A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  89. Leslie Rounds compared Strong with Gates McGarrah, who served as acting governor for a few months after Strong died: “McGarrah could present a case quite effectively, but when it got to the arguments, he was through. . . . McGarrah just wasn’t built on a plan to permit him to argue and win. Strong loved it. He thoroughly enjoyed getting into a fight and coming out on top, as he always did” (CHFRS, Rounds, 13). McGarrah and the New York directors voted for discount rate increases repeatedly in the spring of 1929, but the Board would not approve.

  90. Early in 1928, Miller and others at the Board worked to dilute Strong’s authority by replacing the five-person OMIC, dominated by Strong, with a twelve-person committee consisting of all reserve bank governors. The change, discussed below, was made in 1930 after Strong died.

  91. There are two issues. First is whether Strong would have convinced the Board to raise the discount rate early in 1929. The other, more important issue, is whether he would have convinced the open market committee to expand in 1930 or 1931. I return to that issue in chapter 5.

  James McDougal, the governor at Chicago, was a man of few words. Bentley McCloud, who served as McDougal’s assistant governor, said that if he was asked the time of day, he would not answer but would show you his watch. McDougal came to the Federal Reserve from the Chicago clearinghouse, where he had worked as an examiner. Meyer described him as “a mere bookkeeper” (CHFRS, McCloud, July 27, 1954, 5; Meyer, February 16, 1954, 5).

  The other Board members during most of the 1920s were Edward H. Cunningham and Edmund Platt, the vice governor. Cunningham was a farmer who went into Iowa politics and was active in the American Farm Bureau. He filled the agricultural seat created after the 1920–21 deflation. He often opposed rate increases because he believed they hurt farmers and small businesses (Katz 1992, 67). He served from 1923 to his death in 1930. Platt’s biography appears above (see note 16). He was usually in favor of raising interest rates during 1927–29.

  The general picture that emerges has two features. Many of the principals responsible for policy in the 1920s, and during 1929 to 1933, were weak men with little knowledge of central banking and not much interest in developing their knowledge. There were a few strong-minded individuals, but they were often at loggerheads. Policy decisions became a contest of wills between Strong and Miller and later between Miller, Meyer, and Harrison or Burgess.

  Edward Smead, who served throughout the period as head of the Division of Reports and Statistics, described the scene. At first “Benjamin Strong was more powerful than anybody on the stage.” Later “Eugene Meyer was in constant opposition to Harrison in the New York bank” (CHFRS, Smead, June 14, 1954, 2).93 Meyer confirmed and strengthened Smead’s comments. During his period of service at the Board, he claimed, there was constant strife at the Board and ill feeling between the Board, New York, and Chicago. The “New York bank had built up its power entirely out of proportion with the intent of the Act” (CHFRS, Meyer, February 16, 1954, 4).

  92. Morrill reports that James was from Tennessee and believed that the mule, the horse, and hay were “the basic elements of any economy.” He was “wrapped up in organic fertilizer.” He disliked the automobile and believed that by doing away with the horse and the mule, automobiles contributed to the “decay of the country” (CHFRS, Morrill, May 20, 1954, 6).

  93. Smead added that in the 1940s the “New York–Washington feud” continued under Allan Sproul and Marriner Eccles.

  The struggle for power and control that was inherent in Wilson’s compromise had gathered momentum by the late 1920s. The Federal Reserve entered a critical period for policy decisions with a conflict that made decisions easy to postpone and left basic policy issues unresolved.

  POLICY ACTIONS

  New York and some of the Board’s staff followed the Riefler-Burgess doctrine as a general guide to policy actions. Miller relied mainly on the qualitative test, based on the real bills doctrine, underlying one part of the tenth annual report. Regional reserve bank governors were often more interested in their bank’s earnings than in issues of money or credit management. They were more willing to follow Strong’s leadership and participate in System policy when policy increased earnings. Those who voiced opinions about System policy usually held orthodox gold standard and real bills views.

  The deflation of the early 1920s ended by 1922, but it continued to shape interpretations and actions. Many of the banks in the South and Middle West held distressed agricultural and livestock loans. The problem was particularly acute in the upper Middle West and in the northern plains states. Bank suspensions continued to rise, particularly in these states, during the middle twenties. As late as 1926, the peak year for suspensions in that decade, 976 banks with deposits of $260 million closed. More than one-third of the number of suspensions occurred in three states: Minnesota, Iowa, and South Dakota.

  The potential political impact of agricultural interests heightened the effect of the regional economic problem. Since deflation was widely regarded as the inevitable consequence of prior inflation, avoiding inflation became a paramount interest. Strong had been impressed, however, by the reports of distress in agricultural regions during his appearance before the Joint Commission on Agricultural Inquiry and, despite concerns about inflation, he believed it was prudent to lean to the side of ease in 1922 (Burgess 1964, 223).

  The 1923–24 Recession

  The wholesale price index rose during most of 1922, sharply in the early part of the year, more slowly later. In the fifteen months ending in March–April 1923, the index (base 100 in 1913) increased from 140 to 160. Concern spread that inflation had returned.94

  94. In late April 1923 the National Bureau of Economic Research wrote: “We will soon have a boom, with the standard trimmings and the standard ending” (quoted by Miller in House Committee on Banking and Currency 1926, 701).

  Although it was eager to take credit later, the Federal Reserve’s response was largely fortuitous. Under pressure from the Treasury, the reserve banks began to sell securities after May 1922. By the end of the year they had sold more than one-third of their holdings, $220 million. Sales continued in the first half of 1923. By June, System holdings were $150 million, one-fourth of their peak in May 1922. The System relied on discounts to satisfy seasonal credit demand in the fall. To the surprise of many in the System, after a small seasonal decline in January, member bank discounts continued to rise throughout the spring and summer.

  The Federal Reserve increased discount rates at Boston, New York, and San Francisco by 0.5 percent in late February and early March. Rates were now uniform for all classes of paper, at 4.5 percent, at all reserve banks. Open market rates rose following the rise in discount rates.95

  With market rates above the discount rate, prices and production rising, and speculation developing in stocks and commodities, Platt, the acting governor, wrote to Treasury Undersecretary Gilbert on March 24, 1923, reflecting the general uncertainty about how to conduct policy: “The old Bank of England guides appear to be inapplicable. . . . It may not always be necessary to have reserve bank rates above or exactly even with open market rates, but an increasing spread between them is certainly an invitation to inflation” (Board of Governors File, box 1240, March 24, 1923).

  The March Governors Conference discussed additional discount rate increases. McDougal thought that economic conditions were similar to 1919–20. He favored an advance of 1 percent, to 5.5 percent, at all reserve banks. Calkins (San Francisco) and Norris (Philadelphia) were less aggressive, but both favored rate increases. Case thought another increase would be appropriate by mid-April. All other governors saw no reason for change. Chicago voted on April 6 to raise the discount rate to 5 percent, but the Board refused to approve the increase. The next day the Board sent a letter, proposed by Miller, to all reserve banks saying that discount rates should not be increased until the reserve banks had substantially liquidated their portfolios of governments. This was a reversal of traditional policy; open market sales
were supposed to make discount rates effective. The new policy, under pressure from the Treasury, had the sales precede any increase in discount rates.

  The Board’s correspondence leaves no doubt about the reason for the policy change. The Treasury continued to press the reserve banks to elim

  95. Strong wrote to Norman that the discount rate increases had been delayed until it was clear that Congress would approve a loan to Britain. As reason for the increase in the discount rate, Strong cited the increase in borrowing, market rates 1 percent above the discount rate, rising stock market loans, and production “practically at a maximum” (Chandler 1958, 221).

  inate all government securities. On April 20 Platt wrote to Secretary Mellon, calling attention to the large open market sales in the previous year and pointing out that the System holdings of governments were about equal to the capital and surplus of the reserve banks. The reserve banks were eager to hold governments at this level to ensure sufficient earnings to pay dividends on their capital stock. They wanted the Treasury to agree that additions to surplus could be matched by increases in government securities. Mellon opposed, and Undersecretary Gilbert continued to press for additional sales (Board of Governors File, box 1434, April 20 and 27, 1923, and box 1433, May 3, 1923). Platt replied that additional sales would force higher discount rates and, by eliminating the portfolio, reduce the reserve banks’ ability to influence the market and prevent inflation should it occur.

  The Board had abolished the governors’ Committee on Centralized Purchases and Sales and established the Open Market Investment Committee (OMIC), with the same membership but operating under regulations and subject to supervision by the Board. The Board’s resolution gave two guidelines to the OMIC. First was the effect on commerce, business, and credit markets. Second was the effect on the market for Treasury securities. At its first meeting, April 13, the OMIC adopted a statement, similar to the Board’s, directing open market operations to “the accommodation of commerce and business.” The statement added that a penalty rate of discount “is not always suited to the American bill market” and expressed concern that attempts to maintain a penalty rate “would quickly drive the dollar credit from those [bill] markets” and benefit London. The statement indicated that, although government securities would be bought and sold in the market, acceptances, once bought, would be sold only to another reserve bank. The latter policy represented New York’s view that sales should be avoided to prevent competition with member banks and encourage a domestic bill market (Policy Governing Open Market Purchases by Federal Reserve Banks, Exhibit A, Board of Governors File, box 1436, April 13, 1923).

  Strong was on leave for health reasons from March to November 1923, so he missed the first OMIC meeting, in April. The meeting elected him chairman and selected Case, his deputy, to act in his place. Acceding to the Treasury, the OMIC allowed $36 million of maturing securities to run off and proposed raising the buying rate on acceptances by 0.125 percent. Four days later, New York raised the buying rate.96

  96. The meeting also considered an issue that continued throughout the decade. Banks in California allowed a limited amount of check writing against “special savings deposits, subject to a 3 percent reserve requirement ratio.” By a vote of seven to five, the governors agreed to keep the prevailing policy. The problem spread to other states, and though it was discussed many times, the policy was not changed. The policy allowed banks to lower the applicable reserve requirement ratio and blur the distinction between demand and time deposits.

  The following month the OMIC recommended open market sales of $50 million, about one-quarter of remaining holdings, with sales distributed among the reserve banks in inverse relation to a bank’s earnings. Crissinger had become governor of the Board at the beginning of May. On May 31 he wrote to Case reversing Platt’s position and expressing concern at the restriction to $50 million: “The Board sees no reason why there should be any limitation. . . . [G]overnment securities should be disposed of as rapidly as possible until they are out of the banks” (Crissinger to Case, Board of Governors File, box 1434, May 31, 1923).

  Case’s reply expressed surprise that the Board had not objected to the limitation at the time of the meeting, but his tone was conciliatory. His only criticism of the Board’s action was its timing, coming so soon after the Board had not objected to the decision. But he appended to his letter a letter from Philadelphia denying the Board’s authority to specify the volume of sales (Case to Crissinger, Board of Governors File, box 1434, June 11, 1923).97 Strong was more forceful. From Colorado, he wrote to Miller using the economic arguments of the Riefler-Burgess doctrine. Additional sales of $130 million would force the banks to borrow $130 million, reducing bank profits and increasing pressure to liquidate loans. There were signs of “hesitation in business” and rising bank failures: “Had I been home recently when these failures were popping, I would have bought $25 to $50 million” (Chandler 1958, 232).

  The Treasury continued to urge the OMIC to get rid of all government securities. Despite the OMIC’s decision to support the acceptance market, the Treasury urged that the acceptance market be allowed to develop on its own “without artificial support from the Federal Reserve Banks.” The Treasury wanted the OMIC to limit its actions to the acceptance market, arguing that this could be done if the acceptance rate was a market rate and the reserve banks sold as well as bought (Letter Gilbert to Case, Board of Governors File, box 1434, May 25, 1923). Strong did not share this view, and the Treasury did not press it further.98

  97. Case circulated Crissinger’s letter to the members of the OMIC. Philadelphia’s reply suggests the way many of the reserve banks looked at the issue. The Philadelphia directors had approved sharing in the sale only to accommodate the Treasury. The Board’s program would require selling securities at a loss. Decisions about purchases and sales were not the province of the Board, and the Board lacked authority to have a policy about sales. His directors reserved the right to dissent from future OMIC recommendations (Norris to Case, Board of Governors File, box 1434, June 8, 1923).

  98. Gilbert continued to develop and modify this view and to urge it on the Board until August. (See Letter Gilbert to Crissinger, Board of Governors File, box 1434, August 3, 1923.)

  By fall the country was in a deep recession. The National Bureau of Economic Research ranks the recession as one of the most severe in the years 1920 to 1982, surpassed by only three others. The Board’s index of industrial production (1919 = 100) reached a peak of 127 in May 1923. The NBER trough is in July 1924, with the index at 94, a 23 percent decline (Reed 1930, 45).99 Balke and Gordon’s (1986) real GNP declined 4.1 percent. The decline was irregular, with some recovery in the fall.

  At its November 1923 meeting, the OMIC mentioned “the possibility of harm to business when business is hesitating” but took no action to expand. Most of its attention was on the continued imports of gold and the seasonal increase in borrowing. A principal policy concern at the time was the small size of the open market portfolio available for sale if gold imports continued.

  Strong had returned. His report to the committee, as chairman, noted that purchases would not be inflationary if total earning assets did not increase. He did not urge purchases at that time, however, because he did “not think the Federal Reserve Board would consider that” (Report of OMIC, Board of Governors File, box 1436, November 10, 1923, 29–35).100

  A few weeks later, the OMIC voted to make its first purchases but, mindful of Treasury concerns, added that purchases should not disturb the money market. The Board approved purchases of no more than $100 million on December 3, but it reserved the right to discontinue purchases and resume sales if market conditions changed (Board Minutes, December 3, 1923).101

  Although New York favored the decision to purchase, Strong and his directors feared that purchases of governments would be regarded as inflationary. They wanted the Board to issue a statement endorsing the view that open market operations changed the composition, but not th
e size, of the Federal Reserve’s earning assets. The Board adopted a statement prepared by Strong, Walter Stewart, and Pierre Jay (chairman at New York) that reviewed evidence of the close negative relation between open market operations and member bank borrowing in 1922 and 1923 and emphasized the relation between discount policy and open market policy as a means of accommodating commerce and business (Board Minutes, December 19, 1923). Although the act authorized open market purchases, the emphasis on commerce and business appealed to beliefs about real bills. The Board published the statement in the Federal Reserve Bulletin.

  The Federal Advisory Council accepted Gilbert’s suggestions in principle but decided that the time was not right for further sales. In August Gilbert accepted that the reserve banks’ position was “well liquidated,” ending the issue.

  99. A later index, base 100 in 1992, puts the decline at 18 percent. The Miron-Romer index has an overall decline of 36 percent for the period. Their index has an initial decline of 38 percent between May and September 1923, followed by a rise to February 1924 and a renewed decline to July 1924.

  100. In September the Board approved a request from Dallas to purchase $10 million of long-term Treasury bonds for income. The Board approved because of the weak earnings of the Dallas bank. It denied a similar request from Boston in November. These incidents suggest, correctly, that much of the interest in open market purchases at the reserve banks continued to be for earnings. The tenth annual report had not been written. Strong’s statement at the meeting anticipated part of the report.