Episode 7 - Independence, Part I
Welcome to the Bankster podcast, my name is Alexander Bagehot, and I’ll be your host today. This is Episode 7 - Independence, Part I. Every episode I dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse. The Centralverse is the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support. As you listen you’ll become more and more versed in Centralverse language/lingo/and history. This past week a listener named Jackie wrote in with a question. He asked, “Is there a difference between Centralverse language and lingo?” Great question Jackie.
I’m not sure if there is an official literary difference, but by using the two words I do intend to convey two different meanings. Let me explain. Language consists of the actual vocabulary being used in the Centralverse. For example you may learn new words like liquidity, solvency, or interest rates. Lingo, on the other hand, refers to words or terms you know but apply in a unique way to central banking. For example, you may know what a dove is or individually what the words in the phrases Federal Funds Rate, Discount Window, or dot plot mean. But how they are used in the Centralverse is quite different. So as you listen to the podcast, read or listen to the Centralverse being discussed in the news, and chat with your friends and family about it I hope you pick up on both the new language and the new lingo.Thanks for writing in Jackie. Remember that you can send in any questions or comments to firstname.lastname@example.org.
In between this episode and the following, here in the United States, we will be celebrating what we call Independence Day. So in honor of the holiday, we are going to spend two episodes talking about one of the fundamental foundations upon which all successful central banks must operate - a strong measure of independence from the political arena. I mentioned it in Episodes 3, and Walter Bagehot wrote about it in his book Lombard Street, which we dove into in Episode 6. Although the Federal Reserve was created in 1913, it would take nearly four more decades before true independence was solidified. But first a look at the news.
This past week the Federal Open Market Committee decided to leave interest rates unchanged. Which, if you remember, means that that one very low interest rate, the Federal Funds Rate, will stay at the current range of .25 - .50%. When you heard the news did you ask yourself what that means, or why the Fed might have chosen this path? Well, in her press conference Q&A following the announcement, Janet Yellen, the Chairwoman of the FOMC, mentioned the following as reasons for keeping the Fed Funds Rate unchanged: May’s weak jobs report, uncertainty surrounding Brexit (the term used to describe the vote Great Britain made yesterday about leaving the United Kingdom), and lackluster inflation numbers (running below the 2% target). Remember that if you want to really understand the Centralverse you need to take an active approach to digesting Centralverse news.
There are a few news stories that are written every few months about central banks that read almost exactly the same. Each of them repeat the same conversation about the independence of the central bank. They were especially frequent after the Financial Panic of 2007-09’ subsided. If you follow central banking news you’ll see a congressman propose a new bill in regards to Federal Reserve independence (like Paul Ryan’s Federal Reserve Transparency Act) at least once a session. Or hear economists talk about rule based monetary policy (like the Taylor Rule) any time rates are changed (for example a rule would bind the policy making committee like the FOMC to change rates according to a formula). Or talk radio hosts and think tanks fervently criticizing or passionately defending central bank independence.
But despite the news stories and threats the Federal Reserve has maintained a high level of independence for over 65 years. On the next episode we will talk about some of the specifics in regards to why independence is so critical to a central bank’s ability to effectively influence the economy. But for today, we are going to focus on the incredible story behind how the Federal Reserve gained true independence from the Executive Branch of government over a half century ago. For their exceptional paper on this topic, I owe a great deal to Robert Hetzel (an economist at the Federal Reserve Bank of Richmond) and the late Ralph Leach (who worked as the Chief of the Government Finance Office at the Board of Governors during the entire event we are about to discuss). If we have any movie producers listening to this podcast I recommend checking out the paper. No kidding it reads like a high intensity drama, written for the big screen. So, without further delay, let’s wind the clocks back.
Treasury Fed Accord
As we learned back in Episode 3, in the original 1913 Federal Reserve Act the Secretary of the Treasury and the Comptroller of the currency (both high ranking Treasury Official) were de facto (which means automatic) members of the Board of Governors. This meant that the President of the United States had the power to appoint the two most powerful Governors on the board. This was not uncommon for the time. Many central banks were established with leaders serving at the will of the executive branch. However, this does not make for a very independent or consistent committee that is deciding the monetary policy for the country. The first step towards independence was removing these two Cabinet officials, which congress did as part of the Banking Act of 1935.
However, many years would pass before the next step would be taken. Shortly after the implementation of the Banking Act Europe fell into what would would become World War II. After the Japanese attack on Pearl Harbor in 1941 the United States would hurl themselves into the war as well, joining the Allies in the fight across both oceans. It is said that wars cost blood and treasure. Both can be equally detrimental to a country’s battle efforts on the field as well as public support efforts on the home front. At the time the Federal Reserve was still intertwined with the Treasury Department in regards to the issue of government finances. This is where the trouble began to boil over. Put simply, it worked something like this.
The government needed money to finance the expensive war effort. For a large portion of the needed funds the government planned to borrow on the bond market. And if you remember, how do we measure how expensive borrowing money is? With interest rates. And who controls the interest rates? The Federal Reserve. See where this is going? The government wanted to borrow a lot of money. And they wanted to do so cheaply. The Fed was the only one that could help with that.
For the first few years the Fed went along with the Treasury’s petitions to keep interest rates low in the spirit of helping the war effort. But when the war came to a close the Treasury didn’t let off the pressure. And, unfortunately, one of the side effects of protracted low interest rates is inflation. Before the government could settle into a plan to fight the inflation in the post war country, the United States launched military operations in the Korean Peninsula.
Here again the government wanted money to fund the new war. However, by this time the inflation problem was really getting out of hand. By February of 1951 the annualized inflation rate of the previous three months was over 20%. This means that in order to keep up with the rising costs of goods and services, salaries would have to increase at a rate equivalent to doubling every four years. Imagine the turmoil that would ensue if your salary would have to be doubling every four years in order to simply buy all the same stuff and maintain your current lifestyle as it is today. It makes planning for the future as individuals and as businesses really hard.
The conflict between President Truman’s administration and the Federal Reserve thickened. The president had replaced Marriner Eccles in 1948 as the disagreements in regards to interest rates grew hotter and hotter. According to one of Truman’s staffers, the President had not reappointed Eccles in order to show him, “who’s boss”. Looking back this might be considered one of the first bubbles of the conflict that would eventually boil over.
However, the Chairman is also a Governor on the Board, and although the president has the power to nominate someone else for the position of Chairman the president cannot remove someone from the Board if their 14 year term is not up. This was the situation with Marriner Eccles. He decided to stay on as a Governor even though he had not been reappointed as the Chairman.
Eccles gave a testimony in Congress before the Joint Committee on the Economic Report. After his pretty fiery testimony he had the following exchange with one of the congressman. Their short dialogue demonstrates how heated the controversy was getting. And remember, the positions of the fight are, the Truman administration wants to keep interest rates low to fund the war and keep the value of the bonds made during Word War II high, and the Fed on the other side wants to raise interest rates in order to fight the inflation.
Congressman Patman: Don’t you think there is some obligation of the Federal Reserve System to protect the public against excessive interest rates?
Eccles: I think there is a greater obligation to the American public to protect them against the deterioration of the dollar.
Patman: Who is master, the Federal Reserve or the Treasury? You know, the Treasury came here first.
Eccles: How do you reconcile the Treasury’s position of saying they want the interest rate low, with the Federal Reserve standing ready to peg the market, and at the same time expect to stop inflation?
Patman: Will the Federal Reserve System support the Secretary of the Treasury in that effort [to retain the 2.5% rate] or will it refuse?...You are sabotaging the Treasury. I think it ought to be stopped.
Eccles: Either the Federal Reserve should be recognized as having some independent status, or it should be considered as simply an agency or a bureau of the Treasury.
Over the next few days the Federal Reserve and the Treasury department would tussle trying to each use their own legal authority to implement their very contradictory policies. The actual results were chaotic but the very public nature of the fights was causing more and more public upset and market turmoil. President Truman personally stepped in a few days later as the fight got more and more public scrutiny. For the first time in the History of the Federal Reserve the President invited the entire FOMC to a meeting at the White House.
It was a frigid Wednesday afternoon in January when the the FOMC worked their way down Constitution Avenue towards the White House. To open the meeting President Truman used these words to describe the severity of the situation: “the present emergency is the greatest this country has ever faced, including the two World Wars and all the preceding wars.”
What a somber and incredibly powerful statement to begin this historic meeting. And whatever the following conversation entailed, an agreement was not reached. Or at least that’s what the FOMC thought. But to their shock and dismay the President’s Press Secretary released the following statement the next morning, “The Federal Reserve Board has pledged its support to President Truman to maintain the stability of Government securities as long as the emergency lasts.”
Shortly before the unprecedented meeting with the President, Governor Eccles had written his resignation letter. However, Eccles could not let himself leave Washington in the thick of this massive level of attack on the independence of the central bank. When the Washington Post and The New York Times called him and asked for a comment, Eccles told the men that quite to the contrary of the President’s claim, the FOMC had made no such commitment. Over the next few weeks Eccles, his successor, Chairman McCabe and a number of other members of the FOMC strategized about the best way to address the conflict. They met multiple times with the Treasury Secretary John Snyder, who had been leading the fight against the Fed. However, Snyder had been in great need of cataract surgery and on February 26 he was admitted into the hospital. It was the Assistant Treasury Secretary William Martin that would reestablish ties with staff from the Treasury and the Fed (something that Secretary Snyder had discontinued years earlier).
Staff members from both the Treasury and the Federal Reserve worked together to reach a compromise and a plan was presented to the FOMC on March 1, 1951. The plan provides a classic example of meet in the middle compromise. The Fed would agree to maintain the low interest rates in support of the government for a limited time and for a limited dollar quantity. They would then proceed to normalize operations in order to fight the out of control inflation. Three days after the presentation of the proposal, on March 4, 1951 the following joint statement was issued, “The Treasury and the Federal Reserve System have reached full accord with respect to debt-management and monetary policy...” This simple sentence, released to the Sunday morning newspapers, marked an incredibly important moment for the independence of the Federal Reserve.
The Fed would max out the agreed upon dollar quantity within three days. And when the Treasury asked for more the Fed replied with a simple, “No”. And with the independence finally secured the Federal Reserve was on solid ground.
The whole affair caused a lot of grief and stress on markets, the Fed, and the Treasury. Eccles would leave Washington a few months later. With relationships broken Chairman McCabe bitterly resigned at the end of the month. And for the final twist of the story, McCabe was replaced by William Martin, the Assistant Secretary of the Treasury who had brokered the deal. The essay that I have relied on as the main source for this episode describes what happened next. “... the initial reaction both among Board staff and on Wall Street to Martin’s appointment was that the Fed had won the battle but lost the war. That is, the Fed had broken free from the Treasury, but then the Treasury had recaptured it by installing its own man. However, as FOMC Chairman, Martin supported Fed independence.” So much so, that, “Some years later, Martin happened to encounter Harry Truman on a street in New York City. Truman stared at him, said one word, “traitor,” and then continued.”
Those fateful winter months of 1951 would go down as some of the most important in all of central banking history. It marked a turning point. The Federal Reserve had been created in 1913, but it had taken nearly 40 years before the true independence that was needed to conduct appropriate monetary policy was solidified. With this newly confirmed independence, over the following years, they were able to rein in inflation and put an end to the mass devaluation of the dollar. And independence is now highly recognized as one of the fundamental principles of a well functioning central bank.
On the next episode, Why does central bank independence even matter? On a different note, I’ve been working on something related to the podcast in general that I’m pretty excited about and I’ll be ready to share details with you next time. Until then, if you have comments, recommendations, or questions about the The Bankster Podcast or the Centralverse in general. You can email me, email@example.com. Find me on twitter at the handle alexbagehot. At my website www.thebanksterpodcast.com you can find a transcript of today’s episode with links to all of the sources I used in creating the content, including a link to the movie script worthy essay and the official Treasury Fed Accord statement.
I’d like to thank those of you that wrote a review last week. HezrNY said, “He makes the central banking world actually sound interesting” Thanks Hez. Keep sending in your reviews via whatever podcast app you use.
Today’s episode was written, edited, and produced by me, Alexander Bagehot. I dedicate this episode to Alejandra, who literally drew the idea for The Bankster Podcast on a napkin at a 24 hour diner. And to all of you, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!