Source: James K. Galbraith & William Darity, Jr., "Macroeconomics", p238- 245, 1994.

The powers of monetary policy, in the United States are vested in, the Federal Reserve, our central bank. In this special section, we provide an overview of the Federal Reserve System and of its relationship to the rest of the government and to the banking system.

The Federal Reserve, the' "bankers' bank," was created by an act of Congress in 1913 to help furnish an "elastic currency" to the nation and to serve as a "lender of last resort" to the banking system. The act was, in large measure, a response to the monetary crises of the late nineteenth and early twentieth centuries, in particular the financial panic of 1907. These events had led many U.S. observers to conclude that the gold standard, a strict version of which was then in force, was not a sufficiently flexible basis for a system of money and credit. Yet many also feared the powers that would accrue to a central bank, especially if that bank came too much under the thrall of the "hard money" men at the New York banks or if it became a political tool in the hands of the president. The structure , governance, and purposes, of the Federal Reserve thus reflected long national history of struggle over monetary matters, of popular distrust of central banking dating back to the time of Andrew Jackson, and of efforts to achieve financial stability without compromising the independence of private banking institutions.

To arrive at a compromise between these interests, Congress established a decentralized Federal Reserve System, dividing the country into twelve financial districts. Each district Federal Reserve Bank would be a semiprivate institution, "owned" by shareholding "member" banks and governed by a president and a board of directors nominated by the local community, including especially local bankers. District banks thus would feel a special commitment to stabilize the banks in their own regions and would act as a voice for regional concerns with the Federal Reserve in Washington, D.C. Each district bank would manage its own discount window and thus have the power to lend to banks within the district. Presiding over all would be, in Washington, a board of governors, appointed by the president and confirmed by the U. S. Senate. The seven governors would be appointed for fourteen year terms and thus be largely independent of the president of the moment. On the other hand, the agency would remain a "creature of Congress", subject to congressional mandate because Congress was, of course, the body that enacted and that retains the power to change the Federal Reserve Act.

Over the course of this century, actual power at the Federal Reserve has become concentrated in Washington. Perhaps the major turn in this direction occurred in the 1920s, when open market operations were devised as a means of exerting central control over a national market for bank reserves and over a nationwide rate of interest (the overnight rate on deposits that banks lend to and borrow from each other in order to meet their reserve requirements, known as the federal funds rate ). Open market operations the buying and selling of government bonds- are carried out by a desk at the New York Federal Reserve Bank, but open market policy has been, set in Washington by the Federal Open Market Committee since 1934. This policy making body the seven presidentially appointed Federal Reserve governors and, on a rotating basis, five of the twelve district bank presidents. The powers to set reserve requirements and discount rates and also to take many regulatory decisions are now, also vested in the board of governors in Washington. The district banks no longer exercise (if they ever did) much practical autonomy in major policy matters.

The Great Crash of 1929 provided a the first big test of the grand design of the nation's central bank. As thousands of bank failures and the Great Depression proved, the design was not especially effective. Although the Federal Reserve was quite able to provide interim discount loans to help individual that might that be in trouble, it was either unable or unwilling to provide the massive infusions of cash that became necessary when the entire banking system as a whole was thrown into crisis. As a result, bank runs and bank failures were epidemic from 1929 to 1933, and both the money supply and the economy itself collapsed. Only deposit insurance, a New Deal measure enacted in 1934 and embodied in the Federal Deposit Insurance Corporation (FDIC), proved able to restore confidence in the banking system as a whole.

These developments spawned an interesting and persistent controversy in the history of economics. Monetarists, led by Milton Friedman and Anna Schwartz, 1 have maintained that had the Federal Reserve been attempting to control the level of the money supply rather than interest rates, it would have been able to print enough money to forestall the banking collapse and the Depression itself. All the Federal Reserve needed to do in this interpretation, was to buy up outstanding debt from the private sector, there by flooding the economy with cash.

Keynesians, not surprisingly, resist, this conclusion. They argue that the Depression saw a large-scale collapse in, effective demand. Since people without jobs had no way of getting money, either as income or as loans, to finance their transactions, they would not have been helped by the creation of money per se. Therefore, any amount of money printing would have been largely futile unless accompanied by measures to distribute the printed money, as incomes, to the population. Such measures- whether jobs programs or welfare- of course are described as fiscal policy.

To support their position, Keynesians point to the experience of 1937-38. At that time, the Federal Reserve, by then itself under the influence of Keynesian ideas, attempted, to fight a deepening of the Depression by aggressively creating money and reducing interest rates. In the face of a sharply more restrictive fiscal policy, brought about by the, Roosevelt administration's attempt that year to balance the federal budget, the effort failed. Indeed, even though the interest rate fell almost to zero, the economy did not recover. U. S. Keynesians drew from this the lesson that an expansionary fiscal policy was essential; they coined the phrase "pushing on a string" to describe the ineffectiveness of expansionary Federal Reserve policy during a depression. 2

In 1942, the Federal Reserve was, in effect, "drafted" into the war effort and given the mission of ensuring that the price of U. S. government bonds be maintained at par- 100 cents on the dollar- for the duration. In practice, this meant that the Federal Reserve would have to buy government bonds from the public and create money to ensure that the long-term interest rate on government bonds did not rise above the then prevailing rate of about 2 percent.

Interestingly, this step was considered necessary in order to encourage saving at low interest rates. Policymakers believed that people would not put their money intogovernment bonds if the price of those bonds might fall if interest rates were to rise in the future. If that happened there would be a flight from bonds to money and from money to goods, which would bid up prices and generate runaway inflation. Thus an ironclad commitment to low and stable interest rates alongside an expansionary monetary policy and price controls, became part and parcel of the successful effort to hold down inflation wartime.

After the war and with the dismantling of price controls in 1946, the governors of the Federal Reserve wished to return open market operations to the conventional role of monetary control and macroeconomic stabilization. They did not achieve the power to do so until 1951, when the "Federal Reserve - Treasury Accord" permitted renewed movement of the government bond rate. From that point forward, monetary policy took the form it largely retains day.

As a legal matter, the Federal Reserve's mandate is to support the goals of the Employment Act of 1946, as amended by the Humphrey-Hawkins Full Act of 1978, which sets a national goal of full employment with reasonably stable prices. However, in enacting both of these measures, Congress refrained from specifying exactly how they achieved. The result has been that the Federal Reserve very substantial discretion over its conduct of monetary policy; in practice, the oversight powers of Congress are limited.

With some significant exceptions, the basic macroeconomic operating rule of the Federal Reserve since the 1950s has been to "lean against the prevailing wind" of the business cycle. That is, when the Board of Governors judges the prevailing threat to be inflation, interest rates are driven up and the growth rate of the economy is slowed down. When, as happened on five occasions since 1970, these actions resulted in an actual fall in gross domestic product (GDP)- a recession- then the Federal Reserve responded by easing policy, allowing interest rates to fall and therefore facilitating renewed economic expansion.

In the middle and late 1970s, an academic debate swirled around the question of whether the operating procedures of the Federal Open Market Committee, which emphasized the control of short-term interest rates, were compatible with the basic philosophy of leaning against the wind. In particular, monetarists argued that interest rate stabilization amounted to leaning into the wind. If the economy and the demand for money were growing rapidly, a policy of providing enough bank reserves to keep the federal funds rate stable would entail meeting all of the rising demand for money. In a recession, conversely, a policy of stabilizing the federal funds rate would mean that the Federal Reserve would "follow the economy down." While in principle the FOMC could change its interest rate targets up or down rapidly enough so that policy would be countercyclical in effect, monetarists argued that in practice it would fail to do so.

Moreover, even if officials did move quickly and presciently, the lags between the implementation of an expansionary or contractionary policy and its eventual effects were so long and variable that, as often as not, the effects would come too late. A policy intended to reverse a downturn by cutting interest rates would end up accelerating an inflationary expansion, and policies aimed at curbing inflation would end up making a recession worse. For all of these reasons, the monetarists said, a policy of stabilizing money growth would be much more effective, because it would tend, in their view, to prevent fluctuations of demand growth from occurring in the first place.

Federal Reserve officials, along with most theoretical Keynesians, doubted the monetarist argument for at least three practical reasons. First, they knew that the federal funds rate could be controlled precisely, day to day, by the means of open market operations; they also knew that the linkage from open market operations to money creation was not as precise. For one thing, whereas minute-to-minute information was available about what the federal funds rate was, money supply data were (and are) collected only on a weekly basis and were subject to revision in the following weeks. Thus, although interest rate control was an established art, money supply control might amount to chasing a moving target.

Second, the empirical definition of the money supply was (and remains) quite imprecise, and the monetarists themselves were divided as to whether M1 or M2 should be the object of control. If effective control of one aggregate were sought and achieved, critics could always object that the target should have been the other. Finally, Federal Reserve officials doubted that the relationship between money growth and GDP growth, or between money and prices, was as tight as monetarists believed. There arose among central bankers an aphorism known as Goodhart's law (named after a Bank of England economist), which holds that when you convert an econometric relationship into an instrument of policy, the relationship always changes.

Against these doubts, there emerged an unlikely coalition of theoretical monetarists, whose reasons for favoring monetary control have been described, and of liberals in Congress. This latter group had practical reasons of its own for favoring monetary targets. Leaders of the two banking committees, Henry Reuss in the House and William Proxmire in the Senate, were frustrated by the secrecy that surrounded the operations of the Federal Reserve. Congress could not get even routine information about what policy was. Congressional hearings with the Federal Reserve chairman (at that time, Arthur F. Burns) were notorious occasions for evasion and stonewalling, stoutly defended on the ground that giving out public information about future movements of the interest rate would lead to rampant speculation and financial disorder. Without information, Congress could not exercise even minimal oversight over monetary policy. And by 1975, in congressional eyes, monetary policy bore responsibility for two recent deep and painful recessions, with no effective cure for inflation and no end in sight.

The result was legislation known as House Concurrent Resolution 133, passed in early 1975. It required the chairman of the Federal Reserve Board to appear at regular intervals before Congress to present and explain the Federal Reserve's annual targets for the growth of the money supply. Within a short time, Congress also got the Federal Reserve to present its forecasts for the behavior of the economy itself: real growth, inflation, and unemployment. With this information, Congress could effectively discuss and, if need be, criticize the direction that monetary policy was planning to take.

The creation, announcement, and public discussion of annual monetary targets did not, of course, give Congress power to change those targets or to force thd Federal Reserve to meet them. And the Federal Reserve, having met the letter of the congressional mandate, routinely defied the spirit. High officials of the Federal Reserve were no more monetarist after H. Con. Res. 133 (or its incorporation into law in the Full Employment Act of 1978) than they had been before. Actual money growth rose above or fell below the announced targets, depending on the decisions of policyrnakers taken after the targets were announced, or on changes in underlying economic conditions.

In late 1979, however, the Federal Reserve found it convenient to adopt the monetarist label for purposes of its own. With the second oil shock, the inflation rate was running above 10 percent, and strong calls came from the financial community and elsewhere for decisive action to bring inflation down. In spring 1979, President Jimmy Carter had named Paul A. Volcker, a professional central banker of conservative credentials, as Chairman of the Federal Reserve Board. Volcker, though not himself a theoretical monetarist, determined to act.

On October 6, 1979, Volcker announced that monetary policy would no longer attempt to stabilize interest rates even in the short term; monetary control would be the order of the day. The results were dramatic: short-term interest rates rose to above 20 percent.

The recession of 1980 was caused by a combination of two factors: the tight monetary policies inaugurated in October 1979 and quantitative credit controls imposed briefly in March 1980. Of the two measures, credit controls probably had the greater effect. Abruptly, that spring, people simply stopped using their consumer credit cards, and the economy plunged into recession. When credit controls were lifted in the early summer, there was a rapid recovery.

In 1981, monetary policy put an end to the recovery, and with a vengeance. In March, under pressure from the newly installed Reagan administration, Chairman Volcker determined to tighten again. Money growth rates fell to zero and stayed there for six months, while the economy went into its steepest downturn since World War II. In vain a few congressional liberals protested that, under this purported monetarism, actual money growth was far below the announced monetary targets! In truth, the Federal Reserve was no more monetarist in the early 1980s than it had ever been; it merely found for a time that monetarist arguments could be used to justify a severe credit crunch, and resulting recession, when these were felt necessary to bring about a rapid end to inflation.

The crisis of the Federal Reserve's commitment to monetarism came in late summer 1982, when the recession reached bottom amid growing signs of a financial crisis. In August, Mexico announced that it could not pay its debts, and the country's largest banks, deeply embroiled in shaky loans to Latin America and elsewhere, seemed to teeter on the brink of collapse. The Federal Reserve's response was in keeping with its larger mandate to preserve the stability of the financial system. Monetarism was abandoned, the growth rate of the money supply exploded, and the economy and the financial system were brought back from the brink.

In the years after the 1982 debacle, the Federal Reserve moved away from paying even lip service to monetarism. It never, however, returned entirely to its former preoccupation with short-term interest rates. Rather, one gets the impression that the Federal Reserve moved in three different policy directions more or less at once, first it became more directly concerned with the movements of the macro economy and tried to stabilize the aggregate growth rate at a low level moving the interest rate down when the growth rate was too low or falling, raising it when real growth exceeded an annual rate of 3 or 4 percent. As the recession of 1991-1992 wore on, falling interest rates became the main weapon in the government's efforts to restore positive economic growth; by the end of 1992, short-term interest rates were at their lowest levels in twenty-seven years.

Second, the Federal Reserve became ever more conscious of the role of monetary policy in setting the exchange value of the dollar. At times when the concern with growth was not overriding, U.S. interest rate policy alternated between driving the dollar down (in the late 80s) and holding it up. Third, as savings and loan and banking instabilities grew more severe, the Federal Reserve, increasingly conducted monetary with an eye to reinforcing the stability and profitability of, its primary institutional clients, the large commercial banks. Where this tendency will lead us, in an era when bank instability is likely to get more serious rather than less, is anybody's guess.

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1. See M. Friedman and A. Schwartz, A Monetary History of the United States, (Chicago: University of Chicago Press, 1963).

2. This experience led Paul Samuelson to argue that the simple, one-variable 45-degree Keynesian cross diagram wasn't such a bad depression model after all. Investment was insensitive to falling interest, rates at this time- although another possible interpretation is that since prices were falling at the same time, real rates may not have fallen, very much.

3. These observations are based on James Galbraith's personal experience as a staff economists for the House Banking Committee between 1975 and 1980.

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