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Published by EH.NET (June 2003)

Allan H. Meltzer, A History of the Federal Reserve, Vol. I: 1913-51. Chicago: University of Chicago Press, 2003. xiii + 800 pp. $75 (hardcover), ISBN: 0-226-51999-6.

Reviewed for EH.NET by John H. Wood, Department of Economics, Wake Forest University.

Allan Meltzer has given us a thorough history of the Federal Reserve’s monetary policy from its founding in December 1913 to the Treasury-Federal Reserve Accord in the spring of 1951. Several excellent descriptive and critical studies of various parts of this period of the Fed are available, led by a considerable portion of Friedman and Schwartz’s Monetary History. But Meltzer advances our understanding of the Fed in two respects that that I explore in this review: First, he considers all the significant episodes of monetary policy, usually in more detail than can be found elsewhere. This book must be the starting point for future studies of Federal Reserve monetary policy, not only for the period covered by the book, but also for the succeeding fifty years because the Fed’s organization and most of its beliefs and procedures were developed in the earlier period. The second main contribution is an extension of the first. Meltzer makes unequalled use of the unpublished minutes, correspondence, and other internal papers of the Federal Reserve Board and the Federal Reserve Bank of New York. He takes us further behind the scenes of policymaking.

This review seeks to locate the book in the literature on the Fed, a task made easier by Meltzer’s recognition of previous work and the absence of radically new interpretations. He supports the positions that have been associated with monetarist criticisms by Friedman and Schwartz and his work with Karl Brunner since the 1960s, especially the Fed’s lack of understanding of its role in the economy and its obsession with financial markets, commercial bank free reserves in particular. His support is in the form of information about the ideas, institutions, and personalities behind actions and inactions that are well known. We are told that the inflation and deflation of 1919-21, the Great Depression of 1929-33, the recession of 1937-38, and the post-World War II inflation would have been avoided or greatly moderated if the Fed had make money grow at a constant rate, as Friedman proposed (1959, 92) or as adjusted for velocity and inflation as Meltzer proposed (1984). Whether or not we accept these conclusions, Meltzer enables us to increase our understanding of the Fed’s intentions, or rather the intentions of different parts of an institution that was at war with itself.

The new material may be the book’s most important contribution to research because it adds to the information available for the study of the policy preferences of different interests in the Federal Reserve and their effects on decisions. Internal conflicts often involved battles for control between the Board in Washington and the regional Reserve Banks. The Federal Reserve Act of 1913 was vague about control. The powers of the Fed — particularly discounting and open-market operations — were vested in the Banks under the Board’s supervision. The extent of this supervision — broad or, as the Banks complained, amounting to the micro-management of a central bank from Washington — was the main source of these conflicts, which spilled over into policy decisions. It is also possible that policy differences between the Board and the Banks, especially New York, were partly due to the knowledge and interests arising from their political and economic environments. Given the importance attached to these differences, I would like to have seen more attention paid to their possible reasons beyond institutional grasps for power. It is no surprise to find the Board more sympathetic to (or under the thumb of) the Treasury during the latter’s pressures for continued bond supports after the two world wars. Less expected, perhaps, was the Board’s greater skepticism of market forces. Its preference for controls over interest rates helped to rationalize its support for Treasury low-interest programs. But the Board also differed from New York in believing that controls could control stock speculation in 1928-29 without impinging on “legitimate” credit. Havrilesky (288-331) found that the Banks’ greater reliance on interest rates continued in the second half of the century. Might those, like the New York Fed, who are immersed in the financial markets repose more trust in their operation, specifically in the efficacy of interest rates as rationing devices, compared with credit controls? On the other hand, this tack may not be appealing to monetarists who already find the Fed too sensitive to markets and interest rates. Meltzer finds that a good deal of the Board’s criticism of the New York Bank after the Crash was motivated more by concern for control than different perceptions of economic relations (289).

Meltzer confirms the charge that the Fed neglected to develop a model, or guide, to policy. This neglect can be interpreted with more sympathy than Meltzer and other critics have shown, although they recognize the Fed’s difficulties, because important conditions assumed by the Fed’s creators quickly disintegrated with war and its aftermath. They were adrift without a destination, compass, or anchor. The great inflow of gold caused by European inflations and other disorders divorced the Fed’s actions from the historic central bank concern for its reserve. The Fed’s timid support of credit during the Great Depression may have been partly due to a desire to preserve the gold standard (Eichengreen; Meltzer is doubtful, 405), but its interest in price stability between 1921 and 1929 prevented it from taking full advantage of its more-than-ample reserves.

We must also realize that prevalent economic models did not imply the countercyclical policy to which economists were converted a decade later. An influential theory that implied “liquidation” in depression stemmed from the belief that deflations are reactions to inflations that had been driven by speculations in inventories and fixed assets. These should be allowed to return to normal levels. Deflations must be allowed to run their course (Hayek; Treasury Secretary Mellon, discussed by Meltzer, 400). Attempts to force money into paths “where it was not wanted” merely sow the seeds of future inflation. We can see where this policy was conducive to long-run price stability under the gold standard — price indexes in 1933 still exceeded those of 1914. Even if Meltzer, like Friedman and Schwartz, is right that the Fed should have tried for constant money growth or at least a stable price level, the application of such a policy would have required remarkably prescient theoretical sophistication by a group of committees of mainly conventional businessmen unused to abstractions.

Irving Fisher was a notable exception in his resistance to conventional sound money. But his “compensated dollar” plan for stabilizing the price level by adjusting the price of gold (182) was ridiculed as “a rubber dollar” (Hoover, 119) and dismissed by the New York Fed’s Benjamin Strong as the work of “extreme quantity theorists” (Chandler, 203).

Meltzer’s criticisms of the Fed, like Friedman and Schwartz’s, are meant to be lessons for policy. In its theoretical and policy implications, the book is mainstream monetarism, deserving of the usual plaudits and criticisms: money and output are correlated, so that money must be important, but no convincing evidence of the direction of causation is offered.

Prospective buyers should note that the book is not about Federal Reserve activities that are not directly part of monetary policy. Check clearing and other parts of the payments system, on which most Fed employees work, are ignored, and the structure and regulation of banking receive little attention. The last omission is more the Fed’s than Meltzer’s. The Fed recognized the weakness of the banking system as evidenced by the high failure rate of banks during the 1920s, but it did not work towards an improvement — unlike President Hoover (121-25), who tried unsuccessfully for a system of larger and stronger banks. When Board Chairman Marriner Eccles (266-69) sought measures similar to Hoover’s in 1936, he was rebuffed by President Roosevelt. The Fed’s lack of attention to the banking structure is striking in light of England’s experience, where the encouragement of amalgamations after the Panic of 1825, which was attributed to the fragility of small banks, contributed to the decline in the frequency and severity of panics as the nineteenth century progressed (none after 1866). On the other hand, the Fed might have followed Congress in taking the banking structure as given because the protection of local banks had been a political condition of the Federal Reserve Act.

Returning to the Fed’s model, or lack thereof, Meltzer agrees with his predecessors that monetary policy was an irregular mix of the gold standard rules of the game, the real bills doctrine, and a concern for price stability that seemed important only when inflation threatened. The place of the real bills doctrine in Fed thinking is unclear. The Federal Reserve Act has been interpreted as a legal implementation of the doctrine by its limitation of private discounting to real bills of exchange, that is, short-term lending secured by inventories. This had always been regarded as sound practice for commercial banks, and the Fed favored it in aggregate because lending for productive purposes was more conducive to economic activity and price stability than “speculative” lending on securities. But favoring real bills is not the real bills “doctrine,” as Meltzer would have it. The doctrine’s fallacies had often been shown, particularly the indeterminacy of the price level when credit is linked to expected prices (Thornton, 244-59), and monetary policy (as opposed to rhetoric, for example, Senator Glass; Meltzer, 400) did not suggest that the Fed believed it. If it had, there would have been no role for interest rates. In the closest it came to expressions of policy guides, in the Board’s 1923 Annual Review and statements by Benjamin Strong (Chandler, 188-246), the Fed indicated less fear of inflation from real bills than other lending. But it depended on interest rates to rein in excessive borrowing, whatever the purposes. Whether credit was “excessive” tended to depend on what was happening to the price level, although this connection was cloudy in Fed statements at least partly because it did not wish to be held responsible for price stability. The reasons for the Fed’s opposition to an official goal of price stability probably included its constraints on the pursuit of other goals, such as the alleviation of financial stress, and the fact that its proponents in Congress (especially James Strong of Kansas) were most interested in restoring agricultural prices to previous heights.

Touching on Meltzer’s relations to other controversies: He continues to differ from Friedman and Schwartz (692) in his argument (with Brunner, 1968, and agreed by Wicker, 1969, and Wheelock, 1991) that the Fed’s actions during the Great Depression would have been approximately the same if Benjamin Strong (who died in 1928) had continued at the helm of the New York Bank. Meltzer believes that Strong’s “attachment” to commercial bank borrowing from the Fed and free reserves as policy guides continued after 1928, and were responsible for its failure to increase credit between 1929 and 1933 and its doubling of reserve-requirements ratios in 1936-37. This position dates at least from the 1960s, when he and Brunner assisted Congressman Patman’s investigation of the Fed that initiated the work leading to the book under review.

It was a common belief in government and Congress that “international cooperation,” specifically the creation of inflation in the interests of European currencies (Hoover, 1952, 6-14), interfered with domestic goals. Meltzer agrees with Hardy (228-32) and Friedman and Schwartz that the accusation is unsupported. Quoting the latter: “foreign considerations were seldom important in determining the policies followed but were cited as additional justification for policies adopted primarily on domestic grounds when foreign and domestic considerations happened to coincide” (279).

I do not think that Meltzer’s treatment of bank failures during the Great Depression adequately reflects Wicker’s (1996) investigations that seriously undermine Friedman and Schwartz’s interpretations and suggest that the name “runs” is inappropriate. The three banking crises of 1930-31 identified by Friedman and Schwartz (and accepted by Meltzer, 323, 731) involved mostly small banks that were insolvent. Farm and real estate prices had fallen drastically, and banks failed because their customers failed. The frequency of failures in the “crisis periods” was only slightly greater than in the period as a whole, and were geographically concentrated. None became national in scope or exerted pressure on, not to say panic in, the New York money market. The first consisted largely of the collapse of the Caldwell investment banking firm of Nashville, Tennessee, which controlled the largest chain of banks in the South and was heavily invested in real estate. There is no evidence of contagion. The “crisis” of mid-1931 was concentrated in northern Ohio and the Chicago suburbs, where small banks had multiplied with the real estate boom. The crisis of September-October 1931was wider, but concentrated in Chicago, Pittsburgh, and Philadelphia.

This brings us to Meltzer’s (and Friedman and Schwartz’s) criticism of the Fed’s failure to apply Bagehot’s proposal that the central bank act as lender of last resort. That is, as holder of the nation’s reserve it should stand ready to supply the cash demanded in times of panic. Meltzer contends that “Most of the bank failures of 1929 to 1932, and the final collapse in the winter of 1933, could have been avoided” (729) if the Fed had applied Bagehot’s rule. However, as he (283-91) and Friedman and Schwartz (335-39) recognize elsewhere, the New York Fed actively assisted the financial markets during and after the Crash, and withdrew when there was no evidence of panic in New York, that is, “once borrowing and upward pressure on interest rates” declined (Meltzer, 288). I find Meltzer convincing when he suggests that this “was consistent with the Riefler-Burgess [free reserves] framework,” as opposed to Friedman and Schwartz’s argument that New York eventually yielded to the Board’s opposition to its open-market purchases. “The dispute was mainly about procedure, not about substance,” Meltzer (289) argues. “They [the Board] disliked New York’s decision to act alone.” It appears to this reviewer that the Fed’s actions as described by Meltzer and Friedman and Schwartz, generally conformed with Bagehot’s advice to relieve illiquidity in the money market in times of panic. He had not recommended the rescue of insolvent banks in the hinterlands that did not threaten the money market. This includes at least the beginnings of the nationwide closures of 1933 that were precipitated by the Michigan governor’s decision to close the banks in his state to protect them from the possibility of a run when the failure of Ford’s bank in Detroit (which was also heavily invested in real estate) was announced.

I end with comments that are more differences of emphasis than of substance: The Fed’s irrelevance in planning postwar financial arrangements is interesting, although Meltzer may exaggerate its significance. He wrote: “In the 1930s, the Treasury replaced the Federal Reserve as the principal negotiator on international financial arrangements” (737). In fact, governments have always, directly and firmly, controlled monetary arrangements. Their seizures of the details of monetary policy in the U.S. and U.K. in the early 1930s were remarkable, but the U.S. government’s control of changes in the monetary system as exemplified by the devaluation of 1933, Bretton Woods in 1944, and the Nixon suspension of 1971 had also been the practice of Parliament, which decided (with more or less advice from the Bank of England) suspensions, resumptions, legal tender, and other trade and financial arrangements. The irrelevance of the Fed in the negotiation of post-World War II financial agreements was shared by the Bank of England. Their places in the row behind finance ministers during negotiations continued an age-old practice. It is interesting in light of the high visibility of central banks in the operation of monetary systems that the structures of those systems belong to governments. Without defending the Fed, which ought to have behaved better within the framework that it was given, the real failure to respond to the catastrophe should be laid at the feet of the government. Herbert Hoover was more active than he is often given credit for, but he departed from tradition in leaning on the “weak reed” that was the Federal Reserve (1952, 212; Meltzer, 413).

Meltzer suggests that the Great Depression was not considered a failure of monetary policy at the time (727). He refers to the Federal Reserve and economists, and I agree. But this was not true of the public or of substantial parts of Congress (which he acknowledges on p. 427). Carter Glass was a powerful defender of the Fed in the Senate, but the House passed the Goldsborough Bill directing the Federal Reserve “to take all available steps to raise the present deflated wholesale commodity level of prices as speedily as possible to the level existing before the present deflation” by a vote of 289-60 in 1932, before it was watered down into a meaningless resolution in the Senate. The 72nd Congress (1931-33) introduced more than fifty bills to increase the money supply, which came closer to passage as the depression worsened (Krooss, 2662). It would be difficult to imagine a more damaging commentary on Woodrow Wilson’s idealistic expert (read “remote”) institution than Chicago Congressman A.J. Sabath’s question to Chairman Eugene Meyer in 1931: “Does the board maintain that there is no emergency existing at this time” (letter entered into the Congressional Record, Jan. 19) — or a similar lack of sensitivity of legislators in a democracy. The monetary authority supplanted by the Fed — the Treasury with an attentive Congress — might have done no better. But the sharp actions in 1865 (when Congress reversed its decision to retire the greenbacks after voters complained) and 1890 and 1893 (when it increased and then reduced the monetization of silver during recession and then gold flight) suggest that it would not have stayed on the sidelines if it had not been inhibited by (and waiting for) its expert creation. This is not (necessarily) a plea for free banking, but at least for monetary authorities that are closer to the effects of their actions.

I would have liked to see Meltzer subject the Fed’s existence to a little scrutiny, and to consider what kinds of institutions might have better responded to events or (this is surely an oversight) been more likely to adopt his preferred policy model. My guess is that he, Friedman and Schwartz, and most of the rest of the economics profession share Woodrow Wilson’s desire for experts: The Fed should be independent but use the right model.

References:

Karl Brunner and Allan H. Meltzer. The Federal Reserve’s Attachment to the Free Reserve Concept. For Subcommittee on Domestic Finance, The Federal Reserve after Fifty Years. House Committee on Banking and Currency. Washington, 1965.

Karl Brunner and Allan H. Meltzer. “What Did We Learn from the Monetary Experience of the United States in the Great Depression?” Canadian Journal of Economics, May 1968.

W. Randolph Burgess. The Reserve Banks and the Money Market. New York, 1927.

Lester V. Chandler. Benjamin Strong, Central Banker. Washington, 1958.

Marriner Eccles. Beckoning Frontiers. New York, 1951.

Barry Eichengreen. Golden Fetters: The Gold Standard and the Great Depression, 1919-39. New York, 1992.

Milton Friedman. A Program for Monetary Stability. New York, 1959.

Milton Friedman and Anna J. Schwartz. A Monetary History of the United States, 1867-1960. Princeton, 1963.

Charles O. Hardy. Credit Policies of the Federal Reserve System. Washington, 1932.

Thomas Havrilesky. The Pressures on American Monetary Policy. Boston, 1993.

Freidrich A. Hayek. Prices and Production. London, 1931.

Herbert Hoover. Memoirs: The Great Contraction, 1929-41. New York, 1952.

Herman E. Krooss, editor. Documentary History of Banking and Currency in the United States. New York, 1969.

Allan H. Meltzer. “Overview,” in Federal Reserve Bank of Kansas City, Price Stability and Public Policy, 1984.

Winfield W. Riefler. Money Rates and Money Markets in the United States. New York, 1930.

Henry Thornton. An Inquiry into the Nature and Effects of the Paper Credit of Great Britain. London, 1802.

David C. Wheelock. The Strategy and Consistency of Federal Reserve Monetary Policy, 1924-33. Cambridge, 1991.

Elmus Wicker. “Brunner and Meltzer on Federal Reserve Monetary Policy during the Great Depression,” Canadian Journal of Economics, May 1969.

Elmus Wicker. Banking Panics of the Great Depression. Cambridge, 1996.

John Wood’s main research interest is a history of the ideas and behavior of British and American central bankers since 1694. Recent articles include “Bagehot’s Lender of Last Resort: A Hollow Hallowed Tradition,” Independent Review (Winter 2003), and “The Determination of Commercial Bank Reserve Requirements” (with Cara Lown), Review of Financial Economics (December 2002).