A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  Disputes ended when the United States entered the war. In December 1941 the Board adopted a statement assuring the public and the administration that it was “prepared to use its powers to assure that an ample supply of funds is available at all times for financing the war effort and maintaining conditions in the United States Government security market that are satisfactory from the standpoint of the Government’s requirements” (Minutes, FOMC, Board of Governors File, box 1433, April 4, 1950).

  Controls and Regulations

  Treasury intransigence about interest rates helped to shift the Federal Reserve’s focus toward selective controls. Soon after President Roosevelt declared an emergency. He used his emergency powers to order controls on consumer credit in summer 1941. The Board issued regulation W setting rules for credit allocation and down payment requirements, effective September 1, 1941. Eccles believed the controls would help the defense effort by restraining consumer spending, particularly spending on durable goods. He expected in this way to reduce inflationary pressure.

  287. German conquests raised the issue of ownership of gold earmarked and held for foreign central banks. An executive order, issued on April 10, 1940, extended the president’s authority, under the Trading with the Enemy Act (1917) and the Emergency Banking Act of 1933, to license all transfers between banking institutions in the United States and abroad. The order explicitly protected Norwegian and Danish gold from transfer to Germany. It was extended later to include other countries. On April 19 the order was extended to include transfer of stocks, bonds, or any property in which a foreign state or national had an interest (Board Minutes, April 23, 1940, 12–14). In May the board agreed to assist the Vatican by accepting deposit of its gold under earmark at the New York bank (Board Minutes, May 22, 1940, 1–3).

  The Board’s announcement of credit controls warned about what was ahead—price controls, rationing, and allocation: “Our people can not spend their increased incomes and go into debt for more and more things today without precipitating a price inflation that would recoil ruinously upon all of us” (Board Minutes, September 1, 1941, 2–3). The Board’s announcement recognized that credit controls are “a supplemental instrument to be used in conjunction with the broader, more basic fiscal and other governmental powers in combating price inflation” (3).

  Controls were supposed to work by restricting demand. They work only if the public does not spend on other goods or services but saves instead, and if it uses the saving to finance government spending. Credit controls alone have little effect on aggregate demand.

  To Eccles’s credit, he did not rely only on controls. He strongly urged higher taxes and higher interest rates to finance defense and wartime spending (Hyman 1976, 278–81). Morgenthau opposed. The two protagonists changed sides. Eccles, who had favored government investment and larger deficits to increase output and employment, now wanted smaller deficits and increased taxes. Morgenthau, who had abhorred deficits in the 1930s, welcomed them as an inexpensive way of financing defense and wartime spending.

  Earlier the Board had made the facilities of the Federal Reserve System available to finance construction of defense plants. The Board set rates as low as 1.5 percent, the discount rate at most reserve banks, for loans to finance these facilities. The maximum rate was 4 percent (Board Minutes, October 7, 1940, 2–3).

  PERSONNEL AND ORGANIZATIONAL CHANGES

  Harrison left the New York Bank at the end of 1940 to become president of New York Life Insurance Company. Although his resignation was effective on July 1, the Board asked him to postpone his departure until the end of the year.288 Allan Sproul succeeded Harrison as president of the New York reserve bank, and Leslie Rounds replaced Sproul as first vice president.289 At the same time, Owen Young completed his long service as director and chairman of the bank’s board. Under the 1935 act, he could serve only six years.

  288. There is a hint in the New York directors’ minutes that Harrison was annoyed by the board’s refusal to approve his salary increase for 1940. Discussions of senior officers’ salaries became more contentious in the late 1930s.

  289. Sproul began service as head of research at the San Francisco reserve bank in 1920. In 1924 he became secretary of the bank. He moved to New York, as secretary, in 1930, then became, in turn, assistant to Harrison, account manager, and first vice president. He remained as president until June 1956. Sproul’s initial salary was unchanged at $32,500. In March 1941 he was appointed to a five-year term at a salary of $45,000 (approximately $500,000 in the late 1990s).

  Under the Banking Act of 1935, Boston and New York shared a seat on the FOMC. In practice, Boston ceded the seat to New York by agreeing each year that Roy Young would serve as Harrison’s alternate. Harrison’s resignation reopened the issue. A committee of Boston and New York directors recommended that Boston should be moved to a different group so that Young (and his successor) could serve as a member of the FOMC. New York would hold a permanent seat. This required an amendment to section 12A of the Federal Reserve Act.

  Pending the legislative change, the directors agreed to have Sproul serve for the first year and Young (or his successor William Paddock) serve in the second year. The Board was unwilling to sponsor the legislation, so it was not presented (Minutes, New York Directors, May 1941). Perhaps because of the war, Boston agreed to suspend the agreement in 1942, so Sproul continued as a member of the FOMC with Paddock as alternate.

  In August 1942, Congress amended section 12A to make New York’s president a permanent member of the FOMC with its first vice president as his (or her) alternate. Boston moved to a three-year rotation. Cleveland and Chicago shared the only remaining two-year alternation.290

  To cooperate with the defense effort, the Board approved a letter to the president in June 1940, offering use of the facilities of the Board and the reserve banks and the services of the System. The offer included the directors of the reserve banks, members of the Federal Advisory Council, and the System’s staff. The Council on National Defense used the facilities.291

  290. In 1940 the Board discussed employment of married women whose husbands worked. It declined to reappoint a woman draftsman to a permanent position because she was married to a man who was employed (not at the Board). Governor Ransom was the only member to argue that “women should have the same right to a career as men” (Board Minutes, June 27, 1940, 2–4).

  291. To Eccles’s consternation, one user of the System’s resources wanted to take them over for the duration of the war. In December 1941, a meeting of the chief military advisers to the United States and British governments took place in the Federal Reserve’s boardroom. The United States Joint Chiefs admired the Board’s building and proposed to move in. They suggested the Board could move to Maryland. The meetings are known as the Arcadia Conference. Twelve meetings were held. Eccles successfully defended the Board’s territory by ceding some space to the military. As in most matters of great urgency, the president decided the issue. The Board remained in its home. See Hyman 1976, 282–84, for a more complete account of the incident.

  RECOVERY FROM DEPRESSION

  In 1940 more than 8 million people, 14.6 percent of the labor force, were counted as unemployed. As Darby (1976) noted, some of these people were on work relief or other government work programs. Allowing for Darby’s suggested correction reduces the unemployment rate to 9.5 percent.292 The usual interpretation of these data is that until wartime spending began, economic policies were unsuccessful. Since gold inflows provided substantial growth of money and low market interest rates, this interpretation suggests that monetary policy was weak or impotent. Table 6.8 gives selected data for the period.

  The data show that the labor force grew by 7 million persons, but employment was the same in 1940 as in 1929 and below 1929 in all the intervening years. The economy did not absorb, net, any of the increase in population and labor force, facts that Morgenthau recognized at the time (Blum 1965, 24). Further, hours of work were about 14 percent smaller at the end of th
e period. Real GNP rose modestly, less than 2 percent, and per capita real GNP rose only $50 for the eleven-year period as a whole.

  The experience raises two central questions: First, why after more than ten years was the recovery incomplete before war and defense spending restored high employment and more complete use of resources? Second, why was economic activity more responsive to government spending for war and defense than for public works and relief?

  The Roosevelt administration did not have a uniform answer. At first the administration seemed optimistic that its program would work. By 1937–38, doubts set in. Within the government, many concluded that monopoly pricing by utilities, construction firms, and large manufacturers slowed the recovery. Morgenthau believed that “the best way to stimulate building was to knock down building costs” (Blum (1959, 414). For a change, Eccles agreed: “Big business was exploiting the bad times [in 1938] to drive for repeal of New Deal reforms” (ibid.). The president told Congress in 1938: “One of the primary causes of our present difficulties lies in the disappearance of competition in many industrial fields, particularly in basic manufacture where concentrated economic power is most evident and where rigid prices and fluctuating payrolls are general” (quoted in Cox 1981, 179). To counter monopoly power, the administration began an active antitrust campaign, and Congress ordered an investigation of pricing practices to show how monopoly power hurt consumers and delayed or prevented recovery.293

  292. As new opportunities developed in 1940–41, workers made substantial shifts out of work relief. This suggests that counting this employment as equivalent to private employment overstates employment.

  Alvin Hansen (1938) explained the incomplete recovery as the result of secular stagnation. Investment opportunities had declined, and the economy was mature. This explanation extended the Keynesian argument for government spending and deficits as a cure for the problems of the time.

  Many businessmen took the opposite view. Government deficits were part of the problem. Morgenthau and some others in the administration, including at times the president, held firmly to this view. They believed that deficits promoted lack of confidence and fear of inflation.294 At the Federal Reserve, Harrison held strongly to this view, as did much of the banking community in New York.295 One variant, found in Williams’s memos to Harrison, is that low-risk government debt permitted banks to earn a profit without taking lending risk. Hence bank lending remained low.

  The argument about harmful effects of deficits is difficult to reconcile with the facts. The total increase in government debt from 1932 to 1940 was $23.8 billion. Even if the entire decline in private debt ($8.5 billion) is considered to have been “crowded out” in these eight years, the increase in outstanding debt is relatively small. Most of the increase ($16.4 billion) occurred during the years of rapid recovery, 1932 to 1936. In the five following years, 1940 to 1945, government debt increased $207.7 billion without provoking concerns that prevented expansion. In fact, bankers responded positively to the president’s declaration of an emergency and his announcement of increased defense spending. Within a few days, the same bankers who had opposed deficits and repeatedly urged a balanced budget told Harrison about “their existing desire and ample capacity to finance the credit requirements. . . which might arise from the preparedness program” (Minutes, New York Directors, June 13, 1940, 95).296

  293. The Temporary National Economic Committee (TNEC) was organized to study concentration. Adolph Berle had proposed antimonopoly policy as a means to recovery in 1933. Berle’s argument requires increasing monopoly power, not just its presence.

  294. Morgenthau also believed that a low interest rate was evidence of public confidence in government.

  295. This argument carried some weight in Congress. In1939 Congress defeated some of the administration’s spending proposals. Assistant Treasury Secretary Hanes told Harrison: “Business must show that it has the power to recover through private spending before Congress reconvenes; otherwise, it is very likely that the next Congress, convening in an election year, will resort to unbridled public spending” (Harrison Papers, file 2150.2, August 16, 1939). Hanes added: “The action of both Houses in turning down the President’s spending program . . . was intended as a very definite evidence of a change in the trend and an attempt to give business its chance” (ibid.). Harrison agreed but did not think the action went far enough.

  Businessmen did not limit their criticism and antagonism to deficits. There were frequent complaints about high tax rates, the undistributed profits tax, regulation of securities markets, licensing of foreign exchange, and devaluation. In fact, corporate income tax rates rose sharply under the Hoover administration to forestall criticism of unbalanced budgets. The Roosevelt administration did little to increase these rates before 1938. Chart 6.8 compares the maximum corporate tax rate for the period with average marginal tax rates paid by individuals. The highest corporate and individual tax rates (note the different scales) are at the end of the period, so they cannot explain both the sluggish recovery earlier and the robust wartime expansion.297 Although the increased marginal tax rates in the 1930s were a deterrent, any deterrent effect was dominated by other factors, including the pace of recovery.

  Personal income tax rates rose a bit more than corporate rates under the New Deal, but until 1941 the average marginal personal tax rate remained in the range 3 to 5 percent. From the 1940s to the 1980s, the average marginal rate was 20 to 25 percent.298

  The different explanations for the sluggish recovery offered in the late 1930s show that many contemporary observers accepted the conclusion that the recovery was slow. Here it seems useful to distinguish between early and later views, between explanations applicable to the entire period, like complaints about the New Deal, and those that were offered after 1937–38, when there is more of a puzzle about the absence of full recovery.

  296. The New York bankers asked Harrison to send a letter to the National Defense Advisory Commission in Washington to affirm their interest in lending for industrial expansion and preparedness.

  297. At an income of $10,000, relatively high in the 1930s, a taxpayer paid an average effective rate of 0.9 percent in 1928, 6.0 percent in 1932, and 5.6 percent in 1938. At $100,000 the rates are 14.9 percent in 1928, 30.2 percent in 1932, and 33.4 percent in 1938 (Bureau of the Census 1960, 217).

  298. The undistributed profits tax is not included, but that tax was more a nuisance than a revenue raiser. Excess profits tax was levied also, but average corporate tax payments remained at about 14 percent of corporate income.

  Table 6.9 uses real GNP data from Balke and Gordon (1986) to compare the speed of recovery from deep recessions. These data suggest that, relative to the length and severity of the decline, the speed of recovery was not very different from 1933 to 1937 than it was in the 1890s or 1920–21. Recovery from the 1929–33 depression was not especially slow in the early years; real GNP rose 17.5 percent and 9.8 percent, respectively, in 1935 and 1936. Table 6.10 shows growth of real GNP from Balke and Gordon (1986) and total return on common stocks from Ibbotson and Sinquefeld (1989). These data suggest that much of the problem lies in the period after 1937.

  Two striking features of table 6.10 are that stock prices fell after the 1937–38 recession despite the recovery and output recovered at a relatively rapid rate. By 1940, real GNP had passed the 1929 or 1937 level. We know from table 6.8, however, that average labor hours in manufacturing were no higher in 1940 than in 1933, and more workers were counted as unemployed in 1940 than in 1937.

  Other Explanations

  Kindleberger’s explanation emphasizes international external policy and policy coordination:

  The explanation in this book is that the 1929 depression was so wide, so deep, and so long because the international economic system was rendered unstable by British inability and U.S. unwillingness to assume responsibility for stabilizing it by discharging five functions: (1) maintaining an open market for distress goods; (2) providing counter-cyclical
or at least stable, long-term lending; (3) policing a relatively stable system of exchange rates; (4) ensuring the coordination of macroeconomic policies; (5) acting as a lender of last resort . . . in financial crises. (Kindleberger 1986, 289)

  Let us accept the relevance of tariffs as a factor disrupting trade in 1929–31. United States trade barriers fell after 1934, and most research suggests that the aggregate effect of the 1929 increase was small.299 The failure of the Federal Reserve to serve as lender of last resort is generally accepted as an explanation of 1931–33 but has less relevance for the late 1930s after development of deposit insurance in 1934.

  The remaining items put most of the burden of explanation on international factors, particularly exchange rate variability and absence of policy coordination. Kindleberger does not mention the misalignment of real exchange rates, discussed earlier, before and during the depression.

  The problem in the 1930s, as on other occasions, was that unemployment and misaligned exchange rates required countries to choose. High employment, freedom of capital, trade, and exchange, and price and exchange rate stability could not be achieved simultaneously. Some countries sacrificed fixed exchange rates and capital mobility to increase domestic employment. President Roosevelt’s choice, in 1933–34, of domestic expansion over international stability was a major reason for United States recovery in 1934–36. International cooperation to maintain fixed exchange rates required a different set of choices. France, Belgium, Switzerland and the rest of the gold bloc made this choice until 1935. Results were poor. Deflation continued.