In the early years, 1914–16, the Federal Reserve’s portfolio remained small. The Federal Reserve’s nongold assets were too small to offset gold inflows. Since the United States was on the gold standard the rules required higher prices, so it is not clear that a larger portfolio would have been used at the time to cancel the effect of gold flows on money and prices. Principal gold standard countries had suspended the standard during wartime, but the belligerents and others used gold to pay for imports, and some foreigners sought safety in dollar securities.
Putting aside these early years, table 1.1 summarizes outcomes in the years 1917 to 1951. The table shows that in this period the country rarely experienced price and output stability. The Treasury dominated the Federal Reserve more than half the time. The seven years of stability, 1922–29, are exceptional, not the rule.
The founders of the Federal Reserve expected the new institution to follow gold standard rules. Gold movements would determine long-run price changes. Chart 1.3 shows that the stock of monetary gold rose in the 1920s, particularly from 1920 to 1925, when the dollar was the only major currency convertible into gold. Restoration of the international gold standard increased the demand for gold, contributing to the gradual fall in the United States price level after 1926. Federal Reserve officials worried that the gold flow would reverse. They were reluctant to monetize inflows or permit prices to rise. Despite the gold inflow, prices fell in the 1920s.
Chart 1.3 shows the dollar value of the monetary gold stock. The vertical line at the beginning of 1934 shows the revaluation of gold to $35 an ounce (devaluation of the dollar against gold). At the $35 price, gold flowed to the United States at a rapid rate that slowed during the 1937–38 recession but accelerated after the recession as Europe moved toward war.
The monetary gold stock increased nearly eightfold during the thirty-seven-year period, using troy ounces to abstract from the 1934 revaluation. At its start in late 1914, the Federal Reserve held 74 million ounces of gold, valued at $1.5 billion. After 1934 United States citizens and corporations could not own gold. Only the Treasury held gold. At the peak in 1949 the Treasury held more than 700 million troy ounces, valued at over $24 billion.
The main contribution to this growth came between 1934 and 1939, following the revaluation. The rising gold stock was the dominant force increasing money and credit, keeping nominal interest rates low, and promoting economic expansion with modest inflation. Rising income, rising stock prices, low inflation, and concerns about a European war sustained the gold inflow until 1941.
Potential inflation, driven by gold inflows, was the Federal Reserve’s main concern in the 1930s. Gold certificates representing the monetary gold stock became the largest asset on the System’s balance sheet. Bank reserves rose rapidly; banks held large stocks of excess reserves. As in 1914–17, the Federal Reserve was concerned that its nongold assets were too small to counter the inflationary effects of the gold inflow. In 1936 it persuaded the Treasury to sterilize the gold inflow, ending the increase in reserves. And at about the same time, it used its newly acquired power to double reserve requirement ratios over a nine-month period in 1936–37. These actions contributed to a new, severe recession in 1937–38.
Chart 1.4 shows the sudden reduction in monetary base growth in 1936–37 resulting from these policy errors. The rate of base growth fell from 19 percent in December 1935 to –11 percent a year later. As chart 1.4 shows, the reversal, when it came, was just as sudden and sharp. The Federal Reserve reversed part of the increase in reserve requirement ratios, and the Treasury stopped sterilizing gold inflows. The only declines comparable to the 1937 experience came in 1920–21 and in 1946. Both contributed to severe postwar recessions.
The monetary base is the amount of reserves and currency supplied by the Federal Reserve.4 The principal counterparts or sources of the base are gold and Federal Reserve credit, the latter consisting mainly of member bank discounts and Federal Reserve purchases of government securities. Growth of the monetary base shows the monetary actions that the Federal Reserve permits or takes.
4. Reserves are adjusted for changes in reserve requirement ratios.
The data in chart 1.4 suggest the central role of monetary actions in this period. As noted, the economic contractions of 1920–21 and 1937–38 followed monetary contractions. Although committed to restoration of the gold standard in the 1920s, the Federal Reserve followed a deflationary policy that drained gold from other gold standard countries. In the first half of the 1940s, the Federal Reserve helped to finance World War II by purchasing government securities at fixed interest rates. It continued this policy after the war ended. Although the Federal Reserve complained that it had become an “engine of inflation,” the monetary base fell in the early postwar years. By late 1948 the economy was in recession with falling prices, as shown in earlier charts.
Interest rates are the more conventional way to describe monetary policy actions. Chart 1.5 shows short- and long-term interest rates for most of the period. Long-term rates decline over the entire period with brief interruptions, notably in 1931, following Britain’s departure from the gold standard. Most subsequent movements are relatively small.
Both short- and long-term rates are highest in 1920–21. This was the Federal Reserve’s first attempt to use monetary policy to control inflation. High interest rates were very unpopular with Congress and large parts of the public. The Federal Reserve did not raise rates to this level again for a generation.
Changes in short-term rates from 1922 to 1930 show the beginning of active monetary policy. Short-term rates are highest at the peak of expansions in 1923, 1926, and 1929 and lowest near business cycle troughs in 1924 and 1927. The modest reductions in interest rates in 1927 took on importance well beyond the size of the change. Under the influence of Benjamin Strong, the Federal Reserve lowered interest rates, in part to help Britain remain on the gold standard. Critics within and outside the System blamed the reduction for the subsequent stock market boom and the depression that followed.
Policy changed after 1932. With interest rates near zero, Federal Reserve officials believed that policy was “easy” and that additional monetary ease would not contribute to expansion. During World War II the short-term interest rate remained at 0.375 percent until November 1947. The Federal Reserve would not change rates without Treasury approval until the March 1951 accord.
The Treasury’s reluctance to let interest rates rise after World War II was the traditional reluctance of a large borrower to experience an increase in interest cost. The Federal Reserve had the same problem after World War I. To the treasury secretaries in both periods the debt seemed very large, and it was compared to their previous experience.
Andrew Mellon became treasury secretary after the 1920 election. During his term of office, he retired debt and reduced tax rates. Government debt declined from 34 percent to 16 percent of GNP and from $25 million to $16 million. By 1932 the debt to GNP ratio was above its wartime peak, mainly the result of a decline in GNP. Chart 1.6 shows these data.
New Deal deficits seemed large to contemporaries accustomed to Mellon’s policy and earlier peacetime policies. The chart shows that the debt to GNP ratio was approximately constant from 1933 to 1941 at about 40 percent. Wartime finance brought the debt to nearly $300 billion by the end of 1946, a peak of 129 percent of GNP. The large outstanding stock of debt raised new fears about the operation of monetary policy. A large literature claimed that higher interest rates would cause losses to creditors (debt owners) and that such losses would have severe negative effects on the economy. Arguments of this kind became popular in government, but not just in government. This literature neglected to mention either the gains that debtors received or the losses that creditors would experience if inflation resulted. The argument became part of the case against higher interest rates and an end to the wartime pegging policy.
PLAN OF THE VOLUME
Central banking institutions developed and spread in the nineteenth century. Understanding
of the role of money and monetary institutions followed. Chapter 2 traces major developments in central banking and monetary theory using the work of Henry Thornton, Walter Bagehot, and Irving Fisher. If the Federal Reserve had followed the policies these authors advocated, it would have avoided the most serious and socially costly errors.
The rest of the volume divides the thirty-seven-year history into five chapters. Each chapter covers a major event and the environment in which it occurred. Chapter 3 treats the founding of the System and the early years. The conflict over political versus financial control that delayed the Federal Reserve’s founding began almost immediately. Problems of war finance soon took precedence. During the war, the Treasury’s financial demands controlled monetary policy. After the war, the Federal Reserve faced the problem of freeing itself from Treasury control. Once freed, the System raised interest rates to end inflation. It was more than successful, but at a high cost. Prices and output fell sharply in the 1920–21 recession.
The 1920–21 recession and deflation constituted an important milestone. The severe contraction was costly economically and politically. The severity of the decline raised doubts about the applicability of the operating principles in the Federal Reserve Act. Chapter 4 traces the development of a new framework and the beginning of a more activist role. Instead of depending on banks’ decisions to discount or repay borrowings, the new approach used open market operations to force banks to borrow or repay.
Open market operations required the reserve banks to work together. Portfolio decisions remained with the directors of the individual reserve banks, but the New York reserve bank, aided by a System committee, guided and implemented System decisions to purchase and sell. The Federal Reserve Board had supervisory responsibility only.
The new procedures radically changed the System’s original structure. The reserve banks sacrificed part of their autonomy to the System committee. Control of operations shifted toward the New York bank. Members of the Board resented New York’s increased authority, but they were powerless to combat it. These substantive differences combined with personal antipathies to heighten conflict between Benjamin Strong of the New York bank and members of the Board, particularly Adolph C. Miller. After Strong died, the conflict contributed to the delay in responding to the rapid expansion in the first half of 1929.
Chapter 4 ends at the start of the Great Depression. Chapter 5 follows the decisions and reasoning from meeting to meeting during the depression. It shows why the Federal Reserve remained passive through most of the decline and why it undertook major purchases in 1932 but stopped purchases before recovery was under way. The chapter ends with the financial collapse in March 1933.
President Franklin Roosevelt took office at the climax of the financial collapse. The new administration transformed many institutions, including the Federal Reserve. At the time, the dominant explanation regarded the depression as an inevitable consequence of speculation financed by speculators’ easy access to credit. Legislation separated commercial and investment banking and gave the Federal Reserve authority to set stock market margin requirements. In these and other ways, Congress absolved the Federal Reserve of responsibility for the debacle.
Legislation also corrected deficiencies in the 1913 Federal Reserve Act. That act barred the use of government securities as collateral for the currency. In 1932 the Glass-Steagall Act ended the prohibition as a temporary measure that later became permanent. The Banking Act of 1935 settled the long dispute over the locus of power by greatly increasing the Board’s power and by giving the Board a majority on the open market committee. The act ended the reserve banks’ ability to control their portfolios independently, creating the structure we know today.
Treasury requirements and gold inflows were major influences on money growth and interest rates from 1933 to 1941. The Federal Reserve’s main decision was to double reserve requirement ratios in three steps between August 1936 and March 1937. These actions, along with the Treasury’s decision to sterilize gold inflows, produced a steep monetary contraction. The 1937–38 recession followed.
Chapter 6 reports these events and the reasoning that produced them. The chapter also develops the attempts to reestablish an international financial system at the London Monetary and Economic Conference in 1933 and in the Tripartite Agreement of 1936 to limit exchange rate changes.
President Roosevelt called his programs the New Deal. Economic policy did not follow a consistent strategy. Before World War II, New Deal programs and actions had not restored prosperity or ended high unemployment. Wartime expansion achieved what New Deal policies did not.
The war and early postwar years (chapter 7) bring the volume to 1951. As in World War I, the Federal Reserve took an active part in administering wartime regulations and selling bonds. Its pledge to maintain a “pattern of rates” in effect fixed maximum rates at all maturities. The pledge ended any possibility of using monetary policy to control wartime or postwar inflation. In the postwar years to 1951, Federal Reserve officials became increasingly unhappy with the fixed pattern of interest rates, but they did not believe they could change policy without Treasury consent or support in Congress.
Chapter 7 also traces the development of postwar domestic and international legislation such as the Full Employment Act of 1946, the Bretton Woods Agreement establishing the International Monetary Fund and the World Bank, and the United States decision to finance European recovery. The chapter ends with the financing of the Korean War and the threat of renewed inflation that pushed the Federal Reserve into open conflict with the Treasury and brought about the March 1951 accord.
The concluding chapter summarizes the main findings and the lessons for monetary theory and policy.
two
Central Banking Theory and Practice before the Federal Reserve Act
Modern central banking theory began to develop in the eighteenth and nineteenth centuries under the gold standard. Because of the dominant position of England in trade, finance, and economic theory, much of the development took place either at the Bank of England or in response to its actions. The designers of the Federal Reserve System accepted a theory of central banking and a framework for policy operations that reflected the prevailing practices of European central banks, particularly the Bank of England. More important, the developers of the Federal Reserve System in the 1920s imported many of their aims and much of their understanding from the pre–World War I Bank of England. The blending of these imported elements with practices or principles from United States experience created the broad framework that guided Federal Reserve policy operations at its start and for many years after.1
It would be comforting to find in the history of central banking a record of steady progress and orderly development from earliest antecedents to present knowledge. The facts are different. The discussion reached a high point very near its start in the first decades of the nineteenth century. Thereafter, the level of discussion drifted lower. Some of the subtle points were lost and, more important, the focus of the discussion shifted.
At the start of the nineteenth century Henry Thornton, building on his own earlier work and pieces of analysis taken from Smith, Locke, and Hume, developed some guiding principles for the conduct of monetary policy from an analysis of the relation of money, economic activity, prices, and balance of payments under fixed and flexible exchange rates. This framework was lost between David Ricardo’s emphasis on long-run comparative statics and the concern of men of affairs with short-term fluctuations in market variables. After two nineteenth-century experiments with what they regarded as the essential principles of Ricardian monetary theory, bankers and men of affairs became skeptical about the applicability of economic theory to their problems. Early work was ignored or lost.
1. This refers to the economic framework, not the political and administrative framework. The latter is perhaps uniquely American in its blend of public and private enterprise, of centralism and decentralism. A brief description of some of the domest
ic political forces shaping the Federal Reserve Act is in Dunne 1963.
At their best, as in Walter Bagehot’s Lombard Street, the discussions by men of affairs of the principles by which monetary policy should be conducted reached a very high level. Strict adherence to these principles would have avoided some of the worst errors of monetary policy in later years. Nevertheless, neither Bagehot nor those who followed his lead attempted to combine the theory of central banking or monetary policy with what is now called macroeconomic theory, as Thornton had done. Until Wicksell, Fisher, Marshall, Hawtrey, and later Keynes and Friedman reopened the discussion, very little was done to extend Thornton’s analysis or to develop an alternative framework connecting monetary policy to output, employment, prices, and balance of payments. Monetary policy—or bank rate policy as it came to be known in England—was assigned the task of regulating the gold flow.2
Why did Thornton’s rich and promising analysis degenerate first into a Bank of England policy of using bank rate mainly to protect the gold reserve and later into the Federal Reserve’s concern for short-term market interest rates and money market conditions? Three reasons appear to be important. First is the “automatic” gold standard. The gold standard gave monetary policy a clear and definite objective. Writers such as William Jevons and Alfred Marshall wanted to make improvements in the standard to eliminate or reduce procyclicality of money, but they paid little attention to implementation. Second, much of Thornton’s analysis considers an economy with an inconvertible currency. After the return to the gold standard, the continued relevance of other parts of his work was overlooked. Third, Ricardo and many of his followers not only failed to address the questions uppermost in the minds of the practitioners but failed to make clear that they were not addressing these questions. Ricardo’s analysis is almost entirely long-run comparative statics, and his policy recommendations consisted mainly of a set of rules for restoring and maintaining convertibility of pounds into gold at a fixed exchange rate. Important as is his work for economic theory, it gave very little guidance to the Bank of England on the issues of greatest concern to its directors. The governors and directors of the Bank of England were concerned with the profits of the bank, the avoidance of panic, and the appropriate response to short-term changes—for example, an increased demand for borrowing by the country banks or from banks abroad.
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