Introduction

The decade of the twenties was a period of stability in two senses. As indicated in the last chapter, the decade was one of relative stability in total output produced. Stability in the real economy was accompanied by stability in the government's financing requirements. There were no important shocks which would have led to significant changes in the government's demand for revenue. Accordingly, there were no fundamental changes in monetary institutions during the decade.

The Great Depression upset the stability. The direct effect, of course, was a prolonged period of negative economic growth. The indirect effect was a surge in government financing requirements in its aftermath. This indirect effect is documented in figure 7.1 which shows a measure of permanent government spending (Barro, 1986) over the period 1918–80. The instability in growth and financing led to a flurry of legislative activity representing the most fundamental change in the monetary sector since the founding of the Fed. Legislation was passed which relaxed the gold-backing constraints on the monetary sector, centralized Fed open market operations, established the Treasury as a co-producer of money, introduced upward flexibility in the reserve requirement on retail banks, and created the Federal Deposit Insurance Corporation.

The new monetary environment necessitated a more complex relationship between the government and its monetary agents, which now included the Treasury as well as the Fed. When revenue demands were modest, as in the 1920s, the government could allow a competitively structured Federal Reserve to run more or less on automatic pilot. The best the Fed could do in terms of profits was to “break-even,” as was reflected by the fact that little revenue was transferred to the government during most of the decade.