Federal Reserve System

Central Banking Theory

Development of U.S. Monetary Policy (1914-1923)

The System:

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  Modern central banks control the national money supply, provide a stable but sufficiently flexible currency and a functioning payments system for money transfers and check clearance, and act as lender of last resort.

  There had been broad-based opposition to the creation of a central bank. Pres. Andrew Jackson refused to extend the federal charter of the national bank - then the Second Bank of the United States - for reasons that were good and sufficient involving abuses of the bank's position. The bank had served the role of a central bank, however, and Jackson failed to put anything in its place. Beginning immediately after Jackson's second term, with the financial crisis of 1837, widespread bank failures became a feature of economic downturns until the banking reforms of the New Deal - which themselves left much to be desired.
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  Recent reforms have removed much of the New Deal regulatory restraints on competition between banks and have greatly altered the regulatory framework, but it is very doubtful as to whether this will prove sufficient to prevent future banking crises.. The regulation of banks and other financial entities remains far from perfect and labors under a multitude of inherent difficulties.

Typically, panics were avoided by the suspension of gold or silver payments and liberal lending to other banks on the basis of good collateral that may have been rendered temporarily illiquid due to a collapse of confidence.

  The leading central banks in 1913 were private institutions that recognized their public responsibility to act as lender of last resort during any banking crisis. Typically, panics were avoided by the suspension of gold or silver payments and liberal lending to other banks on the basis of good collateral that may have been rendered temporarily illiquid due to a collapse of confidence. Such loans prevented good banks from being carried away with the weaker institutions.
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  As the crisis subsided, the public would regain confidence, deposits would return to the banking system, and specie payments could resume. Since this emergency lending was at a "penalty" interest rate somewhat above normal market rates, the crisis loans would be paid off as soon as possible, and there would be no long term inflationary impact.
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  However, the system could break down if a crisis were sufficient to put the private interests of the central bank itself in jeopardy. There had been times when a government guarantee had been required to support Bank of England lending during crisis periods.
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There remained widespread suspicion that a central bank would sacrifice agricultural interests and regional commercial interests to those of Wall Street and the major commercial centers.

The reserve banks could lend gold to each other but there were no formal requirements for coordination or cooperation.

  Under the Federal Reserve Act of 1913, the System was a decentralized combination of public and private interests with "semi autonomous privately funded reserve banks supervised by a public board." Each region of the country wanted its own autonomous reserve bank that would take care of its own particular commercial interests. There remained widespread suspicion that a central bank would sacrifice agricultural interests and regional commercial interests to those of Wall Street and the major commercial centers.

  "The Federal Reserve began operations in 1914 as a peculiar hybrid, a partly public, partly private institution, intended to be independent of political influence with principal officers of the government on its supervisory board, endowed with central banking function, but not a central bank. Each of the twelve semiautonomous reserve banks set its own discount rates, subject to approval of the Federal Reserve Board in Washington, made its own policy decisions, and set its own standards for what was eligible for discounting."

  The reserve banks could lend gold to each other but there were no formal requirements for coordination or cooperation. Cooperation and coordination would have to be arranged each time the System had to act as a lender of last resort. As privately funded institutions, the reserve banks could have conflicting responsibilities during a crisis. 
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   Since it was desired that no interest group could be dominant, nobody - and no interest group - was in control. "A struggle for power and control broke out early and continued until resolved by the Banking Act of 1935," which transformed the System into a true central bank.
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  "Money" under the gold standard:

  The basic money supply had consisted of gold, national bank notes, subsidiary silver and minor coin, and an assemblage of assorted relics of earlier monetary episodes -- greenbacks from the Civil War period, silver dollars, silver certificates, and Treasury notes of 1890.
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Federal Reserve notes could be issued by Federal Reserve Banks on the basis of a gold reserve of 40% plus 60% collateral consisting of eligible commercial paper.

When government bills were included as eligible paper, many feared the System could become an engine of inflation since new currency would not be tied to commercial needs and was just monetizing government debt.

  Now, Federal Reserve notes were available as a part of the basic money supply. Now, deposits to the credit of banks on the books of Federal Reserve Banks were available to satisfy legal reserve requirements and were equivalent, from the point of view of the commercial banking system as a whole, to Federal Reserve notes or other currency as a means of meeting demands of depositors for cash.
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  Federal Reserve notes could be issued by Federal Reserve Banks on the basis of a gold reserve of 40% plus 60% collateral consisting of eligible commercial paper. This tied the currency that the System issued to gold flows under the gold standard and commercial needs controlled by the commercial paper discounted with the reserve banks or purchased by the reserve banks with Federal Reserve notes. Gold could be substituted for eligible paper - and was as the reduction of member bank borrowing from the System during the Great Depression exhausted the System's stock of eligible paper.
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  When government bills were included as eligible paper, many feared the System could become an engine of inflation since new currency would not be tied to commercial needs and was just monetizing government debt.

  The inflation problem of government central banking is as old as money. The temptation to expand the money supply - to clip or debase the coinage - to run the printing presses - for short term political budgetary purposes that ultimately result in ruinous levels of inflation - has proven irresistible for 2,500 years - and is again proving irresistible for the U.S. Federal Reserve System here in the first decade of the 21st century.
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  Inflation is in fact a tax by which governments take valuable goods and services from the economy in return for nothing more than expansion in the depreciating fiat money supply. Governments dearly love this method of taxation because most people do not understand that the resulting rise in prices and the absence of pricing benefits from improvements in productivity is in fact a tax imposed on them by their government. See, Understanding Inflation. This allows a government to deflect blame onto convenient scapegoats.
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  By the end of the 20th century, this temptation was being fought by increasing the "independence" of government central banks. However, it is clear that Federal Reserve "independence" is only as good as the political support it gets for making the tough austerity decisions required to prevent inflation from increasing to ruinous levels. As a creature of the political arms of government, it cannot act without such support.
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  The Federal Reserve in this first decade of the 21st century is being forced to monetize vast amounts of government debt to prevent that debt from pushing interest rates up to depressive levels.  Our gallant legislators sanctimoniously belabor scapegoats - OPEC, big oil companies, speculators, economic expansion in China and India. But it is not oil that is going up - it is the dollar that is going down. It is not just oil. All commodities have been rising at double digit rates for several years already. This is chronic inflation, and chronic inflation is solely the result of an expanding money supply. It cannot occur without that.
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  Who is to blame for the high oil prices and the rest of this inflation? Congress is to blame - for creating the massive deficits that have to be monetized. See, Congress: The Engine of Inflation.

But if the System could create money, how could it be prevented from becoming an "engine of inflation?"

  There was an immediate impact on the money supply from the establishment of the new System. By buying and selling gold using Federal Reserve notes, the System could change interest rates and affect the purchasing power of money. But if the System could create money, how could it be prevented from becoming an "engine of inflation?"
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  Discipline was imposed in two ways. Discretion was limited by the disciplines of the gold standard and the reactive nature of reserve bank discounting of member bank "eligible paper."

  "The founders intended the gold standard to work automatically. Discounting was at the discretion of the member banks. The Federal Reserve could decide the timing of discount rate changes, but the rules of the gold standard limited the range within which it could set the discount rate."

Money is fungible. Any credit expansion inherently expands credit for all purposes - productive, speculative and even for consumption.

  The gold standard and gold reserve requirements were supposed to limit the amount of notes that the Federal Reserve System could issue. Commercial rediscounting needs were supposed to provide another limitation. The latter permitted flexible expansion of Federal Reserve money during times of monetary stringency. It permitted member banks to quickly increase their holdings of Federal Reserve money by rediscounting their eligible commercial paper - "notes, drafts, and bills of exchange arising out of actual commercial transactions" - with a Federal Reserve Bank.
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  This was designed to increase liquidity during crisis periods so that member banks could meet demands for cash withdrawals by depositors. It was based on "real bills" used in commerce, not government securities that could be expanded at the whim of the government. By barring the System from using government securities to back its currency, the System was prevented from monetizing government debt - one of the classic engines of inflation.
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  Many (but not all) who supported the "real bills" doctrine also assumed that the "quality" of credit can be controlled and that System credit can be restricted to productive uses. However, money is fungible. Any credit expansion inherently expands credit for all purposes - productive, speculative and even for consumption.
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Market pricing fluctuations and the business cycle are essential to make the gold standard work.

  However, the "real bills" doctrine was pro-cyclical. It could accentuate the business cycle by expanding the money supply when business was good and by contracting it when business was bad. It was the adjustment mechanisms of international trade markets and international payments, with the cyclical price movements of domestic markets, that provided the counter-cyclical elements.
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  Rising prices during periods of rapid economic expansion increased imports and decreased exports and thus reversed the gold inflows that were expanding the money supply. Falling prices during periods of economic contraction increased exports and decreased imports and thus reversed gold outflows that were contracting the money supply. Thus, market pricing fluctuations and the business cycle are essential to make the gold standard work.
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  Right from the beginning, during WW-I, the monetization of government debt to help finance the war became an important System role - the cost of which predictably was a surge of inflation.
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Interference with either international trade or the operations of the gold standard unbalanced the System in favor of either chronic deflation or chronic inflation.

Like waves in the ocean, gold always sought an equilibrium level which it could never sustain because of the persistent impacts of the financial and economic winds.

"With the growth of industrialization, labor unions, and the spread of the voting franchise, voters and governments were less willing to follow such rules in the 1920s."

  The gold standard had worked tolerably well except during times of war when it had had to be dropped. Except during wars, inflation rates were effectively limited by fixed gold exchange rates for national currencies.
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  The international gold system, however, worked through the business cycle. It could not work without it. It required flexibility in prices, employment and economic output so it could adjust to the complex winds of economic change and the passing financial storms that inevitably buffeted the commercial world. It required open international markets so trade flows could reduce or practically eliminate the need for gold flows. Interference with either international trade or the operations of the gold standard unbalanced the System in favor of either chronic deflation or chronic inflation.

  "[Under the gold standard,] each country accepts the rules of the standard, defining currency value in grams of gold, agreeing to buy and sell gold at a fixed price, and allowing money and prices to rise and fall with gold movements. If member countries followed these rules, exchange rates would remain fixed and inflation or deflation would be limited to changes around the world price level, the latter set by world demand for and output of gold. Large productivity shocks might disrupt countries' efforts to maintain employment and stable prices, but prices and output would eventually adjust as required by the fixed exchange rates."

  Discount rate adjustments were the only tool for mitigating gold flow and business cycle swings. Like waves in the ocean, gold always sought an equilibrium level which it could never sustain because of the persistent impacts of the financial and economic winds.

  "[The gold standard] required procyclical policies -- allowing gold inflows to inflate the economy during expansions and to accept contraction, unemployment, and deflation when gold flowed out. With the growth of industrialization, labor unions, and the spread of the voting franchise, voters and governments were less willing to follow such rules in the 1920s."

Evolution of the System:

  The panic of 1907 had been particularly frightening and would have been much worse if J.P. Morgan had not personally taken on the central bank role to organize a financial rescue package.

  "Financial panics, interest rates temporarily at an annual rate of 100 percent or more, financial failures, and bankruptcies were much too frequent. Other countries had a lender of last resort to ameliorate financial crises or even prevent them. The series of crises and financial panics increased support for creation of a new institution."

  Besides that, there were the ordinary credit needs of an economy that was still 30% agricultural, with heavy seasonal credit needs for the fall harvest. Without a central bank to discount export credits, banks in the U.S. were at a disadvantage to London banks in competing to finance agricultural exports. Politicians wanted to reduce seasonal interest rate swings and facilitate domestic financing of the nation's exports. In the 1920s, the System successfully achieved these goals and promoted financial stability - after an initial stumble in 1920-21.

  "Although the economy continued to experience relatively large cyclical fluctuations and many banks failed, old-style financial panics did not return in the three recessions from 1920 through 1927."

  However, times changed, and the System changed with them. Improved communications created a national - and international - financial market. There were wars and a vast expansion of the roles and responsibilities of the federal government. The System originally had too many internal divisions of authority. There were struggles for power and influence within the System and fundamental disagreements about monetary policy and the appropriate roles of the System both domestically and internationally.
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  Above all, there was mission creep, as the System quickly took on responsibilities it was neither intended - nor even capable - of fulfilling. It still, after all, had to learn the techniques of monetary policy - the power of open market intervention - the difference between real and nominal interest rates. There was uncertainty as to the utility of flexible interest rates, and a fear of loss of gold reserves that constrained its ability to act as lender of last resort in a crisis.
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  The System now issues currency backed by government securities, and as feared it has indeed become an engine of inflation.

  The dollar has lost over 50% of its purchasing power since 1960 - 90% since 1940 - and the dollar continues in rapid decline. Pennies - and nickels, too - have been thoroughly debased and are useless, but in an astounding exhibition of the inherent ineptness of government management, the government simply can't stop coining them.

Central banking theory:

  David Ricardo and his followers concentrated on long run consequences. Policies promoting the restoration and maintenance of fixed gold exchange rates after the monetary stresses of the Napoleonic Wars were important. See, Ricardo, "Principles of Political Economy."
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  However, they gave little guidance on the day to day activities of the Bank of England that determined its profits as a private bank and fulfilled its role as a central bank in avoiding panic and responding appropriately to short term changes in financial conditions. Economists and bankers concentrating on immediate responses to current conditions gave little thought to longer term consequences.
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  A further disconnect concerned the relationship of bank rate policy ("monetary policy") and "real" economic factors of output, employment, prices, and balance of international payments ("macroeconomic" theory).
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The monetization of long term debt was resumed during the New Deal. It was permanently authorized in 1945, and the U.S. has duly experienced chronic inflation ever since.

The monetization of government securities and long term debt was resumed during the New Deal. It was permanently authorized in 1945, and the U.S. has duly experienced chronic inflation ever since.

  Henry Thornton at the turn of the 19th century provided a unified framework for monetary policy and macroeconomic theory, but his work was largely neglected during the 19th century until the work of 20th century theorists Knut Wicksell, Irving Fisher, Alfred Marshall, Sir Ralph Hawtrey, John M. Keynes and Milton Friedman.
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  Monetary policy was simply regulated by the gold flow. Later, the Federal Reserve System would restrict its concerns to short-term market interest rates and money market conditions. The "automatic" gold standard would take care of the rest. Thornton's work, after all, was predominantly concerned with an economic system with an inconvertible currency. The other parts of his work, Meltzer states, remained relevant but were overlooked. (Keynesians, too, would neglect the international trade and payments implications of their policies. See, Keynes, The General Theory, Part I, "Elements of the General Theory," at segment on "Offsets," and Keynes, The General Theory, Part II, "Interest Rates, Aggregate Demand, and the Business Cycle," generally and especially at segment on "Trade Policy.")
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  Thus, by 1913, it was believed that (1) maintenance of monetary stability through the gold standard by adjustments to the discount rate, (2) acting as lender of last resort to avoid panics, and (3) accommodating  trade needs by discounting "real bills" - instruments that financed real commercial operations - was all the System should do to facilitate economic activities. The discounting of government securities, mortgages and other long term debt was rejected as potentially an inflationary monetization of debt.
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  However, the monetization of government securities and long term debt was resumed during the New Deal. It was permanently authorized in 1945, and the U.S. has duly experienced chronic inflation ever since.
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  Thornton's contributions to central banking theory that linked changes in money to both short and long run changes in output and employment are summarized by Meltzer. Without this, Ricardian theory proved useless as a practical matter for dealing with immediate monetary policy questions. Thornton recognized that monetary expansion - at that time the expansion of the note issue of the Bank of England - will stimulate employment of idle economic resources, but that the increase in supply will not be enough to prevent inflation.
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  The central bank should (1) protect gold reserves, (2) control the note issue - the money supply, and (3) act as a lender of last resort. This was best done by maintaining the market price of gold at the mint price, using discount rates to limit note issuance, and by lending freely during crisis periods. Qualitative controls - jawboning and efforts to ration credit - were clearly ineffective.
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  The central bank must stay independent of political or commercial pressures, adjust the discount rate to maintain a stable currency within a modestly flexible range, restrain monetary growth when gold reserves decline, but otherwise accept modest rates of monetary growth as the economy grows. It should allow substantial though temporary surges in monetary growth during times of crisis.
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The Bank of England:

  The Bank of England was the only bank to receive a charter.  Other banks were restricted to organizing through partnerships. They were thus small and predominantly engaged in issuing notes and discounting bills of exchange. Country banks cleared bills through correspondent London banks. As volume grew, bill brokers were used to perform part of the market clearing function. Usury law restrictions prevented the interest rate swings that could have facilitated market clearing operations.

  "Just as the present-day federal funds market redistributes reserves from surplus to deficit banks, the bill brokers and correspondent banking system of the time drew bills and money to and through the London money market. The Bank of England participated in the market process as a banker. In addition, the bank absorbed gold and its own note issues as the market required and, without formally committing itself to do so, functioned as lender of last resort by advancing to banks on eligible paper."

  However, bank rates were fixed at 5%, which was frequently negative - below inflation rates. The Bank of England thus had no means of stabilizing the market price of gold at the mint price and maintaining convertibility. From 1790 through the Napoleonic Wars, gold reserves sank, the pound became inconvertible in 1797, and inflation rates soared.
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  Under the pressure of the Napoleonic Wars, the Bank of England monetized vast amounts of private and government securities - with a corresponding surge in inflation. As on so many subsequent occasions, efforts to ration credit - restricting discounts to "sound" commercial bills - along with jawboning and other "qualitative" controls on access to central bank credit - failed to stem the tide. Credit is like money and just flows around such impediments.
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  After the war, substantial budget surpluses were used to retire wartime debt. The Bank quickly unwound its wartime positions, resulting in a crushing decline in prices of more than 50% by mid-1822. Gold convertibility resumed in 1821 - at the historic mint price. Thornton and Ricardo were influential in this decision. (Not coincidentally, there were widespread revolutions in Europe in 1821 after widespread difficulties in paying off war debts and six years of pound deflation.) The discount rate was reduced to 4% - the first reduction in 50 years. A discount rate above the market rate could be a problem, too, as it would not attract discounts and would leave the bank with a portfolio inadequate to sustain its earnings.
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  The government responded to the economic distress by encouraging monetary expansion, which was duly accompanied by an economic boom that busted in 1825 when the Bank of England closed its discount window to protect its rapidly declining gold reserve. The Bank met the panic of 1825 by copious lending on a wide variety of securities - with a government guarantee in hand. The panic subsided within days. The author notes that this was a panic that need not have happened if the Bank had had a proper regard for what Thornton had said about the economic impacts of its monetary actions.
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  Other banks became very conservative after the shock of the panic. As partnerships, failure meant the loss of personal fortune as well as the failure of the bank. However, the bill brokers expanded and picked up much of the slack.
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  The Bank of England was freed from usury law restraints in 1833 - it was permitted to open branches - other banks were chartered as joint stock companies with limited liability - and Bank of England notes were made legal tender. There was a flurry of changes in bank practices that Meltzer summarizes. The Bank of England began experimenting with its flexible bank rate as a means of controlling the basic money supply.
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  The author explores the various theories and methods employed by the Bank of England during the rest of the 19th century as it grappled with the problems of regulating the money supply, maintaining the gold standard, and responding to commercial needs. It couldn't seem to get it quite right. Business waxed and waned, gold reserves flowed in and out, and periodic crises afflicted the financial system. (But overall, England prospered mightily during the 19th century.)
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With prices declining at substantial rates for much of the 19th century, especially after 1870, even a 2% nominal interest rate could be high, and 5% could be punishing.

  The problem was that economic and financial events were dynamic, not static. Changes impacted the monetary system just as money impacted the financial and economic system. There were wars, gold discoveries, additional nations competing for gold reserves as they adopted the gold standard, vast changes in international trade flows as transportation costs plummeted, and major periodic crop failures. Financial crises afflicting trading partners periodically washed ashore in Great Britain, and periodically there were major domestic financial failures as might be expected in a dynamic economy.
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  Between 1844 and the end of the century, the Bank of England discount rate was whipsawed between a low of 2% and a high of 10%, with hundreds of individual changes. The Bank didn't understand the difference between nominal and real - inflation adjusted - interest rates. With prices declining at substantial rates for much of the 19th century, especially after 1870, even a 2% nominal interest rate could be high, and 5% could be punishing. Thus, "during the last quarter of the 19th century as a whole, bank rate remained above 5 percent a combined total of only twenty-six weeks."

  Thus, the gold standard system was successful in preventing inflation and keeping nominal interest rates down while discouraging excessive borrowing the vast majority of the time. Borrowing was generally limited to the financing of short term financial flows, emergency situations and for investments that produced enough income to service the debts and yield a profit - the appropriate purposes of credit.

  During the last half of the 19th century, gold reserve requirements were reduced. However, this meant that gold inflows permitted a larger monetary expansion and outflows required greater monetary contractions. The British economy thus was in a constant state of adjustment to changes in monetary conditions. 1857, 1866, 1873, 1878 and 1890 were crisis years, although not all of these were due to Bank policies.
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  By 1866, the Bank "recognized the role of lender of last resort more clearly" and acted effectively in providing Bank credit into the financial system during times of crisis.
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Central banking and the business cycle:

If there are both internal and external drains at the same time, interest rates must be raised because the stability of the currency is essential to all else.

Bagehot's policy prescriptions, although proven effective on numerous occasions, mean that external drains on gold reserves must be met by periods of deflation and economic decline.

  According to Bagehot, domestic crises are to be met with a substantial volume of loans from the central bank on any good collateral. If reserves are draining abroad, the lending rate must be raised to stop the drain. This slows domestic economic activity and reduces imports, causes domestic prices to decline and thus increases the competitiveness of domestic exports which bring gold back into the country.
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  If there are both internal and external drains at the same time, interest rates must be raised because the stability of the currency is essential to all else. A devaluing currency must eventually become a cause of internal crisis in its own right. However, the central bank should discount liberally at the high discount rate. On no occasion should the central bank reject all loans, as that is a prescription for financial collapse.
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  Of course, Bagehot's policy prescriptions, although proven effective on numerous occasions, mean that external drains on gold reserves must be met by periods of deflation and economic decline - something Bagehot was well aware of but never directly addressed. The central bank was expected to regulate the money market and the currency/gold exchange rate, but these expectations ignored or minimized concern with the policy impacts on the economy.
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There is not a single reference in Board minutes concerning the implications of real interest rates at any time during the rapid deflation from 1929 to 1933 or the rapid inflation from 1933 through the WW-II period or through most of the inflationary period of the 1970s.

When much of the System staff and policy members adopted Keynesian ideas, they "emphasized short-term or transitory effects and ignored long-term, permanent effects."

  The differences between "real" and nominal interest rates were explained by Irving Fisher near the end of the 19th century. His explanation was similar to but much clearer than Thornton's. The problem is most readily resolved by maintaining stability in the purchasing power of the currency.
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  Although Fisher was the leading academic economist of his day, there is not a single reference in Federal Reserve Board minutes concerning the implications of real interest rates at any time during the rapid deflation from 1929 to 1933 or the rapid inflation from 1933 through the WW-II period or through most of the inflationary period of the 1970s. It was nominal interest rates that remained the standard of whether money was easy or tight depending on whether they were high or low.

  "The Federal Reserve Board was dominated throughout the 1920s and 1930s by advocates of the real bills  doctrine who, like their predecessors, denied any relation between their action and inflation or output. They ignored Fisher's emphasis on the role of money, - - -."

  Fisher also explained the relationship between inflation and unemployment and the distinction between permanent and temporary effects. When much of the System staff and many of the System policy members later adopted Keynesian ideas, they "emphasized short-term or transitory effects and ignored long-term, permanent effects."

  Prof. Fisher clearly misunderstood the economic and financial causes of the Great Depression. He filled the financial press with a series of misstatements and faulty predictions during the initial years of economic collapse. See, FUTURECASTS' "Great Depression Chronology" series beginning with "The Crash of '29."

  The disputes over central bank monetary policy that raged throughout the 19th century are summarized by Meltzer. The Bank of England improved its abilities to offset panics, used the gold standard to prevent chronic inflation or recession, and used its discount rate to manage fluctuations in the demand for credit. However,  the understanding of "monetary policy" - of its impact on long term economic trends - actually declined during the century.

  "There is a clearer analysis at the start than at the end of the effect of substituting one means of payment for another. The distinction between money and credit is blurred during the century, and most of the now familiar arguments about the 'ineffectiveness of monetary policy' appeared. Although these issues returned to the academic literature at the end of the century, there is no evidence that academic writing had much influence on central banking. The gold standard and the real bills doctrine dominated policy action."

  Gaps and errors in monetary theory survived to afflict the Federal Reserve System. Meltzer mentions the tendency to distinguish between productive and speculative credit and "the notion that the monetary base is demand determined, an argument that has been used at times to absolve central banks of responsibility for their errors and even for their policies."

  "[None of the proponents] of the real bills doctrine recognized that it is the total quantity of notes, not their backing, that affects the price level. Commodities are sold and resold; each sale gives rise to a real bill. In the limit, there may be one increase in output backing many real bills."

  Meltzer is of course correct - as a matter of both theory and logic. Historically, however, keeping down the government's debt servicing costs becomes a constant preoccupation for the monetary authority. A monetary authority is generally required to be an enabler of chronic government deficits by debasing the currency. Chronic inflation generally involves the monetization of the government's securities.

Deposit banking in a fractional reserve banking system served to expand the money stock because a deposit was still money that is readily available to the depositor but is also money to the borrower from the bank.

  As the payments system became more complex, the definition of "money" and the monetary base blurred. Bills of exchange became negotiable in an established market and banknotes increasingly displaced specie. Deposit banking in a fractional reserve banking system served to expand the money stock because a deposit was still money that is readily available to the depositor but is also money to the borrower from the bank.
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  Questions arose as to how to judge monetary policy in this more complex world - whether by exchange rates, gold stock, gold flows, interest rates, or balance of international payments. Even the vocabulary used in discussing these issues became confused. Varying meanings were given to "velocity" of money and the nature of deposits at the central bank and at other banks were questioned. Also in question, of course, was what constituted "money" and the differing impacts of the different components of an increasingly elaborated money stock.
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  The effect of money on prices remained (incredibly) sharply in dispute well into the 20th century. Thornton clearly recognized at the beginning of the 19th century the monetary nature of bank deposits and the effect of money on prices. "But few later writers saw that both reserves and currency affected market rates, money, and prices; most did not or, if they did, were inclined to emphasize one type of money rather than another."
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  In this sea of confusion, the solid ground of central bank policy designed to avoid domestic crises was maintenance of the exchange rate and the bank's reserves and the maintenance of money market stability. However, central bank control of the money market repeatedly has been cast in doubt for some analysts because of further innovations in finance - most recently in the 1960s by development of the eurodollar market. (Innovations with complex securitized financial products are the current problem area.)
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  There was a failure to accurately define important terms and to "analyze the monetary system as part of the economy." Meltzer goes at some length into the confusion about the varying monetary impacts of different components of an increasingly elaborate money stock and the confusion that existed - and still frequently exists - in discussion of this topic. Indeed, it is fair to say that the System really did not know what it was doing - and still was in substantial confusion in the 1970s while its monetary policy drove the nation into the Great Inflation decade. (See, Meltzer, History of Federal Reserve, v. 2, Part VII, "The Great Inflation (1973-1980)." at segment on "Monetary policy confusion."
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It takes time for markets to adjust to new influences, so markets always start behind the curve and forever end overshooting the mark.

  Price fluctuations associated with the business cycle have been a problem for central banks since the earliest times. The problem is worsened by imperfections in market responses that create delays. It takes time for markets to adjust to new influences, so markets always start behind the curve and forever end overshooting the mark. Monetary policy is similarly tardy due to the time it takes to recognize, interpret and respond to new influences. Often, this makes monetary policies pro-cyclical instead of anti-cyclical. It was Fisher who finally explained the links.
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  Businesses, banks and households fail to anticipate promptly the inflation caused by monetary expansion. A gold standard central bank would thus act too slowly to prevent inflation, and its actions would initially force prices and interest rates to surge even higher to slow economic activity and reverse the cycle. "Most nineteenth-century writers not only failed to analyze the timing and proximate causes of changes in money but did not consider the failures of monetary policy as a main cause of fluctuations in output."
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  The need to control the reserve requirements of the banking system as well as currency was not recognized until Keynes "Treatise on Money" (1930).

The development of System monetary policy:

"Monetary policy was guided by the state of the reserves, not by output, employment, or economic stability."

  Smoothing seasonal money market fluctuations and offsetting the interest rate impacts of Treasury operations were primary responsibilities. "Monetary policy was guided by the state of the reserves, not by output, employment, or economic stability."

  "The promising analysis started by Henry Thornton recognized that money was neutral in the long run but not in the short run. Thornton's work opened the way to a careful analysis of the differences between central banks and intermediaries, between money and credit, between real and nominal rates of interest, between relative and absolute price changes, and between permanent and transitory changes. He recognized the errors in the real bills doctrine. Later Irving Fisher revived and added to the understanding of these issues, but, like Thornton's, his work did not influence central bankers until the Great Inflation of the 1970s.
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  "Walter Bagehot did not have a theoretical framework to match Thornton's. He understood, however, the importance of a lender of last resort. And he emphasized the importance of precommitment by the central bank and of following precommitment with action."

The System was to furnish an elastic currency, rediscount eligible commercial paper, supervise member banks, and set discount rates "with a view of accommodating commerce and business."

The statute compromised many viewpoints with many purposes and so left them out just to get the bill passed.

  The 1913 Federal Reserve Act focused on very narrow objectives. The System was to furnish an elastic currency, rediscount eligible commercial paper, supervise member banks, and set discount rates "with a view of accommodating commerce and business." Otherwise, the vast mass of research and monetary policy alternatives considered during the legislative process seems to have had no effect. The System was supposed to improve the management of the nation's monetary and banking system - but there not only was intense disagreement as to how that was to be done, the understanding of what the System was doing was deeply flawed.
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  The lack of a statement of broader purposes was intentional. The statute compromised many viewpoints with many purposes and so left them out just to get the bill passed. The new Woodrow Wilson administration had a major influence on the final product.

  "The final structure included Wilson's compromise -- a politically appointed Federal Reserve Board in Washington and regional banks in principal centers, run by bankers, with no clear division of authority between the two. As part of the compromise, Wilson proposed a Federal Advisory Council consisting of bankers, appointed by the reserve banks, to serve as advisers to the Board. As with the First Bank and the Second Bank of the United States, Congress did not want to grant a permanent charter, so the initial charter was for twenty years. Permanence was not granted until the McFadden Act of 1927."

By confining discounting to "real bills," crop movements and other commerce could be readily financed without risk of inflation.

Penalty discount rates were blunt instruments and were widely unpopular.

  Dealing with banking crises was one purpose that all agreed upon. The lender of last resort role was widely expected of the System pursuant to the charge to provide an elastic currency. Smoothing out seasonal credit needs, especially during the fall harvest, was another expectation. By confining discounting to "real bills," crop movements and other commerce could be readily financed without risk of inflation.
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  The reserve banks and the Board clashed over control of System policy. The lines of authority had intentionally been left vague in the legislative compromise. The result was a largely passive System "dependent on revenues from member bank discounts but with limited influence over the volume of discounts." A penalty discount rate was a blunt instrument and discount rate increases were widely unpopular.
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  The Board was sworn into office on August 10, 1914, after a contentious politically influenced process for establishing twelve districts and reserve Banks. This was undoubtedly too many. Several of the reserve banks were too small and had trouble operating efficiently.
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  The reserve banks opened November 16, 1914. There were great hopes for improvements in interest rate stability, credit availability, and avoidance of banking crises. Treasury dominance of the Board quickly introduced fears that political considerations would influence Board policy.
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Strong viewed normal business cycle recessions as just the price that had to be paid for international financial stability and the normal international ebbs and flows of gold reserves under the gold standard.

  Benjamin Strong, first governor of the N.Y. Federal Reserve Bank (the "N.Y. Fed") dominated monetary policy in these early years. He was a strong proponent of fixed exchange rates, the gold standard, sound currency, and the development of a market for bills of exchange and bankers acceptances to displace the Wall Street short term call money market. However, the call money market remained dominant until the New Deal.
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  Strong viewed normal business cycle recessions as just the price that had to be paid for international financial stability and the normal international ebbs and flows of gold reserves under the gold standard. His discount policy views were similar to those of Bagehot and the Bank of England at that time. He quickly organized a permanent Governors Conference that could place control of operations in the hands of the Federal Reserve Bank governors rather than in the Board which was located in and dominated by Washington.
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  Strong was the first chairman of the Governors Conference. However, his effort to centralize control and coordinate operations was only partially effective. Individual reserve banks frequently went their own way. The Board quickly asserted its right to control discount rate policy and interbank rediscount rates for loans between the reserve banks. These were especially important for dealing with seasonal financing needs. Governors Conference meetings were thus kept informal and were at irregular times.

  "Initially, discount rates were set above prevailing market rates; they were penalty rates to provide discount facilities in periods of market malfunction, as proposed by Bagehot. This principle was in conflict both with the political desire for lower interest rates during the 1914-15 recession and with the desire of the reserve banks to increase earnings."

  After all, discounted commercial bills provided the income needed to operate the System, but not many discounts would be attracted at penalty rates. The expenses and reserve requirements of the System did not look attractive. Only 34 banks switched from state control to the System in the first 30 months of operation. There were almost 20,000 state chartered banks.
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World War I:

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The gold standard was never restored in its effective prewar form.

  When the U.S. entered the war, wartime financing needs became predominant. The discount rate was kept at artificially low rates, so discounts were attracted and reserve bank earnings soared - as did inflation.
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  By 1919, there were more than a thousand member banks, and they included the largest banks in the nation. Member banks had 40% of the assets of the banking system. By 1920, the N.Y. Fed had become the agent for sale of government securities. All the reserve banks contributed to the wartime bond sales and most agreed to buy acceptances from the N.Y. Fed to facilitate its wartime financing efforts. Treasury debt was increasingly discounted by the System, contrary to the "real bills" intent of the Federal Reserve Act. The Treasury itself bought - monetized - $1.7 billion of its own debt, but could not prevent its bonds from trading somewhat below par value.
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  Of course, there is little difference between direct Treasury monetization of government debt and System discounting of government securities at favorable rates. "The Federal Reserve became 'the engine of inflation,'" the author points out.
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   WW-I and its end brought economic boom and wartime inflation, a brief recession as the economy shifted to peacetime production, an inflationary boom, and severe deflation in quick succession. System policy only worsened these economic swings. Interest rates on war bonds rose from 3.5% to 4.75% between May, 1917 and May, 1919. Inflation accelerated. Consumer prices rose 18% in 1918.
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  Popular expectations, "based on experience in previous wars, was that budget deficits would end and the gold standard would be restored at the end of the war." There was, after all, a gold clause in the war bonds, so their long term rates remained far below the rate of inflation. The government was massively benefiting - as in the Civil War - from its history of rigorous budgetary discipline and financial reliability. It would not stiff its creditors to pay for the war.
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  The "real bills" intent of the Federal Reserve Act was a primary casualty of the war. Collateral for issuance of Federal Reserve notes was materially reduced, and banker's acceptances and bank promissory notes secured by government bonds or notes became acceptable. When the U.S. entered the war and extended financial assistance to its allies, gold inflows were substantially reduced and System credit - mainly discounts - "became the driving force in the expansion of the monetary base and inflation." Nearly all the discounts in the two years from December, 1916 were secured by government obligations.
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  System officials argued about what if anything they could do about inflation under the wartime conditions. From their correspondence, Meltzer provides extensive coverage. Slowly - grudgingly - the Treasury permitted increases in System interest rates - but never even close to penalty levels. Rising interest rates threatened the prices of existing war bonds and thus the attractiveness of subsequent issues.

  As the famous Wall Street rhyme instructs us: "If this you know, you know it all: When rates do rise, then prices [of debt securities] do fall."

  With rates constrained below penalty levels, "direct action" programs - "moral suasion," "qualitative controls," and even the rationing of credit - were proposed. These officials "seem unaware," Meltzer points out, "that their proposals raised the cost" of the 20% of GNP needed for wartime use.

  Image - in this case, the appearance of doing something about a problem - can be far more important to government than effectiveness. This phenomenon can be seen increasing to absurd proportions in 2008 as Congress and the presidential candidates fulminate over inflationary conditions that are caused predominantly by their own budgetary mismanagement and the resulting need to monetize government debt.

Once the credit was out the door, it inevitably increased the pool of credit available for any purpose.

  With the end of the wartime embargo on gold exports, gold began flowing out and reserve ratios declined precipitously. The System was under increasing financial pressure and began increasing its interest rates. Gold reserves at the N.Y. Fed declined to just over the 40% legal minimum for the issuance of Federal Reserve notes.
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  However, some members of the Board - mindful that interest rates were blunt instruments and aware of the fragility of the situation - continued to urge "direct action" instead of higher rates. Other members of the Board doubted that direct pressure could be effective in constraining the use of System credit. Once the credit was out the door, it inevitably increased the pool of credit available for any purpose. Strong recognized early the need to deflate and - as he wrote - the painful consequences "involving loss, unemployment, bankruptcy, and social and political disorder."
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  In the event, as 1919 came to a close, the Board successfully exercised authority over the reserve banks. It prevented the N.Y. and Boston reserve banks from raising their discount rates. The System "had shown itself divided, hesitant, and unable to move promptly against inflation in the face of Treasury opposition, a situation that was repeated in different circumstances after World War II."
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The depression of 1920-21:

  December, 1919, brought release from Treasury domination of monetary policy. Wartime financing needs receded as the budget shifted into substantial surplus. Several reserve banks had to rediscount with others because their gold reserves had fallen below the 40% reserve requirement for issuance of their Federal Reserve notes.
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  The System reacted with extraordinary swiftness. Interest rates on Treasury certificates were quickly raised and commercial discount rates began to rise in January, 1920. System interest rates rose from 4% to 7% in a matter of a few months - although the various reserve banks were fairly uneven in the extent of their individual compliance with the rate hike policy. Economic decline began even quicker, starting in the first quarter, but consumer price inflation continued through the first half of 1920. Consumer prices turned practically on a dime that July, deflating at a 15% annual rate through the second half of 1920. They continued declining at lesser rates through 1921. Gold began flowing back into the System just as it was supposed to.
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  Even 7% was not a penalty rate in the first half of 1920. The market rate for commercial paper was 8% so discounting remained profitable for member banks. Member bank borrowing from the reserve banks thus kept rising through 1920. There was an experiment in applying progressively higher rates to those member banks that were heavy borrowers from the reserve banks, but this was politically unpopular and easily circumvented, and was quickly dropped. Indeed, as always, there was political opposition even to the general rise in interest rates.
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Strong and Norman were determined to restore pre-WW-I gold/currency exchange rates and maintain the credit of the U.S. and England.

  Unemployment soared from 4% in 1920 to 12% in 1921. The System's industrial production index dropped 23% but recovered all lost ground by 1922. Agricultural production fell about 15%. Wholesale prices collapsed by 37% according to the later Bureau of Labor Statistics index - 44% according to a contemporary index. These were sharper declines than for any single year during the Great Depression. Yet the System did not begin to lower its interest rates until the second quarter of 1921, a year after the start of the depression. The System followed the commercial paper market, where interest rates remained high until the second quarter of 1921.

  "The dominant view [in the System], which reappears again in 1929-33, was that deflation was an inevitable consequence of the previous inflation. Federal Reserve officials defended the deflationary policy as a means of reversing the effects of the previous inflation and restoring the gold standard at the prewar gold price." 

  Meltzer asserts that it would have been easier to simply devalue the dollar in line with relative rates of WW-I inflation as many other nations were doing. However, U.S. policy was influenced by Strong, and policy in Great Britain was influenced by Montague Norman, the governor of the Bank of England. They were determined to restore pre-WW-I gold/currency exchange rates and maintain the credit of their nations. As after the Napoleonic Wars and the U.S. Civil War, they would not stiff their creditors to pay for the war.

  This restoration of credit was a tremendous asset in the financing of WW-II, as it had been for financing the nation's previous wars. The creditors of WW-II were caught completely off guard when this concern for credit and creditors was not repeated. That level of credit is now gone forever, and the U.S. and Great Britain have suffered repeated bouts of bankruptcy by means of surges of inflation since then. Over time, as a result of inflation, creditors got back just 80% or 60% or 50% of the purchasing power of the dollars they held or lent to the government and other debtors.
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  Through inflation, the people pay the price for this cavalier attitude towards credit and creditors epitomized by the author in this book. The dollar is now worth less that the 1940 dime, and the nation is in danger of losing the tremendous advantage of a dollar that is the world's primary reserve currency.

  As Strong expected, the depression was sharp but short and left the U.S. in a strong financial position for the rest of the decade. It also imposed significant deflationary pressures on the European WW-I belligerents. At the time, John M. Keynes strongly favored such conservative monetary policies.

  "As long as market rates remained above the discount rates, many Federal Reserve officials opposed reductions in discount rates Their arguments are very similar to the arguments put forward in England a half century earlier. Any attempt to encourage expansion by reducing discount rates or allowing discount rates to remain below market rates was an encouragement to borrowing for profits, speculation, and therefore was inflationary. They believed the discount rate should be a penalty rate."

    As the new administration of Pres. Warren G. Harding took over, Treas. Sec. Andrew Mellon joined farmers and Congress in advocating lower System interest rates. Strong countered that until the bloated inventories of the previous inflationary surge were worked off, a rate reduction would be ineffective. System rates must remain at a penalty level above short term commercial market rates to prevent the System from being used as an engine of inflation, "with all the accompanying evils of speculation and extravagance." (He could have been speaking about the first decade of the 21st century.)
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  However, all manner of interest rate controls were being considered in Congress, and the War Loan Corporation was extended to assist agricultural interests. The System came under intense criticism because of the devastation of the depression. Cotton prices in Texas, for example, had collapsed from 60¢ to 5¢ a bale.

  "[The System responded that reserve banks] had not called agricultural loans. Farmers had borrowed to buy land and increase output during the war and postwar inflation. Worldwide deflation had now reduced the value of farm assets while leaving loan liabilities unchanged. This forced liquidation, low prices, and bankruptcy. The governors were relieved when this interpretation was accepted by Congress's Joint Commission of Agricultural Inquiry."

  By October, 1921, gold inflows had become a torrent, and the reserve ratio at the N.Y. Fed reached 82%. Even Strong now relented and favored lower discount rates. More than that, he favored active purchases of bankers acceptances and even Treasury certificates to increase banking system liquidity and to hurry commercial rates down. In November, the System's open market portfolio began to increase. There was a threefold increase - up over $400 million - in seven months. The uses of an activist open market policy had begun to be recognized.
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  However, the System was again somewhat behind the curve. Industrial production had begun recovering in the third quarter of 1921 - although weakness in the agricultural sector continued into 1922, and stock market recovery didn't begin until August of 1922.
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  The M1 monetary base did not begin to increase significantly until the second quarter of 1922. The gold inflow was offset by declines in System discounts and advances. Discount rates were still at 4.5% until late in June, 1922.

  "This is the only business cycle in Federal Reserve history where market interest rates on many instruments -- including commercial paper, long-term Treasury and corporation bonds -- were higher at the [National Bureau of Economic Research] trough than at the preceding peak. Since prices fell throughout 1921, ex post real interest rates were far above nominal rates."

The sharp price deflation not only raised real interest rates, it also powerfully "raised the value of the public's real balances." Even though the money stock was not growing, its purchasing power was increasing sharply.

  Then, how did recovery begin? Meltzer recognizes that the sharp price deflation not only raised real interest rates, it also powerfully "raised the value of the public's real balances." Even though the money stock was not growing, its purchasing power was increasing sharply.

  "Falling prices raised real balances and attracted gold from abroad. The public used its increase in money balances to purchase goods and assets. Judging from stock market prices, after July 1921 asset prices rose absolutely and relative to prices of new production, stimulating the demand for new production. The change in relative prices and real wealth more than offset the negative effect of high real interest rates on spending."

  Money matters, but it isn't everything. There was also the little matter of sufficient time to work down inventories bloated during the previous inflationary surge.
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  In the days before the spread of New Deal and Keynesian concepts, debt financing was kept in check by sound currency and the risks of the business cycle. As Meltzer points out, price deflation was a natural stimulant that powerfully increased the purchasing power of money and helped to end business cycle declines. Reflecting productivity gains, modest rates of deflation prevailed during eight of the ten decades of the 19th century, providing the nation with a powerful natural healthy economic stimulant. Inflation prevailed only during the 1850s because of  the gold rush and during the 1860s because of the Civil War.
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  Loss of this natural corrective factor is one of the most serious weaknesses in Keynesian theory and policy. Chronic inflation becomes inevitable with Keynesian policies. Rising prices naturally depress consumption and provide a powerful additional incentive for deficit financing. Massive increases in public and private debt have increased economic instability and turned every period of economic contraction into a crisis.

  The author shows that despite the high real interest rates, growth in real GNP closely followed growth in real M1 with a lag of two quarters.
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Gold sterilization and discount rate paralysis:

  Money in circulation was to increase and decrease and interest rates were to rise and fall with gold flows. Member banks presented or paid off "real bills" at the given discount rate at their discretion. These transactions were in Federal Reserve Bank notes, a component of the monetary base which - other things being equal - expanded when the notes flowed out of the System and contracted when the notes flowed into the System. The discount rate was supposed to be a penalty rate that responded to market rates in a way that prevented the System from becoming an engine of inflation.
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  The 1920-21 depression was severe. Despite gold inflows, the System failed to respond. The money base and broader money stock - including money created through the fractional reserve banking system - declined throughout the economic decline. Even nominal interest rates were higher at the bottom than at the previous economic peak. Consumer prices deflated at a rate in excess of 20% for nine months from the last quarter of 1920 and more modestly for a year thereafter.
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  The high nominal and real interest rates attracted gold, discouraged discounting and reduced the acceptances offered to the reserve banks. The net effect was a decline in the monetary base despite the gold inflow. The System made modest sales of government securities as the federal budget swung into surplus, further reducing the money supply.
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By any measure, the System had flunked its first test - making matters worse instead of improving on the automatic gold standard market mechanism.

  If the System had followed the gold standard rule and reduced its interest rates in response to the gold inflows, those inflows would have moderated or reversed, facilitating the efforts of Great Britain and other European WW-I belligerents to get back on the gold standard as well as mitigating the domestic depression.
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  By any measure, the System had flunked its first test - making matters worse instead of improving on the automatic gold standard rules based market mechanism. It was the Treasury, in March of 1922, by implementing a policy of unrestricted gold circulation, that added to the monetary base. However, this increase in the circulation of monetary gold by the Treasury did not prevent System gold reserves from rising to almost 80%.
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  Strong and many others in the System and the academic community no longer had faith in the international gold standard system. After all, it had collapsed in WW-I and had not yet been reconstituted. The gold reserve ratio was an unreliable guide if other countries were no longer playing by the rules. Many argued that the judgment of monetary authority officials was now the best means of guiding monetary policy.

  Eighty years later, this remains an obvious fallacy. With a Great Depression in the 1930s, a Great Inflation in the 1970s that impacted the economy well into the 1990s, and the start of another serious inflationary period in the first decade of the 21st century, the record provides no support for the view that human administration can improve on the automatic workings of the gold standard rules based market mechanisms of a hundred years ago.

  Price stability would be advocated as a guide by many monetary authorities and theorists for many years to come. However, a price stability standard opened the System to political pressure to act when prices fluctuated for reasons unrelated to monetary developments. The public would not distinguish between relative and absolute price changes. Strong forcefully opposed this policy. Price stability was a desirable outcome of policy but not a guide. Strong thus favored the reconstruction of the international gold standard.
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  Meanwhile, Strong cited the 19th century banking theorist Bagehot in support of lending freely but at a penalty discount rate. Member banks must borrow from the System to relieve temporary cash flow problems, not for profit. However, this advice was for periods of gold drain, and gold was now definitely flowing in, Meltzer points out. The result was complete confusion. There were as many opinions as governors and other monetary policy officials within the System.
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  In the event, the commercial credit markets followed System discount rates down but did not go below them. The System discount rate was not a penalty rate. However, it had to be reduced because Congress was angry with the System's performance and its stubbornly high interest rates during the first year of the depression.
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  By the last half of 1921, the economy was recovering and the political heat ebbed. The Republican Congress was only too happy to place most of the blame for the depression on the Wilson administration Treasury department. However, the political criticism would be remembered at the end of the decade. The System would hesitate for months in raising its discount rate to 6% as the economy and stock market roared upwards.
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  One problem with the penalty rate requirement was that the System accepted a wide variety of commercial and government securities with a wide risk spectrum as collateral for discounting. Each type had different market interest rates. The Bank of England accepted only real bills - commercial bills of exchange - with a well defined market rate. The U.S. financial system was simply too diverse in financial, economic and geographic terms.

  "The System had tried progressive rates, nonuniform rates, uniform rates, preferential rates, and moral suasion. None of these methods seemed to them to be an effective means of controlling member bank borrowing."

System limits and achievements:

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  There were successes during this period. There was no panic despite a rate of bank failures that exceeded the rates in 1893, 1907 and 1908. The System successfully pooled its gold reserves to make interdistrict loans to those reserve banks that experienced unacceptably low gold reserve ratios. The system for issuing currency was improved, seasonal swings in currency demand were accommodated, and a market in banker's acceptances was supported. A market in "federal funds" developed principally operating through the N.Y. Fed that enabled member banks with excess reserves to make them available overnight or for a bit longer to banks with deficient reserves.
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  Great progress seemed to have been made in the search for policies that would increase monetary and financial stability. However, lacking the guidance of the gold standard market mechanism, and fearful of the political repercussions of high discount rates, the System was trying to move up the monetary creek without a paddle.
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  (See Meltzer,  "History of Federal Reserve," vol. 1, (1913-1951)," Part II, "The Engine of Deflation (1923-1933)," and Part III, "The Engine of Inflation.(1933-1951)")