File, box 136, January 21, 1938) required the Federal Reserve to make social payments to aged and infirm adults and to dependent children and to finance farms and homes for lower income groups. Senator Elmer Thomas (Oklahoma) proposed to reconstitute the Federal Reserve as a monetary authority responsible for cont
rolling the price level based on the values at home and abroad of tax payments, interest payments, outstanding debt, prices, and other factors (Board of Governors File, box 141, March 25, 1937, 7).

  The staff responded to the price level proposals by sending out a published version of its response to the Patman bill. It accepted the desirability of economic stability, opposed using price stability as a goal, and opposed raising the price level 25 percent to restore the 1926 price level. The memo failed throughout to distinguish between individual prices and the price level (Wyatt to Congressman Kelly, Board of Governors File, box 141, June 17, 1938).

  The lasting feature of these proposals is congressional interest in legislation giving guidelines for improving the economy and maintaining price stability. These concerns eventually led to the Employment Act of 1946.155 Legislative interest in price stability as a goal of monetary policy waxes and wanes, but Congress has not adopted it.

  154. Other provisions of the Patman bill eliminated the restriction on changes in reserve requirements that mandated uniform changes for all reserve city and central reserve city banks, or all country banks. But it also removed the required reserve ratio from banks that did not borrow from a reserve bank. The staff memo liked the proposals to unify the Board and the open market committee (although the timing might be wrong) and eliminate the Federal Advisory Council of twelve bankers. The council “serves no useful purpose,” and “its advice on monetary and credit matters is either useless or worse” (Board of Governors File, box 141, undated, section 7). But the report grudgingly accepted that there would probably have to be consultation with bankers, so it might be best to retain the council.