Inflation as a Remedy

New Deal Monetary Policy

World War II Finance

The System's New Deal:

&

After the initial devaluation and abandonment of the gold standard, the U.S. actually followed gold standard rules for the money stock more closely than before.

Eccles wanted to transform the System into a central bank that was unconstrained by any disciplinary doctrine such as the gold standard or real bills doctrine.

  Mariner Eccles was influential in devising the System reforms and became the first Board chairman in 1936. He was instrumental in centralizing control of the System in Washington and in implementing New Deal policies. He was influential in crafting the 1935 Banking Act.
 &
  Eccles was a Keynesian before Keynes, with strong egalitarian views. He believed that unequal distribution of income was the prime cause of the Great Depression (a Marxian stupidity that has been widely accepted in left wing circles). His economic understanding was shallow and his views opportunistic, shifting in contradictory ways over time. Although convinced that "controlled inflation" was an appropriate remedy for a depression, he responded to the massive growth of "free reserves" in the banking system by doubling reserve ratio requirements for member banks in 1936 and 1937, "thereby contributing to a steep recession in 1937-38" by sharply reducing the bank-money segment of the money stock. His expectations concerning economic developments were repeatedly proven erroneous.
 &
  Eccles wanted to transform the System into a central bank that was unconstrained by any disciplinary doctrine such as the gold standard or real bills doctrine. "He preferred to rely on judgment and wanted a large measure of authority to do what he believed was in the public interest." However, he eschewed System independence and always subordinated his actions to administration policy. He was frequently at odds with George L. Harrison who remained governor at the N.Y. Fed until 1940 and who remained cautious and indecisive throughout.
 &

Emergency authorization provided in 1932 to use government securities as collateral for Federal Reserve notes was made permanent.

For the first time in the nation's history, the nation's creditors were stiffed for a substantial portion of the cost of the war.

  There were extensive regulatory changes made by the New Deal. Some - like the various disclosure oriented Securities Acts - proved highly successful. The Board gained authority over stock market margin requirements.
 &
  There was widespread support for inflating the money supply, but member bank borrowing from the System on the basis of the discounting of commercial paper had declined to minimal levels. Thus, emergency authorization provided in 1932 to use government securities as collateral for Federal Reserve notes was made permanent. (The System thus moved a major step closer to becoming the fiat money engine of inflation that it has been since the total abandonment of gold in the 1970s.)
 &
  WW-II was financed to a substantial degree by accepting wartime inflation levels as permanent. For the first time in the nation's history, the nation's creditors - including all holders of currency and fixed income assets denominated in dollars - were stiffed for a substantial portion of the cost of the war. (After removal of price controls, prices quickly rose to reflect the more than 50% inflation caused by wartime finance.)
 &
  Many of the crosscurrents of the other New Deal policies are sketched by Meltzer.

Reopening the banks:

&

5300 of the 5,938 national banks were able to reopen on March 9.

A "fiduciary" standard is completely dependent for the maintenance of the purchasing power of money on the trustworthiness of the cognizant political officials.

  The 1933 Emergency Banking Act was crafted by Harrison and Hoover administration Treasury Secretary Ogden Mills, who had stayed with the new government to help out. 5300 of the 5,938 national banks were able to reopen on March 9 - a considerable measure of success for the System. Many more were reopened later. They could now borrow from the System based on any sound assets.
 &
  The System was authorized to issue fiat Federal Reserve notes based just on System portfolio assets. Gold was not necessary. Economists call this a "fiduciary" standard, since it is completely dependent for the maintenance of the purchasing power of the money on the trustworthiness of the cognizant political officials (which is almost always ultimately found lacking).
 &
  Banks were licensed for reopening by the Treasury based on System recommendations. This process lasted for several years. A system of government guarantees and the expansion of fiat Federal Reserve notes supported the reopened banks. The RFC played a major role, investing in the preferred shares of many marginal banks to provide them with sufficient capital to reopen. The RFC lasted until 1957. It provided over $2 billion in loans to support banks and trust companies.
 &

  The New Deal achieved a notable success with deposit insurance, but its other banking reforms included some dubious anticompetitive provisions.

  "[The 1933 Emergency Banking Act] established a deposit insurance fund that became the Federal Deposit Insurance Corporation (FDIC), separated deposit and investment banking, restricted member banks from dealing in investment securities, and placed supervision of bank holding companies under the Board. The act also lengthened the terms of the six appointed Board members to twelve years, increased the Board's power to remove bank officers or directors who violated banking laws, prohibited interest payments on demand deposits, and gave the Board power to set ceiling rates on time deposits."

  Board regulations henceforth governed all open market operations, shifting monetary authority to the Board and away from the N.Y. Fed. The Federal Open Market Committee (the "FOMC") was established by statute in July, replacing the OMPC. Eccles was its first chairman. All 12 reserve banks became members. However, it acted through a five member executive committee composed of the OMPC members - N.Y., Boston, Philadelphia, Cleveland and Chicago - with Harrison still as chairman of the executive committee. Individual reserve banks could still refuse to participate in Board open market operations.
 &
  Details of the controversies and the roles played by Sen. Carter Glass (D. Va.) and Rep. Henry Steagal (D. Ala.) and others, and the successes and failures of the reform effort, are provided by Meltzer. Steagal was mainly involved in the deposit insurance program. The insurance scheme went through several permutations before being finalized in the 1935 Banking Act. The limitations of the scheme - such as moral hazard and adverse selection - were recognized at the time and played a role in the banking problems of the 1980s (and in this first decade of the 21st century).

  "Although deposit insurance appears less successful now than before the 1980s, it retains broad public support. The failures of the 1980s convinced Congress that moral hazard was a real problem. Legislation strengthened the capital requirements and required banks with less than minimum capital to close. After 1980, national and regional banking, proposed in the 1930s as an alternative to insurance, increased diversification of portfolios and the banks' average size."

  The System also received broadened authority for qualitative controls on the speculative use of member bank credit, but these powers are always ineffective and, in the event, have since been rarely used.
 &

Dollar devaluation:

&

Those who favored inflation were ecstatic, but the stock market and the economy suffered significant relapses in the last half of 1933, and the Great Depression continued for the rest of the decade.

Political pressure for devaluation and inflation pushed FDR on July 3, 1933, to reject international exchange rate stabilization efforts and undermined a London conference on monetary and trade relations.

  All ties to gold ended - suddenly and unexpectedly - on April 18, 1933. The Treasury refused to approve new export licenses and FDR prohibited new gold exports. Gold clauses in contracts were abrogated. Private gold holdings were called in on August 28, 1933.
 &
  The U.S. held about one third of the world's gold reserves at that time. There thus seemed no reason for the embargo, and it was widely resented. Advocates of inflation were ecstatic. The stock market soared, and the economy surged as businesses rushed to expand inventories in anticipation of price increases. However, these gains proved quite temporary. The stock market and the economy suffered significant relapses in the last half of 1933, and the Great Depression continued for the rest of the decade.

  "Banning private gold holdings and abrogating the gold clauses transferred the profit on the devaluation to the federal government. These steps seem unnecessary interventions into private contracts and asset decisions. Their purposes were mainly political, to show that bankers and wealthy individuals would not gain from the policy."

  Meltzer is too kind. "Profits" is an obvious mischaracterization. The New Deal administration was hungry for the funds gained from this expropriation and, as pointed out below, quickly found uses for them.

  Debtors benefited at the expense of creditors, with the government the biggest debtor. Another casualty was the ongoing cooperative efforts to reopen international markets. Political pressure for devaluation and inflation pushed FDR on July 3, 1933, to reject international exchange rate stabilization efforts and undermined a London conference on monetary and trade relations. At any rate, stabilization at that time faced many obstacles, as explained by Meltzer.

  "Roosevelt had at last made up his mind to emphasize domestic over international considerations as many in Congress wanted. Reflation of the domestic commodity price level became a key element in a policy of domestic recovery."

    A wildly fluctuating dollar quickly forced resumption of efforts to stabilize exchange rates, but there remained no policy commitment. By every measure, the aggressive New Deal monetary and budgetary efforts were a failure, as were the industrial policy measures. The Great Depression continued throughout the rest of the decade despite several episodes of some recovery. The U.S. simply could not prosper until WW-II restored its international markets.

Excess reserves:

Funds just kept piling up in the banking system as member banks increased the amount of reserves above legal requirements that they deemed prudent given the vast risks of the Great Depression period.

  The OMPC authorized $1 billion in open market purchases in May, 1933. This was a major move, equaling 60% of the System portfolio at that time. In the next two months, open market purchases amounted to $200 million, mostly of Treasury notes of up to five years maturity. A total of about $700 million was purchased that year, but it was offset somewhat by sales of shorter term securities.
 &
  The OMPC feared that inaction would stimulate even more radical legislation. A variety of inflationary schemes were being proposed in Congress. A silver currency scheme - the Thomas Amendment - was enacted, authorizing substantial silver purchases and expansion of the fiat currency with silver coinage and silver certificates.
 &
  Reserves at member banks in excess of legal requirements quickly rose to $500 million, but the System purchases continued at the wish of the New Deal administration. FDR wanted higher prices and the Treasury had borrowing needs that had to be accommodated to finance New Deal programs.
 &
  But funds just kept piling up in the banking system. Member banks increased the amount of reserves above legal requirements that they deemed prudent given the vast risks of the Great Depression period and New Deal inflation. Member bank excess reserves rose to $800 million before the end of 1933.

  There was a massive adverse credit shift as credit ratings plummeted. Those businesses that still had the creditworthiness to borrow had no profit inducement for borrowing.

  Pressure for monetary inflation grew fierce. Market interest rates plummeted - to 1.25% for prime commercial paper and 0.25% for acceptances. These rates were far below System rates and perversely discouraged bank lending by making it unprofitable. Indeed, real rates were well into negative territory, as the price deflator rose 11% and wholesale prices rose 18%. The substantial economic bounce from the bank reopening nevertheless petered out in August, and the economy perversely declined in the second half of the year despite System and New Deal inflationary and other stimulatory efforts. After initially surging higher in the inflationary atmosphere, agricultural prices and gold prices fell back.

  After all, FDR had practically abandoned any hope of regaining the nation's vital international markets. The New Deal was all about palliatives. The FDR administration remained in determined denial of the fundamental causes of the Great Depression and thus made no attempt to address them until the last stages of WW-II.

Meltzer puts much of the blame for the economic reversal in the last half of 1933 on System reluctance to continue the purchase program - although the program continued into November and the economic relapse began during the previous August.

  Opposition to the open market purchase program grew within the System. With little to show for it, the System's experiment with monetary inflation ended in November, 1933. Open market operations thereafter merely sustained the System portfolio at about $2.43 billion until April, 1937. Meltzer puts much of the blame for the economic reversal in the last half of 1933 on System reluctance to continue the purchase program. However, the program continued into November and the economic relapse began during the previous August.

  "Federal Reserve officials appear to have learned nothing from the experience of 1929-33. They continued to operate in established ways and to interpret events as they had in the past. The principal reason for large-scale purchases was fear-- fear of legislation or of action by the new administration. Balancing this fear was fear of inflation, a concern more closely related to the real bills doctrine than to the fact that the price level was 25% below its 1929 level." (However, inflation during 1933 reached double digit levels, despite continued double digit unemployment of labor and facilities.)

  The eternal lament of Keynesians and monetarists and others who believe in monetary inflation as a business cycle remedy is that failures were always just the result of too little monetary inflation. There is never enough of it to do the job. After all, didn't inflation work during WW-II? Of course, there is the little matter of the reopening of the nation's international markets, including the all-important export markets for grains and cotton and automotive products, that apparently played some role as well and began showing major results well before the onset of WW-II monetary inflation.
 &
  Meltzer correctly notes the economic and political impracticality - indeed, impossibility - of restoring fixed exchange rates under the circumstances of that time. However, he absurdly assumes that domestic prosperity could have been restored independently in the U.S. and other nations without regard to the restoration of international markets. This assumption, of course, is a part of the Keynesian stupidity.

Destruction of the international gold standard:

  FDR used the RFC to push world gold prices higher. He kept bidding above market rates until the U.S. was offering $34 an ounce. However, all this achieved was a two-tier gold market, with the U.S. the only buyer at the high price. Except for agricultural interests, support for the program evaporated.
 &
  After much technical dispute, a formal devaluation of the dollar was enacted in January with the Gold Reserve Act of 1934. The vote was overwhelming, reflecting the nation's desperation. The price was fixed at $35 per ounce - almost a 60% devaluation. The "profits" in dollar terms provided the Treasury with a $2 billion Exchange Stabilization Fund, $650 million to retire old national bank notes, and $27 million for reserve bank industrial loans. World gold production soared, as U.S. and foreign mining interests reaped a bonanza.
 &
  Unlike private entities, the System received gold certificates for the gold it had surrendered to the Treasury. However, it received them at the old price of $20.67 per ounce. Ultimately, the devaluation had the desired inflationary impact on price levels.

  "The Federal Reserve paid for its inactivity by losing control of monetary policy. The fund gave the Treasury a strong hand in setting policy toward interest rates, money, and debt, and it used its power. The Treasury remained the dominant partner for the next fifteen years, until the March 1951 accord released the Federal Reserve from Treasury control."

One noxious unintended consequence of these gold and silver purchase policies was the undermining of all international monetary arrangements based on gold or silver.

  The Silver purchase policy also went forward. (For details, see, Friedman, "A Monetary History of U.S., (1867-1960," Part III, "The Age of Chronic Inflation (1933-1966)," at segment "C) History of Monetary Silver (1792-1960).") As with gold, production of silver soared but the price didn't remotely approach the desired $1.29 per ounce during the 1930s. Indeed, it rapidly declined after 1935 until post-WW-II inflation drove silver out of the coinage and silver certificates as such out of the currency.
 &
  One noxious unintended consequence of these gold and silver purchase policies was the undermining of all international monetary arrangements based on gold or silver. (Nations would henceforth have to manage fiat currencies, most of which subsequently suffered periods of destructive levels of inflation.) The primary achievement of these inflationary policies was, in fact, price inflation.
 &

New Deal wage and hour legislation and union organizing greatly increased the costs of providing employment, so there was less employment provided by private employers than there might have been.

Unemployment was still 14% in 1940 despite a massive increase in the government payroll.

  The devaluation and gold purchase program is nevertheless viewed as a success by Meltzer. The money stock finally increased and commodity prices rose. There was considerable economic expansion from the beginning of 1934 until the 1937 relapse. He emphasizes how steep the recovery was until the 1937 recession, with GNP rising to a level almost equal to the 1929 peak.

  Much of this recovery came in the first six months of the new administration - a dead cat rebound simply from the reopening of the banks. Unemployment was still at double digit levels, and most of the employment increases after 1933, as Meltzer points out, came from the expansion of government operations - much of which was of dubious value. Much of the GNP growth, too, came in the immediate aftermath of the reopening of the banks or was due to an increase in government.
 &
  Like overhead, certain government activities are essential and some at least desirable. Some even provide competitive advantage. However, Keynes to the contrary notwithstanding, you can't make up for decline in profit centers by an increase in overhead. Government sector growth is not an economically effective replacement for reduced private sector activities and imposes increased burdens on the private economy. See, Government Futurecast.

  New Deal wage and hour legislation and union organizing greatly increased the costs of providing employment, so there was less employment provided by private employers than there might have been. The author points out that capital was substituted for labor wherever possible and the increased costs deterred expansion of labor-intensive industries such as autos and rubber. Indeed, unemployment was still 14% in 1940 despite a massive increase in the government payroll.
 &
  The unemployment figures do not tell the whole story, of course, because average hours worked by employed workers declined substantially during the Great Depression. Indeed, by 1940, average hours worked in manufacturing were no higher than in 1933 or 1937 during the depths of the Great Depression and unemployment figures were still above 1937 levels in 1940.

  Despite massive experiments in inflation, industrial policy, and other nostrums, by the middle of 1939 the Great Depression was continuing practically unabated and FDR was presiding over a failed administration. It was the beginning of WW-II in September, 1939 that forced open the nation's international markets, brought the Great Depression to an end, and gave FDR the chance to become a great wartime president. See, David Kennedy, "Freedom From Fear," Part II, "World War II"

The Banking Act:

&

The accommodation of commerce and business was still an objective of monetary policy, but now the general credit situation of the country was more important.

  The monetary policy objective shifted from the accommodation of business and commerce to the active maintenance of business stability.
 &
  After considerable maneuvering and compromise among legislators with varying views, the 1935 Banking Act shifted control of monetary policy to the Board, diminished the powers of the reserve banks, and weakened the role of the real bills doctrine by removing its statutory basis. The Board now could define eligibility for discount privileges as broadly as it wished. The accommodation of commerce and business was still an objective of monetary policy, but now the general credit situation of the country was more important.

  "[The] new statute now included 'bearing upon the general credit situation,' an open-ended commitment to discretionary action. The rules barred individual reserve banks from making purchases and sales except as part of the committee, and the committee reserved the right to require a reserve bank to sell or transfer to the System Open Market Account any securities held or purchased outside the committee. The old issue of individual bank earnings was put to rest. Earnings would now depend principally on shares in the open market portfolio."

System "independence" would prove less robust in practice than in theory.

  The Board now had the statutory power to act as a central bank, but it would not be until after the start of the Korean War that it would be free to use these powers. It had seven members appointed by the president with Senate approval. The FOMC executive  committee remained at five members, three of whom came from the Board and two of whom came from the reserve banks. Board members served staggered 14 year terms that could not be renewed. The chairman and vice chairman - formerly "governors" - were members chosen for those positions for renewable four year terms. Reserve bank heads were now "presidents" chosen by their directors with Board approval.
 &
  Fears that the System would be subjected to undue political influence were dismissed as unfounded. However, System "independence" would prove less robust in practice than in theory. Right from the beginning, Eccles willingly submitted to influence from the administration.
 &
  The banking system remained diverse, with far more nonmember state banks than member national banks, but the nonmember banks were small and had less than 20% of total deposits. Only member banks were insured by the Federal Deposit Insurance Corp.
 &
  Despite some ups and downs, the Great Depression and its accompanying desperation continued, giving impetus to a variety of radical threats to the System. The 1935 Banking Act did not satisfy those who wanted some greater measure of price inflation as an objective of monetary policy, and legislative proposals along those lines continued throughout the rest of the 1930s. Nationalization proposals also proliferated. The Employment Act of 1946 was eventually passed, but the mandating of full employment - like so many radical ideas - proved as effective as legislating against the incoming tide.
 &

The 1937 relapse:

&

There was in fact considerable economic revival, but unemployment remained well into double digits and most of the employment gain was due to the expansion of government employment.

  Monetary policy was controlled by the Treasury through its Exchange Stabilization Fund and its control of various trust funds. It expended these funds to monetize federal securities to keep interest rates down while it financed New Deal deficits. In response, interest rates on high grade securities dove to ridiculously low levels, but spreads with lesser grades widened. There was in fact considerable economic revival, but unemployment remained well into double digits and the vast majority of the employment gain was due to the expansion of government employment.
 &
  The System lowered discount rates to 1.5% in New York and Cleveland and to 2% elsewhere, but this, too, was ineffective because market rates were even lower, so member banks had no incentive to discount. Otherwise, the System remained passive. It was the vast inflow of gold that resulted in the substantial increases in the money base and money stock.
 &

  By the fourth quarter of 1935, excess reserves of $3.6 billion in member banks substantially exceeded the System's open market portfolio and so could not be controlled by open market sales. Excess reserves could only be reduced by an increase in reserve requirements. But nothing could be done while the Treasury was financing New Deal deficits.
 &
  The combination of high excess reserves and market rates lower than System discount rates reduced member bank borrowing from the System almost to zero. The extent of such borrowing thus could no longer be used as a guide to monetary policy.

 "With short-term interest rates below 0.5 percent, the opportunity cost of holding excess reserves remained low, but banks had other options. Interest rates on long-term Treasury bonds fluctuated around 2.5 percent."

  With the banking collapse still very much in mind, perceived risks remained high, while private sector loan demand remained low due to the continued depression of private sector activity. Because of the high level of perceived risks, Meltzer views the "excess reserves" figure as substantially overstating the real amount of reserves in excess of what banks wanted to hold. "The result was a large overestimate of potential monetary and credit expansion and prospective inflation and an underestimate of the effect of higher reserve requirements."
 &
  Meltzer provides details of how the Board and the FOMC agonized over the excess reserves problem through 1935 and 1936. They feared a renewed inflationary boom and bust cycle. By 1936, with the stock market surging upwards, FDR, too, was concerned about the political implications of another surge of inflation. The only System action was an increase in stock market margin requirements from 45% to 55% and an increase in the requirements for bank collateral loans. Both actions were ineffective since member bank borrowing from the System was at low levels in any event.
 &

  Reserve requirements were increased 50% on July 14, 1936. "The new ratios were 19.5, 15, and 10.5 percent for demand deposits at central reserve city, reserve city, and country banks and 4.5 percent for all time deposits." As a result, excess reserves above these new requirements were cut nearly in half. At this point, government bond yields barely budged. Open market purchases by the Treasury and the System soon reduced bond yields back to previous low levels.
 &
  Eccles agreed to tie the System to the Treasury as a 50% partner in the Treasury Stabilization Fund open market purchases. These were designed to keep recent Treasury bond issues above par. Large amounts of New Deal long term debt was thus being directly monetized. The System, however, balanced its purchases with sales of short term government securities, so there was no portfolio increase on its part.
 &
  Economic expansion and the stock market surge continued robustly through the rest of 1936. However, less than 30% of the 5 million new jobs came from the private sector and unemployment was still about 17%.
 &
  The gold inflow continued, now pushed by increasing security threats in Europe. Excess reserves quickly rose again above $2 billion and were again by October, 1936, as large as the System open market portfolio.
 &

Reserve requirements had been doubled by the three increases.

Excess reserves were excess only of legal requirements, not of the practical requirement thought prudent by member banks in the continuing Great Depression environment.

  The policy response at the end of 1936 was to sterilize gold inflows through Treasury open market debt sales. Growth of bank reserves slowed to a crawl. Two further reserve requirement increases were implemented by the System on March 6 and May 1, 1937, when neither FDR nor Treasury Secretary Morganthau objected. Reserve requirements had been doubled by the three increases. They had reached the statutory maximum.

  "The Board had now used all its new authority to raise reserve requirements. With gold sterilization limiting increases in reserves and an open market portfolio five times the estimated volume of excess reserve, the Board believed it had the power to control future inflation."

  The initial problem was that the second reserve increase coincided with and perhaps was a cause of a decline below par in the Treasury's 2.5% bond. It hit 2.78% by early April, 1937. Meltzer provides details of the rancorous disputes between the System and the Treasury and within the System as massive purchases of bonds by both agencies failed to stabilize the bond back at the 2.5% rate.
 &
  Eccles was forced to admit that banks were selling their government securities to rebuild their excess reserves to the levels they now thought necessary. In other words, excess reserves were excess only of legal requirements, not of the practical requirement thought prudent by member banks in the continuing Great Depression and New Deal inflationary environment. Nevertheless, the FOMC and the Board refused to cancel the final reserve requirement increase scheduled for May. Meltzer believes they continued to fear inflation and simply did not want to admit error. 1936 was a year of rising prices, after all, along with labor strife and another unbalanced New Deal budget. Price inflation was less than 2% for 1936. By the first half of 1937, however, the GNP deflator was rising at an 8.3% rate even though unemployment was still well into double digits.
 &
  Ultimately, Morganthau, supported by Eccles, dragooned the Board into a program of large scale open market purchases of Treasury bonds unaccompanied by sales of shorter term securities. It was "the first increase in the open market account since November, 1933." The account rose $95 million in April to over $2.52 billion. The System had bowed to political pressure.
 &

"New Deal labor legislation increased unemployment rates by raising costs of employing labor." New Deal populist anti-business rhetoric raised perceived risks of a government assault on profits, further deterring new investment.

  The increase in reserve requirements that was coupled beginning in December, 1936, with aggressive Treasury efforts to sterilize gold inflows played a major role in the severe 1937-38 economic relapse, Meltzer points out. First of all, the reserve requirement increase was ineffective. Banks immediately began selling securities to restore their reserves to the "excess" levels that they thought prudent above legal requirements. By the end of 1938, excess reserves were higher than in August, 1936. The money stock accordingly plunged. While interest rates on the highest rated debt barely moved, spreads with lower rated securities widened to levels not seen since the pound devaluation in 1931 as prices on lower rated securities plunged.
 &
  There were fiscal factors involved, Meltzer points out. There were tax increases in 1937 for social security and on "undistributed profits," and the bonus payments for WW-I soldiers were completed. The undistributed profits tax was another failed New Deal experiment. It raised the cost of capital and was ended in 1940. The social security tax was quickly reduced from actuarial levels to "pay as you go" levels. (The New Deal Congress was learning how to be generous at the expense of future generations who could not as yet vote.)
 &
  In addition, the author concludes reasonably that "New Deal labor legislation increased unemployment rates by raising costs of employing labor." New Deal populist anti-business rhetoric raised perceived risks of a government assault on profits, further deterring new investment. The New Deal was indeed achieving the price inflation it had desired, but the reality pleased nobody.
 &
  There was also a major spike in inventories just before the economic downturn, but Meltzer views this as a minor factor.
 &

Average hours worked by employed workers remained substantially below 1929 levels. 

  Starting in June, 1937, GNP plummeted 18%, industrial production 32%, and unemployment soared back to 20%. Meltzer supports the view of most academic and professional economists that there were two separate severe depressions in the 1930s with a "robust" recovery between 1933 and 1937. He asserts that, if not for the monetary policy mistakes of 1936 and 1937, the 1937 relapse might have been avoided and economic growth might have gotten back close to its long term trend line by the end of the decade.
 &
  However, he acknowledges that this "recovery" was from a very low base and left unemployment deep in double digit territory. Much of the growth was in government activity and government employment rather than in the private sector, and average hours worked by employed workers remained substantially below 1929 levels.

  The public experienced the 1937 relapse - correctly - as a low point in the continuing Great Depression. After all, there had been no effort as yet to deal with the fundamental causes of the Great Depression and, as Meltzer points out, these factors had now been joined by a variety of adverse New Deal policies. See, Great Depression Mythology and Facts. There thus had been little recovery of private sector employment above that realized during the immediate rebound from the bank holiday.
 &
  The National Bureau of Economic Research has a formula for calculating business cycle swings - but this is admittedly just a rule of thumb. Most economists haven't the slightest interest in - and some apparently not the slightest capability of - properly evaluating these results and instead handle them uncritically as holy writ. The 1980-82 depression is similarly viewed as two separate recessions just because the System artificially pumped up the economy in 1980 for election year political purposes.

Impacts of New Deal monetary policy:

The primary stimulus for this recovery came not from monetary policy but from the natural market stimulus of price deflation that "raised the real value of the money stock" during the relapse.

  Even without the 1937 relapse, growth was always partial. This whole recovery was artificially propped up on a sea of government debt and monetary expansion and an increase in grossly inefficient government employment. With inflation already accelerating, it was clearly unsustainable.

  There was a discount rate reduction initiated by the reserve banks in August, 1937. This was the only discount rate reduction until after WW-II. Member banks were not borrowing in any event. Seasonal demands were met that fall in cooperation with the Treasury.
 &
  The System response remained passive. The rapid growth in excess reserves was viewed as a sign that money was "easy."  Inflation running at 6% through the first three quarters of 1937 deterred action. Prices didn't begin declining until the fourth quarter. System open market purchases didn't begin until November, 1937. They were modest and hesitant - and not repeated until March, 1938.
 &
  Nominal interest rates were still being used as a guide rather than real interest rates, and nominal rates were spectacularly low for short term high grade debt. The rate of change in the money stock continued to be ignored.

  But even real interest rates had turned negative. Here, it is Meltzer who is ignoring real interest rates. This 6% price inflation immediately pushed real interest rates sharply into negative levels, but this monetary stimulation somehow failed to prevent the 1937 relapse. How could it, when the “recovery” since 1933 was insufficient to provide any business reasons to borrow money? The absence of creditworthy borrowers who had profitable uses for money rendered even sharply negative real interest rates no more effective than "pushing on the end of a string."

Economic recovery was apparently hindered for those nations that chose exchange rate stability during the 1930s.

  It was Morganthau and the Treasury that acted. Gold purchases and an end to gold sterilization in the first quarter of 1938 had an immediate impact on the monetary base. Money stock growth responded in the second quarter of 1938. Real GDP growth began in the third quarter.
 &
  The Board rolled back the third increase in member bank reserve requirements in April, 1938, but this was a bow to political pressure rather than a decision based on its monetary policy. Excess reserves thus increased to $3.9 billion. Yields on short term government securities fell to zero out to a maturity of 18 months. Yields on government bonds fell back to 2.5%.
 &
  The author discusses the monetary policy conundrum created by the contradictory nature of the two primary goals of monetary policy: exchange rate stability and domestic recovery. Some nations chose one during the 1930s, some chose the other, with exchange rate stability apparently hindering economic recovery. Meltzer here views the disciplines of fixed exchange rates as mainly of benefit to a nation's trading partners - ignoring all the manifold domestic benefits of a hard currency.

  This prevalent Keynesian and monetarist argument is based on a conundrum that doesn't exist. It ignores the autarkic context of the Great Depression period. Keynesians and monetarists dislike fixed exchange rates because they understand that their "monetary policies" inevitably involve periods of rapid monetary inflation that inevitably undermine the currency and force disruptive devaluations.
 &
  The value of stable exchange rates naturally varies with the extent of international commerce. It loses all value in the absence of budgetary discipline. As the U.S. is finding out yet again today, no nation has ever prospered with a chronically weak currency. Furthermore, much of the problem of fixed exchange rate nations during the New Deal period was due, as we have seen above, to U.S. gold and silver accumulation policies that heedlessly drained those monetary metals from weaker nations.
 &
  Flexible exchange rates have not permitted Keynesian and monetarist policies to obsolete the business cycle. Fixed exchange rates have never prevented nations from prospering, as Germany proved so decisively after WW-II. All that is needed is reasonable budgetary discipline. Flexible exchange rates have never permitted nations to indefinitely run substantial budgetary deficits while restraining interest rates by monetizing debt, as the U.S. is learning again in this first decade of the 21^st century.

Wartime finance:

&

  A Tripartite Agreement for a loose stabilization regime between the U.S., Great Britain and France was reached in October, 1936, but a socialist government in France and then rearmament in response to German belligerence soon dominated the exchange rate environment. Devaluations began again in France in 1937 and in Britain in 1938.

  The gold standard had its problems and admittedly worked through a periodically painful business cycle, but the administered alternative of exchange rates managed by monetary authorities and political officials had proven considerably worse. The administered alternative failed again in the 1970s and is failing yet again in this first decade of the 21st century because of weakness in the dollar - the world's primary reserve currency. Of course, nothing could offset the financial strains of substantial government deficits and war.

With surging exports and gold inflows, the Great Depression was over - months before actual U.S. entry into the war.

  War fear and preparation soared with the Munich Agreement of September 8, 1938. Gold poured out of Europe into the safe haven of the U.S.
 &
  With the abandonment of sterilization policy, the monetary base expanded 23% in 1938 and 20% in 1939, yet Meltzer concedes that unemployment was still at 17% in 1940. Much of these funds simply poured into excess reserves, which exceeded $5 billion by the end of 1939. System gold reserves soared past 83.5%. System monetary policy nevertheless remained passive, but it made plans for cooperation with the Treasury for war financing.
 &
  War came in September, 1939. It accelerated gold inflows, both from capital flight and the revival of the nation's export markets. Exports increased to the belligerents and to the export customers that belligerents could no longer service. By the end of 1940, the U.S. held 80% of the world's monetary gold. With surging exports and gold inflows, unemployment was declining sharply and the Great Depression was over - months before actual U.S. entry into the war..
 &
  However, disputes over appropriate monetary policy remained unresolved. The effort to create a bill market to compete with London ended in defeat at the end of the 1930s. Keynesian concepts began to influence staff studies. The promotion of economic expansion was increasingly viewed as more important than preventing inflation, but concerns about inflation and the belief that the "easy money" policy of the 1930s had failed remained the prevalent view.
 &

Costs imposed on business by the New Deal could now be more readily covered due to the rising rates of price inflation.

  The U.S. entered the war as financier for the Allies in March, 1941, with the "Lend Lease" Act. With commendable foresight, this statute included authorization for negotiations for the post-war financial arrangements that became the Bretton Woods arrangements. As the wartime economy picked up speed, banks found increasing uses for their excess reserves, which fell from a peak of $6.5 billion in January, 1941, to $3.4 billion that December. Anti-business rhetoric ended as attitudes changed to one of cooperation. Costs imposed on business by the New Deal could now be more readily covered due to the rising rates of price inflation.
 &
  Wartime monetary policy was necessarily active. Discount privileges were extended to nonmember banks. The System was now responsible for liquidity throughout the nation's banking system. It was a true central bank.
 &
  However, wartime needs submerged the System under Treasury requirements. It had no policy discretion and little policy input on Treasury activities. Eccles and Morganthau remained at odds on appropriate policies, with Eccles now conservatively favoring higher taxes and Morganthau favoring deficits. In the event, both rose precipitously.
 &
  Even before the December 7, 1941 attack on Pearl Harbor, inflation rates soared above 10%. Reserve requirements were returned to their maximum statutory levels. Efforts at qualitative credit controls began in September, 1941. Regulation W set rules for credit allocations and consumer down payment requirements.
 &

Inflation averaged about 7.5% beginning from a period with substantial underutilization of productive resources.

The System thus had become "an indirect source of government finance" - a monetizer of government debt - exactly what the System founders had wanted to avoid.

  WW-II was an experiment in administered alternatives to market forces. Monetary policy was enlisted in the war effort. The war was financed by taxation that rose from 7% of GNP to 21% of a much larger GNP, $200 billion of debt - amounting to about 25% of GNP - and a major increase in the money supply as the System struggled to keep interest rates fixed at 0.375% for Treasury bills and 2.5% for bonds. Prices were fixed, goods were rationed or simply became unavailable, strategic resources were allocated, and controls on credit were - ineffectively - imposed. A growing black market was soon undermining the rationing effort.
 &
  Meltzer provides extensive details about the policy disputes, the administered efforts adopted and System participation in them, and the results. Figures vary depending on when the calculation of the "wartime" financing period begins and ends.
 &
  Taxes covered between 40% and 50% of spending, and debt and money expansion covered the rest. Because of the low interest rates, the public was uninterested in government securities. Most debt was bought directly by banks or secondarily as the public quickly sold its bonds to the banks. The monetary base grew by more than 15% per year, and inflation averaged about 7.5% beginning from a period with substantial underutilization of productive resources.
 &
  Meltzer calculates the inflation "tax" as covering just 1.5% of government spending. A variety of problems arose as the public and banks took advantage of weaknesses developing in the schedule of administered interest rates.

  "As in World War I, debt finance was much less successful than claimed after the war bond drives. The monetary base doubled in the four years ending fourth quarter 1945, an 18 percent compound annual rate of increase. Purchases of Treasury securities account for almost all of the $18 billion increase in the base."

    For example, Treasury bills - short term instruments yielding just 0.375% - were almost all sold back to the System in favor of bonds - fixed at 2.5% - even as the bonds approached maturity and thus became equivalent to bills. The System's portfolio soared - dominated by these short term government securities. The System thus had become "an indirect source of government finance" - a monetizer of government debt - exactly what the System founders had wanted to avoid.
 &
  As a temporary measure, the System was given statutory authority to buy bonds directly from the Treasury to assure the success of bond drives. This authority later became permanent. The System now had all the tools needed to be a true "engine of inflation" in support of budget deficits. After the war - in 1946 - the Treasury recouped much of the interest it had paid to the System by a 90% tax on System earnings. The Treasury might just as well have run the money printing presses and dispensed with the charade of issuing debt obligations.
 &

Budgetary deficits with interest rates fixed at low rates by means of monetization of large amounts of debt engaged the System as an "engine of inflation."

  Eccles continued to willingly bow to political pressure to keep interest rates low for the Treasury's post-war financing needs. There remained doubts about the ability of monetary policy to influence the economy. There were widespread fears of a return of the Great Depression. There was the growing influence of Keynesian  concepts that emphasized reliance on budgetary deficits for combating economic downturns.
 &
  However, continued budgetary deficits with interest rates fixed at low rates by means of monetization of large amounts of debt engaged the System as an "engine of inflation." Aside from advocating higher tax rates and the end of budget deficits, Eccles remained content to tie the System to political needs and Treasury influence. Meltzer notes the similarities and differences in the financing of the two world wars, the growth of the public deficit and monetary aggregates, and inflation.
 &

Total wartime and immediate postwar inflation exceeded 50%.

The Korean War was financed primarily by tax revenues as President Truman determined to prevent budget deficits.

  Removal of price and wage controls in the fall of 1946 revealed the damage. Total wartime and immediate postwar inflation exceeded 50%. Not until 1948 did the economy experience a short period of mild price deflation and economic contraction. It was during WW-II that the System finally abandoned the "real bills" doctrine. It was finally widely acknowledged that: "The particular paper used to secure an advance has no relation at all to the use that the bank will make of the funds it secures."
 &
   Allan Sproul, now president of the N.Y. Fed, became the principle advocate for System independence and concern about inflation.  Eccles term as chairman ended in 1948. Thomas B. McCabe was the Board chairman until 1951. He was indecisive and permitted Sproul and the N.Y. Fed to regain considerable influence over monetary matters during his tenure.
 &

Postwar international finance:

  This fixed dollar exchange rate became a powerful factor in maintaining price stability through the next two decades. As the money supply expanded during WW-II, the System's gold reserve ratio declined from a high of 91% just before Pearl Harbor. In June, 1944, legislation reduced the required reserve ratio to 25% and permitted the use of government securities as a substitute for gold. By the end of the war, gold reserves at several reserve banks were under the 25% level.

  "The principal international financial event of the period was the attempt to reconstruct the international monetary system as a fixed exchange rate system and, at the end of the period, the start of the gold outflow from the United States. At first the Federal Reserve and the administration welcomed the loss of gold as a necessary step in the reconstruction of a more viable international monetary framework. A decade later, concerns about the United States gold loss became the subject of an increasingly active discussion about the viability of the monetary standard based on gold and the dollar."

  The Bretton Woods agreements established a system of fixed exchange rates with the International Monetary Fund (the "IMF") providing loans to cover temporary imbalances and with exchange rate adjustments for "permanent" imbalances. Deficit nations would not be forced to contract their economies.

  "A major problem with this provision was that central banks and governments could not distinguish temporary from persistent imbalances ex ante or even for some time after deficits appeared. A related problem was that fund rules did not make it clear what should happen when the principal reserve currency country -- the United States -- ran persistent trade or current account deficits."

  Bretton Woods negotiations and policy disputes are covered in some detail by Meltzer. Keynes and Treasury economist Harry Dexter White were initially the principle architects of the Bretton Woods system. (Both men were heavily influenced by Marxist concepts. See, for Keynes, "The General Theory," Part I.)
 &

The Keynesian-White plan was "a stabilization plan with all the stabilization measures left out,"

  Responsibility for international monetary affairs shifted to the Treasury after WW-II. The System had had this responsibility from WW-I through the Hoover administration. While some System staff and officials played an active role, the System as an entity remained passive in this as in so much else. It was the Treasury that became responsible for the nation's international exchange rate policy - and became the driving force in the chronic loss of gold and subsequent devaluation of the dollar.
 &
  Sproul and John H. Williams, a Harvard economist and N.Y. Fed official, understood the inadequacy of the IMF for the postwar transition period. They understood that Keynesian full employment policies were incompatible with exchange rate stability. The Keynesian-White plan was "a stabilization plan with all the stabilization measures left out," Williams pointed out. This lack of monetary discipline could only collapse in inflationary chaos (a common weakness of Keynesian systems). Keynesians put their faith in "moral restraint against unsound policies."
 &
  Williams and Sproul testified concerning the weaknesses of the Keynes-White plan for the IMF. Aside from their doubts about initiating such an effort during the financial disarray immediately following WW-II, they pointed out substantive weaknesses.

  "The agreement permitted devaluation, so the exchange rates were not really fixed. A country could follow social or economic policies leading to 'fundamental disequilibrium,' then devalue its currency 'if it seemed to advance its interests.' Further, the agreement was very explicit about the obligations of creditor countries, much less so about debtor countries. Since countries could devalue, they could force the adjustment on others instead of accepting it themselves. Countries would not agree on whether a devaluation was to gain competitive advantage or to respond to a 'fundamental problem.'"

Williams offered a simple alternative. The dollar and the pound would be "key currencies" that other nations could use to fix their exchange rates and bolster their reserves.

  The Keynes-White plan was simply too complicated and failed to impose any discipline on debtor nations. Keynes died in 1946. Williams offered a simple alternative. The dollar and the pound would be "key currencies" that other nations could use to fix their exchange rates and bolster their reserves.
 &
  The international system as implemented was heavily influenced by Williams. His proposal for a dollar dependent system fortunately supplanted many of the features of the Keynes-White system. Nevertheless, Williams remained pessimistic about the ability of the IMF to weather the immediate post-WW-II financial turmoil. Instead of the Keynes-White plan, the world was on a key currency plan based on the pound and dollar. Other currencies were fixed to the dollar and the dollar was tied to gold at $35 per ounce. Because of wartime inflation, the gold price in real - inflation adjusted - terms had been about cut in half by 1951. It was back to about its pre-devaluation level.
 &
  In the event, Sproul and Williams were proved correct. The administered exchange rates established at Bretton Woods proved misaligned. This caused trouble until a series of devaluations in 1949. The IMF - even with the World Bank - had inadequate resources to cope with the transition to peace.
 &

The U.S. settled the approximately $17 billion British lend lease obligation for 4¢ on the dollar.

  The U.S. acted unilaterally outside these institutions through loans and the Marshall Plan. The U.S. simply behaved as if Bretton Woods had created a dollar exchange standard - as Sproul and Williams had advocated. However, the IMF and World Bank came into their own in subsequent years - unfortunately not always with beneficial results.
 &
  To meet peacetime transition needs, the U.S. loaned Britain $3.75 billion, and France $800 million, and settled the approximately $17 billion British lend lease obligation for 4¢ on the dollar. Something, at least, had been learned from the WW-I war debt experience. Britain quickly removed its imperial trade restrictions with respect to the U.S., as agreed. However, Britain quickly fell into its first post war exchange rate crisis - in August, 1947. Full convertibility for the pound was not restored until 1979 under Prime Minister Margaret Thatcher.
 &
  Other international agreements followed Bretton Woods. The World Bank, the General Agreement on Tariffs and Trade, and then the Marshall Plan became the foundation stones for U.S. leadership in international affairs. Retreat into isolationism was recognized as simply not an option - yet another lesson fortunately learned from the post-WW-I experience.
 &

Keynesian policy concepts:

Meltzer again notes the fundamental  incompatibility between fixed exchange rates and a world were domestic policy considerations were dominant in many nations.

  By the 1950s, full employment and economic stability were the primary objectives. Keynesian beliefs had become prominent among System authorities and staff, and the System viewed itself as a part of a government dedicated to a policy of actively promoting full employment.

  "Increasingly, the public looked to government to manage the economy. Within a few years, governments would look to their central bankers to take a leading role in making the macroeconomic policies that first produced the Great Inflation [of the 1970s] and then learned how to control it."

  Meltzer again notes the fundamental  incompatibility between fixed exchange rates and a world where domestic policy considerations were dominant in many nations.

  The inherent incompatibilities between and within these objectives was little understood and widely ignored by Washington policymakers and the increasingly influential Keynesian economists. This remains true even today, although few economists admit to being Keynesians any more. However, there is a good deal of Keynes in monetarism.

  Keynesian economists (thinking along Marxist lines) expected a return of depression conditions if government spending didn't take up the slack. The failure of this forecast began the undermining of their influence. (This was just the first of many times when reality would perversely refuse to conform to Keynesian expectations.)
 &
  The market had a more accurate view. The credit risk spreads between high grade and low grade bonds narrowed precipitously. But stock market price/earnings ratios remained low. The market was not yet discounting booming prosperity, either.
 &
  The Employment Act of 1946 was fortunately left sufficiently vague so that the worst aspects of national economic planning and administered alternatives to market mechanisms remained avoidable. The statute was reduced to "a statement of goals, not an outline of policies," and the U.S. dodged a particularly deadly left wing economic policy bullet.
 &
  However, "fiscal policy" - the federal budget - was still viewed as the primary instrument of economic policy. Little was expected of monetary policy or the System - even by Eccles, its chairman.
 &

The struggle for System independence:

  The recession during the industrial transformation to peacetime production was short - approximately 8 months. Military spending declined quickly by about 70%. The nation's budget shifted quickly into surplus, and wartime taxes were modestly reduced. Bond yields remained low - well below 2.5% for top grade bonds - indicating that the public did not anticipate sustained inflation.
 &
  Prices began declining in 1948 and continued downwards until the Korean War began in July, 1950. Treasury debt retirement reduced the monetary base and money stock. Amazingly, economists at that time widely denied that monetary changes played any role in inflation, placing most of the responsibility on the budget.

  "The Board's staff and its members reflected the views of contemporary economists, as they had in the past and would in the future. They minimized or denied the effect of money growth on inflation. Such views now seem extreme, but they dominated professional writings in the 1940s and 1950s."

  If budget deficits force monetary policy to include the monetization of large amounts of debt, then it becomes true that the budget deficits are the reason for inflation. However, it is the monetization that causes the inflation.

  An independent System monetary policy and market interest rates that could rise to stymie inflation were constantly pushed by Sproul and Williams at the N.Y. Fed. Eccles and the Board remained fearful of political reaction to any substantial rise in interest rates, however, and thus chose to remain subservient to the Treasury and political influences.

  "Policy differences between New York and the Board have some aspects of a repeat, in different form, of the policy dispute in 1928-29.  As before, the Board most often favored some type of credit or monetary control that did not require higher interest rates. New York argued for higher interest rates as a necessary step to control money growth and inflation. And as in 1928-29. the Federal Reserve ignored deflation in 1948-49.
 &
  "Both the Board and the reserve banks had political and economic concerns. The main political concern was to avoid an open fight with the Treasury. The two main economic concerns were (1) that an increase in interest rates large enough to prevent postwar inflation would run the risk of reproducing the 1920-21 deflation and deep recession and (2) the mistaken belief that historically low nominal interest rates indicated an easy monetary policy. As in 1928-29, the Board and the FOMC paid less attention to money growth and price changes than to nominal interest rates."

The System was, after all, just a creature of Congress.

  The System needed political cover - some political support - for independent action. It was, after all, just a creature of Congress. It took almost two years from the end of WW-II for the System to finally allow interest rates on short term Treasury bills to rise above 0.375%. However, they remained at 0.79% - well below market rates.
 &
  Eccles and the Board were still not committed to a permanent inflationary stance. They still feared that inflation in one period must be followed by a similar deflation in the next. (That happens to be true if the government has a proper regard for its credit and its creditors - which includes the entire population that uses dollars.) Inflation thus remained the primary concern of the System even after the Great Depression and the monetary changes of the New Deal. It sought new powers with which it could attempt to control the quality of credit - to constrain speculative uses.
 &
  The author notes the widespread contemporary view that inflation was a temporary phenomenon. This was a realistic view as the budget moved into surplus and the U.S. committed itself to $35  gold in international transactions. However,  he nevertheless expresses puzzlement as to why short term rates remained negative during inflationary periods.
 &
  By 1948, the System was regaining some discretionary power to affect short term rates. Short term rates began to rise and there was even a modest discount rate hike in response to fluctuating economic conditions.
 &
  As interest rates edged upwards, banks made some use of reserve bank discounting facilities, but discounts still didn't exceed $300 million. The banks urged the Treasury to inhibit System interest rate increases. The Treasury generally rejected System proposals that the Treasury increase the yields on its bills and certificates, and the System remained committed to the 2.5% cap on the Treasury bond rate, so inflation remained a concern.
 &

  Inflation fears were well grounded. By July, 1948, consumer prices were rising at an annual rate of 15%. They were up 9.3% for the whole year despite a rapid reversal at the end of the year. A modest round of discount rate increases was approved by the Treasury. The spread between short and long term rates accordingly narrowed.

  "The [1948-49] recession eventually forced the System to face facts it had tried hard to avoid; it could not control inflation and was reluctant to respond to recession. Consumer credit controls, changes in stock market margin requirements, or adjustment of reserve requirements, with interest rates unchanged, accomplished little. Interest rates and money growth were set by markets, not by the System.
 &
  "Realization grew slowly and spread even more slowly. More than halfway through the recession, the Board and the FOMC continued to press the Treasury to raise short-term interest rates, despite sustained declines in industrial production and consumer prices. Two closely related reasons help to explain why policy was slow to change. First, the principals regarded the recession as temporary, and for many it was a welcome interlude. The problem of greater concern was long-term inflation. Second, market interest rates were at historic lows, so they believed policy was easy. No one mentioned the effect of falling prices on real interest rates, a repeat of behavior in previous periods of deflation."

  It was not until March, 1949, that the Board made some tentative moves in response to the recession. Some consumer credit controls were loosened, and stock market margins were lowered from 75% to 50%. There was no observable impact. Modest reductions in member bank reserve requirements followed in May. Authority over consumer credit lapsed on June 30, 1949.
 &

"For the first time, there was general recognition that the System could not control the size of excess reserves while maintaining a fixed level of interest rates. It gave up using excess reserves as a target. Instead, it set a target for Treasury bill rates."

  The System began to - tentatively - break free of the Treasury in the summer of 1949 under the pressure of the recession - the extent of which was as yet unknown. The System instituted a series of small reductions in member bank reserve requirements that by the end of the summer were fairly significant.. The stock market and the economy were already turning around that summer, so it is uncertain how important this policy move was, but it couldn't have hurt. Interest rates edged lower from their already low nominal rates - but because prices were declining, they did not decline in real terms, Meltzer yet again emphasizes.
 &
  This was a normal turn in the business cycle. The downturn attracted gold inflows that increased the money stock and the price decline increased the purchasing power of the money stock, helping a quick recovery. These were the traditional instruments of cyclical recovery. This was similar to the end of the 1920-21 and 1937-38 depressions. The chief instrument of System monetary policy was a series of mostly modest changes in bank reserve requirements designed primarily - as in the 1920s - to fend off inflation. The nation's bankers were still spooked by the Great Depression.
 &
  The Board continued to debate further moves, but by October, 1949, recovery was sufficiently evident to shift concern back towards inflation. The Cold War was heating up, the Soviet Union had the atomic bomb, and defense spending and budget deficits would undoubtedly rise.
 &
  McCabe remained subservient to the Treasury and political influence. Sproul and the N.Y. Fed continued to advocate for increased System independence and flexibility to respond to market developments. Eccles remained influential within the System. The System "could only petition and advise but was not free to act."

  "[The members of the FOMC recognized] at last that they could act through open market purchases - or sales - if they were willing to let the market rates change. For the first time, there was general recognition that the System could not control the size of excess reserves while maintaining a fixed level of interest rates. It gave up using excess reserves as a target. Instead, it set a target for Treasury bill rates at 0.94 to 1.06, about the prevailing range."

  With the return of budget deficits in 1950, the Treasury permitted some modest increases in short term rates. By May, inflation rates were at a 5% annual rate, and Sproul pushed for higher interest rates. However, the System could not let new Treasury issues fail and wound up buying up - monetizing - increasing amounts of government debt during the first months of the Korean War.
 &
  President Harry S. Truman financed the Korean War by raising taxes, so long term bond rates remained below 2.5%. Thus, Korean War inflation was limited to a modest initial spurt - much to the surprise of System officials and almost everyone else. This is "one of the few examples of expectationally driven price increases." Since it was unsupported by the monetary fundamentals, however, inflation subsided after an initial price surge.
 &

Sproul perceptively foresaw the main problem of the 1960s and 1970s - that the need to slow the economy to combat inflation would not be acceptable to the public - or to their elected officials.

The System was a mere agent. It could not be so independent as to defeat congressional deficit spending policies.

Inflation was eating far more into the "buying power" of government securities - was costing bondholders far more - than would a decline below par in the market price for their bonds.

  System capacity to impact prices, output and employment were by now generally recognized. The ability to control the "quality" of credit - the "speculative" uses of credit - was much less relied upon but still far from dead. Sproul, in testimony at a congressional hearing, perceptively foresaw the main problem of the 1960s and 1970s - that even when the System was freed from Treasury dominance, the need to slow the economy to combat inflation would not be acceptable to the public - or to their elected officials. Large increases in interest rates would be resented. "People would not submit to that sort of discipline because it required reduced production and employment." (But inflation, too, can impose unacceptable economic pain - sufficient to force an austerity approach even in the face of a developing depression - as it did in 1980.)

  "[After] forty years, political and financial interests had not been fully harmonized. McCabe and Eccles saw the Federal Reserve as mainly a government institution regulating the financial industry and carrying out government policy. Sproul saw the Federal Reserve mainly as a financial institution, blending private and public control. The difference had always been one of degree or mix; although the mix had changed in the 1930s, the difference between New York and Washington continued."

  Eccles, in his testimony, emphasized another political reality. The System was a mere agent. It could not be so independent as to defeat congressional deficit spending policies. It would be obliged to facilitate implementation of congressional budgetary decisions.

  As with all administered alternatives to market mechanisms, reality perversely always proves dauntingly more difficult than originally expected. See, for example, Administered Prices and Health Care.

  It was W. Randolph Burgess, a banker and member of the System's Federal Advisory Council, who most forcefully and perceptively advocated a high degree of System independence, explained the power of the existing tools of the System - the open market operations and discount rate changes - and recognized the difference between real and nominal interest rates. Inflation was eating far more into the "buying power" of government securities - was costing bondholders far more - than would a decline below par in the market price for their bonds.
 &

  Based on such testimony, System independence and a flexible monetary policy were supported in a 1950 report issued by a Joint Subcommittee on Monetary, Credit, and Fiscal Policies.
 &
  Discount rate increases were approved by the Board in August, 1950. These were the first changes in two years. The new rate was 1.75%. The Board also let short term rates rise, but the Treasury marketed new short term notes at the old rate, forcing the System to buy up most of the issue. To limit debt monetization and the monetary effect, the System sold other issues and expended its gold reserves, but the result was a portfolio loss and decline in gold holdings. The conflict with the Treasury became increasingly heated.
 &

  The Treasury was concerned with stable interest rates, while the System was concerned with stable markets. As a result, the increase in short term rates was kept modest and overall monetary policy achieved only minimal constraint on inflation. The primary inflationary impact was absorbed by the gold outflow - a pattern that would become familiar until the devaluation crises of 1972 and 1973. The gold outflow constrained the growth of the money stock.
 &
  However, the Treasury's new security issues were failing in the market at the low rates it insisted on pricing them at. Truman and his Treasury Secretary, John W. Snyder, insisted in no uncertain terms that they expected the System to maintain these artificially low rates. Political Washington, including Truman, were still obsessed with the role of high discount rates in initiating the 1920-21 depression. The result, of course, was that the System was forced to monetize large amounts of this debt on behalf of the government. It kept explaining and advocating the need for higher interest rates, and the Treasury kept ignoring its advice. As economic activity and inflation inevitably responded by surging upwards, the dispute became increasingly bitter.
 &

Confidence in the government's securities would be destroyed "by a flood of newly created dollars [that] will overwhelm whatever price, wage, and similar controls, including selective credit controls, that might be contrived."

By February, 1951, the System was insisting "on ending the monetization of long-term debt."

  Substantial political support for System independence finally began to grow in Congress and the administration as well as in the financial press. By December, 1950, consumer price inflation was rising at a 14% annual rate. Fears that inflation would push up defense costs now balanced against the Treasury's fears of rising financing costs. In one letter to the president, the System explained that confidence in the government's securities would be destroyed "by a flood of newly created dollars [that] will overwhelm whatever price, wage, and similar controls, including selective credit controls, that might be contrived."
 &
  In fact, as stated above, there was little government deficit during the Korean War. Mainly, the Treasury was involved in refinancing and maintaining the value of existing securities. As Eccles pointed out, the inflation was strictly a monetary inflation - the responsibility of the System. The Board and FOMC agonized over their conflicting obligations for sustaining the Treasury's financing program at a time of war and sustaining public faith in the value of the dollar.
 &
  By February, 1951, the System was insisting "on ending the monetization of long-term debt [and] a rise in short term rates to 1.75 percent." By March, the Treasury agreed to issue a 2.75% bond that was not marketed as part of a broad refinancing program. By this agreement, the System at last gained some freedom from the need to support Treasury operations.
 &
  There was an immediate uptick in interest rates followed by market stability at the higher rates. Inflation declined quickly almost to zero. The Treasury's fears of loss of confidence in its securities if interest rates rose and the prices of its securities fell proved "empty." Equilibrium was reached with just a 0.25% increase in long rates and a 0.34% rise in medium term rates. Of course, the absence of major budgetary deficits played a big role in the ease with which inflation was slain and stability regained. Fears that only major increases in rates would have an impact proved unfounded.

  "For the first time since 1934, the Federal Reserve could look forward to conducting monetary actions without approval of the Treasury. The accord ended ten years of inflexible rates, following seven years of inactive and inflexible policies. The System now faced the task of rediscovering how to operate successfully." (See, Meltzer, History of Federal Reserve v. 2 (1951-1986) Part IV, "Conflicting Objectives (1951-1960).") 

Another failure for administered alternatives:

  System monetary policy played a major role in the "sterilization" of gold flows and the undermining of the gold standard. The System followed this up with a series of tactical monetary policy errors that were part of the mix of factors leading to the 1929 collapse and the severity of the Great Depression that followed. Ultimately, System errors also contributed to the collapse of the nation's banking system, the health of which was its primary responsibility.
 &

The System had still not learned how to effectively manage a fiduciary - a "fiat" - monetary system. It had the independence and discretion - it was free of gold standard discipline - but it had no such knowledge or capacity.

  Collective human judgment about money, interest rates and prices was expected to produce results superior to the periods of distress inherent in the business cycle functions of the gold standard. Results to 1951, however, included the financial turmoil in Europe in the 1920s and the worldwide disaster of the Great Depression. Subsequent results would include disastrous experiments abroad with socialism, the Great Inflation of the 1970s and the beginnings of another period of inflation driven boom and bust during the first decade of the 21st century.

  In the 1970s and early 1980s, chronic price inflation was accompanied by sometimes violent swings in the business cycle that System monetary policy was supposed to avoid. Business cycle volatility will return if the current inflation is not soon addressed. (It returned with a vengeance soon after this book review was published.)
 &
  This should surprise nobody. Administered alternatives to market mechanisms - systems relying on human judgment - have yet to prove superior to the automatic functioning of the gold standard or other market based systems. Indeed, the disciplines required for a successful "fiat" currency are in fact similar to those required for successful functioning of the gold standard. As imperfect as market mechanisms may be, administered alternatives invariably prove much worse - and so far that has applied to money as to so much else.

  The System had still not learned how to effectively manage a fiduciary - a "fiat" - monetary system. It had the independence and discretion - it was free of gold standard discipline - but it had no such knowledge or capacity. This level of ignorance would continue through the Great Inflation decade of the 1970s (See,,Meltzer, History of the Federal Reserve, v. 2, Part VII, "The Great Inflation 1973-1980)," at segment on "Monetary policy confusion.) To a large extent, it still continues to this day.
 &

Central banking successes:

&