With the creation of the Federal Reserve, the seasonal panics that had dominated the American economy since the 1870’s ceased as the Fed effectively used the tools of monetary policy to provide greater elasticity to the U.S. money supply. Meanwhile, the Great War—World War I—raged as the Federal Reserve officially opened its doors for operations.

The now debunked real bills doctrine, which originated with Adam Smith, guided the Federal Reserve during World War I. The essence of the real bills doctrine held that short-term bank loans extended to businesses, based upon anticipated profitability of sales of goods produced, were not inflationary, while other loans were. So, as might be expected, the real bills doctrine tended to be pro-cyclical monetary policy: When the economy was doing well and sales of goods were expected to be strong, the central bank would loosen monetary policy—though lending restraint was in order; conversely, when the economy was doing poorly and sales were expected to lag, the central bank tightened monetary policy—though more liquidity was in order.

As the early Fed was guided by the real bills doctrine, loans were expanded to member banks during the war-related boom, and prices soared by 119% between 1913 and 1919. Learning from this experience the Fed’s Board of Directors began to move away from the real bills doctrine, though the doctrine still held sway with the regional Federal Reserve Banks, other than the district of New York.

Read the entire Republican Staff Commentary below in pdf format: