A History of the Federal Reserve, Volume 2 (2 page)

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.
²

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.
³

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.

2. In 2008, the Federal Reserve changed this policy. Abandoning all past precedents, it lent on relatively illiquid long-term debt. Within a few weeks more than half of its portfolio’s consisted of longer-term debt. This represented a break with all previous central bank experiences in developed countries.

3. Small and Clouse (2004, 29) point out that it is clear that the “real bills” limitation in section 14 of the Federal Reserve Act applies to purchases of bills of exchange but unclear whether it applies to bankers’ acceptances. The limitation does not apply to purchases of foreign instruments.

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.”

1. That the price level was constant, so that demand could be expanded without danger of inflation.

2. That the potential output of the economy, or the level of full employment, was given—that it would not be affected by the government’s policy to maintain full employment.

3. That we knew how much output was the potential output of the economy and how much unemployment was full employment.

4. That the economy had a tendency to operate with output below its potential and unemployment above its full employment level.

5. That output and employment could be brought up to their desirable levels by fiscal actions of government to expand demand— specifically by spending enough or by running large deficits.

6. That we knew how much spending or how big deficits would be enough to achieve desired results.

7. That there was no other way to get to the desired levels of output and employment, the main implication of which was that monetary policy could not do it.

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.
⁴

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 finance budget deficits, 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.

4. This paragraph repeats Meltzer (1998, 9).

There is often not a close connection between academic research findings 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 depos
its. 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.
⁵
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.
⁶
In their
Monetary
History,
Friedman and Schwartz (1963) showed that money growth had a major role in fluctuations, inflation and deflation.

5. Michael Bordo and Anna J. Schwartz (1979) review Warburton’s work. This section is based on Brunner and Meltzer (1993, chapter 1).

6. This difference remains as demonstrated in discussions of a liquidity trap in the 1990s. Keynesian thinking emphasizes difficulties for monetary policy caused by a zero bound on nominal Treasury bill rates. A monetarist (non-Keynesian) responded that a central bank could buy other assets, longer-term securities, foreign exchange, or even equities. Brunner and Meltzer (1968).

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.
⁷
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.

Rules

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.

7 Meltzer (1998) has a more complete discussion of the result of the controversy. Modigliani (1977) is a useful statement from a Keynesian perspective of the consensus reached at the end of the 1970s.