Thank you very much for inviting me to join you this evening. It is a great honor to be a part of this lecture series commemorating H. Parker Willis, who, in addition to helping create the Federal Reserve System, also served as the first secretary to the Federal Reserve Board and later as the first research director. As most of you probably know, early in his career, Dr. Willis was a professor of economics here at Washington & Lee. What you might not know is that, according to some accounts, the president of the university at the time thought Dr. Willis spent too much time in Washington, D.C., consulting with Congress and forced his resignation. The students protested--evidence of the abiding wisdom of your student body. (1)
Tonight, I would like to discuss Dr. Willis's wisdom and his original vision for the Federal Reserve. I will also talk about how the Fed's role has evolved and the ways in which the founders' intentions continue to be relevant to policy discussions today. The Fed was founded to manage monetary conditions in the United States, and Reserve Bank lending to member banks was central to accomplishing that goal. In accordance with the "real bills doctrine," of which Willis was a leading proponent, monetary policy would be appropriate if the Fed was permitted to lend only against certain classes of assets. But within a decade of its founding, die Fed shifted toward conducting monetary policy via outright purchases and sales of Treasury securities, as we do today, and over time, lending became entirely divorced from monetary policy. Nonetheless, the Fed's lending powers have persisted and have been used in ways Willis and die other founders likely never envisioned--or intended. This lending contributed to the most recent financial crisis, I would argue, by making our financial system more fragile. A reexamination of the origins of the Fed's lending authorities and the evolution of their use thus seems well warranted. Before I begin, I should note that the views I express are my own and might not be shared by my former colleagues in the Federal Reserve System.
The Currency Problem
In 1923, Willis published a book describing die workings of the 10-year old Federal Reserve System and detailing the vigorous debates that preceded the Fed's creation and continued during its first few years of operation. In the introduction, he wrote:
If the Federal Reserve System is to render the service for which it was originally designed, it must overcome the prejudice and misunderstanding that are now evidently gathering about it. If it is to fulfil[l] its entire function as a genuine central banking system, it must retrace its steps in some particulars and evolve a more effective and general type of service [Willis 1923: iii].
I believe these words are as applicable today as they were nearly a century ago, and that our financial system would be well served by retracing some steps and clearing up some misunderstandings.
The founders of die Federal Reserve System were motivated by the many banking panics the United States had experienced since the end of the Civil War, perhaps most famously the Panic of 1907, which was the final straw for many bankers and policymakers. (2) While these panics varied in their nature and severity, there was widespread agreement on the fundamental problem: the supply of currency (i.e., paper notes and coins) was inelastic, meaning it didn't easily expand and contract with the needs of the economy. This was a result of the National Banking Acts of 1863 and 1864, which required currency to be backed by certain U.S. government bonds. The process a bank had to go through to issue new notes could take as long as three weeks, which made it difficult for banks to supply enough currency during seasonal increases in demand, such as the fall harvest or the holiday shopping seasons (Moen and Tallman 2015b). Banks also struggled to provide enough currency during panics, when many people tried to withdraw their deposits at the same time.
An additional problem was the fragmentation of the banking industry. Branching restrictions meant that essentially every town had its own small bank, to the tune of more than 25,000 banks in the United States by 1914 (Board of Governors 1976). This "unit banking" system meant that banks were highly vulnerable to local economic shocks, and they were unable to diversify risks across regions or head off bank runs by moving funds between branches. (3)
The so-called country banks and city banks were connected via an intricate web of correspondent relationships and clearinghouses. This system made it possible to clear and settle check payments efficiently and distribute currency nationwide. But it also meant that strains could spread quickly from city banks to country banks and vice versa, particularly in the fall, when the seasonal demand for currency was already high. When these strains developed into full-blown banking crises, the country banks often found themselves cut off when clearinghouses restricted the withdrawal of currency in order to protect clearinghouse members in the city. The result was frequent spikes in interest rates and sometimes, when the demand for notes was particularly acute, the suspension of payments to depositors. (4)
Together, the restrictions on new note issue, the prohibitions on branching, and the correspondent bank system had created a "currency problem." This is die problem the Fed's founders were trying to solve.
The Real Bills Doctrine
But how to solve it? Widespread public debate in the 1890s and early 1900s produced a plethora of proposals for banking reform. In 1911, Senator Nelson Aldrich (R-RI) introduced a plan for a new central bank, modeled after the ideas of Paul Warburg, the German-American financier. (5) The Aldrich Plan featured a single national "Reserve Association," but it met stiff resistance from Democrats (see Romero 2015). After Woodrow Wilson was elected president in 1912, he asked Rep. Carter Glass, a Democrat from Lynchburg, Va., to draft a currency bill. Glass enlisted Willis, and together, after extensive research, they settled on a modified plan that featured a system of regional clearinghouse banks that would pool the reserves of their member banks and have the authority to issue paper notes. (6) Through a process called "rediscounting," banks could assign their regional Reserve Bank some of their own assets at a discount-- essentially an implied interest rate--and receive currency or reserves in exchange. This is the origin of the "discount window" lending facility provided by the Federal Reserve Banks. Without the federated structure introduced by Glass and Willis, the Act would have had little chance of success in the Democrat-controlled houses of Congress.
Willis and Glass, along with others with a hand in the Federal Reserve Act, had a critical choice to make. What assets would the Reserve Banks hold? The choice would govern the amount of reserves and currency supplied by the Reserve Banks over time. They considered making U.S. government bonds eligible for rediscounting, but money backed only by government bonds was associated with inflationary wartime finance. Eventually, the founders settled on a class of financial instruments that we now call commercial paper. (7) These were short-term obligations that arose from financing trade. Because they were secured by goods in transit and endorsed by banks, they were relatively safe. So the Federal Reserve Banks were given the authority to purchase or make loans backed by certain types of commercial paper.
This approach reflects what is known as the "real bills doctrine," which held that if currency was backed by banks' lending against sound, short-term commercial paper, then the money supply would automatically fluctuate with the needs of commerce and inflationary increases in the money supply would be impossible. (8) The doctrine is based on a distinction between lending based on "real" productive activity, which would be an appropriate backing for note issue, and so-called speculative lending that financed purchases of financial assets such as stocks or debentures. Note issue tied to "speculation" was believed to cause inflationary boom-bust cycles. Willis was a firm believer in the real bills doctrine and was instrumental in writing it into the Federal Reserve Act. As he wrote in 1923, "Strictly and carefully framed, the...