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Speaking of the Economy
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Speaking of the Economy
March 8, 2023

A View of Monetary History (Part 1)

Audiences: Economists, General Public

Robert Hetzel looks at the evolution of monetary policymaking through the lens of his new book, The Federal Reserve: A New History. In part one of this two-part conversation, he discusses the Fed's policy shifts in the two decades following the Treasury-Fed Accord of 1951 and the role of the Federal Reserve Bank of Richmond during that period. Hetzel was a senior economist and research advisor at the Richmond Fed from 1975 to 2018.



Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. My guest today is Robert Hetzel, a visiting scholar at the Federal Reserve Bank of Chicago, a senior affiliated scholar at the Mercatus Center at George Mason University, and a fellow at the Institute for Applied Economics, Global Health and the Study of Business Enterprise at Johns Hopkins University.

Bob is regarded as a leading expert in monetary history, having studied the policies that the Fed has used to maintain price stability and full employment over its history. He has interviewed prominent figures in monetary policy as well as lived through key moments himself as a senior economist and research advisor at the Richmond Fed from 1975 to 2018.

I talked with Bob about his new book, "The Federal Reserve: A New History." Our conversation spanned several decades of the Fed's more recent history, requiring us to break it up into two episodes. Part one will focus on the 1950s and 1960s. Part two will pick up from the 1970s and lead us to the present.

Let's begin that discussion now.

Sablik: Our topic of conversation today is talking about monetary policy past and present, through the lens of your new book. And, as your title suggests, this is a fresh look at the 110-year history of the Fed.

There have certainly been no shortage of books written about the Fed and central banking. So, I wanted to start by asking you how your book is different from those other approaches and what motivated you to write it?

Robert Hetzel: The Fed influences the economy and the economy influences the Fed. So how do you sort out what causes what? You need to have some understanding of that if you're going to make monetary policy. My identification scheme is as long as the Fed provides a stable, nominal anchor in terms of the expectation of price stability and follows procedures that allow the price system to work, the market economy will adjust pretty well to shocks.

The problem with writing a narrative history that draws out causation is that you identify episodes of instability and stability and treat those as semi-controlled experiments. That's very much in the tradition of [Milton] Friedman and [Anna] Schwartz in their great book on monetary history [A Monetary History of the United States]. But the problem with any one episode is there's so many different things going on. So, what Friedman and Schwartz do and what I do is that you concatenate. You chain these episodes you treat as semi-controlled experiments and you look for systematic patterns over time. I feel like I pretty much can write in the monetarist tradition — for example, control of inflation requires control of money creation. I feel like my book demonstrates that.

Partly, I think that my book is important because I'm explicit about how I deal with the issue of causation. And also because Friedman and Schwartz' [book] was published in 1963, [Allan] Meltzer['s book, A History of the Federal Reserve] was published and goes through 1976. Well, I go through 2021.

Sablik: Certainly, we would need a much longer show to go through all the major events in the Fed's life that you cover in your book. But as you mentioned, you have a focus on some of the more recent Fed history. So, I want to take a look at some of those key periods, weaving in your experiences at the Richmond Fed.

Let's start with the 1950s. This is when the Fed gained independence from the Treasury with the Fed-Treasury Accord of 1951. How would you describe Fed policy in the '50s and '60s?

Hetzel: Let me start by explaining the role of the Richmond Fed and why the Richmond Fed has always taken its participation in monetary policy very importantly, and why it has always been influential.

Before the Treasury-Fed Accord of 1951, monetary policy was run through something called the executive committee. Basically, the key players were the president of the New York Fed and the chairman of the FOMC plus the governors. A requirement was that a regional bank president be a party to the executive committee. Well, the executive committee met every several weeks, but the FOMC only met four times a year, sometimes over the weekend. So, the executive committee basically ran things. In those early days, air travel was very difficult, so the two presidents who would come to these executive meetings — they would alternate — would be the Philadelphia Fed president and the Richmond Fed president because they can drive to Washington, D,C. So, Richmond was always a key player.

Now, I'm going to talk about how William McChesney Martin created the modern central bank. When I do that, I'm really talking about the Richmond Fed, too, because we were there as a party to those discussions.

Let me start with the Treasury-Fed Accord. In March of 1951, the Fed broke loose from Treasury control — we'd had a rate peg and there was a limit on how far interest rates could rise. Bond rates could rise over two and a half percent. The Fed was always considered to be this sort of bit player. Its main role was just to be a residual buyer of whatever Treasury securities the Fed couldn't sell in the market.

The background is that the Fed had dominated monetary policy since March of 1933, when the Roosevelt administration came in. It had just been considered as the organization that would keep interest rates low so that the Treasury could issue its debt. That's the first thing. The second thing is that monetary policy in the first part of the Fed history was based on something called real bills.

Sablik: Can you explain what you mean by "real bills"?

Hetzel: The idea of real bills was that recession and deflation came from the collapse of speculative excess. Markets would get this mania, this urge to gamble, and you build up a debt structure that was disproportionate to the working of the economy. That house of cards debt structure would inevitably collapse and a period of debt liquidation would cause recession and deflation.

That belief collapsed after World War II because the working assumption of real bills was that the Fed would steer credit toward productive uses — real bills — and away from uses that didn't have any grounding in the operation of the economy. Well, in World War II, the credit structure was built on government securities, not real bills. The presumption was that after World War II, that debt structure would collapse and we'd have another Great Depression. Well, we didn't, so we really had to reinvent monetary policy.

Sablik: You mentioned earlier that William McChesney Martin was instrumental in creating the modern central bank. He was the longest-serving Fed Chair, holding that position across four presidents from 1951 to 1970.

Hetzel: Martin came out of the bond markets and his father was president of the St. Louis Fed, so he was a pretty savvy guy. And this is really important: Martin's assistant, Winfield Riefler, and people like the president of the Richmond Fed were very much disturbed by the price controls and the rationing that occurred in World War II. That really interfered with the operation of a free market economy. They really believed in a free-market economy because they thought that's what gave us the economic muscle to win World War II. So, they wanted to create a system that would preserve price stability.

Sablik: What system did he come up with to maintain price stability?

Hetzel: The prelude to the Accord was the Korean War. The Fed was forced to monetize the debt that was being handed over to it by the banks and insurance companies. Marriner Eccles, who had stayed on the Board — he had been FOMC chair under Roosevelt — realized that we couldn't keep inflation under control if we didn't have control over credit creation.

Martin had a sort of a double problem. One is how to have a system to preserve price stability. The other was how not to advertise to the Treasury that we were a big player in credit markets, okay.

To get price stability, Martin wanted steady growth in bank credit in line with the growth of the economy. But he couldn't set a target for bank credit growth because the Treasury would pressure him to raise the target whenever it wanted to accommodate the issue of Treasury debt. Also, Martin wanted procedures that would emphasize the role of the Fed in promoting a healthy economy, as opposed to its prior role of simply being a way of keeping interest rates low for the Treasury when it issued its debt.

Out of this complex of factors, Martin came up with something called "lean against the wind." He implemented that through procedures called free reserves procedures — that is, the cost of banks reserves would depend upon the discount rate and free reserves, excess reserves, minus borrowed reserves. And so when the economy was growing strongly, the Fed would raise the discount rate and lower excess reserves, allowing borrowing to increase. The idea was that would tighten conditions in financial markets and that's what would keep debt issuance from being excessive. It was an indirect way of causing steady growth in bank credit.

The implementation of those procedures — their practical, day-to-day implementation — developed only over a period of time. Coming out of the 1953-1954 recession, the Fed raised interest rates, but not aggressively and in 1955 and 1956 the inflation rate went up to 3 percent. Well, that wouldn't shock us today, but that shocked Martin and the Richmond Fed president. They really believed in price stability.

They drew the conclusion that we'd raised interest rates too slowly coming out of the recession and, from now on, interest rates would have to be pre-emptive to prevent the emergence of inflation. I call these procedures "lean against the wind with credibility" — the idea that when the economy is growing unsustainably strongly and the rates of resource utilization are declining, the Fed needs to raise interest rates. It needs to do so in a pre-emptive way to prevent the emergence of inflation.

Sablik: Okay. Let's fast forward a little bit to the 1960s. Once the Fed under Martin was able to conduct a more independent monetary policy that leaned against the wind, how was the Fed doing?

Hetzel: Going into the 1960s, we had absolute rock-solid credibility for price stability. Initially when Kennedy becomes president, Kennedy is focused on the Cuban missile crisis. We've got the Bretton Woods system in operation. Kennedy does not want a dollar crisis. So, Kennedy defers to the Treasury — which was very conservative — and The Treasury supported the Fed and we continued with this policy of price stability. But in the background, the Kennedy Council of Economic Advisers was run by a man named Walter Heller and it was quintessentially Keynesian — a member of the Council was James Tobin, it was advised by Paul Samuelson. They wanted the fiscal and monetary authorities to set a target for low unemployment. They didn't think the price system worked to maintain full employment. That would have to be the responsibility of the government.

Things worked as long as Kennedy was president. But when Johnson became president, he was a populist. Populists believe that the Fed should keep interest rates low, end of story. Also, Johnson wanted financing for guns and butter — the war in Vietnam and also the Great Society programs. The conflict between the Martin FOMC and the Johnson administration, with the Heller CEA, took shape over the issue of pre-emptive increases in the funds rate.

Coming out of the last recession, the 1960-61 recession, Martin didn't want to repeat the mistakes of coming out of the '53-54 recession. He wanted to raise rates pre-emptively. But the Johnson administration opposed interest rate increases until the unemployment rate actually got down to 4 percent. I call that implementation of lean against the wind "lean against the wind with trade-offs" —coming out of recessions, the Fed didn't raise interest rates preemptively to prevent the emergence of inflation. It would only raise interest rates significantly when it got inflation.

We go through a period at the end of the '60s [where] the Fed is under constant pressure. The administration is able to promote Keynesians to the Board of Governors. So, Martin has a house that is divided and he can't really challenge the Johnson administration.

So, he does what he thinks is a compromise, which is to sign on to promote an increase in taxes that will turn the deficit into a surplus. The idea was that we'd hold off on raising interest rates while we got this tax increase. Well, the problem was the negotiations between Wilbur Mills, head of the Ways and Means Committee, and Johnson went on and on. Johnson did not want to cut Great Society programs and Mills said he had to. So, basically money growth got out of control. We ended up with 5 percent inflation by the end of the '60s.

Martin realized his mistake. Monetary policy was very restrictive. If Martin had a little more time, he would have returned us to price stability. But he didn't have that time. Arthur Burns replaced him in February of 1970.

Sablik: We'll continue this conversation about monetary history in the next episode of Speaking of the Economy. If you'd like to learn more about Bob Hetzel's work, check out his profile page on And if you enjoyed this episode, please leave us a rating and review on your favorite podcast app.

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