240. One explanation for the delay in changing policy is fear of capital losses at banks. This argument is valid as one part of the concern at the time, within and outside the Federal Reserve, about using monetary policy actively in the presence of a large outstanding debt. It finds support in the emphasis given to issuing debt that banks could not buy, although the proposals were not defended on that ground. The argument is incomplete, however. I believe the Federal Reserve would have changed policy after June 1949, and possibly in December 1947, if it had believed that Congress and the public would support its decision.
The Federal Reserve gave little attention to international monetary issues during this period. Gold holdings were large at the end of the war compared with any previous experience. They continued to increase once the initial postwar United States inflation ended. Deflation in the United States and concerns about devaluation of some European currencies added to the gold inflow. Despite exchange controls in most of Europe, the United States gold stock increased more than 22 percent, to $24.6 billion, in the four years following the end of the war in August 1945.
The peak in the United States gold stock came in 1949 when Britain, the sterling area, and Scandinavia devalued by 30 percent, with smaller devaluations by Germany, France, Belgium, and Portugal. Purchasing power parity calculations suggest that the devaluations substantially overvalued the dollar against the British pound and the Swedish krona (Friedman and Schwartz 1963, 771).242 By the following September, the United States gold stock was 4.4 percent lower. A larger decline began after the start of the Korean War.
Chart 7.6 shows the real value of gold from 1934 to 1951 in 1982–84 prices. As commodity prices rose, the price of gold in constant dollars fell. By 1951 the $35 gold price, set in 1934, had fallen by almost 50 percent in real terms.
There was only a slight echo of the Federal Reserve’s earlier concerns about gold inflows in the early postwar years. Gold movements were small relative to changes in the government budget. Gold inflows reinforced demand for new powers to raise reserve requirements, but the demand would almost certainly have been made in any case.
Aside from a few technical adjustments, the Bretton Woods agencies leave no mark in the System’s minutes for the period. The principal reason is that these agencies were inactive at the time. James (1996, 83) describes the IMF as “moribund,” a view apparently shared by the fund’s first two managing directors (83–84).
241. Section 5 of the Bretton Woods Agreement Act, enabling the United States to join the fund and the World Bank, provided that “neither the President nor any person or agency shall propose to the International Monetary Fund any change in the par value of the United States dollar or approve any change in par values unless Congress by law authorizes such action.” When President Nixon stopped the sale of gold in August 1971, he did not get the prior approval of Congress or order a change in par value. He claimed authority under the same Trading with the Enemy Act that President Roosevelt used to stop gold sales in March 1933.
242. The British devaluation lifted the purchasing power of the pound relative to the dollar far more than Britain’s 1931 devaluation. To a lesser extent this is true of the Swedish krona.
The IMF’s minor role reflected both errors in the original plan and changed views in the United States and abroad.243 Roosevelt and Morgenthau were gone. Their multilateral, internationalist views did not survive in the emerging postwar struggle with the Soviet Union. The Truman administration shifted toward a unilateral policy (James 1996, 60, 62). After 1947 the Marshall Plan, providing unilateral aid, became the principal source of European aid.
Even if there had not been a Cold War, it seems unlikely that the IMF and the World Bank would have taken a large role. They had limited resources, and the misalignment of exchange rates was much greater than the IMF’s resources could handle. John H. Williams of the New York reserve bank, W. Randolph Burgess, and Allan Sproul had foreseen the problem. Their writings and testimony in 1945–46 opposed the Keynes-White plan as premature and inadequate for the circumstances they expected after the war. Williams especially argued for a “key currencies” approach, based on the dollar and the pound sterling. He believed that the increased postwar demand for dollars could not be satisfied from the fund’s resources.
The so-called dollar shortage—the excess demand for dollars by foreigners—reflected the misaligned exchange rates agreed to at Bretton Woods. These rates did not take adequate account of the wartime differences in inflation and the destruction of capital and living standards.244 By raising concerns about devaluation, and despite currency controls, discussion of the “dollar shortage” probably contributed to capital flight from Europe to the United States. After the 30 percent devaluation of the British pound in September 1949, followed by a 22 percent devaluation of the German mark and other devaluations, discussion of the dollar shortage ended.
243. James (1996, chap. 3) summarizes changing views in Russia, Britain, and elsewhere.
244. The pound was set at $4.035, its prewar value, whereas the French franc was devalued by about 60 percent in 1946 and the Belgian franc by about 75 percent.
Unlike the postwar 1920s, this time the Federal Reserve had a modest, insignificant role in international monetary affairs. Authority and responsibility shifted to the Treasury, where it has remained through most of the postwar era.
CONCLUSION
From the start of United States participation in World War II to the accord of March 1951, debt management policy dominated monetary policy. To a considerable degree, the period continued the Morgenthau policy of 1934–41: keep interest rates low to minimize the cost of selling and refunding debt. The Federal Reserve willingly supported this policy in wartime. After the war, it feared postwar deflation and depression. The problem seemed much greater after 1945 because the increased stock of debt fostered concern that higher interest rates would impose capital losses, weaken the financial system, curtail lending, and bring back deflation and depression. Many in the System believed that an independent policy was impossible. Table 7.16 shows the wartime rise in debt and the postwar change in ownership.
At its peak, gross debt was much larger than gross national product. Almost 27 percent of the debt was in bills and certificates with less than one year to maturity. The Treasury may have been right in 1945–46 to be concerned about the task of managing the debt while avoiding the (widely predicted) postwar depression that had been the norm after earlier wars. It was wrong, however, when it refused to agree to the very modest changes in interest rates that the Federal Reserve wanted and to insist on continuing wartime interest rates long after the threat of postwar depression had passed.
Table 7.16 shows that the Treasury used budget surpluses to retire debt. In addition, Congress used part of the surplus to reduce taxes by more than $20 billion, overriding President Truman’s veto. However, tax rates remained high by historical standards, thereby contributing to the budget surplus. In addition, the Treasury purchased more than $12 billion of debt for its accounts.
Commercial banks had been the largest wartime buyers; they became the largest postwar sellers. The Federal Reserve was a net seller also. Instead of serving as “engine of inflation,” as Eccles and others often described its role, monetary actions were often deflationary; the monetary base and the money stock fell, and the consumer price index fell more than at any time in the postwar years. Chart 7.7 shows that the base and the money stock rose rapidly during the war, grew more slowly after the war, and declined in 1948–49 in advance of the recession and during its early months.
Converted to constant dollars, base growth remained nearly constant during the war, then collapsed at the end of the war when controls were removed and prices fully reflected earlier wartime inflation. Thereafter, real money balances fell until 1949. With nominal long-term interest rates almost constant, the movement of real interest rates shows mainly the rise and fall of measured inflation. Chart 7.8 shows highly negative ex post real interest r
ates at the end of the war; the one-time effect of removing price controls in 1946 overstates the decline, however. Negative real rates encouraged holding money for its real return. Negative real base growth reduced spending and aggregate demand.
As in several earlier recessions and recoveries, real base growth and real interest rates are positively related during recession and recovery, reflecting the common effect of inflation. Although the two series move together, they have opposite implications. Rising real interest rates produced by deflation imply that policy has become more restrictive; rising real balances may suggest an excess supply of money. In the 1948–49 recession, the effects of the real base again dominated the effects of real interest rates on output and economic activity, a repeat of experience in 1920–21 and 1937–38.245
Historically low nominal interest rates of the early postwar years, and the continued negative real long-term rates from 1946 to 1949, show that monetary policy—measured by the growth rate of money—was not impotent even at the prevailing interest rates. Relative prices, including stock prices, and prices of existing real assets continued to respond to current and prospective rates of money growth and inflation. In 1947 and 1948, with real base growth negative, the total return to common stocks was 5 to 6 percent; when real base growth turned positive in 1949, stock prices rose more than 18 percent, and the recession ended.
245. The influence of the real base represents more than the conventional real balance effect. In Brunner and Meltzer 1976, 1993, the response includes relative price changes of assets to output in addition to the standard wealth effect. These changes induce an excess supply of real balances and an increase in spending.
In 1942, the Federal Reserve volunteered to keep the long-term rate on Treasury bonds at 2.5 percent, fix short-term rates, and hold the pattern of rates prevailing at the time. After the war it did not insist on, or even propose, a free market in Treasury debt. It believed, correctly, that the spread between short- and long-term rates was much too large to encourage banks and others to hold short-term debt. Its goal through most of the period before the Korean War was to raise short-term rates enough to stop holders from selling short-term bills and buying long-term debt.
Most members of the FOMC shared this goal. They differed about how to achieve it. The Board, led by Eccles, preferred to increase reserve requirement ratios, use selective credit controls to ration credit, and require banks to hold secondary reserves of government securities. Influenced by political pressures from the Treasury, and reinforced by his own beliefs, Eccles hoped to control credit expansion without increasing interest rates. The reserve banks, particularly New York, acquiesced in some of these policies or supported them. They argued correctly that none of these actions would be effective unless interest rates rose. Although New York urged a slow and deliberate policy, it took advantage of opportunities to change short-term rates when they arose in December 1947, June 1949, and after the start of the Korean War.
Policy differences between New York and the Board have some aspects of a repeat, in different form, of the policy dispute in 1928–29. As before, the Board most often favored some type of credit or monetary control that did not require higher interest rates. New York argued for higher interest rates as a necessary step to control money growth and inflation. And as in 1928–29, the Federal Reserve ignored deflation in 1948–49.
Both the Board and the reserve banks had political and economic concerns. The main political concern was to avoid an open fight with the Treasury. The two main economic concerns were (1) that an increase in interest rates large enough to prevent postwar inflation would run the risk of reproducing the 1920–21 deflation and deep recession and (2) the mistaken belief that historically low nominal interest rates indicated an easy monetary policy. As in 1928–29, the Board and the FOMC paid less attention to money growth and price changes than to nominal interest rates.
Eccles and several of the Board’s economists, like many private sector economists, did not believe that small changes in interest rates had much effect on economic activity and prices. In the 1930s, Eccles accepted the phrase “pushing on a string” to describe the alleged impotence of expansive policies. In the postwar years he had similar reservations about contractive policies, unless carried far enough to run the risk of deflation. In both periods many economists, influenced by early Keynesian analysis, shared this view. There was no attempt to reconcile the conflicting beliefs that monetary policy was weak or impotent with the expressed concern that allowing interest rates to rise would risk deflation and depression. And along with these divergent views, a third view was often repeated: that deflation must inevitably occur to purge the effects of the previous inflation.
Before the start of the Federal Reserve System, bankers expressed concern about political dominance by a Board located in Washington. The Banking Act of 1935 shifted power from the reserve banks, particularly New York, to Washington. The sixteen years from 1935 to 1951 did little to dispel the early concerns. Resistance to the Treasury was stronger in the reserve banks, particularly New York, than in Washington. After Thomas B. McCabe replaced Marriner Eccles as chairman in 1948, Allan Sproul was able to gradually increase New York’s influence over the direction of Federal Reserve policy and, three years later, to insist on an end to pegged interest rates and a restoration of some of the System’s independence. But Sproul too was cautious, unwilling to push hard for independence until the threat of Korean War inflation made action seem imperative and support in Congress made success more likely.
Restoration of independence was not simply a victory for the reserve banks over the Board. Eccles played an important role, as did Senator Paul Douglas and other members of the congressional banking committees. High-handed actions by the Treasury and President Truman helped to marshal support for the System in the financial press and in Congress.
The FOMC had little to do during the long period when open market policy remained subordinate to Treasury debt management. The committee spent much of its time giving advice to the Treasury about the types of debt to sell, advice that the Treasury usually ignored. The Board also recommended tax changes, wage and price controls, and other policies unrelated to its mission. Within the System, the role of the account manager changed. Since the account manager had more information about the debt markets than the members did, his influence increased. Often he took the lead, making recommendations to the FOMC and, beyond his role, recommending changes in reserve requirement ratios. This shift in the manager’s role remained for years after the accord.
The long period when the FOMC was inactive did not eliminate the Riefler-Burgess doctrine as a guide to policy action. When the FOMC became more active, it reverted to its earlier operating procedure. Riefler was again at the Board, and Sproul used that framework to discuss monetary policy. Discussions at the FOMC before the accord, and the accord itself, refer to future policy actions as intended to “immediately reduce or discontinue purchases of short-term securities and permit the short-term market to adjust to a position at which banks would depend upon borrowing at the Federal Reserve to make needed adjustments of their reserves” (Krooss 1969, 4:3056).
Monetary policy was not the only friction between Washington and New York. Eccles and Sproul disagreed about the International Monetary Fund. The New York bank opposed the multilateral system developed at Bretton Woods. It favored a key currency system based on the dollar and the British pound. Although the Board had no role in the design of the postwar international system, the Treasury gained its support by appointing Eccles to the delegation for the Bretton Woods meeting.
The war opened a wide gap in the relative size and strength of the United States economy. Net exports and, despite controls, capital inflow continued the gold inflow that the war and the lend-lease program of allied war finance interrupted. Low inflation—even deflation—budget surpluses, and an expanding economy attracted foreign investment. Recovery in Europe, foreign aid policies like the Marshall Plan, and the start of the Kor
ean War reversed the inflow. By 1950 the deflated price of gold was back to the predevaluation level. Large outflows began in 1950. For the next two decades, gold and the balance of payments deficit would become matters of increased attention and concern.
eight
Conclusion: The First Thirty-seven Years
Monetary history reveals the fact that folly has frequently been paramount; for it describes many fateful mistakes. On the other hand, it would be too much to say that mankind has learned nothing from these mistakes.
—Wicksell 1935, 4
The Federal Reserve began operations in 1914 as a peculiar hybrid, a partly public, partly private institution, intended to be independent of political influence with principal officers of the government on its supervisory board, endowed with central banking functions, but not a central bank. Each of the twelve semiautonomous reserve banks set its own discount rates, subject to the approval of the Federal Reserve Board in Washington, made its own policy decisions, and set its own standards for what was eligible for discounting. Even branches of reserve banks initially had some independent powers.
The new system had two principal monetary powers. It could buy and sell gold, thereby changing interest rates and money, and it could set the rate at which member banks discounted eligible paper. Other activities and responsibilities included centralizing the country’s gold reserve, developing a domestic market for bills of exchange, acting as lender of last resort in a crisis, and eliminating large seasonal increases in interest rates during the autumn, when the agricultural harvest moved through the commodity markets.
A History of the Federal Reserve, Volume 1 Page 105
