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THE EVOLUTION OF OUR MONETARY SYSTEM:
Adaptation in a Changing Environment
Remarks by
G* William Miller
Chairman
Board of Governors of the Federal Reserve System
before the
Annual Dinner
Graduate School of Business
Columbia University
New York, New York
May 7 9 1979

For any American it would be a privilege to receive this
W. Averell Harriman award. For me, it is a particular honor. As
have Americans and people from throughout the world, I have long
admired Governor Harriman as a giant in his own time. His contributions have spanned the public and private sectors and stand
as a unique model for the total concept of service. Many shall
try, but few will be able to match his achievements.
Tonight, in recognizing the Harriman tradition, I would
like to discuss with you an issue that is crucial to the continued
success and growth of our economic system.

It is an issue that

has been brewing for some years, but is now becoming ripe for
decision. How we resolve this issue will determine whether our
financial system will continue to support the American economic
aspirations or whether it will stagnate and give way to some undefined and ineffective substitute.
Our financial system has shown great resiliency over the
past 200 years. It has adapted successfully to changing economic
conditions. Our nation has already faced a series of watershed
decisions in our financial history. We now face another: the
challenge of up-dating our financial system to adjust to the technological, social and market changes that have occurred in the
financial world over the last 30 years.
Simply put, the issues involve modernizing the nation's
central bank and its relationships to all our financial intermediaries, establishing competitive equality among financial institutions,
and assuring more effective tools for the conduct of monetary policy.




-2Like watershed decisions that were made in the past, the
choice today is between reconciling ourselves to new realities and
needs, or allowing the financial system to flounder in the status
quo.
Let me recall briefly four episodes in the evolution of
our monetary system when the choices that our nation faced were
similar in magnitude to the choice we face today. In each of these
cases, after major debates or minor ones, the resulting decision
was for constructive change. In our democratic and diverse society,
watershed decisions never come easily, and that is as true in 1979
as it was in past eras,
EARLY EXPERIMENTS
To recall those earlier milestones, we must start at the
beginning of U.S. history. The issue of the proper form and substance for a monetary system was at the core of one of the very
first major political controversies following the ratification of
the Constitution in 1789.
Secretary of the Treasury Alexander Hamilton advocated,
as necessary to the growth of American commerce, a strong central
bank to manage the government's money and to regulate the country's
credit. Secretary of State Thomas Jefferson was opposed, arguing
that the Constitution did not specifically empower Congress to create
a central bank. Hamilton responded that in order to carry out its
constitutionally enumerated monetary and fiscal powers, Congress




-3could create a central bank as "necessary and proper" to the exercise
of these responsibilities.
Hamilton prevailed, and the First Bank of the United States
was created in 1791. It was a nationwide bank, headquartered in
Philadelphia and run by 25 directors. The First Bank performed the
basic banking functions of accepting deposits and issuing bank notes,
and it supplied credit needed by business and government.
But the Bank's size and power made it unpopular with those
who opposed a centralized control over money. A bill to recharter
the Bank in 1811 failed by the margin of only a single vote. The
theme in this battle was one that would recur in banking history
up to the 20th century. Rural and urban values clashed, with the
result that the institutions needed for a commercial society -- a
common medium of exchange and a regulator of that medium — were
frequently greeted with hostility.
Indeed, a variation of that theme repeated itself when
Andrew Jackson in 1836 successfully blocked renewal of the charter
for the Second Bank of the United States, which had been established
after the War of 1812.
From 1836, through the next quarter century, America's
banking was carried on by a myriad of State-chartered banks with
no Federal regulation. In some areas of the country this system
functioned well, but in others banking was unstable, producing an
overall picture of difficulty for the American economy.




-4NATIONAL BACKING ACT OF 1863
Consequently, it should come as no surprise that a second
major watershed was crossed during the War between the States. At
the time, there were several thousand different bank notes circulating
in different sizes, shapes, and colors. The Federal government
found itself unable to market securities to finance the war.
In 1863, Congress responded by passing the National Banking
Act- Basically, the legislation provided for the creation of nationally chartered banks. And, by effectively taxing the State bank
notes out of existence, the legislation in reality provided that
only national banks could issue bank notes, these to be backed by
U.S. government securities. To the surprise of many who had opposed
and many who had supported the legislation, there was a particularly
noteworthy result: state-chartered banks were able to survive and
to prosper because the expanding use of checks was decreasing the
importance of bank notes, and demand deposits — checking accounts -became a source of bank funds. Indeed, under this new "dual" system
of banking the number of state-chartered banks increased. Perhaps
there's a lesson for us today.
PERSISTENT PROBLEMS
The National Banking Act strengthened the banking system
and created a national currency, but it did not provide the essentials of central banking. It did not provide a mechanism for regulating the flow of money and credit nor for assuring the security
of the nation's financial system.







-5During ensuing years, America's finances were strained by
two severe problems. First, the currency was inelastic. The national
bank notes grew or contracted in response not to the needs of American
enterprise but fluctuated according to the value of bonds held by
national banks. With such inelasticity in the currency, the economy
swung wildly between boom and bust.
The second problem was immobile reserves, resulting from
the structure established under the National Banking Act. There was
no easy way to expand reserves and reserves could not be shifted
easily to areas of the country where they were needed.
These weaknesses in the national banking system became
increasingly critical as the 20th century approached and America's
industrial economy grew and became more urbanized, while the banking
system stood still. The booms and busts increased in amplitude,
In 1893, a massive depression rocked the economy; money panics
ensued, and by 1908 it was only too clear that the banking system
was out of date and in need of major reforms. For 120 years,
America had been taking slow steps toward the creation of a central
monetary authority, but at each prior opportunity it had ultimately
backed away from the decision.
THE FEDERAL RESERVE ACT OF 1913
A third great milestone -- a watershed decision ~ was
creation of the Federal Reserve in 1913.

-6The period of debate over the Federal Reserve Act is
historically enlightening.

It illustrates a classic textbook case

of the fruits of skillful negotiation and compromise. The basic
questions were: how much monetary control, by whom, under what
kind of structure? Resolution among competing concepts required
legislative, administration and financial leaders of great stature,
good will and determination. And such leadership prevailed.
One issue that was not compromised was the principle of
an independent monetary authority. That principle was recognized
by Nelson Aldrich, Chairman of the preparatory National Monetary
Commission; Carter Glass, who steered the legislation as Chairman of the House Banking and Currency Committee; and President
Woodrow Wilson. They were aware of the need for integrity in the
conduct of the nation's finances, as well as the case for insulating
the central bank from political abuse. They knew the lessons of
history and responded wisely and well.
Essentially, the structure and the responsibilities of
the monetary authority -- the nationfs central bank -- as we know
it today were established in 1913. America was at last on the right
path toward a reasonably stable financial system, with many of the
problems of earlier periods resolved by this monumental reform.
America had at last begun to guide the inevitable evolution of its
financial system.
Before moving to our next historic watershed, let me call
attention to a few of the catchwords that are associated with the




Federal Reserve Act and those benefits that bankers and the nation
came to appreciate: safety and soundness; liquidity or mobility of
reserves; monetary control. These concepts should be kept in mind;
these are the yery principles that are in danger unless we adapt
to today's financial world.
THE GREAT DEPRESSION
Another great watershed for the U.S. monetary system came
during the Great Depression.
Congressional reaction to the cataclysmic events of 1929
and the early 1930's largely set in place the financial system that
we have today. The first priority of the Roosevelt Administration
was to ensure the integrity of the dollar. Therefore* the Banking
Acts of 1933 and 1935 contained measures to halt the rash of bank
failures and prevent their recurrence. Federal deposit insurance
was established. The Federal bank regulators were granted authority




to impose interest rate ceilings on time deposits. Payment of interest
on demand deposits was prohibited in order to prevent the destructive
interest rate competition that was widely believed to have led to
bank failures. A central credit facility for home financing institutions was established with the Federal Home Loan Bank Act of
1932. A system of Federally chartered and supervised savings and
loan associations was created in 1933, with Federal insurance provided
the next year.
Finally, the effectiveness and independence of the Federal
Reserve was improved. Many believed the decentralized policymaking

-8structure of the Federal Reserve System had hampered its ability to
deal with the financial crisis and the Great Depression. Hence,
legislation was enacted centralizing policymaking in an independent
Board of Governors. Independence of the Federal Reserve from the
executive branch was strengthened at the insistence of Senator Carter
Glass, who successfully urged that both the Secretary of the Treasury
and the Comptroller of the Currency be dropped as members of the
Board.
These landmark reforms of the 1930's -- deposit insurance,
interest rate regulation, specialized housing lenders, the Federal
Open Market Committee, and an independent Federal Reserve Board ~
are the dominant features of the financial landscape todciy*
THE POSTWAR YEARS
Recovery from the Depression was slow, and achieved fully
only with the onset of World War II. During the war years, independence of the Federal Reserve was subordinated to the war effort.
Federal Reserve independence from the Executive was reasserted in
1951, however, when the Treasury-Federal Reserve Accord freed the
Board from an obligation to support the government securities market
at unrealistic interest rates, In contrast to the Depression, the
1940!s and 1950's were years of relative financial tranquility.
However, pressures began to build in the economy at the
end of the 1950's and throughout the 1960's -- pressures which now







-9increasingly challenge the adequacy of the financial and regulatory
system in a rapidly changing world.
Banks began to be faced with new competition from other
types of financial institutions. Inflation accelerated.

Interest

rates became increasingly variable and reached new postwar highs at
the peak of each interest rate cycle. Disintermediation periodically
troubled financial institutions as investors chose to place funds
directly into money-market instruments instead of in deposits. Regulations which for years had not constrained banks now became excessively binding.
INNOVATION .IN.THE FINANCIAL SYSTEM
Increasingly private financial institutions reacted to
inflation, high interest rates, and increased competition in a
regulated environment through innovation. Banks began switching
to concentrating on liability management in addition to asset management in the late 1960's. New sources of funds were tapped by means
of negotiable CDs, first offered in 1961; Federal funds; repurchase
agreements; and Eurodollar borrowings. Banks began offering corporate customers "cash management" services, paying interest on
funds placed overnight in instruments that were exempt from Regulation Q interest rate ceilings.
COMPETITION AND MEMBERSHIP
As banks have sought to adjust to the inflation and high
interest rates of the 1970's, they have been faced with increased

-10competition that has eroded their previously unique charter for
providing transactions accounts.

Innovations have allowed thrifts

to offer customers third-party payments services and interest on
transactions balances. These have included the NOW accounts available at depository institutions in New England and New York, "billpayer" services and telephone transfers, credit union share drafts,
and remote service units allowing withdrawals from savings accounts
by electronic means.
Finding themselves in highly competitive markets with high
interest rates, non-earning monetary reserve balances, and consequent
pressures on earnings, many banks have reacted by withdrawing from
membership in the Federal Reserve System. The resultant shrinking
of deposits under central bank cognizance is of grave concern at a
time when more effective monetary control is essential to combat
the clear and present danger of virulent inflation. Consider the
trend:

in 1945, member banks held 86 per cent of banking deposits.

By 1970 this had dropped to 80 per cent. Now, in eight short years,
it has plummeted to just over 70 per cent.
THE PRESENT WATERSHED
These events and trends have brought our monetary system
to another critical juncture. The reformed system constructed in the
1930rs has served us well, but it has become increasingly outmoded
by technology and market-place innovations. Not only must we respond
to the changes of the 1960's and 1970 r s, but also we must take this







-11opportunity to perfect a monetary framework that can serve the needs
of our growing nation in the 19805s and the 1990's and into the 21st
century.
OBJECTIVES OF REFORM
In moving to modernize and strengthen our financial system,
there are several objectives which are of paramount importance.
First, the tools for monetary management must be improved.
Our present instruments are too blunt to cope adequately with the
battle against inflation which threatens our economic well-being.
The continuing and accelerating decline in basic deposits subject
to central bank reserve requirements has made implementation of
monetary policy more uncertain and hence mare difficult. It is not
that we need more reserves; indeed, less reserves, properly structured,
would suffice. But we do need a more certain fulcrum for our monetary
lever so that applied action will have a predictable result in the
growth or diminution of money and credit.
Second, there needs to be competitive equality among
financial institutions: Free and fair competition is at the heart
of our private enterprise system. The present structure places
member banks at a competitive disadvantage because of the burdens
of non-earning reserves. And there are other inequities that need
to be redressed.
Third, attention should be given to improvement in the
mechanism for assuring a sound payments system and appropriate financial
liquidity.

-12THE SEARCH FOR SOLUTIONS
The underlying issue is by no means new. The Congress,
the Federal Reserve, and the financial community have been wrestling
with it for some years. The House Banking Committee, under the
Chairmanship of Representative Reuss, has held extensive hearings.
A bill was reported out of the House Banking Committee in the last
Congress, and the Committee has been considering various legislative
proposals for most of this year. In the Senate, the Banking Committee
reported out related legislation in the 95th Congress and hearings
on more extensive proposals were held late in 1978 and early this
year.
In the meantime, the banking and thrift communities have
devoted extensive time and effort to the subject matter, and have
made valuable contributions toward focusing the issues and developing alternative solutions.
ELEMENTS OF A MONETARY IMPROVEMENT PROGRAM
While as yet a consensus has not emerged in favor of any
specific proposal, there has been tremendous progress in narrowing
divergent views. It seems to me that there is growing and widespread
accord among the affected constituencies in favor of a Monetary
Improvement Program that would encompass the following essential
points:




1, Maintaining the concept of voluntary membership in
the Federal Reserve, thus assuring a vigorous dual
banking system.




-132. Reducing substantially the amount of non-earning
reserves required to be deposited by member banks
with the Federal Reserve. Remaining reserve requirements should be uniform as to type of deposit — rather
than the present graduated system -- and should relate
mainly to transactions accounts and their equivalent.
This will reduce the financial burden of membership
while retaining appropriate reserve levels for monetary control.
3. At the same time, providing that all financial intermediaries shall maintain reserves with the Federal
Reserve with respect to their transactions accounts —
on the same basis as member banks. Such universal
reserves on deposits related to the basic money supply
will provide the fulcrum for effective monetary control
and will assure greater competitive equality among
depository institutions.
4.

Instituting a policy of explicit charges for most
Federal Reserve services -- rather than the present
system of providing such services without any specific
charges. Prices should be based on full costs and an
appropriate return on employed capital, with due
regard to competitive factors. This will contribute to more efficient payment and other services,

-14more opportunities for the private sector to provide
the services, yet assure that a safe clearance system
is always available.
5. Opening up access to borrowing from the Federal Reserve
discount window and access to Federal Reserve services
to all financial institutions subject to reserve requirements ~ non-members as well as members. This will
provide assurance of the liquidity necessary to keep
the financial system working smoothly in time of adjustment or stress.
This is not to overlook or to underestimate the difficulties
in gaining agreement on some important details. The exact reserve
ratios, the specific deposits to be covered, the form and location of
some part of the reserves, are some of the items to be settled.

But

if there is agreement on the need for modernization, the responsible
leadership should be able to deal with these matters.

OTHER PENDING ISSUES
There are other critical issues facing our financial system.
The present period of economic expansion, accompanied by high inflation and consequent high interest rates, has demonstrated anew the
dangers of financial disintermediation when deposit flows are hampered by unrealistic interest ceiling rates, and the threat to financial
institutions1 viability when market rates are paid for deposits while




-15interest rates on loans are limited by law. Moreover, consumers have
properly challenged as unfair a system of limiting interest rates on
savings accounts for small savers.
And5 recently a Federal Court of Appeals barred certain
deposit and financial services, effective next January 1, with an
express suggestion that the issues be addressed by Congress.
Thus, coincident or simultaneous with considering the
Monetary Improvement Program, the Congress may be dealing with two
other areas:
First, what if any additional powers should be extended to
thrift institutions ~ savings and loan associations, mutual savings
banks, and credit unions ~ to offer third-party payment accounts?
As a personal observation, it would seem to me worthwhile
to consider authorizing all depository institutions to offer NOW
accounts -- special savings accounts subject to negotiable orders
of withdrawal which are much like checks ~ for individuals, pro-




vided there was a uniform interest rate ceiling and uniform reserve
requirements.
Second, should the system of interest rate ceilings on
savings accounts and certificates dating back to 1966, and renewed
periodically since, be altered?
Again, as a personal note there would seem to be merit
in considering the phasing out of such ceilings over time « say,
five to ten years ~ coupled with modification or removal of usury
rate ceilings on mortgage loans and possible authorization of

-16variable rate mortgages. At the same time, it would seem appropriate
to provide thrift institutions with some expanded asset powers for
consumer lending.
CONCLUSION
So, at this particular watershed for our monetary and
financial systems, the agenda is extensive and challenging. Such
challenges often bring out the best.
The leaders who shaped the milestones of the past served
our country well. As a result, our system has been second to none
in its capacity to meet the needs of a growing and more complex
society.

It has contributed to attaining the highest standard of

living for the most number of people.
Now, we again turn to the leadership -- in Congress, in
the private sector, in Government -- to meet the challenge of change
and to forge a watershed decision with the same wisdom, vision and
devotion to the national interest that has characterized such decisions
in the past.
It seems to me that the democratic process is working -that the constituencies are responding — that the leadership is
shaping an historic decision.
It is timely. Economic issues are at the forefront. Our
\/ery security depends upon our economic strength — on our ability
to overcome inflation and to achieve our goals of full employment,
price stability and a sound and stable dollar.







-17I am confident that we will succeed. The American
people deserve nothing less.