from the Richmond Fed
— this post authored by Robert L. Hetzel
Since Friedman and Schwartz (1963), monetary historians have been critical of the performance of the pre-World War II Federal Reserve System (see also Hetzel 2014; Meltzer 2003). That poor performance raises the question addressed here. In the first half of the nineteenth century, there was a flowering of the quantity theory. The Bank of England was a solid institution in Great Britain with a rich tradition. Why then did not the founders of the Fed learn from British experience in the nineteenth century?
The objective of the Bank of England prior to World War I was to maintain the gold standard. Maintaining the convertibility of the paper pound into gold made London the center of the world market for financing international trade. That central position complemented Britain’s position as the center of a world empire. The Bank’s success in maintaining the gold standard required solving two related problems. First, it had to become a ‘central bank’ in the sense that management of its discount rate moved predictably the complex of interest rates in money markets. Second, it had to figure out how to be a lender of last resort in bank panics while also maintaining a gold reserve sufficient to maintain convertibility. Solving this latter problem required limiting the moral hazard encouraged by access to the discount window through limiting the risk-taking of commercial banks and discount houses.
Solving these problems was an extraordinary achievement. Moreover, the Bank was successful in the sense of surviving independently of the British treasury [Exchequer]. What is relevant here, however, is that the Bank of England solved these problems pragmatically without the need for recourse to the analytical framework of the quantity theory. At the same time, the gold standard became monetary orthodoxy. The quantity theory would have been essential if the intellectual and policymaking environment had been receptive to consideration of the alternative monetary standard of fiat money. It was not, and the quantity theory withered away. Despite a revival in the 1920s, its ideas were still largely unknown in the Great Depression. Moreover, because of the association with paper money, in policymaking circles, it was considered subversive of the established social order (Hetzel 1985).
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Source
https://www.richmondfed.org/-/ media/richmondfedorg/ publications/research/ economic_quarterly/ 2016/q4/ hetzel.pdf
