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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.

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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