A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The new requirements were unpopular with the public and with many bankers and securities dealers. In September the Federal Advisory Council urged the Board to consider returning to a 50 percent margin. Eccles thought it was premature to consider a reduction. Effective January 2, 1946, the Board increased the margin requirement to 100 percent; all transactions had to be for cash.

  Other Wartime Changes

  Rapid growth of the Federal Reserve’s portfolio and the monetary base, and a small gold outflow, lowered the System’s gold reserve ratio toward the legal limit—40 percent of notes in circulation and 35 percent of deposits at Federal Reserve banks. By mid-1944 the System’s gold reserve ratio had fallen to 55 percent (from 91 percent in November 1941).

  The FOMC minutes first mention the problem in May 1944. The committee voted to reallocate Treasury bills in the System account to prevent the ratio at any reserve bank from falling below 45 percent. Members agreed to buy Treasury bills from the reserve banks with low ratios and to change the allocation of open market purchases (Minutes, FOMC, May 4, 1944, 14–15). Several banks sold Treasury bills to other reserve banks for gold certificates, and the Federal Open Market Committee revised the securities allocation formula to adjust for differences in gold reserves.

  The System’s gold reserve ratio continued to fall. In July the executive committee considered asking Congress to reduce the ratio to a uniform 25 percent against notes and deposits. Eccles favored eliminating the requirement, but the committee thought the public was not ready to remove all ties to gold. The executive committee voted to put off any decision until after the election.

  Legislation introduced in January, and passed in June, lowered the gold reserve requirement to 25 percent and extended the “temporary” authority, first granted in 1932, to use government securities as collateral for Federal Reserve notes.38 The FOMC responded by lowering from 45 percent to 35 percent the gold reserve ratio at which the individual reserve banks would cease to participate in open market purchases. Table 7.3 shows that even after the legal change, several of the reserve banks did not meet the requirement.

  Eccles attempted to coordinate the research functions at the reserve banks under the direction of the Board’s research division. The issue had arisen first in 1936, after the Banking Act of 1935 became law. It arose again in 1943, under the guise of having a “steering committee” to give direction to research work. The reserve banks resisted and, on both occasions, prevented the Board’s staff from acquiring authority over the banks’ staffs (Sproul Papers, Memorandums and Drafts, December 17, 1943). Eccles tried again, claiming that the Board had the right to approve persons appointed to supervisory positions in the banks’ research departments, but he did not prevail over the protests of the banks’ officers and directors (Minutes, New York Directors, August 17, 1944, 267).

  To supplement wartime price controls, the government ordered coupon rationing of gasoline, food, shoes, and other consumer goods. Purchasers presented coupons along with cash to complete transactions. Processing ration coupons became the responsibility of commercial banks and Federal Reserve banks beginning in January 1943.

  The army decided early in 1942 to move Japanese and Nisei living in the western states into camps. After the administration approved the order, Japanese and Nisei had to leave their homes and businesses. The Treasury had responsibility for protecting the property they left behind. The Federal Reserve banks administered the program for the Treasury (Blum 1967, 3–4).39

  38. When the bill was introduced, Senator Elmer Thomas wrote asking the Board to append his bill authorizing all banks and other financial institutions to carry government obligations at par value. It declined (Board Minutes, January 26, 1945, 2). The Board also requested repeal of the Thomas amendment authorizing the president to issue $3 billion of currency (Board Minutes, March 15, 1945, 202). At about this time, Congress considered a proposal to have the General Accounting Office audit the Federal Reserve, as it had done in the System’s early years (Minutes, New York Directors, February 5, 1945, 170). This issue returned many times.

  POSTWAR PLANNING

  Planning postwar economic policies began long before the war ended. Interwar experience convinced many businessmen, economists, and others that it would be unwise, and probably unacceptable, to return to the high unemployment rates and instability that characterized the interwar period. Keynes’s General Theory (1936) seemed to provide an economic rationale for activist government policies to expand or slow domestic economic activity.40 His plan for international monetary cooperation, prepared during the war, made a major contribution to the development of the postwar Bretton Woods institutions. Earlier, in his Treatise on Money (1930), he had made the case for international monetary reform, based on a more flexible gold standard. These topics moved to the forefront in planning for the postwar world.

  Discussion of postwar planning shows significant changes in policy views since the 1920s. Two changes eventually altered the role of United States monetary policy. First was the commitment to economic stabilization. This commitment was a long step away from the Federal Reserve’s denial in the 1920s that its actions affected the price level or the pace of economic activity. Second was the primacy given to domestic over international considerations. The proponents of these changes assigned a very modest role to monetary policy and the Federal Reserve. As the perceived influence of monetary policy changed in the 1950s and 1960s, full employment and domestic stability became dominant policy concerns by the 1960s. Although not fully recognized at the time, the heightened emphasis given to domestic concerns in many countries was incompatible with plans for an international monetary system based on gold and fixed exchange rates.

  Domestic Plans

  In spring 1943 the System began to study postwar reconversion. One set of issues was transitional. For example, when the military canceled contracts, small and medium-sized firms would need loans to convert to peacetime production just as regulation V loans to finance military procurement ended. The System appointed a committee to study transitional lending (Board Minutes, April 29, 1943, 5–7; June 20, 1943, 5–7). In May 1944 the Board authorized a series of studies of postwar policies. A sample of the ideas gives the flavor of many economists’ opinions at the time.

  39. The unique private-public structure of the Federal Reserve left unresolved whether property such as the Board of Governors building was taxable by the District of Columbia. The District agreed to treat the property as government property provided each of the reserve banks disclaimed ownership (Minutes, New York Directors, January 13, 1944, 21).

  40. In fact Keynes (1936) says very little about activist policies. Keynes’s support for such policies antedates his book and is more explicit in his policy tracts. See Meltzer 1988.

  The Board’s economic adviser, Emanuel A. Goldenweiser, recommended the “continuation of wage and price controls, rationing and allocation, as well as licensing exports . . . [as] a prime condition of a successful transition from a war to a peace economy” (Board of Governors of the Federal Reserve System 1945, 1:3). Goldenweiser proposed that the government offer employment to any unemployed worker to sustain consumption. He favored keeping selective credit controls, margin requirements, and “all the powers over the general volume and cost of money that they have had in the past, and they should have additional authority over member bank reserves” (1:15). The “additional authority” is probably a reference to a secondary reserve requirement of securities to prevent banks from selling Treasury bills to the reserve banks.

  Unemployment was a main concern. The second study in the Board’s series warned of another 1929 collapse and unemployment of 6 to 8 million during reconversion to peacetime (ibid., 1:18–49).41 Postwar experience turned out very differently. Reconversion occurred quickly. After a brief adjustment, economic activity rose rapidly. Unemployment remained low.

  Like Goldenweiser, Eccles believed that price controls should be retained until postwar output increased enough to satisfy
demand. He testified that “price controls, rationing, curbs on consumer credit or stock market credit, and similar devices, admittedly deal only with effects and not with basic causes of inflationary pressures” (House Committee on Banking and Currency 1946, 171).42 Nevertheless, he believed that an opportunity to control inflation was lost with repeal of the excess profits tax in 1945, termination of the War Labor Board, and failure to increase the capital gains tax at the end of the war (Board Minutes, November 19, 1945, 10–11). He did not mention that these wartime measures distorted allocation and slowed investment. Nor did he recognize that price and wage controls caused many low-priced goods to disappear and encouraged producers to lower quality as a substitute for raising prices. Similarly, wage controls encouraged both labor “hoarding” and shortages and the substitution of noncash benefits for cash payments.43 Neither he nor his staff recognized that deregulation and correct price signals would speed the transition and reduce waste.44

  41. There is nothing in the studies about the need to restore monetary control by eliminating the interest rate peg. Volume 8, devoted to Federal Reserve policy, is given over mainly to a historical review of past options.

  42. “To the extent that we can deal effectively with the money supply and production factors, we will be getting at the root causes of the inflationary problems confronting the country today” (House Committee on Banking and Currency 1946, 171).

  Congress did not concur. It responded to the general dissatisfaction with wartime controls, rationing, and black markets by removing most controls by fall 1946. The immediate effect was a short-lived surge in the reported price index, as reported prices adjusted to reflect hidden or deferred changes (see chart 7.1 above). Consumer prices rose at a 29 percent annual rate between June and November, with the largest rise in July. By January 1947 the monthly increase had fallen to zero.45 After these adjustments, price levels were 33 percent above the level at the start of the war, a 6.5 percent annual rate of increase.

  Lauchlin Currie, on the White House staff, and Keynesian economists at Commerce, Treasury, and other agencies believed that a severe postwar depression was likely. They bolstered their argument by showing that private spending would not expand enough to replace military spending as a source of employment. Much of the shortfall was a consumption “gap”—the difference between predicted consumption spending and spending consistent with full employment. And because the consumption gap would be large, private investment would remain low and unemployment high.46 Beginning in 1944, Keynesian economists urged gradual release of materials from military use to smooth postwar readjustment. The military opposed the change while the war continued, and nothing was done. Interest in peacetime conversion rose when the European war ended in April 1945. The National Resources Planning Board advocated a comprehensive social welfare program, pollution abatement, public transport systems, and other government programs.

  Nothing in Keynesian analysis favored government spending instead of tax reduction as a way for government to influence the transition from war to peace. Largely as a matter of belief, administration economists and their outside advisers favored government spending.47 System economists were divided.48

  43. World War II wage controls, and tax deductibility, produced a long-term inefficiency—health care benefits paid by employers who deduct the cost. This distortion increases the demand for health insurance and limits opportunities for individual workers or families to choose the health insurance they prefer.

  44. Eccles had a mixed view of price and wage controls. He supported the call for controls in 1942, but he saw them as at best a supplement to taxation that removed private command of resources. At the same time, he seems aware of the conflicts set off by controls—whether costs could be controlled as effectively as, or more effectively than, prices, problems such as setting rents, concerns about excess profits, and so on. See Eccles 1951, 370–72. Morgenthau favored controls on prices but not on wages. He said that labor was not a commodity, so wages should not be treated like other prices.

  45. Price controls expired in June 1946. Congress voted for rapid decontrol, but President Truman vetoed the bill, so controls ended when they expired. In early August, Congress renewed controls (but not food subsidies). This was followed almost immediately by meat shortages. Almost all controls were abolished by executive order on November 11, 1946.

  46. This section is based on Jones 1972.

  President Roosevelt adopted part of the Keynesian program. His last State of the Union message to Congress set a goal of 60 million postwar jobs. At the time, there were 55 million people in the civilian labor force and an additional 11.4 million in the armed forces, but some of these were women who were expected to leave the labor force after the war. The statement was seen as a loose commitment to “full employment.”

  Roosevelt’s statement was soon followed by a proposed Full Employment Act that became the Employment Act of 1946.49 The original proposal recognized a person’s right to employment and the government’s responsibility to provide full employment. To achieve this end, the proposal called for some national planning: a National Production and Employment Budget would forecast the state of the economy and the levels of employment and output consistent with full employment. The president would recommend actions needed to close any “gap” between expected and full employment.

  47. Principal among them were Seymour Harris (1943), Alvin Hansen of Harvard, and Paul Samuelson of MIT (1943). Others such as Herbert Stein of the Committee for Economic Development preferred lower taxes. Stein’s influential essay became the basis for policies advocated by the Committee for Economic Development, a business-sponsored group.

  48. At a meeting of the Board and the presidents to discuss the Board’s studies of postwar problems, John H. Williams was highly critical of a study by Richard Musgrave, a member of the Board’s staff. The study showed that the budget would not be balanced if government spending remained low. The argument, based on a Keynesian model, proposed that the government absorb the excess savings. Williams countered that Musgrave had neglected the crowding out of private spending. Some government spending makes “private business work better, but when you get up to this level, you are bound to ask what these expenditures are doing to the private economy. It is inevitable that it will take its place to an increasing degree” (Board Minutes, March 2, 1945, 5). Williams’s remarks anticipated major controversies about the effects of government spending, deficits, and debt in the 1960s and 1970s. Williams added, “[Economists] are interested in large and even growing public expenditures. I think there is a lot to be looked into on that point before we accept it as a guide for postwar policy” (Board Minutes, March 2, 1945, 6). Seymour Harris (1943) wrote: “These [Keynesian] economists are impressed with the failure of the capitalism of the twenties to provide full employment and are impatient with economic theory that fails to discuss conditions of disequilibrium and underemployment. Keynesian influences will be especially evident in the parts of the volume devoted to the discussion of full employment and fiscal policy” (5). In the same volume Paul Samuelson (1943, 53) wrote: “All our findings lead to the conclusion that there is a serious danger of underestimating the magnitude of the problem of maintaining continuing full employment in the postwar period.”

  49. See Murray 1945. The standard reference to the act is Bailey 1950. The bill was pushed by Leon Keyserling. Later George Terborgh of the Machinery and Allied Products Institute rejected the Hansen-Samuelson argument. “Nothing in the purely economic or technical situation indicates that private investment will have to be propped up by public investment not desired for its own sake. Indeed, the situation is so favorable for a boom after the inevitable transition period” (Sproul Papers, Board of Governors, Correspondence 1943–44). The quotations are from a speech by Terborgh, 14–15. One of the first members of the Council of Economic Advisers and its second chairman, Keyserling had been a legislative assistant to Senator Robert Wagner of New York, one of the sponsors. Keyserli
ng was a principal developer of “the Fair Deal,” President Truman’s economic program. See Brazelton 1997.

  Discussion of the bill shows the large shift in opinion that had occurred in a decade. The bill had three Republican senators as sponsors and more than one hundred sponsors in the House, including Congresswoman Clare Booth Luce, a prominent conservative and the wife of a prominent publisher. Few in Congress criticized the commitment to an expanding economy or the idea that government spending could affect the economy. The right to a job and a commitment to full employment were more contentious. Opponents pointed to the risk of inflation, the possibility of continuous budget deficits, and the possible use of the act to promote “national planning,” price controls, or other restrictions on freedom.

  The act that emerged was a compromise, but it gave more to the opponents than to the original proponents.50 Gone were the commitments to full employment and mandatory computation of the “gap.” The legislation called only for “maximum employment, production, and purchasing power,” a phrase that was undefined, therefore open to whatever interpretation an administration or Congress might put on it. Gone also was a legislated commitment to forecasts of economic activity, although forecasting became standard procedure in all administrations.51

  The act created a Council of Economic Advisers in the Office of the President to help the president decide on economic policy. The intention may have been to keep the council as a professional body, free of politics. In practice the council, as a staff agency, had a weaker position than many of the current and future line agencies representing business, labor, environmental, educational, consumer, and other interest groups. The role of the council has varied with the president’s interest in receiving its advice and the relationship between the council’s chairman and the president.52