A History of the Federal Reserve, Volume 1 Read online

  A HISTORY OF THE FEDERAL RESERVE

  allan h. meltzer

  a history of the

  Federal Reserve

  volume 1, 1913–1951

  with a foreword by alan greenspan

  the university of chicago press • chicago and london

  Allan H. Meltzer is the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon University and Visiting Scholar at the American Enterprise Institute, Washington, D.C. He is the author or coauthor of several books, most recently Money, Credit, and Policy, and served on the President’s Council of Economic Advisers from 1988 to 1989.

  The University of Chicago Press, Chicago 60637

  The University of Chicago Press, Ltd., London

  © 2003 by The University of Chicago

  All rights reserved. Published 2003

  Printed in the United States of America

  12 11 10 09 08 07 06 05 04 03 1 2 3 4 5

  ISBN: 0-226-51999-6 (cloth)

  Library of Congress Cataloging-in-Publication Data

  Meltzer, Allan H.

  A history of the Federal Reserve / Allan H. Meltzer.

  p. cm.

  Includes bibliographical references and index.

  Contents: v. 1. 1913–1951 —

  ISBN 0-226-51999-6 (v. 1 : alk. paper)

  1. Federal Reserve banks. 2. Board of Governors of the Federal Reserve System (U.S.)

  I. Title

  HG2563 .M383 2003

  332.1' 1' 0973—dc21

  2002072007

  ♾ The paper used in this publication meets the minimum requirements of the American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials, ANSI Z39.48-1992.

  To Marilyn

  foreword

  Allan Meltzer, who undertakes projects that to most appear daunting, has delved deeply into the history of the Federal Reserve System, with a result that will add substantially to the discourse on the institution’s role and development. He has reviewed the records of policy discussion at an extraordinary level of detail, and his analysis illuminates the contributions of the many fascinating individuals who shaped the Federal Reserve System we know today.

  Beginning with a history of developments that underlay the initiation of America’s most recent experiment in central banking, Meltzer carries the reader through the challenges of a developing institution faced with enormous economic upheaval, aptly describing the strong personalities that influenced both policy and culture in the System.

  His work explores the Federal Reserve’s inadequate response to the Great Depression and the struggle for dominance in the System. According to Meltzer, the struggle did not wholly preclude agreement in times of crisis; nevertheless, the well-known exhortations of Bagehot and Thornton that a central bank must act to counter a banking crisis and currency drain without regard for the gold reserve were ignored. In Meltzer’s view, the System’s adherence to the real bills doctrine, combined with a belief that the purging of speculative excess was necessary to set the stage for price stability, led to the failure of monetary policy to lessen the decline.

  The book describes in detail the roles played by Federal Reserve bank presidents, which have evolved substantially over the years, as has the relationship between the reserve banks and the Board of Governors. The early dominance of the Federal Reserve System by Benjamin Strong, governor of the Federal Reserve Bank of New York, is an interesting episode. Strong was credited more than anyone else with recognizing in the years after World War I the financial and economic impact of reserve bank purchases and sales of Treasury debt and the need to coordinate those transactions. Meltzer depicts Governor Strong’s opposition to a 1926–27 congressional proposal to amend the Federal Reserve Act to make price stability an explicit policy goal. He describes Governor Strong’s concern that the bill offered by another Mr. Strong—Kansas Republican congressman James A. Strong—would be interpreted to mandate the stability of individual prices, particularly of agricultural products. In a clear example of his willingness to take sides, Meltzer says here that had a mandate for price stability been approved, the Fed “could not have permitted the Great Depression of 1929–33 or the Great Inflation of 1965–80.”

  Ultimately the Banking Act of 1935, largely adopting reforms proposed by Marriner Eccles, resulted with some subsequent refinement in the structure of the Federal Open Market Committee. Eccles had sought an FOMC wholly controlled by the Board rather than so-called private interests. However, Senator Carter Glass of Virginia and others were leery of monetary policy dominated by what they saw as “political interests.” The compromise that emerged mandated that monetary policy be conducted with a broader vision than if either Eccles or Glass had prevailed.

  Meltzer’s book covers with the same methodical illumination the events of more recent years, completing a work both stimulating and provocative. Readers will have substantial material for continued reflection and discussion.

  Allan Meltzer has spent a lifetime inquiring into monetary economics, and he calls the evidence as he sees it. His combination of interests and experience makes him most qualified for this undertaking, and he brings to the endeavor a closeness of analysis that makes his conclusions both fascinating and valuable. Those of us who enjoy the debates he inspires will find much satisfaction in this book, as in his other important works.

  Alan Greenspan

  preface

  The project that eventually became this book began in 1963–64, when the late Congressman Wright Patman asked me to extend a study I had done for the Joint Economic Committee. That study described operations in the dealer market for government securities—the market in which the Federal Reserve conducts its open-market operations. When I explained that the problems that concerned him arose at the Federal Reserve and not in the market, he asked me to undertake a study of the Federal Reserve.

  My former teacher Karl Brunner, later my friend and lifetime collaborator, joined the project. Together we wrote a lengthy study of Federal Reserve operations, emphasizing their use of free reserves as a target and indicator of the thrust of policy. We showed that these procedures were faulty—that the Federal Reserve’s analysis did not go beyond the money market to the broader objectives required by an efficient and effective monetary policy. We proposed an alternative framework.

  The late Harry G. Johnson proposed to the University of Chicago Press that it republish the study. The original studies were hastily written to meet congressional deadlines. I started to rewrite several sections but decided instead to extend the analysis. One set of questions in particular warranted attention: Why had the Federal Reserve acted as it did? Why had it failed to respond to the Great Depression or the deep recession of 1937–38? Why was monetary policy often pro-cyclical?

  This book tries to answer those questions. At various times in the late 1960s and early 1970s, I began to revise the manuscript to complete the history. Karl Brunner always expressed interest, but he never devoted any time to working on the manuscript or commenting on what I had written.

  In the fall of 1994 I returned to work on this book while on leave from Carnegie Mellon at Harvard University and the National Bureau of Economic Research. My thanks to Martin Feldstein for the hospitality and pleasant working conditions at the Bureau.

  In the nearly thirty years since I first started on this project, both the Federal Reserve and my ideas have changed. Some of the ideas in the original study remain, but much of this material is new.

  The most important influence on my thinking and conclusions has come from reading the minutes, correspondence, and other internal documents developed at the t
ime. Records for the Federal Reserve Board and the Board of Governors became available as a result of the Freedom of Information Act in the 1970s. The cooperation of Chairman Alan Greenspan, the secretary of the Federal Open Market Committee, Normand Bernard, and the library staff went far beyond legal requirements. I am indebted to them, to Susan Vincent and Kathy Tunis at the Board of Governors library, and to Elizabeth Jones of the Board’s staff for their helpful assistance.

  I began by reading all the archival material. It soon became apparent that the amount was too great for one person to summarize the material and complete the manuscript in reasonable time. Several researchers have reviewed and summarized material, collected data, and assisted in other ways. I am particularly grateful to Randolph Stempski, Sean Trende, Catherine Pharris, Matthew Korn, and Jessie Gabriel for their perseverance, diligence, and thoughtful selection of material.

  To supplement their efforts, I continue to read and summarize materials at the Federal Reserve Bank of New York. The bank has collections of papers left by its governors and later presidents, Benjamin Strong, George Harrison, and Allan Sproul. These include memos, correspondence, and records of conversations. Lester Chandler used Benjamin Strong’s papers for his biography of Strong. Instead of rereading all the Strong papers, I relied on the quotations in Chandler’s biography. Where I differed on interpretation, I referred to primary sources.

  The New York board of directors, or its executive committee, met weekly. The weekly minutes often have more detail than the daily minutes of the Federal Reserve Board’s meetings. The New York archives directed me to topics in the board’s records and conversely. The New York bank has been extremely helpful not only by providing access to materials but by offering pleasant working arrangements. Although not covered by the Freedom of Information Act, the bank provided materials without hesitation or restriction. I am indebted to President William McDonough for his assistance and to Rosemary Lazenby, the bank’s gracious and ever helpful archivist and her staff.

  Many people read and commented on parts of the manuscript. I am grateful to all of them and particularly to Robert Aliber, Michael Bordo, Kevin Dowd, Milton Friedman, Alan Greenspan, Jerry Jordan, David Laidler, Athanasios Orphanides, Robert Rasche, and Elmus Wicker.

  I owe a special debt to Anna Schwartz, who encouraged and prodded me. Anna commented fully and helpfully on each chapter from her vast store of knowledge. Bennett McCallum listened patiently at lunches over many years and commented with his usual economic insight. Alberta Ragan typed the several revisions and proofread the entire manuscript with her usual care, efficiency, and good humor.

  Several readers have asked why I included the years covered in Friedman and Schwartz’s now classic monetary history. In one respect this is a strange question: in the physical sciences, replication of experiments is the norm. No one appreciates their work more than I, but its quality and importance should encourage, not deter, replication.

  There are additional good reasons for revisiting the early years. First, I had unlimited access to material that they did not have. To the extent that I reach the same conclusions, as I often do, my work strengthens theirs. Where I find differences, as I sometimes do, my work supplements theirs by giving a more complete or more accurate account. Second, I am interested in some different questions, such as those listed above and others.

  To answer those questions, I let the Board members, governors, presidents, and others explain their actions in their own words. Although personal animosities and indecisiveness play a role, there is a remarkable consistency in the statements and explanations. Using the earlier studies for the House Banking Committee, I develop the framework that guided many of their decisions.

  The research for this book required much time in Washington, D.C., and at National Archives II in College Park, Maryland. My continuing association as a Visiting Scholar at the American Enterprise Institute was invaluable. I am greatly indebted to Christopher DeMuth for his generous hospitality and assistance and to my colleagues there, especially Douglas Besharov, for support and encouragement. I am indebted also to Dean Douglas Dunn and others at Carnegie Mellon University. They have encouraged me through more than forty years of an active life.

  The Sarah Scaife Foundation, the Lynde and Harry Bradley Foundation, and the Smith Richardson Foundation have given generously to finance the project. It has taken six years to get to this point. Without their backing, it might never have happened.

  My largest debt is to Marilyn, my wife, whose support, encouragement, and love have always been there during a lifetime of often hectic but always absorbing activities.

  one

  Introduction

  This book is the biography of an institution, the Federal Reserve System, much of it told by its principals. The Federal Reserve is now the United States’ powerful central bank. The founders did not intend to create either a central bank or a powerful institution; had they been able to foresee the future accurately, they might not have acted.

  Institutions, no less than individuals, change as they mature and as the conditions that led to their creation change. In 1913 the United States was a developing country, with agriculture its largest occupation. The enormous shift in political and economic power and responsibility toward the United States that occurred in the twentieth century was at an early stage. The founders did not design or contemplate the Federal Reserve System we have today. They hoped to reduce financial instability, improve the quality of financial services, and strengthen the payments system.

  The leading central banks in 1913 were privately owned institutions vested with responsibility for such public activities as providing currency, maintaining domestic payments systems and international payments, and serving as lenders of last resort in periods of financial disturbance following threat of failure by major banks or financial institutions. Depositors were not insured against these risks, so the threat of financial disruption set off a shift from bank deposits to gold or currency issued by the government. The drain of gold and currency into private hands forced multiple reductions in bank assets and liabilities and threatened additional bank failures. Interest rates on short-term loans rose with the increased demand to borrow and the reduced supply of loans.

  By the late nineteenth century, central bankers in principal countries understood that their responsibility to lend at times of financial panic made them unique. Their public responsibility to prevent widespread failure of banks and financial institutions that would otherwise remain solvent had to dominate the private interests of their stockholders. Private interests would lead them to contract lending, call loans, and shrink their balance sheets. Such action would force unneeded bankruptcies and increase the risks the public had to bear.

  In a well-managed panic under the gold standard, the government suspended the central bank’s requirement to pay out gold or silver on demand. Relieved of the requirement to hold a fixed percentage of the note issue in metallic reserves, the central bank could expand the currency issue to satisfy any increase in the demand for currency. Privately owned banks with good collateral could borrow from the central bank instead of calling loans, reducing deposits, and forcing economic contraction and bankruptcies. When the system worked in this way, financial panics ended quickly. The additions to currency returned to the banks as deposits. Banks repaid their loans at the central bank. As the central bank’s liabilities fell, the government could restore the requirement to pay out gold on demand.

  This system of public-private cooperation, combining suspension of gold payments with a lender of last resort facility, did not survive the economic, political, and financial disturbances later in the twentieth century.1 By the 1950s, privately owned central banks had disappeared. Governments looked to public institutions to manage money and credit.

  Public control of money raised a new issue or, more accurately, reopened an old one—preventing governments from abusing their power to create money and credit for temporary political advantage. After a decade o
r more of rising inflation, central banks became more independent of political control. By the end of the twentieth century, principal countries accepted two organizing principles—public ownership and “independence.” The latter term has many different specific meanings; their common element is limitation of the government’s power to use monetary policy to gain political advantage.

  The structure of the early Federal Reserve System reflected these concerns about reconciling the public nature of the central bank’s task with responsible control of money and credit. Writers and commentators at the time did not use terms like “public goods” and “central bank independence,” but they recognized the problem of designing an organization with proper incentives. Fears that a privately owned bank would place the bank’s interest above the public interest had to be reconciled with concerns about empowering the government to control money. In addition, the new institution was supposed to provide a currency with stable value, capable of expanding and contracting in response to demand; a payments system that efficiently transferred money and cleared checks in a growing national economy; and the services of a lender of last resort.2

  1. Reasons other than effectiveness played a role in this transformation.

  President Woodrow Wilson offered a solution that appeared to reconcile competing public and private interests. He proposed a public-private partnership with semiautonomous, privately funded reserve banks supervised by a public board. The directors of the twelve reserve banks, representing commercial, agricultural, industrial, and financial interests within each region, controlled each bank’s portfolio. The new rules sought to pool the country’s gold reserves to strengthen the individual parts by making the total reserve available in a crisis. Reserve banks could lend gold to other reserve banks. No formal provision required coordination or cooperation of the various parts, however. In practice this meant that if the system was to serve as a lender of last resort, it would have to coordinate the actions of the semiautonomous reserve banks.