A History of the Federal Reserve, Volume 2 (17 page)

Beyond citing the role of Congress in voting the budget, Martin never explained why the Federal Reserve had to limit interest rate increases during Treasury financings. Failure of a Treasury issue (as sometimes happened) was an embarrassment, not a calamity. The Treasury would have to return to the market with a more attractive offer. Even if the Federal Reserve would supply reserves to prevent failure, interest rates could be raised as required for stability once the market absorbed the issue. Further, the Federal Reserve and the Treasury could substantially reduce the risk of “failures” by auctioning Treasury notes and bonds. Both resisted this solution until the early 1970s perhaps out of concern for a failed attempt in the 1930s.

This interpretation of independence suggests one reason why the Federal Reserve under Martin permitted inflation to increase in the 1960s. And it explains an important difference between Federal Reserve policies in the 1950s and 1960s. 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 his last twelve months at the Federal Reserve.

This interpretation may explain, also, why the Federal Reserve complained frequently about deficit finance. In the view of its principals, deficit finance required higher interest rates, an unpopular action always subject to criticism in Congress. Deficit finance also raised the issue of Federal Reserve independence and, on its interpretation, could make control of inflation impossible within the range of interest rates it considered politically feasible.

Later, the Federal Reserve and other central bankers learned about the distinction between real and nominal rates. They could not prevent market interest rates from rising by limiting increases in short-term rates. At most, they could delay increases in real rates and only as long as markets did not anticipate that inflation would rise higher.

The government’s commitment to maintain maximum employment and purchasing power in the Employment Act created pressures of a different kind for policy. Vivid memories of the Great Depression, and alleged Republican responsibility for it, made the Eisenhower administration, including the president, sensitive to rising unemployment and
falling output. In the 1952 presidential campaign, Eisenhower pledged to use the power of the federal government to prevent another depression (Eisenhower, 1963, 304). During the 1953–54 recession, he “talked to the secretary of the Treasury in order to develop real pressure on the Federal Reserve Board for loosening credit still further . . . Secretary Humphrey promised to put the utmost pressure on Chairman Martin of the Federal Reserve Board in order to get a greater money supply throughout the country” (Ferrell, 1981, 278).

The main channel of communications became weekly meetings of the Federal Reserve Chairman and the Treasury Secretary. Later, meetings with the Council of Economic Advisers provided another channel for exchange of views. After 1956, President Eisenhower began periodic meetings with Martin, Secretary Robert Anderson (who replaced Humphrey in 1957), and CEA Chairman Raymond Saulnier, who replaced Burns. After the 1960 election, the Budget Director joined the group. In the Kennedy administration, the group became known as the Quadriad. Martin was careful to remain nonpartisan in these meetings and to avoid making commitments about future monetary policy, but he did not always succeed in the 1960s. Even if he avoided commitments, efforts to coordinate policy further limited independence.
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This challenge became intense in the 1960s, when Martin tried to coordinate actions with President Johnson and some of his staff. Coordination began as an exchange of information, but it evolved into a restriction on Federal Reserve independence.

Appointments are another method by which the administration could influence the Federal Reserve’s decisions. In the early years, many appointees stayed a full term or longer. Salaries declined in real terms, particularly after inflation in World War II and in the 1970s. Opportunities in banking and finance increased. A president might appoint a majority of the Board, but members did not always vote along partisan lines. Loyal appointees could report on the Board’s attitudes, as James K. Vardaman did during the System’s difficulties in the pre-Accord period, or listen carefully to the administration’s position. Two of President Truman’s appointees, Mills and Robertson, dissented frequently (Havrilesky and Gildea, 1990, Table 1).

59. Sproul opposed formal coordination and regarded the Council of Economic Advisers as “a discredited body in terms of objectivity” (Sproul papers, FOMC meeting comments, July 7, 1952). The reference maybe to the Truman council headed at the time by Leon Keyserling, a New Deal economist with strong statist views. New York was very critical of the reports prepared by the Council in part because the Council opposed raising interest rates and favored selective credit controls (memo, Roelse to Sproul, Sproul papers, FOMC Correspondence, January 28, 1952).

The
Martin
Federal
Reserve

By the mid-1950s, Martin had reorganized the Federal Reserve. The Board was more fully in control of the FOMC than at any previous time. Martin had obtained centralization of authority at the Board with the agreement of most reserve banks, and he did so in a way that did not disrupt operations and decisions.

The FOMC became the center for policy decisions. The traditional separation of powers between the Board and the FOMC did not disappear formally. Banks still sent requests for discount rate changes to the Board for decision. The Board decided in advance that it would approve discount rate changes requested by the reserve banks. But the main decision was frequently a collective decision made at the FOMC meeting and ratified by the reserve bank directors for transmission to the Board.

Open market operations remained the main policy instrument most of the time. Martin exerted his influence on these decisions using the “go around” in which members expressed their opinions, and he stated the “consensus.” Members rarely challenged the consensus, and Martin was never defeated once the new procedures were in place. Occasionally, he spoke first to structure the discussion. Often he was willing to wait weeks, even months, until a consensus formed. His difficulties in gaining a consensus increased greatly in the 1960s, after Presidents Kennedy and Johnson had appointed a majority of the Board members.

Martin saw himself and the Federal Reserve as the main, perhaps only, force against inflation. He did not want to become what he called a crusader, but he often described the Federal Reserve’s role as alone in a struggle against powerful forces, using metaphors about “leaning against the wind” or “taking away the punchbowl.” And he often told his colleagues, as in 1957, that “the System was the only instrument of Government that was fighting inflation” (FOMC Minutes, December 17, 1957, 40). When the Democrats made his policies an issue in the 1960 political campaign, he drafted a letter describing his principal objectives: “(1) that a genuine effort be made, by those in authority, to preserve the purchasing power of the dollar that is so vital to our economy and the preservation of our society; and (2) that the Federal Reserve be allowed the freedom from political interference necessary for it to contribute its part to that effort” (draft letter, Martin papers, December 20, 1960).
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60. The letter is not addressed and has no salutation or close. The drafting has several corrections and insertions suggesting that Martin typed it personally. The last paragraph contains: “It is these things that matter—not what happens to me” (draft letter, Martin papers, December 20, 1960). This suggests that Martin may have considered resigning or perhaps
expected President Kennedy to ask for his resignation, since one of Kennedy’s advisers, James Tobin, had proposed publicly that Martin be replaced. The letter suggests that Martin understood the importance of independence.

Martin offered to resign when Eisenhower became president. He told the president that he was a Democrat. After taking time to consider the decision, Eisenhower asked him to remain. He did not offer to resign after the 1956, 1960, 1964, and 1968 elections, but he considered resigning at other times. In 1960 he explained that Kennedy made monetary policy an issue in the election. The Democrats had argued that monetary policy had been too tight. Therefore, he had an obligation to remain until the end of his term (memo, Tobin to Heller, Gordon, and Solow, Heller papers, May 30, 1961).
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The analytic level under Martin in the 1950s did not venture much beyond metaphors and ambiguity.
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Although the System accepted a role in maintaining full employment and price stability, I have not found any discussion in the 1950s of what these terms meant in practice. Many FOMC members recognized that to control inflation, money growth should equal the average growth of output over several years, but the connection between System policy and money growth remained as imprecise as other relations.

In June 1956, Allan Sproul resigned as president of the New York Federal reserve bank. A New York banker responsible for international lending, Alfred Hayes, replaced him. With Sproul’s departure, Martin lost his most skilled and knowledgeable colleague and adversary. In his usual cautious way, with courtesy to others, Martin could direct Federal Reserve actions without facing significant challenge until the 1960s brought a new group of Board members with less concern about inflation, or perhaps greater confidence in their ability to limit it “later.”

61. Martin had “a fine private job offered to him at that time” (Heller papers, May 30, 1961). Monetary and economic policy were issues in the 1968 election, so Martin did not offer to resign when President Nixon took office.

62. Romer and Romer (2002b) correctly point out that the Federal Reserve generally followed a non-inflationary policy in the 1950s. However, they credit the Federal Reserve with a more coherent analysis than the record suggests. The Federal Reserve responded to rising prices especially if brought about by strong private sector demand, and they relied on some vague relation of money growth to growth of real output as an indicator of inflationary pressure, but their analysis did not go beyond this general level. Often Martin rejected a role for money growth. One apparent reason for the generally successful anti-inflation policy appears in the Romers’ figure 3. Most of the time free reserves and short-term interest rates were correlated negatively. The main exception was 1955–57, when inflation rose. Also, standards have changed. Price increases of two or three percentage points were considered serious in the 1950s, especially by Martin. I believe the difference in the size and persistence of budget deficits in the Johnson years compared to the Eisenhower and Kennedy years offers a better explanation of the difference in outcome.

DOMESTIC POLICY ACTIONS, 1951–53

In the months between the start of the Korean War and the Accord, Congress enacted legislation authorizing the Federal Reserve to control the use of credit. The Board reinstituted regulation W, for consumer durables, and regulation X, for real estate credit. It was one thing to allocate such credit during World War II, when production controls limited the amount of durables or housing produced. It was quite another to control credit in a competitive market with firms producing and consumers demanding durables. Regulation induced innovations to circumvent them. The Board’s staff summarized the lesson learned:

[I]ndustry lawyers proved to be highly adept at developing arrangements that effectively circumvented the letter of Reg.
W.
Fed regulators found themselves lagging far behind industry lawyers, first in ferreting out the loopholes, and then in devising measures to close them. Similar enforcement problems developed in the administration of regulation X.

This generally negative experience with mandating credit allocation problems strongly influenced Fed attitudes. Each time Congress has subsequently proposed new programs for direct credit regulation, Fed officials have taken a negative view of their feasibility. (Stockwell, 1989, 19)
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Remembering World War II, President Truman proposed and Congress approved price and wage controls. They remained in effect until 1953, when President Eisenhower ended them.

On March 9,1951, the Board instituted a Voluntary Credit Restraint Program. Its purpose was to restrain “inflationary tendencies” while financing “the defense program and the essential needs of agriculture, industry, and commerce” (Annual Report, 1951, 85). The underlying notion that loans for speculating, carrying securities, or financing real estate contributed to inflation shows the continuing influence of the real bills doctrine.

Most members of the Board and the bankers on the Federal Advisory Council favored direct controls, at least initially. Governor James Vardaman thought production controls would be more effective, but he voted
for the credit control program. Little more than a year later, the Board suspended the voluntary program, on the recommendation of its advisory committee. A few weeks later, it suspended controls on consumer credit (Board Minutes, May 2, 1952). Formal authorization for consumer credit controls expired on June 30, 1952. Real estate credit controls continued until September 16,1952, when housing starts remained below 1.2 million for the third month.
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63. Martin held a very different view when he came to the Board. He told the members of the House Banking and Currency Committee that “selective measures of credit restraint are an effective and necessary supplement to general credit measures” (Martin testimony, House Banking and Currency Committee, May 10, 1951, 3). His 1956 testimony records his change of opinion. After listing some benefits, he opposed use of selective credit controls except in “recognized emergencies.” Controls, he said, interfere with resource allocation and are difficult to administer and enforce without public acceptance and support (Testimony, Joint Committee on the Economic Report, Board Records, February 7, 1956). Martin did not use real bills arguments in his testimony. He described selective controls as a supplement to general controls, not a substitute.