A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  1. There are several nonmonetary changes that supplement the monetary forces. The papers in Brunner 1981 discuss many of these explanations.

  DIFFERENT INTERPRETATIONS

  Following Bernanke (1994) and Mishkin (1976), several authors have revived a version of Irving Fisher’s (1933) debt-deflation explanation of the severity of the Great Depression.2 These authors supplement the monetary explanation by highlighting the role of capital market imperfections resulting from differences in borrowers’ net worth. Borrowers with relatively low net worth face more restricted opportunities to borrow, so they depend more on banks. As firms’ net worth fell during the depression, banks refused additional loans. Also, bank failures removed the principal lenders for businesses with moderate net worth. On this explanation, bank failures contributed to the depression not only by reducing the money stock, as claimed by Currie (1934), Warburton (1966), and Friedman and Schwartz (1963), but by raising the cost and availability of loans more than would have occurred based on the monetary and credit contraction resulting from Federal Reserve policies.

  Friedman and Schwartz (1963, 407–19) attributed the Federal Reserve’s behavior in the early thirties to the death of Benjamin Strong in 1928 and the shift of power from the Federal Reserve Bank of New York to other parts of the System. George L. Harrison, who replaced Strong as governor of the New York bank, lacked Strong’s ability to organize and lead other members of the open market committee. In this interpretation, the period is unique not only because of the severity of the contraction but because the Federal Reserve behaved as it had not behaved earlier and should not be expected to behave again.

  In his history of the interwar gold standard, Barry Eichengreen (1992) revived the idea that lack of central bank cooperation, the workings of the interwar gold exchange standard, and the requirement that Federal Reserve notes be backed 40 percent by gold produced and prolonged the decline. Lack of cooperation weakened the operation of the interwar gold standard Eichengreen (1992, 213). Cooperation would have enhanced the credibility of the System by encouraging speculators to believe that gold parities would be defended with the help of foreign central banks (xi, 257, 390). Monetary contraction in the United States and a decline in its international lending in 1928 put unsupportable strain on a fragile system, necessitated contraction in many countries, and “set the stage for the 1929 downturn” (392).3 Gold stocks were most heavily concentrated at the Bank of France and the Federal Reserve, but even these banks “had very limited room for maneuver” (393).

  2. Calomiris (1993) surveys this literature, and Bernanke (1994) refers explicitly to Fisher’s debt-deflation theory.

  Elmus Wicker (1966, ix, 155, 195) attributed the Federal Reserve’s failure to its incomplete understanding of how monetary policy influenced economic activity and the price level. The Federal Reserve Board and the governors of the reserve banks were confused and misled by their interpretation of the events they watched. Power within the System was so diffused that leadership from New York or Washington was not possible (195). Even if there had been strong leadership, the uniqueness of the events of 1932 and 1933 immobilized the policymakers.

  Wicker argues that Federal Reserve policy in 1929–33 was consistent with its actions in the 1923–24 and 1926–27 recessions. The Federal Reserve followed the practices laid down by Governor Benjamin Strong: use open market operations to reduce member bank borrowing below $500 million and reduce borrowing by New York banks commensurately. Once this was done, policy would be “easy.” Wicker added that international cooperation motivated open market purchases in 1924 and 1927, specifically to help Britain return to and remain on the gold standard.

  A problem with some of these explanations is that the Federal Reserve was not entirely passive for the three and a half years of the decline. More than once it purchased securities or lowered the rediscount rate. It actively responded to events such as the departure of Britain from the gold standard in October 1931 by raising the rediscount rate to stem a gold outflow, as gold standard rules required. Although disputes persisted about the locus of power within the System and there were clashes between personalities, these are overtones that do not adequately explain the dismal record. If the crisis was largely due to an absence of leadership, more effective action would have been taken later, after the System reorganized, given additional authority and a strong chairman. But in the middle and late thirties, just as in the early thirties, the Federal Reserve did next to nothing to foster recovery. In a period of prolonged and widespread unemployment, the Federal Reserve’s principal policy action was the 1937–38 series of deflationary and contractive increases in reserve requirement ratios taken to forestall a possible future inflation.

  3. Clarke (1967) surveys experience with central bank cooperation in the interwar period. Clarke too concludes that cooperation failed after 1928, but he describes the failure differently. “The failure stemmed not so much from the deficiencies of central bank cooperation itself as from the inability of the authorities—including particularly those in the United States—to manage their domestic economies successfully” (220).

  Although Friedman and Schwartz offered an interpretive history based on what might have happened if Governor Strong had lived, a main point of their explanation is of doubtful validity. It is true that W. Randolph Burgess, and others at the New York bank, proposed expansive policies, and at times Harrison suggested purchases. In fact, Harrison argued vigorously for open market purchases at times, but at other times he was a leading proponent of open market sales. The timing of Harrison’s decisions to purchase or sell can be explained (approximately) by the conjunction of the Riefler-Burgess and real bills doctrines. These ideas or beliefs misled Harrison and others in the Federal Reserve at critical points in the early thirties and thereafter. As noted by Wicker (1966), Brunner and Meltzer (1968b), and Wheelock (1990, 1992), Federal Reserve officials behaved consistently in the 1923–24, 1926–27, and 1929–33 declines.4

  The difficult issue to resolve is whether Strong’s colleagues on the Open Market Policy Conference (OMPC) would have supported expansive policies had he proposed them.5 Many of his fellow governors had been persuaded to go along but were not convinced that his arguments were correct in 1924 and 1927. Moreover, member bank borrowing remained high in 1924 and 1927, so domestic concerns (and the desire for earnings) reinforced international reasons for purchasing government securities. During most of 1929–33, member bank borrowing remained low; on Riefler-Burgess views, domestic policy was easy. Further, Adolph Miller and others at the Board blamed Strong’s policies for the depression. They interpreted the depression as the inevitable consequence of the preceding growth of bank credit and asset prices that followed the 1927 policy actions Strong had urged. Because credit expansion had increased without equivalent purchases of real bills, this policy was inflationary. Deflationary policy should have followed in 1928. That mistake had to be corrected.

  Several governors agreed with this interpretation. Although the price level had fallen, Strong’s policy had violated the rules of the real bills doctrine. The violation had to be purged.6

  4. Wheelock (1990) estimates an equation for borrowing by member banks. He shows that increases in nonborrowed reserves, (through gold inflows or Federal Reserve purchases) reduce borrowing, but the reduction is approximately 0.5, not 1 as in Riefler-Burgess. See also the appendix A to chapter 4.

  5. Strong was more persuasive than Harrison and more convinced by the logic of his arguments. Harrison seems more of a diplomat, without strongly held views. Moreover, the OMPC included all twelve governors instead of the five members that Strong dealt with. A serious problem, discussed below, was that Harrison could not persuade the Boston and Chicago reserve banks to participate in open market purchases.

  Eichengreen’s claim that the gold standard prevented action is difficult to reconcile with the System’s responses in the 1923–24 and 1926–27 recessions. These actions had received praise at the time and encouraged the
belief that the System had taken countercyclical action to lessen the downturn. If the Federal Reserve had risked the temporary loss of gold on these occasions, why would it fail to run the same risk in the much steeper decline after August 1929?

  The Federal Reserve was in no danger of abrogating its gold reserve requirements in 1929, 1930, or early 1931. In fact, the System experienced a gold inflow in 1930 and early 1931. By June 1931, the monetary gold stock was almost 15 percent above the August 1929 level, whereas gold collateral required for notes had increased no more than 2 percent and collateral for bank reserves had increased only $40 million—less than 2 percent.

  Eichengreen (1992, 297–98) accepts the argument in the Federal Reserve’s 1932 annual report that its response in 1931 was limited by the decline in the gold stock and the requirement to use gold as backing for Federal Reserve notes, the so-called free gold problem.7 Although there is some dispute about the relevance of the problem, any relevance is limited to the period following Britain’s departure from gold on September 20, 1931, and the passage of the Glass-Steagall Act on February 27, 1932. During the rest of the decline, gold cover for the notes was not an issue.8 The Federal Reserve did not use government securities as collateral for notes until May 1932, after increasing its holdings of governments more than $650 million between February and May.

  6. The same reasoning applied to wartime inflation. Wartime inflation had to be followed by deflation, and it was until World War II.

  7. Federal Reserve notes were backed by a minimum of 40 percent in gold. Eligible paper made up the remainder. The decline in eligible paper at the Federal Reserve required the reserve banks to substitute gold for eligible paper. Government securities could not be used as collateral until the passage of the Glass-Steagall Act in February 1932. All notes issued, including notes held at other Federal Reserve banks, required gold and eligible paper as backing. The collateral requirements applied to each reserve bank separately, so the distribution of notes and gold affected free gold—the gold that was not used as collateral for notes and deposits at reserve banks. Friedman and Schwartz (1963, 400–404) argue that free gold was never a problem and suggest several ways any problem could have been relieved. For example, the reserve banks could have lowered the acceptance rate to acquire eligible paper and free gold for expansion of the note issue.

  8. The Federal Reserve Bulletin for 1932 shows notes outstanding and collateral for each reserve bank on February 28, 1932. Gold was used as collateral for 71 percent of the total note issue. Chicago was at the extreme position with 88 percent gold and 14 percent commercial paper. The largest issuer, New York, had 75 percent gold and 25 percent commercial paper. The third largest bank, Cleveland, had 63 percent gold and 40 percent commercial paper. Open market purchases could have been made by the banks with sufficient gold to issue notes. Since there was no requirement at the time for all reserve banks to participate in an open market purchase, some abstained at times.

  Stripped of its technical details, the free gold explanation asserts that System open market purchases would have reduced the ratio of gold to notes and deposits below the required ratios of 40 percent and 35 percent. Technical restrictions seem a weak explanation for the lack of response. Bagehot’s well-known writings had instructed the Bank of England that it could not protect its gold reserve by failing to expand. On several occasions in the nineteenth century, the Bank of England had suspended the gold reserve requirement and relaxed restrictions on eligible paper for discounts when required to stop a panic. When necessary, the government had indemnified the bank against claims arising as a result of the suspension. This history was known within the Federal Reserve and referred to on more than one occasion.

  Charles S. Hamlin, a member of the Federal Reserve Board from 1914 to 1936, discussed the loss of gold at a meeting in Boston on November 20, 1931, two months after Britain had suspended convertibility (Federal Reserve Bank of Boston 1931, 13–16). Hamlin began by summarizing the main movements of gold into and out of the United States since 1914. He described the $750 million outflow from September 17 to October 30, 1931, as “the largest ever sustained by any country in such a short space of time” (15). Nevertheless, the Federal Reserve, he said, held more than $1 billion of gold reserves above the amounts required for Federal Reserve notes and member bank balances. Then he added: “In addition, there is about $1,000,000,000 in gold certificates in circulation in this country, a considerable part of which could if desired be replaced with other forms of currency. We not only have ample gold to cover the legal requirements but our monetary gold stocks, even after the heavy withdrawals, are only slightly below the prosperous years of 1928 and 1929” (16).

  Hamlin next commented on the reason for protecting the gold reserve: “The experience of recent weeks brings home to Federal Reserve officials their heavy responsibility, the necessity for keeping their powder dry, so that in these troublous times they may remain the rock that can withstand all storms and upon which world confidence may once more be reconstructed” (ibid.; emphasis added).9

  Eichengreen correctly points out that before and during the world economic decline, France contributed to the onset and the severity of the world depression by sterilizing much of its gold inflow. From June 1928 to September 1929, the French bought $2.6 billion in gold and, in the same period, reduced their foreign exchange reserves by an equal amount.10 From September 1929 to March 1933, the Bank of France acquired an additional $1.6 billion in gold while reducing foreign exchange reserves by $800 million. For the period September 1928 to March 1933 as a whole, French gold reserves increased by 2.8 times while French holdings of gold and foreign exchange increased only 30 percent.

  9. Eichengreen’s figure 4.4 (1992, 119) shows that free gold in late 1931 remained well above the levels of 1920–21. Bordo (1994) notes that Eichengreen misstates the amount of open market operations necessary to restore the money stock.

  The French money stock rose 18 percent in the two years 1930 and 1931. Greater expansion and less sterilization by the Bank of France would have lessened the severity and scope of the world decline. At issue is whether the failure to expand more resulted from a lack of coordination. The Bank of France was not obliged to sterilize much of the gold inflow. The United States was not obliged to contract as France sterilized.

  The critical flaw was not the absence of international coordination but domestic decisions at critical times to not interfere with the contraction of money and credit and the resulting deflation. Protecting the United States gold reserve was at most a secondary effect of the principal decision. Leading central bankers and their advisers believed that credit expansion to finance stock market speculation in 1928–29 was a misuse of credit that had to be eliminated. Bankers, economists, and others stated this view repeatedly during the contraction.

  Writing at the time, Oliver M. W. Sprague explicitly rejected both the idea that monetary expansion was desirable and the idea that absence of international cooperation contributed to or exacerbated the depression. Sprague was an expert on banking crises and a close adviser to the Federal Reserve. He also served as economic adviser to the Bank of England from 1930 to 1933.11 In a May 1931 speech in London, Sprague discussed the causes of the depression and the role of international coordination (Board of Governors of the Federal Reserve System, Weekly Review of Periodicals, June 2, 1931, 1–2).12 He began by noting that the depression had become more acute. There was no agreement on its causes or on appropriate remedies. He summarized two divergent views. The “monetary school” wanted the leading central banks to “flood the market with a great amount of additional credit and currency.” The “industrial or economic equilibrium school included all the responsible [sic] people connected with the great central banks of the world.” This school held that falling prices were a symptom, not a cause: “When prices did advance, more currency and credit would be employed, but they did not believe that simply by injecting more currency and credit into the situation they could certainly bring abou
t the desirable rise in prices and business activity.”

  10. Data on French gold stocks and reserves are from Banking and Monetary Statistics (Board of Governors of the Federal Reserve System 1943, 641–42). Data are converted from francs to dollars using 3.92 francs per dollar. Sterilization of the gold inflow was similar to the policy followed by the Federal Reserve in 1921–22. See Strong 1927.

  11. Sprague was a professor at Harvard from 1913 to 1941. He had written an influential study for the National Monetary Commission and was active in policy discussions throughout his career.

  12. The Federal Reserve staff prepared a summary of press discussion. It included the Economist, other financial journals, market letters, and foreign and domestic newspapers. The 1931 Weekly Reviews are available in the Widener Library at Harvard.

  The problem was not lack of agreement between the principal central bankers: “It was not because of any difficulty of securing agreement among the three banks, (France, U.K., U.S.) but because none of them harbored the belief that it was the appropriate remedy” (ibid., 1–2).

  Sprague, like the central bankers in France, England, and the United States that he described, accepted the “industrial equilibrium” explanation. The world’s economies would reach a new equilibrium at lower prices and wages. It would take time, they recognized, but they believed deflation was the correct solution to the mistakes of 1928–29.