Meltzer's History of the Federal Reserve and the evolution of central banking.

• Author: Timberlake, Richard H.
• Position: Book Review

The only limit to a commercial bank's ability to discount is the limit to good commercial paper.... Such paper springs from self-clearing transactions.... It is the duty of the banker to discount freely for his customer in a crisis or panic.... The only limit ... is the limit to good commercial paper.... The whole purpose of the Federal Reserve Act is to enforce this practice. --Rep. Charles Korbly (1913) The Great Monetary Paradox

Most conventional economists are very much aware of markets. Indeed, a sound understanding of the function of markets and prices is what distinguishes economists from everyone else. Nevertheless, few economists seem to realize how far the supply of one major economic item has largely disappeared from any kind of market determination. That item is money, something that appears in all market exchanges with the trivial exception of goods and services bartered. To add insult to ignorance, money originated in private markets, as the Austrian economist Carl Menger showed so well, without the participation or help of any state. According to Menger ([1871] 1981: 262-63): "Money is not the invention of the state. It is not the product of a legislative act. Even the sanction of political authority is not necessary for its existence."

Yet, in spite of the undeniable fact that money was an economic innovation in private markets with no dependence on any state authority, everywhere in the world central banks and government treasuries monopolize the supply of national money stocks and closely regulate all the world's monetary systems. Nowhere is a market-determined money even tolerated much less a dominant feature. I refer to this phenomenon as the "Great Monetary Paradox."

The usual rejoinder is that the state came into the monetary picture primarily to add elements of certainty and stability to monetary systems--that its authority would somehow "gild the gold." The state's primary means for doing so, as Menger noted, was to impress upon the money already circulating the quality of legal tender so that everyone would be forced to accept it. Money in the Mengerian world was an unusual product: When common people had to accept the state's legal tender money, the quality of that money improved (Menger 1981: 262-63). (1)

All laymen and most professional economists today agree without much controversy that management of the monetary system is a "responsibility" of the government, and that a central bank is the institution of choice to do the job. Thus, what started out in all civilizations as a private-market function has become, universally, a prerogative of the state.

Central banks, if they are to be intellectually tolerable, must be at least "second-best" solutions. They must be able to argue that they have managed monetary systems rationally and systematically--that, though not "perfect," their policies have been reasonable in view of the circumstances of the times. The Big Question then to be answered is, Does the detailed history of central banking institutions and their policies justify acceptance of central banks as, possibly, a first-best solution, or indicate that central banks are at least good enough to rate as second-best in the management of money?

Allan Meltzer's A History of the Federal Reserve, Volume 1: 1913-1951 (University of Chicago Press, 2003), hereafter referred to as HFR, presents virtually all the details of institutional development and monetary policy formulation that the Federal Reserve System experienced during the first half of the 20th century. Consequently, his book provides all the evidence needed for evaluating just how well the Fed has managed the U.S. monetary system over the period covered.

The Evolution of Central Banking

Meltzer begins his work appropriately enough with a preview of what his book explores, and its scope. Chapter 2 then summarizes central banking theory and practice before the Federal Reserve Act. For this purpose, Meltzer's work would have profited if he had provided some references to the available scholarly literature on the institutional development of central banking (e.g., Hepburn 1924; Smith 1936; Goodhart 1988; Timberlake 1992, 1993). As it is, the only reference Meltzer offers is to an obscure article by G. T. Dunne (1963) entitled, "A Christmas Present for the President" (HFR: 19, n.1).

Meltzer then briefly examines the evolution of central banking, but only from the perspective of the Bank of England and the doctrinal writings of Henry Thornton and Walter Bagehot. Thornton wrote when the Bank of England had suspended gold payments for Bank of England notes. He had reason, therefore, to suggest rules for the Bank's operations, as it became a surrogate for the self-regulating specie (primarily gold) standard that had been in force until 1797. Bagehot, writing 70 years later, developed a central banking doctrine on the premise that a gold standard was again operational. Bagehot's principles, which Bank of England managers subsequently adopted, were aired in only a few Federal Reserve policy discussions in the 1920s and 1930s. (2)

Meltzer's treatment of the Bank of England covers well-known ground. But what he omits entirely is any reference to the development of central banking institutions in the United States during the 19th century. Although the United States did not then have a central bank, it had First and Second Banks of the United States, an Independent Treasury, a National Banking System, and a private clearinghouse system, all of which exercised various degrees of monetary control, and all of which contributed fundamental elements to the institutional formation of the Federal Reserve System. In spite of that rich history, Meltzer concludes, "The Federal Reserve's approach to policy originated in the Bank of England's nineteenth century practices and the partially developed theory or framework that the practices attempted to apply" (HFR: 64). By failing to take account of what is already known about U.S. monetary institutions and policies before 1913, Meltzer misses the opportunity to integrate his history of the Fed into the broader history of central banking.

When the bill creating the Federal Reserve System was going through Congress, its Democratic sponsors denounced and denied the idea that it might be a central bank. It had to be a regional system of reserve-holding banks with no political connections and no money controlling powers. It was to be an institution limited to helping the self-regulating gold standard work more smoothly. It should be accommodative to banks and act as a lender of last resort, but not take an active role in anticipating or preventing monetary and financial disequilibria. The congressional debates emphasized the principle that the proposed Federal Reserve System would be an institution geared to the specific banking conditions of the United States, with little or no similarities to the Bank of England (Timberlake: 1993, 214-34).

The largely passive role that the new law prescribed for Fed policy was no accident. It was there because the self-regulating gold standard of the time was universally recognized and accepted. The Federal Reserve Act itself confirmed: "Nothing in this act ... shall be considered to repeal the parity provisions contained in an act approved March 14, 1900 [the Gold Standard Act]" (Congressional Record, 63d Cong. 2d sess.: 5100-6).

Federal Reserve Policy in the 1920s and the Real Bills Doctrine

In Chapter 4, Meltzer thoroughly documents how the accommodative role of the Fed changed in its first few years, at the same time that it was under the thumb of the Secretary of the Treasury during World War I. Once the war was over, Federal Reserve Banks and the Federal Reserve Board could resume their bureaucratic encroachment and turf struggles for power. By 1929, Meltzer writes, the Fed had "a new activist policy [that] was supposed to achieve three ends: mitigate business fluctuations, prevent inflation, and restore the international gold standard.... The apparent success of postwar policies in achieving the three main objectives and preventing financial panics increased the credibility of policies and the belief that a new more stable era had begun" (HFR: 261).

It surely did, and it also meant that Federal Reserve managers were now controlling the gold standard. Through much of the 1920s, the Fed sterilized gold inflows resulting from the post-World War I adjustments in Europe, and formulated other policies to prevent the U.S. banking system from using all the gold...