Charleston Voice: How the Fed Authorized Itself to Steal from the World

"And on day one, I have indicated, day one, I will issue an executive order identifying China as a currency manipulator. We'll bring an action against them in front of the WTO for manipulating their currency, and we will go after them."...Mitt Romney, Lying Glass House Stonethrower

Sterilized Foreign Exchange

Intervention: The Fed

Debate in the 1960s

Robert L. Hetzel

[EXCERPT Richmond Fed]

In early 1962, the Federal Reserve System (the Fed) began to buy and sell foreign currency. The decision to intervene in foreign exchange markets was controversial and generated considerable internal debate. The debate involved the fundamental issue of the Fed’s independence from the Treasury.

The Treasury has primary responsibility for official foreign exchange operations in the United States. Hence, participation with the Treasury in foreign exchange operations could jeopardize Fed independence. Moreover, the Federal Reserve Act safeguards this independence by requiring that acquisition of Treasury debt by the Fed be done in the open market, that is, at the Fed’s discretion rather than at the behest of the Treasury. The practice of acquiring foreign exchange directly from the Treasury in support of the Treasury’s operations could erode that safeguard...

4. BACKGROUND TO THE DEBATE

The Federal Reserve Act does not explicitly authorize the Fed to influence the value of the dollar by intervening in the foreign exchange market or to acquire foreign exchange for that purpose by swapping deposits with foreign central banks (establish swap lines). It also does not explicitly authorize the Fed to acquire foreign exchange from the Treasury (warehousing). This omission of powers undoubtedly reflected the adherence of the authors of the Federal Reserve Act to the two dominant assumptions of their era: the discipline of the gold standard and the real bills doctrine.

Adherence to the gold standard (continued in the Bretton Woods system) required that the Fed raise the discount rate in response to gold outflows. It seems unlikely that the authors of the Federal Reserve Act would have authorized actions designed to avoid this discipline. Also, according to the real bills doctrine, a central bank should extend credit only through discounting commercial bills (bills of exchange), that is, on the basis of debt arising from the financing of real productive activity.

Again, it seems unlikely that the authors of the Federal Reserve Act would have authorized deposit creation for U.S. and foreign governments in return for direct asset sales. (Foreign central banks were typically under direct government control.)

Section 14 of the Federal Reserve Act states “Any Federal reserve bank may . . . purchase and sell in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals, cable transfers and bankers’ acceptances and bills of exchange.” Given the existence of the gold standard and the acceptance of the real bills philosophy at the time of the writing of the Federal Reserve Act, the simplest understanding of the power to buy and sell foreign exchange (cable transfers in the language of the Federal Reserve Act) would be as a power facilitating transaction abroad by the Fed in gold or bankers’ acceptances and bills of exchange. H. Parker Willis (1926, p. 488), who drafted the Federal Reserve Act for Carter Glass, discussed the intention of this part of the Federal Reserve Act. He wrote that the power to deal in cable transfers facilitated the ability of Reserve Banks to purchase gold abroad. These foreign gold purchases could be used to supplement the domestic stockpiles of the Reserve Banks. Such purchases could also be used to avoid unnecessary trans-Atlantic movements of gold. For example, a Reserve Bank could use its holdings of gold in London to meet the needs of an individual in London wanting to exchange dollars for gold and thus avoid the need for shipment of gold from New York.

The Federal Reserve Bank of New York had opened swap lines in the 1920s with foreign central banks desiring to make their currencies convertible.5

In 1932, however, Carter Glass, senator from Virginia and author of the Federal

Reserve Act, denounced on the Senate floor those swap lines as inconsistent

with the Federal Reserve Act. As a consequence, in the Banking Act of 1933,

Congress added language to the Federal Reserve Act giving the Board of Governors the power to prevent the New York Fed from dealing directly with

foreign banks. “. . . the Board subsequently (in 1933 and 1934) construed

section 14(e) as limiting foreign accounts to the purchase of bills of exchange”

(U.S. Congress 1962, p. 147).

5. DEBATING FED FOREIGN EXCHANGE

INTERVENTION

At the request of Chairman Martin, Board Counsel Howard Hackley wrote a

memorandum outlining a legal basis for Fed participation in foreign exchange

operations. The FOMC discussed the memo at its December 5, 1961, meeting.

(The full memorandum is reprinted in U.S. Congress [1962]. Appendix B

summarizes the legal arguments of the memorandum.)

President Swan had already expressed his doubts in a November 30, 1961,

letter to Ralph Young (Foreign 1961). He argued that the memo was a “shaky

foundation for proceeding with a full-blown operation” because “the real bills

doctrine of the 1914 law” made it doubtful that the Federal Reserve Act would

authorize opening foreign accounts for purposes other than buying bills of

exchange. Most FOMC members shared the sentiments expressed by George

Clay (Board of Governors 1961, p. 1035), president of the Kansas City Fed:

5 Coombs (1976, p. 75) said of the swap arrangements he was discussing with other central

banks in January 1962, “Such swaps of one currency for another, with a forward contract to

reverse the transaction, say 90 days hence, had long been a standard trading instrument in the foreign exchange markets. Moreover, back in 1925, the New York Federal [Reserve Bank] under Governor Strong had arranged with the Bank of England a similar swap arrangement of $200million of United States gold against sterling.”

Federal Reserve Bank of Richmond Economic Quarterly

Mr. Clay went on to say that he had a basic feeling against Government agencies taking unto themselves authorities that had never been specifically granted. . . . He felt that Congress should be given an opportunity, and in fact urged, to assign this authority to the agency that in its wisdom it would choose.

Governor King (Board of Governors 1961, p. 1043) commented:

He did not think the Federal Reserve was the proper place for these operations if they were to be conducted. Instead, he felt that a political agency or body would be the proper place to lodge the responsibility. As he had heard it said on various occasions, if the System should get into politics at any stage it could founder.

President Bopp (Board of Governors 1961, p. 1046) stated:

Like others who had spoken, he was concerned about the legal basis for System operations in foreign currencies. The legal authority was not based on specific provisions of the law but rather on a construction of the statutes. . . .

In a democratic process it was important . . . to have specific authorization.

President Bryan (Board of Governors 1961, pp. 1048–49) of the Atlanta Fed urged the FOMC to concentrate on maintaining convertibility through the appropriate domestic policies. “Sometimes . . . a great deal more harm can be done, with good intentions, by intervening to save the patient some pain than by letting him realize he is sick.”

Governor Robertson (Board of Governors 1961, pp. 1037–42) argued that sterilized foreign exchange intervention by the Fed was bad law, bad politics, and bad economics:

It does not follow that the power to maintain foreign accounts—basically an incidental power—can be regarded as an authorization to exercise the broad policy functions contemplated by the instant proposal. In other words, even if foreign accounts may be maintained in connection with functions other than dealing in bills of exchange, these must be functions that are authorized by the Federal Reserve Act. Nowhere in the Act can authority be found for the stabilization function that is the core of this proposal (italics in original).

Even if its legality were to be assumed, I think the proposed action would be highly questionable because it is inconsistent with explicit Congressional authority. . . . Purchasing foreign exchange from the Stabilization Fund whenever that fund has been used up or by operating in the same field on its own . . . could be interpreted as circumventing the will of Congress by making available more dollars for the purpose of “stabilizing the exchange value of the dollar” than Congress contemplated. . . . Such a function [selling foreign exchange] . . . involves very sensitive international diplomatic relationships, with which the Federal Reserve is not in the best position to cope. The function would seem to be more appropriately one for the Treasury (which Congress has already designated to handle the problem).

Federal Reserve operations in foreign currencies . . . would merely camouflage the difficulty, which is one of dealing with the balance of payments problem. . . . If the amount of that fund [the ESF] is insufficient, then the Treasury should request Congress to expand the fund. . . . There are no gimmicks by which the position of the dollar can be maintained in the world. It would be unwise to resort to devices designed to hide the real problems and assuage their symptomatic effects. . . . The United States must practice what it has long preached about the need for monetary and fiscal discipline.

6. THE DECISION TO INTERVENE

The main defenders of Fed involvement in the foreign exchange markets were Governor Balderston, Charles Coombs, and President Hayes of the New York Fed. Balderston (Board of Governors 1961, p. 1058) argued that the Fed should intervene in the foreign exchange market because “it was so close to the function carried on by the Open Market Committee in domestic affairs.” Coombs (Board of Governors 1961, p. 1052) argued that “speculative pressures could boil up within a matter of minutes in the exchange market. . . . It would be desirable to have the resources to deal with such periodic emergencies, so that exchange operations could resist speculative trends before they had gone toofar.” Hayes (Board of Governors 1961, p. 1054) argued that, since the ESF was not in a position to intervene in foreign exchange markets, the Fed should do so.

As to the roles of the Treasury and Federal Reserve, some of those who commented had suggested that the Stabilization Fund was set up for this kind of purpose. Actually, however, the Fund had been used for a lot of other purposes.

It had been used to assist United States foreign policy in relation to various weaker currencies that needed shoring up, as a kind of State Department activity.

In a poll conducted by Chairman Martin, thirteen of the eighteen FOMC participants registered the opinion that “legislation is desirable” before beginning to intervene in the foreign exchange market. (The poll is recorded in the notes of Richmond’s President Wayne and are in the Richmond Fed archives for the December 5, 1961, FOMC meeting.) One of the five in favor of intervention, Governor Mills, expressed reservations. “He had no great faith

that operations of this kind could be conducted successfully or without serious danger to the independent status of the Federal Reserve System.” Another of the five in favor, Delos Johns, president of the St. Louis Fed, believed the FOMC should seek enabling congressional legislation at the same time it proceeded.

Chairman Martin ended the meeting by saying that he would explore the matter of legislation with the Treasury and report back to the Committee at its next meeting.

At the December 19, 1961, FOMC meeting, Chairman Martin, supported by President Hayes, asked the Committee’s permission to discuss a working relationship with the Treasury for foreign exchange intervention.6 Most members agreed that Chairman Martin should continue discussions with the Treasury, but agreed with President Deming of the Minneapolis Fed “that he would regard operations in foreign currencies as a proper activity for the central bank if statutory clarification could be obtained” (Board of Governors 1962, p. 1151).

At the January 9, 1962, FOMC meeting, Chairman Martin asked Hackley to report to the FOMC on his discussions with the Treasury’s general counsel, Robert Knight. Hackley noted that the Treasury’s general counsel and the Attorney General concurred with his opinion. He also noted that the Treasury opposed seeking legislation for three reasons (Board of Governors 1962, p. 61):

The international situation was very tender. . . . If there were discussions on the Hill, they might be agitating to the markets. Second . . . it might be better to seek such legislation after the Open Market Committee had some experience in order to determine what its problems and limitations were.

. . . Third, there was a range of ideas on the Hill with regard to the Federal Reserve System. . . . Legislation, if sought, might become a vehicle for adding various amendments the nature of which could not be foretold.

Chairman Martin said that he had conferred with the Secretary of the Treasury, and they agreed that “regarding the question of seeking legislation . . . there were real problems involved.” Martin suggested that he confer with the chairmen of the House and Senate Banking Committees. “If the Committee Chairmen . . . should feel strongly that the introduction of legislation would cause a great deal of stir, it might be better not to embark on that course” (Board of Governors 1962, p. 63). Governor King then commented:

The Federal Reserve was being asked to go a little too far in the name of cooperation. As he understood it, the Treasury was suggesting that it might not favor legislation because of apprehension as to the outcome (p. 63).

The Committee then authorized Chairman Martin to confer with the chairmen of the congressional banking committees.

At the January 23, 1962, meeting Chairman Martin reported to the FOMC “on the general problem of obtaining legislation that would clarify the Committee’s authority to conduct foreign currency operations.” Although the Minutes do not explain why, Chairman Martin no longer considered legislation an option.

The Minutes note then that the FOMC had a roundtable discussion. They record a reference to the opinions of the Committee’s and Treasury’s general 6 On December 18 the Secretary of the Treasury had sent a letter to Chairman Martin asking for prompt resolution of the issue of FOMC involvement in foreign exchange intervention and offering the advice of the Treasury’s legal staff. “I realize that the Committee might be hesitant to embark on operations in which it has not engaged since the establishment of the Stabilization Fund under the Gold Reserve Act of 1934. If the Committee should be interested in the opinion

of the Treasury’s General Counsel . . . the Treasury’s legal staff will be ready to cooperate with yours” (Board of Governors 1961, p. 1146).