THE TIGHT MONEY POLICY: Making the Dollar Worth More

THE TIGHT MONEY POLICY

A Federal Reserve Board official once wryly remarked: "Only a handful of men really understand the credit system." Nevertheless, it is in the field of credit that the Eisenhower Administration has made its swiftest and boldest decisions.

Secretary of the Treasury Humphrey and the Federal Reserve Board had to move swiftly because, in an economy freed of direct controls, the burden of curbing inflation fell upon indirect fiscal controls, chiefly the restriction of credit. Though Eisenhower's moneymen have moved with seeming sureness, even they know that they are sailing, uncharted fiscal waters. For the first time, the U.S. is trying a great experiment: control of the ups and downs of a semi-war economy by fiscal and credit means alone.

The chief burden of the job falls on the FRB (called the "Fed" by bankers), which was created in 1913 as an independent, self-governing agency. Among its functions: to maintain an "orderly market" for Government securities, regulate private and public credit in the U.S. To do this, it has three major weapons:

¶ "Entering into open market operations," i.e., the buying or selling of Government securities. This has a tendency to raise or lower the market price for the bonds.

¶ Setting "reserve requirements," i.e., the proportion of cash reserves a bank is required to hold against its total deposits. The Fed can set reserves as low as 10%, on the average, which means banks can lend $10 for each $1 on deposit. Or it can hike them to 20%, on the average, which means that banks can lend only $5 for each $1 on deposit.

¶ Fixing the "discount rate," i.e., the interest which the twelve regional Federal Reserve banks charge their member banks on loans. By raising the discount rate, the FRB makes borrowing more expensive—and thus harder.

In the Depression, when the New Deal wanted "cheap money" (i.e., low interest rate) the FRB lost much of its independence. To help the Treasury float each new issue of low interest bonds to finance mounting deficits, the Fed had to support the prices of all bonds by buying enough to keep them above par.

In World War II, the FRB also had to peg bond prices to enable the Treasury to float the tremendous additional debt ($226,500,000,000) to finance the war. The issues were so huge that only banks, rather than individuals, could absorb most of them. This "monetized" the debt, for banks did not pay for the bonds outright. They simply created a deposit for the Government to draw checks against it. Receivers of these checks deposited them in their own bank accounts. From these increased deposits, the banks could lend about $5 for each $1 received. Thus credit, and inflation, increased, and the dollar bought less and less.

When World War II ended, so did the biggest justification for the cheap money policy. The Truman Administration wanted to continue it, however, because cheap money held down the interest payments on the debt. But as postwar inflation mounted, cheap money added more to all costs through inflation than it saved in interest.