Table of Contents
| Foreword | |
| Preface | |
| 1 | Introduction | 1 |
| 2 | Central Banking Theory and Practice before the Federal Reserve Act | 19 |
| 3 | In the Beginning, 1914 to 1922 | 65 |
| 4 | New Procedures, New Problems, 1923 to 1929 | 137 |
| 5 | Why Did Monetary Policy Fail in the Thirties? | 271 |
| 6 | In the Backseat, 1933 to 1941 | 415 |
| 7 | Under Treasury Control, 1942 to 1951 | 579 |
| 8 | Conclusion: The First Thirty-seven Years | 725 |
| References | 747 |
| Data Sources | 761 |
| Index | 765 |
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A History of the Federal Reserve
By Allan H. Meltzer University of Chicago Press
Copyright © 2003- Allan H. Meltzer
All right reserved. ISBN: 0226519996
ONE - Introduction This book is the biography of an institution, the Federal Reserve System, much of it told by its principals. The Federal Reserve is now the United States' powerful central bank. The founders did not intend to create either a central bank or a powerful institution; had they been able to foresee the future accurately, they might not have acted.
Institutions, no less than individuals, change as they mature and as the conditions that led to their creation change. In 1913 the United States was a developing country, with agriculture its largest occupation. The enormous shift in political and economic power and responsibility toward the United States that occurred in the twentieth century was at an early stage. The founders did not design or contemplate the Federal Reserve System we have today. They hoped to reduce financial instability, improve the quality of financial services, and strengthen the payments system.
The leading central banks in 1913 were privately owned institutions vested with responsibility for such public activities as providing currency, maintaining domestic payments systems and international payments, and serving as lenders of last resort in periods of financial disturbance following threat of failure by major banks orfinancial institutions. Depositors were not insured against these risks, so the threat of financial disruption set off a shift from bank deposits to gold or currency issued by the government. The drain of gold and currency into private hands forced multiple reductions in bank assets and liabilities and threatened additional bank failures. Interest rates on short-term loans rose with the increased demand to borrow and the reduced supply of loans.
By the late nineteenth century, central bankers in principal countries understood that their responsibility to lend at times of financial panic made them unique. Their public responsibility to prevent widespread failure of banks and financial institutions that would otherwise remain solvent had to dominate the private interests of their stockholders. Private interests would lead them to contract lending, call loans, and shrink their balance sheets. Such action would force unneeded bankruptcies and increase the risks the public had to bear.
In a well-managed panic under the gold standard, the government suspended the central bank's requirement to pay out gold or silver on demand. Relieved of the requirement to hold a fixed percentage of the note issue in metallic reserves, the central bank could expand the currency issue to satisfy any increase in the demand for currency. Privately owned banks with good collateral could borrow from the central bank instead of calling loans, reducing deposits, and forcing economic contraction and bankruptcies. When the system worked in this way, financial panics ended quickly. The additions to currency returned to the banks as deposits. Banks repaid their loans at the central bank. As the central bank's liabilities fell, the government could restore the requirement to pay out gold on demand.
This system of public-private cooperation, combining suspension of gold payments with a lender of last resort facility, did not survive the economic, political, and financial disturbances later in the twentieth century. 1 By the 1950s, privately owned central banks had disappeared. Governments looked to public institutions to manage money and credit.
Public control of money raised a new issue or, more accurately, reopened an old one--preventing governments from abusing their power to create money and credit for temporary political advantage. After a decade or more of rising inflation, central banks became more independent of political control. By the end of the twentieth century, principal countries accepted two organizing principles--public ownership and "independence." The latter term has many different specific meanings; their common element is limitation of the government's power to use monetary policy to gain political advantage.
The structure of the early Federal Reserve System reflected these concerns about reconciling the public nature of the central bank's task with responsible control of money and credit. Writers and commentators at the time did not use terms like "public goods" and "central bank independence," but they recognized the problem of designing an organization with proper incentives. Fears that a privately owned bank would place the bank's interest above the public interest had to be reconciled with concerns about empowering the government to control money. In addition, the new institution was supposed to provide a currency with stable value, capable of expanding and contracting in response to demand; a payments system that efficiently transferred money and cleared checks in a growing national economy; and the services of a lender of last resort.2
President Woodrow Wilson offered a solution that appeared to reconcile competing public and private interests. He proposed a public-private partnership with semiautonomous, privately funded reserve banks supervised by a public board. The directors of the twelve reserve banks, representing commercial, agricultural, industrial, and financial interests within each region, controlled each bank's portfolio. The new rules sought to pool the country's gold reserves to strengthen the individual parts by making the total reserve available in a crisis. Reserve banks could lend gold to other reserve banks. No formal provision required coordination or cooperation of the various parts, however. In practice this meant that if the system was to serve as a lender of last resort, it would have to coordinate the actions of the semiautonomous reserve banks.
President Wilson was proud of his achievement.
It provides a currency which expands as it is needed and contracts when it is not needed, a currency which comes into existence in response to the call of every man who can show a going business and a concrete basis for extending credit to him, however obscure or prominent he may be, however big or little his business transactions. More than that, the power to direct this system of credits is put into the hands of a public board of disinterested officers of the Government itself who can make no money out of anything they do in connection with it. No group of bankers anywhere can get control; not one part of the country can concentrate the advantages and conveniences of the system upon itself for its own selfish advantage. (Wilson as quoted in Kettl 1986, 22)
LAW AND PRACTICE President Wilson's compromise resolved the immediate political conflicts and established an institution, but it left major economic and organizational issues unresolved. The structure of the new system did not concentrate decision-making authority and responsibility. A struggle for power and control broke out early and continued until resolved by the Banking Act of 1935.
Although the Federal Reserve was an independent agency from the start, in practice two political appointees--the secretary of the treasury and the comptroller of the currency--served as ex officio members of its board, with the secretary as board chairman.3 Before the 1930s, treasury secretaries rarely participated actively.
The 1935 act resolved this organizational anomaly by removing the secretary and the comptroller from the Federal Reserve Board. By that time the secretary took an active part in monetary policy and often influenced decisions. The legal change did not change the locus of decision-making power. The Treasury retained its strong influence until 1951.
The 1913 legislation did not ensure that the new system would respond to crises better than the old. On the recommendation of the officers, or on their own initiative, the directors of individual reserve banks could decide not to participate in System operations. The officers who headed the reserve banks were mainly bankers, the same types of individuals that had run banks or clearinghouses in the past. A change of location to the reserve banks was not enough to ensure that concern for financial stability would outweigh other interests. Some did not recognize that the lender of last resort had to place the interests of the financial system above the interests of the individual reserve banks.
Institutions both shape the society of which they are part and adapt to the dominant views in that society. Although the Federal Reserve was independent of the day-to-day political process, the public, acting through its representatives, could insist on structural changes or, without formally changing structures, demand that the Federal Reserve undertake new responsibilities or give up old ones. No institution can be independent of this pressure for change.
In the 1920s the reserve banks learned to coordinate actions that affected interest rates and the stocks of money and credit. A committee, led by the New York reserve bank, took responsibility for securities purchases and sales. The reserve banks adopted a formula for allocating the System's portfolio among the reserve banks. The reserve banks retained the right to reject participation.
The committee was an informal, extralegal arrangement. The Board, acting in its supervisory role, had to approve purchases and sales. The line between supervision and decision making was never clear, so the procedures irritated some Board members and became a source of friction. Friction increased as open market operations became the principal policy instrument.
The Banking Act of 1935 resolved this conflict also. Board members became members of the Federal Open Market Committee for the first time and held seven of the twelve seats and chairmanship of the committee. New York lost its leadership role. The New York bank did not regain a permanent seat on the committee until 1942. Since that time, the president of the New York bank has served as the committee's vice chairman.
The 1935 act permanently shifted the locus of power to the Board. The Federal Reserve became a central bank. The twelve regional reserve banks lost their semiautonomous status and much of their original independence.
The history of the Federal Reserve is in part the story of how social, political, economic, and technological changes affected the institution. The Federal Reserve began operations not in the heyday of the gold standard but near its end. At the time, acceptance of the standard by bankers, economists, leading businessmen, and others, at home and abroad, was so great that the standard seemed to many the social manifestation of a natural order. The standard did not work in the smooth, orderly way that its proponents imagined, but it provided an internationally acceptable means of payment and store of value (Bordo and Schwartz 1984). Debts were settled and payments made without conflict. The movement of gold balances and their effect on domestic prices gave the standard the automaticity for which it is famous.
The gold standard required countries to use monetary policy to keep exchange rates fixed and thus to allow prices, output, and employment to vary as required by the movements of gold and the country's exchange rate. Debtor countries had to pay their obligations in gold even if the price of gold rose relative to commodity prices, and creditors had to accept gold in settlement if commodity prices rose relative to the price of gold. Exporters and importers had reasonable certainty about the payments they would make or receive, since the rate of inflation remained bounded except in wartime, when the standard did not operate.
Efforts at international monetary coordination in the 1920s and 1930s foundered on the conflict between a fixed exchange rate and goals for inflation or employment. The Federal Reserve worked actively to restore the international gold standard in the 1920s, first in Germany, than in Britain, France, Holland, Poland, and elsewhere. It sought to maintain domestic price stability also. The two goals were incompatible once other countries fixed their currencies to gold. Coordination could not resolve the conflict. In the end, the Federal Reserve failed to achieve either its domestic or its international goal.
Again in the 1930s, Britain, France, and the United States renewed efforts to coordinate exchange rate policy. The new approach, known as the Tripartite Agreement, failed also. Countries would not subordinate domestic policy to the exchange rate goal.
The lesson drawn from these experiences by policymakers in Washington, London, and elsewhere was that previous attempts lacked effective mechanisms for enforcing coordination while achieving price stability. In 1944 the Bretton Woods Agreement sought to retain exchange rate stability as a goal of economic policy and to reconcile external and internal monetary stability. The agreement had fixed but adjustable rates in place of the rigid exchange rates under the gold standard. Countries did not have to reduce their price level to remove external imbalances. They could respond to permanent changes in competitive position by devaluing and could borrow from a central facility, the International Monetary Fund (IMF), when facing cyclical or temporary balance of payments deficits. The Fund would lend balance of payments surpluses to countries in deficit. In the early postwar years to 1951, the Fund did little. Most countries had wartime exchange controls and inconvertible currencies.
The Bretton Woods system of fixed but adjustable exchange rates, like the interwar gold exchange standard, tried to supplement the stock of gold by using foreign exchange--dollars and pounds--as reserve currencies. The two differed fundamentally. The stock of gold grew slowly; the stocks of dollars and pounds could grow without limit. Member countries accepted an obligation to treat the two alike. In practice this meant they had to accept inflation or appreciate their exchange rate.
The new system recognized a lasting change in beliefs about the responsibilities of government. As the population moved from rural to urban areas and from agriculture to manufacturing and service industries, governments assumed new responsibilities for social welfare and economic stabilization. The public in many countries would not accept the level of unemployment, deflation, or inflation needed to maintain the exchange rate. Adjusting the exchange rate seemed to be a less costly solution in 1944. At first the IMF had to approve exchange rate changes, but this restriction was not enforced.
President Wilson wanted the Federal Reserve to remain independent of government. Except for wartime and postwar subservience to the Treasury, independence developed in the early years and continued through the Harding, Coolidge, and Hoover administrations.
President Roosevelt and his treasury secretary, Henry Morgenthau, believed that the reserve banks represented bankers, many of whom opposed the president's programs. Devaluation of the dollar in 1934 gave the Treasury the financial resources to affect interest rates by buying securities, and it did so. Also, the Treasury sterilized and desterilized gold, affecting the rate at which monetary aggregates rose.
The Federal Reserve chairman, Marriner S. Eccles, expressed concern about the Treasury's actions but felt powerless to prevent them. And faced with relatively large gold inflows, he wanted to prevent inflation. Equally, he believed that at the interest rates prevailing during the 1930s, monetary policy could do little to stimulate expansion.
The head of the fiscal authority favored an activist monetary policy. The head of the monetary authority proposed more activist fiscal policies. Secretary Morgenthau wanted interest rates to remain low so that he could finance peacetime deficits and much larger wartime deficits. Monetary policy had the important role in his scheme of keeping market rates from rising. Eccles wanted larger budget deficits during the depression and large surpluses after the war.
Eccles, like Morgenthau, did not respect Federal Reserve independence. Although he disliked Treasury interference in monetary matters, he did little to prevent it. He advised and testified on a broad range of government policies including budget, tax, and housing policy. At times he opposed Morgenthau's policies, and on one occasion he proposed an excess profits tax that differed from administration policy.
A most unusual breach of independence occurred in January 1951 when the entire open market committee met in President Truman's office. The president and Secretary John Snyder wanted the Federal Reserve to maintain the long-term interest rate on Treasury bonds at the wartime peg. The president did not ask for a commitment, and the committee did not offer one. Nevertheless, meeting the president in the White House to discuss monetary policy was a long way from the tradition of independence that President Wilson had tried to foster.
IDEAS AND DECISIONS A history of the Federal Reserve is a history of the decisions made and the ideas that prompted them. The chapters that follow allow the participants to explain their actions, and the reasons for them, in their own words. These decisions produced very different results: a steep postwar recession in 1920-21, a period of stability in the 1920s followed by the Great Depression of the 1930s and, much later, the Great Inflation of the 1970s.
The men who made these decisions were not chicane or evil. They did not directly seek the outcomes that their decisions helped to bring about. They did not fail to stop the depression because they liked the outcome and wanted it to continue.
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