An excerpt from
A History of the Federal Reserve
Volume 2, Book 1, 1951-1969
Allan H. Meltzer
Exact scientific reasoning will seldom bring us very far on the way to the conclusion for
which we are seeking, yet it would be foolish to not avail ourselves of its aid, so far as it will
reach:—just as foolish would be the opposite extreme of supposing that science alone can
do all the work, and that nothing will remain to be done by practical instinct and trained
The Federal Reserve that we find in these volumes is very different from the institution founded in 1913. Carter Glass, one of its founders, always insisted it was not a central bank. Its main business was the discounting of commercial paper and acceptances governed by the real bills doctrine and subject to the gold standard rule. The United States was an industrial economy, but agriculture retained a signifi cant role and furnished about 40 percent of exports. Discounting facilitated the seasonal increase in loans that supported agricultural exports.
By the 1980s, when this volume ends, the United States had become a postindustrial economy, by far the largest economy in the world. The Federal Reserve was the world’s most influential central bank. No one had denied it this title for at least fifty years. Much had changed. Discounting became a minor function. The gold standard was gone. Principal central banks issued fiat paper money and floated their exchange rates.
During its early years and for many years that followed, the Federal Reserve System’s concerns included par collection of checks and System membership. Many small banks earned income by charging for check collection. The payee received less than the face amount of the check. Members were required to collect at par. Many small, mainly country, banks did not join the System to avoid par collection and to avoid costly reserve requirement ratios. Both problems ended by the 1980s when Congress made all banks adopt Federal Reserve reserve requirement ratios even if they declined membership.
The most signifi cant change was increased responsibility for economic stabilization, a mission that officials first denied having. Two economic and political forces changed that belief. One was developments in economic theory beginning with the Keynesian revolution in the 1930s and later the monetarist counterrevolution in the 1960s and the Great inflation of the 1970s.
The principal monetary and financial legacies of the Great Depression were a highly regulated financial system and the Employment Act of 1946, which evolved into a commitment by the government and the Federal Reserve to maintain economic conditions consistent with full employment. The Employment Act was not explicit about full employment and even less explicit about inflation. For much too long, the Federal Reserve and the administration considered a 4 percent unemployment rate to be the equilibrium rate. The Great inflation changed that. By the late 1970s, the targeted equilibrium unemployment rate rose and Congress gave more attention to inflation control. The resolution was reinterpretation of the Employment Act as “a dual mandate” to guide policy operations at the end of the last century and beyond. The guide does not clearly specify how a tradeoff between the two objectives—low inflation and a low unemployment rate—should be made when required. But it is now more widely accepted that in the long run, employment and unemployment rates are independent of monetary actions, so that monetary policy is fully refl ected in the inflation rate and the nominal exchange rate.
The founders of the Federal Reserve intended a passive but responsive institution with limited powers. Semi-independent regional branches set their own discount rates at which members could borrow. The borrowing initiative remained with the members. Creation of the Federal Reserve brought regional interest rates closer together. By the mid-1920s, the System became more active. Under the leadership of Benjamin Strong, it initiated action to induce banks to borrow or repay lending. From this modest start, open market operations became the Federal Reserve’s principal and usually only means of changing interest rates and bank reserves. Discounting almost disappeared; advances became a very small activity used mainly for seasonal adjustment by agricultural lenders. Following passage of the Employment Act, the Federal Reserve at first recognized responsibility mainly for employment and to a lesser extent for inflation. The weight on inflation increased in 1979, a result of the Great Inflation.
Like most central banks, the Federal Reserve avoided taking risk onto its balance sheet. Until 2008 both by statute and by its own regulations, it limited the assets it acquired principally to Treasury securities, mainly shortterm bills, and gold (or gold certificates after 1934) and foreign exchange. Originally the Federal Reserve tried to develop a market in bankers’ acceptances, but it did not succeed. In 1977, it ceased open market operations in bankers’ acceptances. Under pressure from Congress to assist housing finance, it purchased small volumes of agency securities in the 1970s.
Small and Clouse (2004, 36) reviewed the legal and regulatory rules that apply to the Federal Reserve’s asset portfolio.
In usual circumstances, the Federal Reserve has considerable leeway to lend to depository institutions, but a highly constrained ability to lend to individuals, partnerships, and corporations (IPCs). The lending to depository institutions can be accomplished through advances (rather than discounts) secured by a wide variety of private-sector debt instruments. In discounts for depository institutions, the instruments discounted generally are limited to those issued for “real bills” purposes—that is agricultural, industrial, or commercial purposes. The Federal Reserve can make loans to IPCs, but except in unusual and exigent circumstances, the loans must be secured by U.S. Treasury securities or by securities issued or guaranteed by a federal agency.
The evolution that changed an association of semi-independent reserve banks into a powerful central bank reflects interaction between policy, events, and monetary theory. Volume 1 showed the importance of the gold standard and, even more, the real bills doctrine that had a powerful role in sustaining the Great Depression. This volume documents the role of Keynesian thinking in creating the Great inflation and mainly monetarist thinking in bringing inflation back to low levels.
Intervention between monetary theory, policy, and events is one part of the story. Changing beliefs about the role of government is another. By the middle of the twentieth century, citizens (voters) in all the developed countries accepted that government had a responsibility to maintain economic prosperity. This raised a critical issue. Voters could punish an administration or Congress for actions of the Federal Reserve. Responsibility and authority remained separate.
The next sections discuss three main themes of this volume. First is the relation of monetary theory to monetary policy. Second is the meaning of central bank independence. Third is inflation, the dominant monetary event of the years 1965 to 1985.
The monetarist-Keynesian controversy had a large role in bringing about changes in policy. Federal Reserve officials never agreed upon a theoretical framework for monetary policy, but the controversy and research influenced them. In the 1980s, Chairman Volcker called his framework “practical monetarism.” This was a major change from the approaches advocated by Chairmen Martin and Burns. Changing views about the meaning of central bank independence and its practical application contributed to the start, persistence and end of the Great Inflation.
THE KEYNESIAN ERA
In the early postwar years, policymakers assigned a major role in stabilization policy to fiscal actions. Monetary actions had a minor supporting role, mainly to support fiscal generated expansions or contractions by avoiding large changes in interest rates. Herbert Stein (1990, 50) listed the seven assumptions used in the early postwar versions of Keynesian economics. Stein described these assumptions as “the simple-minded Keynesianism that a generation of economists learned in school and which became the creed of modern intellectuals.”
To economists in the twenty-first century, these assumptions and claims seem extreme, simplistic, even simpleminded. Three citations suggest how broadly it was held. First is the survey of monetary theory written for the American Economic Association’s sponsored Survey of Contemporary Economics (Villard, 1948). Second is the 1959 report of the Radcliffe Committee in Britain, written after inflation had become a problem in Britain, the United States, and elsewhere (Committee on the Working of the Monetary System, 1959). Third is the American Economic Association’s Readings in Business Cycles (Gordon and Klein, 1965). I cite these studies not because they were unusual but because they reflect the dominant or consensus views found in professional discussion, in popular textbooks such as Ackley (1961), and in econometric models of the period.
Simple Keynesian ideas dominated the analysis in Employment, Growth, and Price Levels prepared by professional economists for Congress in 1959(Joint Economic Committee 1959a). The report denied long-run monetary neutrality, gave no attention to expected inflation, and argued that the economy could not on its own achieve full employment and price stability without guideposts for wages and prices. Chairman William McChesney Martin, Jr., did not share this view, and the Federal Reserve’s statement to Congress did not endorse it.
The Federal Reserve opposed securities auctions and helped to fi nance budget defi cits, a main source of inflationary money growth after 1965. Treasury later began auctions. In time, the Federal Reserve ended “even keel” operations used to reduce interest rate changes during Treasury financings.
The early Keynesian model evolved. By the 1960s a Phillips curve relating some measure of inflation to output, the gap between actual and full employment, or unemployment became a standard feature. Prices no longer remained constant; aggregate demand could exceed full employment output, resulting in inflation.
What remained unchanged was the belief that money growth had at most the secondary role of financing deficits or fiscal changes to prevent interest rates from rising, or from rising “unduly.” Policy coordination became an accepted policy program in the 1960s. In practice, coordination meant that monetary expansion financed government spending or tax reduction and also moderated the negative effects on employment of anti-inflation fiscal actions.
There is often not a close connection between academic research fi ndings and recommendations and Federal Reserve actions. This was certainly true of the 1950s. Chairman Martin had little interest in economic theory or its application. His principal advisers, Winfield Riefler and Woodlief Thomas, revived a modified version of the 1920s policy operations that gave main attention to the short-term interest rate and credit market conditions. To mask its role in affecting interest rates, the Federal Reserve most often set a target for free reserves—member bank excess reserves net of borrowed reserves. Free reserves moved randomly around short-term interest rates.
Keynesian influence became much more visible in the 1960s. President Kennedy brought leading Keynesian economists into the administration. They continued the regular meetings, started in the Eisenhower administration, that brought the Federal Reserve chairman together with the president and his principal economic advisers. These meetings and other contacts sought to increase policy coordination and reduce Federal Reserve independence. And Presidents Kennedy and Johnson chose members of the Board of Governors who shared mainstream Keynesian views. As older staff retired, the Federal Reserve staff and advisers acquired younger economists trained in Keynesian analysis. By the late 1960s, the Keynesian approach dominated discussion.
Similar changes affected Congress. Avoiding recession became the priority. Hearings reflected the urgency felt by many to avoid an unemployment rate above 4 percent, considered full employment.
Chairman Martin at the Federal Reserve did not share these interpretations. He had a restricted view of both Federal Reserve independence and the power of monetary policy. To him, the Federal Reserve was independent within the government. This meant that Congress voted the budget. If they approved deficit finance, the Federal Reserve’s obligation called for monetary expansion to keep interest rates from rising. Martin blamed the deficit for inflation. As he said many times, he did not understand money growth. Thus, he permitted inflation to rise despite his many speeches opposing the rise. Although he did not share the Keynesian analysis, he enabled their policies.
Federal Reserve policy relied on interest rate ceilings (regulation Q) to control credit expansion. Substitutes for bank credit developed to circumvent regulation. The euro-dollar market enabled banks to service their customers and money market mutual funds substituted for time deposits. Governor James L. Robertson especially recognized that the System should end reliance on rate ceilings, but the timing never seemed right. Opposition in Congress contributed to the lack of action. Also, the Federal Reserve did not distinguish between real and nominal rates, a problem after inflation rose. Brunner and Meltzer (1964) formalized the Federal Reserve’s analysis.
THE MONETARIST CRITIQUE
Clark Warburton was an early critic of Keynesian analysis. Warburton concluded from his empirical work that erratic changes in money growth were the main impulse producing recessions. Real factors had a secondary role. In the long run, money was neutral.
One of the earliest propositions of monetary economics, expressed in the quantity theory, claimed that the monetary authority determined the stock of money, but the public determined the price level at which the stock was held. In a modern economy with developed asset markets, an excess supply of money increases the demand for existing assets in addition to or in place of increases in commodity demand. Higher asset prices induce increased demand for investment.
Beginning in the mid-1950s, Milton Friedman and his students and collaborators produced theoretical and empirical analyses of the role of money. In Studies in the Quantity Theory of Money (1956), Friedman challenged the Keynesian view that money substituted only for bonds or, in practice, Treasury bills. In the most developed Keynesian models, wealth owners optimized their portfolio of bonds and real capital, then separately distributed short-term holdings between money and Treasury bills (Tobin, 1956 and elsewhere). Friedman treated money as part of an intertemporal portfolio; money holding substituted for bonds, real capital, and other stores of wealth as in classical analysis. The effect of changes in the stock of money were not limited to the interest rate on Treasury bills. Relative prices on domestic assets and the exchange rate or foreign position responded to the change in money. In their Monetary History, Friedman and Schwartz (1963) showed that money growth had a major role in fluctuations, inflation and deflation.
Discussion and controversy went through several phases. Among the central issues were the properties of the demand for money, the distinction between real and nominal interest rates, real and nominal exchange rates, and between the short- and long-run Phillips curves. By the late 1970s, economists reached a consensus on many of the disputed issues. In his presidential address to the American Economic Association, Franco Modigliani, a leading Keynesian economist, acknowledged that the monetarist position was correct on these issues (Modigliani, 1977). The principal remaining issue between monetarists and Keynesians that he did not concede was whether monetary policy should follow a rule or proceed according to the discretionary choice of officials. Issues no longer in dispute included the long-run neutrality of money, the effects of inflation on money wages, nominal interest rates, and exchange rates, and any permanent real effects of inflation. Four fundamental issues affecting monetary policy remained: the role of monetary rules, the definition of inflation, importance of relative prices in the transmission of monetary policy, and the internal dynamics of a market economy, particularly whether it is mainly self-adjusting.
Classical monetary policy was based on rules. The best-known rule was the gold standard, but other proposed rules included bimetallism, commodity standards, and real bills. The aim was to achieve price or exchange rate stability. Keynesian analysis shifted the emphasis from rules to discretionary actions by governments and central bankers. Monetary policy, at first, had the modest role of financing fiscal actions, as discussed above. Its responsibilities increased until it held a prominent role in stabilizing the economy. Discretionary actions intended to stabilize were based on judgments of current and possibly longer-term consequences of events and policy actions.
Early in the discussion of rules and discretion Friedman (1951) recognized the importance of information and uncertainty in choosing between a rule and discretionary actions. A well-intentioned policymaker may destabilize if he is misled by incomplete or incorrect information. Later work by Kydland and Prescott (1977) and a large literature that followed analyzed time inconsistency and the credibility of policy actions and announcements. Kydland and Prescott showed that the dynamic path that the economy follows depends on the choice of policy rules. A discretionary policy that made an optimal choice today was time inconsistent if it did not follow a rule restricting future actions. An individual or firm planning its future actions experienced increased uncertainty when faced by discretionary policy.
A major change in economic theory came with recognition of uncertainty and the role of information. This heightened attention to the role of expectations. Lucas (1972) developed earlier work on rational expectations. Rational expectations raised a question about the meaning of discretion. In practice, many central banks responded by providing more and better information about current and future actions. Rational expectations implies that central banks depend on market responses and markets depend on central bank actions. Setting and achieving a target for inflation two or three years ahead is a recognized way of reducing uncertainty about future actions. Federal Reserve officials have not adopted a formal inflation target, but, for a time, they encouraged a belief that they try to hold inflation in the 1 to 2 percent range, and in 2007 they began to forecast inflation, output, and unemployment for three years ahead. In early 2008, however, they gave most weight to forecasts of possible recession and less weight to inflation.
These actions constitute a major change from the secrecy traditionally practiced by central banks. It recognized the developments in monetary theory about the role of information, the importance of anticipations, and the success achieved by foreign central banks that announced inflation targets. But United States governments have not adopted fixed rules and are unlikely to do so in the foreseeable future.
Central bankers continue to meet regularly to decide current actions. Prominent central bankers have explained why they do not commit to a fixed rule. The former chairman of the Federal Reserve, Alan Greenspan (2003), explained that a fixed rule could not take account of the many contingencies to which monetary officials might wish to respond. The contingencies are infinite and most are unforeseeable. Many of the contingencies arise from actual or potential financial failures. The monetary rules developed in the literature do not incorporate these contingencies. In the past, following Bagehot (1873 ) the central bank or the government announced in advance that it would suspend the gold standard rule at such times and provide the increased reserves demanded. This became part of the monetary rule.
Greenspan’s successor, Ben Bernanke (2004), recognized that the central bank can do a great deal to reduce uncertainty about its future actions, but “specifying a complete policy rule is infeasible” (ibid., 8). He accepted Greenspan’s reason for infeasibility. Mervyn King (2004), governor of the Bank of England, called for “constrained discretion.” “Suitably designed, monetary institutions can help to reduce the inefficiencies resulting from the time-consistency problem” (promising one thing but later doing another) (ibid., 1). Otmar Issing, former chief economist and board member of the European Central Bank, expressed a similar position on many occasions (Issing, 2003, for example). He regarded as impossible in practice the idea of following a fixed rule.
The chapters that follow show that the Federal Reserve changed its objectives
and its target many times. Often it did not have a precise target. Even
after Congress required the Federal Reserve to announce an annual monetary
target, it did not adopt procedures to achieve the target and allowed excess
money growth to remain by following the practice called “base drift.”