309. Starting in first quarter 1934 avoids the revaluation of the gold stock and the bank holiday. This conclusion would not change greatly if official (annual) data are used instead. For 1933 to 1941, nominal GNP, as reported by the Commerce Department, rose approximately 10 percent a year compared with the 9.7 percent rate of base money growth.
Treasury pressure is not a full explanation for Federal Reserve passivity and subservience to the Treasury. Board members and the Board’s principal staff believed that monetary policy was impotent. One reason is that nominal or market interest rates were low. A second reason is that excess reserves rose.
At first the appearance of excess reserves puzzled the staff and the governors. Gradually they modified the Riefler-Burgess doctrine to include excess reserves. Excess reserves replaced borrowing as the main indicator of the thrust of monetary policy and the position of the financial system. In the 1920s, the Federal Reserve considered borrowing of $500 million neutral; policy was neither easy nor tight at that level. With borrowing almost eliminated, the level of excess reserves and short-term interest rates became the principal measures of policy thrust. Both measures suggested that policy remained easy throughout the decade. Hence there was no reason for action.
One of Morgenthau’s achievements, which he valued highly for political and economic reasons, is known as the Tripartite Agreement. The agreement fixed exchange rates between the British pound, the French franc, and the dollar. Morgenthau believed the agreement showed that the democracies could cooperate politically to achieve a common end. Economically, it fixed exchange rates daily; the parties could change rates with one day’s notice.
In fact, the agreement had little economic effect. The principal reasons are that countries pursued independent policies often unrelated to the exchange rate goal and that after adjusting for differences in inflation, nominal exchange rates were misaligned. The agreement to fix nominal or market rates meant that the French government had to deflate its economy further. After years of high unemployment and repeated cuts in spending on social services and pensions, most French voters were unwilling to accept additional austerity. Even before the agreement was made, a centrist coalition had started an expansive policy. Its successor, a socialist government with Communist support, pursued expansive policies more aggressively. These policies were inconsistent with the Tripartite Agreement, so the agreement could not, and did not, accomplish much economically.
The period between 1933 and 1940 is known as the New Deal, the name President Franklin Roosevelt gave to his administration. The New Deal introduced many programs to redistribute income and initiate welfare state measures. These programs succeeded politically; the administration was reelected by a large majority in 1936 and a smaller but decisive majority in 1940.
At the time, and afterward, many economists regarded the New Deal as a failure or as less than successful (Arndt 1966; Hansen 1938; Kindleberger 1986; Morgenthau, in Blum 1965, 124). A principal reason was continued high unemployment. Between 1929 and 1940, the figure of 6.5 million new entrants in the labor force is about the same as the net increase in the number unemployed. Hours of work declined.
New Deal programs raised real and nominal wages faster than productivity or encouraged these increases. By 1940 per capita real output had returned to the 1929 level, but real wages in manufacturing were 44 percent higher than in 1929. The early New Deal prescribed wage increases through NIRA codes. When the Supreme Court declared NIRA unconstitutional in 1935, other legislation encouraged union organizing, a shorter workweek, a minimum wage, and other measures to raise wages. Similar measures in France after 1936 had a similar effect; wages and prices rose while employment fell.
Although New Deal measures help to explain the sluggish growth of employment and the persistence of unemployment during the 1930s, the long-term effect of these measures was on the price level and the exchange rate. Once the United States entered the war, employment rose rapidly.
The New Deal had a lasting effect on the organization of the Federal Reserve. The Banking Act of 1935 changed the locus of power in the Federal Reserve System by strengthening the role and powers of the (renamed) Board of Governors in Washington. Without ever reaching an explicit, collective judgment, Congress and the Roosevelt administration appear to have concluded that the policies pursued by the reserve banks, particularly New York, had encouraged speculation, leading to the 1929 stock market collapse, bank failures, and depression. Centralization of responsibility and authority in the Board, and measures to prevent security market speculation, were the chosen solutions.
Subservience to the Treasury during the recovery, and in the war that followed, limited the effect of the legislation for a time. The Treasury took control of international economic policy. Both New York and the Board had a limited role. The Board gained nominal control of open market operations and the power to approve appointment of reserve bank presidents. The new powers changed the System’s internal organization and operations in the 1930s. Major effects on policy had to wait for the postwar years.
APPENDIX: STATISTICAL RELATIONS
This appendix shows the regressions underlying chart 6.16, gives some related equations, and reproduces the chart on base velocity, highlighting the data for the 1930s recovery.
Chart 6.A1 compares base velocity to a long-term interest rate as in chapters 4 and 5. The chart notes the points for 1933–41 in relation to the long-term position of the curve. Base velocity declined as interest rates declined. Both reached the lowest values in recorded United States history.
seven
Under Treasury Control, 1942 to 1951
The period from 1942 to March 1951 divides almost equally into years of war and years of peacetime expansion. For Federal Reserve policy, the period can be treated as a whole, a repeat with different details and a different outcome of the experience during and after World War I. Once again the Federal Reserve put itself at the service of the wartime Treasury, and once again it had difficulty extricating itself from the Treasury’s grasp after the war. And again it took almost as much time to free postwar monetary policy as to fight the war.
The Federal Reserve summarized its “primary duty” in wartime as “the financing of military requirements and of production for war purposes” (Board of Governors of the Federal Reserve System 1947). In practice, this meant continuation of the historically low interest rates carried over from the 1930s. Principal efforts to control spending and inflation fell to administration tax policy and, during wartime, to price and wage controls and the rationing of several commodities. The Federal Reserve supplemented these policies mainly by regulating credit used to purchase consumer durable goods. Wartime allocation of materials and conversion of factories to military production restricted the supply of durable goods; consumer credit controls aimed to restrict demand at the controlled prices. After the war, Congress removed controls (1947), but it soon restored them (1948). In the early postwar years, the Federal Reserve used margin requirements to limit securities purchases. Credit controls proved difficult to administer and ineffective against inflation.
Eccles described his work in wartime as “a routine administrative job. . . . [T]he Federal Reserve merely executed Treasury decisions” (Eccles 1951, 382). When his term ended in February 1944, he offered to resign but agreed to remain if the president would commit to consolidation of banking regulation and supervision under a single agency. His reappointment as a member of the Board ran to 1958, as chairman to 1948.1
The Treasury relied more heavily on taxation than in World War I. Tax receipts rose from less than $9 billion (7 percent of GNP) in the 1941 fiscal year to more than $45 billion (21 percent of GNP) in 1945, but expenditures rose more. Public debt increased by $200 billion in the same four-year period (approximately 25 percent of GNP). Secretary Morgenthau’s passionate attachment to low interest rates meant that in practice the Federal Reserve’s “primary duty” was to market the debt at prevailing interest rates and, as in World War I, a
ssist in the periodic war loan drives.2 To carry out this policy, beginning in April 1942, the System fixed ceiling rates on government securities at 0.375 percent for Treasury bills and 2.5 percent for long-term bonds, with intermediate rates on intermediate maturities. This pattern of rates became a main source of difficulty. With all rates expected to remain fixed, banks, financial institutions, and the public increased profits by buying higher-yielding long-term bonds and selling short-term bills in the market, where they were acquired by the System.
The war ended with wartime rates still in place. As in 1919, the Treasury was reluctant to let rates change, first because it wanted to float a Victory Loan, later because it was unwilling to increase the cost of debt service. Unlike 1919–20, no one at the Federal Reserve was willing to challenge the Treasury’s position. Eccles gave three reasons. First, like the Treasury, he was concerned about the budgetary cost. Economists in and outside government cited the large outstanding debt, the higher cost to the Treasury, and potential losses to bondholders from higher interest rates as impediments to the use of orthodox policies. Eccles shared this view. Second, higher interest rates would increase bank earnings, an outcome considered politically unacceptable. Third, Eccles believed there was no political support for higher interest rates. He was unwilling to make the case, certain he would lose to the Treasury, and skeptical that inflation could be controlled without raising interest rates so high that a postwar depression would be likely.3
1. The president’s wartime powers included authority to reorganize government agencies. According to Eccles, Roosevelt agreed to consolidate the banking agencies but soon afterward rejected Eccles’s proposal. Eccles did not resign. Eccles’s service dates from 1934, but he was reappointed to a twelve-year term in 1936 after reorganization. Since he had not served a full term, he could be reappointed for fourteen years. The other members at the time were Governors Ronald Ransom, John K. McKee, Ernest G. Draper, M.S. Szymczak, and Rudolph M. Evans.
2. There is no evidence supporting Toma’s (1997) argument that the low-interest policy was intended to maximize the government’s seigniorage. Under the rules adopted in 1933, the Federal Reserve did not transfer any surpluses to the Treasury to compensate for its subscription to the initial stock of the Federal Deposit Insurance Corporation. This rule changed in 1947 to the present rule, under which the Federal Reserve pays 90 percent of its net earnings to the Treasury. A reader familiar with Secretary Morgenthau’s excessive concern about small changes in interest rates in the 1930s, when debt issues were relatively small (chapter 6), would not seek another explanation for wartime interest rate pegs when the size of debt issue increased by about 20 percent of GNP.
An unspoken fourth reason was also present. The dominant view of professional economists at the time was that the task of monetary policy was to promote budgetary finance. Fiscal or budgetary policy was believed to have much more powerful effects on prices and economic activity than changes in the quantity of money or interest rates. In addition, many economists believed the war would be followed by a return to unemployment and slow growth, as in the 1930s. This view was based in part on historical precedent—most wars had been followed by recessions—but even more on Keynesian analyses showing that private spending would be too small to sustain full employment (Samuelson 1943).
Woodlief Thomas, of the Board’s senior staff, set out the prevailing view on the role of money. His essay emphasizes the role of unmeasured magnitudes such as “availability” and “turnover” as more important influences on the economy than money. Changes in money did not cause changes in output or aggregate income (Thomas 1941, 324–25). The Federal Reserve had limited influence on the stock of money (304–5), and the stock of money was less important than its rate of turnover, or velocity of circulation (330).
Nevertheless, the Federal Reserve had statutory responsibility for monetary control. Because it could be blamed for inflation, it became increasingly restive under tight Treasury control. It claimed that restrictions on interest rates converted the Federal Reserve into an “engine of inflation.” Morgenthau’s resignation in 1945 did nothing to change the Treasury’s stance. His successors, Fred M. Vinson and John W. Snyder, were no less concerned about maintaining the wartime pattern of interest rates.
Fears of a postwar depression soon disappeared as a reason for low interest rates, but other reasons remained. Although Eccles continued to oppose confrontation, he was not passive. He favored raising reserve requirements, mandating that banks must hold a secondary reserve of Treasury bills, higher tax rates to produce a budget surplus, selective credit controls, and during the transition, price and wage controls.
3. Eccles repeated this belief many times. One example is his 1946 testimony on the continuation of price controls after the war ended. On that occasion, Eccles testified that “it would be quite unsatisfactory, it seems to me, to try to meet the present problem by what was considered the usual or the orthodox way of dealing with inflationary forces, which was through increasing the discount rate, raising interest rates. Now, the reason for not following this course is that it would increase the cost of carrying the public debt, which is already very high, and it would likewise increase the earnings of the banking system which are also high. Such a policy would be a very unsatisfactory way to deal with this problem. I am sure that the Treasury would have considerable objection, as Congress and the public would, to increasing the interest burden on the Federal debt for the benefit of the banking system” (House Committee on Banking and Currency 1946, 183).
At first there was little opposition within the System to many of these ideas. After the transition, Allan Sproul, president of the New York Federal Reserve bank, began to advocate a more active monetary policy. Although generally reluctant to clash openly with Eccles and the Treasury or reopen the 1920s split between the New York bank and the Board, Sproul became the principal spokesman for a more independent monetary policy. When Eccles’s term as chairman ended in 1948, Sproul’s influence increased under the new chairman, Thomas B. McCabe.
Little changed until two events altered the political balance. First Congress, under the leadership of Senator Paul Douglas, opposed the Treasury’s position. Second, the start of the Korean War, in June 1950, heightened public concern about renewed inflation. The result was an agreement with the Treasury in March 1951, known as the Treasury–Federal Reserve Accord (the accord), that permitted the Federal Reserve to implement a more independent policy.
In fact, early postwar monetary policy was far from an “engine of inflation.” By the end of 1948 prices were falling, and long-term interest rates were below the Treasury–Federal Reserve maximums. The decline in prices was soon followed by a decline in output and a mild recession. Chart 7.1 shows growth of output and inflation from 1942 to 1951. The large spike in inflation in third quarter 1946 (and some of the increase in the previous two quarters) reflects the removal of wartime price and wage controls in that quarter.
Reliance on selective controls, to limit general price level increases, shows the System’s inability or unwillingness to use more general measures. But it also reflects the lingering effects of the real bills doctrine. Buyers of durables could borrow in ways other than the particular way that controls restricted, just as buyers of stock had done when the Board tried to control stock purchases by restricting credit to the stock market. Discussions at the time did not explain how inflation—a sustained rate of increase in a broad-based price index—could be controlled by limiting the use of credit to purchase particular goods and services.4 To prevent “speculative” accumulation of inventories of consumer goods, the Federal Reserve urged bankers to curtail lending to firms with rising inventories.
4. As late as 1980, the Carter administration imposed selective credit controls seeking to end a general inflation.
In June 1950 the United States went to war again. Spending to fight the Korean War brought nominal government spending back to its peak wartime level. President Truman chose to fin
ance the war out of current revenues, so the cash budget had a surplus. After a brief spurt, inflation remained modest. Despite pegged interest rates, growth rates of the monetary base and the money stock were modest also, in part because gold outflows increased.
Korean War finance shows that wartime inflation can be avoided if policymakers choose to do so. President Truman’s budget policy did not force interest rates to rise, and it did not require the Federal Reserve to increase money growth to prevent the rise. In the two years beginning June 1950, the monetary base rose about 7 percent, a 3.5 percent annual rate. In the same period the consumer price index rose 11 percent, but by far the larger part of the rise occurred as a one-time price level change driven on one side by fear of a return to wartime shortages when the war started and on the other by the expectation that money growth always increases to finance wartime deficits. When the administration chose a balanced budget, expectations of inflation collapsed.
The principal international financial event of the period was the attempt to reconstruct the international monetary system as a fixed exchange rate system and, at the end of the period, the start of the gold outflow from the United States. At first the Federal Reserve and the administration welcomed the loss of gold as a necessary step in the reconstruction of a more viable international monetary framework. A decade later, concerns about the United States gold loss became the subject of an increasingly active discussion about the viability of the monetary standard based on gold and the dollar.5
A History of the Federal Reserve, Volume 1 Page 84
