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Published by EH.NET (January 2010)

Allan H. Meltzer, A History of the Federal Reserve: Vol. II, 1951-85. Chicago: University of Chicago Press, 2010. xii + 1424 pp. $150 (two books, hardcover), ISBN: 978-0-226-52001-8 and 978-0-226-51994-4.

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

Allan Meltzer?s History of the Federal Reserve from its founding in 1913 to near the end of Paul Volcker?s chairmanship in 1987 is primarily an account of the thinking behind monetary policy taken from the records of the chief policymaking bodies ? the Federal Open Market Committee (FOMC) and the Federal Reserve Board ? and the papers of members of those bodies ? the seven governors of the Board and the presidents of the twelve Federal Reserve Banks. Meltzer?s searches are a great service to historians and potentially a useful service to reformers. We know what the Fed did ? open market operations and changes in the discount rate and reserve requirements ? but seldom, if ever, its reasons. This history does not give us the reasons because many people with conflicting and often unclear views participated in these committee discussions and decisions, but Meltzer has given us a better chance to understand them or, in many cases, at least to conclude that a coherent rationale for monetary policy was absent.

Meltzer (Carnegie Mellon University) has been following the Fed since he and Karl Brunner prepared a study of The Federal Reserve?s Attachment to the Free Reserves Concept for the House of Representatives Banking and Currency Committee in 1964.

Volume II (the subject of this review) begins with the Treasury-Federal Reserve Accord of March 1951 that released the Fed from its obligation to support Treasury bond prices, and thereby recognized its freedom and responsibility to conduct an ?independent? monetary policy. There is more about independence below, but it was qualified immediately by the Accord?s condition that the Fed assist Treasury financing. This qualified independence of the Treasury was given or taken away in the late-1960s and early 1970?s, regained in 1979, and thrown away in 2008 (which is after Meltzer?s History but recognized in the Epilogue).

The years of this volume can be divided into three periods according to inflationary regimes: mostly 1-2% per annum between 1951 and 1966, rising to double digits in the 1970s, and falling to less than 2% in 1985. It is notable that these periods correspond to those of more or less independence. This review is limited to domestic monetary policy, which is the main emphasis of the book, abstracting from regulation and international monetary affairs.

Meltzer?s discussion is organized around the interwoven concepts of structure, independence, and procedures. At the center of the discussion for over half the volume is William McChesney Martin, Jr., the longest-serving chairman of the Board of Governors (1951-70; three months longer than Alan Greenspan. ?The structure of the modern Federal Reserve is, in large part, Martin?s creation? (p. 43).) The Fed?s main instrument, open market operations, is decided by the FOMC, composed of the seven governors of the Board (whose chairman is also chairman of the FOMC), the president of the Federal Reserve Bank of New York (vice-chairman of the FOMC), and four of the other Bank presidents on a rotating basis. When Martin arrived, the FOMC met four times a year, the minimum mandated by the 1935 Banking Act, to decide general policy while its five-person Executive Committee (including the chairman and vice-chairman) met every two weeks to implement the full committee?s objective and instruct the manager of the open market desk. The desk is in New York, where open market operations are conducted, and the manager is a subordinate of the president of the New York Bank, who had dominated FOMC discussions. Over the next few years, Martin persuaded the FOMC to meet more often and abolish the Executive Committee, thereby reducing the influence of New York. The Board?s power was increased but so was that of the presidents outside New York. Meltzer calls attention to the value of the presidents? market view that frequently opposed the governors in Washington who are more subject to political influence (pp. 55-59, 70-75). The presidents have been allies of the chairmen who opposed inflation (Martin, Volcker, and Greenspan) and the chief dissenters of the policies of Burns, Miller, and Bernanke (pp. 507, 934, 991; Wood 2005, pp. 347-49; FOMC Minutes).

Martin also persuaded the FOMC to limit open market operations to Treasury bills, ostensibly to avoid market breaks arising from operations in long-term bonds, but which also limited New York?s discretion and was defense against political pressures to reduce long rates (pp. 59-70).

These structural changes were qualified by the Fed?s understanding of its independence, defined by Martin as ?independence within the government, not independence of the government? (p. 48). This included, following the Accord, the duty to support Treasury financing, which restricted the Fed?s ability to fight inflation by raising interest rates in the presence of government deficits.

?Procedures? refer to the process by which the ideas of FOMC members are converted into policy. They studied economic conditions with the aid of their economic staffs, met, discussed, and voted on ?directives? to the manager of the desk. Sounds simple, but the difficulties in the way of understanding policy are great. The FOMC did not possess an explicit model of the relations between its instruments and its objectives. It was certainly not the Keynesian model prevalent among economists, including the Board?s staff. Its objectives were not transparent. Were they general conditions such as prices, employment, and output as directed by the Employment Act of 1946, or money market conditions, whose relations to the former were not clarified? ?Nothing in the 1950s compares [even to] the Board?s Tenth Annual Report or the Riefler (1930) and Burgess (1927) books.? (Both were Fed advisors.) Even so, the treatment of the effects of monetary policy in the third edition of The Federal Reserve System: Purposes and Functions (Board of Governors, 1954) ?was more complete than mainstream academic views of that time. … Although the various elements [of the transmission process] were not combined in an explicit framework, the emphasis given to expectations, capital values, and relative prices … suggests an underlying sophistication that anticipated much future research? (p. 79) ? although any policy influence of the staff economists is doubtful.

The Fed?s response to the 1953-54 recession, ?its first major trial after it regained independence,? was in many ways characteristic of later episodes, even to the present. It paid more attention to general economic conditions than in the 1920s and 30s, which was in line with President Eisenhower?s reaction to Council of Economic Advisor Arthur Burns? report to the cabinet that a recession had started: Ike ?recalled the Republican party?s commitment to use the full resources of the federal government to prevent another 1929.?

The Fed?s ?performance was mixed. It recognized the slowdown promptly and voted to provide additional ease. In June, a month before the start of the recession, the FOMC decided on a policy of ?aggressively supplying reserves to the market? rather than ?exercising restraint upon inflationary developments? as agreed at the March meeting.? However, the manager?s instructions that ?reserves should be supplied in sufficient volume to prevent further tightening, but not in such volume as to ease the degree of credit constraint? leaves much to be determined because of the lack of agreed measures of ease and other terms. Long rates were falling but short rates were rising, so that the rise in free reserves (because of a decline in member bank borrowing) ?probably misled the manager on this as on other occasions? [notably 1929-33]. ?Martin criticized the desk for ?failing to purchase Treasury bills more aggressively?? and keeping the FOMC informed, but ?rejected any specific measure of ease or restraint? (pp. 107-109).

Meltzer notes in connection with the onset of recession in 1960: ?Several members referred to the decline in the money supply and wanted to end it by using quantitative targets. The manager preferred to concentrate attention on the tone and feel of the market. … There was no agreement about how to define and conduct policy. [New York] President Hayes proposed more active use of regulation Q ceiling rates to signal the direction in which interest rates should change, and Leedy (Kansas City) proposed using an interest rate target. The FOMC could not reach a consensus. … Vague instructions gave the manager considerable freedom to make decisions or perhaps respond to direction from Martin or Hayes? (pp. 208-209).

Returning to 1954, conflicts continued into the recovery phase. ?Until December 1954, seven months after the recession ended, the System continued the policy of ?actively maintaining a condition of ease in the money market?,? although ?Martin expressed concern about a speculative boom. ?[T]here were indications of an exuberance of spirit among intelligent businessmen with respect to 1955 business prospects that seemed to him to be dangerous?.? Fed ?operations remained procyclical. Money growth was higher in the expansion than in the recession? [a tendency that continued into the next century] because ?the decline in member bank borrowing and rise in free reserves [was interpreted] as evidence of ease? (pp. 112-14).

Friedman and Schwartz (1963, pp. 628-31) wrote about this period that the Fed?s new attention to money represented ?a near-revolutionary change,? although it continued to ?lean against the wind.? As in Volume I, Meltzer?s accounts and interpretations of Federal Reserve actions give us no reason to revise those of Friedman and Schwartz, but reinforce them with the System discussions behind them.

The Fed was not free of easy-money pressures from the Eisenhower administration (pp. 135-53), but those were weaker than in the 1960s, especially during the Vietnam War when the seeds of the Great Inflation were sown. Meltzer gives Martin generally low marks, especially for failing to resist the later pressures more strongly. The reasons for the start of the Great Inflation were, first, ?Martin?s leadership and beliefs? (especially his willingness to coordinate policy with the administration). ?Second, neither Martin, nor his colleagues in the FOMC, nor the staff had a valid theory of inflation or much of a theory at all (which might have bolstered their resistance?). And some of their main ideas were wrong.? Meltzer?s third reason, ?institutional arrangements [that] hindered ? timely effective action? ? coordination with the administration and ?even keel? policies ? fit within the first two (pp. 472-78).

Meltzer?s rating of Martin was shared by most economists at the time, Keynesian and monetarist, who held him largely accountable for the longest peacetime inflation (averaging 2.3% over nineteen years) in history. However, many, probably most, students of monetary policy changed their opinions of Martin after the dozen unhappy years succeeding his tenure, when inflation averaged 7.1%. Some of them credit a sophisticated, if informal, model for what they came to see as the Fed?s success in the 1950s (Romer and Romer 2002), although Meltzer finds ?no evidence to support? this claim. ?A more important factor was the Eisenhower administration?s conservative fiscal policy … The Federal Reserve was not under pressure to finance budget deficits most of this decade? (p. 48).

This reviewer shares Romer and Romer?s view, and finds even more theoretical completeness/sophistication than they do. Contrary to his frequent protestations that ?I am not an economist? (p. 476), Martin was more sophisticated than his critics. Meltzer saw no evidence of ?economic explanations of inflation? (p. 476) but his quotations of Martin are filled with incentives, expectations, and the importance of credibility. Martin anticipated Greenspan?s definition of price stability as one in which inflationary expectations are not a factor in business and consumer decisions. He was explicit about the neutrality of money (or absence of a Phillips curve) in the long-run. His bills-only policy was designed to supply money (although he refused to define it) without obstructing the efficient allocation of resources. He understood that the Fed could not permanently reduce interest rates; reducing them led to inflation. He did not talk of real rates, but he understood them. ?The history of money demonstrates the difficulties which men have to distinguish the permanent from the temporary. … [M]aking this distinction is a constant imperative? (p. 843). Above all, he understood and embraced the idea that inflation was the Fed?s responsibility (pp. 59-60, 89, 112, 126, 207, 242). He rejected the argument of Senator Paul Douglas (himself an eminent economist) that inflation was a cost-push phenomenon generated by unions and oligopolistic industries. Martin wrote to Douglas in 1959 (as Greenspan told Congress in the 1990s; Wood 2005, p. 397): ?My interest in a monetary policy directed toward a dollar of stable value is not based on the feeling that price stability is a more important national objective than either maximum sustainable growth or a high level of employment, but rather on the reasoned conclusion that the objective of price stability is an essential prerequisite for their achievement? (p. 243).

Meltzer recognizes this in places. ?Pressure from the administration to increase purchases of long-term debt remained strong [1961]. Martin cooperated within the limits set by his concern about inflation and his beliefs about how monetary policy worked. But he regarded some of [James] Tobin?s [of the Council of Economic Advisors] arguments as ?hopelessly na?ve?? (p. 323).

Martin?s statements, and perhaps more important, the Fed?s performance under his chairmanship, show an almost explicit sophisticated modern model of monetary policy subject to a survival constraint measured by the costs of resisting political pressures, which Meltzer?s reaction to Romer and Romer seems to support.

The 1970s saw improvements in Federal Reserve data, increased transparency in more frequent reports to Congress, a state-of-the-art econometric model, quantitative money and interest targets, economic forecasts in ?green? and ?blue? books, and a distinguished economist (Arthur Burns, 1970-78) as chairman to join the growing number of economists on the FOMC (pp. 582-92). Unfortunately, the result was ?the Fed?s second great mistake? that produced the Great Inflation and stagflation. The reasons given for the excessive money growth are many: mistaken forecasts, an increased natural rate of unemployment (?bad luck?? Velde 2004), unwillingness to bear the social costs of disinflation, reliance on controls, a preference for an ?even keel? approach that inhibited action, and submission to political pressures (pp. 667-81, 843-63).

Underestimations of inflations could not realistically have persisted for years on end. ?The simple explanation of why inflation persisted and rose … through the 1970s is that the Federal Reserve did not sustain actions that would end it? even though it ?was aware that its actions increased inflation.? ?That was basically political,? said advisor Stephen Axilrod (p. 1005).

The summer of 1979 saw high and rising inflation and unemployment, and falling approval ratings of President Carter. He reorganized his administration, sending Fed Chairman G. William Miller to the Treasury and replacing him with New York Fed President Paul Volcker, a known inflation hawk. On October 6, with the Fed funds rate at 11.6% and inflation at 12.5%, the Fed announced that it would no longer control interest rates, but shift to money control. Interest rates skyrocketed ? the Fed funds rate reached 19.85% in March 1980 ? and recession ensued. The Fed was supported by Carter and his successor (Ronald Reagan, elected in November 1980), and it stuck to its guns. Inflation fell below 4% in late 1982, although real interest rates remained high for several years, until the public was persuaded that low inflation was permanent.

The Fed returned to interest targeting in 1982, but as Meltzer says about 1979, the ?change in objective [a genuine commitment to reduce inflation] was more important and more durable than the change in procedures? (p. 1034). The Fed?s aggressive actions in 1979, as in the months leading up to the Accord in 1951, were made possible by the support of a public and Congress weary of inflation, along with grudging acceptances by politically weak presidents (p. 1128).

The lesson that I draw from this book is that the necessary and sufficient conditions for price stability (or low inflation) are a Fed that recognizes its effect on inflation, is committed to its control, and is supported politically.

Meltzer?s primary proposal for ?better results? in the last chapter is to follow the example of inflation-targeting countries. This ?rule-like behavior? reduces short-term policy influences and improves credibility (pp. 1234-39), although he recognizes elsewhere that procedures are less important than objectives.

In any case, as Meltzer reports in his Epilogue on the 2007-2009 crisis, the current Fed shows no sign of having learned anything. Current pressures dominate its actions, it has no credibility (no one knows what it will do), it favors controls (like Burns and the Keynesian critics of Martin), and, after the Volcker-Greenspan era restored independence, ?Chairman Bernanke has acted frequently as a financing arm of the Treasury? (pp. 1243-56).

This book, or parts of it, should be required reading for students of American monetary policy. Those who study textbook chapters or journal articles about what policy is or ought to be learn only a small part of the subject, and that part contains much misinformation. Monetary policy is a complex combination of politics, structure, and monetary theory, and the least of these may be the last. ?The most comprehensive recent statement of modern macroeconomic theory, Woodford (2003), is an elegant, erudite development of the rational expectations model that currently dominates academic thinking. … Many central bank economists use this model. No central banker uses it? (p. 14).

References:

Burgess, W. Randolph. 1927. The Reserve Banks and the Money Market. Harper & Bros.

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

Meltzer, Allan H. 2003. A History of the Federal Reserve: Vol. I, 1913-51. University of Chicago Press.

Riefler, Winfield W. 1930. Money Rates and Money Markets in the United States. Harper & Bros.

Romer, Christina D. and David H. Romer. 2002. ?The Evolution of Economic Understanding and Postwar Stabilization Policy,? in Rethinking Stabilization Policy. Federal Reserve Bank of Kansas City.

Velde, Francois R. 2004. ?Poor Hand or Poor Play? The Rise and Fall of inflation in the U.S.,? Federal Reserve Bank of Chicago Economic Perspectives.

Wood, John H. 2005. A History of Central Banking in Great Britain and the United States. Cambridge University Press.

Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press.

John Wood, Reynolds Professor of Economics, Wake Forest University, is author of A History of Macroeconomic Policy in the United States (Routledge 2009) and is working on a book provisionally titled The Political and Economic Genius of William McChesney Martin, Jr..