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The Anatomy of Crisis
77
By the end of the war the United States had replaced Britain as
the center of the financial world. The world was effectively on a
dollar standard and remained so even after a weakened version of
the prewar gold standard was reestablished. The Federal Reserve
System was no longer a minor body reacting passively to external
events. It was a major independent force shaping the world mon-
etary structure.
The war years demonstrated the power of the Federal Reserve
System for both good and ill, especially after the United States
entered the war. As in all previous (and subsequent) wars, the
equivalent of the printing press was resorted to in order to finance
war spending. But the System made it possible to do so in a more
sophisticated and subtle manner than was possible earlier. The
literal printing press was used to some extent, when the Federal
Reserve Banks bought bonds from the U.S. Treasury and paid for
them with Federal Reserve Notes that the Treasury could pay out
to meet some of its expenses. But mostly the Fed paid for bonds it
bought by crediting the Treasury with deposits at the Federal Re-
serve Banks. The Treasury paid for purchases with checks drawn
on these deposits. When the recipients deposited the checks in their
own banks and these banks in turn deposited them at a Federal
Reserve Bank, the Treasury deposits at the Fed were transferred
to the commercial banks, increasing their reserves. That increase
enabled the commercial banking system to expand, largely—at the
ti me—by buying government bonds themselves or making loans
to their customers to enable them to buy government bonds. By
this roundabout process, the Treasury got newly created money to
pay for war expenses, but the increase in the quantity of money
mostly took the form of increases in deposits at commercial banks,
rather than of currency. The subtlety of the process whereby the
quantity of money was increased did not prevent inflation, but it
did smooth the operation and, by concealing what was actually
happening, lessen or postpone the public's fears about inflation.
After the war the System continued to increase the quantity of
money rapidly, thereby feeding the inflation. At this stage, how-
ever, the additional money was being used not to pay for the
government's expenses but to finance private business activities.
A third of our total wartime inflation occurred after the end not
only of the war but also of government deficits to pay for the war.
78
FREE TO CHOOSE: A Personal Statement
Belatedly, the System discovered its mistake. It then reacted
sharply, plunging the country into the sharp but short depression
of 1920-21.
The high tide of the System was undoubtedly the rest of the
twenties. During those few years it did serve as an effective balance
wheel, increasing the rate of monetary growth when the economy
showed signs of faltering, and reducing the rate of monetary
growth when the economy started expanding more rapidly. It
did not prevent fluctuations in the economy but it did contribute
to keeping them mild. Moreover, it was sufficiently evenhanded
so that it avoided inflation. The result of the stable monetary
and economic climate was rapid economic growth. It was widely
trumpeted that a new era had arrived, that the business cycle
was dead, dispatched by a vigilant Federal Reserve System.
Much of the success during the twenties can be credited to
Benjamin Strong, a New York banker who was the first head of
the Federal Reserve Bank of New York and remained its head
until his untimely death in 1928. Until he died, the New York
Bank was the prime mover in Federal Reserve policy both at
home and abroad, and Benjamin Strong was unquestionably the
dominant figure. He was a remarkable man, described by a mem-
ber of the Federal Reserve Board as "a genius—a Hamilton
among bankers." More than any other individual in the System,
he had the confidence and backing of other financial leaders in-
side and outside the System, the personal force to make his views
prevail, and the courage to act upon them.
Strong's death unleashed a struggle for power within the Sys-
tem that was fated to have far-reaching consequences. As Strong's
biographer puts it, "Strong's death left the System with no center
of enterprising and acceptable leadership. The Federal Reserve
Board [in Washington] was determined that the New York Bank
should no longer play that role. But the Board itself could not
play the role in an enterprising way. It was still weak and di-
vided. . . . Moreover, most of the other Reserve Banks, as well
as that in New York, were reluctant to follow the leadership of
the Board. . . . Thus it was easy for the System to slide into
indecision and deadlock."
1
This struggle for power proved to be—as no one could have
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