A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  His proposals show the absence of careful analysis at the time. Eccles often favored higher reserve requirement ratios, secondary reserve requirements to force banks to hold more (low yield) Treasury bills, and controls requiring higher down payments and shorter duration of consumer loans.

  With interest rates fixed (or pegged), increases in reserve requirement ratios transferred incomes from banks to the government. Banks sold securities to meet the additional requirement. To keep interest rates unchanged, the Federal Reserve supplied the additional reserves by buying the securities that banks sold.

  Congress never agreed to secondary reserve requirements. Such requirements would force banks to hold more government securities, reducing their profits. With unchanged growth of base money and government debt, the total supply of credit would remain unchanged. Portfolio composition of the principal institutions would differ. Banks would own more Treasury bills; other lenders would acquire loans that the banks would forgo.

  The Federal Reserve was not alone in these errors. Many in the academic profession, and other economists, made similar statements.

  The Federal Reserve had some notable successes during its first four decades. Evidence of success and acceptance was the agreement in 1927 to replace the Federal Reserve’s twenty-year charter with a permanent one. The new charter evoked little of the passion and attention so much in evidence in 1913. The relatively stable price level and stable interest rates from 1922 to 1929 lay behind acceptance of the Federal Reserve and its increased congressional support. Strict adherents to the real bills doctrine criticized the use of open market operations to supplement discounting of real bills. They saw open market operations as a departure from the letter and spirit of the law. These criticisms found little congressional support as long as the System avoided major recessions or a return of financial crises accompanied by failures and surging interest rates.

  Before 1914, United States interest rates rose sharply during the scramble for liquidity that became a standard feature of a financial panic. The Federal Reserve avoided financial panics between 1914 and 1928. Interest rates rose much less in the 1920–21, 1923–24, and 1926–27 recessions than in the 1890s or in 1907–8. Also, before 1914 interest rates had a large seasonal element. The Federal Reserve removed the seasonal swing using discount policy and acceptance and open market purchases. This fulfilled one of the founders’ main reasons for creating the institution.

  The Federal Reserve helped to finance both world wars; it provided credit and money by lending to commercial banks at fixed interest rates or by open market purchases. In addition, the System acted as the principal bond salesman for the Treasury, using its network of regional and branch banks, and its relations with the leading commercial banks, to place the bonds. The Federal Reserve’s decision to allow banks to profit from bond sales to the nonbank public gave banks a powerful incentive to cooperate in the financing.

  During the 1920s, the System undertook pathbreaking research and the development of new statistical series to support its work. The absence of an operative gold standard immediately after World War I, and widespread criticism of discount policy and discount rates in the 1920–21 recession, encouraged consideration of operating procedures and market signals about the need for policy action. Concern for market signals, in turn, required the development of new data series and fostered the use of new analytical techniques. By the mid-1920s, System economists had constructed measures of production, inventories, department store sales, and other variables. These are the forerunners of the data series that markets and policymakers rely on to this day. Developing these series and combining them required skillful use of index number theory.

  In its 1923 annual report, the System discussed a general framework that sought to reconcile the passive stance implied by the real bills doctrine with more active use of open market operations. The new framework tried to achieve the Bank of England’s control of discounting without relying very much on the discount rate. Also, it tried to satisfy both advocates of the real bills doctrine and their opponents. Subsequently, economists at the Board and the New York bank developed a more explicit framework to guide policy decisions. This framework, though based on observations by many people, was mainly the work of Winfield Riefler and W. Randolph Burgess. Their work implied that the Federal Reserve could control the volume of member bank borrowing with fewer and smaller changes in interest rates. Open market purchases supplied reserves and encouraged banks to repay borrowing, offer more loans, and reduce interest rates; open market sales drove banks to borrow, restrict lending, and raise interest rates. The emphasis satisfied real bills advocates. Quantitative control through the use of open market operations satisfied Strong and others who no longer believed that the quality of credit restricted the quantity.

  The new framework brought together open market operations, discounting, discount policy, and credit expansion as part of a theory of central banking. The theory required the strong proposition that banks did not borrow to profit from higher market rates. This proposition removed the need for an unpopular penalty rate, set above the rate on prime commercial paper. Experience in 1928–29, when the Federal Reserve tried to control the volume of discounts without increasing the discount rate, rejected the proposition but failed to change it. Federal Reserve officials continued to claim that banks did not borrow for profit. They found it necessary, however, to inform bankers that borrowing was a privilege and not a right of membership and to impose administrative restrictions to limit the amount and duration of borrowing. This was a long step away from the original idea that the Federal Reserve’s main function was to discount for member banks.

  The Riefler-Burgess framework combined banks’ reluctance to borrow with another proposition that did not distinguish between individual banks and the banking system: “Banks disliked being continuously in debt and hence tended to contract credit when the level of indebtedness was increased and to expand credit when the level of indebtedness was reduced. Because of the tradition against continuous borrowing, when the Federal Reserve System sold securities, the resulting increase in indebtedness tended to cause banks to control credit” (Subcommittee on General Credit Control and Debt Management 1951, 283).

  This reasoning does not explain why open market sales would contract total bank credit. Why didn’t other banks borrow when an individual bank repaid its indebtedness? The proper answer would have required the Federal Reserve to develop a framework linking its operations to market interest rates and the supply of bank reserves or monetary base.

  The tenth annual report and the Riefler-Burgess framework covered over, but did not resolve, differences between opponents and proponents of the real bills doctrine. The conflict emerged first in the 1924 and 1927 recessions when, under the leadership of Benjamin Strong of the New York bank, the System expanded credit and the monetary base both to help the British and to encourage recovery from domestic recessions. The conflict became more open in 1929, when the Board wanted to control borrowing by discouraging speculative credit and New York and some other reserve banks wanted to raise the discount rate.

  The Riefler-Burgess framework retained a central role in the Federal Reserve’s analysis of monetary developments until the 1950s. The staff adjusted the framework to reflect new developments, notably the increase in excess reserves during the 1930s.

  The 1923 annual report, books by Riefler and Burgess, speeches by Strong and Adolph C. Miller (a prominent Board member from 1914 to 1936), and other statements and publications moved toward greater openness about procedures and analysis. Nineteenth-century central banks were secretive about what they did and why they did it. Gold standard rules were known, of course, but central banks often did not follow the rules automatically. One of Bagehot’s (1962) main criticisms of the Bank of England in the nineteenth century is that it failed to preannounce its policy response to financial panics. The movement toward transparency was slow, but by the end of the twentieth century, all leading central banks had
moved decisively toward greater openness.

  Other major accomplishments included extension of the par collection system, development of the payments system, and a national money market. Interest rates and discount rates became more uniform within the country as banks’ size increased and new money market instruments were developed. The founders failed in their attempts to create a broad national acceptance market to replace reliance on stock market call loans as a money market instrument. By the 1930s, Treasury bills and certificates served this function. Wartime increases in government debt made the government securities market the market of choice for short-term reserve adjustment. By the 1950s, the government securities market and the market for federal funds (bank reserves) achieved one of the founders’ goals in a way they did not envisage. These markets replaced the call money market as the market in which banks adjusted reserve positions. Monetary operations and bank adjustment were freed from dependence on stock market activity.

  The lasting achievements of the early years include the development of a high-quality professional staff. Although research on central banking lagged in the 1930s and 1940s, Federal Reserve staff pioneered in research on topics such as the measurement of government deficits and the effects of budget deficits on the economy. In areas such as supervision, regulation, and banking law, Federal Reserve staff made important contributions. Two notable examples are legislation closing the banking system for the 1933 bank holiday and the Banking Act of 1935.

  In the early years, international monetary policy was a central bank responsibility. Central bankers dealt with their counterparts abroad. In the 1920s the New York reserve bank and its governor, Benjamin Strong, negotiated and granted loans to foreign central banks to help restore the gold standard and to coordinate actions. Governments borrowed in the marketplace, assisted by investment bankers.

  Although central banks attempted policy coordination, the Federal Reserve was explicit that it would not change its course for the benefit of another country if the change required inflation or deflation at home. This restricted the role of coordination. Some economists assign a large role to insufficient policy coordination. They claim that governments could have maintained the gold standard and prevented worldwide deflation and depression by acting together in the 1920s and 1930s.

  This claim neglects exchange rate misalignment, particularly the misalignment of real exchange rates. Lending and borrowing or simultaneous intervention in exchange markets had a limited role at best. In the 1920s, countries on the gold standard had to accept inflation or deflation to adjust real exchange rates. Surplus countries would not inflate; deficit countries were reluctant to deflate after the mid-1920s. The remaining solution was to devalue or revalue against gold and other currencies. Britain left the gold standard in 1931. Other countries followed.

  In the 1930s, the Treasury replaced the Federal Reserve as the principal negotiator of international financial agreements. Secretary Henry Morgenthau signed the Tripartite Agreement with Britain and France. The agreement sought to stabilize exchange rates between the three countries, but again real exchange rates were misaligned, and countries followed independent policies. French policy, especially, was inconsistent with the agreement, necessitating devaluations of the franc that violated the spirit of the agreement.

  Again in the 1940s, the Treasury negotiated an international monetary agreement. The Bretton Woods Agreement attempted to formalize international policy coordination. Member countries agreed to fix exchange rates but retained the right to devalue (with international approval) to correct structural imbalances. The agreement tried to reconcile domestic and international stability and provide a means by which surplus countries could lend to deficit countries.

  The agreement divided the Federal Reserve. The Board sided with the Treasury, favoring the agreement. The leaders of the New York bank opposed. They preferred a return to the gold standard, not adjustable exchange rates. Neither side had much influence on the agreement. The Treasury took control and retained it.

  INDEPENDENCE AND CONTROL

  The Federal Reserve’s independence was so well established in the first twenty years of its existence that President Hoover was reluctant to even ask its advice during the financial crisis at the end of his administration. Within a few years, this independence was lost. From 1934 to 1951, the Treasury Department severely restricted Federal Reserve actions. When William McChesney Martin Jr. became chairman of the Board of Governors in 1951, one of his tasks was to reestablish the independence of the Federal Reserve System from the executive branch, particularly the Treasury.

  Independence

  One of the anomalies of the 1930s and 1940s is that the Treasury had more influence over the Federal Reserve after the secretary left the Board. Secretary Morgenthau permitted Congress to eliminate his statutory position as chairman of the Federal Reserve Board, but he acquired another means of influencing the Federal Reserve. He held most of the profit from devaluing the dollar against gold in the Exchange Stabilization Fund. He used the fund, and other Treasury trust funds, to buy and sell gold or foreign exchange, and he could threaten the Federal Reserve with his power to supply reserves and lower interest rates. Occasionally he did just that.

  Morgenthau’s threats and influence were not the only reason the System failed to resist Treasury control. Eccles believed that monetary policy was powerless, since interest rates were at historically low levels. His greater interest was fiscal policy. He wanted to advise the president and participate in budget and legislative decisions. His principal interest in Federal Reserve independence in the 1930s surfaced when Morgenthau threatened to act in place of the Federal Reserve.

  Wartime Treasury influence or control had a different origin. The Federal Reserve agreed in 1942 to finance the war at low nominal interest rates, as central banks traditionally have done. Regaining independent authority to set interest rates after World War II proved difficult, just as it had after World War I. Regaining independence of decisions and actions required political support from the administration, the Congress, or the public. Political support began to form in 1949 under the leadership of Senator Paul Douglas. Support strengthened after the Korean War started in 1950. Heavy-handed action by Treasury Secretary John W. Snyder and support for an anti-inflation policy in Congress helped the Federal Reserve get an agreement that allowed interest rates to rise provided they rose slowly during the transition to greater independence.

  Independence was never thought to be absolute. Independence prevented an administration from deciding unilaterally to use monetary expansion to gain temporary political advantage or to finance too much of the budget at the central bank. Allan Sproul, president of the New York reserve bank from 1941 to 1956, recognized the nuances hiding in the term “independence”:

  I don’t suppose that anyone would still argue that the central banking system should be independent of the Government of the country.1 The control, which such a system exercises, over the volume and value of money is a right of Government, and is exercised on behalf of Government, with powers delegated by the Government. But there is a distinction between independence from Government and independence from political influence in a narrower sense. The powers of the central banking system should not be the pawn of any group or faction or party, or even any particular administration, subject to political pressures and its own passing fiscal necessities. It is clear that in war or in any other great emergency, the policy of the central banking system must support the national plan of action. It seems to me equally clear that in less emergent circumstances it is wise for government to set-up barriers or buffers of protection of the central banking system from narrow political influence. (Letter to Robert R. Bowie, Sproul Papers, Memorandums and Drafts, September 1, 1948, 2)

  1. The European Monetary System suggests that this statement is no longer true.

  This statement of general principles seems well crafted. However, it does not say what happens if the government and the Federal Reserve disagr
ee about the importance of the emergency. Secretary Snyder argued that “the President has the right, and the duty, to discuss disputes without attempting to dictate to the Board of Governors but by full and complete consultation with the Board” (Subcommittee on General Credit Control and Debt Management, Answers to Questions 1951, 31).

  The secretary also favored creating a “discussion group” consisting of the secretary of the treasury, the chairman of the Board of Governors, the director of the budget, the chairman of the Council of Economic Advisers, and the chairman of the Securities and Exchange Commission (ibid., 31).2 The Federal Reserve’s statement did not mention a coordinating body. It favored a more independent role. When conflicts arise “each agency involved shares the responsibility for finding ways to resolve the conflict” (264).

  The meaning assigned to “independence” did not progress much subsequently. Resolution of its conflict with the Treasury did not settle what a central bank should do if the government ran large or regular deficits in peacetime. FOMC members recognized that Congress approved the spending plan and deficit finance. A central bank could not, and they believed should not try to, reverse congressional decisions. But that appeal to democratic rule did not answer the question, How much should the central bank raise interest rates, or permit them to increase? It took years of sustained inflation to force attention to that question. In the 1950s the Federal Reserve hoped it could avoid the issue by joining a coordinating body of the four leading economic agencies known as the quadriad during the Kennedy administration. The quadriad continued through the early 1970s until replaced by less formal arrangements.