A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  In testimony before the Royal Commission on Indian Currency and Finance in 1926, Strong gave four reasons for changing gold certificate policy in 1922. First, the amount of gold certificates in circulation had fallen to $170 million; continued reduction might give gold certificates a scarcity value relative to Federal Reserve notes. Second, although the economy was recovering from the 1920–21 recession, “there was prevalent, especially in the agricultural sections, a feeling that possibly it would be a good thing for the country to have some expansion of credit” (Strong 1930, 301). Third, to restore the working of the gold standard, a country like the United States could fix the amount of gold in domestic circulation and permit inflows and outflows to be reflected in the monetary base. Fourth, he feared that the high reserve ratio would become the norm, so that a reduction from 85 percent to 65 percent would be considered serious (301–2).

  Strong gave greatest weight to his third reason, letting the monetary base respond to gold movements, although the Federal Reserve did not follow this policy subsequently. His reasoning probably reflects the period in which he spoke, after Britain had returned to gold. Initially, the principal concern was the pressure from agricultural representatives to expand credit.44

  43. The $1 billion was about equal to the value of gold certificates in circulation at the start of the Federal Reserve System. The Treasury also tried to increase the circulation of gold coins, but this policy was not successful, suggesting that the reserve banks were now sufficiently established in the public’s mind as the main source of money that the public was unwilling to bear the costs of using gold coins.

  The net new issues of gold certificates, about $800 million from 1922 to 1926, equaled about 20 percent of the gold reserve. Together, the policies of earmarking gold and issuing certificates reduced the gold reserve by about 25 percent at peak issuance.

  Restoring the Gold Standard

  The Federal Reserve consistently favored restoration of the gold standard in the principal countries, and it worked toward that end as long as it was consistent with domestic policy.45 At the end of the war, this meant that foreign governments had to either deflate or devalue prewar parities. Britain chose deflation; France, Germany (and others) chose devaluation.

  Wholesale prices in Britain had increased 115 percent from the beginning of the war (August 1914) to March 1919, when the pound was allowed to float. In the following year, the pound declined 30 percent against the dollar. Devaluation and the effect of removing wartime price controls contributed an additional 40 percent price increase. From this inauspicious starting point, the Bank of England began to reestablish the prewar parity at $4.86 per pound by deflating rapidly. By the end of 1922 the Sauerbeck index (1867–77 = 100) had fallen almost 50 percent, from 251 to 131. At the 1922 level, the index was lower than in 1925, when Britain restored convertibility. The dollar exchange rate reached $4.61 per pound.

  Achieving the remaining 5 percent appreciation took more than two additional years. Political and economic tension over reparations, including occupation of the Ruhr by French and Belgian troops, contributed to the fluctuation in the European exchange rates against the dollar during this period. The Dawes Plan of 1924 rescheduled reparations payments and provided loans to Germany that removed a major source of instability, at least for a time, by ensuring prompt payment of reparations and wartime debts.46

  44. McDougal had a very different reason for issuing gold certificates—they reduced expenses by the reserve banks for issuing and replacing currency. In 1928 he proposed replacing all Federal Reserve notes with gold certificates to save $700,000. All other governors were opposed (Governors Conference, April 1928, 199–213).

  45. The 1924 annual report relates the opinion of the Federal Advisory Council that it was “imperative” that England and Germany return to the gold standard. At the time, French restoration seemed unlikely.

  46. The Dawes Plan removed reparations as a source of current instability but did not resolve either the reparations problem or the transfer problem. The latter problem arose because German reparations payments required a surplus on the German current account. Hence other countries collectively had to be in deficit relative to Germany. The Dawes Plan did not settle the total reparations to be paid by Germany. Instead, the plan required Germany to pay reparations of £50 million, rising to £125 million in the next five years. To stabilize the German mark against gold, loans of $190 million were offered to support the currency. The plan did not restrict import tariffs by the receiving countries or assess Germany’s ability to pay. However, by limiting and rescheduling German payments and stabilizing the mark, the plan removed a major source of European instability. The Dawes Plan achieved its reparations targets because stabilization encouraged foreign loans to Germany, principally from the United States, but also from Britain. Germany received more loans than the amount of its reparations payments under the Dawes Plan, so foreigners financed the reparations payments that Germany made. According to Hjalmar Schacht (1955, 211), governor of the Reichsbank between 1924 and 1932, Germany paid only $10 billion to $12 billion of the $120 billion promised. Germany never achieved a current account surplus; all the payments were made from the proceeds of $20 billion in loans that foreigners “pressed upon her to such an extent that in 1931 it transpired she could no longer meet even the interest on them” (211). The result was that foreign governments received the $10 billion to $12 billion, and the lenders lost their money.

  Germany’s return to the gold standard, or more accurately, the gold exchange standard, put pressure on Britain.47 Further, the British embargo on gold exports expired at the end of 1925. Aided by lower rates in the United States and speculation that the embargo would not be renewed, the pound rose toward its prewar parity (Howson 1975). On April 28 Winston Churchill, chancellor of the Exchequer, announced that Britain would not extend the embargo. This decision made the pound convertible de facto. Two weeks later Parliament passed the Gold Standard Act of 1925, restoring the prewar parity de jure.48

  To achieve and maintain the $4.86 parity, the Federal Reserve offered the Bank of England a two-year standby loan of $200 million. On two occasions, 1924 and 1927, to help Britain it encouraged gold exports from the United States by lowering interest rates.49

  The financial press and Congress criticized the loan as beyond the authority of the New York Federal Reserve bank.50 Strong responded at length in congressional hearings (House Committee on Banking and Currency 1926). The loan was secured by British Treasury obligations, payable in dollars. Governor Crissinger of the Federal Reserve Board had been present when it was discussed, and he had asked for and received approval from all members of the Board. The Open Market Investment Committee approved the loan unanimously, with Secretary Mellon present: “Mr. Mellon asked specifically if there were any objections to the arrangement . . . and the making of the commitment, and no objection being made, he stated it was understood that I was to go ahead” (Chandler 1958, 315).51

  47. To conserve limited gold stocks (and earn interest on reserve balances) countries other than the United States, Britain, and later France held part or all of their reserves in dollar or pound securities, exchangeable for gold. These dollar or pound claims could be exchanged for gold reserves on demand as long as the United States and Britain maintained convertibility; hence the name gold exchange standard.

  48. Norman was the main proponent; Churchill was a reluctant follower of his advice and the advice of Otto Niemeyer in the Treasury. Churchill, influenced by Keynes, was concerned about the effect on industry and employment.

  49. Strong negotiated the loan to the Bank of England on behalf of the Federal Reserve, not the United States government. This was a standard feature of international monetary policy at the time; central bankers negotiated with other central bankers. Typically they informed their governments and kept them apprised of foreign developments and negotiations. Governments borrowed in the market using investment bankers as agents. Britain used J. P. Morgan.


  50. Parker Willis, former secretary of the Board and editor of the Commercial and Financial Chronicle, was a main critic. He had worked for Carter Glass at the House Banking Committee in writing the act, so his criticisms were taken up by members of Congress. Willis favored Britain’s return to the gold standard and recognized that section 14 authorized transactions with foreign banks. He criticized the size of the loan and the use of section 14 to aid a foreign government. Willis interpreted the act narrowly. He wanted a penalty discount rate, and he opposed the issuance of gold certificates as a violation of the principle that the act intended to centralize gold holdings. Currency should be backed by gold and commercial paper only, and the Federal Reserve should limit its activity to discounting real bills. Similar views were held, perhaps not independently, by Senator Carter Glass.

  International Cooperation

  As part of its policy to help countries return to the gold standard, the Federal Reserve lowered discount rates in August 1924. The United States was in recession, so the System had a domestic as well as an international reason for acting. Wicker (1966, 77) claimed that “the desire of the Federal Reserve Bank of New York to establish a rate spread between New York and London to encourage capital outflows and reduce gold imports was indeed the chief determinant of policy. It was not, however, the only one.”52 Chandler (1958, 241) was at the opposite pole, claiming that the policy was mainly an anticyclical policy that also was expected to encourage a capital outflow. This was also the view of Hardy (1932, 108), who found “a great deal of exaggeration” about the attention given to international considerations in setting Federal Reserve policy. Hardy recognized that Strong held such views, and stated them often, but he noted correctly that there was little evidence that other members of the OMIC shared them. They agreed on the desirability of reestablishing the gold standard but were more skeptical about using policy actions to help the British. Friedman and Schwartz (1963, 269) agreed with Hardy.

  51. The loan was fuel for Strong’s critics, who feared that Strong acted like the head of a central bank instead of being one member of a system of semiautonomous banks. After the loan commitment was announced, Miller changed his opinion about the legal authority for the loan. He is recorded as “not voting” when the Board approved a resolution confirming the transaction (Board Minutes, May 19, 1925). The credit expired after two years and was never drawn upon. Miller was a strong supporter of the gold standard and a partisan of the policy of restoring the standard. He described restoration this way: “The fantastic vagaries which a certain school of economics on both sides of the Atlantic embraced in their efforts to find a substitute for the gold standard have given way before the world’s resolution to tie its fate in monetary matters . . . to something more objective and less capricious than fallible human discretion” (Miller 1925b, 4).

  52. Wicker (1966, 90) based much of his argument on the decline in New York member bank borrowing after February or March 1924. Total system borrowing remained above $400 million until June and did not fall below $300 million until August. Open market purchases began in March and ended in November. These data are consistent with the Riefler-Burgess view that high borrowing in recession called for open market purchases.

  Chart 4.3 leaves no doubt that the spread between short-term rates in London and New York turned sharply in favor of capital flows to London during the summer and fall of 1924. The spread again moved in favor of Britain in the summer of 1927, the second occasion that some observers cite as evidence that international considerations had an important influence on United States policy. The covered interest parity shows the same general pattern, though the changes are smaller (Clarke 1967, 129). The difficult problem for an international explanation of policy action is that the spread reversed early in 1925, just as Britain was about to restore the gold standard. The reason for the reversal was a rise in the discount rate in New York on February 27, two months before the British decision. The reversal came for domestic reasons. The trough of the recession had occurred the previous July. By early 1925, recovery and expansion were well under way and the price level was rising. Despite the emphasis Strong gave to capital movements and restoration of the gold standard, he did not hesitate to raise the New York discount rate. This action required Norman to raise rates in London by 1 percent in early March to keep the spread in favor of London. Strong was fully aware that the British decision on gold was imminent; he was negotiating the standby credit at the time.

  With hindsight, Strong told Congress in 1926 that policy in the summer of 1924 might have been too expansive for too long: “I think myself, if it were to be done over again, we might have stopped a month earlier or even sixty days earlier. We might have bought $50 million or even $100 million less, but there is no mathematical formula that will tell you where to stop or to begin” (House Committee on Banking and Currency 1926, 336). In a memo to his files written in December 1924, he defended the policy as a response to the recession in business starting in the fall of 1923 and problems in the farming and cattle industries. These “became perilously near a national disaster, and feeling became so strong throughout the West that all sorts of radical proposals for legislation and other government relief were being urged” (quoted in Chandler 1958, 242). The memo mentioned international considerations as a third reason for open market purchases “when [domestic] prices were falling generally and when the danger of a disorganizing price advance in commodities was at a minimum and remote” (243).

  What remains of the role of international cooperation as a reason for easing policy in 1924? In his testimony to Congress, and in his conversations with Norman about the stabilization credit, Strong always insisted that international cooperation could not run counter to domestic policy considerations.53 Control of domestic inflation had priority for both political and economic reasons. Strong and others understood that a 10 percent United States price increase would make restoring the international gold standard easier, particularly for Britain. The Federal Reserve might have defended such action by appeal to gold standard rules or to the gold reserve ratio. Instead, Strong made price stability a more important goal and sought to avoid a repetition of the damaging 1920–21 inflation cycle.

  Again in the summer of 1927, international cooperation played a role during a recession and at a time of falling prices. The Federal Reserve made larger than seasonal open market purchases during the fall, and all reserve banks reduced discount rates by 0.5 percent, to 3.5 percent, in August and September.54 Once again, the gold inflow reversed after the policy change.

  53. One of many examples of Strong’s view of limited international cooperation is in a letter to Norman in March 1921: “I have always taken the position that both you and we had three possible courses in our relations with each other. One was to deal wholly independently with our respective problems . . . in other words to ignore each other; another might be to pursue a wholly selfish policy . . . ; and the third might be to adopt a policy of complete understanding, and exchange of information and views, and to cooperate where our respective interests made it possible” (Chandler 1958, 247).

  54. Chicago at first refused to reduce its rate. The Board ordered the reduction. The incident is discussed more fully below.

  The 1927 reduction in discount rates was part of an agreement between Strong, Norman, Governor Hjalmar Schacht of the Reichsbank, and Deputy Governor Charles Rist, acting for Governor Émile Moreau of the Bank of France, made at a secret meeting in New York held in July.55 Capital flows to Germany, fiscal reform and stabilization in France in the summer of 1926, the aftermath of the 1926 British general strike (implying that further deflation was unlikely), and continued gold flows to the United States weakened the British position. French interest rates were considerably above rates in Germany, Britain, or the United States, adding to the British problem of attracting short-term balances from abroad. Between January 1926 and February 1927, the Reichsbank reduced its discount rate in steps from 9 percent to 5 percent to slow its capit
al inflow (Board of Governors of the Federal Reserve System 1943, 656). The reductions soon produced a short-term capital outflow and a fall in the Reichsbank’s gold reserve that threatened its gold parity. Higher German rates, widely expected, implied increased short-term capital flows from Britain to Germany (Clarke 1967, 114). By the end of 1927, the German discount rate was back to 7 percent.

  In May the Bank of France began to sell pounds against gold, withdrawing gold from the Bank of England and weakening the British position. Both central banks wanted the capital flow to slow or stop, Moreau because he resisted both appreciation of the franc and inflation, Norman because a large loss of reserves would force Britain to raise interest rates or suspend gold convertibility. At a meeting in late May at the Bank of France, Moreau told Norman that France would stop exchanging pounds for gold if Britain increased its discount rate. Norman responded that an increase was difficult given the weak state of the British economy. He told Moreau that the French capital inflow would not be solved by higher rates abroad. Moreau’s notes of the meeting record Norman’s comments:

  Is it surprising that . . . you have an influx of capital! . . . Never before have such favorable conditions existed. 61/2% for life with, in addition, the hope of a premium on the revalorization of the currency which maybe considerable! In these circumstances, it is a hopeless task to check the influx of foreign exchange whatever you do. . . .

  If you buy gold in order to cut short credits for speculation, people will say: “The franc has more gold behind it, it is therefore worth more.” If you abolish the law on the export of capital, many Frenchmen will conclude that there is no longer any risk in repatriating and they will bring their money back. . . .