A History of the Federal Reserve, Vol. II, (1951-1986)
by
Allan H. Meltzer

Part IV: Conflicting Objectives (1951-1960)

Page Contents

Modern Federal Reserve System

Bretton Woods agreements

Employment Act of 1946

Keynesian and monetarist monetary policies

Eisenhower administration

1950s monetary policy history

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N) The Modern Federal Reserve System

Independence:

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  That Federal Reserve System independence is at best greatly limited is emphasized repeatedly by Allan H. Meltzer in  "A History of the Federal Reserve, Volume 2 (1951-1986)."
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  As the Federal Reserve System regained some measure of independence under the Treasury-Federal Reserve Accord of March, 1951, See, Meltzer, History of Federal Reserve, vol. 1, (1913-1951) Part III, "The Engine of Inflation (1933-1951)," it found its policy options severely constrained by the 1946 Employment Act.

  "[The] Employment Act of 1946 committed the country to maximum employment and purchasing power but did not further define these terms. When passing the Employment Act, Congress did not explain how to reconcile its domestic employment goal with the Bretton Woods Agreement and with the political and military obligation the United States soon accepted as part of the cold war with the Soviet Union and its allies."

The System interpreted its role as primarily concerned with the domestic financial system and economy, leaving exchange rate and international concerns to the Treasury with which it cooperated. Inflation was interpreted as a secondary concern. Congressional pressure made this interpretation unavoidable.

 

Many administration, congressional and even System officials viewed monetary policy as playing a supporting role in financing budget deficits and restraining interest rate increases. Sustaining the purchasing power of the dollar was viewed as a highly desirable but definitely subsidiary objective.

 

It was thus Congress, not the monetary authority, that determined the extent of the inflation and financial instability suffered by the nation in the 1970s.

  Freed from direct wartime subservience to the Treasury, the Federal Reserve System (the "System") still understood that it was obligated to support congressional and administration policies and assure the success of Treasury financing and refinancing operations. The System interpreted its role as primarily concerned with the domestic financial system and economy, leaving exchange rate and international concerns to the Treasury with which it cooperated. Inflation was viewed as a secondary concern. Congressional pressure made this interpretation unavoidable.

  "Under the Employment Act, Congress expected the Federal Reserve to do more than avoid another Great Depression. It expected the act to lower the average and variability of the unemployment rate, and for many years it gave much greater weight to unemployment than to inflation. The new emphasis on employment heightened congressional interest in what the Federal Reserve did, in how and why it made its decisions. Increased frequency of congressional hearings reflected this political interest. Later, rising pressure for policy coordination with the administration challenged the Federal Reserve to find ways of reconciling independence and coordination. It did not succeed."

  The System is, after all, just a creature of Congress and lived in fear that Congress would reduce even the limited independence that it had for the conduct of monetary policy. Many administration, congressional and even System officials viewed monetary policy as playing a supporting role in financing budget deficits and restraining interest rate increases. Sustaining the purchasing power of the dollar was viewed as a highly desirable but definitely subsidiary objective.

  "[The] Federal Reserve often found it difficult to follow an independent course. Mistaken beliefs and the lack of courage sustained inflationary actions."

  The existence of substantial budget deficits beginning in the 1960s and political pressure to maintain low interest rates thus tied the System's hands in its losing fight to restrain price inflation. It was thus Congress, not the monetary authority, that determined the extent of the inflation and financial instability suffered by the nation in the 1970s. Nevertheless, when there was public and political support for the fight against inflation in the 1980s, the System was able to make the hard austerity decisions needed to triumph over inflation.

  "The monetarist-Keynesian controversy had a large role in bringing about changes in policy. Federal Reserve officials never agreed upon a theoretical framework for monetary policy, but the controversy and research influenced them. In the 1980s, Chairman [Paul] Volcker called his framework 'practical monetarism.' This was a major change from the approaches advocated by Chairmen [William M. Martin, Jr.] and [Arthur] Burns. Changing views about the meaning of central bank independence and its practical application contributed to the start, persistence and end of the Great Inflation."

  The System did, however, have financial independence. It was not subject to the congressional appropriations process. It was still a banking organization with a paid in capital from its member banks. Its substantial income from its large portfolio of securities and commercial paper was far more than required to cover its operating and administrative expenses. This shielded it somewhat from political pressure,  much to the continuing chagrin of populists.
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  However, Meltzer notes, during the 1950s the System paid about 90% of its earnings to the Treasury. Its retained surplus was sizable and growing in nominal terms, but remained relatively steady as a percent of paid in capital. In 1959, the System's Board of Governors (the "Board") agreed to limit its surplus to 200% of paid in capital. In 1964, the System surplus was reduced to 100% of paid in capital, providing a $500 million windfall for the Treasury.
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  Moreover, as Meltzer points out, the Board was pursuing anti-discrimination in employment policies a decade before the anti-discrimination legislation of the 1960s. A record of 90 years without major scandal is itself a major achievement for the monetary authority.
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Bretton Woods:

  The U.S. held almost $25 billion in gold in 1949. This was about two thirds of the world's non-Soviet monetary gold.
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The Bretton Woods exchange rate structure was proving tremendously successful in restoring economic prosperity throughout the advanced economic world, but it was actually inherently incompatible with the U.S. government's impossible full employment obligations under the 1946 Employment Act.

  Under the Bretton Woods agreements, the dollar was the principal reserve currency and the pound a secondary reserve currency. Other nations held their exchange rates within a 1% band on each side of its dollar parity. France and Canada were the main floating exchange rate nations. The dollar was convertible into gold on the major international gold markets at $35 per ounce. The IMF could provide loans to nations having a temporary payments imbalance.
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  Economic recovery from WW-II took about a dozen years for the advanced nations. During that time, U.S. gold reserves declined marginally due mainly to almost $42 billion in foreign aid in the first half dozen years. Indeed, it was U.S. policy to encourage this gold outflow to rebalance the international financial system. By 1958, however, economic recovery abroad was complete and the U.S. suddenly found itself at a competitive disadvantage due to its higher cost structure.
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  The Bretton Woods exchange rate structure was proving tremendously successful in restoring economic prosperity throughout the advanced economic world, but it was actually inherently incompatible with the U.S. government's impossible full employment obligations under the 1946 Employment Act. In 1958, gold started to flow out at an alarming rate, and this incompatibility became increasingly apparent. However, appropriate alterations of the full employment policy obligation were politically impossible.
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  As the nation hurtled towards dollar devaluation and the inflationary tumult of the 1970s Great Inflation decade, (See, Meltzer, History of Federal Reserve v. 2 (1951-1986), Part V, "Obsoleting the Business Cycle" (1960-1969).) Treasury and System officials played the confidence game. They repeatedly climbed capitol hill to solemnly assure Congress and the American people of their unquestionable will and ability to keep the dollar as good as gold - but they really never had a clue as to how that might be done under the political conditions of that time.
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During a period of increasing inflationary instability, rigid systems like fixed exchange rates become impossible, regardless of their benefits under non-inflationary policies.

 

The U.S. would have to sacrifice price stability and fixed exchange rates to retain currency convertibility, free international capital flows and pursuit of permanent full employment.

  Milton Friedman began explaining this incompatibility as early as 1950. During a period of increasing inflationary instability, rigid systems like fixed exchange rates become impossible, regardless of their benefits under non-inflationary policies. By the end of the decade, this incompatibility was recognized by many others. System staff member Woodlief Thomas explained that the gold outflow was chronic and could not be controlled as long as monetary and fiscal expansion were used in the equally doomed effort to achieve sustained full employment.

  "These policies raised prices and wages and reduced the country's competitive position. - - - [Monetary] policy could not achieve two separate goals, one domestic, the other international."

  However, Congress remained intentionally, determinedly ignorant. The U.S. would have to sacrifice price stability and fixed exchange rates to retain currency convertibility, free international capital flows and continuation of its impossible pursuit of permanent full employment levels.  In 1958, the System's Federal Open Market Committee (the " FOMC") began to include the balance of payments, the U.S. competitive position and gold losses in its regular congressional briefings, but it was paralyzed by domestic political considerations and could make no effective response.
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  The major weakness of all fixed exchange rate systems is the lack of an adjustment mechanism. When adjustments become necessary, they arrive suddenly in the form of a financial crisis. Nations - like the U.S. and Great Britain - that do not accept monetary and budget discipline must suffer currency devaluations that come suddenly during repeated financial crises, or give up the substantial commercial benefits of a fixed exchange rate. Even the minor level of inflation accepted after WW-II proved ultimately incompatible with fixed exchange rates.

  Bretton Woods was thus doomed from birth. Its success for its first two decades was due entirely to the vast hoard of gold held by the U.S. after WW-II, which extended its life long enough to help the economically advanced nations recover from WW-II and get off to a good start in dealing with the burdens of the Cold War. 

  Meltzer favors a floating gold price rising at a rate governed by expanding trade or by a price index instead of floating exchange rates. After all, $35 gold had lost 25% of its purchasing power between 1946 and 1960. (This is another administered policy alternative that is much easier in contemplation than it would be in practice.)
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The engine of inflation:

 

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  Monetary policy operations under Bretton Woods were initially restricted to Treasury securities - mainly bills - and gold or gold certificates and foreign exchange. Depositary institutions could borrow from the System on the basis of short term commercial paper or Treasury bills that the System could simply allow to run off if it wanted to reduce its monetary position.
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Congress and many administration officials began to view the System as a source of funding for their programs.

  The System was increasingly viewed as a source of funds for administration and congressional programs. This was perhaps inevitable and precisely as feared by the founders of the System.
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  Under congressional pressure, the System began to purchase housing finance agency securities to assist congressional efforts to allocate credit into the housing market. With the advent of the Credit Crunch recession in 2008, the System began to accept relatively illiquid collateral for recession lending and monetary policy open market purchases. Quickly, more than half its portfolio consisted of longer term debt. (With government budgets deeply and chronically in debt, the U.S. was increasingly coming to resemble Argentina.)
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  While many foreign central banks tie themselves to the dollar or some other monetary standard, and the European Central Bank has a disciplined policy with respect to its member states, the System remains free of such fixed rules and is likely to remain that way as long as the dollar remains the world's primary reserve currency. The System has vacillated repeatedly in its so far vain effort to achieve its often contradictory objectives.
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  Keynesians assert that discretion is needed when unforeseen financial problems arise, but the need for temporary suspension of monetary rules in such cases was a feature of the gold standard and was limited to major disruptions like war or financial panic. For Keynesians, budget deficits and debt monetization is in practice a permanent policy.

  Assertions that debts will be paid off in prosperous times are risible. There has been no overt effort since the Eisenhower administration to reverse periods of budget debt and monetary inflation. The budget surpluses that were a fortuitous result of the end of the Cold War were quickly followed by the budgetary madness of the Bush (II) administration years.

  Monetary inflation above target levels is never reversed. Since the end of WW-II, it has simply been accepted as the base from which subsequent monetary targets are set.

  "[This volume demonstrates that] the Federal Reserve changed its objectives and its target many times. Often it did not have a precise target. Even after Congress required the Federal Reserve to announce an annual monetary target, it did not adopt procedures to achieve the target and allowed excess money growth to remain by following the practice called 'base drift.'"

  Even Keynes acknowledged that his policy recommendations would break down if applied as long term policy. He asserted that about 25 years of determined usage would destroy the viability of capitalism and require transformation to a government administered market socialist system. See, Keynes, "The General Theory," Part II,  at segment entitled "A promise of utopia." There are in fact many Keynesians who would applaud such an economic breakdown, but only fools expect utopia.

  Free reserves - reserves in excess both of reserve level requirements and member borrowing from the System - were both indicator and target. The System account manager operating through the New York Federal Reserve Bank (the "N.Y. Fed") monetary trading desk, attempted to control free reserves within a margin of plus or minus $100 million. However, the distribution of free reserves between country and city banks could shift in meaningful ways not accounted for by the aggregate figure.

  "[The] response of credit markets to any particular level of free reserves may vary considerably from time to time depending upon pressures for monetary expansion, shifts in anticipations, and other factors difficult to detect or measure."

  Policy difficulties were explained by the FOMC staff. Meltzer summarizes their explanation.

  "[Both] the money stock and reserve measures varied unpredictably, so precise control of money was not feasible. Money stock projections influenced projections of required reserves and, in this way, affected projections for free reserves. - - - [Data] on money were not available promptly. - - - [Broad seasonal changes were not adequately considered.] [Control] was subject to large errors both because of random fluctuations in free reserves, the variable link between the level of free reserves and the stocks of money and bank credit, and changes in velocity that alter the quantitative relation between money and ultimate goals such as output and the price level."

  By 1960, the use of free reserves as a target was widely viewed as unsatisfactory.

  "Free reserves rose when member bank borrowing [from the System] fell, and conversely. Borrowing rose and fell cyclically, so free reserves moved counter-cyclically. Also, free reserves often moved opposite to or independently of total reserves, the money stock or the Treasury bill rate. - - - Concerns about setting interest rate targets were mainly concerns about congressional pressure if the Federal Reserve claimed to control an interest rate."

  Further complications arose from a policy decision in November 1960, when the Board permitted banks to include vault cash in their reserves. That became a game changer in the 1980s when large amounts of "vault cash" was increasingly being kept in ATM machines.
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  Treasury bill rates and later the federal funds rate, as well as "the general tone of the market," provided supplemental information. 

  In short, as FUTURECASTS repeatedly explains, administered alternatives to market mechanisms are never as easy in practice as they seem in contemplation.

Monetary aggregates, exchange rates, price inflation, financial market stability, and the strength of the economic expansion were all among the System's primary concerns.

 

Vital statistical measures of productivity and output growth are very inexact and are major causes of the unreliability of economic and inflation econometric forecasts. Indeed, price inflation in those days was probably overstated because the inflation indexes did not consider quality changes and new product introductions.

  By the 1980s, the Board was mixing a whole bunch of objectives, with sometimes greater emphasis on one or another, leaving observers and market participants befuddled and uncertain. Monetary aggregates, exchange rates, price inflation, financial market stability, and the strength of the economic expansion were all among its primary concerns. Indeed, by the 1990s, no major central bank was following a disciplined rule.
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  The inflation measure followed by the System
is the "core" deflator for private consumption expenditures, which excludes food and energy because of their high volatility and the frequently transitory nature of their price swings. However, food and energy do respond substantially to price inflation pressures and comprise important segments of public consumption. In 2007, the System accepted the need to control these prices over the longer term. The GNP deflator index has different weights for housing, medical care, food and energy than the Consumer Price Index ("CPI").
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  Vital statistical measures of productivity and output growth are very inexact. These statistical limitations are major causes of the unreliability of economic and inflation econometric forecasts. Indeed, price inflation in those days was probably overstated because the inflation indexes did not consider quality changes and new product introductions. These factors would be included (and clearly overemphasized) in the 1990s along with other changes that tended to reduce inflation figures (so the inflation figures ceased being comparable to those of the 1970s and began to understate inflation).
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  The "monetary base" frequently referred to by Meltzer includes currency and bank reserves. The "money stock" frequently referred to by Milton Friedman includes currency and demand deposits, and is thus generally a broader measure than monetary base. Financial reform in the 1980s, however, fudged the distinction between demand and savings and other time deposits and money market funds and much else, rendering the money stock - and M1 - ambiguous designations.
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Throughout the period covered in this book, as before, business contractions continued to follow declining real base growth rates.

  Monetary policy was shifted to control of monetary aggregates in the 1980s by Chairman Paul Volcker. He understood that chronic inflation was always a monetary phenomenon. However, there was increasing uncertainty as to just what the monetary aggregates were.

  "The so-called experiment with monetary control is generally regarded as a failure. The experiment was never complete; the FOMC considered but did not adopt institutional changes that would have improved its ability to control money growth. Also, large changes in the public's asset allocation followed after Congress deregulated banking and financial markets. These changes made it difficult to interpret changes in monetary aggregates during the transition to a less regulated system."

  Real - inflation adjusted - monetary base growth rates are the indicator and monetary policy target favored by Meltzer. Throughout the period covered in this book, as before, business contractions continued to follow declining real monetary base growth rates. Inflation followed increases in base growth rates that were sustained. Meltzer emphasizes that the monetary base was actually more accurately correlated with both economic contractions and price inflation than was real interest rates, another of Meltzer's favorite indicators.
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The 1946 Employment Act:

 

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  The Keynesian  conceit concerning government ability to suppress the business cycle supported passage of the Employment Act of 1946. Although not explicitly stated, the legislation was viewed as a commitment "to maintain economic conditions consistent with full employment." (The government might as well have committed itself to prevent the incoming tide.)
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The System had to monetize enough debt to prevent interest rates rising to constraining levels. This transformed the System into an enabler of the growing Keynesian deficits and the price inflation of the 1960s and 1970s.

  Congress had accepted responsibility for maintaining "full employment," soon interpreted as a rate of 4% unemployment. It put considerable pressure on the System and the administration to sustain that level. Chairman Martin's rhetoric supported anti-inflation policies and System independence, but he nevertheless viewed the System as obligated to support Treasury financing and respond to congressional and administration policies.
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  The System had to monetize enough debt to prevent interest rates rising to constraining levels or disrupting Treasury bond  financing operations. This transformed the System into an enabler of the growing Keynesian deficits and the price inflation of the 1960s and 1970s. "Even keel" efforts to maintain interest rate stability usually began one week before and lasted one week after Treasury financing operations other than with bills. The effect generally was a surge in growth of the monetary aggregates that was not thereafter unwound. 
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  Price inflation quickly exposed the weaknesses of other nostrums beloved of those in denial of economic reality, such as interest rate ceilings, price and wage controls and reliance on nominal interest rates as a guide to monetary policy.

  Credit allocation schemes, however, remained a favorite legislative nostrum until the bubbles burst during the Credit Crunch recession. Even today, Congress remains in denial as to the damage its credit allocation schemes cause.

A low inflation rate is a precondition for achieving and sustaining low unemployment levels.

  Low inflation was recognized as of equal importance with low unemployment during the three decades beginning in 1980. As Meltzer points out, a low inflation rate is actually a precondition for achieving and sustaining low unemployment levels. Except in the short run - which can be very short indeed - there is no tradeoff between unemployment and price inflation.

  ""Persistent price changes -- inflations -- occur if sustained money growth rises in excess of sustained output growth. The inflation rate changes, therefore, if money growth rises relative to output growth or if normal output growth changes relative to money growth. The latter change occurred in the mid-1990s in the United States. It produced a fall in the sustained rate of inflation."

  For a less restricted definition of inflation, see, Understanding Inflation. Zero price inflation means that the government, through an expansion of its money supply, is appropriating for itself all the pricing benefits of rising productivity. Monetary growth - monetary inflation - is like a tax. It permits the government to take valuable goods and services from the economy in return for nothing but a depreciating fiat currency. That's the real reason why Keynesians, and their political masters, love it so much.

Keynesians and monetarists:

  The simplistic Keynesian assumptions of the post-WW-II period are summarized by Meltzer. In the late 1960s, the "Phillips Curve" assumption that there was a natural tradeoff between inflation and unemployment was added to account for the persistence of price inflation.
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  The Phillips Curve itself was obviously flawed. It was derived from experience during the period when a dollar-gold exchange standard anchored the purchasing power of the dollar and thus limited price inflation and inflationary expectations. Keynesian policies dependent on this "Phillips Curve" tradeoff were doomed to failure as soon as the dollar-gold exchange standard was abandoned.. (To this day, many Keynesians remain stupidly in denial that their only period of apparent success, during the 1960s, is attributable solely to the "barbaric metal.")
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  Monetarists, led by Milton Friedman, soon launched a counterattack. Money matters, they insisted. They supported a classical view of the relationship between money and asset prices, commodity prices and exchange rates. See three articles beginning with Friedman & Schwartz, "Monetary History of U.S., Part I, "Greenbacks and Gold (1867-1921).".
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  More to the point for current interest, the monetarists showed that there was no "liquidity trap." If short term interest rates hit zero without preventing economic contraction, a central bank could buy longer term securities, foreign exchange or even equities to pump more base money into circulation. This view now guides the monetary response to the Credit Crunch recession.

  It undoubtedly mitigated the severity of the Credit Crunch recession but has neither prevented double digit levels of unemployment nor observably speeded up recovery, and leaves the entire world with destabilizing levels of monetary inflation and indebtedness going into the next business cycle contraction.

  Their policies in ruins by the end of the 1970s, the Keynesians have conceded the validity of most monetarist positions.

  "Four fundamental issues affecting monetary policy remain: the role of monetary rules, the definition of inflation, importance of relative prices in the transmission of monetary policy, and the internal dynamics of a market economy, particularly whether it is self-adjusting."

  The assertion that market economies are not self adjusting is an old left wing stupidity particularly favored by Marx and his followers. See, six articles beginning with Karl Marx, Capital (Das Kapital) (vol 1) (I). Belief in market instability that is chronic rather than cyclical provides important support for those who favor active government intervention in the economy and is thus a point Keynesians will not easily surrender.

  "Keynesians viewed the private sector of the economy as unstable, subject to waves of optimism or pessimism that produced economic booms and recessions. Government had to act as a stabilizer, at first by changing its expenditures and tax rates and later by adjusting interest rates."

  John K. Galbraith still expressed doubts about the self adjusting powers of market economies as late as 1992. However, he thereafter reluctantly abandoned his socialist predilections and shifted his ideological support to the entitlement welfare state. In the introduction to "A Journey Through Economic Time," he disowned three decades of his prior work as an ideological lie. He perforce had to assert the strength and stability of capitalist markets and how easily they could support the modest burdens of broad scale entitlements. His ideological positions were stupid both before and after the big switch.

Monetarists recognize market resiliency and its capacity for appropriate adjustments. They recognize that governments can nudge markets towards equilibrium, but fear that government policy errors will over-correct and thus just cause increased instability.

  Monetarists favor monetary policy constrained by rules such as the gold standard or bimetallism or some other commodity standard. They recognize market resiliency and its capacity for appropriate adjustments. They recognize that governments can nudge markets towards equilibrium, but fear that government policy errors will over-correct and thus just cause increased instability. Keynesians assert that discretionary authority is essential so that monetary policy can support budget deficits and play a lead role in stabilizing the economy.

  "Discretionary actions intended to stabilize were based on judgments of current and possibly longer-term consequences of events and policy actions."

  Ah, but there are devils in the details, as 90 years of System history and a record full of major mistakes amply demonstrates. Friedman and others began emphasizing weaknesses in the statistics that often misled the policymaking efforts of the System's Board of Governors (the " Board") as well as theoretical misunderstandings of ultimate impacts of monetary manipulation. "Until 1944, monetary policy was typically procyclical until late in the inflation or recession." Rational expectations within the markets could develop in ways that would lead to responses that the Keynesians could not account for.

  "A major change in economic theory came with recognition of uncertainty and the role of information. This heightened attention to the role of expectations."

Rational expectations econometric models add important factors to the simplistic Keynesian models - but still fail to reflect reality sufficiently to be reliable guides to policy. No central bank relies on them.

  Rational expectations econometric models are now used by the System staff. These models add important factors to the simplistic Keynesian models - but still fail to reflect reality sufficiently to be reliable guides to policy. No central bank relies on them. See, Hendry & Ericsson, "Understanding Economic Forecasts"  There are costs to acquiring the information required, and interpretation of the pertinent information may be uncertain. There are vast uncertainties in the statistics. The pace of productivity growth, for example, is never precisely known. The very process of aggregation destroys vital information about the structure of the aggregates relied upon by the econometric models. Vital aspects of the economy cannot be modeled. They cannot be expressed as an equation.

  "Federal Reserve policy discussions show that major differences in interpretation and anticipations were common. Members lacked a common framework of analysis, so they often differed about the expected policy consequences of current information."

  Econometric models and Keynesian analyses in general remain absurdly narrow, ignoring all manner of outcome determinative factors. See, Scott, "Concept of Capitalism:" Akerlof & Shiller, "Animal Spirits:" Baumol, Litan, Schramm," Good Capitalism, Bad Capitalism," Weaknesses in government policy are frequently ignored. See, Tavakoli, "Dear Mr. Buffett:" and Cooper, "Origin of Financial Crises."

  Long term expectations forecasts are very unreliable. What will the shape of the yield curve be? How will exchange rates fluctuate? For these and many other reasons, macroeconomic models routinely fail to accurately forecast inflation rates or business cycle swings - which happen to be the type of information needed for monetary efforts to stabilize the economy. Despite the increasing sophistication and professional training of the Board members and their chairmen since 1970, "analytical errors and misjudgments had a large role in mistaken policy choices."
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  The advent of the Credit Crunch caught the System embarrassingly by surprise. In 2007 they were forecasting inflation, increasing output and decreasing unemployment levels but in 2008 they had to shift to recession forecasts instead. (How can you mitigate the business cycle when you obviously don't understand it?) Meltzer points out that congressmen or presidents may lose office due to economic contractions or high inflation, but neither the Great Depression nor the Great Inflation caused any resignations in the System.
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  Meltzer summarizes other disputes within the economics profession.

  • Keynesians absurdly believed in the effectiveness of wage and price controls and guidelines. Controls are either wastefully ineffective or if effective they are necessarily inflationary. Meltzer points out that controls proved to be inflationary during both the Nixon and Carter administrations. Even the Labor government in England now recognizes this.
  • Meltzer notes that deflation that is faster than the decline in money growth has not had significant negative real effects.

  Modest rates of deflation increase the purchasing power of the money stock, but a highly indebted economy is subject to collapse and thus cannot take advantage of this powerful instrument of recovery from business cycle contractions.

  • Abandoning the Phillips Curve, economists now recognize that relatively low and stable rates of price inflation contribute to economic expansion and high levels of employment - but they still quibble over degree.
  • The workings of the vast, complex financial system, once generally taken for granted, is now coming under more appropriate study. (See, "Capital as Purchasing Power.")

  "Except for control of money, monetarist arguments prevailed eventually. The Phillips curve tradeoff vanished in the long run, as Friedman - - - predicted. Policy distinguished real and nominal interest rates and exchange rates. Long-run neutrality of money again became standard in economic theory. Strangely, models incorporating these ideas are called neo-Keynesian."

  Monetary manipulation is now the primary weapon for economic stabilization. Fiscal policy - budget deficits - are now recognized as relatively ineffective in combating recessions. (Of course, the politicians do love to spend the money and posture as the saviors of jobs.) However, monetary policy has proven far more difficult in practice than in the simplistic rationalizations of academic and intellectual theorists. Monetary policy has frequently proved to be procyclical instead of countercyclical during the initial stages of business cycle swings. Thus, the disputes over the best monetary policy techniques rage on.

  Both unemployment and price inflation levels are unfortunately lagging indicators. The processes that lead to price inflation can grow to prodigious strength before they are fully reflected in price inflation, and employment levels take many months to recover even after economic recovery has begun. Yet, the monetary authority is under tremendous political pressure to maintain high levels of monetary inflation as long as unemployment levels remain high.

  Misinterpretation of short term interest rate fluctuations was one of the primary reasons for the procyclical impacts of  monetary policy.

  "Interest rates typically rise during periods of economic expansion and decline in recessions. For most of the period [1951-1986], the Federal Reserve interpreted the rise or fall in interest rates, particularly short-term rates, as an indicator of its policy. When market rates declined, it interpreted the decline as an easier policy; when rates rose, it interpreted the rise as more restrictive. Usually, it slowed growth of the monetary base and money when rates fell and permitted faster growth when rates rose. Consequently, measures of money growth usually moved procyclically instead of countercyclically."

  The System monetized increasing amounts of the federal budget debt. From about 9% in the 1950s, this rose sharply after 1964 to almost 17%  of massively increasing deficits in 1973-1974 and then declined back to about 9% of the even more massively increased federal deficits in 1986.
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  However, the dollar was the world's primary reserve currency and so to a great - but not unlimited - degree, the System could print gold. During the 1970s, foreign central banks took vast amounts of federal dollar denominated debt both as their foreign exchange reserve and pursuant to their mercantilist efforts to prevent the appreciation of their currencies against the dollar.

  Monetary inflation is thus a tax not only on the American people but on all governments that hold dollar denominated securities as reserves. China, Russia, Saudi Arabia, and many other creditors of the U.S. are paying this tax that helps finance U.S. domestic and international expenditures. Ultimately, of course, creditor nations become relatively stronger while debtor nations become relatively weaker, although the status of the dollar attenuates that process for the U.S.

O) The Eisenhower Administration

Personnel and procedures:

 

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  William McChesney Martin, Jr., became chairman of the Board of Governors in April, 1951, and served until January, 1970. His father had been a chairman and Reserve Bank governor between 1914 and 1941. Two of the most influential staff members when Martin took office, Winfield Riefler and Woodlief Thomas, had served in the System in the 1920s and 1930s.
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  Martin paid no heed to economic theory, and began as during his father's time employing member bank borrowed reserves under the Riefler rule as a primary guide to policy. $500 million was still considered the neutral level, although there had been about a 50% price inflation due to WW-II. The 1923 Tenth Annual Report remained the primary guide to policy. See, Meltzer, History of Federal Reserve, vol. I, (1913-1951) Part II, "The Engine of Deflation (1923-1933)" at segment on "Gold sterilization."

  "Minutes of meetings show that the System's principal concern was with current money market conditions, mainly control of the volume of member bank borrowing, By controlling borrowing, it expected to influence the banks' supply of credit and thus the pace of economic activity. If this were done properly, officials and staff expected the price level to fluctuate around some stable value, but they did not have a framework linking their actions to these objectives, and they made no effort to develop one."

  Unfortunately, the statistics on member bank reserves had many ambiguities, such as seasonal adjustments, projections of Treasury deposits, and distinctions between temporary and persistent changes. The Board's calculations frequently differed from those of the N.Y. Fed. Unfortunately, at any level of free reserves or borrowing, "policy could be lax or restrictive depending on what happened to the growth of money or credit."

  "Although the minutes contain references to money growth, it remained in the background at FOMC meetings. Many members believed that, in the long run, excessive money growth caused inflation, but long-term considerations of this kind received less attention than short-term events reflecting both long-standing practices and Chairman Martin's lack of interest in statistics and in  forecasts or projections of more distant concerns. - - - Frequent meetings and the Riefler rule concentrated attention on current events."

  Martin made major changes in System operations, further diminishing the role of the N.Y. Fed and concentrating policy making in the FOMC in Washington, where monetary policy was increasingly subjected to political pressure. He increased FOMC influence over the manager of the System Open Market Account. The manager was chosen by the N.Y. Fed and executed monetary policy at the N.Y. Fed  money market trading desk in accordance with FOMC directives but under N.Y. Fed supervision..

  "By 1955, the FOMC had adopted a policy of purchasing only Treasury bills -- except in crises --, eliminated the Executive Committee, greatly increased the frequency of its meetings, expanded the scope of its deliberations to include not just open market operations but all the tools of monetary policy, and encouraged all FOMC members to contribute to the policy discussion."

  The five member Executive Committee that had executed monetary policy between the previously infrequent FOMC meetings had been presided over and dominated by the president of the N.Y. Fed due to his greater expertise and knowledge of money market conditions. By requiring all members of the FOMC to state their opinions and recommendations before hearing from the N.Y. Fed president, Martin forced them to develop pertinent expertise with which to counter N.Y. Fed influence.
 &
  Allan Sproul served as president of the N.Y. Fed through WW-II and continued in that office until June 1956. He was replaced by Alfred Hayes, who served until August 1975. Robert Rouse was the manager until 1962 and was replaced by Robert W. Stone. Both were vice presidents of the N.Y. Fed. There was actually no place else to find people with the requisite expertise, and all subsequent managers have come from the N.Y. Fed..
 &

  The discretionary authority of the N.Y. Fed trading desk was temporarily limited when open market purchases were restricted to Treasury bills. However, the FOMC provided the manager of the System Open Market Account only general, remarkably imprecise guidance. Typical FOMC directives might call for "monetary ease" or "monetary restraint" to achieve "sustainable growth - - - without inflation." The manager thus retained considerable discretion, and often was able to switch monetary policy emphasis before the FOMC could get around to revising the language in its directives. Both Martin and Sproul undoubtedly had considerable influence on the manager. They resisted suggestions for more explicit directives that might limit the manager's discretion.
 &
  The primary target was based on "free reserves,"
defined as member bank reserves in excess of both required reserves and member bank borrowing from the System. Unfortunately, there was disagreement about even the appropriate range for this target. When free reserves grew, this was interpreted as indicating monetary policy ease. When they declined, that was viewed as restraint. However, increased borrowing tended to increase the monetary base. Policy thus frequently remained procyclical during the early stages of business cycle swings.

    "When output expanded and customer borrowing increased, banks borrowed from the Federal Reserve, and open market rates rose relative to the Federal Reserve's discount rate. The Federal Reserve interpreted higher nominal interest rates, increased borrowing, and reduced free reserves as evidence of restrictive policy. Often it allowed growth of the monetary base and money to increase, adding first to spending and later to inflation. When spending declined, the process worked in reverse."

By the 1960s, reducing unemployment had become the System's primary concern.

  Stabilization policy became increasingly important not only because of Keynesian assertions about the capabilities of fiscal and monetary policy but also because of public fear of a return of the Great Depression and public expectations about government responsibility for prosperity and employment levels. Chairman Martin was quickly included in regular conferences with administration economic policy officials where he was increasingly subjected to political influence.
 &
  Political pressures regularly intensified during election years. Vice President Richard Nixon would blame his narrow defeat in his 1960 presidential election campaign on the failure of Martin to assure robust economic conditions for the election year. After 1960, Presidents Kennedy, Johnson and Nixon increasingly subjected the System to political influence.
 &
  While no Keynesian, Martin was an activist. He responded to output levels, unemployment, inflation, and later to housing sales, among other things. Of course, he always supported Treasury financing and refinancing operations. The Board tried to smooth seasonal and longer term changes in money market conditions, and even tried to manage the business cycle. Unemployment and interest rates were primary political concerns that the Board had to respond to. By the 1960s, reducing unemployment had become the System's primary concern.
 &

  Complicating matters were the System's inadequate monetary policy tools.

  "Federal Reserve staff in New York and Washington continued to use free reserves -- excess reserves minus borrowing -- or member bank borrowing as their principal operating target, and the FOMC often used a level of free reserves as a quantitative guide for the manager of the System Open Market Account. This is not surprising since principal members of the senior staff--especially Winfield Riefler and Woodlief Thomas--had been active in the 1920s, when the Federal Reserve developed these procedures. The surprising change was that the System, using unchanged procedures, could now claim to affect output or the price level, contrary to their claims in the 1920s."

  Thus, there was price inflation in the 1950s - for the first time in U.S. peacetime history. While only a few percent on average, efforts to control it led to mild recessions in 1953-1954, 1956-1957, and 1960-1961 during a hotly contested presidential election.
 &
  Inflation led naturally to higher long term interest rates, which usually rose above short term rates in an upward slopping "positive" yield curve. Higher interest rates of course are a constraint on the economy when they rise above price inflation levels. They also increase the costs to member banks of maintaining reserves at the System. Member bank reserve requirements were thus reduced not to stimulate the economy but to decrease the costs of membership. Only 50% of commercial banks were members, but they held 97% of deposits.
 &

  Regulatory efforts to control credit for consumer durables - Regulation W - and real estate - Regulation X - as well as price and wage controls were tried during the Korean War and quickly proved unenforceable. The Korean War ended in June, 1953. Eisenhower ended the control efforts and the experience made the System an opponent of all further efforts of this kind. The regulators were simply no match for the ingenuity of private entities and their lawyers in working around the regulations.
 &
  The effort to control credit conditions through Regulation Q ceilings on interest payments for time and savings deposits was more persistent - and more destructive. "The policy failed eventually, like most efforts of its kind."
 &
  However, inflation was kept at low levels during the 1950s, due less to Martin and the Board than to Eisenhower's conservative fiscal policies. The System was simply not under pressure to monetize significant proportions of Treasury issues. The monetization of Treasury securities increased bank reserves and increased the monetary aggregates. Since these increases were not subsequently removed, some price inflation was unavoidable.
 &
  Economic revival from the WW-II destruction in Europe and Japan progressed throughout the 1950s. European currencies became convertible in dollars which were convertible into gold under the Bretton Woods dollar-gold exchange standard. As Europe and Japan became serious economic competitors, the U.S. began to suffer substantial deficits in its international payments. The dollar - and Bretton Woods prosperity - were supported by the nation's huge reserves of gold - until the gold reserves were almost gone.
 &

Monetary policy innovation:

 

&

  The 1950s were generally prosperous, with real GNP rising at a 2.6% compound annual rate. However, the trends were downhill. Although varying with the business cycle, unemployment levels and budget deficits were getting worse and the dollar was weakening as the decade progressed.
 &

Discounts were increasingly collateralized with Treasury bills, and open market purchases of Treasury bills were increasingly  used to inject cash reserves into the banking system and support Treasury financing operations. The "real bills" doctrine of the 1920s faded away and - as feared by the founders of the System - the System did indeed become an engine of inflation.

  Price inflation, too, was worsening until the 1957-1958 recession. Price inflation averaged 2.5%, but hit 5% in 1957. Thus, interest rates, too, were rising, A Treasury note yielded 5% by the end of the decade - the highest yield since formation of the System. The markets were beginning to expect price inflation to be a persistent presence.
 &
  The monetary base grew within a modest 1% to 2% range from 1953 to the end of the decade. However, this was a result of System efforts to regulate short term interest rates, rather than a direct effort to control the base money supply.
 &
  The permanence of the government debt became acknowledged in the 1950s and System policy shifted accordingly. Banks were holding their reserves in Treasury bills instead of commercial paper. Thus, discounts were increasingly collateralized with Treasury bills. Open market purchases of Treasury bills were increasingly  used to inject cash reserves into the banking system and support Treasury financing operations. The "real bills" doctrine of the 1920s faded away and - as feared by the founders of the System - the System did indeed become an engine of inflation.
 &

The bills only policy was formally revoked in 1961, as personnel changes increased Keynesian influence within the System.

 

In practice, few long term securities were purchased until the Credit Crunch recession in 2008 when more than half the System's portfolio quickly came to consist of longer term issues.

  The FOMC got out of the business of intervening in long term bond markets for awhile on March 4, 1953, when it restricted its open market operations - except during moments of disorderly markets - to short term Treasury bills. For longer term issues, the markets were free to set prices. System intervention had in fact proven to be a disruptive influence in the price discovery functioning of the markets.
 &
  However, this policy was intensely controversial politically and within the FOMC. Meltzer sets forth the controversy at some length. He points out that the controversy completely missed the fact that any intervention, even in short term bills, expanded the money supply and thus generated price inflation pressures. The "bills only" policy had few outside supporters and a growing number of academic opponents as a result of the spread of Keynesian influences. Sproul, too, was a critic. He chafed at the restriction of the discretion of the manager of the System account at the N.Y. Fed trading desk.
 &
  The FOMC staff contended that substitution arbitrage and expectations spread the impact of interventions in the bill market throughout the yield curve and maturity spectrum. Moreover, the System would be impacting bank reserves similarly wherever it intervened, and that was the primary impact of monetary policy. Congress and academic critics rejected this argument. They chafed at rising long term interest rates and wanted the System to bring them down.
 &
  The bills only policy was formally revoked in 1961, as personnel changes increased Keynesian influence within the System. The Keynesians dominated Kennedy/Johnson administration economic policy. Meltzer points out, however, that even under the bills only policy, the Treasury itself was free to impact the yield curve simply by altering the mix of securities that it issued.
 &
  In practice, few long term securities were purchased until the Credit Crunch recession in 2008 when more than half the System's portfolio quickly came to consist of longer term issues. However, the System did buy the securities of agencies designed to allocate credit into the housing market. Expectations theory asserts that the impacts on prices and yields of interventions in the long term markets can be little more than transitory.
 &

 By 1956, the federal funds interest rate had displaced the Treasury bill rate as the primary short term interest rate indicator and System interest rate policy target.

  The federal funds market was a new and very useful development. The  vast increase in government short term debt provided a new mechanism for banks to manage their reserves and for System open market operations.
 &
  Banks and corporations could buy and sell claims to balances at the reserve banks. Purchasers gained overnight use of funds in return for interest at the federal funds rate. The call money market withered and died, and the call money rate was displaced by the federal funds rate as a financial indicator of supply and demand for reserve balances. By 1956, the federal funds interest rate had displaced the Treasury bill rate as the primary short term interest rate indicator and System interest rate policy target.
 &

Monetary policy operations:

 

&

  Market interest rates rose substantially above the discount rate in the 1952-1953 period. It became a no-brainer for member banks to borrow from the System not just to meet short term liquidity needs but for an easy profit. Discount borrowing surged above $1 billion in 1952, but the System persisted in interpreting this as a tight money condition - as evidence of financial system distress - despite a surge in base money growth.
 &

  The System stumbled into the 1953-1954 recession still misinterpreting the impacts of member bank borrowing levels and free reserve levels, and still failing to distinguish between real and nominal interest rates. Meltzer points out that real - inflation adjusted - base money growth rates  - ignored by the System - provided the best indicator of events. They declined four months before the recession and rose a couple of months before it ended.
 &
  The 1953-1954 recession was no surprise. Excessive auto inventories and rising market interest rates and the end of the Korean War in June of 1953 were recognized as possible precursors of a recession. Fears of a return of the Great Depression were widely held, and the new Republican administration didn't want to expose itself to blame for another economic contraction, so all arms of government were primed to act against the recession.
 &
  The FOMC actually voted to "aggressively" ease monetary conditions a month before the start of the recession. Nevertheless, it took several months for policy implementation to reach desired levels. As often happened, the free reserves data and the decline in member bank borrowing misled the account manager into believing that bank reserves were adequate even though interest rates rising into the first months of the recession indicated that money was still tight.
 &
  Over $300 million in open market purchases in May 1953, a month before the recession began, proved inadequate. Required reserves were reduced at the beginning of the recession, but this too proved inadequate. In fact, the decline in member bank borrowing was due to the decline in short term market rates below the discount rate. This transformed the discount rate into a penalty rate, which naturally led to a massive reduction in member discounts. The Board did not get around to reducing the discount rate until the last months of the recession. Meltzer points to a substantial reduction in the growth rate of the real monetary base as indicating that monetary policy had not in fact eased during the first months of the recession.
 &
  By the end of 1953, declining interest rates and ballooning free reserves indicated money had indeed eased substantially, but the recession lasted until May 1954 and was fairly deep.
 &
  Expansive monetary, budgetary and tax policy efforts all accelerated towards the end of the recession and were kept in place well beyond the end of the recession. The FOMC maintained its stimulatory monetary policy for more than 6 months after the end of the recession. By the end of 1954, there were fears of a speculative boom. Martin noted "an exuberance of spirit among intelligent businessmen with respect to 1955 business prospects." Yet once again, System monetary policy was proving procyclical for extended periods of time.

  "As before, the principal reason was that the Federal Reserve interpreted the decline in member bank borrowing and rise in free reserves as evidence of ease."

  Recovery was vigorous well into 1955. Modest levels of deflation did not seem to hinder economic growth. (They never do!) The System's indicators remained steady in 1956. Member borrowing remained between $700 million and $800 million. Monetary base growth remained around 1%. Federal funds rates rose but stayed below 3% throughout the final quarter. Nominal GNP nevertheless rose 5.5%, so the monetary aggregates had to support an increasing level of economic activity.
 &
  Martin and the other members of the FOMC were very aware that 1956 was a presidential election year. They repeatedly expressed fear of the political repercussions if they raised interest rates to combat price inflation. Nevertheless, under pressure from the Reserve Banks that were increasingly experiencing rising market interest rates, the discount rate was increased in April and again in August, 1956.
 &
  It took awhile, as usual, for monetary inflation to be reflected in price inflation, but by the spring of 1957, CPI inflation was up to 3.5%. The GNP deflator was almost as high.
 &
  Monetary "velocity" - the ratio of GNP to the money stock - surged at a 5% rate during this expansion. What this really means is that the purchasing power provided by the complex financial system was expanding as optimism increased. Meltzer points out how banks maneuvered to get customers to increase their time deposits, which had lower reserve requirements. (This happened in both 1928 and 1929, also.) The recovery was robust and the stock market was booming. Unemployment fell below 4% in the summer of 1955.
 &

Martin was prophetically pessimistic about the political will to restore lost purchasing power once lost to inflation.

 

Discount rate changes were becoming increasingly frequent - and contentious - as stabilization efforts perversely created increasing instability.

  The U.S. had never suffered price inflation in peacetime before this time, and Martin was especially concerned about it. He was prophetically pessimistic about the political will to restore purchasing power once it was lost to inflation. Meltzer provides considerable detail about the uncertainty and conflicting opinions of the Board and FOMC members as they wrestled meeting after meeting seeking a discount rate and open market policy that might be adequate to control inflation yet avoid the ire of congressional critics. Many factors were considered, but still not the ebb and flow of the monetary aggregates.
 &
  The System responded between 1955 and 1957 by raising the discount rate in steps seven times to 3.5%. However, it was yet again behind the power curve as market rates rose to 4%. The discount rate was thus again procyclical - below penalty rate levels. Although rising, it had become stimulatory. Free reserve levels - the System's primary indicator and target - yet again failed to reflect the shift from deflation to inflation. The System attempted to tighten, but because it neglected the difference between real and nominal interest rates, it failed to tighten enough. The cause of rising CPI inflation puzzled economists and policymakers alike.
 &
  Discount rate changes were becoming increasingly frequent - and contentious - as stabilization efforts perversely created increasing instability. Monetary policy was again proving far more difficult than in the contemplation of the academics and other theorists who scorned the gold standard but had themselves neither to execute monetary policy nor deal with the consequences.
 &

Like so many others, including recent efforts to allocate financial assets into the housing market, the Regulation Q government effort to allocate financial assets ended badly. It "began the process that culminated in the massive losses by savings and loan insurance systems in the 1980s."

  Regulation Q controls became a casualty of the rising inflation and interest rates. Regulation Q established the maximum interest rate that could be paid for time and savings deposits. The rate had been set at 2.5% since 1936, but now short term interest rates were around 3%. Banks adopted numerous circumventions involving "free" services to retain depositors.
 &
  The Board fudged - allowing monthly compounding of interest for time deposits instead of quarterly compounding, and maintaining a loose attitude towards the circumventions. Capital seeking to escape the restrictions simply fled abroad, becoming a major factor in the generation of the unregulated eurodollar market. Meltzer summarizes the myriad complications that afflict regulated rates when conditions force change. Like so many others, including recent efforts to allocate financial assets into the housing market, the Regulation Q government effort to allocate financial assets ended badly. It "began the process that culminated in the massive losses by savings and loan insurance systems in the 1980s."

  To repeat yet once again, administered alternatives to market mechanisms are always easier in contemplation than in execution, and ultimately become impossible in execution.

  There were heated debates within the Board and its staff. Deposits were draining away from regulated banks. By December, 1956, the Board surrendered and increased Regulation Q to 3%. There was also a 4.25% ceiling on Liberty Bonds and subsequent bonds with five or more years to maturity that also bumped up against rising market rates. This forced the Treasury to finance with shorter term securities. During the 1950s, the average maturity of the growing federal debt dropped about 2 years to a new level of 4 years and 4 months. Refinancing became considerably more expensive. The bond interest rate ceiling was finally lifted in 1960.
 &
  Interest rate ceilings are fine - until they actually have to hold down interest rates. Rather than controlling volatility, Regulation Q ceilings and federal bond ceilings became impossible under the volatile conditions of even the beginnings of an inflationary era. Differing political interests paralyzed pertinent decision making just when powerful financial forces required flexible responses.
 &

The recession of 1957-1958:

 

 

 

 

&

  Generally prosperous conditions continued through the first three quarters of 1957, with no remarkable shifts in the prominent indicators - except for price inflation. Both the CPI and deflator indexes rose to a 3.75% average rate.

  "The government budget remained in surplus, and money growth remained below the growth of real GNP. Monetary velocity continued to rise with interest rates, inflation, and new ways of economizing on cash holdings, including the spread of deposit banking. The public reduced its very large wartime accumulation of cash balances relative to income."

  The Board raised the discount rate and sold government securities to drain some money from member banks. This forced them to increase their borrowing at the higher discount rate. The manager of the trading desk was being wrong-footed by temporary surges and retreats of financial and economic indicators.
 &
  The prime indicator remained free reserves, not because the FOMC was satisfied with it, but because there was no agreement on any alternative. The Board was still intent on deflecting persistent political pressure for lower interest rates and was loath to admit responsibility for the inevitable periods of rising interest rates. The waxing and waning of the money aggregates were determinedly ignored - undoubtedly for similar reasons. So reserves remained the indirect - and unsatisfactory - primary lever of policy.
 &

By its administered efforts to stabilize the economy, the System was encouraging the increase in leverage that must inevitably increase instability.

  The advent and permanence of "creeping inflation" was by this time recognized by the Board. The markets now expected permanent and even increasing inflation levels, reflected in permanently higher long term interest rates. Monetary inflation had "validated" WW-II and Korean War price increases, and the System had responded to the 1953-1954 recession with a surge of monetary inflation that was not thereafter unwound.
 &
  The credit of the U.S. government had been undermined, and it would henceforth have to pay higher rates of interest on its bonds. The FOMC recognized that, as inflation expectations firmed, the job of resisting or reversing inflation became increasingly difficult.
 &
  The private sector was saving less and borrowing more, relying less on equity capital and more on borrowed capital. By its administered efforts to stabilize the economy, the System was encouraging the increase in leverage that must inevitably increase instability. (Noxious incentives in the tax statute were even more destabilizing.) As interest rates rose, the Treasury feared failure of its financing operations. Yet political pressure for even "easier" monetary conditions was relentless. The FOMC directives thus included instructions to assist Treasury financings.
 &
  "On one side was a continued rise in velocity and a flight from the dollar, on the other a run on the Treasury." A rise in market interest rates from this point would undermine Treasury financing operations and cause massive liquidation of savings bonds. Yet once again, the System was paralyzed by its conflicting objectives and fears of congressional action that might remove what little independence that it had. Base money growth remained low - around 1% - so real base money was shrinking at a rate in excess of -2%.
 &
  However, the financial system was still building on the vast expansion of the money aggregates during WW-II and the Korean War. This was reflected in the calculation of "velocity," that increased 7%  in 1956 and was still increasing through the first half of 1957. Inflation expectations were reflected in inventory accumulation and wage increases running at 1% per month.
 &

  The discount rate was increased to 3 .5% in August, 1957, after a Treasury financing was completed. This was the peak of the economic expansion. The whole exercise had an eerie similarity to the August 1929 discount rate hike.

  "[The] System was slow to act against rising inflation. The variable growth of output explains part of the delay. Neglect of the difference between real and nominal rates, concern for Treasury refinancing problems, and reluctance to raise rates to levels not experienced in twenty-five years played a role also. The problem of agreeing on effective action returned many times in the next twenty years."

  Meltzer concludes that monetary policy was again procyclical

  "Once again, the shrinking value of the real base more than offset the stimulus from falling real interest rates early in the year. Later, the rising real rate modestly reinforced the effect of negative real base growth, slowing the economy and contributing to recession."

There were prescient fears that if the recession ended too soon, it would not bring down inflation rates, the higher prices would become entrenched and the next price surge would ratchet up from that point.

  The 1957-1958 recession was short - calculated at 8 months - but fairly sharp. Unemployment hit 7.5%, considerably higher than in the 1953-1954 recession. A substantial budget deficit was employed by the Eisenhower administration to combat the recession, but the vast majority of it was spent after recovery had already begun. The administration thus credited the natural resiliency of the nation's free economy for the recovery, a belief that the increasingly influential Keynesians denigrated.
 &
  The recession was not long enough to substantially reduce price inflation. CPI inflation remained over 3% although the GNP deflator did decline somewhat more. It took three months for the FOMC to become convinced that a recession requiring an easier money response had begun. Discount rate reductions didn't begin until November 1957. There was a reduction in bank reserve requirements. The federal funds rate began to decline and monetary base growth increased.
 &
  By December, 1957, the FOMC was expressly battling recession. However, there were prescient fears that if the recession ended too soon, it would not bring down inflation rates, the higher prices would become entrenched and the next price surge would ratchet up from that point. There was continued dissatisfaction with the imprecision of the free reserves target. Expressions of dissatisfaction were coming from Congress. There was a congressional election in 1958.
 &
  The federal funds rate dropped to 1%, but long term Treasury rates declined very little, probably reflecting expectations of a rapid recovery and renewal of inflationary pressures. The federal funds rate hit 0.2% by the end of May 1958. Despite discount rate reductions to 2.25%, banks could borrow cheaper in the federal funds market. Thus, discounting declined and the free reserves figure consequently rose to $500 million. The markets recognized the end of the recession and pushed up long term rates, but both the System and Congress continued stimulatory policies for months thereafter.

  "As often before, the rise in real rates contributed to the Federal Reserve's misinterpretation of its actions. It interpreted the decline in nominal rates as an indication that policy had eased. This ignored both the effect on rates of the change in anticipated inflation and the change in economic activity."

  The recovery was robust but short. Both the Board and the Eisenhower administration shifted swiftly to containing inflation.
 &
  Base money growth subsided to negative real rates. By August 1958, the discount rate was going back up. As usual, the discount rate increases were behind market rate increases, so the discount rate was procyclical and stimulatory despite the increases. The discount rate was increased in steps to 4% in September, 1959. Nominal interest rates at these levels had the effect of increasing the cost of System membership, increasing concern that members would leave the System.
 &
  By the end of 1959, both free reserves and the federal funds rate were back to their August 1957 peak levels. The budget returned to substantial surplus in 1960, but the expected deficit in 1959 was an alarming $12 billion. The CPI inflation rate declined below 2%. However, the recovery simply didn't last long enough to get unemployment below 5% from its 7.5% peak, or to get Richard Nixon elected in 1960.
 &

The Federal Reserve could maintain low inflation -- or price stability -- despite large government spending and deficits, despite frequent periods of even keel [support for Treasury financings], and despite its contrary belief. It had to be willing to allow market interest rates to increase in the face of criticisms, even mounting criticisms, in the Congress and elsewhere.

 

The free reserves target and indicator did not reflect the monetary aggregates factors.

  Recovery remained strong through October 1959, despite a steel strike. Price inflation and growth of the monetary aggregates remained very low despite Board and widespread financial system fears. Market interest rates were rising in response to surging credit demand. This was reflected in the rising monetary velocity calculation. Bank loans increased at a 10.3% annual rate during the two year expansion.

  "A lesson from the 1958-1960 experience was that the Federal Reserve could maintain low inflation -- or price stability -- despite large government spending and deficits, despite frequent periods of even keel [support for Treasury financings], and despite its contrary belief. It had to be willing to allow market interest rates to increase in the face of criticisms, even mounting criticisms, in the Congress and elsewhere. This was always a difficult choice, made more difficult  by the firm belief that the System had an obligation to support Treasury issues. It would take many years of inflation before the System drew the conclusion that to control inflation required independence."

  It also required political cover from Eisenhower in the 1950s and Reagan in the 1980s. No other administrations would expend the political capital to provide such cover.

  Worries about the monetary aggregates surfaced within the FOMC in January 1960. The slow to negligible growth of base money and M1 for several years was noted with alarm by two of the Regional Bank presidents. The slow growth of the money aggregates had been overcome by increasing factors of velocity, but that could not continue. The banking system was getting dangerously overextended.
 &
  Meltzer speculates that Milton Friedman's views were already circulating and becoming influential at that time. The free reserves target and indicator did not reflect the monetary aggregates factors.
 &

   The peak of the expansion and the start of the next contraction came inconveniently for Richard Nixon in April 1960. The decline in the growth of the monetary base to an annual rate of just % provided an accurate monetarist indicator. Rising free reserves provided the FOMC with an inaccurate indicator. Closer examination indicates that the rise in free reserves resulted from a decline in member bank borrowing which was a typical result when the federal funds rate declined to or below the level of the discount rate. It had nothing to do with monetary policy ease. FOMC staff forecasts of continued economic expansion thus proved false.
 &
  Weakness in the economy became apparent in February, 1960. By the beginning of March, the FOMC directive eliminated references to inflation and called for "fostering sustainable growth" and an increase in free reserves.
 &
  Several FOMC members thought this standard response inadequate. Some wanted to directly target the money supply with quantitative targets. Some wanted to directly target interest rates. There was no agreement, so the FOMC stayed with its standard policy tools. There was still fear of congressional interference if the System started to directly control interest rates.
 &
  Meltzer points out that the FOMC had indeed been alert to critical economic turning points. The policy changes in its directives to the manager were never more than four months behind the economic turns as calculated by the Commerce Department's National Bureau of Economic Research and were usually more accurate than that. Moreover, the account manager generally changed policy emphasis even before the FOMC issued a changed directive, thus justifying the discretion that he retained.
 &

Administered stabilization efforts were clearly increasing instability. Three recessions in eight years and 19 changes in the discount rate left the System exposed to criticism.

  Nevertheless, the System - and the money markets - were being whipsawed by the increasingly frantic FOMC efforts to stabilize the markets. These interest rate and business cycle fluctuations were unprecedented in their rapidity. Administered stabilization efforts were clearly increasing instability. Three recessions in eight years and 19 changes in the discount rate left the System exposed to criticism as the Keynesians gained predominant influence under the Kennedy/Johnson administration.
 &
  However, the decisive action at the end of the Eisenhower administration reversed inflation expectations, which consequently remained low for several years into the Kennedy/Johnson administration. The last Eisenhower budget was one of his three surplus budgets and also helped suppress inflationary expectations for the Democrats.

P) Conclusion

A deeply flawed administered alternative:

 

 

&

  Martin had succeeded in centralizing control of monetary policy in the FOMC by the end of the 1950s. Sproul was no longer president of the N.Y. Fed. The twelve Reserve Banks still sent requests for discount rate changes to the Board of Governors, but it was the FOMC - with its majority of all seven Board governors and minority of five Reserve Bank representatives - usually the presidents - that made the main decision to be sent to the Board for ratification. The seven Board governors were appointed by the president with Senate approval. Open market operations were the main policy instrument.
 &

  Martin's practice was to gain consensus for decisions. He had little trouble during the 1950s, but faced increasing difficulty with the Keynesian appointees of the Kennedy/Johnson administration. He took his anti-inflation role seriously and viewed himself and the System as the only entities in government concerned with maintaining the purchasing power of the dollar. However, he understood that the fight against inflation had to be secondary to cooperation with administration and congressional policies expressed in the budget.

  The Keynesians were unconcerned with inflation. With colossal intellectual hubris and intentional ignorance of 2500 years of economic and monetary history, they considered inflation just a minor irritant that they would be able to easily deal with later. Later, when it was time to deal with it in the 1970s, they acknowledged that they could not and just as ridiculously asserted that nobody could. Chronic inflation is, after all, a result of political factors, not economic factors.

  The board recognized that its various monetary tools were often in conflict with one another. It continued with attempts to discourage extended borrowing from the System and recognized the need for high discount rates to control borrowing.

  "The Board, at last, recognized that when one bank repaid its borrowing, another might be forced to borrow, so that aggregate reserves did not decline. And it recognized that increased borrowing offset open market sales and that the 'attitude of member banks toward operating with borrowed resources varies from bank to bank.'"

  There were several weaknesses that still afflicted System monetary analyses, as pointed out above. The FOMC and the N.Y. Fed recognized the lack of precision of the free reserves target policy. The System used free reserves as a policy target so it could deflect political criticism by blaming the markets for rising interest rates. Even Paul Volcker during his harsh austerity campaign against price inflation in 1979-1982 sought to "avoid some criticism by attributing the rise in interest rates to market forces" rather than System policy.
 &

At least "Martin avoided the bad advice that the economic models of the period urged on the FOMC."

  Staff analyses during the 1950s finally recognized that price levels fluctuated for many reasons but that chronic price inflation was possible only with excessive growth in the money supply. Precise calculation of appropriate rates of money growth were not attempted or thought desirable, but it was concluded that long term money growth should equal long term economic growth rates and should wax and wane against rather than with the business cycle to counter procyclical fluctuations in credit.
 &
 
Control of the monetary aggregates was thus recognized as vital to control price inflation. However, precise controls were considered impossible because of the volatility within the financial system - set forth as changes in monetary "velocity." Even under the comparatively calm financial conditions of the 1950s, base money growth figures vacillated erratically. The prevailing trend does not appear until revealed by a three year moving average. The annual moving average was highly volatile.
 &
  However, control of the monetary aggregates was an indirect objective - achieved as a result of free reserves and market oriented policies. There is no evidence of direct efforts to target the monetary aggregates in the 1950s. Indeed, there is "no evidence that the Federal Reserve developed or systematically applied any explicit theory or framework in the 1950s." There was "both a lack of agreement about how monetary policy worked and disinterest in developing a more complete understanding."
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  At least, Meltzer points out, "Martin avoided the bad advice that the economic models of the period urged on the FOMC." In the 1960s, the Keynesians dominated within the System staff and would (with incredible stupidity) ignore or dismiss money growth rates as unimportant.
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"Operations were more a matter of guess or judgment and trial and error." Policy responses to changing conditions were frequently delayed as the FOMC awaited clarifying developments. The statistics were uncertain and frequently took weeks and months to reflect what was happening.

  The wide variety of theories advocated - most of them clearly wrong - led Chairman Martin and many other FOMC members to distrust theory in favor of short term responses to actual market conditions - which themselves could be devilishly hard to interpret. "Operations were more a matter of guess or judgment and trial and error." Policy responses to changing conditions were frequently delayed as the FOMC awaited clarifying developments. The statistics were uncertain and frequently took weeks and months to reflect what was happening.
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  Despite defects, the 1950s approach ultimately proved far superior to the Keynesian approach of the next two decades. An important factor in this success and the subsequent failure in the 1960s was the budgetary restraint of the Eisenhower administration and the budgetary deficits of the Kennedy/Johnson administration. Inflation control was simply easier in the 1950s and became politically impossible in the 1960s. Short term interest rates never rose above 4% in the 1950s. Inflationary expectations came to permeate periods of Keynesian monetary policy.
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  At least the System knew in the 1950s that low inflation was essential for economic growth and low unemployment rates (something the haughty Keynesians were too stupid to understand - and many still stupidly deny). Importantly, Eisenhower shared the System's view. The overriding concern of the chairman was the budget deficit, and the pressure on the System to help finance it. Ike had three surplus years out of eight - a record during the Cold War. As a percentage of GDP, gross debt declined from 87% to 44% between 1946 and 1959.
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 Martin and the Board concentrated on the short term - the very short term - conditions in the money markets. They concentrated on maintaining stability and adequate but not excessive availability of credit. They avoided forecasts or policies that looked further ahead than just a few weeks.
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  However, there was considerable unease within the staff and Board due to recognition that the Board didn't really know what it was doing - what the longer term impacts of its monetary manipulations might be. Indeed, in the first years of the 1950s, there wasn't even any attempt to define the System's primary objectives. What did "full employment" and "price stability" consist of? By 1960, "full employment" was interpreted as the 4% unemployment believed inherently associated with economic dynamics.

  "[The System] had to relearn control techniques in an environment with a large, outstanding government debt. It had to become convinced that changes in interest rates, credit, and money influenced the pace of economic activity and inflation. It had to acquire some sense of the quantitative effects of its actions and the markets' reactions. And it worried about the political response to higher interest rates and policy actions taken independently of the Treasury and the administration."

  Meltzer discusses the constant analytical ferment within the System. Analysis was constrained by awareness of the political constraints on the actions of the "independent" System. The System was relying on imprecise and relatively ineffective policy tools with which it struggled to achieve its monetary policy objectives. There were overt efforts by administrations - from Truman to Nixon - to pressure Board chairmen to loosen monetary policy. Melzer provides a brief summary.

  "The Federal Reserve had always been aware that Congress could change its status, but political influences inserted themselves in the 1950s to a much greater degree than in the 1920s. Congressional approval of the Employment Act made a major difference. The Federal Reserve had formerly denied that it could control output and the price level. Now it shared responsibility with other agencies for economic welfare. Martin often described this mix as independence within the government."

  In short, "independence" only extended to protection against narrow partisan influence. Broader economic policies reflected in the budgets and their deficits had to be supported. The System could not prevent price inflation if the government ran large deficits and insisted on low interest rates. The primary responsibility of a central bank - to maintain the purchasing power of the currency - had to be sacrificed whenever there were large continuous budget deficits that could only be prevented from pushing interest rates up to constraining levels if the monetary authority monetized large amounts of the debt. Board chairmen thus became frequent advocates for the reduction of federal deficits.

  The chairmen were always received respectfully by Congress which nevertheless routinely disregarded their advice except for a short period in the 1990s. Chairman Ben Bernanke today finds himself in the same position. Will he have the independence to raise System interest rates when price inflation gathers steam?

  In Germany, reinforced by powerful popular opposition to price inflation as a result of the experience of the 1920s, Bundesbank independence was sufficient to resist political pressure. (Germany also rejected Keynesian policies and thus Germany thrived as the economic and financial powerhouse of Europe.)

  "Martin was very concerned about inflation and was willing to tolerate three recessions in the 1950s to avoid or reduce inflation. Several times, he raised interest rates enough to slow or stop a private investment boom. In contrast, he was slow to respond to inflation in 1957 and after 1965. Despite his concerns and frequent warnings, expressed publicly and privately, consumer prices rose 6 percent in [1969,]  his last twelve months at the Federal Reserve."

Keynesian criticism:

 

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  Keynesians viewed the Eisenhower years with disdain. Meltzer views the 1950s as the second most successful decade for the System after the 1920s, even though the growth rate was less than the nation's 3% historic average. Growth averaged 2.7% per year between 1954 and 1959 and the GNP deflator rose only 2.25% per year.
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  However, the Keynesians asserted that growth rates in excess of 4% could have been achieved if an increased rate of monetary growth had been permitted and price inflation had not been so rigidly constrained. Many had absurd faith in credit, price, wage and interest rate controls. They claimed there was no real connection between monetary inflation and price inflation. The real changes occurred in "velocity" - in the complex financial system - and in factors such as "cost push" or "wage push" inflation. They assumed that such factors impact general price levels regardless of whether monetary expansion ratified the higher prices. They believed that their Keynesian policies could avoid business cycle contractions and thus retain high rates of economic growth. They provided confident assurances that their policies could deal with price inflation.
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  In the 1960s and 1970s, the nation would experience Keynesian policies and learn how destructive the Keynesian conceit was.
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  Meltzer briefly summarizes the wide variety of views among academic economists who testified at a 1959 congressional hearing. They are wildly impractical - indeed, other-worldly - with here and there a glimmer of real understanding on the many complex problems afflicting budget and monetary management in the absence of a gold standard rules based market mechanism.
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  The System could no longer avoid responsibility for maintaining the full employment and stable prices promised by the Keynesians. Since the two objectives are incompatible, the System failed at both - although the large gold reserve and lack of economic competitors after WW-II temporarily kept the problem submerged. International competition was restored and international payments problems became severe after 1958, and by 1971, the gold cushion was gone. See, Meltzer, History of Federal Reserve, Part V, "Obsoleting the Business Cycle (1960-1971)."

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