The principal antagonists learned nothing from the experience. Carter Glass and Miller blamed Strong’s 1927 policy for the speculative boom and the 1929 collapse. Using a phrase that was repeated many times in the next few years, they described the collapse as an inevitable consequence of the preceding expansion. For them, the problem was the violation of real bills by financing speculation. They believed the speculative boom had started when excessive open market purchases were used to help Britain in 1927. They usually neglected the Board’s supporting role, including its insistence on forcing Chicago and others to reduce their discount rates.
Miller (1935) set out to show why it was wrong to conclude that in 1927–29 the reserve banks had been right and the Board wrong.184 He made three claims: that the New York Federal Reserve bank initiated the 1927 reduction in discount rates; that between August 1928 and February 1929 the reserve banks took no action to check speculation; and that the first attempt to increase the New York discount rate in 1929 came after the Board announced its policy of direct action. The timing of New York’s action was important to Miller. The Board’s February 2 statement said: “There are elements in the situation which are not readily amenable to recognized methods of banking control.” This meant, he said, that the time for a rate change had passed (Senate Committee on Banking and Currency 1931, 142).
At first New York’s 1927 policy seemed to work. The pound strengthened, and the economy recovered from recession. Many people praised this result as the beginning of a “new era” in which “well timed monetary policy” would substantially reduce “the terrors of the business cycle” while ensuring price stability Miller (1935, 447).
Unfortunately, he continued, the policy had other effects:185 “Cheap credit gave a further great and dangerous impetus to an already overex-panded credit situation, notably to the volume of credit used on the stock exchanges” (1935, 449).186 The reserve banks tightened in the spring of 1928 by selling securities and raising interest rates, but this had only a brief, temporary effect on the stock market. In Miller’s view the policy did not work for three reasons. First, “the astonishing increase in the earnings of large corporations and the extremely low rate of interest . . . appeared to supply a basis for the high prices that were being paid for stock of companies whose earnings were rising and whose dividend disbursements. . . were far above the going price for money” (451). Second, banks believed there would be no classical money panic because the Federal Reserve would rediscount in an emergency. Third, nonbank funds supplied large amounts of credit for the stock market.
184. The specific references are to Lionel Robbins and a New York Times editorial. Miller recognized that the Board approved some of the policies he cites, so he assigned it secondary responsibility for the outcome.
185. The policy was originated by “the distinguished Governor, the late Benjamin Strong. Brilliant of mind, engaging of personality, fertile of resource, strong of will, ambitious of spirit, he had extraordinary skill in impressing his views and purposes on his associates in the Federal Reserve System” (Miller 1935, 447). Miller ignored not only Strong’s absence during most of 1928 and the increase in the acceptance rate that came before the Board’s announcement in February 1929 but also his own initial praise of the operation.
186. Miller cited a secondary factor in 1927—larger than expected redemptions of the Second Liberty Loan. Federal Reserve banks supported the issue to help the Treasury.
The reserve banks failed to tighten in the fall of 1928 partly because they expected normal seasonal demands to raise rates and partly because they did not want to be blamed for harming agriculture. Banks sold acceptances to the reserve banks, then used the proceeds to finance stock purchases. Miller characterized this policy as “lacking in strong conviction” (451–52).
The mistaken policy was the work of the New York Federal Reserve bank.187 The Board’s role was secondary; its mistake was a delay in taking leadership. The error reflected the division of responsibility in the Federal Reserve Act and the primary role given to the reserve banks to propose policy action.188
By early 1929 “the rate of speculative expansion had attained such speed and the thirst for credit had attained such intensity . . . [that] control through discount rate increase . . . is at best to be regarded as a frail reliance and a dubious expedient” (Miller 1935, 455). Direct pressure, on the other hand, was a more flexible method of control of the particular banks and type of credit that had to be controlled.
Miller, writing in 1935, cited the provisions of the Banking Act of 1933 (and the Securities and Exchange Act) as evidence that Congress had accepted the Board’s view. The specific features included control of margin requirements and restrictions on brokers’ loans. These changes were made to prevent credit from being diverted from commercial to speculative uses. In the real bills view, financing the stock market did not lead to new output, hence it “diverted” credit from productive to unproductive uses.189
187. “The incontrovertible fact is that during this period . . . the leadership of the Federal Reserve System rested with the Federal Reserve Bank of New York” (Miller 1935, 452).
188. Miller cited the public outcry against the Board for its actions in the 1927 Chicago rate controversy as a reason for the Board’s failure to act in 1928. This is a weak defense. Nothing prevented the Board from suggesting discount rate changes, as it had done several times. Also, he failed to recall his statement to the Strong (Kansas) hearings on stabilization, where he gave the Board credit for initiating “most of the changes in the discount policy” and credited the Board with a longer view. See House Committee on Banking and Currency 1926, 640–41. Although Miller defended the Board and criticized the reserve banks, particularly New York, he never explained why the Board waited until it believed the time for a discount rate increase had passed. Nor did he explain his vote in March 1928 against an increase in the discount rate.
Earlier, Miller had testified on the reasons for the Board’s refusal to raise rates in 1929: “It was our belief that an increase to 6 percent in February, 1929, would have been nothing but a futile gesture; that it would have been a practical declaration to the speculative markets of the country that the doors of the Federal Reserve System were open to all comers. . . . With call rates mounting to 8, 9, 10, 15, and 20 percent, a 6 percent discount rate would have been an admission of defeat and given great relief to the speculating public” (Senate Committee on Banking and Currency 1931, 143).190
Harrison made a weak defense of New York’s policy. He didn’t question that the growth of speculative loans was a major problem, but he was more confident than Strong had been earlier that raising the discount rate would have been an effective response. His difference with Miller was mainly about whether “direct action” was, or could be, effective without an increase in rates. He was ambivalent about whether the Federal Reserve should lend only on productive credit, but he understood, as Miller and Glass did not, that limiting rediscounts to real bills did not change the marginal loan at member banks or the volume of credit outstanding.191
Harrison stated the quantitative guide: When credit expands faster than trade or business, the Federal Reserve System should raise rates, “whether the expansion is due to speculation in real estate, securities, or commodities, or whether it is due to abnormal growth of business” (Senate Committee on Banking and Currency 1931, 55). The task of deciding who borrows was the job of the member banks, and he insisted that the New York Federal Reserve bank did not admonish its members to reduce brokers’ loans in 1929. These statements puzzled, and infuriated, Chairman Glass.
189. Woodlief Thomas (1935) argued that more effective control of stock market credit was necessary for economic stability. Thomas was a leading economist on the Board’s staff and later an adviser to the Board. Credit control prevented diversion of credit, which he took to be a major reason for policy failure in 1928–29. This was a widely held view. Reed (1930) devoted many pages to analysis of whether there was dive
rsion. The idea of “absorption and diversion of credit” lacks analytic content except, perhaps, in a real bills framework.
190. Senator Carter Glass chaired the hearing and heartily agreed with Miller’s testimony. The following exchange is representative: “Mr. Miller: An alternative use of discount policy would have been what you alluded to yesterday, Mr. Chairman . . . successive increases to 6, 7, 8 or 9 percent, in other words, a race between the call rate and the discount rate. The Chairman [Glass]: With legitimate commerce the victim” (Senate Committee on Banking and Currency 1931, 143).
This position was not uniformly held in Congress. Warburg (1930, 514) reported that the chairman of the House Banking Committee, Henry Steagall, did not share Glass’s views and wanted the Board to stop interfering with stock exchange loans. Former senator Robert Owen was counsel for plaintiffs in a suit to stop the Federal Reserve from restricting the credit supply.
191. His difference with Glass became clear in this exchange: “Governor Harrison: If we have to go beyond the paper presented and determine the loan not on the character of the paper but the business of that bank—The Chairman: You have to determine it upon the purpose for which the borrowing bank wants money from you. Governor Harrison: In the usual case, I will have to say that I could not tell. The Chairman: What are your examiners for if you cannot tell? . . . Governor Harrison: At times, the banks themselves do not know whether the borrower is speculating. The Chairman: But ought they not to know that? Governor Harrison: It is sometimes pretty difficult to find out” (Senate Committee on Banking and Currency 1931, 54).
The Chairman: It [the act] says expressly that you are not to permit the facilities of the Federal Reserve banks to be used to purchase or to carry—
Governor Harrison: We do not—
The Chairman: To purchase or to carry—oh, you may not do it directly, but you practically vitiate this act in the way you do it.
Senator Walcott: The borrowing bank does it.
The Chairman: The Federal Reserve bank permits the borrowing bank to do it. It is the business of the Federal Reserve bank to know what the borrowing bank is doing and for what purpose it is doing it. If this is not the meaning of this act, why should . . . your board of directors ever feel—in any sense or degree—warranted in admonishing member banks in New York to reduce their loans to brokers?
Governor Harrison: Senator, we never did it.
The Chairman: You did not?
Governor Harrison: No, sir. (55)
Harrison then gave two reasons. First, brokers’ loans did not increase at New York banks. Second, the directors believed that the correct policy was to raise rates, not admonish individual banks. He explained again why rate increases would work where direct action would fail to control the amount of lending. None of his arguments reached Glass.192
Harrison acknowledged two mistakes in 1928–29: “First we raised our rate the first time too late, and, second, we did not raise it enough. I mean that had we had at that time the light of the experience we have since had, it would have been better perhaps to have raised the rate 1 percent in December of 1927” (ibid., 66). Harrison went on to blame the “bootleg banking system” through which corporations and individuals lent to brokers and dealers outside the regular banking system.
J. Herbert Case also testified about the New York bank’s position. He explained that the collapse was regarded as inevitable because speculation in farmlands during the war and postwar inflation were followed by speculation in Florida real estate and, finally, in the stock market, “which adversely affected the general business of the country. These movements have each in turn culminated as they inevitably must in a deflation” (ibid., 111).
192. Glass responded: “I have never been able to see, and I did not see in 1920, either the fairness or the effectiveness of increasing the discount rate and thereby imposing a penalty upon the ordinary business of the country, commercial or industrial, in order to control the activities of the stock market” (ibid., 57).
THE STOCK MARKET BOOM
The rise in stock prices that ended in 1929 is extraordinary by almost any standard except 1998–2000. From the end of 1924 to September 1929, Standard and Poor’s index rose at a 21 percent compound annual rate. The Dow Jones industrial average, at its peak of 381 in September 1929, had doubled in less than two years. The rise was propelled in part by rising profits and economic activity. Real GNP and corporate profits rose at annual rates of 4 percent and 12 percent, respectively, with only one mild recession during the nearly five-year period. The increase in market capitalization relative to nominal GNP brought the ratio of the two to a level that was not surpassed until 1996.
The rate of rise in corporate profits was much greater than the rate of increase in GNP but only half the rate of increase in the value of traded stocks (market capitalization). Chart 4.4 shows that between 1925 and 1929 the ratio of market capitalization to corporate profits doubled.193 In absolute value, the ratio rose from 6.2 in 1925 to 12.7 at its peak in 1929.
For those brought up on the belief that the 1929 stock market was a wild speculative orgy, chart 4.4 is surprising. It shows that the capitalization rate rose most rapidly in 1926, with rising profit anticipations.194 The rate then remained between 10 and 12 until the market break in 1929. These data suggest that the so-called speculative boom of 1927–29 was driven by rising profits and, most likely, by anticipations of further increases to come. The 17 percent decline in corporate profits in fourth quarter 1929 and the 30 percent decline in first quarter 1930, or anticipation of the decline, must have reversed some of the beliefs built up during the expansion. At the time, many could vividly recall the volatility of the late nineteenth century and the frequent banking panics that Congress intended the Federal Reserve to prevent. Call money rates briefly reached 20 percent (a year) in 1929. Rates of 100 percent or more had not occurred in the fifteen years of the Federal Reserve’s existence. There had been recessions, but the only major deflation, in 1921, was universally attributed to the end of wartime excesses. The belief spread that the Federal Reserve had learned how to maintain prosperity, damp recessions, and prevent inflation. The return of many countries to the gold standard by 1927 reinforced the view that the world economy was on a stable foundation and that inflation and deflation were unlikely to occur.
193. Market capitalization includes new issues and valuations of shares not included in the S&P index.
194. In the nearly seventy following years, there were only two periods when the ratio came close to its 1929 peak. One was in the latter part of 1936, just before a steep recession. The other was 1965 to 1968, just before the Great Inflation of the 1970s.
In the 1920s, low inflation, sustained growth, and technological change convinced many that the United States had a “new economy.” At the time, Irving Fisher commented that the stock market “went up principally because of sound, justified expectations of earnings, and only partly because of unreasoning and unintelligent mania for buying” Fisher (1930b, 53). He credited increased profits to the application of science, technology, and new management methods.
Annual rates of inflation (consumer price index) remained negative from July 1926 to May 1929. Restoration of the international gold standard—raising the demand for gold—and Federal Reserve actions were the main reasons for the sustained, mild deflation. The twelve-month moving average of monetary base growth fell below 1 percent in November 1926, turned negative in May 1928, and remained negative through June 1929. In this period of rapid economic growth, monetary policy was deflationary.
Federal Reserve records show that the 1929 increase in output and fall in prices was known at the time. The United States economy had a spectacular performance in the first half of the year. Corporate earnings increased about 30 percent in the first nine months: “Large corporate earnings, together with the ability of corporations to float stocks at high [stock] prices. . . put them in possession of funds with which to complete contemplated expansion programs” (“Review
of Business in 1929,” preliminary, Board of Governors File, box 2461, January 15, 1930, 4).195 The only negative influence reported at the time was a decline in residential structures. Industrial and commercial building was at a record level. Exports of manufactured goods increased 50 percent for the year, despite the recession in the last four to six months (ibid., 2).
These data suggest that the optimistic projections underlying the rise in stock prices had a factual base. Even after the severe decline at the end of 1929, the Board’s staff described the first six months of 1929 as “the continuation of the steady expansion throughout the year 1928” (ibid., 5). It reported industrial production as 26 percent above the trough in the 1927 recession.
Some questioned or dissented from these optimistic beliefs. Allyn Young warned about deflation early in 1929.196 Unlike many of his contemporaries who blamed deflation on either a decline in the gold stock or a maldistribution of gold holdings, Young blamed central bank gold hoarding. He saw that central bank policies forced deflation.
Paul Warburg was critical of Federal Reserve policies from a technical perspective. A thoughtful representative of the real bills view, Warburg believed that the Federal Reserve System had serious flaws. He saw the principal flaw as short-term investment in call loans instead of real bills. The problem was that call loans made the banking and financial system depend on the stock exchange. Since call loans could be called daily, a sudden decline in stock prices would weaken the banking system. Warburg favored a secondary reserve against call loans as a temporary expedient and the development of the acceptance market to replace the call market (Warburg 1930, 1:457–58, 501–18).197
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