The good years could not last. The three aims of Federal Reserve policy were incompatible. As Adolph Miller foresaw, restoration of the gold standard increased the demand for gold; with gold prices fixed in nominal value, commodity prices had to fall. Britain was unwilling to continue the restrictive policies required to lower domestic price and wage levels until they were consistent with its exchange rate and prices abroad. France wanted Britain to increase interest rates and deflate to slow or stop the loss of gold; it was motivated partly by classical gold standard reasoning, partly by its political aim of making Paris a financial center rivaling London and New York. The United States and France drained gold from many of the other gold standard countries, forcing them to contract, but both countries sterilized the gold inflow to prevent domestic inflation. The international system therefore had no way to make an orderly transition by adjusting price levels or exchange rates.
Eichengreen (1992), Clarke (1967), and others attribute the policy failures to insufficient cooperation among central banks. This charge is more true of France than of the United States, but it was not wholly true of either country. The Federal Reserve, principally the New York reserve bank as agent for the System, actively aided Britain and other countries to restore gold convertibility. It lent dollars to Britain and changed domestic policy in 1924 and again in 1927 partly for international purposes—to restore or maintain gold convertibility. These actions were always taken with an understanding, on both sides of the Atlantic, that cooperation would not be allowed to affect domestic inflation. The latter restriction meant that cooperation could not succeed. Exchange rates were misaligned: the pound was overvalued, the franc undervalued. Ruling out inflation in the creditor countries and deflation in Britain left only one course—exchange rate changes—to adjust the system.
The New York reserve bank and its governor, Benjamin Strong, received much criticism at the time and subsequently for lowering interest rates in 1924 and 1927 partly to assist Britain. Although United States prices generally declined, New York’s policy was considered inflationary by the financial press, the Federal Reserve Board, and leading members of Congress. Strong was charged with allowing credit expansion based on purchases of government securities. That the price level fell after 1925 did not mute this criticism.
The conflict over policy in 1928 and 1929 was part of the continuing struggle between the Board and the reserve banks and mainly between New York and Washington. Strong was convinced of the correctness of his policy views and his ability to manage the system. The Board, particularly Adolph Miller, wanted to use the supervisory powers granted in the Federal Reserve Act to gain control of policy decisions. Decisions to change discount rates or purchase and sell remained under the control of the reserve banks, subject to the Board’s approval.
The Board wanted to expand its power to approve changes into the power to make changes. By 1929 the System’s holding of securities had been reduced to a level too low to be useful. The System had to rely on other policies, but the reserve banks and the Board could not agree on what the policies should be. New York and other reserve banks wanted to raise discount rates. The Board believed that higher rates would penalize industry and trade without deterring stock exchange speculators. It insisted on selective controls implemented by direct pressure or moral suasion and would not approve a 6 percent discount rate.
Disputes were not limited to personal and power conflicts. A main substantive issue was central to the dispute. Miller, other Board members, and several reserve bank governors accepted the real bills doctrine as the only correct guide to policy action. The Federal Reserve Act was written by people who accepted “real bills” and the gold standard as proper guides, so there was a firm legal basis for the positions held by the proponents of real bills.
The central tenet of the real bills doctrine is that increases in credit achieved by discounting real bills finance production and output. Hence credit and output expand together, and there is no inflation. Credit expansion based on government securities (or real estate) is speculative credit. No new production results, so the expansion is inflationary. The proponents of this view disliked open market purchases of government securities. They wanted such purchases to be limited to bills of exchange or banker’s acceptances arising from financing trade or production. They might tolerate using open market operations to affect discounts, but not to change the amount of money or credit outstanding.
Strong was the chief spokesman for the opposing view. He did not dispute the importance of discounting. Strong, Warburg, and others wanted an acceptance market, like the British bill market, to replace the call loan market as a short-term credit market. Differences with the Board on these issues were small.
The major difference and substantive source of dispute concerned the ability of a reserve bank to control the volume of credit or money, hence inflation, by limiting discounts to real bills. Strong understood that the collateral offered to the reserve banks had no fixed or logical connection to the marginal use of bank credit. Banks borrowed in the most efficient way and lent for the most profitable uses. Miller and other Board members, Carter Glass and other members of Congress, and many bankers and economists did not accept this conclusion.
In the early years of the decade, research at the Board and the New York bank uncovered a negative relation between open market operations and member bank discounts. They gave a causal interpretation to the relationship: open market sales caused banks to borrow; open market purchases caused repayments. At times the relation was viewed as one-to-one or dollar-for-dollar. On this interpretation, open market operations could be used to control the volume of member bank borrowing. I have called this relation the Riefler-Burgess doctrine.
The Riefler-Burgess doctrine is ambivalent about the role of the discount rate. At most, it has a supporting role; at worst, it has little supplementary effect. Strong, who used the doctrine as a guide to policy, was ambivalent about the independent effect of discount rate changes.
For a time, the emphasis given to control of discounting at New York fit well with the real bills views in Washington. Conflict was muted as long as the governors used open market operations mainly to force borrowing or repayment of discounts based on real bills. Purchases for other reasons, as in 1924 and 1927, were more contentious.
Strong died in October 1928 and was ill and absent for months before his death. His commanding influence during the 1920s invites speculation about what he might have done in 1929 to reverse the Board’s policy. Leslie Rounds, a vice president of the New York bank, conjectured that Strong would have succeeded in raising the discount rate early that year (CHFRS, Rounds, May 2, 1955, 13). If this inference is correct, policy would have been more deflationary at an earlier date. With the open market portfolio at a minimum, raising the discount rate was the only remaining way to reduce borrowing.
In Strong’s absence, traditional ambivalence about the power of discount rate changes left New York in a weak position to urge such changes as an alternative to direct action in 1929. New York and other reserve banks nevertheless voted to raise the discount rate to control credit expansion. The Board vetoed all requests for four months in the winter and spring; it insisted on using direct action to control speculative credit by urging banks not to make loans to finance stock exchange purchases.
Political concerns reinforced the Board’s desire to hold the discount rate at 5 percent. Higher discount rates in the early twenties had been extremely unpopular in Congress and in agricultural areas. Neither the Board nor the reserve banks wanted to repeat that experience. The Board felt the pressure directly from members of Congress, many of whom, like Carter Glass, believed that credit was financing speculation, not commerce and agriculture. Higher rates, they believed, would deprive legitimate users of credit without deterring speculators. Miller and other Board members shared this view.
Both sides in this dispute were misled by the rise in interest rates, particularly call money rates, the relatively high volume
of discounts, and the growth of loans to finance securities. Based on these indicators, they regarded policy as highly expansive and inflationary. Since they did not distinguish between real and nominal interest rates, they remained unaware that real rates remained above market rates after 1925.
Growth of the monetary base or the money stock tells a different story. These indicators implied that policy was deflationary. In 1920–21, deflationary policy attracted gold imports and raised real money balances, thereby contributing to expansion despite relatively high real interest rates. In 1927–29 the Federal Reserve followed a more activist policy by sterilizing the gold inflow to prevent monetary expansion. Misled by the level of discounts and the growth of borrowing, the System forced further deflation instead of moderating policy to prevent deflation. The evidence suggests that a less restrictive policy that avoided deflation would have ameliorated or possibly prevented the 1929 recession.
Experiences in the 1920s also show that the Federal Reserve was misled by the stock market. A rapid rise in stock market prices does not permit a central bank to distinguish between well-founded anticipations of increased productivity and output growth and mistaken speculation. Rising expenditure and output, with falling prices, suggests that the public reduced desired real balances to buy claims to real assets. If it had given attention to deflation instead of the booming stock market, the Federal Reserve could have recognized the symptoms of an excess demand for money and increased money growth. Or it could have achieved the same result by ending gold sterilization. The latter course would have required similar action by the Bank of France—an end to gold sterilization.
The 1923–29 experience highlights a major flaw in activist policy, a flaw that reappears in many subsequent periods. Increasingly, policy focused on short-term changes, smoothing the money market, gold inflows and outflows, or Treasury operations. These concerns were visible; longer-term considerations were more remote and conjectural. Hence longer-term aims tended to be sacrificed or postponed to satisfy immediate concerns.
The 1929 recession began with the Federal Reserve System divided on personal and substantive issues. With Strong dead, the Board was in a better position to shift power from New York and the other banks to Washington. The shift of power strengthened Miller and the real bills faction. The financial system entered the Great Depression divided, unprepared to take decisive action, and uncertain whether policy action was useful or desirable to stop economic decline and price deflation.
APPENDIX A: DETERMINANTS OF INFLATION—RELATION OF THE MONETARY BASE AND ITS COMPONENTS
Data are quarterly values at annual rates. The first equation is used in the text. The others are for comparison.
Inflation
Table 4.A1 shows some regressions used to estimate the relation between inflation and money growth for different periods. The text reports on predictions of inflation in the 1920s using quarterly data for 1923 to 1933, regression (1). Regressions (2) and (3) are for comparison. The similarity of the coefficients in equations (2) and (3) suggests that the relation of money to inflation remained the same in the two periods.
Relation of the Monetary Base and Its Components
Chart 4.A1 shows the relation between the monetary base, discounts, gold, and government securities held by the Federal Reserve. The estimates come from a four-variable vector autoregression (VAR) using the following order: discounts, gold stock, monetary base, government securities. Data are monthly from March 1922 to October 1929.
The estimates are based on two lags, eleven seasonal dummy variables, and a constant. Alternative estimates use twelve lags of each of the four variables and no seasonal correction. Main conclusions are the same for both VARs.
The Riefler-Burgess hypothesis specifies a causal relation relating open market purchases and sales to discounts. Open market operations are said to force banks to borrow or permit them to repay. The VARs find no effect of government securities on discounts. To the extent that there is a relation between the two, the data suggest that Federal Reserve operations responded to higher discounts by selling.
Gold has no significant effect on discounting in the short term and a negative relation after a quarter. Over the longer term, government securities have a modest negative effect on gold. Nevertheless, the variance decomposition (not shown) suggests that past gold movements dominate all other influences on the gold stock.
The monetary base appears to be relatively independent of its asset components. The exception is a longer-term positive effect of gold flows on the base. The short-run response of gold to the base is small and insignificant, suggesting the active program of short-run gold sterilization during these years. Chart 4.2 above shows that the contemporaneous relationship is weak also.
The very weak association between the base and its principal components suggests that the deflationary policy of the period was a consequence of Federal Reserve actions. Over the longer term, the base moved with net gold inflows; for the period as a whole, the gold stock increased by $650 million, and the monetary base rose $970 million. These increases were produced by compound average annual growth rates of 2 percent and 1.7 percent, respectively. All of the increase occurred before summer 1927.
APPENDIX B: SOURCES AND USES OF THE MONETARY BASE AND OPEN MARKET OPERATIONS
The basic statement of the Federal Reserve’s monetary position is the table Member Bank Reserve, Reserve Bank Credit, and Related Items, published in the Federal Reserve Bulletin. The table was developed at the Board in the 1920s by combining the balance sheets of the twelve reserve banks and the monetary accounts of the Treasury. This appendix rearranges these data as sources and uses of the monetary base.
The principal sources of the monetary base are Reserve Bank credit and gold and foreign exchange assets. Under a pure gold standard or a fixed exchange rate system without intervention, gold and foreign exchange are the principal sources of the monetary base. Under a fluctuating rate system, without intervention, gold and foreign exchange is constant. Reserve bank credit is the principal source item.
Other source items are mainly small positive and negative accounts. Historically, the principal positive item here has been treasury currency outstanding, because the Treasury formerly issued currency. During much of Federal Reserve history, these were small-denomination notes.208 The principal liabilities here are Treasury deposits with Federal Reserve banks and deposits of foreign governments and central banks.
Reserve bank credit consists of three principal items: bills discounted, bills bought, and United States government securities. The first is usually referred to as discounts and advances. These are made at the option of the member bank, under rules prescribed by the Federal Reserve. The founders of the Federal Reserve believed this item would be the major source of short-term changes. The text refers to “bills bought” as acceptances. The founders intended this source to become an important item and the main source of adjustment and policy operations, as in London. From the 1920s on, its role was taken by the third source—United States government securities.
The uses of the monetary base include member bank reserves and currency held by the nonbank public. Rules permitting member banks to count vault cash as part of reserves add to the base by including currency held by banks as a use of the monetary base.
In January 1928 the statement of sources and use of the monetary base, appeared as in table 4.A2.
An open market purchase of acceptances or government securities increases one of the items on the sources side and balances the increase by adding to member bank reserves. An open market sale of government securities reduces this source and, correspondingly, reduces bank reserves.
By law the Federal Reserve cannot buy securities directly from the Treasury (with some minor exceptions). Open market operations are therefore conducted in the credit markets.
208. For more detail, see Friedman and Schwartz 1970.
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Why Did Monetary Policy Fail in the Thirties?
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sp; From the peak of the cycle in the summer of 1929 to the bottom of the depression in March 1933, the stock of money—currency and demand deposits—fell by 28 percent and industrial production fell by 50 percent. The sizable declines in the two series merit attention not only because the social consequences of the decline in output were large and pervasive, but because the policies pursued during the period and the justification of them provide considerable evidence about the framework that guided Federal Reserve policy and the response of the Federal Reserve to a crisis.
This chapter gives special attention to the Federal Reserve’s response to the contraction, considers some previous explanations of its actions and inaction, and uses the history of the periods and the statements of participants to discriminate among alternative explanations of Federal Reserve behavior. Inevitably, this leads to a central issue about the 1929–33 decline: why the decline was so severe. There is no doubt that early in the decline the Federal Reserve knew a major contraction was under way. Whatever its causes, monetary policy could have lessened the decline. At issue here is why it failed to do so.1
The chapter does not attempt to resolve the more difficult problem of assessing the relative contribution of nonmonetary factors to the start of the Great Depression. It is now generally accepted that the depth of the depression, its duration, and its spread through the world economy are mainly the result of monetary actions or inactions. Warburton (1966), Friedman and Schwartz (1963), and at an earlier date Currie (1934) highlighted the role of monetary forces in the United States. More recent work by Eichengreen (1992) and Bernanke (1994) accepts the role of money and concentrates on the international character of the decline and the influence of the international gold standard. Agreement is limited, however. There are several different, and at times conflicting, explanations of the severity of the decline.
A History of the Federal Reserve, Volume 1 Page 40