Academic journal article The Cato Journal

Current Lessons from the Past: How the Fed Repeats Its History

Academic journal article The Cato Journal

Current Lessons from the Past: How the Fed Repeats Its History

Article excerpt

Here, then, the rulers of society have an opportunity of showing their wisdom--or folly. Monetary history reveals the fact that folly has frequently been paramount; for it describes many fateful mistakes.

--Knut Wicksell

The Federal Reserve System came into existence 100 years ago after lengthy debate and discussion. It seems timely to look back on its founding, its history and development, and to consider its major successes and failures. This article looks at that history and discusses how the past is reflected in the present.

The Founding of the Fed

The new institution had little scope for discretionary policy actions. None of the parties discussing the proposed Federal Reserve Act of 1913 doubted that it would continue to follow a monetary rule--the international gold standard. Actions and initiatives remained greatly restricted by the Act. Monetary, credit, and interest rate actions consisted principally of setting discount rates on commercial paper and banker's acceptances. Rates influenced the amount of discounting, but the initiative for discounting remained with the banks. The Federal Reserve could purchase or sell bankers' acceptances on its own initiative, but individual Reserve Banks could decide whether to participate.

Agreement about economic issues included more than the gold standard. A series of financial disturbances in the 1890s and 1907 convinced most of Congress, the Wilson administration, and the informed public that the social cost of bank failures could be greatly reduced by creating a lender of last resort (LOLR) with power to lend on acceptable collateral in a financial crisis. The gain came from protecting the payments system, not, as now, protecting banks.

Agreement on another vital economic issue concerned the financing of government borrowing. The 1913 Act prohibited any direct loans to the Treasury. The authors understood, perhaps better than their modern counterparts, that financing government debt was likely to bring inflation.

Many economists act as if monetary policy is entirely an economic issue. Many articles analyze optimal economic policy. These articles neglect that the Federal Reserve is governed by political as well as economic concerns. That has been true since the founding, and it remains true, perhaps even truer now that discretionary actions have replaced the very restricted rules in the original design.

Article 1, Section 8 of the U.S. Constitution assigns the monetary power to Congress. The Federal Reserve is its agent. That makes political influence inescapable. Despite words about independence, it takes a very strong leader to remain independent. As former Fed chairman William McChesney Martin Jr. often remarked: "The Federal Reserve is independent within government, not independent of government" (Meltzer 2003: 713). That is not a very restrictive definition of independence.

The gold standard and discounting did not delay the 1913 legislation. The agreements that were difficult to reach were political issues. (1) Two issues stand out: (1) the issue of who would control the new agency--the Board in Washington or the 12 Reserve Banks spread across the country. And (2) where would the Reserve Banks be situated? The law assigned the second issue to a three-person board.

President Wilson, a former political science professor, proposed a compromise. The Reserve Banks would be semi-autonomous, with directors drawn from their region, with power to approve or dissent from purchases and authorized to set regional discount rates with Board approval. The Board in Washington had a supervisory role. The compromise satisfied the Western and Southern populists who thought that the Board would keep New York from setting interest rates at levels that would squeeze farmers and merchants. The large financial firms in New York preferred a structure like the Bank of England with no government participation. …

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