View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

THE RULES VERSUS DISCRETION DEBATE OVER
MONETARY POLICY IN THE 1920s
Robert L. Hetzel

From the advent of central banking in the nineteenth century to the present, debate has continued
over whether monetary policy should be conducted
according to rules or left to the discretion of the
policymaker. In the 1920s the Strong Hearings,
held by the House Committee on Banking and Currency, offered a forum for debate over this question.
The subject of these hearings, the Strong bill, in its
original form, required that monetary policy be conducted according to a rule in that the objective of
policy, stability of the price level, was not left to the
discretion of the Fed. The bill required that the
discount rate be set with a view to “promoting a
stable price level for commodities in general. All of
the powers of the Federal Reserve System shall be
used for promoting stability in the price level” (Stab.,
pt. 1, 1926, p. 1). Many eminent individuals testified at these hearings, for example, the economists
Irving Fisher from Yale, Oliver Sprague from Harvard, and Gustav Cassel from Sweden. For this
reason, the testimony offers an instructive review of
the rules versus discretion issue. A historical review
of this sort can offer useful insights for the current
debate.
One argument made by the proponents of rules in
these hearings was that discretion was undesirable
because it made monetary policy depend upon the
vagaries of the selection of policymakers. In retrospect, given the situation of the 1920s, this argument
proved to be correct. Benjamin Strong, Governor
of the Federal Reserve Bank of New York since the
inception of the Fed, dominated monetary policy in
the 1920s through the force of his personality.1 His
death in 1928 was the key event that produced a shift
in power within the Fed. Power shifted away from
New York to a committee comprised of Federal Reserve Board members and regional Federal Reserve

1

In 1935, the title governor was changed to president.

Bank governors. 2 The format of the discussions in
the Strong Hearings elucidated the sharp difference
of views over appropriate monetary policy among the
New York Fed, the Board in Washington, and the
regional Bank governors. For this reason, a review
of these hearings clarifies the way in which the shift
of power within the Fed in the late 1920s determined
the monetary policy followed during the Depression.
Background of the Strong Hearings
The founders of the Federal Reserve System had
assumed that the Fed would operate subject to the
discipline of the international gold standard. This
system, however, collapsed in World War I. The
void created by this collapse stimulated the emergence within the Fed of two new and divergent views
over the appropriate role of monetary policy. One
view developed at the New York Fed under Governor Benjamin Strong. This view developed out of a
perceived immediate need to offset the inflationary
impact of gold inflows and emphasized open market
operations. Under the leadership of Strong, open
market operations were used in order to offset gold
inflows and to stabilize the level of bank reserves.
The alternative view developed at the Federal Reserve Board under Board member Adolph C. Miller
and economist W. W. Stewart. It involved a reformulation of the real bills doctrine and emphasized
2

This shift in power is described in detail in Friedman
and Schwartz (1963, pp. 413ff). With the death of Strong,
effective control over monetary policy shifted away from
New York to a committee, the Open Market Investment
Committee, comprising regional Fed governors and members of the Board in Washington. Not only did the
regional Bank governors begin to assert their independence on this committee after the departure of Governor
Strong, but also the Board assumed effective veto power
over the committee’s open market purchases and sales.
After March 1930, this committee was replaced by the
Open Market Policy Conference. In this latter organization, all the regional Bank governors participated as
equals, so that the influence of the regional Reserve
Banks on the policy of the Federal Reserve increased

even further.

FEDERAL RESERVE BANK OF RICHMOND

3

changes in the discount rate.3 The criterion for determining changes in the discount rate was to consist of
an assessment of the extent to which credit extensions
by the banking system derived from a speculative
motive. This assessment was considered to be of
necessity judgmental, although the Board instituted
the collection of a number of statistical series on real
economic activity in order to assist it in this task (for
example, the industrial production index). Finally,
the regional governors of the Federal Reserve Banks
simply retained the beliefs of the real bills doctrine,
without questioning whether these beliefs remained
valid in the absence of the gold standard. These
three divergent views regarding the proper role of
monetary policy are summarized in this paper.
In the 1920s, there was an active group of influential individuals who organized into Stable Money
Associations in order to promote the objective of
price level stability for monetary policy. [See Fisher
(1934).] There was also an interest in price level
stability among politicians representing farm states.
This interest derived from the perception that agrarian interests had suffered disproportionately during
the disinflation of 1921. Individuals from the stable
money group persuaded Representative James G.
Strong from Kansas (no relation to Governor
Strong) to introduce a bill to require the Federal
Reserve to make price level stability its primary
Congressman Strong held two sets of
objective.
hearings on this bill, in 1926-1927 and in 1928.
The particular character of the hearings derived
from the belief by Congressman Strong and his supporters, especially economists John R. Commons and
Irving Fisher, that the period of relative price stability beginning in 1922 derived from Governor
Strong’s policy of stabilizing bank reserves. Much
of the hearings are devoted to discussions between
congressmen and Fed officials intended to elucidate
the monetary policy of the Fed in the 1920s and to
determine the relationship between this policy and
the behavior of the price level. Congressman Strong
and his supporters, from their perspective, were trying to institutionalize the policy of the New York
Federal Reserve. To this end, they attempted, on
3

According to the real bills doctrine, the appropriate
qualitative restriction on the kind of credit that banks
could extend would provide a quantitative restriction on
bank deposits and the money supply that would ensure
price stability. In particular, banks were supposed to
lend only on collateral arising out of productive activities.
that is, to discount only “real bills.” The self-liquidating
character of such loans was supposed to ensure that the
deposit creation associated with credit extension would
be limited and proportioned to the “needs of trade.”

4

the one hand, to persuade Governor Strong to support the bill of Congressman Strong. On the other
hand, they attempted to persuade Board member
Adolph Miller to abandon his view of policy and to
adopt the objective of price stability as the guideline
for monetary policy.
The Policies of Benjamin Strong and
New York
The Discovery and Development of Open Market
Operations Open market operations were discovered
accidentally when the Reserve Banks purchased
government securities in an effort to increase their
earnings. The Treasury complained of these purchases because their effect on interest rates made it
difficult for the Treasury to determine the interest
rate to set on new debt issues. In order to coordinate
open market purchases so that the Treasury would
know when the Reserve Banks were in the market,
Governor Strong, in May 1922, formed a committee
of some regional Bank governors (Stab., pt. 1, 1926,
p. 309):
. . . in the latter part of 1921 and early in 1922,
the member banks had liquidated so large a portion
of their discounts [borrowings] at the reserve
banks that there was some concern felt by some of
the Federal reserve banks as to their earnings. . . .
I think I should state very frankly to the committee
that many directors, or many of the reserve banks,
strongly held the feeling that a part of their duty
was to earn enough to pay expenses. . . . So that in
that period the reserve banks, being autonomous
and having the power to invest money, were making
considerable investments in the market, buying
bills and buying Government securities. It was
found that in the actual execution of the orders,
and in the effect upon the price of Government
securities in the market, there seemed to be some
cause for complaint in the Treasury; that sometimes we were treading on the toes of the Treasury.
. . . So, in May of 1922, at a meeting of the governors of the reserve banks, it was decided to get
some sort of supervision of the way this was done,
so as to satisfy the Treasury and equally so as to
have a more orderly procedure. A small committee
was appointed to deal with the matter. . . .
In February 1923, Governor Strong took a leave
of absence due to illness. In March, the Board, led
by Adolph Miller, dissolved the Strong Committee
and established a new one intended to be under its
control. 4 Strong testified (Stab., pt. 1, 1926, p. 309) :
4

Governor Strong registered his private response to this
takeover in a letter written on April 21: “The Federal
Reserve Board had no right to discharge the committee
and wouldn’t have done so had I had a crack at them.
I’d see them damned before I’d be dismissed by that
timid bunch” (Chandler, 1958, p. 228).

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

In 1923, in the spring of that year, the Federal Reserve Board decided that it was wise to reorganize
the committee procedure. The original committee
was discharged, a new committee was appointed,
consisting of the same men; and commencing in
1923 purchases of Government securities and sales
of Government securities were actually made for
the account of the system as a whole. . . .

Strong returned in October 1923 and regained control of the Open Market Investment Committee. 5
Carl Snyder attributed the formation of Governor
Strong’s views on monetary policy to Strong’s observation of the effects of the open market purchases
undertaken by the regional Reserve Banks in 1921
and 1922. [Snyder was a self-taught statistician and
economist. He was at the Federal Reserve Bank of
New York from 1920 to 1935. See Garvy (1978)
for an interesting discussion of his work.] In particular, according to Snyder, Strong believed that
these purchases arrested the recession then in progress. Snyder (1940, p. 226) later wrote:
Following the close of the World War there was, it
will be recalled, general apprehension as to the
effect . . . of restoring an immense number of men
. . . to their previous occupations. . . . and there
was almost universal expectation that . . . there
would be a heavy fall in prices. . . . For a time it
looked as if such a fall were in process. Then . . . a
wild rise [occurred] in commodity prices. Finally,
after a long wait, the Federal Reserve Board approved the policy Governor Benjamin Strong had
so urgently presented and allowed the Federal Reserve Bank of New York to raise its discount rate
to 6 per cent. Even this did not bring an immediate
check, and so in May the New York rate was again
raised, this time to 7 percent. . . . there was an
abrupt fall in the stock market, and then in commodity prices, bringing on the depression of 1921.
Towards the end of 1921 several Reserve Banks
found themselves facing a deficit. . . . So to acquire
some earning assets, they began considerable purchases of government securities. Within six months
the fall in prices had stopped, business began to
recover and confidence returned. A . . . result
which did not escape the attention of careful observers, and most noticeably of Governor Strong.

Monetary Control Governor Strong argued that
bank deposits and the money supply were derived as a
multiple of bank reserves. The money supply could
be controlled by the Fed through its control over
bank reserves.6 Failure to control bank reserves and
the money supply would lead to either inflation or
deflation. Strong presented a set of charts in order
to make these points. (These charts, labeled here as
Charts 1 through 4, are from Stab., pt. 1, pp. 422,
334, 471, and 332, respectively.) Chart 1 illustrates
the way in which the reserves-deposit ratio of banks
and the currency-deposit ratio of the public determine
the extent to which a multiple dollar quantity of
deposits can be supported by a single dollar of reserves. In particular, it shows how with a reservesdeposit ratio of 1 to 10 and with a currency-deposit
ratio of 1 to 5, $1 of high-powered money creates
$3.33 of deposits.7 Chart 2 illustrates the multiple
expansion of deposits deriving from an increase in
high-powered money. Strong testified (Stab., pt. 1,
1926, pp. 334-35) :
. . . when a gold dollar is put in the reserve bank it
creates a dollar of reserve balance for the member
bank depositing with us. Now, leaving out altogether the question of the requirements of the
country for currency, the average reserve of all
the banks of the country works out roughly at one
dollar of reserve to ten dollars of deposits. If the
demand for currency does not increase, theoretically, the amount of gold deposited in the banking
system will expand the credit volume generally to
ten times the amount of reserves created by imports
of gold which is deposited with us. It does not
work out always that way, because, after an expansion of loans if some business activity arises, and
prices are rising, the need of the country for currency increases, and when the banks come to us for
6

Elsewhere, Governor Strong had already rejected the
idea that the Fed could control bank reserves and deposits through the criteria proposed by “real bills” proponents. [See fn 3.] In November 1922 in a speech to
the Graduate Economics Club at Harvard, he stated
(Chandler, 1958, pp. 195-96) :
I fear there are many people who still hold to the
notion that some mysterious influence or process
will operate when this enlarged volume of credit is
no longer needed so that it will be induced. without
any compulsion or persuasion. complacently to
walk back to the Reserve Bank and surrender itself
for cancellation. . . . it is my belief that the
greatest influence upon the member bank in adjusting its daily position is the influence of profit or
loss . . . . if borrowing at the Reserve Bank is
profitable beyond a certain point, there will be
strong temptation to use surplus reserves when
they arise for the purpose of making additional
loans rather than for repaying the Reserve Banks.

Snyder then asserted that Governor Strong based
his response to the recession in 1924 on the prior
experience of 1921 and 1922 (Snyder, 1940, p. 227) :
. . . in 1924, not as a means of meeting expenses
but as a deliberate policy, Governor Strong proposed that the Federal Reserve Banks again lower
their rates and buy heavily of government securities. . . . The recession in business was soon over
and normal conditions restored.
7

5

Miller used the Strong Hearings to ask for legislation
that would effectively place control of open market operations under the Board (Stab., pt. 2, 1927, pp. 865-66).

High-powered money consists of currency in circulation and in bank vaults and of bank deposits with the
Fed. The term “high-powered” derives from the way in
which a dollar of this money supports a multiple dollar
quantity of bank deposits.

FEDERAL RESERVE BANK OF RICHMOND

5

Chart 2

Chart 1

HOW THE DEPOSIT OF
A MILLION DOLLARS OF GOLD MAY GROW
INTO $10,000,000 OF BANK CREDIT

THEORETICAL EXPANSION OF
DEMAND DEPOSITS OF MEMBER BANKS
ON THE BASIS OF IMPORTED GOLD

SURPLUS RESERVES

This ratio of currency to
deposits has been fairly constant for the past 16 years.

Every $1 of imported gold
may carry more than $3 of
deposit credit, without any
borrowing from Reserve
Banks.

Note: Reproduced from Stabilization, Part 1, P. 334.

Note: Reproduced from Stabilization. Part I, p. 422

In the old days there was a direct relation between
the country’s stock of gold, bank deposits and the
price level because bank deposits were in the last
analysis based upon the stock of gold and bore a
constant relationship to the gold stock, and the
volume of bank deposits and the general price level
were similarly related. But in recent years the
relationship between gold and bank deposits is no
longer as close or direct as it was, because the
Federal reserve system has given elasticity to the
country’s bank reserves. Reserve bank credit has
become the equivalent of gold in its power to serve
as the basis of bank credit. A bank can meet its
legal requirement for reserves by borrowing from
the reserve bank, just as fully as though it deposited gold in the reserve bank. Hence, as [Chart
3] shows, the present basis for bank credit consists
of gold plus Federal reserve credit. Federal reserve bank credit is an elastic buffer between the
country’s gold supply and bank credit. . . .

currency as distinguished from balances, they take
the entire 100 per cent of what they borrow in
currency.

Governor Strong desired to stabilize the reserve
base upon which bank credit and deposits rested.
During the period immediately following formation
of the open market committee in 1922 by Strong,
control of the reserve base required offsetting gold
inflows (Chandler, 1958, p. 191) :
If I were Czar of the Federal Reserve System I’d
see that the total of our earning assets did not go
much above or below their past year’s average,
after deducting an amount equalling from time to
time our total new gold imports. This is the song
I’ve been singing in Washington since April 1922
with but moderate success. Most of them don’t see
the point about gold!

After 1922, gold inflows were no longer sterilized.
Federal Reserve credit was kept approximately constant so that gold inflows provided for moderate
expansion of the reserve base. Strong made these
points in the following statement and in Charts 3
and 4:
6

Chart 4 is similar to Chart 3. It shows the initial
impact of gold inflows in causing an increase in the
money supply through an increase in gold certificates.
This initial increase in money, however, was offset
by a decline in Federal Reserve notes. 8 The net
result was a roughly steady money supply and approximate stability of the price level.
8

Gold certificates were warehouse receipts for gold.
Federal Reserve notes were currency issued by the Fed.
Both circulated interchangeably as money.

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

Chart 4

Chart 3

GENERAL EFFECTS OF
FEDERAL RESERVE POLICY
Billions of Dollars

G.P.L. Percent

MONEY IN CIRCULATION IN THE UNITED STATES,
CUMULATIVE NET GOLD IMPORTS, AND THE
GENERAL PRICE LEVEL, INCLUDING WHOLESALE
AND RETAIL PRICES, RENTS, AND WAGES
Price Level

Billions of Dollars

1914

Note: Reproduced from Stabilization. Part I, p. 471.

In 1924, the central concern of Governor Strong
that gold inflows would cause inflation was replaced
by a concern for economic recession. He testified in
the Strong Hearings that he had the Federal Reserve
purchase government securities in order to relieve
“pressure for loan liquidation,” to cause “a somewhat
lower level of interest rates in this country at a time
when prices were falling generally,” and “to check
the pressure on the banking situation in the West
and Northwest and the resulting failures and disasters” (Stab., pt. 1, 1926, p. 336).
Governor Strong and the Mandate for Price Stability Governor Strong was sympathetic with the
goal of price level stability. He viewed his own
policy as having been directed toward this objective
(Stub., pt. 1, 1926, p. 307) :
Mr. Williamson. Do you think that the Federal
Reserve Board could, as a matter of fact, stabilize
the price level to a greater extent than they have
in the past by giving greater expansion to market
operations and restriction or extention of credit
facilities?
Governor Strong. I personally think that the administration of the Federal reserve system since
the reaction of 1921 has been just as nearly directed as reasonably human wisdom could direct it
toward that very object.

1916

1918

1920

1922

1924

1926

Sources: General price level-Computed by the Federal
Reserve Bank of New York.
Money in circulation-Circulation statement of the
United States Treasury.
Federal reserve note circulation-Federal Reserve
Board.
Cumulative net gold imports-Compiled from reports issued by the Department of Commerce.
Note: Reproduced from Stabilization, Part I, p. 332.

He believed that the Fed exerted a major influence
on the price level. In the following passage, Strong
explained his view of the way in which the Federal
Reserve raises the price level (Stab., pt. 1, 1926, pp.
578-79) :
. . . the first reaction from cheap money will be felt
in the security markets. . . . when we have very
cheap money, corporations and individuals borrow
money in order to extend their business. That
results in plant construction ; plant construction
employs more labor, brings in to use more materials
for plant construction, and gives more employment.
It may cause some elevation of wages. It creates
more spending power; and with that start it will
permeate through into the trades and the general
price level.
Governor Strong, however, was concerned that the
control of the Federal Reserve over the price level
was imprecise. He offered the following explanation
for lack of complete control by the Federal Reserve
over the price level (Stab., pt. 1, 1926, p. 482) :
Professor Fisher’s equation is that the volume of
money multiplied by its velocity equals the price
level multiplied by the volume of trade, a very
simple equation to understand except when you
attempt to understand what “velocity” means, that
is the speed with which money turns over. You

FEDERAL RESERVE BANK OF RICHMOND

7

are not dealing then with a mathematical propor-

tion, but with the state of mind of people, and let
me express it, if I may, in this way. . . . We will
divide all the currency, the hand-to-hand money
that circulates in the retail trade, etc., into two
classes. One class we will call dynamic and the
other class we will call static. The dynamic is the
portion which is actively used and which has an
effect upon the price level. The static portion is
that not used and not spent and which presumably
has no effect on prices. Let us suppose that in this
country we have a per capita circulation roughly
of $50 and that it is the habit of all the people in
the country, on the average, to have $10 of their
$50 per capita, tucked away in the chimney at
home. It does not perform any function whatever
so far as having an effect on prices. Then, suddenly, by reason of some shock to confidence or
some development which makes people rather more
economical and careful about contracting ahead,
they take $15 more and put it up the chimney. You
increase the amount of static money from $10 per
capita to $26 per capita and reduce the dynamic
proportion from $40 to $25, that would have some
of the effects of a sudden contraction of the currency and doubtless prices would fall.

Governor Strong was afraid that if the Federal
Reserve had an explicit mandate to stabilize the price
level and if its ability to control the price level were
imprecise, misses of the targeted value of the price
level would subject the Federal Reserve to political
attacks, which would weaken the Federal Reserve
as an institution. Irving Fisher (1934, p. 151)
reported the following conversation with Governor
Strong (apparently in the spring of 1928) :
In talking with him, he said, “Don’t compel me to
do what I am doing. Let me alone and I will try
to do it. If I am required by law to do it, I don’t
know whether I can, and I will resign. I will not
take the responsibility.” I said to him, “I would
trust you to do it without a legislative mandate,
but you will not live forever, and when you die I
fear this will die with you.” He said, “No, it will
not.”

This quotation illustrates the gap between Governor Strong, who as a policymaker was inclined to
depend upon individual discretion and good judgment in order to ensure desirable policy, and the pro-

ponents of the Strong bill like Irving Fisher, who
looked to institutional arrangements to ensure desirable monetary policy. The compromise between
Governor Strong and Congressman Strong over the

language of the Strong bill was an attempt by both
sides to bridge this gap. This compromise is discussed in the final section of the paper.
Governor Strong and the Gold Standard Governor
Strong believed that the international gold standard
was in the process of being restored permanently.
He preferred the gold standard to the managed cur8

rency envisioned by Congressman Strong and his
supporters. First, Governor Strong felt that the
United States would benefit from stability abroad
through a worldwide return to the gold standard
(Stab., pt. 1, 1926, p. 518) :
I really have a feeling in my own mind that the
prosperity of our country is so wrapped up in
general world prosperity that . . . the best that we
can do for our people is to try in any way that we
can to maintain these markets on which our prosperity so largely depends. . . . I earnestly believe
that the greatest service that the Federal reserve
system is capable of performing to-day in this
matter is to hasten . . . monetary reform in the
countries that have suffered from the war.

Second, Governor Strong believed that the government should not have the power to control the price
level, and the gold standard was the accepted means
of keeping this power from the government. Like
other conservatives, Strong’s attitudes in this respect
had been determined by the perceived threat to social
stability represented by the populist campaign of
William Jennings Bryan. Strong had more faith in
the automatic operation of a gold standard to limit
inflation and to preserve social stability than he had
in the managed currency envisaged by Congressman
Strong, Irving Fisher, and others. The legislation
of Congressman Strong endowed the Fed with the
authority to control the price level. This legislation
made stability of the price level the objective of
monetary policy. Governor Strong, however, believed that the authority to control the price level
would of itself create political pressure to use this
authority to redistribute income, rather than to stabilize the price level. (Stab., 1928, pp. 20-l and Stab.,
pt. 1, 1926, p. 295) :
. . . the gold standard is a much more automatic
check upon excesses in credit and currency than
is a system where gold payment, if you please, is
suspended and it is left to the human judgment of
men to determine how much currency shall be
issued which they do not need to redeem in golddo you see the distinction? And when you speak
of a gold standard, you are speaking of something
where the limitation upon judgment is very exact
and precise and the penalty for bad judgment is
immediate.
If the Federal reserve act is amended in these
words, is it possible that the farmers of the country
will be advised, or will be led to believe upon
reading it, that a mandate has been handed to the
Federal reserve system to fix up this matter of
farm prices. . . . I am assuming what interpretation may be put upon it, and especially by the
farmers. Is it possible that the farmers of the
country will interpret this as an effort by Congress
to place the responsibility upon the Federal reserve
system for attending to the particular problem of

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

prices in which they are interested. . . . I am
endeavoring to express some doubts about the
effect of the bill on the minds of people who are
not economists, and who really can not distinguish
between individual prices and general prices.

The Policies of Adolph Miller and the Board
The 1923 Annual Report of the Federal Reserve
System At both sets of hearings on the Strong bill,
1926-1927 and 1928, the Federal Reserve Board was
represented by Adolph C. Miller, a Board member
since the inception of the Fed. Miller defended the
view of policy advanced in the Board’s 1923 Annual
Report. This report had been written in part in response to criticism of the Federal Reserve made at
the House hearings in 1922-1923 on the Goldsborough bill, a bill incorporating the “compensated
dollar” plan of Irving Fisher for stabilizing the price
level. 9 Miller referred to the 1923 Annual Report as
“a reasoned interpretation of (Board) experience”
and as “the fullest exposition of . . . the working
principles and the attitudes of the Federal Reserve
System” and had portions introduced into the Hearings. His defense of the annual report was repeated,
in the first set of hearings, by E. A. Goldenweiser,
Director of Research and Statistics at the Board,
and, in the second set of hearings, by the latter’s
predecessor, Walter W. Stewart, who had been the
Director when the 1923 Annual Report was written.
The authors of the Annual Report viewed the price
level as a nonmonetary phenomenon.10 The collapse
of the gold standard did not necessitate the creation
of an alternative institutional arrangement for determining the price level. The Annual Report denied
Fed responsibility for the behavior of the price level
or the quantity of money (Federal, 1924, p. 31) :
[The inoperability of the gold standard] has led to
much discussion in the United States and elsewhere
as to workable substitutes for the reserve ratio as
guides to credit and currency administration.
Particular prominence has been given in discussions of new proposals to the suggestion frequently
made that the credit issuing from the Federal
reserve banks should be regulated with immediate
reference to the price level, particularly in such
9

Fisher’s plan would have provided for regular adjustments to the gold content of the dollar in order to stabilize its purchasing power,
10

Miller said of the rise in the price level in 1923 (Stab.,
pt. 2, 1927):
Our conclusion was, therefore, that prices were
rising because manufactured goods were scarce.
. . . The people were beginning to want goods
a g a i n . . . The goods were not there.
Retail
prices rose in response to that situation. . .

manner as to avoid fluctuations of general prices.
. . . it must not be overlooked that price fluctuations
proceed from a great variety of causes, most of
which lie outside the range of influence of the
credit system. No credit system could undertake
to perform the function of regulating credit by
reference to prices without failing in the endeavor.
It is the view of the Federal Reserve Board that
the price situation and the credit situation, while
sometimes closely related, are nevertheless not
related to one another as simple cause and effect;
they are rather both to be regarded as the outcome
of common causes that work in the economic and
business situation. The same conditions which predispose to a rise of prices also predispose to an
increased demand for credit.
The demand for
credit is conditioned upon the business outlook.
Credit is created in increasing volume only as the
community wishes to use more credit- hen the
opportunity for the employment of credit appears
more profitable,

According to the 1923 Annual Report, the criterion
for evaluating the appropriateness of the quantity of
credit extended by the Federal Reserve was maintenance of equilibrium between goods being produced
and goods being purchased. This equilibrium would
be maintained as long as credit was not used for
speculative purposes (Federal, 1924, pp. 34-S) :
It is the belief of the Board that there will be little
danger that the credit created and contributed by
the Federal reserve banks will be in excessive volume if restricted to productive uses. . . . The
characteristic of the good functioning of the credit
system is to be found in the promptness and in the
degree with which the flow of credit adapts itself
to the orderly flow of goods in industry and trade.
So long as this flow is not interrupted by speculative interference there is little likelihood of the
abuse of credit supplied by the Federal reserve
banks and consequently little danger of the undue
creation of new credit. . . . the solution of the
economic problem of keeping the volume of credit
issuing from the Federal reserve banks from becoming either excessive or deficient is found in . . .
the prevention of the uses of Federal reserve credit
for purposes not warranted by the terms or spirit
of the Federal reserve act.

It was argued that the policy recommended in the
1923 Annual Report could not be implemented by
following explicit guidelines, but rather had to be
implemented through the ongoing exercise of judgment (Federal, 1924, p. 32) :
No statistical mechanism alone, however carefully
contrived, can furnish an adequate guide to credit
administration. Credit is an intensely human institution and as such reflects the moods and impulses
of the community-its hopes, its fears, its expectations. The business and credit situation at any
particular time is weighted and charged with these
invisible factors. They are elusive and can not be
fitted into any mechanical formula, but the fact

FEDERAL RESERVE BANK OF RICHMOND

9

that they are refractory to methods of the statistical laboratory makes them neither nonexistent nor
nonimportant. They are factors which must always
patiently and skillfully be evaluated as best they
may and dealt with in any banking administration
that is animated by a desire to secure to the community the results of an efficient credit system. In
its ultimate analysis credit administration is not a
matter of mechanical rules, but is and must be a
matter of judgment---of judgment concerning each
specific credit situation at the particular moment
of time when it has arisen or is developing.

Miller commented on this excerpt, “I should say, so
far as it may be said that anything in the nature of a
formulated procedure exists in the Federal reserve
system, that comes perhaps as near expressing it as
anything” (Stab., pt. 2, 1927, p. 636).
Credit Administration Miller criticized the validity of the assumptions underlying the Strong bill
(Stab., 1928, pp. 109, 348, and 180, respectively) :
One of those assumptions is that changes in the
level of prices are caused by changes in the volume
of credit and currency; the other is that changes in
volume of credit and currency are caused by Federal reserve policy. Neither one of those assumptions is true of the facts or the realities. They are
both in some degree figments-figments of scholastic invention-that have never found any very
substantial foundation in economic reality, and less
to-day in the United States than in other times.
. . . undertaking to regulate the flow of Federal
reserve credit by the price index is a good deal like
trying to regulate the weather by the barometer.
The barometer does not make the weather; it indicates what is in process.
The total volume of money in circulation is determined by the community. The Federal reserve
system has no appreciable control over that and no
disposition to interfere with it.

Miller also made the case for allowing the Federal
Reserve to operate a discretionary monetary policy
(Stab., 1928, p. 193) :
Mr. Strong. You think the law, then, could be
changed so that it would read for the accommodation of commerce and business or at the will of the
Federal Reserve Board?
Doctor Miller. It is the same thing.
Mr. Strong. I am afraid it is.
Doctor Miller. The phrase “accommodation of
commerce and business” has always struck me as
one of the rare inventions that occur occasionally
in American statesmanship.
Whoever was the
author of that phrase did a magnificent thing. It
is great language. The word “accommodation” is
susceptible of the wisest interpretation and reaches
the noblest of economic purposes.

10

Board View of Open Market Operations According to the Board’s real bills view of the world, it was
desirable that the initiative for changes in the reserves of the banking system lie with the public.
Open market operations, where the initiative for
reserve changes lay with the Federal Reserve, were
considered either relatively unimportant or undesirable. In the Board’s 1923 Annual Report, o p e n
market operations were considered important only
as a way of determining whether the amount of bank
credit extended was “excessive for the needs of
trade,” that is, was being employed in part for speculative purposes. Reserves from the discount window
could only be obtained if they met the real bills
criteria. If, therefore, the effect of an open market
sale in draining bank reserves was offset by increased
reserve provision arising from additional use of the
discount window, credit provision was not excessive
(Federal, 1924, p. 13). Miller repeated this contention with reference to the sale of securities by the
Federal Reserve in 1923, in which the initial effect
on bank reserves was offset by additional borrowing
from the Federal Reserve (Stab., pt. 2, 1927, p.
708) :
. . . it gave a fair indication that, in the judgment
of the member banks, it [the amount of credit in
use] was needed, because as cash was taken out of
the market by the reserve banks the member banks

came right back to the Federal reserve banks and

rediscounted in substantially the same amount. We
thus threw upon the member banks of the country
the responsibility of exercising their judgment as to
whether or not they should continue in use the
existing volume of credit extended to their customers; that is, we threw upon them the responsibility of saying whether or not, from their knowledge of business conditions and the requirements of
their customers, they were justified in coming to
the Federal reserve banks and asking for this
amount of credit or rediscounts.

The attitude of the Board toward open market
operations was influenced by its rivalry with New
York and by the fact that open market operations, as
opposed to discount rate changes, were under the
control of New York. This rivalry showed through
in dialogue prompted by the eventual participation of
Governor Strong in rewriting the language of the
Strong bill (Stab., 1928, pp. 212-13) :
Rep. Strong. . . . the language you refer to has
been dictated and suggested by members of the
Federal reserve system.
Doctor Miller. I regret to say that I do not think
it is a very creditable exhibition of their understanding of the seriousness of this whole matter.
. . . The Federal reserve system is a pretty big
organization. There are many persons in it. We

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

have a considerable number of amateur economists,
and from my point of view they constitute one of
its dangerous elements. . . . There are altogether
too many in and around it for the good of the
system, and there has been some influx into the
Federal reserve mind of half-thought-out ideasnotions almost metaphysical in their character.
These have penetrated the minds of some of the
operators of the Federal reserve system. . . . And
I venture to say that some of the men whom you
have consulted do not know what this is all about.
These are high-sounding and captivating words you
are using in your proposed amendment.

Because the increased credit made possible by the
open market purchases was in excess of the needs of
trade, it was put to speculative uses (Stab., 1928, pp.
174 and 172) :
We are lower in the actual amount of money in
circulation in the country than we have been since
1922. . . at the same time that the Federal
reserve bank was putting money into the market to
offset the restrictive effects of gold exports, the
country, because of reduced requirements for monetary circulation, was, so to speak, also putting
money into the market, thus adding to the supply
of basic credit. and giving rise to what. I think,
can be very properly described as a plethora of
money in the autumn and early winter of the year
under review.

Mr. Strong. Of course, one of them has been
Governor Strong.
Doctor Miller. Of course, he is a very able man.
But when it comes to economic insight and understanding . . . that is very unusual in any group of
men anywhere. . . .

The rivalry between the Board and New York increased in 1927 when a group of foreign central
bankers (Norman, governor of the Bank of England ;
Schacht, president of the German Reichsbank; and
Rist, deputy governor of the Banque de France)
visited New York to confer on policy with Governor
Strong, but paid only a courtesy visit to the Board. 11
These bankers were concerned that the imminent
return of France to the gold standard would produce
an increased demand for gold and would require a
restrictive policy on the part of European central
banks. In particular, they did not want the New
York Fed to allow rates to rise in the United States
in response to gold outflows. Subsequent to this
visit, the Open Market Committee engaged in open
market purchases.
During the Hearings, Miller criticized these open
market purchases as causing speculation in the stock
market. He argued that the decline of the money
supply in the 1920s indicated a redundancy of credit.

The money that was released by the Federal reserve banks to the open market through its policy
of open-market purchases had to go somewhere.
. . . the low money rates that resulted from Federal
reserve policy, in the light of subsequent developments, appear to have been particularly effective in
stimulating the absorption of credit in stock speculation. . . . I would say that cheap and easy
money in the New York market the last autumn
must be recognized to-day as having been a distinctly provocative factor in the remarkable speculative movement that has been in process now for
several months.

Miller urged that the discount rate be considered
the primary policy variable of the Federal Reserve
(Stab., 1928, p. 125) :
. . . in my opinion the importance of discount policy
as an instrument of credit regulation shall be
emphasized by the Federal reserve henceforth and
an abridgement of open-market operations as a
primary instrument of credit policy. I am of the
opinion that open-market operations have been the
cause of almost as much mischief in credit and
economic situations as of good.
A Preview of Policy During the Depression

Miller implied that he, rather than Governor Strong,
was better equipped to negotiate with European central
bankers (Stab., 1928, pp. 165 and 237.):
11

Personally, I feel a deep interest in the state of the
European world. I first saw Europe shortly after I
was out of college, and I have tramped hundreds
of miles in Europe. I know it; I know the people;
I know the country, its lovely valleys, its impressive beauty; and above all I have a very tender
and warm feeling for the peasantry of western
Europe. But I also know something of European
psychology. I have not travelled there simply for
fun, but have observed something of their mental
and emotional traits. . . .
There are apparently few Americans who make
their first acquaintance with Europe in their maturity who are practically well equipped to deal
with Europeans. . . . I am inclined to think, to
use Mark Twain’s phrase, that we have had a good
many American “Innocents Abroad”. . . .

Miller and Stewart The aversion to the use of
open market operations just described helps to explain the policy followed by the Federal Reserve
during the Depression.12 In other respects as well,
the testimony offered in the Strong Hearings foretold
the character of monetary policy during the Depression. Miller contended that the creation of an elastic
currency with the founding of the Federal Reserve
had made bank panics impossible. Contractions in
Miller remained influential during the Depression.
Karl Bopp (1932) wrote, “. . . Mr. A. C. Miller, who
seems to be the dominant figure in the Board, has stated
that he is opposed to open-market operations . . . except
as a ‘surgical operation.’ ” [This quote is from Friedman
and Schwartz (1963, p. 410).]
12

FEDERAL RESERVE BANK OF RICHMOND

11

currency and credit had to be in response to a diminished demand on the part of the public (Stab.,
pt. 2, 1927, p. 848 and Stab., 1928, p. 193) :
. . . under the old condition these banks were working, so to speak, in a limited market, a market in
which the total supply of money, practically speaking, was absolutely limited. Now, on the other
hand, they conduct their operations in a market
having great elasticity. That elasticity gives more
assurance-it gives perfect assurance-that no
matter how much in the way of balances maintained in the New York market by outside banks
should be withdrawn, new money can always be
put in the market in order to support such a withdrawal and prevent the old-fashioned collapse.
. . . such a thing as a currency and credit panic
can not exist under the Federal reserve system.

Miller asserted the impotence of monetary policy
during a depression (Stab., pt. 2, 1927, pp. 840-41
and Stab., 1928, pp. 182-83) :
. . . the moment currency became redundant it
would be used to pay indebtedness at the Federal
reserve bank. It comes right back to the Federal
reserve bank. Every dollar a member bank gets
from the reserve bank costs it something and there
is no use to get money accumulating in its hands
when there is no demand for it. . . . it is conceivable that credit and currency might become so redundant that they would carry their cash accumulations as idle balances at the reserve banks for
some period of time pending the resumption of commercial demand for credit and currency. , . . You
do not want to overlook the situations that we
designate as credit plethora. Some one has to see
the business outlook attractive before he will borrow money. People do not like to be in debt. They
do not borrow simply because money is cheap.
. . . in a time of recession you can not stop the
recession by the lowering of the discount rate, the
cheapening of the cost of credit, or by making
credit more abundant. . . . You have got to have a
demand for something before you can either stimulate that demand or restrain it. And at a time
when the business community does not want to
make any business commitments, when it wants to
reduce commitments, when it is hesitant about the
business outlook, you can not do very much with
your rate. . . . We must rid ourselves of the
impression that lowering the discount rate will
stimulate business when business is not in a mood
to respond to stimulation. A part of the rare
wisdom and the rarer skill in the application of
discount policy is the knowing or sensing when you
may and when you may not expect to get a response. It can not be done mechanically.

Stewart asserted the perverse effects from employing an expansionary monetary policy during a depression (Stab., pt. 2, 1927, pp. 763 and 770-71) :
To test whether or not the credit condition is sound,
one has to begin by determining the volume of
production, and whether or not that production is
moving promptly through the channels of distribu-

12

tion and whether or not inventories are accumulating. I can see, as an example, a situation where
prices may not be advancing, but, on the other
hand, declining, yet inventories of commodities
were accumulating, and where, if additional credit
were granted, it would be used for the purpose of
adding to the stock, and would mean simply encouraging the accumulation of additional stocks.
To what extent, by an addition to credits at a time
when prices are declining, not as an aftermath of
war inflation but of maladjustments in business,
can you cure the causes which lay back of declining
prices? My point is that in such circumstances you
take a chance of aggravating the very causes
which are responsible for the declining prices. If
stocks are accumulating and the mood in the community is speculative, then an attempt to use credit
for the purpose of stabilizing prices is more likely
to aggravate the causes responsible for the movement in prices. In instances where production has
been proceeding at a rapid rate and prices decline
and stocks accumulate, to pursue a policy of easing
the money market simply makes possible a piling
up on the shelves of inventories. To use the price
index as a guide would tend to make credit conditions increasingly unsound. . . . But to assume
that declining prices, which are, after all, largely a
readjustment to take care of the mistakes made
previously can be overcome by an additional extension of credit is more likely to add to the difficulties in the situation rather than to cure it.

Norris The views of George Norris, governor of
the Federal Reserve Bank of Philadelphia, were
typical of those of regional bank governors and help
to explain monetary policy during the Depression.
These views reflected the prevalence of the real bills
doctrine in financial circles. They express the belief
that the Federal Reserve cannot control the price
level and that any such attempt would produce undesirable consequences (Stab., pt. 1, 1926, p. 381) :
Prices, be they either of particular commodities or
even the price level, are the result, in the first
instance, of the constant struggle between the producer for high prices and the consumer for low
prices. In that continuing struggle there are ebbs
and flows as various cross currents intervene. . . .
Therefore, all prices, either of a particular commodity, or of commodities in general, are affected
by these various influences, and while I would not
undertake to say-and I do not suppose anyone
would-that the price level is not influenced somewhat at times by the cost of credit, it nevertheless
is true that the cost of credit is a very small item
in the cost of production or distribution of goods,
and if you refine that still further to the difference
in the cost of credit between borrowing money at
4 per cent and borrowing at 5 or 6, that difference
becomes almost negligible. . . .
When the movement of prices is under way, it seems
to me that it is always a doubtful and generally a
dangerous thing for any outside agency to interfere with and attempt to alter the current. It is,
to my mind, very much like erecting a dam to stop
the flow of the natural current. To give a homely

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

illustration of that, several years ago, when the
price of wool was dropping almost out of sight, the
largest wool merchant in Philadelphia came into
my office and said, in the course of the conversation, that he made his money when wool was going
up and when wool was going down he was pretty
nearly sure to lose money. “But,” he said, ‘I would
not give anybody 5 cents to try to stop this downward movement in the price of wool. I would much
rather have it go down as low as it wants to go,
because if it does that, then I know I can start in
to buy and do business with perfect confidence,
whereas, if anybody attempts to put a peg in it, I
do not know whether the peg will hold or not and I
can not deal with the same confidence.”

The Appeal to Adolph Miller and to
Governor Strong
Prophetically, Congressman Strong appealed for
his bill in order to avert the problems of a future
deflation (Stab., 1928, p. 363) :
we are seeking to put the world back upon a gold
basis. I am very much afraid . . . it might bring a
deflation in this country; and I would like to direct
the Federal reserve system to continue the policy
they have been pursuing of stabilizing [the price
level].

Congressman Strong and his supporters wanted to
institutionalize the policy of the New York Federal
Reserve Bank, which they credited for the considerable price stability that existed after 1922 (Stab., pt.
1, 1926, p. 600) :
Mr. Goldsborough. As I have understood the testimony on the part of Governor Strong and yourself
[Carl Snyder], the policy of the Federal reserve
system is to carry out just what would be this
legislative direction. If that is the policy of the
system and the system thinks it is a wise policy,
but that it is doing it on its own initiative and exercising its own judgment in the matter of the welfare of the country, what is the objection to crystallizing, in legislation, that very policy in order to
fortify the Federal reserve system in the future.

Miller remained unalterably opposed to the Strong
bill. He not only objected to a policy of price level
stabilization, but also to the limitation of discretion
inherent in a clear Congressional mandate to guide
monetary policy (Stab., 1928, p. 252) :
Mr. Strong. Let me ask you a very frank question.
Congress having given these tremendous powers to
the Federal Reserve Board undirected, do you not
think that the Congress on behalf of the people,
ought to lay down a policy toward which these
powers shall be used?
Dr. Miller. I regard the statement which occurs
in section 14 of the Federal reserve act in connection with the board’s power to determine discount
rates, to the effect that such “rates shall be fixed

with a view of accommodating commerce and business,” as giving about as good an indication of the
whole complex of considerations and factors to be
reckoned with by the Federal reserve system in
charting its credit policy as you can get. The word
“accommodation” is one that can be weighted with
as big a meaning as the men who are chosen to
administer the act are capable of conceiving.

Congressman Goldsborough appealed to Governor
Strong to support the Strong bill (Stab., pt. 1, 1926,
p. 552) :
. . . the system has been, for the last few years,
managed exceptionally well. I feel also that the
mandates of the Federal reserve act did not require
-did not demand-of the Federal reserve system a
great many of the things which you have told us
the Federal reserve system has done to stabilize
conditions . . . in other words, the human element
has entered very largely into the practical management of this system. That human element, however, changes in time. It might not be as adequate
as it is now. It might be more subservient to
powerful influence than it is now, and, as I understand legislation of this character, it is for the
purpose if assisting, if it has any purpose at all,
the Federal reserve system in maintaining a high
standard of independence from any influences
which would tend to an undue exoansion of credit,
which, of course, results in an undue period of
deflation.
This appeal was repeated by Congressman Strong
(Stab., pt. 1, 1926, pp. 569 and 601) :
I think Governor Strong has convinced every member of this committee . . . that the Federal reserve
is now properly trying to bring about stabilization
of the financial condition of the country, and I
believe they have been doing it satisfactorily for
several years. But condition; might change; Governor Strong might not always be at the head of
this great Federal Reserve Bank of New York
City; there might be others at the head of it, with
different views, who do not feel that they ought to
use the powers that Congress has given them in
the Federal reserve system to try and bring about a
condition of stabilization. Therefore, it seems to
me that it would be proper for Congress to direct,
as a matter of policy, that the Federal reserve
system should be by statute made to adopt this
policy; and if a year from now, Governor Strong,
you should not be at the head of the great reserve
bank of New York, and they should have a different idea, and not use the powers they now have to
try to bring about stable conditions . . . then it
would be very practical and helpful to have that
provision in the law.
. . . suppose Governor Strong should pass away
and [deflationary] action should be taken, as was
taken shortly after the war . . . would not then the
people say, -“Why did not Congress direct that
board to keep on doing the work they were doing?”

Governor Strong responded positively to these
appeals (Stab., pt. 1, 1926, p. 553) :

FEDERAL RESERVE BANK OF RICHMOND

13

If I could find it possible to frame language which
would accomplish the very desirable purpose that
you have described and which I stated at the first
hearing by saying I thoroughly agreed with, I
would not hesitate to do it, and with the approval
of my associates, because I am simply one small
element in the system-one bank-1 would not hesitate to do it, and I do not know but what it may be
possible to devise some language. . . . I will try to
if you would like to have me.

Congressman Strong and Governor Strong redrafted
the mandate of the Strong bill to instruct the Federal
Reserve to maintain “stable purchasing power of the
dollar, so far as such purposes may be accomplished
by monetary and credit policy.” This language included a mandate for monetary policy of price stability, but accommodated the concern of Governor
Strong that control by the Federal Reserve over the
price level might be imprecise. Irving Fisher wrote
(Fisher, 1934, p. 171) :
The final draft of the bill was made by the two
Strongs at Atlantic City where Congressman
Strong visited Governor Strong who was ill. Governor Strong reserved official approval of this
final draft in order first to confer with his associates. As soon as he was able to come to Washington, he conferred with the Federal Reserve Board
in company of Congressman Strong and Professor
Commons. The Board disapproved of the bill and
Governor Strong felt bound by their action.

the continuation of desirable monetary policy over
time. To this end, proponents of rules urge institutional guarantees. These guarantees take the form of
explicitly legislated, meaningful objectives for monetary policy. Proponents of discretion urge reliance
upon institutional traditions that are built up over
time. These traditions develop over time out of
practical experience.
In this article, a striking episode was examined in
which monetary policy was determined by chance as
much as by conscious public debate. Whether this
episode retains a relevance for the present, or whether
subsequent changes have rendered it irrelevant, will
be debated. Hopefully, however, such debate will
contribute to an understanding of how to provide for
continuity over time in desirable monetary policy.

References
Bopp, Karl R. “Two Notes on the Federal Reserve
System.” Journal of Political Economy 40 (June
1932) : 379-91.
Chandler, Lester V. Benjamin Strong, Central Banker.
Washington, D. C.: The Brookings Institution,
1 9 5 8 .

Governor Strong’s last public appearance was at the
hearings on the Strong bill in spring 1928. He died
that fall.

Concluding Comments
As revealed in the hearings on the Strong bill, a
sharp divergence existed within the Federal Reserve
over appropriate monetary policy. After the death
of Governor Strong, effective control over monetary
policy passed out of the hands of the New York Bank
and into the hands of individual members of the
Federal Reserve Board and of individual governors
of the regional Banks. This shift in control over
policy determined the character of monetary policy
during the Depression. Later, Irving Fisher, commenting on the Depression, said, “I myself believe
very strongly that this depression was almost wholly
preventable and that it would have been prevented if
Governor Strong had lived, who was conducting
open-market operations with a view of bringing about
stability” (Fisher, 1935, p. 517).
The debate over rules versus discretion in monetary policy has continued unabated to the present. A
primary issue in this debate is how best to ensure
14

“Statement.” Banking Act of 1935. Extract from Hearings before the Committee on
Banking and Currency, House of Representatives,
74th Cong., 1st sess., Washington, D. C.: Government Printing Office, March 1935.
Friedman, Milton, and Anna Jacobson Schwartz. A
Monetary History of the United States, 1867-1960.
Princeton : Princeton University Press, 1963.
Garvy, George. “Carl Snyder, Pioneer Economic Statistician and Monetarist.” History of Political
Economy 10 (Fall 1978) : 454-90.
Snyder, Carl. Capitalism the Creator. New York: The
Macmillan Co., 1940.
Stabilization, pt. 1. Hearings before the Committee on
Banking and Currency, House of Representatives,
69th Cong., 1st sess., Washington, D. C.: Government Printing Office, March and April 1926.
Stabilization, pt. 2. Hearings before the Committee on
Banking and Currency, House of Representatives,
69th Cong., 1st sess., Washington, D. C.: Government Printing Office, April, May, and June 1926
and February 1927.
Stabilization. Hearings before the Committee on Banking and Currency, House of Representatives, 70th
Cong., 1st sess., Washington, D. C.: Government
Printing Office, March, April, and May 1928.

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

CBO AND OMB PROJECTIONS,
ADJUSTED FOR INFLATION, SHOW
FEDERAL BUDGET DEFICIT UNDER CONTROL*
William G. Dewald†

Introduction
The main point of this article is to illustrate how
standard measures of the federal budget deficit may
be deceptive inasmuch as they do not adjust the
budget for inflation. The article takes budget projections of the 1986 Congressional Budget Resolution
made in August 1985 by both the Congressional
Budget Office and the Office of Management and
Budget and deflates them, that is it expresses them
in inflation-adjusted terms. No attempt is made to
evaluate the quality of these deficit projections for
fiscal years 1986 through 1990. But even if the more
conservative of the two projections should prove to
be correct, what emerges from the analysis is the very
optimistic interpretation that the budget deficit problem, as defined by the budget offices, would essentially be eliminated in real terms over the next few
years without the need to raise taxes or cut social
security benefits. This view is sharply in contrast
with the general interpretation of the budget deficit
problem that has appeared in the press. (See accompanying Box.)
Why Adjust Budget Deficits for Inflation?
It is extremely important to take inflation into
account in evaluating the real effect of deficits on the
economy. What appears to be a deficit may turn out
to be a surplus when adjusted for inflation. The real
budget deficit is the dollar deficit adjusted for the
effect of inflation not only in increasing the interest
rate at which the government borrows but also in
* The Review offers this article in the belief that readers
should be aware of the widest spectrum of opinion on
such key policy issues as the federal deficit. The views
expressed herein are solely those of the author and not
necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.
† Professor of Economics, Ohio State University, and
former editor of the Journal of Money, Credit and
Banking.

reducing the real value of outstanding government
debt to be financed. The real deficit represents the
net claim on credit markets for funds to finance the
federal government. Eliminating the deficit in real
terms could free credit markets both in the United
States and other countries from supporting large
annual net flows of funds to the federal government.1
Lower real interest rates both in the United States
and other countries would be a prospect to the extent
that deficits in recent years had kept rates extraordinarily high.2
Deflating the budget deficit removes the effect of
inflation on both the interest rate at which the government borrows and the value of its outstanding
debt. This amounts to recalculating government
interest payments in real terms. Suppose the government borrowing rate is 10 percent and the outstanding debt is $1,500 billion as is approximately true for
the current fiscal year. Nominal interest payments
thus would contribute $150 billion to the deficit. The
10 percent nominal interest rate includes an inflation
premium to compensate lenders for depreciation in
the real value of their claims to future repayment by
borrowers. Consequently an increase in inflation
would increase the deficit because inflation is reflected in nominal interest rates as in recent experience. On the other hand an increase in inflation
would decrease the real cost of financing government
debt because of two fundamental gains to the government attributable to inflation. One is that it would
collect additional taxes from recipients of increased
interest income on government securities due to inflation. The other is that inflation reduces the real value
of its outstanding debt, thereby reducing its claim on
1

Gerald P. Dwyer, Jr., “Federal Deficits, Interest Rates,
and Monetary Policy,” Journal of Money, Credit and
Banking, Part II (November 1985), pp. 655-81.
2

William G. Dewald, “Federal Deficits and Real Interest
Rates: Theory and Evidence,” Federal Reserve Bank of
Atlanta, Economic Review (January 1983), pp. 20-29.

FEDERAL RESERVE BANK OF RICHMOND

15

The Deficit Problem: Views from the Press

Jane Seaberry, “CBO Cuts Forecast on Deficits,” The Washington Post, August 16, 1985, p. El.
[ CBO Director Rudolph] “Penner’s enthusiasm for the resolution contrasted with remarks
by members of Congress. The leaders of the House and Senate Budget committees said the
resolution was the best that could be done under the circumstances, and high deficits would
persist unless taxes were raised or major benefits programs such as social security were cut.
“President Reagan said the budget compromise marked the beginning of the deficitreduction process and this week he vowed to seek deeper cuts in spending.”

Haynes Johnson, “The 134-Mile-High Stack,” The Washington Post, September 22, 1985, p. A3.
“The forecasters say the geometric symmetry of our debt will continue to circle neatly
ever upward. In 5 more years, on our present course, . . . the total national debt will have
jumped again from $2 trillion to $3 trillion, a tripling of the debt in less than a decade.
“Well, I leave it to experts in the ‘dismal science’ of economics to sort out the theoretical
and technical hows and whys of all this. But you don’t have to be an expert to get the meaning
of this blunt message. We’re hurtling pell-mell into debtor status at all levels of American
society, and no amount of smiles and soft soap from the White House can keep this news from
being understood.”

Helen Dewar, “Reagan Budget Policies Blasted on Both Sides,” The Washington Post, September 25, 1985, p. A2.
“Why is he [President Reagan] on tax reform when he should be on deficits? Why does
he undercut the [Senate] budget resolution? asked [Senator David F.] Durenberger [RMinn] in reference to Reagan’s spurning of a Senate budget that would have raised taxes and
cut Social Security to achieve larger long-term deficit reductions than Congress ultimately
approved.
“Similar rumblings on the deficit issue came during the weekly Senate Republican caucus
luncheon dominated by appeals for further action to contain deficits. These included interest
in a plan by Sens. Phil Gramm (R-Tex) and Warren B. Rudman (R-N.H.) to force spending
cuts sufficient to balance the budget by fiscal 1990.”

Bob Setter, Los Angeles Times, September 30, 1985, sec. 1, p. 4.
“Former budget director David Stockman called Sunday for a tax increase of at least $100
billion a year to help reduce the federal budget deficit and prevent what he called ‘traumatic
economic dislocations.’
“ ‘If we’re going to get out of this situation and restore any semblance of national solvency
and fiscal discipline, it’s going to take a very major tax increase, larger than we’ve ever had
or contemplated before,’ Stockman said.”

16

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

resources to finance expenditures. If the nominal
interest rate on government debt is 10 percent and
the marginal tax rate on interest income is 30 percent, 3 as is approximately true today, the effective
interest rate on government borrowing which incorporates the feedback of tax receipts is only 7 percent
[10 percent x (1-.3)]. The effective borrowing
rate which incorporates a 4 percent inflation rate is
only 3 percent [10 percent x (1-.3) - 4 percent].4
Essentially adjusting the deficit for inflation eliminates $45 billion of the $150 billion of nominal interest payments because of a feedback of taxes on interest income and $60 billion because of depreciation in
the real value of the outstanding debt. Assuming the
noninterest part of the deficit (the so-called primary
deficit) was balanced, the deficit would not be $150
billion (the nominal interest payments on the debt)
but only $45 billion (the real after-tax interest cost
of financing the debt if the marginal tax rate is 30
percent and inflation is 4 percent). The effective
real interest rate on financing the government debt
would thus not be 10 percent but only 3 percent.
Federal Deficits and Debt, 1952-1974
Chart 1 records the nominal budget deficit as a
percentage of GNP. This deficit ratio typically has
risen during recessions and fallen during expansions.
Until 1975 deficits generally peaked during recessions at about 2 percent of GNP as in 1953, 1958,
and 1971. There were occasional surpluses (negative
deficits) as in 1955-57, 1960, and 1969. Nevertheless
there were more and larger deficits than surpluses.
As a consequence the publicly held federal debt increased from $218 billion in 1952 to $343 billion in
1974, a 2.2 percent average annual increase. But
GNP grew at a faster rate, 7.0 percent on the average. Chart 2 shows the ratio of publicly held federal
debt as a percentage of GNP. It fell from over 60
percent in 1952, a level that reflected financing
World War II and the Korean War, to a level of
less than 24 percent in 1974 before the onset of the
deficit problems that followed.

Chart 1

FEDERAL NOMINAL BUDGET DEFICIT
AS PERCENT OF GNP

through 1985. There were no surpluses and much
larger deficits relative to GNP than previously had
been observed, for example, 4.5 percent in 1975 and
an unprecedented string of about 5 percent deficits
the past four years. The publicly held federal debt
more that quadrupled from $343 billion in 1974 to
$1,522 billion in 1985, an 11.6 percent annual increase. This was significantly more than the GNP

Chart 2

PUBLICLY HELD GOVERNMENT DEBT,
PERCENT OF GNP

Bad News on the Deficit: Observations,
1975-1985
Charts 1 and 2 also document how dramatically
the federal deficit and debt picture changed from 1975
3

U.S. Treasury Department, Private communication.

4

William G. Dewald, “Government Deficits in a Generalized Fisherian Credit Market,” Departmental Memorandum, International Monetary Fund, August 30, 1985.
FEDERAL RESERVE RANK OF RICHMOND

17

growth rate. Consequently the ratio of publicly held
federal debt to GNP rose from a low of 23.9 percent
in 1974 to a high of 39.4 percent in 1985. That is the
bad news that still pervades the general perception of
the budget deficit situation in the United States.
Good News on the Deficit: Projections,
1986-1990
The good news is that actually implementing the
1986 Congressional Budget Resolution-which
promises to cut both defense and domestic spending
programs but to leave taxes and social security essentially unchanged-would be enough to substantially
reduce budget deficits and start shrinking federal
debt relative to GNP. Additional domestic spending
cuts such as the Administration has proposed could
significantly speed the process. So would the tax
hikes favored by a number of Senators and Congressmen.
Table I gives some sense of the magnitude of the
good news in the Congressional Budget Resolution.
In February CBO projected deficits of more than 5
percent of GNP with federal debt growing faster
than GNP as far as it could see. By contrast, in
August CBO projected that implementing the 1986
Congressional Budget Resolution coupled with its
own more optimistic assumptions about interest rates
would cut the deficit from 5.2 to 4.2 percent of GNP
in the current fiscal year and from 5.3 to 2.1 percent

Table I

CBO PROJECTIONS OF FEDERAL DEFICITS AND
DEBIT HELD BY THE PUBLIC, 1985-1990

Federal Debt Held by
the Public to GNP

February

August

February

August

1985

5.6

5.5

39.6

39.6

1986

5.2

4.2

41.8

41.1

1987

5.2

3.7

44.0

41.7

1988

5.1

3.0

46.0

41.6

1989

5.2

2.5

47.9

41.1

1990

5.3

2.1

49.7

40.2

Sources: Congressional Budget Office, The Economic and Budget
Outlook, February 1985, Table E-2, p. 160; and Congressional
Budget Office, The Economic and Budget Outlook: An Update,
August 1985, Summary Table 4, p. xxi and Summary Table 5,
p. xxi.

18

The ‘Real’ Good News: Real Deficits
Projected to End
This article explains why, when inflation is taken
into account, even the less optimistic CBO projections of a deficit to GNP ratio falling to 2.1 percent
by 1990 imply that the federal deficit in inflationadjusted terms would essentially be eliminated. The
more optimistic OMB projections imply significant
real budget surpluses in 1989 and 1990. Further
reductions in federal spending or increases in taxes
than embodied in the Congressional Budget Resolution would imply even larger surpluses.
Adjusting Deficits for Inflation: An Example

(As a percentage of GNP)

Federal Budget
Deficit to GNP

by 1990. Based on more optimistic assumptions
about both economic growth and reductions in federal
spending, in August OMB projected that the deficit
to GNP ratio would fall to a mere 0.3 percent by
1990. The CBO and OMB projections of the budget
deficit as a percent of GNP are plotted in Chart 1.
They show a significant decline in the deficit ratio,
but CBO projects the deficit declining by 1990 only
to 2.1 percent of GNP. Before 1975 this had represented not a relatively low but a relatively high deficit
ratio over the business cycle. Nevertheless, as Chart
2 shows, both CBO and OMB were projecting that
the debt to GNP ratio would peak and start to decline
beginning in 1988, thus restoring the normal peacetime pattern of declining debt to GNP ratios that had
been observed from 1952 through 1974. An implication of these projections of declining debt to GNP
ratios is an elimination of the federal deficit in
inflation-adjusted terms as explained in the next
sections.

To lay the groundwork for calculating the real
budget deficit, consider some hypothetical numbers.
Suppose a borrower owes $20,000 and promises to
repay the principal and 5 percent interest ($1,000)
at the end of a year. What the $21,000 repayment is
worth in real terms depends on inflation. If inflation
were 10 percent, $21,000 would be worth only
$19,090.91 ($21,000/1.10) in inflation-adjusted
dollars. The borrower would have struck a good
bargain and the lender a bad one because the real
interest rate would have turned out to be a negative
4.5 percent (-$909.09/$20,000).
If inflation were correctly anticipated, lenders
would not accept such bad bargains. Suppose 10
percent inflation is expected and lender and borrower
negotiate a 15.5 percent nominal interest- rate. This

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

would yield a nominal return of $3,100 on $20,000.
Thus the real or inflation-adjusted return would be
only $1,000 ($23,100/1.10-1$20,000) which is a 5
percent real rate. The real cost of financing the
$20,000 of debt is not 15.5 percentbut only 5 percent.
The $23,100 of debt including nominal interest in
current dollars at the end of a year amounts to only
$21,000 of debt in inflation-adjusted dollars which
are dollars calculated to have the same purchasing
power as at the beginning of the year. To continue
the hypothetical example, the interest cost of financing his debt in current dollars or nominal terms
would be $3,100-his nominal interest cost. But the
change in his debt in inflation-adjusted dollars or
real terms would be only $1,000 which is the net cost
of financing the loan including both nominal interest
payments and depreciation in its real value.
Real Budget Deficit Calculations : 1952-l990
These very same principles apply in translating the
federal government deficit in current dollars into real
or inflation-adjusted dollars. The easiest way to do
this correctly is to calculate the real federal deficit
as the change in the inflation-adjusted (deflated)
value of the publicly held federal debt. 5 F e d e r a l
government outlays totaled $851.8 billion and revenues $666.5 billion in fiscal year 1984. Its nominal
deficit was the difference which rounded out to $185
billion. Its real deficit was much less. The reason is
that 3.8 percent inflation reduced the real value of
$1,142 billion of publicly held debt outstanding by
$42 billion in inflation-adjusted dollars. Thus the
real deficit was only $136 billion, that is,
$185 billion - (.038-x.$1,142 billion)
1.038
in terms of 1983 prices. That is still a comparatively
large number. As shown in Chart 3, it is 4.0 percent
of real GNP. However, it is considerably less than
the 5.2 percent ratio of the nominal deficit to GNP, a
figure that does not adjust the deficit for inflation.
5

Michael Dotsey’s article in the previous Economic
Review 6 surveys the theoretical literature regarding
the effect. of budget deficits on the economy. He
explains how optimal deficits would account not only
for inflation as in the present article but also for the
business cycle and for secular factors affecting real
interest rates; The business cycle, as has been mentioned, is important to the extent that deficits normally rise when output is below normal as in the
early 1980s and fall when output is above normal.
Dotsey cites a recent Wall Street Journal article by
Robert J. Barro7, a principal contributor to the literature on deficits, in which he estimated that the 1984
budget deficit ratio was not unusually high because
two percentage points of it was attributable to inflation and about one and one-half percentage points to
cyclical factors. By comparison, the present paper
estimates the effect of inflation on the budget deficit
but makes no attempt to calculate the effect of other
factors. This is in keeping with CBO and OMB outyear projections which do not account for the business cycle but are averages that are expected to
prevail.
Chart 3 shows that real deficits were generally
much smaller than the nominal deficit over the years
1952-1985, especially when inflation increased so very
much in the late 1970s and early 1980s. Even though
inflation was comparatively low in 1953-1974, as
Chart 4 shows, adjusting for inflation makes a big
difference in the deficit picture. There were real surpluses (negative deficits) in 16 of these 23 years in
contrast to only 7 nominal surpluses. In the years
since 1974 there have been no nominal surpluses at
all, yet there were real surpluses owing to high inflation in each of the years 1978 through 1981. Substantial real deficits of 3 to 4 percent were encountered only in the years 1982 through 1985 when lenders were finally demanding and getting interest
returns that compensated them: for actual inflation.
The effective after-tax real interest rate at. which
the government borrows is plotted in Chart 5. 8 T h e
6

Michael Dotsey, “Controversy over the Federal Budget
Deficit: A Theoretical Perspective,” Federal Reserve
Bank of Richmond, Economic Review (September/
October 1985), pp. 3-16.
7

Federal debt held by the public is defined to include
Federal Reserve holdings. There is a close correspondence, especially in recent years, between the amount of
base money held by the public and Federal Reserve
holdings of federal debt. Thus, federal debt held by the
public approximates the sum of privately held federal
interest bearing debt plus federal noninterest bearing
debt (base money). Inflation depreciates the real value
of both categories of debt and thus reduces the real cost
of financing the government.

Robert J. Barro, “A Deficit Nearly on Target,” Wall
Street Journal, January 29, 1985, p. 32.

8

where
r = after-tax real interest rate
i = before-tax nominal interest rate
= tax rate
= inflation-rate

FEDERAL RESERVE BANK OF RlCHMOND

19

Chart 3

Chart 5

NOMINAL AND REAL FEDERAL BUDGET
DEFICITS AS PERCENT OF GNP

REAL AFTER-TAX GOVERNMENT
BORROWING RATE
Percent

Chart 4

INFLATION
Actual and Projected

reason why the net interest cost on government borrowing is an after-tax interest rate is that the government collects tax revenue from taxpayers who earn
interest on government securities. As mentioned, if
the government pays a 10 percent before-tax rate but
collects 30 percent of interest income in taxes, its
effective interest cost rate would be 7 percent [10
20

Actual and Projected

percent x (1-.3)]. It is essentially the same rate
at which taxpayers earn interest income. Taking
inflation into account Chart 5 shows that the after-tax
real interest rate on government securities was low,
generally negative, from the middle 1960s through the
1970s and early 1980s as inflation accelerated. Only
since 1982 have after-tax real rates at which the
government borrows and taxpayers lend been positive
and only since then have there been persistently high
real deficits.
By incorporating such effective real interest costs
of financing the federal government debt in calculating real deficits, Chart 3 shows how both the CBO
and OMB projections of budget deficits embodied in
the 1986 Congressional Budget Resolution would cut
the deficit in 1988-1990 to well within the range of
variation that was observed in the 1950s and 1960s
which is the main point of the present article. To
the extent that high real interest rates have been
associated with high real deficits, these projections
imply lower real interest rates in the future than
were observed in recent years. The calculations used
to adjust the CBO and OMB projections to inflation
are shown in the Appendix.
Conclusion
My conclusion is that implementing the Congressional Budget Resolution would go a lot further in
cutting back government spending and deficits than

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985

is generally understood. My argument has used
CBO and OMB assumptions and projections, but
expressed deficits in inflation-adjusted terms. The
deficit picture may be even brighter than these figures
suggest when one considers that eliminating deficits
might spur real growth and cut government borrowing rates more than have been projected by the
budget offices. In any event, taking account of inflation, this article has shown that even CBO’s conservative assumptions, rather than OMB’s optimistic
assumptions, imply that the 1986 Congressional Bud-

get Resolution promises to accomplish a lot more to
alleviate the deficit problem than its authors seem to
have recognized. Perhaps the budget resolution will
be disregarded as has often been the case in recent
years. But if it is implemented and if the economic
assumptions of CBO and OMB prove to be accurate,
then the federal budget deficit in inflation-adjusted
terms would be eliminated without the necessity of
raising taxes or cutting social security benefits. May
one conclude that application of the “dismal science”
need not yield dismal results?

Appendix Table I

CONGRESSIONAL BUDGET OFFICE DEFICIT PROJECTIONS
(Fiscal Years, Billions of Dollars, and Percent)

Source: Congressional Budget Office, The Economic and Budget Outlook: An Update, August 15, 1985.
Columns:

FEDERAL RESERVE BANK OF RICHMOND

21

Appendix Table II

OFFICE OF MANAGEMENT AND BUDGET DEFICIT PROJECTIONS
(Fiscal Years, Billions of Dollars, and Percent)

Source:

Office of Management and Budget, Mid-Session Review of the 1986 Budget, August 30, 1985.

Columns:
(1) Table 2, p. 3.
(2) Figures are for the beginning of the fiscal year. 1984.86: Table 23, p. 39.
1987-90: Means of financing other than borrowing from the public assumed to be zero.
(3) Table 3, p. 5.
(4) Calculated from (3).

(10) Figures are for the end of the fiscal year. (2) ÷ (6).

22

ECONOMIC REVIEW, NOVEMBER/DECEMBER 1985


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102