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M arch/April 1992

Vol. 74, No. 2

3 M on etary Policy in the Great
Depression: W h at the Fed Did,
and W h y
29 Seigniorage in the United States:
H o w Much Does the U.S
G overnm ent M ake fro m M on ey
41 T h e FOMC in 1991: An Elusive
R eco very
62 H ow T h e 1992 Legislation W ill
A ffe c t European Financial

I1VNR of


In the first article o f this issue, "M one­
tary P olicy in the G reat D epression:
W hat the Fed D id and W hy," the bodies
o f figure 3 (U nem p loym ent Rate) and
figure 4 (Bank Suspensions) should be
sw itched. In addition, the "gold cur­
rency" line on figure 9 should read "gold
m inus currency." W e regret these errors.


Federal R eserve Bank o f St. Louis
R e v ie w

March/April 1992

In T h is Is s u e . . .

During the recent recession, there has been considerable discussion of
the appropriate policy response by the Federal Reserve. Monetary policy
often receives close scrutiny, and recently Congress has considered
legislation that would reorganize the Fed’s policymaking structure. In
the first article in this Review, "Monetary Policy During the Great
Depression: What the Fed Did, and W hy,” David C. Wheelock examines
the extent to which the Federal Reserve System's organization affected
policy during the Great Depression. Some authors contend that the Fed’s
organization caused it to be more receptive to private interests—or to
the interests of policymakers wishing to extend their bureaucratic
domain—than to the public’s interests. Others argue that leadership
changes at the onset of the depression put authority into the hands of
inexperienced officials who failed to understand the appropriate policies
to counteract the depression. Wheelock finds, however, that organiza­
tion affected policy little during this episode. Rather, the Fed’s policies
can be attributed largely to continued pursuit of a procyclical policy
rule and to the gold standard regime, which proved deflationary.
* * *
In the second article in this issue, “ Seigniorage in the United States:
How Much Does the U.S. Government Make from Money Production?”
Manfred J.M. Neumann considers one of the oldest and most interesting
issues in monetary economics, "seigniorage”—the revenue associated
with the creation of money. The author extends a traditional measure
of seigniorage with a new measure, "extended monetary seigniorage,”
that he has developed. Neumann’s new measure shows the distribution
of seigniorage between the central bank and the Treasury. Neumann
calculates extended m o n etary seigniorage for the U nited States for the
period 1951-90. He estimates that the Treasury's share of seigniorage,
which he calls fiscal seigniorage, has amounted to between 1 percent
and 2.8 percent of federal spending. He also examines the relationship
between inflation and seigniorage and estimates that seigniorage in­
creases with inflation until the inflation rate reaches about 7 percent,
then declines with further increases in the inflation rate.



In the third article in this issue, "The FOMC in 1991: An Elusive
Recovery,” James B. Bullard presents an overview of recent actions
taken by the Federal Open Market Committee, the arm of the Federal
Reserve System with the primary responsibility for monetary policy.
Since 1991 was a year that began with declines in aggregate economic
activity and ended with some slight gains, this article provides a case
study of policymaking during the recovery phase o f the business cycle.



In the context o f a chronology of FOMC decisionmaking, the author
focuses on two key problems faced by the Committee. One is that, be­
cause of lags in data collection and the difficulty of forecasting, it is
hard for the FOMC to assess the strength o f the economy at a point in
time. The other is that the magnitude and even the direction o f policy
thrust can be a matter of interpretation. The author shows how the
FOMC grappled with these two problems through the year and ended
up supporting relatively steady policies during the spring, when recov­
ery seemed likely, and relatively easy policies in the fall, when recovery
seemed elusive.



In the final article in this issue, "How the 1992 Legislation Will Affect
European Financial Services,” K. Alec Chrystal and Cletus C. Coughlin
identify and examine the impact of the "1992” regulatory changes that
pertain directly to banking and other financial services. The authors
view the 1992 reforms as a small step toward the liberalization of the
financial services sector. The reforms will prove to be beneficial, but
the extent of the gains are unlikely to be large. The reason, they say, is
that virtually all of the potential efficiency gains in the financial services
sector can be (or have already been) achieved by abolishing exchange
controls and allowing foreign firms to enter domestic markets.
The key innovation of the 1992 legislation is the split between home
country authorization and host country conduct of business rules. This
dichotomy will create problems, especially regulatory complications.
Whereas wholesale markets already are highly integrated, 12 quite
different retail markets will continue to exist in the near future. The
authors stress, however, that the advent later in this decade of a single
currency for the European Community will cause pressures to revise
the regulatory structure so that the conduct of business rules become



David C. W heelock
David C. Wheelock, assistant professor of economics at the
University of Texas-Austin, is a visiting scholar at the Federal
Reserve Bank of St. Louis. David H. Kelly provided research

Monetary Policy in the Great
Depression: What the Fed Did,
and W hy

IXTV YEARS AGO the United States—
indeed, most o f the world—was in the midst of
the Great Depression. Today, interest in the
Depression’s causes and the failure o f govern­
ment policies to prevent it continues, peaking
whenever the stock market crashes or the econ­
omy enters a recession. In the 1930s, dissatisfac­
tion with the failure of monetary policy to pre­
vent the Depression, or to revive the economy,
led to sweeping changes in the structure of the
Federal Reserve System. One of the most impor­
tant changes was the creation of the Federal
Open Market Committee (FOMC) to direct open
market policy. Recently Congress has again con­
sidered possible changes in the Federal Reserve
This article takes a new look at Federal Reserve
policy in the Great Depression. Historical analy­
sis of Fed performance could provide insights
into the effects o f System organization on policy
making. The article begins with a macroeconomic
overview of the Depression. It then considers
both contemporary and modern views of the

1“ The Monetary Policy Reform Act of 1991” (S. 1611)
would have abolished the FOMC and thereby ended the
voting on open market policy by Federal Reserve Bank
presidents. Although hearings on the bill were held, it was
not brought to a vote before Congress adjourned at the
end of 1991. The Banking Act of 1935 established the

role of monetary policy in causing the Depression
and the possibility that different policies might
have made it less severe.
Much of the debate centers on whether mone­
tary conditions w ere "easy” or “tight” during the
Depression—that is, whether money and credit
were plentiful and inexpensive, or scarce and
expensive. During the 1930s, many Fed officials
argued that money was abundant and “cheap,”
even "sloppy,” because market interest rates
w ere low and few banks borrowed from the dis­
count window. Modern researchers who agree
generally believe neither that monetary forces
were responsible for the Depression nor that
different policies could have alleviated it. Others
contend that monetary conditions were tight,
noting that the supply of money and price level
fell substantially. They argue that a more aggres­
sive response would have limited the Depression.
Among those who conclude that contraction­
ary monetary policy worsened the Depression,
there has been considerable debate about why

present form of the FOMC, whose members include the
Board of Governors of the Federal Reserve System and
the 12 Reserve Bank presidents. Five of the presidents
vote on policy on a rotating basis.



Federal Reserve officials failed to respond ap­
propriately. Most explanations fall into two cate­
gories. One holds that Fed officials, though wellintentioned, failed to understand that more ag­
gressive action was needed. Some researchers,
like Friedman and Schwartz (1963), argue that
the Fed’s behavior during the Depression con­
trasted sharply with its behavior during the
1920s. They contend that the death of Benjamin
Strong in 1928 led to a redistribution of authori­
ty within the System that caused a distinct de­
terioration in Fed performance. Strong, who
was Governor of the Federal Reserve Bank of
New York from the System's founding in 1914
until his death, dominated Federal Reserve policy­
making in the years before the Depression.2
These researchers argue that authority was dis­
persed after his death among the other Reserve
Banks, whose officials were less knowledgeable
and failed to recognize the need for aggressive
policies. Other researchers, like Wicker (1966),
Brunner and Meltzer (1968), and Temin (1989),
contend that Strong’s death caused no change in
Fed performance. They argue that Strong had
not developed a countercyclical policy and that
he would have failed to recognize the need for
vigorous action during the Depression. In their
view, Fed errors were not due to organizational
flaws or changes, but simply to continued use
of flawed policies.
A second category of explanations holds that
the Fed’s contractionary policy was deliberate.
Epstein and Ferguson (1984) and Anderson,
Shughart and Tollison (1988) contend that Fed
officials understood that monetary conditions
were tight. Epstein and Ferguson assert that the
Fed believed a contraction was necessary and
inevitable. When it did act, they argue, it was to
promote the interests of commercial banks,
rather than economic recover}'. Anderson,
Shughart and Tollison emphasize even more the

2Until changed by the Banking Act of 1935, the chief ex­
ecutive officers of the Reserve Banks held the title “ gover­
nor.” Today these officers are titled “ president,” while
members of the Board of Governors, which replaced the
Federal Reserve Board in 1935, now hold the title
“ governor.”
3The appendix provides a list of sources for the data used
in this article. The GNP and unemployment series used
here are standard, but Romer (1986a, 1986b) presents
new estimates of GNP and unemployment for the 1920s.
Both new estimates exhibit less variability than those tradi­
tionally used; Romer’s estimate of the unemployment rate
in 1929 is 4.6 percent, compared with 3.2 percent plotted


Fed's interest in aiding its member banks. They
argue that monetary policy was designed to
cause the failure of nonmember banks, which
would enhance the long-run profits of member
banks and enlarge the System's regulatory

Analysts generally agree that the economic
collapse of the 1930s was extremely severe, if
not the most severe in American history. To
provide a sense of the Depression, Figures 1-3
plot GNP, the price level and the unemployment
rate from 1919 to 1939. As the figures show, af­
ter eight years of nearly continuous expansion,
nominal (current dollar) GNP fell 46 percent
from 1929 to 1933. Real (constant dollar) GNP
fell 33 percent and the price level declined 25
percent. The unemployment rate went from un­
der 4 percent in 1929 to 25 percent in 1933.3
Real GNP did not recover to its 1929 level until
1937. The unemployment rate did not fall below
10 percent until W orld W ar II.4
Few segments of the economy were unscathed.
Personal and firm bankruptcies rose to unpre­
cedented highs. In 1932 and 1933, aggregate
corporate profits in the United States were
negative. Some 9,000 banks, with $6.8 billion of
deposits, failed between 1930 and 1933 (see
figure 4). Since some suspended banks eventually
reopened and deposits were recovered, these
figures overstate the extent of the banking dis­
tress.5 Nevertheless, bank failures were numer­
ous and their effects severe, even compared
with the 1920s, when failures were high by
modern standards.
Much of the debate about the causes of the
Great Depression has focused on bank failures.

4Darby (1976) argues that the unemployment rate series
considerably overstates the true rate after 1933 because it
takes persons employed on government relief projects as
unemployed. Kesselman and Savin (1978) offer an oppos­
ing view. Regardless of which argument is accepted, un­
employment during the 1930s was exceptionally severe,
particularly since there were relatively few multi-income
5There was no deposit insurance in these years. The Bank­
ing Act of 1933 created federal deposit insurance. During
the 19th and early 20th centuries a number of states ex­
perimented with insurance plans for their state-chartered
banks, but none was still in existence by 1930. See
Calomiris (1989) for a survey of the state systems.


Figure 1
Nominal and Real Gross National Product
B illio n s o f do llars

Figure 2
Implicit Price Index





Figure 3
Unemployment Rate
Number of banks










W ere they merely a result of falling national in­
come and money demand? Or were they an im­
portant cause of the Depression? Most contempo­
raries viewed bank failures as unfortunate for
those who lost deposits, but irrelevant in macroeconomic significance. Keynesian explanations of
the Depression agreed, including little role for
bank failures. Monetarists like Friedman and
Schwartz (1963), on the other hand, contend
that banking panics caused the money supply to
fall which, in turn, caused much of the decline
in economic activity. Bernanke (1983) notes that
bank failures also disrupted credit markets,
which he argues caused an increase in the cost
of credit intermediation that significantly
reduced national output. In these explanations,
the Federal Reserve bears much of the blame
for the Depression because it failed to prevent
6See Belongia and Garfinkel (forthcoming).




the banking panics and money supply con­

Today there is considerable debate about the
causes of business cycles and whether government
policies can alleviate them.6 Just as there is no
consensus now, contemporary observers had
many different views about the causes of the
Great Depression and the appropriate response of
government. A few economists, like Irving Fisher
(1932), applied the Quantity Theory of Money,
which holds that changes in the money supply
cause changes in the price level and can affect the
level of economic activity for short periods. These
economists argued that the Fed should prevent
deflation by increasing the money supply. At the


Figure 4
Bank Suspensions






0 --------- L
I----U L
---- I----U
----L U
I— ----U U
— ----U U— U U— U—


other extreme, proponents of "liquidationist” the­
ories of the cycle argued that excessively easy
monetary policy in the 1920s had contributed to
the Depression, and that "artificial” easing in
response to it was a mistake. Liquidationists
thought that overproduction and excessive bor­
rowing cause resource misallocation, and that
depressions are the inescapable and necessary
means of correction:
In the course of a boom many bad business
commitments are undertaken. Debts are in­
curred which it is impossible to repay. Stocks
are produced and accumulated which it is im­
possible to sell at a profit. Loans are made
which it is impossible to recover. Both in the
sphere of finance and in the sphere of produc­
tion, when the boom breaks, these bad commit­
ments are revealed. Now in order that



revival may commence again, it is essential that
these positions should be liquidated. . . ,7
One implication o f the liquidationist theory is
that increasing the money supply during a
recession is likely to be counterproductive. Dur­
ing a minor recession in 1927, for example, the
Fed had made substantial open market pur­
chases and reduced its discount rate. Adolph
Miller, a member of the Federal Reserve Board,
who agreed with the liquidationist view, testi­
fied in 1931 that:
It [the 1927 action] was the greatest and boldest
operation ever undertaken by the Federal
Reserve System, and, in my judgment, resulted
in one of the most costly errors committed by
it or any banking system in the last 75 years. I
am inclined to think that a different policy at
that time would have left us with a different

7Lionel Robbins, The Great Depression (1935) [quoted by
Chandler (1971), p. 118],



condition at this time. . . . That was a time of
business recession. Business could not use and
was not asking for increased money at that
In Miller’s view, because economic activity was
low, the reserves created by the Fed’s actions
fueled stock market speculation, which led in­
evitably to the crash and subsequent
During the Depression, proponents of the liquidationist view argued against increasing the
money supply since doing so might reignite
speculation without promoting an increase in
real output. Indeed, many argued that the Fed­
eral Reserve had interfered with recovery and
prolonged the Depression by pursuing a policy
o f monetary ease. Hayek (1932), for example,
It is a fact that the present crisis is marked by
the first attempt on a large scale to revive the
economy. . . by a systematic policy of lowering
the interest rate accompanied by all other possi­
ble measures for preventing the normal process
of liquidation, and that as a result the depres­
sion has assumed more devastating forms and
lasted longer than ever before (p. 130).
Several key Fed officials shared Hayek's views.
For example, the minutes o f the June 23, 1930,
meeting of the Open Market Committee report
the views of George Norris, Governor of the
Federal Reserve Bank o f Philadelphia:
He indicated that in his view the current busi­
ness and price recession was to be ascribed
largely to overproduction and excess productive
capacity in a number of lines of business rather
than to financial causes, and it was his belief
that easier money and a better bond market
would not help the situation but on the con­
trary might lead to further increases in produc­
tive capacity and further overproduction.9
While the liquidationist theory of the business
cycle was commonly believed in the early 1930s,

8U.S. Senate (1931), p. 134.
9Quoted by Chandler (1971), pp. 136-37. De Long (1990)
details the liquidationist cycle theory, and Chandler (1971),
pp. 116-23, has a general discussion of prevailing busi­
ness cycle theories and their prescriptions for monetary
10See Temin (1976) for a survey of Keynesian explanations
of the Great Depression.


it died out quickly with the Keynesian revolu­
tion, which dominated macroeconomics for the
next 30 years. Keynesian explanations of the
Depression differed sharply from those o f the liquidationists. Keynesians tended to dismiss
monetary forces as a cause of the Depression or
a useful remedy. Instead they argued that
declines in business investment or household
consumption had reduced aggregate demand,
which had caused the decline in economic ac­
tivity.1 Both views, however, agreed that mone­
tary ease prevailed during the Depression.
Friedman and Schwartz renewed the debate
about the role of monetary policy by forcefully
restating the Quantity Theory explanation of the
The contraction is. . . a tragic testimonial to the
importance of monetary forces. . . . Different
and feasible actions by the monetary authorities
could have prevented the decline in the stock
of money. . . [This] would have reduced the con­
traction’s severity and almost as certainly its du­
ration (pp. 300-01).
Friedman and Schwartz argue that an increase
in the money stock would have offset, if not
prevented, banking panics, and would have led
to increased lending to consumers and business
that would have revived the economy.
Many disagree with the Friedman and Schwartz
explanation, although some recent Keynesian ex­
planations concede that restrictive monetary
policy did play a role in the Depression.1 Other
studies, such as Field (1984), Hamilton (1987),
and Temin (1989), conclude that contractionary
monetary policy in 1928 and 1929 contributed
to the Depression. Bordo (1989) and Wicker
(1989) provide detailed surveys of the monetaristKeynesian debate about the causes of the Great
Depression, and interested readers are referred
to them. Since most recent contributions to this
literature emphasize the effects o f monetary
policy, a new look at the policies of the Federal
Reserve during the Great Depression is war­

"M o s t criticize the Fed’s discount rate increases and failure
to replace reserve losses suffered by banks in the panic
following Great Britain’s departure from the gold standard
in late 1931. See Temin (1976), p. 170, and Kindleberger
(1986), pp. 164-67.


Figure 5
Interest Rates



A fundamental disagreement within the Feder­
al Reserve System and among outside observers,
even today, is whether monetary policy during
the Depression was easy or tight. Most Fed offi­
cials felt that money and credit were plentiful.
Short-term market interest rates fell sharply af­
ter the stock market crash of 1929 and remained
at extremely low levels throughout the 1930s
(see figure 5). To most observers, the decline in
short-term rates implied monetary ease. Long­
term interest rates declined less sharply,
however, and yields on risky bonds, such as
12The short-term rate series through 1933 is the average
daily yield in June of each year on three- to six-month
Treasury notes and certificates, and the yield on Treasury
bills thereafter. The long-term series is the average daily



Baa-rated bonds, rose during the first three
years of the Depression (see figure 5).1 Never­
theless, the exceptionally low yields on short­
term securities has suggested to many observers
an abundance of liquidity.
Other variables also have been interpreted as
indications of easy monetary conditions. Rela­
tively few banks came to the Fed’s discount
window to borrow reserves, for example, and
many banks built up substantial excess reserves
as the Depression progressed (see figure 6).1 To
most observers, it appeared that there was little
demand for credit and, since most policymakers
saw their mission as one of accommodating
yield in June of each year on U.S. government bonds.
13Data on excess reserves before 1929 are not available,
but they were not likely very large.



Figure 6
Borrowed and Excess Reserves of
Federal Reserve Member Banks
Millions of dollars

ing credit demand, few believed that more
vigorous expansionary actions were necessary.1
Low interest rates and an apparent lack of de­
mand for reserves have led many researchers
to conclude that tight money did not cause the
Depression. Temin (1976), for example, writes:
There is no evidence of any effective deflation­
ary pressure from the banking system between
the stock-market crash in October 1929 and the
British abandonment of the gold standard in
14The Federal Reserve System’s founders intended that it
operate according to the Real Bills Doctrine. Fed credit
would be extended primarily through the discount window
as member banks borrowed to finance short-term agricul­
tural or business loans. A decline in economic activity
would reduce discount window borrowing, causing Federal
Reserve credit to decline. By 1924, System policy had
evolved away from a strict Real Bills interpretation, but it


September 1931. . . . There was no rise in short­
term interest rates in this two-year period. . . .
The relevant record for the purpose of identify­
ing a monetary restriction is the record of
short-term interest rates (p. 169).

Other indicators of monetary conditions,
however, suggest the opposite conclusion. Defla­
tion implied that the value o f the dollar rose 25
percent from 1929 to 1933, which Schwartz
probably continued to have considerable influence on
many Fed officials. See West (1977) or Wicker (1966) for
discussion of the influence of the Real Bills Doctrine on
policy over time.


Figure 7
Money Supply
Millions of dollars

(1981) argues reflected exceptionally tight
money. Another indicator, the money stock, fell
by one-third from 1929 to 1933 (see figure 7).1
Friedman and Schwartz contend that:
It seems paradoxical to describe as ‘monetary
ease’ a policy which permitted the stock of
money to decline. . . by a percentage exceeded
only four times in the preceding fifty-four years
and then only during extremely severe
business-cycle contractions (p. 375).

justed for changes in the price level, rose shar­
ply during the Depression (see figure 8).1 While
the nominal yield on short-term government
securities fell to an exceptionally low level,
deflation implied that their real yield rose above
10 percent in 1930 and 1931. Thus, in contrast
to the apparent signal given by nominal interest
rates, member bank borrowing and excess
reserves, the falling money stock and deflation
suggest that monetary conditions were far from

And finally, numerous studies point out that the
real interest rate, that is, the interest rate ad­

Many economists now conclude that the Fed­
eral Reserve should have responded more

15M1 is the sum of coin and currency held by the public and
demand deposits. M2 also includes time deposits at com­
mercial banks.

17Yet another indicator is the real money supply, i.e., the
growth rate of the nominal supply of money less the ex­
pected rate of inflation. Since the price level fell faster
than the nominal supply of money (M1 or M2) during the
first two years of the Depression, Temin (1976) argues that
monetary conditions were not tight. The increase in real
money balances was relatively slow, however, which
Hamilton (1987) argues was contractionary.

16See Meltzer (1976) and Hamilton (1987), for example. The
real interest rate plotted in figure 8 is calculated as the
prevailing yield on short-term government securities in
June of each year, less the rate of inflation in the subse­
quent year. Since actual, rather than anticipated, inflation
is used to calculate the real rate, it is considered an ex
post, rather than ex ante, rate.



Figure 8
Ex Post Real Interest Rate

vigorously tc the Depression. There is little
agreement, however, about why the Fed did
not. The next sections examine alternative ex­
planations for Federal Reserve behavior during
the Depression.

Irving Fisher testified before Congress in 1935
that the Depression was severe because “Gover­
nor Strong had died and his policies died with
him. . . . I have always believed, if he had lived,
w e would have had a different situation.”1 Ac­
cording to Fisher, Benjamin Strong had disco­
vered how to use monetary policy to maintain

18U.S. House of Representatives (1935), p. 534.


price level stability, “and for seven years he
maintained a fairly stable price level in this
country, and only a few of us knew what he
was doing. His colleagues did not understand
it.”1 In Fisher's view, Strong adjusted the quan­
tity of money to maintain a stable price level;
had he lived, Fisher says, he would have
prevented the deflation of the 1930s by not al­
lowing the quantity o f money to decline.
Friedman and Schwartz agree with Fisher that
Strong’s death caused monetary policy to
change significantly. They argue that Strong’s
aggressive open market purchases and discount
rate reductions in 1924 and 1927 had quickly al­
leviated recessions, but that his death produced
a sharply different policy during the Depression:

19lbid, pp. 517-20.


If Strong had still been alive and head of the
New York Bank in the fall of 1930, he would
very likely have recognized the oncoming li­
quidity crisis for what it was, would have been
prepared by experience and conviction to take
strenuous and appropriate measures to head it
off, and would have had the standing to carry
the System with him (pp. 412-13).
Friedman and Schwartz make a persuasive
case. Strong was an experienced financial lead­
er. He had served as an officer of Bankers
Trust Company, and during the Panic of 1907
as head of a committee reporting to J. P. Mor­
gan that determined which financial institutions
could be rescued.2 He was the first governor of
the Federal Reserve Bank of New York and
emerged as leader of the Federal Reserve Sys­
tem both because of his personality and stature
in the financial community and because o f the
relative importance of New York member banks
in the international financial market.2 He chaired
a committee of Federal Reserve Bank governors
that coordinated System open market operations
and represented the System in dealings with
foreign central banks and Congress.2 It is clear
that, with his death, the Fed lost an experienced
and forceful leader.
Some researchers argue, however, that
Strong’s death had little effect on policy. Temin
(1989), for example, writes that "The death of
Strong was a minor event in the history of the
Great Depression" (p. 35). And Brunner and
Meltzer (1968) argue that, "While there is some
evidence that the death of Benjamin Strong con­
tributed to a shift in the balance of power w i­
thin the Federal Reserve. . . we find that a
special explanation o f monetary policy after
1929 is unnecessary. . .” (p. 341). The disagree­
ment between these authors and those such as
Fisher, Friedman and Schwartz rests on their
views of whether Strong’s policies would have
prevented the monetary collapse and Depression.

20Chandler (1958), pp. 27-28.
21The Federal Reserve Act gave the individual Reserve
Banks authority to initiate discount rate changes and open
market operations. The Federal Reserve Board could ap­
prove or disapprove these actions, but its role was primari­
ly supervisory, with no clear authority to determine policy.
Because of this, and perhaps because it lacked forceful
leaders, the Board did not dominate policy making until af­
ter the System was restructured by the Banking Act of
1935. See Wheelock (forthcoming) for details of this reor­

Much of Strong’s testimony before Congres­
sional committees, as well as other speeches and
writings, suggests that he had developed a poli­
cy of money supply control to limit fluctuations
in the price level. For example, in an unpub­
lished article dated April 1923, he wrote: “If, as
is now universally admitted, prices are in­
fluenced to advance or to decline by increases
or decreases in the total of 'money’. . . then the
task of the System is to maintain a reasonably
stable volume of money and credit. . . ”2 And,
in a speech to the American Farm Bureau in
December 1922, he said that monetary policy:
. . .should insure that there is sufficient money
and credit available to conduct the business of
the nation and to finance not only the seasonal
increases in demand but the annual or normal
increase in volume. . . . I believe that it should
be the policy of the Federal Reserve System, by
the employment of the various means at its
command, to maintain the volume of credit and
currency in this country at such a level so that,
to the extent that the volume has any influence
upon prices, it cannot possibly become the me­
ans for either promoting speculative advances
in prices, or of a depression of prices.2
These statements suggest that Strong would not
have permitted the money supply collapse or
deflation that occurred after 1929.
Other aspects of Strong's testimony, speeches
and writings give different or ambiguous im­
pressions of his views, however, making it
difficult to infer what policies he would have
advocated during the Depression. In testimony
before the House Banking Committee in 1926,
Strong described the relationship between Fed
policy and the quantity of bank deposits, dis­
cussing in detail the multiplier relationship be­
tween bank reserves and deposits.2 But he also

they made it difficult to price new debt issues and a grow­
ing understanding of the impact of open market operations
on economic activity, led the Banks to form a “ Governors
Committee” to coordinate open market operations. This
committee was replaced in 1923 by the Open Market In­
vestment Committee, which Strong headed until his death.
23“ Prices and Price Control,” in Burgess (1930), pp. 229-30.
24Quoted by Chandler (1958), p. 200.
25U.S. House of Representatives (1926), pp. 334-35.

22lnitially, each Reserve Bank determined its own open mar­
ket operations. But Treasury Department complaints that



testified that, "when it comes to a decline of
price level, the origin of which can not be at­
tributed to a credit policy, this effort that you
make by a credit policy to arrest a fall of prices
may do more harm than good. . . ,”2 It is also
difficult to interpret his writing that "the task of
the System is to maintain a reasonably stable
volume of money and credit, with d u e al­
low an ces f o r sea so n a l flu ctu a tio n s in d em an d, f o r
n orm al annual g row th in the country's d ev elo p ­
m ent. . . an d with su ch allow an ce a s m ay b e im ­
p o s e d b y th o se g reat cycles o f p ro sp erity an d
d ep ressio n . . . .”2 What sort o f allowance for
fluctuations does he mean? This statement could
be read as advocating an increase or a d e c rea se
in money in response to a decline in economic
activity. The latter is suggested by the following
statement: "there should be no such excessive
or artificial supplies of money and credit as will
simply permit the marking up of prices when
there is no increase in business or production
to warrant an increase in the volume of money
and credit.”2 This sounds like the warnings by
some officials during the Depression that mone­
tary expansion would be inflationary or cause
speculation b e c a u s e economic activity was low.
Strong also seems to have concluded that the
deflation from mid-1920 to 1921 had positive
The deflation which took place in the United
States following the collapse of prices resulted
in extricating the reserve system—the whole
monetary system of the country—from a posi­
tion of permanent entanglement. . . and I think
that was one of the fortunate results of the
policy. . . . One of the results of this liquida­
tion. . . has been to put this country on as
sound or a sounder monetary basis than any
other country in the world, without the in­
troduction of a lot of money or credit into cir­
culation, based solely upon the Government
debt to the bank of issue. I mean to explain
that there have been offsetting advantages to
that deflation. . . ,2
26lbid, p. 577.
27“ Prices and Price Control,” April 1923, in Burgess (1930),
p. 230 (italics added).
28From a speech to the American Farm Bureau in 1922
[quoted by Chandler (1958), p. 200].
29U.S. House of Representatives (1926), p. 309.
3°Federal Reserve credit is supplied by Fed purchases of
securities and discount window lending (member bank bor­
rowing). It consists also of some miscellaneous compo-


This quotation suggests that Strong might have
found similar offsetting advantages to the defla­
tion that followed the stock market crash in
1929 and might have been reluctant to expand
the money supply through purchases of govern­
ment securities.
These quotations illustrate the ambiguity of
many of Strong's statements and the difficulty
of inferring what policies he would have pur­
sued in the 1930s. To determine whether mone­
tary policy was changed by Strong's death, it is
probably more instructive to examine the poli­
cies he actually implemented.
Tw o aspects of Strong’s policies have received
attention from scholars studying Federal
Reserve behavior. First, beginning in the early
1920s, the System offset or "sterilized” gold
flows and other changes in reserve funds by al­
tering the volume o f Fed credit outstanding.3
This policy limited fluctuations in bank reserves
and, thus, in the money supply and price level.
According to Friedman and Schwartz (1963), pp.
394-99, however, the Fed permitted gold out­
flows during the Depression to reduce bank
reserves and the money supply and more than
offset gold inflows. What had been an essential­
ly neutral policy, therefore, became a contrac­
tionary policy after Strong's death.
Miron (1986) argues that a similar change oc­
curred in the Fed’s accommodation of seasonal
credit and currency demands. From the Sys­
tem's inception, Federal Reserve credit was sup­
plied to prevent seasonal demands from
draining bank reserves and increasing interest
rates. According to Miron, the Fed was less ac­
commodative after 1928, which contributed to
the frequency o f financial crises during the
Beyond the offsetting o f gold and currency
flows, a second aspect of Strong’s policies has
received considerable attention. In 1924 and
1927, the Fed made large open market pur­
chases and discount rate reductions that were
followed by increases in bank reserves and the
nents, such as float. In this era, the Federal Reserve pur­
chased both U.S. government securities and bankers ac­
ceptances (at fixed acceptance buying rates), and discount
window lending consisted of both rediscount of eligible
paper and advances to member banks at the discount
3 Miron does not test this claim except to show that Federal
Reserve credit was somewhat less seasonal after 1928
than before.


money supply. Friedman and Schwartz (1963)
argue that the Fed's purpose was to combat
recessions and that its failure to respond as ag­
gressively during the Depression reflected a dis­
tinct change in System behavior. Other
researchers, however, such as Wicker (1966)
and Brunner and Meltzer (1968), find no incon­
sistency in Fed behavior, arguing that the com­
paratively weak response to the Depression was
in fact predictable from the policy strategy de­
veloped by Strong.

The Sterilization P olicy
Before entering W orld W ar I, the United
States absorbed large gold inflows that added
directly to bank reserves and caused a signifi­
cant money supply increase.3 Although inflows
ceased after America entered the war, bank
reserves and the money supply continued to in­
crease rapidly as Federal Reserve credit was ex­
tended to help finance the war. After the war,
gold outflows reduced the reserves of the
Reserve Banks, leading them to raise their dis­
count rates and thereby restrict credit to mem­
ber banks.3 The resulting decline in Fed credit
coincided with a sharp decline in the money
supply and deflation.3
Following the violent inflation-deflation cycle
of 1917-21, the Fed began to intervene to pre­
vent gold flows from affecting bank reserves.3
In testimony before the House Committee on
Banking and Currency, Strong gave a clear ex­
planation of this policy, presenting charts show­
ing the relationship between gold flows, Fed
credit, bank reserves and the price level.3 He
In the old days there was a direct relation be­
tween the country's stock of gold, bank deposits
and the price level because bank deposits
32The accompanying shaded insert discusses the sources
and uses of reserve funds and explains the mechanics of
the Fed’s sterilization policy.
33The Reserve Banks were required to maintain gold
reserves of 40 percent against their note issues and 35
percent against deposits. A discount rate increase was in­
tended to reduce discount loans and, thus, the Fed’s note
and deposit liabilities, as well as encourage gold inflows
as investors sought higher yields in the United States.
34ln January 1916, the All Commodities Price Index stood at
112.8 (1913=100). In April 1917 (when the United States
entered the war), it was at 172.9. At its peak in May 1920,
the Index was at 246.7. It then fell to a low of 138.3 in
January 1922.
35Before the war, the Fed lacked the resources to offset
gold inflows, so sterilization was impossible. By the end of
1921, the Reserve Banks had sufficient reserves to reduce

were. . . based upon the stock of gold and bore
a constant relationship to the gold stock, and
the volume of bank deposits and the general
price level were similarly related. But in recent
years the relationship between gold and bank
deposits is no longer as close or direct as it
was, because the Federal Beserve System has
given elasticity to the country's bank reserves.
Reserve Bank credit has become the equivalent
of gold in its power to serve as the basis of
bank credit. . . . Hence. . . the present basis for
bank credit consists of gold plus Federal
Reserve credit. Federal Reserve bank credit is
an elastic buffer between the country’s gold
supply and bank credit.3
Strong credited the Federal Reserve System for
preventing inflation in 1921 and 1922:
As the flow of gold imports was pouring into
the United States in 1921 and 1922, many
economists abroad, and in this country as well,
expected that this inward flow of gold would
result in a huge credit expansion and a serious
price inflation. That no such expansion or infla­
tion has taken place is due to the fact that the
amount of Federal Reserve credit in use was
diminished as the gold imports continued. Thus,
in the broad picture of financial events in this
country since 1920, the presence of the Reserve
System may be said to have prevented rather
than fostered inflation.3
Figure 9 illustrates the policy of offsetting
gold and currency flows during the 1920s.3
The shaded insert on pages 18-19 describes the
mechanics of this policy. Since gold is a source
of banking system reserves, gold inflows, unless
offset, add to the stock of reserves. A gold in­
flow thus has the same effect on reserves as a
their discount rates, and individually they began to pur­
chase government securities. By 1923, there seems to
have been a conscious effort to offset gold flows [Fried­
man and Schwartz (1963), pp. 279-87].
36These charts are reproduced by Hetzel (1985), p. 7, who
examines Strong’s unwillingness to support legislation that
would require the Fed to adopt a price level stabilization
37U.S. House of Representatives (1926), p. 470.
38lbid, p. 471.
39ln practice, the Fed also offset changes in other sources
and uses of reserve funds, but gold and currency flows
were the most substantial; the others can be ignored for il­
lustrative purposes.



Figure 9
Gold and Currency Sterilization
Millions of dollars

Federal Reserve purchase of securities. Currency
held by the public is a use of reserves: in­
creases in public currency holdings reflect
reserve withdrawals from banks. Thus, if not
offset, an increase in currency would correspond
to a decrease in bank reserves. The difference
between gold and currency is plotted in figure 9.
It is clear that net increases (decreases) in this
difference were largely offset by declines (in­
creases) in Fed credit outstanding, so that total
bank reserves changed relatively little.
It is also clear that Benjamin Strong’s death
did not interrupt the offsetting of gold and cur­

40The multiplier plotted in figure 10 equals (1 +k)/(r + k),
where k is the ratio of currency held by the public to de­
mand deposits and r is the ratio of bank reserves to
deposits. The multiplier is defined as the money supply
(here M2) divided by the monetary base, or “ high-powered
money,” which is the sum of bank reserves and currency
held by banks and the public.


rency flows, at least until the fourth quarter of
1931. The money supply contraction and defla­
tion during the first two years o f the Depres­
sion were not caused by a decline in bank
reserves. Instead, as figure 10 illustrates, the
money supply fell because the money multiplier
declined.4 This was particularly true beginning
in the fourth quarter of 1930, when banking
panics caused marked increases in the
currency-deposit and reserve-deposit ratios.4
The relative stability o f bank reserves ended
abruptly in September 1931. On September 21,
Great Britain left the gold standard. Speculation
4 Friedman and Schwartz (1963), pp. 340-42, conclude that
the money supply decline between August 1929 and Oc­
tober 1930 was caused by a decline in the monetary base
This decline was due to a decrease in currency, not bank
reserves. Thereafter, the base rose, but less than neces­
sary to offset the sharp decline in the multiplier.


Figure 10
Money Supply and Base Multiplier

M illions o f dollars

January 1929 to February 1933


7 _____



















Monthly Data

that the United States would soon follow led to
a large withdrawal of foreign deposits from
American banks and a consequent gold out­
flow.4 In the six weeks ending October 28,
1931, the gold stock declined $727 million (15
percent).4 The Fed raised its discount and ac­
ceptance buying rates, hoping that an increase
in domestic interest rates would halt the gold
outflow by raising the relative yield of U.S.
financial assets. This action was hailed as
demonstrating the Fed’s resolve to maintain gold
convertibility of the dollar, and the gold outflow

42lf the United States had left the gold standard, it is likely
that the dollar would have depreciated against gold and
other currencies that remained linked to gold. This would
have meant an immediate loss of wealth in terms of gold
for anyone holding dollar-denominated assets.

Banks continued to lose reserves, however, as
depositors panicked and converted deposits into
currency. Member banks were able to partially
offset the reserve outflows by borrowing and
by selling acceptances to the Reserve Banks, al­
beit at the recently increased discount and ac­
ceptance buying rates. But the Fed made only
trivial purchases o f government securities, and,
in all, Federal Reserve member banks suffered a
$540 million (22 percent) loss of reserves be­
tween September 16, 1931, and February 24,

44Non-borrowed reserves declined $1112 million (52 percent), while discount loans (borrowed reserves) increased
$572 million,

43Board of Governors of the Federal Reserve System (1943),
p. 386.



The Federal Reserve Balance Sheet and Reserve
A simplified version o f the Federal Reserve
System’s balance sheet on December 31,
1929, is shown below. The principal assets of
the Federal Reserve were its gold and cash
reserves and Fed credit outstanding. The lat­
ter consisted of member bank borrowing
(bills discounted),1 bankers acceptances held
by the Reserve Banks (bills bought),2 U.S.
government securities held by the Reserve
Banks and a miscellaneous component, made
up primarily by float. The principal liabilities
of the System were Federal Reserve notes
outstanding, deposits of member banks, and
deposits of the U.S. Treasury and others,
such as foreign central banks.
Most System transactions involve member
commercial banks and directly affect member
bank reserves. If the Fed makes an open
market purchase o f government securities
from a member bank, for example, it pays
for the securities by crediting the member
bank's deposit with the Federal Reserve.
Since a deposit at the Fed is the principal
form in which banks hold their legal
reserves,3 an open market purchase adds
directly to bank reserves.4
Many Federal Reserve transactions are in­
itiated by commercial banks. When the Unit­
ed States was on the gold standard, the Fed
held substantial gold reserves, and transac­
tions in gold w ere common. For example,
suppose gold coin was deposited by a cus­
tomer of a member bank. The bank could
send the coin to its Federal Reserve Bank and
receive an increase in its reserve deposit of
that amount. The Fed’s gold reserves and
member bank deposits would increase by the
same amount. Suppose instead that a member
bank was experiencing large cash withdraw­
als and needed extra currency. It could re­
quest currency, in the form of Federal
Reserve notes, from its Reserve Bank and pay
for the currency with a reduction in its
reserve deposit. Hence, as Federal Reserve
notes outstanding increased, bank reserves
would decline by the same amount.
The Fed could offset, or "sterilize,” the im­
pact of one transaction on bank reserves


Federal Reserve System Balance Sheet
December 31,1929 (billions of dollars)
Gold and cash reserves
Federal Reserve credit
Bills discounted
Bills bought
Government securities
Other assets
Total assets
Liabilities and Capital
Federal Reserve notes
Member bank
Other liabilities
Capital accounts
Total liabilities and capital



with a second transaction having the opposite
impact on reserves. For example, if the Fed
sold government securities in the amount of
a gold inflow, there would be no net change
in aggregate member bank reserves. The
open market sale would reduce reserves just
as the gold inflow added to them, leaving no
net reserve change. Similarly, a bank could
borrow reserves from its Reserve Bank to
pay for Federal Reserve notes needed to satis­
fy withdrawal demands, and thus avoid
drawing down its reserve deposit. In this
case, Federal Reserve credit (bills discounted)
would increase by the amount of the increase
in Federal Reserve notes outstanding, and
bank reserves would not change. Note that,
in this case, the Fed did not initiate the o ff­
setting transaction. Indeed, much of the
sterilization of gold and currency flows dur­
ing the 1920s and early 1930s was at the in­
itiative of member banks, although it was
definitely the Fed’s intent that sterilization
Federal Reserve sterilization of gold and
currency flows from January 1924 to Febru­
ary 1933 is illustrated in figure 9. Note that
increases (decreases) in Federal Reserve


credit accompanied declines (increases) in the
net of gold and currency outstanding, and
thus bank reserves changed comparatively lit­
tle. In 1930, for example, member bank
reserves rose from $2395 million in Decem­
ber 1929 to $2415 million in December 1930,
an increase of just $20 million. Over the same
'Loans to member banks consisted of discounts and ad­
vances. Many commercial loans, which often were
called “ bills,” were made on a discount basis; hence,
when they were endorsed by a bank and sent to a
Reserve Bank in exchange for reserve balances, they
were “ re-discounted” by the Reserve Bank at the
prevailing discount rate. Alternatively, bills were used
as collateral for direct advances to member banks,
hence the term “ bills discounted.”
2The terminology is confusing because “ bills” in this
case refer to bankers acceptances, not to the promisso­
ry notes that member banks used as collateral for dis­
count loans.

months, there was an increase of $259 mil­
lion in the monetary gold stock and a $120
million decline in currency in circulation. The
gold inflow and decline in currency would
have added $379 million to bank reserves,
but Fed credit declined by $370 million to
offset their impact almost entirely.5
gal reserves. At other times, vault cash has also
“ Even if the Fed were to purchase securities from some­
one other than a member bank, bank reserves would
still increase once the check issued by the Fed to pay
for the securities was deposited in a member bank.
Open market security sales reduce bank reserves
since, ultimately, a member bank reserve deposit is
reduced to pay for the securities sold by the Fed.
5The gold inflow, decline in currency and decline in Fed­
eral Reserve credit do not sum exactly to the change in
bank reserves because of the effect of other, small
transactions affecting reserves.

3From 1917 to 1960, such deposits were the only form
in which member banks were permitted to hold their le-

The Fed’s failure to fully offset the gold and
currency outflows suffered by banks permitted
the money supply contraction to accelerate. Fed
officials claimed that the Reserve Banks’ lack of
reserves precluded government security pur­
chases to offset the reserve losses suffered by
banks.4 The Reserve Banks w ere required to
maintain gold reserves equal to 40 percent of
their note issues and reserves o f either gold or
“eligible paper” against the remaining 60 per­
cent.4 Since gold outflows had reduced the Sys­
tem's reserve holdings, and since the System
lacked other eligible paper, Fed officials asserted
they could not increase Fed credit by purchas­
ing government securities, which w ere not eligi­
ble collateral.
Friedman and Schwartz (1963), pp. 399-406,
dispute the Fed’s justification for not buying
government securities. They argue that the Sys­
tem had sufficient gold reserves and, in any
event, that the Federal Reserve Board had the
power to suspend the reserve requirements
45See the Board of Governors of the Federal Reserve Sys­
tem. Annual Report (1932), pp. 16-19.
46Eligible paper consisted of either bankers acceptances or
commercial notes acquired by direct purchase or pledged
by member banks as collateral for discount loans. See
Board of Governors of the Federal Reserve System (1943),
pp. 324-29, and Friedman and Schwartz (1963), p. 400.
47Why the Fed undertook these purchases is unclear, espe­
cially if fear of undermining the gold standard explains

temporarily. Epstein and Ferguson (1984),
pp. 964-65, contend, however, that Fed officials
did feel constrained by a lack of gold. Wicker
(1966), pp. 169-70, suggests that Fed officials
feared that open market purchases would
weaken confidence in the Fed’s determination to
maintain gold convertibility and thereby renew
the gold outflow.
In any case, the Glass-Steagall Act o f 1932 re­
moved the constraint by permitting government
securities to serve as collateral for Federal
Reserve note issues. In March 1932, the System
began what was then the largest open-market
purchase program in its history.4 Between
February 24 and July 27, 1932, the Fed bought
$1.1 billion of government securities. Member
bank reserves increased only $194 million in
these months, however, because of renewed
gold and currency outflows and a reduction in
member bank borrowing. Moreover, the supply
of money continued to fall because o f a sharp
decline in the money multiplier (see figure 10).4
why purchases were not made immediately following Bri­
tain’s departure from gold. Friedman and Schwartz (1963),
pp. 384-89, argue that the Fed succumbed to pressure
from Congress, while Epstein and Ferguson (1984) con­
clude that pressure from both Congress and commercial
banks was important.
^D urin g these months, both the reserve-deposit and
currency-deposit ratios rose.



The Fed ended its purchase program in July
1932, largely because officials believed it had
done little good.4 Bank reserves continued to
increase, however, as gold inflows were not o ff­
set by a corresponding reduction in Fed credit
outstanding. Although the money supply ceased
to fall, it also failed to rise significantly. In early
1933, large gold and currency outflows caused
a renewed money supply decline.5 On this oc­
casion, the crisis was stopped by Franklin D.
Roosevelt’s decision to declare a Bank Holiday
and suspend gold shipments. In essence, the
Fed’s failure to insulate the banking system
from gold outflows and panic currency with­
drawals had caused the president to act to pre­
vent further reserve losses.
While failure to sterilize gold and currency
outflows in 1931 and 1933 was inconsistent
with previous actions, it did not represent a
fundamental change in regime. Fed officials ap­
parently believed strongly in the gold standard,
and there seems to have been no discussion of
following Great Britain o ff gold. Benjamin
Strong had been a committed advocate of the
gold standard, and it seems doubtful that he
would have proposed actions that might have
weakened it.5 As an institution, the Federal
Reserve System was willing to forego short-run
stability to preserve the gold standard, which it
saw as its fundamental mission.5
Reserve sterilization constituted one aspect of
System policy begun under Strong, and the Fed
deviated little from the policy after his death, at
least until the fo u rth q u arter o f 1931. In fact,

from the stock market crash in October 1929 to
Britain’s departure from gold on September 21,
1931, the Fed did little but offset gold and cur­
rency flows. It certainly did not make large
open market purchases, despite the deepening
depression. On the surface, this lack o f vigor
appears at odds with the relatively large open
market purchases the Fed made during the
minor recessions of 1924 and 1927.
49Banks’ excess reserves increased substantially during the
months of the open market purchases, which many saw as
idle balances that were unneeded and potentially inflation­
ary. See Friedman and Schwartz (1963), pp. 385-89. As
discussed below, Epstein and Ferguson (1984) suggest
that pressure from commercial banks contributed to the
Fed’s decision to end the program.
50The money supply fell both because of a decline in
reserves and a decline in the money multiplier induced by
panic deposit withdrawals.
51Strong testified before the House Banking Committee in
1928 that, “ When you are speaking of efforts simply to

Federal Reserve Bank of St. Louis

Strong’s Countercyclical Policy
The Fed’s actions in 1924 mark its first use of
open market operations to achieve general poli­
cy objectives. In that year, the Fed purchased
$450 million of government securities and cut
its discount rate (in three stages) from 4.5 per­
cent to 3 percent. In testimony before the
House Banking Committee in 1926, Benjamin
Strong listed several reasons for these actions,
including the following:
1) To accelerate the process of debt repay­
ment to the Federal Reserve Banks by the
member banks, so as to relieve this weaken­
ing pressure for loan liquidation.
2) To give the Federal Reserve Banks an asset
which would not be automatically liquidated
as the result of gold imports so that later, if
inflation developed from excessive gold im­
ports, it might at least be checked in part by
selling these securities, thus forcing member
banks again into debt to the Reserve Banks
and making the Reserve Bank discount rate
3) To facilitate a change in the interest rela­
tion between the New York and London mar­
kets. . . by establishing a somewhat lower
level of interest rates in this country at a
time when prices w ere falling generally and
when the danger of a disorganizing price ad­
vance in commodities was at a minimum and
4) By directing foreign borrowings to this
market to create the credits which would be
necessary to facilitate the export of com­
modities. . . .
5) To render what assistance was possible by
our market policy toward the recovery of
sterling and the resumption of gold payment
by Great Britain.
6) To check the pressure on the banking situ­
ation in the west and northwest and the
resulting failures and disasters.5
stabilize commerce, industry, agriculture, employment and
so on, without regard to the penalties of violation of the
gold standard, you are talking about human judgment and
the management of prices which I do not believe in at all.”
[Quoted by Burgess (1930), pp. 331.] See also Temin
(1989), p. 35.
52See Temin (1989), pp. 28-29 and 78-87, and Wheelock
53U.S. House of Representatives (1926), p. 336.


The Fed undertook a second large purchase
program in 1927, purchasing $300 million of
government securities and reducing the dis­
count rate again. Strong left no written justifica­
tion for these operations. Friedman and
Schwartz (1963) argue that they were made in
response to a recession, and that the 1924 pur­
chases had also been intended to bring about a
domestic recovery. Wicker (1966), pp. 77-94 and
106-16, challenges this interpretation, arguing
that the actions were motivated by international
considerations. According to Wicker, the pur­
chases in 1924 were intended to encourage the
flow of gold to Britain by reducing U.S. interest
rates relative to those in London, with the goal
of assisting Britain’s return to the gold standard.
The 1927 purchases were intended to help Bri­
tain through a payments crisis, again by direct­
ing capital toward London; these purchases
followed closely a meeting between Strong and
European central bank heads.
Chandler (1958), p. 199, argues that both
domestic and international goals were important
in 1924 and 1927, and Wheelock (1991), ch. 2,
finds empirical support for this view. Wheelock
also shows that, relative to the decline in eco­
nomic activity, the Fed made substantially few er
open market purchases in 1930 and 1931 than
it did during 1924 and 1927. This might reflect
a significant change in System behavior between
the 1920s and early 1930s. But an analysis of
the Fed's policy methods suggests that its anem­
ic response in 1930-31 might also be explained
as the consistent use of a single strategy.
During the early 1920s, the Fed developed a
strategy of using open market operations and
discount rate changes to affect the level of
member bank discount window borrowing. Fed
officials observed that, when the System pur­
chased government securities, member bank
borrowing tended to decline by nearly the same
amount and, similarly, that open market sales
led to comparable increases in member bank
borrowing. But, while the Fed’s operations had
little impact on the total volume of Fed credit
outstanding, they appeared to have a significant

54lbid, p. 468.
55Presumably, discount rate changes alone could achieve
the same impact on interest rates, but the Fed preferred to
precede discount rate changes with open market opera­
tions. Strong testified that “ the foundation for rate
changes can be more safely and better laid by these
preliminary operations in the open market than would be

impact on money markets. According to Chan­
dler (1958):
Federal Reserve officials soon discovered. . .
much to their amazement at first, that open
market purchases and sales brought about
marked changes in money market conditions
even though total earning assets of the Reserve
Banks remained unchanged. When the Federal
Reserve sold securities and extracted money
from bank reserves, more banks were forced to
borrow from the Reserve Banks, and those al­
ready borrowing were forced more deeply into
debt. Since banks had to pay interest on their
borrowings and did not like to remain continu­
ously in debt, they tended to lend less liberally,
which raised interest rates in the market
pp. 238-39).
Strong testified that “the effect of open market
operations is to increase or decrease the extent
to which the member banks must of their own
initiative call on the Reserve Bank for
credit. . . .”5 Security purchases led to less mem­
ber bank borrowing and lower interest rates,
while sales increased borrowing and rates.5
Strong believed that monetary policy could
stimulate economic activity by easing money
market conditions:
. . .[W]hen we have very cheap money, corpora­
tions and individuals borrow money in order to
extend their businesses. That results in plant
construction; plant construction employs more
labor, brings in to use more materials. . . . It
may cause some elevation of wages. It creates
more spending power; and with that start it
will permeate through into the trades and the
general price level.5
Chandler (1958) and Friedman and Schwartz
(1963) conclude that under Strong’s leadership
the Federal Reserve System attempted to stimu­
late economic activity during recessions by
promoting monetary ease (cheap money). This
explains why Strong listed “to accelerate the
process of debt repayment. . . by the member
banks” as a reason for the open market pur-

possible otherwise, and the effect is less dramatic and
less alarming. . . than if we just make advances and
reductions in our discount rate.” [U.S. House of Represen­
tatives (1926), p. 333].
56U.S. House of Representatives (1926), pp. 578-79.



Table 1
Fed Policy During Three Recessions
(dollar amounts in millions)________



1929 Jul
1930 Jan
1931 Jan



1923 Apr
1924 Jan
1925 Jan



1926 Oct
1927 Jan
1928 Jan















Variable definitions: AIP: Index of Industrial Production
(seasonally adjusted); GS: Federal Reserve government secu­
rity holdings; DR: discount rate of the Federal Reserve Bank
of New York; DL: discount loans (member bank borrowing)
of all Federal Reserve member banks; DL(NYC): discount
loans of reporting banks in New York City.

chases in 1924. Strong used the level of mem­
ber bank borrowing to determine the specific
quantity of security purchases necessary to
bring about monetary ease:
Should we go into a business recession while
the member banks were continuing to borrow
directly 500 or 600 million dollars. . . we should
consider taking steps to relieve some of the
pressure which this borrowing induces by pur­
chasing Government securities and thus ena­
bling member banks to reduce their
indebtedness. . . . As a guide to the timing and
57Presentation to the Governors’ Conference, March 1926
[quoted by Chandler (1958), pp. 239-40].
58Wicker (1969) agrees that, to the extent that the Fed
responded to domestic conditions, it used member bank
borrowing as a guide. See also Meltzer (1976).


extent of any purchases which might appear
desirable, one of our best guides would be the
amount of borrowing by member banks in prin­
cipal centers. . . . Our experience has shown
that when New York City banks
are borrowing in the neighborhood of 100 mil­
lion dollars or more, there is then some real
pressure for reducing loans, and money rates
tend to be markedly higher than the discount
rate. On the other hand, when borrowings of
these banks are negligible, as in 1924, the
money situation tends to be less elastic and if
gold imports take place, there is liable to be
some credit inflation, with money rates drop­
ping below our discount rate. When member
banks are owing us about 50 million dollars or
less the situations appears to be comfortable,
with no marked pressure for liquidation. . . ,5
Table 1 compares Federal Reserve actions dur­
ing the 1924, 1927 and 1930-31 downturns. The
Fed’s index of industrial production indicates
the severity of each recession. Following the
stock market crash in October 1929, the New
York Fed purchased $160 million of government
securities and, by the end o f December, the Sys­
tem had purchased an additional $150 million.
But, from January 1930 to October 1931, the
Fed made only modest purchases, particularly in
comparison with those made in 1924 and 1927,
when the declines in economic activity were
The relatively small purchases in 1930 and
1931 appear consistent, however, with the use
of member bank borrowing as a policy guide.
This, according to Brunner and Meltzer (1968),
explains the Fed’s failure to respond aggressive­
ly to the Depression.3 Member bank borrowing
fell substantially following the stock market
crash in October 1929 and averaged just $241
million from January 1930 to August 1931. Bor­
rowing by reporting member banks in New
York City averaged just $8 million over the
same months. Thus, by Strong's guidelines,
money was exceptionally easy and substantial
open market operations w ere unwarranted.
The Fed’s use o f member bank borrowing as
a guide to monetary conditions could explain


why it permitted the money supply to decline
sharply during the Depression. During a reces­
sion, loan demand declines and banks have few er
profitable investment opportunities. Consequent­
ly, the demand for borrowed reserves declines.
If this decline in demand is not offset, total
reserves and the money supply fall. In a minor
recession, as in 1924 and 1927, member bank
borrowing falls little. The Fed’s guidelines would
have suggested that monetary conditions were
relatively tight and, in response, it would have
made large open market purchases. In a severe
economic downturn, as in 1930-31, however,
member bank borrowing may fall substantially.
But, by Strong’s rule the Fed would have made
few open market purchases. Thus, ironically,
this strategy could result in a greater contrac­
tion in the supply of money, the more severe a
decline in economic activity.5
If, as Brunner and Meltzer (1968) argue, Sys­
tem officials followed Strong’s prescription to
use the level of bank borrowing to guide policy
during the Depression, then it seems that the
Fed made no fundamental change in policy after
Strong’s death.
Although Friedman and Schwartz (1963),
pp. 362-419, believe that Strong would have re­
sponded aggressively to the Depression, they
agree that a majority of Fed officials interpreted
the low level of member bank borrowing in
1930 and 1931 as signaling monetary ease. They
contend, however, that officials o f the New
York Fed understood the flaws in using member
bank borrowing as a policy guide and would
have pursued appropriately expansionary poli­
cies if they had the authority.6

that the Policy Conference was established to
wrest power from the New York Bank. And
they show, pp. 367-80, that New York officials
proposed more expansionary actions, particular­
ly in 1930, than were accepted by the rest of
the System. Wicker (1966) finds, however, that
Harrison ceased to advocate open market pur­
chases once New York banks were no longer
borrowing reserves. Thus, while the Federal
Reserve would likely have pursued somewhat
more expansionary policies had New York offi­
cials held more authority, the modest open mar­
ket purchases of 1930 and 1931 were
apparently consistent with the guidelines out­
lined by Strong.
In sum, during the Depression, the Federal
Reserve continued to sterilize gold and currency
flows and made limited open market purchases
and discount rate reductions in response to the
economic decline. Notable deviations from these
policies occurred, such as the incomplete sterili­
zation of gold outflows during the crises of
1931 and 1933. But it seems likely that mone­
tary policy would have been somewhat more
responsive to the Depression, particularly in
1930, had officials of the Federal Reserve Bank
of New York been able to dominate policymak­
ing in the way Strong had before his death.6
The general thrust of policy, however, appears
consistent with that of Benjamin Strong.


In March 1930 the Open Market Investment
Committee, which consisted of five Reserve
Bank governors, was replaced by the Open Mar­
ket Policy Conference, in which representatives
o f all 12 Banks participated. The Investment
Committee had been led by Benjamin Strong,
and then by George Harrison, Strong’s successor
as governor of the Federal Reserve Bank of New
York. Friedman and Schwartz, p. 414, contend

Until recently, most studies of Fed behavior
have concluded that policymakers failed to per­
ceive a need to take expansionary actions,
despite deflation, rising unemployment and
widespread bank failures. Some researchers
now argue, however, that Fed officials were
quite aware that their policies were contribut­
ing to the contraction. These researchers con­
clude that policymakers responded to interest
group pressure and their own desire for in-

59lndeed, except for a brief decline in M1 in 1927, the abso­
lute quantity of money did not fall in 1924 or 1927, although
its rate of increase declined. The Fed's strategy and the
consequences of using bank borrowing as a policy guide
are examined in greater detail in Wheelock (1991), ch. 3.

policies, particularly in 1927, had contributed to stock mar­
ket speculation and the crash and depression that fol­
lowed. See Wheelock (1991), ch. 4, for analysis of
disagreements among System officials during the

60See also Schwartz (1981), pp. 41-42.
6 It is by no means clear that Strong could have retained
this degree of influence, as many officials believed that his



fluence, rather than the public interest. Epstein
and Ferguson (1984), for example, contend that
a combination o f ideology and conflicting in­
terests explain the System’s policy. And Ander­
son, Shughart and Tollison (1988) argue that
"the restrictive monetary policy o f the Fed in
the 1929-33 period was not based on myopia
but instead on rational, self-interested behavior"
(p. 4).
Epstein and Ferguson (1984) focus their study
on the Federal Reserve’s $1.1 billion open mar­
ket purchase program of 1932. They ask why
the Fed waited so long to begin an expansionary
program, what had changed to cause the Fed to
begin the program when it did, and what led to
the decision to end the program.
To the first question, Epstein and Ferguson
(1984) conclude that the liquidationist business
cycle theory was dominant among Fed officials.
Liquidationists believed that depressions were
“vital to the long-run health o f a capitalist econ­
omy. Accordingly, the task of central banking
was to stand back and allow nature’s therapy to
take its course.” (p. 963). This certainly was the
opinion of some key officials, such as George
Norris, who argued at the September 25, 1930,
meeting of the Open Market Policy Conference:
We believe that the correction must come
about through reduced production, reduced in­
ventories, the gradual reduction of consumer
credit, the liquidation of security loans, and the
accumulation of savings through the exercise of
thrift. These are slow and simple remedies, but
just as there is no ‘royal road to knowledge,’ we
believe there is no short cut or panacea for the
rectification of existing conditions. . . .
We have been putting out credit in a period of
depression, when it was not wanted and could
not be used, and will have to withdraw credit
when it is wanted and can be used.®2
Norris clearly believed that monetary policy had
been too stimulative and was interfering with
the natural process of liquidation and recovery.
Strong and other officials apparently held
similar views during the recession of 1920-21.
According to Wicker (1966):

62Quoted in Chandler (1971), p. 137.
63See also Friedman and Schwartz (1963), pp. 249-54, Wick­
er (1966), pp. 57-66, and West (1977), pp. 173-204.
“ Quoted by Chandler (1958), p. 239-40.


In the view of System officials the money sup­
ply in 1920 was redundant (excessive) and
should decline to restore the ‘proper’ relation­
ship between prices, credit, and volume of
production. The term most frequently used to
describe this process was ‘liquidation,’ the
necessity for which was not disputed by either
the Board or by any other Federal Reserve offi­
cial including Benjamin Strong. . .(p. 49).
Most researchers argue that Strong’s views
changed significantly after the 1920-21 episode,
however. Chandler (1958) writes:
Like most other Federal Beserve officials, [in
1920-1921 Strong] believed that some deflation
of bank credit was essential and that some
price reduction was inevitable and desirable.
Within three years, Strong himself had rejected
many of these ideas. A much smaller business
recession in 1924 led him to advocate large and
aggressive open-market purchases of govern­
ment securities and reductions of discount rates
to combat deflation at home as well as to en­
courage foreign lending (p. 181).8
In rejecting the importance of Strong’s death,
Epstein and Ferguson (1984) implicitly deny that
Strong sought to prevent loan liquidation during
recessions by pursuing monetary ease or that
he subscribed to the countercyclical policy guide­
lines he presented to the Governors Conference
in 1926: "Should we go into a business reces­
sion. . . we should consider taking steps to
relieve. . . the pressure. . . by purchasing
Government securities. . . .”6
Epstein and Ferguson emphasize two addition­
al reasons for the timing and extent of Fed ac­
tions during the Depression. First, in contrast to
Friedman and Schwartz, they conclude that a
lack o f gold reserves did keep the Fed from
making open market purchases in the fourth
quarter of 1931. They argue further that, while
the Glass-Steagall Act of 1932 lessened the
problem for the System as a whole, some o f the
Reserve Banks were reluctant to continue the
purchase program in 1932 because they lacked
sufficient gold reserves.6
Second, Epstein and Ferguson argue that Fed
concern with member bank profits contributed

65Each Reserve Bank was required to maintain its own
reserves. Pooling was not permitted, although the Banks
could lend to one another.


to the timing and extent of open market pur­
chases in 1932. During the first two years of
the Depression, leading bankers generally ar­
gued for loan liquidation and lower wages. But
the sharp increase in interest rates in the
fourth quarter o f 1931 reduced the value of
bond portfolios and threatened the solvency of
many banks. Bankers then began to press the
Fed to support bond prices. Epstein and Fergu­
son argue that "a major goal of the [purchases
of 1932] was to revive railroad bond values. . .
and bond prices in general." (p. 967).
Just as constituent pressure contributed to the
decision to make open market purchases, it also
seems to have caused the program’s end. Dur­
ing the Depression banks generally had shifted
their bond portfolios toward short-term maturi­
ties. And, while the need to support bond prices
was paramount in early 1932, as the year
progressed short-term interest rates fell sharply
and bank earnings declined. The decline in
earnings was especially acute in Boston and
Chicago because banks in those cities had un­
usually large holdings of short-term securities.
Epstein and Ferguson conclude: “That the gover­
nors o f the Boston Fed and, especially, the
Chicago Fed should be early critics of the refla­
tion program is therefore no mystery.” (p. 972).
Declining interest rates and questions about
the willingness o f the United States to maintain
the dollar's gold convertibility led to deposit
withdrawals by foreigners, causing commercial
banks to raise further doubts about the pur­
chase program: “The continued loss of gold and
deposits put many New York banks in an in­
creasingly uncomfortable position. . . . Many
complained that the reflation program had
'demoralized money and exchange markets’.”6
Thus, pressure from member banks experienc­
ing falling earnings and deposit outflows and
the desire of some Reserve Banks to protect
their gold reserves caused the System to aban­
don its program of open market purchases.6

Epstein and Ferguson (1984) were the first to
explain Federal Reserve behavior during the
Depression as a response to pressure from com­
mercial bankers. Anderson, Shughart and Tollison (1988) push this view to the extreme,
arguing that the principal aim of Fed policy dur­
ing the Depression was to enhance the long-run
profitability of member banks by eliminating
nonmember competitors. This, in turn, benefited
the Fed by increasing the proportion o f the
banking system under its regulatory control:
The fall in the money supply presided over by
the monetary authority between 1929 and 1933
eliminated a large number of state-chartered
and small, federally-chartered institutions from
the commercial banking industry. The profits of
those banks that survived. . . rose significantly
as a result. Coincidentally, the monetary con­
traction expanded the proportion of the com­
mercial banking system within the Fed’s
bureaucratic domain. Thus, rather than
representing the leading example of bureaucratic
ineptitude, the Great Contraction may instead
be the leading example of rational regulatory
policy operating for the benefit of the regula­
tors and the regulated.6
Nonmember banks made up 75 percent of the
banks that suspended operations between 1930
and 1933. Failures were highest among small in­
stitutions located in rural areas. Policymakers
typically argued that such failures were caused
by bad management or transportation improve­
ments that made many banks redundant. George
Harrison, Governor of the New York Reserve
Bank, for example, testified before the Senate
Banking Committee in 1931 that:
. . .with the automobile and improved roads, the
smaller banks. . . with nominal capital, out in
the small rural communities, no longer had any
reason really to exist. Their depositors wel­
comed the opportunity to get into their automo­
biles and go to the large centers where they
could put their money.6

66Epstein and Ferguson (1984), p. 975.

68Anderson, Shughart and Tollison (1988), pp. 8-9.

67ln a comment on Epstein and Ferguson, Coelho and Santoni (1991) present econometric evidence suggesting that
banks did not suffer reduced profits as a result of the
Fed’s 1932 purchases, and they question whether pres­
sure from commercial banks caused the Fed to end its
program. Indeed, they even doubt that expansionary policy
was ended since the monetary base continued to rise. Ep­
stein and Ferguson (1991) present additional qualitative
evidence showing that banks thought that low interest
rates had reduced their earnings.

69U.S. Senate (1931), p. 44.



From the Federal Reserve's inception, Fed offi­
cials argued that it was important that all banks
join the System. Benjamin Strong argued in 1915
that “no reform of our banking methods in this
country will be complete and satisfactory to the
country until it includes all banks. . . in one
comprehensive system."7 Policymakers were
likely less concerned with the failure of non­
member banks than they were with the health
of member banks.7 But it remains to be shown
that Federal Reserve policies were deliberately
intended to cause the failure o f thousands of
nonmember institutions.
Anderson, Shughart and Tollison (1988) argue
that “the Great Depression. . . was a by-product
o f economically rational behavior on the part of
Federal Reserve member banks seeking rents
through the elimination of their nonmember
rivals.” (p. 9) Member banks did not capture the
Fed directly, they argue, but rather exerted
pressure through members of the House and
Senate Banking Committees. To test this hypoth­
esis, the authors regress deposits in failed nonmember banks in each state on dummy varia­
bles indicating whether a state was represented
on the House or Senate Banking Committees.7
They find that nonmember bank losses were
higher if a state had a representative on the
House Banking Committee. This, they argue,
supports their view that the Fed deliberately
caused nonmember bank failures to be highest
in states having a congressman on the Banking
Committee, thereby enhancing the long-run
profits of the member banks that remained. The
Fed’s payoff came in 1933 when it was freed
from having to return a portion of its revenues
to the Treasury.7
This explanation of Federal Reserve policy
provokes a number of questions. Left unclear,
for example, is why member banks had more
influence over Congress than nonmember banks.
Nor is it explained how the Fed was able to af­
fect the fortunes of nonmember banks in partic­

70Quoted by Chandler (1958), p. 80.
71Friedman and Schwartz, pp. 358-59, also make this point.
72They include deposits in failed member banks, total bank
deposits, and other control variables as additional
73Anderson, Shughart and Tollison (1988), pp. 16-17.
74Anderson, Shughart and Tollison (1990) reply by pointing
out that member bank share prices rose dramatically rela­
tive to those of nonmember banks during 1930. Even the


ular states with the tools at its disposal. The Fed
cannot control the destination o f reserve flows
generated by open market operations, and the
discount window was not open to nonmember
banks. Perhaps Fed officials could have selec­
tively restricted credit to member banks that
lent to nonmember banks in particular states,
but it is doubtful that such a circuitous route
would have had a large impact on losses.
Huberman (1990) casts further doubt on the
Anderson, Shughart and Tollison (1988) view.
He notes that, although 75 percent of banks
that suspended during the Depression were
nonmember banks, the ratio of nonmember to
member bank suspensions from 1930 to 1933
was lower than it had been during the 1920s.
Nonmember banks that suspended, moreover,
reopened twice as often as member banks.
Membership in the Federal Reserve System
grew at a comparatively low rate during the
Santoni and Van Cott (1990) also report evi­
dence contrary to the Anderson, Shughart and
Tollison hypothesis. They calculate a share price
index for large New York City member banks
and show that, relative to both the wholesale
commodity price index and the Standard and
Poor’s index, bank share prices declined sub­
stantially from 1929 to 1934. They show also
that the index of bank stock prices was not af­
fected by changes in the money supply, suggest­
ing that monetary policy did not enhance the
fortunes of banks in their sample.7

The Federal Reserve’s failure to respond
vigorously to the Great Depression probably
cannot be attributed to a single cause. Each of
the explanations discussed in this article clarifies
certain points about Fed behavior during the
Depression. A number of contemporary observ­
ers, both within and outside the System, attrib-

share prices of “ small” member banks rose relative to
those of nonmember institutions. Neither study tests
whether the profits of surviving member banks were en­
hanced in the long run, although the former note that in
1936 the average national bank profit rate was higher than
in 1925. Unfortunately, it is impossible to determine
whether the increase in bank profits was caused by the
demise of nonmember banks or by New Deal reforms,
such as deposit interest rate ceilings, deposit insurance,
and increased chartering requirements, which reduced
competition and enhanced bank charter values.


uted some of the blame to what they viewed as
excessively easy monetary policy during reces­
sions in 1924 and 1927. They argued that the
Fed’s actions had promoted stock market specu­
lation and led inevitably to the crash and
Depression. The best policy during the Depres­
sion, according to these observers, was to pro­
mote loan liquidation and wage rate reductions,
to allow recovery on a “sound basis.” While
those officials subscribing to the liquidationist
view did not win approval o f open market sales,
they were able to prevent significant open mar­
ket purchases until 1932. It is likely that the
Fed would not have made large purchases even
then without pressure from major bankers and
The most important explanations of Federal
Reserve behavior during the Depression,
however, appear to be the dedication of
policymakers to preserving the gold standard
and their attachment to policy guides that gave
erroneous information about monetary condi­
tions. Benjamin Strong’s death robbed the Sys­
tem of an intelligent leader at a crucial time and
undoubtedly imparted a contractionary bias to
monetary policy during the Depression. It seems
clear, however, that Strong’s death did not
cause a fundamental change in regime. Strong
believed in the gold standard, and he would not
likely have done anything to jeopardize gold
convertibility of the dollar. There was also little
deviation from either the gold sterilization or
the countercyclical policy rules that Strong had
developed during the 1920s—at least until the
fourth quarter of 1931, when maintenance of
the gold standard became the overriding goal of
policy. Thus, while leadership changes and in­
terest group pressure probably had some effect,
monetary policy during the Depression was not
fundamentally different from that of previous
years. Federal Reserve errors seem largely at­
tributable to the continued use of flawed

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City member banks).
Federal Reserve System balance sheet: Board of
Governors of the Federal Reserve System
(1943), p. 331.


implicit price index: Department of Commerce
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series F5.
Index of Industrial Production: Board of
Governors of the Federal Reserve System
(1937), A nnual R eport, pp. 175-77.
Interest rates: 1) Baa-rated: Board of Governors
of the Federal Reserve System (1943), pp.
468-70; 2) long-term (daily average yield in
June of each year on U.S. government
bonds): ibid, pp. 468-70; 3) short-term (daily
average yield in June o f each year on U.S.
government three- to six-month notes and
certificates (1919 to 1933), and on Treasury
bills (1934 to 1939): ibid, p. 460.
Money supply: Friedman and Schwartz (1963),
table A-l, col. 7 (M l) and col. 8 (M2).
Unemployment rate: Lebergott (1964), p. 27.


M anfred J.M. Neumann
Manfred J.M. Neumann, a professor of economics at the
University of Bonn, Germany, was a visiting scholar at the
Federal Reserve Bank of St. Louis. Courtenay C. Stone made
many helpful comments on an earlier draft. Lora Holman and
Richard I. Jako provided research assistance.

Seigniorage in the United
States: H ow Much Does the
U.S. Government Make from
Money Production?


ONEY IS CERTAINLY one of the greatest
inventions of mankind. As Brunner and Meltzer
(1971) have noted, its vast social productivity
arises from the enormous reduction in transac­
tions and information costs that it provides by
serving as a standardized medium of exchange.1
Of course, these benefits, like those o f any other
good or service, are not provided at zero cost.
The revenue received from producing and
maintaining a nation’s money stock covers its
production costs and, perhaps, some profit as
well for its producers.
In monetary economics, the revenue from
money creation is called "seigniorage.” Unfor­
tunately, this term has been subject to a variety
of interpretations in the literature. After review­
ing several traditional definitions, this article de­
velops a new seigniorage measure, extended
monetary seigniorage, and shows how it is dis­
tributed between the Federal Reserve, member
banks and the U.S. Treasury during the 1951-90

period. Then, it examines the relationship be­
tween inflation and seigniorage during this peri­
od and shows that this relationship is analogous
to the well-known “Laffer curve” that relates
tax rates and tax revenues: seigniorage in­
creases as inflation rises until the inflation rate
reaches about 7 percent; thereafter, inflation
and seigniorage are inversely related. Indeed,
for each percentage point rise in inflation above
7 percent, the U.S. Treasury’s share o f seig­
niorage fell, on average, by $1.4 billion (meas­
ured at 1982/84 consumer prices).

The term "seigniorage” dates back to the early
Middle Ages, when it was common for sover­
eigns o f many countries to finance some of
their expenditures from the profits they earned

1See Brunner and Meltzer (1971).



from the coinage of money. In the money litera­
ture, seigniorage has often been used inter­
changeably for either the total revenue or the
profit derived from money production and
maintenance. Of course, revenues and profits
are identical only if costs are zero. Although
theoretical analysis can be simplified by assum­
ing that costs are zero, this assumption cannot
be maintained in empirical applications. Since
this article focuses on the empirical issues as­
sociated with seigniorage, the total revenue, cost
and profits associated with money production
must be carefully distinguished and the relevant
notion of seigniorage must be clearly defined.
In the analysis that follows, seigniorage is de­
fined as the revenue associated with money
production and maintenance, rather than the
resulting profit. Also, the focus is on the reve­
nue accruing to the government and, therefore,
on the creation of monetary base rather than
the creation of deposits by private depository
Monetary theorists have used two main con­
cepts of seigniorage in analyzing its relationship
to inflation. These concepts are termed “oppor­
tunity cost seigniorage” and "monetary seig­

Opportunity Cost Seigniorage
As its name indicates, opportunity cost seig­
niorage defines seigniorage as the total “oppor­
tunity costs” of money holders. It asks the
question, What additional real income would in­
dividuals have earned if they had held interestearning assets instead of non-interest-earning
money? The real interest earnings foregone by
holding money are called its opportunity cost.
Real opportunity cost seigniorage (sQ is:
(1) s0 = rB/P,
where B denotes total base money holdings, r is
the representative nominal rate of return on as­
sets other than base money and P is the con­
sumer price level.
This concept of seigniorage has been used as
an elegant tool of theoretical analysis.2 Its ana­
lytical attraction is that it derives the value of
2See Bailey (1956), Johnson (1969), Auernheimer (1974)
and Barro (1982).
3For a different view, see Gros (1989), p. 2. He interprets
equation 1 to represent “ the interest savings the govern­
ment obtains by being able to issue zero interest rate
securities in the form of currency.” This interpretation,

Federal Reserve Bank of St. Louis

seigniorage from the individuals’ valuation of
the services of money. It does this by identify­
ing seigniorage with the interest income that in­
dividuals voluntarily forego by holding some of
their wealth as money instead of as earning as­
sets. This concept, however, presents some
problems when it is used for empirical studies
of seigniorage.
To make the concept of opportunity cost seig­
niorage operational for empirical analysis, some
actual nominal rate o f return must be chosen as
the measure of the representative rate of return
(r) in equation 1. Estimates of seigniorage will
differ widely depending on which rate of
return — for example, the federal funds rate,
the average yield on government bonds or the
rate o f return on stocks of, say, the computer
industry — is used. Thus, the problem is to de­
termine a weighted average of observable asset
returns that meaningfully approximates the true
opportunity cost o f money holders.
There is also a conceptual problem with using
this definition of seigniorage: opportunity cost
seigniorage does not equal the monetary author­
ity’s actual revenue from money creation.3 Be­
cause the structure of the monetary authority’s
portfolio differs markedly from the asset struc­
ture preferred by private investors, opportunity
cost seigniorage does not provide a measure of
the gains to the monetary authority from money
creation and maintenance.

Monetary Seigniorage
The concept of monetary seigniorage permits
a more straightforward and unambiguous em­
pirical measurement. Monetary seigniorage (s*,)
is defined as the net change in base money out­
standing (AB), deflated by the consumer price
level (P):
(2) s* = AB/P.
Monetary seigniorage measures the transaction
value of non-monetary assets that money holders
trade in to the monetary authority to obtain the
desired increase in their base money balances
(AB). Because the data necessary to calculate this
measure are easily available, the concept of
however, is valid only if the nominal rate of return (r)
equals the effective yield on government debt and operat­
ing costs are zero.


monetary seigniorage has been widely used and
measured by monetary economists.4

Extended M onetary Seigniorage
Unfortunately, the traditional concept of
monetary seigniorage does not provide a com­
plete account of the government's revenue from
base money provision. It abstracts from the ac­
tual process of base money creation and, there­
fore, neglects the fact that the total flow of
revenue in addition depends on the asset struc­
ture of the central bank.
The total flow of seigniorage to the govern­
ment consists o f two components. The first is
the real value of the non-monetary assets that
the central bank receives from the public in ex­
change for an increase in the monetary base.
This is measured by the traditional concept of
monetary seigniorage as defined above. The se­
cond component is the interest earnings the
central bank receives on its stocks of non­
government debt.
Since domestic private and foreign debtors
have to service the debt held by the central
bank, there is a flow of seigniorage to govern­
ment even if the public does not desire to in­
crease its cash balances. It is important to note,
however, that only the interest earnings on
non-government debt qualify. The Treasury’s
payment of interest on its debt held by the cen­
tral bank is an inside transaction between gov­
ernment institutions that does not affect the
resource transfer from the private money
holders to government. Finally note that the
central bank occasionally realizes capital gains
(losses) by subsequently selling assets in the
open market at higher (lower) prices than it had
purchased them.
To take these additional components of the
revenue from base money production and main­
tenance into account, let the interest rates on
the monetary authority’s holdings of private
domestic debt (D) and official foreign debt (F) be
denoted by d and f, respectively, and unrealized
capital gains by GR Then, the extended mone­
tary seigniorage, sM is:
(3) sM = s* + (dD + fF + G„)/P.
4See Friedman (1971), Calvo (1978), Fischer (1982), Dornbusch (1988), Grilli (1989) and Klein and Neumann (1990).
5“ Foreign deposits” include the demand balances of for­
eign central banks, the Bank of International Settlements,

Extended monetary seigniorage encompasses the
traditional measure o f monetary seigniorage.
The new concept provides the seigniorage meas­
ure best suited for this study for two reasons.
First, it directly measures the total real net flow
of assets that the Federal Reserve System and
U.S. Treasury receive from their monopoly over
base money production; second, it can readily
be computed from available data.

An analysis of extended monetary seigniorage
in the United States can begin at either of two
points: the "sources” side shows us how the
gains were achieved, while the "uses” side tells
us who received the gains.

Sources o f U.S. Extended Monetary
From the sources side, the extended monetary
seigniorage is shown by equation 3. In more de­
tail, it can be written as:
(4) sM = (AB + dD + fF + G„)/P,
where B = C + R„ + RF
It is important to note that, in this analysis, the
monetary base (B) is defined more broadly than
is usually the case. Here, official foreign deposits
at the Federal Reserve System (RF are added to
the usual monetary base components of curren­
cy in circulation (C) and reserves of depository
institutions (RB This expanded definition is ap­
propriate because the Federal Reserve obtains
seigniorage from producing foreign deposits in
precisely the same way it does from producing
deposits for domestic depository institutions.

Uses o f U.S. Extended Monetary
To develop the uses side of extended mone­
tary seigniorage, two financial accounts are uti­
lized: (1) the combined Federal Reserve-Treasury
"monetary” balance sheet and (2) the income
statement of the Federal Reserve System.
foreign governments, and international organizations, like
IMF and World Bank; it excludes the Treasury’s Exchange
Stabilization Fund.



The U.S. monetary authorities’ combined bal­
ance sheet can be written in first-difference
form to show the changes that have occurred
over some specific time period as follows:
(5) AA fr + AD + AF + ACc + AOA
= AB + ARg + AK.
The left-hand side of equation 5 describes the
ch an g es in the Federal Reserve’s assets that sup­
ply funds: outright purchases o f U.S. Treasury
and federal agency obligations (AAF ), loans to
depository institutions via the discount window
and government securities bought under repur­
chase agreements (AD), the acquisition of gold,
special drawing rights, and foreign exchange
(AF), issuance of coin by the Treasury (ACc) and
other Federal Reserve net assets (AOA).6
The right-hand side of equation 5 describes
the ch an g es in the factors that absorb these
funds: the monetary base (AB), deposits o f the
Treasury (ARg) and the Federal Reserve System's
capital accounts (AK).7 Again, note that the mon­
etary base definition used in this analysis in­
cludes foreign deposits (RF held at the Federal
The Fed’s income statement is summarized in
equation 6. The left-hand side describes the
Fed’s current income and expenses that give
rise to its net revenue; the right-hand side of
equation 6 shows how the Fed’s net revenue is
(6) dD + fF + aAp„ + GR + G^ - OCF


^FR +


As noted earlier, d and f represent the inter­
est rates that the Federal Reserve receives on its
loans to the domestic private sector and its in­
ternational assets, respectively; similarly, “a”

6ln contrast to their practice of valuing the domestic assets
at the original purchase price, the Federal Reserve Banks
mark their foreign exchange holdings to the market. As a
consequence, reported changes in the stock of the Feder­
al Reserve System’s international assets include net pur­
chases at the actual transaction values (AF) and valuation
gains (or losses) on the previous stock of these assets if
foreign currency prices have changed. Because these
valuation changes do not directly increase or absorb
reserves, they are not included in equation 5. Incorporat­
ing them explicitly would simply introduce the same value
on both sides of equation 5 and, hence, they would be
“ netted out” of the analysis.
7RGincludes Treasury cash holdings.
8The Federal Reserve’s international assets include the na­
tion’s gold stock on which it receives no interest earnings.

Federal Reserve Bank of St. Louis

denotes the average interest return it receives
on its portfolio of government securities bought
The next two terms are the "realized” profits
(Gr) that the Fed receives from sales of its bonds
and foreign assets at prices above those that it
paid for them, and the "unrealized” profits (G,;)
that result from the Fed’s practice o f marking
the prices of its foreign exchange holdings to
their market value. This accounting practice
was introduced in 1978; before foreign exchange
holdings w ere valued at historical rates.9
The term (OCF ) measures the current operat­
ing costs or expenses of the Reserve Banks and
the Federal Reserve Board minus the fees and
reimbursements that the System collects for the
services it sells to the banking industry, the
Treasury and other government agencies. These
service fees and reimbursements are "netted
out” to remove receipts and expenses that are
presumably unrelated to the Federal Reserve
System’s monetary authority role.
The right-hand side of equation 6 shows how
the Federal Reserve’s net revenue (Y) is distri­
buted. The Fed pays its member banks statutory
dividends (YB on their paid-in capital and uses
an amount YF , which is equal to .5AK, to raise
the Reserve Banks’ surplus capital to the level of
its member banks’ paid-in capital. The remain­
der of the System’s net income is transferred to
the U.S. Treasury under the heading o f "In­
terest on Federal Reserve notes” (YG ).1
N 0
Subtracting equation 6 from 5 and using the
identity that the current issuance of coin (ACc)
equals the operating cost of the U.S. Mint (OCM
plus the profit to the Treasury on the issuance
of coin (YG ) yields:

9Most European central banks do not mark their foreign ex­
change holdings to market values; instead, they evaluate
their holdings at the lowest market price that occurred
since they were acquired. As a result, their income state­
ments never show unrealized profits from their foreign ex­
change holdings; however, they show unrealized losses
whenever the prices of foreign currencies fall below their
acquisition values.
10As an historical aside, prior to 1933, the income transfer to
the U.S. Treasury was effected as a franchise tax based
on a provision of Section 7 of the Federal Reserve Act.
This provision was repealed in 1933 to permit Reserve
Banks to restore their surplus accounts, after they had
been cut to one-half by the enforced subscription to the
Federal Deposit Insurance Corporation, founded in 1933.


(7) AB + dD + fF + GR
= (OCF + OCM + y fr+ y b
"*■ ^G,N "*■ Y g,c —

— AK( )

+ A(Afr + d + f + OA - K)

- GU
where: B = C + RB + RF and
^G ~ ACc — OCM
Y fr = .5AK.
Dividing equation 7 through by the consumer
price level (P) and using the definition of ex­
tended monetary seigniorage shown in equation 4
(8) sM = sc + s„ + sG + s, + sL
where: sc = (OCF + OCM
sB = Yb
S = (YGc + YG\ + AA i!{ — sA fr — ARg)/P,
s, = A(D + F + OA - ,5K)/P and
sL = ( —Gu

Equation 8 shows how the extended monetary
seigniorage in each period is used: (1) sc is the
cost o f providing the public’s desired real base
money balances, including the costs associated
with monetary policy and the Federal Reserve’s
contribution to bank supervision, (2) member
banks receive sB the statutory dividends, (3) the
government receives sGfor spending purposes,
(4) the Federal Reserve uses s, to increase its
portfolio of assets other than government debt
and (5) the Fed uses sLto make up for booklosses resulting from adverse changes in asset
It is useful to consider in detail the seignior­
age distributed to the U.S. government, which
may be termed “fiscal seigniorage.”1 Fiscal seig­
niorage can be written in two different ways.

11See Klein and Neumann (1990)
12ln the theoretical literature, it is usually taken for granted
that the net revenue received from the Federal Reserve
(y g .n - a A f r ) cannot be negative since the government
receives back as part of the transfer (YGN the interest
paid on its debt to the central bank (a A F ). This conclu­

The first way, using the government’s budget
constraint, is
(9a) sG = (G - T + aA0 - AA0
where (G - T) is the government’s primary
budget deficit or surplus and aA0is the govern­
ment’s interest expenditure on its debt held out­
side the System (A0). Equation 9a shows that
fiscal seigniorage is the portion of the govern­
ment’s deficit that is not financed by borrowing
from the public (AA0 This means that fiscal
seigniorage contributes to the finance of the
primary budget deficit and of the interest ex­
penditures on debt held by the public (outside
the Federal Reserve System).
The second way o f writing fiscal seigniorage,
as shown in equation 8 above, is
(9b) sG = [Ygc + (Ygn - aAF ) + A(AF - RG
Equation 9b breaks down fiscal seigniorage into
three source components: the net revenue from
issuing coin (YG ), the net revenue received
from the Federal Reserve (YGN- aAF ), and the
net borrowing from Reserve Banks (AAfr- ARg).1
The treatment of net borrowing as a source
o f fiscal seigniorage is not an obvious one, since
the Fed does not lend directly to the Treasury;
instead it purchases Treasury securities in the
open market. From a purely technical point of
view, the Treasury receives the borrowed funds
from the public on the date of security issue,
not from the Fed at the later date when the
public resells the securities to the Federal
The above treatment of borrowing can be
justified by the following considerations: First,
from the economic point of view, what counts
is not the first but the final placement of the
Treasury securities. Thus, if the security dealers
do not hold but resell the Treasury securities to
Reserve Banks after a short duration, it is, in
fact, the Fed that supplies the borrowed funds
to the Treasury. At the same time, these trans­
actions permit the security dealers to buy an­
other load of new debt from the Treasury.
Second, the bulk of the Federal Reserve’s pur-

sion, however, holds only if the costs of the monetary
authority are assumed away. In the United States, for ex­
ample, the Treasury’s interest payments to the Fed typical­
ly exceed the Treasury’s income received as “ interest on
Federal Reserve notes.”



Figure 1
Extended Monetary Seigniorage and Operating Cost
(in 1982/84 Consumer Prices)
Billions of dollars

chases of Treasury securities is at the short­
term end of the maturity spectrum. During the
1980s, for example, 83 percent of the securities
purchased had maturities o f less than one year.
For this large portion of newly acquired debt,
the time difference between the public's buying
and reselling plays no significant role in the em­
pirical analysis below based on annual observa­
tions. Third, some portion of new Treasury
debt issued with maturities exceeding one year
is also purchased by the Federal Reserve during
the year of its issue. Finally, any approximation
error with respect to the annual time unit ceases
to play a role when annual average data for de­
cades are examined below.

Figure 1 shows the magnitudes of the extend­
ed monetary seigniorage (sM and the monetary
authorities’ operating costs (sc) as measured in
1982/84 dollars, from 1951 to 1990. During the


Billions of dollars

past four decades, the annual real value of ex­
tended monetary seigniorage has generally risen,
while ranging over that period from -$ 6 billion
in 1954 to $31 billion in 1986. As figure 1 indi­
cates, a comparatively small portion of this
amount—only about 7 percent on average—was
used to cover the costs of producing the mone­
tary base by the monetary authorities. Conse­
quently, the government’s production of base
money has resulted in sizable and rising net
profits, which are equal to the difference be­
tween the two curves in figure 1.
This result is shown in somewhat different
form in table 1, which provides annual average
data for each of the past four decades. During
the 1980s, the annual real net profit from base
money production and maintenance averaged
more than $14 billion, while, during the 1950s,
it averaged $1 billion per year. The steepest in­
crease in extended monetary seigniorage oc­
curred in the 1960s, when it jumped to almost
$10 billion annually, on average, up sharply


Table 1
The Uses of Extended Monetary Seigniorage1
Extended monetary
seigniorage sM
- Operating cost, sc
= Net profit
- Dividend payment to
member banks, sB
- Book-loss on foreign
exchange, sL























-3 7 9

- Investment in loans and
foreign assets, s,

-1 ,3 9 7

-1 ,1 5 9



= Fiscal seigniorage, sG













Traditional monetary
Fiscal seigniorage as
percent of real federal
on-budget spending

'Annual averages in millions of dollars, 1982/84 consumer prices.
2Net of revenue from priced services ($501 million).
3Starting in 1978.

from its 1950’s level. About 80 percent of this
rise resulted from drastic increases in average
reserve requirements during the 1960s.
As table 1 shows, the average annual total
operating costs of the monetary authorities in­
creased by about 50 percent during the 1970s
from its earlier levels. This rise primarily
reflects the Federal Reserve’s efforts to in­
troduce a variety of services in the 1970s as­
sociated with the payments mechanism. The
monetary seigniorage used for covering operat­
ing costs fell in the 1980s when the Fed began
to charge explicitly for these services.1
Dividend payments to member banks on their
paid-in capital (sB which run about $.1 billion
per year, and the System's accounting losses on
its holdings o f foreign exchange (sL represent
13For example, if the cost of priced services was added to
the operating costs for the 1980s, it would raise the figure
shown by almost 75 percent.
14During the 1970s, the Fed’s realized (as opposed to ac­
counting) losses on foreign exchange amounted to about
$148 million per year in real terms. These losses resulted
from foreign exchange intervention attempts to stem the

fairly negligible uses o f the total monetary seig­
niorage. As table 1 indicates, these accounting
adjustments began in 1978, when the Fed start­
ed valuing its foreign exchange holdings at cur­
rent market prices.1
During the 1980s, the Federal Reserve System
accou nted an annual valuation gain on its for­

eign exchange holdings averaging $380 million.
This gain reflects the appreciation of the
Deutschmark and yen against the dollar from
1985 to 1987 and again in 1989/90. Occasionally,
the Fed also realized profits on foreign ex­
change holdings; they averaged $151 million per
vpar rhirinff thp 1980s

As in all countries, the bulk of the extended
monetary seigniorage went to the government,
The average annual flow o f fiscal seigniorage
sharp decline in the value of the dollar during the 1970s.
They appear, of course, on the sources side of the seig­
niorage equation and, hence, reduce the total monetary
seigniorage collected; see equation 4.



Table 2
The Components of Fiscal Seigniorage1








-5 2 9

-54 1

-1 ,2 3 3







-2 0 1

-6 2 1

-3 0 2





Interest received on FRnotes





Interest paid to Federal


$ 5,755



U.S. government debt
bought outright by Fed
+ Interest received on FRnotes net of interest
paid to Fed
+ Coin issued net of
outlays of U.S. Mint
-C h a n g e in Treasury’s
deposits with Fed
= Fiscal seigniorage

'Annual averages in millions of dollars, 1982/84 consumer prices.

rose from $2.4 billion during the 1950s to
$11.2 billion in the 1980s. The dominating source
component of fiscal seigniorage is the outright
acquisition of government securities by the Fed.
Just how important it is can be seen in table 2;
for all practical purposes, it matches the total.
This observation underscores the fact that the
seigniorage flow to government must not be
identified with the Fed’s payment to the Treasu­
ry of "interest on Federal Reserve notes.” In ser­
vicing the debt held by the Fed, the Treasury
makes interest payments of roughly the same
order of magnitude as the Fed pays to the
Treasury (see the bottom lines in table 2).1 In­
deed, the Fed’s portfolio of U.S. government
securities can be interpreted as an interest-free
loan to the Treasury.
While during the 1970s and the 1980s fiscal
seigniorage amounted to 80 percent of mone­
tary seigniorage collected, it even exceeded the

15Barro (1982) was not aware of this, when he identified the
interest on Federal Reserve notes as the revenue from
money creation. But note that Barro would be correct if
the Fed, like the Deutsche Bundesbank, would mainly hold
earning assets other than government debt.

Federal Reserve Bank of St. Louis

total flow during the 1950s and the 1960s. How
was it possible that the government consumed
more seigniorage than was collected? The an­
swer to that question is asset substitution in
favor of U.S. government debt: for a given base
money stock, the Fed can reduce its loans to
the banking sector or sell foreign assets and use
the proceeds for buying outright government
debt. For example, if the Fed replaces foreign
assets worth $100 million with Treasury bills of
the same amount, it foregoes foreign interest
earnings of, say, $5 million. As a result, the cur­
rent flow of fiscal seigniorage is increased by
$95 million (see equation 9b).1 To be sure, this
is a one-time effect. During subsequent periods,
the flow of fiscal seigniorage will be smaller
than otherwise, because of the lost stream of
foreign interest earnings.
As table 1 indicates, the observed differences
between the annual flows of monetary and fis­
cal seigniorage are largely due to asset substitu­
tion. During the 1950s and the 1960s, the Fed

16While the discussed transaction reduces the Fed’s interest
earnings on foreign assets, it raises the interest earnings
on the portfolio of Treasury securities. But, as noted
above, this does not affect the net flow of fiscal seig­


raised the annual flow of fiscal seigniorage above
the flow of extended monetary seigniorage by
replacing non-government debt worth more
than $1 billion each year, on average, with U.S.
government securities. The reverse policy was
chosen thereafter so that the annual flow of
fiscal seigniorage fell behind monetary seignior­
age by an average of almost $4 billion during
the 1980s.
While the continuous flow of fiscal seigniorage
helps to finance the federal budget, it is a fairly
small source of funds. On average, it contrib­
uted about 2 percent to the finance of federal
expenditures over the past 40 years.

Seigniorage and Inflation
In the monetary economics literature, seig­
niorage is often discussed and analyzed in terms
of an “inflation tax,” a term that was coined by
Milton Friedman (1953). This association reflects
the fact that, other things the same, a nation’s
monetary authorities can increase monetary
seigniorage by increasing the supply of base
money relative to its demand. Because the re­
sulting rising price level reduces the real value
of the public's base money holdings, the public
will demand more nominal base money balances
to make up for the price-level-induced decline in
its real cash balances. As a result, the price rise
produces an increase in monetary seigniorage.
Extended monetary seigniorage, however, will
not rise in some fixed proportion to inflation;
the demand for real cash balances is inversely
related to the rate of inflation. Hence, the in­
crease in seigniorage associated with higher and
higher inflation becomes smaller and smaller;
eventually, some inflation rate is reached at
which monetary seigniorage is maximized.
Thereafter, higher inflation will reduce the level
o f seigniorage as the inflation-induced effect
dominates the price-level effect on the public’s
demand for real cash balances.

flation rate has passed a certain threshold. Thus,
the predicted relation resembles the shape of
the Laffer curve in public finance where the
revenue from the income tax first rises with the
effective tax rate but begins to decline once the
disincentive effect of too high a tax rate be­
comes dominant.
Monetary theorists have applied profit-maxi­
mizing conditions for a monetary authority to
generate the seigniorage-maximizing rate of in­
flation.1 This concept, however, is unlikely to
yield much insight in the actual behavior of
monetary authorities. While, in history, mone­
tary authorities of several countries have re­
peatedly produced larger inflations in the
attempt to accommodate fiscal problems, central
banks, in general, are not profit-oriented organi­
zations, and ascribing profit-maximizing motives
to them is misleading.1
Thus, instead of looking for some theoretically
justified story about inflation and the motives of
the Federal Reserve System, we are better o ff
by simply looking at the "stylized facts” about
the relationship between inflation and the ex­
tended monetary seigniorage in the United States.
Figure 2 provides one way of assessing this rela­
tionship. The points in the diagram show the
rate of inflation and the associated monetary
seigniorage in each year from 1951 to 1990. As
expected, the data reveal an initial positive rela­
tionship between inflation and extended mone­
tary seigniorage. As also expected, however, this
positive association slowly disappears, then be­
comes negative for sufficiently high rates of
inflation. Thus, the empirical relationship resem­
bles the shape of a Laffer curve.
The curve drawn in figure 2 shows the re­
sults of estimating extended monetary seignior­
age (sM as a quadratic function of the rate of
inflation ( tt):
(10) sM = aQ + ajTi - a 2n2 + e,

In sum, monetary theory predicts that seig­
niorage rises with inflation but falls once the in­

where e is a white-noise residual. The estimated
parameters imply that monetary seigniorage be-

17Consider the traditional concept of monetary seigniorage,
as defined above by equation 2. It can be rewritten as:
(a) Si, = (AB/B)(B/p).

um in which y and r are constant. This implies: n = AB/B.
Maximizing equation a subject to equation b yields the
seigniorage-maximizing rate of inflation:

Next, assume a standard money demand function:
(b) B/p = y exp[ - A.(r + n)],

(c) n°p' = 1/A.
18For a different view, see Toma (1982).

where (y) is real income, (r) is the real rate of interest and
n the inflation rate. Finally, assume a steady-state equilibri-



Figure 2
Extended Monetary Seigniorage and Inflation
(1982/84 Consumer Prices)
B illions of dollars

Billions of dollars

P ercent

gins to decline once inflation exceeds a rate of
7.9 percent.1
From the point of view of the U.S. govern­
ment, fiscal seigniorage is more interesting than
monetary seigniorage because the former meas­
ures what the government actually receives for
budget finance. As figure 3 shows, fiscal seig­
niorage is quite similarly related to the level of
inflation, except that it reaches a maximum at
an inflation rate of 7.2 percent.2
These estimates suggest that high inflation, at
least more than 7 percent or 8 percent per
year, has been less profitable for the U.S.

19Estimating equation 10 with a dummy for 1986 yields:
a0 = -9 7 9 (-0 .5 5 ), a, = 4,325 (5.94), and a, = 269
(4.73), numbers in parantheses are t-values. R 2 =.62,
DW = 1.52.
20The respective curve is computed from estimating equa­
tion 10 with fiscal seigniorage as the dependent variable.
Denoting the estimated parameters by b yields: b0 = 1,233
(0.56), b, = 3,123 (3.51), b2 = 217 (3.07), R 2 = .28,
DW = 1.88.

Federal Reserve Bank of St. Louis

government when monetary or fiscal seig­
niorage alone are considered. This is demon­
strated in table 3, where average annual
seigniorage flows are compared over different
inflation ranges. During the high inflation years,
when inflation exceeded 9 percent annually, fis­
cal seigniorage averaged 7.7 billion per year.
This is about 5 percent lower than it averaged
during the low inflation years and even 45 per­
cent lower than during the medium inflation

The government's monopoly in issuing base
money yields profits that facilitate its fiscal

21While it may be tempting, given the evidence presented in
table 3, to conclude that the U.S. government should
prefer inflation in the 4.6 percent to 9 percent annual
range, it would be a mistake to do so. First, there are
other social (and governmental) gains from lower inflation
that are not examined here. Second, and perhaps more
relevant, the U.S. rate of inflation has been below 4.5 per­
cent for 25 of the 40 years between 1951 and 1990.


Figure 3
Estimated Seigniorage and Inflation
(in 1982/84 Consumer Prices)
Billions of dollars

Billions of dollars


Table 3
Seigniorage and Inflation1
Inflation range
- 0 . 3 to 4.5%

4.6 to 9.0%

9.1 to 13.6%

Monetary seigniorage, sM




Fiscal seigniorage, sG



$ 7,685

Number of years
Average inflation rate







'Annual averages in millions of dollars, 1982/84 consumer prices.



finance. This paper developed a new measure
of monetary seigniorage and presented a frame­
work for analyzing and measuring the total
seigniorage flow from base money production
and its allocation to various uses, including fis­
cal finance, in the United States.
In addition, the paper analyzed the relation­
ship between monetary and fiscal seigniorage
and inflation in the United States from 1951 to
1990. While it is well-known that, within certain

limits, governments are able to increase their
seigniorage flows through higher inflation, the
limits to such actions are not as well-known.
The evidence presented here suggests that the
U.S. government's fiscal seigniorage declines
when the rate of inflation exceeds 7 percent. In
deed, in those years when inflation exceeded
9 percent, the U.S. government’s fiscal seig­
niorage fell short of the levels achieved when
U.S. inflation rates were less than 4.5 percent.

Auernheimer, Leonardo. “ The Honest Government’s Guide
to the Revenue from the Creation of Money,” Journal of Po­
litical Economy (May/June 1974), pp. 598-606.

Friedman, Milton. “ Discussion of the Inflationary Gap,”
Essays in Positive Economics (University of Chicago Press,

Bailey, Martin J. “ The Welfare Cost of Inflationary Finance,”
Journal of Political Economy (April 1956), pp. 93-110.

________“ Government Revenue from Inflation,” Journal of
Political Economy (July/August 1971), pp. 846-56.

Barro, Robert J. “ Measuring the Fed’s Revenue from Money
Creation,” Economic Letters Vol. 10 (1982), pp. 327-32.

Grilli, Vittorio. “ Seigniorage in Europe,” in Marcello de Cecco
and Alberto Giovannini, eds., A European Central Bank?
Perspectives on Monetary Unification after Ten Years of the
EMS (Cambridge University Press, 1989).

Brunner, Karl, and Allan H. Meltzer. “ The Uses of Money:
Money in the Theory of an Exchange Economy,” American
Economic Review (December 1971), pp. 784-805.
Calvo, Guillermo A. “ Optimal Seigniorage from Money Crea­
tion: An Analysis in Terms of the Optimum Balance of Pay­
ments Deficit Problem,” Journal of Monetary Economics
(August 1978), pp. 503-17.
Dornbusch, Rudiger. “ The European Monetary System, the
Dollar and the Yen,” in Francesco Giavazzi, Stefano Micossi and Marcus Miller, eds., The European Monetary System,
(Cambridge University Press, 1988).
Fischer, Stanley. “ Seigniorage and the Case for a National
Money,” Journal of Political Economy (April 1982),
pp. 295-313.


Gros, Daniel. “ Seigniorage in the EC: The Implications of the
EMS and Financial Market Integration,” IMF Working Paper
(Washington, D.C., January 23, 1989).
Johnson, Harry G. “A Note on Seigniorage and the Social
Saving from Substituting Credit for Commodity Money,” in
Robert A. Mundell and Alexander K. Swoboda, eds., Mone­
tary Problems of the International Economy (University of
Chicago Press, 1969).
Klein, Martin, and Manfred J.M. Neumann. “ Seigniorage:
What is It and Who Gets It?” Weltwirtschaftliches Archiv
(Heft 2/1990), pp. 205-21.
Toma, Mark. “ Inflationary Bias of the Federal Reserve Sys­
tem: A Bureaucratic Perspective,” Journal of Monetary Eco­
nomics (September 1982), pp. 163-90.


James B. Bullard
James B. Bullard is an economist at the Federal Reserve Bank
of St. Louis. David H. Kelly provided research assistance.

The FOMC in 1991: An Elusive


J- JLS 1991 BEGAN, the U.S. economy was in
the second quarter of a downturn in aggregate
economic activity. Real output, as measured by
the gross national product (real GNP), had fallen
in the fourth quarter of 1990 at a 2.5 percent
annual rate; the first quarter of 1991 would
turn out to be even worse, with output falling
at a 2.8 percent annual rate. As the year wore
on, the pace of real output growth turned posi­
tive, although it seemed to stall somewhat
toward the fourth quarter. The recession and
the subsequent slow recovery put pressure on
the primary policymaking group of the Federal
Reserve, the Federal Open Market Committee
(FOMC), to take action to spur greater output
growth in the short term.1 This paper provides
a chronologically based assessment of the Com­
mittee's policymaking in this environment. As
such, it provides a case study in the making of
monetary policy during the recovery phase of
the business cycle.

Generally speaking, the FOMC has well-defined
goals but faces two daunting uncertainties when
making decisions. One is that the immediate
past, current and future path o f real output is
not easily surmised by considering current data.
This inhibits the Committee’s ability to assess
the state of the economy in a timely fashion
and, thus, to make short-run policy decisions.
Secondly, the Committee has a difficult time
assessing its own policy stance at a point in
time, primarily because alternative measures of
policy actions sometimes send conflicting signals.

In order to put FOMC decision making into
context, a framework for discussion is outlined.
The framework is intended to provide a basis
for thinking about how monetary policy is made
and why, in a broad brush sense, certain con­
cerns reign paramount in Committee delibera­
tions. The framework is meant to be qualitative
and suggestive, so as not to belabor the techni­
cal details of theoretical arguments.

To understand the FOMC’s decision making in
1991, a general framework or reference point is
useful in order to put into focus the arguments
presented for various policy actions. For the
most part, FOMC members and the Board staff,
the primary participants in these meetings, pre­
sent broad points of view and avoid technicali­
ties. Disagreement, when it occurs, is often a
matter o f the interpretation of recent economic

The next section provides the framework for
understanding FOMC decision making. The chro­
nology is presented in the subsequent section.
T h e fin al section p rovid es sum m ary com m ents.


1See the shaded insert on the following page for a discus­
sion of the structure of the FOMC in 1991.



The Organization of the FOMC
The Federal Reserve System consists of 12
regional Federal Reserve Banks located in
major cities across the country, with the ad­
ministrative offices o f the Federal Reserve
Board o f Governors in Washington, D.C. The
Federal Reserve Board consists of seven mem
bers, and each o f these members has voting
rights on the Federal Open Market Commit­
tee (FOMC). The president o f the New York
Federal Reserve Bank also is a permanent
voting member of the FOMC. The remaining
11 Reserve Bank presidents attend meetings
and present views, but only four of the 11
have voting privileges at any one meeting.
The voting rights are held for terms of one
calendar year and rotate among these presi­
dents annually.
The Committee typically meets eight times
per year, as it did in 1991, and sometimes
consults by telephone between scheduled
meetings. At the end of each meeting, the
Committee agrees on a directive to issue to
the Federal Reserve Bank of New York; the

developments, but sometimes concerns the
amount of weight to attach to certain broadly
theoretical arguments. Before beginning an anal­
ysis of Committee deliberations, it is therefore
helpful to consider, in a nontechnical way, the
ideas that underlie Committee debate. A frame­

directive is implemented by the Manager of
Domestic Operations. The directive contains
instructions for the conduct of open market
operations until the next regularly scheduled
A summary of each FOMC meeting is
released to the press within a few business
days following the next regularly scheduled
meeting and is subsequently published in the
F ed era l R eserv e Bulletin. The summary,
known as the "Record of Policy Actions of
the Federal Open Market Committee,” is pre­
pared by the Board staff and approved by
the Board. It typically contains: (1) a synopsis
of recent economic data, (2) a review of re­
cent open market operations and money mar­
ket conditions, (3) a Board staff projection of
likely near-term economic developments, (4) a
summary of Committee deliberations, (5) the
policy directive along with a Record of votes
and any dissenting comments, and (6) a sum­
mary o f other policy matters discussed.

The Federal Open Market Committee seeks
monetary and financial conditions that will
foster price stability, promote a resumption
of sustainable growth in output, and contrib­
ute to an improved pattern of international

w o r k o f this sort w as presen ted in Bullard (1990),

and this section briefly describes that approach.

F O M C Monetary P olicy Objectives
The Committee states its goals for monetary
policy repeatedly in documents released to the
public throughout the year. In particular, at the
conclusion o f each meeting, the Committee is­
sues a directive which contains, with other in­
formation, a statement o f the following type:

2Federal Reserve press release, March 29, 1991, p. 22.
The Federal Open Market Committee releases its record of
policy actions (in the remainder of this article, simply ‘‘the
Record” ) for a particular meeting shortly after the next
regularly scheduled meeting. The press releases referred
to in the remainder of this article are dated May 17, 1991;
July 5, 1991; August 23, 1991; October 4, 1991; November
8, 1991; December 20, 1991; and February 7, 1992. All
press releases will be referred to by month.

Federal Reserve Bank of St. Louis

This statement of objectives has three parts.
The first goal, to foster price stability, is based
on the idea that FOMC policy, over long periods
of time, can influence the inflation rate. The se­
cond objective, to promote sustainable growth,
is associated with the idea o f countercyclical
monetary policy, in particular that the FOMC
can influence real output over short time hori­
zons, say, less than a year.3 The third part of
the statement of objectives, an improved pattern
of international transactions, is more oblique,

3The statement of objectives quoted above is noteworthy
for the inclusion of the words “ a resumption of.” Available
information suggested that real output was declining at the
time this statement was released, and hence the more
standard phrase, “ . . . promote sustainable growth in out­
put,” was modified. Later in the year, when real output
again appeared to be growing, albeit rather slowly by
historical standards, the term “ resumption” was dropped.


and beginning about midyear, this phrase was
dropped from the Committee’s statement.
Therefore, for the last five meetings o f the year,
the statement of objectives was:
The Federal Open Market Committee seeks
monetary and financial conditions that will
foster price stability and promote sustainable
growth in output.4
In this article, focus will be placed on this last
statement o f objectives, as the price stability
and real output goals are consistently mentioned
throughout the year, and the international goal
is not.

Controlling Inflation
A widely held view among economists is that
inflation, over long time periods, is closely relat­
ed to the rate of money growth within a coun­
try. In fact, the idea is that the rate o f money
growth eventually translates directly to the rate
of inflation. The theory, which dates to Hume
(1742), is broadly supported by international
cross-section evidence, which shows that coun­
tries choosing high rates of money growth over
a decade or more tend to have the highest infla­
tion rates. The United States, for instance, has
experienced an average annual rate o f inflation
o f 5.4 percent in the 1980s, which was associat­
ed with an average annual money growth (M2)
rate o f 7.5 percent. Iceland, on the other hand,
experienced 32.1 percent average annual infla­
tion over the same period, associated with a
money growth rate o f 38.2 percent. Similarly,
Mexico had 50.1 percent average annual infla­
tion associated with money growth of 45.9 per­
cent. A look at other countries in which data
are available reveals similar patterns.
Of course, despite the fact that such views
are widely held, the theory is incomplete. It is
not clear, for instance, what constitutes a suffi­
ciently long time period. In addition, as the ex­
amples given above indicate, the relationship is
far from exact, even over a decade or more. Fi­
nally, the theory by itself gives no indication of
what to expect from, say, a short but intense
burst of money growth. Despite these caveats,
the theory and evidence are sufficiently strong
to suggest that, in the long run, inflation is a
policy-induced phenomena, and thus that con­
trol of inflation is an important aspect of central
bank policymaking.
“•February press release, p. 16.
5March press release, p. 15.

Sustaining Real Output Growth
The notion that monetary policy actions can
significantly affect the growth o f real output
over short time horizons, such as a quarter or a
year, is deeply seated among macroeconomists.
It is also controversial and largely unresolved.
Nevertheless, the Committee has generally
adopted the view that monetary policy actions
do have material effects on real output growth
within the following few quarters. It is not
difficult, for instance, to find statements in the
Record that attest to members' views in this
regard. For instance, at the February meeting,
there was talk that “inadequate monetary stimu­
lus . . . could fail to cushion possible further
deterioration in the economy.”5 Similarly, in
March, “if the economy was indeed near its
recession trough, additional easing would not be
necessary,” in May, "the System’s earlier easing
actions . . . had provided a good deal of insur­
ance against cumulative further weakening in
business activity;” and in July, "policy was posi­
tioned to foster a sustainable economic expan­
sion.”6 Statements of a similar sort can be found
throughout the year.
Since the Committee operates in an environ­
ment in which the short-term effects of mone­
tary policy on real output are taken for granted,
in this paper these effects are simply assumed
to exist and to be substantive, with due notice
to the ongoing debate on that topic in academic
circles. Generally speaking, it will be assumed
that an "easing” of monetary policy is associated
with a temporary gain in output (relative to
what would have occurred without the easing)
a few quarters hence, and that a "tightening” of
policy has the reverse effect.

The R ole o f Forecasts in ShortRun Policy Actions
It is important to note that these postulated
real output effects occur only with a lag, which
many economists suppose is at least one quarter
and may be as long as a year or more. The no­
tion of lagged policy effects is an important
theme in Committee debates, as it forces mem­
bers to form opinions about the path of real
output several quarters into the future. Such
forecasting is notoriously difficult. The inability
to forecast accurately tends to produce uncer6Respectively, the May press release, p. 12, the July press
release, p. 12, and the August press release, p. 14.



tainty among policymakers when choosing ap­
propriate short-run policy actions.
If the members of the FOMC were concerned
solely with long-run policy, as would be suggest­
ed by the available theory and evidence on in­
flation, they would presumably have much less
concern for current forecasts o f real activity
over the next few quarters. But the Committee
is not concerned solely with inflation, as their
statement of objectives attests; therefore, the
Committee members and Board staff have an
acute concern for the daily goings-on of the
U.S. economy. In fact, the Record consists pri­
marily of a recitation of recent economic devel­
opments as captured in various measurements
produced by the Federal Reserve or the U.S.
government, often with an associated inference
about what seems to be in store for real activi­
ty. The idea that policy actions taken today will
affect real output in the not-too-distant future
drives the concern for up-to-the-minute informa­
tion about the status of economic activity. Shortrun forecasting is a necessary ingredient of any
strategy based on the notion o f significant
short-run monetary policy effects on real output.

Measuring the Policy Stance
The Committee also has some difficulty in as­
sessing the policy stance at a point in time be­
cause various measures of the thrust of policy
can give conflicting signals. The Record and
other Federal Reserve documents describe poli­
cy in terms of whether it is "tight” or “easy.”
These vague terms, which have a long history
o f use within the Federal Reserve, cannot be as­
sociated directly with System actions. This has
created the situation in which two observers,
and indeed Committee members themselves, can
easily disagree about the thrust of monetary
policy at a point in time. To see how this might
be so, consider how most monetary policy ac­
tions are implemented.
Commercial banks must maintain reserves
against certain types of deposits. Reserve posi­
tions are maintained on a two-week basis, so
that a particular depository institution might
find itself either over- or under-supplied with
reserves at a point in time. These reserves are
traded among banks on a daily basis in the fed­
eral funds market, and the interest rate in this
7For a recent discussion, see Garfinkel and Thornton

Federal Reserve Bank of St. Louis

market is the federal funds rate. The Federal
Reserve can supply or drain reserves from the
system through intervention in this market.
Such op en m arket o p eration s are carried out by
the Federal Reserve Bank of New York based on
the directives from the FOMC.
Given a conventional downward-sloping de­
mand for reserves, the Federal Reserve can in­
crease (decrease) the federal funds rate by
decreasing (increasing) the supply of reserves.
Total reserve supply is subject to close control
by the System. A standard analysis relates the
sum of total reserves and currency, the m o n e­
tary base, and measures of the money supply,
such as M2, by a proportional factor called the
m on ey m ultiplier.7 Thus, increases in total
reserves, increases in the money stock and
decreases in the federal funds rate are simply
different aspects of the same mechanism in this
simple framework and are associated with the
term "ease.” “Tight” policy would involve move­
ments of these variables in opposite directions.
Since, generally speaking, lower long-term in­
terest rates are associated with higher rates of
investment and greater consumer purchasing,
which in turn are associated with higher levels
of real output, easy policy is often thought to
be stimulative in the short run. Tight policy is
viewed as having the reverse effect. Of course,
the federal funds rate is only a short-term in­
terest rate, and there might be some question
whether movements in a short rate will actually
be reflected in the spectrum o f interest rates.
Theories on this topic abound, and, as will be
apparent in the following chronology, members
of the Committee sometimes disagree about the
net interest rate effects of a lower federal funds
The essential problem in practice is that total
reserves, the federal funds rate and the money
supply can, and sometimes do, give conflicting
signals about whether monetary policy is actual­
ly easy or tight. Casual consideration of the
above analysis suggests why this might be so. In
particular, the demand for reserves is probably
shifting over time in response to the level of
economic activity, implying that the federal funds
rate could rise or fall even when reserves are
constant. Additional reserves, therefore, need
not signal a lower federal funds rate. M2 growth
might also be affected by vagaries in real activity.


These and other concerns produce the funda­
mental problems in assessing the FOMC’s policy
stance at a point in time.
The Federal Reserve also occasionally lends
reserves to commercial banks directly through
the discount w indow . The rate on these loans,
the discount rate, is administered by the Board
of Governors, and the FOMC plays no official
role in changing it. The volume of loans made
by the Federal Reserve at the discount rate is
relatively small, so that the direct impact of a
change is viewed as relatively unimportant. In
the past, however, the discount rate has been
set somewhat below the prevailing federal
funds rate, so that, in 1991, when the federal
funds rate declined through most of the year, a
lower discount rate was sometimes taken by
market participants as a signal of a lower feder­
al funds rate at some point in the future. In
fact, in 1991, the Committee often allowed a
lower discount rate to sh o w through to the fed­
eral funds rate, meaning that the funds rate
was allowed to fall when the discount rate was
lowered. Therefore, discount rate changes play
an important role in the following chronology,
even though the discount rate is not, strictly
speaking, under the jurisdiction of the FOMC.
Based on the simple framework outlined
above, the three indicators of policy that will be
considered in this paper are the federal funds
rate, the M2 monetary aggregate and total
reserves.8 The behavior of these indicator varia­
bles in 1991 is summarized in figures 1-3; refer­
ence will be made to these graphs throughout
the chronology. Figures 4-7 provide a synopsis
of the recent behavior of several other key
variables—namely, real output, total nonfarm
payroll employment, industrial production and
consumer confidence.
The framework that will be used to summa­
rize FOMC decision making is now complete.
The Committee states its major objectives fre­
quently: to control inflation and maintain sus­
tained growth in real output. International
evidence suggests that low inflation rates can be
achieved by maintaining low rates of money
growth. The real output effects of monetary
policy are less certain, but summaries of Com­

8While there are many other possible indicators of mone­
tary policy, in this article these three are the only ones
9A summary of FOMC actions in 1991 is contained in
table 1.

mittee deliberations indicate that members be­
lieve temporary easing can mitigate downturns
in economic activity. Pursuit of this objective re­
quires an assessment of the current and future
path of real output, but knowing whether the
incoming data signal a change in direction for
the economy is complicated by lags in data
releases and errors in economic forecasts. To
summarize FOMC policy actions, some measure
of the monetary policy stance is required. Since
various measures sometimes suggest differing
interpretations of the thrust of monetary policy,
several indicators will be employed.

On the whole, the chronology in this section
indicates that the FOMC became increasingly
pessimistic about the prospects for a sustained
recovery as 1991 progressed, and this led to
particularly aggressive easing actions late in the
year.9 In the first meetings of 1991, when a
substantial amount o f information suggested a
decline in real output, members were neverthe­
less hopeful that easing implemented since the
December 1990 meeting would be enough to lay
the groundwork for a moderate recovery begin­
ning in the spring and summer. In fact, several
directives in the first half o f the year called for
steady policy with no bias toward ease, although
some easing actions actually w ere implemented
according to the Record.1 Beginning in August,
in an atmosphere o f increasing concern about
the strength of the recovery, the Committee
turned to asymmetric language toward ease in
the directive. The trend toward easing actions
peaked in the November directive, with the
C om m ittee vo tin g to su pport im m ediate ease

with additional bias toward ease during the intermeeting period.
As emphasized in the chronology, however,
merely outlining the content of Committee direc­
tives does not provide a complete summary of
monetary policy during this period. At times,
for instance, the thrust of policy is open to in­
terpretation. In addition, policy changes are
sometimes implemented via other methods, such
as intermeeting conference calls, or in concert
with discount rate changes.

10The Committee sometimes uses so-called asymmetric lan­
guage in the directive, which is one way of making policy
changes contingent on intermeeting developments. This
phenomena is also sometimes described as “ bias” in the



Table 1
Important Dates in the Chronology of 1991 FOMC Actions
The following summary is based solely on statements in the Record regarding policy actions.
See the text for a discussion of measures of the thrust of policy.
Early January. An easing action is implemented.
February 1. The Board of Governors approves a reduction in the discount rate to 6 percent from
6.5 percent. The FOMC allows the entire amount of the cut to show through to the federal funds
February 5-6. The FOMC meets. The target range for M2 growth is kept at 2.5 to 6.5 percent.
The directive calls for an unchanged policy with some bias toward ease depending on intermeet­
ing developments.
Early March. An easing action is implemented.
March 26. The FOMC meets. The directive calls for an unchanged policy without bias.
End of April. The Board of Governors cuts the discount rate from 6 percent to 5.5 percent. The
FOMC allows part of the 50 basis-point decline to show through to the federal funds rate.
May 14. The FOMC meets. The directive calls for an unchanged policy without bias.
July 2-3. The FOMC meets. The target range for M2 growth is kept at 2.5 to 6.5 percent. The
directive calls for an unchanged policy without bias.
Early August. An easing action is implemented.
August 20. The FOMC meets. The directive calls for an unchanged policy with some bias toward
ease depending on intermeeting developments.
Mid-September. The Board of Governors lowers the discount rate from 5.5 percent to 5 percent.
The FOMC allows part of the decline to show through to the federal funds rate.
October 1. The FOMC meets. The directive calls for an unchanged policy with some bias toward
ease depending on intermeeting developments.
End of October. An easing action is implemented.
November 5. The FOMC meets. The directive calls for immediate ease with bias toward addition­
al ease depending on intermeeting developments.
November 6. The Board of Governors lowers the discount rate to 4.5 percent. An easing action
is implemented in concert with the discount rate cut.
Early December. An easing action is implemented.
December 17. The FOMC meets. The directive calls for an unchanged policy with bias toward
ease depending on intermeeting developments.
December 20. The Board of Governors lowers the discount rate by a full percentage point to
3.5 percent. The FOMC allows partial show-through to the federal funds rate. RESERVE BANK OF ST. LOUIS
Federal Reserve Bank of St. Louis


Figure 1
Weekly Federal Funds Rate

Jul 90


O ct

Nov Dec

Feb 91

M ar




O ct



Feb 92

Vertical lines represent FOMC m eeting dates

Figure 2
13 Week Growth Rates of M2
Annualized Percent Change

Vertical lines represent FOMC m eeting dates



Figure 3
Intermeeting Growth of Total Reserves1
A n n u alized P e rc en t C h ange
A u gust 1990 to February 1992

-2 0
A u g 90

O ct

N ov


Feb 91

M ar

M ay



O ct

1D a ta a re Board series, ad ju sted fo r res e rv e req u irem en ts.
V e rtic a l lin es re p rese n t F O M C m eetin g d ates

Figure 4
Private Forecasters’ View of Real Output1
An nualized P e rc en t Change

'A v a ila b le data and Blue Chip forecasts


N ov

D ec

Feb 92


Figure 5
Total Nonfarm Payroll Employment
M illio n s o f P e rs o n s

Figure 6
Industrial Production
A n n u a liz e d P e rc e n t C h a n g e

J a n u a ry 198 9 to J a n u a ry 1992



Figure 7
Consum er Confidence
In d e x L e v e l 1 9 8 5 = 100

Meeting o f February 5-6, 1991
In keeping with standard practice and Con­
gressional requirements, the FOMC took up a
review of long-range policy at the February
meeting. As in the past, most of the discussion
focused on target ranges for monetary and debt
aggregates, primarily the M2 monetary aggregate.
In July 1990, the Committee had tentatively set
the 1991 target range for M2 growth at 2.5 to
6.5 percent, measured from the fourth quarter
o f 1990 to the fourth quarter of 1991. As can
be seen from figure 2, the recent 13-week
growth rates for M2, at the time of this meet­
ing, had mostly been below the target band.1
In recent years, the FOMC has pursued a
strategy of gradually reducing the target ranges
for M2 growth, usually in increments of 0.5
percent per year, with the idea of eventually at­
taining a range consistent with price stability.1

At this meeting, however, "most of the mem­
bers indicated a preference for affirming the
ranges that had been established on a tentative
basis in July.”1 The essential reason for the in­
terruption in the usual sequence was the weak
economy, in particular, that “lowering [the tar­
get range]. . . could lead to concerns about the
System’s objective of fostering an upturn in bus­
iness activity.”1 On the other hand, increasing
the ranges, perhaps in an effort to show reces­
sion-fighting resolve, was also viewed with sus­
picion, since it “could raise questions about the
System’s commitment to its anti-inflationary
goals.”1 After further debate on these points,
the Committee agreed to a directive calling for
maintenance of the tentative M2 target ranges,
that is, with the lower end at 2.5 percent and
the upper end at 6.5 percent.1
In terms of short-run policy, that is, policy for
the immediately upcoming intermeeting period,

" O f course, it is not necessarily of concern that the 13-week
M2 growth rates sometimes fall outside the target band; it
is the growth rate over the entire year that is of im­

13March press release, p. 14.

12March press release, p. 14.

16March press release, p. 17.


14March press release, p. 15.
15March press release, p. 15.


the developments since the previous FOMC
meeting were an important consideration. The
December 1990 directive had called for some in­
itial easing along with additional easing should
conditions warrant. The Board o f Governors,
which exercises authority over discount rate
changes separately from the FOMC, voted to
lower the discount rate to 6.5 percent immedi­
ately following the December meeting, and, ac­
cording to the Record, some of this decline was
allowed to show through to the federal funds
rate.1 Further easing followed in January, and,
when the Board of Governors approved a fur­
ther discount rate cut on February 1 to 6 per­
cent, the entire amount of the cut was allowed
to show through to the federal funds rate.1 As
figure 1 shows, the federal funds rate, although
relatively volatile, had dropped approximately
100 basis points during the intermeeting period.
By this measure, dramatic ease had taken place
during the intermeeting period.
The intermeeting growth rate of total reserves,
graphed in figure 3, also seemed to indicate
substantial ease in the period since the December
meeting. The annualized growth rate for this
period was in excess of 30 percent. M2 growth
had begun to pick up somewhat by February,
with the 13-week growth rate moving slightly
higher than 2.5 percent at the time o f the meet­
ing. According to the Record, "the continuing
weakness in M2. . . appeared to reflect in part
heightened concerns about the financial condi­
tion of many depository institutions in the wake
o f the closing of privately insured banks and
credit unions in Rhode Island and the failure of
the Bank o f New England.”1
At the time of this meeting, it appeared that
real output had declined in the fourth quarter
of 1990 and was on a path of further decline in
the current quarter. In particular, total nonfarm
payroll employment fell in January, on the heels
o f a December decline. Industrial production
declined sharply in the fourth quarter of 1990,
as had capacity utilization. Consumer spending,
“partly reflecting [a] lackluster. . . holiday sea­

son,” was weak in the fourth quarter.2 These
factors w ere somewhat offset by a relatively
strong nonagricultural export performance.2
The Board staff's forecast for real output pre­
pared for the February meeting suggested that
"some further decline in economic activity” was
likely in the near term.2 The staff forecast as­
sumed that the war in the Persian Gulf, which
was just getting under way, would be short­
lived, perhaps lasting a few months, and that
further disruption of oil supplies would be
avoided for the foreseeable future. The economy
was expected to begin growing again "subse­
quently,” aided by export growth, falling oil
prices and interest rates, and improved con­
sumer confidence.2
Committee members saw the economic situa­
tion at the time o f the February meeting as
marked by “heightened. . . uncertainties,” due in
part to the outbreak of war in the Persian Gulf.2
In general, members saw a “relatively mild
recession followed by a moderate upturn in eco­
nomic activity. . . as a reasonable expectation.”2
"Risks," however, “w ere clearly on the down­
side,” and even a “relatively long recession
could not be ruled out.”2 In assessing the out­
look, members w ere particularly concerned
about business and consumer confidence. In­
dices of sentiment were already at low levels
and were poised, in the eyes o f the Committee,
to go lower, owing not only to the unfolding
conflict in the Middle East, but also to “financial
excesses of the past decade.”2 Nonetheless, not
all of the news was gloomy, as the Committee
noted that a lower spectrum o f interest rates,
lower oil prices and a depreciating dollar would
probably contribute to a rebound in aggregate
activity.2 On the inflation front, “several mem­
bers stressed that the slowing in monetary
growth over a period of years was likely to be
reflected increasingly in lower inflation.”2
According to the Record, "the considerable
easing of monetary policy. . . [in] recent months”
encouraged members to endorse unanimously

17March press release, p. 4.

24March press release, p. 7.

18March press release, p. 4.

25March press release, p. 7.

19March press release, p. 6.

26March press release, p. 8.

20March press release, p. 2.

27March press release, p. 9.

2 March press release, p. 3.

28March press release, p. 10.

22March press release, p. 6.

29March press release, p. 13.

23March press release, p. 7.



an unchanged policy for the intermeeting period
ahead.3 In particular, "sufficient time had not
yet elapsed for the effects of the lower [interest]
rates to be felt in the economy or indeed to any
measurable extent in the growth of the monetary
aggregates.”3 While many members mentioned
sluggish M2 growth as an area of concern, most
seemed to agree with a staff analysis that sug­
gested faster rates of growth by the end of
March, given a steady policy course. Some
members, however, reiterated a call for a "rela­
tively high priority [on] achieving satisfactory
rates of growth in reserves and money.”3
The degree of bias in the directive, if any, was
a slightly more contentious issue. One view held
out for a tilt toward ease in the weeks ahead,
owing primarily to “the downside risks to the
economy and the potential for inadequate mone­
tary growth.”3 Some members were especially
concerned that there would be "a high premium
on avoiding any tendency for the weakness in
the economy to cumulate because [of|. . . the se­
vere consequences of a potentially deep and
prolonged recession.”3 An alternative view held
by some members was that, while easing might
be necessary in the future, there were "con­
siderable risks of overreacting” and that “condi­
tions for a recovery in economic activity already
appeared to be in place.”3 The former view,
however, carried the day, and the directive con­
tained bias toward ease, giving "special weight
to potential developments that might require
some easing during the intermeeting period.”3

Meeting o f March 26, 1991
During the intermeeting period, the bias
toward ease in the directive was acted upon.
According to the Record, "in early March, in
response to information suggesting that econom­
ic activity had continued to decline through
February, pressures on reserve positions were
eased slightly.”3 The indications that economic
activity was weakening further included a sharp
decline in total nonfarm payroll employment

and a fall in industrial output.3 Accordingly,
the federal funds rate, depicted in figure 1, fell
to a level just over 6 percent by the time of the
March meeting. Money growth, as measured by
13-week M2 growth rates, continued to pick up
during this period and seemed to indicate ease
relative to previous rates, as outlined in
figure 2. According to the Record, members cit­
ed "the strengthening in M2 growth in February
and March [as] a welcome development follow­
ing an extended period of limited expansion.”3
Total reserves, shown in figure 3, were more
puzzling during this period, as they actually
declined, indicating a net drainage of reserves
from the system instead of an injection. The
reserves measure, therefore, seemed to indicate
a relatively tight intermeeting policy.
The Board staff expected a resumption of real
output growth within a few months o f the
March meeting.4 Positive factors cited included
the end of the war in the Persian Gulf (which
presumably would brighten consumer and busi­
ness attitudes), lower nominal interest rates and
oil prices, and expected improvement in ex­
ports.4 The staff felt that "reduced availability
of credit” and "a moderately restrictive fiscal
policy” were factors restraining near-term
The Committee’s assessment of the outlook
was essentially in agreement with that of the
Board staff. Members were especially en­
couraged by the improvement in consumer con­
fidence at the end of the war and felt that "an
upturn in economic activity was widely expect­
ed.”4 Many members emphasized, however,
that little hard evidence of growth in real out­
put had accumulated thus far and that, in fact,
"there was some risk that the recession could
deepen considerably further.”4 Many members
did not share the staff’s optimism about a sig­
nificant contribution to the recovery coming
from export growth, as such effects were likely
to be “curtailed by slower growth abroad.”4 Ac5

30March press release, p. 18.

39May press release, p. 12.

3 March press release, p. 18.

40May press release, p. 6.

32March press release, p. 19.

41May press release, p. 6.

33March press release, p. 20.

42May press release, pp. 6-7.

34March press release, p. 20.

43May press release, p. 7.

35March press release, p. 20.

44May press release, p. 7.

36March press release, p. 21.

45May press release, p. 10.

37May press release, p. 4.
38May press release, pp. 1-2.

Federal Reserve Bank of St. Louis


cording to the Record, real output growth had
slowed in Germany and Japan, and “some weak­
ening in activity apparently had occurred in
several other major industrial countries.”4
Most members supported the notion, with
regard to short-run policy action, that sufficient
easing had already taken place to foster a recov­
ery.4 In fact, some members commented that
"the most likely direction of the next policy move
was not clear at this point and. . . caution was
needed before any action was taken.”4 In par­
ticular, further easing was a “possibility” due to
“prevailing uncertainties,” but, “if the economy
was indeed near its recession trough, additional
easing would not be necessary.”4 Firming was
viewed as "premature,” although there might be
a "potential need to tighten reserve conditions
promptly if emerging economic and financial
conditions. . . threatened progress toward price
stability.”5 Given these considerations, all of the
members agreed to support a directive calling
for an unchanged policy in the weeks ahead.5
While the members "expressed a range of
views” relating to the possible degree of bias in
the directive, the directive issued was symmet­
ric.5 As noted in the Record, the symmetry
represented a deviation from the policies adopted
since July 1990, as virtually all of the directives
since that time had been biased toward ease.5
The policy shift was consistent with the "assess­
ment that the risks to the economy. . . were
now more evenly balanced.”5 In one view, the
recession had bottomed out, and therefore little
could be achieved through further easing. In
fact, "policy adjustments should be made only in
the event of particularly conclusive evidence. . .
that the recession might be deeper. . . than an­
ticipated.”5 An alternative view was that down­
side risks still predominated and that “the
Committee should react relatively promptly”
should real output appear to decline further.5
One member suggested that recoveries tend to
be stronger than expected, and therefore the

“[greatest] risks were in the direction of too much
ease and o f persisting or increasing inflation.”5
In this view, the bias in the directive should be
toward a tighter policy, especially considering
the lags in monetary policy effects. Considering
all o f these views, however, the Committee
elected to issue the symmetric directive.
The Committee also discussed the interaction
between discount rate changes and open mar­
ket operations as a technical matter of operat­
ing procedure.5 The policy in recent years has
been to keep the discount rate somewhat below
the federal funds rate. Discount rate changes,
which again are governed directly by the Board,
“usually had been allowed to pass through auto­
matically to the federal funds rate” in the recent
past, although there were some exceptions.5
Therefore, actions implemented by the Board
alone might influence open market operations
without explicit FOMC approval. Comments by
members indicated the practice of show through
should be continued, in general, “but that con­
sultation among members of the Committee
would be particularly appropriate in [some] cir­
cumstances.”6 In particular, the members men­
tioned cases in which a partial show through
was more appropriate or particularly large policy
actions were being considered.6

Meeting o f M ay 14, 1991
Immediately following the March FOMC meet­
ing, a steady open market policy was main­
tained.6 As figure 1 shows, however, the
federal funds rate began declining immediately
after the March meeting; the Record notes, “the
rate was under downward pressure at times
from market expectations of some further eas­
ing.”6 At the end of April, two weeks before
the May meeting, an easing action was imple­
mented when the Board voted to reduce the
discount rate to 5.5 percent and a portion of
the drop was allowed to show through to the
federal funds rate. Federal funds traded at about

46May press release, p. 3.

55May press release, p. 13.

47May press release, p. 11.

56May press release, p. 13.

«M ay press release, p. 12.

57May press release, p. 14.

49May press release, p. 12.

58May press release, p. 14.

50May press release, p. 12.

59May press release, p. 14.

5 May press release, p. 11.

60May press release, p. 14.

52May press release, p. 13.

6 May press release, p. 14.

53May press release, p. 13.

62July press release, p. 4.

54May press release, p. 13.

63July press release, p. 4.



5.75 percent as the FOMC convened in May.
Quarterly money growth rates had begun to
slow at the time of this meeting, as shown in
figure 2, but remained squarely within the target
band. Reserve growth had resumed, eliminating
some of the puzzle of the sharp decline recorded
in the previous intermeeting period.
The easing action was taken in response to
"indications of [continuing] weakness in the
economy.”6 The Record describes incoming
data as "mixed,” perhaps broadly suggestive that
real output growth might be flat or slightly
positive after declining in the fourth quarter of
1990 and the first quarter of 1991.6 While total
nonfarm payroll employment fell again in April,
the rate of decline was less than in previous
months. Industrial output was flat in April. The
available data on foreign economies suggested
that they grew at a relatively slow pace in the
first quarter.
Calling an upswing in economic activity “immi­
nent,” the Board staff at this meeting forecast a
recovery fully under way in the summer months
of 1991 and continuing through 1992.6 The
growth in real output was expected to be slower
than that experienced during other postwar
recoveries.6 Restraint in the recovery was sug­
gested, according to the staff, by "the absence
of further significant impetus from net exports”
and "moderately restrictive” fiscal policy, at all
levels of government.6 The staffs changing view
on the contribution of net exports, relative to
its forecast from the previous meeting, was con­
sistent with the evidence that major foreign in­
dustrial economies continued to slow in the first
months of 1991.
The Committee "generally viewed a business
recovery in the months ahead as a reasonable
expectation.”6 While most members felt that
signals were "mixed,” many felt that "a variety
o f developments appeared to have laid the
groundwork for a recovery.”7 An important

factor would be the evolution of consumer and
business sentiment.7 Many members seemed to
concur with the staff forecast that the strength
of the recovery was questionable, as "current
conditions did not point to major sources of
stimulus.”7 Some members, however, did discuss
inventory investment and housing construction
in such a role. As for inflation, "the members
continued to express confidence that the ongo­
ing effects of earlier monetary policy actions
and reduced monetary growth over an extended
period. . . would tend with some lag to exert a
favorable restraining effect on prices.”7
The Committee unanimously supported a
directive with the thrust of policy unchanged
from that of the previous meeting, and virtually
all members supported instructions avoiding
bias.7 At this point, in members’ eyes, “a steady
monetary policy appeared to. . . [reflect] an ap­
propriate balancing o f the risks of an overly
stimulative policy that would threaten progress
against inflation versus the risks of a deepening
recession or an overly delayed recovery.”7
While some members felt that the costs o f a
further fall in real output were much more se­
vere than an unexpectedly strong burst of
growth, most agreed that the easing actions that
had already been taken, given the presumed
lags in effects on real output, w ere enough to
insure against a further downturn.7 In particu­
lar, “the System’s commitment to the goal of
reducing inflation argued for a cautious ap­
proach to any further easing at a time when
the economy might be close to its recession
The growth rate of the Committee’s primary
monetary aggregate, M2, was a point of discus­
sion at the May meeting. The Board staff pre­
pared a report suggesting that M2 growth
would improve in the summer following a flat
performance in April. Members showed some

64July press release, p. 4.

73July press release, p. 11.

65July press release, p. 1.

74July press release, p. 12.

66July press release, p. 6.

75July press release, p. 12.

67July press release, p. 6.

76July press release, p. 12.

68July press release, p. 6.

77July press release, p. 12.

69July press release, p. 7.
70July press release, p. 7.
7 July press release, p. 7.
72July press release, p. 8.



concern that, in particular, "subnormal mone­
tary growth might be an indication that mone­
tary policy was still too tight.”7 For this reason,
according to the Record, “a number o f members
underscored the desirability of achieving mone­
tary growth within the Committee’s ranges for
the year.”7

Meeting o f July 2-3, 1991
The midyear meeting of the FOMC included a
review of long-term objectives as required by
law. The target range for M2 was the focus of
discussion. The growth of this monetary ag­
gregate was slowing at the time of this meeting,
to the point where the 13-week growth rate
had dropped to just over 2 percent, as illustrat­
ed in figure 2. For the year, however, M2
growth was in the middle of the target range,
thanks to faster growth rates earlier.8 Neverthe­
less, members felt that the “growth of this ag­
gregate thus far in 1991 had fallen short of
what might have been expected on the basis of
historical relationships with nominal income and
interest rates.”8 Furthermore, “the reasons for
the shortfalls were not fully understood.”8 The
view of the Committee seemed to be that there
was simply a good deal of uncertainty sur­
rounding the behavior of M2, but that “the
four-percentage point range provided adequate
leeway for any adjustments that might be need­
ed.”8 As in February, the Committee decided to
leave the target range unchanged.
With regard to short-run policy, operations
had focused on maintaining the existing policy
stance since the last meeting. The federal funds
rate seemed to bear this out, as the weekly
average rate shown in figure 1 remained steady
for the most part at about 5.75 percent, except
for a 50 basis-point spike on the week of the
July meeting. According to the Record, there
was some upward pressure on interest rates in
the intermeeting period due in part to "expecta­
tions that no further easing of monetary policy
was likely in the near term.”8 While figure 2
shows that M2 growth continued to slow, meas­

ured on a 13-week basis, intermeeting reserve
growth as captured in figure 3 appeared satis­
The Board staff forecast “considerable growth”
through the end of 1991.8 Again at this meet­
ing, the staff felt that this phase of the recovery
would be slow relative to past experience. The
restraint was attributed, in part, to weakness in
nonresidential construction, which would be
“depressed by high vacancy rates,” and "fairly
restrictive” fiscal policy, again at all levels of
Members of the Committee "generally agreed
that a recovery very likely was under way.”
While “puzzling aspects” were noted, it was also
pointed out that “ sources of strength in an eco­
nomic expansion often have been difficult to an­
ticipate near a cycle trough.”8 The Committee’s
policy of moderate money growth over the last
several years was expected to pay o ff in the
form of lower inflation in the upcoming quart­
ers.8 Many members agreed with the staff
regarding the restrictive effects of fiscal policies
at all levels of government relative to past
recovery phases. In particular, “despite burgeon­
ing [federal] borrowing requirements in the
near term, cutbacks in defense spending and
other efforts to curb expenditures” had the ear­
marks of a restrictive fiscal approach.8
The Committee unanimously supported a
directive that called for an unchanged policy in
the weeks until the next meeting. According to
the Record, “an unchanged policy course [was
viewed as offering] the greatest promise of
reconciling the Committee’s goals of sustaining
the nascent business recovery while also foster­
ing further progress against inflation.”9 I m m i­
nent policy change was viewed as "unlikely,"
despite "obvious. . . uncertainty.”9 Recent slug­
gishness in M2 growth, which can be seen in
figure 2 as the declining 13-week growth rates
in May and June, was a concern o f some mem­
bers, who commented that perhaps "monetary
policy had not been eased sufficiently in recent

78July press release, p. 13.

85August press release, p. 5.

79July press release, p. 13.

86August press release, p. 6.

80August press release, p. 13.

87August press release, p. 6.

8 August press release, p. 13.

88August press release, p. 7.

82August press release, p. 13.

89August press release, p. 12.

83August press release, p. 14.

90August press release, p. 18

84August press release, p. 4.

9 August press release, p. 18.



months.”9 It was pointed out, however, that
other measures, “especially. . . reserves,” seemed
to show growth that was relatively strong. Most
members felt that "the behavior of M2 . . . did
not call for any policy adjustments at this
point.”9 In any event, the staff projected faster
M2 growth in the near future, under a presump­
tion of an unchanged policy stance.

Meeting o f August 20, 1991

growth rate of real output for the second half
of the year, however, was now forecast to be
somewhat lower than previously suggested. The
staff outlook emphasized "a cyclical swing from
substantial liquidation to modest accumulation
in business inventories” as a stimulus for recov­
ery. As in previous forecasts, restrictive fiscal
policy was thought to be retarding real output
growth rates from their more usual cyclical

As the Committee convened in August, the
“recovery was proving to be sluggish.”9 While
operations during the intermeeting period ini­
tially had been directed toward maintaining ex­
isting policy, an easing move was implemented
in early August.9 One reason for the unsche­
duled action was weakness in M2 growth; as
can be seen in figure 2, the 13-week growth
rates were approaching zero at the time of the
easing action and had turned negative by the
time of the meeting. By any of the measures of
the policy stance considered here, however, an
easier policy was not obvious. Federal funds,
which had been trading at about 5.75 percent,
moved only slightly lower by the time of the
meeting according to the weekly averages
graphed in figure 1. M2 growth continued to
falter as the Committee convened. Intermeeting
total reserve growth was flat, perhaps suggest­
ing a relatively tight policy.

FOMC members saw an economy that was
“uneven," although they appeared to agree with
the staff in principle that real output growth
would be positive over the next several quart­
ers. In particular, a “ sustained expansion . . .
was still viewed as a reasonable expectation,
[but] many members now believed that the risks
were tilted toward the downside.”1 0 The coup
attempt in the Soviet Union, the outcome of
which was unknown at the time of the meeting,
added in the view of the Committee additional
uncertainty to the outlook. Closer to home,
weakness in M2 growth was cited as “a matter
of increasing concern to the extent that it im­
plied. . . a faltering economic expansion.”1 1
Again at this meeting, according to the Record,
the FOMC seemed to concur with the staff as­
sessment that fiscal policy effects would proba­
bly be "somewhat negative” for the immediate
future.1 2

The Record again describes the information
on the economy at this juncture as "mixed,” but
generally suggestive that sluggish growth in real
output would continue in the near term.9 In­
dustrial production increased in July, in part be­
cause of a rise in automobile production. July
total nonfarm payroll employment increased
slightly, as did retail sales, but business fixed in­
vestment declined in the second quarter and
was expected to remain weak.9 Interest rates
generally fell in the intermeeting period; one
reason cited, in the case of short-term Treasury
securities, was the attempted coup in the Soviet

The shift toward pessimism in the Commit­
tee's outlook is reflected in private sector fore­
casts from August 1991 and December 1991 for
quarterly growth in real output, as illustrated in
figure 4. As of August, projections for the
fourth quarter of 1991 and the first quarter of
1992 were relatively robust, although perhaps
somewhat low relative to previous recoveries.
By December, however, the projected growth
rates for these quarters had dropped substan­
tially, far below that which might have been ex­
pected based on historical experience.

The Board staff forecast a “moderate expan­
sion over the next several quarters.”9 The

92August press release, p. 19.

The Committee voted to issue a directive
maintaining current policy for the immediate fu­
ture but with an asymmetry toward ease. Ac­
cording to the Record, "an immediate easing

98October press release, p. 4.

93August press release, p. 19.

"O cto b e r press release, p. 5.

94October press release, p. 4.

' “ October press release, p. 6.

95October press release, p. 4.

101October press release, p. 7.

96October press release, p. 1.

' 02October press release, p. 11

97October press release, p. 2.

Federal Reserve Bank of St. Louis


move would be premature because the most re­
cent economic information, although mixed, still
suggested a moderate rate of economic expan­
sion.”1 3 Advocates of asymmetry argued that
"risks. . . w ere largely on the side of a weakerthan-projected economy” and that the Commit­
tee should “react promptly” if any cumulative
decline should become apparent.1 4 Some mem­
bers disagreed, however, because they ’’were
concerned about responding to what might
prove to be short-lived fluctuations in the eco­
nomic data and anecdotal information.”1 5 Even
these members, however, could accept some
asymmetry toward ease in the directive.1 6
The Record indicates that members paid "con­
siderable attention” in their discussion to sag­
ging M2 growth rates.1 7 While members found
explanations "difficult to disentangle,” some saw
the slow growth to be of "little import” if it
merely reflected shifts into alternative invest­
ment instruments that are not counted in the
broad monetary aggregates.1 8 On the other
hand, the “behavior. . . might be indicative
of. . . a monetary policy stance that was too
tight.” The Board staff analysis continued to
forecast some pick-up in the growth o f M2 in
the near term.1 9
Some members suggested that, in current cir­
cumstances, the Board should emphasize move­
ments in M2 more explicitly when "guiding
possible intermeeting adjustments in policy.”
The majority, however, did not support this
idea, for at least three reasons. One was that
broad monetary aggregates like M2 were
viewed by some as "unreliable indicators” of
real output growth paths. Another was that nar­
rower measures, such as M l and total reserves,
"might be more indicative o f the underlying
thrust of monetary policy." Finally, some mem­
bers felt that including stronger reference to
monetary aggregates in the directive might “mis­
construe the views o f many members,” who
might not be willing to support a policy response
to "aberrant fluctuations” in money growth.1 0

Meeting o f O ctober 1, 1991
Again, the bias in the August directive was
acted upon during the intermeeting period. The
Board voted to lower the discount rate to 5 per­
cent in mid-September and part of the 50 basispoint decline was allowed to show through to
the federal funds rate. Accordingly, federal
funds traded at about 5.25 percent by the time
the Committee met in October, as shown in
figure 1. Monetary growth, as measured by the
13-week M2 growth rate displayed in figure 2,
was actually negative at the time of the meet­
ing, but apparently the fall in this growth rate
had stalled somewhat relative to the decelera­
tion apparent in the graph since the spring of
the year. Figure 3 indicates that intermeeting
growth in total reserves had resumed, almost
reaching the rates observed at the May and July
meetings; by this measure, policy appeared to
have been eased somewhat since August.
According to the Record, the information on
the economy reviewed at the October meeting
suggested a continuing recovery, but one that
was “uneven across sectors.”1 1 Total nonfarm
payroll employment had been essentially flat
since March. Industrial production had increased
in August. Consumer spending was rising, but
retail sales fell in August. Overseas, the growth
rates o f the Japanese and German economies
fell in the second quarter, although real output
growth appeared to have strengthened in other
large economies.1 2
The Board staff projected continued recovery,
tempered by downside risks and somewhat slow
relative to previous cyclical upturns because of
"persisting weaknesses in some sectors of the
economy.”1 3 In this forecast, consumer spend­
ing would be a significant positive factor, with
"a swing from inventory liquidation" providing
an "additional boost.”1 4 Other sources of stimu­
lus included business equipment spending and
housing construction.1 5 Dampening factors
were still seen on the fiscal policy side and also
in commercial construction, where high vacancy
rates were viewed as a deterrent to building.1 6

103October press release, p. 12.

" “October press release, pp. 14-15.

104October press release, p. 12.

"'N o ve m b e r press release, p. 1.

105October press release, p. 12.

" 2November press release, pp. 1-3.

106October press release, p. 13.

" 3November press release, p. 5.

107October press release, p. 13.

" 4November press release, p. 6.

108October press release, p. 13.

"^Novem ber press release, p. 6.

109October press release, p. 14.

" 6November press release, p. 6.



Committee members seemed to agree with the
staff prognosis, viewing the fledgling recovery
as somewhat threatened.1 7 According to the
Record, "members commented that the anecdo­
tal reports on economic conditions and on busi­
ness and consumer sentiment continued to have
a generally negative tone that did not appear to
be fully consistent with the available economic
statistics.”1 8 Reports on business attitudes in
particular seemed to suggest that key participants
in the economy thought momentum in economic
activity was stalled.1 9 Members were concerned
about risks to the recovery arising from "finan­
cial strains in the economy” as well as slow
money growth. On the whole, however, the
Committee appeared to feel that "the prospects
remained favorable for a sustained expansion
[in economic activity] at a moderate pace over
the next several quarters.”1 0
In the discussion about operating instructions
for the upcoming few weeks, all of the members
of the FOMC supported language leaving the
policy stance initially unchanged. According to
the Record, “the present policy stance provided
an appropriate balance between the risks of a
faltering economic expansion and the risks of
little or no progress toward price stability.”1 1
Some previous easing had not yet filtered
through to effects on real output growth.1 2
Several members asserted, however, that the
Committee should remain "particularly alert to
indications of renewed weakening in business
activity,” in part because they felt a second
downturn might be less responsive to monetary
stimulus.1 3 Other members emphasized the ad­
verse consequences o f easing too much, focus­
ing on the prospect of higher long-term interest
rates due to increased inflationary expectations
which might then retard growth.1 4 On balance,
however, a steady course proved to be the con­
The slow growth of M2 continued to be a
concern. While some members emphasized spe­
cial factors that might be depressing otherwise

robust growth, such as the resolution of the cri­
sis in the thrift industry, others felt that the
broad monetary aggregates "needed to be moni­
tored with special care.”1 5 As at previous meet­
ings, the Board staff continued to predict some
pick-up in the growth of M2, even in the ab­
sence of further easing action.
As for contingencies in the directive, most of
the members "indicated a preference for a
directive that was biased at least marginally
toward easing.”1 6 The downside risks cited
earlier provided the primary justification in the
majority view. A minority preferred a symmet­
ric directive, citing likely cumulative effects
from previous easing actions as a sufficient
safeguard against further declines in real out­
put.1 7 Nevertheless, these members indicated a
willingness to accept an asymmetric directive.1 8
In the discussion, some members in the majori­
ty emphasized that “there should be no strong
presumption that any easing would be under­
taken during the intermeeting period ahead.”1 9

Meeting o f N o v e m b e r 5, 1991
Because the recovery appeared to be weaken­
ing during the intermeeting period, an easing
action, consistent with the bias toward ease con­
tained in the October directive, was implement­
ed at the end of October.1 0 According to the
Record, a key concern in taking this action was
evidence on “flagging consumer and business
confidence.”1 1 The federal funds rate fell after
the easing action to just above 5 percent by the
time of the November meeting. The 13-week
growth rates of M2 accelerated substantially,
even before the easing action, and turned posi­
tive during the intermeeting period. Growth for
the year remained near the lower end of the
Committee’s range. Intermeeting total reserve
growth was substantial, hitting the second
highest level of the year, as outlined in figure 3.
All measures of the policy stance therefore
seemed to indicate at least some ease.
The Board staff, concerned about "recent
reports on business and consumer confidence

117November press release, p. 6.

125November press release, p. 12.

118November press release, p. 7.

126November press release, p. 12.

119November press release, p. 7.

127November press release, p. 12.

i2°November press release, p. 6.

128November press release, p. 12.

1 1November press release, p. 11.

129November press release, p. 12.

122November press release, p. 11.

130December press release, p. 4.

123November press release, p. 11.

1 1December press release, p. 4.

124November press release, p. 11.

Federal Reserve Bank of St. Louis


combined with other information,” continued to
forecast an expanding economy in the quarters
ahead but made an “appreciable markdown” in
the expected rates of growth in real output
relative to past forecasts.1 2 The staff saw the
downside risks to the forecast as “predomi­
nant.”1 3 In particular, real output was expected
to grow quite slowly over the winter months,
with the more robust growth normally associated
with cyclical upswings a possibility in the spring
of 1992 or later.1 4 Except for the decline in the
measures o f sentiment contributing to less con­
sumption than previously predicted, the staff
foresaw the same sources of strength and the
same retarding factors that w ere given appreci­
able weight in previous forecasts.
FOMC members were concerned about the re­
cent developments in the measures of confidence,
but "generally concluded that the available eco­
nomic data appeared consistent with continuing,
albeit sluggish, expansion in overall economic
activity.”1 5 Some commented that the measures
of business and consumer sentiment "had to be
viewed with caution because they had tended in
the past to be coincident rather than leading in­
dicators o f economic activity.”1 6 In terms of
downside risk, several members indicated con­
cern for "the vulnerability of the expansion
stemming from the troubled condition of many
financial institutions,” while others felt risks
were symmetric or even on the upside.1 7 Some
members noted that any potential downturn
was expected to be confined to the fourth
quarter of 1991 or the first quarter of 1992 and
that "a resumption of growth next year. . .
[was] a reasonable expectation.”1 8 Given the
lags associated with short-run policy actions,
these members believed that stimulus already in
the economy should be given a chance to take
effect, and any actions taken to stimulate real
activity within the quarter might be viewed as
somewhat late.1 9

At the end of the meeting, a majority of the
voting members supported a proposal to ease
immediately and to bias the directive toward
further ease should conditions warrant. While
recognition that "monetary policy had been
eased considerably over the course of recent
months” was forthcoming from most members,
many felt that "further modest easing . . .
[might] provide some added insurance” against a
decline in real output.1 0 The majority felt that
additional easing would help bolster consumer
confidence and lead to further declines in key
long-term rates.1 1 The Record indicates that
there was "considerable” discussion of a proposal
to make "a somewhat stronger move,” mainly
because "small moves would lack the visibili­
ty. . . needed.”1 2
A minority of members argued against sub­
stantial easing.1 3 The notion that confidence
could be appreciably affected by monetary poli­
cy actions was questioned.1 4 Long-term interest
rates, it was argued, might well increase on a
substantial easing move, as fears of rekindled
inflation took hold among investors. Several
members also reiterated that several easing
steps recently taken should be allowed to work
through the economy before further action was
taken.1 5

Meeting o f D ecem b er 17, 1991
On November 6, the Board of Governors ap­
proved a 0.5 percentage-point reduction in the
discount rate, and a "slight easing” was carried
out in concert with this move.1 6 The bias in the
November directive was acted upon in the intermeeting period, as "an additional slight easing”
was implemented in early December.1 7 The se­
cond move was made, according to the Record,
"as economic indicators continued to point to a
faltering recovery and growth of the broad
monetary aggregates remained sluggish.”1 8 The

132December press release, P- 6.
133December press release, P- 6.

143December press release, p. 12.

134December press release, P- 6.

145December press release, p. 12. The timing of the easing
action was also discussed “ at some length,” as the
Treasury auction beginning the day of the FOMC meeting
would normally not be an appropriate time to intervene in
the market for reserves. In particular, an immediate action
could hurt the participants in the auction. Nevertheless,
the Committee did not wish to delay action, and the direc­
tive contained no delay.

135December press release, P- 7.
136December press release, P- 8.
137December press release, P- 7.
138December press release, P- 7.
139December press release, P- 7.

144December press release, p. 12.

' ““ December press release, P- 11.

,46February press release, p. 4.

141December press release, P- 11.

147February press release, p. 4.

142December press release, P- 11.

148February press release, p. 4.



federal funds rate fell 0.5 percentage points be­
tween the November and the December meet­
ings, indicating substantial ease. The 13-week
M2 growth rates continued to accelerate during
the intermeeting period, as illustrated in figure
2, also indicating a relatively easy policy. Similar
interpretations are possible for intermeeting to­
tal reserve growth, which, while down somewhat
from the previous meeting, was still robust.
Growth in real output appeared at this meet­
ing to be slow and perhaps waning.1 9 Depressed
levels of business and consumer confidence, a fall
in November industrial production and weakness
in consumption expenditures led the Board staff
to suggest, according to the Record, that “a
pause in the recovery. . . might extend into early
1992.”1 0 Faster growth was expected to return
at that time in part because o f “the cumulative
effects of declines in interest rates in recent
months.”1 1 The staff felt that key sources of
growth would be provided by “increases in
residential construction, somewhat larger con­
sumption expenditures and some pick-up in busi­
ness equipment spending.’’1 2 Restrictive fiscal
policy was still viewed as a key element retarding
growth relative to what expectations might war­
rant based on historical relationships in past
recoveries.1 3
The members seemed to agree with the staff
that past policy actions would eventually lead to
increased growth and that “the economy might
well remain quite sluggish over the months im­
mediately ahead.”1 4 Focus was placed on the
"evident pause in the business recovery and its
interaction with very gloomy business and con­
sumer sentiment.”1 5 Factors that had been pre­
viously identified as dampening growth "had in
fact proved to be stronger and more persistent
than anticipated.”1 6 The measures of sentiment
combined with some anecdotal reports on busi­
ness confidence received “considerable empha­
sis” in the Committee’s deliberations, although
the reasons behind the dismal attitudes were
"difficult to ascertain.’’1 7 Growth in the mone­

tary aggregates was viewed as a positive sign by
some members.1 8
In the discussion o f short-term policy for the
period immediately ahead, the Committee sup­
ported a directive that left unchanged the policy
stance for the time being, but which contained
an “especially strong presumption” that an eas­
ing action would be necessary, "unless improve­
ment in the economy became evident fairly
promptly or there was significant evidence of a
pick-up in M2 growth.”1 9 Some members again
argued for "a more substantial policy move at
some point.”1 0 They hoped that "a larger and
more visible policy action. . . would have greater
effectiveness in part because it would be more
likely to bolster confidence.”1 1
Other members argued for more deliberate
policymaking.1 2 According to the Record, they
"expressed reservations about the urgency to
ease in the near term” and suggested that
“monetary policy could do little” to alter the fac­
tors that w ere restraining the economy at this
point.1 3 In this minority view, the fact that the
extent of recent easing actions was substantial
and the effects on real output were yet to be
realized was given a good deal of weight.
Any easing action needed to be coordinated
with the Board’s approach to the discount rate.
On December 20, the Board voted to move the
discount rate down by a full percentage point.
The FOMC then considered, in a telephone con­
ference, reactions to the move and decided to
allow part of the cut to show through to the
federal fu nds rate.1 4 A s sh ow n in figure 1, the
funds rate fell below 4 percent on a weekly
average basis by the end of the year.

In 1991, the FOMC operated in an environ­
ment in which growth in real output was
resuming. This paper has therefore provided a
case study of the making of monetary policy
during the recovery phase of the business cycle.

149February press release, p. 1.

157February press release, p. 7.

150February press release, p. 6.

'ssfebruary press release, p. 8.

15'February press release, p. 6.

159February press release, p. 11.

152February press release, p. 6.

160February press release, p. 12.

153February press release, p. 6.

1 1February press release, p. 12.

154February press release, p. 7.

162February press release, p. 12.

155February press release, p. 7.

163February press release, p. 12.

156February press release, p. 7.

164February press release, pp. 16-17.

Federal Reserve Bank of St. Louis


Relative to past cyclical upswings in economic
activity, growth in 1991 was slow, and the
recovery itself seemed at times elusive.
The Committee states its objectives on a regu­
lar basis, and members support policy actions
primarily based on their assessment of the out­
look for inflation and real output. Since growth
in economic activity was sluggish in 1991 and
since inflation was low by recent standards, the
Committee’s objective of sustaining real output
growth played a predominant role. Repeatedly,
members wrestled with arguments about the
lagged effects of monetary policy actions, noting
that if the economy had bottomed out, easing to
mitigate real output declines would be unneces­
sary. Still, at times, incoming data seemed to
suggest a renewed decline in economic activity,
and the Committee took actions throughout the
year in the hope of avoiding this possibility.
Measuring the thrust of monetary policy at a
point in time was a continual topic of discussion
at FOMC meetings in 1991. While the federal
funds rate played a dominant role in this capac­
ity, the Committee devoted a considerable
amount of time to analyses of M2 growth, which
seemed to falter at times during the year. In
general, conflicting signals of the thrust o f mon­
etary policy played a significant role in Commit­
tee deliberations.
During the first half of 1991, the FOMC dis­
played considerable optimism that a recovery

would begin and gain momentum as the year
progressed. Three o f the first four directives of
the year called for an unchanged policy without
bias, although, as indicated in the chronology
and table 1, some easing was implemented dur­
ing this period. Beginning about August, how­
ever, the Committee's confidence in the recovery
began to wane. The four directives issued in the
second half of the year all contained bias
toward ease, as Committee members expressed
deep concern about declines in industrial
production and consumer confidence. By the
end of the year, the FOMC had approved a
number of easing actions designed to provide
insurance against further declines in real output.

Blue Chip Economic Indicators. 1991 Issues.
Bullard, James B. “ The FOMC in 1990: Onset of Recession,”
this Review (May/June 1991), pp. 31-52.
Federal Reserve. Press Releases, Record of Policy Actions of
the Federal Open Market Committee, dated March 29, 1991;
May 17, 1991; July 5, 1991; August 23, 1991; October 4,
1991; November 8, 1991; December 20, 1991; and February
7, 1992.
Garfinkel, Michelle R., and Daniel L. Thornton. “ The Multipli­
er Approach to the Money Supply Process: A Precaution­
ary Note,” this Review (July/August 1991), pp. 47-64.
Hume, David. Essays Moral, Political, and Literary (London:
Oxford University Press, 1742).



K. Alec Chrystal and Cletus C. Coughlin
K. Alec Chrystal is the National Westminster Bank Professor of
Personal Finance at City University, London. Cletus C.
Coughlin is a research officer at the Federal Reserve Bank of
St. Louis. Kevin White provided research assistance.

H ow The 1993 Legislation
W ill Affect European Financial

(EC) was created by the Treaty of Rome of
1957. Its intention was to create an integrated
"Common Market” within which goods, services,
labor and capital would move freely. In its early
years, the implementation o f the Treaty of Rome
focused on eliminating tariff barriers on trade
in goods between the member countries. Barriers
affecting capital movements and trade in serv­
ices were neglected, while those affecting labor
mobility, such as lack of recognition of profes­
sional qualifications across member countries,
were greatly reduced but not eliminated.

that pertain directly to banking and other finan­
cial services.2

A major initiative to eliminate all remaining
barriers to intra-EC trade began in 1985. This is
referred to as the "single market program” or
"1992,” its target date for completion (in reality,
the end of 1992).1 The legislation underlying the
single market program affects virtually every
product area. This paper examines one key por­
tion of the legislation: the regulatory changes

The commitment to eliminate the remaining
EC trade barriers was formalized in the Single
European Act (SEA), which was signed in 1985
and came into force on July 1, 1987. (See the
shaded insert on pages 64-65 for additional high­
lights on EC history and a description of institu­
tions and legislative instruments.) The SEA
defines both the goal—"an area without internal

•For a recent overview of 1992, see Boucher (1991).
2Grilli (1989b) summarizes the numerous restrictions affecting international trade and investment transactions in the
financial services sector, both in the EC and in other deve­
loped countries.

Federal Reserve Bank of St. Louis

In 1985, this sector accounted for 6.4 percent
o f total output and 2.9 percent o f employment.3
Since the sector provides services for other sec­
tors, the integration of EC financial markets will
affect efficiency not only within the financial
services sector, but also in sectors using finan­
cial markets.


3See Emerson et al. (1988) for additional details on the
economic dimensions of the financial services sector,


frontiers in which the free movement o f goods,
persons, services and capital is ensured”—and
the target date—the end of 1992. It also incorpo­
rates reforms to speed up decision-making within
the EC by establishing "qualified majority voting”
to decide most issues o f the reform process.4
In 1985, the EC Commission produced a White
Paper entitled "Completing the Internal Market.”
It listed numerous measures thought to be neces­
sary for the completion of the program, many
of which have not yet been adopted.5 Because
o f the large number of required measures, all
barriers cannot be eliminated at once.6

Before the 1980s, no systematic attempts had
been made to reduce trade barriers in financial
services. Although services had been addressed
when the EC was formed in 1957, the implemen­
tation of intra-EC free trade in services had
been neglected. Moreover, trade in financial
services had not been covered by multilateral
negotiations under the General Agreement on
Tariffs and Trade (GATT). (This may change in
the current Uruguay Round of negotiations.)

The large number of proposals and the time
necessary to consider a given proposal contrib­
ute to 1992 being a process rather than an
event. Each directive must go through a com­
plex process of discussion, first within the Com­
mission and then in the Council of Ministers.
Member state governments must be informed at
each stage because they wish to consult with
the domestic parties that will be affected. Parlia­
ments of member states, as well as the Europe­
an Parliament, also comment on each proposal.
Finally, each agreement has to be ratified and
reflected in the legislation of each member state.

More important, many countries maintained
exchange controls for capital account transac­
tions long beyond when they liberalized current
account transactions.7 Without a free flow of
financial capital to balance the flows o f goods
between countries, "free” trade is constrained
by capital controls. That is, financial services,
which include a range o f banking, investment
and insurance services, cannot be freely provid­
ed across borders if access to foreign exchange
is restricted.

A typical EC directive could take three years
from first draft to Council ratification, with
another two years or so for full implementation.
Only measures close to adoption in early 1992
(or already adopted) will be implemented by the
end of 1992; and measures not yet drafted will
not be implemented before the mid-1990s.

Thus, an important step before removing
specific restrictions on cross-border trade in
financial services is to remove all exchange con­
trols. Such a step was provided for by the Coun­
cil Directive of June 24, 1988—The Capital
Liberalization Directive—which removes con­
trols on all capital flows within the EC and, for

4Key (1989) notes that under qualified majority voting, the
number of votes of each member is weighted roughly ac­
cording to its population. To adopt legislation, 54 votes out
of a total of 76 are required.
5According to Hill (1991), as of December 1991, 65 of the
282 measures outlined in the White Paper remained to be
adopted. A goal of the EC Commission was to have all
measures adopted by year-end 1991 to allow member na­
tions to convert the directives into national legislation.
Problems with the directives are also occurring at the na­
tional level. For example, Italy has converted only half of
the relevant directives into national law.
6Capie and Wood (1990) stress that gradual deregulation of
the financial system is unlikely to cause instability. The
history of deregulation, they note, reveals that only rapid
changes in regulation threaten the stability of the financial
A ccording to Bannock et al. (1972), exchange controls are
government policies that attempt to control the purchases
and sales of foreign currencies undertaken by the resi­
dents of a specific country. For example, the Exchange
Control Act of 1947 restricted the purposes for which for­
eign currencies could be bought by British residents and
limited the use and retention of foreign currencies and
gold they acquired.



An O verview of the European Community
The European Community (EC) is a group­
ing o f 12 member states.1 These are the origi­
nal six signatories of the Treaty of Rome in
1957—France, Italy, Belgium, Luxembourg,
the Netherlands and West Germany—plus six
countries that joined later—Denmark (1973),
Ireland (1973), the United Kingdom (1973),
Greece (1981), Portugal (1986) and Spain
(1986). Further expansion of the EC to in­
clude Austria and Sweden, as well as other
countries, is a strong possibility. Key dates
and events in the history of the EC, including
the recent Maastricht Summit Accords on
monetary and political union, are provided in
the accompanying table.

E C Institutions
There are four major EC institutions. The
C om m ission is the civil service of the EC. It is
divided into 23 functional areas (Directorates
General). There are 17 commissioners who
are responsible for managing these areas.
The Commission proposes new laws and poli­
cies and is responsible for implementing deci­
sions made by the Council.
The Council is the ultimate decision-making
authority. It is a committee whose members
represent their own national governments.
The Council makes final policy decisions
based on Commission proposals. Participants
at Council meetings vary according to subject
matter. For example, if the topic is finance,
then the finance ministers of the 12 member
nations attend. If the topic involves the exter­
nal relations of the EC, then foreign ministers
attend. Council meetings involving heads of
state occur twice a year. The chairmanship
of the Council rotates among member states
in alphabetical order for six-month periods.
In some areas, such as for most labor and
taxation questions, unanimity is required; for
most single market issues, however, "qualified
majority voting” is used.
The E u ropean P arliam ent is a chamber of
elected representatives from all member
states. It offers opinions on most European

1For more details on the EC, see Rosenberg (1991).

Federal Reserve Bank of St. Louis

legislation but it has no formal legislative
The E u ropean Court o f Ju stice is a body of
13 judges, including at least one from each
member country. The Court rules on applica­
tions and interpretation of EC laws. Judgments
o f the Court are binding on each member state.

Legislative Instruments
There are four main legislative instruments.
To become effective, legislation generally
must be "adopted” by the Council. In some
circumstances, however, the Commission may
make laws itself. Typically, this will involve
legislation that is required to implement
previous Council decisions.
One instrument is regulations, which are le­
gally binding on all member states whether
or not ratified by national parliaments. If a
regulation conflicts with national law, the
regulation dominates. A second instrument is
directives, which are legally binding only as
to their ultimate effect; it is up to member
states to decide how to implement the rules
in their own national legislation. Virtually all
of the 1992 program is being implemented by
directives. D ecisions are the third instrument.
Decisions, which are more narrowly focused
than directives, are legally binding on all
those to whom they are directed. All deci­
sions with financial implications are enforcea­
ble in courts of member states. Finally,
recom m en d ation s (or opinions) have no legal
support but merely state a view about some
desirable condition or policy change.
EC legislation normally is subjected to a
lengthy process of consultation and discus­
sion before it is adopted by the Council. The
"right of initiative” lies with the Commission.
Once the Commission has drafted a proposal,
there are consultations with all affected par­
ties both directly and via the relevant minis­
tries o f member states. The European
Parliament also has the right to be consulted
and is given the opportunity to propose


Major Post-War Steps Towards European Integration

Customs Union formed between Belgium, Netherlands and Luxembourg - "Benelux” .


Organization for European Economic Cooperation (OEEC) formed to administer U.S.
aid for rebuilding post-war Europe.


France, West Germany, Italy and Benelux form European Coal and Steel Community
(ECSC) providing for a “ Common Market” in these products.


Treaties of Rome establish the six-member (Belgium, France, Italy, Luxembourg,
Netherlands and West Germany) European Economic Community (EC) and the Europe­
an Atomic Energy Community (Euratom).


European Free Trade Association (EFTA) formed to promote free trade between nonEC Western European countries - Austria, Britain, Denmark, Finland, Iceland, Norway,
Portugal, Sweden and Switzerland.


Common Agriculture Policy (CAP) started.


Britain’s application to join EC vetoed by President de Gaulle.


France boycotts EC in protest at excessive speed of integration moves.


Customs union completed.


“ Werner Report” calls for Economic and Monetary Union within Europe - including a
single currency.


European exchange rate “ Snake” arrangement formed, but the United Kingdom
leaves the Snake after six weeks.


United Kingdom, Denmark and Ireland join the EC.


European Monetary System (EMS) formed - establishing the Exchange Rate Mechan­
ism (ERM) and the European Currency Unit (ECU). Britain joins EMS but not ERM.


First direct elections to European Parliament.


Greece joins EC.


Common Fisheries Policy established.


White Paper on completing the internal market published.


Spain and Portugal join EC.


Single European Act comes into force.


Delors Report calls for Economic and Monetary Union - including a single currency.
Undertakings for Collective Investment in Transferable Securities took effect.


United Kingdom joins ERM and Capital Liberalization Directive and Second Non-life In­
surance Directive took effect.


Maastricht Summit Accords on monetary and political union. The third and final stage
of Economic and Monetary Union will begin by January 1, 1999. A single European
currency will begin by this date (possibly as early as January 1, 1997). An independent
European Central Bank will be set up six months before the single currency.


Second Coordinating Bank Directive, Own Funds Directive, Solvency Ratio Directive
and Second Life Insurance Directive take effect. Council Directive on Investment Serv­
ices in the Securities Field and the Capital Adequacy Directive likely take effect.

The enforcement o f EC laws is the respon­
sibility of the Commission. W here breaches of
EC laws are suspected, the Commission may
issue a formal letter of notice to the govern­

ments of member states. Where this proce­
dure proves insufficient, the Commission may
refer the issue to the European Court of



the most part, on capital flows between an EC
member and a non-member. For most member
states, this directive was to apply from July 1,
1990.8 The deadline has been met, though several
countries, like the United Kingdom, Germany,
the Netherlands and Denmark, had eliminated
explicit controls before 1988.9
Various approaches have been used to quanti­
fy the integration o f international financial mar­
kets. One way to see the effects of the relaxation
of capital controls is to examine interest rates
on comparable financial instruments in different
countries that are denominated in the same cur­
rency. The elimination of capital controls should
allow capital flows to equalize these interest
rates.1 This is exactly what has happened in
the EC countries that have already eliminated
capital controls. Figure 1 presents evidence for
the United Kingdom, which abolished exchange
controls as of October 24, 1979, and undertook
a series of domestic liberalization measures in
the 1980s. The U.K.’s deregulation has caused
the Eurosterling-London Interbank Offer Rate
(LIBOR) spread to collapse near zero.1 Similar
evidence exists for other EC countries that have
This evidence suggests that most of the effects
of liberalizing capital flows for some, but not
all, countries have already been realized, rein­
forcing the point that 1992 is a series o f changes.
There are, however, additional gains possible
from the 1992 process. One is that 1992 will
make it less costly for financial firms from one
member country to be authorized to provide
services in other EC countries. New financial
services, as well as lower prices for existing
services, might also occur. Before discussing
these potential gains, we will summarize the
major directives that pertain directly to financial

8lreland, Spain, Greece and Portugal have until the end of
1992 to comply, with the latter two having the option to de­
lay compliance until 1995.
9According to Blundell-Wignall and Browne (1991), the in­
tegration of financial markets internationally began in the
mid-1970s with the removal of capital controls in Germany,
the United States and Canada. Japan and the United
Kingdom relaxed capital controls in the late 1970s, while
France, Italy and some other EC countries realized the
complete elimination of controls by the middle of 1990.
10This result is analogous to the effect of eliminating trade
barriers on goods. When a country eliminates a tariff on a
specific good, the difference between the price of the good
in the country’s domestic market and that in the interna­
tional market should narrow.


The major directives of the 1992 program for
financial services can be divided into four cate­
gories: banking, investment services, undertak­
ings for collective investments and insurance.1
B a n k i n g . Efforts at EC coordination did not be­
gin with the Single European Act for any of the
four categories of financial services. Rather, the
SEA has accelerated the process of harmonizing
regulations. For example, the First Banking
Coordination Directive, which was approved by
the Council in December 1977, required mem­
ber states to establish systems for authorizing
and supervising credit institutions.1
A second example is the Consolidation Super­
vision Directive of June 1983, which required
that credit institutions be supervised on a con­
solidated basis. Any credit institution owning 25
percent or more of the capital o f another finan­
cial institution was to be supervised on a con­
solidated basis by the authorities in the owning
institution’s home state. Another provision man­
dated the exchange o f information between su­
pervising authorities to obtain an overview of a
consolidated company’s affairs. To assist this su­
pervisory cooperation, the Bank Accounts Direc­
tive of December 1986 harmonized accounting
rules for credit institutions.
In the 1992 legislation, the Second Coordinat­
ing Banking Directive (2BD) is the primary bank­
ing directive. The 2BD allows any credit institu­
tion authorized in one member country to es­
tablish branches and provide banking services
anywhere in the EC. While this so-called "com­
mon passport" allows home-country authoriza­
tion, the credit institution must conform to all
local laws. Thus, the host country's business
rules, such as reporting requirements and res-

"T h e two interest rates are ones charged by banks to other
banks for three-month loans denominated in British
pounds. The Eurosterling rate pertains to loans made out­
side the United Kingdom and the LIBOR applies to loans
made inside the United Kingdom.
,2See Blundell-Wignall and Browne (1991) for charts similar
to figure 1 for Germany, the Netherlands and France.
13See U.K. Department of Trade and Industry (1991) for a
summary of EC Directives relating to 1992.
14We refer to credit institutions rather than “ banks” because
these regulations include institutions other than banks.
These would include the European equivalent of thrifts.



F igure 1

Difference Between the Three-Month Eurosterling and Libor Rates
P e rc e n t

M o n t h ly D a ta

trictions on permissible products and activities,
must be followed.
The 2BD also gives the commission some in­
fluence in authorizing institutions from outside
the EC—the so-called "Reciprocity Clause.” The
first, but not the final, draft of this clause created
much controversy and is partly responsible for
the label "fortress Europe” that has inappropri­
ately been associated with the 1992 program.
(See the shaded insert on page 68 for additional
discussion of this topic.)
The 2BD is supported by the Own Funds
Directive and the Solvency Ratio Directive. The
former provides common definitions for the
components of the capital base; the latter uses
these definitions to establish minimum asset ra­
tios to be met by all credit institutions. All three
directives become effective on January 1, 1993.

I n v e s t m e n t S e r v i c e s . A related, but more
problematic, set of measures deals with invest­
ment services. This category covers all aspects
of the markets in tradeable securities, including
investment banking, stock brokerage and the or­
ganization of the exchanges themselves. The key
elements of the 1992 program are formulated in
the Council Directive on Investment Services in
the Securities Field and the Capital Adequacy
Directive, neither of which has been adopted
Until recently, observers generally thought
both directives would begin operation at the
same time as the banking directives because the
2BD gives banks (and other credit institutions)
the right to do securities business throughout
the EC on a single passport basis. As time pass­
es, this simultaneity becomes less likely. If an
identical single passport is not extended to non-



The Second Banking Directive and
Fortress Europe
One o f the great concerns, often heard out­
side the EC, is that the 1992 program will
lower barriers to internal trade but at a cost
o f higher external trade barriers. The 1992
program does not introduce new barriers to
trade in goods between Europe and the rest
of the world. Nonetheless, a mistaken belief
persists that access to the EC market will be
harder after 1992.
This belief stems partly from the
"Reciprocity Clause” in early drafts of the Se­
cond Banking Directive. This required the
Commission to evaluate all applications for
new subsidiaries where the parent company
was based outside the EC. The Commission
would have had the power to delay approval
if the other country did not offer "m irror im­
age” reciprocity. Mirror image reciprocity
would have required that EC firms be al­
lowed to operate in foreign countries, just as
they could at home, before access would be
offered to nationals o f that country. This
would have been very restrictive. For exam­
ple, because there is no legal separation be­
tween investment banking and commercial
banking in the EC, it would have required
abolition of the Glass-Steagall Act in the United
States before U.S. banks could gain access to
the EC.
This requirement was weakened in later
drafts of the directive. The final directive
simply calls for negotiations with third coun­

'See Title III, Article 9, paragraph 4 of the 2BD. In offi­
cial documents, the 2BD is the “ Second Council Direc­
tive of 15 December 1989.”
2 See Title III, Article 9, paragraph 6 of the 2BD.

Federal Reserve Bank of St. Louis

tries (that is, countries outside the EC) in the
event that EC firms are denied "effective
market access.” The critical criterion now is
that EC firms should not be discriminated
against in third markets—they should be ac­
corded “national” treatment. “W henever it ap­
pears to the Commission . . . that EC credit
institutions in a third country do not receive
national treatment offering the same competi­
tive opportunities as are available to domestic
credit institutions and the conditions of effec­
tive market access are not fulfilled, the Com­
mission may initiate negotiations in order to
remedy the situation.”1
If negotiations about unfair treatment in a
non-EC country have been initiated, approval
o f EC market access by credit institutions from
that country may be delayed by up to three
months. After this time, the Council must de­
cide whether such delays should continue.
This procedure will not apply to any firm al­
ready authorized to trade in an EC country.
Finally, this intervention in the approval
process must not contravene “the Community’s
obligations under any international agree­
ments, bilateral or multilateral, governing the
taking-up and pursuit o f the business of
credit institutions.”2 The general structure of
the reciprocity clause in the Second Banking
Directive is expected to be copied for the
other major areas of financial services, in­
cluding investment services and insurance.


bank securities firms at the same time, they will
be at a disadvantage.
A key problem in formulating regulations in
investment services has been that the range of
activities covered is much more heterogeneous
than in the banking area.1 Arguments have
arisen about which activities to include and how
much capital should be required for different
lines o f business. Initial proposals, for example,
incorporated such high capital requirements
that some businesses objected strongly. Non­
bank securities houses argued that the require­
ments were so onerous, their business would be
driven outside their countries. Universal banks,
on the other hand, feared they would be at a
disadvantage if securities houses had lower re­
quirements than banks.1 The latest drafts of
the directives incorporate a compromise that ap­
pears acceptable to both camps. Banks will be
permitted to treat their securities business
separately and calculate capital requirements
under the investment services rules rather than
the banking rules.
Another point of controversy concerns the
provision o f compensation schemes for inves­
tors. A commission recommendation in 1986
suggested the establishment of compensation
schemes for depositors (that is, deposit insur­
ance) in credit institutions. In the wider area of
investment services, the position of compensa­
tion schemes is even less clear. Some countries,
like the United Kingdom since the implementa­
tion of the 1986 Financial Services Act, have
compulsory compensation schemes for invest­
ment business, while many others do not. This
position raises potential anomalies in crossborder business.
A final sticking point in the Investment Serv­
ices Directive relates to the monopoly of or­
ganized stock exchanges over securities trading.
Some countries, like France, have argued for
the official stock exchange to have a monopoly.
15Another reason for the relatively faster agreement on
banking is that bank regulation had already been well
worked out globally—through the Bank for International
Settlements and formalized in the Basle Agreement. The
1988 Basle Agreement replaced differing national regula­
tions for measuring capital adequacy by a single, interna­
tionally accepted standard. The goals were to strengthen
the soundness of the international banking system and re­
move regulatory differences that affected the international
competitiveness of banks. See Blanden (1988).
16Generally speaking, EC countries did not have counter­
parts to U.S. banking regulations that limited their spread
geographically or their lines of business activity. As a
result, a small number of large banks evolved. For exam­

Without a monopoly, the present French system
could not be used throughout the EC. Others,
especially the British, are strongly opposed.
U n d e r t a k in g s f o r C o l l e c t i v e I n v e s t m e n t s . In
contrast to the banking and investment services
directives, the directive governing Undertakings
for Collective Investment in Transferable Securi­
ties (UCITS), which are open-ended mutual funds,
has already come into effect. The Council Direc­
tive on the coordination o f laws relating to UCITS
took effect in October 1989. The directive estab­
lishes minimum requirements for authorization
of UCITS and permits their marketing through­
out the EC. This freedom is subject to the usual
proviso that the host state be notified and local
marketing rules be obeyed. Minimum require­
ments are established for adequate risk spread­
ing, the separation of trustees from managers
and the specification of acceptable investments.
Before it was implemented, there was some
concern that the UCITS Directive would lead to
a migration of UCITS managers to countries,
like Luxembourg and Ireland, with the most
favorable tax treatment. It is too early to deter­
mine whether this expectation is correct. To
counteract this possibility, however, efforts
were made to reduce tax differences. For exam­
ple, the British budget of 1989 reduced taxes on
unit trusts.
I n s u r a n c e . A final set of directives on financial
services deals with insurance. Insurance pro­
vides examples of 1992 initiatives already in ef­
fect as well as those many years away. The
primary directives are the Second Non-Life In­
surance Directive and the Second Life Insurance
The Second Non-Life Insurance Directive es­
tablishes freedom of services for cross-border
business within the EC. This freedom, however,
applies only for large commercial risks. What is
ple, German banking is dominated by a small number of
banks engaging in normal commercial banking as well as
buying and selling stocks for others, underwriting new
stock issues and owning stock on their own behalf. In fact,
German banks are represented on the boards of directors
of many companies. In the United Kingdom, merchant
banks specialized in the securities business, while com­
mercial banks had the bulk of deposits. Since the deregu­
lation of British financial markets that began on October
27, 1986, known as the Big Bang, U.K. commercial banks
have gone universal in that they have merchant bank sub­
sidiaries and are expanding into insurance services, espe­
cially life insurance. Belgium is the only EC country that
separates investment and commercial banking.



referred to as "mass risk,” which includes most
things insured by people other than their lives—
theft and fire damage to personal property—
remains subject to numerous restrictions. A
new, more liberal regime applies to all marine,
aviation and shipment risks, and other fire,
property and financial risks for situations in
which the policy holder is a large commercial
company. Here, the insurer has an obligation to
notify the authorities (in the insured company’s
country), but may write the business directly.
For all other businesses, the authorities in each
country may continue to control the terms of
authorization, premiums, policy conditions and
reserve assets.
This Directive took effect in July 1990 and,
hence, the large commercial risk market has ef­
fectively achieved the single market position al­
ready. Unlike banking, this directive did not
create a common passport. Thus, branching in
other countries is not freely permitted, and es­
tablishment still requires authorization in each
member state. Two draft "Framework Direc­
tives” for life and non-life insurance appeared in
1991 and 1990, respectively. These would estab­
lish the single passport for insurance; the fact
that the first drafts o f these directives did not
emerge earlier, however, suggests that they will
not be in operation until 1995 at the earliest.
Only modest progress has been made on life
insurance so far. The Second Life Insurance
Directive was adopted in November 1990 for
implementation on May 21, 1993. It only goes a
small way, however, toward creating a single
market in life insurance. A liberal regime is
provided for, but only in cases where the con­
sumer takes the initiative in buying a life insur­
ance policy from a firm in another member
country. In all other cases, the restrictive re­
gime applies, under which the insurer may be
required to obtain special approval (depending
upon local law) and the policy terms may be
Under the most recent draft of legislation in­
volving life insurance, whose date of implemen­
tation has yet to be agreed upon, insurance com­
panies are permitted to advertise, but they may
not approach consumers directly. It also is pos­
sible that “local” asset backing for the policy

17For example, the U.K. Financial Services Act of 1986 re­
quires any firm selling investment products in the United
Kingdom to register with either the Securities and Invest­
ment Board or a recognized regulatory organization. The


may be required. This means that, for example,
an Italian firm selling insurance in Germany
would have to back its German policies with
German securities. This draft o f the legislation
also restricts the role of brokers. For three
years after implementation, member states will
be able to forbid consumers from seeking poli­
cies from other member states through brokers.
Considerable resistance exists in some quart­
ers to the creation of a genuine single market
in life insurance. The basic conflict arises be­
cause some countries—notably Germany—have
had a very conservative attitude to life insur­
ance, while others—like the United Kingdom—
have been very innovative. German insurance
companies have typically invested in safe fixedinterest securities, and innovation in the indus­
try has been strictly controlled. The United
Kingdom, in contrast, allows its firms to invest
across a range o f assets including property and
equities. Thus, the typical British firm’s portfolio
is riskier than its German counterpart, but has
a much higher average yield, producing signifi­
cantly lower prices for British products.

The Com m on Passport
Before discussing the reform process, an im­
portant distinction must be made between
wholesale and retail financial markets. As
demonstrated above, the globalization of inter­
national financial markets in the 1970s and 1980s
has already led to highly competitive wholesale
capital markets across many EC countries.
These markets, in which financial firms deal
directly with each other, experienced considera­
ble competitive pressures in the past 20 years.
Faced with the choice of deregulation or the
loss of firms to less-regulated environments in
other countries, most nations dismantled much
of the regulatory structure in wholesale finan­
cial markets.
Retail markets, in which consumers deal with
firms to borrow money, purchase insurance
and trade stock, are quite different and present
the biggest problem for deregulation. These
markets retain a myriad of complex regulatory
structures and external barriers that are gener­
ally justified on the grounds that they protect
the small consumer.1 Regardless of whether

firm must conform to a complex set of rules, subject itself
to inspections and pay membership charges, which in­
clude investor compensation schemes.


domestic officials actually believe this or are
simply disguising their protection of domestic
firms, the abolition o f regulations to increase
cross-border trade and competition in retail
financial markets is the primary challenge of
the 1992 program.
Starting with the existing regulatory struc­
tures in each member country, the central prin­
ciple guiding deregulation is that regulators in
each member state are competent to judge which
firms are "fit and proper” to do business in the
industry. Once a firm has been authorized by
the regulatory authority in its home cou n tryso-called home authorization—it is automatically
authorized to do business in any other member
country and is said to have a "common passport.”
Previously, many countries have allowed firms
from other EC countries freedom of establish­
ment, but this freedom has been subject to a
separate process of approval in each country.1
The abolition of this requirement, therefore,
will make it easier for firms to establish subsidi­
aries in other member countries.
Home authorization, however, is not the end
of the story. Firms operating outside their home
states still have to obey “host country conduct
of business rules.”1 In other words, foreign
firms must obey all the local regulations about
the nature o f acceptable products and the way
in which they may be advertised and sold. For
example, France does not allow interest pay­
ments on checking deposits, while most other
EC countries do.
The fact that business rules will continue to
differ across countries limits the extent to
which there will be a genuine single market.
The various rules increase the costs of crossborder activity and are sometimes even anti­
competitive. For example, the business rules in
some member states define which products can
be sold and their respective prices. Thus, one of

For example, Emerson et al. (1988) note that each EC
country allows freedom of establishment for foreign banks;
however, the conditions under which this may be done
vary substantially across countries. High establishment
costs make it difficult for a foreign bank to enter and com­
pete successfully with an existing domestic retail bank. Ad­
ditional obstacles in certain countries, like Italy and Spain,
are restrictions on foreign acquisitions and involvement
with domestic banks.
19For an alternative interpretation of the implications of
home authorization in the context of the 2BD, see Key
(1989). In our view, home authorization aplies to the issue
of a license and prudential control, but it does not apply to

the main incentives for attempting to enter new
markets—the introduction of new products not
offered by local firms—is not guaranteed.

Regulatory Complications f r o m
the Com m on Passport
The move to a common passport will compli­
cate the regulatory process.2 At this point, only
hypothetical situations can be offered to suggest
the potential difficulties. While firms require
authorization only in their home states, the regu­
latory authorities of other nations have to moni­
tor the activity of these firms within their do­
main because they are responsible for consumer
protection and adherence to business rules.
To illustrate, suppose a German bank estab­
lishes a subsidiary in the United Kingdom after
1992 on the basis of its German banking license.
It takes deposits and makes loans in British
pounds sterling. As the German banking authori­
ties are responsible for prudential supervision,
the bank must file the reports required by
these authorities. The bank, however, must also
register with the Bank of England, fulfill all
reporting requirements and conform to all Brit­
ish banking regulations in the United K ingdom including reserve requirements and banking
codes o f practice. It must also pay regulatory
fees just as any British bank must do.
The lower costs of establishing an office in
the United Kingdom may increase the regulato­
ry burden of both the British and German
authorities. Suppose, for example, the German
bank gets into difficulties, like a run on deposits,
or is involved in a breach of rules, like fraud.
Clearly, both British and German authorities will
have to get involved to resolve the problem. In­
deed, a bank with branches (or subsidiaries)
across Europe could draw 12 sets of regulators
into a dispute over its operations. The number
o f regulators would rise even further if the

any behavior that falls under conduct of business rules.
Home authorization is much different than home control.
Even though a bank is given a license to operate abroad
by its home authorities, the bank’s subsidiaries will have
to obey all the laws attached to banking practice in the
foreign countries in which they operate.
20Capie and Wood (1990) make a similar point that the Se­
cond Banking Directive will make supervision and regula­
tion much more complicated. They speculate, however,
that this complexity may cause a change in regulation
from detailed supervision to one in which central banks
are primarily lenders of last resort.



Table 1
Deposit Insurance in the EC1
(in U.S. dollars
as of July 6, 1990)

United Kingdom

in foreign

Deposits in
domestic branches
of foreign banks

in foreign

30% of bank’s
liable capital









SOURCE: Bartholomew and Vanderhoff (1991).
1Greece and Portugal have no formal systems of deposit insurance.

” indicates no information was available.

bank’s activities spread beyond banking into
securities or insurance.
It is also noteworthy that the British authori­
ties have no power to withdraw the banking
license if the bank transgresses business rules
in the United Kingdom. Even though the Bank
of England could stop a bank from trading tem­
porarily, a high degree of communication and
cooperation between regulators of the member
countries will be required to manage such a
problem. Eventually, there might be a formal
regulatory agency that operates on a
community-wide basis.
The preceding example, which pertains to all
member countries, is relatively simple in com­
parison to the regulatory issues that might arise
when services are provided across national
borders. Suppose the German bank takes de­
posits and makes loans in sterling with retail
customers in the United Kingdom only by mail
or telephone from its head office in Frankfurt.
In this case, the German bank need not register
with the Bank o f England, but has an obligation
to conform to British conduct of business rules.
This means that the Bank of England must mo­
nitor this business in some way. While cases
like this may be of trivial quantitative significance
(especially in retail trade), they also may gener­
ate the greatest regulatory headaches, in terms


of allocating regulatory responsibilities for the
monitoring and enforcement o f standards of
business practice.
Such jurisdictional problems may be greatest
where deposit insurance is involved. Table 1
summarizes the deposit protection schemes for
commercial banks in the EC. The amount of
protection for depositors varies substantially
across countries. This may influence where a
specific deposit may be made. The high level of
protection in Italy could attract large depositors.
By the same token, the different levels of pro­
tection may confuse depositors. A Spanish depo­
sitor, who made a deposit in a French branch in
Spain that fails, for example, may mistakenly be­
lieve that the French deposit insurance scheme
applies. Since deposit insurance is politically sen­
sitive, controversy is not difficult to envision.
The EC Commission has drafted a proposal, not
yet published, for the harmonization of deposit
insurance, but any changes are unlikely to take
effect before the mid-1990s.
The almost complete harmonization of regula­
tory standards is inevitable when transactions
within an industry are predominantly of an in­
ternational nature. By itself, however, 1992 is
unlikely to make the transactions in European
retail financial markets to be primarily interna­
tional. Thus, the regulation of retail financial


markets in Europe involves a compromise be­
tween host country control and the creation of
a single market. Harmonization of business
rules will not be complete and, in some cases,
may not be even close.

Product Innovation
The potential gains from removing barriers to
the spread o f new products across borders
seem to be positive and potentially quite large.
Lower-cost producers of financial services prod­
ucts would prosper at the expense of less effi­
cient firms that now survive only because of
regulations that limit competition by foreign
firms. Consumers would benefit from having a
greater variety of products from which to choose
and would pay lower prices for them.
The basic problem is the resistance by some
countries to relaxing domestic regulation o f an
industry. Frequently, a country’s business rules
inhibit product innovation. For example, current
German regulations restrict the introduction of
new insurance products into Germany. Even
with a common passport, a foreign insurance
firm faces a major deterrent to entering the
German market. Taken together, German citizens
and foreign insurance firms clearly would benefit
from free trade in new products, but it is also
clear that some German insurance companies
would suffer from the influx of competition.
This is the area where the least progress has
been made in the 1992 program. In view of the
time required to reach and implement EC deci­
sions, as well as the current controversy about
these decisions, the potentially large gains from
product innovation and lower prices in many
financial services will not be realized any time
in the near future.

The preceding discussion raises doubts about
how sizable the gains will be from the 1992
legislation in the financial services sector;
however, we do not provide an estimate of the

21To reiterate, we are not questioning the gains from the
abolition of exchange controls; rather, we are questioning
the gains from the common passport in light of the con­
tinuation of different conduct of business rules.
22ln theory, the abolition of trade barriers for goods traded
among a group of countries may or may not yield net
benefits. An elementary demonstration of this result can
be found in Coughlin (1990).

gains themselves.2 These doubts are at odds
with the potential gains estimated in the Cecchini Report, the best-known attempt to measure
such gains.2 This report found substantial
potential gains from the creation of a single
market in many industries.2 The gains from the
liberalization of the financial services sector,
which are presented and examined below, were
found to be substantial as well.

Financial Services: The Estimated
Gains o f Eliminating Trade
The reduction of trade barriers can generate
gains via a number o f routes, all of which are
driven by increased competitive pressures. For
example, the reduction of trade barriers will al­
low firms with lower production costs to ex­
pand their production, increasing total output
and economic welfare. Other gains can be real­
ized as larger markets increase the opportuni­
ties to use certain production technologies that
lower per-unit production costs. Finally, in­
creased competition tends to drive down profit
margins, eliminate waste and stimulate the de­
velopment of new products and less costly
methods to produce existing products. Ultimate­
ly, the competitive pressures will allow con­
sumers throughout the EC to consume (use)
more financial services at lower prices per unit.
The competitive pressures resulting from 1992
are expected to narrow the price differences of
a financial service across the EC. As part of the
Cecchini Report, Price Waterhouse calculated
prices across eight EC countries for the 16
financial services—seven banking services, five
insurance services and four securities services—
listed in table 2. The average o f the four lowest
prices for each service was chosen as the likely
price after the elimination of trade barriers.
The potential price declines for financial serv­
ices are listed in table 3. Exactly how much of
this potential decline will be realized is difficult
to estimate, so an expected decline (with a
plus/minus 5 percentage-point range) was de­
fined as one-half of the potential decline.

23The Cecchini Report estimates that the gains from com­
pleting the internal market range from 4.3 percent to 6.4
percent of gross domestic product in the EC. See Cough­
lin (1991) for an examination of the approach used in the
Cecchini Report as well as other approaches used to esti­
mate the economic effects of 1992.



Table 2
List of Standard Financial Services or Products Surveyed
Name of standard service

Description of standard service

Banking services

1. Consumer credit

2. Credit cards
3. Mortgages
4. Letters of credit
5. Foreign exchange drafts
6. Travellers checks
7. Commercial loans

Annual cost of consumer loan of 500 ECU. Excess in­
terest rate over money market rates.
Annual cost assuming 500 ECU debit. Excess interest
rate over money market rates.
Annual cost of home loan of 25,000 ECU. Excess in­
terest rate over money market rates.
Cost of letter of credit of 50,000 ECU for three
Cost to a large commercial client to purchase a com­
mercial draft for 30,000 ECU.
Cost for a private consumer to purchase 500 ECU
worth of travellers checks.
Annual cost (including commissions and charges) to a
medium-sized firm of a commercial loan of 250,000

Insurance services

1. Life insurance

Average annual cost of term (life) insurance.

2. Home insurance

Annual cost of fire and theft coverage for house
valued at 70,000 ECU with 28,000 ECU contents.
Annual cost of comprehensive insurance, 1.6 liter car,
driver 10 years experience, no-claims bonus.
Annual coverage for premises valued at 387,240 ECU
and stock at 232,344 ECU.
Annual premium for engineering company with 20 em­
ployees and annual turnover of 1.29 million ECU.

3. Motor insurance
4. Commercial fire and theft
5. Public liability coverage

Brokerage services

1. Private equity transactions

Commission costs of cash bargain of 1,440 ECU.

2. Private gilt transactions

Commission costs of cash bargain of 14,000 ECU.

3. Institutional equity transactions

Commission costs of cash bargain of 288,000 ECU.

4. Institutional gilt transactions

Commission costs of cash bargain of 7.2 million ECU.

SOURCE: Emerson et al. (1988), p. 102.

Using the expected price declines for financial
services, the gains for the eight EC countries ex­
amined are estimated to be 21.6 billion ECU,
which is 0.7 percent of their gross domestic
product.2 The distribution o f these gains across
the EC are listed in table 4. One's confidence in
these estimates, as acknowledged in Emerson et
al. (1988), should not be great. First, the price
comparisons themselves can be questioned.
Products such as “credit” and “life insurance”

More important, even if price differences exist
for identical products, it is far from clear that
the 1992 legislation will eliminate such differ-

24The ECU, which stands for the European Currency Unit, is
composed of the weighted averages of the currencies of
the 12 member countries and is the unit of account for the
EC. Even though much negotiation remains, the ECU is

likely to become the single currency of the EC. For a brief
history of the ECU, especially recent developments, see
Tyley (1991). One ECU was equal to $1.29 on February
11, 1992.

Federal Reserve Bank of St. Louis

have been priced as if the characteristics are
the same in each country. For example, no at­
tempt has been made to adjust for theft and
mortality differences across countries, and,
hence, it is not clear that homogeneous
products are compared.


Table 3
Potential and Expected Price Declines
for Financial Services
United Kingdom

price fall

Table 4
Estimated Gains Resulting from the
Expected Price Reductions for
Financial Services

Range of
expected fall

SOURCE: Emerson et al. (1988), p. 104.

ences. The reason is that business rules will
continue to differ from country to country,
thereby impeding trade in financial services and
limiting potential gains to levels below those es­
timated in the table.2 Thus, the value of the
single passport is diminished considerably by
the inability of firms entering new markets to
offer a full line of products and services.
Grilli (1989a) has also raised doubts about the
estimates in the Cecchini Report on the likely
effects of liberalization on wholesale and retail
banking throughout the EC. Grilli doubts whether
a perfectly competitive market structure is an
accurate approximation of retail banking
post-1992. Much evidence suggests that banks
have market power in their retail markets that
will not be eliminated by the 1992 legislation.
For example, within the same country, which is
already a homogeneous regulatory and institu­
tional environment, the terms o f a deposit con­
tract, such as the interest rate paid on a time
deposit, frequently vary across banks. In addi­
tion, the transaction costs of switching between
domestic and foreign bank accounts will remain
after 1992, and a business relationship with a
local bank will remain less complicated than
with a foreign bank. Furthermore, Grilli argues,
25Evidence that supports this view was highlighted by Grilli
(1989b). For individual financial services, he noted that the
price dispersion across countries that had already liberal­
ized, like Germany, Belgium, Luxembourg, the Nether­
lands and the United Kingdom, was no less than across
the remaining EC members.

(million ECU)

United Kingdom


of GDP

SOURCE: Emerson et al. (1988), p. 106.

the use of other, more appropriate market struc­
tures produces smaller estimated gains from
1992 than those based on perfect competition.
The bottom line is that the estimates in the
Cecchini Report are probably optimistic. Of
course, the absence o f better estimates precludes
any quantitative statements about the degree of

Single Currency
The preceding discussion, including the esti­
mates in the Cecchini Report, has presumed
that 12 currencies continue to exist within the
EC, albeit tied together by the exchange rate
target zones of the European Monetary System
(EMS). Thus, far from there being a single mar­
ket in financial services, there will continue to
be 12 quite separate markets at the retail level.
Within those markets, firms will operate separa­
ble portfolios and most retail customers will
stick almost exclusively to their domestic en­
The creation o f a single currency, which was
agreed upon at Maastricht, the Netherlands, in
deposit and loan book in each currency. For example, a
Dutch bank with a subsidiary in Greece will use drachma
deposits rather than guilder deposits to fund drachma

26Separable portfolios means that a bank with subsidiaries
in more than one member state will operate a matched



December 1991 will induce major changes, ir­
respective of the regulatory regime.2 Obviously,
the foreign exchange market—and with it the
costs of currency conversion—among the EC
members will be eliminated. Closely related is
the fact that the international accounting of
many businesses will be simplified by the elimi­
nation of multiple currencies. On the other
hand, many contracts will have to be rewritten.
For example, a long-term bond contract that re­
quires interest and principal payments in a
specific currency, say French francs, will have
to be modified.
Generally, retail customers will continue to do
business with familiar institutions in their own
countries, while wholesale market arbitrage and
potential competition ensure that product prices
are brought closely into line throughout the EC.
These competitive pressures will lead to changes
in the regulatory structure so that the conduct
of business rules become more similar and, in
some cases, identical; otherwise, firms in some
countries will be at a competitive disadvantage
relative to firms in other countries.2 It is
difficult to predict exactly how business rules
will be harmonized for each financial service
and, thus, how extensive the potential gains
from a “free” single market will actually be. A
more homogeneous and unitary monitoring
mechanism is likely, although its full implica­
tions are equally hard to anticipate. Nonetheless,
the gains from a single market are more likely
to be realized if monetary union is achieved.

The goal of 1992 is to create a single Europe­
an market, a goal that encompasses the finan­
cial services sector. Our assessment is that the
1992 reforms are a small step toward the liber­
alization o f the financial services sector. Clearly,
1992 will contribute to the realization of some
gains, especially in countries that have previous­
ly resisted liberalization. Nonetheless, serious
doubts exist about how extensive the changes
will be in the near future and, thus, the magni­
tude of the gains to be realized overall. In reali­
27A recent issue of The Economist (“ The Deal is Done,”
1991) characterizes the Maastricht Treaty as important as
the Treaty of Rome because it lays the foundation for a
much closer union of countries via a single currency, a
common foreign and defense policy, common citizenship
and a parliament with power. A summary of the Maastricht
Treaty as it pertains to monetary union can be found in
“ Mapping the Road” (1991), page 5.

Federal Reserve Bank of St. Louis

ty, the 1992 legislation will not cause major
changes. The reason is that virtually all of the
potential efficiency gains in the financial serv­
ices sector can be (or have been) achieved
through the combination of the abolition of ex­
change controls and the freedom of foreign
firms to enter domestic markets. In fact, the
former was implemented in July 1990 (in all but
Spain, Portugal, Greece and Ireland).
The key innovation o f the 1992 legislation is
the split between home country authorization
and host country conduct o f business rules.
This dichotomy will create problems. Whereas
wholesale markets already are highly integrated,
not just within Europe but at the global level,
12 quite different retail markets will continue to
exist in the near future. This segmentation means
that many existing regulatory burdens will re­
main; however, regulatory complications may
multiply as numerous domestic and EC authori­
ties become involved in the supervision of a sin­
gle firm. Finally, in some markets, like insurance,
rigid regulation of domestic markets will delay
any implementation o f the current model o f a
framework directive until well beyond 1992.
The greatest boost to financial market integra­
tion, once markets are open, will be the use of
a single currency. With a single currency, pres­
sure will mount to revise the regulatory struc­
ture so that the conduct of business rules are
Major changes in the regulatory structure lie
ahead. It is these changes that will create a sin­
gle market and allow for the realization o f sub­
stantial gains in the next century.

Bannock, Graham, Ron Baxter, and R. Rees. A Dictionary of
Economics (Penguin Books, 1972).
Bartholomew, Philip F., and Vicki A. Vanderhoff. “ Foreign
Deposit Insurance Systems: A Comparison,” Consumer
Finance Law: Quarterly Report Vol. 45 (1991), pp. 243-48.
Blanden, Michael. “ Ironing Out Those Troublesome Bumps,”
The Banker (February 1988), pp. 56-59.

28Not surprisingly, the U.S. legal system has had considera­
ble experience with conflicting laws and regulations across
states. The Uniform Commercial Code is an excellent ex­
ample of states reaching general agreement on numerous
laws. See Levine (1976) for additional details.


Blundell-Wignall, Adrian, and Frank Browne. “ Increasing
Financial Market Integration, Real Exchange Rates and
Macroeconomic Adjustment,” OECD Department of Eco­
nomics and Statistics Working Paper No. 96, 1991.
Boucher, Janice L. “ Europe 1992: A Closer Look,” Federal
Reserve Bank of Atlanta Economic Review (July/August
1991), pp. 23-38.
Capie, Forrest H., and Geoffrey E. Wood. “ Financial Struc­
ture in a Changing Regulatory Environment: Europe after
1992,” in Game Plans for the '90s (Federal Reserve Bank
of Chicago, 1990).
Coughlin, Cletus C. “ Estimating the Economic Effects of
1992,” 1991 International Trade and Finance Association
proceedings, forthcoming.
_______ . “ What Do Economic Models Tell Us About the Ef­
fects of the U.S.-Canada Free Trade Agreement,” this
Review (September/October 1990), pp. 40-58.
“ The Deal is Done,” The Economist (December 14, 1991), pp.
Emerson, Michael, Michel Aujean, Michel Catinat, Philippe
Goybet, and Alexis Jacquemin. The Economics of 1992
(Oxford University Press, 1988).

Grilli, Vittorio. “ Europe 1992: Issues and Prospects for the
Financial Markets,” Economic Policy (October 1989a), pp.
_______ . “ Financial Markets and 1992,” Brookings Papers
on Economic Activity (No. 2, 1989b), pp. 301-24.
Hill, Andrew. “ EC Leaders Reminded of Single Market Goal,”
Financial Times, December 9, 1991.
Key, Sydney J. “ Mutual Recognition: Integration of the Finan­
cial Sector in the European Community,” Federal Reserve
Bulletin (September 1989), pp. 591-609.
Levine, Mark Lee. Business and the Law (West Publishing,
“ Mapping the Road to Monetary Union.” Financial Times, De­
cember 12, 1991.
Rosenberg, Jerry M. The New Europe: An A to Z Compendi­
um on the European Community (Bureau of National Af­
fairs, 1991).
“ Second Council Directive of 15 December 1989,” Official
Journal of the European Communities, December 30, 1989.
Tyley, Robert T. "The ECU: A New Global Currency,” Inter­
national Economic Insights (July/August 1991), pp. 38-40.
U.K. Department of Trade and Industry. The Single Market:
Financial Services, March 1991.


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