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You imply spreading the Gospel makes the world a better place. It does not. Nor is this what Christ intended.
-- Brother Dave - CTS Forums
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Exclusive: Toward a Preterist Understanding of Economics—Part 5
Posted on Friday, August 12 @ 05:38:23 PDT by John Evans |
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by John Evans
In this article, I examine some important aspects of the American banking system since 1932 and highlight key features of U.S. monetary policy since that time. In looking at monetary policy, I focus upon the operation of the Federal Reserve System (the “Fed”), which carries most of the responsibility for the conduct of monetary policy in the United States...
...by monetary policy, I have in mind the management of the nation’s money supply so as to achieve the fundamental objectives of a high level of employment and the degree of stability in the price level that the nation regards as optimal. Because the management of the nation’s money supply necessarily entails actions that affect interest rates, I add that the conduct of monetary policy is inextricably intertwined with concern over interest rates as well. I regret that the article is as long as it is, but I could not accomplish what I felt I needed to do without sacrificing information that I regard as vital to an understanding of the subject at hand.
Although monetary policy is primarily the responsibility of the Fed, the U.S. Treasury also plays a significant role. The Treasury, it should be understood, is an agency of the executive branch of government while the Fed is largely independent of presidential control. The Secretary of the Treasury serves at the pleasure of the President of the United States, but because of the length of the terms of the seven members of the Board of Governors of the Federal Reserve System (fourteen years), a sitting President has only limited control over the Board’s composition. Complicating matters is the fact that the President does get to pick a member of the Board to serve as its Chairman, but while the chairmanship is a powerful position, the Chairman casts only one of seven votes in the policy decisions made by the Board and only one of twelve on the Federal Open Market Committee (FOMC), whose work I shall briefly describe later.
In understanding the Treasury’s role in monetary policy, it helps to keep in mind that the Fed serves as the Treasury’s fiscal agent and that when the Treasury spends, it generally does so by writing checks on its funds in the Federal Reserve banks. Also keep in mind that the Treasury keeps funds in many commercial banks scattered throughout the nation. Thus, when the Treasury transfers funds that it has on deposit with commercial banks to the Federal Reserve banks, bank reserves decrease because the Federal Reserve banks reduce the reserve accounts of member banks to the extent that they increase the deposits of the Treasury. The money supply then tends to decrease. When the Treasury writes checks on its funds in the Federal Reserve banks, the recipients of those checks generally deposit them in commercial banks, who receive increases in their reserve accounts. The money supply then tends to expand.
In my view, there are four ways in which the Treasury significantly affects the U.S. money supply. First, the Treasury’s allocation of its deposits of funds between commercial banks and the Federal Reserve banks has a monetary impact. Second, in its management of the national debt and its borrowing of funds on behalf of the federal government, the Treasury exerts an impact on the factors that influence the Fed’s conduct of monetary policy. Third, since the monetary impact of Treasury actions can conflict with actions taken by the Fed, the Treasury exercises some impact upon the Fed through the compromises that are negotiated between the two agencies. Fourth, the Treasury is responsible for managing the value of the dollar against foreign currencies; i.e. it conducts exchange rate policy, and how it does so has monetary effects. For example, if the Treasury decides to strengthen the dollar by selling some of its holdings of foreign currencies, it can order the Fed in its capacity as the government’s fiscal agent to carry out the desired intervention in the foreign exchange market. When foreign currencies are sold, for reasons whose complications I shall avoid explaining here, the monetary impact in the United States tends to be a reduction in bank reserves and the money supply. On the other hand, when the Treasury buys foreign currencies, or orders the Fed to do so, the U.S. money supply tends to expand.
Obviously, monetary policy and history are very complicated subjects. I shall touch only lightly upon them in the course of the next few pages. I hope that the historical summary that I offer here will be of value to some of the visitors to this site. In my next article on economics, I shall take up the subject of debt, including the national debt.
Immediately after the election of 1932, which provided Franklin Roosevelt and the Democrats with a huge victory over the hapless Republicans, the nation entered into the worst banking crisis in its history. Approximately 4,000 banks failed in 1933 prior to Roosevelt’s inauguration on March 6 of that year. To the already gloomy prospects for the economy confronting President-elect Roosevelt were added the impact of uncertainty about what direction economic policy would take and the impact of rumors that he intended to devalue the dollar by raising the price of gold. For the first time since the depression had begun, the American public began the large-scale conversion of bank deposits, Federal Reserve Notes, and other forms of paper money into gold.
On the day of his inauguration, Roosevelt declared a national bank holiday requiring banks to shut their doors so as to buy time to get their financial houses in order. On March 9, Roosevelt signed the Emergency Banking Act, which authorized the President and the Secretary of the Treasury to take the nation off the gold standard and set the conditions under which member banks of the Federal Reserve System would be allowed to resume operations. It also authorized the Federal Reserve banks, for a period not to exceed two years, to lend to member banks at interest rates at least 1 percent above their discount rates on whatever collateral they deemed acceptable. Moreover, it authorized the Federal Reserve banks to lend directly to business firms for periods of up to 90 days using obligations of the U.S. Government as collateral. In other words, the Emergency Banking Act cleared the way for the Fed to serve as the economy’s “lender of last resort” so as to restore confidence and facilitate economic recovery. By the beginning of April, many banks had been allowed to reopen and the bank panic had subsided.
Roosevelt wasted little time in taking the nation off the traditional gold standard. On April 5, 1933, he issued an executive order making it illegal for U.S. citizens to own gold coins, gold bullion, or gold certificate paper money, and he outlawed the export of gold except under license from the Treasury. The government established a daily price for gold that, I believe, stayed below $30 per ounce for the rest of the year. Then, in January 1934, the Gold Reserve Act was passed, whose most important provision was the establishment of a fixed price of $35 per ounce at which the Treasury would buy and sell gold. Foreign governments were to be allowed to convert their holdings of dollars into gold at this price, and U.S. citizens who had not yet sold their gold to the government were ordered to do so at this price. The Gold Reserve Act required the twelve Federal Reserve banks to turn their gold holdings over to the Treasury in exchange for a new type of “gold certificate” that the twelve Reserve banks were to use as backing for Federal Reserve Notes and their deposit liabilities.
It is common to read that Roosevelt took the nation off the gold standard in 1933-34, but this is not quite accurate. The dollar was still tied to gold internationally, and the note and deposit liabilities of the Federal Reserve banks were still technically tied to gold by the requirement to hold gold certificates as reserves. U.S. citizens could not legally hoard gold, however, and the private gold market was eliminated. The increase in the price of gold from $20.67 to $35 per ounce provided the U.S. Government with a hefty profit of over $3 billion because it increased the dollar value of its gold holdings.
While I carry no torch for the gold standard and, in fact, regard it as an archaic monetary system, I also regard Roosevelt’s devaluation of the dollar as a huge mistake. When a nation devalues its currency against the currencies of other nations, as Roosevelt did in 1934, it almost always does so because it is having difficulty maintaining its currency’s value and is threatened with the loss of its international reserves (possibly gold, but these days mainly freely tradable foreign currencies). In 1934, however, the dollar was still a strong currency internationally and the United States did not have what economists call a significant balance of payments deficit with the rest of the world.
Roosevelt’s decision to devalue the dollar was in the “great” tradition of protectionist Republicans in the 1920s that culminated in the appallingly misguided enactment of the Smoot-Hawley Tariff Act of 1930. It forced other nations to devalue their currencies and resort to measures, such as imposing exchange controls and raising tariffs, which added further damage to the already devastated system of international trade and capital flows. In combination with political turmoil in Europe and Asia, it did succeed in bringing most of the world’s gold to the United States, where it was stored in the vaults of Fort Knox and the Federal Reserve Bank of New York. Billions of dollars that might otherwise have been spent productively were spent instead to finance the acquisition of this vast treasure. In return for this expenditure, we acquired a metal that had been dug at great expense out of holes in the ground in order to store it in other holes in the ground. Since the government’s price of gold remained fixed at $35 per ounce until 1971, any return that the nation received on its investment during the intervening thirty-seven years was primarily in the form of whatever stimulus to the economy our gold policy brought with it. Less tangibly, knowing that the gold was there undoubtedly made some people feel better, and as long as gold continued to play an important role in international monetary affairs, our possession of so much of it increased the nation’s influence. Such gains must be balanced against the fact that any gains we derived from the increase in the price of gold came largely at the expense of other nations.
It is true that the “golden avalanche” from the rest of the world into the hands of the U.S. Government contributed to a much-needed expansion of the U.S. money supply. That expansion could have been accomplished, however, without the gold inflows. As it was, however, the Treasury “sterilized” a good part of the potential monetary impact of the gold inflows by increasing its funds on deposit with the Federal Reserve banks. That action, in combination with disastrous increases in member banks’ reserve requirements in 1936 and 1937, helped restrain the growth in the money supply sufficiently so that even as late as 1940, the U.S. price level was considerably lower than it had been in 1929 and the level of unemployment was higher.
Roosevelt evidently raised the price of gold because he bought into a crackpot economic theory that a rapid increase in the price level would follow dollar devaluation and bring with it an accelerated economic recovery. It is true that devaluations of currencies tend to be inflationary, and I have personally witnessed cases (Mexico, 1976, 1982) where currency devaluation sparked rapid inflation. In the United States in 1934, however, there was no chance that a dollar devaluation that raised the price of gold by over 69 percent (and lowered the gold content of the dollar by almost 41 percent) was going to bring about a commensurate rise in the price level—and if the U.S. price level had risen by anything like 69 percent, all hopes for economic recovery would have been dashed. An economic recovery tends to lead to at least a modest rise in the price level, but a sharp rise in the price level at the nadir of a depression is not going to promote a recovery.
The first term of Roosevelt’s “New Deal” included additional legislation impacting the American banking system, most notably the Banking Act of 1933 (also known as the Glass-Steagall Act of 1933) and the Banking Act of 1935. Whether the net effect of this legislation has proven to be beneficial over time is open to debate on various points. It is undeniable, however, that it brought about a greater centralization of the Fed’s control over the U.S. monetary system. Sadly, the monetary authorities initially botched the job that was turned over to them, thereby helping to further prolong the depression, and they had a very mixed record of performance for many years after the depression ended. I tend to give them high marks, however, for the period from 1979 to the present.
The most consequential impact of the Banking Act of 1933 (Glass-Steagall) was the separation of domestic commercial banking from the securities business that it effected. Many members of Congress had become convinced that the lack of separation between these fields had led to rampant speculative excesses and facilitated outright fraud, and that these abuses were a major cause of the depression. That there were serious financial abuses is a matter of historical record. They supplied the journalistic establishment with an abundance of sensational material that sold newspapers and magazines and helped convince many members of the public that their economic misery had been brought about by crooked financial manipulators and the “malefactors of great wealth.” In reality, however, that the linkages between commercial banking activity and the securities industry were a prime cause of the depression is highly questionable. Furthermore, the banking industry was tending to move away from its traditional focus on short-term commercial loans, and the net effect of the integration of banking with the securities industry was economically beneficial. In any event, it became clear with the passage of time that the restrictions imposed by the Glass-Steagall Act of 1933 upon the involvement of banks with securities had become excessive and were probably so at the outset. Bit-by-bit, therefore, Congress, the Fed, and other regulatory agencies chipped away at Glass-Steagall, and it was finally repealed in 1999.
The Glass-Steagall Act of 1933 also provided for the establishment of a system of deposit insurance and the centralization of the authority for the conduct of open market operations. These parts of Glass-Steagall were substantially modified by the Banking Act of 1935 and later legislation. Also noteworthy about Glass-Steagall is that it embodied the belief that a major contributing cause of the bank failures of the past had been that there was too much competition (!) in the banking industry. Accordingly, it prohibited banks from paying interest on demand deposits and authorized the Federal Reserve Board to set the maximum interest rates that could be paid on time deposits (including savings accounts).
The Federal Deposit Insurance Corporation (FDIC), which was created by the banking legislation of 1933 and 1935, is, of course, still with us today. It has proven to be very popular, yet there have always been financial experts who have had serious reservations about the federal government’s approach to deposit insurance. One can object to it on equity grounds by arguing that the insurance assessments have been levied in such a way as to force sound financial institutions to subsidize weaker ones, but it does relieve depositors who have less than the insured maximum on deposit from the worry that they may incur loss if a bank fails. That our deposit insurance system has the effect of increasing the overall riskiness with which banking activity is conducted seems to me, however, to be an inescapable conclusion.
That generous extensions of federally provided deposit insurance can be highly dangerous is amply attested by the collapse of the saving and loan industry in the 1980s, which resulted in losses to the federal government through the collapse of the Federal Savings and Loan Insurance Corporation (FSLIC), the saving and loan industry’s equivalent to the FDIC, of over $175 billion. That deficit had to be made good by the federal government. This is not the time and place to analyze the savings and loan debacle, but I assure the reader that it is a wonderful demonstration of what can happen when political considerations and excessive government meddling ride roughshod over sound economic principles. Fortunately, the American commercial banking industry is far more diversified and resilient than the saving and loan industry was.
The Federal Reserve Act of 1913 authorized the individual Reserve banks to engage in open market operations involving the purchase or sale of U.S. Government securities. As I pointed out in Part 4 of this series, however, the inability of the Reserve banks to follow a coordinated open market policy contributed to the discontinuance of a promising program of open market purchases of government securities in July 1932. In light of this experience and other demonstrations of the need for the coordination of open market operations, the banking legislation of 1933 and 1935 created the Federal Open Market Committee (FOMC) to solve the coordination problem. Within a decade, open market operations directed by the FOMC became the Fed’s primary tool for the management of the nation’s money supply, and they have continued to play that role ever since.
From the outset, the FOMC has consisted of twelve members. As provided by the Banking Act of 1935, seven of the twelve are the members of the Board of Governors (formerly known as the Federal Reserve Board), and the other five are Reserve bank presidents. Originally, the five presidents were chosen on a rotating basis from all twelve Reserve banks, but because it came to be realized that open market operations could be conducted more effectively if they were handled by the Federal Reserve Bank of New York (FRBNY), legislation was passed in 1942 that makes the President of that bank a permanent member of the FOMC. The other four positions are rotated among the eleven remaining Reserve bank presidents, and the Chairman of the FOMC is also the Chairman of the Board of Governors. The net purchases of U.S. government securities by the FRBNY are allocated among all twelve banks.
The FOMC now meets about ten times per year in Washington, D.C. It establishes the general guidelines for open market operations that are to be followed by the FRBNY until the next meeting. The Chairman of the FOMC/Board of Governors checks frequently with the trading desk of the FRBNY to see how matters are progressing. Although the FRBNY both buys and sells government securities, it tends, of course, to be a net buyer since the money supply is generally expanding. When the FRBNY buys government securities from security dealers in the open market, the dealers deposit the funds they receive in New York banks, which then collect payment from the FRBNY by having their reserve accounts with it increased. The banks that receive the funds can then transfer funds to affiliated banks in other parts of the country or expand their loans and investments based on their reserve increases. In a short time, the increase in bank reserves spreads uniformly over the country, and the nation’s money supply increases by a multiple of the increase in reserves. Given the quantity of the new reserves, the amount by which the money supply increases depends upon the reserve requirements to which banks are subject; how the increased supply of money is allocated among demand deposits, time deposits, and increases in currency in circulation; and the quantity of excess reserves that banks decide to hold.
In principle, rather than rely upon this cumbersome procedure for increasing the nation’s money supply, we could simply have the Treasury print money and spend it. The recipients of this paper money would then (probably) deposit most of it in banks, thereby increasing banks’ reserves (since vault cash can now be counted in meeting reserve requirements). Most of the currency thus deposited would, no doubt, be sent to the Federal Reserve banks for deposit credit there, which would also be bank reserves. The idea of allowing the Treasury to finance some of its expenditures by simply printing money instead of borrowing by selling securities would, no doubt, give rise to rampant political demagoguery, which is why we are unlikely to simplify matters by doing it anytime soon. Obviously, of course, sharp limits would have to be placed upon the Treasury’s ability to finance government expenditures via the printing press.
A curious aspect of open market operations is that because of them, the Federal Reserve banks tend to make substantial profits even though they were not originally designed with the idea of enriching their stockholders, the member banks. There is no great mystery here since any of us could get by very comfortably indeed if we had the power to buy an ample quantity of U.S. Treasury securities at very little cost to ourselves. The member banks receive a six percent cumulative dividend on their stock in the Federal Reserve banks of their respective districts, and the earnings above that level are turned over to the U.S. Treasury, which was the primary source of the earnings in the first place.
Now back to the legislation of the 1930s. The Banking Act of 1935 created the position of Reserve Bank President for each of the twelve banks. This individual was to be chosen by the nine directors of each bank for a five-year term, subject to the approval of the Board of Governors. Previously, each Reserve bank had dual executive leadership with both a chairman and a governor. This, of course, had led to much confusion about who was in charge of what.
The change of the name of the Federal Reserve Board to the Board of Governors of the Federal Reserve System in the Banking Act of 1935 reflected important changes in that body’s composition, terms in office, and powers. Like the Federal Reserve Board, the Board of Governors was to consist of seven members, but the Secretary of the Treasury and the Comptroller of the Currency were no longer to be among them. As before, no two members of the Board could come from the same Federal Reserve District, but the terms were lengthened from ten years to fourteen, and it was provided that no member could serve more than one full term. Not ruled out, however, was the possibility that a member of the Board could serve for more than fourteen years if there was an unfilled position on the Board as a result of a death or a resignation. This explains why Alan Greenspan, who was appointed to the Board in 1987 to fill an opening resulting from a retirement, is to continue to serve on it until 2006. It is common, incidentally, for members of the Board to resign before completing their terms, a major reason for this being that they can earn much larger incomes in private employment based on their experience and connections. Greenspan, however, gave up a position in which he earned millions of dollars annually as head of a leading consulting firm in order to serve the nation at a modest salary.
The independence of the Board of Governors from the Treasury Department was increased by the removal from the Board of the Secretary of the Treasury and the Comptroller of the Currency. Incidentally, before 1937, the Board met in the Treasury building. With the passage of the Banking Act of 1935 it was decided to install the Board in a new headquarters building. This physical separation no doubt contributed in an intangible way to an increase in the Board’s independence.
Among the changes in the Board’s powers in the Banking Act of 1935, the most eye-catching was the power it received to alter the reserve requirements of member banks. Specifically, the Board was empowered to raise the existing requirements of member banks by as much as 100 percent. Unfortunately, having become alarmed about the possibility of inflation as a consequence of the enormous increases in banks’ reserves since the passage of the Gold Reserve Act of 1934, the Board elected to take full advantage of this new power, and it proceeded to double the reserve requirements of member banks in three stages, beginning on August 16, 1936 and ending on May 1, 1937. These increases were followed by a 6 percent decline in real output from the middle of 1937 to the middle of 1938. Reserve requirements were reduced somewhat in April 1938, but going into World War II, they remained well above their 1935 levels. With the benefit of hindsight, it seems doubtful that they should have been raised above the levels that were set in 1917: 7 percent on demand deposits for country banks, 10 percent for reserve city banks, and 13 percent for central reserve city banks, plus 3 percent for all banks on time deposits. Under the conditions that existed in the latter half of the 1930s, bankers generally wanted to hold substantially more reserves than they were required to hold. Moreover, there was so much slack in the economy in the form of idle and underemployed resources that a very large expansion of economic activity would have been possible without generating a high inflation rate.
The reserve requirement increases and the economic downturn 1937-38 coincided fairly closely with various tax hikes that undoubtedly reinforced their negative impact. In particular, the Revenue Act of 1935 introduced changes in income taxes, the estate tax, and excise taxes that were openly advertised as highly desirable “soak the rich” actions. The Social Security Act was also passed in that year, and the first payroll taxes introduced under it were collected in January 1937. That these measures made business firms, whether single proprietorships, partnerships, or corporations, less creditworthy is difficult to deny with any plausibility.
In understanding the issues involved in evaluating reserve requirements, we must keep in mind that prudent practice mandates that banks hold reserves beyond their ordinary need for vault cash in order meet unusually large claims against them arising from demands for cash and adverse clearing balances due to other banks. During the 1930s, member banks were permitted to count only their deposit balances with their Federal Reserve banks as legal reserves; i.e. reserves that met the Fed’s reserve requirements. Bankers’ attitudes about the immediate future were generally pessimistic, and economic uncertainty was rampant. Moreover, when the chips were down during the years 1930-32 and banks had badly needed the Fed to come to their rescue as the “lender of last resort,” they had been badly disappointed. In these circumstances, bankers wanted to hold reserves well in excess of what they were required to hold. If they had not wanted to hold them, they could have bought government securities and at least earned something with funds that were returning them nothing. They were returning them nothing because the Fed paid no interest on member banks’ deposits with their Federal Reserve banks—and still does not. In short, when the Board of Governors doubled reserve requirements in 1936-37, it acted to confront a danger that did not exist.
There have been numerous changes in reserve requirements since the 1930s, but I shall skip very lightly over them. Beginning in 1959, the Fed phased in the counting of vault cash in meeting reserve requirements. In the late 1960s, the Fed began moving away from the archaic threefold classification of banks based on city size. In its place it developed a system of graduated reserve requirements based on banks’ total deposits. The Monetary Control Act of 1980 gave the Board of Governors the authority to set reserve requirements for banks that are not members of the Federal Reserve System. On the whole, the trend in reserve requirements since 1951 has been decidedly downward. At present, the first $7.0 million of a bank’s “net transaction accounts” (net balances which can be used for payments) are exempt from reserve requirements; a 3 percent requirement is used for the range between $7.0 million and $47.6 million; and a 10 percent reserve requirement exists above $47.6 million. Time deposits are currently exempt from reserve requirements, though the Board could impose them. In any event, except for an annual adjustment in the ranges to which the 3 percent and 10 percent requirements are applied, changes in reserve requirements have become infrequent.
With the benefit of experience, we can now see that a major structural weakness of the American banking system was the very limited existence of branch banking. The legislation of the 1930s dealt with this problem, but only to a minor degree. The legislative timidity of the federal government in this area embodied a longstanding tradition that reflected American federalism, the popular fear in relatively rural areas that branch banking would allow the drainage of banks’ funds to large cities, and the fact that small, independent bankers carried tremendous political clout.
After the passage of the National Bank Act of 1864, the Comptroller of the Currency generally allowed national banks to follow the rules on branching in the states in which they were located. At the time, it was not an important issue because not many states allowed bank branches. By the beginning of the 1920s, however, the practical advantages of branches were leading to a noticeable growth in them among both national and state banks in the states that permitted branches to be established. In 1924, however, the Supreme Court ruled that national banks did not have an implied power to establish branches under existing legislation. This decision led to the McFadden Act of 1927, which provided that member banks of the Federal Reserve System, including state banks, could establish branches if they were authorized by state law, but branches could be established only in the same city as a bank’s main location.
An obvious defect of the McFadden Act—from the perspectives of economic efficiency, the Fed, and member banks—was that it placed member banks at a competitive disadvantage in those states—most notably California—that allowed statewide branch banking. Accordingly, the Glass-Steagall Act of 1933 allowed member banks, whether national or state, to establish branches within any state to the extent allowed by state law. After the passage of Glass-Steagall, matters were rather quiet on the branch banking front for two decades. Even the biggest banks were pretty much confined to having their banking offices in a single state.
To most foreigners who study American banking, the reluctance of both state and federal regulatory authorities in the United States to accept nationwide branch banking is curious. It is noteworthy, that Canada, which has long allowed nationwide branch banking, did not have a single bank failure during the Great Depression.
In due course, the larger banks found ways to get around most of the restrictions on branch banking. A favorite device was establishing a bank holding company that would have a controlling interest in banks operating within more than state. Legislative attempts were made, with some success, to delay and derail the process of creating a system in which big banks would be allowed to offer full banking services nationally. On the whole, however, the nation has inexorably moved toward nationwide banking. What we have now is a banking system with many relatively small banks and a considerable number of large banks that compete with each other nationally and regionally and with both smaller banks and specialized financial services firms of various types. State law still has some impact upon the nature and extent of branch banking activity within individual state boundaries, but from the practical standpoint, the United States now allows extensive interstate banking and banks are more diversified in their operations than they have ever been before. In my opinion, these are very good things.
Before finally touching lightly upon the highlights of the Fed’s conduct of monetary policy since the 1930s, I shall return briefly the Fed’s performance as the economy’s “lender of last resort.” Recall that early in this article, I pointed out that the Emergency Banking Act of 1933 authorized the Federal Reserve banks to lend to member banks on any collateral they deemed acceptable at interest rates higher than their regular discount rates and that it also authorized the Federal Reserve banks to lend directly to business firms for up to 90 days using U.S. Government securities as collateral. Subsequent banking legislation has kept the authority to lend on special terms to member banks intact, but the Fed has retreated from the area of direct lending to business firms without entirely giving up on the possibility.
In actuality, similar legislation to that described in the last paragraph had been enacted in 1932, while Hoover was still President. Moreover, it was also in 1932 that legislation was enacted that created the Reconstruction Finance Corporation (RFC), a federal agency whose function was to lend directly to business firms. In 1934, the Federal Reserve banks were authorized to make working capital loans to established industrial and commercial firms for periods as long as five years. In subsequent years, the Reserve banks made a modest volume of loans to non-banking business firms, but they were surpassed in this regard by the RFC, which offered more attractive terms. Considerable political effort was made until the 1950s to expand the Fed’s capacity to offer such “industrial” loans, but those efforts were turned back; and in 1958, legislation was passed that repealed Section 13(b) of the Federal Reserve Act, as amended in 1934, which had authorized working capital loans. In 1991, however, the FDIC Improvement Act authorized the Fed to lend directly to securities firms in an emergency situation.
In my judgment, by preventing direct industrial lending from becoming more important than it did during the 1930s and repealing the legislation authorizing such lending in the 1950s, the Fed dodged temptation and kept itself from getting involved in activity that would inevitably have encouraged undesirable political meddling in financial matters that should be worked out by private parties in a market-driven economy. With the 1991 legislation and the earlier legislation authorizing the Federal Reserve banks to lend to member banks on whatever collateral they deem acceptable, the Fed has the power to come to the aid of financial institutions in an emergency. This, I believe, is a good thing.
The economy finally emerged fully from the Great Depression with the nation’s entry into World War II. Taxes were increased substantially, but the rapid growth in government spending necessitated Treasury borrowing on an unprecedented scale. Interest rates were at very low levels going into the war, and the Fed quickly adopted a policy of keeping them there by making huge open market purchases of Treasury securities. General price controls were adopted to suppress inflation. When the war ended, the Treasury successfully pressured the Fed to keep the open market purchases going in order to minimize the cost of servicing the enormous national debt. In short order, the inflation rate sharply accelerated.
The absurdity of allowing inflation to run rampant as a consequence of large-scale open market purchases motivated by the desire to minimize the cost of servicing the national debt eventually drove the Board of Governors to reassert its independence from the Treasury. In March 1951, the Secretary of the Treasury and the Chairman of the Board of Governors reached the famous “Accord of 1951,” which released the Fed from its commitment to keep interest rates pegged at low levels in return for a commitment to try to keep market conditions “orderly.” Even without the Accord, however, it is doubtful that the Fed could long have prevented interest rates on Treasury securities from rising because of the upward pull on interest rates in the private sector. Lenders were not in business to lose money in real terms by lending at less than the inflation rate.
From March 1951 until October 1979, the Fed conducted monetary policy on a semi-independent basis. It frequently intervened to keep interest rates from rising too sharply, but the general trend of interest rates was upward, especially after the middle of the 1960s. A major reason for the long-term rise in interest rates was the insertion of an inflation premium into interest rates as the population realized that allowing inflation had become standard government policy and the expectation of a postwar depression receded.
In writing that inflation had become government policy, I do not mean that the government acknowledged that reality. To the contrary, officials at the highest level frequently denied that they were deliberately causing inflation and assured the nation that price stability was almost at hand. To some extent, I am convinced, they did this because they wanted to mislead the public. The federal government had become a very large debtor, and debtors gain from inflation—if the extent of it is unanticipated by lenders.
The government’s interest in promoting inflation did not stem solely from its desire to hold down the national debt. By and large, the architects of economic policy between 1945 and 1979 bought the theory that the simultaneous attainment of full employment and a stable price level was unlikely and that the optimal policy mix was one that combined full employment with a moderate inflation rate. Increasingly, however, it became clear that this theory was flawed and that the attempt to apply it was generating the combination of a higher inflation rate and a higher unemployment rate.
The “creeping” inflation of the period 1945-1979 was fueled in considerable part by politicians’ adherence to a misinterpretation of Keynesian macroeconomic theory. Writing during the depth of the Great Depression in 1936, John Maynard Keynes explained in lucid terms why it made sense for a government to run a substantial budgetary deficit when unemployment was rampant. He also indicated, however, that when prosperity reigned with a fully employed labor force, it made sense for the government to restrain inflationary pressures by running a budgetary surplus. Given the natural inclination of politicians to spend more money than government collects in revenue, Keynes’s endorsement of deficit spending was sweet music to politicians’ ears. So sweet it was, in fact, that the part about running surpluses in times of prosperity was forgotten. And so we wound up with a federal government that ran chronic budgetary deficits and then applied pressure on the Fed through the Treasury department to keep buying government securities so as to keep interest rates as low as possible.
By 1979, fueled in part by the OPEC-generated increases in the price of petroleum in the middle of the decade, the United States had reached a double-digit inflation rate with an uncomfortably high unemployment rate, and it became very difficult to defend what had been the prevailing economic orthodoxy with a straight face. The time had come for a sharp break with the economic policymaking of the past, and in the person of Paul Volcker, President of the FRBNY from 1975-79, and Chairman of the Board of Governors from 1979-1987, the Fed had the right person to do what was needed. In October 1979, the Fed declared its full independence (at last) from the Treasury and adopted a policy of targeting the achievement of a stable price level. Interest rates soared; the economy went into a steep recession; and the saving and loan crisis intruded its way into the public eye. Within a few years, however, the economy emerged in much sounder condition than before.
In my judgment, an often overlooked factor in explaining why there is less tolerance for “creeping” inflation than there was in earlier decades is the change in the age structure of the population. Debtors gain from unanticipated inflation and creditors lose. When voters who are net debtors greatly outnumber voters who are net creditors, politicians will lean toward pursuing inflationary policies because they perceive (perhaps wrongly) that such policies will keep them in office. During the twentieth century, we had many more debtors than creditors, and we generally had inflation. In the twenty-first century, however, things are changing. An aging population with more people dependent upon Social Security and pension arrangements is, ceteris paribus, less inflation tolerant than a younger population. Moreover, increasing numbers of workers are building up retirement nest eggs that give them an interest in keeping the inflation rate as low as is feasible.
But what about gold? Much earlier in this article, I referred to the fact that the Gold Reserve Act of 1934 required the Federal Reserve banks to hold gold certificates as reserves behind their note and deposit liabilities. These gold certificates were technically claims on gold held by the Treasury. The reserve percentages were 40 percent for Federal Reserve Notes and 35 percent for the Federal Reserve banks’ deposit liabilities to member banks. In theory, therefore, gold still played some role in restraining the growth of the money supply. In practice, things were quite different. From 1934 through World War II, the Federal Reserve banks had no problem meeting their reserve requirements. In 1945, by which time the Reserve banks’ gold certificate holdings were starting to be a problem, the required reserve percentages were reduced to 25 percent. Then, in 1968, the gold certificate reserve requirement was eliminated. Finally, in August 1971, Richard Nixon eliminated the government’s commitment to sell gold to foreign governments at $35 per ounce, thereby altogether severing the historic tie of the dollar to gold.
That completes the mission I undertook in the writing of this article. I hereby promise visitors to this site that I shall never write an article this long again in a single installment! For those with the patience to wade through this article, I express my hope that it has been a worthwhile experience for you. It reflects some of what I learned in more than forty years of teaching economics at the university level, and I am glad to have had the opportunity draw upon knowledge that I otherwise have no use for in retirement.
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John Evans is a columnist for PlanetPreterist.com. John is the author of The Four Kingdoms of Daniel and he is a retired professor of economics at the U. of Alabama at Tuscaloosa, and a dedicated student of preterism, especially of the book of Daniel.
View John Evans archives
Note: Opinions presented on PlanetPreterist.com or by PlanetPreterist.com columnists may not necessarily reflect the position of PlanetPreterist.com, or reflect the beliefs, doctrine or theological position of all other preterists. We encourage all readers to first and foremost carefully analyze all articles in the light of God's Word.
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Re: Toward a Preterist Understanding of Economics—Part 5 (Score: 1)
 by Virgil on Friday, August 12 @ 10:01:12 PDT
(User Info | Send a Message) | | John, this series you did was just fantastic! It made me realize how little I knew about U.S. economics, and especially about how intrusive the federal government is in the economy. It's amazing the stuff the got/get away with. Thanks for educating me John! :) |
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- by MiddleKnowledge on Saturday, August 13 @ 19:08:18 PDT
- by Virgil on Saturday, August 13 @ 19:14:04 PDT
Re: Toward a Preterist Understanding of Economics—Part 5 (Score: 1)
 by Windpressor (Giddi_one) on Wednesday, August 17 @ 23:18:22 PDT
(User Info | Send a Message) | I was finally able to read this series. If memory serves, this discourse predominantly addressed issues at the historical, pragmatic and regulatory levels. Did I miss significant mention of the constitutional constraints?
such as --
Article. I.
Section. 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.(emphasis added)
http://www.constitution.org/cs_money.htm
Has the U.S. Constitution been abrogated?
What IS a preterist understanding regarding the implications of de facto governance that appear to be obviously contrary to "the supreme law of the land"(Article VI)?
What is to prevent the conclusion that economics is little more than a study in the distributions of stolen property?
G1
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