dence. The Fed could have minimized the collapse by feeding money and credit into the banking system. It failed to do so, because prevailing economic thinking, governed by the gold standard and the so-called "real bills" doctrine, rationalized timidity. To bolster the economy, the Fed did cut interest rates, but at crucial moments, it refrained from aggressively rescuing the banking system—providing more funds to deter the runs—because it feared that supplying too much money would drain the system of gold. Americans and foreigners would trade in their extra dollars for coins or bullion. Too much paper money would subvert faith in gold.25

The "real bills" doctrine reinforced the timidity. A "bill" is a short-term business loan. The "real bills" doctrine held that the Fed should provide credit only for productive loans: loans that increased output of goods and services. But in a collapsing economy, this meant the Fed had little reason to increase money and credit. "The Federal Reserve Act was written on this basis [the "real bills" doctrine]," explained Allan Meltzer, author of an extensive history of the Fed. "It talks about lending to industry, commerce, agriculture. The idea was that if you lent on productive credit, you'd never get inflation because it would provide inventories or capital. The capital would produce more output [and that would prevent prices from rising]." But in the Depression, loan demand had collapsed. The "real bills" doctrine provided no rationale for expanding credit to stimulate recovery. "They [Fed officials] didn't do anything," said Meltzer, "and they thought they were doing the right thing."26

The mistake with inflation was almost the exact opposite. The impulse was to push money and credit onto the economy in the hope that the result would be accelerating growth and declining joblessness. This justified more and more money and credit creation. Periodic efforts to suppress inflation were halfhearted and not sustained, just as in the early 1930s the efforts to mitigate the banking crisis were halfhearted and not sustained. By and large, the Fed was aware of the dilemmas, but in both cases, there was a strong bias in one direction or the other. In the 1930s, it was too stingy in supplying money and credit; in the 1960s and 1970s, it was too profligate. Down both paths lay ruin. What ultimately governed their decisions was the conventional economic wisdom.

With inflation, personal political pressure, sometimes crudely applied, pushed the Fed powerfully in the same direction. Presidents knew their political fortunes rested on the economy and were willing to run inflationary risks to preserve low unemployment. After the Fed raised its discount rate in December 1965—against President Johnson's wish—the president privately excoriated Fed chairman Martin at his Texas ranch. "You've got me in a position where you can run a rapier into me, and you've done it,"Johnson said. "You went ahead and did something I disapproved of and can affect my entire term here____I just want you to know that's a despicable thing to do." The incident did not embolden Martin to oppose Johnson again. Nixon was only slightly less subtle with Burns. Burns often informed Nixon of Fed decisions—nothing necessarily wrong with that—but Nixon frequently reminded Burns that the president's political fortunes depended heavily on the Fed's ability to increase economic growth. Just after nominating him as Fed chairman in December 1969, the president privately said, "I'm counting on you, Arthur, to keep us out of recession." At an Oval Office meeting in October 1971, barely a year before the 1972 election, Nixon was equally blunt: "I don't want to go out of town fast." No one could have missed the message.27

By the late 1970s, the Fed had maneuvered itself into a political and intellectual cul-de-sac. The advent of fiat currency had transformed its chief responsibility into guarding the stability of the nation's currency.Yet both the public at large and the nation's political leaders saw the Fed as an essential instrument in achieving rapid economic growth and maintaining "full employment." The Fed had adhered to economic doctrines that promised to accomplish both these goals, but in practice, it was achieving neither. There seemed to be no way out, and there wouldn't be until both economic ideas and political objectives changed. In the 1980s, that is what happened.

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