Between the Federal Reserve and the treasury, over financing the war. How would it be resolved . 1965, Lyndon Johnsons administration was spending on both a war and a Great Society without raising taxes. The fed was left to fight the resulting inflation alone. The nations central bank, originally created to protect the Banking System against panics, acquired more power to affect the economy than even it imagined at the outset. The Federal Reserve does money matter . With the help of economic analyst richard gill, well explore that question on economics usa. Im david schoumacher. Coins, bills, checks our basic money supply. The amount of money and where it goes wiin the Banking System has been the main concern of our nations central bank. At the feds headquarters here in washington, dc, closed deliberations are held by experts who continuously monitor our Financial Health and prescribe remedies. How did these experts prescribe a remedy that plunged us even deeper into the Great Depression . Early in the 20th century, american banks operated with little regulation and great vulnerability. In 1907, that vulnerability became apparent when depositors lost confidence and demanded their money. The banks couldnt get shortterm loans, and many colpsed. It took a powerful banker, j. P. Morgan, to end the 1907 panic. But should an entire country be dependent on an individuals whim . A central bank, a lender of last resort, seemed a better solution. Just before christmas of 1913, president wilson signed the Federal Reserve act. It created a Federal Reserve system. Though its real operating powers resided in 12 regionalanks, its official headquarters was in washington, d. C. Merritt sherman, active with the fed since 1926, describes one of its early tools to regulate banking activity the discount rate. That was the first tool used when the fed was created, the discount rate being the rate that is charged to member banks when they need to come in to get additional reserves. And it is raised to restrain their borrowing, lowered to encourage their borrowing. Through world war i, through the roaring twenties, most bankers believed the system was safe and went about their business. Then one day, it all came tumbling down. October 24, 1929, the greatest stock market crash in history marked the beginning of years of economic devastation. Banks failed by the thousands. The fed failed its major test. We asked economist Lester Chandler for an explanation. Professor chandler, the fed was set up to prevent Bank Failures and avoid depressions, all of which happened in the 1930s. What went wrong . Within the Federal Reserve system, nobody knew who was to do what where the Federal Reserve act was concerned. They had turned down the aldrich plan for one central bank with branches and adopted a system of 12 independent banks. On top of that they put a Federal Reserve board that was supposed to do something centrally, but they couldnt decide who was to do what. Ill put it this way. We didnt have very many central bankers in this country in 1914. Central banking was not a recognized profession. Fearful that the United States was not a safe harbor, Foreign Investors withdrew their gold deposits from american banks. In a short time, 30 million went overseas. We asked dr. Andrew brimmer, former member of the Federal Reserve, why gold alarmed the fed. Dr. Brimmer, in 1931, Foreign Investors were pulling their gold out of american banks. Reserves were being depleted. What does that do to a bank . What does the reserve do to try to combat it . For the Banking System as a whole, if theres a significant reduction in reserves, from whatever source, it has to cut back on loans and the extension of credit unless it can get some relief. Only the Federal Reserve, acting as a central bank, can provide more relief. So, in 1931, as the gold flowed to europe and so on, that was a loss in reserves the central bank had to make it up. The fed would not stand by. It raised its scountate to forceanks to increase the rate of inrest paid to depositors. The resultForeign Investors earned more interest and left their money in u. S. Banks. Th ended the gold drain. But raising thdiscount re had other, less fortunate, consequences. If the Federal Reserve raises the discount rate, that transmits a message to banks and the money market that it wants to be restrictive. For the economy as a whole, the result was disastrous. High Interest Rates discouraged borrowing, choking off business credit. More businesses failed, more jobs lost, and more banks collapsed. The country was pushed deeper into the Great Depression. Well, professor, if you graded the fed a, b, c, d, f what would it be in the 1930s . I would grade it as an f applying todays standards. Probably a d, applying even the standards the most advanced standards of that day. Sure, you can criticize the fed. It made mistakes. But what it did wrong was a matter of degree, mostly, rather than. Total mistakes of policy. The men who met around this table were some of the countrys most influential bankers. They were the Federal Reserves board of directors. When they met to change discount rates, they sent ripples across the nation. They were practicing a rudimentary form of Monetary Policy. They were affecting the money supply. How important was the money supply . Economist richard gill has an analysis. To understand this question, we need some sense of how the money supply affects the economys general workings and how the fed can affect the money supply. This diagram suggests the general nature of the answers to these questions. Theoretically, in a depression situation, the fed should increase reserves available to the commercial Banking System provide more reserves, as stated in the first box. The hope is that banks will lend more credit to businesses, thereby increasing the quantity of money in the economy. More money, in turn, should lead to more spending by businesses who have borrowed to invest in new machinery and factories, possibly also by consumers like ourselves. More spending, in turn, should lead to higher gnp and more jobs. It may also lead to higher prices, though that didnt seem a problem then. 1930s prices were generally falling. When the fed tried to stem the gold outflow by raising the discount rate in 1931, it was doing the opposite of what this analysis suggests. It made it more difficult for commercial banks to borrow, creating a negative effect on reserves. In fact, during those years of the depression, the countrys money supply shrank drastically. A number of economists today believe the feds misdirected policies were a major factor in turning an ordinary downturn into a Great Depression. We quickly add, however, that most economists in the years immediately following came to a different conclusion. They concluded that there was little the fed could have done, that these links suggested by the arrows in our diagram would snap in a serious depression. The fed might make more reserves available, but the banks might be scared to lend them and businesses too frightened to borrow. Even if more money were somehow created, people wouldnt spend it. They would hoard it, have a strong desire for liquidity in such treacherous times. Hence, more money might not mean more spending. But without more spending, the final link to raising gnp and employment would never come into play. In fact, for many years, Monetary Policy was generally in disrepute in this country, particularly when it came to curing business downturns. You can lead a horse to water, but you cant make him drink. Such was the common opinion. Our great new Federal Reserve system, like the economy it was supposed to defend, had come upon hard times. The banking act of 1935 gave the fed the authority it needed to use Monetary Policy to stabilize the economy. It also provided the fed with an important tool openmarket operations. Why, then, when the fed attempted to exercise its authority 15 years later, did they conflict with the treasury . Our union is asking its members to invest every dollar it can in these bonds. And with gods help and your dollars, well win this war. In world war ii, as part of its openmarket operations, the fed bought Treasury Bonds to help finance the war. Fed officials felt that providing that service was essential to victory. As we entered world war ii, the Federal Reserve undertook a commitment in january 1942 to support the market for government securities. It would buy and sell all the government securities anybody wanted to offer on the market to keep Interest Rates from rising. The fed bought bonds the treasury issued that the public didnt buy. Dr. Brimmer explains more on how openmarket operations affect the economy. Openmarket operations consist of purchase or sale of government securities. Purchases supply reserves. Sales reduce reserves. The reserves are the basis for expanding loans and therefore expanding money and credit. Very important activity. Pumping so much money into the economy did not lead to inflation because the economy had room to expand and because strict controls were imposed on wages and prices. After the allied victory, the treasury insisted on keeping the same arrangement, and the controversy began. The fed felt they were merely acting as the treasurys agent. It was unclear how long it would continue. As far as the conduct of Monetary Policy was concerned, the treasury straitjacketed the fed. Why were their interests in conflict . As the economy expanded after the war, the demand for credit rose. Banks found an opportunity to lend to private companies, individuals, and so on. Where will they get the reserves, the cash to do that . Sell your government securities. These were very lowyielding 2. 5 , 2. 75 interest. You could lend at 5 6 to private borrowers. So the banks, insurance companies, others, began to sell off government securities. The Federal Reserve was committed to buy them because of that legacy of war commitment. As it bought securities, it added to Bank Reserves. That gave the banks the basis for new lending. So the banks would lend, sell securities, get the deposits, make more loans. That was adding to an enormous expansion in the money supply and availability of bank credit. The Federal Reserve was afraid that such an expansion of money and credit would lead to inflation. Then, in june of 1950, fighting broke out in korea. A limited, but very costly war, it brought out the treasuryfed conflict. The treasury is part of the executive branch. The Federal Reserve is an independent agency, created by congress, with independence of the political pressures from the white house. In that sense, the treasury could not mandate instructions to the Federal Reserve. Chairman thomas p. Mccabe believed the feds role was to restrain inflation. Treasury secretary john snyder and president truman wanted the fed to help finance the war. President truman, in his memoirs, described the experience he had in 1917. He bought liberty bonds. He didnt know, and most people didnt know, that those liberty bonds, certainly the series he bought, went up and down with market prices. After the war, Interest Rates rose, bond prices fell, and many people had to sell bonds below what they paid for them. Truman never forgot that experience. He thought the government shouldnt cheat people. Truman called the federal Openmarket Committee to the white house for a tonguelashing. Never before had a president tried so directly to influence fed policy. There was so much misunderstanding on both sides that truman ordered a commission to study the matter. Rather than let a third party dictate a settlement, the fed and the treasury met on their own to find a solution, resulting in the accord of 1951. The Federal Reserve would be free to control money and credit without having to buy government securities. The treasury agreed to issue some nonmarketable bonds that carried a somewhat higher interest rate. As in any battle, there were casualties. Thomas p. Mccabe resigned under pressure from truman. He was replaced by William Mcchesney martin, a key negotiator of the accord and a treasury undersecretary. Following the accord, the fed was free to conduct monetary policies unhampered by treasury constraints. The fed had flexed its muscle and won. Using openmarket operations in the fifties, it proved to be very effective in combating inflation. The relationship with the treasury became more equal and symbiotic. For more on openmarket operations, we talked with richard gill. When the fed made openmarket puhases of government securities as it did prior to 1951, it was effectively increasing the reserves available to the commercial Banking System. And thus potentially making more money available to the economy in general. Heres how it works. The fed purchases, say, 1 billion of government bonds from the treasury. It pays for these bonds by adding 1 billion to the treasurys account. The treasury uses this to write checks to people who are providing services to the government. These private individuals deposit these checks in their own commercial banks. These deposits become part of these banks reserves. With these new reserves, banks can create more money. This is very much like printingpress money. The fed was saying at the time of the accord that this easy money policy may have been appropriate in the depression years, but was no longer appropriate to an economy showing definite inflationary tendencies. It was also serving notice that Monetary Policy mit not be so weak a tool as once imagined. We worked for two centuries to climb this peak of prosperity, but were only at the beginning of the road to the Great Society. Great society notwithstanding, there was also the matter of fighting a little war in a place called vietnam. This is the memorial to that war, an undeclared war whose full cost was kept secret even from the president s own economic advisers. It posed a challenge for the fed. Could Monetary Policy alone harness the runaway inflation caused by gunsandbutter spending . A gunsandbutter war meant we would try fighting abroad without any major sacrifice of social programs at home. War spending spurred the economy even higher. Factories reached full capacity. Labor was in demand and could command higher wages. Here were sown the seeds of inflation. I believe we can continue the Great Society while we fight in vietnam. The military chiefs were asking for more money. Yet president johnson rejected a tax increase. We asked his economic adviser, james duesenberry, why. We had, after all, just gone through a big program of tax reduction, so that turning around did not appeal to him. But i think a more significant matter was that it brought the issue of the vietnam war into a very sharp political focus. William mcchesney martin, then chairman of the Federal Reserve, had very good contacts with the pentagon and with the defense producers. And through the Federal Reserve system, those directors and branches all around the country, the information was pouring in, showing that the economy was heating up. To martin, inflation was more than a distant threat. It was a present reality. The Federal Reserve board decided to fight it. In december 1965, they raised the discount rate. Johnson hit the ceiling. He announced publicly he would call bill martin, the chairman of the Federal Reserve, down to the ranch for a tonguelashing. But raising the discount rate didnt keep inflation from growing. It breaks my heart to go shopping. The war kept growing, too. When neither the administration nor congress applied fiscal restraints, the fed decided to go it alone again. They used an openmarket operation. In january 1966, they sold government bonds to tighten up the nations money supply. Interest rates rose dramatically. Soon, any business sensitive to Interest Rates was caught in a credit crunch. The housing industry was hardest hit. The full effect of the feds solitary action took hold in early 1967. Inflation dropped, but at a terrible cost a zero growth rate for the Gross National product. To economists, this was an impressive lesson. The fed was very effective in 1966. The discount rate increase and the reduction in the rate of creation of Bank Reserves drove up market Interest Rates, reduced investment in Residential Construction by several billion dollars. That served to offset, from a broad economic point of view, the increase in vietnam expenditures. I later, years later, asked president johnson what he really thought of that episode. He said, you know, andy, bill martin was right, but he should have told me about it ahead of time. The war, fought half a world away, feedvespec of amecan liomeoe totitionsy hasignificanwe buon agrcost we askedomntatorrichargill, o economne policy . Mrtt wa certainly by the mid to late 1960s, everybody realized Monetary Policy was important. Even in the old days, most people realized that although you cant push on a string, you could pull on one. In an economy beset by inflation, the reverse links, reduced reserves, to less money, to less spending, to lower prices, worked well, perhaps too well. We might get not just lowered prices, but also lowered real gnp. And not just lowered real gnp in general, but higher Interest Rates and the collapse of interestsensitive Industries Like housing and commercial construction. The crunch in the credit crunch of 1966 was for real. Monetary policy, it seemed, was a lot stronger tool than many had imagined. There was a general rethinking of the whole subject of money and its relationship to the economy. Perhaps money mattered in depressions as well as inflations. The keynesian consensus that emerged from the 1930s was beginning to break up. The fed was created as a bankers bank, but it has developed over the years into an institution with a much broader mandate. Monetary policy has evolved in response to the demands of history. The Great Depression showed the fed didnt understand its own power. The korean war underscored the need for the feds independence. The vietnam eras inflation graphically illustrated both the power and the problems of Monetary Policy. Theres a good deal more to Monetary Policy. Well be returning to it again in future editions of economics usa. Im david schoumacher. Captioning performed by the national captioning institute, inc. Captions copyright 1986 Educational Film Center annenberg media for information about this and other annenberg media programs call 1800learner and visit us at www. Learner. Org. Annenberg media annenberg media in the early 1970s, battles raged in the middle east. And throughout the world, disastrous weather caused crop failures of immense proportions. Why did these two events affect inflation and unemployment in the american economy