But the story of Genoa, World War I, and Bretton Woods is incomplete without grasping the importance of the Federal Reserve System. Established in 1913, the central bank of the United States was designed for the express purpose of creating an “elastic currency.” An elastic currency was thought to be one which could expand with the needs of trade, one which could resist the contracting forces implicit in a financial panic. Briefly, the idea of the Federal Reserve System was born in the aftermath of the banking panic of 1907. A national monetary commission was appointed to study institutional remedies for the defects of the American banking system. The most profound influence on the legislature process was of course the bankers themselves, and certain foreign luminaries like Paul Warlburg of Germany. Five years of study and debate gave rise to the Federal Reserve System, which was modeled in the German Reichsbank and the Bank of England. Essentially, the Federal Reserve System is a private corporation, with a statutory monopoly over the currency issue and near monopoly over the regulations of the banking system. Just as the ICC regulates the railroads, so does the Fed regulate monetary institutions.
The power of the Fed consists not only in its regulating power, but in its control over the supply of credit to the banking system. Under the original statute the Fed could create credit only by advancing money against secured promissory notes of merchants and producers. The government did not qualify for credit at the Fed, and thus a government deficit could not be financed by the central bank. Additionally, the Fed was limited by the gold standard. Since the dollar was a fixed weight of gold, and the law required the maintenance of this value, the Fed could create only a limited amount of credit, such as new deposits and Federal Reserve notes. If the limit was not observed, holders at arm and aboard of excess dollar deposits and currency would redeem them for gold, thus jeopardizing the guarantee of convertibility of bank deposits and currency for standard money, namely gold dollars.
Oversimplified, this description characterizes the Federal Reserve System in 1913. But the World War changed everything. First European gold flowed to the United States in a panic and in order to finance war purchases. Second the Fed extended credit, at interest rates below market, to commercial banks in order to finance the “Liberty Bonds.” Above all, the power to create and expand credit, inherent in the monopoly powers of the Federal Reserve System, became evident during the course of the war. During the recession of 1920-21, these credit creating powers we activated through mechanism, of open market operations, i.e., the technique of Fed purchases of government securities, now permitted since World War I. In a word the Fed was able to extend credit to the Federal government. Given hypothetical conditions of a permanent deficit and a need for government financing, all the potentialities of the Federal Reserve System as an engine of world inflation were opened up. Only one check on this engine remained the gold standard. In its absence, there would be no limit on the Fed’s charter to create money and credit.
In effect, World War I was a catastrophic and suicidal act which destroyed not only the European peace; it also destroyed the monetary system of Western civilization. World War II and its aftermath were the last historical acts of the unfolding drama.
All European countries struggled with inflationary disorders during the war-torn 1940s and reconstruction during the 1950s. In the mid 1950s the world passed through what was forecast by the experts of the time to be a “permanent dollar scarcity.” Remember if you will that the United States economy dominated the planet as no country ever had before. During this period the gold-linked Bretton Woods dollar remained the reasonably stable epicenter around which other fluctuating currency systems orbited. But after 1958, a great event occurred. The western European governments restored the mutual convertibility of their currency systems, abolished most exchange controls, sought to establish budgetary equilibrium and (?) dollar primacy began to wane. From that very year, when the once prostrate nations of Europe hardened the value of their national monies, the U.S. has experienced virtually a “permanent” balance-of-payments deficit. The economists and experts were confounded, as overnight, the “permanent dollar scarcity” of the 1950s became “the permanent dollar glut” of the 1960s and 1970s.
Throughout the 1960s the inflation and external deficit of the dollar, generated by expansive U.S. monetary policies, led to annual foreign exchange crises and ultimately to foreign exchange controls under Kennedy and Johnson. This was the period of “the permanent balance of payments crises.” The Bretton Woods system groaned under the flood weight of excess U.S. dollars, awash in financial markets abroad, where perforce they were accumulated in the official foreign exchange reserves of our trading partners. This was also the period when politicians and civil servants led by academic neo-Keynesians Professor Paul Samuelson and Walter Heller suggested that a little inflation was controllable and desirable.
Since the U.S. dollar was the primary reserve currency, under the gold exchange standard embodied in the Bretton Woods treaty, foreign central banks were in effect required to purchase and to hold as reserves against the creation of their own money, undesired dollars received and sold by their citizens. It was also during this period (1920) that the Special Drawing Right (SDR), an international “paper” money, was invented by the International Monetary Fund in order, it was argued, to avoid a potential “liquidity shortage” in world reserves. Indeed, it was even said that the SDR, an artificially created reserve asset, to be allocated among its members by the International Monetary Fund, was necessary to finance growing world trade. But as one foreign economist remarked, the creation of the SDRs, under the existing conditions of inflation and permanent U.S. deficits, reminded him of irrigation plans during a flood.
More was to come. From 1945 on, the Federal Reserve was required to hold gold reserves equal to 25 percent of the Federal Reserve notes and deposits it created against the purchase of government securities and other financial assets. Now when President Johnson decided simultaneously to expand the Vietnam War and to build the Great Society, he moved, with the consent of Congress, to void the statutes which limited, by virtue of a stipulated gold cover, the amount of currency and credit which the Bank of Issue, the Federal Reserve System, could create. The full inflationary potential inherent in the Federal Reserve Act of 1913 was about to be realized. The institution of financial discipline, the gold-link or legal gold cover, which had limited the creation of paper and credit dollars, was virtually terminated. And predictably, with the ultimate discipline of a legally-required gold cover brushed aside, budget deficits, Fed credit expansion, inflation, and the balance-of-payments crises intensified. Unimpeded by any statutory rule limiting either budget deficit or the growth of the money supply during the late 1960s, the Federal Reserve System had complete discretion to create, subject to demands for gold from generally foreigners, servile generally servile, the new credit and money required by the Congress to finance the President’s war budgets and his Great Society deficits.