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Early Monetary Policy
In the 19th century a major part of monetary policy in
the United States consisted of trying to link the dollar to
commodities, first to gold and silver, and then, after 1879,
to gold. The hope was that these systems would provide
automatic stabilization. That hope was poorly realized;
economic crises were frequent and sometimes severe. Congress
finally decided that the system needed reform after a
financial panic in 1907 was stopped only with bank
cooperation organized by J. P. Morgan, the most prominent
banker of his time. The result was the Federal Reserve Act
of 1913.
The establishment of the Federal Reserve did not
introduce monetary policy as we know it. The goals of the
system were vague; the establishing legislation said that
the Federal Reserve was to provide an "elastic currency,"
whatever that meant. With a decentralized system of twelve
banks, it was not clear who was charge. Although some of the
new leaders of the system were talented and knowledgeable,
others had no clue as to what they were doing.
There was no consensus about how to conduct monetary
policy in the first decades of the Federal Reserve. Some of
the leaders, especially those at the New York bank, thought
the Fed should conduct counter-cyclical policy, adding to
bank reserves during business downturns. Others believed in
the "real-bills" doctrine, which held that if banks limited
their lending to sound business loans, the proper amount of
money would be automatically generated. The danger, in this
view, was that banks might lend too much for "unsound"
purposes, such as loans for buying stocks and bonds. Notice
that if the real-bills prescription is followed, movement in
money stock will be pro-cyclical because business loans
swell during upturns and decline in recessions.
The economy performed quite well during the 1920s as the
Fed began to develop the tools of monetary policy. Open
market operations in U. S. government securities were of
minor importance. Rather the Fed loaned reserves through the
discount window and bought and sold banker's acceptances, a
financial instrument of little importance today. But as the
1920s ended, the Great Depression confronted the Fed with
novel challenges.
There were some in the Fed, especially those in New York,
who wanted to vigorously counteract the decline in spending
by increasing bank reserves, but changes in personnel and a
shift of power away from New York to Washington often left
them in a minority. Those who viewed the world through the
lenses of the real-bills doctrine believed that stock market
speculation had caused the Depression. Banks had erred in
making too many "unsound" loans that had been used for stock
speculation, and there was now little the Fed could do to
remedy the situation. "The predominant sentiment was that
with the economy weakening, the needs of trade were
declining, making the contraction in money and credit
appropriate." 1
After the Roosevelt Administration abandoned the gold
standard in 1933 and then raised the price of gold, gold
flowed into the United States, raising bank reserves and
stimulating the economy. Although banks increased their
lending, they also accumulated large amounts of excess
reserves. The Fed believed that these excess reserves
indicated that there was little demand for bank loans, and
hence Fed action to increase total reserves could not
stimulate the economy. In 1936 they began to worry about the
large level of excess reserves, fearing they might lead to a
rash of undesirable bank lending in the future. To forestall
this possibility, they raised reserve requirements in 1936
and 1937. The result was a brief but deep recession. Banks
held those excess reserves for liquidity, and when the Fed
took them away, the banks cut lending in order to restore
them. The Fed realized that it was at least partly
responsible for this recession and, as a result, a belief
developed that although tight money might cut spending, easy
money might not increase it. For many years this belief was
encapsulated in the statement that one could pull on a
string but not push on it.
As the 1930s ended, the Fed itself doubted that monetary
policy was of great importance. Hence, it was willing to
surrender its independence during World War II to the
Treasury Department. Its role during the war was to
stabilize the war bond market, which helped the Treasury
borrow to finance the war. Only after the war did monetary
policy revive.
1Meulendyke, Ann-Marie. U.
S. Monetary Policy and Financial Markets. (New York: The
Federal Reserve Bank of New York, 1998) p. 29.
Copyright
Robert Schenk
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