Allan H. Meltzer (1928–2017)

Inventing the American Central Bank: The Federal Reserve’s First Thirty-Seven Years
In the early twentieth century, Paul Warburg, a prominent Wall Street banker, reflected on the prospects for the creation of a central bank that would help forestall financial crises that periodically threatened to materially disrupt the US economic system. In a 1907 article in the New York Times, Warburg observed that the affluence of the United States “makes us an important but dangerous factor in the world’s financial community, with immense resources indeed, but without a central organization of our own, using and sometimes abusing the financial organizations of Europe in order to atone for our own shortcomings; unable effectively to put on the brakes ourselves, we compel the Government banks of Europe to take measures for the regulation of our own household.” Subsequently, Warburg, writing in 1910, pointed out that “[a] system of decentralized reserves without any provision for transforming cash credits readily into cash must inevitably come to grief in a period of distrust, no matter whether the…banks keep reserves of 30 per cent or 25 per cent in easy times.” He thus recommended the establishment of a united reserve bank which would serve as a central repository of the banking system’s cash reserves, thereby making funds available to the financial system during liquidity shortages – “a centralized power to protect us against others and to protect us from ourselves.”

Despite his extensive experience in banking matters – he was a partner in M.M. Warburg & Co. in Hamburg before joining Kuhn, Loeb & Co. – Warburg could not have completely foreseen that the organization that ultimately emerged from his musings as the Federal Reserve System, the instrument that was envisioned to adequately protect the US financial system from panic and turmoil, would instead be pursuing chimeras and implementing half-measures. Hobbled by conflicting agendas between the System’s twelve district banks and the Federal Reserve Board, constrained in the implementation of monetary policy through its employment of the doctrinally inferior real bills principle, the Fed was, for all intents and purposes, unqualified to implement countercyclical monetary policies. Nearly two decades after the Federal Reserve was established, Warburg wrote that the institution he helped create was “too complicated to be either safe or efficient” and that it is “weighed down with the burden of political compromises which menace its future.” The Fed’s institutional schizophrenia during its initial decades, among other issues, is amply documented and explored in Meltzer’s mammoth first volume of the history of the Federal Reserve.

In this volume, Meltzer presents a meticulous, incisive account of the United States’ central monetary authority, from its founding in 1913 to its ‘emancipation’ from the US Treasury in 1951. The author, a pioneering monetary economist and co-founder of the Shadow Open Market Committee, has conducted extensive research in the Federal Reserve’s hitherto unexploited archives to assemble a manuscript which skillfully chronicles the Fed’s growing pains and deftly describes the maneuverings behind the institution’s decisions and public pronouncements. Statistics used by the Fed’s open market committee to formulate responses to the economic downturn of the 1930s, among other crucial data, are presented; this, combined with an exhaustive description of the roles of key Federal Reserve and US government personnel in making monetary policy, gives the reader an intimate glimpse into the decision-making processes of the most powerful financial institution in the world. Arguably nowhere else can as comprehensive a history of the Federal Reserve be found.

This authoritative volume has two primary themes. Firstly, the congenitally flawed organizational structure of the Fed greatly impeded its learning faculties. Secondly, the Fed’s pursuit of monetary stability during the institution’s first thirty-seven years left much to be desired because of doctrinal missteps: the Fed’s analytical framework centered on the so-called real bills doctrine, which permitted the discounting only of self-liquidating commercial bills (as opposed to discounting bills issued for speculative purposes) in the mistaken belief that doing so would inhibit the issuance of excessive and consequently inflationary quantities of credit. In view of the depth of Meltzer’s research and the policy lessons that the author draws from his findings, this book will long remain the orthodox work on the Fed, and is expected to modify the terms of inquiry pertaining to US central banking for years to come. Any further study of the Federal Reserve—indeed, any in-depth inquiry on central banking practices and monetary policy in the United States—must start with and continually rely on this book.

It is clear from this book that the Fed was unsure about its ‘true’ place in the US economy. Although it claimed to be aware that its overarching function was “not to await emergencies but, by anticipation, to do what it can to prevent them”, the Federal Reserve failed to prevent or even mitigate the recession of 1920-1921, the Great Depression of 1929-1933, and the recession of 1937-1938. The institution was created in response to the financial panic of 1907, as clamor increased for a central authority to regulate a national banking system vulnerable to panics, to buttress the payments system, and to establish a truly elastic currency base. However, the Fed did not emerge from the ferment fully formed, as Athena did from Zeus, ready to determine the direction of monetary policy; it had to grapple with policy issues and unclear lines of authority. With regard to lines of authority within the Fed, the Federal Reserve Act did not properly define the chain of command within the Fed itself. Such ambiguity with respect to lines of authority led to internecine disputes within the organization, negatively influencing the policy-making process during the Fed’s early decades. With regard to policy issues, many at the Fed believed that activist monetary policy during downturns would be akin to “pushing on a string”; as policy was deemed incapable of turning the tide, economic retrenchment, under this view, was needed to cleanse the economy’s undue exuberance.

Meltzer, a long-time critic of the Federal Reserve, brings to light the failings of an institution that was long held to be an ‘expert organization’ with its intricate secrets inaccessible to the layman. The real bills principle, considered an unalterable article of faith during the early years of the Fed, underpinned decisions to forego monetary growth during economic downturns, with unfortunate consequences. The Fed failed to realize that the real bills doctrine, which is premised on the precept that discounting real, i.e., commercial, bills would lead to an expansion of credit which in turn would be utilized to fund inventory production, could not serve as an effective control mechanism with respect to influencing the volume of credit extended by banks. Banks could and did lend funds to economic activities that maximized bank profit, even if such activities involved speculation. At the time, many policymakers believed that inflation could be forestalled if monetary authorities discounted real bills instead of discounting bills that existed only to finance speculative trade in the asset markets. In essence, they believed that bank credit should expand only in response to an expansion in real output. Hence, under this line of reasoning, the dramatic growth of the equities market during the late 1920s and the propensity of stock market participants to use borrowed funds to acquire and trade shares would translate into an increase in the general price level; prospective inflation must thus be forestalled through deflationary policies. Pursuit of such policies contributed in no small part to the onset of the Great Depression. Furthermore, the Fed believed that monetary policy was already expansionary during 1930-1933 in view of low nominal interest rates and low levels of bank borrowings. A financial China syndrome, writes Meltzer, need not have happened had the Federal Reserve chosen to believe that liquidation was not a precondition for economic revival. The Fed could have chosen to conduct open market operations on a broader scale. The Fed could have heeded Bagehot’s well-known advice to lend freely at a penalty rate.

In addition to the institution’s fixation with the real bills doctrine, Meltzer highlights another insidious infirmity in the Fed’s doctrinal framework: throughout the first thirty-seven years of the Federal Reserve’s existence, the Fed consistently failed to distinguish between nominal and real interest rates. Believing that the value of nominal interest rates accurately specified whether monetary policy was loose or tight, the Federal Reserve typically ignored the conditions that determined demand for bank credit. Thus, during the Great Depression, Fed officials often saw no need to do anything substantive to revitalize the economy in the belief that monetary policy was already in expansionary gear, noting that nominal interest rates were already at historical lows. Furthermore, many officials in the Fed and in the US government believed that the economic contraction during 1929 to 1933 was inescapable, that the Depression was an inevitable outcome of the speculative frenzy of the Jazz Age, that liquidation of the era’s excesses was a necessary corrective; this line of reasoning implied that monetary measures would be ineffectual in influencing the direction of the US economy. Despite the Fed’s missteps, the institution’s attempts to recalibrate the US financial system and thus the economy were in accordance with analytical tools and economic norms prevailing in the first half of the twentieth century. Meltzer concludes that, had the Federal Reserve paid close attention to money growth, episodes of economic dislocation and contraction during the interwar years could have been averted, avoided, or mitigated.

If Meltzer’s goal is to be the chronicler and critic of “a centralized power” established, in Warburg’s words, “to protect us against others and to protect us from ourselves”, he has admirably succeeded with this first volume. It would be indeed highly interesting to see where Meltzer, with his monetarist pedigree and impeccable command of the Fed archives, will take the readers of the second volume.… (mer)