Both tests required judgment. The assets used to support bank borrowing need have no relation to the marginal extension of credit. Judgments about quantity could be made only by looking at many indications of business conditions, including indexes of production and employment.
The report rejected both the gold reserve ratio and the price level as the principal quantitative guides. The gold reserve ratio had the benefit of tradition and wide acceptance, but its usefulness depended on the reestablishment of the international gold standard. In response to critics who urged the Federal Reserve to adopt price level stability as its main objective, the report argued that there are many causes of price level changes. Several of the causes are independent of “the credit system,” so a central bank that tried to control the price level would fail. The quantity theory of money was brushed aside: “The interrelationship of prices and credit is too complex to admit of any simple statement.” The discussion of the price level ended with the following: “Credit is an intensely human institution and as such reflects the moods and impulses of the community—its hopes, it fears, its expectations” (Board of Governors of the Federal Reserve System, Annual Report, 1923, 32). Credit administration cannot be done by “mechanical rules.” It must be done by judgment guided by the principles of the Federal Reserve Act.24
Some members of the Board, particularly Miller and Hamlin, did not accept the activist view of policy and the quantitative guides. They could accept the new policy as a means of getting banks to discount or repay, since that was consistent with the Federal Reserve Act and the real bills doctrine. Further, to satisfy proponents of real bills the report advocated a policy of qualitative control by “direct supervision” of the use of credit by member banks, contradicting the clear statement about the fungibility of credit.
23. The report does not recognize, however, that making the latter change without changing the authorized backing for currency created a potential mismatch between assets and liabilities. If government securities became a relatively large part of the asset portfolio, there would be fewer real bills to back currency and bank reserves. The Glass-Steagall Act removed the problem temporarily in 1932. Permanent authority waited until 1945.
24. These statements reflect the strong belief that monetary (or credit) velocity was unstable. This was the basis of the statements by Miller and others that the Federal Reserve could control credit but not the price level.
These different statements became the basis later in the decade for disputes between the Board and the reserve banks. In 1924 and 1927, Miller objected to open market purchases made not to reduce discounts but to expand money and credit. In 1929, the Board and the reserve banks quarreled over reliance on direct supervision (qualitative control) to prevent increases in stock exchange credit.25
Differences of Opinion
Burgess later claimed that most of the reserve banks regarded direct supervision of the use of credit as “theoretical and impractical” (1964, 222 n. 2). Clearly there was little enthusiasm for direct controls at some of the larger reserve banks, and New York was opposed. Governors of several reserve banks held to the real bills view, however, and accepted qualitative controls. They disliked Board interference in lending as a violation of their autonomy, but their views were closer to Miller’s than to Strong’s.
Case praised the discussion in the tenth annual report, calling it “a most excellent report and a good set of principles to follow” (Governors Conference, May 6, 1924, 240).26 New York had applied the quantitative principles on April 30, lowering its discount rate in recognition of what appeared to be the start of a recession. At a joint conference of the Board and the Governors on May 7, Governor Daniel R. Crissinger27 of the Board asked New York “on what theory they acted” (Joint Conference, Governors Conference, May 7, 1924, 1).28 This question started a lengthy discussion of discount rate policy that gives insight into prevalent views. Some of the differences reflected in the discussion became central issues later in the decade and help to explain the failure to act during the depression.29
25. Concerns about the quality of credit and real bills were common in the academic profession, the financial community, and Congress. Beckhart (1972, 214) quotes congressional testimony by leading academics who refer to “diversion of large amounts of credit into speculative enterprises which are bound to breed ultimate collapse.” This view is closely related to the alleged inevitability of depressions following increases in speculative credit that the System used to absolve itself of responsibility for the Great Depression.
26. At the time, J. Herbert Case was deputy governor at New York. Later he served as chairman and Federal Reserve agent. Case substituted for Strong on the Open Market Investment Committee (OMIC) in the 1920s when Strong was absent.
27. Daniel R. Crissinger was a boyhood friend and neighbor of President Warren Harding. He served as Comptroller of the Currency, and ex officio member of the Board, from March 1921 to April 1923. On May 1 he became governor of the Board. Crissinger was a small-town lawyer who had served as president of a small bank. Secretary Mellon opposed his appointment as governor, but President Harding insisted and he was confirmed, perhaps because he came from a rural and agricultural background (Katz 1992, 62). He is generally regarded as an ineffectual manager who could not achieve agreement within the Board or control Strong and the reserve bank governors. He resigned to join a mortgage loan firm in November 1927 after the Chicago discount rate controversy discussed later in this chapter.
The governors had agreed at an earlier meeting that in place of a penalty discount rate, the discount rate should be held at the average of commercial paper rates and the lending rates at banks in the principal cities of the district (Governors Conference, May 6, 1924, 240). This set the level of the discount rate relative to a market rate, but it left the decision to the market, in contrast to the part of the tenth annual report that proposed activist Federal Reserve policy.
Case used this agreement to justify the New York decision. The decision was taken to align the discount rate with market rates and with the principles of the tenth annual report. Several governors, who disliked the lower discount rate, challenged the decision as an unduly activist policy out of keeping with the Federal Reserve Act. One reason for the criticism is that the lower discount rate in New York drew borrowing to New York, reducing the earnings of other reserve banks and encouraging Boston, Philadelphia, and others to lower their rates, further reducing their earnings. Governor Harding of Boston described business conditions in New England as showing “a very distinct recession,” but he did not want to lower the discount rate. A reduction would not stimulate business but would probably encourage speculation. Further, the member banks did not want a reduction because they did not want to reduce their lending rates (Joint Conference, Governors Conference, May 7, 1924, 9–11). Governor Norris supported Harding’s statement. Banks in the Philadelphia district also opposed a reduction in discount rates. Norris believed that any recession “should be allowed to run its course, provided it does not become too violent” (ibid., 19 and 20).
Neither Norris nor Harding gave either recognition or support to the new policy principles. McDougal also opposed activist policy. In an exchange with Miller, he argued that lowering the discount rate was “squarely against the policy that Federal Reserve banks should pursue.” It would lead to an “abuse of credit [and] . . . encourage inflation.” The discount rate reduction was wrong because “it is not reflected in the demands upon the Reserve banks.” “I think we should not lead the rates down, and that is what has been done recently by one bank” (ibid., 38–40). Although they were members of the OMIC, McDougal and Norris threatened to purchase securities for their banks to increase earnings.
28. This particular report of the Joint Conference was treated as confidential within the System. It was not circulated to the governors or included with the report of the meeting. The report is filed at the end of the report of the Governors Conference, but the pages are numbered inde
pendently.
29. Wicker (1965) correctly distinguishes between quantitative and qualitative guides but separates their application by time period. A closer reading suggests that some members relied on one, some on the other, throughout the period.
John U. Calkins (San Francisco) and Fancher (Cleveland) criticized New York’s action also. Calkins took a standard real bills approach. The open market committee “has put money into the market when it is unduly easy and it will. . . be taking money out of the market when the market is beginning to tighten” (ibid., 19). He did not oppose Strong’s purchases in principle, but the purchases had not lowered market rates. The failure was evident in New York’s decision to lower rates by reducing its discount rate. The only reason for reducing the discount rate that he had heard from Case was that it could be raised later.
Stewart then reported on business conditions. Wholesale prices had fallen by 6 percent in three months, and employment by 2 percent, since the start of 1924. Other indicators also showed the beginning of a moderate to steep decline.30 The report had no perceptible effect on the discussion. The Board and the New York bank continued to argue for lower interest rates; the other reserve bank governors continued to oppose them. Seay (Richmond) thought 4.5 percent was attractive, since banks in his district paid 5 percent for time deposits. He challenged Miller to explain why a reserve bank should try to lead rates down (ibid., 57). Roy A. Young (Minneapolis) and David C. Biggs (St. Louis) saw no reason for lower rates. Willis J. Bailey (Kansas City) put forward an argument that some of the others may have been hesitant to make—the effect on reserve bank income: “How are we going to pay dividends and salaries?” (80).
Miller and Crissinger said that rates should have been reduced in January or February. Miller made the argument for the Board, but all the Board members concurred (ibid., 80, 83–84). Leading the market to rate reduction was the right policy unless the increase in credit was for speculation. Policy actions must be symmetrical. When the Federal Reserve “undertakes to use its rates for the purpose of restricting credit, it has got to show that it is also willing to do what it can to give the public and the borrowing community the benefit of lower rates when conditions warrant it” (59). If the recession continued or deepened, Miller said, New York should reduce its rate to 3.5 percent: “It will be very much easier for the directors of the New York reserve bank and its officers to bring the rate up if they move from 3.5 percent than if they had stuck at 4.5 and desired to raise it from 4.5 to 5” (60–61). Miller concluded: “The Federal Reserve is on trial, and I do not want to acutely attract destructive attention to us through niggardly, parsimonious or hesitant action with respect to the discount policy” (75).
30. Industrial production reached a peak in May 1923, then fell until August 1924. The annual rate of decline reached 18 percent in July. At the time of the meeting, the year-to-year decline was 13 percent. Balke and Gordon’s GNP data show a 7 percent decline in the price level and an 8.6 percent decline in real GNP for the second quarter of 1924. The recession had started a year earlier but had been interrupted by a strong recovery early in 1924. The recovery ended, however, and the decline in the price level and real GNP resumed.
Much of this argument was political, so it was unlikely to persuade the governors who thought the Board was overly responsive to political pressures. The argument hardly spoke to the main concerns felt by most of the governors—concerns about earnings and dividends and what later became known as “elasticity pessimism,” the belief that demand did not respond much to changes in interest rates. Although Miller claimed that rate reductions could have sizable effects on the amount of borrowing, many of the governors contended the opposite. This was particularly true of the governors from the agricultural regions, but the point was voiced by others, including Norris, McDougal, and Harding.31 None of the principals except Case (New York) made any reference to, or expressed support for, the principles in the tenth annual report.
Meeting in conference without the Board, the governors discussed whether to continue centralized purchases through the OMIC and, if so, the principles that should guide the OMIC. Calkins argued that reserve bank earnings were an inappropriate guide. Earnings would be low when borrowing and interest rates had fallen. If earnings were the guide, the reserve banks would purchase and ease the money market when the market was “easy” and conversely. Policy would be countercyclical. This, he said, is “exactly the reverse of what is desired” (Governors Conference, May 1924, 17). The reserve banks were supposed to take money out of the market in recession when the market was “unduly easy” because the supply of real bills had declined (19). This policy was procyclical.
McDougal, Fancher, and others criticized earlier decisions, taken in response to Treasury pressure, requiring reserve banks to sell all government securities. McDougal wanted to purchase long-term bonds to increase earnings (ibid., 20). Case acknowledged that selling off most of the portfolio in 1923 was a mistake, but recently the Open Market Investment Committee had bought back $235 million. The purchases had not increased reserve bank credit as Calkins implied. Reserve bank credit declined as purchases were made in recession. The effect of purchases, he said, was much more on the volume of discounts than on the aggregate portfolio.
31. These claims that the discount rate had only modest effect were not forgotten when the reserve banks wanted to increase discount rates in 1929 and the Board opposed.
The discussion turned again to earnings. The governors discussed three options: If earnings fell below expenses plus dividends, the reserve banks could curtail check processing, currency deliveries, and other services, purchase securities, or pay dividends from their accumulated surpluses. Three governors favored curtailing services. Nine favored paying dividends from surplus. The consensus was that open market operations should be conducted independently of earnings and dividend requirements and that the OMIC should continue. The governors retained the right to purchase or sell independently of the OMIC if their directors decided to do so.
Economists’ Views
The tenth annual report marks a turning point in Federal Reserve policy and, later, in the policies of other monetary authorities. Leading economists commented on the development of more activist policy and the use of open market operations to adjust bank borrowing.
The British economist Ralph Hawtrey found the new view of open market operations “highly encouraging to those who hope for enlightened management of credit with a view to the stabilization of prices” (1924, 284). He praised the report for its contribution to solving some of the practical problems of monetary control. He found the analysis flawed in two respects, however. First was the continued reliance on real bills and the qualitative test. These are “time-honored fallacies from which practical bankers seem to be quite incapable of emancipating themselves.” (285) Second was the “delusion” that the United States received gold because of its balance of payments: “Apparently they have not yet learnt that they receive all this gold simply because they offer a higher price for it” (286). However, Hawtrey did not go on to say that, at the current gold price, the Federal Reserve’s aims of achieving price stability and restoring the international gold standard required continued deflation abroad or changes in exchange rates.
John Maynard Keynes (1930, 2:225–21) accepted the new role for open market operations but thought that Federal Reserve officials underestimated their effectiveness (2:231). He praised the Federal Reserve for its policy from 1923 to 1928. It had shown “that currency management is feasible in conditions which are virtually independent of the movement of gold” (2:231). Although he recognized that the policy failed after 1929, he did not relate the failure to the previous policy.32
Charles O. Hardy (1932, 27, 273) was more representative of contemporary views. He argued that the new approach missed an important difference between discounts and open market operations. Control of discounts provided quantitative and qualitative control, whereas open market operations controlled only the quanti
ty of credit. Like many of his contemporaries, he accepted the central idea of the real bills doctrine.
32. One reason is that he misinterprets Federal Reserve policy in the 1920s. Keynes claimed that the policy worked because the United States public was willing to absorb “the remarkable growth in the volume of bank money.” In fact, base money and M1 rose at average rates of 2 to 3 percent a year, slightly less than output growth.
THE RIEFLER-BURGESS DOCTRINE
The tenth annual report does little more than sketch a new framework for monetary policy.33 During the 1920s, many people contributed to filling in the details. The best of this work was contained in two remarkable books by Winfield Riefler, an economist at the Board, and W. Randolph Burgess at the New York bank (Riefler 1930; Burgess 1936). I refer to the framework they developed as the Riefler-Burgess doctrine.34
The central relation was the member bank borrowing function. Although the reserve banks had tried in the early years to operate an English system with a penalty rate, Riefler and Burgess discarded that approach; they explained that banks were reluctant to borrow, borrowed only if reserves were deficient, and repaid promptly.35 To repay borrowing, banks called loans, raised lending rates, and sold government securities.36 Discount rate policy reinforced open market policy. A rise in the discount rate lowered the level of member bank borrowing, reduced credit and money, and raised market interest rates; a reduction in discount rates lowered market rates. Thus policy actions influenced market rates by changing the level of member bank borrowing and the discount rate.
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