A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  Miller proposed open market sales, to be followed by an increase in the New York discount rate if discounts increased seasonally, as they were likely to do. The motion was defeated. The OMIC suggested that purchases might be needed in December, followed by sales in January, for seasonal reasons. The only action at the meeting was to suggest that reserve banks carefully consider whether discount rates should be raised (OMIC Minutes, Board of Governors File, box 1436, September 22, 1925; Board memo, box 1434, July 1, 1927). The following day, Boston voted to increase its discount rate to 4 percent. Miller was strongly in favor, but the Board was not, so it tabled the increase and did not approve it until November 10, 1925, six weeks later.

  The semiannual Governors Conference met from November 2 to 4. The agenda included McDougal’s (Chicago) proposal to discuss discount rates, normally reserved for the individual banks. He believed New York’s rate was too low. Other governors shared his view, possibly to increase earnings. Norris (Philadelphia) argued that if the 3.5 percent rate in New York had been appropriate in midsummer, it was now too low because business conditions had improved and open market rates had increased. Others supported the increase, using as a main reason the increase in stock exchange credit.

  Strong defended New York’s policy. He saw no sign of speculative borrowing for inventory accumulation.117 The main problems were local—real estate speculation in Florida and stock exchange speculation in New York. He then made the argument that he had made earlier and that New York would repeat many times in the next four years: loans to finance stock market accounts came from all over the country. A rise in the New York discount rate would reduce discounting in New York but increase discounting in the rest of the country without any effect on the call money market. Strong argued that at $210 million, the open market account was too small for additional sales to be useful. Member banks were already in debt to the reserve banks; increased indebtedness would not matter much. Higher rates would bring more gold to the United States, and that “would make the situation worse” (Governors Conference, November 2–4, 1925, 353).

  117. At about this time, Miller (1925a) publicly criticized the financing of speculation and urged his readers to accept greater variability in discount rates, as in England. To real bills advocates like Miller, increases in speculative credit were evidence of inflation even if commodity prices remained unchanged.

  Harding (Boston) urged a general increase in rates, to 4 percent at Boston, New York, Philadelphia, Cleveland, and San Francisco, but Calkins and Norris argued that the effect on speculative credit would be small. Fancher (Cleveland) and Norris agreed, however, that their rates should go to 4 percent. In the next two or three weeks the Board approved increases in discount rates to 4 percent at Boston, Philadelphia, Cleveland, and San Francisco. New York remained at 3.5 percent until early January 1926.

  Underlying the discussion was the widely held belief that Strong was holding New York’s rate at 3.5 percent to help the Bank of England. Under pressure from British industry, the bank had lowered its rate from 5 percent to 4 percent in September and October. Gold flows to the United States stabilized during the summer and began to reverse. With United States commodity prices falling, Strong could help Norman without sacrificing price stability at home. This was always his policy, as he told Norman many times. Norman agreed and accepted it.118

  In November 1925, after Britain removed restrictions on foreign lending, the gold flow reversed again. Norman was not disturbed. The size of Britain’s gold stock was now large enough to absorb the loss. In correspondence with Strong, he expressed concern about the effects of gold inflows on future inflation, either directly or through public pressure to reduce interest rates. The loss of gold gave him the opportunity to raise interest rates back to 5 percent in early December 1925.

  Strong was in Europe during the summer of 1925. His correspondence with Norman and with the New York bank showed him shifting between two positions. Growing stock exchange speculation and concern about possible commodity price speculation and future inflation suggested the time had come for an increase in the New York discount rate, but higher rates would reverse the gold outflow and force higher rates in countries that had restored gold payments—Britain, Germany, Switzerland, and Holland. From Europe he explained the dilemma as seen by the four European banks. They were concerned about having gold forced on them and the inflation that would follow. They believed “that their own future depends upon establishing lower prices for what they produce and consume, especially what they produce for export” (Chandler 1958, 325).

  118. In his 1926 testimony to Congress, Strong said (about the standby credit to the Bank of England): “[The New York bank] is free to raise and lower its discount rate; quite as free, in fact, as though no such arrangement had been made” (quoted in Chandler 1958, 320).

  The United States faced a classical central banking problem under a fixed exchange rate system. The gold outflow was deflationary but not large enough to offset increased borrowing. Higher rates seemed called for, but they would attract more gold, with longer-term inflationary consequences. Further, stock market speculation had increased. From New York, Strong wrote to Norman in November 1925: “Now all of this reads very much like an attempt to manipulate the stock market. I confess I hate it. It is repugnant to me in every possible aspect. It is the sort of thing that would not be necessary at all if general resumption of gold payment had been effected throughout the world and we had been able to effect some distribution of our excess vault reserve. . . . It is merely another chapter in the argument against a managed currency” (ibid., 329).

  I believe this statement is as close as Strong ever came to recognition that he, Norman, and others had to choose between short- and long-term objectives. To get the gold standard operating as automatically as before World War I, either Britain had to deflate or the United States had to inflate. Reaching this long-term solution involved short-term changes that neither country would accept.

  The problem was not, as is often suggested, lack of cooperation or unwillingness to cooperate. The failure was a failure of a managed system operating under inconsistent objectives on both sides. Forecast errors about short-term responses added to the problem, but these errors were minor compared with the inconsistent objectives: restoring the prewar gold standard at prevailing exchange rates without additional adjustment of the relative prices of traded goods on both sides of the Atlantic. European countries wanted to lower the real cost of exports, and the United States wanted to avoid inflation. All of them wanted the gold standard, but none wanted more gold. Coordination could not solve this problem; the countries’ objectives were incompatible with the international monetary system they had adopted.

  Strong was more than a little misleading when he complained to the November 1925 Governors Conference about the “unjustified assumption that there was some arrangement with the British which made it impossible for us to increase our rates.” The key word is impossible. He had not pledged to keep rates unchanged. His correspondence with Norman during this period shows, however, that foreign considerations were important. His report on open market policy at the November meeting stated that “this country has a definite responsibility to determine its monetary policy with some regard to the effects of such policy outside of our own borders.”

  Some of the governors were openly skeptical about Strong’s commitment. To Strong’s statement denying an arrangement with the British, Governor Calkins replied: “It is an assumption that still prevails, I believe” (Governors Conference, November 2–4, 1925, 351–52). Soon after, Calkins added: “I believe there is a widespread belief throughout the country that the Federal Reserve banks will not raise their rates because of some understanding with England.” Strong did not reply on the record. Discussion went off the record at this point.119

  With the recovery and increased borrowing, all reserve banks could cover expenses and pay dividends. The November 1925 meeting, however, reconsidered the apportionment of the portf
olio. The OMIC approved a resolution apportioning acceptances among the banks, based, first, on estimated expenses and dividends and, second, after these expenditures were covered, to take account of charge-offs for loan losses. By accommodating some of the regional reserve banks, Strong was able to maintain support for his policy actions. The November meeting suggests, however, that this support could not be taken for granted. The real bills view was firmly held, and several of the governors were openly critical of a policy they regarded as inflationary.120

  The November conference also discussed an issue that continued to irritate some of the governors. Differences in reserve requirement ratios, combined with nonpayment of interest on required reserve balances, gave banks an incentive to minimize required reserves by encouraging customers to shift deposits from demand to time account. The customer received higher interest payments on the deposit, and the bank reduced its required reserves. The reserve banks’ desire to increase membership worked in the opposite direction. Oliver M. W. Sprague, as part of his work with the legislative committee, proposed a reduction to 2 percent in reserve requirements on savings deposits, with time deposits remaining at the 3 percent rate. The objective was to strengthen the System’s political base by increasing membership by savings banks. The reserve banks overwhelmingly rejected the proposal. Although the issue did not die, they took no action in the 1920s.121 Partly as a result of inaction, the ratio of time to demand deposits increased by 10.8 percentage points from 1920 to 1929. Inaction permitted bank credit to grow relative to money by about $1.5 billion.

  119. Short-term changes at year end induced New York to purchase $50 million to prevent an increase in call money rates to 6 percent. The Board agreed reluctantly when New York explained that it had bought $18 million and would put the purchases in its own portfolio instead of the System account (Board memo, Board of Governors File, box 1434, July 1, 1927; Riefler 1956, 63–64).

  120. At the November 1925 Governors Conference, Strong raised the issue of charter renewal. Although the original charter did not expire until 1933, Congress had started consideration. Strong urged the governors to make sure that no scandals would be uncovered if Congress examined the System’s operations before renewal. His list includes issues of discrimination for religious or political belief, nepotism, favoritism for one or another person or group in purchasing, dealing in securities, and similar matters. No officer at the New York bank was allowed to borrow money without Strong’s approval. He urged the other governors to adopt similar standards.

  The OMIC held meetings in January, March, June, August, September, and November 1926, but it made few decisions to purchase or sell government securities other than temporary changes to smooth the money market or replace maturing issues. Concern about renewed recession prompted purchases of $65 million in May and a reduction in New York’s discount rate to 3.5 percent. These decisions were soon reversed: in August New York restored the 4 percent rate, and the OMIC voted to sell $80 million.

  Inactivity reflected an atypical year of general consensus on appropriate actions.122 Total return on common stocks was less than 12 percent, so total brokers’ loans and the stock exchange rose modestly, satisfying the real bills faction. Reserve bank earnings not only covered expenses and dividends but increased earned surplus by $8.5 million, satisfying those for whom earnings were the primary concern. The gold stock increased modestly, and member bank discounts remained between $500 million and $650 million throughout the year. This range reflected moderate pressure. Strong reminded the governors of the Riefler-Burgess principle:

  Experience in the past has indicated that member banks when in debt to the Federal Reserve Bank of New York, and in less[er] degree at other money centers, constantly endeavor to free themselves from that indebtedness, and as a consequence such pressure as arises is in the direction of curtailing loans. . . .

  The total volume of borrowing undoubtedly exerts some pressure upon the business community. Should we go into a business recession while the member banks were continuing to borrow directly 500 or 600 million dollars, (if bills [acceptances] are included nearly 800 million dollars,) we should continue taking steps to relieve some of the pressure which this borrowing induces by purchasing government securities and thus enabling member banks to reduce their indebtedness. (OMIC Minutes, Board of Governors File, box 1436, March 20, 1926, 3–4)123

  121. Seventy years later, banks used computer programs to shift deposits from demand to time account overnight, reducing bank reserves. The System reduced the reserve requirement ratio against time deposits to zero.

  122. Agricultural problems continued. A drought in Texas increased the demand for discounts at the Dallas reserve bank. Governor Talley tried to be selective, angering local bankers who thought they had a right to borrow. A local congressman introduced a bill to remove Talley, and there was a congressional hearing in 1928. Talley remained (CHFRS, Dreibilbis, March 4, 1955).

  Notwithstanding general agreement on actions, conflict between the Board and the OMIC continued. The Board was often reluctant to give the OMIC standby discretion to purchase or sell without prior approval by the Board. For example, in November 1925 the OMIC voted no change in open market policy but asked for authority to purchase up to $100 million, if necessary, to offset near-term seasonal movements. Purchases would reverse in January if business conditions warranted. The Board rejected the request.

  The Board continued to press the governors about continuous borrowing and stock exchange lending by member banks, particularly banks that discounted at the reserve banks.124 Despite his frequent claim that banks were reluctant to borrow, Strong agreed that governors should stop “continuous borrowing.” He reported that nine hundred banks had borrowed continuously for at least one year. The reasons differed. Some were problem banks, others were heavy seasonal borrowers or large borrowers that repaid.

  Strong recognized that pressure on small banks to repay borrowing would shift the borrowing without affecting the total. Small banks would borrow from their correspondents. Given the stock of reserves, the correspondents would borrow from the Federal Reserve or, if the Federal Reserve would not lend, credit would contract. The question, he said, is, “Who is going to borrow this money from us to make good the reserves of the banking system as a whole? Somebody has got to do it” (Governors Conference, March 1926, 53).

  Strong’s answers did not satisfy the Board. In April it asked the governors to supply the names of banks that borrowed continuously in 1925 and to identify those that could liquidate loans by selling government securities or other securities—nonreal bills. The Board justified this intervention in the management of the reserve banks as a means of helping individual member banks “to conserve their capacity to borrow at the Reserve banks” (Board of Governors of the Federal Reserve System, Annual Report, 1926). The reserve banks did not welcome the interference. The policy difference that paralyzed decision making in 1929 had begun.

  123. Later in the same report, Strong added an additional condition—borrowing by New York City banks of $100 million or more. With only $50 million borrowed, there is less tendency for credit to flow to New York (in the form of call loans). Thus, for Strong, the key to reducing call loans was to reduce borrowing by New York banks without increasing borrowing elsewhere.

  124. Stock prices fell sharply from February to April, then renewed their rise. Every month in 1926 is above the corresponding month of 1925.

  Member bank borrowing rose to $650 million in the fourth quarter, about 30 percent of total reserves. The Board continued to press the reserve banks. In November some governors proposed that members be required to repay all borrowing at least once a year, but the only decision was to review the issue at the next meeting in spring 1927. By that time, borrowing had declined.

  The Board took an additional step; it urged New York to collect data on loans to New York Stock Exchange members. Strong was reluctant, but he discussed the issue with the governors of the stock exchange. They agreed to collect a
nd publish the data, but the published data included only borrowings in New York. A stock exchange firm that borrowed at a branch outside New York did not include those borrowings in its report (Governors Conference, March 1926, 83–85).125 The report also excluded nonmember firms (124).

  Differences between New York and Washington on this issue continued for the rest of the decade. The Board wanted the governors to reduce loans for speculative, stock exchange credit. New York replied that the uses of Federal Reserve credit could not be controlled “once it leaves our doors” (ibid., 122).

  In addition to these substantive issues, there were minor irritants. In March, just before the Governors Conference, the Board tried to return to the policy it had enforced before 1920. It voted to require that all meetings be held in Washington. The governors responded by voting that the action was an “inadvisable restriction upon the freedom of the Committee” (OMIC Final Minutes, Board of Governors File, box 1436, May 20, 1926).

  Banks could choose to participate in open market purchases. Even if a governor voted to approve purchases at the Governors Conference, the directors of the bank did not always agree to share in the purchases. Several banks did not participate unless they were operating at a loss. Other banks—Dallas, Kansas City, and Minneapolis—were usually short of earnings, so they participated more than proportionally in the System portfolio. Table 4.3 compares the relative size of the open market portfolio at each bank in December 1926 and 1928 with the bank’s relative size.

  The table suggests that Strong used New York’s portfolio to increase earnings at the regional banks. In December 1926 and 1928, New York’s holdings were ten to twelve percentage points below its proportional share.126 Together, St. Louis, Kansas City, and Dallas held ten to thirteen percentage points more than their proportional share. These banks were not members of the OMIC, but they had an incentive to support Strong’s policies at the Governors Conferences, particularly when he wanted to purchase. On the other hand, Richmond and Atlanta typically participated much less than proportionally, often not at all.