The Korean War inflation is one of the few examples of expectationally driven price increases. Concerns about shortages and possible rationing increased demand, and an anticipated reallocation of resources from civilian to military uses reduced expected supply. Growth of the monetary base or M1 was modest in the first nine months of war. The federal budget shifted from a $3 billion deficit to a $6 billion surplus, driven mainly by a large increase in personal and corporate tax rates. Government revenues increased by $12billion in fiscal year 1952, a 30 percent increase.182 Tax revenues reached $51 billion, the highest level up to that time. Income tax rates were near (or above) peak World War II rates.
The Federal Reserve could not know at the time that the first year of war would be financed by taxes. Its concern was that wartime deficits would bring back inflation. Unlike the decision in 1942 to finance the war at prevailing, low interest rates, to many in the System the war gave greater urgency to the need for higher interest rates. This view was widely but not uniformly held.
The eight months from the start of the Korean War to the end of February 1951 brought a growing rift between the Treasury and the Federal Reserve. Faced with the prospect of having to finance expected wartime deficits and to roll over large parts of the $250 billion marketable debt, the Treasury became less willing to increase short-term rates or acknowledge Federal Reserve responsibilities for restraining inflation. Since Snyder was a longtime close friend of President Truman, he was confident that the president would rebuff a Federal Reserve appeal.
181. In May President Truman nominated Edward L. Norton to be a member of the Board of Governors. In July he named Oliver S. Powell. Norton was from Alabama. He served from September 1, 1950, to February 1, 1952, completing Ernest Draper’s unexpired term. Powell had been a vice president of the Minneapolis reserve bank. He served from September 1, 1950, to June 30, 1952.
182. As another sign of the Federal Reserve’s role in government policy at the time, the Treasury asked the Federal Reserve to present its ideas about the tax program. McCabe designated Riefler as its representative (Board Minutes, July 18, 1950, 2).
THE DOUGLAS HEARINGS
That left matters to Congress. In fall 1949 a subcommittee of the Joint Committee on the Economic Report (later the Joint Economic Committee) under the chairmanship of Senator Paul Douglas (Illinois) held hearings on monetary, credit, and fiscal policies.183 The hearings gave the Federal Reserve a public forum in which to make its case under the sympathetic questioning of Senator Douglas, Senator Ralph E. Flanders (Vermont), and Congressman Jesse P. Wolcott (Michigan). While there is no way to directly connect the hearings to the System’s subsequent behavior, System policy discussions changed in 1950, before the Korean War started. Many in the System believed that the Treasury’s reluctance to let rates rise during the recovery broke the 1949 agreement under which it reduced rates in the recession. Nevertheless, the FOMC remained unwilling to act without Treasury agreement.
Eccles had often said that the System could not act independently without congressional support. The hearings gave the first public evidence of that support.184 McCabe, Sproul, and Eccles testified for the Federal Reserve. Snyder spoke for the Treasury. Other witnesses included Leon Key-serling, chairman of the Council of Economic Advisers, the heads of other financial agencies, and representatives of labor, agriculture, and finance.
Secretary Snyder denied there was a conflict. The Treasury had final responsibility for debt management. The Federal Reserve had principal responsibility for credit and monetary policy, but debt management required the cooperation of the Federal Reserve: “I have been very happy with that cooperation. I think it has been splendid” (Subcommittee on Monetary, Credit and Fiscal Policies 1950a, 408). He refused to be drawn into a discussion of possible conflicts. Most of his testimony discussed the difficulty of managing a large debt and the Treasury’s successful management. At one point he compared his record favorably with debt management after World War I, when government bonds went below par value.
183. Paul Douglas was a distinguished economist who had been an economics professor at the University of Chicago before his election to the Senate. As is often the case, senators who had little understanding of the technical issues relied on a colleague’s expertise, so Douglas’s opposition to pegged rates carried considerable weight.
184. Eccles’s book does not emphasize the role of the Douglas committee, but he later recognized that congressional support helped the Federal Reserve to regain its independence (CHFRS, May 18, 1954, 2).
Snyder denied that the Treasury was unwilling to let interest rates change: “The Treasury Department has never taken an inflexible position” (ibid., 409). Senator Flanders responded by reading from a letter Eccles sent to the committee to supplement his testimony. Discussing the Board and the FOMC, Eccles wrote: “Under present circumstances the talents and efforts of these men are largely wasted. Views of the Federal Reserve Board and the Open Market Committee regarding debt-management policies are seldom sought by the Treasury before decisions are reached. . . . Decisions are apparently made by the Treasury largely on the basis of a general desire to get money as cheaply as possible” (410).185 Snyder would not comment publicly, but he agreed to meet privately with McCabe, Sproul, Eccles, and the members of the subcommittee.186 Later in his testimony, however, he denied that the Treasury’s decisions were based on the desire to borrow cheaply (425).
The System did not speak with a single voice. Its three spokesman differed in both tone and substance. McCabe was most conciliatory, Eccles characteristically the most outspoken. On substance, however, Sproul was the strongest proponent of an independent central bank, McCabe most willing to accommodate the needs of the Treasury.
Differences in style and presentation reflected differences in personality. Substantive differences show that after forty years, political and financial interests had not been fully harmonized. McCabe and Eccles saw the Federal Reserve as mainly a government institution regulating the financial industry and carrying out government policy. Sproul saw the Federal Reserve mainly as a financial institution, blending private and public control. The difference had always been one of degree or mix; although the mix had changed in the 1930s, the difference between New York and Washington continued.
185. In a later hearing, Snyder described the consultative role of the Federal Reserve in debt management. Until 1943, Secretary Morgenthau called on a large number of experts for advice on the pricing, timing, and maturity of new debt issues. He included presidents of reserve banks among the experts. Eccles and Sproul objected to this procedure on the grounds that advice from the presidents should come through them. Citing the statutory responsibility of the FOMC, the Board asked the Treasury to recognize the chairman and vice chairman of the FOMC as the representatives of the FOMC. The Treasury agreed. This procedure continued in effect under Secretaries Vinson and Snyder (Subcommittee on General Credit Control and Debt Management 1951, 78–79).
186. There is no record of the discussion at this meeting. Snyder was either misleading or not well informed. He denied that there had been a recession in 1948–49 (Subcommittee on Monetary, Credit and Fiscal Policies 1950a, 412) and claimed that the United States was on a gold bullion standard (422).
The testimony brought out several changes in analysis and outlook. Unlike the 1920s, all System spokesmen accepted responsibility for countercyclical policy and recognized that System actions affected prices, output, and employment. Although there were occasional references to “speculative” uses of credit, these have a much less prominent role.
Witnesses offered reform proposals, including abolishing the Board and vesting all monetary powers in the FOMC. At the opposite extreme, Eccles repeated his earlier wish for a five-person Board without reserve bank participation in open market decisions. Such perennial issues as required membership, uniform reserve requirements for all commercial banks, and coordination with other banking and financial regulators reappeared. Members of the subco
mmittee and the witnesses considered whether some type of domestic policy council would help to coordinate policy actions. The three System spokesmen differed on these issues, reflecting their views on the role of government.
The main focus remained on Federal Reserve–Treasury conflicts and whether there was a legal obligation or commitment to prevent bonds from going below par value. Snyder denied any legal obligation. It was a policy, not a binding commitment. McCabe denied that the FOMC had been pressured by the Treasury to support the 2.5 percent long-term rate (ibid., 465). There were “widely varying shades of judgment” about appropriate policy. His view was that the System had to avoid the “repercussions that would ensue throughout the economy if the vast holding of the public debt were felt to be of unstable value” (465). The Treasury had been slow to accept higher short-term rates, but McCabe did not challenge the ceiling on the long-term rate.187
McCabe quoted from the June 1949 announcement that interest rates would be more flexible: “I regard June 28, 1949 as a most important date. It signified removal of the strait-jacket in which monetary policy had been operating for nearly a decade” (ibid., 471). The public debt was now sufficiently settled in the hands of stable holders that monetary actions could be more flexible. Coordination would continue to be required: “A splendid degree of cooperation exists between the Treasury and the Federal Reserve” (472).188
187. Unlike Sproul, McCabe argued that raising reserve requirement ratios had been useful. Sproul argued correctly that the changes simply shifted securities between the Federal Reserve and banks without effects on money or credit.
188. Douglas gently but repeatedly challenged McCabe. Coordination and cooperation, he said, are vague terms, often covering up disagreement. The June 1949 agreement came in a period of recession and called for a reduction in interest rates. The Treasury would, of course, agree to that. “Does it follow that . . . the Treasury will go along with primary regard to the general business and credit situation in other periods?” (Subcommittee on Monetary, Credit and Fiscal Policies, 493–94).
Sproul asked Congress to issue a directive to the Treasury requiring it to carry out debt management within a structure of rates “appropriate to the economic situation” (ibid., 431). He described policy coordination as “better than might have been expected . . . but agreed action . . . has most often been too little and too late so far as the aims of an effective monetary program were concerned” (431). Neither he nor members of the committee mentioned that the Employment Act gave the Treasury some of the guidance that Sproul wanted.189
Like Strong in the 1921 hearings, Sproul showed far greater sophistication about the working of monetary policy than Board spokesmen and many economists of that period. Interest rate changes did more than change borrowing costs, as in the simple Keynesian framework of that period or the Board’s view: “I think in dealing with the interest rate, you are dealing both with expectations as to the future business situation and as to future profits. . . . I think you have an effect far beyond what I admit is the minor cost of interest in the carrying out of any business undertaking” (ibid., 436). Sproul rejected the prevailing view that monetary policy was either ineffective or too powerful to use in an economy with a large outstanding debt. Monetary policy could be used effectively to maintain a satisfactory degree of economic stability. The large debt was not a deterrent to effective policy, as many believed. Small changes in interest rates could be helpful if they were supported by stabilizing fiscal, labor, and debt management policies.190 The main limitation was political. With great insight, he forecast a central feature of the policy of the 1960s and 1970s. Large changes in interest rates were impractical. People would not submit to that sort of discipline because it required reduced production and employment: “I do not think that is the kind of climate we live in” (438). On the critical issue of whether there was an implied or explicit commitment to bondholders, Sproul was firm. No such commitment had ever been made or discussed. A contrary statement by the chairman of the Federal Deposit Insurance Corporation was “grossly mistaken” (439).191
189. Sproul recommended uniform reserve requirements for commercial banks and was willing to open the discount window to nonmember banks as compensation.
190. Douglas asked Sproul to comment on a statement he had sent to the Board: “The problem of the budget is not merely that of deficits and surpluses but also one of size. . . . Carried beyond some point, a large budget destroys incentives throughout the whole community” (Subcommittee on Monetary, Credit and Fiscal Policies, 438). Sproul agreed.
191. Sproul testified that reserve requirements, margin requirements, and other controls should be decided by the FOMC. He strongly defended the regional character of the System and its importance for decision making (Subcommittee on Monetary, Credit and Fiscal Policies, 444–45). The System should continue to combine the political influence from Washington with financial concerns (445). In a letter to McCabe, he endorsed Eccles’s proposal (see below) that Congress should require the Treasury to consult with the FOMC about debt management (Sproul to McCabe, Sproul Papers, Board of Governors, Douglas Hearings, December 16, 1949).
The start of Eccles’s testimony repeated the themes he had emphasized throughout—the need for additional powers over nonmember banks and secondary reserve requirements. Eccles argued, with customary force, that the policy of fixed rates of interest rendered the System powerless to control the supply of money. The process of making decisions continued, but the Treasury controlled the substance of decisions (ibid., 223). Congress had to choose one of three courses. It could retain the present arrangement under which the Treasury controlled monetary policy and the Federal Reserve advised the Treasury; give the Federal Reserve additional powers as a partial substitute for open market and discount powers; or restore the Federal Reserve’s powers to carry out the mandate of the Employment Act and compel the Treasury to take account of the mandate when managing the debt (225).192
Eccles did not argue for a change in the 2.5 percent interest rate. Nor did he argue that the Federal Reserve should force the Treasury to increase interest rates. Federal Reserve independence did not go that far. His statement explains some of the reason for a long delay in implementing an anti-inflation policy in the 1970s: “Congress appropriates the money; they levy the taxes; they determine whether or not there should be deficit financing. The Treasury then is charged with the responsibility of raising whatever funds the Government needs to meet its requirements.. . . I do not believe it is consistent to have an agent so independent that it can undertake, if it chooses, to defeat the financing of a large deficit, which is a policy of the Congress” (ibid., 231). Chairman William McChesney Martin Jr. also held this view in the 1950s and 1960s.
None of the three Federal Reserve witnesses criticized the 2.5 percent ceiling or asked Congress to remove the ceiling. That recommendation was made most forcefully by a banker, W. Randolph Burgess.193 In contrast to Eccles, Burgess argued that the Federal Reserve did not need new powers. The System’s problems arose from insufficient independence, “The wise executive will yield to the Reserve System a substantial measure of independence of action so that its judgments can be objective and free from political bias” (ibid., 178). Open market operations and discount rate changes are powerful tools, Burgess said: “If we will act to restore the prestige of the Federal Reserve System, to give it greater independence and better cooperation from other Government agencies, I believe it does not need any new powers” (179).
192. McCabe was reluctant to have Congress mandate consultation between the Federal Reserve and the Treasury about interest rates and debt management. His concern was political. He thought that “it would be inexpedient to inject language as explicit as is embodied in this directive into the political arena of Congressional debate” (Letter McCabe to Senator Douglas, Sproul Papers, Board of Governors, Douglas Hearings, December 22, 1949, 6–7). His concern was that the populists in Congress would use the opportunity to mandate low int
erest rates.
193. W. Randolph Burgess was chairman of the executive committee, National City Bank. He had been a vice president of the New York reserve bank in the 1920s and 1930s and was a member of the System’s Federal Advisory Council.
Burgess distinguished between real and nominal values, a subject that Reserve officials never mentioned. He compared the relative fixity of interest rates to the loss of value from inflation.194 His testimony also made the strongest argument for allowing interest rates to change. Unlike Snyder, McCabe, and Eccles, who argued that losses on the debt had major consequences that made interest increases too socially costly to impose, Burgess testified that “a moderate decline in bond prices is nothing very serious” (ibid., 182). Small savers were protected from capital losses. The Treasury, mindful of experience in the 1920s, had offered nonmarketable savings bonds, redeemable at the Treasury at a fixed price, including interest, that could only increase in nominal value. Then, he added: “The responsibility of the United States government for the buying power of the savings bonds. . . is fully as important as the cash redemption of these bonds at the price you sell them” (184).195
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