1977 and the Undermining of Fed Independence: Today the U.S. central bank's sense of a shared mission with the administration has been internalized.

• Author: Lowenstein, Roger

Postwar, there were two revolutions in American central banking.

The second occurred in 1971. On a Sunday night in August when most Americans were returning from beaches and preparing to watch Bonanza, President Richard Nixon stunned the country by delinking the American dollar from gold.

Nixon closed the gold window because America had issued too much paper for its available bullion. Once the window was shut, America discovered what inflation really looked like. Over the next decade, the dollar lost more than half of its purchasing power.

Bonanza is not coming back, but it is fashionable to think that another Nixon shock, that is, monetary upheaval, is a-comin'. Maybe, but people looking for an historical mirror should be familiar with the first revolution, twenty years earlier.

This one did not occur on national television. Its architects were little-known monetary officials. But it gave us the independent monetary authority that many think of as essential. The story is worth telling in some detail, because it demonstrates the danger of political capture of the central bank.

The Federal Reserve was essentially a tool of the Treasury through World War II and its aftermath. It not only committed to a short-term rate of 0.375 percent, but set an upper limit of 2.5 percent on bonds. This accommodative policy enabled the government to finance the war and the recovery, but in the late 1940s it led to severe inflation.

By 1950, the Fed was chafing to reassert control. President Harry Truman and his Treasury Secretary, John Snyder, wanted none of it. Both Truman and Snyder, an Arkansas businessman, were populists with little regard for the theory of an independent central bank. When the Korean War erupted, the dispute turned into the monetary equivalent of a shooting war.

Allan Sproul, president of the New York Fed, insisted that the Fed reassert control of monetary policy. With FOMC support, he raised short-term rates.

By September, newspapers were reporting a rift, and Fed officials were pushing for a further rate increase. This would clearly threaten the long-term rate.

With the war (and Treasury's borrowing needs) intensifying, Truman was adamant that the Fed publicly guarantee the 2.5 percent bond ceiling--which meant monetizing bonds at the pegged rate. The president tartly observed to Thomas McCabe, the Fed chairman, that raising rates was "exactly what Mr. Stalin wants."

In January 1951, even as inflation accelerated, Secretary Snyder...