A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  62. Later Strong amplified his view about the difficulty of implementing control in testimony before the Joint Congressional Commission on Agricultural Inquiry (1921, pt. 13, 693–98). He argued that qualitative control would require examining each loan by each member bank, so it was not feasible in practice. Governor Harding recognized that the policy had not worked (Harris 1933, 1:224). Nevertheless, the Board returned to the policy at the end of the decade. With hindsight, several Board members concluded that September 1919 had been the time to increase rates (Miller 1921, 188). Recognition came after the Federal Reserve was blamed for the subsequent deflation.

  A new element now entered. Inflation reduced the real value of cash balances, inducing conversion of dollars to gold. The continuing fall in the gold reserve threatened to force suspension. The problem was most acute in New York, where most foreign balances were held. New York’s reserve ratio fell to 40.2 percent.

  On November 7 the Board voted to suspend for ten days, if necessary, the reserve requirement against deposits at the New York bank.63 Adolph Miller opposed the action, arguing that New York had available $150 million in gold from the other reserve banks. Further, Miller noted, New York had allowed its credit facilities to be used for speculative borrowing. The Board was reluctant to let New York borrow gold by rediscounting in other districts. It had to be punished for permitting the increase in speculative credit.

  The Federal Advisory Council met on November 19. A majority favored a rate increase, but Leffingwell convinced the members that a rate increase would be harmful. Their report to the Governors Conference the following day recommended no change. Many of the governors disagreed. They wanted a prompt increase in rates. Governor Charles A. Morss (Boston) expressed concern about speculative activity. The gold reserve ratio was approaching 40 percent. He “strongly advocated higher rates, even for commercial paper.” Governor Maximillian B. Wellborn (Atlanta) saw the credit situation in the country as more important than Treasury borrowing rates. But others were hesitant and preferred to hear the Treasury’s arguments before deciding (Governors Conference, November 19, 1919, 59–71).

  When the governors meeting resumed after hearing Glass and Leffingwell, Strong asked each of the governors whether control could be achieved by moral suasion and admonition and what would happen to market rates if moral suasion succeeded in controlling credit. Although Strong was a proponent of the real bills view at the time, he did not believe that qualitative controls and moral suasion could replace quantitative controls. He believed that direct action to control the quality of credit would not work without an increase in rates. Even if the New York bank succeeded in getting its members to withdraw loans for stock exchange credit, loans would be available from banks in other districts. Many of the lending banks did not borrow from their reserve banks, so they were not subject to direct pressure. Several governors accepted that direct pressure could have an effect but doubted that it would work without an increase in rates. Governor Roy Young (Minneapolis), in particular, recognized that money and credit are fungible; the lender does not truly know what is financed at the margin. Governors who took this position argued that substituting one type of credit for another undermined the effects of direct action. These governors concluded that, if effective, moral suasion would raise interest rates.64

  63. This action contrasts with the inaction in 1931–32 when faced with the alleged free gold problem. The law required a 35 percent reserve against deposits and 40 percent against notes. The note issue was about three times the amount of reserves, so the 40 percent reserve was considered a minimum for the sum.

  The conclusion was not unanimous, however. Governor George Seay (Richmond) claimed that moral suasion had a “very widespread effect.” A concerted effort would, he claimed, reduce credit demand and interest rates. Some shared this view, at least in part, qualifying their answers in various ways (Federal Reserve Governors Conference, November 19, 1919, 74–88).

  The Board wanted to avoid harming the Treasury’s January refunding of $1.5 billion in certificates. Leffingwell agreed that rates should rise, but not until after the refunding. Miller expressed a common concern about the effects on the prices of government bonds. He favored an increase in rates only after the Treasury refunding.65 Strong argued that it was wrong to follow certificate sales with an increase in rates and compared this proposal to a “sharp” commercial practice. Strong’s position was weakened, however, by his own and the New York directors’ concern, earlier in the month, about the effect of a discount rate increase on bond prices and by his apparent ambivalence on the issue of a preferential rate.66

  Strong recognized, correctly, that banks would borrow at the lowest rate available. He weakened his argument for higher rates, however, by buying banker’s acceptances at a 4 percent rate even after the discount rate on Treasury certificates was raised to 4.25 percent. Strong considered this preferential rate necessary to encourage the market for banker’s acceptances, one of his main aims. He wrote to Governor Harding that it was

  64. Young’s position is of interest because he was governor of the Board during the 1928–29 period of qualitative controls. Many have noted that the dispute over policy in 1919–20 was a prelude to the policy dispute in 1928–29 when the Board again favored moral suasion and direct pressure to control speculative credit without raising interest rates and most of the reserve banks wanted to raise rates as a supplement to direct pressure. In both periods the Board was able to delay an increase in rates. An important difference between the two episodes is often overlooked. In 1919–20, monetary growth was fueling inflation, and ex post real interest rates were negative. Balke and Gordon’s (1986) data show the price deflator rising at a 16 percent annual rate at the end of 1919 and nearly 25 percent in the first quarter of 1920. In 1928 the deflator rose only 4 percent, and the consumer price index fell. In the first half of 1929, the price level appears to have been stable or falling.

  65. Miller (1921, 188) later admitted that it was wrong not to raise rates in September 1919.

  66. Wicker (1966, 39) quotes Hamlin’s diary: “I cannot help feeling some lack of confidence in Strong—his health is bad and he is inclined to be panicky.” In October, Strong had insisted on a minimum rate of 4.75 percent. Two days later, he phoned saying that any increase would hurt Liberty bonds and finally accepted Leffingwell’s proposal to increase the rate to 4.25 percent. See also Friedman and Schwartz 1963, 226.

  essential to the Federal Reserve System and, particularly, to the financing of the foreign commerce of the United States by American banks instead of, as heretofore, by foreign banks. But this preferential rate was also established in recognition of the fact that a bill drawn against an actual shipment of commodities and accepted by the largest and richest bankers of the country was a credit instrument of greater value commanding a lower rate than the average of the commercial paper which would reach us. (Chandler 1958, 160)

  This argument for a preferential rate has some similarities to the Treasury’s argument. The principal difference is that Strong wanted a preferential rate for a particular type of real bill. The Treasury wanted the preferential rate for itself, based on its claim that its debt had lower risk because the government would not default. A central issue was whether the rate structure should give preference to real (commercial) or speculative (government) borrowers. Beneath the surface was the continuing struggle over the control of policy and the requirements of Treasury finance.

  The November Governors Conference made no decision.67 On November 24 New York and Boston voted to increase their discount rates. When the Board met two days later to consider the request, Leffingwell attacked Strong both personally and for several of his actions and policies.68 He accused Strong of making “a direct attempt to punish the Treasury of the United States for not submitting to dictation on the part of the Governor of the Federal Reserve Bank of New York even though it be at the cost of a shortage of funds of the Treasury to meet its outstanding obligations.” Treasury had
consented to a rate increase early in November because Governor Strong had agreed to do three things: insist that stock exchange accounts be adequately covered; prevent a scramble for deposits (higher rates on deposits) by New York banks; and raise the buying rate on acceptances. Strong had done none of the three. Further, he said, Strong had made an agreement with the governor of the Bank of England to increase rates for Treasury borrowing. The Bank of England had forced the British Treasury to raise rates, thus encouraging a gold outflow and the fall in the gold reserve. The United States Treasury had to borrow $500 million every two weeks until January 15. Leffingwell urged the Board to wait until January 15, when Treasury borrowing would be completed.

  67. The governors also noted but took no action against the effects of inflation on the melting of silver coinage and the reduction in silver certificates outstanding.

  68. Glass told Hamlin that he had almost made up his mind that Strong should be removed. The section of Hamlin’s diary is in Board of Governors File, box 1240, November 26, 1919.

  The Board disapproved the increases by New York and Boston. Miller said that he believed rates should rise, but he would not vote against the Treasury. Albert Strauss, a New York investment banker who had replaced Warburg, saw “no occasion for an increase in rates” that would only add to the cost of credit with no effect on the credit situation. Williams opposed a rate increase because of heavy borrowing by banks that lent to Wall Street. The Board rejected the increase in discount rates and voted to advise Boston and New York that acceptance rates were too low (Board Minutes, November 26, 1919).69

  The criticism found its mark. Strong at last fulfilled his commitment by raising buying rates on acceptances to 4.375 percent on November 26 and to 4.5 percent on December 4.70 Within a month, the rate was 4.75 percent. At a meeting in Secretary Glass’s office, Strong threatened to increase the discount rate without Board approval, claiming that section 14 of the Federal Reserve Act gave power over discount rates to the reserve banks. This was too much for Glass. He threatened to have the president remove Strong, and in a lengthy letter to the attorney general that left no doubt about his view, he requested an interpretation of section 14.71

  On December 9, the Justice Department responded: “I am of the opinion that the Federal Reserve Board has the right, under the powers conferred by the Federal Reserve Act, to determine what rates of discount should be charged from time to time by a Federal Reserve bank, and under their powers of review and supervision, to require such rates to be put into effect by such bank” (quoted in Warburg 1930, 2:822).

  69. The criticism of acceptance policy had merit. Acceptance rates in October and November were almost a full percentage point below rates on prime commercial paper. Banks therefore sold acceptances to the reserve banks at the preferential rate and bought commercial paper. Acceptances held by the reserve banks increased from a low of $187 million in May 1919 to $570 million in January 1920. During the same period discounts, although a much larger stock, increased only $160 million.

  70. Hamlin wrote in his diary for November 29 that Strong was “in a panic.” He “feared an industrial panic.” Raising rates might bring on a crisis. Rates should have been raised “long ago” (Board of Governors File, box 1240, November 29, 1919).

  71. A month earlier the Board’s legal staff had concluded that the act gave the Board wide authority, so the Board could require a reserve bank to change discount rates. Glass sent the staff opinion to the attorney general and added his recollection that it was the “intent of Congress to give the Federal Reserve Board complete power in the matter of fixing the rate of discount.” Attorney General King’s opinion repeated many of the arguments in Glass’s letter to him (Board of Governors File, box 1239, October 29, November 14, and December 9, 1919).

  The Treasury won the point, and the Board won another round in the continuing dispute about the locus of power in the System.72 The Federal Reserve System had shown itself divided, hesitant, and unable to move promptly against inflation in the face of Treasury opposition, a situation that was repeated in different circumstances after World War II.

  The Inflation Phase, Part 2

  The attorney general’s opinion came just as the Treasury’s cash position improved. On December 9 Leffingwell wrote to Glass: “I do not think that a moderate further increase in rates at the present time would have a disastrous effect upon the Treasury’s position” (quoted in Wicker 1966, 42). On the following day he gave a similar message to the Board, offering several reasons for the change in position. Recent Treasury issues had been successful; the chance of a coal strike had diminished; and he was concerned about renewed speculation. He no longer objected to an increase in rates or the elimination of the preferential rate for debt secured by Liberty and Victory bonds. The preference for certificates should remain (Board of Governors File, box 1239, December 10, 1919).

  The Board immediately sent a telegram to the reserve banks informing them that they could now propose a rate increase. New York and Richmond responded at once, raising rates on paper collateralized by Treasury certificates and Liberty bonds by 0.25 percent to 4.5 percent and 4.75 percent, respectively. The minimum discount rate, 4.5 percent, was now above the rate on the Treasury’s latest certificates. Most other banks followed within the week. On December 30 New York voted to increase the rate on certificates to 4.75 percent. Despite the Treasury’s sale of certificates on the same day, Leffingwell permitted the increase, although he described the change as unwise.73 Other banks followed.

  72. Less than eight years later, the Board used the ruling to lower the discount rate at Chicago without a vote by the Chicago directors. Glass, then a senator, opposed the move as an unwarranted centralization of authority, “a long stride in the direction of making the Federal Reserve Board a central bank, with the Reserve banks as mere branches” (quoted in Warburg 1930, 2:493). Hamlin wrote to Glass reminding him of his position in 1919. Glass responded that his request for a ruling by the attorney general in 1919 was opportunistic, done “more in anger than in reason” (Chandler 1958, 104).

  73. Strong went on a year’s leave soon after. On December 31 the Board met to decide whether Strong could have a year’s leave of absence (for health reasons) at half salary as recommended by the New York directors. The Board’s discussion shows the divisions and controversy within the System. Glass favored an indefinite leave, saying that if Strong were well he would favor calling for his resignation. Harding, Strauss, and Hamlin voted for the resolution; Miller and Comptroller Williams voted no. Miller urged the Board to demand Strong’s resignation, “in view of the conditions existing in the Second Federal Reserve District.” This motion was tabled. The reference was to the use of speculative credit, the need to borrow from other reserve banks, and continuous heavy borrowing by some member banks.

  By mid-January the Treasury had completed its current financing operations. Leffingwell now became a proponent of higher rates on commercial loans but continued to demand a preferential rate for borrowing on Treasury certificates.74 He proposed a 6 percent rate on commercial paper and a 5.5 percent rate on Liberty bonds but wanted to retain the 4.75 percent rate on certificates. Comptroller Williams offered a substitute motion with a lower rate schedule. Williams’s proposal was approved by a vote of four to three. After further discussion, the Board voted to reconsider; Adolph Miller changed sides, and the Board approved Leffingwell’s proposal for Boston, New York, and Philadelphia (Board Minutes, January 21, 1920, 79–81). The new schedule put rates on commercial paper above the rates proposed by the New York directors. Relying on the earlier letter from the acting attorney general, the Board interpreted section 14 of the Federal Reserve Act as giving the Board authority to initiate increases in the discount rate and require reserve banks to adopt them.75

  Why did the Board change its views about rates at this time? Years later, Adolph Miller answered: “It is a terrible thing to admit that the only thing that really awakened us was the fact that we were in sight of the
40 percent [gold reserve] ratio” (Governors Conference, March 1923, 766). In 1924 the Board’s staff gave several reasons. The gold reserve ratio is mentioned first, but the staff also cites data on gold exports following the end of the embargo, borrowing from the Federal Reserve banks, the increase in note circulation, and the rise in the wholesale price index (Board of Governors File, box 1240, July 28, 1924). The staff did not mention the change in the Treasury’s view.

  The Treasury’s change of view was not adventitious. It had completed its borrowing, and inflation had increased with no sign of credit liquidation yet visible. Treasury debt outstanding was past its peak and continued to fall. The monthly average gold reserve ratio was probably most important. The ratio had continued to fall after the wartime gold export embargo ended the previous June. By January the monthly average reserve ratio for the System was 42.7 percent, down five percentage points in a year. Gold reserves in excess of statutory requirements had fallen to $233 million, a 50 percent decline in twelve months. Several reserve banks had less than a 40 percent reserve. They had to either suspend gold reserve requirements or rediscount acceptances with other reserve banks.

  74. Leffingwell wrote to Strong: “I became an earnest and, in some respects, successful advocate of dear money” (quoted in Chandler 1958, 167).

  75. The New York directors hired a law firm to give an opinion on section 14. The opinion said that the initiation of a rate change was the responsibility of the reserve banks, but the Board had authority to change the recommendation.

  The Federal Reserve overcame the problem by using interbank loans to pool System reserves.76 The risk of suspension was greater than at any time in the next fifty years. Even in the fall and winter of 1931–32, after the British devaluation, the gold reserve ratio never fell below 60 percent, and excess reserves remained above $1.2 billion.77 The System’s later claim that the gold reserve prevented them from acting in 1931–32 is belied by the actions taken in 1920.78 Although the problem was inflation in 1920 and deflation in 1931–32, the remedy of pooling reserves to meet a deficiency at one or more banks applied in both periods.