A History of the Federal Reserve, Volume 2 (49 page)

Walter Heller of the University of Minnesota, and soon to be chairman of the Council of Economic Advisers, addressed two issues, the development of human capital by increasing educational spending and improving stabilization policy by “shifting emphasis from tight money to tight budgets” (ibid., 2988). In office soon after, he abandoned this proposal and favored larger deficits.

Milton Friedman of the University of Chicago emphasized the stabilizing actions of the private sector and the destabilizing actions of government or its agents, particularly the Federal Reserve. He commented explicitly on monetary policy, debt management, fiscal policy, and trade policy (Joint Economic Committee, Hearings, 1959, October 30, 3021–28). His was the only response by an academic that commented on the committee’s main concerns—the use of open market operations, relation of monetary policy to debt management, and the role of the rediscount rate. He called for a constant rate of money growth consistent with price stability. He proposed to restrict monetary policy actions to open market operations by removing the power to change reserve requirement ratios and discount rates. Deposits should be subject to a 100 percent reserve requirement ratio, so the banking system could expand only if it received more reserves. He preferred to float the dollar and use monetary policy to maintain domestic purchasing power. Friedman also proposed assigning responsibility for debt management to the Federal Reserve. Even if this were not done, the Treasury should restrict debt issues to a ninety-day bill and an eight- or ten-year long-term bond and sell all securities at auction. The form of the auction should change to allow bidders to present a schedule of quantities they would take at various prices. The Treasury would determine a single market-clearing price and charge all buyers that price.
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Friedman’s fiscal proposals included integrating corporate and personal income taxation by replacing the corporate income tax with taxation of corporate income at individual tax rates. Stockholders would pay tax as if they directly received their share of corporate net income. He favored
broadening the base and lowering individual income tax rates. His trade proposals included removing tariffs and import quotas.

333. This auction proposal overcame the Treasury’s main objection to auctioning longterm bonds. Friedman’s call for a single price avoided the “winner’s curse.” Many years later, the Treasury adopted single price auctions.

The recommendations of these and other witnesses covered a wide range. Lack of agreement by the academic witnesses reduced the limited chance that some of their ideas would be adopted.

The
Dealer
Market

Speculative activity in the government securities market in the spring and summer of 1958 raised concerns in Congress and the administration about the way the market distributed government securities. Much of the attention centered on the dealer market, the seventeen dealer firms that bought and sold government securities. These firms served as a principal buyer of new Treasury issues that they later sold to investors.

The principal concerns were the small number of dealers, the extent of competition, and the profitability of dealer operations.
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Broader issues included the distribution system itself, whether the Treasury should auction all securities, and whether the institutional arrangements, including bills-only, contributed to the increase in interest rates and the pressures on Congress to remove the ceiling interest rate on long-term issues.

The Treasury and the Federal Reserve’s detailed study of market arrangements gave much attention to the 1958 market break. Their joint report concluded that the Federal Reserve did not collect enough information on dealer positions and transactions. Also, the market operated on very thin margins; on average dealer borrowings to finance positions equaled thirty times their net worth (Joint Economic Committee, 1960, 91). The Federal Reserve and Treasury staff report discussed allowing dealers to arrange repurchase agreements with the Federal Reserve, subject to adequate margin, and considered starting a dealer’s association to set standards for their operations (Joint Economic Committee, Hearings, 1959, July 24, 1219–20).
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The Board and the Treasury considered a proposal to channel all trans
actions through the New York Stock Exchange so that securities would be purchased and sold in an organized auction market and subject to market rules. The Board’s staff concluded that the proposal was not feasible. The exchange required the System to make all open market purchases and sales on the exchange
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(Board Minutes, October 5, 1959, 3). The remaining recommendations called for increased reporting of dealer information, standardized accounting procedures, and minimum margin requirements.
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The main change was a decision to collect and publish, with a lag, statistics on dealer financing, short and long market positions, and transactions volume. Dealers had to submit statements of financial condition, but these were not published.
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334. In the 1940s, the Federal Reserve designated recognized dealers. Formal recognition ended in 1953. The Federal Reserve agreed to transact with any firm that “made markets.” In practice, this excluded brokers who did not hold inventories. Most of the dealers held only short-term securities in their position at the time. They acted as brokers for longer-term securities. There were a few exceptions, dealers that made markets in long-term bonds.

335. As part of the
Employment,
Growth,
and
Price
Levels
study, the committee’s staff collected data on positions, transactions, profits, and capital of the seventeen dealer firms. The staff did not use this material. Subsequently, Senator Douglas and Congressman Patman invited Gert von der Linde and me to analyze these data. We interviewed many of the dealers and wrote a detailed description of the market. We found no evidence of the high profitability or lack of competition that concerned Congressman Patman in particular. See Joint Economic Committee (1960).

CONCLUSION

The Federal Reserve began to assume its current form in the 1950s under changing perceptions about the influence of monetary actions on economic activity and the leadership of a new chairman, William McChesney Martin, Jr. For most of the preceding eighteen years of depression, war, and postwar recovery, the Federal Reserve had made few policy decisions. Monetary policy became subservient to debt management. The Federal Reserve assisted the Treasury to issue debt at historically low interest rates and advised the Treasury on the type of debt to issue. The Treasury could veto interest rate changes, and it did not hesitate to do so.

The March 1951 Accord with the Treasury changed the Federal Reserve’s formal status from subservient to co-equal partner with the Treasury. The Treasury remained responsible for debt management; the Federal Reserve gradually regained authority to change market interest rates, reserves, and money. The two institutions shared responsibility for the success of the Treasury’s offerings. The Treasury had to price its issues to attract buyers; the Federal Reserve accepted that it had to assist the Treasury by supplying additional reserves, if offerings failed to attract buyers in sufficient number to sell the issues at the offering price.

336. The president of the exchange also asked for Federal Reserve support of the market and tax exemption for government bonds (Board Minutes, December 30, 1959, letter, Keith Funston to Anderson).

337. One of the dealers, Aubrey Lanston, protested that providing information on positions and transactions to the trading desk would permit the Federal Reserve to trade against him. Riefler replied that the desk could not offer repurchase agreements without information on positions, but it did not require reports on holdings of individual securities (Board Minutes, October 13, 1959, 53).

338. The decision about whether collection would be done by New York or Washington reopened the struggle between New York and the Board (FOMC Minutes, November 4, 1959, 2–11). In the 1920s, an issue of this kind would be quickly resolved in New York’s favor. In the 1950s, it took longer, but the New York bank prevailed.

The Federal Reserve’s responsibilities to the Treasury were not easy to reconcile with its broader responsibilities or with its independence. Congress gave it two mandates. The Bretton Woods Agreement of 1944 fixed the dollar price of gold and created a system of fixed but adjustable exchange rates. This set a possible external constraint, to avoid a change in parity. The Employment Act of 1946 set the internal constraint as the loose objective of maintaining maximum employment and purchasing power. Given the large U.S. gold stock at war’s end, Congress did not explicitly say, or perhaps realize, that the two objectives would often be mutually inconsistent and at times inconsistent also with the budget and debt management. It left the problem to the Federal Reserve, reserving the right to criticize.

The external constraint did not bind for most of the 1950s. With its preponderant share of the world’s gold stock the United States permitted countries to discriminate against its producers in trade and to draw gold. This policy, the general prosperity, and economic assistance to promote recovery and military alliances abroad succeeded enough to restore current account convertibility of most West European currencies by the end of 1958. Soon after, concerns increased about U.S. firms’ inability to compete effectively in some markets, reductions in the gold stock, and the size of the international payments deficit. These concerns did not lead to action in the 1950s.

In practice, the Employment Act required the Federal Reserve to accept increased responsibility for recessions and unemployment. During the 1920s, it had denied any direct influence of its actions on output or employment. Postwar politics changed the Federal Reserve’s objectives. President Eisenhower was the first Republican president since Herbert Hoover. Despite his concern for fiscal responsibility and balanced budgets, he wanted to avoid the mistakes of the late 1920s and early 1930s. The administration took expansive fiscal measures in recessions or allowed built-in stabilizers to increase budget deficits. After 1954 the Democrats controlled Congress, but cooperative working relations between the president and Congress permitted the administration to get agreement on the budget.

The choice of objective made United States monetary policy depend on employment. De facto, the Employment Act made the Federal Reserve responsible for maintaining full employment even if its responses produced mild inflation. The System attempted to use monetary policy instruments to moderate fluctuations in economic activity and employment without causing inflation, but it did not fully succeed. Although there were two recessions in the 1950s and a third soon after, the recessions were shorter
in length but not less severe than the 1923–24 and 1926–27 recessions (Zarnowitz and Moore, 1986, Table 7).
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By the middle of the decade, inflation was 3 percent or more.

The change in objective did not lead to a change in procedures. Federal Reserve staff in New York and Washington continued to use free reserves (excess reserves minus borrowing) or member bank borrowing as their principal operating target, and the FOMC often used a level of free reserves as a quantitative guide for the manager of the System Open Market Account. This is not surprising since principal members of the senior staff—especially Winfield Riefler and Woodlief Thomas—had been active in the 1920s, when the Federal Reserve developed these procedures. The surprising change was that the System, using unchanged procedures, could now claim to affect output or the price level, contrary to their claims in the 1920s.

FOMC members and some staff criticized the use of free reserves at times, and some proposed alternatives. Malcolm Bryan, president of the Atlanta Federal Reserve bank, stands out among his peers. He urged the FOMC repeatedly to adopt quantitative targets for growth of reserves and money.
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The FOMC ignored his efforts, and Vice Chairman Sproul dismissed Bryan’s approach as overly mechanistic. Martin preferred to use free reserves or color, tone, and feel, leaving the trading deck to decide how to implement the FOMC’s loose discussion. FOMC members, including Martin, criticized free reserves as an inadequate measure of ease and restraint, and they did not always use it. But they returned to it many times and did not resolve the issue or adopt another target in the 1950s.

In part, free reserves served as a substitute for an interest rate target that many would have preferred. The concern was that Congressman Patman would have urged a lower target, so System spokesmen denied that they controlled interest rates.
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That was not the only reason. Like many bureaucratic organizations, the Federal Reserve avoided taking responsibil
ity. Also, Martin always preferred picturesque imagery to careful analysis or precise instructions. One consequence was that the manager had considerable autonomy. Policy measures such as free reserves often changed before the FOMC voted to change.

339. I base this judgment on the decline in industrial production, the maximum unemployment rate, and the decline in real GNP. Zarnowitz and Moore (1986, Table 7) give −4.1 and −2.0 for the decline in real GNP in the 1920s recessions and −3.2, −3.3, and −1.2 for the 1953–54, 1957–58, and 1960–61 recessions.

340. Bryan developed the short-run growth cones later used by the Federal Reserve, when it announced money growth targets in the 1980s and 1990s. The cones showed the growth path and the band or range around the path. An observer could see whether money growth remained above or below the specified path. Hafer (1999) discusses Bryan’s efforts. Delos Johns (St. Louis) supported Bryan at times.

341. From 1979 to 1982 the Federal Reserve used reserve measures as the target and claimed that it did not control interest rates. This permitted larger changes in interest rates, and higher rates than the FOMC was likely to vote for, and it permitted the Federal Reserve to blame the market for interest rate changes.