Shaky steps to centre stage

Howard Davies charts the rise of a most powerful economic institution.

Gordon Brown and the Treasury were widely ridiculed for the volume of paper they produced in connection with the five euro tests in June. Every television news bulletin included film of a fleet of Stationery Office vans delivering shedloads of documents to parliament. There was some justification for this treatment: in addition to the overall assessment of the tests, the Treasury published 18 separate studies that amplified, clarified or, in some cases, obscured aspects of the analysis. Even now, euro anoraks continue to wade through this extensive material, panning for nuggets.

Yet by US standards, this was a superficial, rushed job. The National Monetary Commission, chaired by Senator Nelson Aldrich, which examined the case for the establishment of a central bank in the US in 1912, produced 30 volumes of analysis and evidence. And this was not the only commission of inquiry involved. There was, predictably, a parallel report from the House Banking and Currency Committee.

The American political establishment, which had twice flirted with central banking at an earlier stage, was not about to rush into a decision that would have serious consequences for the nature of the US financial system and the US economy overall. There was strong political pressure for a lender of last resort: 240 banks had failed or needed recapitalisation in the recession of 1907-08. But the unhappy experiences of the two Banks of the United States established in the late 18th and early 19th centuries made the American establishment especially cautious.

So, even when the debate was concluded, congress had spoken and President Woodrow Wilson signed the act establishing the Federal Reserve System, a 20-year sunset clause was included. Indeed the Federal Reserve System was not made a permanent feature of the landscape until the passage of the McFadden Act in 19.

It is hard now to imagine a world without the US Federal Reserve, so it is salutary to recall that the institution is a mere 90 years old. Allan Meltzer's weighty tome describes the first 38 of these 90 years. He has himself been working on the project for 30 years, which might put the conclusion of the exercise in some doubt: his productivity will need to step up, in line with the US economy as a whole, if he is to finish the job. It would be most unfortunate if Meltzer did not do so, because in him the institution has found a worthy, and correspondingly weighty, economic historian. He is also the first historian who has had full access to the Fed's internal papers. As I know from my own experience at the Bank of England, central banks are squirrels of the highest order: Meltzer acknowledges that he has needed a team of researchers to help him digest the material.

The structure of the history that emerges is, for the most part, straightforwardly chronological. Meltzer begins with a fascinating discussion of the intellectual ancestry of US central banking - which was very largely derived from what he considers to be an imperfect understanding of the functions and operations of the Bank of England.

Thereafter, he identifies five distinct phases of life.

The mewling and puking period, when the infant Fed was establishing itself, ran through the first world war and up to the postwar financial reconstruction in 1922. For most of that time, the war dominated, and it was still hard to see how the institution would evolve in more normal times.

He sees the second phase as running from the end of the postwar reconstruction up to the Wall Street crash in 1929. The Fed grew up but arguably not rapidly enough to cope with the challenge that ensued. The third phase from 1929 to 1933 is handled rather differently. It is the core of the book, and to show his hand Meltzer titles this central chapter "Why did monetary policy fail in the thirties?"

He then identifies a fourth period, from 1933 to 1941, when he sees the Fed as being in the back seat as President Franklin Delano Roosevelt and his New Deal policies reshaped the US economic landscape, following the devastation brought by the depression. His last chapter runs from 1942 to 1951, which he identifies as a period of growing Treasury control of monetary policy, originally put in place as a wartime measure but continued for some time afterwards. Indeed, as the first volume ends, the Fed board is reduced to meeting in the White House with President Harry Truman, to determine interest rates under the nose of the commander-in-chief. Donald Rumsfeld and Dick Cheney, even at their most pugnacious, would never be so bold today.

This is thorough narrative history of a high order. But there is considerably more to Meltzer's work than competent narrative. His added value is of two kinds, both analytical and critical. His view is that the Fed began life as a "peculiar hybrid", endowed with some central banking functions but not a central bank on the European model. The complex regional structure, whereby a network of locally constructed reserve banks, heavily influenced by the financial communities in their cities, interfaced with a politically appointed board in Washington, guaranteed the Fed's uniqueness and idiosyncrasy. (Even today, the tensions inherent in that arrangement are often apparent, although they are skilfully handled by the current incumbents.) Yet the structure, however complex, has allowed the institution to evolve without obvious need for constitutional change. By 1951, the Fed had become a central bank in all but name and could exercise effective control over the financial system if it had the political will to do so. Meltzer's analysis of the way in which this happened, and particularly of the power struggle between the Fed and the Treasury, is fascinating, if sometimes a little overengineered. It shows the influence of personalities, as well as policies, and any student of the US political system will be well rewarded.

The role of Benjamin Strong is particularly well, if critically, handled.

Meltzer does not share the view that had Strong lived, the 1930s depression would have been averted.

But as an economist Meltzer's aims are even higher. And he is more than ready to pass judgement on the institution and its success, or otherwise, in managing the crises that strewed its path. Overall, his verdict is highly critical. "The economies of the United States and much of the rest of the world became victims of the Federal Reserve's adherence to an inappropriate theory and the absence of basic economic understanding."

These are hard words, which lie at the core of his critique. Meltzer believes that the US paid far too little attention to the works of Bagehot, in particular. Bagehot, indeed, is a ghost at the Fed's feast throughout the first half of the 20th century.

While this judgement applies particularly to the institution's performance in the early 1930s, Meltzer sees the whole period as one of relative failure. "Looking back from 1951, few would conclude that the Federal Reserve had achieved the hopes of its founders and early proponentsI (it) had not prevented thousands of bank failures, the collapse of the financial system and the devaluation of the dollar." Meltzer sees the development of deposit insurance, the arrival of stock market regulation and the Glass-Steagall separation of commercial and investment banking as all signs of a lack of confidence in the Fed's ability to maintain a stable and solvent financial system.

How accurate is this view? Certainly, it is not a charitable interpretation of the early years when the institution was struggling to establish itself in a highly complex political environment. In the foreword, Alan Greenspan distances himself from Meltzer's conclusions, describing his work as "both stimulating and provocative", and concluding that "readers will have substantial material for continued reflection and discussion". Greenspan evidently does not regard Meltzer's history as the final word on the Fed's early life. I can appreciate this - and there are times when one senses that the facts are knocked into shape to meet the theory. But Meltzer's analysis is persuasive and acute.

There are, however, some significant gaps. Although one hesitates to ask for more after wading through 800 pages, there is too little, for example, on the debates leading up to the Bretton Woods institutions. The Fed was not in the lead on the US side, but its methods of operation internationally were significantly affected by the creation of the International Monetary Fund and the World Bank, yet Meltzer treats both cursorily. Robert Skidelsky's biography of John Maynard Keynes, the last volume of which adds greatly to our understanding of these debates, does not even figure in the list of references.

There is also little discussion of the interplay between monetary policy and oversight of the banking system. The two are often described interchangeably. Meltzer's narrative certainly explains why the Fed remains so firm in its attachment to a role in supervising the US banking system, in spite of the problems and burdens that role brings with it. But Meltzer shows no awareness of the current debate about whether it is appropriate for central banks to carry out the supervision role, and how far it influences their monetary policy decisions if they retain it. My view is that some of the errors Meltzer describes may have originated in part from the institution's extremely close links with the banking system, and too little understanding of the dynamics of the real economy. The current trend towards the separation of monetary policy and banking supervision is partly driven by that recognition.

His understanding of other forms of regulation is also modest. Remarkably, he refers to the additional powers given to the Fed by the Securities Exchange Act of 1934 without mentioning the main feature of the legislation: the creation of the Securities and Exchange Commission.

But these are quibbles. Meltzer's work, whether completed or not, will stand for a generation as the benchmark history of the world's most powerful economic institution. It is an impressive, even awe-inspiring achievement.

Sir Howard Davies is a director of the Bank of England and chairman, Financial Services Authority.