America’s Money Machine

The nature of this “revolution,” it appeared, went beyond routine questions of the techniques to be employed in easing or tightening credit. It “involved a basic shift in the concept of monetary management.”

“The Federal Reserve,” the Times stated hopefully, “is now following a dynamic course, pursuing an aggressive policy of managing money.” This represented an about face from the “passive course followed in the nineteen fifties” when the Federal Reserve “all but abdicated its responsibility for monetary management.”

This passive role, it was explained, consisted of “self-imposed restrictions on open-market operations,” of reliance upon the discount function, and of disuse of member bank reserve requirements. These had now been abandoned in favor of a willingness to experiment with new techniques in response to changing conditions. “Now, for the first time,” said the Times, “flexible monetary policy is in operation.”

In detailing the specifics of the new dynamism, however, the Times account grew understandably vague. It reported that the Reserve had relaxed its “rigid technique for conducting open market operations, and could claim some measure of success for expanding the supply of credit and at the same time holding up short-term interest rates to defend the dollar.” It raised the discount rate—“the first time that it had been used to safeguard the international status of the dollar.” And it now engaged in extensive foreign currency operations, “another indication of its new look.” These seem to be the sum and substance of the “revolution” as reported by the Times.

A more accurate reflection of the status to which the Federal Reserve had fallen is found in the violent attacks upon it by Representative Wright Patman. Patman, a Texan from Texarkana (which straddles Arkansas and Texas) who had represented his Eastern Texas district in Congress since 1928, had been an ardent exponent of the Bryan cheap money school and, as his influence rose along with his seniority, became the leader of that persuasion. He favored lower interest rates, a greater abundance of circulating media, abundant and easy credit. As chairman of the House Banking and Currency Committee when the Democrats controlled the House, and senior minority member when the Republicans were in control, Patman was in a position to exert great influence and to some measure control legislation in this field.

His bills proposed a drastic diminution of the independence—such as it was—of the Federal Reserve System. They would abolish the System’s Open Market Committee and transfer its functions to the Reserve Board; enlarge the Board to twelve members with four-year terms, the twelfth member to be the Secretary of the Treasury and at the same time chairman of the Board; abolish the system whereby the member banks owned the stock of the Reserve banks, and theoretically determined their policies; require audits of the System by the General Accounting Office; and finally require the Federal Reserve to operate under annual Congressional appropriation. In short, the institution would be made dejure, as it was de facto, an arm of the Federal government. Two other bills would permit commercial banks to pay interest on demand deposits (forbidden since 1933 by the Banking Act of June 16, 1933), and would require the banks to pay interest to the Treasury on government deposits.

Despite the audacity and violence of this assault, the actual threat to Federal Reserve solvency came from another quarter—from old and until recently indigent friends, and from one ancient ally—the French Republic.

The German currency reform had occurred in June, 1948, before the impact of U. S. economic aid. The year before, as we have noted, the British attempt to restore the pound sterling had collapsed, with consequences felt throughout Europe. On September 18, 1949, the pound was devalued to a parity of $2.80 with the dollar.1 The pound continued to be a feeble currency, however, and in 1961, the United Kingdom was compelled to borrow $900 million from the United States and European countries. When this loan could not be repaid, the government was forced to borrow $1 1/2 billion from the International Monetary Fund and to obtain an additional $1/2 billion stand-by credit.2

In June, 1958, conditions in France had reached the state of revolutionary crisis that brought General Charles de Gaulle to power with the authority of a dictator and a mandate to draft a new Constitution. As with Bismarck, with Napoleon, with Constantine the Great, almost his first step in the reform of the state was the restoration of a sound currency. On December 29, under the guidance of the French economist Jacques Rueff, the franc was again revalued, from 420 to the dollar to 493.706 to the dollar, and at this point the franc was abolished in favor of a new franc equivalent to 100 of the former. The restoration of stable currency, the resolution of the Algerian war, and the firmness of the de Gaulle rule now produced a remarkable economic resurgence. Within five years France regained its historic position as the political and economic leader of Europe.

The French revival occurred along with the deterioration of the U. S. international position, which we have already charted, and was accompanied by a foreign policy of independence from, if not veiled hostility toward, the United States. From the days of the French Occupation, when de Gaulle was a young leader of the Free French forces, the proud and lofty Frenchman had never forgotten the cavalier treatment he had received from Churchill and Roosevelt; he continually referred to the “Anglo-Saxons” as an earlier age referred to the Mongols; he spoke frankly of the necessity of resisting “Anglo-Saxon imperialism” in Europe. He was the cause of rejection of the British from the European Common Market—an economic and quasi-political association of France, Germany, Italy, the Netherlands, Belgium and Luxembourg, that had been created in 1957 with American sponsorship and blessing.3 He reduced French support for the grand alliance forged by U. S.diplomacy, the North Atlantic Treaty Organization (NATO); and later offended U. S. sensibilities by entering into treaty relations with Red China, which was then abhorrent to American policy makers.

What permitted de Gaulle to indulge his independence and veiled hostility toward the U. S. and enfeeble any diplomatic counter-reaction was, paradoxically, the French power to dictate U. S. monetary policy, the result in turn of the strengthening of the French monetary position at U. S. expense and the corresponding weakness of the U. S. monetary position.

The Federal Reserve System held now less than $2.4 billion in free gold —that is, gold not required under the Federal Reserve Act to be held as reserve against note and deposit liabilities outstanding. Meantime, French holdings of dollars had risen to nearly $1 1/2 billion. It was uncomfortably apparent to all that the French were in a position to precipitate a dollar crisis merely by converting these dollars into gold and demanding delivery. That the French leadership was not averse to such tightening of the noose was made evident in 1963 by their refusal, which we have noted above, to accept U. S. Treasury obligations stated in French francs.

As the balance of payments deficit deepened and uneasiness spread abroad over the stability of the dollar, the Treasury in 1961 indicated its need for assistance from the International Monetary Fund, but as the Fund’s resources were depleted it was necessary to appeal to the principal powers.4 Out of this emerged the Committee of Ten 5 which reluctantly agreed to create “special borrowing arrangements” whereby a pool of $6 billion credit would be created (of which the U. S. share would be $2 billion), upon which the United States would have certain drawing privileges. Significantly, however, the restrictions (which were imposed at French insistence) were so severe, requiring for instance a two-thirds majority consent of the lenders, that the arrangement became a practical nullity, and the device was adopted, to which we have referred, of bilateral swap arrangements between the Federal Reserve and certain foreign central banks.

At the International Monetary Fund’s annual meeting in Vienna in 1961, the French finance minister, Wilfred Baumgartner, was caustically critical of U. S. fiscal policies, and foreshadowed a further withdrawal of French cooperation. It was recognized however that a complete break would bring down the house of Dagon upon the French as well, and that some support of the dollar was in order. The mechanism of cooperation became the Committee of Ten† which the French exercised a decisive voice and which appropriately met in Paris.

At the International Monetary Fund’s 1963 assembly the U. S. voice was considerably subdued, and Secretary Dillon, who a year before had disparaged any view that U. S. authorities could not keep their own financial house in order, indirectly conceded the need for aid. As a consequence several committees were created to study means of warding off the approaching crisis.

Meantime, as evidence of the frailty of the Federal Reserve structure, Congressman Abraham J. Multer introduced a bill in Congress in 1961 to remove the 25 per cent gold reserve requirement on Federal Reserve notes and deposits. This would release gold to meet foreign demands for conversion of dollars.

The fact is, of course, that when confidence is threatened no reserve requirement short of 100 per cent will meet the bill. No commercial creditor would lend money to a debtor who undertook to maintain assets to only a fraction of the amount lent, and no banker would make a demand loan to a borrower who could not show quick assets equivalent to, or greater than, the amount lent. Regrettably for the cause of sound money, influential schools of conservative monetary economists6 boxed themselves in and became ineffectual advocates by reason of their accepting the delusion of the fractional reserve theory.

Nevertheless, so strong then was the attachment to the fixed ratio reserve—or perhaps the general alarm over the state of the dollar—that Multer was compelled to drop his bill even before hearings by reason of the widespread protests that arose.

Following the British sterling crisis, the French government announced on January 7, 1965, that it would reduce its holdings of dollar exchange by converting an increasing amount into gold beginning with an initial purchase of $150 million. It indicated that within the year it would draw down possibly $1 billion in gold.

The effect was an ill-concealed panic in Washington fiscal circles. Already, the twelve Federal Reserve banks were making daily adjustments among themselves in order to maintain their minimum gold requirements, and on January 28 President Johnson asked Congress to repeal the gold reserve requirement against Federal Reserve deposit liabilities in order to free gold in defense of the dollar abroad.

Representative Patman now abandoned for the time being his crusade against the Federal Reserve, and after hurried one-day hearings, brought out, on February 1, a bill meeting the Administration wishes. Representative Patman had in reality no further need of his campaign. Whatever the appearances, the Federal Reserve System was completely captive to the Treasury, in turn captive to the State Department.

The bill was passed and became law on March 3, 1965. The System was now freed of the major restraint on the excessive creation of debt through Federal Reserve lending power; the other restraint, the gold reserve against note issue, would soon fall.

The consequences of this profound change, that accelerated to a crisis within the following decade, will now occupy our attention.

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7 Since the dollar had itself been devalued in 1934, the new pound represented $1.654 in terms of the 1914 dollar, compared with the parity at that time of $4.867.

8 In November, 1964, a further crisis occurred, compelling a spectacular, overnight rescue, led by the New York Federal Reserve Bank, in which 11 countries provided short-term credits totaling $3 billion.

9 Actually, an outgrowth of the Organization for European Economic Cooperation set up in 1948 to implement the Marshall Plan.

10 The Fund held on December 31, 1961, $2.1 billion in gold and $11.5 billion in member currencies, but these currencies were largely of the “soft” variety. Apart from dollars, the Fund held only $1.6 billion in hard (convertible) currencies. (Testimony of Secretary of the Treasury Douglas Dillion before the Senate Foreign Relations Committee, March 30, 1962. Hearings on H.R. 10162)

11 U. S., United Kingdom, Germany, France, Italy, Belgium, Netherlands, Canada, Sweden, and Japan.

12 Long headed by the Economists’ National Committee on Monetary Policy founded by Walter E. Spahr.

• 1Mrs. Fish’s social invasion of Washington may have been the result of the intimacy that existed between her husband and Roosevelt. It is important to recall this camaraderie in any attempt to understand the tangle of subsequent events. Both were New York aristocrats; both were Republicans; they had a common fondness for rural estate life; they had gone together on hunting trips to the South. It is reported that during the Fish residence in Washington, Roosevelt, who was accustomed to early morning canters in Rock Creek, would ride over to the house and shout up, “Stuy!” and when the railroad president came to the window would joke with him for a while before continuing his ride.
• 2Nevertheless, not all railroads were prosperous, and much of Harriman’s success lay in his careful husbandry of his properties and his superb railroading management. He was like a good householder. If he milked his cow, he also fed it well. No sooner had he acquired control of the Union Pacific than he began a large scale rebuilding of tracks and stations, and modernizing equipment. He continually travelled inspecting his properties. He paid particular attention to public relations. He cultivated new customers by offering inducements to industries to establish themselves on his routes. In the only magazine article he is known to have written, he gave his creed of railway management: “The railroad that does not seek to build up the territory through which it passes by offering good service, pursues a policy that will only bring it grief in the long run.” When the Colorado River left its banks and flooded the Imperial Valley of California in 1907, Harriman sent Southern Pacific engineers to the area and he personally directed the work of relief and rehabilitation. Before the control of the river was achieved, the Southern Pacific had invested $3 million in the effort.
• 3About the same time rumors drifted in another region of Manhattan of a falling out between Harriman and his long-time associate Stuyvesant Fish. Tongues wagged that Marian Fish had declined to sponsor the debut of Harriman’s daughter Mary, known more for her fondness for fox hunting in Virginia than for the Virginia reel in the ballrooms of New York.
• 4*New York Times, Oct. 24-26, 1913. There may have been an element of pique in Wilson’s reluctance to see Vanderlip. As a trustee of the Carnegie Foundation, Vanderlip had been one of a committee that had rejected Wilson’s application for a pension, and though Vanderlip had been in favor of the grant, he was accused of having gossiped about the matter to Wilson’s discredit.
• 5*The Comptroller of the Currency was also a member, but he kept to a passive role.
• 6†Head of the Mellon National Bank, and later to become “the greatest Secretary of the Treasury since Alexander Hamilton.”
• 7Theodore Roosevelt returned from a year of big game hunting in Africa and a triumphal tour in Europe to find again an opprtunity and a demand for his political talents. Drawn by an appeal to public service, and perhaps to a considerable degree by ambition,* he began to angle for the leadership of the insurgent wing. In a speech at Osawatomie, Kansas, on August 31, 1910, on “The New Nationalism” he backed the Supreme Court’s attitude toward social legislation and announced the political doctrine “that every man holds his property subject to the general right of the community to regulate its use to whatever degree the public welfare may require it.”
• 8Wilson came into office under considerable popular momentum toward centralization of government. Ten days before his inauguration the Sixteenth Amendment to the Constitution, which had been proposed only three years before, was finally ratified and declared in effect. This revolutionary fiscal measure, authorizing a tax on incomes, vested in the Federal government almost unlimited taxing power and gave it the financial means by which it could dominate and eventually overwhelm the state governments. On February 28, 1913, the Pujo Committee investigation into the “money trust,” which had been authorized the February before,* reported an unwholesome concentration of money and credit through bank consolidations, company mergers, interlocking directorates, security syndicates, and increased banker representation on the boards of insurance companies, railroads, public utilities and industrial corporations.
• 9Following the passage of power to the Democratic Administration, the principal protagonists of currency legislation the Congress were Carter Glass, chairman of the House Banking and Currency Committee, and Robert L. Owen, chairman of the corresponding Senate committee, along with academic figures like H. Parker Willis (who served as an assistant to Glass) and A. Piatt Andrew, who had served as special assistant to the National Monetary Commission.* William Gibbs McAdoo, a New York lawyer, had been named Secretary of the Treasury and the spokesman of the Administration on monetary matters.
• 10Nine of the twelve Committee members indicated their approval of the Vanderlip plan, but as the House was effectively under Presidential domination, enthusiasm cooled when Wilson issued a statement reiterating his warm endorsement of the pending bill. At the same time he declined to receive Vanderlip and Henry P. Davison at the White House, on the ground that banking was a subject with which he was not familiar.*
• 11HISTORY ALLOWED THE ADMINISTRATION Seven months to construct its new financial ark before the deluge of the First World War. The immediate task was purely political—where to locate the regional reserve banks provided by the Act. The Reserve Bank Organization Committee, which meant, in short, Secretary of the Treasury William Gibbs McAdoo and Secretary of Agriculture David F. Houston,* was provided with $100,000 for its investigations.
• 12The two officials fitted out a special car, organized a corps of secretaries, and right after the New Year began a country wide tour to study the advantages and disadvantages of each proposed reserve center. Hearings were held in eighteen cities and concluded on February 18. Over two hundred cities requested that their claims be heard. Certain decisions were foreordained. The influence of New York City would be cut down by lopping off New England and creating a reserve bank in Boston and another in Philadelphia. Pittsburghers, led by Andrew Mellon, † protested loudly at being neglected, urging the importance of their city as the center of the steel industry. Baltimore was disappointed to lose out to Richmond, Va., but this was inevitable considering Carter Glass’s origins.