A History of the Federal Reserve, Volume 1

1. The Federal Reserve's Founding: A Compromise Leading to Unintended Evolution

The founders did not design or contemplate the Federal Reserve System we have today.

A Hybrid Institution. Established in 1914, the Federal Reserve System (FRS) was a unique blend of public and private interests, a compromise born from intense political debate. It was envisioned not as a powerful central bank, but as a decentralized system of twelve regional reserve banks, each with significant autonomy, supervised by a Board in Washington. Its primary goals were to reduce financial instability, provide an "elastic currency" (one that could expand and contract with economic needs), and improve the payments system, particularly by replacing the call money market with a robust market for commercial paper.

Early Conflicts and Limited Powers. From its inception, the FRS was plagued by internal conflicts over authority between the Washington-based Board and the powerful regional banks, especially the Federal Reserve Bank of New York (FRBNY) under Governor Benjamin Strong. The FRS's initial monetary powers were limited to buying and selling gold and setting discount rates, which were intended to be penalty rates. This structure, coupled with the prevailing belief in the automaticity of the gold standard, meant the FRS had little scope for discretionary action, often reacting passively to economic events rather than proactively shaping them.

Evolution Beyond Intent. Despite its founders' intentions, the FRS was fundamentally reshaped by external events like World War I and internal dynamics. The war forced the FRS to abandon the penalty discount rate and prioritize war finance, leading to a significant expansion of its balance sheet. The post-war period saw the FRS grappling with inflation and recession, revealing the inadequacy of its initial passive framework and prompting a search for more active policy approaches, ultimately transforming it into a more centralized and powerful institution than originally conceived.

2. The Real Bills Doctrine: A Flawed Guiding Principle Leading to Procyclical Policies

The "real bills" notion, that credits advanced for productive purposes could not be a cause of inflation, had been proposed by several writers including James Stewart and had been used unsuccessfully to limit the note issue of the Bank of England before the Restriction.

The Doctrine's Core Belief. The real bills doctrine, deeply embedded in the Federal Reserve Act of 1913, asserted that central bank credit should only be extended against "self-liquidating" commercial paper arising from real production and trade. Proponents believed that such credit would expand and contract naturally with economic activity, preventing inflation (as it was tied to real output) and avoiding "speculative" excesses associated with loans for stocks, real estate, or government securities. This doctrine effectively tied monetary policy to the perceived "needs of trade," leaving the initiative for credit expansion or contraction largely to commercial banks.

Procyclical Outcomes. Adherence to the real bills doctrine led to inherently procyclical monetary policies. When the economy expanded, the supply of eligible commercial paper increased, prompting the FRS to provide more reserves and currency. Conversely, during contractions, the supply of real bills dwindled, leading the FRS to restrict credit, thereby exacerbating economic downturns. This passive, reactive stance meant the FRS often amplified economic cycles rather than moderating them, a direct contradiction to its stated goal of reducing financial instability.

Blindness to Speculation and Inflation. The doctrine's focus on the quality of credit blinded policymakers to the quantity of money and its broader effects. FRS officials, particularly during the late 1920s, viewed rising stock prices and increased borrowing for securities as "speculative inflation" that needed to be purged, even when commodity prices were stable or falling. This misinterpretation, rooted in the real bills framework, led to inaction during the onset of the Great Depression, as officials believed the downturn was a necessary "liquidation" of past excesses, rather than a monetary phenomenon requiring active intervention.

3. The Great Depression: A Catastrophic Failure of Monetary Policy Driven by Misguided Beliefs

The main reason for the failure of monetary policy in the depression was the reliance on an inappropriate set of beliefs about speculative excesses and real bills.

Inaction Amidst Collapse. From 1929 to 1933, the U.S. money supply plummeted by 28%, industrial production halved, and thousands of banks failed. Despite these alarming indicators, the Federal Reserve remained largely passive. Policymakers, steeped in the real bills doctrine, interpreted the crisis as an "inevitable consequence" of prior speculative excesses, believing that a painful "purge" was necessary before recovery could begin. This fatalistic view prevented decisive action, as officials saw no legitimate "needs of trade" to warrant credit expansion.

Misleading Indicators and Ignored Warnings. The FRS relied on misleading indicators like low nominal interest rates and declining member bank borrowing to conclude that monetary policy was "easy." They failed to distinguish between nominal and real interest rates; as prices fell, real interest rates soared, making borrowing prohibitively expensive. Warnings from within the FRS (e.g., from Lauchlin Currie and some New York directors) and from prominent economists like Irving Fisher about the dangers of monetary contraction and deflation were largely ignored or dismissed, reinforcing the System's inaction.

Failure as Lender of Last Resort. The FRS's most egregious failure was its inability to act as a lender of last resort during the waves of bank failures. Despite Bagehot's well-known dictum to "lend freely at a high rate" during a panic, the FRS allowed thousands of banks to collapse, exacerbating the currency drain and deepening the financial crisis. This inaction stemmed from a combination of:

• Adherence to the real bills doctrine, which restricted lending to solvent banks with eligible paper.
• Internal divisions and lack of decisive leadership.
• Fear of "wasting ammunition" on what was perceived as an inevitable downturn.

4. The Gold Standard's Demise: Incompatible National Goals and Sterilization Policies

The problem was not, as is often suggested, lack of cooperation or unwillingness to cooperate. The failure was a failure of a managed system operating under inconsistent objectives on both sides.

A Fragile Restoration. The FRS, along with other central banks, prioritized the restoration of the international gold standard after World War I. By the late 1920s, most major trading nations had returned to fixed exchange rates. However, this restoration was fragile, undermined by fundamental inconsistencies:

• Misaligned Exchange Rates: The British pound was overvalued, while the French franc was undervalued, creating persistent trade imbalances.
• Reluctance to Adjust: Britain was unwilling to deflate further, and France and the U.S. were unwilling to inflate, preventing the necessary price adjustments under gold standard rules.

Sterilization and Deflationary Bias. Gold flowed predominantly to the U.S. and France, but both countries largely sterilized these inflows to prevent domestic inflation. This policy, while aimed at domestic price stability, effectively prevented the gold standard's self-correcting mechanism from functioning. Countries losing gold were forced to deflate or abandon the standard, contributing to a global deflationary bias that exacerbated the Great Depression.

The Final Collapse. The inherent contradictions of the interwar gold standard, coupled with nationalistic economic policies, led to its inevitable collapse. Britain's departure from gold in 1931, followed by many other nations, signaled the end of an era. While often framed as a failure of international cooperation, the deeper issue was the unwillingness of sovereign nations to subordinate domestic economic goals (like full employment or price stability) to the rigid demands of a mismanaged fixed exchange rate system.

5. Internal Power Struggles: Decentralization and Personality Clashes Hampered Effective Action

The struggle for power and control that was inherent in Wilson’s compromise had gathered momentum by the late 1920s. The Federal Reserve entered a critical period for policy decisions with a conflict that made decisions easy to postpone and left basic policy issues unresolved.

Strong vs. Miller. The FRS's decentralized structure, a compromise from its founding, fostered persistent power struggles between the Federal Reserve Board in Washington and the regional reserve banks, particularly the FRBNY. This was personified by the clash between Benjamin Strong, the influential Governor of the FRBNY, and Adolph Miller, a dominant figure on the Board. Strong, a decisive banker, often pushed for proactive policies (like open market operations), while Miller, an academic economist, favored strict adherence to the real bills doctrine and greater Board control.

Paralysis by Design. The ambiguous division of authority in the Federal Reserve Act meant that critical policy decisions often became bogged down in procedural disputes and personal animosities. The Board could approve or reject regional bank decisions (like discount rate changes), but it often lacked the power to initiate or enforce a unified System policy. This structural weakness was particularly evident during the onset of the Great Depression, where disagreements over how to address "speculative credit" led to prolonged inaction.

Leadership Vacuum. Strong's death in 1928 created a leadership vacuum at a critical juncture. His successors at FRBNY, while capable, lacked his commanding influence to forge consensus among the diverse and often recalcitrant regional banks and the increasingly assertive Board. This fragmented leadership, coupled with deeply entrenched and often conflicting economic theories, left the FRS ill-equipped to respond decisively to the escalating financial and economic crisis, contributing significantly to the depth and duration of the Great Depression.

6. Treasury Dominance: Wartime Finance and New Deal Policies Subordinated the Fed

From 1934 to 1951, the Treasury Department severely restricted Federal Reserve actions.

New Deal Subordination. The Great Depression and the subsequent New Deal era fundamentally altered the FRS's relationship with the executive branch. President Roosevelt, distrustful of bankers and eager to implement his recovery programs, asserted strong control over monetary policy. The Treasury, under Secretary Henry Morgenthau, used its powers (such as the Exchange Stabilization Fund and control over gold policy) to dictate interest rates and influence FRS actions, effectively relegating the FRS to a "backseat" role.

Wartime Compliance. During World War II, the FRS willingly subordinated its policy to the Treasury's war finance needs. It committed to maintaining a "pattern of rates" on government securities, pegging short-term rates at historically low levels (e.g., 0.375% for Treasury bills) and capping long-term bond yields at 2.5%. This policy, while facilitating cheap war borrowing, turned the FRS into a "residual buyer" of government debt, monetizing a significant portion of the war effort and fueling post-war inflationary pressures.

Post-War Inertia. Even after the war, the Treasury, under Secretaries Fred Vinson and John Snyder, resisted any changes to the pegged interest rate structure. Their primary concern was minimizing the cost of servicing the massive national debt and avoiding any market instability. Despite growing inflationary pressures and internal dissent, the FRS, lacking strong political backing and fearing a repeat of the 1920-21 backlash against higher rates, remained largely subservient, unable to pursue an independent monetary policy for nearly six years after the war's end.

7. The Riefler-Burgess Doctrine: A New Framework with Persistent Flaws

The central relation was the member bank borrowing function. Although the reserve banks had tried in the early years to operate an English system with a penalty rate, Riefler and Burgess discarded that approach; they explained that banks were reluctant to borrow, borrowed only if reserves were deficient, and repaid promptly.

A Shift from Penalty Rates. Emerging from the policy failures of the early 1920s, the Riefler-Burgess doctrine (developed by Winfield Riefler and W. Randolph Burgess, with Benjamin Strong's influence) offered a new framework for FRS operations. It moved away from the strict penalty discount rate system, positing that banks were inherently "reluctant" to borrow from the FRS and would promptly repay any indebtedness. This implied that open market operations could effectively control member bank borrowing, thereby influencing market interest rates and credit conditions.

Open Market Operations as the Primary Tool. Under this doctrine, open market operations became the FRS's primary tool. Selling securities would force banks into debt, prompting them to contract lending and raise rates. Conversely, buying securities would allow banks to repay debt, easing credit and lowering rates. This framework provided a rationale for proactive FRS intervention, a significant departure from the earlier passive, real bills approach.

Lingering Flaws and Misinterpretations. Despite its advancements, the Riefler-Burgess doctrine retained critical flaws that contributed to later policy errors:

• Neglect of Real vs. Nominal Rates: It failed to distinguish between nominal and real interest rates, leading policymakers to believe policy was "easy" when nominal rates were low, even if deflation meant real rates were high.
• Misinterpretation of Excess Reserves: In the 1930s, large excess reserves were seen as "redundant" and a threat of future inflation, rather than a symptom of depressed demand or increased bank liquidity preference.
• Ignoring Money Supply: The focus remained on member bank borrowing and market interest rates, largely neglecting the broader money supply aggregates, which often provided a more accurate picture of monetary thrust.

8. The 1937-38 Recession: A Policy-Induced Downturn Driven by Fear of Inflation

The Federal Reserve’s error was the belief that excess reserves could be reduced without consequence.

Preemptive Strike Against Inflation. By 1936, the U.S. economy was recovering, and gold inflows had swelled bank reserves to unprecedented levels. Despite persistent unemployment and a price level still well below 1929, FRS officials, particularly Chairman Marriner Eccles, became convinced that these "superfluous" excess reserves posed a serious threat of future inflation. Driven by this fear, and armed with new powers from the Banking Act of 1935, the FRS decided to act preemptively.

Doubling Reserve Requirements. Between August 1936 and May 1937, the FRS doubled member bank reserve requirement ratios in three steps. This drastic action absorbed over $3 billion in reserves, a significant contractionary shock. Simultaneously, the Treasury initiated a gold sterilization policy, preventing new gold inflows from replenishing bank reserves. These combined monetary tightenings, coupled with a contractionary fiscal policy (reduced bonus payments and new Social Security taxes), abruptly halted the recovery.

Denial of Responsibility. The FRS, misled by its focus on low nominal interest rates, denied that its actions contributed to the ensuing severe recession. Real GNP plummeted by 18%, and industrial production by 32%. Policymakers, including Eccles, attributed the downturn to non-monetary factors like inventory accumulation or labor unrest, clinging to the belief that their policies had merely absorbed "redundant" reserves without consequence. This episode starkly illustrated how flawed theories and a misplaced fear of inflation could lead to devastating policy errors, even in the face of clear economic distress.

9. Post-War Independence: The Hard-Won Accord Freed the Fed from Treasury Control

For the first time since 1934, the Federal Reserve could look forward to conducting monetary actions without approval of the Treasury.

Wartime Subordination and Post-War Inertia. During World War II, the FRS willingly pegged interest rates to facilitate war finance, committing to a "pattern of rates" that capped long-term bond yields at 2.5% and short-term rates at 0.375%. After the war, the Treasury, concerned about the cost of servicing the massive national debt and potential market instability, insisted on maintaining these pegs. Despite rising inflation and internal dissent, the FRS remained largely subservient, with Chairman Eccles often prioritizing political harmony over monetary independence.

Growing Dissent and External Support. As post-war inflation persisted and the Korean War began, dissent within the FRS, particularly from FRBNY President Allan Sproul, grew stronger. Sproul argued forcefully for greater interest rate flexibility and an end to the pegs, recognizing their inflationary consequences. Crucially, the FRS began to garner external support:

• Congressional Hearings: Senator Paul Douglas's subcommittee hearings in 1949 provided a public platform for the FRS to articulate its concerns.
• Press Support: The financial press increasingly sided with the FRS, criticizing Treasury dominance.
• Korean War Inflation: The surge in prices after June 1950 highlighted the urgency of monetary restraint.

The Treasury-Federal Reserve Accord (1951). The escalating conflict culminated in a direct confrontation between the FRS and the Treasury, mediated by President Truman. After a period of intense negotiation and public dispute, the two institutions reached the Treasury-Federal Reserve Accord in March 1951. This landmark agreement formally ended the wartime interest rate pegs, allowing the FRS to pursue a more independent monetary policy. It marked a pivotal moment, restoring the FRS's autonomy and setting the stage for its modern role in macroeconomic stabilization.

10. Enduring Lessons: Repeated Errors Highlight the Persistence of Flawed Economic Theories

Monetary history reveals the fact that folly has frequently been paramount; for it describes many fateful mistakes. On the other hand, it would be too much to say that mankind has learned nothing from these mistakes.

A Cycle of Misinterpretation. The first thirty-seven years of the Federal Reserve's history are a testament to the powerful, often destructive, influence of prevailing economic theories and institutional inertia. From the real bills doctrine of the 1910s and 20s to the "liquidationist" views of the Great Depression and the "monetary impotence" arguments of the 1930s and 40s, flawed beliefs repeatedly led to procyclical policies, inaction during crises, and exacerbated economic downturns. The FRS often ignored clear signals from money growth and real interest rates, instead focusing on misleading indicators like nominal rates or the volume of bank borrowing.

The Difficulty of Learning. Despite experiencing severe recessions (1920-21, 1929-33, 1937-38) and periods of inflation, the FRS struggled to learn from its mistakes. Key lessons, such as the importance of acting as a lender of last resort, distinguishing real from nominal interest rates, and controlling the money supply, were often rediscovered or articulated by a few, only to be resisted by the majority. This resistance stemmed from deeply entrenched orthodoxies, internal power struggles, and a reluctance to admit policy errors or incur political costs.

Evolution, Not Perfection. By 1951, the FRS had evolved into a centralized central bank, shedding much of its original structure and gaining greater independence. However, the intellectual journey was far from complete. The period ended with a new set of challenges and a lingering belief in the secondary role of monetary policy, setting the stage for future debates and policy adjustments. The history underscores that while institutions can adapt, the influence of dominant, even flawed, economic theories can persist, shaping policy decisions for decades.

Last updated: September 18, 2025