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annenberg media ♪ 1931. the great depression. banks were failing by thousands. the federal reserve, created to prevent suca tragedy, only made things worse. what had gone wrong? 1951, during the korean conflict, president truman also faced another battle, between the federal reserve and the treasu, over financing the war. how would it be resolved? 1965, lyndon johnson's administration was spending on both a war and a greasociety 1965, lyndon johnson's admiwithout raising taxes.g the fed was left to fight the resulting inflation alone. the nation's 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, we'll explore that question on economics usa. i'm david schoumacher.

coins, bilchecks-- our basic money supply. the amount of money and where it goes wiin the bankingysm has enhe main concern of our nation's central bank. at t fed's headquarters here in washington, dc, closedeliberatio are held bs who continuously monitor our financial health and prescribe remedies. how did these experts prescribe a remedy that pnged us even deeper in the great depression? american banks operated eay iwith little regulation and great vulnerability. in907, that vulnerability became apparent when depositors lost confince and demandedir money. e nks coul't get short-termoa when depositors lost confince and many colpsed.ney. e nks coul't get it took a powerful banke short-j.p. morgan,

but should an entire country be dependent on an individual's whim? a central bank, a lender of last resort, seemed better solution. just before christmas of 1913, esident wilson sigd 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 whenhe fed was created, the discount rate being the rate that is charged to member banks when they need to come in toet additional reserves. and it is raised to restrain their borrowing,

lowered to encourage their borrowing. through world war i, through the roaring twenties, most and went about the stheir 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 e thousands. the fed failed its major test. we asked economist lester chandler for an explation. professor chandler,the fed was p to prevent bank failures and avoid depressions, all of whichappened in the 1930s.

what went wrong? within the federal reserve system, nody knewwho was too what wherthey hadurnedownthe aldricpn was coerneystem, r one ceral bank winches and adopd a system of 1indepeenbas. at wasupposeoey t someing centrally, t they coun'cidewho was do. i'll we didn't have very many central bankers at wasupposeoey t someing centrally, in this country in 1914. centrabaing was not a recognizedssion. fearful that the uted states was not a safe harbor, foreign investors withdrew their gold deposits in a short time,$30 mil. from amecan banks. we asked dr. andrew brimmer,

former member of the federal reserve, why gold alarmed the fed. dr. immer, 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? if tre's a sigficantem reduction in reserves, from whatever source, it has to cut back on loans and the extension of credit fromunless ican gete, some relief. can provide more relief. acti as a central bank, so, in 1931, as the gold flowed to europe and so on, that was a loss in reserves. acti as a central bank, the centraba had to make it up. the fed would not stand by.

itaiseits scouate orceanksase i the centraba the sult--foreiginvestors the earned more interestby. itaiseits scouate orceanksase i and left their money in u.s. banks. th ended theoldrain. t raisg thdiscount rate had other, less fortunate, consequences. if the federal reserve raiseshe discount te, that transmits a message banksnd the money market thatt wants be strictive. for the economy as ahole, the result was disastrous. high interest rates discouraged borrowing, choking off business credit. more businesses failed, more jobs lost, the country was pushed deeper into the great depression.ed. 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 today's standards.

probably a "d," applying even the standards-- the most advanced standards of tt day. sure, you can criticize the d. it made mistakes. but what it did wrong was a matter of degree, mostly, ther than... total mistakes of policy. the men who met around this table were some of the country's most influential bankers. ey were the federaresee'sard o. were when they met to change most discouatesl bankers. ey sent ripplesacross t. they were practicing a rudimeary form of monetary policy. they were affecting the money suly how important was the money supply? economist richard gill has an analysis. to understand this question, we neesome sense of how the moneyupply

affects the economy's general workings and how the fed caaffecthe money supply. this diagram suggests the general nature of the answers theseuestions. theotically, 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 didn't 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 country's money supply shrank drastically. a mber of economists today believe the fed's misdirected policies were a major factor in turning an ordinary downturn into a great depression. we quickly add, however, thatoseconomis i the years immediately following cameo a different conclusion. theat twould snapuggestedas in a serious depression.am thatoseconomis i litthe fed could have doneowing

the fed might make more reserves available, but the banks might scared to le tm and businesses too frightened to borrow. even if more money weomehow created, peopleouldn't spend it. in such treacherous times. a strong desire for liquidity hence,ore money might not mean more spending. but without more spending, would never come into ay. to raisingnp and employment in fact,or many years, monetary policy was generay in dispute in this country, particularly when itame to curing business downturns. you can lead a horse to water, but you can't make him drink. such was the common opinion. our great new federal reserve system, ke tcomy itas supsed defend, had come upohard times.

the banking act of 1935 gaheed the authority iteede se monetary licy tabili theconomy of 1935 it also ovided the fed wi an importantool-- open-markeoperations se monwhy, twhen the fed ae, tabili theconomy of 1935 ouunion isconflict wasking its membe to invest every dollar it can in these bonds. and with god's help and your dollars, we'll win this war. in world war ii, asarof its open-market operations, the fed bought treasury bonds help finance the war. fed officials felt that providing that service was essential to victory. as we entered world waii, the federal reserve undertook a commitment in january 1942

to support the market for government securities. it would buy and sell all the governme securities anybody wanted to offer on the market to keep interest rates from rising. the fed ught bonds the tread that the publicdidn't . dr. brimmer explains more on how open-market operations affect the economy. open-market operations consist of purchase or sale of governmensecuries. the resees are the basissales r. foexpaing loans ry impornt activity. exnding money and credit. pumping so mucmoy into the ecoy ry impornt activity. exnding money and credit. did not lead to inflation because the economy had room to expand and because strict controls were imposed on wages and prices. after the alliedictory,

the treasurynsisted on keeping the same arrangement, and the controvey began. the d felt they were merely acti as e treasury's agent. itasnclear w ng it would continue. as far as e couct of motary 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 prite companies, individuals, and so on. where will they get the reserves, the cash to dohat? sell your government securities. these were very low-yielding-- 2.5%, 2.75% interest. you could at 5%-6% to priva borrowers. sohe banks, insurance companies, others, began to sell off govement 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 theanks would lend, sell securities, get the desits, make more loans. that was aing to an enormous expaion in the money supply and availabity of bank credit. the federal resee was afraid that sucan 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 treasury-fed conflict. the treasury is part of the executive branch. the feral serve is an independent agency, createby congress, with independence of the political pressures

from the white house. in that sense, the treasury cou not manda instructions to the federal reserve. chaian thomas p. mccabe believed the fed's 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. heidn't know, and most people didn't know, that those liberty bonds, ct went up and down with market ices after the war, interest rates rose, bond prices fell, and ma people had to sell bonds below what they paid for em. truman never forgothat eeri. he thought the government shouldn't cheat people. truman called the federal open-market committee to the white house for a tongue-lashing.

never before had a preside tried so directly to influence fed policy. there was so much misunderstanding on both sides that truman ordered a commission study t 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 e accord of 1951. the federal resee would be free to control money and credit without havi to buygovernm. the treasu agreed to issue someonmarketable bonds at carried a somewhat higher intest rate. the treasu agreed to issue as in any battle,bonds there wereasualties. 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 open-market operations in the fifties, it proved to be very effective in combating inflation. the lationship with the treasury became more equaland sy. for more on open-market operations wealked with richard gill. when the fed made open-market puhases of government securities as it diprior to 1951, it was effectively ireasing the reserves availab to the commercial banking system. and thus potential making more money available to the economy in general. here's how it works. the fed purchases, say, bilfit pays for these bonds

to thereasury's account. the treasu uses is torite checks to people who are providing services tohe government. ese private individuals posit ese checks thesof these banks' reserves. with these neweserves, banks can create more money. is is very muc like pnting-press money. the fed was sayingatheime oy may have been appropriate inepressioyears, buwas longeappropate an econome it waslso serving noticeheime oy that monetary pocydeies.e mighnot be so weak a ol

buwas longeappropate an econome it waslso serving noticeheime oy that we worked for two centuries to climb this peak of prosperity, but we're only at the beginning of the road to the great society. great society notwithstanding, ere was also the matter in a place called vietnam.ar this is the memorialto that, an undeclared war whose full cost was kept secret could mone policy alonent'sown . harness the runaway inflatio caused byguns-a-but? meant we would try fighng abroad war without any major sacrifice of social programs at home. war spending spurred the economy even higher. factories reached full capacity. labor was inemand ancould command higher wages.

here were sown the seeds of inflation. i beeve we can continue the greatociety 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, sohaturning around did not appeal to him. but i thinkam a more significant matter was that it brought the issue of the vietnam war into a very sharp political focus. william mcchesney martin, thenhairman of the federal reserve, had very good contacts with the pentagon

anwith the defense producers. and through the federal resee system, those directors and anches all around the cou, the infoationwas pouri, showing that the economy was heating up. to martin, inflationasmoren a s. it was a present reality. to mthe federal reserve board s. 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 tongue-lashing. but raising the discount rate didn't 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 open-market operation. in january 1966, they sold government bonds to tighten up the nation's 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 fed's 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 totitis.ty significanwe buon agrcost we askedomntatorrichargill, o economnery policy?"tt 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 can't 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 interest-sensitive 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 banker's 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 didn't understand its own power. the korean war underscored the need for the fed's independence. the vietnam era's inflation graphically illustrated both the power and the problems of monetary policy. there's a good deal more to monetary policy. we'll be returning to it again in future editions of economics usa. i'm david schoumacher.

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