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in honor of


F o r e w o r d ........................................................................................................

. •


Joseph A . Livingston .............................
Thomas B. M c C a b e ............. .................
Alfred H. W illiam s............... .........................................
Robert N. H ilk e r t.................................................... ..
David P. Eastburn ........................ . . . . . . . . . . . . . .


A bo ut K arl R . B o pp

I n t r o d u c t io n

William McC. Martin, J r . ............. ...................


Im p a c t s o f T h eo r y o n P o l ic y :
T h e E arly Y ears o f th e F ederal R eserv e

Lester V. C handler................................... ..


S o m e C h a n g e s i n I d e a s o n C e n t r a l B a n k in g

Elmer W o o d .......................... .................................... ....


P o l ic y N o r m s a n d C e n t r a l B a n k in g

Allan S p r o u l...................................................... ..


R e a p p r a is in g t h e F e d e r a l R e s e r v e
D is c o u n t M e c h a n is m

Robert C. H o lla n d ................. ......................... ..

1966 C r e d i t C r u n c h
Alfred H a y e s .......................... ............ .........................


N e w S t a n d a r d s f o r C r e d it a n d M o n e t a r y P o l ic y

George W. M itc h e ll..................................................


B a n k C o m p e t i t io n a n d M o n e t a r y P o l ic y

Guy E. N o y e s .......................................................... ..


C o m m e r c ia l B a n k in g a n d t h e F e d e r a l R e s e r v e :
A R e c o r d o f M i s u n d e r s t a n d in g

Willis W. A lexa n d er......................................................



N e w T ools o f M o netar y C o ntro l A broad

George G a r v y .................................................... ..


M a k in g P e a c e W it h G o l d

Ralph A . Young ............................... . . .......................... 151
C a p it a l M o v e m e n t s a n d B a l a n c e - o f -P a y m e n t s
A d ju st m e n t

Robert V. R o o s a ........................................................... 171
C u r r e n c y C r is e s : T h e R ecord a n d t h e R e m e d y

Frederick L. Denting .......................................... ..


E c o n o m is t s a n d P u b l i c P o l ic y

Charls E. W a lk e r ............. ............................................. 213
C en tr a l B ank L eaders a n d C en tr al
B a n k C r e d ib il it y

C. R . Whittlesey . ......................................................


C e n t r a l B a n k e r s : T h e ir A t t r ib u t e s
and D evelopm ent

Canby B alderston.................................................. ..


T h e R o l e o f t h e D ir e c t o r :
T h e Ideal a n d th e R eal

Willis J. W in n ..................................... ..


T h e F e d e r a l R e s e r v e a s a L iv in g I n s t i t u t i o n :
A P r e s c r ip t io n f o r t h e F u t u r e

David P. Eastburn ...................................................


from time to time of the tribulations of editors of
books of essays, I launched this enterprise early in 1969 with full ex­
pectation of many delays and complications— especially given the fact
that the authors of the essays are busy and important men. That the
expectation was not realized is testimony to the respect and affection
all of us have for Karl Bopp. This volume is clearly a labor of love.
The contributors were selected because of their close association
with Karl in various stages of his career, principally as teaching or
Federal Reserve colleagues, and/or as students. A complete biography
of the authors would be much too voluminous to include here. But at
the risk of omitting important chunks of many illustrious careers, I
have listed below the primary relationships between the contributors
and Karl Bopp.
H a v in g H e a r d

Joseph A. Livingston—Economic Columnist, Philadelphia Evening
Bulletin, and syndicated columnist.
Thomas B. McCabe— Member, 1937-1948, Deputy Chairman,
1938, Chairman, 1939-1948, Board of Directors of Federal Re­
serve Bank of Philadelphia; Chairman, Board of Governors of
the Federal Reserve System, 1948-1951.
Alfred H. Williams—President, Federal Reserve Bank of Phila­
delphia, 1941-1958.
Robert N. Hilkert—Staff, 1942-1958, First Vice President, 19581970, Federal Reserve Bank of Philadelphia.
David P. Eastbum—Student of Karl R. Bopp, University of Penn­
sylvania; Staff, 1942-1970, President, 1970— , Federal Reserve
Bank of Philadelphia.
William McC. Martin—Chairman, Board of Governors of the Fed­
eral Reserve System, 1951-1970.
Lester V. Chandler— Student with Karl R. Bopp, University of
Missouri; Professor, Princeton University, 1950-1969; Member,
1954-1959, Deputy Chairman, 1958-1959, Board of Directors
of Federal Reserve Bank of Philadelphia.
Elmer Wood— Professor, 1930-1962, Professor Emeritus, 1962— ,
University of Missouri.


Allan Sproul—President, Federal Reserve Bank of New York,
George W. Mitchell— Staff, Federal Reserve Bank of Chicago,
1944-1948, 1951-1961; Member, Board of Governors of the
Federal Reserve System, 1961— .
Alfred Hayes—President, Federal Reserve Bank of New York,
1956— .
Robert C. Holland— Student of Karl R. Bopp, University of Penn­
sylvania; Staff, Federal Reserve Bank of Chicago, 1949-1961;
Staff, Board of Governors of the Federal Reserve System,
1961— .
Guy E. Noyes— Student of Karl R. Bopp, University of Missouri;
Staff, Board of Governors of the Federal Reserve System, 19481965.
Willis W. Alexander— Student of Karl R. Bopp, University of
Missouri; President, 1968-1969, Executive Vice President,
1969— , The American Bankers Association.
George Garvy— Staff, Federal Reserve Bank of New York, 1943— .
Ralph A. Young—Staff, Board of Governors of the Federal Re­
serve System, 1946-1967.
Robert V. Roosa— Staff, Federal Reserve Bank of New York,
1946-1960; Under Secretary of the Treasury for Monetary Af­
fairs, 1961-1964.
Frederick L. Deming— Staff, 1941-1953, First Vice President,
1953-1957, Federal Reserve Bank of St. Louis; President, Fed­
eral Reserve Bank of Minneapolis, 1957-1965; Under Secretary
of the Treasury for Monetary Affairs, 1965-1969.
Charls E. Walker—Student of Karl R. Bopp, University of Penn­
sylvania; Staff, Federal Reserve Bank of Philadelphia, 1953;
Staff, Federal Reserve Bank of Dallas, 1954-1961; Assistant to
Secretary of the Treasury, 1959-1961; Executive Vice President,
The American Bankers Association, 1961-1969; Under Secre­
tary of the Treasury, 1969— .
Charles R. Whittlesey— Professor, 1940-1967, Professor Emeritus,
1967— , University of Pennsylvania.

C. Canby Balderston—Member, 1942-1953, Deputy Chairman,
1949-1953, Board of Directors of Federal Reserve Bank of
Philadelphia; Member, 1954-1966, Vice Chairman, 1955-1966,
Board of Governors of the Federal Reserve System.
Willis J. Winn— Member, 1962— , Deputy Chairman, 1965-1966,
Chairman, 1966— , Board of Directors of Federal Reserve Bank
of Philadelphia.
I am greatly indebted to the contributors for their cooperation and
Thanks are due also to many others for help in various respects,
especially to Robert N. Hilkert, Lester V. Chandler, and George W.
Mitchell for assistance in planning the volume; Charles J. Mustoe and
Dorothy Bowen for considerable editorial help; and James A. Craw­
ford for being a patient and understanding printer.


February, 1970



commanded the
Red Queen. “Knave, read!”
The Knave of Hearts faced the assemblage,
unrolled a scroll and read:
“For his 29 years of diligence, devotion, and
distinction in the Federal Reserve System, for his
dedication to research, teaching, and learning, for
his commitment to excellence and originality, for
the freedom he granted to others, for his integrity
and modesty, and for never wearing his Phi Beta
Kappa key in public . . .
“Stop, Knave, stop,” intervened the Lord High
Privy Councilor. “This is a fiction of a demented
imagination, a hoax on the Queen, a weird jest:
Who can measure to such qualifications?”
Alice jumped to her feet. “If it please your
majesty, the Lord Councilor has the object where
the subject should be. In this case the qualifica­
tions fit the man, not the man the qualifications.”
The Red Queen paid heed neither to Alice nor
the Lord Councilor. She declared: “This is a
courtroom, not a commencement, a hearing, not
a ceremony. I came to listen to a petition, not a
citation. Proceed!”
“The petitioner should be permitted to speak
for himself,” answered Alice.
“Can he do that?” demanded the March Hare.
“His dossier says he’s a constant husband, mar­
ried to the same wife— Ruth— for 38 years. How
can he speak for himself?”
“As his counsel in this proceeding,” responded
Alice, “I assure you he does. He believes in the
freedom of speech, the division of labor, the law
of diminishing returns, the marginal utility of
excess verbiage, and, as a modern economist, he’s
familiar with the Phillips curve.”
“What’s that?” the Carpenter asked hopefully,
putting aside his copy of Playboy.
“What’s what?” replied Alice.
“The Phillips curve,” answered the Carpenter.
“Not what you’re thinking of,” said the Privy
“ L e t t h e P r o c e e d i n g s B e g i n ,”

Councilor. “It’s a statistical model for unemploy­
ment, not in the least related to a Powers model.”
“But let me go on,” pleaded Alice. “Early in
his married life, the petitioner made his choice:
To live tolerantly in preference to Ruthlessly.”
The Red Queen shuffled some papers, whis­
pered to the White Queen who sat next to her,
and said: “Where is this petitioner?”
The Knave of Hearts brought in a man of med­
ium height, gray-white hair, and erect mien.
“Your last name, please,” said the Red Queen.
“Spell it for the record.”
“ B O P P.”
“Pronounce it,” said the Queen.
“Bopp to rhyme with pope.”
“Very interesting,” said the Walrus. “Can you
think of a few more rhymes?”
“Mope, rope, lope.”
“Excellent, excellent,” said the Red Queen, who
was catching on to the Walrus’s purpose. “How
about some more rhymes?”
The petitioner, without hesitating, answered:
“Of course, if it please your royal highness—
slope, nope, cope.”
“Fine,” said the Walrus. “Can you continue?”
“If it please the Queen.”
The Queen nodded.
“Well, then, there’s grope and . . . ”
Alice was on her feet again. “Don’t you think,
your majesty, that gives the idea. It’s Bopp to
rhyme with soap and hope, not sop and hop.”
The Red Queen yielded, and said: “Does he
have given names?”
“Karl Richard,” the petitioner replied.
“And what is your petition?” the Red Queen
“I plan to retire. I would like your permission.”
“What do you intend to do in retirement?”
“I shouldn’t think that would take planning,”
interjected the Mad Hatter.


“Oh, but it does,” interceded Alice. “It’s easy
to do what you have to do. You have to plan to
do what you want to do.”
“Substantiate that!” demanded the Lord High
“My client,” said Alice, “is 64. He has served
his time!”
“That’s not the question,” declared the Walrus.
“Has time served him?”
“Very well,” said Alice. “So well that he’s
asking for early retirement. He saved a year.”
“How does one learn to do that?” asked the
Red Queen.
“From parents,” answered Alice. “His father
was a carpenter, who worked hard and lived ac­
cording to Benjamin Franklin. A penny saved is
a penny earned and time is money. The petitioner
used his time well. Let me show you.”
Alice unfurled on a huge chart a curriculum
vitae of Karl Richard Bopp, born February 2,
1906, in Kirkwood, Missouri.
“So, he’s from Missouri,” said the March Hare.
“Very much so,” said Alice. “He went to school
in Missouri and was the first member of his family
ever to go to college. He entered the University of
Missouri in 1924. He got his A.B. in 1928, his
M.A. in 1929, and in 1931 married Ruth Callies,
also a Missouri graduate. And as a reward for
his good judgment, Missouri granted him a Ph.D.
and made him an assistant professor!”
“So Missouri is in the blood stream,” said the
Lord High Privy Councilor. “But where is it?”
“At Columbia,” answered the petitioner.
“And where’s that?” persisted the Privy Coun­
“Midway between St. Louis and Kansas City,”
replied Bopp.
“In other words neither here, nor there,” as­
serted the Mock Turtle.
“You mean not anywhere?” asked the Mad

“It’s everywhere,” protested Alice. “Every­
where that men gather to communicate ideas,
reflect on the nature of the universe, study the
behavior of men— everywhere that men devote
their minds to understanding. Education has no
locale. It’s ubiquitous, irrepressible, omnipresent,
and eternal.”
“Nevertheless,” decided the Red Queen,
“Columbia, Missouri, is a strange place. Where I
come from you have to run twice as fast to stay in
the same place, but this man Bopp progressed by
staying in the same place.”
Alice beamed. “You’re so perceptive, your
royal highness. He won a Social Science Re­
search Council grant to study the central bank­
ing system in Germany, he taught summer school
at the University of Seattle, and was advanced
to an associate professorship at Missouri in
The Walrus began counting on his tusks—
aloud: “One, two, three . . . ” Finally, he ex­
claimed: “Utterly unbelievable. Bopp must have
the patience of Job. In 1937, he had been at
Missouri 13 years.”
“Yes,” said Alice, “that’s right. And he re­
mained in academic limbo until 1941, but in be­
tween he won a Guggenheim fellowship to study
central banking in the United States and Great
The Red Queen summoned the Executioner.
“Stand by,” she commanded. “I think you’ll have
work to do.”
Alice was alarmed. “Why do you say that?”
she asked.
“Why do I say that, why do I say that?” shout­
ed the Red Queen. “I can read, can’t I? I see
what’s in the newspapers. I know the shape of
the pound and the dollar and the Bank of Eng­
land and the Federal Reserve System. If this is
the result of Bopp’s study, he ought to do another
study. But if the first study got us where we are,


I hardly think we can afford another. I ’m con­
sidering: Can we afford Bopp?”
“Maybe he studied too much,” suggested the
March Hare. “According to the chart, he became
successively director of research at the Federal
Reserve Bank of Philadelphia, then vice president
in charge of research, and in 1958, president.”
“Fancy that,” exclaimed the Mock Turtle. “An
economist—president of a Federal Reserve
“That was a depression year. The country was
in bad shape,” said the Lord High Privy Coun­
cilor, as if that explained everything and anything.
The Red Queen nodded and bade the Execu­
tioner to relax.
Hastily Alice continued. “Bopp is not here as a
defendant. He’s a petitioner, expecting his due.”
“I think we’re making too much ado about his
due,” said the Lord High Privy Councilor.
“Let him get up early in the morning,” said
the irrepressible Mad Hatter. “An early riser gets
the dew. Besides, if he has done all Alice says
he’s done, I should think he has gathered more
dew than most men in a lifetime.”
“If it please your majesty,” persisted Alice,
“I ’d like to go on. Dr. Bopp did what had to be
done. He was technical secretary of the Bretton
Woods Monetary Conference. He did one of the
first papers on Hjalmar Schacht, head of the Ger­
man Reichsbank, and he was special assistant to
Thomas B. McCabe, when President Truman ap­
pointed McCabe chairman of the Federal Reserve
Board. Later Bopp became chairman of meetings
of the Sunday Breakfast Club in Philadelphia,
he . .
“Hmph,” hmphed the Walrus. “When a man
becomes chairman of something, it means he
hasn’t enough to do.”
“On the contrary,” said Alice, “the busier a
man is, the more he’s in demand. And these are
such strange meetings. The Sunday Breakfast Club

convenes Wednesday evenings for dinner at the
Midday Club. Dr. Bopp had to find speakers who
had something to say and at the same time hold
the attention of Philadelphia’s leading business­
men. That’s a major achievement!”
“An achievement! What’s so hard about that?”
argued the Walrus.
“Have you ever tried to keep a Philadelphia
businessman awake after dinner?” asked Alice.
The White Queen broke her silence: “If Bopp
did that, we can’t afford to let him retire. Such
talent, wisdom, and experience must not go to
“It won’t,” promised Alice.
“How can you promise that, when he plans to
do nothing?” asked the Red Queen. “Do you plan
to upset his plan?”
“I won’t have to,” said Alice. “I’ll leave that to
others. Dr. Bopp has lectured at the Stonier
School of Banking, the School of Banking of the
South, University of Pennsylvania, Princeton,
Columbia, Wisconsin. He has made commence­
ment speeches, has been granted honorary de­
grees, is a trustee of Temple University. Dr. Bopp
knows what time is for— to use it in behalf of
“I get it, I get it,” chortled the March Hare.
“Then, in retirement, he’ll have the other half
for himself!”
“That’s not what I wanted to say,” responded
Alice. “In modern society, a man saves up time
by working. He produces more than he consumes.
His underconsumption— his pension and his
stocks and bonds— gives him time to be his own
taskmaster. Then a man does what he has to do.”
“I could have told you that,” said the Mock
Turtle. “Retirement is a continuation. A man’s
past is his future compulsion.”
“I quite agree,” said Alice. “Dr. Bopp began
his working career during the Great Depression.
He helped piece together the post-World War II


monetary system at Bretton Woods . . .
“God is merciful, he’ll forgive him for that!”
said the March Hare. “But can we?”
Alice paid no attention, but went right on:
“He was active in the Federal Reserve System
when it supported President Truman’s bond
market before the 1951 Accord. He was a policy­
maker at the Federal Reserve during the 19601969 Kennedy-Johnson prosperity.”
“Hmph, hmph,” hmphed the Walrus, who was
especialy skilled at hmphing. “And now look at
the state of the world! Inflation, inflation every­
where. I don’t see how Dr. Bopp can afford to
“Well, Dr. Bopp is following the Federal Re­
serve’s too-early formula. The Open Market Com­
mittee used to act after the fact. It didn’t make
credit easy until it could see the whites of a re­
cession’s eyes. Then, when it was accused of tardi­
ness, it followed the other course. It decided to
act before a recession was evident. It didn’t wait
for a trend, it anticipated turning points.”
“That explains everything,” said the Mad Hat­
ter. “Retire early before it’s too late.”
The Red Queen began tapping her mace.
“Enough of this prattle,” she shouted. “Let’s get
to the question. What will a man do who plans
to do nothing?”
“If you’ll forgive me,” said Alice, “there’s a
better question. That is, what won’t Dr. Bopp
do? He’ll have a problem.
“He has lectured in so many places, made so
many speeches, been consulted by so many busi­
nessmen and bankers, that he’ll be hard put to
find time to do nothing. He’ll be asked to lecture
here, lecture there, serve on this board, chair that
panel, speak here and there and everywhere.”
“Well, we can now come to a decision,” said
the Red Queen with finality. “Can we grant a
retirement petition to a man who won’t be allowed
to retire?”

She conferred briefly with the White Queen.
Finally, she pronounced: “The petition is granted.
Karl Richard Bopp has our consent to do what
is beyond his nature to do— nothing. He has his
freedom to stop one career— and to begin an­
At the pronouncement, Alice, the Walrus, the
Mad Hatter, the March Hare, and the Knave of
Hearts rushed up to the petitioner. “Congratula­
tions, congratulations,” they shouted in unison
and separately.
“But is a man who intends to do nothing to be
congratulated?” asked Dr. Bopp.
“No,” replied the Lord High Privy Councilor,
“and I speak for the Queens when I say this. You
are to be congratulated because freedom to a man
like you is a license to do what you have always
done— serve others. But if you overdo it, you’ll
be penalized. You’ll lose your Social Security!”
“So,” advised the White Queen, “you must try
to say ‘no’ more often than ‘yes.’ The secret of
doing nothing is doing what you want to do.”
“Please, your majesty, may we adjourn on
that?” asked Alice.
The Red Queen looked at the White Queen,
the White Queen looked at the Red Queen, and
both pronounced in unison: “Adjournment is our
prerogative. Besides, this is a beginning not an
“But that is what adjournment means,” said
Alice. “An ending for a new beginning.”
Even the Red Queen was pleased. She said: “If
that be so, the proceeding is adjourned.”


R. B o p p is one of the most competent
students of the functions and problems of central
banking that we have in the Federal Reserve
System. His extraordinary talents came to my
attention in the summers of 1940 and 1941, when
he participated in the special studies on executive
development in the Federal Reserve Banks as
conducted by C. Canby Balderston, Dean of the
Wharton School of Finance and Commerce of the
University of Pennsylvania.
At the time, I was Chairman of the Federal
Reserve Bank of Philadelphia and I had been
delegated by the Chairmen’s Conference of the
Federal Reserve Banks to serve with General
Robert Wood, Chairman of the Federal Reserve
Bank of Chicago, and Owen D. Young, Chairman
of the Federal Reserve Bank of New York, to
make a comprehensive study of one of the most
controversial issues between the Federal Reserve
Banks and the Board of Governors in Washing­
ton— executive development and compensation in
the Federal Reserve Banks.
In making this study, Karl Bopp made such an
impression on me that I tried to persuade him to
leave the academic world and join the Federal
Reserve System. I found that the Governors and
staff of the System in Washington were as deeply
impressed with him as I was, and they offered him
a position in Washington at the same time that we
offered him one with the Philadelphia Reserve
Bank. Karl finally decided to accept the Philadel­
phia offer and was made Director of Research of
the Bank in 1941. His work was so outstanding
that he was made Vice President of Research in
1947 and became President of the Bank in 1958.
When I went to Washington as Chairman of
the Board of Governors of the System in 1948,
Karl became a special assistant to me in the sum­
mer of that year. During my three years’ service
as Chairman of the Board of Governors, he and
Alfred H. Williams, Karl’s predecessor as presi­
K arl

dent of the Philadelphia Bank, were among the
few of my closest advisors on the innumerable
problems which faced the System in that critical
period, 1948-1951.
I recall an incident during Karl’s early service
with the Federal Reserve when Chief Justice
Biggs of the United States Court in Philadelphia
asked me who could make the best presentation
to him on the subject of gold. I told him that I
thought Karl Bopp was well-qualified on the sub­
ject and that if he would come to lunch at the
Bank with Karl and me, I would have Karl give
him an illustrated lecture on the subject. Judge
Biggs then asked if he could bring his associates
on the bench. I gladly acquiesced, and Karl made
the presentation to the entire court. When he had
finished, the Chief Justice told him it was one of
the most comprehensive presentations he had ever
listened to in or out of court.
Since my service with the Federal Reserve
System, Karl has been of inestimable value to me
over the years as an advisor on innumerable eco­
nomic questions. My affection and admiration for
him have grown deeper with the passage of time.
who write in this volume, the
occasion offers an opportunity to reexamine some
of our basic philosophies. Accordingly, I have
found it illuminating to think of Karl Bopp in
terms of a simple formula which has proved
itself many times, at least to my satisfaction, as a
prescription for a fruitful life. This formula has
four components.
First is technical competence— the understand­
ing and mastery of a special field. This knowledge
gives its possessor great opportunity to serve his
fellow man and, by the same token, brings rich
rewards to the possessor. Karl has been fortunate

For A ll o f Us


in this regard. Possessed of a brilliant mind, an
endowment for which he can take no credit, he
has applied his mind rigorously and imaginatively
so that he has become one of the leading author­
ities in the field of central banking. During my
stint as president of the Philadelphia Reserve
Bank, I was a beneficiary of Karl’s expertise; and
for that I am grateful.
Second is a broad intellectual outlook. For ex­
ample, a knowledge of history gives one a com­
prehension of social change. It gives one a tie to
the past and a sense of continuity. This attribute
Karl has in abundance. He takes an intellectual
approach in solving problems by drawing on a
vast background of knowledge and experience.
Such breadth and depth adds stability and per­
spective— characteristics which have served Karl
Third is social intelligence. This may be rough­
ly defined as capacity to understand and deal
with men, especially men in groups— for mass
action is increasingly a characteristic of human
behavior. A dozen years ago, when I sat in the
chair which Karl is now relinquishing, I was
greatly impressed by the fact that the human
family was on the move; it was experiencing a
social flux, worldwide. Today this momentum is
so rapid that few of us can keep up with it. Karl
has both observed the changes and has been part
of the action, doing “his thing” with skill and in­
sight, and keeping his antennae always alert to the
tempo of social change.
Finally, a fourth element is a well-knit set of
ethical, moral, and spiritual values. These values
set up a central drive, within the leader, of in­
terest in and respect for the other fellow— his per­
sonality and worth as an individual. In this Karl
has few peers. He has carried on and developed
in his own distinctive style what has been for
many years a tradition at the Philadelphia Bank—
a concern for people. It is this concern which

will enable us to overcome the almost overwhelm­
ing problems confronting us. If I may be per­
mitted to plagiarize myself, I should like to quote
from a talk given many years ago: “To those of
you who would become leaders I say, if you have
a spark of interest in your fellow man, fan it into
a flame. If you succeed, there follows an integra­
tion of your many loyalties, some of which
hitherto, no doubt, have been conflicting. If you
are entirely successful you will achieve the inner
poise and strength so necessary in these days of
economic doubt, social tension, personal frustra­
tion, and seeming defeat.” In the case of Karl the
evidence speaks for itself.

I n a L e c t u r e at one of the schools of banking, I
said that a man might do a better job of solving
personnel problems by first asking himself, “How
should I as a gentleman handle this situation?”
Called upon to explain the term, not commonly
used today, I said:

/ think of a gentleman as one who is a kind
person, who is considerate, who would not will­
ingly hurt another person, a man who retains his
personal dignity even when under pressure, and
who respects the dignity of others even when it
seems not to be deserved. I think of a gentleman
as one who commands respect but does not
demand it. I think of him as a man exercising
inner strength which is so much more effective
than the outward flexing of one's physical or
managerial muscles.
That is a fairly good description of Karl Bopp,
and I am sure I had him in mind when I made the
statement. For many years he has influenced al­
most everything I have said and done so that I
am never quite sure whether I am expressing my
own thought or his. At best it’s a mix.


Of course, I know why I was invited to write in
personal vein about Karl. No man knows him as
I do, and no man knows me as he does. For more
than a quarter of a century we have had almost
daily association. We have shared our thoughts
and feelings on every conceivable subject from
Federal Reserve to family. We have dealt with
each other with complete honesty and full candor.
Ours is a deep and abiding friendship. Ours has
been a managerial partnership, but with never a
question as to whose word was final. Our simul­
taneous retirement won’t change the quality of
our friendship and I don’t think it will change the
basic nature of the partnership. It is because of
my love and respect for him that he will always
be the senior partner.
In the light of this it must be clear that I ac­
cepted this invitation with grateful enthusiasm,
and yet not without a twinge of reluctance. Karl
would not want me to write about his virtues and
neglect to say anything about his faults. It is one
thing for us to discuss our limitations with each
other, as we have done. It is quite another thing
to air them in public. Karl has always insisted
upon honesty of presentation, and I must abide
by that demand.
Fortunately, what appears to be a fault, looked
upon short-run, turns out in most instances to be
a virtue when viewed long-run. We are dealing
with a very complex person, one whose thoughts
and actions are never off-the-cuff, even though
they often appear to be. With Karl each judgment
is weighed in the light of the past, the present, and
the future. Those who evaluate his decisions oc­
casionally lose sight of the time perspective. Karl
has no use for judgments which are merely ex­
pedient or opportunistic. His thought-processes
and his methodology, just to give this a pragmatic
touch, enable him to avoid that which he abhors.
This point has not always been fully understood
by some of the day-to-day administrators. Even I

occasionally lost sight of this, and I should have
known better. One of Karl’s lasting gifts to his
colleagues is the sharpening of abilities to see
things in perspective.
We must consider carefully Karl’s modesty. Of
course, it is a virtue, but on many occasions I
looked upon it as a fault. I often told him so and,
curiously, he agreed. However, modesty is such
a part of him that he can do little about it. One
can overcome false modesty, but genuine modesty
is quite intractable. There isn’t anything about
Karl that is false. His faults, if faults they are, are
as genuine as his virtues.
Let me illustrate the complexity of Karl’s
modesty. On the agenda of each meeting of our
Board of Directors is the item called “Opening
Statement of the President.” It was only on in­
frequent occasions that Karl made such a state­
ment, but it was carefully prepared, often worked
on for many days, and usually tried out on me.
And when he made the statement at the meeting,
we saw Karl at his very best. I know of no such
occasion when at least one board member didn’t
say, “I wish we had a tape of that.” One would
think that with the enthusiastic response he in­
variably received he would have done it with
greater frequency. I urged him many times, but
to no avail. What was the reason?
Karl felt that even as president he should not
always occupy the center of the stage. In the de­
velopment of men he believed that others should
have that opportunity. He felt that there was al­
ways the possibility that by making the opening
statement he would take the edge off presenta­
tions about to be made by other economists. This
was fully in character. Karl set the climate and
the stage which enabled others to grow and to
demonstrate their abilities.
And yet I feel sure in my own mind that his
motivation was not totally managerial, even
though he genuinely believed it. Underneath it all


was that old business of personal modesty and in­
nate humility. At this point in time I have con­
vinced myself that Karl was right as he thought
in terms of the continuing institution. Had he,
however, been less modest we would have had
more gems, and I think the directors would have
liked it better. On the other hand, it would have
reduced the opportunities of men coming along.
Everybody judges the trade-off from where he sits.
Karl saw it all in realistic perspective. Modesty—
virtue or fault? Or both?
Similarly, Karl made few speeches, fewer than
the office certainly permitted. But when he made
a speech, it drew attention. He had something to
say and he said it well. He had an intuitive sense
of timing. He understood that there were times
to talk and times to remain silent, times to be an
individual president and times to be, first of all, a
member of the System. No one knows as I do that
he had many speeches that he never made, and I
am sure that the reasons for not making them
were sound. I speak with understandable bias,
however, when I say that the banking world
would have gained much by hearing more from
Karl. I always wanted others to share the inspira­
tion and stimulation which I received from him.
I know that he was fully convinced of the cor­
rectness of his forbearance as a matter of policy,
but I am equally convinced that that old modesty
greatly influenced the policy. Karl simply is not
a showman and he felt that others might misin­
terpret his motives were he to make too many
speeches, a risk he was unwilling to take. But
again, he was thinking more of the institution
than of himself. Others took on high-level speak­
ing assignments and were, of course, greatly in­
fluenced by Karl’s thinking. It was all part of
Karl’s planned development of the coming gen­
To be sure, there were times when Karl occu­
pied the center of the stage, and on each of these

occasions he turned in a stellar performance. I
remember so vividly the time he was called upon
to speak on the Federal Reserve to a large group
of businessmen from Germany. State Department
technicians began to set up headphones and other
apparatus to permit simultaneous translation. This
seemed to bother Karl so he said, “If you will
bear with me, I ’ll try to do this in German.” For
nearly an hour he held forth, and at the end the
group rose as one man and gave him a resounding
and long-lasting round of applause. I had never
heard Karl speak German before, so I knew he
had to be out of practice. He has the kind of mind
that doesn’t need it.
Most people know that Karl is verbal-minded.
He has an unusual command of the language,
and this time I mean the English language. Those
of us who have worked closely with him know
that he is also figure-minded. He has a sixth
sense about numbers. On numerous occasions I
have sat with him as he perused a report from a
subordinate, saying, “These numbers can’t be
right, at least not all of them.” He has a quick eye
for a sour number, but also an intuitive sense of
internal consistency. Anyone who turns in a table
of figures to Karl had better double check his
numbers. He’s sure to be caught if there is an
I have often thought that Karl would have
made a good judge on the bench. On the one
hand, he can be about as objective as any man
can be; at least he keeps his biases under com­
plete control. On the other hand, he knows when
to inject just the right amount of subjectivity,
especially when dealing with the destiny of human
beings. Over the years I have admired the quality
of mercy which characterized his decisions. He
never failed to take into account what seemed
best for the man as well as best for the institution.
More than once he explained his decision to me
by saying, “The institution can survive this, but


the man can’t. We must save the man.” On some
of these decisions he lost sleep even though he
knew that his is a thoroughly reliable conscience.
Everyone knows of Karl’s firmness. I am one
of the few who knows that it goes further than
that. Karl can be plain stubborn. Few of his posi­
tions have been absolutely rigid and inflexible, but
there has been an occasional one. Although to
others his firmness was displayed with outward
calm, his tensions were shown when we were
alone, in his office or mine. I ’ve seen him set his
jaw, dig his heel into the rug, press down on the
arms of the chair, and just let go. He would ad­
mit his sheer stubbornness, usually adding that the
issue required it. These occasions were few and
far between, and always carefully considered, but
they were electric. Somehow I usually managed
to make some remark that relieved the tension.
After all, what’s a first vice president for?
It was always a great event when Karl took on
single-handed a group of academic economists,
especially when one knew in advance that some
would use the occasion to voice their strong criti­
cism of Federal Reserve policy. Having been an
academic economist Karl understood fully the
difference between having the responsibility for
policy and not having it. Those who don’t have
the responsibility typically create the impression of
being braver men. I remember only one occasion
when he answered a barrage with just a bit of pique.
His comment was:
When I was a professor of money and banking
I used to wonder how Federal Reserve officials
could be so stupid. Now that I ’ve had some
years as a central banker with responsibility, I
often wonder how professors of money and
banking can be so naive.
He may have overstated the case, but it cleared
the atmosphere. One must not infer from this that
Karl ever tried to cover up Federal Reserve mis­

takes. He did, however, feel it important for peo­
ple to know why the Fed can’t play errorless ball.
He felt it important, too, that we learn from our
So many of Karl’s attributes and skills testify
to his qualifications as an ideal teacher. One
learns from him in the ivory tower, in the market­
place, or at the other end of his log which seems
always to be close by. He avoids producing an­
swers because he has faith in his ability to ask
the right questions. His object is to get the rest of
us to think, to come up with our own answers.
He has a sly way of pressing so that one is soon
transported from the shallow to the deeper water.
He never tries to trap his learner, but the learner
often traps himself by not recognizing the errors
in his thinking. A lesson learned from Karl stays
learned. So does a lesson learned by him. It may
be that he is an ideal teacher because he is an
ideal student.
Men from other Federal Reserve Banks have
often said that they don’t quite understand how
the Philadelphia Bank operates. They have char­
acterized the management as democratic and in­
formal. Even the word loose has been used. It has
been none of these. The management, under Karl’s
direction— and I mean direction— has been as
democratic as could be tolerated at any given time.
Karl has never believed in management by commit­
tee or by town meeting. Functions were assigned,
responsibilities allocated, and accountabilities fixed.
There was never anything informal or loose about
Karl’s belief in the principle of delegation. He never
lost sight of the fact that no matter how effectively
duties and powers might be distributed, it was he,
the president, who had to bear the final responsi­
bility for the results achieved by the institution.
While not one to throw his weight around, Karl
never lost sight of the fact that the president is
chief executive officer.
It was this specific assignment of powers and


accountabilities which enabled men to have a
strong sense of operational freedom. It was this,
as well as the setting of the climate and manage­
rial tone, that enabled men to cooperate, to con­
sult one another, to work together, to form their
own temporary ad hoc groupings in finding solu­
tions to problems. Each man knew the decisions
he was expected to make. When an officer called
in other officers for consultation, a common
occurrence, it might have looked as though a
group decision were being made. Not so, the
officer was using the talents of others to help him
make the decision which he alone had to make,
and which all the others knew was his to make.
The president was available for consultation, but
he carefully avoided making the decision which
had been delegated. This is not to say that he
didn’t influence the decision, but it never came as
an order. Karl tried very hard to be just another
member of the group seeking the appropriate
solution to the problem. In this situation the
cynical person might say that, after all, it really
was the president who made that decision. In say­
ing this he failed to appreciate Karl’s great skill
in group discussion. Karl made the decisions he
was supposed to make, not the ones somebody
else was supposed to make. He saw to it that we
understood this.
Karl knew how to use a first vice president. He
never believed that the office called for him to be
a chief operating officer. His job was to be chief
administrative officer, and there is a difference.
He took his cue from the Federal Reserve Act
which says that the first vice president is to act in
the absence or disability of the president. This
means he has to think more like a president than
like an officer in charge of operations. Being a
chief operating officer is such a vast assignment
that it can’t be given to the first vice president if
he is to be the continuous understudy of the presi­
dent. He has to be in continuous association with

the president, working on the problems with
which the president is constantly occupied. It is
because of Karl’s behavior toward me that as
junior partner with him I have never had the
slightest urge to be a senior partner elsewhere. He
saw to it that there could be no more rewarding
job anywhere in the System than mine. He did
it by just being himself.
Karl’s job has in some ways been a lonely one,
especially in social relationships. This was delib­
erate. Rightly or wrongly, and I think rightly,
Karl has not fraternized or engaged in social ac­
tivities to any appreciable extent with commercial
bankers. He has always been friendly with them
and they have all respected him. He did his social­
izing in groups, seldom with individuals. He had
a kind of inner feeling that with his responsibil­
ities as a central banker his behavior might just
possibly be misconstrued were he to become too
closely attached socially to the heads of large
commercial banks. I sometimes thought he over­
did this obsession, but he again was thinking of
the institution, and appearances can often be as
damaging as the realities.
It was about for the same reason that both he
and I have done very little socializing with our
officers. We knew that we had responsibilities for
promotions and salaries and we knew the possi­
bilities of misinterpretations of our decisions if
made against a background of excessive frater­
nization. We believe that the officers have under­
stood this and appreciated it. TLey have looked
upon our behavior, I hope, as something of a
sacrifice because they must all know how much
we would have enjoyed seeing them extracurricularly more than we have. No doubt all this has
had something to do with our social dependence
upon each other, but, of course, it is not the
whole story.
During his entire presidency one of Karl’s chief
concerns has been the Board of Directors. He has


fully understood the chafings of the directors over
restrictions on the scope of their powers of deci­
sion, particularly in the various authorizations
which must be obtained from the Board of Gov­
ernors. Karl made it clear to them, however, that
no president would want to manage a Federal
Reserve Bank without the invaluable help given
by the directors. Without them, a live and virile
institution could soon become just another old
line agency. Over the years the Philadelphia Fed
has been fortunate in having on its Board firstclass men, men of tremendous experience, de­
voted men with unusual talents. Much of this has
been due to Karl himself. A president needs a
good board, but a board needs a good president
It is a temptation to say that Karl’s retirement
will mark the end of an era. But that would be
a half-truth. When he walks out he will be leaving
behind him a great tradition, some of which he
inherited from his predecessor. Others will carry
on where he left off. New men will place their
own stamp on the institution but they will adhere
to the Karl Bopp demands for integrity, compe­
tence, and respect for human dignity. The spirit
is here to stay.
Karl will retire a happy man because in the
minds of all who know him will be the thought,
“Well done, thou good and faithful servant.” And
Karl will remember this Markham quotation
which he knows I have used many times:
There is i destiny that makes us brothers,
None goes his way alone.
All that we send into the lives of others,
Comes back into our own.
He also knows that our simultaneous retirement
will not dissolve the Bopp-Hilkert mutual admira­
tion society.

I s a S t o r y about Mark Twain to the effect
that his wife once tried to break him of profanity
by swearing in his presence at every opportunity.
Twain’s reaction was simply that “she knew the
words but didn’t quite have the tune.” An attempt
to summarize Karl Bopp’s beliefs as an economist
and central banker is certain to produce the same
results. I have been a student of Karl Bopp’s for
over a quarter of a century— for a short time in the
University of Pennsylvania classroom and the rest
at 925 Chestnut Street. During the same period, I
have also been, if I can make the distinction, a
student of Karl Bopp. The subject has been at once
the most fascinating and most difficult I have ever
tackled; the results have been the most incon­
One reason is that Karl is many persons, some of
whom Bob Hilkert has already described. As an
economist and central banker, Karl has sometimes
been an observer, sometimes a participant, and it
is as hard for a biographer to keep the two roles
straight as it often must have been for him. Early
training inculcated in Karl a lifelong fascination
for central banking. At Missouri he probed deeply
into official records to come up with an insightful
view of the agencies of Federal Reserve policy. In
subsequent years he has kept detailed notes on
index cards of the day-to-day unfolding of mo­
mentous events in Federal Reserve history, all the
while participating in important policymaking de­
cisions. The combination of the two personalities
— one recording and analyzing with great objectiv­
ity, the other debating, deciding, defending, and
rationalizing with considerable subjectivity— has
made Karl a much more complex person than
many of his colleagues. Most of the time it has
made for strength, as I intend to demonstrate; but
when the two motivations were at war, it could be
Similarly, Karl Bopp has been both a deeply
emotional and an intensely intellectual man; the
T here


two characteristics cannot be disentangled. It is as
an intellectual that Karl has had his greatest im­
pact, however, and, I suspect, as he would wish
to be judged. All of us who have worked with him
have had reason to be awed by— indeed, have on
occasion been impaled by— Karl’s brilliantly logi­
cal mind. It is a mind intolerant of, although
through self-discipline patient with, sloppy think­
ing. It is a cultivated mind, quite as likely to
produce an argument from Aristotle or a verse by
T. S. Eliot as a subtlety of Wicksell. Of all his
associations, I suspect Karl values most highly his
membership in the American Philosophical So­
And it is a scholarly mind. Karl has never felt
comfortable with a ghost writer. The list of his
own publications, however, is not long; a number
of studies emerged in the Missouri days, several
more in the 1940’s and 1950’s during the period
in research at Philadelphia, practically none dur­
ing his presidency of the Bank. But all are the
product of deep and careful thought, many of
back-breaking research. Perhaps there is, some­
where, a student of central banking who has
pored over as many reports, minutes, hearings,
and memoranda involving as many central banks
as has Karl; but if so I am not aware of his exist­
ence; and certainly he has not been a practicing
central banker.
This is the unique combination— scholarly re­
search of the major central banks in critical
periods, and day-to-day confrontation with cur­
rent problems of Federal Reserve policy—which
has shaped Karl Bopp’s philosophy. It has, above
all, given him a strong sense of history. By habit,
almost compulsion, Karl tends to approach any
problem from the direction of historical experi­
ence. The result is a curious blend of assurance
and skepticism, confidence and humility.
Let me illustrate. In the course of his career,
Karl has seen a severe depression, several reces­

sions of varying intensity, and some periods of
inflation. From all this he has emerged, so far as
I can tell, with no fixed view about the future
course of the American economy. True, he has
observed many times that something very different
happened after World War II than after earlier
major wars: the economy has not experienced a
decline in prices, and this does signify a basic
change in the economy and in public policy. But
to say that depressions are ruled out henceforth
or that the major problem of the future is chronic
inflation is to go too far. History demonstrates
that nothing—prosperity, inflation, chronic stag­
nation, dollar scarcity, or dollar glut—is inevi­
table. This can be a hopeful view; the problems
of the moment can’t last forever. Or it can be a
pessimistic view; despite all we have learned about
how the economy works and how to shape it to
our ends, things can happen which we don’t antic­
Above all it is a humble view. Humility is
much in evidence in Karl’s most revealing “Con­
fessions of a Central Banker.” “The simple truth,”
he says, “is that no one comprehends enough to
be an expert in central banking.”1 This confession
of ignorance apparently reflects an evolution from
Karl’s days in academia when, as he describes
himself, he was an intellectual grandson of Irving
Fisher. Through Fisher’s students, James Harvey
Rogers and Harry Gunnison Brown, he learned of
the importance of money as a determinant of eco­
nomic activity. But in the course of time, exposure
to the realities of policymaking and recognition of
the chaotic state of monetary theory have led him
to distrust (although not, he says, without a twinge
of conscience) the monetarists’ explanations of
1 Karl R. Bopp, “Confessions of a Central Banker,”
Essays in Monetary Policy in Honor of Elmer Wood,
Edited by Pinkney C. Walker (Columbia, Mo.: University
of Missouri Press, 1965), p. 12.


economic behavior and their mechanistic ap­
proaches to policy. It is clear from his “Confes­
sions,” however, that his view of the unsatisfactory
state of knowledge is not a counsel of despair, but
of patience. It is a challenge to research, an invita­
tion to be tolerant of the ideas of others.
And despite what appears to be a thorough­
going agnosticism about the monetary process,
Karl is not without foundations on which to build
his view of monetary policy. One of the firmest
of the foundations is a strong sense of the role of
markets. As he has come to distrust rules of
thumb and formulae, he has become impressed
by the complex workings of markets. This has
led him, on the one hand, to advocate a great
deal of discretion in the execution of policy. For
example, he has always shrunk from quantifying
instructions to the Manager of the Open Market
Account. Close observation of the money market
has convinced him that the best person to de­
termine the tactics of policy is the man on the
scene, in the thick of the market. As a participant
in determining the strategy of policy, Karl has
tended to be brief and concise in presentations
before the Open Market Committee and has
avoided the semantic exercises that sometimes
characterize Committee discussions.
On the other hand, his view of markets has
convinced him of the fallibility of money man­
agers who attempt to usurp markets’ functions.
Selective credit controls have always been dis­
tasteful, both on philosophical and practical
grounds. Voluntary credit restraint has smacked
of the real-bills fallacy. As Reserve Bank presi­
dent, Karl has resisted pressures to lecture com­
mercial bankers about credit restraint, not only
because his natural modesty has made it difficult
to do this but also because he has not been willing
to superimpose his judgments as a central banker
on theirs as commercial bankers. He has preferred

to let monetary policy speak for itself through the
As a non-interventionist, Karl has been pretty
much in the mainstream of Federal Reserve tra­
dition. But in a number of other respects he has
been an individualist. Three examples come to
mind, one having to do with objectives of policy,
a second with instruments, and a third with agen­
cies. All are illustrative of his broad, historical
approach to policy problems.
Some years ago, as Karl examined the various
objectives of monetary policy over time, he saw
clearly the conflicts that often exist.2 This was
before the term “trade-off” became commonly
used to describe the problem. More recently he
has taken exception to the conventional wisdom
of including economic growth as an objective of
monetary policy. His position has been that
monetary policy has relatively little to do with the
germinal elements of growth; that an appropriate
policy will produce maximum sustainable use of
available resources and this, in itself, is a large
contribution to growth.
As to the instruments of policy, his views have
been influenced strongly by an intensive analysis
of operations of the German Reichsbank from its
foundation until World War I.3 Despite the facts
that the Reichsbank had no information on the
volume of reserves, could not achieve a given
level of reserves, and dealt with a banking system
whose reserve ratio varied considerably over time,
it nevertheless achieved its basic objective. While
he has not advocated that the Federal Reserve
System actually try to do without reserve require­
ments as an instrument of policy, still Karl has
concluded that the ultimate power of the central
2 Karl R. Bopp, “Central Banking Objectives, Guides,
and Measures,” The Journal of Finance, Vol. IX, No. 1,
March 1954, pp. 12-22.
3 Karl R. Bopp, “Die Tatigkeit der Reichsbank von
1876 bis 1914,” published in Germany only, Weltwirtschaftliches Archiv, 1954.


bank lies in its ability to create and destroy money
and reserves, at times supplying more liquidity
and at other times less liquidity than commercial
banks wish to hold. A fixed reserve ratio is not an
essential ingredient of monetary policy.
Finally, Karl for years has been puzzling over
the proper relationship of the Federal Reserve and
Government. And although he is still rather tenta­
tive in his conclusions, he has arrived at a general
position that may seem heretical to staunch de­
fenders of “independence.” Because he has be­
come convinced that monetary policy must be part
of a coordinated economic policy of Government,
he believes that in the rare event of an irrecon­
cilable conflict, the central bank must give way,
the central banker must resign. Furthermore, in
such a situation the Government, perhaps by
joint resolution of Congress, should give clear
directions to the central bank as to how to pro­
ceed. Karl has arrived at this view not only be­
cause such an arrangement is an orderly way to
fix responsibility, but also because “independ­
ence,” carried to its logical extreme, is undemo­
cratic. And while such a position runs the risk
that the people may be “wrong,” this is likely
only in the short run; we must have faith that the
democratic process will work in the long run.
Finally, his position means that the central bank
must earn its “independence.” Only by demon­
strating that it is right most of the time can it
build the public support which enables it to per­
suade Government to its way of thinking. With
that support, the central banker’s power of
resignation becomes a potent instrument indeed.







How to evaluate the contribution of a man? In
some cases it may be primarily by written works,
in others by policy actions. In the case of Karl
Bopp, neither criterion is determining. His con­
tribution, I believe, lies primarily in the impact of

these ideas and his personality on people with
whom he has worked. In the policy area, he has
not been one to dominate deliberations. But he
has spoken up at crucial times with an authority
that has brought fresh insight to the discussion.
Above all, his influence on staff— and here I
speak with particular knowledge and feeling—has
been profound. He has transmitted a philosophy
of freedom in the pursuit of ideas to all of us who
have worked with him. And he has made us all
aware that monetary policy— as well as every­
thing else of any importance, for that matter— is
a human process.
Perhaps the most fitting way to summarize is to
relate part of a conversation between us not long
before Karl’s retirement. In a reflective mood, he
wondered whether, after all, perhaps he should
have remained in teaching. My reply was that he
has never left it.

A n y o n e R e a d in g the five foregoing appreciations of Karl Bopp will,
I think, be struck by one underlying theme. It’s a common idea that
runs through five different views of a many-sided man and a distin­
guished career spanning four decades. It is summed up in the phrase:
“the cultivated mind.”
As those of us who know Karl Bopp— students, colleagues, above
all friends— can happily attest, as rare a quality as it is, it is one which
he has exemplified in everything he does. But it is more than a rare
quality. It is a subtle one that combines several mutually critical com­
ponents. It implies professional competence, disciplined curiosity, a
sense of perspective, a reasonableness tempered (perhaps enriched is
a better verb) by the gifts of humility and humanity.
I would like to suggest that it is possible for the men who have con­
tributed to this collection of essays to turn their thoughts constructively
toward a wide array of issues confronting our nation today because
of the example set by Karl Bopp. And I would add further that his
example is a criterion of fundamental importance to central banking
at this point in American financial evolution.
Karl Bopp, who is both a student and practitioner of monetary
policy, stated the ever-present challenge himself some 20 years ago
when he observed that “the history of money demonstrates the diffi­
culty which men have to distinguish the permanent from the tempo­
rary.” I can affirm from personal experience over much of the same
40 years Karl Bopp has been teaching and serving the Federal Reserve,
that making this distinction is a constant imperative.
Ordering our minds to winnow the significant from the transitory,
the perceptive from the doctrinaire, and the judicious from the merely
expedient is never simple. But for men and women in our central bank­
ing profession grappling with the events of our time, it is particularly
essential— at least to the best of our individual abilities.
One of the most extraordinary events of this epoch is the explosion
of information with which men in public life must endeavor to work.
The statistics of this growth, stimulated by the development of the
computer and the full flowering of the communications arts, are so
familiar there is no need to itemize them. What does deserve mention
is the too-often forgotten truth that information is only a human tool


and its uses ultimately depend on the cultivated mind to give it mean­
ing and direction. We must search for the place of value in our world
of facts.
The business process, which is the concern of most of the contrib­
utors in this volume, is a rational process, not a mystical or magic one.
And those of us in positions of public trust can function only in the
faith that men can master and improve it by the exercise of reason,
sharpened and clarified by the discipline of objective study.
The need for rational economic thought is one of the most impor­
tant of our time. But rationality alone is not enough. The catch is that
in economics as in most other public affairs we are dealing with human
nature and human beings, and no one has yet devised any system of
levers or any formulas or devices by which you can infallibly anticipate
or regulate human nature or human beings.
Economists at the Board of Governors and many others working
independently are laboring continuously— aided considerably by the
advances in communication and computer technology— to isolate and
measure more exactly the impact of changes in policy at various stages
of this process so we may think and speak with more precision about
the ultimate effects of policy changes. But so far, and for some time in
the foreseeable future, we must recognize that the precise timing and
magnitude of these effects are not subject to exact scientific, proofpositive determination. And so the meaning and direction of facts
remain matters of judgment, and matters on which judgments may
I stress these limits on our knowledge in order to suggest why cen­
tral banking remains an art rather than a science. And as an art, it is an
art of moderation, of the balanced way. At all times, we must be aware
of the risk that the economy might be undermined by either inflation
or deflation. And this is a risk that involves human side effects, side
effects which impinge on our polity as well as our economy. Economics
involves moral decisions as well as abstract technical ones.
Only a couple of centuries ago the business civilization, or, more
precisely, the market system that would furnish its cornerstone, was
just coming into recognition as a new way of life that offered a promise
of material advancement and individual freedom such as men had
never known before.
The market system lifted men’s hearts when they first saw in its
development an alternative to the other two systems around which
society had been organized from time immemorial.
One of these systems, prevailing in the Orient until recent years,

employed the forces of tradition to ensure the execution of the count­
less jobs that had to be done to keep society going— disagreeable jobs
as well as pleasant ones. By custom and usage, jobs were assigned
from father to son for generation after generation, and men did the
work deemed appropriate to their caste.
The other system antedating the market system was that of authori­
tarian rule, in which the whip of centralized power drives workers to
the necessary tasks. It was used in ancient Egypt to build the pyramids.
It is used in modern Russia to execute the Soviet’s five-year plans.
Against these age-old systems of social control, the market system
must have appeared to men of vision as a magnificent achievement in
social engineering, for it provided a mechanism for sustaining and
maintaining an entire society by the free and voluntary activity of its
individual members. It constituted a way of life affording to the indi­
vidual a dignity unknown under the older social systems. In the market
system, each man would be guided to his work by the hope of reward
rather than the lash of authority or the chains of caste. Yet, though
each might freely go wherever he thought his fortune lay, the interplay
of one man in competition with another would result in accomplish­
ment of all the tasks society needed done.
The transformation of this country from a wilderness to a highly
developed business civilization in less than two centuries demonstrates
the results that can be obtained through a system which is directed
toward releasing rather than shackling the energies and abilities of
the individual.
The advantages of a system where supply capacities and demand
wants and needs are matched in open markets cannot be measured in
economic terms alone. In addition to the advantages of efficiency in
the use of economic resources, there are vast gains in terms of personal
liberty. Powers of decision are dispersed among the millions affected,
instead of being centralized in a few persons in authority.
The basic concept of the market system has remained with us since
the founding of the nation. It has remained the keystone of our society
down to this day, although we have done some extensive remodeling
of the structure as a whole from time to time.
Some of the remodeling we have done in the past has been for the
admirable purpose of correcting structural defects and distortions that
were warping the system. Competitive, freely functioning markets are
one thing, and rigged markets another. Rules and regulations to prevent
manipulation are necessary and essential to a sound structure.
Other remodeling has come about because the American people


have refused to accept economic goals as their sole objective. That was
true in older generations, as well as our own. Let it be said, to our
credit, that American economic action has often been determined by
balancing material advance against other human objectives.
Over the years, the American people, working under their free enter­
prise system, have produced and are producing material abundance as
no people in histoiy. Yet, great as are the wonders of production that
have been achieved in the American system, still greater are the won­
ders of distribution. There would be little gain in convenience, comfort
or luxury for Louis XIV or Charles II, or for Anthony and Cleopatra,
in living today. Our mass production and distribution system could not
do much for them. It can and does provide abundance for the mass of
people. It is a system for the many rather than for the few. It has pro­
vided greater equality in worldly possessions than any socialist or com­
munist society has done, or showed the slightest prospect of doing.
Most noteworthy of all, perhaps, the American people and the
American system of free enterprise have come a bit closer to abolish­
ing poverty and its attendant evils than anyone has ever come before.
This is an unfinished task, however, and one that requires the use of
our minds and the gift of our hearts—both.
A suggestion is often made these days that if only the Federal
Reserve’s monetary policy were changed, in some way or another, we
could have more new homes, more rapid construction of vitally needed
schools, hospitals, and other community facilities, more new automo­
biles, and more new highways to relieve the traffic jams we have
Well, it would certainly be a fine world indeed if, by merely opening
wider the spigot of credit, the Federal Reserve could increase the flow
of goods and services sufficiently to meet all human wants at any time.
If the Federal Reserve possessed such magic, I assure you it would
use it. But of course there is no such magic, and all of us will be better
off if we do not act as if there were.
What is this Federal Reserve policy that some people are so anxious
to change?
It is a policy of endeavoring, at all times, to assure monetary and
credit conditions that will foster high levels of business and employ­
ment, maintain the stability of the currency, and promote sustainable
growth in the economy.
It is a policy of combating, with equal vigor, the excesses of infla­
tion and deflation alike. It is a policy that recognizes that inflation
compounds its own cruelties by bringing deflation with its further

cruelties—the cyclical progression we have suffered many times in the
past with consequences heavy in human hardship.
Operations in execution of that policy must, of course, be adapted
to the particular circumstances of an economy which, like everything
else in life, is always changing.
As a central bank, the Federal Reserve System inevitably func­
tions as an institution which itself has its most immediate contact with
other institutions. But institutions are composed of human beings and
are, over time, shaped by human beings. As I’ve sought to suggest in
these few pages, this realization alone suffices to caution us toward
great humility— especially humility about our ability to cope with
transition through the use of mere logic and no more. We must not
allow ourselves to be beguiled by our growing facility in gathering
and juggling information, to succumb to the belief that information is
a substitute for understanding.
We should not, in sum, fail to put the highest premium on the very
special qualities of men such as Karl Bopp— men who have the culti­
vated mind and use it.

. . . the ideas o f econom ists and political philosophers, both
when they are right and when they are wrong, are more pow ­
erful than is com m only understood. Indeed the world is ruled
by little else. Practical men, who believe themselves to be
quite exem pt from any intellectual influences, are usually the
slave o f som e defunct econom ist.1
— / . M . K eynes
The Federal Reserve A c t was clearly not designed to create
a m onetary agency with ample powers for controlling the stock
o f m oney in accordance with any rational objective, although
som e o f the provisions o f the A c t are not wholly unsuited to
such a purpose.2
— L loyd W. M ints

How D if f e r e n t the original Federal Reserve Act would have been
if it had been based on some sort of quantity theory of money, and
how different might have been the speed, if not the direction, of
evolution of Federal Reserve policies! The Act would undoubtedly
have referred repeatedly to the supply of money and to regulation of
its quantity in line with the needs of the economy for money
balances. And a natural line of evolution would have been to use
Federal Reserve powers ever more positively to stabilize price levels,
or perhaps to regulate some specific flow of expenditures, such as
MV. However, the Act was based not on a type of quantity theory
but on a commercial loan theory of banking, and its prime con­
cern was not with money but with credit. A major purpose was to
adjust credit to “the needs of trade” as evidenced by demands for
commercial loans, not to adjust the supply of money to the economy’s
demand for money balances; its infrequent references to quantities
1 The General Theory of Employment, Interest and Money, (New York: Harcourt Brace and Company, 1936), p. 383.
2 A History of Banking Theory, (Chicago: University of Chicago Press,
1945), p. 281.


were to the quantity of credit, not that of money; and it emphasized
the “quality” of credit.
Though, as many of them claimed, other Congressional leaders
influenced the new legislation, the original Federal Reserve Act bore
the unmistakable imprint of Carter Glass and of his closest advisor
on banking affairs, H. Parker Willis, the most unbending and bestknown commercial loan theorist of the period. Nor did their adher­
ence to the commercial loan theory or their influence end with the
passage of the Act. For example, Senator Glass declared in 1931 that
the Federal Reserve Act would never have permitted the Reserve
Banks to lend on Government security collateral if its proponents had
not believed that the Federal debt would continue to decline.3 During
the next year he agreed only reluctantly and under strong pressure to
permit Government securities to serve as collateral for Federal
Reserve notes, and he tolerated an amendment broadening the Federal
Reserve’s lending power only on condition that the ineligible paper
not be used as collateral for Federal Reserve notes. Even at that late
date Willis was still inveighing against “artificial” easing through
Federal Reserve purchases of Government securities and was advo­
cating passive adjustment of credit to the “needs of trade.”
Many provisions of the Federal Reserve Act betray its origin in
commercial loan ideas. The two enumerated purposes of the new
System, other than to provide a more effective supervision of bank­
ing, were to furnish an elastic currency and to afford means of redis­
counting commercial paper. Even the provision of an elastic currency
was basically a credit rather than a monetary reform; its basic pur­
pose was to prevent currency flows into and out of the banking
system from having adverse effects on credit conditions. Only types
of paper conforming to the commercial loan theory were eligible for
discount at the Federal Reserve— “notes, drafts, and bills of exchange
arising out of actual commercial transactions; that is, notes, drafts,
and bills of exchange issued or drawn for agricultural, industrial, or
commercial purposes, or the proceeds of which have been used, or
are to be used, for such purposes. . . .” Only such paper and
Federal securities were eligible as collateral for Federal Reserve
advances. Specifically excluded were “notes, drafts, or bills covering
merely investments or issued or drawn for the purpose of carrying
or trading in stocks, bonds, or other investment securities, except
bonds and notes of the Government of the United States.” As
3 Hearings on S. Res. 71, 71st Congress, 3rd Session (Jan. 20, 1931), p. 53.

examples par excellence of commercial loans, acceptances were given
favored treatment; member banks were permitted to create them on
the basis of “real transactions,” and they were made eligible for pur­
chase by the Reserve Banks. This, it was believed, would both adapt
credit to the legitimate needs of trade and divert loan funds away
from the stock market. To provide an appropriate elasticity of
Federal Reserve notes to the needs of trade, they should be collateraled only by gold and eligible paper.
Thus the Federal Reserve Act clearly favored types of paper con­
forming to the commercial loan theory, intended that the Federal
Reserve should issue and withdraw funds primarily by dealing in
such paper, and implied rather vaguely that the System could con­
trol the use of funds created by it by regulating the types of assets
acquired. However, the Act provided but little guidance concerning
the amounts of funds to be provided or withdrawn, or the general
principles which should guide discounting. Such guidance as was
implied suggested a policy of more or less passive accommodation
of “the needs of trade.” For example, it stressed “elasticity” of
Federal Reserve notes and provided that discount rates should “be
fixed with a view of accommodating commerce and business.” The
following statement by Governor Norris, of the Federal Reserve
Bank of Philadelphia, in September 1930, was not an unreasonable
interpretation of the intent of the Act.
W e have always believed that the proper function of the
System was well expressed in the Tenth Annual R eport o f the
Federal R eserve Board— “The Federal Reserve supplies the
needed additions to credit in tim es o f business expansion and
takes up the slack in tim es o f business recession.” We have
therefore necessarily found ourselves ou t of harmony with the
policy recently follow ed o f supplying unneeded additions to
credit in a time o f business recession, which is the exact anti­
thesis o f the rule above stated*

In view of the basic theory of the Act, it is ironic that the first
large-scale provision of funds— that during the World War I period,
1917-1920— did not conform to the commercial loan theory at all.
The Reserve Banks supplied funds not on the basis of commercial
paper but on the basis of Government securities, and their prime
purpose was not to “accommodate commerce and business” but to
4 Except where indicated otherwise, quotations are from records and
memoranda in Federal Reserve archives.


accommodate the borrowing needs of the Treasury. However, at the
end of this episode commercial loan ideas again came to the fore
and for the next decade and a half vied with new ideas for
Commercial loan ideas, with their emphasis on the “quality” of
credit, were one reason, though not the only one, for the deflationary
policies of 1920-1921. Both Federal Reserve and commercial bank
credit based on Government securities, which did not reflect “the
needs of trade,” should be eliminated in order to restore “normal”
conditions. Many Federal Reserve officials accepted the definition of
“normal” offered by Governor Seay, of the Federal Reserve Bank of
Richmond, in October, 1920.
. . . It would probably be fair to say that a normal credit
condition exists when bank loans are made very largely, and
loans from Reserve banks entirely, for the purpose o f pro­
ducing, purchasing, carrying, or marketing goods in one or
m ore steps in the process of production, manufacture, and dis­

The rise of open market operations in Government securities as a
major policy instrument after 1922, sponsored primarily by Gover­
nor Benjamin Strong and his colleagues at the Federal Reserve Bank
of New York, challenged the basic tenets of the commercial loans
policy prescriptions in at least two ways. For one thing, such opera­
tions supplied Federal Reserve funds not on the basis of paper
arising out of “real transactions” but on the basis of Government
debt. Also, they supplied funds not in response to “the needs of
trade” as reflected in applications for discounts but on the initiative
of the Federal Reserve itself. They were “forcible insertions” or
“forcible withdrawals,” which were likely to lead to “artificial credit
conditions,” especially if purchases were made when “the needs of
trade” were declining or if sales occurred when “the needs of trade”
were rising. The fact that large Federal Reserve operations in
Government securities did occur during the remainder of the 1920’s
might be viewed as an unqualified victory of the new concept of
positive control on the initiative of the Federal Reserve over the
older concept of accommodation of “the needs of trade.” However,
commercial loan ideas were by no means dead, and they continued
to influence thinking, attitudes, and policies.
Neither open market operations in Government securities nor the
positive use of Federal Reserve powers to promote stability of prices

and business conditions enjoyed full support within the System. How
numerous and strong were the dissents did not become fully apparent
before the 1930’s, though objections were voiced earlier. For
example, Governor Roy A. Young, Governor of the Federal Reserve
Board, stated in 1928 that the primary concern of the System should
be to maintain “a healthy banking situation” and that “it would be
unfortunate if the Federal Reserve System were to be charged with
still further responsibilities which are not directly related to banking,
such as responsibility for the stability of the general price level or
for moderation of ups and downs in business conditions.”3 In the
early 1930’s, as Governor of the Federal Reserve Bank of Boston,
he consistently opposed purchases of Government securities and
favored allowing credit to adjust to the declining “needs of trade.”
Adolph C. Miller, another member of the Board, was generally un­
favorable to open market operations until the depression had been
under way for more than a year. He stated in early 1931:
believe that our troubles will be enormously m inim ized—
in fact I think we will pretty nearly get rid o f m ost o f them—
if the Federal R eserve banks are operated as institutions o f

The commercial loan theory, or at least ideas consistent with that
theory, continued to appear in various other ways during the
remainder of the 1920’s.
In evaluations of the behavior of bank credit. Many writers
referred to the “excessive” expansion or inflation of bank credit
during the 1920’s, usually inferring that a sound basis for recovery
could be established only when the “excess” was eliminated. Empiri­
cally, it would be difficult, it not impossible, to establish that there
was, in the 1920’s, an “excessive” rate of growth in the quantity of
either total bank loans and investments or of the money supply,
whether narrowly or broadly defined. Those who found “excessive”
growth appear to have based their judgments on “quality” rather
than quantity. Commercial loans grew only slowly during this
period; a far larger part of the increase of bank credit was in the
form of loans on security collateral, real-estate loans, and bonds. To
commercial loan theorists, this was clearly an “excessive” expansion;
5 Journal of the American Bankers Association, October 1928, Vol. XXI,
p. 281.
6 Hearings on S. Res. 71 (January 23, 1931), p. 150.


it was an expansion in excess of “the needs of trade” as evidenced
by demands for commercial loans. Also, some credit, including some
bank credit, was used for speculation in securities and real estate.
This, in itself, was convincing evidence of overexpansion for those
who believed that only credit in excess of the legitimate needs of
trade would flow into speculative uses.
(2) In contentions that the form of assets acquired by the bank­
ing system controlled the use to which the resulting money would
be put— e.g., that money issued for commercial loans would remain
in commercial uses and that issued on the basis of collateral loans or
bonds would remain in the securities markets. Some believed this
true of both the Reserve Banks and the commercial banks. Strong
and others had shown the errors of such ideas in the early 1920’s,
yet they lingered on. For example, Adolph Miller testified as late as
. . . when the Federal Reserve banks operate as investment
banks, by buying investments, they force the m em ber banks of
the country also to operate as investm ent banks by buying
investm ents or loaning against investments or by making loans
o f the kind here described as loans on real estate.7

Apparently such effects would not follow when the Federal Reserve
supplied funds by discounting commercial paper or by purchasing
acceptances or gold.
(3) In the Federal Reserve’s concern, in 1928 and 1929, with
the alleged “absorption of credit in the stock market.” It is still not
wholly clear why the Federal Reserve became so deeply concerned
about the use of credit in stock speculation that it virtually aban­
doned its other objectives and adopted a policy of severe and pro­
longed restriction, with deleterious effects on the domestic and
international economy. However, the idea stressed most at the time
was that loans on security collateral led to “absorption of credit in
the stock market” and to a decrease in the supply and increase of
the cost of funds for legitimate business. They concentrated on the
form of the loan and ignored subsequent uses of the money. It was,
of course, clear that a lender, whether a bank or nonbank, on
security collateral could not lend the same money to another bor­
rower. But the money was not “absorbed” by the borrower; he
passed it on to the seller of securities, who was free to use it as he
7 Hearings on S. Res. 71 (January 1931), p. 139.

wished to finance his own consumption or productive activities, to
lend to someone else, and so on. We do not know the net effects of
the rise of bank loans on security collateral on the total supply of
funds, both equity and debt, to “legitimate” business or on the cost
of capital to business. But two things are clear. First, the fact that
loans were collateraled by securities did not necessarily mean less
money or higher interest rates for business. And second, the highly
restrictive policies adopted to remedy the situation contributed far
more to higher interest rates for “legitimate” business than did any
“absorption of credit in the stock market.”
The first years of the great depression brought a sharp conflict
between those who believed that the Federal Reserve should use its
powers actively and on its own initiative in an expansionary way and
those who favored a more passive policy of “accommodation” or of
allowing credit to adjust to “the needs of trade.” Commercial loan
theorists were highly prominent in the second group, though some
others shared their policy views. This group was especially antago­
nistic to Federal Reserve purchases of Government securities, but it
also opposed “excessively easy” policies of purchasing acceptances
and lowering discount and bill-buying rates.
The failures of Federal Reserve policies, which allowed the money
supply to decline by a quarter during the first three years of the
depression, are well known. The rate of liquidation was especially
rapid in the months following the international financial crisis which
hit the United States in September 1931. However, the money supply
had already fallen more than 10 per cent before the crisis impinged
upon the United States and while the freedom of Federal Reserve
action was not in any way limited by considerations relating to its
gold reserve or free gold position or to the nation’s balance of pay­
Why were Federal Reserve policies so inadequate and inappro­
priate in the early years of the great depression? One fundamental
reason was the unsatisfactory, confused, and conflicting state of
business-cycle and monetary theory, both within and outside the
Federal Reserve System, and among professional economists as well
as laymen. There was simply no valid, comprehensive, and generally
accepted theory that could command a consensus and provide solid
theoretical support for an appropriate and ambitious expansionary
monetary program. The Keynesian Revolution was still years in the
future. There was one type of monetary theory that suggested a
positive policy of monetary expansion—the quantity theory. It is no


eoincidence that the principal proponents of large purchases of
Government securities by the Federal Reserve were such well-known
quantity theorists as Irving Fisher, John R. Conmons, Wilford I.
King, James Harvey Rogers, and Harry Gunnison Brown. However,
both their theory and their policy prescriptions were rejected by
large numbers of other professional economists, including some of
the most prestigious names of the time. Among them were H. Parker
Willis of Columbia and most other commercial loan theorists;
Benjamin M. Anderson, Jr., influential economist of the Chase
National Bank; O. M. W. Sprague of Harvard, Economic Advisor to
the Bank of England and frequent consultant to the Federal Reserve
and the Treasury; most members of the Yale Economics Department
except Fisher and Rogers; Edwin W. Kemmerer of Princeton, famed
“money doctor” and author of the most widely read book on the
Federal Reserve; and George W. Dowrie of Stanford.
Though members of this group were united in their opposition to
positive and ambitious measures for monetary expansion, they
offered a wide variety of reasons for their opposition.8
(1) Such a policy would be harmful and would prolong the de­
pression by inhibiting the “natural process of liquidation.” The
depression was caused, it was claimed, by maladjustments created in
the preceding period of prosperity, and a sound basis for recovery
could be created only by liquidating these maladjustments. The pre­
ceding “inflation” and “excessive expansion of credit” had to be
purged from the system. Expansionary monetary and credit policies
would only prolong both the necessary process of liquidation and the
(2) The appropriate policy was to allow the volume of credit to
adjust to the needs of trade at “normal” interest rates, and it was
healthful for the volume of credit to fall in response to a decline in
the needs of trade reflecting a decline of business activity or price
levels. Central bank attempts to manipulate interest rates “artificially”
to induce recovery would generate troubles and lead later to excessive­
ly high interest rates.
(3) The Federal Reserve, as custodian of liquidity for the entire
financial system, should conserve its own liquidity, and this could
be assured only by limiting its earning assets to short-term, selfliquidating paper conforming to the commercial loan theory. Even
8 The state of economic theory at this time is discussed more fully in a
forthcoming study of American monetary policies, 1928-1941.

short-term Government securities were not self-liquidating,, and
longer-term Government securities were still less liquid. Even as late
as 1935 a group of 69 economists sent a memorandum to Congress
urging that:
. . . The supply o f non-comm ercial paper eligible for discount
should be further restricted, not enlarged. . . . It is the function
o f a central banking system to maintain at all tim es a liquid
portfolio, since the system holds the ultimate reserves o f the
nation’s banks.
A ll measures designed to correct weaknesses in the Federal
R eserve System should seek . . . to increase, not reduce, its
com m ercial nature. They should assure, not impair, its

Even if an expansionary monetary policy did no harm, it
had little chance of inducing recovery. For example, Kemmerer
believed that the large Federal Reserve purchases in 1932 lowered
“confidence,” made business unwilling to invest and banks unwilling
to lend, and lowered the velocity of money.10
Under the conditions of early 1931, Sprague stated, “. . . 1 am
disposed to think that monetary agencies are almost helpless of
themselves to stay the downward course of the price level, to say
nothing of being able to induce an upward movement.”11
Such wide differences in theory and in policy prescriptions were
by no means confined to professional economists; they were also
evident in Government, in the financial community, among business­
men, and in the community at large. In this confusion of theory and
policy advice, Federal Reserve officials must have wondered: which
advice should we take? Should we take positive measures to expand
money and credit? Should we encourage “natural liquidation”?
Should we simply respond passively to demands for credit at
“normal” interest rates reflecting “the needs of trade”? Should our
primary concern be to conserve the liquidity of the Reserve Banks
themselves? Or should we relax because what we do or don’t do isn’t
very important anyway?
9 Hearings before the House Banking and Currency Committee on H. R.
5357, 74th Congress, 1st Session (March 1935), pp. 760-761.
10 American Economic Review Supplement, March 1933, p. 134. See also
same publication, March 1934, p. 99.
11 Minutes of Evidence Taken Before the Committee on Finance and
Industry, Vol. II, February 19, 1931, p. 312.


Theories and policy attitudes within the Federal Reserve System
during the early 1930’s were almost as diverse as those outside. A
few officials were strong and consistent advocates of active ex­
pansionary policies, including both large purchases of Government
securities and sharp reductions of discount and bill-buying rates.
But these were few indeed. Of the members of the Federal Reserve
Board, only one consistently took this position— Governor Meyer
after his appointment in September 1930. Harrison of New York and
Black of Atlanta were the only Reserve Bank Governors to advocate
and support consistently active expansionary policies. Even these
officials tended to think in terms of credit conditions rather than the
money supply, and they sometimes, but not always, judged credit
conditions by the behavior of interest rates. Thus they sometimes
made the mistake of assuming that a decline of interest rates signified
in some sense an “easier monetary policy” even if the fall of rates
resulted largely from declines in demands for credit. Such a mistake
would have been less likely if their guide had been the quantity of
money or of total bank credit.
The ideas and policy positions of the other members of the
Federal Reserve Board and of the other Governors of the Reserve
Banks differed considerably. Some did on occasion support active
expansionary policies. However, a large majority of them displayed
a strong affinity for commercial loan ideas, including the desirability
of “natural liquidation,” passive adaptation of credit to the needs of
trade, and avoidance of “artificial” easing measures. Their general
approach was indicated in a recommendation made in January 1930
by Governor Norris of the Philadelphia Reserve Bank for the
majority of the members of the Open Market Investment Com­
. . . the recomm endation is m ade that we see no necessity
for operations in G overnm ent securities at this tim e either to
halt or to expedite the present trend o f credit. The m ajority o f
the C om m ittee is not in favor o f any radical reduction in the
bill rate or radical buying o f bills which would create an arti­
ficial ease or necessitate reduction in the discount rate. If that
reduction com es about naturally from further liquidation or
reduced demand, all well and good, but we do not feel that
there should be any active effort to bring that about. . . . W e
distinctly feel that no operation in bills should be undertaken
for the purpose o f either forcing or facilitating a reduction of
discount rates by any bank.

These and other similar attitudes were expressed repeatedly by
Reserve Bank Governors. For example, Governor McDougal of
Chicago consistently opposed purchases of Government securities,
complained that credit conditions had become so easy as to be
“sloppy,” and sometimes advocated sales of securities or reductions
of bill holdings in order to firm money market conditions. Chairman
Austin of the Philadelphia Reserve Bank objected to purchases of
securities and bills in March 1930, noting that:
. . . it lays us open to the apparent undesirable charge that
the action is not justified by the dem and for credit but for some
other purpose, it m ay be fo r boosting business, making a
m arket fo r securities, or fo r som e other equally criticizable
cause that will certainly com e back to plague us.

In refusing to participate in purchases of Government securities in
June 1930, Governor Calkins of San Francisco explained:
With credit cheap and redundant we do not believe that
business recovery will be accelerated by making credit cheaper
and m ore redundant.
We find no reason to believe that excessively cheap money
will prom ote or create a bond market, seeing evidence in the
recent past to the contrary, and, further, d o not consider the
prom otion or creation o f a bond m arket one o f the functions
o f the Federal R eserve System.

In early 1930, officials of the Boston Bank preferred “to see things
go along as they were for a time” because “there is more cleansing
to be done.” As late as August 1931 Governor Young voted against
further purchases of Government securities, commenting that he
. . . would rather see the portfolios o f the Federal Reserve
System com posed o f bills and discounts, and regretted to see
two im portant functions nullified by operations in government

Governor Talley of the Dallas Reserve Bank complained in March
E veryone wants to keep business jazzed up all the time, and
have it run along at boom figures. I t seem s to me the sounder
course to pursue, after having done this fo r som e tim e, is to
catch up and let the public pay som e o f its debts.

He added later, “Satisfaction of a demand for further capital supplies
would tend to increase overproduction.”


Governors Seay of Richmond and Fancher of Cleveland some­
times supported positive expansionary actions, but on several occa­
sions they objected that interest rates had been pushed too low.
Deputy Governor Atteberry of St. Louis expressed the view in mid1930 that “fictitiously easy money” might have adverse effects.
The discussion here develops the idea that excessive efforts
in the interest o f fictitious easy m oney m ay have just the op­
posite effect from that intended. It has been suggested that
such efforts have the psychological effect of increasing the
feeling o f uncertainty and thus discouraging buying other than
necessity demands.

Officials of both the Minneapolis and Kansas City Reserve Banks
usually opposed positive expansionary actions.
As noted earlier, Governor Meyer was the only member of the
Board who strongly and consistently supported positive expansionary
policies. The others were generally no more than reluctant supporters
of security purchases before September 1930; some became more
favorably inclined after that time. They were usually more favorable
to reductions of discount and bill-buying rates, though they often
favored less rapid and smaller reductions than those proposed by
New York.
The examples cited above suggest the wide variety of implicit
theories and policy attitudes which permeated the System during the
early 1930’s, influenced policy decisions, and made it impossible for
the System to formulate and carry out strong and active expansionary
In concentrating on the influence of theory on monetary and credit
policies, I do not imply that policies can be explained wholly in
terms of theory, either of current theory or that of “some defunct
economist.” A full explanation would require an investigation of the
entire intellectual, social, political, and economic environment. For
one thing it would have to explain why, when alternative theories
are available, one theory is chosen over another. Why, for example,
did so many adhere to the commercial loan theory, with its implica­
tions of relatively passive accommodation to private demands for
commercial credit, rather than to the quantity theory, which suggests
more positive control? Yet the commercial loan theory did have pro­
found effects on the Federal Reserve. It influenced the very structure
of the System; no quantity theorist setting up an agency to control

the nation’s money supply would have created 12 central banks,
each originally expected to be largely autonomous. It influenced the
powers granted to the System, and especially its emphasis on com­
mercial credit. It influenced the thinking of professional economists
and others outside, and thus the environment in which the System
operated. And it had a profound effect on large numbers of Federal
Reserve officials.
Nor can we be certain that this theory, with its remarkable ability
to survive repeated refutations, is finally dead.

It was forty years ago that I first heard about K arl Bopp. N orth Carolina
State College needed a teacher for a term while I was on leave and Harry
Gunnison Brown recom m ended K arl as the m ost brilliant o f the young
men he knew. H e had been doing graduate work at M issouri and (among
other things) had had courses in the m onetary field with H arvey Rogers,
A fter finishing the term o f teaching at N . C. State, K arl went to Wisconsin
for further graduate work in econom ics and then cam e back to M issouri to
work on his Ph.D. It was then that I first m et him (as I had just joined the
D epartm ent). From that tim e I considered him a friend and soon one o f
m y closest friends. For ten years we were colleagues on the M issouri Fac­
ulty and during that tim e I had the advantage o f free discussion with him.
The things about him that appealed to m e m ost were his com plete objec­
tivity and honesty and his fundamental kindness. In a discussion he made
one feel that there was no gap to cross. I ow e a great deal to Karl, both
from m y association with him over the years and for the ideas in his pub­
lished work. His writings on central banking, particularly in the field of
the criteria o f policy, have becom e classics, as has his work on Reichsbank
Operations, 1876-1914.

I propose to comment on some of the changes in
approach to central banking analysis that seem to me to have oc­
curred during the past half century. Many of the ideas were not new
in the sense that no one had ever thought of them before; it is rather
that the order of importance of things changes until finally one realizes
that the whole approach is different from that of former days.

I n T h is P a p e r

Variations in Public Opinion About the
Capabilities of Monetary Policy
The public’s views about what can be accomplished with monetary
policy in maintaining prosperity and stabilizing the price level have
varied considerably over the past half century. In the very early
period of the System a limited stabilizing effect was expected—
beyond the avoidance of panics; we had to follow the gold standard.
During the twenties confidence picked up. The very large gold re­
serve seemed to give more freedom in developing policy, and central
banks in the leading countries seemed willing to coordinate their
policies. A few readers may remember the Stable Money luncheons
at the national meetings of the A.E.A. Brown, Fisher, Kemmerer,


and Young were often there. Strong told Congressional Committees
that he was hopeful about the prospects for maintaining business
stability but stated that there were causes of instability that monetary
policy might not be able to deal with. Everything considered,
however, including his record of accomplishment, one should
count him among the optimists. It was a period of intense study of
the business cycle— Persons’s work at Harvard and Mitchell’s at
Columbia were widely known. On the whole, people were hopeful
about what monetary policy could do in moderating the cycle—
though in that era there was wide interest in fiscal policy also.
During the thirties there were many who advocated a very ag­
gressive monetary expansion, and there was finally new legislation
for this purpose. No short statement can summarize public opinion
in that strange period. It was the beginning of a much greater
reliance on fiscal policy for influencing the level of economic
activity. As the depression wore on there was a widespread belief
in the secular stagnation theory. Hansen referred to monetary policy
as the “handmaiden” to fiscal policy. The ideas of Keynes’s General
Theory were taking hold.
It was not until the Korean war that confidence in the effectiveness
of monetary policy was restored. The Federal Reserve, Congress,
and the public feared serious inflation with a frozen rate structure.
Monetary policy now shares the honors with fiscal policy, partly be­
cause the public understands monetary policy better and partly be­
cause the mammoth spending by national and local governments has
driven people to search for means of reducing the rate of inflation,
or to halt it.
Not long ago the use of monetary and fiscal policy to control the
level of spending—with high employment and very little inflation—
enjoyed more prestige than ever before. At the moment there is more
doubt; there is a question as to whether public spending will be
sufficiently restrained.
In an economy where the whole physiology is changing rapidly
and where all sorts of decisions about spending and pricing are
getting more into the hands of the Government and power groups—
and where the political structure itself is changing—monetary con­
trols have to be geared into the economic-political complex as seems
best to an informed judgment.
Money in Existence and Money Potential in a Practical Sense
During the past half century there has been a shift in the way

people view the monetary expansion potential; not perhaps in the
way they formally state the matter, but in the way they reason and
operate. The money concept we inherited from the past dealt with a
quantity of money in being, precious metals. When paper currency
of limited elasticity and deposits were included in the analysis, the
amount of money in the hands of the public plus deposits seemed
to give the best calibration of the independent monetary variable
that the members of the public could not control but must adjust to.
The Federal Reserve System was given the rather vague assign­
ment to accommodate commerce, industry, and agriculture, and
through experience had to work out for itself a set of procedures
and objectives. Its assignment certainly did seem to include the
prevention of undue tightness of money, seasonally and generally,
within the limits of redeeming in gold and meeting various legal
requirements. In dealing with their day-to-day problems the officials
developed a reliable procedure for governing conditions in the money
market, against the background of other rates and business develop­
ments. Possibly some of those who guided operations did not at
first understand the monetary implications of what they did. Some of
their critics claimed that, in standing ready to lend at a price (with
certain limitations) to banks needing reserves, they created money
for reasons extraneous to the needs of the economy for money
balances on social grounds.
But experience taught System operators what havoc they would
create if they denied advances. They had the most convincing proof
that they could not set their note circulation and deposit liabilities
at some predetermined level. In addition to finding what instruments
to use and how they might be worked together most advantageously,
they gradually developed the criteria for deciding how to use them—
measures of immediate results and indicators of business develop­
ments in the making. Finally they had to decide on the broad objec­
tives they should aim at. Some of these seemed in partial conflict and
the officials had to decide what weight to give them. The complex
of the decisions they were likely to make and the way they would
operate were what constituted the American monetary potential. It
was not a quantity of anything. What they did had an impact on the
economy, and the creation of money was the modus operandi, but
they could not use the quantity of money as their immediate guide to
action. This was because the economy did not respond mechanically,
but cumulatively, and the quantity of deposits and currency depend­


ed upon the targets of the public for balances as well as the level
of spending and the liquidity of the banks making the loans.
In 1840 S. J. Lloyd said, “The rate at which the Bank (of Eng­
land) may lend money is a fallacious criterion by which to test its
measures; the amount of its issues compared with the bullion is the
only true criterion . . . .”1 Events proved him to be mistaken.
In recent years some people have revived the idea that the central
bank should take as its main criterion of action the volume of cur­
rency and bank deposits. If it attempted to do so, it would cause
strange variations in the money market and confusing signals of its
intentions. Another group of economists would go further and require
a predetermined rate of increase in total deposits and currency. To
at least some members of this group, it would be a serious mistake
to deviate from their rule in order to maintain an orderly money
market and avert a financial crisis.
When people work with something they gradually learn what they
can do with it and what they cannot; sometimes this is quite different
from what they previously thought. The implication is not that one
should reject scientific analysis in favor of engineering, but that the
analytical structure should be built on facts of special knowledge.
Congress can of course prescribe such standards as it chooses, e.g.,
introduce a price stabilization feature into the Employment Act,
overriding other objectives. In that event the monetary potential
would be specified within limits, but it seems doubtful whether a
particular procedure would be tied to it.
The Shift Somewhat from Static Analysis
Economists have always realized that the rate of spending in the
economy has a momentum that is only gradually changed by mone­
tary conditions, as well as by other impacts. But during the past two
generations there has been a tendency to work this approach further
into the framework of the analysis and to shift somewhat from the
idea of an equilibrium of static forces. This is true, for instance, in
the explanation of the impact of monetary conditions on prices.
This shift in approach is exemplified also in many of the explana­
tions that were developed within the System. Officials in discussing
open market operations (during the 1920’s) pointed out that the
purchase of securities by the Reserve Banks might have little im­
mediate effect on the total reserves of the member banks, but would
1 Letter to J. B. Smith, Tracts, p. 169.

usually lead to a reduction of advances to members. (Many students,
including Karl, used to read such passages in Burgess.) The reduc­
tion of advances, however, would tend to ease credit conditions and
might contribute toward improved business conditions. It was then
that deposits and required reserves would tend to increase. What
seemed to be implied, though probably not stated explicitly, was that
the inertia in the rate of spending worked back through deposits and
required reserves. People do not change their spending plans quickly
just because credit is easier.
Also, the explanation of the factors influencing the currency in
circulation showed that the economy had a momentum that would
be modified only gradually by changes in credit conditions. It was
only as retail trade and payrolls and the like increased that more
currency would be required.
Making appropriate allowances, a somewhat similar explanation
could have been given for the behavior of deposits. At times it seemed
implicit in some of the discussions. Perhaps there was not always a
full appreciation of the relation between the demand for bank loans
and the demands of the public generally for deposit balances. These
demands for cash could not take effect immediately through a decline
of aggregate spending for obvious reasons. The line of least resist­
ance was for some people to borrow more from the banks.
A further example of the shift from the static analysis: in reason­
ing about the impact of fiscal policy we do not consider that the level
of spending depends on an equilibrium of tendencies at a moment but
on the cumulative effect on an economy already in motion.
Changes in Ideas About Interest Rates
Graduate students used to be taught that Hume was right and that
the Mercantilists were fundamentally wrong in assessing the influence
of money on interest rates. Financial writers and people in the money
market, though they held that rates were determined mostly by
natural forces, considered that a change in the gold reserve was a
natural force. Teachers of economics tried to reconcile the two
points of view. The economy, in their view, had little tolerance for
rates that were depressed by monetary means; though in their prac­
tical discussions they were less adamant about it than in their formal
theory. Depressing rates by monetary means would, with a metallic
standard, require later correction, with rates higher than they had
been to begin with; with a paper standard, inflation prospects would


in time surpass in importance the direct effect of the monetary ex­
pansion. Rates might rise to fantastic heights.
One thing we have learned from the experiments of the past two
generations is that interest rates can be administered by monetary
means to a much greater extent, and for much longer periods, than
people used to believe. Economies in very large monetary areas are
relatively impervious to incorrectly administered policies, or policies
imposed by the requirements of the international standard; they
can get along in a fair state of prosperity for decades with rates that
are too high— at least they used to— and avoid any frightening in­
flation for long periods with rates that are too low. Fiscal policy
could be a moderating factor, but more often public spending has
been large when rates have been too low. The historical backdrop,
of course, makes a great deal of difference as to what the tolerance
of the economy will be. (Smaller monetary areas naturally have less
freedom of action in administering rates.)
There has been quite a swing in ideas on the matter during the
past four decades. The very low rates of the middle and late thirties
were in considerable part the accident of circumstances, though they
were welcomed by the Treasury. The continuation of those low rates
in the face of obviously inflationary conditions during World War
II and the postwar period seemed shocking to some people, but they
were very much in the minority. Most people seemed to believe there
were far better means for avoiding inflation than raising interest
rates— taxation and various kinds of direct economic controls.
Chronic depression, they believed, was the real postwar danger to
During the early fifties predominant opinion turned back again.
Although by 1952 most middle-aged people could scarcely remember
when rate levels on Government securities had not been approxi­
mately administered, in a short time the usual opinion expressed was
that rates were determined by the natural forces of the market, i.e.,
when not interfered with by the monetary authorities. The latter
should follow the market. This switch in financial opinion was
somewhat surprising, but historically the consequences have on the
whole been favorable. It helped the Federal Reserve to regain control
of monetary policy and resist the gradual erosion of the dollar.
Debt Structure in Connection with Monetary Control
Interest in the volume and structure of debt is not new. Nine­
teenth century writers gave a great deal of attention to the matter,

especially in connection with financial crises. During the 1920’s brokers
loans, especially those made by nonbank lenders, attracted wide
attention and Congressional inquiry. Since the crisis of the early
thirties there has been a more intensive study of debt as a whole and
its relation to monetary control. The deterioration in the quality of
debt led to the destruction of thousands of banks and their deposits,
and much of the effort in reconstructing the economy following the
crisis was devoted to restoring the debt structure and the solvency of
financial institutions. Government agencies made loans or guarantees
to corporations and individuals on a vast scale and under a wide
variety of conditions. Many contemporaries regarded these accom­
plishments as the most important part of the monetary reconstruc­
tion. Since World War II the private and local government debt has
become so vast and such an integral part of the economy that an
analysis of all phases of it has become important to central banking
The influence of debt on the economy has attracted attention from
several angles. For instance, there was a time in the forties when
some Federal Reserve officials thought that for a few years it would
be dangerous to the economy to tighten credit to the point of caus­
ing appreciable capital losses to banks and other large holders of
At times there has been concern over the impact of new debt on
purchases in particular areas of the economy, as well as on aggre­
gate demand. The Federal Reserve has been given control over
several different classes of debt at one time or another in addition
to its permanent jurisdiction over margins for securities loans. While
these regulations (delegated by law or Presidential order) were
aimed especially to prevent excessive expenditure in particular areas,
they were intended also as a reinforcement for general controls. The
Federal Reserve has never been power hungry for these selective con­
trols and for the most part prefers general monetary controls.
Then there is the liquidity angle, the effect on the holder of debt.
Everyone is familiar with the use of debt instruments partly in place
of cash on corporation balance statements. Also, the great supply
of debt in general promotes the growth of financial institutions,
which can issue liquid claims against it to the public. People have
come to realize that it is not merely the supply potential of money
that influences spending; the nonbank members of the economy can


provide liquidity for one another in varying degrees. It is true that
the debtor may have his liquidity reduced, partially offsetting the
liquidity of the creditor, but the net effect is often great.
One needs a broader term than liquidity to describe the expansive
potential of debt. In a large economy that is stable and resists rapid
acceleration, an increase of debt can find placement easily; for the
public collectively there is no immediate alternative but cash. Indi­
vidually there is an escape into real assets, but a comparatively small
rise of prices or business expansion usually deters one from going
very far. The general growth of debt is nevertheless expansive. A
tightening of credit can be used as a counteractive, but that has to
be decided on the basis of all the guides to credit policy. The causes
of expansion are not earmarked.
During the 1950’s there was a widely held view that nonbanking
financial institutions, since they were not required to maintain a
reserve at the Reserve Banks, seriously interfered with the control
of credit conditions by the Federal Reserve. Insofar as it referred to
rate levels in the money market and other rates moving in sympathy,
this was a mistaken view. There was still a minimum of a special
kind of money required by the economy that only the Federal Re­
serve could provide, and the terms and conditions that it set for
providing this amount would be reflected in the loan market as a
whole. But though the nonbanking institutions were no threat to the
System’s grip on competitive loan rates, their activities did favor
the growth of debt generally and in particular areas.
The properties of debt, as well as its volume, affect its expansive
potential. At the present time (July 1969) one can be sure that the
authorities are very much interested in how the quality of debt can
stand up under the continued pressure of tight money. Everyone sees
the possibilities of the cumulative effects of a change in attitude
about the future safety of debt. A spasm of distrust might cause a
flight toward cash and debt assets of unquestioned security. Yet there
lurks a fear of inflation, the possibility of a panicky rush toward real
assets. It is a rare thing for these two kinds of problems to be pre­
sented so close together. It is here that one sees the need for an
intimate knowledge of what is going on in the financial world— even
what is about to happen; and it is here that central bank technique
has made great strides.
Changes in Ideas About the International Standard
The theoretical beliefs about the gold standard when the Federal

Reserve System was established were those which had been develop­
ed in England. Though the facts about London’s position as the
world financial center were certainly understood, it was not fully
appreciated what influence England had on the world economy.
Other countries used sterling balances and short-term investments
as an important part of their reserves;2 but the whole arrangement
in turn depended on England’s financial skill and upon her economic
and political strength. Professor Clay (in recent years) emphasized
that England always provided a source of international reserves by
serving as a buyer of last resort. The formal theory of the gold stand­
ard, however, was that each country had to conform to the aggregate
behavior; a country that got out of line would lose gold.
After World War I the special position of the United States was
thought to be due to the currency disturbances abroad and to the
strength of the American economy. The large gold reserve here gave
this country a great deal of leeway in developing its policies, but
this was not thought to be a permanent situation. United States
policies were aimed at bringing about a return to gold by other
countries and bringing about a “better” distribution of gold. There
was a serious effort to promote cooperation among leading central
banks, but there was not full appreciation of the dollar’s new posi­
tion as an international currency and how much influence it exerted
on monetary action abroad. The Federal Reserve in raising the dis­
count rate in November 1931 was following the rules of the game
as they were then understood.
The Great Depression brought a complete revision of ideas about
the gold standard in the world generally. We are all familiar with
the wide variety of devices that were used to promote trade and
revive employment in the thirties. Many of them seemed to be as­
sociated with nationalist ideology and state regulation of the internal
economy. During the forties the problem shifted from unemployment
to one of inflation and shortages of goods, but exchange controls,
rate variations, and a wide variety of trade restrictions continued. The
International Monetary Fund was intended to bring some order in
the exchange network, gradually to get rid of exchange controls, and
to provide temporary relief in balancing international payments, but
it was not intended to restore the old mechanism of the gold
2 In Indian Currency and Finance (1913), Keynes pointed out that the gold
standard was actually a kind of gold exchange standard.


To many observers in 1950 the nineteenth century theory of the
gold standard seemed no longer applicable to modern arrangements.
The standard had scarcely been restored in the twenties before it
crashed, and it had not been in operation in a meaningful sense
during the thirties and forties. Congress maintained its outward
forms in the United States, but few people believed that the mone­
tary systems of the world would be operated according to the state
of their reserves. It would scarcely have been in keeping with the
Employment Act and it would not have been in keeping with the
then current ideas in other countries for maintaining full employ­
ment and for broadening the scope of the state control of economies.
With the remarkable recovery of European and many other
economies in the fifties and sixties, their reserves of gold and dollar
exchange improved strikingly. Scarcely had this position been at­
tained before some of them raised questions about the soundness of
the dollar. Considering the record of the dollar in maintaining pur­
chasing power, relative to that of other countries, this seemed a very
odd criticism.
Here in the United States financial public opinion seemed to shift
quickly back to the old orthodoxy about the gold standard. In the
light of later events, however, it seems doubtful that opinion within
the System could be described in that way. Since the events of the
past few years are so well known, there is no need to attempt a
summary. The unfortunate part was that the press led the public
to believe that the drain of gold for hoarding purposes was insepar­
able from the problem of the balance of international payments—
that the payments deficit was the basic cause of the drain. All of the
leading financial countries were concerned with the drain of gold.
It would have harmed all of them for the United States to contract
credit to the point of causing a world crisis in an attempt to stop the
flow of gold into hoarding channels. The United States displayed no
weakness in losing gold to hoarding channels; the reserve here was
the main source available.
Once again the monetary authorities of the United States adapted
methods to circumstances, maintaining the essentials and the desir­
able features of what has come down to us from the past. The dollar
continued as an international reserve currency and the network of
exchange rates was preserved. The leakage of gold into hoarding
channels from the monetary reserves of the leading countries was
practically stopped, while at the same time gold can still perform its
traditional function as a means of payment among official institutions

at a fixed rate. Under these circumstances the value of gold in the
speculative market is of no great importance.3
There is still a problem of large foreign holdings of dollars. There
are good grounds for believing that international reserves are not
too large, provided confidence in the dollar continues. (The main
reason given by the former Secretary of the Treasury for wanting
approval of the SDR’s was that there was need for greater interna­
tional liquidity.) Confidence will depend on substantially reducing
U. S. Government expenditure at home and abroad and stopping
internal inflation.
One of the fruitful ideas of the present is that foreign holders of
dollars should assume some of the responsibility for keeping supplies
at appropriate levels. There are many kinds of restrictions on the
use of dollars that they could ease. (Exchange controls, for instance,
are by no means a thing of the past.) In ordinary times, however,
there is good reason to believe that other countries, in their own
interest, will invest and purchase here (directly or indirectly) with
dollars beyond reasonable reserve levels.







A final word about Karl: If the country should ever face a great em er­
gency, I hope he will be among those who decide what to do about it.

8 It is hard to see what advantage there was to either the United States or
Great Britain in restoring the London gold market in the fifties, aside from the
profits to the dealers.


of central banking in its primitive forms to
the present era in which central banks, as the national monetary
authorities, are charged with promoting the general economic interests
of the nations they serve, domestically and internationally, there has
been a continuous pursuit of a will-o’-the-wisp— a policy norm which
would guide the operations of such banks with a minimum intrusion
of fallible human judgment. The theory has been that a central bank,
or any monetary control, must have a supreme norm of reference;
that it cannot use more than one norm of reference.1
The modern beginnings of this passionate pursuit of an elusive ob­
ject may be traced to misconceptions which have grown up concerning
the operation of the international gold standard during the period
1880 to 1914. Prior to that period, the forerunners of present-day
central banks were designed primarily to finance governments or
acquired a tinge of public responsibility because of the magnitude of
their private banking operations. In the years following 1880, how­
ever, most of the principal trading nations of the world had linked
their currencies to gold— either they were on a “full” gold standard
or a “limping” gold standard or a “gold exchange” standard or some
combination of these standards— and the central banks of the finan­
cially developed countries had taken primary responsibility for main­
taining the international convertibility of their national currencies,
directly or indirectly, into gold at a legal parity.
Responsibility for a system of fixed exchange rates necessarily
focused attention on international movements of goods and services,
capital and credit, and on the rise and fall of the country’s inter­
national reserves (gold or other legal reserves) which could be used
as a buffer to confine fluctuations in the exchange rate within a narrow
band around parity. The central bank’s response to a fall in the ex­
change rate and a loss of reserves was usually an increase in its dis­
count rate designed to reverse the movement and, with less uniformity,
the response to a rise in the exchange rate and a gain of reserves was
a reduction of the discount rate. But the timing and extent of such
changes were matters of judgment and their effect on the domestic
F r o m t h e E a r l ie s t D a y s

^Unpublished paper o f Robert B. Warren, Institute o f Advanced Study,
Princeton, N ew Jersey.


economy, while secondary to the primary objective, did not always
go unattended, particularly in times of loss of public confidence and
financial crisis. The whole working of the system depended upon a
complex of institutions and techniques and economic conditions, do­
mestic and international, favored by a period of relatively moderate
shifts of trade and capital movements around multilateral balance,
and fostered by the absence of great wars. To describe the system as
an automatic gold standard, hardly touched by human hands, is to
misrepresent it.
As the studies of Arthur T. Bloomfield have indicated, “Not only
did central banking authorities, so far as can be inferred from their
actions, not consistently follow any simple or single rule or criterion
of policy, or focus exclusively on considerations of convertibility, but
they were constantly called upon to exercise, and did exercise, their
judgment in such matters as whether or not to act, the kind and ex­
tent of action to take, and the instrument or instruments of policy to
use. . . . Discretionary judgment and action were an integral part of
central banking before 1914, even if monetary management was not
oriented toward maintenance of domestic economic growth and em­
ployment and stabilization of prices in the broader modern sense.”2
The discussion in the United States concerning the creation of a
central bank, or a central banking system, during the years before the
passage of the Federal Reserve Act in 1913 took place in a period
when belief in the automatic character of the international gold stand­
ard was little tarnished by later heresies; and gold redeemability at
home and internationally was a widely accepted article of faith in this
country. Attention was centered on changes in the national monetary
system which would correct weaknesses in the domestic banking
structure, but which would not interfere with domestic adjustment to
“automatic” international monetary arrangements under the gold
The principal purposes of the Federal Reserve Act in a monetary
sense, and aside from matters of bank supervision and the pyramiding
of bank reserve funds in New York, were as stated in the preamble
to the Act: “. . . to furnish an elastic currency and to afford a means
of rediscounting commercial paper.” The panic of 1907 had focused
attention on these problems. Subsequent studies had pinpointed the
difficulty as being inherent in a currency largely in the form of gold
certificates and national bank notes and in bank reserve requirements
2 Monetary Policy Under the International Gold Standard, 1880-1914, pub­
lished by the Federal Reserve Bank of New York.

which placed a limit on bank loans and investments more or less
regardless of the appropriate and changing needs of the economy.
Although there was little specific reference in the final Federal
Reserve Act to the promotion of general economic stability and sta­
bility of prices, there was a thread of theory running through the con­
sideration of various drafts of the bill which saw in the legislation a
means of automatically controlling the volume of currency and bank
loans and investments in a way which it was thought would go far to
accomplish these purposes. This theory found expression in the socalled “eligibility” provisions of the Act. The paper which the Federal
Reserve Banks could discount or purchase ordinarily had to be, in the
terminology of the time, “self-liquidating commercial paper”— that
is, it had to be based on short-term agricultural, industrial, or com­
mercial transactions which gave assurance of payment at maturity.
This was the kind of paper which the Federal Reserve Banks could
pledge as collateral (in addition to gold) for Federal Reserve notes,
which were to become the elastic part of the currency, and this was
the kind of paper which member banks could present to the Federal
Reserve Banks for rediscount in order to acquire additional reserve
funds with which to support additions to their existing loans and
investments. Since the volume of such paper would rise and fall with
the transaction needs of the economy, whether in the form of currency
or bank deposits subject to check, excessive increases or decreases of
currency circulation and excessive expansion or contraction of bank
loans and investment would not occur. Or so it was believed.
This experiment in a species of automatic control of central bank­
ing operations did not long survive its inclusion in the Federal Reserve
Act. It was first eroded because it proved to be impractical in the
day-to-day operations of the Reserve Banks, and then was voided by
amendment to the Act (in 1916) which permitted Reserve Banks to
make advances to member banks on their promissory notes secured
by deposit or pledge of United States Government securities.
This was done partly in preparation for financial needs which might
arise if the United States entered the war then raging in Europe, but
the permanence of the change was the result of an acquired awareness
that the concept of eligibility was unrealistic. As stated by Goldenweiser: “Member banks borrow from the Federal Reserve Banks
almost exclusively for the purpose of building up their reserve deposits
(with the Reserve Banks) to the necessary (required) level. The
banks lend money to such customers (and make such investments)
as they choose and meet the currency requirements of their depositors.


If, as a net result arising out of all their operations, they find them­
selves short of reserves, they borrow from the Reserve Banks. . . .
There is thus no relationship between the character of the discounted
paper and the use to which the funds are put.” Furthermore, . . the
theory disregards the fact that banks can expand at a multiple rate on
the basis of Federal Reserve credit; consequently paper representing
the movement of goods to market, when discounted with the Federal
Reserve Banks, can become the basis of several times its value in
loans of an entirely different character.”3 Self-liquidating commercial
paper as an automatic means of controlling the expansion and con­
traction of bank credit or adjusting the money supply to the produc­
tive requirements of the economy was a theoretical and mechanical
failure. It provided neither a quantitative nor a qualitative norm of
central bank policy.
Along this chronological road, the idea that central bank policy
should find its normal guide in stability of prices was never far from
the surface of discussion. It had been around for a long time, but it
received increased attention in the United States following World
War I, when there was a sharp increase and then a sharp fall in prices,
and when Professor Irving Fisher of Yale became a champion and
articulate advocate of a dollar of “invariable purchasing power.”
He held that the only unstable unit of measurement in civilized
countries was the unit of money, that this was a survival of barbarism,
and that it was manifest that an economic system which is largely
based on agreements made at one date to pay money at another date
would have to find a way to adjust its contracts to changes in the pur­
chasing power of money. (The problem is still with us.) This, he
argued, had become possible because a means had been devised for
measuring the aberrations of an unstable monetary unit, to wit a
representative index number of prices. And his specific proposal was
that the monetary authorities should use such an index number of
prices as a guide for adjustments (perhaps every two months) in the
weight of the gold content of the dollar so as to keep its purchasing
power invariable. If prices tended to rise or fall the movement would
be corrected by “loading” or “unloading” the gold in the dollar.
This idea of a “goods dollar” or a “market basket dollar” or a “com­
pensated dollar,” in the form suggested, sounded academic and im­
practical in a country (or a world) which had become accustomed to
the idea (if not the practice) that, if external price levels were unstable,
it could not keep both its domestic price level and the exchange rate
3 American Monetary Policy (1951), p. 126.

of its currency stable and that (under whatever form of the gold stand­
ard it adhered to) it must put stability of the external exchange ahead
of stability of the internal price level.
The idea was opposed on other grounds than those growing out of
habit and custom, however. It was argued that (a) no price index,
no matter how comprehensive, could include all of the things for which
money is spent; (b) that the relation between the volume of credit
and the level of prices is not precise and determinable but is indirect
and inconstant; (c) that things which do not enter into the pricemoney relationship, such as an increase or decrease in the efficiency
of production and distribution, and changes in quality of product
would affect an index of prices; and (d) that the movements of a price
index which might be used to trigger monetary counteraction would
usually be late, since they would refer to past rises or falls in prices,
whereas it would be future price moves which should be counteracted.
Despite its break with gold-standard thinking and the defects of the
proposal itself, it had a simple and direct appeal which led to its con­
sideration by the Congress at hearings of the Committee on Banking
and Currency of the House of Representatives. The proposal was put
forward and was the subject of hearings of the Committee in 1926,
that all of the powers of the Federal Reserve System should be used to
promote stability of the price level.
A principal witness opposing such a statutory instruction to the
Federal Reserve System was Governor Benjamin Strong of the Federal
Reserve Bank of New York. Governor Strong was aware of and used
the various arguments which had been advanced in opposition to
legislation that would order the Federal Reserve to use all of its powers
to stabilize price levels, but the main thrust of his testimony was that
there could be no mathematical formula for the administration of
Federal Reserve policy nor for the regulation of prices. He accepted
the view that credit is a major influence on prices and that the pro­
motion of price stability should be a major policy objective of the
Federal Reserve, but his views had a broader scope, comprising ideas
later finding expression in the Employment Act of 1946. They were
that the Government, through its various agencies, has a responsibility
for maintaining maximum employment and production and promoting
economic growth, and that the objective of credit policy should be to
insure that there is sufficient money and credit available to conduct
the business of the nation and to finance not only seasonal increases
in demand but also the annual normal growth of the economy. He was
willing to have the powers of the Federal Reserve System used to


promote stability of the price level, but he also recognized that choices
and compromises had to be made between various objectives at vari­
ous times and that, in the end, human judgment has to govern the
decisions which are made.
Stability of prices as a norm of central bank policy as a supreme
norm of reference did not survive. (Although the Employment Act of
1946 does include promotion of maximum purchasing power in its
policy declaration.) Other candidates for that honor have arisen or
persisted, however. The doctrine of “bills only” (common name) or
“bills preferably” (botanical name) may be placed in this category,
not because when viewed as a technique of Federal Reserve open
market operations it deserves this prominence, but because its propo­
nents came to place so much stress on the avoidance of price and yield
effects of open market operations that they finally asserted (and made
it a part of the operating directives of the System Open Market
Account) that the sole purpose of open market operations is the pro­
vision and absorption of reserves (excepting the correction of dis­
orderly markets in Government securities). This was an attempt to
elevate what first had been advanced as a matter of technique to the
eminence of a mechanical rule of Federal Reserve policy— a “supreme
norm of reference” for the principal element of flexible and effective
central bank policy in the United States.
The controversy which this doctrine aroused for several years until
it was abandoned in 1961 resulted in a considerable literature and
involved emotions which seemed to widen and distort the differences
of those who favored and those who opposed the policy. In a broad
survey such as this, no extended discussion of all of the arguments
which were brought forward on both sides can be attempted. Only a
summary presentation of its life history from birth to death is possible.
The formal birth certificate was recorded in May 1951 when the
Federal Open Market Committee voted to authorize its Chairman
(William McC. Martin) to appoint a committee to make a study of the
Government securities market. But the idea had been conceived earlier
by members of the staff of the Board of Governors (and of the Open
Market Committee) who not only were interested in the operation of
the Government securities market as a channel through which to reach
and regulate the reserve position of the member banks, but who also
were dissatisfied with the performance of the management of the Sys­
tem Open Market Account at the Federal Reserve Bank of New York
and with the power distribution involved in the linkage between policy­
making by the Federal Open Market Committee at Washington and

the execution of policy by the New York Bank. The study committee,
which became known as the Ad Hoc Subcommittee, was set up and
began its work in May 1952, and its findings and recommendations
became a subject of discussion at a meeting of the Federal Open
Market Committee in March 1953, after a delay which was reported
to have stemmed from the fact that it had become apparent that “the
issues involved in the Committee’s terms of reference are of a most
fundamental and far-reaching character. They involve not only the
most complicated problems of technique and organization, but pro­
found problems of a more theoretical or philosophical nature.”
And yet, at the March 1953 meeting of the Federal Open Market
Committee there was unanimous approval of the two most important
statements of policy with respect to the operations of the System Open
Market Account which had been suggested by the Ad Hoc Subcom­
mittee. (Underlining supplied).
(1) Under present conditions, operations fo r the System ac­
count should be confined to the short end o f the m arket (not
including correction o f disorderly markets);
(2) It is not now the policy of the C om m ittee to support any
pattern o f prices and yields in the G overnm ent securities market,
and intervention in the G overnm ent securities m arket is solely
to effectuate the objectives o f m onetary and credit policy (in­
cluding correction o f disorderly markets).

The second of these ordinances, which really should have been first,
put a seal of disapproval on any future pegging of prices of Govern­
ment securities such as had been practiced during World War II, and
in the postwar period of readjustment in the Government securities
market while the consequences of financing the war were being
unwound. The first ordinance represented a consensus that, in most
circumstances, the Open Market Committee would be able to attain
its policy objectives by operating in the market for Treasury bills and
other short-term Government securities.
The apple of discord became apparent later when there was a creep­
ing movement to give constitutional permanence to the doctrine which
had become known as “bills only,” and to engrave it permanently in
the public mind, and particularly in the minds of Government securi­
ties dealers, by a dribble of statements of individuals concerning the
“ground rules” for all future open market operations, even though the
question of publicizing ground rules had been deferred by the Open
Market Committee for further study.


At the September 1953 meeting of the Open Market Committee4
the phrase “under present conditions” was dropped from the directive
that operations for System Account be confined to the short end of the
market, and replaced by the clause “until such time as (it) may be
superseded or modified by further action of the Federal Open Market
Committee.” And, at the December meeting of the Committee in 1953,
the general statement with respect to System intervention in the Gov­
ernment securities market was changed to read “transactions for
System account in the open market shall be entered into solely for the
purpose of providing or absorbing reserves, except in the correction of
disorderly markets.”5
The major differences of opinion, at least within the Federal Open
Market Committee, had now become (1) whether it was misleading
and undesirable to promulgate a capsule version of the whole theory of
central banking, and the whole purpose of open market operations,
which mentioned only the providing and absorbing of reserves and
omitted the essential linkage between such actions and the cost and
availability of credit; (2) whether it was unnecessary and undesirable
to endow the doctrine of “bills only” with an air of permanence as a
norm of System open market operations, no matter what changes in
economic conditions and in the market structure of interest rates
might occur; (3) whether it was desirable to attempt to provide the
Government securities dealers with a continuing set of “ground rules”
for System open market operations, which would seek to protect the
market from the hazards of there being a central banking system whose
policy decisions, and whose every action to make its policy decisions
effective, must influence the cost and availability of credit throughout
the economy and, therefore, the movements of interest rates and prices
4 There was a June meeting of the Open Market Committee at which there
were five presidents of Federal Reserve Banks and four members of the Board
of Governors, and at which the March directive relating to confining operations
for System Account to the short-term sector of the market was rescinded, with
the understanding that the Executive Committee of the Federal Open Market
Committee (which was later abolished) would be free to determine how oper­
ations should be carried on in the light of the current general credit policy of
the full Open Market Committee. The five presidents voted for the motion to
rescind and the four Board members voted against it (following the meeting,
the Executive Committee, consisting of three Board members and two presi­
dents, decided to confine current operations to Treasury bills). By the time of
the September meeting of the Open Market Committee, three of the presidents
had changed their minds concerning preserving such limited freedom of action
and the March pronouncement, as amended, was restored by a vote of nine
to two.
5 This change had a special application to so-called “swap” transactions in
connection with Treasury financing, but it also was an attempt to nail down
permanently a general philosophy of open market operations.


through the whole range of maturities in the Government securities
In the running debate which followed, a great deal of discussion
was devoted to elucidating the obvious necessity of having a properly
functioning Government securities market in which to conduct System
open market operations; to trying to prove that confining such opera­
tions to the short end of the maturity scale would improve, or had
improved, the “breadth, depth, and resiliency” of the market; and to
asserting that substitutability was more important than arbitrage in
carrying impulses throughout the whole range of maturities. But the
major questions involving the promulgation of a norm of central bank­
ing and the publication of permanent “ground rules” for the conduct
of open market operations tended to be neglected, while the Federal
Open Market Committee annually voted to perpetuate the views of
its satisfied majority. It is ironical, perhaps, that the so-called “bills
only” policy, which was hailed by one of its chief architects in October
1960 as “the greatest advance in central banking technique in the last
decade,” was overtaken by events and abandoned in February 1961.
The Federal Open Market Committee then announced that the System
Open Market Account was purchasing Government notes and bonds
of varying maturities “in the light of conditions that have developed
in the domestic economy and in the U.S. balance of payments.” The
question of “bills only” may arise again, of course; its abandonment
can be endowed with no more real permanence than its adoption, but
it is unlikely that it will ever be revived as the basis for the sweeping
assertion that transactions for System Account in the open market
shall be entered into solely for the purpose of providing or absorbing
It is reassuring on this score that the latest Joint Treasury-Federal
Reserve Study of the U.S. Government Securities Market (April
1969) recommends that “System purchases of intermediate- and long­
term U.S. Government coupon issues should be continued—even apart
from use in correction or forestalling disorderly market conditions—
as a useful supplement to bill purchases in providing reserves to the
banking system and, when compelling reasons exist, for affecting to
the extent consistent with reserve objectives interest rate pressures in
specific short- or long-term maturity sectors of the debt market.”
The mechanical purpose formula for Federal Reserve open market
operations which grew out of the doctrine of “bills only” is a not too
distant relative of what is, at the moment, the most virulent form of
norm addiction, the “money supply” addiction. Both would rely


wholly on market forces to produce desired effects flowing from Fed­
eral Reserve action affecting a single monetary aggregate. The present
virulence of the money supply proposal for getting rid of the fallible
judgment of central bankers, and substituting a mechanical formula
for their gropings, may be ascribed to the existence of a “school” for
the propagation of the faith and to a combination of circumstances
relating to the respective merits of fiscal and monetary policy in help­
ing to order our economic affairs which has stirred up academic dis­
pute and endowed the views of the “school” with a modicum of public
attention and political acceptance.
Once an energetic and forensically formidable economist assembles
a massive collection of empirical historical evidence to provide appar­
ent support for his opinions, and indoctrinates enough disciples who
then go forth and preach the gospel, a “school” becomes established.
If there happens to be another “school” of followers of another leader
whose views have found wide professional and political acceptance in
the past, and which now may be attacked with some hope of success,
the stage is set for a rash of academic and journalistic coverage of the
battle. The whole subject then comes to the attention of a growing
group of men of affairs in politics and in business, and the risk arises
that a shaky hypothesis may become something more than a source of
academic argument and journalistic enterprise.
We are not concerned here, however, as to whether Keynes or
Friedman is the economic messiah of our time, but with the claim of
the monetarists that the money supply should be the sole or, at least,
the supreme norm of reference of monetary policy. We are concerned
with the proposal that the Federal Reserve should content itself with
attempting to increase the money supply at a fixed annual rate (4 or 5
per cent a year is suggested) calculated on the average to be consistent
with stable prices, thus providing a stable monetary framework in
which other economic goals may be realized and avoiding the hazards
of trying to use monetary policy as a flexible and sensitive instrument
for influencing our economic affairs.
In the more restrained versions of this theory, it is admitted that
monetary growth is not a precise and infallible source of future eco­
nomic stability but that, on the average, (which conceals much vari­
ability in both the time delay and the magnitude of the response)
there is a close relationship between the rate of change in the quantity
of money and the rate of change in national income (at current prices)
some six months or more later.
This is an appealing doctrine which “rolls up into one simple


explanatory variable all of the many complex forces which determine
aggregate demand.” No wonder political interest has been aroused
and a public following has emerged. But the economic peers of the
monetarists are skeptical. They have raised many questions concerning
the money supply theory which the monetarists have yet to answer
convincingly. Drawing on the work of those who have addressed
themselves to the problem and are competent to discuss it as profes­
sional economists, I shall list some of these questions.
First and foremost is the question of whether the asserted causal
connection between cycles of growth of the money stock and cyclical
movements of the economy runs from money to business activity or
from business activity to money. It is akin to the question phrased by a
British writer: “Did man begin to lose his general covering of hair
when he began wearing clothes, or did he begin wearing clothes when
he noticed he was going into a permanent moult?”
Second, what monetary aggregate is to be used as the guide of
monetary policy; is it the money stock narrowly defined as currency
in circulation and demand deposits at banks, or is it currency and
demand deposits plus time deposits at banks, or is it the “monetary
base,” or is it the money supply which is “currently most meaningful
in indicating monetary influence in economic activity”? Recent revi­
sions of the most commonly used money supply series, and the patent
sketchiness of such series stretching back into the historical and sta­
tistical past ( “over a century” ) add point to this basic question.
Third, are the econometric models which the monetarists use to
demonstrate how the transmission process proceeds from money to
business activity adequate for the purpose?
Fourth, are not both price and quantity of money important; do
you not have to take into account shifts in demand and in interest
Fifth, do the observed variations in monetary time lags and mone­
tary velocity cast doubts on the suggested simple causal relationship
between the money supply and general economic activity; do they not
suggest that there are unpredictable variables other than the money
supply which influence the level of economic activity and which must
be taken into account in devising monetary policy?
Sixth, the suggested monetary framework for the economy is put
forward most precisely in terms of a closed economy, although it is


admitted that it should involve a free foreign exchange market (float­
ing exchange rates) in the open economy of which this country actually
is a part. Is this a practical directive for monetary policy?
Even if some of these murky areas are cleared and the monetarists
become less rigid in their formulations, experience suggests that the
money supply norm of central bank policy eventually will take its
place on the library shelves along with the policy norms of the past.
With improvement of our knowledge and understanding of the present
state of the economy and its likely future course, the money supply
norm may leave a trace; the use of annual rates of change in the money
supply as a navigational aid for central bank action (channel markers
indicating maximum and minimum rates of growth to be sought)
cannot be ruled out, but the discretionary band would have to be wide
enough to accommodate the flexible requirements dictated by experi­
Practicing central bankers (and the governments to which they are
responsible) cannot afford to be confined by formulae which attempt
to cope, in precise measure, with the actions and anticipations of
millions of human beings exercising a high degree of economic freedom
of choice. Monetary policy can continue to make its contribution to
the goals of vigorous sustainable economic growth, maximum attain­
able production and employment, and reasonable stability of prices,
if its practitioners continue to sharpen their analyses of complex eco­
nomic developments and continue to base their actions upon a bal­
anced view of total situations. They cannot be relieved of this difficult
task by doctrinaire policy norms.



is replete with examples which emphasize
the necessity for institutions to undergo periodic reevaluation and
reform if they are to serve the needs of an evolving society. As one
of the nation’s key institutions, the Federal Reserve System has been
subject to a wide variety of such revisionary efforts, internal and ex­
ternal; and, even if these may not always have been so timely, so ob­
jective, so organized, or so comprehensive as some may have wished,
nonetheless they have been essential contributors to the evolution of a
central banking mechanism that has come a long way from the insti­
tution envisioned by the drafters of the Federal Reserve Act.
The mode of organization of the Federal Reserve System contains
enough different power centers and accommodates enough diverse
points of view to generate a continual flow of internal reappraisals of
one aspect or another of relevant theory and practice. Some have been
modest, some have been major— depending on the criticalness of the
issue and the time and resources available for its investigation.
One of the most ambitious of recent System exercises of this type
has been a reappraisal of the philosophy and operations of the Federal
Reserve lending function, popularly termed the “discount window.”
Karl Bopp was intimately involved in this reappraisal, as indeed he
was in most of the significant internal studies of Federal Reserve
operations over the past three decades— one concrete indication of
the value his colleagues have placed on his judgment and his schol­
arship.1 I was also a participant in the discount window reappraisal,2
and I should like to draw on that experience to outline in following
pages the general approach to the study, environmental considerations
dictating the design of the discount mechanism, and the manner in
which the proposed revision of the discount window is expected to
P r e s e n t - d a y A m e r ic a

* Unless otherwise indicated, the views expressed in this essay are the respon­
sibility of the author and do not necessarily represent official Federal Reserve
positions. Special acknowledgment is due Miss Priscilla Ormsby of the Board’s
staff for her assistance in the preparation of this paper.
1 Mr. Bopp served as a member of the top-level Steering Committee that was
responsible for the overall direction and resolution of the discount study.
2 As chairman of the staff Secretariat that was responsible for implementing
the discount study under the guidance of the Steering Committee.


overcome deficiencies in the present operation and deal with prospec­
tive challenges in years ahead.
Scope of the Study
Because discounting problems giving rise to the study were not so
much immediate as progressive, the investigative effort could be ex­
tensive and time-consuming, with a deliberate orientation toward
fore-handed preparation to deal with future developments. In the
interests of a complete consideration of all possible alternatives, the
study, at least initially, assumed away all current legal restraints.
The intent was to study what the ideal role and design of the dis­
count mechanism would be in the financial system, and secondly to
determine what legal changes would be needed to achieve this design
and/or what compromises would be necessary in that ideal design
to make it legally and politically feasible. On the other hand, the
specific recommendations of the study, intended as they were for
fairly prompt implementation, were designed to be completely within
current law.
As had been done for several preceding major studies of discount­
ing and open market operations, a wide range of talent was brought
to bear on the subject. Top-level direction was supplied by a steer­
ing committee consisting of three members of the Board of Gov­
ernors and four presidents of the Federal Reserve Banks, under the
chairmanship of Governor Mitchell. Under this steering committee a
secretariat composed of research, discount, legal, examination, and
operating personnel from within the System was responsible for
developing proposals for steering committee review and implement­
ing the study outline as determined by the parent committee.
Over 20 individual research projects were commissioned to pro­
vide historical perspective and quantitative and theoretical back­
ground for considering policy alternatives.3 Most of these projects
were undertaken by members of the research staffs of the Board of
Governors and the Reserve Banks. Academic economists were asked
to prepare several formal papers, and also to contribute advice and
suggestions more informally through an exploratory seminar and
written communications. Central bankers abroad were consulted con­
cerning their lending experience, and added insight into domestic
8 Most of the research papers prepared in this connection have subsequently
been published by the Board of Governors; see the September, 1969 Federal
Reserve Bulletin, p. A100 for a list of currently available papers.


commercial banker attitudes was obtained from a survey conducted
by the American Bankers Association.
Drawing upon the results of these investigations, and suggestions
received from a variety of other sources, the staff secretariat formu­
lated specific proposals for the redesign of the discount window.
These proposals with amendments and refinements growing out of
further discussion within the steering committee and by other Sys­
tem personnel, were presented for System and public consideration
in a July 15, 1968, report of the steering committee.* Since that time
comments have been received from a wide segment of the financial
community, and a Congressional Committee hearing has been con­
ducted on the proposals. Following further study to take into ac­
count these outside reactions as well as experience in the intervening
period, the report, with limited suggested modifications, is now await­
ing consideration and action by the Board when the general mone­
tary climate is regarded as appropriate.
Need for Discount Mechanism
A comprehensive study of the appropriate role of the discount
mechanism must begin conceptually with the basic question of
whether in fact there exists such a role. As is well known, a few
respected academic scholars have argued that the discount window
no longer serves a useful function and can and should be eliminated.
Federal Reserve officials have consistently opposed this view, but
not even this long-established position was taken for granted in the
recent study.
In reaffirming the need for a discount mechanism currently and
predicting that this need would grow rather than diminish in the
foreseeable future, the study identified and examined pertinent char­
acteristics and underlying trends in the financial system. Probably
the most important of these is the continued fragmentation of the
United States banking system. In contrast to many other countries
with only a relatively few commercial banks, this nation has almost
6,000 banks that are members of the Federal Reserve System, the
vast majority of which are small and relatively isolated from day-today dealings with the central money market. The result is a serious
lack of homogeneity in financial pressures and flows.
All banks are at times subject to day-to-day, temporary, seasonal,
4 “Reappraisal of the Federal Reserve Discount Mechanism: Report of a
System Committee,” Board of Governors of the Federal Reserve System, July 15,


cyclical, and emergency shifts in the supply or demand for funds
which may be either unanticipated or larger than anticipated. Since in
many cases an outflow for one bank represents an inflow for another,
the net of these shifts for the banking system as a whole seldom ap­
pears very large. However, the gross size and distribution of swings in
fund flows can produce abrupt pressures on individual banks for which
they can prepare only at the cost of excessive liquidity and a significant
limitation on the credit resources they make available to their commu­
nities. Moreover, the liquidity instruments used are dependent on
financial markets and mechanisms which often do not function with
sufficient speed and elasticity to guarantee that a bank can always
effect its desired adjustments through these means. And not all mem­
ber banks have adequate access to such markets.
The size of these fluctuations impinging on individual banks has
grown over time, while the banking system’s ability to deal with them
has tended to lag behind and in fact may actually have declined in
many individual circumstances. In most years since World War II,
private debt has expanded rapidly relative to public debt and to in­
come and locally generated savings. Bank portfolios have reflected
these developments, with holdings of easily salable unpledged Gov­
ernment securities dwindling relatively and the asset side of bank
balance sheets becoming dominated by much less salable business,
consumer, and mortgage loans and municipal obligations. With de­
mands for these loans rising steadily and almost all of the oncetypical sources of funds— investment sales and deposit growth—
proving inadequate, many banks have been caught in a funds squeeze
The most striking and innovative bank response to this squeeze
has been the increasing issuance of liquid liabilities. This develop­
ment can be seen in the rapid growth of the Federal funds and Euro­
dollar markets, in the intense competition for negotiable certificates
of deposit (when such competition is not inhibited by the effect of
Regulation Q ceilings), and most recently in the use of repurchase
agreements, sales of loan participations, and sales of commercial
paper through parent holding companies.
These developments have unquestionably been accelerated by the
effects of monetary stringency but nonetheless are responsive in part
to underlying trends. In contrast to the sale of Government securities,
however, bank issuance of liquid liabilities places a clear and direct
premium on attributes which many banks lack—namely, geographic
proximity to the central money market, adequate informational flows,
national reputation, and the ability to trade in large blocks of funds.


As a result, such “disadvantaged” banks have been unable to par­
ticipate effectively in the growing reliance on new methods of funds
transfer and, in order to be even minimally prepared to meet the
shifts in funds flows mentioned earlier, they have been forced to
continue holding fairly substantial portions of their assets in liquid
or near-liquid form despite the constantly growing credit needs of
the communities they serve. This necessity has put smaller banks in
particular at a competitive disadvantage with other financial institu­
tions which may serve the same communities, or in the absence of
such institutions has sometimes left the communities’ needs unfilled.
Under these conditions, some limited direct bank access to Fed­
eral Reserve credit can contribute to more homogeneous credit avail­
ability by cushioning what otherwise might be seriously destabilizing
movements arising in the short run from the structural inequities and
market imperfections now existing.
A corollary attribute of the discount window— and one of key
importance to the implementation of Federal Reserve monetary
policy— is its functioning as a “safety valve” for open market opera­
tions. Since reserves are provided through the window at the initia­
tive of member banks, there is an opportunity for individual banks
to cushion, partially and temporarily, operations by the Open Market
Account that impinge with excessive stringency on particular banks.
It is not accurate to argue, as some do, that the discount mechanism
dilutes the effectiveness of open market operations. In practice, the
discount mechanism enables the Federal Reserve to conduct its open
market operations more freely in response to overall market condi­
tions, without being inhibited in these decisions by any unevenness
in the impact of its operations within the banking system and the
possibility that individual banks will be hurt excessively.
Another important although seldom called-upon function of the
discount mechanism is in carrying out the System’s role as lender
of last resort to the economy. In a complex and heavily layered fi­
nancial system subject to strong surges of demands, there is impelling
need for an ultimate source of pinpointed liquidity available in in­
stances when damaging disruptions threaten. The Federal Reserve
is the only institution capable of assuring such liquidity. The carry­
ing out of this responsibility may in rare instances require loans to
institutions other than member banks; however, it should be ex­
pected that such loans would be carefully circumscribed, with an
interest rate above the discount rate, and would be extended only
when their absence would almost certainly cause significant damage


to the economy’s financial structure. Nonetheless, the means of ex­
tending this type of loan and thereby placing the funds directly in
the institutions or sector involved, rather than relying on normally
effective market mechanisms for reserve distribution, need to be ready
for contingent use.
The discount window can also serve as an incentive to membership
in the Federal Reserve System. So long as the present voluntary
membership arrangement is retained, the Federal Reserve needs to
extend advantages to its members sufficient to offset the burden of
meeting reserve requirements. Access to discount credit can repre­
sent one such advantage. There are clearly limiting considerations
which constrain this role. To serve this purpose, the terms and con­
ditions for member bank access to the window must be significantly
more favorable than those available to would-be nonmember borrow­
ers under the lender-of-last-resort function outlined in the preceding
paragraph; yet the general public interest argues against such liberal
terms as to give a major subsidy to the member banking system. But
the stakes involved in adequately offsetting the costs of membership,
and therefore in providing meaningful borrowing assistance to mem­
ber banks, are considerable; the protracted decline in Federal Re­
serve membership, if not stemmed, could eventually threaten the
ability of the System to effectively implement monetary policy.
Another function that the discount mechanism can serve— one
that is clearly secondary but still useful— is the provision of an op­
portunity for direct communication between Reserve Banks and
member banks. While the impersonality of reserve injection through
open market operations has obvious advantages, the more direct
communication involved in discount operations can also prove useful
on occasion. This does not mean that the discount window should
serve as a primary vehicle for bank supervision; that task is appro­
priately reserved to the bank examination function. The potential
rather lies in helping to increase member bank understanding of
Federal Reserve views as to policy issues at the aggregate level, and
bank liquidity and soundness considerations at the individual bank
level. Opportunity is also provided at the window for a reverse flow
of information, making the Reserve Banks more aware of and re­
sponsive to developments at the individual member bank level.
A last reason for keeping and improving the discount mechanism
is simply uncertainty about the future. While the policymakers try
to look ahead as far as possible, the banking system is constantly
changing and no one can confidently describe what it will look like


20, 10, or even one year from now. In such an uncertain world
there are clear advantages to “keeping options open.” What may
seem superfluous today— and the discount window clearly did not
to those involved in the study— may nonetheless become vital to­
morrow. For instance, to cite an extreme example, in a war emergen­
cy a decentralized discount mechanism might become the only prac­
ticable way of providing (and absorbing) reserves if normal open
market operations were rendered impractical.
Changes Needed In the Discount Mechanism
Giving varying weight to all of the considerations outlined in the
preceding section, the recent study concluded that the discount
mechanism must be preserved as a means of reserve injection and,
further, that it should be strengthened and brought into closer touch
with the prevailing and prospective economic climate.
As presently designed, the discount mechanism accommodates
only minimal use. The volume of borrowing from the Federal Re­
serve is at least in theory held down to narrow dimensions by banker
reluctance to borrow, although this reluctance is in practice rein­
forced if not replaced by Reserve Bank application of subjective
administrative discipline whenever bank use of Federal Reserve credit
is deemed to have become “inappropriate.” This design, clearly out­
dated in an era when banker reluctance to borrow from other sources
appears in many cases largely eroded— or at best reduced to the
minimum allowed by soundness considerations— is already generat­
ing a good deal of misunderstanding and hostility, permitting nonuniform accommodation of banks in similar circumstances, and fur­
ther eroding member bank interest in borrowing from the Federal
Reserve, even at strikingly attractive interest rates. Moreover, one
can only expect that projected trends in banking will leave the win­
dow, as it presently exists, even more out of date. A redesign is
therefore imperative if the discount mechanism is to remain viable
and to encourage the more active use which would be involved in
making a significant contribution to an effectively functioning mone­
tary system.
The precise details of the changes proposed in Federal Reserve
lending facilities by the steering committee report are summarized
in a table at the end of this article. In general terms, that proposal
can be thought of as introducing two major and interrelated changes
in emphasis from current discount operations. The first of these is
the articulation of several complementary arrangements for borrow­


ing at the window, designed to provide credit for short-term ad­
justment needs, seasonal needs, and emergency needs, respectively.
Short-term adjustment credit would be further divided into two
parts. First, there is the “basic borrowing privilege”— which would
provide credit on a virtually automatic basis, within preset relative
limits on amount and frequency, to all member banks meeting mini­
mum specified conditions. On top of this would be provided what is
termed “other adjustment credit.” The latter would be available, un­
der administrative control much akin to what is now applicable, to
meet needs larger in amount or longer in duration than could be ac­
commodated under the basic borrowing privilege. Seasonal credit
would be provided, under the title of a “seasonal borrowing privi­
lege,” to accommodate recurring intra-yearly demands for funds over
and above a minimum relative amount, for such amounts and dura­
tion of months as the applying member bank is able to demonstrate
a need.
The proposed redesign provides that the Federal Reserve would
continue to supply liberal help to its member banks in general or
isolated emergency situations. In addition, it recognizes a Federal
Reserve responsibility to be lender of last resort to other sectors of
the economy— and it provides that the System will stand ready, un­
der extreme conditions, to provide circumscribed credit assistance to
a broader spectrum of financial institutions than member banks.
The second major change included in the proposal is a move to­
ward more objectively defined terms and conditions for discounting.
This would be accomplished first by introducing specific quantity
and frequency limitations on a part of borrowing from the Federal
Reserve— the basic borrowing privilege and the seasonal borrowing
privilege, as has already been mentioned. Secondly, more reliance
would be placed on the discount rate as an influence on member
bank borrowing. This would require a closer alignment of the dis­
count rate to the general level of market rates, almost certainly call­
ing for more frequent changes in the discount rate than have been
typical up to now.
Hopefully, this sought-for greater objectivity in the provision of
discount credit would achieve several results. Member banks would
be able to achieve a much clearer understanding of the limitations on
their borrowing from the Federal Reserve. This should relieve con­
fusion and irritation, and should permit banks to evolve better plans
for meeting the ebb and flow of demands upon them. Furthermore,
keeping the discount rate more closely aligned to relevant national


market rates should produce more rational and hence more pre­
dictable recourse to the various borrowing arrangements proposed
without socially undesirable subsidy. It should also allow room for
the development and improvement of market mechanisms for the
transfers of funds, whenever and wherever private institutions can
produce innovative efficiencies.
One of the most visible effects of adoption of these proposals
would probably be a generally higher level of borrowing being done
by changing groups of member banks. But such a higher level of bor­
rowing would not necessarily mean a corresponding increase in total
reserves, because the increased borrowing would be expected to be
offset to the extent necessary by correspondingly smaller net System
purchases of securities in the open market, thereby maintaining an
overall level of reserve availability appropriate to existing conditions.
The proposed redesign also contains a potential for the introduc­
tion of a fairly stable element into the larger borrowing total which
can serve as a base of reserve injection upon which open market
operations can build. Up to now the discount window has acted
somewhat in the role of a sponge, soaking up or releasing reserves
on a net basis chiefly in response to the underlying cyclical forces
in the economy and/or policy-induced pressures. To be specific, in
an inflationary situation, when credit demands are high and the Sys­
tem is squeezing the reserve positions of the banking system through
its open market operations, one result is that a limited but cyclically
high volume of cushioning reserves oozes out through the discount
window. On the other hand, when the economy slows down and the
System loosens its grip on bank reserves by increasing its open
market purchases, a part of these reserve injections are used to re­
pay indebtedness at the window. Thus the analogy is completed, with
the discount window soaking up a part of the reserves put in.
There can be a second kind of discounting, however, less respon­
sive to the tides of contracyclical policy, which serves to provide
more in the nature of a stable building block of reserves from the
point of view of the banking system as a whole. This kind goes on
today to the extent that needs largely seasonal but also shorter-term
are being met which reflect regular operational needs of the economy
which continue regardless of the fluctuations in overall economic
activity and policy. It is of course impossible to draw a clear dividing
line between the aggregate component of discounting which is sponge­
like cyclically and that which is more of a stable building block.
While the credit needs satisfied by the latter kind of discounting may


not vary a great deal from one year to the next, the relative attrac­
tiveness of different means of filling them inevitably does.
Nevertheless, there can be a useful place in the Federal Reserve
kit of monetary tools for such a category of discounting, consisting
of a continuously changing collection of limited-term loans but repre­
senting in the aggregate a relatively stable block of reserve injection
into the economy. And the proposed redesign of the window moves
in a direction which should encourage the evolution of such a block,
especially through the innovation of the seasonal borrowing privilege.
While the size of the block might be modest initially, it could be ex­
panded if and as it proves a useful development by relaxing the terms
for a qualifying seasonal loan and perhaps by making it a more gen­
eral source of intermediate-term credit. In time it could come to
represent a fairly significant proportion of the ongoing reserve base
of the banking system as a whole.
An Evolutionary Philosophy
This last comment illustrates a philosophy which pervades the
recommendations of the recent discount study. The proposed rede­
sign was at no stage viewed as the ultimate, destined to remain
appropriate indefinitely in a constantly changing financial system.
Rather it was regarded as an evolutionary step, constrained both by
uncertainty as to the future and by currently applicable law, in a
continuing effort to bring the discount mechanism more closely into
line with developing needs and conditions. In line with this goal, an
attempt was made to create a proposal which, in addition to breath­
ing new vitality almost immediately into what in recent years has
become a relatively minor tool of reserve injection, would establish
worthwhile new directions for discounting philosophy and contain the
seeds for further growth and adaptation as that proves desirable
and practicable.
Certainly this study did not exhaust all the possibilities for useful
innovations at the discount window. Many others will undoubtedly
be put forward from time to time in response to the emerging needs
of the banking system. Continual reappraisal and reevaluation will
be necessary to assure that the design of the discount mechanism
remains appropriate to its implicit objective— helping the banking
system to extend credit on a homogeneous basis in forms that serve
the public interest and in dimensions that comport with overall
stabilization policy. Such reappraisal ought to be conducted with
enough sense of developing trends so that it anticipates needs and


does not wait until they are immediate and already causing prob­
lems. Furthermore, it ought to deal with these needs by measures that
complement market allocation and that can wax and wane as a com­
pensating adjustment to the success, or lack of success, of the private
credit market itself in evolving mechanisms to meet developing credit
The spirit of inquiry appropriate to this kind of appraisal has
rarely been better expressed than by Karl Bopp, himself, in his essay
entitled, “Confessions of a Central Banker” :
The w orld in which we live never quite measures up to the
w orld o f which we dream. This does not mean either that we
should cease to live or that we should give up our dreams, but,
rather, that we should strive constantly both to enrich our vision
and im prove our perform ance.5
8 Pinkney C. Walker, et al, Essays in M onetary Policy in Honor of Elmer
W ood (Columbia, Missouri: University of Missouri Press, 1967), p. 17.



Frequency or
duration limitations

Basic borrowing

Other adjustment



Member bank access to
credit upon request,
within precisely stated
limits on amounts and
frequency and on speci­
fied conditions.

Supplemental discount
accommodation, subj eel
to administrative proce­
dures, to help a member
bank meet temporary
needs that prove either
larger or longer in dura­
tion than could be cov­
ered by its basic borrow­
ing privilege.
Discount rate

Discount rate

—(20-40) per cent of first None specified.
$1 million capital stock
& surplus plus—(10-20)
per cent of next $9 mil­
lion, plus—(10) per cent
of remainder.
-(6-13) of any—(13-26) None specified.
consecutive reserve com­
putation periods.

Administrative proce­

None other than general
discouragement of net
selling of Federal funds
by borrowing banks.

Other restrictions

Must not have been None specified.
found to be in unsatis­
factory condition.

Method of provisions

Appraisal and, where
necessary, action broad­
ly similar to procedures
developed under existing
discount arrangements.

Seasonal borrowing

credit to
member banks


Member bank access to Credit extended to mem­
credit on a longer-term ber banks in unusual oi
and, to the extent possi­ exigent circumstances.
ble, prearranged basis to
meet demonstrable sea­
sonal pressures exceed­
ing minimum duration
and relative amount.
Discount rate

Discount rate.

Seasonal needs in excess None specified.
of—(5-10) per cent of av­
erage deposits subject to
reserve requirements tn
preceding calendar year.


Credit extended to insti­
tutions other than mem­
ber banks in emergency
circumstances in fulfilling
role as lender of last re­
sort to the economy.

Significantly higher rate
than discount rate.
None specified.

Need and arrangement
must be for more than a
weeks. Maximum 9 con­
secutive months.
Prearrangement involves
discussion between dis­
count officer and bank
management concerning
amount, duration, and
seasonality of need.
Administrative review
maintained during bor­
rowing to prevent abuse
or misuse.
None specified.

None specified.

None specified.

Continuous and thor­
oughgoing surveillance.
Require that bank de­
velop and pursue work­
able program for alle­
viating difficulties.

Continuous and thor­
oughgoing surveillance
(may have to be through
Require that institu­
tion develop and pursue
workable program for
alleviating difficulties.

None specified.



Required to use all
other practicable sour­
ces of credit first.
agency; (2) direct; (3)
conduit through membei

* “Reappraisal of the Federal Reserve Discount Mechanism,"Federal Reserve Bulletin, July 1968, p. 551.

credit to



1966 will probably long be re­
membered as the year of the “credit crunch,” when the nation’s vast
and complex credit system appeared to teeter on the brink of collapse.
Admittedly the term “credit crunch” inadequately captures the deep
uncertainties, the genuine fears, and the real hardships experienced
by borrowers and lenders during that time. Yet I think most of us feel
that it expresses, as well as any one or two words can, what was hap­
pening in the summer of that year. Although the crunch involved in
the first instance a sharp drop in deposit flows to thrift institutions that
resulted in a real wrenching of the mortgage market, I would define it
largely in terms of psychology in the financial markets. Generated in
an atmosphere of virtually unmanageable credit demands from the
Federal Government and its agencies, and severe and increasing Fed­
eral Reserve restraint, there was a widespread and growing apprehen­
sion as the summer wore on that various kinds of credit might be­
come unavailable at any price, perhaps leading to a general financial
panic with drastic consequences for financial and even nonfinancial
In view of New York's unique position in the country’s financial
structure, we in the Federal Reserve Bank of New York were especial­
ly well-situated to keep a close watch on these developments. I am try­
ing in this article to set forth a few observations on this whole phe­
nomenon as we observed it from our vantage point.
Although the entire 1966 financial experience is now popularly
described as “the” crunch, in fact there were two such episodes sep­
arated by several months and even more widely in terms of their
origins, psychological impact, and consequences. The first, the mortgage-market crunch, occurred from about April through June; the
second, the short-lived securities and money-market crunch, came
in the latter days of August and the early days of September. The first
of these two financial disturbances impinged primarily on the nonbank
thrift institutions— the savings and loan associations and mutual savI n A m e r ic a n F in a n c ia l H ist o r y

* I wish to acknowledge my debt to many colleagues at the Federal Reserve
Bank of New York who offered valuable comments and suggestions during the
preparation of this article. Special thanks are due to A. M. Puckett, S. V. O.
Clarke, and Linda Karagosian of the Bank’s Research and Statistics Function.


mgs banks—and involved massive outflows of interest-sensitive de­
posits from these institutions. The most obvious result of this loss of
competitive position by the thrift institutions was an abrupt drying-up
of funds to the residential mortgage market and a drop of great se­
verity in home building. So extensive were the deposit and share losses
that a good many institutions during that time became keenly appre­
hensive about their ability to meet further deposit drains, and some
probably considered themselves in imminent threat of insolvency.
The securities market crunch began to evolve during the summer
of 1966, as Federal demands on the credit markets soared at a time
when the Federal Reserve System sought to apply steadily increasing
restraint to the overheated economy. The major lending institutions
and many borrowers became increasingly apprehensive about the
ability of our complex financial system to continue to meet the de­
mands being placed on it in an environment of monetary restraint
greater than had been experienced in the memory of many market
participants. These fears fed upon themselves. They provided an in­
centive for potential borrowers to accelerate their demands on the
market and threatened a scramble for liquidity that would make
money unavailable at any price. This atmosphere of crisis, which
gradually built up through August and at its peak lasted for only a
few brief days, reflected to some degree a misplaced feeling on the
part of the market that the Federal Reserve System would not or
could not stem the tide of financial pressures, which were believed to
be largely out of control.
Prelude to the Credit Crnnch
Before discussing the actual events of 1966, it may be worthwhile
to discuss briefly the developments leading up to that period which
appear to have contributed in a major way to the crunch. In retrospect,
it is apparent that the financial markets and institutions at the begin­
ning of 1966 in many respects were more vulnerable to tight money
and high interest rates than they had been in a number of years. In
some specific areas of the market this fact was well-recognized before
1966 began, but other areas of weakness in the financial structure
came to light only as the events of 1966 unfolded.
The potential vulnerability of the thrift institutions and residential
mortgage market was being widely discussed prior to 1966. It had
become almost a matter of fashion, as the first half of the decade wore
on, to “point with alarm” at the deteriorating quality of mortgage
credit in general and of residential mortgage credit in particular. Many


observers were especially apprehensive about the soundness of the
huge mortgage portfolios of the thrift institutions. Defaults and de­
linquencies in the mortgage portfolios of thrift institutions were run­
ning at postwar highs, and there were scattered instances throughout
the country of failures of savings and loan associations due to slow
and defaulted loans. The concern was heightened by the steady shrink­
age during the 1960’s of these institutions’ holdings of liquid assets
and, in the case of savings and loan associations, by their growing
reliance on money borrowed from the Federal Home Loan Banks.
These developments at the thrift institutions were only symptomatic,
however, of broader financial and economic trends during the first half
of the 1960’s. The period from 1961 through mid-1965— before the
Vietnam war began to intensify— was one of strong economic growth,
but for most of the period the economy remained well below its full
output potential. Business spending for plant and equipment, while
increasing, could for the most part be financed with only modest
resort to the credit markets. In this environment, the supply of funds
to the credit markets was more than ample to meet demands. This
situation was reinforced by a relatively easy monetary policy, as the
Federal Reserve System sought to encourage the economy's growth
and to reduce the high rate of unemployment.
Reflecting the ease in the financial situation, interest rates in the
securities markets, which were already considerably below their 1959
peaks as economic growth resumed in early 1961, generally edged
lower until reaching stable levels around 1962 and 1963. However,
largely because of great demand for mortgage funds, the rates paid
by the thrift institutions did not fall during this period— in fact they
increased gradually. Indeed, by late 1962, savings associations on
average were paying interest (dividend) rates on their liquid share
accounts fully as high as those available on new corporate bonds and
considerably higher than those available on long-term United States
Government securities. In some regions of the country, such as Cali­
fornia, savings associations were offering far higher rates on their
liquid obligations than could be obtained on almost any other relalively low-risk investment and thus were attracting a large volume of
interest-sensitive funds from faraway points.
The result of this development in the structure of interest rates
available to individuals and other small- to medium-sized investors
was a flood of money into the thrift institutions— a flood that later
was to prove to contain a substantial proportion of highly interest-


sensitive money ready and able to move out in response to the emer­
gence of better alternatives elsewhere.
The thrift institutions and the mortgage market, however, were not
the only areas of the financial structure to experience an increase dur­
ing the early 1960’s in their vulnerability to a tightening of credit
conditions. Many commercial banks also became more vulnerable,
and the sharp expansion of commercial bank lending and investment
activity throughout the early 1960’s extended that vulnerability into
the municipal and other securities markets.
A major banking development of the early 1960’s was the emer­
gence of the large certificate of time deposit (CD) as a means of at­
tracting loanable funds. The growth of this means of bank finance in
the early 1960’s was remarkable, and it had widespread effects on the
breadth and depth of commercial bank participation in the credit
markets. One apparent consequence of the growth of CD’s was a much
greater bank role in financing state and local governments. The sharp
growth of interest-bearing CD’s placed bank profits under some pres­
sure, and the tax-exempt status of municipal obligations offered one
means of offsetting that pressure. Banks also began to reach for
higher-yielding, less liquid loans. Term lending to business rose
sharply, and banks also penetrated more deeply into mortgages and
consumer finance. Additionally, many banks sharply reduced their
holdings of liquid United States Government securities during the early
1960’s, placing those funds in better-yielding loans to help cover their
mounting deposit costs.
It would be possible to argue that the decreasing liquidity, a reach­
ing out for less liquid, higher-yielding investments, and a deteriora­
tion in loan quality were characteristic of almost all classes of financial
institutions during the first half of the decade. The period generally
was one of sharply increased competition among financial intermedi­
aries, paralleled by a growing reliance of all borrowers on funds ob­
tainable from financial institutions. As a result, the facilities of the
securities markets for distributing issues to noninstitutional investors
were weakened, and those markets tended to lose some of their re­
The 1966 Mortgage-Market Crunch
Around mid-1965 the stage for 1966 was set when the decision
was made to increase sharply this country’s involvement in the Viet­
nam war without at the same time providing for higher taxes to finance
the heavy cost involved. The Federal income tax reductions of 1964


and 1965 had provided a strong stimulus to the private sectors of the
economy, and by mid-1965 the remaining idle resources available
for growth were being absorbed by a sharply rising civilian demand
for goods and services. The imposition of large-scale military pur­
chases on an economy already operating close to its peak output
capability brought a dramatic end to the long period of growth with
stability that had lasted since early 1961.
The economic effects of the country’s widening involvement in the
Vietnam war began to emerge even before 1965 came to a close. Un­
employment declined steadily in the closing months of that year, and
price pressures became increasingly apparent. Against this back­
ground, the Federal Reserve System in early December raised the dis­
count rate from 4 per cent to 4Vi per cent and increased the maxi­
mum interest rate permitted on time deposits to 5Vi per cent. These
actions coincided with, and helped to spur, a growing public aware­
ness of the impact of soaring military demands for manpower and
material on the country’s economy and financial markets.
The financial markets had already sensed the impending strains on
the country’s financial and economic resources well before 1966 be­
gan. Interest rates moved steadily higher throughout the last half of
1965. However, following the discount-rate increase in December,
interest rates soared as market awareness of the swiftly changing fi­
nancial climate became full blown. By the late winter of 1965-1966,
the level of interest rates had in three short months risen a half per­
centage point or more from the level prevailing in November 1965.
To many of us, these developments pointed ever more clearly to the
need for restrictive fiscal action to support the policy of monetary
restraint if the effort was to be effective. Unfortunately, however, the
Congress and the Administration were slow to react to the swift in­
crease in the Federal deficit and the inflationary pressures that were
being generated. A major factor in the steep rise of interest rates early
in 1966 was the growing concern about the ability of the markets to
absorb the sharp increase in Federal borrowing that lay ahead.
In the early months of 1966 it was quite evident that responsible
banking and other financial executives were growing increasingly res­
tive and concerned about the outlook. Many banks had begun to
tighten loan policies even before the turn of the year and later were
able to point to substantial tumdowns of loan requests from new
customers or for patently speculative purposes. Nevertheless, loan
requests from good customers were still usually being met without
question. The banks were understandably eager to satisfy the borrow­


ing needs of customers who had maintained excellent deposit balances
over the years, and the potential drain on funds from greater use of
existing credit lines and formal commitments loomed as a major
worry. A number of leading bankers with whom I talked at this time
were much concerned over a growing tendency of corporate treasurers
to convert existing credit lines into formal legal commitments in order
to feel a little “safer” about getting funds when they might be needed.
Other customers were already indulging in “scare” or “anticipatory”
borrowing. Some big banks had been approached by major insurance
companies for credit facilities in case the drain from heavy policy
loans should become too large. Commercial bankers were also aware
of the fears of savings bankers and, in some instances, were beginning
to arrange large special credits for the savings institutions in case de­
posit losses were to burgeon.
As the bankers surveyed their sources of loanable funds over the
coming months, the prospects were anything but encouraging. Certifi­
cates of deposit, while holding up rather well early in 1966, were gen­
erally expected to run off at an accelerating pace—though there were
some bankers who still felt optimistic on this score. Remaining securi­
ties holdings of the banks consisted in large part of longer-term taxexempt securities showing large potential capital losses, so that the
banks hoped they would not have to sell many of these securities and
at the same time were beginning to worry about a very thin market
in case sales could not be avoided.
Not surprisingly, the banks were reaching for ways to back their
efforts to ration credit more effectively. One obvious help might be an
increase in the prime rate, but the bankers were acutely conscious that
Washington might not take kindly to such a move. While generally
approving of the Federal Reserve’s tough stance on monetary policy,
several bankers felt that further tightening by means of the usual pol­
icy instruments (principally open market operations) was no longer
feasible as it would doubtless invite a financial crisis. In a number of
conversations it was suggested to me that some form of informal credit
selectivity program should be initiated by the System. Views varied as
to details. There was some thought of a revived set of “guidelines” of
the kind used in the Korean war. It was even hinted in one talk that
the banks might welcome a more formal limitation of the volume of
bank lending, if this was the price of avoiding a banking crisis.
Such was the atmosphere in which we had to formulate monetary
policy. Let us turn now to the actual unfolding of events.
For the securities markets, the soaring of interest rates in early


1966 caused little disruption in the flow of funds and, indeed, the
functioning of the markets for the most part seemed little affected by
the sharp adjustment in rates. Commercial banks, by raising their
offering rates on large CD’s and aggressively bidding for consumer
savings through smaller denomination certificates of time deposits,
were able to remain competitive in the financial markets. However,
the same was not true of the thrift institutions and the mortgage
market. The leap in market rates of interest brought them substantially
above the rates the savings banks and savings associations were able
to offer. The result was a predictable one. Highly interest-sensitive
money that had found its way into the thrift institutions earlier in the
1960’s, when their deposit rates were among the highest available,
now moved out rapidly. In April of 1966, following quarterly interest
crediting, deposit outflows surged, fully offsetting the inflow of new
money on a seasonally adjusted basis. This was a dramatic shift away
from the 8 per cent to 10 per cent annual rate of growth enjoyed by
these institutions in earlier years.
The April deposit losses were a traumatic shock for the thrift insti­
tutions. With their liquidity low and many of their mortgage loans
subject to slow repayment or outright default, they became acutely
concerned. To help calm these fears and to relieve the stresses on the
mortgage market caused by a virtual drying-up of loans from the
thrift institutions, the Federal Reserve Banks, with the approval of
the Board of Governors, quickly arranged to make emergency discount-window facilities available to those institutions if needed to
prevent temporary insolvency.
In the event, the fears of a collapse of the thrift industry proved
greatly exaggerated, and not a single institution found it necessary to
use discount-window funds. The deposits that had moved out of the
thrift institutions in April proved to have contained a good part of the
interest-sensitive money accumulated in earlier years of exceptionally
attractive deposit rates. Thus, in July, following midyear dividend and
interest crediting, deposit losses— while as large as April’s— were less
than had been generally expected, and calm began to return to the
industry. Also, Congress had become increasingly concerned with the
situation facing the thrift industry and, although legislation permitting
the Federal agencies to set competitively uniform ceiling rates on thrift
deposits and smaller denomination bank time deposits was not enacted
until September, the thrift institutions were encouraged as the legisla­
tion gathered support in Congress through the summer. Nevertheless,
the mortgage markets remained exceptionally tight, and the home­


building industry entered into one of the steepest declines on record.
The Securities-Market Crunch
After the critical midyear interest and dividend crediting period for
the savings banks and savings associations had been traversed with
far less savings loss than had been feared, concern with their financial
solvency generally abated. However, pressures in the remaining areas
of the financial markets continued to mount as the Federal Reserve
System pursued its policy of restraint amid ever-rising credit demands
from business and the Federal Government.
Open market operations in the opening months of the year had
been conducted with the aim of easing the adjustment to higher interest-rate levels that followed the December discount-rate hike and
the liberalization of Regulation Q ceilings on bank time-deposit rates.
But in May, open market operations began to place increasing pres­
sures on bank reserve positions, and those pressures were gradually
intensified through the summer. In July, the Federal Reserve Board
increased reserve requirements against time deposits in excess of $5
million at each member bank. The steadily mounting strains on mem­
ber bank reserve positions coincided with increasing limitations on
the banks’ ability to attract funds through issuance of consumer and
large CD’s. The System in July had acted to reduce the rate banks
could offer on small multiple-maturity time deposits— those that com­
peted most directly with nonbank savings accounts. At the same time,
banks were finding it increasingly difficult to attract and retain funds
obtained through large CD’s as competing market rates began to sur­
pass the Regulation Q ceiling on new CD offering rates.
The squeeze on banks that began to develop in the summer of 1966
was quickly transmitted to the securities markets. Just as banks had
stepped up their acquisitions of state and local obligations earlier in
the 1960’s in response to a rapid growth of CD’s, they began to with­
draw from this market as their competitive position in the time-deposit
markets started to decline. Total bank holdings of municipal securities
increased little in June and then began to decline in July as banks sold
these tax-exempt obligations in volume to make room for intense loan
demand from business borrowers. The municipals sector was thus the
first to feel the impact of a gathering storm in the securities markets.
Indeed, while the tone of the money and corporate bond markets re­
mained fairly steady, the climate in the municipal market began to
reflect pessimism in June, and by early July the market was disorderly
and confused. The situation continued to worsen when, around mid­


month, the market felt the full effects of the swing of commercial
banks from principal buyers of state and local issues to net sellers. The
selling by banks was described by one commentator as “continuously
undermining the market by a heavy volume of securities that has
nowhere to go even at distress prices.”
In July, business loans at banks grew very sharply, in part because
of large special tax payments to the Treasury required in connection
with the placing of payments on a more current basis with accrued
liabilities. This tax acceleration had the effect of shifting, from the
Treasury to corporate businesses, a part of the borrowing that had to
be done to supply the Federal Government with funds. At the same
time, the Federal Government throughout 1966 diverted much of its
borrowing away from direct Treasury issues, resorting instead to in­
creased agency borrowing and sales of participation certificates. The
result of all this was to place considerably more pressure on the capi­
tal markets than would otherwise have been the case and, in the case
of the tax speedups, to focus that pressure more directly on the bank­
ing system by increasing corporate demand for funds.
The System became increasingly concerned with the rapid growth
of bank loans to business. For some in the System, this concern pri­
marily reflected the role business loans were playing in the excessive
rate of growth of bank credit. Others stressed the fact that these loans,
while partly tax-related, were also helping to finance a huge, inflation­
ary increase in capital spending. Still others were concerned that a
disproportionate share of bank credit was going to businesses, creating
especially severe hardships for other borrowers such as state and lo­
cal governments and homebuilders.
The System’s desires for more bank rationing of credit to business
borrowers and reduced sales of securities, especially tax-exempt obli­
gations, were expressed candidly during the summer of 1966. The
banks, however, were reluctant to take the strong measures needed to
curtail their lending to businesses, which they felt might jeopardize
valuable customer relationships built up over time. They also pointed
out that they were faced with very heavy commitments, entered into
earlier. One important result of this loan situation was a growing re­
luctance of many banks to resort to discount-window borrowings as
a means of relieving unusual strains on their reserve positions. They
feared that seeking discount-window accommodation might bring their
portfolio decisions, and particularly their business lending policies,
under close scrutiny by the Federal Reserve. Many banks thought
such fears were confirmed when, in announcing the July increase in


reserve requirements against time deposits, the Board of Governors
said that, while the discount facilities would be available to assist
banks in making an orderly adjustment, “such adjustments will be ex­
pected to emphasize increased restraint in lending policies and mainte­
nance of an appropriate degree of liquidity on the part of the bor­
rowing banks.”
In the face of prospective heavy bank losses of large CD’s, restric­
tive open market operations, and mounting demands for credit
throughout the financial markets, the gloom that infected the taxexempt markets in July began to spread to other sectors in August.
Early in August, the word “crisis” began to be used with reference to
the liquidity squeeze potentially faced by banks if maturing CD’s could
not be rolled over. The first half of the month was, however, a period
of relative calm before the storm. A routine Treasury financing pro­
ceeded without difficulty, and a nationwide airlines strike tended to
ease banks’ reserve positions temporarily by creating unusually large
amounts of check float.
During August, I talked with officials of most of the principal New
York banks and found a growing feeling of grave concern. Investment
bankers and brokers also telephoned me on several occasions to warn
that we might be on the brink of a financial crisis. Banks had already
sharply curtailed their lending to brokers and dealers, and there were
fears that this kind of lending might dry up altogether. Along with the
gloomy atmosphere in the tax-exempt market, pessimistic views were
heard as to a probable surge of mutual fund redemptions that would
put the stock market under heavy pressure. I was told that Washing­
ton was not sufficiently aware of the danger of a financial panic and
was urged to issue some form of assurance that the Federal Reserve
would be ready to meet seasonal needs as usual and would move
promptly if necessary to prevent any financial crisis. One banker
thought that a crisis might come later in the autumn, while others felt
that it might be much more imminent.
On August 17 the Board of Governors announced a second increase
in reserve requirements against member bank time deposits to take
effect around September 15 when the banks were expecting to be
under the greatest pressure from CD runoffs and midmonth tax bor­
rowing. This was taken— correctly— as an indication that the System
had decided to press its battle against inflation to the fullest. Thus,
the Federal Open Market Committee’s August 23 directive to the
Trading Desk was the most restrictive of the year. The directive told
the Desk to supply “the minimum amount of reserves consistent with


the maintenance of orderly money market conditions and the modera­
tion of unusual liquidity pressures; provided, however, that if bank
credit expands more rapidly than expected, operations shall be con­
ducted with a view to seeking still greater reliance on borrowed re­
Market psychology deteriorated seriously further as August neared
a close. Market interest rates scaled up sharply following the X
A percentage-point increase on August 16 in the bank prime rate and
broker loan rate, and were given a further boost by the announce­
ment of the increase in time-deposit reserve requirements. The period
was characterized by a flood of other depressing news and rumors.
The flow and calendar of expected corporate bond offerings were in­
creasing; there were rumors that a huge sale of agency participation
certificates was being planned for September, and news about the
prospects for fiscal action continued to be gloomy. At the same time,
rt was becoming increasingly apparent to bankers that the Federal
Reserve System was not prepared to ease the pressures on their flows
of loanable funds by raising the Regulation Q ceiling on large CD
issuing rates.
The bond market reached frightening lows on Friday, August 26.
One observer described the market psychology as “the coldest, bleak­
est I have ever experienced on Wall Street.” Later, on August 30,
another described “old timers” on Wall Street as “scared.” At the
Federal Open Market Committee meeting on September 13, I sum­
marized the conditions in the market as follows:
The financial m arkets were m arked by convulsive m ovem ents
and an atm osphere o f great uncertainty. A t the nadir o f the bond
m arket about tw o weeks ago there is no doubt that the financial
com m unity was experiencing growing and genuine fear o f a fi­
nancial panic. This fear seem ed to stem mainly from the convic­
tion that credit dem ands would remain very strong (with corpo­
rate and governm ent needs fo r funds unabated), that fiscal policy
was making no contribution toward a dampening o f the econom y,
that the agency financing program was actively stimulating higher
interest rates, and that the Federal R eserve System was deter­
m ined to push its restrictive policy ruthlessly.

Government securities dealers were particularly hard hit during the
latter days of August by the sharp decline in the prices of their secu­
rities holdings and by a shrinkage of their usual bank sources of
finance. The market was rocked on August 25 by the auctioning of
new one-year Treasury bills at a discount rate of 5.84 per cent, nearly


a full percentage point above the rate set in the previous month’s auc­
tion and, at the time, the costliest short-term borrowing by the United
States Government since the early days of the country. Following this
auction, the market focused nervously on the next Monday’s auction
of three-month and six-month bills.
However, on the day of the auction, August 29, the Trading Desk
took the unusual step of asking for bill offerings from dealers as early
as 10:30 in the morning. The action was the first in a series of rapidfire events that were to turn the tide of market psychology. It helped
to assure the markets that, contrary to the opinions being expressed
in some quarters, the System was keenly aware of the deterioration of
market psychology and had both the means and the intention of pre­
venting a market crisis.
The second piece of good news to hit the market came on August
30 when the then Under Secretary of the Treasury, Joseph W. Barr,
told the House Rules Committee: “We can’t rely on monetary policy
much m o re. . . . If we have to do more, we will have to do it by taxing
or [reducing] spending. There is no other way,” This statement, which
indicated a growing recognition on the part of the Administration of
the excessive burden being placed on monetary policy and the finan­
cial markets by a lack of fiscal restraint, resulted in a substantial im­
provement in market psychology. Thus, The New York Times re­
porter described the bond market on that day as “encouraging.”
A third step toward easing market tensions came on September 1,
when the Federal Reserve System published a letter to all member
banks requesting their cooperation in moderating the growth of busi­
ness loan demand and reaffirming the availability of discount-window
credit assistance. While the intent of this letter was subject to some
misunderstanding and erroneous interpretation that may have in­
creased some banks’ reluctance to use the discount window, the letter
was interpreted more favorably outside the banking system. In partic­
ular, by stating that the System sought orderly bank credit expansion
in the context of a moderation in the rate of expansion of loans, the
letter helped to ease fears of further large bank sales of securities in
the Treasury and tax-exempt markets. Moreover, the letter also helped
to counter rumors of further “drastic” System action that had emerged
toward the end of July, when it had become known publicly that the
System was contemplating a statement regarding the administration
of the discount window.
The improved tone that began to develop in the money and capital
markets on the final two days of August carried over into September.


To be sure, there were occasional setbacks, but it was apparent that
the worst was over. The announcement on September 9 of President
Johnson’s program of fiscal action provided the final turning point.
That program included (1) a cessation of agency borrowing and sales
of participation certificates, (2) the temporary suspension of the in­
vestment tax credit and accelerated depreciation on business capital
spending, and (3) a $3 billion reduction in nonessential Federal
For the most part, interest rates by the end of September had almost
fully reversed the steep increases of August. This reversal was encour­
aged by growing evidence pointing to a slowdown in business later in
the year, although such views were by no means unanimous. The
major exception was Treasury bill yields, but the further climb in
these rates past mid-September reflected in part anticipations of
greater supplies as more Federal borrowing took the form of bill
issues. And, shortly after mid-September, these rates also began to
drop sharply.
Thus, the credit crunch was over, and monetary policy was soon
destined to ease in response to the important changes in the economy
that presaged the modest economic pause of early 1967.
Let me add one closing observation: It may appear ironic to be
dramatizing the 1966 crunch at a time when money is probably
tighter, and interest rates certainly much higher, than they were three
years ago. Yet, at the time of writing (late September, 1969) we have
not seen any such crunch as 1966 brought forth. This is due in part
to the fact that the business and financial community was better pre­
pared this time, as a direct result of the 1966 experience. I would not
want to rule out the possibility that a crunch may yet occur before the
current anti-inflationary campaign succeeds. But we must all hope
that this will not happen, and a full understanding of the events of
1966 may help us avoid a repetition of history.




in recent years have been
numerous and significant. Many of the changes were overdue or
inevitable in light of the nation’s economic development. Several have
implications for monetary and credit policy because the banking sys­
tem is the primary transmission link for the Federal Reserve’s monetary
and credit actions.
At least three such facets of postwar banking developments emerg­
ing in the 1960’s appear to foretell significant trends in the 1970’s.
These are: (1) changes in commercial banking structure and func­
tion; (2) the introduction of new and varied intermediation instru­
ments of both a deposit and non-deposit character; (3) the progress
toward computerizing monetary transactions.
My comments on new standards for credit and monetary policy are
organized around these unfolding developments in commercial banking
because they will determine to a considerable degree the efficiency and
effectiveness of alternative monetary techniques and devices.
I n n o v a t io n s i n C o m m e r c ia l B a n k in g

Banking Structure and Function
It was becoming more and more apparent in the 1950’s and early
1960’s that banking’s growth was being constrained by geographical
confinement of major conventional types of banking activity. Stunting
the growth potential has been accomplished by limiting the economies
of scale realizable in a modern corporate organization. For banking
these economies and efficiencies are significant in such diverse areas as
data processing, capital adequacy, resource allocation, management
succession, portfolio management and planning.
Banking organizations today ordinarily compete in the markets for
checking, saving, and loan services only in areas around their banking
office locations. There are exceptions, of course. Banks are continu­
ously active in the impersonal money and capital markets. They also
provide services to remote corporate and individual customers whose
balances are large enough to justify a competitive effort. But, by and
* This essay was originally given as a talk before a Conference on Money and
the Corporation sponsored by Business Week on December 8,1969.


large, most banks grow either by extending their service areas or as the
communities around their existing locations grow. And a community
might, in these terms, be a neighborhood, a city, a county, or a group
of counties. If economic growth in a community is slow relative to
that in the nation, its banks are also faced with relatively sluggish
growth prospects. As the higher rates of population and industrial
growth in the past 20 years have been in the South and West, banks in
those regions have had the greater growth potentials. The established
financial institutions in the East and Midwest, on the other hand,
have had to develop new activities, markets, and sources of funds in
order to show significant rates of growth.
Aggressive banking organizations of sufficient size to exploit econ­
omies of scale have extended their operations and competitive posi­
tions in many ways. Results of their efforts are manifest in the acceler­
ated growth of registered holding companies and in the recent spurt in
the organization of one-bank holding companies. Their efforts have
borne fruit in relaxed branching restrictions and quickened merger
activity in a few states; in the development of new lending and borrow­
ing services; and in the expansion, mainly through subsidiaries and
affiliates, into related and financial services such as equipment leasing,
mortgage servicing, data processing, insurance, factoring, international
finance, and mutual funds.
Some of the thrust of these developments can be seen in the com­
parative statistics over the past decade. There has been a decline in
unit banking, a drastic shift in the balance in the dual banking system,
and an erosive change in the influence of correspondent banking con­
nections. The main fact though is that banking’s structural horizons
are changing in ways that will be more apparent in the statistics of
the 1970’s.
For the banks that are participating, the extension in markets has
been both geographical and in broadened services. In general, the
competitive effects on both bank and nonbank competition have been
salutory although there is much apprehension evident in the congres­
sional deliberations on the one-bank holding company bill that larger
banks will, by these means, become too dominant in too many markets.
Coming now to the implications for credit policy. As banking organ­
izations become more diversified in form, function, and geographical
extent they become more resourceful in coping with regulatory con­
straints and more protean in their resistive capacities. Shaping or con­
fining the resource-gathering and credit-granting activities of banking


conglomerates through interest-rate ceilings, reserve requirements, and
other regulatory restraints might be likened to punching a bag of sand
into an erect position. And many doubt it is possible, necessary, or
even desirable to do so.
Most sectors of the United States financial structure are less ham­
pered by regulations affecting credit conditions than banks, but the
banking sector has been so pervasive in its influence on other financial
institutions and market participants that it has had the capacity to pass
on or “lay off” restraint. This action is not costless so far as the bank
and its customers are concerned. But a bank can, for a market-deter­
mined price, sell assets, borrow money, or attract deposits and use
these resources to meet its loan and investment commitments. This
ability to transmit restraint to the market and other intermediaries has
meant there has been no real difficulty in making public credit and
monetary policies work even though many institutions and their cus­
tomers are not directly touched by Federal Reserve policies.
Recent trends toward conglomerate corporate complexity indicate
the possibility of stripping some activities and functions away from the
banks proper and lodging them in subsidiaries, affiliates, joint ventures,
or trusteed stock arrangements. These moves would, at least tempo­
rarily, frustrate regulatory constraints and might serve other corporate
objectives, but they would, if thought to be running counter to the
overall public interest, invite further regulatory complications. My
expectation is that financial conglomeration will remain peripheral to
a banking system which will retain credit market shares in the neigh­
borhood of those realized in the late 1960’s. In that case there seems
to me to be little cause for concern that existing forms of credit and
monetary control will be hampered by the functional and structural
developments under way today.
On the other hand, banking as it has existed for most of the 1960’s
may be forced into a role of steadily diminishing importance if regula­
tory constraints on attracting funds are long continued. In that case,
financial conglomerates, or spun-off elements of such conglomerates,
are the most likely inheritors. They have the expertise to take over
many banking activities. It is hard to see how they could not in some
form or manner retain the use of techniques which would afford them
continuing access to financial markets for the disposition of assets or
the purchase of liquidity. The ensuing fractionization of financial in­
termediaries might not be without parellel in world experience, but it
would seem highly unsuitable to the well-developed financial markets
and for long-established financial institutions in the United States.


Time Deposits and Liability Management
A drastic decline in the major component of money— demand
deposits— has occurred in the 1950’s and 60’s. Such deposits have
long been regarded as the life blood of commercial banking; they have
also been the source of predictable stability in loanable resources. In
mid-1947 the net contribution of such deposits to commercial bank­
ing’s resources was equivalent to 37 per cent of the then-current GNP;
in mid-1957 to 25 per cent; in mid-1969 to 17 per cent.
Banking had a response to the 50 per cent decline relative to GNP
in check-book or noninterest-bearing bank money. It was the develop­
ment and promotion of a variety of interest-bearing deposits and other
liability instruments. The long-established passbook accounts were
glamorized and their rates made more competitive. Negotiable and
nonnegotiable certificates of deposit were tailored in size, maturity,
rate, and name. In a variety of forms they have been suited to the
needs and convenience of the banks’ regular customers as well as
customers of other intermediaries. These certificates have also appealed
to large numbers of money-market participants.
In the aggregate these measures worked to extend banking’s share
of credit markets from roughly 20 per cent in the late 1950’s to around
40 per cent in the late 1960’s. Within banking, the relative roles of
demand and time deposits in providing loanable resources have shifted
from a 2.4 to 1.0 relationship in 1947 to an 0.8 to 1.0 relationship in
Experience with monetary restraint in 1966 showed banks how
regulatory ceilings on rates of interest for deposits might become a
threat to their capacity to retain contact with the sources for funds
they had developed in the early 1960’s. In consequence, new channels
of communication with markets were developed in the form of non­
deposit liabilities which were subject neither to interest-rate ceilings
nor reserve requirements. Among the devices used, Euro-dollar bor­
rowings, repurchase agreements, and commercial paper sales by hold­
ing company affiliates and banking subsidiaries have been the most
important or promising.
As banks extended in scope and magnitude their access to money
and credit markets in 1969, apprehension that such techniques would
undermine the force of monetary restraint grew despite the magnitude
of the decline in their deposit flows.
On July 24, 1969 the Board of Governors restricted the use of
repurchase agreements by commercial banks. This was done by making


the bank liabilities on such agreements deposit liabilities, provided the
agreements had been entered into with nonbanks and on assets other
than Treasury securities and agency issues. The purpose of the regula­
tion was to prevent banks from borrowing on their portfolios of loans,
mortgages, and municipal securities and thus obtaining funds for other
lending and investment or to meet liquidity needs. The constraint of
Regulation Q ceilings applied to such transactions as it would to time
deposits generally.
This action had the effect not only of limiting the banking system’s
access to money and credit markets but also of downgrading mortgages
and municipal securities as liquidity assets relative to Treasury and
agency issues.
On August 13, 1969 marginal reserve requirements were imposed
on Euro-dollar borrowings and the sale of outstanding loans to foreign
branches. And subsequently a regulation imposing interest-rate ceilings
on commercial paper sold by banking affiliates was proposed by the
Without doubt regulatory policies have been aimed at insulating
the banking system from money and credit markets. This has been
done with rate ceilings, regulations curbing banks’ ability to substitute
other liabilities for deposits, and restrictions on contingent sales of
assets. In total, these measures have limited the banking system’s
ability to lend to its customers, a fact that is abundantly clear from
the magnitude of the decline in market shares of funds going to banks
in both 1966 and 1969. The same rate ceilings have hampered the
savings and loans and the mutual savings banks in serving their cus­
tomers, too, although their plight in 1969 has been ameliorated by the
operations of FNMA and the lending policies of the FHLB Board.
The policy of reinforcing monetary restraint by constraining bank­
ing’s access to money and credit markets may be more controversial
than its practical significance at this writing (December, 1969) war­
rants. But for the long run it clearly raises important issues relating
to financial structure and the role of credit policy.
As seen by their proponents today, regulatory constraints have
forced a sharp contraction in the rate of bank and other intermediary
lending and investment. The rationale for this approach is that Q ceil­
ings, by limiting bank access to funds, have led to greater restraint on
business loans than would otherwise have occurred— a desirable distri­
butional effect on credit availability in view of the role of business
investment in generating excess demand and inflation. Furthermore,
since intermediaries are more efficient in their credit allocative function


than direct lenders and markets, the reduction of intermediation is
seen as the quickest and surest way to slow and restrict the availability
of credit and thus to bring about the modification of spending and
investment decisions. All of those borrowers who are exclusively
dependent on intermediaries encounter credit restraint even though
they may be preferred customers.
The main argument against sealing off the intermediaries from
markets is that the effectiveness of overall restraint is not significantly
diluted as a result of its being shifted by a bank—whether it is shifted
to the market or to another intermediary, however different the inci­
dence. As banks disperse monetary restraint, and they cannot disperse
all of it, they force borrowers other than their customers to pay higher
prices for credit and to face uncertain availability. Their action in sell­
ing assets, raising interest rates paid for funds, entering into repurchase
agreements of assets and the like does not result in much diminution of
overall restraint. Even if intermediaries were given unlimited access
to money and credit markets they would themselves be increasingly
restrained by the market environment they would be creating. The
argument continues that the channeling and confinement of restraint to
intermediaries and their customers results in the unnecessary disloca­
tion of credit patterns, in inequities in the distribution of credit and
inefficiencies in the operation of the financial system.
The differential effect of forcing intermediaries to contract their
lending operations has the most certain and serious effect on smaller
customers who do not have significant access to capital and credit
markets. Shutting off or restricting the flow of bank credit to large
corporate borrowers only means they become more dependent on
markets. And since such borrowers are better able than most others
to obtain funds in the market using such nondepository credit instru­
ments as commercial paper, it can be argued that corporate borrowers
were more favorably situated with respect to credit availability as a
result of bank disintermediation.
While I am persuaded that intermediaries should have had more
ready access to markets, the contrary position is not without merit
from a pragmatic short-run standpoint. However, I believe the real
problem is not one of making monetary and credit restraint effective
at some given time but the longer-run effect of such tactics on the
process of intermediation and the institutions providing this service.
A significant change in the financial environment during the 1960’s
has been the greatly expanded role for intermediation. Liquidity serv­


ices have been shifted on a large scale to intermediaries or specialized
intermediary devices. There has been a resulting relative decline in
demand deposits and nonintermediary holdings of nonintermediary
debts. If long-run policies are adopted to cut off their access to markets,
intermediaries will be greatly handicapped in fulfilling their liquidity
function. In this view, they are more in need, from a public policy
standpoint, of being assisted in dispersing restraint than being con­
strained from doing so.
Looking beyond the current period and its requirement of monetary
restraint, therefore, I believe the view that banks should be barred from
access to financial markets by regulations of one type or another pre­
sents neither a stable solution to the problem nor one that is in our
long-run interest. It is unstable in the sense that the banking system
can develop quite an array of alternative techniques for maintaining
contact with sources of funds and users. While it may be true that
commercial banking “cannot fight city hall” very effectively in the
short run, given time it can develop flexible instruments and durable
relationships to break down most of the barriers regulators can think
up. And if it cannot and the belief prevails that banking must in the
public interest be isolated from financial markets, many of commer­
cial banking’s present-day functions will be scattered to other inter­
mediaries and financial agencies.
But, it seems to me, this, in addition to being undesirable, is entirely
unnecessary to the objective of monetary restraint. If, in fact, it should
be determined that monetary restraint ought to be aimed at selected
types of institutions or specific uses of credit, it would be better to
impose differential reserve requirements on all such institutions and
assets. While I believe we need not shrink from being concemd with
the social objectives served by the economy’s use of credit, I question
whether this period of monetary restraint is one in which to launch
such a policy explicitly or by indirection.
We would improve the effectiveness of the linkages by which mone­
tary restraint is transmitted if we could develop techniques for bring­
ing commitments to lend under pressure more promptly. No reasonable
application of monetary restraint is intended to bring about “fails” on
prior commitments. The process is aimed rather at prospective spend­
ing and investing decisions. The tardy response to monetary restraint
in 1969 can be traced to the weakness of its initial impact on commit­
ment policy of lending institutions.


Computerizing and Scheduling Monetary Transactions
noted earlier the decline over the past twenty years, in relative
terms, of the demand deposit component of the money stock. A similar
decline has occurred in currency. Coin usage, on the other hand, has
stepped up about 25 per cent in the same period, primarily as a result
of requirements for meter hoards.
Money serves two basic functions: as a transaction tool and a source
of liquidity. Technological changes in the past decade have greatly
extended money’s efficiency as a transactor and greatly reduced its
relative attractiveness as a liquidity source.
The relative decline in currency can be linked to the expansion in
consumer checking accounts, charge accounts, and credit cards. Non­
cash sales make up over two-thirds of the transactions of many of our
largest retailers. Convenience credit is widely available via vendors’
credit facilities and, more recently, through bank, oil company, and
travel and entertainment cards. It has been estimated that by late 1970
at least 50 million bank credit cards will have been issued. There are
75 million charge accounts in use today.
The most striking decline in holdings of demand deposits has
occurred in business accounts. These are no higher today than they
were in the early 1950’s. Actually corporate demand balances today
probably reflect more than anything else compensating balance require­
ments for check processing, loan, and other banking services. Theo­
retically, a skilled money-managing, computer-equipped treasurer,
unhampered by compensating balance requirements, could manage his
firm’s checking account so that toward each day’s end he would know
if he had a balance large enough to cover the transaction costs for an
overnight investment. And if he had, his resultant late-day investment
action might, under certain circumstances, indirectly turn out in effect
to be lending that residual in his account to his own bank. Electronic
facilities for check processing will make possible much closer man­
agement of cash positions, particularly if scheduled credit transfers
become commonplace.
The best information we have on the ownership of the demand
deposit component of the money supply indicates that households own
about $70-75 billion, nonfinancial businesses $45 billion, financial
businesses $15 billion, and State and local government $13 billion.
About $4 billion is in foreign accounts. It is safe to say that all pro­
fessionally-managed accounts are at or near minima established by
banking rules or practices.


Households these days are managing their money position more
closely, too— many use a fee-no-minimum balance-type account. They
have become increasingly sensitive to interest costs and interest yields.
Their response to the promotional efforts on the advantages of time
and savings accounts has been to progressively reduce demand bal­
ances to the minimum levels consistent with the timing of income
receipts. Such attitudes are evident in the average holdings in house­
hold checking accounts. According to mid-1968 data, the latest we
have, there were 7 9 + million demand deposit accounts. Most of these
were owned by households. Sixty-four million accounts had balances
of less than $1,000 and the average holding was only $240!
Computer facilities becoming available will enable households to
schedule regular periodic payments through pre-authorization arrange­
ments even more precisely in relation to the timing of their salary and
wage credits. This will bring within their reach still more of the money
economies that corporate treasurers presently enjoy.
The reduced relative attractiveness of money— currency or demand
deposits— as a source of liquidity arises chiefly from the competition
of near monies— mainly savings and time deposits in commercial and
mutual savings banks and savings and loan associations, but, of course,
including short-dated Government debt and money market paper.
Since these interest-bearing deposits or paper have instant liquidity
or conveniently scheduled maturities they can serve as both liquidity
reserves and earning assets.
The relevance of these facts on deposit trends and prospects is to
the controversy over the use of money supply as a guide for monetary
policymakers or as an indicator of their actions. In recent years rates
of change in various financial aggregates have been increasingly recog­
nized for their analytical value in both of these roles.
For example, the Federal Open Market Committee has, since 1966
and regularly beginning in 1968, used an aggregate called the “bank
credit proxy” to quantify intervention limits on monetary or credit ex­
pansion or contraction arising out of a directive couched in terms of
money market conditions and interest rates.
The primary instructions to the Manager are for “no change,”
“firmer,” or “easier” posture supplemented by specified ranges in mar­
ginal reserve measures and short-term interest rates. This pattern is
internally consistent, so far as can be foretold, with a projected range
for the “credit proxy.” But if the proxy begins to move outside of its


range this fact begins to modify the Manager’s reserve supplying
Our experience using aggregative measures as supplementary oper­
ating guides has not been spectacularly successful but it has been good
enough to encourage further development and use. Since the only
measurable monetary action the Committee can take is to alter the
amount of reserves supplied to the banking system, it is necessary to
estimate how quickly a change in reserve injection will affect changes
in various aggregative measures. The relationships are far from stable
and the results have been necessarily approximate and subject to sig­
nificant errors.
Another example is from the Joint Economic Committee of the
Congress. This Committee in recent years has urged greater attention
to a particular monetary aggregate—Mx, the narrowly defined money
supply. In its 1969 report it said:
Over the long run, the increase in the money supply should
be roughly at the same rate as the growth of U.S. productive
capacity. A s indicated by this committee in its report, the ex­
pansion of the money supply should be somewhat above the
long-run real growth rate during periods of high unemployment
and excess capacity. On the other hand, monetary expansion
should be below real growth in periods of inflation. We recom­
mended a rate of increase ranging from 2 percent to 6 percent.
The principle of harmony between the rate of growth of the
money supply and the rate of growth of the economy has been
recommended by the committee for many years.
A s long as inflation continues at a high rate, the pace of ex­
pansion in the money supply should remain near the lower end
of the range suggested; that is, near 2 percent per annum.

.. .

By the Committee’s standards the Federal Reserve’s recent per­
formance may or may not be in the ball park. For 1969 as a whole
(up to December) money supply rose at a 2.7 per cent rate but the
growth in the first half was 4.3 per cent and in the past five months
was 0.8 per cent.
There is no doubt, in my opinion, that financial aggregates will
steadily become more useful in guiding policymakers and the judg­
ments of those who are searching for clues to policy changes. But I
believe we are a long way from being able to specify a particular aggre­
gate as a “North Star” for monetary navigation. Nor would I expect
that in our researches we will be able to find for our constantly chang­
ing environment a single aggregate—monetary or credit— of predict­
able durability and reliability.


On the other hand, if the analytical insights that can be gained from
the study of the Flow of Funds were available on a more current basis
our reliance on changes in credit aggregates and aggregates generally
would be significantly extended.
The most popular of all the aggregates— M x— seems, given present
technological and institutional trends, to have the shortest life expect­
ancy. Its significance for policy is being chipped away, on the one
hand, by steadily increasing variety and attractiveness of near monies
and, on the other, by the long-continued and prospective further rise
in velocity being made possible by computer and communications tech­
nology. Turnover (velocity) in demand deposits has been increasing
steadily: it more than doubled in the 1960’s and has increased 7 per
cent through October of 1969.
The technological obsolescing of
does not mean that money
supply is dead or only alive in St. Louis. If it were to be rid of its
transaction component and become primarily a liquidity measure its
meaning and interpretation would be in the tradition of M2 and M3,
and, in my judgment, this would add significantly to its stature as an
important financial aggregate.


I n 1920 P r o f . C h e st e r A r t h u r P h il l ip s published a book entitled
Bank Credit: A Study of the Principles and Factors Underlying
Advances Made by Banks to Borrowers.1 Directly or indirectly every
student of money and banking since has been reared on Phillips. While
Phillips’s book itself has been little used as a text since the 1930’s, it
has literally been rewritten a thousand times in texts on money and
banking that have been the basis for courses in our colleges and uni­
versities— and his analysis has survived the years very nearly intact.
In many ways this has been a good thing. Certainly the Phillips
analysis represented a great advance over that of his predecessors—
it is more accurate to think of the loan as the father of the deposit than
vice versa and it is well to understand that a 10 per cent reserve
requirement (O, happy day!) permits the commercial banks taken all
together to parlay their loans and deposits tenfold on the basis of an
infusion of new reserves, but a single bank, the “Mad River National
Bank of Springfield, Ohio,” can expand its loans by only $122,000 on
the basis of $100,000 borrowed from the Federal Reserve Bank of
Cleveland, assuming the 10 per cent reserve requirement and an auto­
matic 20 per cent reciprocal balance (O, still happier day!). These are
good things to know and it is well that millions of eager young minds
have learned them.
But along with these venerable truths the students who grew up on
Phillips, directly or indirectly, have also acquired a wholly unrealistic
notion of the almighty market power of the commercial banker over
his customers. It may or may not have been true in the 1920’s, but it
certainly isn’t true today. Prof. Phillips’s banker had no problem in
expanding or contracting the loans of his bank— he simply said “yes”
or “no” in a positive, if courtly, manner. His style is well-illustrated
in a little discussion of “derivative” balances. “You are straining your
credit” says the banker to the credit-seeking customer, “and, with tight
money staring us in the face, I shall have to ask you to keep a more
1 The Macmillan Company, New York, 1920. Page references are to a 1931


liberal balance in relation to loans than previously, as a requisite to
additional accommodation.”2
This snug little monopolist who ran Prof. Phillips’s Mad River
National in Springfield, Ohio, has been taken as a microcosm for
the banking industry by several generations of students who have
grown up to be Congressmen, Federal Reserve Board members, Fed­
eral Reserve Bank presidents, Comptrollers of the Currency, and
Chairmen of the FDIC—to say nothing of the thousands who are pro­
fessors of money and banking; some of whom are intermittent mem­
bers of the President’s Council of Economic Advisers. And, of course,
like Keynes and Friedman, Phillips has suffered at the hands of his
followers. Phillips never said it, but there is hardly an economist now
alive, who, confronted by the uncomprehending faces of the eight
o’clock section of Economics A or the friendly, but confused, counte­
nances of the local Rotary, has not blurted out, in the course of an
effort to explain deposit creation, “Think of the banking system as one
large bank.” In fact, there is hardly an economist now alive who hasn’t
blurted it out so often that he has slipped into the habit of thinking
that way himself.3
Of course, we all know that the commercial banking system in the
United States isn’t one large bank and can’t be expected to behave like
one. But I am not sure we are as acutely aware as we should be of just
how misleading this “simplifying” assumption has been and continues
to be.
Except in a few rural areas— and they are fast becoming fewer and
farther between— competition among banks is intense, in fact, fierce.
This is, when one considers it, hardly surprising. From the earliest days
of our national existence competition among banks has been protected
and nourished by public policy. As every high school history student
knows, the dragon of nationwide banking, in the form of the Second
Bank of the United States, was so effectively slain by Andrew Jackson
in 1836 that it has been hard to even make much political capital out
of the issue since. The threat of a “money monopoly” has been rolled
out from time to time as a subject of campaign oratory, as it was by
the Populists in the late 19th century, but the old dragon has properly

2Op. cit., p. 51.
8 To those who know that I had the good fortune to take my first course in
economics under Karl Bopp in the summer of 1931, let me say that I am not
accusing him of using this pedantic crutch. On the contrary, I seem to recall a
very vigorous and earnest young man filling a blackboard that covered one whole
side of the room with individual bank T accounts before he finally unveiled the
magic 10 to I.


been regarded by the public with about as much awe as the balloon
version of a comic strip character in a Thanksgiving Day Parade.
The pervading and overpowering philosophy was well-expressed by
the Banking and Currency Committee of the House of Representatives
in its report on “The Bank Holding Company Act of 1955” when it
said, “The United States early in its history . . . adopted a democratic
ideal of banking. Other countries, for the most part, have preferred
to rely on a few large banks controlled by a banking elite. There has
developed in this country, on the other hand, a conception of the inde­
pendent unit bank as an institution having its ownership and origin in
the local community and deriving its business chiefly from the com­
munity’s industrial and commercial activities and from the farming
population within its vicinity or trade area.” If this bucolic ideal is not
precisely the reality of today, it is certainly closer to it than the “monied
oligarchy” Jackson “exterminated” in the words of Bostonian David
Heughon—who may have been slightly prejudiced, as were many New
York financiers of the period, because the Second Bank was head­
quartered in Philadelphia.
In fact, of course, competition reaches its pinnacle in the efforts of
larger banks to attract and hold a share of the business of large national
and multinational corporations. Because of the legally enforced frag­
mentation of the commercial banking system, no single bank is large
enough to accommodate alone the financial needs of any of our larger
corporations. Most large companies have four or five continuing bank­
ing connections, and some have hundreds ranging over banks of all
sizes. In terms of market power this puts the corporate treasurer in an
extremely favorable position. He can always play the banks with which
he has established relationships off against one another, or, alterna­
tively, play all or any of them off against 100 more or less identical
banks that would be delighted to provide him with more or less identi­
cal accommodation. Moreover, quite aside from the practical problems
that the intensely competitive banks would have in trying to deal jointly
with a large customer, they are legally prohibited, except with explicit
permission of the customer, from even discussing with one another the
terms and conditions on which they will lend to him. At least in the
initial stages of negotiation banks must rely wholly on the integrity of
the borrower for any information as to the terms and conditions on
which other banks are prepared to accommodate him.
In these circumstances bankers who deal with large corporations
are, if not exactly in, very close to the position one New York banker
described when he said “Sure, we would turn down a loan to a good


corporate client who had maintained good balances with us over the
years, but not until after we had sold our building and all the furni­
What are the implications of this for monetary policy? It depends,
of course, on what monetary policy is trying or should be trying to do.
If one feels that the task of monetary policy is to establish some desired
rate of increase in the narrowly defined money supply, the conse­
quences are comparatively minor. The problems of measuring the rate
of increase in money that has been or is actually taking place or in
determining what rate of increase is optimal are magnified only very
modestly by the intensity of competition for “business” business. In
this case, as in others, the pressure to accommodate business borrowers
may produce allocative effects that will cause the monetary authority
to falter in its determination to adhere to a given money supply objec­
tive when credit demands are generally strong, but in the view of the
true monetarist this is only evidence of human fraility— not the product
of the competitive process. This problem of the contribution of hyper­
competition to the selective impact of general policy will be touched on
again in connection with other alternative objectives of policy where
it appears to play a more important role.
If one leans to the broader money supply, or the closely related
bank credit proxy, as the appropriate objective of policy, the problem
is more complicated, especially if one includes in the defined objective
all or part of the claims arising from the money market fund raising
activities of banks. These problems become overwhelming if one
injects the further complication of a sub-market Regulation Q ceiling,
but that is another story. Sub-market Q ceilings are a sufficient evil
unto themselves and have amply demonstrated their capacity to pro­
duce such massive distortions as to make rates of change in any of the
conventional broad measures of bank credit and money practically
meaningless. In these circumstances the modest contribution to the
confusion that stems from the relative market power of banks and
their customers seems insignificant.
If we abstract from the Q ceiling distortions (which is difficult to do
in the current setting in which their impact is so pervasive), it does
appear that the inability of banks to ration credit to large business bor­
rowers, especially in the early stages of a move toward credit restraint,
operates to lessen the precision and increase the time lag with which
the monetary authorities are able to control the rate of growth of total
bank credit, the bank credit proxy or the broadly defined money supply.
In the long run the availability of reserves must operate as a limiting


factor, but for a considerable period footings on both sides of bank
balance sheets can expand at a rather high rate even in the face of an
extremely parsimonious policy of new reserve creation by the central
bank. The reasons for this do not have to be explained to the typical
reader of this sort of paper who is doubtless thoroughly familiar with
the factors affecting member bank reserves and their relation to the
volume of money and bank credit. Suffice it to say that in the circum­
stances set forth and in the short run, banks are prepared to go far
beyond the optimal, equilibrium or profit-maximizing point in the
intensity with which they utilize total reserve balances and the extent
to which they pull reserves normally occupied in other ways into the
“member bank balance” component of the uses of the monetary base.
How much this delays the ability of the central bank to achieve con­
trol over monetary aggregates, such as the broadly defined money
supply, depends importantly, of course, on how ruthless it is prepared
to be in the pursuit of its objective. Even the most strong-willed,
broad-definition monetarist would doubtless find himself compelled
to employ some gradualism in stemming an excessive rate of growth
in bank credit or broadly defined money, and there can be little doubt
that the willingness of banks to compete for funds, among themselves
and with others, to satisfy the borrowing demands of their customers
enhances this problem. But even so, the problem is one of timing and
the determination of the authorities and one would conclude that, if
control over the broader banking system aggregates is the appropriate
objective of policy, then competitive conditions in the banking indus­
try aggravate only modestly the difficulty of achieving that objective.4
Substantially the same conclusion emerges if one accepts interest
rates or some other broad measure of credit conditions as an objective.
4 There has been very little empirical work in this field. While I would not
pretend to have researched the literature thoroughly, I am encouraged to believe
that I have not overlooked any highly significant contributions by the fact that
a recent article on the subject did not refer to anything that had escaped my
attention. This article, “The Banking Structure and the Transmission of Mone­
tary Policy,” by Sam Peltzman in The Journal of Finance, Volume XXIV,
No. 3, June 1969, pp. 387-411, addresses itself primarily to the question of how
the market structure affects the speed with which deposit growth is influenced
by changes in reserves or reserve requirements. The results cannot be directly
related to the judgmental observations in this paper, since the categories used
by Peltzman do not necessarily reflect the differences in market power as between
banks and their customers. In a general way, however, the fact that the differ­
ences in bank structure which Peltzman explores make only modest differences
in the speed with which policy changes are transmitted would seem to support
the proposition that if the rate of deposit change is the objective of policy, the
intensity of competition among banks plays a comparatively unimportant role
in the efficiency with which policy operates.


In fact, it can be argued that a desired level of market rates can be
achieved more rapidly than might otherwise be the case because of
the intensity with which banks are prepared to compete in funds
markets. But the problem of selective impact, or burden sharing, is
more visible, if not more acute, and, therefore, more likely to interfere
with policy formulation. If the authorities are focusing on general
credit conditions as the objective, it is hard for them not to be aware
of conditions in the separate markets and succumb to the temptation
to moderate their general objectives in order to relieve what seem to
be unduly harsh conditions in specific markets— and again, the intense
competition among banks to accommodate business borrowers tends
to amplify the problem. The wide swings in bank participation in the
market for state and local obligations is an obvious case in point.
But while the highly competitive structure we have chosen to main­
tain and encourage in the United States banking system may compli­
cate the problems of conducting a general monetary policy directed to
any of the above objectives— and increase the temptation to super­
impose selective controls to “even out” the burden— it cannot be said
to frustrate such policy or even make it significantly less effective.
However, there is one objective that appears to be literally beyond
the reach of general monetary policy under present competitive condi­
tions. This objective is the more or less precise regulation of the rate
of increase in business loans at commercial banks. If this is taken to
be an appropriate immediate objective of monetary policy, i.e., if
effective control of the rate of bank business-loan expansion is assumed
to be the essential financial link through which monetary policy makes
its contribution to overall economic stability, then monetary policy
simply cannot do what it is supposed to do with the tools it has to work
with, given the present distribution of market power as between banks
and their business customers. If one goes further— as, once started
down this path he might logically proceed— and adopts the objective
of regulating the total flow of credit to business borrowers from all
sources, then the attainment of the objective in present circumstances
and with the present policy tools is even more remote from reality.
Thus, if one sincerely believes that it is essential to stable economic
growth that the monetary authorities be able to influence directly and
promptly the availability of credit to business borrowers, he must con­
clude either that a basic change in banking structure is needed which
will re-allocate market power in such a way as to permit banks to pass
on to business borrowers more effectively restraint imposed on them
by the monetary authorities or that the monetary authorities should


have the explicit power to regulate selectively the volume of business
borrowing, probably from nonbank as well as bank sources. Mean­
while it makes no sense to belabor either the central bank or the private
banking system for not doing something neither of them has within
its power.
While the change that would be needed is put above in terms of two
alternatives, it could just as well have been expressed in terms of
two ways of doing the same thing—reducing the market power of the
corporate borrower. If we move toward any form of selective regula­
tion of bank lending, it would be, in effect, an abridgment of the
benefits borrowers enjoy as a result of the banking competition we
have pursued so vigorously through legislation and regulation. The fact
that it would be done under the banner of public policy does not change
its character. It is for this reason that jurists have always concluded
that efforts to regulate business credit, like the “voluntary” credit
restraint program of the Korean War period, can work only under the
protective umbrella of an exemption from the Sherman Act. In order
for selective regulation of bank lending to work, some sort of col­
laboration among banks with regard to which loans are appropriate
and which are not, would be unavoidable even if broad guidelines were
provided by a Government agency. Business credit simply cannot be
regulated by the type of “down-payment” and maturity regulations
that have been used in the case of consumer installment credit and
real-estate credit regulation.
Doubtless some students of the monetary mechanism will conclude
that the national interest requires a de-intensification of the zeal with
which banks compete with one another for business customers and
accommodate their credit needs even at times when policy is limiting
the growth of total money and bank credit. They also will reason that
this can be most equitably done by superimposing some form of selec­
tive regulation on top of the existing general authority to regulate the
growth of broad aggregates or influence general credit conditions. But
we should all be very clear just what we would be doing if we follow
that path—we would be impairing with one hand the competitiveness
that we have so zealously protected with the other. One would want to
be very sure that regulating business-loan volume is an essential objec­
tive of monetary policy. I, for one, am not.


C e n t r a l B a n k in g in the United States has a rather unusual history. It
was not until well into the twentieth century that it was possible for this
nation to establish a central bank, much later indeed than other modern
nations and then only after considerable controversy.
Perhaps the major problem and the reason for much of this delay
was the strong and pervasive antagonism toward concentration of eco­
nomic power, especially where financial institutions were involved. The
unit banking system, which still characterizes much of American bank­
ing, testifies to this attitude. So far as central banking is concerned, the
difficulties attached to its eventual establishment are best illustrated by
the struggle over the Second Bank of the United States. This institution,
which lost its Federal charter in 1836, gave evidence of eventually be­
coming a full-fledged central bank. But the violent political controversy
which swirled around its operations, as well as around its president,
Nicholas Biddle, derived much of its support from the egalitarianism
of the frontier with its fear of monied monopolies.
Three-quarters of a century were to pass after the demise of the
Second Bank of the United States before it was possible to establish a
central bank in this nation. Even then, when the Federal Reserve Sys­
tem came into being in 1913 it was a regional system, reflecting still the
distrust of “Wall Street” and the centralization of financial power.
Commercial banks have always had an ambivalent attitude toward
the Federal Reserve. At the outset, and to some extent yet today, banks
in major financial centers regard the local Federal Reserve Bank as a
possible competitor. At the same time, bankers work quite closely with
the Federal Reserve at all levels and of course rely heavily on its princi­
pal services.
The attitude of commercial bankers toward the Federal Reserve to­
day is a rather curious mixture of affection, respect, and irritation. It
is worth considering the reasons for each of these attitudes.
Affection is basically an emotional attitude and thus the most diffi­
cult to explain. Essentially, it may stem from the fact that the Federal
Reserve System is, after all, comprised of 12 regional Banks with many


of the characteristics of commercial banks. Accordingly, to some ex­
tent, bankers are more likely to view Federal Reserve officials as col­
leagues rather than as supervisors or central bankers.
Few would question that the regional structure of the Federal Re­
serve has contributed to this attitude. Individual Federal Reserve Banks
have a long history of involvement in the welfare and problems of thenrespective areas. By making their research facilities available to help
solve local problems or to plan for future economic growth the various
Federal Reserve Banks provide major assistance to local economies.
Finally, we should not overlook the fact that in common adversity
there is likely to be, if not affection, at least a feeling of camaraderie.
The continual criticism leveled by the populists in the Congress at the
banking system makes little or no distinction between the Federal Re­
serve and the banks themselves. First one and then the other is the
principal target, but neither is ever entirely overlooked.
The respect which commercial bankers hold for the Federal Reserve
is based on certain well-recognized facts. More than any other Govern­
mental agency, Federal or state, the Federal Reserve is regarded as
above politics. At a time when cynicism as to Government is rampant,
rarely if ever does one hear even a whisper of undue influence or politi­
cally motivated decisions when the Federal Reserve is discussed.
The respect which bankers have for the Federal Reserve is based on
more than the System’s ability to free itself from the political thicket.
The record of the System, whether it be in the management of mone­
tary policy or the regulation of banks is one which commands respect,
though not always agreement or admiration. There are, of course, the
usual exceptions, but generally speaking an examination of the reasons
for Federal Reserve actions reveals a painstaking and thorough analy­
sis which can only be impressive.
The publications program of the Board and of the Banks is one with
which every banker has some familiarity, whether or not he is a mem­
ber of the System. Indeed it would be difficult to be involved in any
financial activity without being aware of the volume and quality of in­
formation made available by the Federal Reserve System. Since this
reflects a large and capable staff under competent direction, a banker
does not have to be personally aware of the existence of this staff— al­
though of course many are— to recognize the solid research under­
pinnings for much of what the Board and the Banks do. Add to this the
frequent exposure of member banks to Federal Reserve bank exam­
iners and supervisory personnel, which along with those of the other


Federal agencies are known to be of high quality, and another good
reason for banker respect for the System is apparent.
But perhaps the most important explanation for the respect which
bankers accord the Federal Reserve is attributable to the decisions
which come forth, particularly from the Board. Whether it be a new set
of regulations, a bank merger application, or a particular action having
to do with monetary policy, there is rarely if ever any question that the
decision reflects the Board’s and the Banks’ view of the best course in
the public interest. This does not mean that these decisions or actions
are unanimously accepted as being in the public interest, but simply
that it is the public interest which the Board or the Banks are seeking
when these decisions or actions are taken.
From the foregoing account of banker attitudes toward the Federal
Reserve, it would seem most unlikely that one would be irritated with
the System, aside from a few congenitally disgruntled individuals. But
the fact is that bankers have always been critical of many of the actions
taken by the Board or the Banks, and never has this attitude been more
pronounced than in recent years. Indeed, the respect and affection to
which I made reference earlier must be working overtime at the mo­
ment to keep the large majority of bankers from becoming bitter critics
of the Federal Reserve.
One reason for this irritation is monetary policy. This is a complex
subject, not easily understood. Nonetheless, bankers and the general
public today are much more sophisticated on these matters than even
a decade ago. The popular press now carries, as a matter of course,
articles on economics, finance, and monetary policy which, 10 or 20
years ago, would have been required reading in college economics
courses. Together with this increased awareness, must stand the ob­
servation that Federal Reserve monetary policy at certain times during
the past few years has not been on target. The 1966 crunch and the ex­
cessive expansion in the money supply in 1968 have caused serious
dislocations in the economy; the latter in particular has led to serious
problems in 1969. And the financial press has not been very far behind
the academicians in pointing this out.
It is doubtful, however, that monetary policy is the major source of
irritation for bankers. For many bankers, what the Federal Reserve
does in its open market operations is not so clearly identifiable and
therefore nearly so important as what it does in the regulatory area. A
decision involving a holding company acquisition, a bank merger, or
the formation of a subsidiary corporation can be of particular impor­
tance to a bank, largely because the effect of such a decision can be


measured rather precisely in terms of cost and potential profits. Here
again, in its regulatory activities, the record of the Federal Reserve
leaves something to be desired.
The major criticism is that the Federal Reserve is so ponderous in
its decisionmaking process, and so wedded to what may be described
as a “strict constructionist” philosophy of the banking laws, that it has
lost sight of the fact that the banking industry, notwithstanding its ex­
tensive regulation, is, or at least would like to be, a dynamic and rapidly
expanding industry. Bankers today feel that the Federal Reserve is a
major roadblock in their drive to become more competitive and to re­
act more promptly to the changing demands of a burgeoning economy.
Recently the Board has given some indication that this posture will
change. The decisionmaking process is apparently being speeded up
through passing more responsibility back to the regional Banks. State­
ments made by Federal Reserve officials, as well as certain recent ac­
tions, suggest a more enlightened view of present and future problems
of the banking industry. Nevertheless, there are many who, based on
past performance, are dubious.
From the banker viewpoint, the curious mixture of attitudes toward
the Federal Reserve naturally results in misunderstandings. Too often,
bankers simply cannot reconcile the Board’s action or decision with its
demonstrated abilities and its concern for the public interest. One would
assume that there are equivalent misunderstandings on the part of offi­
cials of the Federal Reserve, who must wonder why it is that bankers
frequently fail to comprehend what the Board or the Banks are trying
to do. Is it possible that there can be any resolution of this matter?
Doubtless there can and will be better understanding and quicker
resolution of difficulties as each side becomes more aware of the inter­
ests and concerns of the other. However, it is doubtful that the time
will ever come when the Federal Reserve System and the banking in­
dustry will see eye-to-eye on all matters. The major reason for this is
the fact that the Federal Reserve is, after all, a public agency whereas
banks are private institutions operated with a different set of objectives
in view.
Beyond this, however, there lies a question as to whether this history
of misunderstanding between the System and the banks may not be
indicative of a structural defect within the System itself. Specifically, is
it possible for one agency to be both a central bank and a regulatory
agency? If one were talking of another nation, particularly a European
nation, the answer might be a quick “yes.” However, there are some


rather unusual factors to take into consideration when it comes to the
United States.
First, there is clearly a need for the central bank to maintain a rela­
tively independent posture within Government. The degree of inde­
pendence has been frequently overstated but, in general, there should
be some kind of arm’s length dealing between the agency which must
obtain funds for the Government—the Treasury— and the agency
which is responsible for the quantity of money within the economy.
Certainly the two cannot be so independent as to be unconcerned as
to each other’s problems but neither should they be merged.
Another rather unusual feature of the American banking system is
its essentially competitive nature. This is not a system with only four
or five major banks but, rather, one with more than 13,000 banks, a
situation unique in the modem world. Of course, not all 13,000 banks
are in direct competition with one another but, nevertheless, banking
is still an industry for which entry, while difficult, is reasonably possi­
ble. It is likely that in a city of any size, and in most counties, there
are more individual banks in this country than there are in an entire
nation overseas.
Given the desirability of some degree of independence for the Fed­
eral Reserve, is it possible for that agency to be an effective regulatory
agency when dealing with thousands of individual banks? Can it af­
ford to operate in the manner traditional for United States bank regula­
tory agencies, that is, with a maximum emphasis on informal proce­
dures and quick action? The answer would seem to be “no” if, at the
same time, the Federal Reserve must guard its flanks from critics who
would destroy its monetary independence. Put another way, one
method of insulating one’s self from the hurly-burly of politics and en­
tanglement in dangerous political issues is to rely heavily on formalistic
procedures, rule making, hearings, extensive and thorough research,
and, in general, a kind of deliberateness that is characteristic of much
of what the Board does. These are the very characteristics of which
banking is most critical and, indeed, for which banking’s case is particu­
larly good. Yet to ask the Federal Reserve to change because it is a
regulatory agency may, at the same time, be asking it to endanger its
ability to remain independent within Government in carrying out its
central banking responsibilities.
The foregoing would suggest that the record of misunderstanding
between the Board and the banking industry might well be seriously
diminished if consideration were given to eliminating much if not all
of the regulatory functions now exercised by the Board. Indeed, a


rather strong case can be made for doing this on purely mechanical
grounds; there is, after all, little real need for the Federal Reserve to
be engaged in examining some state banks while the FDIC insures vir­
tually all banks and has adequate funds and resources to take over the
Board’s responsibilities in this regard. There may well have been need
for bank regulation by the Board in 1913, but certainly not since 1933
with the establishment of FDIC.
There is, of course, a case which can be made against transferring
Federal Reserve regulatory powers to another Federal agency. It is
not within the scope of this paper to debate that particular issue.
Rather, we simply point to the fact that any analysis of banker attitudes
toward the System would suggest that there is an important reason for
at least re-studying the present bank supervisory structure.


G oals , I n s t r u m e n t s , a n d P rocesses of monetary policy all have
undergone considerable change since World War II. These changes
reflect a variety of factors, some of wide impact, others characteristic
of individual countries. Even where trends of broad applicability are
involved, the timing of changes has differed. Innovations originating
in one country underwent mutations and adaptations to meet the spe­
cific conditions, traditions, constraints, and challenges operating in
another. In attempting a few generalizations within the limited scope
of this short essay, I am acutely aware of the pitfalls of such an under­
taking, in particular in an area where superficially similar arrangements
operate in a considerably different environment.
It is not the array of available instruments but their actual use, singly
or in combination, that is significant for an assessment of the conduct
of monetary policy. But drawing the distinction between what a central
bank can do and what it actually does would require a thorough review
of actual country-by-country experience. My attempt to identify the
nature of, and the reasons for, the broadening of the range of tools
available to central banks since World War II is thus nothing more
than a modest beginning. It is limited to the group of leading industrial
countries, roughly coinciding with the “Group of Ten” (although some
comments on developing countries are also ventured). Since innu­
merable variants are encountered even in this limited group, and in
some cases numerous changes and refinements have been made in the
application of individual instruments, only the main lines of develop­
ment can be put into relief, and no attempt can be made to indicate in
each case where and at what time individual techniques have been used
or introduced.

Postwar Setting in the Advanced Countries
Central banks of the industrially advanced countries found them­
selves after World War II operating in a substantially different domestic
and international environment from that of the thirties. In most cases,
the institutional setting, the problems, and the policy goals had changed.
However, the degree to which the central banks sought new powers
and undertook to adapt old tools to new tasks varied a good deal, not


necessarily in relation to the newness of problems and the magnitude
of the challenge.
Since World War II, central banks have been faced with the problem
of meeting new policy goals designed to promote broader and more
specific national goals in economies that have been growing more
complex and integrated among themselves and with the rest of the
world. Acceptance by most of the developed countries of national
goals similar to those embodied in our Employment Act required a
reorientation of policies of the older central banks. Central banks
began to direct their efforts increasingly towards contributing to con­
ditions conducive to optimum economic growth, to maintaining ade­
quate aggregate demand, and to achieving socio-economic objectives
which, while differing from country to country, typically encompassed
a greater equality in living standards and also a reduction of inequali­
ties in welfare and opportunity between various parts of the country.
Achieving a desired composition of output has been frequently re­
garded as a means for achieving these goals. Partly as a result of capital
destruction or under-maintenance during World War II, the older
central banks, such as the Bank of France, became increasingly con­
cerned with domestic capital formation, frequently using traditional
tools of monetary control to stimulate the flow of financial resources
into favored sectors of the economy.
Another consequence of events precipitated by World War II was
the nationalization of important segments of industry in several coun­
tries and the nationalization of central banks. The fact that significant
segments of industry are government-owned, while other important
units involve some degree of government participation or sponsorship
(or official tutelage, as in Japan), has become an important considera­
tion for the conduct of monetary policy in most countries. Municipal
ownership of public utilities is widespread, and communications as
well as the main railroad, air, and shipping lines are usually publicly
owned, directly or indirectly. A considerable part of assets owned by
commercial banks (including those publicly owned) consists of credits
to publicly owned units, even though the form of accommodation
extended may be indistinguishable from that available to private bor­
rowers. In effect, they represent loans extended to, or guaranteed by,
government institutions that implement official economic policies.
After World War II, the central banks of Western Europe, as well
as of Japan, were nationalized. The newest of the leading central banks,
the Bank of Canada, was created in 1934 as a government bank,
while the oldest of the central banks, the Swedish Riksbank, was a
State bank from the very beginning of its history. The change in the


institutional setting altered the modus operandi, thinking, and style of
central banks surprisingly little.1 Even prior to nationalization, while
they also operated for the profit of shareholders and carried on sub­
stantial private business, the banks of issue were banks of their respec­
tive governments, cooperating in various degrees in the implementation
of economic policy objectives, as then established or understood. Gov­
ernment ownership of central banks and changes in central banking
legislation, involving in some cases creation of administrative, advisory,
or planning bodies for formulating and coordinating credit policy,
have not necessarily by themselves resulted in radical changes in the
position of the central bank vis-a-vis the government.
In most industrial countries, the central problem of the postwar
period has been to limit and, as necessary, neutralize the effects of
excess liquidity inherited from the war and, later, increasingly, from
temporary or persistent balance-of-payments surpluses. In many in­
stances, the range of tools of monetary control available to the central
banks was not adequate to cope with excess liquidity. Confronted
with the huge task of reconstruction while coping with the monetary
overhang of war and occupation, the central banks of Europe impro­
vised. Of necessity, whenever new expedients were tried in extraordi­
nary circumstances, direct and administrative measures emerged, even
where conservative attitudes counseling reliance on indirect and gen­
eral measures had typically dominated.
As a new environment gradually emerged after the immediate
effects of the war were overcome, there was a natural tendency to seek
a return to “normalcy” by liquidating the restrictive measures imposed
by the financial collapse of the Great Depression, war economics, and
the exigencies of reconstruction. The dismantling of war and postwar
controls seemed to pave the way for a return to traditional reliance on
general monetary controls. In the international sphere, it was expected
that the return to convertibility at the end of 1958 would lead to less
rather than greater need for innovation in the management of inter­
national liquidity. Before long, however, controls introduced to cope
with wartime problems of scarcity of goods and abundance of money
proved handy in dealing with new objectives of directing credit into
areas favored by macro-economic priorities. At the same time, the
growing integration of economies following the acceptance of con­
vertibility and the freer flow of capital across national borders created
its own problem for monetary policy.
In spite of the broadening of domestic goals, external equilibrium
1 As Karl R. Bopp had anticipated in his “Nationalization of the Bank of
England and the Bank of France,” The Journal of Politics, August 1946.


remained a principal focus of monetary policy. Even in the nostalgic
memory of the simplicity of pre-World War I days, defense of the
exchange value of the national currency was, of course, a primary
concern of central bank policy. But since the return to convertibility,
in a world with a considerably greater economic interdependence and
a vastly enlarged financial structure, defending fixed exchange parities
and protecting the proper functioning of the monetary system has
become considerably more complex. While proper behavior became
codified on an international scale by the Bretton Woods institution
and various other group arrangements, such as the European Pay­
ments Union and the European Monetary Agreement, and the ex­
change provisions of the Treaty of Rome, individual central banks
still had to devise and operate appropriate defense, neutralizing, and
adjustment mechanisms as wartime exchange controls were dismantled.
Because the general framework of public policy gives little scope
to price and employment flexibility, equilibrating capital flows have
been assuming a greater role since World War II, in particular since
the return to convertibility. Thus, the task of central banks widened
from defending exchange parities through operations in exchange
markets and the skillful management of international reserves to con­
cern with the regulation of financial flows across international borders.
Such regulations usually required close cooperation among the central
bank, the Ministry of Finance, and other parts of the government.
Indeed, while, typically, the central bank continued to supervise ex­
change controls and to manage exchange stabilization funds, the
national government usually appeared on the scene whenever broad
problems of international monetary cooperation were under discus­
sion. Thus, the growing complexity of international financial inter­
relationships became one of the main reasons why concern with the
financial environment emerged more and more as a part of overall
governmental policy.
Discovery of fiscal policy as a potent tool of economic policy was
the other main reason for closer coordination of monetary and other
policies. The burden which monetary policy had to carry diminished
as fiscal and income policies, as well as a variety of direct and indirect
controls, were applied in individual countries, with varying success,
to cope with the problems of excessive domestic demand and external
disequilibrium. But advanced as well as developing countries continued
to place considerable reliance on monetary policy as a means of in­
fluencing aggregate demand.
The following sections briefly review the main lines along which


monetary policy instruments have developed since World War II.
Space does not permit dealing with the coordinated use of these tools,
with the problem of aligning monetary and fiscal policies, or with the
increasingly felt need for coordinating both kinds of public policy
within the Common Market.
The Need for New Tools
With notable exceptions, changes in tools available to central banks
of the advanced countries arose largely from improvisation and adapta­
tion of existing tools, rather than as the fruit of systematic efforts based
on comprehensive inquiries. Monetary control techniques which the
central banks had at their disposal as they confronted new problems
at the close of World War II were forged essentially at a time when
belief in the inherent tendency of the economic system to return to
equilibrium was strong, and faith in automatism was not deluded by
suspicion that the response might be capricious, or even perverse.2
The role which central banking should play in achieving the newly
accepted or gradually evolving goals of government economic policy,
and the changing policy environment and credit needs of the economy
required a searching re-examination of the financial structure, mone­
tary policy, and of its tools and processes. In some countries, broad
official inquiries were undertaken which produced monumental reports
that vastly enriched our knowledge and offered new insights and inter­
pretations, such as the Radcliffe Report in England and the Report of
the Royal Commission in Canada. In France, a series of reports by
special committees of experts probed into the need for changing the
financial structure as well as monetary policy tools, thus laying the
groundwork for important reforms. Official as well as private inquiries
were also conducted in some other countries, but in many cases the
initiative for obtaining new tools or developing new techniques was
left to the central banks themselves. Nowhere has monetary policy and
the changing financial structure been subject to the kind of continued
and searching examination it has received in the United States, largely
as a result of continuing Congressional interest, as well as numerous
private initiatives. And it was in the United States that most of the
new monetary techniques used by central banks around the world
2 In his study of the pre-World War I policy of the Reichsbank (“Die Tatigkeit der Reichsbank von 1876 bis 1914,” Weltwirtschaftliches Archiv, 1954),
Karl R. Bopp was struck by the difficulties the German central bank had en­
countered in reconciling, in day-to-day operations, its frequently conflicting rate
objectives as well as by its failure to pay adequate attention to controlling the
reserve base of the banking system.


originated, transforming “banks of issue” in the advanced countries
into one of the most important channels through which public policy
affects the economy.3
Closer integration of monetary and overall economic policy requires
shifting from commercial banks to the central bank the initiative for
injecting and withdrawing reserves, and open market operations emimently suits this purpose. Effective use of open market operations has
remained, however, limited to the United Kingdom and Canada, in
spite of the more recent endeavors in Japan, West Germany, France,
Sweden, Austria, and elsewhere to develop such operations. The nar­
rowness of their money markets and the limited number of instruments
traded in them hinder a more vigorous use of this tool. Indeed, in no
other country is the debt of the central government so widely held by
individuals, business firms, lower-level governmental units, and others
as in the United States. Nowhere is this debt so actively traded, and its
yields subject to day-by-day changes in demand or to reassessment by
money market participants as the Treasury undertakes frequent new
financing or refunding operations. There is, indeed, a great difference
between the willingness of the central bank to buy or sell government
securities at infrequently changed posted rates, as in West Germany,
or to make periodic purchases of certain previously announced
amounts of government securities, as in Japan—with the initiative for
transactions left to the market— and a broad, impersonal market in
which the central bank can operate as merely one of the major par­
ticipants, buying and selling on the market to affect bank reserves
rather than being the market.
Since relying on open market operations for controlling the liquidity
of the banking system was not feasible in most countries because
central bank portfolios were not suitable and the money market was
too narrow, central banks had to seek other means for influencing the
reserve base. One such new tool was the introduction of mandatory
minimum reserve ratios4 (Italy). More frequently, however, the oldest
tool of monetary control— the discount mechanism—was adapted to
achieve the desired policy objectives, frequently as a means of direct­
3 How distant, indeed, appears the time when the National Monetary Com­
mission commissioned a translation of a series of monographs on banking in
various countries to help decide how the new central bank to be created in the
United States could benefit from foreign experience!
4 References to individual countries are to well-known or early examples of
the techniques referred to. They are not meant to be complete. For more de­
tails, see George Garvy, The Discount Mechanism in Leading Industrial Coun­
tries Since World War 11, Board of Governors of the Federal Reserve System,


ing the purposes for which bank credit was used and not only to con­
trol its total volume (France).
Where central bank control traditionally focused primarily on the
level of interest rates rather than on the volume of bank credit, the
approach of setting the discount rate and letting the banking system
determine how much central bank credit it wanted to use at any given
time was, by and large, replaced by a system which combined quali­
tative and quantitative limitations to achieve control over the total
volume of bank credit and to influence its use. The shift of emphasis
from avoidance of undesirable developments, such as excessive cycli­
cal swings and loss of international reserves, to positive goals, formu­
lated in terms of employment, growth, or social welfare, seemed to
make exclusive reliance on indirect tools inadequate. The narrowing
of the range of socially acceptable rates, possible conflicts between
domestic and external objectives and, in some cases, pressure for
fostering preferential or subsidy rates in certain sectors of the economy
caused central banks to seek additional tools for achieving overall
objectives of monetary policy. Thus, in many advanced (as well as
developing) countries, considerable reliance has come to be placed
on controlling expansion of bank credit directly, mostly by quantita­
tive limitations on loans (Belgium, France, Switzerland). Quantitative
controls operate largely through the imposition and manipulation of
absolute bank credit ceilings, which continue to be supported by more
traditional tools of credit control aimed at liquidity and rate objectives.
In most advanced countries, even where quantitative controls are
used, central bank policy continues to be guided by rate objectives,
as authorities attempt to achieve rate levels that will stimulate capital
formation and avoid undesirable short-term international capital
flows. In most recent years, rates of growth of the money supply and
bank credit have been given more attention. This is true even in coun­
tries which have traditionally focused on rate objectives and in which
the discount rate has served as an anchor for the entire structure of
interest rates. Since the 1950’s, for example, the Bank of Eng­
land has expanded its means of controlling the banking sector. In
addition to the traditional cash and liquidity ratios, a system of special
deposits for the clearing banks was introduced in 1965 as a means of
influencing bank liquidity, and a cash deposit scheme for other banks
was established in 1968 (although it has not been used). Loan prior­
ities and quantitative controls (initially introduced by means of letters
issued by the Governor) to achieve nonrate bank credit rationing have
also been used.


Widening of the Scope of Controls
In most advanced countries, institutional changes since World War
II have affected the place of money in the spectrum of liquidity, and
of commercial banks as the main source of credit. Commercial banks
themselves have been operating in an atmosphere of greater freedom
from traditional inhibitions and of fewer rigidities in legal restrictions.
Fairly universally, the emergence of new financial institutions and
processes, or the greater willingness of the older institutions to com­
pete with banks for deposits as well as loans, presented new challenges
to central banking. It has become evident in many industrial countries,
although to different degrees, that it can no longer be assumed that
the central bank can exercise adequate control over total credit by
affecting reserves of commercial banks. As the financial environment
and objectives of public policy changed after World War II, reliance
on the rate mechanism and manipulation of access conditions to cen­
tral bank credit in order to affect the liquidity of the banking system
became increasingly more difficult, and at times inadequate.
The growth and proliferation of nonbank financial institutions and
the emerging importance of money substitutes introduced significant
changes into the environment for the conduct of monetary policy. The
role of financial intermediaries, which first became the subject of a
lively debate in the United States, has become a problem for most
advanced countries in the application of monetary controls. Its acute­
ness varies, largely as a function of the degree to which institutions
other than commercial banks can issue deposit-like liabilities which,
in fact, are an adequate substitute for money, or can compete with
commercial banks for various categories of credits traditionally asso­
ciated with the sphere of banking activities in a given country. As a
result, there was a need to adapt traditional techniques of monetary
control to new objectives, to forge new tools, and to widen the area
of concern from commercial banking to a wider and widening circle
of financial institutions and instruments.
By and large, the range of institutions subject to monetary controls
has grown, as financial intermediaries multiplied, and older institu­
tions, such as savings banks, tended to broaden the scope of their
operations. Central banks began to seek powers (or use existing
powers) to regulate institutions issuing money substitutes. They did so
largely because they became convinced that the size and direction of
total credit flows was a financial variable most relevant for the
achievement of national economic goals, rather than because they


became convinced that there was no significant distinction between
money and near-money. The solutions adopted vary, but more and
more countries have found it necessary to extend the scope of at least
the main monetary controls to savings banks and various types of spe­
cialized credit institutions catering to individual segments of the econ­
omy, such as agriculture. When the scope of power of the older central
banks was redefined by new legislation, it was often expanded to
include a range of financial institutions other than commercial banks.5
When this was not done, central banks found themselves compelled
to find ways of controlling credit flows that increasingly bypassed insti­
tutions subject directly to central bank policy actions and/or super­
Where considerable reliance continues to be placed on voluntary
compliance, as in the United Kingdom, the Governor of the Bank of
England found it necessary to address his requests to limit credit out­
standing to a widening circle of credit institutions. Thus, when in
1955-1956 the Bank of England limited advances by clearing banks,
it later sought to limit growth of commercial paper as well, and also to
extend loan ceilings to banks other than clearing banks. In countries
in which monetary mechanisms were supplemented by a variety of
quantitative restrictions, it was also found necessary in many cases to
extend such restrictions beyond the area of traditional commercial
banking. And, indeed, one of the aspects of the cash deposit scheme
recently developed, but as yet not implemented, is to extend control
of the Bank of England to nonclearing banks.
Evolution of the Discount Mechanism
The choice of instruments used by an individual central bank is
normally a function of the degree of precision that may be expected
from using any of them, singly or in combination, to achieve the
desired effect. Frequently, however, the role of any particular mone­
tary tool depends on the availability of alternative control mechanisms.
By and large, granting of new controls to the older central banks
tended to lag behind changes in economic and financial structure, and
in the objectives these banks were supposed to pursue. As a result,
the oldest tool of central banking has been given in many countries new
functions requiring adaptations far beyond the original mechanism,
5 The Bundesbank, for instance, applies reserve requirements to savings banks;
the French National Credit Council has jurisdiction over a wide range of finan­
cial institutions, including credit unions and discount houses. The Canadian
Porter Commission recommended imposition of cash reserve requirements on
all financial institutions issuing near-money claims.


which is closely linked to the oldest theory of central banking—the
commercial-bills doctrine. In most advanced countries, the discount
mechanism remains the centerpiece of domestic monetary controls.
In most, it was, until very recently, almost the only significant tool
available to the central bank. The precise form of its current use, of
course, varies, ranging from the traditional coordination with open mar­
ket operations in England to the preservation of archaic trappings, such
as the local discount committees of leading merchants and wealthy
citizens in Belgium.
From the very beginning, the discount mechanism had two aspects
—rate and eligibility requirements. For a variety of reasons, the use
of the rate as a price, and thus as a rationing device, has declined
since World War II. The diminished role of the bank rate as a signal
of the central bank’s wishes stemmed, in part at least, from changes
arising out of socio-political, as well as purely monetary, considera­
tions.6 Thus, in England, the discount rate remained unchanged from
July 1932 through October 1952, with the exception of a short epi­
sode during which it was raised immediately before the outbreak of
the war and then lowered in two steps to the original level a few
weeks later. A more recent example involves Italy, where the rate was
raised in 1969— the first change since it was lowered in 1958— while
in Norway at this writing (July 1969) the discount rate remains at
the level set almost fifteen years ago. In a broad sense, it is not im­
proper to speak of a “politicization” of the discount rate.7 Yet, redis­
counting with the central bank (or obtaining advances from it) remains
the only routine and generally used means for adjusting short-term—
and in some countries also cyclical—fluctuations in reserve positions
With the revival of monetary policy in the early fifties, most indus­
trial countries, however, have again been using changes in the discount
rate for domestic as well as for international reasons.8 Indeed, moves
in either direction by one of the leading countries are now usually
6 Linking the discount rate automatically to a market rate— the Treasury bill
rate— as was done in Canada between 1956 and 1962, was another attempt to
escape constraints on moving the discount rate.
7 Karl Bopp, who has devoted so much of his attention to studying policies
of the leading central banks of Europe, had no difficulty in documenting that
“Napoleon viewed the Bank rate as a political tool.” “Bank of France Policy:
Brief Survey of Instruments, 1800-1914,” The American Journal of Economics
and Sociology, Vol. II, No. 3.
8 In the less-developed countries, in which a large segment of commercial
banking frequently consists of government- or foreign-owned institutions, the
effectiveness of the discount rate as a rationing device is limited and the rate
typically serves primarily as a signal.


followed by similar defensive or coordinated moves by other countries.
In some countries the discount rate remains an important element in
the credit situation, even though it is changed infrequently, because
deposit and/or lending rates are tied to it by custom (United King­
dom ), practice (Belgium, Italy), or agreement (Austria, Japan).
Recently there has been a tendency to relax the resulting rigidity, in
part because it imposes additional constraints on the use of the rate.
Eligibility requirements governing access to the discount window
are easily traced to the commercial-bills doctrine. To a surprising
degree, central banks have retained traditional forms and practices
by continuing to give preferential treatment to credit extended by
means of discounting customer notes. In some cases, as in France,
formal compliance with the rule that central bank credit should be
extended on the basis of short-term paper only was achieved by inter­
posing special primary discounting institutions; such institutions issue
short-term instruments discountable at the central bank against
medium- and even long-term claims which they keep in their port­
folios; thus, in fact, acting as primary discounting institutions.
In spite of the survival of the trade bill as the single or preferred
instrument of short-term accommodation at the discount window,
central banks use their considerable discretionary powers to regulate
access to discount facilities by varying eligibility requirements in
accordance with policy objectives (Germany, Netherlands). This in­
creases their ability to influence commercial bank behavior in the
direction consistent with the objectives of monetary policy. Indeed,
in some countries the discount mechanism has also been used as an
enforcement mechanism— access to the window is dependent on com­
pliance with overall objectives of monetary policy attuned to achiev­
ing specific national policy objectives. Even in countries where access
to the window within ceilings is considered a right, differentiated vari­
ations in such ceilings have become a means of inducing or enforcing
In countries in which the discount window has been used for influ­
encing credit flows by means of differentiated discount rates, compart­
mentalized discount procedures have been used to implement a variety
of official programs. In countries which use this technique, it is be­
lieved that by controlling the cost (rather than the quantity) of credit,
differentiated discount rates can be helpful in directing the use of
credit and in influencing the direction of growth of the economy. Such
use of the discount window to stimulate investment in certain sectors,
to finance farm price-support programs or in other ways to substitute


for budgetary financing, resulted, in fact, in the provision of central
bank credit on a semi-permanent basis. The techniques used include
giving preferred categories of credits automatic access to the discount
window. Where discount quotas applicable to individual banks exist,
preferred paper may be discountable outside such quotas or within
special, additional quotas.9 Perhaps the most outstanding example of
this technique is the Bank of France’s use of preferential status at the
discount window and of a lower discount rate to stimulate residential
construction and the re-equipment of industry. Preferential treatment
of foreign-trade credits goes back to the period between the two world
wars, but the extent to which central bank facilities have been made
available for this purpose expanded considerably after World War II.
Preferential access may be formalized by giving prior approval
( “visa” ) to such paper (Belgium, France, Italy, Japan), in which case
the paper is often discountable at a lower rate.
Progressive rates at the discount window are usually applied in
combination with quantitative limitations rather than as an alternative
to quantitative restrictions. Scaled rates are usually a function of the
size and duration of borrowing, or they may be applied to borrowing
in excess of basic quotas (France). Access to the discount window
now usually involves a complex structure of discount rates, but in
recent years there has been a clear tendency (France, Japan) away
from excessively complicated multi-rate structures and from extreme
penalty rates.
In some countries, advances obtainable on credit instruments not
eligible at the window incur a higher cost, but continue to provide a
safety valve for obtaining central bank credit for reserve or liquidity
adjustment purposes and at the same time set an effective ceiling on
money market rates (Belgium). Where the conceptual difference
between discounts and advances is being maintained, there has been
a clear tendency to confine the role of advances to the provision of a
temporary safety valve— if necessary, by imposing rigid restrictive
conditions on its use (Germany). In some cases, when the scope for
open market operations still remains very limited, as in France, dis­
count window operations at the initiative of the central bank, designed
to relieve excessive market tightness, have been used as a substitute
for such operations.
9 Interestingly enough, Yugoslavia, the only socialist country which has sepa­
rated the central banking from the commercial banking function and introduced
rediscounting, also uses eligibility requirements and discounting outside the quota
as a means of selective credit control.


The complexity of the discount mechanism has stemmed largely
from endeavors to channel credit into uses to which economic or social
priorities were assigned by government policy, rather than to achieve
broad objectives of monetary policy. However, the use of the discount
mechanism as a tool of selective credit control tends to render the
implementation of overall monetary policy more difficult, especially
when the discount window is used to stimulate particular activities. In
recent years, therefore, there has been a tendency away from using the
discount mechanism as a tool for achieving multiple and, at times,
conflicting objectives. Conditions of access and administration have
been simplified, especially where they had become exceedingly com­
plex and involved a wide range of rates, including several penalty
rates, and highly differentiated conditions for access, as in France and
At the same time, the availability of new control tools, in particular
the introduction of minimum reserve requirements, has tended to
reduce the need for relying heavily, or even excessively, on the dis­
count mechanism and on the related “Lombard loans” (advances).
In several advanced countries, the development of a true money market
(and in some countries, of an impersonal market for reserve balances)
also served to reduce the need for relying on borrowing from the cen­
tral bank (Netherlands). Concentration of banking resources in a
diminishing number of banks, and the concomitant growth of branch
systems, which tended to reduce seasonal and cyclical fluctuations in
deposits and loan demand, had a similar effect on the need for dayto-day recourse to central bank credit.
Reserve Requirements
While the discount rate affects the cost of credit, minimum reserve
requirements affect its availability. Legal reserve requirements have
emerged as a most important tool of monetary control, supplanting
in many countries the primacy of the discount mechanism.
Liquidity ratios have traditionally played a role in central banking
as an instrument of control or as a requirement deemed essential to
assure adequate performance of the banking system.10 In the latter
case, they are enforced primarily from a bank-supervisory rather than
10 Formal liquidity ratios, instead of, or in addition to reserve requirements,
have been imposed in a few instances (Belgium, France), to be satisfied by the
holding of assets otherwise eligible for discounting or as collateral for advances.
(Proposals for imposing similar “security reserve requirements” were made in
the United States after World War II.)


policy-oriented point of view (Switzerland). In some countries, as in
France, liquidity ratios (where they had to be satisfied by holding
specified percentages of government obligations) had been introduced
after World War II to neutralize (sterilize) the effect of excessive
liquidity inherited from wartime developments. In others, with Eng­
land as the classic example, they have been viewed as a means for con­
trolling total bank liabilities. But even in England, voluntary observ­
ance of traditional liquidity ratios, which after World War II were
formalized by the Bank of England, was supplemented first (when
the need for additional restraint arose) by special deposits for clearing
banks and more recently by cash deposit requirements for other banks.
In Canada, liquidity reserves have been introduced as a supplement to
minimum reserve ratios.
Minimum reserve ratios (legal reserve requirements), and the
authority to vary them within stipulated ranges, gave the central bank
a new tool for controlling the base of deposit creation and thus of
bank credit expansion. The requirement that reserves be maintained
at the central bank in amounts related to commercial bank deposit
liabilities makes the central bank share in the growing role of banks
in the creation of money. Part of the monetization of debt associated
with the creation of demand deposits can thus be used for the public
benefit. Legal reserve requirements, first introduced in the United
States, are an integral part of monetary powers conferred upon new
central banks by laws passed since World War II; the older central
banks have gradually acquired such powers and learned to use them
effectively and to devise variants specifically suited to conditions in
their countries. In some countries, the use of reserve requirements has
been hesitant and intermittent and their level so low as to be of slight
significance. In Japan, the burden of a low requirement was made
even less onerous by payment of interest by the central bank. Other
countries have moved toward making minimum reserve ratios more
effective by requiring observance on a continuing (average) basis and
not only on the last day of the month or some other report period.
Several countries have effectively used reserve requirements to pre­
vent undesirable inflows of foreign funds by imposing such onerous
requirements on foreign deposits as to make it unprofitable for banks
to accept them (Germany). In fact, imposition of requirements in
amounts of up to 100 per cent on marginal increments is tantamount
to direct control of additional foreign liabilities that banks can incur.
Lesser percentages applied to total or marginal amounts permit the


central bank to vary the degree of profitability of such deposits for
commercial banks.
Quantitative Controls
Since World War II, quantitative controls have been used frequently
to reinforce or replace reliance on discount policy as a means of regu­
lating the banking system’s lending base. Central banks in several
advanced as well as developing countries have resorted to such non­
price rationing, often because social and political constraints or inter­
national considerations interfered with the full and effective use of
more general controls. In some countries, the scope of selective con­
trols, introduced to achieve limited objectives, has simply been ex­
tended. Where adequate legislation to impose formal controls is not
available, quantitative restrictions have occasionally been introduced
and enforced by means of moral suasion— “window guidance” in
Japan and the “gentlemen’s agreements” between the commercial
banks and the National Bank of Switzerland being conspicuous ex­
amples. In some cases, quantitative restrictions are quite congenial
to the broad philosophy of governments which apply controls to other
economic activities as well. But it would be wrong to identify the use
of quantitative credit or other monetary controls as a concomitant of
an economic policy committed to planning or “dirigisme,” as the case
of Germany clearly demonstrates.
Not all monetary controls involving quantification are quantita­
tive controls. This term is best reserved for techniques that involve the
establishment either of quotas for individual (or groups of) banks for
specific categories (or the total amount) of credit obtainable at the
central bank (France, Germany, Italy, Japan), or of absolute limits
on the growth of various types of loans or of the total amount of credit
extended by individual banks to their customers (Belgium, France,
Japan, Netherlands, Switzerland). Several central banks have con­
cluded that using discount quotas as a means of regulating the total
volume of bank credit and as a fulcrum against which rate policy
becomes effective is inadequate. In some countries, therefore, discount
quotas have been supplemented or replaced by ceilings on total loan
volume, or other quantitative controls applying to total (or selected)
bank assets, most commonly taking the form of maximum limits for
permissible expansion during specified periods. In some cases, loan
ceilings have been extended to a variety of other financial institutions
as well.
Many of the quantitative controls have been built around the dis­


count window, in particular where discounting remains the primary
means of access to central bank credit. Others have been grafted onto
liquidity ratios, by freezing a certain volume of bank assets eligible
at the discount window. Discount quotas for individual banks may be
made quite complex by using changes in such lines not only to permit
secular growth, but also to discipline banks that do not adhere to rules
laid down by the monetary authorities. Separate, but more flexible,
quantity limitations on advances frequently supplement quantitative
rules at the discount window. In addition, a certain degree of flexibility
is usually provided by permitting banks to exceed discount quotas at
their option at the cost of a severe penalty rate, or under specified
special conditions only, and then usually for limited periods. The cost
of such “overline” borrowing at the discount window has at times been
pushed to such extreme levels as to make it prohibitive and, therefore,
Quantitative restrictions applied to the volume of discounts, to total
bank loans or credit, or to bank liabilities may be linked to overall na­
tional economic targets or merely represent the judgment of the central
bank as to the extent to which further credit expansion is compatible
with internal and external equilibrium. In several countries, they are
used almost exclusively to combat the development of inflationary
pressures (Belgium, Switzerland). In some cases, control over domes­
tic credit is reinforced by separate controls over the foreign positions
of commercial banks (Netherlands).
Obviously, the administration of credit lines at the central bank,
and of quantitative rules in general, requires frequent review by the
monetary authorities of various problems, such as the equity of the
system and its potentially stifling rigidity. Linking discount quotas or
credit ceilings to some “objective” variable, such as bank capital
or some measure of past performance, may reduce, but can never com­
pletely remove, the area of administrative discretion. The use of
complex formulas, no less than of informal guidelines, for setting
quantitative limits usually involves central banks in close supervision
of the actual performance of the banking system and, indeed, of the
entire range of financial institutions subject to central bank control.
Pursuance of multiple goals by countries using quantitative credit
tools results at times in complex schemes under which the overall
effectiveness of ceilings is undermined by various exceptions.
Defending the International Value of the National Currency
After World War II, the central bank’s traditional concern for the


external value of the national currency became institutionalized within
the framework of an international organization. With the creation of
the IMF, stability of exchange rates became a matter of codified inter­
national behavior. Inevitably, strains developed in a system which
failed to acknowledge that maintenance of stability requires prompt
adoption of appropriate adjustment policies. Since the return to con­
vertibility, individual countries have experienced disequilibria of vary­
ing degrees of seriousness. Demand pressures have at times led to
balance-of-payments strains (periodically in Japan) and occasionally
to confidence-shaking deficits of major proportions (as in the United
Kingdom, Canada, Italy, and, more recently, France).
In contrast to the years prior to World War I, when central banks
relied primarily on rate policy to defend the external value of national
currencies and to cope with international capital flows, the post-World
War II period has witnessed the development of a host of special poli­
cies and devices. Reduced price, wage, and employment flexibility
make it necessary to rely more heavily on capital flows as a means of
equilibrating the balance of payments. Central banks have had to find
new techniques to deal with capital flows and in some cases, with
embarrassingly large balance-of-payments surpluses. New techniques
had also to be developed, and some old techniques adapted to mini­
mize temporary pressures on, or speculative surges against, individual
currencies and to assure an adequate functioning of the international
monetary system as a whole.
After 1949, exchange-rate adjustments have been used only spar­
ingly. A much more intricate policy than in the day of the gold stand­
ard, or even in the uncertain inter-war years, evolved as most advanced
countries found it necessary to seek new ways to cope with undesirable
capital inflows, or to control outflows, by direct as well as indirect
means. In more recent years, the use of credit lines for meeting tem­
porary pressures and disequilibria—borrowing from the IMF, drawing
on the currency swap network centered in the United States, or relying
on other, mostly ad hoc, arrangements— became an important aspect
of international monetary cooperation.
Greater central bank control over the management of foreign assets
appears to have been more readily accepted by commercial banks than
control over domestic credit flows, perhaps because of the widespread
use of wartime exchange controls. Measures adopted by individual
countries have included control over commercial bank borrowing
abroad, regulation of their net positions in foreign exchange or in
individual foreign currencies, and the establishment of limits on the


volume of foreign currency claims or liabilities of banks (and, in some
cases, of nonbanks as well). Forward exchange operations (Italy),
variation of the rates at which the central bank is ready to provide
foreign exchange cover (Germany), separate reserve requirements
against foreign deposits (as already mentioned), and prohibition of
payment of interest on foreign deposits (Switzerland) also have been
used. Some central banks (like the German Bundesbank) have gone
so far as to prescribe where foreign currency (dollars) that it supplies
on favorable conditions to commercial banks and others should be
In addition to regulating the foreign-exchange positions
of domestic banks (or of the entire private sector), central banks
have increasingly used active foreign-exchange operations to support
domestic monetary controls. The scope of these activities has been
widened by the development of the swap network and by the opera­
tions of some central banks in the Euro-dollar and other Euro­
currency markets.
In recent years, with closer monetary cooperation growing out of
economic interdependence, individual banks have sometimes acted
in the interest of mutual accommodation. Indeed, central bank co­
operation— together with other forms of economic coordination
among advanced countries— has developed on an unprecedented
scale. Bilateral and multilateral consultations have become more
frequent, extensive, and in some respects also more informal than
during the inter-war period. At the same time, such cooperation and
the various institutions under whose aegis it has grown have pro­
vided frequent opportunities for analyzing and comparing the ef­
fectiveness of monetary measures taken by individual countries, be
it to cope with domestic or international problems. Consultations and
meetings sponsored by the IMF, the BIS, the OECD, the Group
of Ten, and the Monetary Committee of the European Community,
as well as less formal international contacts, spread knowledge of
new techniques and processes and frequently permit a collective
appraisal of their value and limitations. Sometimes such meetings
also produce strong pressure for the adoption of new techniques in
countries where they seem appropriate.
Developing Countries
In the newer countries, financing developmental expenditures is an
important objective of monetary policy; central banking, from its
inception in these countries, has played a leading role in the process of


economic development. Central banks of the newly independent coun­
tries of Asia and Africa typically have fostered the development of an
appropriate financial structure, encouraged savings, created new
specialized credit institutions, and developed capital markets. Similar
objectives have been pursued since World War II by the central banks
in the former dominions of the British Commonwealth. The older
central banks of Latin America, fashioned mostly in an earlier period
and initially much imbued with more traditional central bank philos­
ophy, have come to regard stimulation of savings and development of
financial structures as a main objective of central bank policy. En­
deavors to foster the development of capital and credit markets fre­
quently led to capitalizing development banks and a variety of special­
ized institutions for medium- and long-term credit in specific sectors
of the economy, such as agriculture.
The framework for central bank actions in developing countries has
typically included irresistible social and political pressures to go faster
than real resources, the institutional framework, available external
finance, and the volume of foreign-exchange reserves permitted. In
many of these countries, central banking laws have been fashioned
after examples of countries with much more advanced economies. By
and large, however, the developing countries have not been more suc­
cessful than the older countries in applying traditional tools of mone­
tary policy or in developing new tools suitable for their own problems.
Individual developing countries have used various combinations of
general, selective, and direct monetary controls. Some techniques were
patterned after the example of advanced countries; others have been
developed to deal with these countries’ specific problems (such as ad­
vance deposit schemes for imports, more recently also used by the United
Kingdom). Frequently the temptation to find shortcuts through selective
controls proved irresistible when attempting to meet sectoral problems,
to speed up the pace of development, or to cope with recurring
balance-of-payments difficulties. It is a melancholy observation that
many of these central banks had to learn from bitter experience that
no degree of sophistication in sharpening the most modern and com­
plex tools of monetary controls could overcome chronic capital short­
ages, misuse of financial resources obtained from abroad, insufficiency
of fiscal resources, political instability, and inadequacy not only of
financial but also of legal and social institutions, aggravated in many
countries by politically dictated misallocation of human, physical, and
financial resources. To be sure, some countries have quite successfully


preserved monetary equilibrium in the face of the inflationary forces
generated by development. But such an outcome was more frequently
than not achieved as a result of pressure from international organiza­
tions, such as the IMF and IBRD, and from aid-giving countries,
rather than because of the skillful and timely use, at the initiative of
the central bank, of controls available to it.







Post-World War II experience clearly shows that successful con­
duct of domestic and external monetary policy hinges not so much
on the forging of new tools as on judgment and determination. Nor
is explicit theorizing on means and processes of monetary policy a
prerequisite for success. Even where monetary policy was provided
with a fresh and original theoretical underpinning— as in The
Netherlands under Dr. Holtrop’s leadership— achieving growth with­
out inflation and applying reason and quantitative guidelines were
thwarted by explosive forces rooted in the struggle for distribution
of the social product or in uncontrollable foreign influences.
Fifteen years ago, when discussing “Central Banking Objectives,
Guides, and Measures,” Karl Bopp wrote: “We have a responsibility
to develop techniques best suited to our dynamic society.”11 In spite
of the proliferation of techniques and instruments since World War
II, his conclusion “that simple and direct methods may be effective,
and that even the most ingenious central banking techniques will not
be effective, unless they can and are permitted to influence the rate
of interest, the availability of credit, or both” still stands unchallenged.
11 The Journal of Finance, Vol. IX, No. 1, March 1954, p. 21.


W h il e G o l d H a s P l a y e d a role in monetary organization throughout
the entire history of civilization, it was not until after the discovery of
the New World that gold coinage acquired a parity with silver among
the economic elite, i.e., merchants, traders, goldsmiths, bankers, and
rulers. Even more recent was the use of gold as the basis for a money
system. Great Britain was the innovator when, in a series of actions
between 1816 and 1821, it adopted a weight of gold as its primary
monetary unit; gave existing Bank of England notes full and ready
convertibility into gold coin; and undertook to limit the supply of
nongold money in order to assure that its ready convertibility into
gold would be indefinitely maintained.
For 50 years thereafter, Great Britain stood alone in adhering to a
relatively “pure” gold money system. In the 1870’s, however, a gold
money system also was established by Germany and France. By 1900,
the system had been adopted by most countries of importance in the
trading world, including the United States. Thus, it was not until the
turn of the 20th century that an international gold-standard monetary
system was fully launched and set on course.
This point is made to emphasize that what is known as an interna­
tional gold standard is not a mechanism long imbedded in world
monetary organization, as is widely believed. The notion of the sanc­
tity of gold as an impersonal and nonfiduciary monetary standard is
largely a product of recent times.
Moreover, the era of the international gold standard proper was
short—barely 50 years. The disruptions of World War I gave it a
shattering blow from which it was never to recover. Probably its life
would have ended in a few decades in any case, for nongold money
in the form of paper currency and bank checks was gradually dis­
placing gold in domestic monetary usage. Gold was coming to serve
primarily as a reserve base— and an increasingly slender base at that.
Why did the international gold standard hold undisputed reign for
even as long as half a century? Why and how did the gold standard
work? It worked because national governments accepted three neces­

* This essay originally appeared in The Morgan Guaranty Survey (New York:
Morgan Guaranty Trust Company of New York, June 1968). It has since been
revised and is reprinted here with permission.


sary conditions. First, the unit of national money was defined as a
weight of gold, i.e., gold was given a fixed price in national money.
Second, ready convertibility of nongold national money into gold was
provided. Third, the price of gold in national money was so related
to domestic price and interest levels that there was no incentive to
convert nongold money into gold and to export it for profit.
The first condition called for a higher price of gold on world mar­
kets than would be fixed by the free play of market forces without a
monetary demand— a price that would serve as an incentive to gold
production and assure a continually growing supply of gold for mone­
tary usage. Through most of the 19th and early 20th centuries this
condition was sufficiently satisfied to keep prospectors searching for
new gold fields, and capital quickly flowed to develop new finds. As
a result, gold output was maintained well enough to permit a growth
in monetary gold stock averaging just under 3 per cent a year from
1850 to 1914— about a fifth lower than the rate of growth in real gross
national product.
Meeting the second condition of a gold-standard money system—
namely, the requirement of convertibility for nongold money— furn­
ished a basis for confidence in that money. Anyone who preferred
the commodity to nongold money— mainly paper, check money, or
silver coin— could, if he wished, convert; and gold could readily be
obtained for payment in international transactions. Furthermore, the
convertibility requirement had two further consequences. It acted to
set a limit—to be sure, a very broad limit— on the creeping creation
of nongold money for whatever purposes national governments
deemed expedient or tolerated. Equally important, it effectively re­
duced the responsibility of the monetary authorities—in most cases,
central banks— to a simple matter of providing a mechanism of con­
vertibility. An aura of non-political objectivity in governmental ad­
ministration of the monetary system was thus created. In the then
prevalent view that the sovereign should provide a good money but
not meddle with its usage or value, this consequence was both con­
genial and acceptable.
De facto debasement of the international gold standard by the
faster creation of nongold money was so gradual during that stand­
ard’s heyday as to be ignored for all practical purposes by the vast
majority of people, and, accordingly, by governments. In fact, this
faster growth of money in relation to the growth of tangible wealth
and services is what kept the variation of the price level under the
gold-standard reign within tolerable limits. And so long as interna­


tional convertability of money could be counted on as a matter of
high probability, confidence in the gold standard was maintained.
The third condition of a gold-standard monetary system—national
gold prices equated internationally with what money could buy or
earn domestically— had broad implications for world trade. It yielded
a system of stable exchange rates for the continuing interconvertibility
of national currencies and reduced money costs and risks in trade and
investment among countries. It also furnished the world with an inte­
grated price system as a guide to international output and commerce
and fostered the development of specialization in accordance with
the comparative advantages of regional resources.
During the ascendancy of the gold standard, world trade flourished;
world markets for new national products emerged; industrial produc­
tion was progressively concentrated in ever larger-units at lowered
cost; and the fruits of industrial revolution became widely distributed
over the face of the globe, and most widely over its gold-standard
This is not to say that the international gold standard was never
threatened, economically and politically. On three occasions in the
mid-19th century the Bank of England temporarily suspended the
Bank Act of 1844 (thereby producing de facto inconvertibility of its
notes), and a fourth suspension was narrowly avoided at the time of
the Baring crisis in 1890. Likewise, the dominance of gold in United
States monetary affairs was threatened severely by the populist wave
culminating in William Jennings Bryan’s grave warning that the peo­
ple were in danger of being crucified on “a cross of gold.”
But the domestic convertibility of gold and nongold money into
goods and services varied little enough in any relatively short period
that public indignation never reached a boiling point which could
bring the standard’s downfall. And always when the threats were most
grievous, the bounty of nature came to the rescue. As one gold field
became exhausted, another took its place: California, Australia, the
Yukon, Western Canada, the Transvaal Rand, and (most recently)
the Orange Free State. Gold output was enough, after satisfying in­
dustrial and hoarding demands, to sustain an increment in monetary
stocks sufficient to frustrate the severest critics of the international
gold standard.
Disruptions and devastations of World War I, together with the
creation of money by governmental fiat to finance that war and eco­
nomic reconstruction after it, spelled the doom of the international
gold standard in its pristine form. The financial world was in a state


of confusion as to what next to do. Future uncertainties and the pres­
sure of events made action both necessary and inevitable.
Modifying the Gold Standard
Monetary beliefs, like other forms of social belief, tend to rest on
a mixture of accepted tradition, experience, and myth. Hence it is not
surprising that the responsible leaders in the monetary area finally
reached a consensus after World War I favoring some kind of recon­
structed gold standard. This consensus was not reached suddenly
upon the termination of hostilities, but only in the face of widespread
monetary disorder in Europe and dependent areas. It did not find
formal expression until the International Economic Conference held
at Genoa in 1922.
What governments were then advised to do was, first, to revalue
their money realistically in terms of gold according to its current
ability to purchase goods and services domestically. But in revaluing
domestic money in terms of gold and in beginning once again to de­
mand gold for monetary purposes, countries were further advised to
reduce sharply the volume of gold coin in circulation and otherwise
to economize on the use of gold by holding foreign exchange along
with gold as monetary reserves to provide assured international con­
vertibility. Thus, a subtle and critical change in the character of the
traditional gold standard was to be introduced.
Lastly, governments were advised that their central banks— to
whom responsibility for maintaining convertibility had previously
been entrusted— might need henceforth to keep a closer eye on
domestic money creation. The point also was made that central banks
would find it desirable to cooperate actively with each other in keep­
ing domestic monetary expansion in closer harmony among countries
with a view to the overall as well as the domestic stability of money
purchasing power. This advice gave recognition to a likelihood that
the link between domestic money and monetary gold stocks might
become looser than it had been.
By about the mid-1920’s, a fixed exchange-rate system had been
largely re-established among major trading countries, under the guise
that it represented a legitimate and practicable return to an interna­
tional gold standard. Countries did make every effort, and with suc­
cess, to add to monetary reserves by reducing gold-coin circulation.
And they did experiment fairly widely with the accumulation and use
of foreign exchange— partly in sterling and partly in dollars— as a
supplement to gold in maintaining external money convertibility, thus


converting the gold standard into what came to be called a goldexchange standard.
For a time, the reconstructed gold-exchange standard seemed to
work commendably. World trade revived and grew; the output of
goods expanded everywhere—with one ironic exception: gold itself.
At the higher level of costs of exploration and costs of mining com­
pared with prewar years, gold production languished.
That the world of that period should quite suddenly have become
sucked into a maelstrom of industrial and commercial equity specula­
tion, centering in New York, and that simultaneously a visible erosion
of ethical standards and accounting practices in domestic banking
and finance in major countries should have taken place, was more
than a piece of very bad luck, for political and financial leadership
should have been more alert and responsive. But it was not, and the
world was plunged into a state of extreme distress by a catastrophic
decline in equity prices, followed by an appalling collapse of urban
and farm real-estate values and a precipitous drop in the prices of
currently produced goods and services— in short, a near universal
deflation without precedent in the history of capitalism.
The world was soon caught up in a vicious circle of money deval­
uations, including one for the United States dollar. This was followed
by monetary reorganization in major countries that completed the
banishment of gold coin from service as national money. The world’s
post-World War I gold standard—reconstructed as a gold-exchange
standard— was in full collapse. In retrospect, that such disruption was
permitted to happen seems incredible.
By the mid-1930’s, world deflation bottomed out, but at very
low levels. Thereafter national— and clearly nationalistic—recovery
policies gradually began to take hold, accompanied by a slow com­
mencement of world recovery. However, the shock of world recession,
of widespread monetary devaluations, and of rampant nationalistic
“beggar-thy-neighbor” policies was too much politically and eco­
nomically, and soon forces threatening an outbreak of international
conflict were in full control. International disorganization had gone so
far as to defy any efforts by the leadership of major powers to re­
establish world economic order. With the Far East in turmoil and with
growing threats of conflict within Europe, the United States became
the world’s haven for refugee money and for gold. By the close of
1939, United States official vaults held more than three-fifths of the
then existing monetary gold stock of the whole world.


Bretton Woods
This time wartime disruption and disorganization of production,
trade, and finance, plus accompanying disintegration of the monetary
mechanisms of many participants, was more than a repeat of World
War I and its aftermath; it was much worse. But at least while the
hostilities of World War II were going on, the best brains, monetary
and financial, on the Allied side were concerning themselves pro­
foundly and deeply with the problem of monetary reconstruction that
seemed certain to present itself immediately after the war. Readers
will recall the dramatic monetary conference held at Bretton Woods,
New Hampshire, in July 1944, which negotiated a charter—known
as the Articles of Agreement—for establishing the International
Monetary Fund.
The concept underlying the Articles of Agreement of the Inter­
national Monetary Fund represented radical innovation. For the first
time in world history, all countries accepting and ratifying the Fund
Agreement were called upon to surrender a measure of their inde­
pendent monetary authority, in short, to share their monetary sover­
eignty. This they were to do by ceding to an international body the
right to participate in determining the value of their respective national
moneys in relation to the value of money in other countries and in
relation to gold. Put more simply, all countries accepting the Fund
Agreement consented to the fixing of a value for their money in con­
sultation with the Fund, which, in turn, would have a responsibility
for protecting the interests of other participating countries.
The Fund Articles of Agreement included critical supporting pro­
visions, as well as a workable apparatus for cooperative monetary
decisionmaking among members and for sustaining the viability of
the new arrangement. Thus, each consenting country obligated itself:
first, to maintain a monetary reserve position in gold or foreign ex­
change sufficient to support its spot exchange rate vis-a-vis the money
of each other member within a range of 1 per cent of parity; second,
to advise the Fund should any change in parity become necessary for
reasons of fundamental disequilibrium in payments; and, third, not to
change its parity for corrective purposes by more than 10 per cent
without Fund concurrence.
To support the system of fixed exchange rates that was to be estab­
lished upon the advent of peace, each Fund member was to contribute
to a pool of resources, partly in gold (25 per cent) and more largely
in its own currency with gold-value guarantee (75 per cent), in ac­


cordance with an assigned quota related to its production and trade

importance in the world economy. With the Fund’s consent, this pool
could be drawn upon by individual members to cope with temporary
imbalances in foreign payments. Ordinarily, such drawings were to be
limited to 25 per cent of quota in any year and a total of 200 per cent
of quota. But these limits might be waived by the Fund in the light of
special circumstances and proper safeguards of the Fund’s interest.
Any drawing became subject to a charge graduated by the length of
time outstanding. And each drawing was to be repayable in accord­
ance with terms set by the Fund itself— presumably related to the
payments problem occasioning the drawing.
The Fund Agreement contemplated that national policies regarding
the expansion of domestic money supplies would be left to national
determination. But they were to be subject to review and criticism by
the Fund should they depart too far from requirements for sustained
maintenance of external convertibility. Finally, to achieve good stand­
ing as full-lledged Fund members, nations electing to participate were
to dismantle as rapidly as feasible all restrictions or controls on inter­
national payments that were a legacy of prewar nationalism or war­
time needs.
Beyond these arrangements for the orderly administration of world
monetary development, the Fund Agreement included one further
radical innovation in international authority. It contemplated that
Fund members as a group at different points in the future might want
to make uniform changes in the par values of their currencies— in
other words, to effect an increase or a decrease in the monetary price
of gold by international fiat. With this provision, the framers of the
Articles of Agreement presented what proved to be an almost insuper­
able roadblock to United States acceptance of membership.
A Managed Fiduciary Standard
At the time, the International Monetary Fund was thought of as a
vehicle for re-establishing a form of international gold standard, or
more accurately a form of gold-exchange standard. Such a conception,
however, did less than justice to the revolutionary character of the
accomplishment. For the new monetary arrangement was to be one
in which:
1. The full faith and credit of member nations transcended gold in
governing monetary relations between them;
2. National monetary management was “good” if it took reason­


able account of the interests of other nations, and transgressions of
“good behavior” might be subject to monetary sanctions;
3. National monetary authority was to be elevated from a bureau­
cratic role of maintaining convertibility to a policymaking role within
government establishments;
4. The interconvertibility of currencies was to be both a national
responsibility and an international task to be worked on in coopera­
tion with the Fund’s membership;
5. Conditionally available monetary reserves— drawings on the
Fund—were to be as legitimately usable in maintaining external con­
vertibility as owned reserves.
If we need to type this new international arrangement in some
shorthand way, we should probably call it a “managed fiduciary
One year after the signing of the Bretton Woods Agreement and
just a month and a half before the Japanese surrender, the United
States Congress passed the Bretton Woods Act authorizing the Presi­
dent to accept membership in the International Monetary Fund, but
with two highly important reservations. First, the act made it manda­
tory for the United States to advise the Fund that it would continue
the existing gold parity of the dollar. Second, it prohibited the Presi­
dent or any person or agency on behalf of the United States to “pro­
pose or agree to any change in the par value of the . . . dollar . . .” or
to “approve any general change in par values” under the Fund Agree­
ment “unless Congress by law” should authorize such action.
Thus, in asserting its authority over the dollar price of gold via a
general change in par values of money internationally, the United
States Congress in effect indefinitely froze the monetary price of gold.
For what change could there be if the United States could not go
along without Congressional initiative? And if Congress were to de­
bate at length the world price of gold, the whole international mone­
tary system could disintegrate from uncertainty while the debate was
going on. The world’s monetary authorities could only tremble at the
These reservations, however, were not so unacceptable as one
might have thought to United States administration officials. Appar­
ently they had concluded from the evidence at hand as to known gold
resources, advances in the technology of gold extraction, and trends in
gold-mining costs that the existing dollar price of gold of $35 an ounce
was high enough to permit postwar gold mining and output to prosper


and for ample supplies of new gold to become available for the world’s
monetary uses. And in addition, United States administration officials
had to take into account other considerations that underlay the reser­
vations of Congress.
For one thing, the 1934 devaluation of the dollar in terms of gold
had come to be looked upon by many as a breach of faith with the
domestic and foreign public, and as a serious blow to United States
international prestige— an action not to be repeated again solely on
Executive initiative and responsibility.
And a special fact making the reservations desirable to Congress
and acceptable to United States officials was that existing United
States gold reserves were much more than ample by modern stand­
ards of a sufficiency of monetary reserves. In addition, under the new
arrangement, it would be possible and profitable for other monetary
authorities to rely on dollar balances as a supplement to gold in mone­
tary reserve usage.
Finally, the view that the future evolution of the world monetary
system should be managed by the community of nations was gaining
acceptance. Hence, should gold and dollar supplies prove inadequate
for world reserve needs, the new institution— the International Mone­
tary Fund—would provide a mechanism through which cooperative
international effort might find a practicable remedy.
Whatever the real truth may have been about the United States
reservations to the Bretton Woods charter for an International Mone­
tary Fund, they were not so vital as to prevent the Fund’s establish­
m ent By late 1945, in fact, enough nations had accepted the Agree­
ment’s main provisions to make possible the Fund’s establishment.
A decade later, it had achieved a membership of 67 nations, including
the principal industrial nations of the free world. Switzerland declined
membership, preferring the role of neutral in economic as well as
political matters. By the late 1960’s, Fund membership totaled 113
nations in actual number. Of these, 34 were recognized as having
attained full interconvertibility of their national money with other
currencies at agreed parities.
Problems lor the New Standard
What was to be the outcome of this new monetary arrangement?
Could it and would it be sustainable and durable? Would it realize the
vision of its conceivers? And what would be its effects on gold?
Actually, the new monetary arrangements met with remarkable
success, and Fund members twice (in 1959 and 1966) joined in en­


larging the Fund’s resources appreciably. But its functioning was, for
an extended period, greatly aided by the largesse of the American
people in allowing their Government to extend huge amounts of post­
war aid, economic and military, first to governments in areas devas­
tated and disrupted by war and later to developing and less-developed
Within a decade following World War II the “miracle” of European
and Far Eastern recovery was there for the world to see. Production
and trade flourished as never before; economic growth generally
achieved unprecedented rates; and a new era of human enlightenment
and welfare seemed to have opened up. If the new monetary system
was not the cause of this almost unbelievable development, it palpably
served to facilitate it.
Why then, by the closing years of the 1960’s, was the free world
faced with a fresh breakdown of its monetary arrangements?
Obviously, the causes of the new threats were complex— political
as well as economic and financial. A critical legacy of World War II
was an unsteady balance of world political and military power, with a
continuing chill of Cold War. And a succession of localized conflicts
at the margin of the power balance gave danger of spreading into
wider conflict. In such an atmosphere, a pervasive undercurrent of
inquietude could hardly help finding expression in widespread public
unease—even distrust of ultimate power balance.
Economically, the recovery in Europe and the Far East had con­
siderably altered the free world’s economic power base. In the case of
Europe, however, further strides in economic power had come to
hinge heavily on further strides towards economic integration, and
these further strides seemed temporarily blocked by insurmountable
political obstacles. As for the Far East, its economic base of power
rested too heavily on United States power and, further, continued to
show vibrant strength partly in consequence of United States procure­
ment there on behalf of the Vietnamese war. Naturally, observers
hoping for steady progress toward a better or firmer distribution of
world economic power viewed the overall situation with misgivings
which were contagious.
Financially, the free world’s monetary-reserve growth had taken
too largely the form of dollar and sterling balances and too little the
form of gold, at least in the sight of private financial communities.
Moreover, when reserve growth took the form of gold, it was too
largely drawn from the monetary-reserve stocks of the two countries
whose money had been earlier regarded as satisfactory foreign ex­


change for the monetary reserves of other countries. And when the
growth of monetary reserves took the form of foreign-exchange bal­
ances in dollars or sterling, the dollars or sterling largely constituted
payments deficits of the parent countries.
At long last, the monetary authorities of major European countries
reached a consensus that the quantity of dollars and sterling in the
world’s monetary-reserve base had attained, if not exceeded, a desir­
able ceiling, and that the United States and the United Kingdom
should take decisive steps to correct their excessive internationalpayments deficits. These views were formally communicated to the
representatives of these two countries through the facilities of various
agencies of international economic cooperation, including the Inter­
national Monetary Fund. In due course, the substance of the confi­
dential discussions among officials inevitably became known to the
private financial communities and subsequently to the world public.
In this moment of embarrassment, Soviet Russia saw fit to discon­
tinue sales of gold on world markets. Concurrently, growing public
concern found expression in a spreading purchase of gold coin, frac­
tional gold bars, gold wafers, and gold leaf. And those who could
afford it began to acquire standard gold bars, while the more specula­
tive saw in the gold market an opportunity seldom presented— a one­
sided speculation, at some cost to be sure, but with no risk of sub­
stantial loss. Before long, private demands far exceeded new gold
supplies available for purchase. A worldwide run on gold was in the
What was happening in the meantime to the world’s output of and
demand for gold? In the years just preceding World War II, gold
output had spurted, reflecting in part the increase in its real value
during world deflation and in part the stimulus of the 1934 increase in
its dollar price from $20.67 to $35.00 an ounce. For a decade after
World War II gold output was well below immediate prewar levels.
By the late 1950’s, however, it had regained these levels and then
exceeded them. At about this stage, Soviet Russia began to release to
the market part of its rising gold production.
All told, from 1950 through the early months of 1968, some $23.8
billion in additional gold became available from output and from
Russian sales. Of this large sum, industrial uses, objects of adornment,
and the arts took only an estimated $5 billion and net additions to
official monetary gold stocks roughly an equal sum. Thus the amount
going into private hoards and speculative holdings aggregated some­
thing like $13.8 billion, of which as much as $3 billion apparently


vanished into private holdings during 1967 and the early months of
Clearly, if this amount of hoarded gold had been available for
monetary-reserve uses, along with the amount actually added to
monetary-gold stocks, the world’s monetary system would have had
quite enough, perhaps more than enough, to “make peace with gold.”
The aggregate of new gold for monetary-reserve uses, however, was
not that abundant, and there is little point now in deploring that fact.
Response to Disturbances
But it would have been deplorable if the world’s monetary author­
ities had not become sharply aware of developing threats to its mone­
tary arrangements. Actually, every government received due warning
at the turn of the 1960’s by four events. One, occurring just before
President Kennedy’s election, was a sudden surge of demand for gold
on the London gold market which raised its price there from $35.20
(its normal limit) to $40.00 an ounce. Only the joint efforts of United
States and United Kingdom monetary authorities brought this splurge
under control. But the traumatic impact on the newly elected Presi­
dent Kennedy was such that, shortly after his inauguration, he pledged
the entire United States gold stock to defense of the dollar.
The second event was the 5 per cent upward revaluation in terms
of gold of the German mark and the Dutch guilder in the early spring
of 1961 to correct their presumed undervaluation vis-a-vis sterling and
the dollar.
The third event was a heavy run against sterling in the spring of
1961, which gave rise to a sizable package of emergency credits from
European central banks and the United States authorities to help the
Bank of England until it could arrange an International Monetary
Fund drawing adequate to defend sterling.
The fourth was not strictly an event but the succession of three
large and alarming deficits in United States international payments.
Their occurrence prompted the International Monetary Fund, under
United States urging, to negotiate an agreement with its ten leading
members (the so-called Group of Ten countries) establishing special
borrowing facilities that would complement the regular facilities that
then existed. Under the agreement—formally known as the General
Arrangements to Borrow—participants committed themselves to pro­
vide enough of their respective currencies, upon due consultation, to
finance concurrently, if necessary, maximum permissible drawings
from the Fund by two or three larger member countries.


With these portentous warnings of rough international financial
waters ahead, three further developments of major import took place.
The monetary authorities of the United States and the United King­
dom, together with those of six other major trading nations, organized
a pool to support the London gold price within the market’s parity
with the United States Treasury’s gold price.
Next, the United States Federal Reserve System launched a pro­
gram of foreign-currency operations for the defense of the external
convertibility of the dollar. And to facilitate the execution of any such
operations, it established a network of standby credit (currency-swap)
arrangements with the principal central banks abroad.
Lastly, the ministers of finance of the principal trading nations that
were members of the International Monetary Fund plus Switzerland
joined in authorizing their deputies to engage in a study of the world’s
future needs for monetary reserves and of ways to assure their steady
growth. Significantly, the finance ministers instructed their deputies
to proceed with the study on the premise that a world price of gold
of $35 an ounce would be indefinitely adhered to.
Of these three developments, the first, the gold-pool arrangement,
was brought to an end by the “gold rush” of 1967 and early 1968.
The second, the central-bank reciprocal credit network, continues to
prove useful and has indeed expanded from a modest beginning in
1962 of $700 million of potential temporary credits between partici­
pating central banks (including the Bank for International Settle­
ments) and the Federal Reserve System to today’s impressive total
of nearly $10.5 billion. This expanded sum bears testimony to the
concern among monetary authorities that resources in ample supply
be promptly available to cushion large temporary flows of funds inter­
nationally and thus to help assure the maintenance of orderly exchange-market conditions. The third development— the product of
four years of arduous international study, debate, and negotiation—was a concrete proposal for the creation of a new international asset
to supplement gold in meeting the world’s future needs for growth in
national monetary reserves.
A New Kind of Reserve Asset
Of these three revolutionary developments, the third is the most
far-reaching in its implications for future world prosperity and opti­
mum freedom for international trade and payments. In September
1967, a plan for a new reserve asset was put before the annual meet­
ing of the Board of Governors of the International Monetary Fund.


That body approved the plan and instructed the Fund’s Executive
Directors to reformulate it as an amendment to the Fund’s Articles
of Agreement. Completion of this technical task required more than
a year, and thereafter a number of months had to elapse before mem­
ber governments could process the proposed amendment and trans­
mit to the Fund their formal acceptance. By midsummer 1969, an
amended Fund Agreement was an accomplished fact. At the annual
meeting of the Fund’s Board of Governors in Washington in Septem­
ber 1969, that Board took the further historic step of approving acti­
vation of the new plan on January 1, 1970, a step described by the
Fund’s Managing Director, Pierre-Paul Schweitzer, as “. . . a mo­
mentous innovation, a landmark in international monetary coopera­
The amended Fund Agreement provides for the annual issuance to
participating member countries over stated periods of a quantum of
Special Drawing Rights. Normally, the duration of such periods is
five years, but the Fund, with reason, may modify the “normal”
duration. Any Fund member is eligible to participate in an allocation
of Special Drawing Rights provided it has formally accepted explicit
obligations to a Special Drawing Account of the Fund, established to
administer the Rights. Even if it has accepted these obligations, a
participant country may decide not to share in an approved allocation
of Special Drawing Rights.
The Special Drawing Rights are exchangeable on demand into
equivalent value of any currency held or issued by other participating
countries. Also, they are fully usable in transactions with the Fund to
repurchase excess Fund holdings of a country’s currency or in meeting
assessments and charges of the Special Drawing Account.
Decisionmaking as to a creation of Special Drawing Rights is by
elaborate formal process. It begins with informal consultation of the
Fund Managing Director with participant members; is followed by his
recommendation for Rights creation to the Fund Board of Governors,
with justification in terms of world needs for supplementary monetary
reserves; and concludes in formal action on his recommendation by
that body. Protection against excessive Rights creation rests in the
requirement of approval by 85 per cent of the Fund’s voting power.
Once created, unless or until extinguished by Fund decision, the Spe­
cial Drawing Rights will have a continuing life of their own apart from
the ordinary drawing rights Fund member countries have available
by virtue of membership.
Upon authorization for creation, annual allocation among partici-


paring countries accords with each country’s Fund quota. Members
are free to use their Special Drawing Rights without condition as to
their own monetary and fiscal policies. Expected uses, however, are
to meet a country’s balance-of-payments needs or to cushion adverse
changes in a country’s monetary-reserve position (though not for the
sole purpose of altering the composition of its reserves). A further
legitimate use of Special Drawing Rights is to help another country
cope with its balance-of-payments or monetary-reserve problems.
A transfer between participants of Special Drawing Rights can only
be effected through the Fund’s facilities. Fundamentally, their value
in use rests on the obligation of every participant to accept them in
these uses, when properly transferred through the Fund, subject only
to the qualification that no member is required to hold Special Draw­
ing Rights in excess of 300 per cent of its cumulative allocation. In
addition, each Special Drawing Right unit has the same gold value as
the dollar, a feature consistent with existing arrangements under the
Fund Agreement and providing technical or legalistic support to ac­
ceptability in use.
Each participant country is obligated by Fund Agreement to main­
tain holdings of Special Drawing Rights equal on the average to at
least 30 per cent of its cumulative allocation. That is to say, if its uses
of Special Drawing Rights cause its holdings to fall below a moving
average of 30 per cent, it is obligated, within a specified period, to
reconstitute them to equal that average. Reliance on transfer of own­
ership through Fund facilities has in part the purpose of assuring all
participants that a minimum average holding will be adhered to by
each participant and that, as a group, member monetary systems will
sustain a reasonable balance between holdings of Special Drawing
These features of the recently adopted plan for a new reserve asset
plainly represent a sensible compound of contemporary financial wis­
dom. Furthermore, prompt decision to activate the plan beginning in
1970, with a $9.5 billion issuance and allocation of Special Drawing
Rights over the three years 1970-1972, expresses tangibly the confi­
dence of world monetary leaders in that wisdom. While press head­
lines greeted the action as a “vote for ‘paper gold’,” this label failed
to convey the true importance of the innovation. For the first time in
civilization’s history, the world is incorporating an international fidu­
ciary money unit into its exchange mechanism— in other words, a
money unit backed by the full faith and credit of all the national gov­
ernments that voluntarily join together in its creation.


Termination of the Gold Pool
Let us next shift our focus to the dissolution over a mid-March
weekend of 1968 of the international gold pool and the decision made
on that occasion to allow the market price of gold to fend for itself,
while continuing to have gold transactions among central banks them­
selves at the official price of $35 an ounce.
This decision by the central bankers of the seven major trading
nations then participating in the gold pool was in effect one made
“looking down the barrel of a shotgun.” It had to be taken for the allimportant reason that the world public’s gold buying fever had to be
allayed. And as the principal monetary officials of leading govern­
ments—charged with carrying out a public trust to keep solid the
interconvertibility of their respective money units— these central
bankers simply had to buy time for deliberation and decision as to
further steps.
Was it, however, just a case of buying time? The gold panic had
been months in forming. The participating central bankers must surely
have discussed among themselves the possibility of an ultimate con­
tingency and considered strategy alternatives for dealing with it. But
one can only speculate about what transpired before the action and
about its implications for the future.
As for the two-tier scheme for the price of gold— a market price
independent of an official price— one might surmise that the central
bankers concerned went through a planning process somewhat as fol­
lows. With the help of their experts, they individually looked at the
long-term record of new-gold availability, at the best private and
governmental estimates of gold-taking for industrial purposes, and at
the record of annual increments in the world’s monetary gold stock.
Simple subtraction of the latter two sources of gold absorption from
gold availability would have provided them a reasonable record of
private gold-taking for hoarding, temporary investment, and specula­
tion. If the central bankers had then weighed the private takings of
gold in the past 18 months, they could have arrived at the inference
that world gold markets faced a large overhang of gold in private
hands which might, in the face of gold-price uncertainty, become ac­
tual market supply. From this conclusion, it would follow that the
risk was minimal that the “free market price” for gold would soar to
the skies, while the chance that the price would settle at a level close
to or even somewhat below the official price was good.
But the action taken by these important central bankers on that
fateful mid-March weekend seemed to go much further than mere


technical consideration of what might happen to the market price of
gold. In their published communique, they stated: “The Governors
believe that henceforth officially-held gold should be used only to effect
transfers among monetary authorities and, therefore, they decided no
longer to supply gold to the London gold market or any other gold
market. Moreover, as the existing stock of monetary gold is sufficient
in view of the prospective establishment of the facility for Special
Drawing Rights, they no longer feel it necessary to buy gold from the
market. Finally, they agreed that henceforth they will not sell gold to
monetary authorities to replace gold sold in private markets.”
Such a communique wording suggested decision of far-reaching
portent. It implied that monetary demand for gold might be perma­
nently withdrawn from the market. It further intimated a potential
severance of national monetary systems from any further dependence
on an ever-expanding supply of new gold. And it also hinted that the
central bankers present might be willing to accept the new interna­
tional money unit as a displacement of future available gold in monetary-reserve usage. These interpretations may be stretching the intent
of the communique, but, if legitimate, dethronement of gold as a
monetary reserve asset was possibly a realized fact.
Political Leavening
Central bankers are experts in the techniques of money manage­
ment but not necessarily in politics. When, a fortnight after their
action, they accompanied their ministers of finance to the Group of
Ten meeting in Stockholm to discuss the proposed amendment to the
Fund’s Articles of Agreement that would authorize the creation of
Special Drawing Rights literally by the stroke of a pen, they found
their superiors in a mood to compromise with political realities. While
the ministers were prepared “. . . to cooperate in the maintenance of
exchange arrangements of the world based on the present official price
of gold . . . they considered only that the Special Drawing Rights
would “. . . make a very substantial contribution to strengthening the
monetary system . . . ,” but “. . . not provide a solution to all inter­
national monetary problems . . . . ”
Thus we are led to the judgment that “making peace with gold”
remains an objective for the future. If so, the private financial com­
munity as well as the managers of national monetary systems must
determine whether they are prepared to live indefinitely with a twotier pricing of gold. And if they are not so prepared, they must decide
upon an arrangement that will reconcile prevailing psychology about


gold with practical necessities in a setting in which the community of
nations may no longer be willing to leave the expansion of its com­
bined monetary reserves to the vagaries either of gold production or
of the public’s caprice in hoarding gold. In addition to this adjustment,
the two giants of international finance must prove that they can at
least approach an equilibrium in their international payment flows, if
not a firmly lasting balance. Perhaps, if each of these important steps
can be accomplished, the way to “peace with gold” will simply be one
of leaving gold alone— some of it to repose comfortably in private
vaults and mattresses.
And, we may further infer that, as long as the community of na­
tions has it within its power to supplement new-gold availability for
monetary uses by creating, when needed, a supplementary reserve
asset voluntarily acceptable in settlement of world commerce, the in­
ternational monetary system can get along with present gold holdings
and with whatever additional gold authorities choose to acquire. Per­
haps a logical next step in extending the temporary truce with gold
would be a pooling of the free world’s monetary gold stock in an
international agency. But probably for our time, it would be unduly
optimistic to expect the modern state’s reliance on gold as a symbol
of independent sovereignty entirely to “wither away.”
In closing, one may conclude that the thinking of leading monetary
authorities has now reached a stage where the trappings of the gold
standard are largely irrelevant. From such a standpoint, the sooner
the international monetary mechanism is rid of the remaining vestiges
of the traditional ties with gold the better.
At the same time, the world’s statesmen in the monetary area—
that is, its finance ministers— know that the myths surrounding gold
remain a political reality with which they must deal. Persistence of
lip service to a gold standard and retention of its symbols have merit
to them for it provides continuity with society’s past. Indeed, with the
world yet to establish firmly a monetary system rooted in the full faith
and credit of the community of nations acting jointly, the ministers
would appear to find unconvincing an argument that respectful defer­
ence to the symbolism of gold as a monetary heritage is harmful.
It can be agreed that democracies today are trying, perhaps in a
cumbersome way, to recognize their ever-closer monetary interde­
pendence through a variety of procedures, intergovernmental arrange­
ments, and ingenious institutional innovations such as the International
Monetary Fund. The urgent incentive to these innovations has grown
out of the long struggle to accommodate the use of a commodity— as


unreliable in monetary supply as gold— as the base for an interna­
tional monetary system in an ever-shrinking planet. As a matter of
survival, world economic society is having to conclude: “If we can’t
make do with it, we’ll have to learn to make do with as little reliance
on it as we can.”
As far as the general public is concerned, most of this struggle has
had a very low visibility as compared with more obvious diplomatic
and political activity; it is too complex, and too remote from everyday
concerns. In this respect, it resembles international cooperation in
scientific fields. Compared with these scientific fields, however, the
area of money and finance is closer to politics and diplomacy, even if
its visibility is low. Because of this, and because the social utility of
money is so palpably relevant to human progress, cooperation in the
monetary field is of immense and urgent importance.
The monetary authorities have been trying to “make their peace
with gold” by persistently challenging its indispensability— and as time
has passed, with mounting success. Eventually— perhaps none now
living will see it— the world’s statesmen will be found following in
their wake.



When Karl B opp was giving me some of my early instruction in central
banking, he once stunned me with this thought: no policymaker ever
has enough theoretical analysis available for the job he is doing; look
out for the one who thinks he has. Now, some twenty-odd years later,
as a testimonial to the persisting validity of that thought, I venture to
suggest that much of the conventional analysis of imbalances in pay­
ments flows among nations rests on a distressingly incomplete theoret­
ical base. While neither I nor anyone else to my knowledge can offer
a more inclusive and satisfactory theory of balance-of-payments ad­
justment, there may be some gain in floodlighting the gaps.
My own conviction is that the classical conception of the causes of
imbalance in a nation’s external accounts— on which so many assured
prescriptions have been written—presumes an unrealistically simple
structure of the determinants of international payments. Although
discreetly avoiding explicit articulation of their premises, the tradi­
tionalists (including many in that fraternity of international bankers
to which I belong) imply that the bulk of international transactions
consists of trade in goods, and that such trade in turn represents a
sizable proportion of each country’s domestic product. That is why
they can urge with assured conviction repetitively similar designs for
the balance-of-payments programs of any countries, large or small,
developed or developing, regimented or free. In essence, the formula
has been: when in deficit, deflate until equilibrium is reached; for
countries in surplus, do nothing. Appropriate action by the deficit
countries, it has been thought, will in time restore a more nearly even
balance in the accounts of the surplus countries as well. My concern
is not that this formula is altogther wrong, indeed much that it implied
may still be relevant, but for the decade of the 70’s and beyond, I
fear, it is woefully incomplete.
The more significant missing elements in this simple structure are,
of course, capital flows, debt servicing, and governmental transfers.
They have not been ignored in the customary balance-of-payments


diagnosis, but they have generally been pushed aside as residuals,
fitting into whatever place the trade accounts would allow. And quite
consistently, many countries have long maintained controls over their
capital accounts to assure that they would be accommodated to the
flows of trade. Indeed, the Articles of the International Monetary
Fund were designed in 1944 to recognize this position. The converti­
bility to be sought for currencies was only for current-account trans­
actions (Article V III), and paralleling this objective the IMF was to
encourage unrestricted freedom for the movement of goods in interna­
tional trade (as it has done through the General Agreement on Tariffs
and Trade). Restrictions on capital movements were condoned as
long as they did not become direct impediments to trade.
Under the Bretton Woods system after 1944, it was only the United
States, the country whose currency was treated interchangeably with
gold as an international unit of account, which undertook an implied
obligation to avoid capital controls. Even that role for the United
States was, at the beginning, self-imposed; it did not represent an
agreed requisite for the functioning of the new system. Yet by the end
of the decade of the 50’s there was also a spreading belief among the
newly convertible (Article V III) countries that freedom for capital
movements was also an appropriate objective for other countries,
particularly larger ones, whenever they reached a suitable stage of
economic maturity. Their balance-of-payments programs, it was fre­
quently suggested, should be judged not only by their effect on trade
but also by the impetus such programs gave toward greater freedom
for inbound and outbound capital flows. This change of attitude was a
by-product of the exhilaration accompanying the achievement of
Article VIII convertibility by most leading countries in 1959. But
underneath, the old premise was unchanged; for the unstated assump­
tion still was that only trade really mattered. The emphasis was on
free trade, to be sure, but the criterion of balance-of-payments policy
was still to promote trade surpluses. Once successful in that, countries
would then find, it was suggested, that they could also allow capital
to flow freely.
This was a doctrine for the more developed countries, and perhaps
only for some of the larger among them, but the less developed were
not to be left out. With strong trade surpluses and freedom for capital
outflow in several of the developed countries, private investment and
Government aid could provide for the excess of imports that less
advanced countries would need for their development.
The misfortune is that this simple, indeed elegantly symmetrical,


system— which has been the conceptual basis for so many resolute
proposals— has not existed in even the crudest approximation since
the early postwar years when the United States stood alone on the
one side as a net capital exporter and the rest of the world was on
the other. Through the decade of the 60’s, as some of the more devel­
oped countries edged closer, at least in potentiality, to the older pat­
tern (though not the dimensions) of the United States, the United States
in turn seemed to be edging into a new pattern as well.1 Net transfers
of capital from the industrialized countries to less developed countries,
while rising modestly in absolute amounts, actually declined as a pro­
portion of the capital formation occurring either in the developed
countries or in the developing countries.
Despite these underlying changes, the prescriptions for national
action, whenever one country or another slipped out of economic
viability with the rest of the world, were still for the most part the
same. Moreover, because of the continuing heavy emphasis on goods
in trade as the primary moving force in balance-of-payments adjust­
ment, a disconcerting tendency to resort to direct limitations on im­
ports or to unusual subsidies for exports— albeit with protestations of
temporary expediency— began to appear alongside the classical em­
phasis on deflation by the deficit countries. Meanwhile, there was
almost universal dismay when the United States began gingerly placing
limitations on the free outflow of capital, even though it did make
suitable obeisance to the “temporary” nature of its succession of new
Having participated in the early phases of the United States’ fall
from grace, and having anguished over each new step with diligent
concern for the need to return promptly to the conditions of freedom
for flows of goods and capital, 1 am beginning now to wonder whether
I fully grasped the significance of what we were doing, at the time,
and of the causes for the action we were initiating. Indeed I wonder
now whether anyone’s understanding of the complex of forces at work
is yet sufficient to warrant the kind of assurance many of us have as
to the proper pattern of policy to be pursued and of the objectives
toward which we should return. Most of my questions seem to come
1 Cf. my article “The American Share in the Stream of International Pay­
ments,” The Annals, July, 1969, p. 21: “The United States position in the world
economy has been changing fundamentally over recent years. The traditional
large surplus accumulated through foreign trade disappeared in 1968. Gross
capital inflows became as large as the proceeds of exports in that year. And the
dollar declined in use as a reserve currency among central banks while its use
expanded in private transactions outside the United States.”


back to a central theme: that capital movements— including both
short and long maturities, and direct investment as well as portfolio
purchases and sales— may no longer be considered mere resid­
uals of the trade accounts, but instead may often have an independent
propelling force of their own. Debt servicing and Government ex­
penditures abroad are in a way subsets of this generalization concern­
ing capital movements, but they also have become independent rather
than dependent variables.
Along with this apparent change have come other critical changes
in the admissible scope for variation in the domestic economic policies
of nations. Neither recession, nor unemployment, nor price declines
can be permitted on any substantial scale. The result is that variations
in economic policy to achieve domestic stability and external viability,
country by country, can for the most part effect only differences in the
pace of advance in economic activity, or in its composition, not a
substantial or sustained decline. Thus the range for deliberate in­
fluences upon the outflow or inflow of resources through generalized
policies working in a deflationary direction to spur exports and check
imports, must necessarily be much narrower than was implied by
conventional theories of balance-of-payments adjustment.
The outcome then, it seems to me, can be summed up in this di­
lemma: at the same time that capital movements (and their subsets)
are becoming more nearly independently determined, and thus cannot
be regarded as passive offsets to the major swings occurring in a
nation’s trade position, the traditional methods for adjusting the trade
accounts themselves are becoming weaker and more circumscribed.
The traditional conception of balance-of-payments equilibrium, and
of the path toward restoring it, once a country has moved into deficit
or surplus, has come apart. Is it little wonder then, in the face of such
momentous change in the entire structure of international flows, that
the international payments system which serves such flows should
itself have been going through a series of convulsions during most of
the decade of the 60’s?
Without pretending to have a theory for knitting all of these dis­
parate pieces together, I can perhaps help in clearing the way for
others, who may attempt that task, by identifying a number of the
problems which seem to me to have been created. And for those not
content to wait for the theory, perhaps I can suggest a few of the
approaches that may, after further critical analysis by others, prove
helpful in meeting some of these problems or in modifying some of
their more disturbing effects* The following pages will, then, be


divided between “New Problems” and “New Approaches.” And I
hasten to interject that, of course, nothing is ever totally “new,” and
that my intention is to stress new emphasis rather than a new in­
The new problems which arise outside the boundaries of the old
theory all have their roots in major institutional changes that have
occurred since World War II. They can best be catalogued as changes
related to long-term capital flows, to short-term flows, to Govern­
mental transfers, and to debt servicing. Running across these four
kinds of changes, two other ways of singling out the principal prob­
lems may also be helpful: the changing function and behavior of in­
terest rates as a part of the adjustment process, and the still changing
but special position of the United States.
Long-Term Capital Flows
The remarkable increase in capital requirements and capital forma­
tion over the two decades from 1947 to 1967 has not only produced
a virtual mutation in the scale of worldwide economic activity, it has
also generated flows of long-term capital among nations on an un­
precedented scale. Direct investment through the multinational corpo­
ration, and portfolio investment across frontiers through a host of new
instruments— debentures, convertibles, and equities, denominated in
Euro-dollars, or units of account, or other Euro-currencies—have,
both in multiplicity of directions and in total size, completely dwarfed
anything experienced before World War II. As capital has sought
every open doorway to free movement, the possibility for a neat and
natural balancing of any country’s capital outflows with its own trad­
ing position has become more and more remote.
In earlier times, when the typical pattern was for long-term capital
to flow from the more developed countries to countries in a dependent
or colonial status, there was, in the nature of the relationship, a builtin link between the flows of capital and of goods and services. In
turn, the receiving countries, whether these were the United States in
the early 19th century or Brazil or India later on, paid a return to the
long-term outside investor which could be largely reinvested in the
host country. Consequently, the chances were rather slight that a
serious divergence would develop for the capital-exporting countries
between the flow of goods across their frontiers and the actual export
of long-term capital.


In the world of the latter half of the 20th century, however, auton­
omously generated outflows of longer-term capital are becoming a
larger and larger element in the balance of payments of many of the
developed countries. Moreover, the volume of this capital flowing to
other developed countries is at least as large as that flowing to the
less developed countries. It thus becomes almost inevitable that this
segment of the balance-of-payments accounts will no longer passively
adapt itself to a dominating pattern imposed by the flow of goods in
Short-Term Capital Flows
As current-account transactions were being freed and payments on
current account were becoming fully convertible during the later
1950’s, a parallel development was introducing a comparable degree
of internationalization in the flows of short-term capital among na­
tions. To be sure, most countries, including many of the most fully
developed in Europe, still maintained relatively tight control over
identifiable long-term capital movements as a buttress for their effort
to restore current-account convertibility. But the mere necessity to
assure ready short-term financing for a growing volume of currentaccount transactions, dispersed among a larger variety of trading
countries, created an urgent demand for the use of a single currency
as an international transactions vehicle. The dollar met much of that
demand. As this need expanded during the 60’s it was, in the best
spirit of energetic enterprise, paralleled by a rapid spreading of
branches of American banks overseas.
Under competitive influences, not only the branches of American
banks but also the offices of most of the leading banks in other coun­
tries began to accept and service dollar-denominated deposits, regard­
less of where the branch or bank might be domiciled. And almost as
if fatalistically determined, the Federal Reserve’s Regulation Q, by
placing a relatively low ceiling on the rates of interest payable on time
deposits in the United States, encouraged American banks to develop
their dollar-denominated deposit business abroad. At the same time,
these American branches were being called upon increasingly to
finance the working capital requirements of overseas corporations,
particularly the multinational corporations headquartered in the
United States which wanted to rely upon the banking techniques with
which they were familiar.
Out of all this emerged the Euro-dollar market— a market which by
1969 could be variously estimated at $25 billion to $35 billion in


magnitude, depending upon the extent to which any statistician felt
able to remove certain elements of double counting from sequences of
deposits pyramided upon a single underlying account. The resulting
market was highly sensitive to marginal shifts in demand or supply
and was truly international in character, though buffeted at times by
those whims of the foreign exchange markets that might create doubts
concerning the established parity of a weaker currency, or create
hopes concerning the prospects for possible revaluation of a stronger
In this setting, reliance on traditional methods for promoting bal­
ance-of-payments adjustment became almost inevitably self-defeating.
When Germany, for example, with a strong economy, relatively stable
prices, and a somewhat undervalued exchange rate, began to fear
internal inflation, the indicated response was to tighten modestly on
credit availability. Yet in the presence of a large and volatile Euro­
dollar market, the initial effect of an increase in German interest
rates was to draw additional funds into Germany, enlarging the credit
base and providing an additional problem for monetary authorities
aiming to assure some degree of overall restraint. In time, of course,
this situation degenerated further. Interest rates were raised; in the
absence of other adequate control limitations, additional funds flowed
in; and expectations became greater that Germany would find it
necessary, in order to maintain the desired degree of domestic price
stability, to adjust the parity of the Deutsche mark upward.
In different circumstances, the United Kingdom had to undergo in
quite another way the effects of the contradictory influences of trade
flows and short-term capital movements. While much of the explana­
tion for persistent British deficits, as I have argued elsewhere,2 was
attributable to the maintenance of enormous Governmental expendi­
tures overseas as an inheritance of the obligations of pre-World War
II empire, the simple position as seen on traditional lines was that of
insufficient exports in relation to the rising volume of imports. For
this situation, the prescription should have been, as in fact intermit­
tently it proved to be, that of severe domestic restraint in order to
limit price increases at home, check the rise of incomes, release home
production for export, and reduce import demand.
What happened instead was that from time to time, as domestic
interest rates rose higher and higher in the United Kingdom under the
2 “Where is Britain Heading?” Foreign Affairs, April, 1968, especially pp.


pressures of internal credit restraint, funds were attracted temporarily
from abroad. Their arrival seemed both to lessen the pinch of restraint
at home and to improve the British reserves, with the result of tem­
porarily lulling British opinion until additional reserve losses on trade
and Government account revived doubts again. And then, as fears of
exchange-rate devaluation became predominant, the same short-term
funds, and more, found ways— despite the continuance of exchange
controls and a very high premium for transfers into securities pur­
chases abroad— to flow out again, thereby making the later position
of the British balance of payments even worse on an overall basis.
To be sure, throughout this period there was also essential validity in
the implications of the conventional view that Britain should readjust
by restraining. But because this had to occur in an environment char­
acterized by large flows of volatile short-term funds, even the appro­
priate implementation of a traditional action program was disrupted.
Government Flows
The world before World War II had seen, of course, large and
varied overseas commitments by many of the governments of leading
countries, but there was no precedent for the scale of international
aid—both military and economic—undertaken by the United States
(and in time by several other countries) in the post-World War II
period. Through most of the decade of the 50’s, as the bulk of these
international transfers on Government account were either effected by
the United States, or cleared without substantial balance-of-payments
distortions by means of the European Payments Union, there was no
challenge to the traditional concept of balance-of-payments adjust­
ment. But by the end of the 1950’s both the United States and the
United Kingdom— which had by then become the leading deficit
countries and remained so throughout the 1960’s— were sending
abroad through economic and military aid, and through expenditures
in support of their troops overseas, amounts which annually far ex­
ceeded the size of their own balance-of-payments deficits. And there
were good reasons, defensible in terms of world order and security,
for maintaining such overseas expenditures.
One early reaction, as the deficits themselves continued, was to
attempt to “tie” more and more of these overseas disbursements to
direct shipments of goods by the donor country. The record of that
tying, and of the many ways through which its intention was frustrated
while its spirit was criticized, has been too often reported to need


repetition here.3 The record of various “offset” agreements to cover
in part the balance-of-payments costs of British and American troops
stationed in Western Germany is probably equally well-known. More­
over, in the face of persisting deficits, there was an intuitive validity
in the arguments advanced for forcing the amount of these overseas
aid and military commitments to conform to whatever magnitudes
could be permitted by the principal elements, in combination, of a
donor country’s balance of payments. Without arguing over the prin­
ciples, or the costs, however, the mere citing of this record is enough
to emphasize the nature of the new dilemma. All leading countries
must, almost regardless of the current status of the other elements
of their balance of payments, if they are not to abdicate the responsi­
bility of leadership, undertake some commitments to assist the eco­
nomic advance, even if not the military defense, of many of the less
developed areas of the world And those commitments, however they
may be trimmed from time to time to reflect long-run changes in a
donor country’s basic economic position, will have to be determined
at least in part from year to year by independent considerations. By
their nature, and because of their critical importance for other prime
objectives, they cannot be left to vary purely as balancing residuals
of the trade accounts of leading countries.
Debt Servicing
While the leading countries have, both directly and through various
multilateral agencies, been extending Government assistance to many
of the developing countries, and while the great multinational corpo­
rations have been adding impressively to their own direct investments
in these countries, the recipient countries have been encountering new
problems of their own. The magnitude of their requirements for out­
side resources, as they have attempted to telescope into decades a
scale of progress that had earlier required centuries, has involved
imports of capital on a tremendous scale. Not only has much of this
capital come on terms requiring regular amortization after an initial
period, but much of it has also carried sizable rates of interest.
As a result, by the later 1960’s, the annual requirements for ex­
ternal debt service in most of the less developed countries were about
as large as the total volume of new capital arriving. Indeed, because
of the debt-servicing obligation, many of the less developed countries
3 Compare the conclusions in the report of the Pearson Commission, Part­
ners in Development (Praeger, New York, 1969), pp. 172-177.


were able only to earn with their enlarged capital base enough to pay
the interest and amortization due on that capital.4 This was a circular
flow that could eventually spell virtual stagnation as far as the ad­
vance of domestic living standards was concerned.
The expedient of interest subsidies or a moratorium on repayments
did not offer a fully satisfactory way out. For measures of this kind,
understandably proposed in order to reduce the transfer burden
across the frontiers of the developing countries, could also seriously
misguide the patterns of capital and resource allocation for the future.
The alternative of attempting to apply the traditional analysis to these
less developed countries, by expecting them to deflate in order to in­
crease the attractiveness of exports while reducing imports, was on
its face unacceptable except for brief periods of temporary correction.
Interest Rates
As each of the problem areas just described was coming into clearer
visibility, some of its effects were also being etched across the ex­
perience of many countries in another way. For it began to appear
that with prices often free to vary up and down only from an upward
trend line, and with employment to be kept virtually full, the rates of
interest paid for short- or long-term funds in various countries would
have to become a much more important variable for implementing
overall economic policy.
In terms of the balance of payments, given the narrow range within
which adjustments could occur in the trade position even if traditional
prescriptions were followed, greater reliance for policy purposes
might have to be placed on changes in underlying domestic credit
availability and thus on variations in rates of interest. Ways might
have to be found to increase the size and flexibility of offsetting shifts
in capital flows, to take the place of what had been larger swings in
the trade balance or to compensate for what had now become an
intractable minimum of disbursements abroad by governments. Par­
ticularly during the decade of the 60’s, the potentialities for relying
on variations in credit availability and interest rates to influence capi­
tal flows among nations have had to be much more extensively ex­
Statistical verification is extremely hazardous in matters of this
kind. In attempting to make some check on my own marketplace
observations, however, one of my colleagues has tried several different
4 Cf. Partners in Development, op. cit., pp. 74 ff.


measures. One approach, mentioned here only as an illustration, has
been to examine the relative impact of exports and of interest-rate
differentials on the outflow of short-term capital from the United
States over these years. His results thus far, always conditioned by
the fact that correlation does not mean causation, are quite striking.
The difference between the two periods 1961-1964 and 1965-1968,
is so great that, even after appropriate allowance is made for vagaries
and variations in the data representing the underlying phenomena
being measured, one general conclusion can scarcely be avoided. The
correlation between exports and outflows of short-term funds declined
sharply, to become almost trivial in the latter period. At the same
time, the correlation between the United States-United Kingdom in­
terest-rate spread and variations in the outflows of short-term funds
from the United States increased significantly by every test attempted.®
Yet it has begun to appear that even interest-rate flexibility, and
the underlying variations of credit availability which induce rate
changes, have limits. In part this comes from the perverse pattern
indicated by the references to Germany and the United Kingdom
above. In part it also comes because the impact of sizable changes in
current interest rates to effect external flows may have gravely dis­
torting effects upon domestic capital flows in national economies whose
institutions are geared to relatively slow changing rates of return.
Moreover, the existence of the nonnational Euro-dollar market has
provided a vehicle through which an intensification of credit restraint,
for domestic as well as for external reasons, will, in a market as large
as that of the United States, be speedily transmitted into the markets
of many other countries whether or not their own immediate external
position requires reserve drains (or reserve gains) of the dimensions
that result.
No doubt many countries affected by the tightening of the Euro­
dollar market during the later half of the 1960’s have overstated the
seriousness of the impact, partly because they have not yet experi­
enced the impact long enough to develop the techniques for offsetting
that impact through appropriate central bank action. Nonetheless,
after recognizing all of these qualifications, the fact remains that the
international transmission of short-term capital movements has be­
come a highly volatile influence upon the foreign exchange reserves
5 The supporting analysis by Richard Fischer would require all of the space
allotted to this paper for adequate presentation. His findings, after further test­
ing, will be published separately.


and the external overall balance-of-payments position of most of the
leading countries, and indeed on that of many others. Because these
flows cannot be presumed to fit comfortably into place as mere resid­
uals in the complex balance-of-payments adjustment among nations
— since they do not simply run parallel with trade— something more
is needed, in theoretical analysis and in operating techniques, if the
adjustment process is to function effectively.
The Special Position o£ the United States
Throughout the decade of the 60’s, there has been an ambivalence
among the critics of the United States balance-of-payments perform­
ance. Our deficits have been continually criticized; our efforts to cor­
rect them, particularly when the traditional formulae of deflation
were being applied, have brought anguished complaints. Yet these two
approaches need not be either surprising or inconsistent. They flow
from four major aspects of the United States position which, in their
combined effect, distinguish us from all other countries— and dis­
tinguish us enough to require a separate addendum to, if not a com­
pletely separate version of, any comprehensive theoretical formulation
of an appropriate process of balance-of-payments adjustment within
the world economy.
First, the United States is large, accounting for nearly one-third of
all production and capital formation in the world, although for much
less than one-sixth of all trade. Second, the United States dollar is far
and away the most widely used transactions currency in international
commerce, and it now provides the principal common medium for the
Euro-currency market. Third, the United States has spawned a widely
diversified complex of multinational corporations that is unique in
scale and performance across the world. Fourth, as political leader of
the free world, the United States has undertaken external commit­
ments, both miltary and economic, that together far exceed the ex­
ternal expenditures for these purposes of any other nation, not only
in gross amounts but also as a proportion of gross national product.
How can the balance of payments of such a country be expected
to conform to the same pattern, and correct its aberrations by resort
to the same measures, as those indicated by the traditional norms?
Such an attempt was made, nonetheless, during the early years of the
60’s. Even though the United States was already running a sizable
trade and current-account surplus at that time, dollar outflows to the
Euro-currency markets, capital outflows on portfolio as well as direct


investment account, and seemingly intractable Government outlays
overseas brought about a net deficit position. The United States re­
acted by trying to raise productivity more rapidly, in turn holding
prices relatively steady as domestic incomes and employment rose.
The result, up through 1964, was a resounding rise in the surplus on
trade and current account; but as capital outflows and Government
payments continued rising, the net deficit shrank only slowly.
After 1965, with the stepping-up of Government expenditure at
home and abroad to meet the Vietnam commitment, a price and in­
come inflation got under way. Imports rose much more rapidly than
exports. By 1968 the trade surplus was gone; the current-account
surplus was reduced by three-quarters; and only a sequence of tight­
ening controls over net capital outflows made possible some further
reduction of the overall deficit. In 1969, a severely restrictive (defla­
tionary) monetary and fiscal policy came into play, and perverse
though it seems, the deficit skyrocketed. But just as paradoxically,
because the domestic restraint made Euro-dollars even more attrac­
tive to banks in the United States than to holders abroad, the dollar
was in greater overall demand, and its current technical position in
the foreign exchange markets was stronger, than at almost any other
time in the decade.
Such, in stark oversimplification, is the strange record of the United
States balance of payments and the dollar through the 60’s. Toward
the close, a classical tight money policy, aiming at deflation, brought
a massive inflow of short-term funds. Statistically, the deficit zoomed;
in the markets, the dollar was strong; yet the balance of trade did
nothing. Moreover, fragmentary evidence, too tentative for presenta­
tion here, was beginning to suggest that the trade balance might not
be capable of substantial improvement. Data suggested that as long
as incomes rose, the United States economy, in its present form,
would continue to draw in a more-than-proportional rise of imports—
that the relevant elasticity determining purchases of goods abroad was
income change in the United States, and that even if relative price
stability could be attained, imports would go on rising at about the
same pace.6 Since no economic policy for the United States could
contemplate static incomes over time, the chances of regaining a trade
surplus sufficient to carry most of the other United States overseas
6 H. S. Houthakker and Stephen P. Magee, “Income and Price Elasticities in
World Trade,” Review of Economics and Statistics, May 1969, pp. 111-125.


disbursements on capital and Government account were beginning to
seem remote indeed.
Some way would have to be found, it would appear, for the United
States at least, if not for other countries, to effect changes in overall
capital and Government outflows, in net terms, as a response to gen­
eral measures of economic policy, if our external accounts were ever
really to balance. Perhaps by conventional standards the United States
would have to become a habitual renegade, able barely to keep its
trade accounts in balance, with a modest surplus on current account,
with an entrepot role for vast flows of capital both in and out, with a
more or less regular increase in the short-term dollar liabilities used
for transactions purposes around the world, and with Government
disbursements tailored to fit whatever proved to be the residual of all
these other elements, after some allowance for increases over time in
monetary reserves.
The arresting challenge presented by the array of “new problems”
just described is to find a comprehensive new theory that can envelop
all of them. Until that challenge is met-—and I will insist here, without
pausing for the argument, that the theoretical structure of a “floating”
exchange-rate system is no answer— the approaches taken will have
to be eclectic. Perhaps as they are followed through, a new and com­
prehensive theory will emerge. Meanwhile, there is one proposi­
tion, it seems to me, that cannot be avoided under any approach: in
the aggregate the accounts of any solvent country must balance, on
the basis of transactions willingly undertaken and of balances willingly
held, in accordance with generally accepted standards of performance.
The search now should be for those additional parts of an equilibrat­
ing mechanism that will enable each country to achieve its own viabil­
ity with less interruption or strain in its all-round economic perform­
What is needed, then, if the new problems have to be confronted
individually, rather than in one new all-embracing system, is an airing
of various possible approaches to each of the problem areas. The hope
can be that wider discussion and debate will produce a consensus of
reasonable acceptability, at least for improved handling of some of
them. The beginning of such an effort will be sketched here for six
possible approaches, not with any pretense at completeness, not with
the conviction of advocacy, but in the hope of stimulating critical
elaboration. The six are: (1) general influences on long-term capital


flows, (2) specific influences on long flows, (3) short-term money
flows, (4 ) Government flows, (5) interrelations between interest
rates and exchange rates, and (6) the United States potential as an
entrepot for world capital mobility. In all six, of course, attention
should be directed to gross flows, both inward and outward, and not
merely to the critical net position.
General Influences on Long-Term Capital Flows
Ordinarily, the prerequisite for sustained and substantial outflows
of long-term capital from a country is the continuation of a surplus on
trade and current account. Yet for decades, even centuries, a by­
product of this emphasis on surpluses has been the development of a
mercantilist mentality, with emphasis focusing on the accumulation of
reserves. To the extent that an overriding desire for additional re­
serves has been a deterrent to the massive outflow of long-term capi­
tal, the recent completion of arrangements for Special Drawing Rights
in the International Monetary Fund should serve as a major correc­
tive influence.
During the course of the debate preceding agreement on the SDR’s,
there was spreading recognition of the inherent risks in rivalry for
acquisition of a severely limited aggregate of usable monetary re­
serves. A built-in deflationary bias was beginning to distort the func­
tioning of the international payments system and drive individual
nations, large and small, into undesirable protective or restrictive
measures aimed at improving the current-account position in order to
acquire a larger share of a relatively constant total of primary reserves.
From 1970 onward, however, substantial annual increments to the
supply of primary reserves will become available in the form of SDR’s.
Henceforth, with each country receiving an annual increment to its
reserves through direct allocation of SDR’s, the pressures of reserve
accumulation will be somewhat lessened. Many individual countries
will still seek to earn more, but the strain imposed by this effort will
not be so great when the total of reserves is continually growing. In
turn, countries may find it easier to use some part of their resources,
and their external earnings, in the normal extending of longer-term
capital commitments. The SDR’s may thus provide lubrication for a
system that had been “seizing up.” Indeed it is through the release
of other resources, much more than through any direct siphoning of
additional SDR’s themselves into the less developed countries, that
the system may be “freed up” for much more meaningful flows of


long-term capital from the developed to the developing countries
over the years ahead.
Thus what may prove to be one of the most significant “new ap­
proaches” for encouraging equilibrating capital flows during the next
decade, particularly long-term flows from developed countries in sur­
plus to the developing countries, is already under way. To be sure,
the potential which the SDR’s may represent, in terms of greater
freedom for the exporting of long-term capital, is only a prerequisite
for such flows and not an assurance that the flows will occur. How­
ever, by reducing the preoccupation of developed countries with re­
serve accumulations, the new arrangements should greatly encourage
capital flows from surplus countries to developing countries in deficit.
Direct Influences on Long-Term Flows
Most countries, recently including the United States, have had to
resort, at least at times, to specific governmental controls over one or
more components of their long-term capital outflows. Despite the
undoubted advantage of widespread freedom for the optimum diffu­
sion of direct investment around the globe, for example, or for the
uninhibited investment of funds in various types of portfolio assets
anywhere, complications have developed. As the scale and diversity
of these capital flows have grown, almost unavoidably a bunching of
excesses has occurred in one country or another, threatening to push
its immediate balance of payments into deficit, or actually doing so.
So far as direct investment is concerned, the installation of oper­
ating facilities in other countries cannot practicably be varied from
year to year in response to current changes in the balance-of-payments
position of the country in which the head office is domiciled. More­
over, attempts to control the aggregate of direct investment flows from
the home country are likely to be frustrated, if they continue very
long, by the ability of established international corporations to pursue
most of their objectives by reinvesting earnings that arise abroad, in­
stead of repatriating them.
Without disturbing the orderly evolution of a firm’s foreign invest­
ment program, however, there is a short-run potential for regulatory
devices to induce the multinational corporation to raise some part of
its funds in the countries whose balance-of-payments position is cur­
rently strong. One of the fortunate results of the rapid growth of the
Euro-dollar market has been the emergence of a truly European-wide,
in fact almost free-world-wide, international money and capital mar­
ket to which such demands can be diverted. Paralleling this develop­


ment, partly for reasons of imitation and partly under the pressure
of growing competition, more active markets have also begun to
emerge within several of the other leading countries. The problem is
how to direct some of the capital requirements of the multinational
corporations toward the savings available in surplus countries, without
also exceeding the aggregate of the surpluses available in these coun­
tries themselves.
No single technique, nor combination of several, can do more than
help toward achieving more evenly distributed results. One approach,
of some limited usefulness, can be to work with the host countries to
space out direct investment inflows. Most of them, both developed
and developing, already maintain controls over investment within their
borders by firms domiciled or headquartered outside. To fit in, by
agreement with other countries, some consideration for the sources
of outside funds should not, as a temporary approach at times, be out
of the question.
Another approach, particularly for instances in which the capital
inflow depends in part upon insurance facilities of various kinds, is to
effect a degree of variation in the initiation of investment projects by
using the leverage available to the creditor nation (or international
agency) which extends the guarantees. Regrettably, but perhaps in­
escapably, there has been an increasing propensity on the part of less
developed countries for nationalization of concerns owned outside
their borders. Investment in many of the less developed parts of the
world is thus becoming increasingly dependent upon the obtaining of
some kind of insurance guarantee from the home country, and as a
result the potential for purposive variation from year to year to reflect
variations in balance-of-payments availabilities has become consider­
Resort by the home country to compulsory controls over capital
exports, or earnings repatriation, on the part of international corpora­
tions may also from time to time prove inescapable and, at least on a
temporary basis, may be moderately effective in shielding some coun­
tries from an unbearably heavy concentration of long-term capital
With respect to curbing outflows to acquire portfolio investments,
preference should, one would think, be for those types of limitation
that most nearly reflect the functioning of market processes. That was
the intention of the designers of the interest-equalization tax in the
United States. To be sure, for a number of years, that tax was re­
garded simply as an absolute prohibition and very little business was


transacted on the basis of payment of the tax. However, with the
passage of time, more and more investors in the United States have
discovered that fruitful opportunities for portfolio investment can be
found abroad, even after payment of the tax, though to be sure the
magnitude of these opportunities has been much smaller than it
would have been without the tax. The success of several mutual funds
in the equity market in Japan late in the 1960’s illustrates, moreover,
the potential that remains for purely market considerations within the
framework of the tax. Therefore, it may be reasonable to conclude
that the variable use of instruments such as the interest-equalization
tax by one country or another, at particular times, may be a helpful
method of regulating, without totally interrupting, the outflow of funds
for portfolio investment.
United States experience since 1965 illustrates still another dimen­
sion of potential influence, in this case, upon inflows of capital. The
Foreign Investors Tax Act, as mentioned again shortly, opened up the
possibility of not only improving, but also varying, the inducements
for long-term capital to flow into the United States or to remain here.
Still another possibility is suggested by the more or less ad hoc
approach that the United States has used in screening the borrowing
of various international financial institutions in the United States
market. As the scale of lending activity by the IBRD, or the various
regional development banks, becomes greater— as it undoubtedly
should and will—the scope of their borrowing operations becomes
correspondingly larger. The potential which these borrowings contain
for variation from year to year, in the extent to which one market or
another is tapped, offers another meaningful method for distributing
over time the balance-of-payments burden of the transfers likely to
follow the placing of such securities in any given country.
Indeed a case can be made for extending this approach from an ad
hoc to a systematic arrangement. One such possibility would be for a
group of leading countries to make a firm commitment to one or more
of the international lending institutions, undertaking to provide a
fixed amount of resources each year for a period of, say, five years. By
agreement the initial distribution of shares among the participating
countries could be established on some independent criterion, such as
the gross national products of each, possibly modified in some meas­
ure by the proportion of gross national product devoted to inter­
national trade or represented by some other grouping of international
transactions. With a quota for each country’s contribution over the
five-year period agreed upon, the group of countries could then pro­


vide for variation from year to year in the actual contribution made
by each within its quota. Recognition could in this way be given to the
recent balance-of-payments position of each of the participating con­
tributors— perhaps that of a year of two earlier in order to allow for
the lag in reliable statistical data.
Provision would no doubt have to be made that every country must
fulfill its quota within the five-year period. However, it might also be
understood that any country in sustained balance-of-payments deficit,
or suffering a series of unpredictable misfortunes, could satisfy its
requirement by borrowing from others before the end of the five-year
agreed interval. In this way, it would simply carry over into the next
five-year period a somewhat larger charge against its own resources,
to be met across its own exchanges.
Short Money Flows
The most conspicuous causes of aggravation in balance-of-pay­
ments difficulties, or of foreign exchange strains, through the decade
of the 60’s was the volatile movement of short-term funds in large
amounts. For the most part these movements were motivated by
rumors or expectations concerning possible changes in exchange rates.
With the completion of the French franc and Deutsche mark cur­
rency changes in 1969, one might have hoped that sufficient realign­
ment had occurred to provide a reasonable assurance of continuity
in most exchange-rate parities for some time in the future. Unfortu­
nately, that would be an illusory point of view. The economic progress
of nations cannot be in lock-step unison, neither in the performance
of their domestic economies nor in their changing relative capabilities
to expand exports or imports, of goods or of capital. As these differ­
ential rates of change are reflected in performance, some changes in
exchange rates will from time to time be almost inevitable. That is
why the discussion of exchange-rate questions became so fervent and
widespread as the 60’s were drawing to a close.
Whether or not any major change may ultimately be introduced
into the currency parity system under the aegis of the International
Monetary Fund, one possibility which has attracted particular atten­
tion could be pursued further without requiring any change in IMF
procedures. This is the suggestion that exchange-rate changes, when
the need for them becomes reasonably clear, should be made with
somewhat greater frequency, and in somewhat smaller amounts, than
was considered customary or appropriate during the first decade of
convertibility, beginning in 1959. Should that approach become ac­


cepted, neither the potentialities for gain, nor the uncertainties of
prolonged delay, could be so great, nor could they have as much im­
pact on movements of short-term funds, as they did during the decade
of the 60’s.
In addition, following the United States initiative in developing its
own $10 billion “ring of swaps” during the 60’s, many of the leading
countries have developed arrangements for making short-term trans­
fers of sudden inflows of reserves back to the country from which they
had flowed. For conditions in which the normal reversal of swap lines
within one year could not be -readily fulfilled, additional techniques
have been developed. These provide for the debtor country to extend
the credit for two or three or more years by issuing to the creditor a
security denominated in the creditor’s currency. Varying provisions
for redeemability, in order to assure central banking liquidity, have
been introduced.
In some instances this intermediate-term instrument was used, in
effect, as a transferable means of shifting reserves as an offset to
short-term capital flows from one country to another outside the
United States. A country holding such claims on the United States
might, when losing reserves, redeem the claims; the United States at
the same time could issue a corresponding amount of similar securities
to the country receiving much of the money in transit, denominated
in that country’s currency. The net effect would be a return of dollars
from the country receiving them to the country losing them. This
occurred, for example, when there were heavy movements of funds
from Italy to Germany late in 1963 and early in 1964. Italy redeemed
United States bonds, denominated in lire, and the United States in
turn issued new bonds to the Bundesbank, denominated in Deutsche
While neither the swaps nor the foreign currency bonds provides
a totally adequate offset to the impact of speculative flows of short­
term funds, they have served an essential purpose and should occupy
an important, perhaps an increasing, place alongside the facilities of
the IMF itself in the roster of routine instruments available for use
in minimizing the balance-of-payments disruption related to short­
term money flows. But, of course, expectations concerning exchangerate changes were not the only factor in such “hot money” flows.
Another factor has been the influence of interest-rate differentials
among the short-term markets of leading countries. These will be
discussed further below.


Government Flows
As already suggested, perhaps the most important single area for
deliberate variation in flows across the exchanges lies in the transac­
tions carried out by governments themselves. The hope would be that
governments could develop within their regular overseas payments a
capability comparable to that of the so-called “built in” or automatic
stabilizers that help to promote stability in the domestic economy.
The general format of one such approach has already been sug­
gested in outlining the possibility for variation among countries in the
contributions that each might make toward an agreed annual collec­
tive contribution of resources to the international development banks.
Similar arrangements might very well be considered for consortia
arranged among leading countries for the extending of other kinds
of direct aid. Clearly, to the extent that aid, whether through loans or
through grants, can be extended on a multilateral basis, the poten­
tialities become much greater for variation from year to year in the
burden placed upon one contributing country or another.
There are still two other ways in which, preferably through multi­
lateral forms of agreement, some more or less automatic variation In
balance-of-payments burden could be accomplished. One would fol­
low from a more general recognition that individual governments,
even of developed countries, can appropriately borrow abroad to ac­
complish particular purposes at times when the need for continuity
in a program conflicts with the immediate balance-of-payments posi­
tion of the particular country. Or in cases in which government ac­
counts themselves are not involved, there would also be a possibility,
at times of balance-of-payments strain at home, of extending guar-r
antees or inducements to private concerns engaged in investment
abroad, in order to encourage borrowing in other markets, possibly
denominated in other currencies.
Perhaps the zone of greatest interest, however, is also that which,
from the point of view of the less developed countries, is that of
greatest need. This is the question of debt servicing emphasized earlier
in the outline of “new problems.” A considerable part of the receipts
of many of the leading countries in any given year now comes from
the return of amortization payments (and in many instances the
receipt of very high interest payments) from loans made earlier to
many of the less developed countries. To some extent, through con­
sultation among the leading countries, there would seem to be scope
for outright renegotiation of some of these terms in order to minimize


the future burden of past indebtedness. Even where this is not prac­
ticable, the possibility for postponing such payments for several years
at a time offers an important opportunity for extending balance-ofpayments relief to the less developed countries, while spacing out
the inflow of hard currency in the accounts of creditor countries dur­
ing periods when they are already enjoying balance-of-payments
gains. To the extent that postponement would be contemplated by
private lenders domiciled in strong creditor countries, the postpone­
ment might have to be paralled by either guarantees or actual govern­
ment “takeouts,” with recourse as to ultimate credit risk. For any
of these approaches, the most promising procedure would seem to be
for a multilateral undertaking, worked out under the aegis, for ex­
ample, of the Development Assistance Committee of the OECD, or
of the IBRD.
Interrelations between Interest Rates and Exchange Rates
As indicated earlier, interest-rate comparisons among financial
markets, and between the Euro-dollar market and any other given
market, seem to have become much more important factors in causing
short-term money flows during the late 60’s than the characteristic
patterns of trade financing. Indeed, we have seen that at times a per­
verse relationship developed between domestic interest rates and the
balance-of-payments results intended by the authorities when intro­
ducing either a restrictive or an easing monetary policy. The same
experience has also suggested, however, that as long as some uncer­
tainty remains concerning the actual exchange rate likely to be in
effect in the marketplace when foreign short-term investment is un­
wound, another dimension can be at work to help minimize any un­
wanted effects of interest-rate spreads. That is, the gain from an in­
terest-rate differential must be adjusted for the cost of forward cover.
The possibility consequently exists at times to induce or deter
short-term money flows by narrowing or by widening the margin of
forward discount or premium on the currency in question. To be sure,
the scope is not unlimited for variation in such forward rates, but
the Articles of the International Monetary Fund do not lay down
any mandatory limits. Consequently, there have been times when,
even though no imminent crisis was threatening, the discount in one
direction or the premium in another might rise to as much as 3 or 4
per cent in the forward market. Just as a discount would offset some
of the attraction of higher interest rates, and probably diminish the
flow of funds into a currency, so a forward premium might encourage
flows in the other direction.


For some time, a number of central banks have been reluctant to
nudge forward rates upward or downward as a conscious instrument
of policy. However, as one experiment after another was attempted
during the decade of the 60’s, the practice began to acquire some
degree of acceptability. To be sure, heavy forward purchases of
sterling by the Bank of England for many months before the devalua­
tion of November 1967 did eventually prove rather costly when the
parity was in fact changed, but this experience might well turn out
to be the “exception to prove the rule.” Particularly if parity changes
are to be made in smaller amounts and somewhat more frequently,
the potential burden on central banks or their governments can be
reduced, while the scope for meaningful variation in cost of forward
cover, over the 3 or 4 per cent range, for example, would still exist.
One other important possibility has been discussed in recent
months. That would be to provide for a widening of the band around
the exchange parity. While some have suggested a widening on both
sides of parity, the case may perhaps be stronger for a widening on
the up side. Surely, as far as reluctance to change parity is concerned,
it is readily demonstrable that revaluations occur less readily than
devaluations. Out of the last one hundred changes in exchange-rate
parities, only three had been appreciations prior to the German move
near the end of 1969. Yet possibly the greatest distorting influence
upon short-term money flows, particularly when a mixture of interestrate and exchange-rate uncertainties were involved, has occurred
because of the pull of funds into a currency which was clearly under­
valued. If there were a range, with a wider band, above parity, for
the spot rate to move up as much as 2 or 3 per cent, while the for­
ward might move correspondingly above that, the potential for de­
terring speculative inflows could be very great. Many of the more
extreme swings of short-term money flows of the 1960’s might have
been averted, or held to much smaller figures, if this approach could
have been followed.
The United States as an Entrepot for Capital Mobility
If some of the questions already raised concerning the United States
should prove to be valid, then the prospects for this powerful nation
to go on contributing directly to development in other nations pri­
marily by means of a substantial trade surplus appear doubtful. There
should, of course, be room for other kinds of contributions through
other elements in the current account, perhaps notably through the
deferral or forgiveness of some debt service. Moreover, interest and
royalty and other “invisible” earnings derived from other developed


countries should provide considerable support for this country’s ex­
ternal commitments. Nonetheless, taking all these together, the scope
for United States activity overseas would appear severely limited in
relation to the aspirations and demands likely to arise.
One very important additional source of future capital outflows
may come through attracting more capital inflows, through a greater
development of the United States role as an entrepot capital market
There is little doubt that the highly developed facilities of this coun­
try’s capital markets, and the skills of its many participants who now
operate actively abroad through the Euro-currency markets, can
effectively place much larger amounts of funds than can be raised
in the domestic United States market. Conversely, one of the greatest
shortcomings, even now, among most of the other rapidly advancing
developed nations is that they do not have the capital market facilities
for effectively putting their own savings to use outside their own
economies. The opportunity still exists, consequently, despite all that
has already been accomplished during the 60’s, for the United States
to move more aggressively into the role of intermediary, drawing in
nearly as much capital from outside as it distributes. That was a part
of the philosophy underlying the Foreign Investors Tax Act of 1966.
Although not intended as a variable influence on inflows of foreign
capital to the American markets, its role in increasing the volume of
these inflows can be of immeasurable help toward achieving, over
the years, a closer approach to balance in the United States external







There is much more to be said, of course, on this approach, as on
all of the others so briefly touched upon in these comments. But my
aim has not been to present a fully detailed brief. Instead, in the spirit
of open inquiry that has been the epitome of Karl Bopp’s career, my
hope has been to present enough circumstantial evidence to raise a
presumption of doubt concerning the traditional identification be­
tween the trade balance and the total balance of payments. Having
raised the doubt, and indicated that capital flows and government
transfers have become critically important, independent influences on
the balance-of-payments positions of many countries, I have gone on
to suggest some approaches for coping with these influences, along­
side the flows of goods in trade, as part of a comprehensive process
of balance-of-payments adjustment. From all of this at least one con­
clusion seems to emerge, in confirmation of the counsel that Karl
Bopp gave me years ago— there are still many more problems than
answers in the formulation of appropriate adjustment policies.


I n J u s t T w o H o u r s of the morning of Monday, September 29, 1969
some $250 million flowed into Germany in anticipation of a revalua­
tion of the D mark. The German authorities re-closed the German
exchange markets which had just been re-opened after being closed
the previous Thursday and Friday to avoid speculative runs into the
D mark prior to the German elections. The authorities announced that
when the markets were opened again, as they were on Tuesday, there
would for a time be no official intervention to hold the official parity,
as is required under IMF rules. Thus the D mark was allowed to float
temporarily, as an answer to the latest questioning of the international
monetary system. Late in October it was officially revalued to a new
and higher fixed parity.
In November, 1968 and again in May, 1969 the world had ques­
tioned seriously the viability of the then current D mark parity. In the
first instance some $3 billion, and in the second some $4 billion had
rim into the D mark in the belief that it was a prime candidate for
revaluation. Despite heavy capital export which more than offset a
strong current account surplus, German reserves gained sharply in the
first nine months of 1969, reflecting the short-term capital inflow.
Neither the November nor the May runs brought a D mark revalua­
tion. The Bundesbank managed to “recycle” a significant portion of
the inflows, and general international monetary cooperation worked
to make relatively tolerable the impact on reserves of weak currency
nations. But it is noteworthy that it was not only the so-called specu­
lators who believed the D mark was a candidate for revaluation. In
November the Ministers and Governors of the Group of Ten coun­
tries, the most powerful financial nations in the world, believed that
revaluation was both necessary and desirable and urged that course
on Germany. The argument made good economic sense but apparently
no political sense in Germany. In May, both the Bundesbank and the
Economics Ministry strongly backed revaluation, and many indus­
trial leaders in Germany were prepared to accept a higher parity;
but the government rejected that course again and in doing so de­
clared the then current parity was “for eternity”— a period which
turned out to be five months.


In May, 1968 riots and strikes in France brought the (up to then)
highly regarded franc into a weak position. For more than a year,
with massive foreign assistance, France fought off capital outflow,
balance-of-payments deficits and heavy reserve losses. In basic eco­
nomic terms a reasonable case could be made as to the viability of
the then current franc parity. France herself evidently regarded that
case as convincing, for she forewent devaluation in November, 1968
when all of her Group of Ten partners were prepared to accept a
modest downward movement in the franc parity. Then, despite large
reserves, large foreign credits, a program of austerity and fairly strong
exchange controls, France was finally forced to devalue in August,
1969, and by the same amount regarded as acceptable (even though
in French eyes unnecessary) in November, 1968. According to
Finance Minister Giscard d’Estaing, French reserve losses were very
heavy and the drain showed no sign of abating significantly, so that
France had no choice but devaluation.
In March, 1968, the Gold Pool, operated by seven of the key finan­
cial powers in the world, gave up its fight to hold the free market
price of gold equal to the monetary price. The London market was
closed for a short period and the link between monetary and non­
monetary gold was broken by stopping supply of the residual demand
in the London market. This move was regarded widely as desirable
on its own merit; there was a considerable body of opinion that held
that a two-tier gold system was both feasible and desirable. That
opinion has proved to be correct. But the move also might be regarded
as making a virtue out of a necessity. The run into gold really reflected
in large part a run out of currencies and a broad lack of confidence in
the international monetary system.
That, in turn, was a partial product of the fall of sterling in No­
vember, 1967. The struggle to preserve the $2.80 sterling parity be­
gan in earnest three years earlier, in November, 1964, when a massive
credit package for Britain was put together by the leading financial
powers of the world. Britain took a series of restrictive actions de­
signed to improve her external position. Results were disappointing
and sterling remained weak. In September, 1965 another credit pack­
age and further international monetary cooperation repelled a major
bear raid on sterling. A year later the same thing happened again.
Yet, by the spring of 1967 Britain had repaid all her short-term debts
and was in process of repaying her IMF advances. It looked as though
the struggle had been won. But then came the Arab-Israeli war, which
led to heavy British reserve losses, and there were some bad trade re­


suits during the summer and fall. By November, Britain had lost so much
in reserves (almost $1.5 billion alone on the day before devaluation)
that the parity change could be resisted no longer. In this instance,
also, a case could be made that on economic grounds the old parity
was viable, but that case could not be made credible to holders of
short-term funds, both British and foreign, for any sustained period.
And even after devaluation and still more austerity, the pound stayed
basically weak and suspect for some two years.
In March, 1964 a large balance-of-payments deficit in Italy brought
a massive run on the lira. Much opinion of the time was that the lira
should and would be devalued. But a large credit package and a sav­
agely restrictive economic policy combined to break the speculative
attack and restore the external position of Italy. While the broad
economic cost to Italy, and perhaps the world, of the strongly restric­
tive policy was fairly high, the Italian current account position has re­
mained strong since that time. But even with a substantial current
account surplus the lira suffered from capital outflow in 1969 when
the impact of the French and German currency situations plus the un­
settled political situations in Italy led to some loss of confidence in the
In the spring of 1962 the Canadian dollar faced a major speculative
attack. It had had no fixed parity for a number of years but during
a large part of that period it had an effective rate of more than par
with the United States dollar. By 1962, however, it seemed evident
that the parity, effective or fixed, would be sharply reduced. The
Canadians finally settled on a fixed parity of 92.5 cents but had to
defend it fiercely at the time, and could do so only with large financial
help from the United States. And, even with a fairly solid economy,
Canada suffered another period of heavy reserve losses in early 1968,
following announcement of a new and stronger United States balanceof-payments program. That drain was arrested only after Canada was
effectively and publicly insulated from the impact of the United
States program.
In March, 1961 the D mark and the Dutch guilder were revalued.
The revaluation was mild— only 5 per cent— but it was the result
of and triggered what at the time was regarded as major flows of
speculative funds. It is noteworthy that comment from the Federal
Reserve Bank of New York on this development was:
However effective these moves may ultimately prove to
be as a contribution to international balance-of-payments


equilibrium, their immediate effect was a shattering blow to
market confidence in a system of fixed currency parities. All
major currencies immediately became labeled as candidates
for either revaluation or devaluation, and an unparalleled
flood of speculative funds swept across the exchanges.1
In late 1960 and early 1961 there was an earlier rush into gold.
This run reflected two factors: three years of very large American
balance-of-payments deficits, and widespread uncertainties about con­
tinuation of the American policy of converting dollars held by mone­
tary authorities into gold at the fixed price of $35 an ounce. In a real
sense the run was the result of a crisis of confidence in the dollar,
and involved not only a sharp rise in the price of gold in the private
markets but large conversions of dollars into gold from the United
States Treasury. This crisis was overcome following a strong public
statement from President Kennedy that the United States would con­
tinue to convert dollars into gold at the $35 price. But from that time
forward the United States has been constrained to adopt a number
of restrictive programs designed to improve her international pay­
ments position and maintain confidence in the dollar.
The above record adds up to 15 major currency crises since late
1960. Except for those directly concerning the Canadian dollar in
1962 and 1968 and the lira crisis of 1964, all of the crises produced
severe strains in the entire international monetary system. The system
has become ever more closely interlinked so that either excessive
strength or weakness in one major currency has tended to produce
repercussions on other major currencies and to have serious impact
on the host of minor currencies. That excessive strength or weakness
may occur solely as a result of growth or failure of confidence without
a clear economic basis for the confidence change.
Interdependence of Currencies
The 1969 Annual Report of the International Monetary Fund
observes that since most major currencies became convertible some
ten years ago there has been a great growth in the volume of short­
term funds that can flow from one currency into another. “In this re­
spect the framework within which countries can conduct policy differs
1 “Treasury and Federal Reserve Foreign Exchange Operations,” reprint from
the Federal Reserve Bulletin, September, 1962, p. 1140. It is an interesting
historical note that the “unparalleled flood” of early 1961 was less than onetenth the size of the May, 1969 flows into the D mark and just a bit larger than
the two-hour flow of September 29, 1969.


importantly from that envisaged at the time of Bretton Woods . . . .
The drafters were well aware that a country might have to alter its
exchange rate in response to relative changes in its real economic
position. But they did not envisage that a country would have to be
so much concerned about the public’s changing views on the strength
of its currency. Speculative capital movements were expected to be
suppressed rather than financed . . . .”2
It is important to recognize that the growing interlinkage in the
monetary system makes today’s currency crises dangerous for the en­
tire system. It might be expected that a crisis for the dollar would
have widespread impact. The dollar is the world’s great reserve and
trading currency; the United States is the greatest economic power in
the world and stands at the very core of the Bretton Woods system.
Practically speaking, the parity of the dollar cannot be changed rela­
tive to other currencies; they peg against the dollar which is convertible
into gold at the fixed price of $35 an ounce for monetary authorities.
Even should the dollar price of gold be changed, it would be highly
unlikely that the parities of other countries relative to the dollar would
be changed. That is not to say that another currency cannot appreci­
ate against the dollar, but it is not practical nor would it be desirable
to change the dollar parity against the system as a whole or any sig­
nificant portion of it.
Nevertheless, there can be a crisis of confidence in the dollar, as
there was in late 1960-early 1961. In a sense the gold crisis of late
1967-early 1968 was a crisis of the dollar also, but only in a sense.
That reflected, as noted, more lack of confidence in currencies as a
whole rather than in the dollar itself even though much of the impact
fell on the United States gold stock.
Still, since 1960 the United States has had to struggle to maintain
confidence in the dollar; the United States balance-of-payments pro­
gram of January 1, 1968 itself was designed in part to moderate a
gold crisis. And because of the economic size of the United States, its
various balance-of-payments programs, particularly the 1968 pro­
gram, had adverse impact on other currencies—notably the Canadian
dollar and probably sterling. So weakness or strength in the dollar
affects many other currencies.
But strength or weakness in other major currencies also has major
impact on the system. The chronic weakness of sterling before de­
valuation kept the whole monetary system in a state of nervousness,
2 1969 Annual Report, International Monetary Fund, p. 31.


and the immediate post-devaluation effect was a massive run into
gold. The excessive strength of the D mark had serious adverse
effect on the system, and particularly on the French franc and on
sterling. It also brought heavy reserve losses to Denmark and Belgium,
led to capital outflow from Italy, and produced speculative upward
pressure on the guilder and the Swiss franc. From May, 1968 to the
present the French franc has been a destabilizing factor in itself but
has also had severe impact on Belgium, adversely affected Italy and
at times added to sterling’s problems.
Different Positions
Because of the triple fact of crisis frequency, the heavy flows of
short-term funds that move at times without real economic reasons,
and the strong interlinkage of the system, a number of people have
raised questions about the viability of the system itself. Given the
facts that the world has prospered greatly and that world trade has
expanded markedly under the Bretton Woods system, is there not
some better way to achieve these desirable ends— a way that would
at least cut down on the frequency and fierceness of currency crises?
Relatively few people contend that the system should go on un­
changed; the basic differences lie between those who would make
radical changes and create, in effect, a new system and those who
believe that modest change, essentially within the present system’s
framework, would meet the need.
In part, the differences reflect differing economic philosophies but
in part they reflect differing economic analyses of the causes of crises.
While there is no general agreement as to the causes of crises among
those who would make only modest changes within the present frame­
work, the following points are usually made in support of that posi­
tion: (1) The basic weakness lies in the failure of countries to follow
sensible economic policies; they know better than they act. The
balance-of-payments adjustment process would be made to work
smoothly if countries had the political courage to take appropriate
economic action; (2) a particular version of this argument, widely
accepted in Europe, is that the persistent weaknesses in the interna­
tional payments positions of the United States and the United King­
dom have been the major factors of instability. If the reserve cur­
rency countries, with their especial responsibilities, followed better
economic policies the crises would be both less frequent and sus­
ceptible of easier containment; (3) the system could be made to work
far better than it has if it operated in the manner envisaged by the


Bretton Woods founders. That system was designed to accommodate
parity changes when they were indicated. Obtuse resistance to desir­
able changes in parities is a major factor in crises; (4) at least part of
the instability of recent years has reflected nervousness about needed
reserve-growth sources for the future. A few have believed that this
should be accomplished by an upward change in the monetary price
of gold. The great majority sought other means and this has led to
the new fiduciary reserves, the Special Drawing Rights.
Many of those who wish to work within the present framework of
a fixed parity system seemingly would be willing to accept changes
in the system that even a short time ago would have been regarded
as radical: a modestly wider band above and below parity, a modest
crawling peg, or a combination of these two. But these remedies do
not satisfy those who believe that the system needs really radical
change, by which they mean a major breakaway from a system of
fixed parities usually accompanied by a demonitization of gold. Basi­
cally they hold a fixed parity system is destabilizing in itself, that
it leads to bad economic policies both internally and externally, that
it is absurd for countries to follow restrictive economic policies which
hurt growth in those countries and in the world, that the adjustment
process should rest essentially in the exchange rate, and that the
rate should be allowed to fluctuate widely.
E. M. Bernstein has written that the objective at Bretton Woods
was to retain the fixed parity aspect of the gold standard while aban­
doning the rigidities imposed by the traditional gold standard. Article
IV, Section 5, of the Fund’s Articles of Agreement says in part that
a change in the par value of a member’s currency may be made only
on the member’s proposal and after consultation with the Fund, but
that the Fund shall concur if it is satisfied that the change is neces­
sary to correct a fundamental disequilibrium in the balance of pay­
The 1969 Annual Report of the Fund states:
This system was intended to provide a stable environment
which, by encouraging international transactions, would
stimulate the growth and sharpen the efficiency of the
world economy. Stability, as the Fund has stressed in the
past, does not mean rigidity . . . changes in par values were
contemplated as one of the means of adjustment . . . ex­
8 “Flexible Exchange Rates and Balance-of-Payments Adjustment,” E M B
(Ltd.), December 11, 1968.


change rates that are no longer appropriate . . . contribute
to the persistence of payments disequilibria, the encourage­
ment of speculation, and crises in the exchange m arkets-----*
The Report, on this subject, concludes by noting that the Fund
Board has been discussing extensively the mechanism by which ex­
change rates can be changed. No conclusions have yet been reached
and the study will continue. But the Executive Directors stressed
. . . any changes that might be made should preserve the
essential characteristics of the par value system, which re­
main as beneficial for the world as they were when written
into the Fund’s Articles of Agreement 25 years ago: that the
stability of exchange rates at realistic levels is a key con­
tribution to the balanced expansion of international trade,
and that the determination of the rate of exchange for each
currency is a matter of international concern,s
The Thesis: A More Flexible Approach to Parity Changes
The thesis of this paper may be expressed in three propositions:
1. The international monetary system of fixed parities has proved
highly beneficial to the world and should be preserved essen­
tially in its present form. No basic structural changes are neces­
sary or desirable.
2. The workings of the system can be improved significantly, and
the frequency and intensity of currency crises can be moderated
by some relatively simple procedural changes that would involve
only the big financial and industrial countries.
3. A generalized system with more flexibility would not be par­
ticularly useful but a more flexible approach to necessary or
desirable parity changes for the big countries would be helpful
and should be adopted.
The thesis rests on six major premises:
a. The smooth working of the international monetary system
depends primarily on the conduct of the big industrial and
financial powers. A currency crisis that involves a major
country almost always has the potential to shake the entire
system. This is not true of a minor country, nor is it true of
a big country which has a relatively minor currency.
4 1969 Annual Report, International Monetary Fund, p. 31.
5 Ibid., p. 32.


b. Necessary and desirable changes in parities of the big coun­
tries are likely to be infrequent. In the past ten years there
have been only six parity changes among the major curren­
cies— three up and three down. While the manner, timing,
and magnitude of some of these changes may be subject to
criticism, it is highly doubtful that there should have been
more changes.
c. No system of fixed parities, and probably no system of float­
ing rates, can be made to work without a reasonable degree
of agreement among the big countries on a set of principles
concerning broad economic policies and responsibilities for
the workings of the adjustment process and a reasonable
degree of assurance from each of them that the principles
will be implemented by appropriate action.
d. There is no need to amend the Articles of Agreement of the
Fund. The present Articles are sufficiently broad to permit
the Fund to pursue a more flexible approach to any necessary
or desirable parity change for either a big or a small country.
e. A workable and acceptable procedure of meaningful con­
sultation and discussion at a high political level and in con­
fidence prior to a parity change by any big country can be
f. Adequate credit facilities, both outside and inside the Fund,
will remain available to aid in a smooth adjustment process
and to repel speculative attack on a currency. It should be
possible to enlarge and improve such credit facilities, espe­
cially those designed to “recycle” funds received from specu­
lative currency flows.
Problems of Parity Changes
Before proceeding to discussion of the simple procedural changes
and the more flexible approach to parity changes, it is useful to de­
lineate three basic problems with respect to parity changes by big
countries. First is the problem of frequency and timing. With appro­
priate policies, changes in parity should not be required frequently;
it was noted above that there were only six changes in the past ten
years and that probably no others were needed or desirable. But cer­
tainly questions can be raised about the timeliness of some of the
changes. The big countries have tended to regard a parity change as
an indication of failure of policy and consequently to utilize such only
as a last resort. One consequence of this approach is that change


almost automatically is the product of crisis and may well be instru­
mental in producing a crisis. It would be well for the big countries to
regard parity change as a useful but infrequently used part of the
adjustment process, to be employed with care and sparingly but not
to be completely foresworn except in case of a catastrophe. The big
countries have the right to expect that their trading partners will not
depend on parity change simply to avoid other hard policy choices and
thereby shift the burden of adjustment to others. But maintenance
of a nonviable parity carries costs of its own and parity change may
be the best course of action in certain cases.
Second is the problem of magnitude of change. Unfortunately, the
art of economics cannot yet determine with any precision just what
is a viable exchange rate. And particularly in recent years, as the
1969 Fund report notes, pressures can develop on an exchange rate
almost apart from basic and real economic factors. Any exchange
rate change has to be “credible” to the market itself as well as viable
in an economic sense. The tendency, therefore, is to err on the side
of safety and make the change relatively large, particularly when a
devaluation is involved. That tendency in itself raises additional prob­
lems— e.g., the “domino effect” both for self-protection and because
of shifting market pressures.
Third is the problem of confidentiality. It is self-evident that gov­
ernments cannot publicly discuss parity changes without inviting
major market movements of short-term capital. But some people have
to know about prospects for change if any change is to be carried out
successfully, and it is of key importance for a government contem­
plating change to reach a judgment as to the response of its major
trading partners. In addition there is the stated requirement in the
Fund’s Articles of Agreement that parity changes should take place
only after consultation with the Fund.
All of these difficulties might be muted if devaluations and reval­
uations were the product of full international discussion and under­
standing and if the approach to a parity change were made more
flexible. A change stemming from full international discussion would
carry the real endorsement of the country’s big trading partners and
the explicit pledge of no counteraction. It would carry with it pledges
of necessary credits. And perhaps most importantly, it might be made
in more timely fashion and in a way that would enhance credibility.
Probably that would mean that the change could be kept smaller and
would be regarded as a real part of the adjustment process to be
accompanied by other appropriate policies.


In this connection there is much to commend the recent German
method of finally revaluing the D mark. Germany could not gain the
formal approval of the Fund to float but she gained Fund acquiescence,
and the final parity fixing was really a reflection of market judgment
as well as political judgment.
Procedure for Changing Parity
The procedural changes which would improve the workings of the
international monetary system relate to premises (c) and (e). With
respect to premise (c) it probably is more correct to suggest that
further evolution of present procedure is what is needed rather than a
change in procedure.
In 1966 the Organization for Economic Cooperation and Develop­
ment issued a report on the adjustment process6 which had been pre­
pared in Working Party Three of its Economic Policy Committee and
was agreed to by the countries represented in the Working Party,
basically the big financial and industrial countries. It spelled out in
fairly explicit terms the responsibilities of both surplus and deficit
countries and laid down a series of policy actions which might be
taken to smooth the adjustment process. Thus there is in essence
an agreed set of principles already in being. The Fund’s Articles of
Agreement also constitute an agreed set of principles.
The regular meetings of the Economic Policy Committee, Working
Party Three, the Group of Ten, and the central bank governors at
Basle provide discussion forums for analysis and policy recommenda­
tions in an international setting. The Fund’s consultations with in­
dividual countries can supplement these multilateral discussions. Par­
ticipants in these meetings are sophisticated and have a high level
of understanding of the political, economic, and social facts of life.
In these groups it should be possible to foster implementation of the
principles agreed to, and produce the necessary assurances and inter­
national support for sound economic policies.
It would be politically naive to expect a single and agreed set of
economic policies among the big countries; there are significant dif­
ferences among them in political, economic, and social structures and
goals, and in the available mix of policy instruments. Furthermore, it
is unlikely that there will ever be absolute agreement on the trade-offs
between domestic goals and international responsibilities. Nor, with
6 The Balance-of-Payments Adjustment Process, Report by Working Party
Three of the Economic Policy Committee of the O E C D , August, 1966.


the best of intentions, is it likely that any government can give ab­
solute assurances that it will follow a given set of policies and achieve
a particular goal. But it is possible for the big countries to assure each
other that, insofar as is possible, they will act responsibly to make
the adjustment process work and that in their formulations of policy
they will pay due regard to the prospective impact of their policies
upon their trading partners.
The key points on which agreement should be reached and assur­
ances given are that no country will, either by action or lack of action,
deliberately shift an undue portion of the adjustment burden to its
trading partners; and that it will use changes in the exchange rate
responsibly when needed as part of the adjustment process but will
not regard changes, particularly depreciations, as the sole method
of adjustment.
It is not unduly optimistic to expect the reasonable degree of
agreement and assurance required. There already has been consider­
able progress and it should continue. And with growing understanding
there also should be improved political performance.
With respect to premise (e) it is instructive to examine the Bonn
meeting of the Ministers and Governors of the Group of Ten in No­
vember, 1968. That meeting was a real international consultation at
a high and responsible political level where firm commitments could
be made. It was designed to discuss fully and in advance of any an­
nounced action possible parity changes by one or more important
countries. It was called in haste, was by necessity not well planned,
and was conducted in the white heat of worldwide publicity. Since no
parity changes followed the meeting it was widely criticized as a bad
example of financial diplomacy.
While much of the criticism was justified, the critics seem to have
overlooked the positive features of the Bonn meeting. The basic ob­
jective of the meeting was multilateral consultation in advance of
parity change. It underlined the point that parity changes are a matter
of international concern, and that essentially unilateral action and
pro forma consultation and approval are unsatisfactory expressions
of that principle.
The substantive achievements of the meeting were not trivial. It
was called and conducted in the midst of a great currency crisis, and
with its conclusion the crisis was resolved for the time being. There
were three specific results. First, the conferees urged Germany to re­
value the D mark. Basically for domestic political reasons Germany
rejected that course but did agree to take certain actions aimed at re­


ducing her large current account surplus and at repelling speculative
flows. The fact that these actions proved inadequate is a principal
reason for criticizing the meeting. Second, the meeting was designed
to insure that any prospective French devaluation would be contained
within moderate and acceptable magnitude and that the other big
countries would not follow a modest French move. France made two
points quite clear: there might be no devaluation, a course most of the
conferees favored; if there were, it would be no more than 11 per
cent. The other countries committed to hold their parities and to par­
ticipate in additional credits for France.
In sum, there are both positive and negative lessons to be learned
from the Bonn meeting. There are also lessons to be learned from
normal Fund procedures in dealing with parity changes.
When big country parity changes are involved the Fund’s role has
tended to be mainly passive. As noted earlier, Article IV of the
Fund’s Articles of Agreement states that a change in a member’s
parity may be made only on the member’s proposal after consultation
with the Fund, which shall concur if it is satisfied the change is neces­
sary to correct a fundamental disequilibrium. Partly because big
countries are important and jealous of their sovereignty, partly be­
cause a big country parity change may have severe market impact and
shake the entire system, partly because such changes have been infre­
quent in recent years, and partly because in the case of revaluation
the Fund has no effective financial leverage to employ, the process
of consultation for the big countries has tended to be not much more
than very short-term advance notification, and Fund concurrence by
necessity has been almost pro forma. Even in cases of devaluation
where the Fund will have some financial leverage the big country
knows that it can count on support for a drawing from the Fund, if
necessary. In many of those cases the Fund can impose some condi­
tions, but they tend to be drawn up post hoc and are not really part
of the consultation process.
The important point to note here is that the consultative process
in the sense of a full discussion and negotiation simply does not exist.
The Fund, of course, will have background staff papers; when a major
currency is under pressure that fact is known and preparatory work
will have been done. But the time framework is such that there can
be no meaningful international discussion. Usually the country con­
cerned will have announced its intention after market closing for the
weekend with effective action before market opening after the week­
end. With the possibility of very large currency flows no country can


afford a protracted discussion that would carry past the weekend,
once an intention is announced. And there is no practical way to re­
ject the proposal—the currency would be suspect. Thus the Fund
Board is forced to concur willy-nilly; it faces a fait accompli.
The Fund’s role in situations concerning countries of lesser eco­
nomic and financial importance, whether developed or developing,
is considerably less passive. Both the consultative and admonitory
policies and procedures are handled with greater efficacy and accept­
ability than those with major countries. That is not to say that the
correct policies are easy to formulate, that they necessarily are imple­
mented well, or that they always lead to the desired results. But the
simple fact is that Fund management, board, and staff have carried
more weight and worked more effectively with the smaller countries
than with the bigger ones. Usually more time is available to discuss
timing and magnitude of parity changes and programs to accompany
them; there is less speculative pressure and less prospect of untimely
publicity. The latter point may reflect partly the fact that parity
changes come with more frequency in the minor countries and are
more acceptable because they rarely strain the whole monetary system.
It should be possible to devise a procedure under which the Fund
will play a more active role in big country parity changes and one
under which meaningful international consultation can take place
without the glare of publicity. Two possible methods suggest them­
selves and, in an emergency, a third might be followed.
One key requirement for the success of any approach is a more
activist role for the Fund management in connection with big country
parity changes. The Fund management might well take the lead in
pressing for parity changes it regards as desirable. This role would be
perfectly consonant with the provisions of Article IV. There is nothing
to prevent the Fund management from discussion with and making
suggestions to a country; it does so with many of its smaller members.
The country concerned, of course, makes the formal proposal. The
Fund management should assume a more positive role in ascertaining
a country’s views on a possible parity change and undertake to par­
ticipate actively to ascertain the positions of the other big countries
toward any change. Finally, the Fund management could make spe­
cific suggestions as to the approach taken in reaching a new parity.
The other key requirement is security, which means essentially
that very few people should be privy to the discussions. Practically,
that requirement means that there should be no formal meetings at­
tended by full-scale delegations and staff. The discussions simply


have to be kept confidential in every respect. One way to proceed
would be to follow the pattern that developed in connection with the
devaluation of sterling. Sterling was under periodic pressures over a
long period. Every big country treasury and central bank was fully
aware that the fight to preserve the sterling parity might be unsuccess­
ful. As the situation developed there were many quiet conversations,
largely bilateral but some multilateral, and from them it became
reasonably clear that a devaluation of no more than 15 per cent
would be acceptable to the big countries and that none of them would
be likely to take retaliatory action, either by changing its own parity
or by other measures. In the actual event, no major country followed
sterling down. Actually very few countries outside the sterling bloc
made parity changes.
The above should not be taken to mean that the timing, magnitude,
or method chosen for sterling devaluation was optimum. The central
point is that there were meaningful consultations of a sort and rea­
sonably clear understandings reached without publicity and in a
confidential atmosphere. These, however, were mostly outside the
Fund; its management, board, and staff did not participate very
There is no reason why the Fund management should not play a
more active role and follow this kind of pattern. Senior Fund man­
agement and staff travel extensively. Quiet conversations with highlevel political and technical officials can be arranged easily. Either
by positive Fund suggestion, made in utter confidence, or by secret
advance notification by the country contemplating a parity change,
the consultation process could be started; and it could be carried out
in confidence and with reasonable speed.
This approach basically involves a set of bilateral consultations
with heavy engagement of Fund management and very senior staff.
Another approach might be employed which would be more multi­
lateral and in which Fund management and staff would play a smaller
role in the consultative process. This approach would not preclude
a more activist part for the Fund management in its discussions with
the country or countries making the actual parity change.
The deputies of the Ministers and Governors of the Group of Ten
are essentially the same people who head the country delegations in
Working Party Three, and the countries represented are essentially
the big countries. Furthermore, the Group of Ten might be enlarged
to bring in the three or four countries which are not now members
but which are of importance in a financial or industrial sense. It has


become a standard habit for the heads of the delegations to meet for
dinner and discussion on the occasion of any meeting of the Ten or
the Working Party, and a meeting can be called quickly if necessary.
The schedule is periodic but not necessarily regular. These people
are very high-level officials with sophisticated understanding and
with virtually instant access to their principals, who themselves are
political leaders in their governments. Certainly, quiet and confidential
consultations could take place within this group of delegation chiefs,
and both technical and political decisions could be taken. Since a
senior Fund official normally attends both the meetings and the din­
ners, Fund representation would be assured; and since the countries’
representatives on the Executive Board of the Fund normally get
instructions from the same people who are the deputies, the actual and
formal final consultation in the Fund board would have more meaning.
The third, or emergency, approach would be to convene the Mini­
sters and/or Governors of the Ten— hopefully with no public notice.
This is possible. A meeting of central bank governors in Frankfurt
late in November, 1967 was convened on a Sunday with virtually no
publicity. It dealt with a most sensitive subject, the policy of the Gold
Pool, and was kept quiet until its conclusion when a communique was
issued. The specifics of the Bonn meeting pattern should not be re­
peated but the basic objectives of the Bonn meeting— real interna­
tional consultation at a high political and decisionmaking level— should
be susceptible of attainment in a better way.
Greater Flexibility Possible Now
The last point for discussion is the suggestion that the Fund follow
a more flexible approach to methods for making parity changes in big
countries; that this would be more satisfactory and useful than to
seek to modify modestly and generalize the modest change within
the present fixed parity system.
It has already been stated under premise (c) that the present
Articles of Agreement seem sufficiently broad to permit the Fund to
pursue a more flexible approach, and the belief that there is no need
to amend the Articles. That belief, of course, requires underpinning
in a legal sense by an opinion of the Fund’s counsel. As expressed
here, it rests on the following points.
First, with the possible exception of an automatic crawling-peg
system, a crawling-peg approach to parity change is well within both
the spirit and letter of the Articles. A crawling peg that is publicly
announced as a policy action by a government and expressed in terms


of specific amount and with specific timing can be viewed as either a
discrete change in parity to be made effective in a series of steps, or
a series of discrete changes in parities. In either case the Fund should
have no legal or procedural difficulties in approving such an approach
if a country requests it.
Second, as a matter of practice the Fund has condoned, without
giving formal approval to, or in certain instances has found the legal
authority to approve, a whole variety of parity arrangements that can
be regarded as conforming to a fixed parity system only in a highly
technical sense. In particular, the Fund permitted the Canadian dollar
to float, albeit that float was an effectively controlled one, for years.
Quite recently, as noted, it condoned a float for the D mark—al­
though that move was a very short-time one. The German float was
a fairly free one with minimum market intervention by the Bundes­
bank. The operation was carried out most successfully and certainly
should be regarded as a step toward strengthening the international
monetary system.
Third, it does not seem legally possible without amendment of the
Articles for the Fund to permit a generalized system of operation
within a wider parity band. Whether such a system would be useful
or not may be open to question and is not considered here on its
merits. But, if the Fund can condone a temporary float as a means of
reaching a more viable parity there would seem to be little logic in
opposing a wider band for temporary use by a particular country. In
practical effect, a wider band would merely be a definitively limited
float in one direction. Surely a currency would not be likely to vary
widely on both sides of par in a short time period unless the central
bank were deliberately avoiding any offset to seasonal forces, or unless
market appraisal of the currency fluctuated violently, or unless the
underlying economic situation changed radically. In either of the last
two instances, the situation which had suggested use of the temporary
wider band would require reappraisal. The first case would seem
highly unlikely.
There would seem to be little or no reason why the Fund in practice
could not condone any of these methods as a means of reaching a
more viable fixed parity in the future. And equally, there would seem
to be little or no reason to opt for a generalized system of modestly
greater flexibility which probably could encompass only one or per­
haps two of the above-noted approaches, particularly if that general­
ized system would require legislative amendment of the Articles. The
more flexible approach outlined does not foreclose any of the options.


The point might be carried one step further. If the Fund manage­
ment is to play a more activist role, there is no reason why it should
not suggest methods to a particular country concerned with reaching
a new and more viable parity. Particularly if the departure from the
formal rules of the Fund is to be relatively short-term, it would seem
the course of wisdom to suggest temporary breaching of the letter of
the rules, if the alternative is a struggle to maintain a nonviable parity
and possible major disturbance to the whole system. This does not
mean that Fund management should publicly advocate breaking Fund
rules. It does mean that Fund management could give reasonable as­
surances to a country that temporary breaching of the letter of the
rules would not invoke automatically any sanctions, because in prac­
tice such violations do not bring retaliatory action anyway.
It is important to stress that the above approach is not an approach
geared to expediency alone. The whole thrust of the argument has
been that no big country should take unilateral action but that action
should come only after full consultation and discussion among its
international partners, with the Fund management playing a leading
and active role in analysis, consultation, and decision.
If the big countries are agreed on the wisdom of a course of action
for one of them, if the country concerned follows a course in good
faith and does not attempt to shift an undue portion of the necessary
adjustment process to its trading partners, and if it keeps in close con­
sultation with them and the Fund, the procedure and program out­
lined would be positively useful for the international monetary system.
Such a program and procedure should help meet the problems noted
with respect to big country parity changes and should help moderate
both the frequency and intensity of currency crises.


. . . the ideas of economists and political philosophers, both
when they are right and when they are wrong, are more
powerful than is commonly understood. Indeed the world
is ruled by little else.
Practical men, who believe themselves to be quite exempt
from any intellectual influences, are usually the slaves of
some defunct economist.
. . . the power of vested interests is vastly exaggerated com­
pared with the gradual encroachment of ideas. Not, indeed,
immediately, but after a certain interval . . .
. . . soon or late, it is ideas, not vested interests, which are
dangerous for good or evil.
So Spoke John Maynard Keynes in the concluding paragraphs of
his General Theory in 1935. Have these observations stood the test
of time?
Indeed they have. As we enter the 197Q’s, the influence of ideas
on events, particularly in economic policy, seems even more powerful
than when Keynes wrote. And the wide acceptance of Keynesian
analysis among policymakers justifies Keynes’s optimistic remarks,
which were made in response to his own query as to whether the
policy actions implicit in the General Theory represented anything
more than a visionary hope.
If anything, Keynes was overly modest, if not for the 1930’s then
certainly for the 1960’s and 1970’s. “Defunct” economists, especially
Keynes himself, do indeed influence the actions of “practical” men.
But so do the ideas of the hale and hearty. I also believe that the time
lag between the inception of ideas and their impact on policy has de­
creased as the number and influence of economists in Government
have grown.
The support for the view that “live” economists are increasingly
influential in Government is easy to find. The Council of Economic
Advisers may be small in terms of staff and de minimis in terms of
budget, but it makes up in prestige and clout for what it lacks in num­
bers. Dangerously close to extinction in 1953, the Council was saved
by Gabriel Hauge and Arthur F. Burns. Its stature increased signifi­
cantly during the first half of the 1960’s, when expansive fiscal and


monetary policies appropriately moved the economy back close to
full employment without inflation.
The role of economists in the Executive departments and in Con­
gress has also expanded greatly. In the Cabinet departments, the
influence of economists has grown as more and more policy-level
positions have been filled by men with professional economic training
or experience. In the Congress, professional economists work on the
staffs of the banking, taxation, and Joint Economic committees.
The influence of the Joint Economic Committee deserves special
emphasis. Although lacking the power to initiate legislation, the Com­
mittee more than makes up for this deficiency by the depth and
breadth of its studies.
The beneficial effects are twofold. First, the conclusions of the
studies have been very useful in pointing the way to appropriate Fed­
eral economic policies. (I am not referring to the Committee’s annual
comments on the President’s Economic Report, which unfortunately
in recent years have acquired a highly partisan color, but to the care­
ful studies carried out by the Committee’s subcommittees and staff,
and by outside economists.)
Second, the studies and hearings conducted by the Committee have
provided a valuable education process for the Committee members
and, through them, for other members of Congress. Several members
who had only a smattering of economic knowledge when they joined
the Committee have since developed a high degree of sophistication.
The size and quality of the economic staffs of several of the inde­
pendent agencies, including the Federal Reserve Board, have also
been strengthened considerably. I shall have more to say about the
importance of the economic function in the Federal Reserve, along
with Karl Bopp’s contribution to that function, later.
The influence of professional economists in Washington has not
been confined to economic policies. The pervasiveness of economists
in the Federal establishment assures that the economic aspects of all
domestic and foreign policies will be carefully considered. In addition,
the methods of the economic analyst have been adopted in handling
other problems. In the Kennedy Administration, professional econ­
omists applied systems analysis to problems of national security.
Later, these techniques, under the leadership of the Bureau of the
Budget, spread to other departments. At this writing, the top leader­
ship of the Bureau is dominated by professional economists.
And it should not go without notice that during the first year of the
Nixon Administration the top White House staff position was held by


Dr. Arthur F. Burns, an outstanding professional economist and a
past president of the American Economic Association.
Clearly, the day of the economist in Government has arrived. The
influence of the “living” economist on policy is great indeed.
Thus it is not at all surprising that the time lag between the incep­
tion of ideas and their impact on policy has decreased. Keynes laid
the modern base for compensatory fiscal policies, including intentional
Government deficits, in the General Theory. His disciples refined
these ideas and instilled them into college students, including men such
as John F. Kennedy, in the late 30’s and in the 1940’s and 50’s.
But it was not until 1964, almost thirty years after publication of
the General Theory, that the United States Congress could bring it­
self to approve an income tax cut in the face of a Federal deficit—
and then only after more than a year of debate.
In contrast, the lag between the rebirth of money supply theory and
its impact on policy has been only a decade or so. To be sure, the
acceptance of Milton Friedman’s basic thesis does not require a
flouting of the “Puritan ethic”— the term that Walter Heller applied to
the reluctance of the American people to cut taxes in the face of a
Federal deficit. It is probably also true that the simplicity of the
Friedman theory has its own special appeal to many policymakers.
But the fact remains that in a relatively short period of time a large
number of analysts and policymakers have swung to the view that
money does indeed matter, and that it matters a great deal more than
Keynes and his disciples were willing to admit.
Noteworthy examples of the rapid transmission of ideas into policy
can also be found in the international monetary field. A case in point
is the willingness of finance ministers, central bankers and interna­
tional civil servants to discuss, if not yet embrace, the concept of
exchange-rate flexibility— at least, greater flexibility than was en­
visaged at Bretton Woods.
Even more striking is the relatively short period of time from
drawing board to adoption of the SDR’s. The importance of this step
in diminishing the significance of gold in the international monetary
system should not be underestimated. One reason for the rapidity of
its design and adoption was the fact that the group of deputy finance
ministers who designed the SDR were also highly qualified profes­
sional economists.
The factors that account for the rising importance of economists
in Government—thus helping to free “practical men” from the ideas
of “defunct economists”— are manifold and complex. The rising


level of economic understanding on the part of both the public and
their leaders in Government is undoubtedly one of the more important
factors. This is not meant to imply that the goal of widespread eco­
nomic understanding among the American people has by any means
been reached. But progress has been made, and this progress has in
turn contributed to the rising influence of economists in Government.
The success of post-World War II economic policies has also rein­
forced the role of economists in Government and raised their prestige.
The recessions of the late 40’s and the 1950’s were mild and short­
lived compared with those of earlier years. The inflation that occurred
in those years was not excessive in comparison with the liquidity
stored up in financing the war.
Even more important, the success of the “New Economists” in
promoting growth without inflation in the first half of the 1960’s—
resulting in an unprecedented period of economic expansion— con­
vinced many skeptics that the business cycle could indeed be stabilized
and that growth without inflation was a real possibility. The disap­
pointments of economic policy during the last half of the decade are,
as they should be, recognized by thoughtful men as errors of politics
rather than errors of economic analysis.
The Federal Reserve System has played an important institutional
role in elevating economists in public policy. This has resulted in part
from the Federal Reserve Board’s heavy emphasis on high-quality
research and a willingness to give largely a free rein to the district
Reserve Banks in their research efforts.
It was not always thus. Except for the New York Bank, the re­
search departments of the district Banks in the 2Q’s and 30’s were
relatively small. Their studies were largely confined to regional eco­
Today things are different. Regional economic matters still receive
heavy and appropriate attention in the district Banks. But their ex­
pertly staffed research departments now range far and wide; some
even go as far as to challenge the very assumptions that underlie
the System’s monetary policies.
Karl Bopp played a leading role in widening the research activities
of the district Banks. Before the end of World War II he was pub­
lishing a monthly Business Review that not only treated matters of
national economic importance (the Philadelphia Review was in the
select minority that forecasted inflation, not recession, for the postWorld War II period), but one with articles that the intelligent lay­
man could enjoy and understand.


These efforts of Karl Bopp and the other district research directors
served the cause of economic policy in two ways. The widely read
district economic reviews have helped raise the level of economic
understanding throughout the country, thus facilitating sound but
sometimes unpopular policies, such as the surtax actions in 1968 and
1969. Second, the analytical inputs of the district experts, directly
and through their principals on the Federal Open Market Committee,
help make for better national economic policies. Gusts of fresh air
from the hinterland can be more than a tonic— they help immensely
in fighting the parochialism that often prevails both in Washington
and on Wall Street.
Karl Bopp has therefore played a meaningful role in reducing the
influence of Keynes’s mythical “defunct economist” and cutting down
the lag between inception of ideas and their use in public economic
policy. Although by no means his only contribution to the world in
which he has lived (the strength of his personal friendship and loyalty
will always be remembered by those, such as myself, who were privi­
leged to study and work with him), I suspect that it might well be the
contribution of which he himself is most proud.
For from the start of his career until today Karl Bopp has been
a teacher, regardless of the title he has held at any given time. And he
knows full well that not all of the teaching takes place in classrooms—
when it comes to economic policy, much of it of necessity occurs
in the very halls where such policies are made.



A N o ta ble F e a t u r e of central banking in the twentieth century
has been the extent to which the current scene, here and abroad,
has been dominated by a few outstanding personalities. Norman in
England, Schacht in Germany, Strong, Eccles, and Martin in this
country— all of these were giants in their time. The influence of the
personal element in the early history of the Federal Reserve was
commented upon by Karl Bopp in his Agencies of Federal Reserve
Policy. One wishes that after more than a quarter century of
viewing central banking from within, much of the time from a
lofty seat among the policymakers, he would tell us what his evalua­
tion now is of the role of the individual in policymaking. Would he
conclude as he did then that “rivalry, jealousy, etc. may be more
important in conditioning policy than are matters of high principle”?1
Whatever human frailties may exist at those levels or elsewhere,
there has been a succession of outstanding figures among central
bankers. Is it to be conjectured that they have influenced the course
of central banking development to a degree corresponding to their
contemporary prominence? Or might central banking have progressed
in much the way that it did if they had been men of milder stamp?
Influential as these men were for varying periods of time, how
lasting has been their influence? Of significant changes that have
taken place in the art of central banking, what proportion can be
traced to them? Did great leaders make for great events or is the
reverse nearer the truth, namely, that great events tended to make
the leaders great?
Background of Central Bank Leaders
There is another line of questioning, different from the first but
not unrelated to it. It has to do with the sources of the exceptional
1 Karl R. Bopp, “Agencies of Federal Reserve Policy,” The University of
Missouri Studies, a Quarterly of Research, Vol. X, No. 4 (Columbia, Missouri:
University of Missouri Press, 1935), p. 80. Insiders have access to much
knowledge to which outsiders obviously do not. But it is likewise true that
they are bound by constraints from which others are free. The two factors
partially offset one another. Considerations of official responsibility, loyalty, and
personal propriety can be expected to seal lips in many situations where close­
ness of association has opened eyes.


power and status held by these few individuals during their terms
of office. Why did they overshadow others about them, as well as
others who preceded or followed? They were clearly superior in
administrative influence whether or not they were of superior tal­
ents; from what did their superiority derive? Do similarities of back­
ground, personality, or character offer clues as to why they came
to hold positions of exceptional authority and influence?
The latter set of questions, bearing as it does on the sources of
their power as central bankers, is more easily disposed of than the
first, which bears on the durability of their influence. In both cases,
however, one must rely more on general impression than on con­
clusive evidence. Contrary to normal expectation, high academic
achievement was not a requirement for high position as a central
banker. Honorary degrees were fairly generously distributed among
those mentioned but the same cannot be said for earned degrees.
Two were college graduates, each with an advanced degree. Another
was a dropout and two did not attend college, one because of
straitened family finances and the other for just the opposite rea­
son, i.e., to share in managing the family’s burgeoning business
That all were intelligent is certain; that they were highly intel­
lectual, as we know the term, is not. Nor were their qualifications as
economists or experts in their field particularly high. Norman’s con­
ception of the role of an economist is said to have been to explain
to him why he decided as he did, after a particular action had been
taken. Another felt obliged on one occasion to call on a staff
economist to identify the terms of the Quantity Theory equation to
a Congressional interrogator rather than do it himself.
If outstanding academic accomplishment was not a precondition
of success in central banking, the same cannot be said of success in
business. All had demonstrated extraordinary ability as businessmen
before being chosen as heads of central banks. As an imaginative
and vigorous younger man in New York banking circles, Benjamin
Strong early came to the attention of the city’s financial leaders. Nor­
man had achieved prominence on both sides of the Atlantic as a
leading investment banker. Schacht, the man who stabilized the
Reichsmark; Eccles, the Mormon banking tycoon; Martin, the boy
prodigy as investment banker, head of the New York Stock Ex­
change, and draftee made colonel in three years— all of them had
demonstrated ability in ways that established their prestige in busi­
ness circles and provided solid credentials in places where those


credentials mattered most for appointment to governing posts in
central banking. There can be no doubt that past success in business
also counted with the public and with political leaders in the weight
their opinions subsequently carried. Equally important, in all prob­
ability, was the assurance which success of this sort gives the
individual himself when it comes to dealing with others.
That they came from families with the right connections was
surely no disadvantage. But it is not unreasonable to believe that this
did little more than set their steps in promising directions. They had
within themselves qualities of mind and personality that furnished
the drive to carry them forward, rapidly and far. These qualities
included a high degree of self-confidence and self-assertiveness. To
say this is not to overlook evidences of introversion and personal
doubt which, in the case of Norman at least, sometimes reached
pathological proportions. (That such qualms became more acute in
later years when his influence was on the decline suggests a sequence
of interaction that helps confirm the original hypothesis as to the
bearing of self-confidence on effectiveness as central banker.)
Combined with all this was deep devotion to the cause of public
service in general and to central banking in particular, a devotion
more profound in some than in others but lacking in none. In the
case of Norman this attitude fell little short of a religion. In the case
of Martin, whose father had been a central banker before him, it
was to become a way of life. It is reasonable to suppose that without
this devotion neither Norman nor Martin would have remained in
central banking as long as he did or been half so effective.
Sources of Influence as Central Bankers
All of the men were conspicuously skillful, each in his own way,
in handling other men. Martin in particular became a master in deal­
ing with Presidents and with Congress, though there is little doubt
that the time and effort which this required was often extremely
burdensome to him. Mere length of time in office can become a
source of strength, as the experience of Norman and Martin clearly
demonstrated. Situations may come to exist where the Government
of the day would hardly dare to dismiss a particular central banker
because of the alarm which that might cause among businessmen and
the public. This is most likely to be the case, of course, where the
official has acquired a reputation for caution and dependability in


financial matters, especially if the Government in power is less
esteemed for these virtues.2
There have been other sources of central banker power aside from
those mentioned. During the period of the New Deal and then of
World War II, Eccles derived strength from the confidence reposed
in him by President Roosevelt. After the Presidency changed, Presi­
dential support declined and so did the influence of Mr. Eccles. Not
to be overlooked, also, are the exigencies of problems arising out of
depression and war as contributing to the influence exercised by cen­
tral bankers of the day. This was true of Schacht, Norman, and, not­
ably, Eccles. But war or no war, a man of Eccles’s temperament
would have tended to dominate the scene of which he was a part.
A central banker who has achieved a reputation for responsible
leadership acquires significant personal power just because of that
fact. This was unquestionably an important element in the strength
of the position held by Mr. Martin on Capitol Hill. It is widely
believed to have deterred President Kennedy—who later became a
staunch ally of Martin—from replacing Martin early in his Admin­
istration. The same consideration contributed to the influence, in
their day and respective countries, of Hjalmar Schacht and Montagu
Norman. At the same time, it is a factor that could conceivably cause
an official to remain on after he had outlived his greatest usefulness.
Behind the influence that derives from past service lies the weight
of public opinion. The basis of popular support for Schacht was not
the length of his service but his reputation as the man who stabilized
the Reichsmark. There is little doubt that Schacht and Hitler held
each other in profound disregard. Hitler apparently would have liked
to appoint a favorite, a little-known economist named Feder, to head
the Reichsbank (risking the opportunity this would give critics to
exploit the term “Federgeld” which translates as “feather money”).
But Schacht enjoyed enormous prestige in financial circles abroad.
His name was certain to contribute to the strength of the mark in
foreign exchange markets. And so he and not Feder was placed at
the head of the Reichsbank.
Without much question, the respect accorded Benjamin Strong by
other central bankers and by students of central banking over the years
2 The same point was made in the popular saying that Chairman Martin
was worth $5 billion (or whatever the figure) in gold reserves. On the other
hand, at a time when his conservative policies were said to be holding back
the stock market, it was likewise said that Martin was costing 50 points on
the Dow Jones!


has exceeded that accorded any of the others. The early years of the
Federal Reserve System were a period when the prevailing point of
view shifted only gradually from the micro-orientation appropriate
to a member bank to the macro-orientation consistent with the status
of a central bank. That the Governors of the Reserve Banks, who
were mainly drawn from the ranks of experienced bankers, should
have shared the narrower view is less surprising than that members
of the Board, for whom this was not the case, also did so. Strong
was one of the first to adopt the wider conception.
While the possible effect of open market operations on credit con­
ditions was early recognized,3 such operations continued to be thought
of as primarily a means of providing income for the Reserve Banks.
Strong was the most persistent in advocating the use of open market
operations as a policy instrument. He did so initially as an offset to
gold imports and later as a means of regulating credit conditions.4
Either way, it was a repudiation of the narrow, micro point of view.
What we regard as the broader and therefore more truly central
banking approach would ultimately have come to prevail in any case.
But Strong was the leader in bringing it about. His intimate knowl­
edge of banking and the money market meant that he was familiar
with the mechanics of open market operations. Where he was most
distinctly ahead of his colleagues and his times, however, was in basing
open market policies on the state of the economy without regard to
the effect on earnings of the Federal Reserve Banks. Chief opposi­
tion, curiously enough, came from A. C. Miller, who, despite his
credentials as the most highly qualified professional economist on the
Board if not in the System, continued into the late 1920’s to urge
their use solely as a means of providing earnings for the Banks.
Strong look a leading part in facilitating a return to the interna­
tional gold standard after World War I. Accordingly, he attempted to
respond to gold movements in ways that would make them less dis­
turbing to internal economic conditions in this country. At the time
and subsequently, he was criticized for the particular measures which
he espoused. The principal objection was that by interfering with
adjustment processes his methods impaired the long-run viability of
the international gold standard. It was further charged that the
3 Lester V. Chandler, Beniamin Strong, Central Banker (Washington:
Brookings Institution, 1958), p. 76.
4 Ibid., pp. 220, 228.


resulting credit expansion contributed to the financial crash of 1929
and events that followed. The criticisms may well be valid. Yet the
fact remains that he, more than anyone else, helped to shift the focus
of central banking in this country from the point of view of an indi­
vidual bank to that, not only of the nation, but of the nation within
a community of nations.
The ideological orientation of central bankers may be expected to
play a part in the position they come to occupy. None of the five
men was notably conservative but all would readily be classified as
safe. Mr. Eccles is the only one who stood out among contemporary
businessmen as a liberal. His right to be regarded as liberal stemmed
from his early endorsement of policies for expanding employment
and his close association with Franklin D. Roosevelt. He came to the
attention of the Roosevelt Administration because of speeches indi­
cating a point of view sympathetic to New Deal philosophy, an atti­
tude which, among successful businessmen of the day, marked him
as an anomaly. Following his appointment to the Federal Reserve
Board, his personal drives quickly carried him to a position of extra­
ordinary influence. It was a time when the System in general and the
New York Federal Reserve Bank in particular were signally lacking
in strong leadership. Conditions were ripe for reorientation and reju­
venation of the entire Federal Reserve System. He, the New Deal,
and the war and its aftermath all contributed to that end.
That Eccles carried off the role of leader at the highest Govern­
mental levels forcefully and effectively is not to be denied. But that
it was the times of crisis that lifted him from a position of relative
obscurity is likewise true. Eccles served the System well— as did the
System, Eccles. His experience contrasts with that of the other out­
standing central bankers, all of whom tended to be identified with
relatively conservative causes: Strong, Norman, and Schacht with
monetary stabilization in terms of gold, and Martin with the preven­
tion of inflation. Schacht and Norman specifically disavowed respon­
sibility for attempting to combat unemployment.
It must, of course, be remembered that in the earlier period,
before the publication of Keynes’s General Theory, it was easier than
it is now to overlook the relief of unemployment as a policy objec­
tive. Moreover, prevailing attitudes tend to reflect recent experience.
Events of the early years after World War I had dramatized the evils
of inflation, as depression was to dramatize the evils of mass unem­


ployment a decade later.5 Perhaps it would be fair to say that the
central bankers were as conservative as it was necessary to be in
order to be chosen for the position in the first place and, in the sec­
ond place, to command that degree of popular trust and respect
thereafter that was the precondition of their continuing effectiveness.
Role in International Affairs
It is significant that of the five individuals mentioned as most out­
standing during their time of service three are especially noteworthy
because of their international interests and activities. Montagu Nor­
man, like Strong, was actively involved in the monetary reconstrution that followed World War I. The leadership of Winston Churchill
in bringing about Britain’s return to the gold standard was largely
based on advice from Norman. Churchill is said to have blamed
Norman for the unfortunate economic results that followed, with a
resulting rift between the two men.
Norman’s internationalism was carried to the extreme of lending
Bank of England support, and even pledging its resources, to eco­
nomic reconstruction abroad. A far cry, this, from the parochialism
evident at the same time in the United States where monetary policy
was based on the protection of central bank earnings. The objective
of Bank of England policy, far from concentrating on the state of the
Bank, had reached beyond the state of the economy all the way to
the state of national economies abroad. The extension was presum­
ably based on enlightened self-interest: as a trading nation Britain’s
prosperity was thought to depend upon the recovery of countries that
constituted her natural markets. Norman sought “to save Britain by
saving the world.”6 But at times indirect benefits to England seemed
to take second place in Norman’s thinking; he refused to accept mass
5 Concern for stable prices rather than employment is not to be regarded
as a dependable index of a central banker’s conservatism. It is not only that
fashions change with the times, even in central banking. More important is the
fact that the priority of objectives varies with changing conditions. In particular,
it depends on the degree to which current economic trends deviate from
accepted norms. At a time when the price level is rising and employment is
relatively full, price stability takes precedence over full employment as a
policy objective. At a time when prices are stable and unemployment is
rising, on the other hand, employment becomes the prime objective. A better
measure of central banker conservatism might be the length of time it takes
him to accept a change in conditions and adjust his thinking accordingly.
The fact that conseratives tend to be thought of as being more concerned
with price stability than full employment may only reflect the fact that for a
longer time stable prices have been a recognized aim of central bank policy.
6 E. R. Wicker, Federal Reserve Monetary Policy, 1917-1933 (New York:
Random House, 1966), p. 139.


unemployment as his official concern or to admit that depression
might be aggravated by the international orientation of his policies.7
Hjalmar Schacht was also involved in monetary reconstruction
after World War I, though in quite different ways. But for his repu­
tation at home and abroad as the man who finally succeeded in
stabilizing the Reichsmark, he would never have been placed at the
helm of German financial fortunes and given almost unlimited au­
thority. He claimed to have been responsible for the establishment of
the Bank for International Settlements, though that honor is more
commonly ascribed to Montagu Norman. Perhaps his principal claim
to fame is as the man who shaped exchange control into a major
instrument of policy. He is reputed to have found the uses to which
it was put highly distasteful; but it was undeniably effective in
accomplishing political as well as economic and financial ends. In
milder forms exchange control has remained in use in different parts
of the world ever since, without significant advance over the tech­
niques which Schacht developed.
Monetary reconstruction and exchange control are essentially spe­
cial situations, even when the situations become chronic. Of greater
continuing interest and importance is central bank cooperation. The
beginnings of such cooperation could doubtless be traced to when­
ever it was that there was another central bank with which to coop­
erate. The exchange of substantial financial assistance between the
Bank of England and the Bank of France throughout the nineteenth
century is well-known. Central bank cooperation was commented
upon explicitly by Walter Bagehot, R. G. Hawtrey, and others long
before it became a commonplace in recent years. Cooperation among
the central banks of countries which are allies is a natural concomit­
ant of war finance. In the decade after World War I there was close
cooperation between Strong and Norman, as has already been men­
A notable step in the development of central bank cooperation
was the establishment of the B.I.S. in 1930. Almost immediately it
became a meeting place— a private club— of central bankers. So
effectively did it serve this function that central bankers of the
belligerent countries continued to meet there, though somewhat less
frequently, throughout World War II. Its role, however, is primarily
that of a forum for discussion where central bankers meet face to
face, rather than a channel through which cooperative undertakings
are mainly carried out.
7 Op. cit., pp. 194, 282.


All this is preliminary to saying that the years after World War II
were a period of increasing central bank cooperation. Starting at
Bretton Woods or before, a host of central bankers and Treasury
officials had a share in this development. The name of no individual
central banker stands out conspicuously above the others in bringing
it about. Thirty or forty years earlier that was not the case.
Concrete manifestations of international central bank cooperation
took the fbrm of organizing financial assistance for central banks un­
der pressure, swap agreements, and so-called re-cycling arrange­
ments, to name only the most familiar. These innovations and many
others took place in the term of office of Chairman Martin. They
may be presumed to have met with his approval. But they are in no
way identified with him personally either as originator or as sponsor.
Staff members, officials outside the System, and central bankers
abroad had as much to do with their development as he did, or more.
In Martin’s case, then, fame as a central banker rests less on
activities in the international field than was the case with Strong,
Norman, or Schacht. This is not because changes of an international
character have been less important than those made earlier; the
opposite is quite certainly true. One of the reasons is that, in the
United States at least, Treasury officials now have more influence
than they once did on international monetary policies, and more,
quite probably, than their central banking colleagues. Another reason
may be that the entire structure of international financial institutions
has become more integrated. We now have a relatively close-knit
international financial system. Innovation and development are a
normal output of the system and no longer depend to the extent that
they once did on the inspiration and initiative of any one person/
Contribution to Internal Organization
Matters of internal structure and organization received little con­
scious consideration throughout the earlier history of central bank­
ing. The Bank of England apart, central banks were typically given
their form at the time they were established and from then on simply
proceeded to grow. After World War I and even more after World
War II, the situation was quite different. Mention has already been
made of the changes introduced as part of the sweeping banking
reform following the Banking Holiday which, along with suspension
of the gold standard, ushered in the New Deal. The intensive re­
8 Measures of centralization introduced in the 1930’s probably mean that
the head of the New York Bank could never again exert the influence in
international affairs that Benjamin Strong did in the 1920’s.


examination of the financial structure of Great Britain by the Mac­
millan and Radcliffe Committees, culminating in famous reports
published in 1931 and 1959, had their counterpart in Congressional
investigations in the United States under Senator Douglas and Repre­
sentative Patman, respectively, with publication of their reports in
1950 and 1952.
Strong, Eccles, and Martin each made distinctive contributions to
the process of internal reorganization of the Federal Reserve. Strong
was involved in what at times resembled power struggles turning on
the role which the New York Federal Reserve Bank would play
relative to the Board on the one hand and to the remaining Federal
Reserve Banks on the other. No one can say how the conflict would
have come out if Strong had lived and the depression had not inter­
A few years later Eccles’s influence was decisive in settling the
structural issues in favor of greatly increased centralization. Impor­
tant changes toward that end were embodied in the Banking Act of
1935. And, by force of personality more than of law, Eccles helped
to determine that thenceforth the Chairman of the Board of Gover­
nors would be the dominant figure not only on the Board but in the
Martin succeeded to this central position in 1951, and during his
long tenure did much to enhance it. His unique contribution, how­
ever, was in the direction not of centralization but of unification. The
principal means of bringing this about was through vitalization of
the Federal Open Market Committee. Meetings were put on a regular
three-week schedule with attendance by the presidents of all twelve
Banks, accompanied by a senior economist from each. The result was
to provide a forum in which all governors and presidents partici­
pated and which at the same time became an avenue for the exchange
of information and a channel for influencing policy. Practices were
introduced which extended the lines of communications further down
within the staff in both Board and Banks. At sessions of the Com­
mittee, Martin proved supremely successful in deriving a consensus
from among diverse and sometimes divergent points of view.
The results were as noteworthy in terms of morale as of current
operating procedure. Esprit de corps was enormously strengthened.
A sense of participation and of being abreast of what was going on
came to prevail throughout the System. All this was accomplished
without the necessity of adding an elaborate bureaucratic superstruc­


ture. A significant by-product of bringing all parts of the System into
the stream of policymaking was to generate an extraordinary degree
of respect and personal loyalty for Chairman Martin.
There is something peculiarly fitting in the thought that the most
apparent contribution of the more outstanding of the central bankers
should have been in the area of internal organization. All of them
had been highly successful businessmen, and organization is essentially
a management problem. The qualities of a business executive no less
than a background of experience in business should, in all logic, pro­
vide the expertise required for dealing with it. And that appears to
have been the case.
Contributions by Others
To stop at this point would be to leave out of consideration by
far the largest number of those who occupy positions at the center
of power and influence in the Federal Reserve System.9 It is pertinent
to ask whether persons whose hierarchical position is less high, or
whose conduct brings them less into the public eye, may nonetheless
exert a greater, and perhaps a most lasting, influence on central
banking. These would include staff members who may have origi­
nated the innovative ideas for which their chiefs received credit.
There can be no doubt that significant contributions to central banking
have come from outside the charmed circle at the top. The nature and
extent of such contributions are exceedingly difficult to identify in
terms of individuals and are likely to remain largely unrecognized.
In the nature of things, unsung heroes are destined to remain un­
sung. Only within a limited coterie inside the organization are the
signal contributions of subordinates likely to be known, even if they
exist. In most cases significant advances are the product, first, of
evolution and, second, of combined efforts where no individual’s con­
tribution stands out markedly from that of others. This is not to dis­
parage the importance of group efforts by staff members or of germi­
nal minds undoubtedly to be counted among them. It is to amplify,
rather, what was said earlier to the effect that the prominence of a
9 That nexus was explored briefly a number of years ago in an analysis
which undertook to rank the holders of power within the Federal Reserve in
order of the influence exerted (C. R. Whittlesey, “Power and Influence in
the Federal Reserve System,” Economica, February 1963). The substance of
what was said there may be regarded as still applicable. An insider comment,
undoubtedly correct, was that the attempted ranking failed to bring out the
great degree to which the influence of the Chairman of the Board of Gover­
nors, Mr. Martin, exceeded that of any of the others.


few outstanding central bankers seems traceable more to feats of
action than of intellect.
Discussion of the influence of particular individuals on the devel­
opment of central banking would be incomplete without recognizing
the part played by persons outside the circle of central bankers.
Without much question the most important influence was that ex­
erted by Walter Bagehot, the author of Lombard Street. And Bagehot
was never a central banker. Another such case was Ricardo. The
influence of Keynes was likewise very great; while membership on
the court of the Bank of England made him technically a central
banker, that role was entirely secondary to his academic status. In
our own times, Milton Friedman must be accorded credit, if that is
the correct term, for considerable influence on monetary policy.
Conclusions: The Credibility of Monetary Policy
We arrive in the end at the conclusion that enduring contributions
to the art of central banking by the few most outstanding central
bankers were hardly proportional to the prominence they occupied
during their terms of office. By talents and by training they were far
better equipped to apply and to lead than to invent or innovate. But
what they undoubtedly did bring to the conduct of central banking
was an invaluable element of credibility and conviction. Their pres­
ence at the summit of the central banking establishment added im­
measurably to a belief that the policies they advocated had merit and
would succeed. It was primarily the weight they were able to bring
to bear through prestige and personality that made this possible.
To find in the contribution which they made to the credibility of
monetary policy the secret of the success of this handful of outstand­
ing central bankers is not to disparage the importance either of
monetary policy or of outstanding leadership. For it is in the nature
of economic policy in general and of monetary policy in particular
that the priceless ingredient of success lies in being believed. The
reason why this is so is very simple: in situations where a conviction
prevails that stabilization policies will succeed, market forces are set
in motion which assist powerfully to that end. To the extent that
doubt as to final success exists, on the other hand, resulting market
responses operate to impede and defeat a successful outcome.
We are left with a crucial question. Can ways be found to estab­
lish more securely the credibility of central bank policy? Or must we
continue to rely on chance to supply us spontaneously and at the
right time with uniquely prestigious central bankers? It is of comfort


to be able to say that, in a democracy, times of crisis help to call
forth qualities of leadership suited to coping with them, as the history
of the American Presidency clearly demonstrates. Nevertheless, a
policy of drift fails to commend itself. Rational man must aspire to
mastery of his destiny, even in the face of evidence reminding him
of its dependence on fortuitous elements.
Two courses of action suggest themselves for lessening our reliance
on the emergence of an occasional preeminent leader to bolster the
credibility of monetary policy. One is to strengthen the processes
whereby capable leadership is developed from within the System.
(Progress in that direction may prove to have been Chairman Mar­
tin’s finest achievement!) The other is to strengthen the tools which
central bankers have at their disposal. It may seem presumptuous to
suggest adding to Federal Reserve powers at a time when the authori­
ties are under criticism for the manner in which they have exercised
the powers they have. But inadequacy is no less a cause of failure
than ineptitude. And it may well be that the only route to achieving
credibility of stabilization policy and the benefits that would flow
therefrom is by assigning to the central authorities— monetary, fiscal,
and Presidential— powers so complete as to leave no doubt that an­
nounced goals can and will be achieved.
The credibility gap that plagues monetary policy today could be
closed, as has been said, by elevating central banking powers to the
level of existing goals. Or it could be closed by admitting defeat and
lowering aims to the level of existing powers. The worst of all
worlds is where goals demanded are kept high while authorities
are starved for powers adequate to assure the attainment of those
goals; the effect can only be to defeat policy and discredit policy­
makers. Yet that is the world in which we have lived for, lo, these
many years. We have reaped the harvest of such a course in the form
of mounting skepticism as to the effectiveness of monetary policy and
an insistent belief in the inevitability of inflation, a state of mind
that has consistently confounded efforts to stabilize prices while
maintaining employment and growth.
To urge the granting of a greater panoply of economic powers is
not to favor increased intervention in economic activity by the cen­
tral authorities. The intended inference, in fact, is just the opposite.
The aim should be first and foremost to diminish the credibility gap
by fostering the conviction that announced goals will be realized.
We can then expect that market responses will be induced that will
promote those ends with a minimum of Governmental intervention.


There is an analogy with the enforcement of law and order. The
effectiveness of a police force is measured not by the number of
arrests that are made but by the encouragement given to the sort of
behavior that makes arrest unnecessary. The same holds true, in a
free society, of an ideally functioning central bank within a larger
structure of stabilization authority.
No lesson stands out more clearly from over a half century of
Federal Reserve experience than the importance to the success of
stabilization policy of being believed. We have witnessed the sudden
crippling effect of fear of devaluation and the long-drawn-out frustra­
tion of a belief that inflation is inevitable. For brief periods out­
standing leadership, coupled, perhaps, with strong measures to meet
the emergency of war or other crisis, has helped to replace doubt
with credence. We have seen that we approach the goals of economic
stabilization only to the degree that we succeed in establishing the
conviction that those goals can and will be achieved.
“Government of laws or of men” takes on whatever meaning it has
according to the laws and the men we have in mind. Safeguards de­
signed as protection against the acts of the inexperienced or incom­
petent when a central bank is in its infancy inhibit the talented when
that bank has assumed professional status. The same applies to all
other areas of government by agency where power, even autocratic
power, is delegated by democratic processes.
The shortcomings of monetary policy are not to be laid solely at
the door of central bankers. It is not just they who fail the cause of
stabilization. It is, rather, the legislators, and behind the legislators
the public, who demand stability but fail to provide the means that
would make stability sure. To succeed, monetary policy must be
credible, and credibility involves us all.


The financial husbandry of a nation centers in the soundness of
its money. The monetary unit pervades the economy so completely
that its stability is a matter of daily concern to investors and bor­
rowers alike. It is at the heart of the calculations of businessmen.
Hence it influences their willingness to venture by borrowing. Con­
versely, it affects the willingness of savers to incur the risks of lending.
The wide concern with such matters need not be labored here.
Politicians are torn between pressures for public spending and fears
about the impact of rising prices upon savings and upon living costs.
In achieving financial husbandry of a high order, a country’s
central banking plays a key role. But a central bank consists es­
sentially of human beings, hopefully endowed with objectivity,
knowledge, skill, and dedication. What are the attributes of a central
banker? How may their possessors be found? How may their talents
and knowledge be developed? These are the questions treated herein.
The central banker’s responsibility is to keep changes in the money
supply in tune with the needs of the economy. Since the latter has
an ever-changing pace, either up in expansion or down in contrac­
tion, its needs fluctuate faster than they can be reflected in current
data. The reported data lag the actual transactions. Conversely, the
decisionmaking of entrepreneurs, to the extent events leave them
free to exercise choice, takes place long before the event in the case
of capital investment. Expectations govern decisions to buy or not
to buy, to invest or to save, to “go long” or to “stay short.” Knowl­
edge of the trend of these expectations is hard to come by. Even if
up-to-date news becomes known to a central banker, the sampling
is often so small as to mislead.
Then, too, the central banker works within limitations imposed by
fiscal policy. The spending of governmental units is superimposed
upon private spending and must be taken into account in regulating
the pool of credit. The power to spend governmental funds, however,
is beyond the reach of the central banker, except as the cost and
availability of funds reflect credit restraint. Nor can central bankers
influence the taxes levied and the size of the spending above tax


receipts for which governments must resort to the capital markets.
In short, fiscal policy is beyond the reach of central bankers, but
creates the milieu within which they operate.
But central bankers perform functions within that milieu which
are vital to the nation’s economic well-being. The steady hand of
Nicholas Biddle was a beneficent force for good in our own country
and the aftermath of his removal by President Jackson from a posi­
tion of power and influence bears testimony to the value of his serv­
ice. Whatever his diplomatic shortcomings, he kept, through the
Second Bank of the United States, a money climate in which the
country could make steady progress.
Or, take the careers of such central bankers as Lord Norman of
the Bank of England, as Sir Henry Clay has described it, or of
Benjamin Strong of the Federal Reserve Bank of New York, as Pro­
fessor Lester Chandler has portrayed it. In Italy’s crisis of the late
1940’s, Einaudi turned raging inflation into relative price stability.
Those who have met similar crises in Italy and other countries since
that date are a small, little-publicized corps of central bankers who
have demonstrated their prowess as problem solvers. Little does the
general public know or appreciate the crises that have been avoided
by their imaginative devices, supported by faith in the integrity of
their colleagues.
It would be premature for me to single out any of the current
group of stalwarts for comment. The list of distinguished bank
governors is long, indeed. Eventually their struggles, policies em­
ployed, successes, and failures will be worthy subjects for competent
It was as a historian of central banking that I first met Karl Bopp.
He had been granted a year’s leave-of-absence by the University of
Missouri where he was a faculty member and had received his col­
lege education. The year was to have been spent in the same sort
of intensive study of the Bank of England that he had already made
of Hjalmar Schacht, Central Banker, and of the German Reichsbank.
The outbreak of World War II, however, made that period in­
auspicious for research, and so he returned to the United States just
when needed for a 1940 survey desired by the Chairmen of the
twelve Federal Reserve Banks. They appointed a committee consist­
ing of Thomas B. McCabe (Philadelphia), Owen D. Young (New
York), and General Robert E. Wood (Chicago) to oversee an in­
vestigation of the official compensation paid by the Federal Reserve
Banks and their branches.


To carry out this mission, a team of Karl R. Bopp, who had a
special interest in central banking, William H. Newman, now Samuel
Bronfman Professor of democratic business enterprise at Columbia
University, and I devoted the summer to visiting all twelve Banks.
At each one we met with the board chairman, other directors, the
president, and his fellow officers. Our purpose was to describe the
duties and responsibilities of each officer, appraise his relative im­
portance to the conduct of the Bank’s affairs, and suggest com­
pensation in relation to commercial bank salaries in the area.
In the following year the same team of three was asked to study
the problems of executive development in the Federal Reserve Sys­
tem. Again there was a round of summer visiting (and a very pleas­
ant round it was!) to find out how each of the Banks discovered and
developed those with the talents needed for their top posts. Although
there was some attention to aids to improve selection, the bulk of
the inquiry centered in methods of broadening and grooming those
who appeared to have potential capacity for officers. A greater stress
was laid upon policymaking positions rather than upon the more
routine supervision of daily activities.
These two studies, to which Karl Bopp contributed so significantly,
led inevitably to the question: What is a central banker, and how
do his functions differ from those of a commercial banker? The dis­
tinction lies at the heart of the questions posed for us. One obvious
difference is that a top commercial banker must be able to “get
business.” He must have the ideas, contacts, and drive to increase the
loans and deposits of his institution. He must withstand the rigors
of formal dinner courses and of golf courses where business is to be
found. All the while he must understand the essentials of solvency
and of running a sound, safe bank. “No loan looks bad at the time
it is made,” as a late Philadelphia banker used to observe, and so
the commercial banker, if prudent, will look to the liquidity of his
institution as setting limits to his urge for it to grow in size and in
Within the limitations of such soundness, that the confidence of
depositors and other customers may be preserved, present-day com­
mercial bankers are bursting the traditional bounds of their industry.
This new aggressiveness results in extensive competition as distinct
from the intensive cultivation of previous markets. As David P.
Eastburn stresses in his introduction to The Federal Reserve on
Record, “Modern society is undergoing a process of rapid and ac­
celerating change.” Bankers share the urge to mechanize, com­


puterize, and devise. In addition, they broaden their offerings, partly
by innovations like the credit card, and partly by “poaching” on
territory that other industries had considered their own. They lease
equipment, they share computer time, they service mortgages and
sell insurance, they make travel arrangements, they increase their
lendable funds by capital debentures, certificates of deposit, and
short-term promissory notes. They own and lease offices. Through
their foreign branches, they help corporations finance new opera­
tions abroad, and in addition tap the Euro-dollar market when funds
are scarce at home. By now, hundreds of banks have changed their
corporate attire and dressed as one-bank holding companies.
The harder part of the distinction between commercial and cen­
tral banking is to portray the latter. The function varies from coun­
try to country and from time to time. How the function is admin­
istered depends upon the economic philosophy, understanding,
business sense, and political astuteness of the central banker.
On this point, Professor Newman and I prudently leaned upon
Karl Bopp who had studied Schacht in depth and looked, too, at
other central banks including the Federal Reserve System. Hence, I
quote from the chapter of our 1940 report that dealt with “The
Role of the Reserve Banks in a Balanced System.”
“The role actually played by the Reserve Banks in the economic
structure has varied materially since the establishment of the System
and, more particularly, since the depression. For convenience these
variations may be grouped under these heads:
a. The power of monetary instruments—whoever employed
them— has fluctuated widely from time to time.
b. The agencies which control these instruments have changed.
(1) The power of the Reserve System has decreased rela­
tively as that of other agencies has increased.
(2) Within the System itself, the power of the Board of
Governors has increased relative to that of the Reserve
c. The technical services performed by the Reserve Banks have
increased greatly.
d. The provision of leadership in crises continues to be an im­
portant function of the System.
“The history of money demonstrates the difficulty which men have
to distinguish the permanent from the temporary. In the 1920’s only


a few skeptics doubted that America had entered a new era of
permanent prosperity or that the wise exercise of great monetary
powers was responsible in considerable degree for that prosperity.
In the 1930’s, on the other hand, the pendulum swung to the op­
posite extreme. The notion of permanent prosperity was replaced
by the notion of a matured economy with a large amount of perma­
nent unemployment. At the same time the idea became widespread
that monetary policy could not accomplish anything, and that it
would never be able to do so.
“If one adopts the longer view, it appears that monetary powers
vary in importance from time to time, but that they are never either
omnipotent or impotent. Consequently, whatever their importance
may actually be or appear to be at the moment, the provision made for
the exercise of monetary powers is never a matter of indifference. . . .
“When the Government determined in the early 1930’s to use
monetary instruments as an integral part of national policy, it no
longer delegated their control exclusively to the Reserve System.
In the first place, the Government instructed the Treasury to exer­
cise some of its ‘latent’ monetary powers actively. For example, when
the Government decided to vary the price of gold in 1933, it did
not delegate the power to do so to the Reserve System, but retained
it in the Treasury. Another illustration is variations in Treasury
deposits at the Reserve Banks. Increases in these deposits have pre­
cisely the same monetary effect as an open market sale of securities,
and decreases have the same effect as a purchase of securities by the
Reserve Banks. The added importance of Treasury deposits has
resulted from the much larger variations during the past seven years
than formerly.
“The monetary powers of the Reserve System have been de­
creased still further because certain powers formerly exercised al­
most exclusively by the Reserve System have been delegated in part
to other agencies. When the Government created new institutions,
such as RFC, to deal with specific problems, it allocated both mon­
etary and nonmonetary powers to them without distinction. At the
same time, the Reserve System, cautious after the crash of 1929 and
feeling that the use of at least some of the unconventional monetary
instruments would aggravate rather than relieve the depression, was
disinclined to be aggressive to secure control over them. For ex­
ample, formerly the Reserve Banks were alone among public insti­
tutions which extended credit to banks. The Reserve Banks were
active during the depression in lending on eligible and acceptable


commercial paper or Government securities; but at the outset they
were not empowered to extend credit on miscellaneous assets. Other
agencies, such as the RFC and the FDIC were created and em­
powered to extend such credits.




“Indeed, the history of the major central banks of the world shows
that it would be a mistake to suppose that the recent tendencies
which have been described for the Federal Reserve System are
permanent. In other countries and in other times, periods of ex­
treme economic disturbance have witnessed similar tendencies to
weaken the powers of central banks (e.g., England and France dur­
ing Napoleonic Wars; France in 1870; England, France, and
Germany during and after the War of 1914-1918). But the policies
of weak central banks have frequently resulted in financial difficulties,
and sooner or later monetary powers have been returned to the
banks (e.g., England and France after the Napoleonic Wars; France
in 1871; Germany in 1923-1924; England in 1925; France in 1926).
This strength continues until the next period of extreme strain (such
as the crisis of 1933) when the whole cycle starts anew.”
The foregoing recital of the ebb and flow of central bank power
and influence ends with World War II. Were Karl Bopp to up-date
his narrative, what changes would he stress? Again he would note
the destruction and inflationary aftermath of war. Hyperinflations in
the defeated countries of Austria, France, Germany, and Italy were
followed by the rebuilding of industry with capital supplied by the
United States. The recovery was most rapid in the so-called defeated
countries of Japan, Germany, and Italy and most sluggish in Britain,
a victor.
To cope with all this, central bankers and their cohorts in their
respective treasuries devised the International Monetary Fund and its
twin, the World Bank. American loans supplied the badly needed
capital and bridged the “dollar gap” so that United States exports
could pass over and the corresponding export income cross back.
The dollar became the leading reserve currency and, with sterling,
helped to stretch the stock of gold available for central bank reserves
in other countries.
Then came troubles that challenged the ingenuity and courage of
central bankers as a group. Countries whose currencies were sup­
posed by speculators to have weakened because of disequilibrium in
their respective balance of payments were subjected to raids. Not


only did speculators sell short, but these currencies were further hurt
by the “leads and lags” of their foreign trade. To offset these specu­
lative fevers, “swaps” were devised as a loss-free method of mutual
assistance among developed, industrialized countries (originally re­
ferred to as the “ten” ). These lines of credit have helped the United
States to guard the dollar, but have given other currencies life-giving
injections when sick and in crisis. The Canadian dollar, English
pound, Italian lira and, more recently, the French franc all bear wit­
ness to the efficacy of an injection of adequate liquidity in time.
A central banker of these days has problems both domestic and
foreign. He must seek effective support from fiscal policy so that
monetary and fiscal policies may be in balance. He must persuade
the government of the moment that delay in the making of unpopu­
lar decisions damages the country’s money. A weakened and faith­
less currency rots the underpinnings of the economy. But these de­
cisions that are so vital cannot be arrived at by formula or by book,
though scientific research helps enormously. Rather, central banking
is an art featuring the solving of endless problems both domestic
and international.
Its scope and complexity suggest that a central bank should stress
the finding and hiring of enough young people with real potential
for development. A satisfactory product will not result from an offi­
cer-training program if the raw material is deficient. Consequently
effective selection at appropriate age levels is an essential first step
toward developing a stream of those with the requisite talent and
experience for top positions.
But the process needs to be planned to avoid either an under­
supply or oversupply at each age level who are thought to have ex­
ceptional promise. To have too few would waste the effort and ex­
pense of training. To have too many in relation to the job opportu­
nities at higher echelons would cause those who are most aggressive
to lose the hope of rapid recognition and larger responsibility. Stagna­
tion would lead to loss of morale and departure of the best prospects.
The team of Bopp, Newman, and myself suggested that a guide
to such planning should take the form of a pyramid with the presi­
dency and first vice-presidency at the apex. On the echelon just be­
low them, the board should plan to provide at least two, and perhaps
three, officers ready to fill each of the two top posts. At a stage of
development just below these, there should be four to six individuals,
still younger by five to ten years, who might qualify for the top posts.


At a still younger age level there should be an additional eight to
twelve “comers.”
To plan such a pyramid of posts to be filled by those who are
being watched and developed is a responsibility at the highest ad­
ministrative level, i.e., the board of directors, because it relates to
the long-run organizational strength of the Bank.
Although the team of three did not turn their backs completely
upon the efficacy of aptitude testing to discover executive talent,
they recommended that a practical selection method would certainly
involve group judgment by means of a number of interviews. Those
selected for hiring should then be watched closely and their per­
formance judged on a series of jobs. Such an appraisal requires the
systematic accumulation of comments by superiors close to the work
being done.
On-the-job training is the oldest and most widely used method of
executive development. Although it needs to be supplemented by
continuing education off-the-job, it can never be eliminated or by­
Positions that may prove to have special training value are those
in bank examination and in research and statistics. The former does
more than familiarize one with commercial bank operations and
problems— it requires an aptitude for meeting and dealing with people
in situations that may involve tension. Here, at least, one’s judgment
can be tested.
Research and statistics develops an understanding of the financial
aspects of our complex economy. Not only does it keep the employee
intimately acquainted with the ebb and flow of business, but with
the myriad of forces that play upon the state of business. Insofar
as factual analysis aids in policy decisionmaking, those engaged in
research and in the reporting of trends that are significant get an ad­
mirable education. They will learn, if they are truly wise, that beyond
the inferences to be drawn from factual data there is an area influ­
enced by mass psychology and shifting expectations. In short, they
learn the role of judgment in policymaking.
Not only has Karl Bopp been a student, but a practitioner of the
art of central banking. First attracted to the field by an intellectual
interest, he was drawn into the aforementioned investigation as to
how to create a supply of central bankers. Then he himself became
an outstanding example of the combination of talents, knowledge,
and judgment that is the true central banker.


A N omination to become a director of a Federal Reserve Bank
is both flattering and puzzling. No call to public service, of course, is
ever to be taken lightly by anyone concerned for the effective function­
ing of a democracy. And to citizens accustomed to viewing the central
banking organization as the very apex of the vast financial structure that
undergirds our capitalistic system, an invitation to join the board of a
Reserve Bank is a signal honor indeed. That the honor and opportu­
nity of directorship are well-recognized is attested by the generally
strong boards that have been the rule at the various Reserve Banks
throughout the history of the System.
On closer examination, however, it is hard to escape the conviction
that the status of the director falls considerably short of what it ideally
might be. Nor is this impression greatly altered by actual experience
as a director. It is not that rewards in terms of remuneration, in­
fluence, prestige, and even of perspective on what is going on are
circumscribed. It is the feeling, rather, that achievement is not always
up to potential. The very fact that boards are strong exaggerates the
anomaly— with boards of lesser competence, the loss from failure to
use their talents fully would not matter so much. The boards have
been quite conscious of this situation and have been the leaders in
repeated questioning and self-appraisals of their role and function
within the System. On more than one occasion such discussions have
raised doubts as to the viability of the present organization and struc­
ture, and also as to the ability of the System to continue to attract
strong leadership at the regional level. But the System survives, new
directors join the boards, and the debates continue.
Centralization and the Plight of the Administrator
In all facets of our society, from schools and colleges to highest
levels of government, we are witnessing serious questioning of highly
centralized structures of organization. The discontent arises from the
fact that organizational restraint, stemming from central control that
is often inefficient, tends to limit the scope of human behavior. Not
infrequently, problems confronting organizational structure are so
large and complex that they seem to overwhelm the ability of admin­
istrators to solve them.


Even the ablest individuals equipped with all the known technical
tools cannot hope to deal perfectly with the manifold complexities
confronting centralized structures. The remoteness of central direction
adds to the oppressiveness and discontent which breed in this environ­
ment. It becomes increasingly difficult to persuade individuals, faced
by these complexities, frustrations, and potentialities for misunder­
standing and personal abuse to participate as leaders of such organ­
Increasingly, the need for decentralization is being discussed, in
government and business circles, with a view to transferring power to
smaller units and relating the decision process to the scale of problems
to be solved. It is worth noting that these discussions do not en­
visage the removal of operating guidelines or centrally formulated
general policies, rigorous general standards, or centralized supervision.
The discussions do indicate, however, that by gaining the counsel of
a greater number of individuals, improving two-way communication,
and closer personal contact throughout the organization, institutions
may become far more viable in our society by becoming more sensi­
tive to the needs of their clientele and more efficient and effective in
carrying out their mission.
The Federal Reserve System, unfortunately, is not immune to or­
ganizational pains and pressures. No high marks will be given the
central bank simply on the basis of its mystique. If such marks are
to be accorded they will have to be earned, and to be able to earn
them the Federal Reserve System will have to strive continuously to
develop the most effective organization possible. Among the major
components of any such organization will be the boards of directors
of the local Federal Reserve Banks. Directors can play a genuinely
vital role only if they are permitted to reach their full potential within
the System. Such a role, of course, will carry great responsibilities and
The Director in the Table of Organization
The Federal Reserve System has been criticized as outdated,
archaic, and obsolete from the standpoint of its organizational struc­
ture. Nevertheless, with its division of powers among the Board of
Governors, the Federal Reserve Banks, and various committees and
councils, it may represent a possible forerunner of things to come in
more and more business and governmental organizations. Far from
perfect in theory and in fact, the organization of the System does
contain a number of features sought in the further democratization of


both governmental and business activities. Many of these features
presently exist, however, only on paper, and the full potential of
others remains to be fulfilled.
Banking legislation in 1935, which substantially cut the powers
of the boards of directors of Reserve Banks, officially recognized and
sanctioned the trend toward centralized control over the nation’s cen­
tral banking system. The trend which existed then continues today.
It can be argued that much of the elaborate organization and ritual that
has been maintained in the System is, in fact, a facade.
In view of the trend toward centralized control in the System, some
observers have suggested that the district Banks should be operated
solely as service facilities to clear checks and to provide currency and
coin for community needs. Such a suggestion would signify abandon­
ment of the remaining feature which has provided the real strength of
the System, namely, the sharing of responsibilities for both policy and
operations between the Board of Governors and the staffs of the
Federal Reserve Banks. This elaborate check-and-balance organiza­
tion with its procedures for joint decisionmaking has at times been as
frustrating to the Chairman of the Board of Governors as it has been
to a member of the board of directors of a Federal Reserve Bank.
Nonetheless, it probably represents a unique source of strength for
the System. Under greater centralized control within the Federal Re­
serve, the check-and-balance system would tend to disappear and
mistakes, which are inevitable under any structure, could be that
much bigger. This price could be too high even if the System organ­
ization were to become less costly to operate.
The challenge to the System is to make its still relatively decen­
tralized structure function as effectively as is administratively possible.
This does not necessarily involve any extensive transfer of power
within the System from the Board of Governors to the Reserve Banks
or vice versa, but it does call for a conscious effort by each part of the
System to carry its full share of the burden while permitting other
segments to carry their share.
Only in an appropriately decentralized organization can directors
maximize their distinctive contributions to the System. Unlike all other
officials within the System, directors of the Reserve Banks have no
vested interest in their positions—in any sense of the term. Moreover,
they are serving in the public interest to make whatever contributions
they can to the effective functioning of our nation’s monetary system.
It is the obligation of the directors to make the System function as
effectively as possible within the guidelines provided by Congress and


the Board of Governors, or to get the guidelines changed if this would
result in a more efficient monetary system. In fact, they are under
obligation to seek changes in the System, as drastic as the possible
elimination of the present role of the Federal Reserve Banks, if they
feel that such changes would contribute to the better achievement of
the nation’s monetary goals. The director’s place in the organizational
structure is that of an independent monitor, counselor, advisor, in­
terpreter—yes, even critic of their place as a regional component in
the organizational structure of the Federal Reserve System.
Selection of Directors
The procedures for nomination, election or appointment, and ro­
tation, as well as the personal qualifications of the directors of the
Federal Reserve Banks, have been carefully spelled out both in statute
and in regulations of the Board of Governors. In practice, these partic­
ulars are far more detailed than any description of or statement concern­
ing the duties and functions of a director. The rigid selection process
makes it impossible for any group to seize control or to dominate
the policies of a Federal Reserve Bank. In addition, they are designed
to accomplish certain purposes. Commercial banks which are mem­
bers of the System elect six directors and the Board of Governors
appoints three. Each bank has one vote irrespective of the number of
shares it owns, and the member banks in each district are divided into
three groups based on asset size. Each group selects two directors—
one to represent the member banks on the board and one who is
actively engaged in business in the District to represent the interest of
business, agriculture, and commerce.
Member bank representatives (Class A directors) have responsi­
bilities for communicating with their constituency. This is normally
achieved simply by the selection of officers or directors of a member
bank and assumes that in the course of their activities they will be
engaged in two-way communication with their constituency. From the
communication standpoint alone, it is essential that Class A director­
ships be filled by active leaders of the banking community. The direc­
torates should not be used as a pro forma or honorific post for those
who have the time to undertake public service or who are no longer
in the mainstream of the operations of their own institutions. A Class
B director, elected to represent the business interests of each member
banking group, has the responsibility of sharing his expertise and
knowledge with officials of the Federal Reserve Bank, but is in no way
obligated to report back to the business community. The member


banks, the banking system, and the business community are weakened
by this gap in the communication feedback system. Class B directors
are not selected from any particular size category nor are they neces­
sarily even customers of any bank in the groups they are presumed to
represent. Consequently, the size of the businesses represented by
Class B directors is not so well-balanced as the member bank repre­
Both Class A and Class B directors are elected for a three-year
term, but the latter may be reelected for a second term while the
former may not. Each year one A and one B director must stand for
The three C directors who are appointed by the Board of Gov­
ernors to represent the public interest cannot have any affiliation with
a commercial bank. There are no other restrictions on them except
a requirement of residency within the district and the general pro­
hibition, applicable to all directors, against anyone holding political
or public office or holding a major committee post in one of the
political parties. In practice, a majority of the C directors have been
businessmen. While this may have strengthened the informationgathering network of the System with respect to business develop­
ments, it is by no means clear that a somewhat broader representation
of the public might not improve the overall information flow into the
System and back into the community at large. In the Third District, a
conscious effort has been made to assure geographical representation
in all three groups of directors.
In spite of the very elaborate structuring of representation on the
boards, all members operate as public members, in fact if not in
theory. Promoting the general welfare of our society is the pre­
dominant objective of both policy and operational deliberations, and
an unacquainted observer at the meetings of the board would be hard
put to identify the particular constituency of individual directors
from the discussion or voting records.
Existing procedures for selection of directors may, in fact, provide
an inadequate representation of the banking and financial commu­
nity on the boards. With only one representative permitted from the
large banks and with little or no representation from other large
financial institutions, absenteeism or limited knowledge can seriously
restrict the informational input of directors in an area of primary
concern to the Reserve Banks. Accordingly, provisions designed to
avoid any undue influence by a particular group may, in practice, be
an obstacle to the more effective functioning of the System.


The rigid tenure restrictions applicable to directors have merit for
a number of reasons. For example, the more people who become
involved in a responsible way with the Bank and the System, the
greater the informational inflow to the System and the larger the num­
ber of semi-official representatives of the System in the community.
But the tenure restrictions have major disadvantages as well. Limited
terms keep the System from tapping most effectively the considerable
talent represented on the boards. It takes time for any new director
to become familiar with the personnel, operating practices, and prob­
lems of the organization. Moreover, time is also essential in order for
people to become sufficiently acquainted with one another to work
most effectively together and to develop an esprit de corps and an
operating style. And because of complicated jurisdictional relation­
ships and divided responsibilities between the Board of Governors and
the individual Reserve Banks, it takes time for the directors to gain
an understanding of their zone of action and to develop into an
efficient and effective part of the System structure.
Finally, if the Banks are to attract to directorates the top leadership
of the community, the directors must be given the maximum opportu­
nity to use their talents. It is not clear that this objective is achieved
if turnover is so rapid that the potential contributions of any board
member are never fully tapped. On the other hand, the dangers inherent
in relatively permanent boards which have become sterile provide all
too pointed examples of the desirability of reasonably limited tenure.
Whether present tenure rules are the proper ones is an open question.
Role of Directors
Every job or position has its rewards as well as its burdens and
obligations, and a directorship of a Federal Reserve Bank is no ex­
ception. Directors who have served with the man who is being honored
in this volume are quick to realize that their rewards are manifold and
far exceed any obligation they may have incurred. Great teaching is
a rare talent; thanks to Karl Bopp, every board meeting at the Phila­
delphia Reserve Bank became a rich learning experience for the direc­
tors and staff that was both exciting and real. The directors’ under­
standing of central banking and economic analysis grew at each
meeting, and their admiration for a warm, sensitive, human being
whose every breath conveyed a concern for principle and truth, knows
no bounds. While the classroom performance of the students may not
have merited a Phi Beta Kappa designation, the shape of the learning
curve was very real and will remain a prized possession of the group.


At the same time, a directorship does entail its frustrations. Ninetyfive per cent of the personnel of the Reserve Bank are engaged in
operational activities relating to the flow and storage of money and
credit, with only 5 per cent or less concerned with issues of monetary
and credit policy. Quite properly, deliberations of the Board of Gov­
ernors fall into, roughly, the reverse proportions; yet in one sense,
the board of directors has almost been divorced from the determina­
tion of monetary policy. With the heavy reliance on open market
operations as a policy tool, the role of the local Federal Reserve Bank,
and more particularly the role of the director, was substantially re­
duced. While all presidents of the Reserve Banks participate in delib­
erations of the Federal Open Market Committee, they participate
as individuals and are not bound by instructions from their boards of
directors. Moreover, they have no obligation to report on these delib­
erations to their boards. This gap in the flow of information makes
some of the advice and guidance offered by directors on policy ques­
tions less useful than it might be. In view of the number of individuals
currently privy to the deliberations of the Federal Open Market Com­
mittee, and in view of the leaks which have occurred within this
group, one cannot but wonder if the added secrecy which the present
policy affords is worth the sacrifice in terms of directors’ morale and
in the effectiveness and quality of their advice on policy issues. While
board opinions undoubtedly influence the views of the presidents, it
is recognized that board reactions are by no means unanimous and
the president clearly has the right to his independent judgment. It is
the information loop— input into the System from the board and the
feedback to the board—which is missing.
Directors do participate in the discussions concerning discount-rate
policy. In this role, directors make a unique contribution by present­
ing information regarding sectors of the economy with which they are
familiar. Directors have a feeling for developments in their partic­
ular areas of competence, and they can often report those develop­
ments to bank officials before statistical evidence becomes available.
Their collective input on underlying conditions and attitudes is by no
means confined to questions related to the discount rate; it influences
all monetary policy deliberations.
The importance of the directors’ activities regarding the discount
rate is often questioned. Although by law directors establish the dis­
count rate at least every 14 days, any action regarding rates is subject
to approval by the Board of Governors. Moreover, relatively little use
is presently being made of the discount window by the member banks.


So it is difficult to make discount policies the major contribution of a
director. Even if the System should modify the discount rules to en­
courage greater use of the window by member banks, it is by no
means certain that the role of the director in this area would increase
materially. It is nevertheless important to recognize the positive con­
tribution that the director makes through his discussion of discountrate policy, and that the directors’ influence on the monetary policy
is broader than this. For example, the directors may help in the eval­
uation of the weights to be assigned to different social or monetary
goals at various stages in the political-economic cycle. It is recognized
that many of these goals may be in conflict at any particular time.
Society clearly needs all that the best minds available have to offer,
not only in the resolution of these conflicts but also on the establish­
ment of appropriate priorities.
All too often monetary policy issues focus too simplistic an ob­
jective. For example, much of the discussion of the goals of monetary
policy treats full employment as an alternative to price stability. The
possible conflict between the two goals under certain economic cir­
cumstances is recognized, but to accept this conflict as inevitable is to
assume the availability of only limited solutions to the problem. The
directors can influence policy and issues by asking for a thorough
reexamination of underlying assumptions and by pointing up new
policy tools both within and without the System to resolve such con­
flicts. The influence of a single director on policy decisions is minis­
cule; but the cumulative impact of the opinions of 108 directors of the
12 Reserve Banks can be a significant element in the decision process.
In the operating area, too, it is essential to recognize that freedom
of action of each Bank is circumscribed because it is part of a larger
System. In spite of each board’s lack of autonomy, the directors can
nonetheless exert considerable influence on operations. Moreover,
these contributions may have real impact not only upon the individ­
ual Bank but also upon a wide range of institutions.
Directors play an important role by providing advice and guidance
on the internal operations of the Bank. They bring a wide range of
expertise and experience to considerations concerning labor relations,
salary administration, financing policies, public relations, building
maintenance, audit policies, and long-range planning for physical
facility needs, to mention only a few. Because officers of Federal Re­
serve Banks are not permitted to hold outside directorships, Bank
management may tend to lose touch with latest management tech­
niques developed in the corporate world. The board of directors as­


sures a considerable degree of protection against the development of
institutional insularity by providing a link with the procedures, prac­
tices, and policies of other corporate institutions. This role is impor­
tant not only in terms of the operations of the Reserve Bank; it is
highly relevant also in terms of the role the Reserve Bank and its
staff can play in improving the operational efficiency of member
banks. The same applies to other financial institutions falling within
its sphere of influence.
Primary responsibility for selection of bank management rests with
the board of directors, and the achievements and success of the lead­
ership exercised by officers depends in part upon the support and
guidance they receive from the board. Restraints imposed by the
necessity for the Bank officers to operate within restraints and rules
of a larger System can be as frustrating as is realization that the direc­
tor’s role is not to direct in the traditional sense of the term. But a
strong board of directors can provide the guidance and the balance
which will channel these frustrations into useful influences both within
and without the System. If the Reserve Banks are to play a construc­
tive and innovative role within the region, and at the same time are
to influence the formulation and execution of policy on both the na­
tional and international level, top caliber talent is a prerequisite.
As essential as the role of directors in management succession
may be, the majority of directors serve out their terms without par­
ticipation in this process, inasmuch as the turnover in top personnel
in the Bank is so low. Even though periodic reviews of personnel
planning are conducted by the board, this is hardly a raison d'etre for
a board. Thus the ability to attract strong board members must rest
upon a considerably broader base than this.
All components of the System can profit greatly from the chal­
lenges and demands continually advanced by an active and imagina­
tive board which not only reacts to the problems placed before it, but
is constantly pushing and probing on its own initiative on all fronts.
The Challenge to Directors
Despite their restricted role within the organization of the Federal
Reserve System, directors have challenging opportunities to make
positive contributions to the System and, thus, to society.
In the operating areas, directors have great opportunities to exercise
more initiative than they have evidenced in the past. For example,
our understanding of the monetary system and its impact on the
economy is far from complete. Under the leadership of their directors,


staffs of individual Reserve Banks should be encouraged to attack
particular segments of the unknown for concentrated study, e.g., con­
sumer and corporate behavior, organizational structure, regionalism,
institutional flows, and money substitutes. Such efforts would not only
help to strengthen the research thrust of the Bank and the System in
these areas; they also would make it easier to attract top personnel to
the staffs and provide new and important bridges to many external
interfaces between the Reserve Banks and the community. Innova­
tions in Reserve Bank operations and management techniques can
provide important means for establishing better communications and
contacts with the banking and business community.
Directors are faced with challenges in the policy area— among them,
the effectiveness of voluntary restraints. This challenge is more than
just an informational function, important as that may be; it touches
on the basic philosophy of volunteerism (to coin a clumsy term ), i.e.,
obedience to verbal appeals to follow generally prescribed courses of
action in pursuit of desired social and economic goals. There is evi­
dence that wide variations exist in the degree of restraint exercised as
a result of such appeals. Among possible causes of the inadequacies
of volunteerism is insufficient knowledge, a difference of opinion on
the relevance or the accuracy of the underlying conditions leading to
these verbal appeals, a simple unwillingness to cooperate, or a cynical
evaluation of the rewards from deliberate flouting of the request. The
question arises as to what penalties, tangible or otherwise, should be
applied when problems arise from failure to cooperate for whatever
reason. Can the directors play a role in this milieu, or is volunteerism
suspect and inherently weak as an appropriate policy tool?
Congress has the power stemming from the Constitution to issue
money and regulate the value thereof. To transfer this power to pri­
vate interests without adequate regulation or supervision is highly
questionable, but abhorrence of centralized control has led to the de­
velopment of a monetary mechanism which at best is an anachronism.
Here again, directors are challenged to reexamine the structure and
functioning of the monetary system from their particular vantage
point, and to stimulate discussion regarding both strengths and weak­
nesses. The possible expansion of the type of institution permitted to
issue demand deposits, the fragmented coverage of regulatory agencies
of the monetizing institutions engaged in the process, and the ability
of private institutions to change the structure of the Federal Reserve
System more or less at will— all these pose very real problems of both
equity and efficiency. Directors can take the initiative in expanding


public understanding of the issues involved and in warning of the
problems inherent in these conditions. While history provides little
evidence of basic changes in our banking structure short of a major
crisis, the latter may be closer than we realize. But it is to be hoped
that greater public understanding of both issues and problems can
provide a corrective mechanism short of the crisis stage.
Perhaps the greatest challenge to directors is to appraise the or­
ganization and operation of the Federal Reserve Banks within the
context of the Federal Reserve System in order to assure that both
attain their realistic potential. By word and deed, directors must play
a major role in this appraisal. If they are content merely to follow the
traditional ritual of board meetings developed through fifty years’ ex­
perience, to exercise little or no initiative and to be passive in their
actions, the role of a director will be little more than a walk-on part
at best. But if they use their wisdom and experience to invigorate the
System, they may serve as a critical catalytic agent in multiplying the
effectiveness of the System and in demonstrating the strengths of a
decentralized organization. Moreover, this can occur without any
change in the responsibility, power, rights, or prerogatives of other
components of the System.


To O ne W ho H as been part of an organization for any length of
time, observing and sharing its successes and failures, its manic and
depressive moods, its victories and defeats, a question of enduring
fascination is what keeps the thing alive and well. What are the in­
gredients of a living institution?
The Federal Reserve is now well into its second half century. It is
a mere adolescent compared with the Bank of England, but has been
around considerably longer than most central banks. In this time it
has established a record and developed a personality which I propose
to examine here— rather impressionistically, and, of course, nonobjectively— as a sort of case example of a living institution.
In search of guidance, one tends to look for a general theory of the
rise and fall of institutions. Many writers, in fact, have touched on
various aspects of the problem. Bernstein has detected a kind of life
cycle in regulatory commissions in the United States.1 Kenneth Boulding has distinguished three ages of an institution, with varying effects
upon what he calls its legitimacy.2 John Gardner has offered much
inspirational insight on self-renewal.3 C. Northcote Parkinson has
analyzed the decline of organizations, a phenomenon which he attrib­
1 According to his analysis, the typical progression is from gestation, a phase
stimulated by public pressure for reform; to youth, a chaotic period of conflict
and enthusiasm; to maturity, a stage of high professionalism with policies and
procedures well-established and adhered to; and finally to old age, a condition of
passive conservatism and inefficiency. Marver H. Bernstein, Regulating Business
by Independent Commission (Princeton: Princeton University Press, 1955), pp.
2 He points out that institutions build up legitimacy “just by sticking around,”
but that the function may be non-linear. “When things are new, they have the
special legitimacy of babies, young people, or the new fashion. At a certain
point they become middle-aged or old-fashioned and legitimacy declines sharply.
Then as time goes on further they become antiques and legitimacy increases
once again.” Kenneth E. Boulding, “The Legitimacy of Central Banks,” Funda­
mental Reappraisal of the Discount Mechanism (Washington, D. C.: Board of
Governors of the Federal Reserve System, July 1969), pp. 4-5.
3 John W. Gardner, Self-Renewal: the Individual and the Innovative Society
(New York: Harper & Row, 1963).


utes to a disease— “injelititis.”4 These observations are helpful but, as
far as I am aware, the definitive work on growth and decline of or­
ganizations remains to be written.
Observation of the Federal Reserve System leads me to believe that
three factors go far to explain its past and, more importantly, could
have a profound influence on its future. These are: (1) the values it
holds; (2) the professionalism of its personnel; and (3) the nature
of the decisionmaking process.
Proposition 1: The Federal Reserve System will be strong and ef­
fective in the long run to the extent that the values which govern its
actions are in accord with the values held by the society which it serves.
Although the concept of values often carries with it ethical con­
notations, and although moral purpose may be essential to the strength
of an organization,5 it is not necessary for my thesis to go this route.
By values I have in mind simply the
. . norms or principles
which people apply in decision-making, that is, the criteria they use
in choosing which of alternative courses of action to follow . . . .”6
In a very broad sense, however, the basic value, or criterion, gov­
erning decisions of Federal Reserve authorities does have strong
4 This is “the disease of induced inferiority” caused by the fusing of incom­
petence and jealousy to produce a new substance, “injelitance.” An infected
individual can spread the disease to an entire organization, systematically
eliminating all people of ability. The first phase of the disease is characterized
by a too-low standard of achievement; the second by smugness as these aims
are achieved; and the third by apathy. Cases of recovery are rare, but occasion­
ally an organization recovers because some individuals have developed a natural
immunity. “They conceal their ability under a mask of imbecile good humor.
The result is that the operatives assigned to the task of ability-elimination fail
(through stupidity) to recognize ability when they see it. An individual of merit
penetrates the outer defenses and begins to make his way toward the top. He
wanders on, babbling about golf and giggling feebly, losing documents and
forgetting names, and looking just like everyone else. Only when he has reached
high rank does he suddenly throw off the mask and appear like the demon king
among a crowd of pantomime fairies. With shrill screams of dismay the high
executives find ability right there in the midst of them. It is too late by then
to do anything about it. The damage has been done, the disease is in retreat,
and full recovery is possible over the next ten years.” C. Northcote Parkinson,
Parkinson’sL aw (Boston: Houghton Mifflin Co., 1957), p. 82.
5 Chester Barnard, in his classic study of the functions of the executive, for
example, maintains that: “Organizations endure, . . . in proportion to the
breadth of the morality by which they are governed. This is only to say that
foresight, long purposes, high ideals, are the basis for the persistence of co­
operation.” Chester I. Barnard, The Functions of the Executive (Cambridge,
Mass.: Harvard University Press, 1958), p. 282.
6 Philip E. Jacob, “Values Measured for Local Leadership,” Wharton Quar­
terly, Vol. Ill, No. 4 (Summer 1969), p. 31.


ethical connotations. The fundamental mission of the Fed is to pro­
mote the fullest sustained realization of the nation’s economic poten­
tial. A similar goal, of course, is held by most individuals in American
society. For better or worse, the typical American spends a great pro­
portion of his working and “leisure” hours striving to “make it”—
trying to put his talents and resources to the best possible use as he sees
it. The fact that the Fed’s objective is in close conformity with a basic
value also held by society lends great strength to the Federal Reserve’s
position in society— its legitimacy, as Boulding would say.
A critical question for the future, however, is whether this material­
istic view of human endeavor will continue to apply. From the time
of the Greeks, philosophers have held out as the highest achievement
of Man his self-realization, the fullest development of his potential.
Even in this context, the Fed’s basic value is in general conformity to
society’s; but, as and if society changes— perhaps as and if the “new
generation” carries its less materialistic view of life with it into later
years— it is possible that the relationship will become less strong.
This raises an obvious corollary to Proposition 1: namely, that
the Federal Reserve’s values must change as society’s values change.
Barnard has made the point that an organization disintegrates if it
fails to achieve its purposes; but it destroys itself if it does achieve
them.7 What it must do is constantly seek new goals. These, in the
case of the Federal Reserve, should be new goals which society is
In the past, the Federal Reserve System has succeeded, and suc­
ceeded remarkably well in view of the narrow charge given it by
Congress, in updating its objectives. Indeed, had the Fed been content
with a literal interpretation of its original assignment to provide an
elastic currency, etc., it would not be important enough to bother
about today. Response to changing needs may not always have been
as prompt, full, and voluntary as everyone might like, new objectives
may not always have been achieved effectively, but on the whole I do
believe the Fed has renewed itself over the years by broadening its
objectives and values.
Two questions, however, arise about the future. One I have already
suggested: if the public at large is shifting its emphasis from materialistic-economic concerns to humanistic-social concerns, how will the
Fed respond? It is dangerous, of course, to extrapolate a short-run
movement into a long-run trend, but it is clear that some such shift has
7 Op. cit., p. 91.


been in the making. The legitimacy of the Federal Reserve System may
well hinge importantly on how its officials react.
Economic policies carried out by the Federal Reserve will have
very great social impacts as they always have. Decisions in trading
off unemployment against price increases do not simply involve sta­
tistics expressed in a Phillips curve, but impacts on human lives. The
social costs of unemployment among Negro teenagers, for example,
must be weighed against those of inflation for pensioners. Federal
Reserve authorities know this—they are not bloodless computers—
but they may have to give more consideration to this kind of calcula­
tion in the future than in the past. Moreover, the Fed traditionally has
resisted pressures to deal with specific problems in specific parts of
the economy. Would it be wise, for example, to devise some way of
channeling Federal Reserve funds into the ghetto? The role which the
Fed is to play in our society in the future may well depend on re­
sponses to and anticipation of pressures like this.
A second question for the future flows from this thought: how
much weight will the Federal Reserve give to the value of freedom in
trying to achieve new objectives? The very creation of the Federal
Reserve System was an act of intervention, a departure from laissezfaire resisted by conservative elements at the time. Nevertheless, the
philosophy under which the System has operated for the most part
since has stressed freedom of the market place, and the tradition of
minimum intervention in markets served the Fed well for many years.
Freedom, however, must be put in a relative context, relative to
other values. This, in fact, is what society has been doing, especially
since the 1930’s. Society has tolerated, indeed demanded, increasing
intervention by public authorities in markets in order to get greater
security, justice, and other values. There is no evidence to indicate
that this trend will not continue.
In this environment the Fed will find itself facing a dilemma: its
stated philosophy is noninterventionist; its practice is increasingly
interventionist. A review of history indicates that Federal Reserve
authorities almost invariably resort to unorthodox “gimmicks” when
crises arise and pressures become intense.8 This behavior might be
excused as necessary in rare and difficult circumstances, but I would
8 Some of these devices include “direct action” in the late 1920’s, margin re­
quirements, moral suasion, Regulations W and X. “Operation Twist,” the Sep­
tember 1, 1966, letter from the Federal Reserve to member banks. David P.
Eastburn, “Uneven Impacts of Monetary Policy: What to Do About Them?”
Business Review (Federal Reserve Bank of Philadelphia, January 1967), p. 21.


guess that the Fed will be confronted more often, not just in crises,
with the need to innovate via special types of controls. Banks, much
more innovative than ever before anyway, have been further stimu­
lated by Regulation Q to explore new sources of funds. As the Fed,
attempting to restrain the expansion of money and credit, closes one
loophole after another, banks promptly discover new ones.
What to do about this schizophrenia? If my prediction is correct,
the Federal Reserve will have to reconsider its philosophy of non­
intervention in markets. This, I believe, would bring philosophy into
conformity with practice and make possible a rational and consistent
approach to regulation rather than one of ad hoc loophole plugging.
And it would bring philosophy more nearly into the mainstream of
what society now wants. The public demands an increasingly high
performance of the economy and of public policymakers responsible
for the economy. It is less tolerant of unemployment and alert to the
slightest tendency toward recession. A t the same time, it is increas­
ingly concerned about inflation. It is more interested in how things are
distributed— unemployment among disadvantaged groups, tax avoid­
ance by the wealthy, the impact of tight money on housing.
All of this has greatly reduced margins of error for policymakers.
Their response has been to try to “fine tune” the economy, not only
by making small changes as promptly as possible to influence overall
aggregates, but by dealing in specific ways with specific parts of the
economy. The public at large has no interest in fine tuning per se, but
the influence of its many growing and conflicting demands— and this,
I believe, is an irreversible influence—is to force policymakers to fine
Many experts believe that fine tuning is beyond our capability, and
certainly much of the 1960’s provides ample evidence to support this
view. Therefore, they maintain attention should be directed to making
markets more efficient by removing impediments to competition. For
example, rather than imposing a ceiling on interest rates on time and
savings deposits and devising special techniques for channeling funds
into mortgage markets, efforts should be devoted to removing usury
ceilings, liberalizing restrictions on competition among various kinds
of institutions in various kinds of markets, and the like.
What economist, brought up in the competitive tradition, could
argue against such a course? The only problem is that the likelihood
of success is low. Vested interests are so entrenched that results are
bound to be slow and incomplete. Much as we all would like markets
to be free (at least in the abstract), the likelihood is that many serious


impediments will remain. Meanwhile, the public continues to exert
pressure which forces policymakers to fine tune.
It may be that public officials, including those at the Federal Re­
serve, cannot deliver what the public wants. Attempts to intervene in
markets, efforts to fine tune, may fail because of human frailty. Per­
haps the only evidence that can be brought to bear on this is history.
I believe history shows that public policy can perform and has per­
formed at ever-higher levels of competency. There is no reason to
believe we have reached the ultimate. Today’s fine tuning becomes
tomorrow’s orthodoxy.
The public, of course, should be made aware of the limited state of
the art at any given time so that it does not demand the utterly im­
possible. This thought suggests a second corollary to Proposition 1:
the Federal Reserve’s values should be clearly made known to and
understood by society.
Some kinds of institutions, like the church, may thrive for centuries
on values which their constituents are asked to accept on faith. For
most institutions, however, mystique, charisma, and ritual, although
powerful forces for legitimacy over a short period, prove to be weak
reeds in the end.9 Federal Reserve authorities undoubtedly have
yielded to the temptation to lean on them many times in the past, but
chances of getting away with this are fast disappearing, if not already
gone. The public is too sophisticated.
As the Fed confronts its sophisticated constituents, it may well find
the going easier in some respects, more difficult in others. Up to a
point, a more knowledgeable public should be more sympathetic with
what the Federal Reserve is trying to do. Inflation is a good example.
Proposition 1 should not be interpreted to mean that Federal Reserve
authorities should supinely adopt inflation as an objective simply be­
cause society is ill-informed about its evils. The Fed must try to influ­
ence society’s choice of values as well as adapt to them. The problem
of overcoming inflation should be easier as the public becomes in­
creasingly sophisticated.
In some respects, however, the Fed may find communications more
difficult. It may not be so hard to enunciate and gain society’s accept­
9 Boulding suggests that legitimacy of central banks might be fostered
. .
by preserving a certain air of charismatic obscurity about their operations.
Their officers might even take to wearing gowns and robes and their public
pronouncements might be couched in even more mysterious and impressive
language than they now use.” Op. cit., p. 20. He suggests, however, that in the
long run an important source of legitimacy is payoff; an institution must pro­
vide good terms of trade with those who are related to it. (p. 3)


ance of the basic values governing the Fed’s policies, but at a more
technical level the criteria for action will be hard to explain and sell.
Nor are prospects for success enhanced by history. The Federal Re­
serve all too frequently has tended to devise simplistic rationales for
policy, develop a vested interest in them, and nurture them long past
the period of whatever validity they may have had. The terms “pro­
ductive credit,” “pegs,” “bills only,” perhaps recall a few instances.
Confronted by an increasingly sophisticated public, the Fed may
find the best course is to admit unashamedly that it has, as yet, no
adequate theory of how monetary policy works. I say unashamedly
because, although Federal Reserve economists should have been
working much harder and longer on the problem than they have, no
one else has an adequate theory either. If the Fed assumes a posture
of humble agnosticism, it is likely to come out better in the long run.
And it should feel perfectly at home with such a posture in today’s
relativist world distrustful of the old absolute values.
A third corollary which flows from this is that the Federal Reserve
must at all times be alert to society’s changing values.
Riesman, Glazer and Denney, in their influential study, The Lonely
Crowd, drew the distinction between “inner-directed” and “otherdirected” personalities. An inner-directed person is governed by abso­
lute values and tradition. An other-directed person sees things in more
relative terms and is influenced more by his peers.
If the Federal Reserve is to maintain values in conformity with
those held by society, it will need to be more other-directed than in
the past. This is not just a matter of information, but of attitude.
Other-direction fosters an attitude of openness to change, of flexibility.
And it is a matter of involvement. As the economy becomes more
and more complex, the Fed is increasingly tempted to withdraw into
its specialty of monetary policy. Good arguments can be made for
this course, but the institution will be stronger, I believe, if it is in­
volved in other matters as well. Obviously, there must be limits. Not
only could the Fed become over-committed and its efficiency im­
paired, but excessive involvement could produce severe conflicts of
values and objectives, confusion, and a general weakening of purpose.
On balance, however, the greater danger is that the Fed will become
aloof. Such activities as bank supervision and truth in lending, trouble­
some though they may be, help to give it a sense of what is really
going on, insights into the way other institutions really work, and
how people are thinking.
A fourth corollary to Proposition 1 is that the Federal Reserve


should have confidence in Its values, and its ability to establish them.10
In a recent convention of people concerned about social welfare,
one speaker remarked on the attitude of young people toward theol­
If som eone holding to the m ore traditional theology should attend an
experim ental liturgy on a campus, he would probably be horrified. The
songs, the readings, dialogues, prayers, and homily would make as their
chief emphasis: 1) how confident we can be that all o f the barriers to
true human life will be overcom e, and 2) the awareness that G o d has
given this task of breaking down barriers to us. The visitor would be
sure that the students were guilty o f colossal pride and that they had
left Christianity far behind for a new humanism.11

Today’s young people are a remarkable lot, but in at least one
important sense they are simply carrying on—in their own distinctive
style, of course— what has been a trend over recent decades. In the
realm of economics, at least, society has been less and less willing to
subject itself to “economic laws” and “market forces” which appear
to make the individual a helpless pawn. Not so long ago everyone
believed that periodic recessions were inevitable; indeed, good for
what ails us. But the Great Depression effectively destroyed the no­
tion that widespread unemployment may be good medicine, and
experience in the 1950’s and 1960’s has raised hopes that even mild
recessions may not be inevitable. Society has been coming to believe
it is master of its own destiny, and as the “new generation” takes
over, this belief is likely to be intensified.
The Federal Reserve is not yet old enough to be preoccupied with
its past heritage, but it is entering the dangerous age. Moreover, one
can detect at times a latent persecution complex that, if permitted to
develop, could prove debilitating. Sensitive to the fact that monetary
policy must frequently frustrate people’s plans and desires, Federal
Reserve officials have been known to refer somewhat plaintively to
their lack of popularity. They have said, for example, that the Fed is
often in the position of the chaperone who removes the punchbowl
just when the party is getting good. Also, in an understandable desire
to have the public make a proper assessment of credit and blame for
public policy, the Fed sometimes tends to underplay the extent of its
10 C. R. Whittlesey has argued elsewhere in this volume that for monetary
policy to be effective it must be believed in. My point is complementary to
his: the Federal Reserve must believe in its policy.
11 Catherine L. Gunsalus, “A Theological and Campus Perspective on Chang­
ing Values,” a talk given before the National Conference on Social W elfare
N ew York City, May 28, 1969, p. 6.


And, finally, there is the attrition in membership in the Federal
Reserve System, a problem which makes no impression on many
economists but which, I believe, is a cancer eating at the morale of
the System. The problem is not— at least yet— one of a central bank
losing control of the financial aggregates necessary to implement its
policy, but one of an organization losing support of a major part of
the community. The Federal Reserve does not exist to serve com­
mercial banks, and a good economic case can be made that member­
ship is unnecessary. Nevertheless, membership has been an important
aspect of the System for over half a century, and its decline inevitably
has a deteriorating effect within the Fed and on its image in the com­
munity— not the least of which is the political community. The Fed­
eral Reserve does, after all, live in a political world, and, like any
public body, needs a strong, concerned, grass-roots support if it is
itself to remain vital. The time is overdue to move vigorously and
decisively to deal with the inequities created by present requirements
for membership. Success in this effort would do much to increase the
Fed’s confidence in its ability to solve its problems.
A final corollary to Proposition 1 is that the Federal Reserve must
be responsive to the public through the political process.
Officials of the Federal Reserve System are surrounded by certain
safeguards designed to insulate them from the influence of party
politics.12 Yet it is clear that, as public servants, they must be involved
in politics in the broad sense; they must respond to the wishes of the
people as expressed through the political process. Mr. Dooley’s
comment that the Supreme Court watches the election returns, despite
its note of cynicism, has real meaning for the Fed. The Federal Re­
serve is responsible to Congress which, in turn, is responsible to the
people; and as the people express their wishes in elections, these
wishes must influence Federal Reserve actions.
It is true that history demonstrates abundantly the abuses to which
Government can subject money, and that the fathers of the Federal
Reserve had this history clearly in mind when they made the Fed
independent of the Executive Branch of Government. But they did
not make the Federal Reserve independent of Government, and
officials of the Federal Reserve System are very much aware of this.
12 Albert L. Kraus has adopted Noam Chomsky’s term, the New Mandarins,
in describing Federal Reserve officials. Like the original governors of China, he
says, they belong to a “secular priesthood” that is aloof from the people they
serve. New York Times, April 9, 1969, p. 59.


They are less inclined to stress their “independence” than are many
businessmen and bankers.
Nevertheless, the danger of becoming aloof is ever present.13 It will
be particularly important to guard against this tendency as the Fed­
eral Reserve becomes increasingly professionalized.
Proposition 2: The Federal Reserve will be strong and effective in
the long run to the extent that it fosters professionalism in its personnel.
It is not enough for the Federal Reserve to want what society
wants; it must have the technical competence to make good on those
Congress long ago assigned to the Federal Reserve System various
tasks of a highly technical nature which Congress felt it could not,
and should not, undertake in detail itself. One of the advantages
claimed for the regulatory commission approach always has been that
it provides a means by which technical skill and expertise can be
brought to bear on specific matters. The need for professional know­
how is receiving even more attention today as the “knowledge ex­
plosion” grapples with the problems of an increasingly complex
The Federal Reserve demands professionals of many kinds in many
fields— law, personnel, management, accounting, computer technique,
to name only a few. In its conduct of monetary policy, it requires
professionals in the field of economics, especially monetary economics.
A number of years ago Fed personnel enjoyed outstanding reputations
among professional economists; for a decade or so their standing
seemed to deteriorate, but more recently it has improved. The Fed’s
research organizations have always been unsurpassed at intelligence
gathering, but deficient at basic research. This gap is being slowly
remedied. The greater number of economists among top decision­
makers undoubtedly has contributed to the professionalization of the
There are limits to professionalism, however, and this suggests a
corollary to Proposition 2: professionalism must be balanced with
other values.
13 Bernstein concluded his study of independent regulatory commissions with
this warning:
. . the theory upon which the independence of the commission
is based represents a serious danger to the growth of political democracy in
the United States. The dogma of independence encourages support of the naive
notion of escape from politics and substitution of the voice of the expert for
the voice of the people.” Op. cit., p. 293.


Gardner indicates that one symptom of stagnation is that “how-to”
becomes more important than “what to do”; technique supersedes
purpose.14 One can detect this symptom at times in the Federal Re­
serve. In open market operations, for example, technique in some
respects becomes so sophisticated that there is danger of losing sight
of the objective. Some critics have complained that the finesse of de­
fensive operations gets in the way of an effective monetary policy.
This kind of thing happens because professionalism so often means
specialization. The professional becomes intellectually involved in
problems; he probes deeper and deeper, often passing the point of
diminishing returns. Accordingly, any institution like the Fed must
have its generalists, men with broad backgrounds who can see the big
picture. If the professional can be both specialist and philosopher, so
much the better, but this often is asking too much. This is one reason,
undoubtedly, why Karl Bopp, himself an economist, has spoken of the
need for some non-economists in top decisionmaking positions of the
Federal Reserve organization. Another may be that the Fed must live
and deal with many non-professionals. Reserve Banks must, for ex­
ample, exist in their local communities. As their staffs become increas­
ingly professional, as they pursue their interest in national monetary
policy, there is a danger that they will lose touch, interest, and prestige
in their communities.
If properly balanced, however, professionals can bring to the Fed
the necessary characteristics for vitality— a creative attitude, a joy in
playing with ideas regardless of the outcome— that lead to innovation.
But an organization heavily composed of professionals must encour­
age freedom of thought, the heretical idea, and possess a decision­
making machinery which gives a true sense of participation. This leads
to my last proposition.
Proposition 3: The Federal Reserve System will be strong and ef­
fective in the long run to the extent that decisions are made by a
pluralistic process.
John LeCarre, author of spy novels and former member of British
intelligence, once made this revealing comment about espionage:
A ll our societies, even the Am erican one, is adm inistered by an ex­
traordinarily lugubrious apparatus and the very developm ent o f events
is controlled and paced by a pleasant human slowness and reluctance
to take decisions, . . .
14 Op. cit., p. 47.


N ow an efficient intelligence service moves at 20 times that pace
and is frequently outrunning the decisive capacity of the people who
should be controlling it. . . . frequently there is a short-time desirability
to produce a revolution in a country X, but if it went through all the
committee stages of bumbledom it is quite possible that one would
reach a different decision.15

Only this, he says, prevents us moving from one international
catastrophe to another.
It might be a backhanded compliment to the Federal Reserve Sys­
tem to say that only its complex decisionmaking machinery prevents
it from moving from one monetary disaster to another. For there is
no question that decisionmaking in the Fed—with the Reserve Banks
and boards of directors, the Federal Open Market Committee, the
Board of Governors, and staff all in the act in one way or another—is
The dangers of multiple direction of an organization are fairly ob­
vious. They include inconsistency of policy, delay, compromise, ad­
herence to status quo, dissipation of enthusiasm and vitality, and
general inefficiency.16 It is not clear to me, however, that such re­
sults are inevitable. And even if there is a tendency in this direction,
the disadvantages should be weighed against the advantages.
The main advantage of the pluralistic process is that decisions are
more carefully considered. Each individual brings to bear on the com­
mon problem his own set of information, his own particular insights
and interests.17 As our society becomes increasingly complex, indeed,
there is a serious question whether any other process will work.18
Major decisions today require so much technical information, so
many different kinds of expertise, that no one individual can be en­
trusted to make them. Finally, it often may be the case that the plural­
istic process not only produces sounder decisions but more innovative
15 New York Times, January 28, 1969, p. 46.
18 Bernstein has observed all of these in regulatory agencies. Op. cit., pp.
17 Charles E. Lindblom makes essentially this argument for what he calls
“partisan mutual adjustment.” The Intelligence of Democracy (New York: The
Free Press, 1965).
18 Philip E. Slater and Warren G. Bennis have concluded that because of
growing complexity, “democracy is inevitable.” The Temporary Society (New
York: Harper & Row, 1968).
19 John Gardner has written: “In an organization with many points of initia­
tive and decision, an innovation stands a better chance of survival; it may be
rejected by nine out of ten decision-makers and accepted by the tenth. If it then
proves its worth, the nine may adopt it later.” Op. cit., p. 68.


All this suggests a corollary to Proposition 3: the Federal Reserve
should take maximum advantage of its federal structure.
The fact that the Federal Reserve System resembles the United
States Government in some important respects is no accident. The
same fears of concentrated power induced the authors of both systems
to build in a separation of powers and a federal structure. In both
cases, however, the trend has been toward centralization, and a vital
question for the future is how much further this trend can go without
producing serious weakening.20
The Federal Reserve System has always been stronger for the fact
that contributions to policy are made by many people from all parts
of the country, not just in Washington. As formulation of monetary
policy becomes increasingly difficult, as standards expected of the Fed
become ever higher, as the System becomes involved in more and
more activities of a complex nature outside of monetary policy per se,
the Federal Reserve will need to rely increasingly on these contribu­
This is not just a matter of decentralization of work. The Board of
Governors, for example, recently has passed on to the Reserve Banks
some responsibilities in the field of bank supervision. More of this
could be done. But a truly federal system requires that the sub-units
contribute to the overall goal as a matter of right, not merely at the
pleasure of the central unit. There is no real federalism unless “ . . .
local management derives its power and function from structural neces­
sity, . . .”21
Not only does increasing complexity of the economy and the fi­
nancial system enhance the unique role of the regional Reserve Banks
as administrative units of the System and as centers of information,
but it calls for continued participation of the Banks in the formulation
of monetary policy. Because the Reserve Bank presidents serve on the
20 Alexis de Tocqueville detected the weakness of centralization almost a
century and a half ago: “Centralization imparts without difficulty an admirable
regularity to the routine of business; provides skilfully for the details of the
social police; represses small disorders and petty misdemeanors; maintains
society in a status quo alike secure from improvement and decline; and perpet­
uates a drowsy regularity in the conduct of affairs, which the heads of the
administration are wont to call good order and public tranquillity; in short, it
excels in prevention, but not in action. Its force deserts it, when society is to be
profoundly moved, or accelerated in its course; and if once the co-operation of
private citizens is necessary to the furtherance of its measures, the secret of its
impotence is disclosed.” Democracy in America (New York: The New Amer­
ican Library, 1956), p. 67.
21 Peter F. Drucker, The New Society (N ew York: Harper & Brothers,
p. 275 .



Open Market Committee as a matter of statutory responsibility, they
are much more effective than if they were to participate simply as
advisers to the Board of Governors.







As a prescription for a vigorous, long life, the foregoing proposi­
tions undoubtedly overlook many important ingredients; yet they are,
I believe, the essential ones. Perhaps the most hopeful thing about
them is that they require nothing radically new, but basically a con­
tinuation of what the Federal Reserve has been doing. The Fed has
changed its values over the years. It has been developing an increas­
ingly professional attitude toward its task. And it does follow a plural­
istic approach in making decisions. What is needed is to be more
prompt and sensitive in changing its values, to broaden and deepen
its professionals’ knowledge of the economic process, and to make
even greater use of its federal structure.
All this, of course, is harder to do than it sounds. Many trade-offs
must be made along the way. To become too professionalized runs a
risk of losing touch with society’s values. A decisionmaking apparatus
that permits too-long deliberation over too many views cannot adapt
promptly as these values change. But the path to the good life is
strewn with hard choices. The Fed has made many wrong ones along
the way, but if it can better its percentage of right ones, it can look
forward to a long and useful existence.