A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The Federal Reserve had little discretion. The founders intended the gold standard to work automatically. Discounting was at the discretion of the member banks. The Federal Reserve could decide the timing of discount rate changes, but the rules of the gold standard limited the range within which it could set the discount rate. It could set the rate at which it bought acceptances, but despite its efforts, the acceptance market did not become large and active.

  The original structure, organization, and methods of operation did not survive. Establishment of the Federal Reserve helped to create a national financial market that undermined the system of separate discount rates. Banks used the correspondent banking system to borrow in markets with lower rates. By the early 1920s, the System had moved toward more uniform discount rates; although differences between districts continued, they were smaller, and rate schedules became more uniform.

  Wars, the growing role of the federal government, and other external forces contributed to the major changes in structure and organization in the years to 1951. Flaws in the original plan and different conceptions about the roles and responsibilities of the Board and the reserve banks combined with these external events to force changes. Different beliefs about the roles of the reserve banks and the Board, and rivalry over power and influence, worked to delay change and disperse power.

  By 1951 the Federal Reserve System had become a central bank with its headquarters in Washington. The accord with the Treasury in March of that year released the Federal Reserve from Treasury control and began the evolution toward the modern Federal Reserve. Although struggles over power and influence continued, the Board of Governors had final control over decisions. The semiautonomous regional banks were now part of a unified system. The Federal Open Market Committee (FOMC) made binding portfolio decisions for the reserve banks. Open market purchases and sales of government securities replaced discounting as the principal means of implementing policy. The discount rate had a minor role.

  The System’s founders would not have liked or even recognized the Federal Reserve that existed in 1951. Gold no longer had an important role. Activist policies, based on collective judgment, determined money, interest rates, and prices. A small, mostly passive institution had become the most important central bank in the world.

  The Federal Reserve’s founders wanted to base currency or note issue on discounts of commercial paper to free currency from dependence on government securities. They believed that the new arrangement would permit currency and money to expand and contract with the needs of trade and the public’s demand. In the Great Depression a change, believed to be temporary, permitted the Federal Reserve once again to issue currency backed by government securities. Eventually the change became permanent. Government securities became the Federal Reserve’s principal asset. Discounts of commercial paper and bills of exchange had only a modest and inconsequential role.

  Volume 1 tells how and why these changes occurred in response both to external events and to flaws in the original plan. It is also a record of the achievements and failures of the first thirty-seven years.

  ACHIEVEMENTS AND FAILURES

  Looking back from 1951, few would conclude that the Federal Reserve had achieved the hopes of its founders and early proponents. The Great Depression, though at the time not considered a failure of monetary policy, was the deepest and longest in United States history. The Federal Reserve had not prevented thousands of bank failures, the collapse of the financial system, and the devaluation of the dollar. The dominant view in 1951 regarded monetary policy as unimportant for economic stabilization, but it recognized that the Federal Reserve had failed to maintain financial stability. Deposit insurance, stock market regulation, and separation of commercial and investment banking, among other New Deal measures, showed that the public, through its representatives, no longer trusted the Federal Reserve alone to maintain a stable and solvent financial system.

  Central bankers and most economists in the 1920s regarded the gold standard as essential for monetary stability. The Federal Reserve achieved one of its major goals when Britain and France followed Germany back to a fixed exchange rate with their currencies convertible into gold. Other countries pegged to gold also; by 1928 all major trading countries, and many others, had adopted a gold exchange standard. The Federal Reserve and other central bankers considered restoration of a type of gold standard one of the major achievements of the 1920s.

  Although central bankers and governments wanted the gold standard restored, several were reluctant to accept its implications. Three problems arose. First, after restoration, exchange rates in major trading countries were incompatible with domestic price stability. The British overvalued the pound; the French undervalued the franc. Britain would not deflate after 1925; France would not inflate after 1927, so price changes could not adjust real exchange rates to remove these differences, as the gold standard required. Second, countries would not permit dynamic adjustment to work. Gold flowed to the United States through much of the decade and to France at the end of the decade. Both countries sterilized most gold flows to prevent prices from rising. With receiving countries sterilizing, the countries paying gold had to deflate or leave the standard. The gold standard had an unwelcome deflationary bias. As countries returned to the gold standard, the increased demand for monetary gold stocks added to deflationary pressure.

  Third, under the gold exchange standard the United States and Britain held their reserves in gold. Other countries held dollar or pound sterling balances. France, especially, regarded its status as second-rate. As in the 1960s, the rules permitted the Bank of France to convert its reserves into gold. France’s gold purchases, and sales of dollars and pounds, added to the deflationary pressures imposed by the return to gold. Unwilling to follow the rules or give up the standard, countries resisted steps to restore equilibrium real exchange rates. In retrospect, the breakdown of the gold standard seems inevitable; at the time, it seemed calamitous.

  As the world economy moved toward deflation and depression. The Federal Reserve’s principal concern was inflation. To contemporary economists, this concern is puzzling because the price level fell slowly from 1927 to 1929, then more rapidly. Federal Reserve officials did not base their concern about inflation on price changes or sluggish money growth. To most of them, rising stock prices and growing use of borrowing to purchase shares was all the evidence of inflation they needed. Their interpretation relied on the real bills doctrine—the belief that credit extended for common stocks, real estate, government securities, or commodity speculation created inflation because the additional credit did not give rise to additional output.

  Deflationary policies contributed to the start of the 1929 recession. When the Federal Reserve raised the New York discount rate in August 1929, part of the world was in recession. Although it was not known at the time, the United States economy was at a peak. The Great Depression had started.

  There is no single cause of the Great Depression or a unique monetary shock. A series of financial shocks followed—bank failures, Britain’s departure from the gold standard followed by other departures, and financial failures in the United States. Most Federal Reserve officials favored a passive policy. They viewed the depression as the inevitable consequence of excessive speculation in stocks financed by credit creation. On their view, the proper response was to purge the economic system of its excesses—excesses made more serious by credit expansion unrelated to real bills. Monetary or credit expansion to end the depression would require purchases of government securities. On the real bills interpretation, such purchases prevented the inevitable adjustment and purge of previous excesses.

  If the Federal Reserve had maintained monetary growth, the country and the world would have avoided years of depression. Failure to act during the Great Depression was the Federal Reserve’s largest error, but far from its only one. Failure to expand can be explained as the result of prevailing beliefs about the inevitability of a downturn following the stock market bo
om. Nothing in theory or central banking practice can explain why the Federal Reserve did not respond to the failure of thousands of banks. Most of the banking failures from 1929 to 1932, and the final collapse in the winter of 1933, could have been avoided. The failing banks included many member banks. After years of recession, banks had little eligible paper to borrow against. The Federal Reserve, following the real bills doctrine, saw no reason to expand. This was a destructive and mistaken interpretation of banking theory. In Lombard Street, his classic work on banking, Walter Bagehot quotes the spokesman for the Bank of England in the 1825 panic: “We lent it . .. by every possible means and in modes we had never adopted before .. . in short, by every possible means consistent with the safety of this Bank, and we were not on some occasions over-nice” (Bagehot 1962, 25).

  Bagehot’s work was known at the time. Senior officials referred to him, but they did not follow his advice. They tried to protect the gold reserve and, at crucial times, did not function as a system. Individual reserve banks refused to participate in open market purchases to protect their banks’ gold holdings. A design failure and a failure of leadership permitted individual banks to opt out of System purchases. There was too much autonomy built into the 1913 Federal Reserve Act, and the Board failed to use its powers to force the reserve banks to expand together.

  Ideas were important too. The original Federal Reserve Act wrote the real bills doctrine into law. At the Federal Reserve Board, and at several reserve banks, officials followed this doctrine. They considered real bills—commercial credit—to be the only correct foundation for credit expansion. If banks did not borrow, they believed it was wrong to expand credit. This policy gives rise to procyclical policy action: credit and money expand when output expands and contract when output contracts. The gold standard, too, makes policy action procyclical.

  The Federal Reserve’s attachment to the real bills doctrine was not peculiar. Economists, bankers, congressional leaders, and many others accepted the theory and believed the Federal Reserve was right to follow it. There were few critics at the time.

  Early in the nineteenth century, one of the founders of economics, Henry Thornton (1962) recognized the principal flaw in the real bills doctrine: controlling the quality of credit did not ensure control of the quantity. At the Federal Reserve, Benjamin Strong rediscovered this proposition in the 1920s. Neither the discovery nor the rediscovery convinced real bills proponents.

  Strong’s conclusion reflected experience in the postwar recession of 1920–21. After the Federal Reserve convinced the Treasury to end wartime restrictions on interest rates, the nominal discount rate rose to 7 percent in New York. Use of marginal discount rates at regional banks raised interest rates far above that level. Discounting continued to increase, in part because banks could borrow at preferential rates using Treasury securities as collateral. But that was not the lesson drawn by Strong and others.

  The 1920–21 experience affected subsequent developments in two ways. First, the Federal Reserve became convinced that the traditional British central banking procedures would not work in the larger, more diverse circumstances of the United States. Second, and closely related, complaints from agricultural and commercial interests, particularly in the South and West, aroused congressional concerns. Topmost among the political concerns was the fear that the Federal Reserve would operate for the benefit of Wall Street and large banks and against the interests of farmers, ranchers, and the general public. Federal Reserve policy in the 1920–21 recession seemed to confirm these fears.

  Failure to distinguish between real and nominal interest rates was another, no less important error. As prices fell, real interest rates rose. Federal Reserve officials, and outsiders, failed to distinguish between the two rates, a distinction recognized early in the nineteenth century by Henry Thornton and later developed more fully by Irving Fisher. Although there are occasional references to the possibility that a low nominal interest rate did not necessarily connote an easy policy, none of those making these comments offered a clear analysis of the effect of falling prices on real interest rates and exchange rates.

  Failure to distinguish clearly between real and nominal interest rates is puzzling. Fisher was professionally active in the 1920s and 1930s. He warned about the high cost of deflation and urged officials to pay attention to measures of deposits and money. In the 1920s Fisher worked to get Congress to mandate price stability as the Federal Reserve’s goal. The Federal Reserve opposed the legislation, and it did not pass.

  The Federal Reserve also ignored Walter Bagehot’s analysis of the role of a lender of last resort. At times Board members and governors referred to Bagehot’s Lombard Street, but they did not follow his doctrine: In a financial crisis, lend freely at a penalty interest rate; do not try to protect the gold reserve.

  Theories, or beliefs, go a long way toward explaining why the Federal Reserve did not avoid crises in 1920–21, 1929–33, and 1937–38. The beliefs that officials used to interpret events, and the interpretations they reached, were conventional at the time. The Federal Reserve Act used the gold standard and the real bills doctrine as guiding principles. Faith in the gold standard and belief in its stabilizing power constituted a cornerstone of the orthodoxy of the time, an orthodoxy that was widely shared by leading members of the business, banking, and academic communities. It would have required a strong, forceful leader to recognize the need to abandon orthodox beliefs. A divided Federal Reserve could not supply that leadership. It is highly uncertain that even a strong leader could have overcome the firmly held beliefs that led to the mistakes of 1929–33 and 1937–38.

  Between 1930 and 1933, the Federal Reserve did little to prevent the collapse of the United States financial system and thousands of bank failures. President Herbert Hoover and Secretary Andrew Mellon proposed a National Monetary Commission and, soon after, the Reconstruction Finance Corporation (RFC) to prevent failures from spreading. Initially the Federal Reserve was wary of these efforts, concerned that it would have to lend to insolvent banks or to institutions like the RFC that lent to insolvent banks. By June 1932, the Federal Reserve wanted the RFC to be more active. In part this change of view reflects two opposing influences. One was the System’s desire to limit or end bank failures and the large increases in the demand for currency by concerned depositors. The other was the firm belief that it could, or should, do nothing to prevent bank failures.

  Financial collapse in the winter of 1933 was not inevitable. President Hoover appealed to the Federal Reserve to offer guidance. Hoover also appealed to President-Elect Roosevelt to support a bank holiday. Hoover believed he lacked authority to act, and Roosevelt was unwilling to accept responsibility when he lacked authority.

  Political maneuvering and hesitancy do not explain the Federal Reserve’s failure to act. Chapter 5 offers three plausible explanations. First, some members of the Open Market Policy Conference believed that the very large open market operations in 1932 accomplished little. Additional operations would do no more. Failures, they believed, were the inevitable consequence of bad decisions and speculative excesses that had to be purged before stability could return. Second, some reserve banks, notably Boston and Chicago, refused to participate in additional purchases during the summer of 1932. They would likely have refused again, if asked, in the winter of 1933. Third, some reserve banks may have feared that open market purchases would be offset, in part, by a loss of gold. Protecting the gold reserve by refusing to lend was one of the main errors of central banking practice that Bagehot warned against.

  Reliance on discounting gave monetary policy a procyclical bias. In the severe recessions of 1920–21 and 1937–38, the Federal Reserve imposed deflation. The 1920–21 recession resulted from a decision to restore the prewar dollar–British pound exchange rate by deflating prices in both countries. Britain had experienced more inflation, so it had to deflate most to restore the prewar exchange rate. Deflation by Britain alone, however, would not have removed the effects of wartime
finance on the United States stocks of money and credit, contrary to the real bills doctrine. The decision delayed Britain’s return to the gold standard and raised the social cost. The two governments did not repeat this mistake after World War II.

  The decision to deflate together also raised the social cost in the United States. The 1920–21 recession is the only recession in Federal Reserve history that has short-term nominal interest rates higher at the trough of the recession than at the previous peak. Severe deflation made real interest rates higher still.

  The Federal Reserve took no action to end the recession. Rising real interest rates, however, attracted gold, raising the stock of base money. The counterpart of rising real interest rates was a rising stock of real balances. As prices fell and gold flowed in, real money balances rose rapidly. When the public’s real balances exceeded the amount it wished to hold, spending increased and the recession ended.

  The pattern of rising real money balances and rising real interest rates contributed to ending recession in 1937–38 and 1948–49. This dynamic did not work to restore prosperity in 1929–33 because the Federal Reserve allowed the nominal stock of money to decline so much that real money balances fell despite the expansive effect of deflation on the stock of real balances. Bank failures, and fears of additional failures, contributed to the decline in real balances. Efforts to shift from deposits to currency drained reserves from the banking system. The Federal Reserve’s failure to offset the loss of reserves added to bank insolvency and brought about the result the public feared.

  Theory or beliefs also contributed to the Federal Reserve’s reluctance to end pegged interest rates after World War II. Many economists and businessmen claimed that a large outstanding government debt limited the size of permissible interest rate changes. Marriner Eccles, Federal Reserve chairman at the time, repeated frequently that, to be effective, interest rate increases had to be large. Large increases, however, imposed large losses on debt owners (with gains to the Treasury). Unwilling to impose large losses, Eccles sought other ways to reduce spending growth.