A History of the Federal Reserve, Volume 2

A HISTORY OF THE FEDE
RAL RESERVE

To Christopher C. DeMuth, Marilyn Meltzer, and Anna J. Schwartz

For
their
support
and
encouragement
over
the
many
years
this
history
was
in
process.

preface

The second, and last, volume of this history covers the years 1951 to 1986 in two parts. These include the time of the Federal Reserve’s second major mistake, the Great Inflation, and the subsequent disinflation. The volume summarizes the record of monetary policy during the inflation and disinflation.

Early in the Fed’s history, and even in its prehistory, few doubted the importance of separating the power to spend from the power to finance spending by expanding money. The gold standard rule and the balanced budget rule enforced the separation of government spending and monetary policy. By 1951, both rules had lost adherents, especially among academics and increasingly among policymakers and many congressmen.

The men who led the Federal Reserve during these years made many speeches about the evil of inflation. They made mistakes and gave in to political and market pressures for expansion. Many of their mistakes represented dominant academic thinking at the time. A minority view that opposed the policies was heard from some outsiders and some reserve bank presidents at meetings of the Federal Reserve, but most often it was dismissed or disregarded. The role of the reserve bank presidents fully justifies their continued presence on the open market committee. They often bring new or different perspectives that are not entirely welcome but valuable nonetheless.

The volume starts with the first major change in Federal Reserve policy following agreement with the Treasury to permit a more independent monetary policy. The volume ends following the second major change to a policy of disinflation. It would be comforting to see these changes as evidence that “truth will out.” It must be added that both changes followed
a shift in political support that facilitated the change. The change to an independent policy did not survive the 2007–9 crisis.

The Federal Reserve is said to be an independent central bank. The meaning of independence changed several times. In the years after World War II, Congress and several administrations recognized the political implications of unemployment and later of inflation. As a result, the Federal Reserve often found it difficult to follow an independent course. Mistaken beliefs and lack of courage sustained inflationary actions.

A subject that I do not raise in the text deserves mention. One of the outstanding achievements of the Federal Reserve in Washington and at the regional banks is the high level of integrity and purposefulness of the principals and the staffs. More than ninety years passed without major scandal. There are very few examples of leaked information. This fine record has been abused rarely. Although I find many reasons to criticize decisions, I praise the standards and integrity of the principals.

Volume 2 records some successes and achievements but many persistent errors. As in the earlier volume 1, I let the principals explain their reasoning. Much of the material uses the records of meetings of the Federal Open Market Committee. The Federal Reserve refers to these records as transcripts or memoranda of discussion. I refer to them as minutes. They find officials explaining their decisions many times but also showing an understanding of their mistakes and the reasons they continued.

It took six or seven years to complete this volume. To write a volume with such enormous detail I needed much help. It would have taken much longer without the support of the bright and energetic assistants who read and summarized the minutes and provided assistance in collecting data and searching archives. I thank the nine assistants who worked at different times on the volume for their often insightful contributions. Thanks to Matt Kurn, Mark de Groh, Richard Lowery, Randolph Stempski, Jessie Gabriel, Jonathan Lieber, Hillary Boller, Daniel Rosen, and Danielle Hale. I regard their efforts as indispensable. They were supported and assisted by the helpful library staff at the Board of Governors. Thanks are due especially to Susan Vincent and Kathy Tunis, who guided me and many assistants through the records, and thanks also to David Small, Debby Danker, and Normand Bernard of the Board’s staff for their help and support.

To supplement the Board’s records, I read the papers and records at the Federal Reserve Bank of New York. The reserve banks are not subject to the Freedom of Information Act. I am grateful to President William McDonough and to the archivist Rosemary Lazenby and her successor Joseph Komljenovich for making the records available and for their assistance and
guidance through their extensive files. With the passage of time and the changed positions of Washington and New York, meetings of the New York directors became a less important source of information. The papers of the presidents and correspondence remained valuable.

Presidential libraries were a more important source of material after 1951. No one can read these volumes without seeing the influence of politics and politicians. Papers of presidents, presidential assistants, and other officials contain records of policy development and conflicts. I benefited from the able assistance of archivists and librarians at the Millar Center at the University of Virginia, the Missouri Historical Society for the papers of William McChesney Martin, Jr., the Kennedy Library in Boston, the Johnson Library in Austin, the Carter Library in Atlanta, the Ford Library at the University of Michigan in Ann Arbor, and the National Archive II for the Nixon papers and the Nixon Oval Office tape recordings.

To supplement the written records and documents, I interviewed several participants. All of the following graciously gave their time and interpretations. They were particularly helpful in describing the atmosphere in which decisions were made or rejected. I am grateful to each of the following: Steven Axilrod, Andrew Brimmer, Joseph Coyne, David Lindsey, Kenneth Guenther, Jerry L. Jordan, Sherman Maisel, William Miller, James Pierce, Charles Schultze, George Shultz, and Paul Volcker.

Sherman Maisel permitted me to use the diary that he kept during his years as governor. These were very helpful and, as instructed, they are now deposited at the Board of Governors.

On a visit to the research department in May 2003, I discussed the meaning of Federal Reserve independence with Governor Donald Kohn, Athanasios Orphanides, and Edward Ettin. Their comments helped me to understand how Board members and their staff regard this central concern of any monetary authority.

Along the way, I had the good fortune to have several readers who commented on drafts of the main chapters, in some cases on all of them. I am especially grateful to Marvin Goodfriend, David Lindsey, and Anna Schwartz, who read and commented helpfully and extensively on all of the historical chapters. Jerry Jordan, David Laidler, Athanasios Orphanides, and Robert Rasche made insightful comments on several chapters. Responsibility for accepting comments and for remaining errors or misunderstandings are, of course, mine.

Much of the archival material is in Washington. Without my long association with the American Enterprise Institute and its support for me and the many assistants named above, this work would not have been
completed. I thank especially Chris DeMuth and David Gerson for their support. I benefited also from the support of the Tepper School at Carnegie Mellon University.

Several foundations provided support. I am especially grateful to my friend Richard M. Scaife for his many contributions and to the Sarah Scaife Foundation. The Earhart Foundation, the Lynde and Harry Bradley Foundation, and the Smith Richardson Foundation also gave helpful assistance. Thank you.

Alberta Ragan typed, proofread, and revised the manuscript several times. Her cheerful, capable, and willing assistance made completion much easier.

Finally, I owe much to my wife, Marilyn, whose support and encouragement were never in doubt and always present.

one

Introduction

Exact scientific reasoning will seldom bring us very far on the way to the conclusion for which we are seeking, yet it would be foolish to not avail ourselves of its aid, so far as it will reach:—just as foolish would be the opposite extreme of supposing that science alone can do all the work, and that nothing will remain to be done by practical instinct and trained common sense.

—Marshall, 1890, 779, quoted in Blinder, 1997, 18

The Federal Reserve that we find in these volumes is very different from the institution founded in 1913. Carter Glass, one of its founders, always insisted it was not a central bank. Its main business was the discounting of commercial paper and acceptances governed by the real bills doctrine and subject to the gold standard rule. The United States was an industrial economy, but agriculture retained a significant role and furnished about 40 percent of exports. Discounting facilitated the seasonal increase in loans that supported agricultural exports.

By the 1980s, when this volume ends, the United States had become a postindustrial economy, by far the largest economy in the world. The Federal Reserve was the world’s most influential central bank. No one had denied it this title for at least fifty years. Much had changed. Discounting became a minor function. The gold standard was gone. Principal central banks issued fiat paper money and floated their exchange rates.

During its early years and for many years that followed, the Federal Reserve System’s concerns included par collection of checks and System membership. Many small banks earned income by charging for check collection. The payee received less than the face amount of the check. Members were required to collect at par. Many small, mainly country, banks
did not join the System to avoid par collection and to avoid costly reserve requirement ratios. Both problems ended by the 1980s when Congress made all banks adopt Federal Reserve reserve requirement ratios even if they declined membership.

The most significant change was increased responsibility for economic stabilization, a mission that officials first denied having. Two economic and political forces changed that belief. One was developments in economic theory beginning with the Keynesian revolution in the 1930s and later the monetarist counterrevolution in the 1960s and the Great Inflation of the 1970s.

The principal monetary and financial legacies of the Great Depression were a highly regulated financial system and the Employment Act of 1946, which evolved into a commitment by the government and the Federal Reserve to maintain economic conditions consistent with full employment. The Employment Act was not explicit about full employment and even less explicit about inflation. For much too long, the Federal Reserve and the administration considered a 4 percent unemployment rate to be the equilibrium rate. The Great Inflation changed that. By the late 1970s, the targeted equilibrium unemployment rate rose and Congress gave more attention to inflation control. The resolution was reinterpretation of the Employment Act as “a dual mandate” to guide policy operations at the end of the last century and beyond. The guide does not clearly specify how a tradeoff between the two objectives—low inflation and a low unemployment rate—should be made when required. But it is now more widely accepted that in the long run, employment and unemployment rates are independent of monetary actions, so that monetary policy is fully reflected in the inflation rate and the nominal exchange rate.

The founders of the Federal Reserve intended a passive but responsive institution with limited powers. Semi-independent regional branches set their own discount rates at which members could borrow. The borrowing initiative remained with the members. Creation of the Federal Reserve brought regional interest rates closer together. By the mid-1920s, the System became more active. Under the leadership of Benjamin Strong, it initiated action to induce banks to borrow or repay lending. From this modest start, open market operations became the Federal Reserve’s principal and usually only means of changing interest rates and bank reserves. Discounting almost disappeared; advances became a very small activity used mainly for seasonal adjustment by agricultural lenders.
¹
Following passage of the
Employment Act, the Federal Reserve at first recognized responsibility mainly for employment and to a lesser extent for inflation. The weight on inflation increased in 1979, a result of the Great Inflation.

1. The Federal Reserve can also change reserve requirement ratios to add or reduce available reserves. If it keeps the interest rate unchanged, the only effect of the change is to raise
or lower the multiplier applied to reserves and the transfer of bank reserves to or
from the Federal Reserve.