A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  114. Some of the actions were entirely cosmetic. For example, when President Truman asked all departments and agencies to reduce spending so as to increase the budget surplus, Eccles proposed cutting the Board’s expenditure and asked the reserve banks to do the same even though they were not part of the budget and, at the time, did not pay a tax to the Treasury (Board Minutes, August 2, 1946, 3).

  reserve cities In August 1945 the Board approved a change in regulation D to require member banks with branches in reserve cities to maintain reserves based on the reserve city classification. This opened a long-dormant issue about the criteria for classifying cities as reserve cities. The Board could not at first agree on criteria, so none were adopted.115

  The Board later chose two explicit criteria: the proportion of interbank demand deposits held at member banks in each city to total Systemwide interbank deposits or the proportion of interbank demand deposits at member banks to total demand deposits at member banks in the city. Designations would be renewed or changed every three years.116 The new rule took effect on March 1, 1948 (Board Minutes, December 19, 1947, 2–7). New York and Chicago continued as central reserve cities. All other cities with Federal Reserve banks or their branches continued as reserve cities.

  consumer credit The president authorized regulation of consumer credit, under the Board’s regulation W, by proclamation under the Trading with the Enemy Act of 1917. Six months after the war ended, many wartime restrictions and regulations expired. The Trading with the Enemy Act was permanent, but the grant of emergency powers to the president expired, and with it the authority to control terms and conditions for consumer credit.

  President Truman endorsed continued regulation, and so did the Conference of Reserve Bank Presidents, in a divided vote (Board Minutes, October 4, 1946, 19). The Republicans controlled Congress after the November 1946 election. They wanted to end all wartime regulation and controls. Many merchants who had to enforce controls agreed, but the Board wanted to retain controls, citing the need to control spending. It failed to recognize that aggregate spending could not be controlled by restricting credit for purchasing particular goods. Households could borrow in other ways.

  115. The classification system was archaic, carried over from the National Banking Act when central reserve and reserve cities had held the principal reserves of country banks as correspondent balances. Under the Federal Reserve Act, banks continued to serve as correspondents, but most reserves were held at Federal Reserve banks. In discussion with the Federal Advisory Council, Eccles favored uniform reserve requirements for all banks, a position that was inconsistent with his efforts to get congressional approval of an increase in reserve requirements for central reserve city banks only (Board Minutes, May 20, 1946, 6). Some bankers opposed eliminating the reserve city classification because they claimed banks would lose correspondent deposits. There was nearly general agreement that the classification system had lost its logical basis. The problem was that no one could suggest an appropriate revision (1–7). In 1930–31, 1932, and 1934, the System considered basing reserve requirement ratios on activity. Congress turned down these requests. It returned to these proposals in 1945, when it considered three classes of deposits—interbank, other demand, and time. The revised system would count vault cash as reserves (Sproul Papers, Memorandums and Drafts, 1945, October 1, 1945). The System offered the proposal again in 1948, with ratios of 30, 20, and 7 percent for the three types of deposit (ibid., April 22, 1948).

  116. If all the member banks in a city chose to continue an existing reserve city classification, the Board agreed to maintain the classification.

  The Board claimed that by restricting consumer credit regulation W limited total credit outstanding and thereby reduced total spending. Since the Federal Reserve would not raise interest rates and banks no longer held idle reserves, the Board omitted from its argument the step by which credit control reduced banks’ demand for reserves and the monetary base at prevailing interest rates. Without a change in interest rates or reserves, controls did not change the amounts of money and bank credit.117

  The reserve bank presidents had the job of enforcing regulation W. They claimed that enforcement would be easier if Congress authorized regulation instead of relying on an executive order. The Board’s annual report for 1946 asked for such legislation. President Truman supported legislation, but he warned that if Congress did not legislate, he would vacate the executive order and allow authority for consumer credit regulation to lapse (Board Minutes, June 6, 1947, 22).

  Congress ended controls in August, effective November 1.118 The Board sent a letter, approved unanimously, urging merchants to exercise self-restraint and reduce prices instead of lengthening credit terms to attract new customers. Data for consumer credit show no evidence of acceleration after controls ended.

  secondary reserve requirements At the October FOMC meeting, Woodlief Thomas of the Board’s staff led a discussion of three options for slowing or preventing inflation: permit a gradual further increase in short-term rates to observe whether credit demand slows; adopt a policy of controlling bank reserves, a return to earlier procedures; and push more vigorously for passage of the Board’s legislative program. John H. Williams followed Thomas’s discussion by arguing against control of money and credit. These methods “might operate to bring about a deflation through reducing production” (Minutes, FOMC, October 6, 1947, 7). As usual, Eccles opposed rate increases or control of reserves as ineffective. Sproul disagreed. He urged the System “to accommodate itself to the powers it already had and not continue to refer to powers that it might have had” (10). He urged also that the System not exaggerate the amount of bank credit expansion.119

  117. The Board confused relative and absolute changes in demand. “It has not seemed to the Board that any change in the regulation [W] would be advisable at the present time. With employment and incomes high and the supply of spendable funds excessive, credit beyond that now available would only waste itself in stimulating undesirable price rises and retarding needed price adjustments” (Board to T. Schlesinger, Board Minutes, May 13, 1947, 14–15). Schlesinger was vice president of Allied Stores Corporation. Other letters from congressmen and their constituents questioned the legality of peacetime regulation. In its 1946 annual report, the Board made its error explicit. “It [regulation W] can restrict excessive demands for credit by limiting the borrowing capacity of prospective purchasers of goods without operating, as general instruments of credit policy must do, by increasing the cost of credit to the Government or to industry” (Board of Governors of the Federal Reserve System, Annual Report, 1946, 8).

  118. The Board’s press release, a mixture of annoyance and economic error, is remarkable for its implicit criticism of Congress. “The continuance of strong inflationary pressures has confirmed the belief of the Board that this is no time for the relaxation of terms by banks, finance companies and installment dealers” (Board Minutes, November 24, 1947, 6).

  The committee agreed on a six-point program that included increasing short-term rates to 1.125 percent by the end of the year (1947), raising discount rates and reserve requirements for central reserve city banks, and moral suasion to call bankers’ attention to the dangers of rapid credit growth. The FOMC voted eleven to one to approve the program and authorized Eccles and Sproul to discuss the program with the Treasury. Governor Rudolph M. Evans opposed. He saw no evidence that higher interest rates would reduce credit expansion.

  Eccles did not endorse the System’s program when asked in November about recommendations to slow the rise in prices. His main proposal called for a secondary reserve requirement, originally proposed in the Board’s 1945 annual report, that made all banks (including nonmember banks) hold a reserve consisting of government securities with less then two years to maturity. The FOMC would have authority to vary the requirement up to 25 percent of gross demand deposits.120 His only other proposal was to reinstate consumer credit controls.

  119. This was a response to
Eccles’s use of rising bank loans to make his case for control, neglecting sales of securities that limited total credit expansion. Eccles argued, also, that a further increase in interest rates would have little effect on the demand to borrow—another example of “elasticity pessimism” (Minutes, FOMC, October 6, 1947, 4).

  120. Governor Draper opposed the plan. He had not received any advance notice, nor had other governors. There had been no analysis. He thought the plan was too drastic. Nevertheless, he voted in favor to make the vote unanimous (Board Minutes, November 5, 1947, 5). The reason for haste in presenting the plan was that Eccles had been asked by the White House to recommend policies for the president’s speech to a special session of Congress. Bankers opposed the plan as “impractical, socialistic, and unnecessarily drastic” (Eccles 1951, 428). Snyder opposed and had the proposal replaced in Truman’s message by a general statement favoring a reduction in credit. Snyder nevertheless agreed to support the Board’s proposal for consumer credit controls (430–31), and to refrain from testifying against the secondary reserve plan. When asked his opinion, however, he said that “he didn’t think it would work” (432).

  Concerns about inflation were well founded at the time. A very large increase in the gold stock during the third and fourth quarters of the year temporarily raised the growth rate of the monetary base. From June to December, consumer prices rose at a 12 percent annual rate. The burst of inflation was short-lived, however. It ended before Congress could act on the president’s proposals for new controls on consumer credit, commodity speculation, price and wage controls, stronger rent controls, and new powers for the Federal Reserve over reserve requirements. Congress did not approve any of the new controls.121

  The arguments made by proponents and opponents of controls show the reasoning at the time. Bankers argued that there was no need for additional controls. At a meeting with the Board, the Federal Advisory Council rejected Eccles’s argument that bank credit expansion was excessive. There was no evidence of excessive growth of money: “As bank loans have increased, the banks have decreased their investments” (Board Minutes, November 18, 1947, 3). In a sharply worded statement, the council pointed out that the growth of bank loans reflected demands by businesses and households, not speculative actions by the banks. It cited some of the many ways government policy encouraged borrowing: the Reconstruction Finance Corporation guaranteed risky loans; foreign aid programs raised farm prices and encouraged expansion; and mortgage guarantees for war veterans and others increased construction and mortgage lending. The council challenged the Federal Reserve to control bank reserves using the powers it had instead of seeking new ones, and it opposed the request for secondary reserves as impractical and as a transfer of power from individual bankers and their directors to the Federal Reserve.

  The council’s argument did not change Eccles’s views. Testifying before the Joint Committee on the Economic Report a week later, he urged Congress to give the System additional powers. He told the committee that “there is no easy, simple, or single remedy. We are already in the advanced stages of this disease” (Board Minutes, November 26, 1947, 3).122 The problem was not just inflation. Ultimately, inflation would be followed by deflation: “The higher prices rise and credit expands, the greater the subsequent liquidation and downward pressure on prices is bound to be” (5–6).

  This is an extraordinary statement for the head of a central bank. Not only did he fail to recognize his ability to prevent inflation using existing powers, he treated deflation as an inevitable consequence of the preceding inflation, just as the System had done in 1929–33. The new powers the Board had gained in 1933 and 1935 did not affect his analysis or argument. Although he asked Congress to restore consumer credit controls (ibid., 7) and to establish secondary reserve requirements, the only general control he recommended was to adjust fiscal policy so as to use “the largest possible budgetary surplus” to retire government debt (6). He opposed the tax cut that the Republicans in Congress favored.

  121. Contemporary observers point out that the administration knew that Congress, under a Republican majority, would reject the program. The president wanted to blame Congress for inaction. Congress provided more stimulus by reducing tax rates in April 1948 and overriding the president’s veto of the tax bill (Fforde 1954, 163–64).

  122. The verbatim statement is part of the Board Minutes.

  Although he favored using the budget surplus to reduce the money stock, the usual methods of monetary control could not be used, Eccles said, because (1)the cost of servicing the large outstanding debt would rise, requiring higher taxes; (2) the increase in interest rates would have to be very large, “substantially above the present relatively low levels” (ibid., 10); (3)the Treasury would not know at what price it could sell its securities, and (4) there would be massive liquidation of government bond holdings, including series E, F, and G bonds held by households. Despite these dire consequences, he added, if Congress favored ending wartime policy, “we would welcome such an expression from the Congress” (9). This was hardly a likely outcome after his warnings.

  Eccles’s statement had several errors. First, he neglected the effect of inflation on interest rates. The statement presumed that the structure of rates could be held indefinitely, with only a few additional powers. Second, he endorsed a comment by a New York banker that raising interest rates to control inflation would be highly inflationary. Removing the interest rate peg, he said, “would be the most dramatically inflationary move that could be made at this time . . . so catastrophic as to make present fears appear as one raindrop in a storm” (ibid., 10). Third, after removing the peg, the System would remain powerless to offset increases in bank reserves from gold inflows.123 Fourth, to control credit expansion, the System would have to sell securities in competition with private credit demands and gold inflows: “Private borrowers might outbid us for these reserves” (10).

  Eccles used the experience in 1928–29 to bolster his argument: “We are convinced that the remedy of letting interest rates on Government debt go up on the theory that this would bring an end to inflationary borrowing is dubious at best, as has been demonstrated in past monetary history, notably in the 20s when high rates were unsuccessful in restraining speculation in the stock markets, real estate, or otherwise” (ibid., 12). This is a misstatement of history. The Board had opposed interest rate increases in 1928–29. Although Eccles had often said that a large increase in interest rates would be required to stop inflation, he had not previously based his case on the disaster scenario he sketched for Congress. Nor did he mention Sproul’s contrary view.124

  123. This statement denies that the System could sterilize gold inflows, as in the 1920s. At best the statement is misleading. The System held more than $22 billion in securities at the time, a sum larger than the combined monetary gold stock of all countries other than the United States.

  Doing nothing was dangerous too, he warned. To make the case for a special security reserve requirement, Eccles exaggerated the risks of excessive expansion. He assumed that banks might sell half of the $70 billion in government securities to the Federal Reserve. The increase in bank reserves would support a $200 billion increase in credit and money, six times the increase in reserves.125 The money stock, currency, and demand deposits would increase from $112 billion to more than $300 billion, and gold inflows would add an additional $2 billion to $3 billion to reserves. Further, he told the committee, other holders of securities could sell up to $70 billion of securities to the Federal Reserve.

  The Board’s solution was to increase the demand for government debt by imposing a security reserve of up to 25 percent against demand deposits and 10 percent against time deposits. It would phase in the new requirement gradually. At the maximum percentages, Eccles said, the new requirements would reduce credit expansion by about 60 percent. Further, banks would reduce the supply of loans, so lending rates would rise without increasing rates on Treasury debt: “Hence, the cost of restraining credit would b
e borne by private borrowers who are incurring additional debt, and not by the government which is reducing its debt” (ibid., 14). Eccles and the Board did not explain why banks would not sell debt and make loans if loan rates rose relative to rates on government bonds.

  Bankers regarded the reserve banks as more concerned for their interests than the Board. To reduce bankers’ criticisms, Eccles proposed giving the FOMC power to set secondary reserve requirements. He concluded by submitting the Federal Advisory Council’s statement opposing secondary reserves.

  124. After reading Eccles’s proposal to the president, asking for a secondary reserve requirement, Sproul telegraphed: “It would be most unfortunate if in our zeal to acquire new powers which might not be granted we were unnecessarily to minimize the effectiveness of our present policy, exaggerate the role of monetary factors . . . and expose the System to the risk of being held responsible for not checking or remedying a situation due primarily to non-monetary causes. In the circumstances I want to reaffirm that as a member of the Federal Open Market Committee I cannot regard myself as in any way committed to what is proposed” (Sproul Papers, Memorandums and Drafts, 1947, November 13, 1947).

  125. The money multiplier of six appears to be based on the average reserve requirement ratio with no allowance for a spillover from deposits into currency. At the time the average base money multiplier was about three.

  The Board approved Eccles’s statement unanimously and voted to send a copy to all banks and banking supervisors. It also unanimously approved a lengthy reply to the Federal Advisory Council and voted to send a statement of its views to the Joint Committee on the Economic Report. The reply to the council argued that if interest rates increased, the System would have to supply more, rather than fewer reserves.126