Current lessons from the past: how the Fed repeats its history.

• Author: Meltzer, Allan H.
• Position: Report

Here, then, the rulers of society have an opportunity of showing their wisdom--or folly. Monetary history reveals the fact that folly has frequently been paramount; for it describes many fateful mistakes.

--Knut Wicksell

The Federal Reserve System came into existence 100 years ago after lengthy debate and discussion. It seems timely to look back on its founding, its history and development, and to consider its major successes and failures. This article looks at that history and discusses how the past is reflected in the present.

The Founding of the Fed

The new institution had little scope for discretionary policy actions. None of the parties discussing the proposed Federal Reserve Act of 1913 doubted that it would continue to follow a monetary rule--the international gold standard. Actions and initiatives remained greatly restricted by the Act. Monetary, credit, and interest rate actions consisted principally of setting discount rates on commercial paper and banker's acceptances. Rates influenced the amount of discounting, but the initiative for discounting remained with the banks. The Federal Reserve could purchase or sell bankers' acceptances on its own initiative, but individual Reserve Banks could decide whether to participate.

Agreement about economic issues included more than the gold standard. A series of financial disturbances in the 1890s and 1907 convinced most of Congress, the Wilson administration, and the informed public that the social cost of bank failures could be greatly reduced by creating a lender of last resort (LOLR) with power to lend on acceptable collateral in a financial crisis. The gain came from protecting the payments system, not, as now, protecting banks.

Agreement on another vital economic issue concerned the financing of government borrowing. The 1913 Act prohibited any direct loans to the Treasury. The authors understood, perhaps better than their modern counterparts, that financing government debt was likely to bring inflation.

Many economists act as if monetary policy is entirely an economic issue. Many articles analyze optimal economic policy. These articles neglect that the Federal Reserve is governed by political as well as economic concerns. That has been true since the founding, and it remains true, perhaps even truer now that discretionary actions have replaced the very restricted rules in the original design.

Article 1, Section 8 of the U.S. Constitution assigns the monetary power to Congress. The Federal Reserve is its agent. That makes political influence inescapable. Despite words about independence, it takes a very strong leader to remain independent. As former Fed chairman William McChesney Martin Jr. often remarked: "The Federal Reserve is independent within government, not independent of government" (Meltzer 2003: 713). That is not a very restrictive definition of independence.

The gold standard and discounting did not delay the 1913 legislation. The agreements that were difficult to reach were political issues. (1) Two issues stand out: (1) the issue of who would control the new agency--the Board in Washington or the 12 Reserve Banks spread across the country. And (2) where would the Reserve Banks be situated? The law assigned the second issue to a three-person board.

President Wilson, a former political science professor, proposed a compromise. The Reserve Banks would be semi-autonomous, with directors drawn from their region, with power to approve or dissent from purchases and authorized to set regional discount rates with Board approval. The Board in Washington had a supervisory role. The compromise satisfied the Western and Southern populists who thought that the Board would keep New York from setting interest rates at levels that would squeeze farmers and merchants. The large financial firms in New York preferred a structure like the Bank of England with no government participation. They did not get that, but they regarded the new arrangement for discounting as a very profitable opportunity to finance the annual crop movement to Europe in place of foreign banks, British especially, that could borrow from the Bank of England (Warburg 1930; Meltzer 2003: 69).

Popular discussion referred to the Board as "political representatives" and the Reserve Bank officials as "bankers." Populist concern that the bankers would run the system for their benefit continues throughout history. Most crises reduced the role of Reserve Bank directors, broadened director membership, ended their authority to decide on portfolio purchases and sales at their bank, and centralized discount rates and made them uniform. The last was as much the result of the creation of a national money market as a political decision to restrict Reserve Bank influence. The Board was subject to political pressure and influence, so a change in its relative power increased efforts at political influence. Political influence increased after the Second World War as a consequence of the Great Depression and passage of the Employment Act of 1946.

The Federal Reserve's Past Errors

The Wilson compromise got the legislation passed but did not end the struggle for control. Soon after the Federal Reserve began, the United States was at war. The Fed helped to finance wartime spending not by buying government debt as in later years, but by lending on favorable terms to banks that bought large amounts of debt. The prohibition against direct lending to the Treasury was still strong.

The prohibition was soon after circumvented. It is not correct to repeat that the Federal Reserve or Benjamin Strong discovered open market operations. The Bank of England first used open market operations about 100 years earlier. What the New York Fed learned was that open market purchases and sales could be used to change commercial bank reserve positions. The 1920-21 effort to control reserves by raising discount rates, as the Bank of England did, caused a political backlash and renewed fears of high rates dictated by New York. Raising rates, especially the selective high discount rates at several southern Reserve banks, created the need for an alternative means of control. (2) Punitive interest rates at some southern and western Reserve Banks raised political concerns. The Wilson compromise had not worked to keep interest rates low as the Act's sponsors had claimed. The conclusion was that raising rates for farmers and merchants was not a monetary control mechanism that worked in the United States. This was as much a political as an economic judgment, but it retained a controlling influence in 1928, when the board repeatedly vetoed discount rate increases above 6 percent. The political decision to avoid raising rates above 6 percent remained in effect until the Great Inflation and the anti-inflation policies of 1981-82.

In the 1920s, the Reserve Banks controlled decisions. Under the leadership of Benjamin Strong of New York, the Reserve Banks established the Open Market Committee to agree on purchases and sales of government securities and setting rates for acceptances. Open market operations circumvented the outright prohibition on financing the federal government. The Act permitted the Reserve Banks to engage in open market operations. The Reserve Banks could not directly lend to the Treasury, but they could purchase Treasury issues in the open market at rates that they influenced by their decisions. One of the main restrictions on inflationary policy was gone. The gold standard remained but not for much longer.

Strong was not an inflationist. In the 1920s, he agreed with Montague Norman of the Bank of England to allow gold flows to affect rates as long as they did not cause inflation. Other Reserve Bank governors (as they were called at the time) went along with Strong's policy because it provided income to pay reserve bank operating costs and the dividends promised on the member banks' shares. In the 1920s, some of the regional banks had insufficient earnings in some years.

The New York Reserve Bank managed the system's international transactions in the 1920s. Senator Carter Glass strongly opposed Strong's decision to lend to Great Britain to sustain return to the gold exchange standard. And he blamed the New York Bank for causing the Great Depression. In the 1933 and especially the 1935 legislation, Glass reduced the role of the Reserve Banks and strengthened the Board's role. Glass always opposed having a central bank. He would ask the regional governors: "Do we have a central bank?" The required answer was, no, we have an association of Reserve Banks. Yet, Glass, probably unwittingly, sponsored the Banking Acts of 1933 and 1935 that centralized control of monetary, credit, and interest rate policy in the renamed Board of Governors. Gone were the Reserve Banks' control of their portfolios and the power to refuse to participate in purchases and sales. Board members had often attended open market meetings in the 1920s, but they had no vote at the meeting. Nevertheless, they could veto an action using their supervisory responsibility. The new legislation gave them majority representation on the Open Market Committee. After 1935, New York lost the right to a permanent seat. In 1942, the Board restored New York's position on the Federal Open Market Committee (FOMC).

The next major changes came in the early to middle 1950s when William McChesney Martin Jr. was chairman of the Board of Governors and the FOMC. In a series of steps, he gained support for procedural changes that transferred control of policy operations from New York to the Board. One very controversial action was to adopt a "bills only" policy that limited New York's power to intervene in long-term markets when demand for Treasury issues shifted. The Martin Fed maintained that the Federal Reserve should limit its operations entirely to the money or...