In both world wars, the Federal Reserve surrendered its independence to assist in war finance. Each time it found that regaining independence was difficult and long delayed. It did not learn from its experience after World War I to negotiate an end to pegged interest rates before it made a commitment in 1942. It did not foresee that raising interest rates would be unpopular after the war. It worked hard to gain public support for independence among journalists, academics, bankers, and the public, and within the government by undertaking unpopular duties that Congress and the executive branch did not want to do. Only after the Korean War started and concern about inflation rose did the Federal Reserve muster the popular and congressional support necessary to sustain an independent policy.
2. The Treasury also pointed out that section 10 of the 1913 Federal Reserve Act gave the Treasury power to override the Board in the event of conflict (Subcommittee on General Credit Control and Debt Management 1951, 28). The wording is: “Wherever any power vested by this Act in the Federal Reserve Board or the Federal Reserve agent appears to conflict with the powers of the Secretary of the Treasury, such powers shall be exercised subject to the supervision and control of the Secretary” (Krooss 1969, 4:2450). The section protects the Treasury against any interpretation of the Federal Reserve Act that limited the Treasury’s authority. The Treasury’s interpretation seems extreme.
Control
President Wilson’s compromise, establishing semiautonomous reserve banks and a supervisory Federal Reserve Board, did not resolve the issue of control. Conflicts arose not only because the act dispersed control but because, from the start, officials had different ideas about how the new System should function. New York bankers especially wanted a central bank, under their leadership. The Board often tried to stretch the term “supervise” until it meant “decide.”
Benjamin Strong avoided the Board’s control by responding to the interests of other reserve banks. Several of the governors thought of their activity as banking, and they wanted their banks to profit. The act granted a dividend on the shares held by member banks, so earnings had to be sufficient to pay the dividend. In the early years some reserve banks—particularly the smaller banks in predominantly agricultural regions—did not have enough discounted paper to pay expenses and the dividend. Strong offered to pool the income on acceptances and then on government securities. By adjusting the allocation formula, he helped the smaller banks solve their problem. In return, they supported his decisions.
In 1919 the Board was able to get the acting attorney general to interpret its power to include changing discount rates even if a reserve bank opposed the change. The Board used the power again in 1927 when it ordered Chicago to reduce its rate.
By the mid-1920s, discounting had a much-reduced role compared with the original plan. Open market operations became the instrument of choice for affecting interest rates and member bank borrowing. Board members could reject the reserve banks’ decision, but they could not order the banks to buy or sell. That decision remained with the directors until changed by the 1935 act. The 1935 act not only placed all Board members on the Federal Open Market Committee, for the first time it gave the Board a majority of the votes.
During the years of depression and war, the Board was slow to use its powers. Regular open market operations did not begin until the Federal Reserve was again independent.
In 1927 Strong decided to help Britain remain on the gold standard by lowering interest rates, without first consulting the Board or other governors. The Board and some of the governors later concluded that Strong erred. They blamed the decision for the stock market boom and blamed Strong for the mistake. The Banking Act of 1933 stripped New York of its dominant role. After devaluation of the dollar, control shifted to the Treasury.
WHAT REMAINED IN 1951?
Much of the original plan and organization did not survive to 1951. Gold remained part of reserves, but the dollar, not gold, became the world currency. The Federal Reserve neither thought nor acted as if interest rates and money creation depended on capital flows. Monetary policy became discretionary. In the 1920s the Federal Reserve sterilized part of the gold inflows. In the 1950s it ignored them as a reason for policy action. Increasingly, domestic objectives became the main guide to action.
Vestiges of the real bills doctrine remained part of Federal Reserve thinking. Credit controls such as regulation of down payment requirements and length of loan reflected the mistaken idea that the Federal Reserve could control inflation and the quantity of money by controlling the type or quality of credit. Later these ideas faded away, encouraged both by the difficulty of administering controls and by their ineffectiveness as an anti-inflation policy.
Open market operations in government securities had much earlier replaced the discounting of eligible commercial paper as the principal means of intervening. These operations were more efficient. They did not require decisions about what was eligible, and they did not require the Federal Reserve to accept credit risk. The Federal Reserve determined the size and timing of purchases and sales.
One of the Federal Reserve Act’s major innovations removed government securities as collateral behind Federal Reserve notes. The intent was to make note issues more “elastic,” capable of expanding and contracting with commerce, agriculture, and trade. When borrowing declined in the 1930s, the Federal Reserve had to use more than the required percentage of gold as backing for its notes. The Glass-Steagall Act of 1932 reversed the original innovation by permitting the Federal Reserve to use government securities in place of eligible paper as backing for its note issue. Originally a temporary measure, after several renewals the use of government securities as collateral became permanent. Later, Congress removed the required gold backing.
The change in collateral behind notes symbolizes the decline in the real bills doctrine as a guiding principle. The doctrine required procyclical monetary expansion: the Federal Reserve provided additional currency and reserves as the economy expanded and withdrew currency and reserves in economic contractions. The revised Federal Reserve Act, in 1935, retained “the needs of commerce” as a policy objective but added “the general credit situation.” The Employment Act of 1946 did not impose a clear objective on the Federal Reserve, but it emphasized employment and production. Maintaining production and employment required countercyclical policies.
The 1946 legislation suggests the change in public attitudes about the role of government. The change affected the Federal Reserve by endorsing its transformation from a largely passive authority to an activist policymaker. The 1913 Federal Reserve Act gave little scope for discretionary action. By the 1950s, a generation trained in Keynesian analysis rose to prominence at the Federal Reserve and elsewhere in society. Its members believed that budget policy would have the senior role. The role of monetary policy was secondary, supportive of fiscal actions, but useful as a means of keeping interest rates from rising. The emphasis on interest rates fit well with traditional practices.
POLICY LESSONS FROM THE EARLY YEARS
The wide range of monetary experience—wartime inflation, deflation, economic expansion in the 1920s, depression in the 1930s—provides evidence of the relative roles of money and interest rates in the transmission of central bank actions. In some cases money growth falls as interest rates rise or money growth rises as interest rates fall. Since changes in money growth change interest rates, binary comparisons cannot distinguish in these cases whether the transmission of monetary impulses operates principally through changes in interest rates or through changes in money operating through other relative prices and real wealth.
Previous chapters showed that at times interest rates and money growth moved in opposite directions. In 1937–38 and 1947–48, deflation occurred with the short-term interest rate near zero. In both cases the economy recovered without much expansive action by the Federal Reserve. Deflation increased real money balances and real interest rates. The increase in real money balances dominated the effect of
the higher real interest rate; output and economic activity increased. These experiences contradict the belief that monetary policy becomes ineffective when the short-term interest rate remains close to zero.
The 1920–22 experience was similar. The short-term interest rate was not zero in this case, but the economy experienced severe deflation. As prices fell, real balances and real interest rates rose. Falling prices also attracted gold from abroad, increasing the monetary base. The ex post real interest rate on government bonds reached 37 percent at its peak. Nevertheless, economic activity and output recovered, consistent with the increase in real balances but contrary to the rise in the real interest rate.
Chart 8.1 shows changes of the real monetary base and the real interest rate during most of the early Federal Reserve history. Growth of the base is measured year to year. The year-to-year change in the GDP deflator measures the rate of price change subtracted from the Treasury long-term rate to convert nominal rates to real rates. The very high real interest rates in 1921 and 1931–32 reflect the severe deflation at these times.
Real base growth is negative before the Great Depression and in its early years. Ex post real interest rates were comparatively high, above the average for the period shown in chart 8.1 but consistent with cyclical peaks in the 1920s. Both measures suggest that monetary policy was restrictive in 1928–29, contrary to the interpretation made at the time. The data for the late 1920s suggest that a productivity-based expansion, as industry adopted new technologies, was ended at least partly by a deflationary monetary policy.
At the start of the depression, real base growth remained low and ex post real interest rates rose. Base growth rose in 1931 and remained high under the impact of the currency drain. The real interest rate is a better predictor than real base growth for this exceptional period.3
Notable also is the collapse of real base growth in 1937 and renewed expansion in 1938. The real interest rate and real base growth moved together in the early postwar years. The common movement reflects the rate of price change, highly positive in 1946, modestly negative in 1948–49, briefly positive at the start of the Korean War in 1950–51. After each of these periods, economic activity moved in the direction implied by base growth.
We can summarize these data in three propositions:
Proposition 1: when growth of real balances rises sharply, expansion follows whatever happens to the real interest rate. Some examples are 1921, 1934–36, 1939–41, and 1943–45. An exception is 1931–33.
Proposition 2: when real balances decline, or their growth is comparatively slow, the economy goes into recession even if the real interest rate is comparatively low or negative. Examples are 1920, 1923, 1926, 1929, 1933, 1937, and 1947. An exception is 1941.
Proposition 3: if the real interest rate is comparatively high, the economy expands if real balances rise and does not expand if they fall. Examples are 1921, 1925, 1927, and 1938–39. Again, 1931–33 is an exception.
These comparisons suggest that the Federal Reserve erred by ignoring the information in the growth rates of real and nominal balances. For short periods, changes in real balances may have little information. The data suggest, however, that attention to money growth would have enabled the Federal Reserve to avoid its largest errors.
The errors the Federal Reserve made in the years 1913 to 1951 were not unique to the System. The few critics of the real bills doctrine and the gold standard were out of step with the dominant views of the period. Many shared the belief that the Federal Reserve could not have prevented the Great Depression or reduced its duration. Historically low nominal interest rates were considered relevant evidence. The view that monetary policy was akin to “pushing on a string” antedates Keynes’s liquidity trap.
Similarly, many bankers and economists as well as ordinary citizens believed that the gold standard was the correct way to harmonize international monetary policy. Efforts to restore the gold standard in the 1920s, and to fix exchange rates within a gold-based system, met little opposition. Many opponents of the Bretton Woods Agreement criticized its differences from a gold standard.
3. The real money stock, M1/p, fell.
The gradual dissemination of Keynesian ideas in the 1940s slowly transformed the consensus view. Keynes’s emphasis on the role of interest rates and neglect of money fit well with the views widely held by central bankers and in time displaced them. The change to activist, discretionary monetary policy that produced the Great Inflation of the 1970s had not yet occurred by 1951, but important changes had been made. The Federal Reserve gained scope for a more independent, discretionary policy. The United States had an ample supply of gold and, like other parts of the government, a mandate to maintain a high level of employment.
Increasingly, the public looked to government to manage the economy. Within a few years, governments would look to their central bankers to take a leading role in making the macroeconomic policies that first produced the Great Inflation and then learned how to control it.
The shift toward government responsibility required a change in the intellectual consensus on two issues: the roles of gold and government budget deficits. Although some populists opposed the gold standard in the nineteenth century, by 1900 most contemporary opinion in the industrial countries, and many others, viewed the gold standard as the proper way to restrict monetary policy and prevent long-term inflation. The gold standard was a main issue in several presidential elections in the United States. Each time, the gold standard candidate won.
This consensus no longer existed in the 1950s. The population had become more urban and more educated, the country more industrialized, and the workforce more unionized. The public in many countries favored policies that stabilized output, even if the currency value changed.
The belief that balanced budgets should be the norm except in wartime gave way to a loose commitment to cyclically balanced budgets. When private spending declined, government deficits could replace private spending until employment rose.
Weak attachment to the old standards of financial rectitude left the financial system without a belief system that central bankers could appeal to. The new consensus eliminated what had gone before without offering a clear set of rules. At the next stage in the evolution of central banks and governments, the major problem was to learn how to operate in the new, more discretionary environment.
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