A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  In a speech to the Royal Statistical Society a few weeks later, Sprague explained why the deflationary solution was proper. There had been overproduction particularly in the American automobile industry. Further, there had been a speculative boom. He blamed Federal Reserve policy in 1928, when it would have been “possible to check the speculative wave on the New York Stock Exchange” (Weekly Review, June 24, 1931, 1).

  Paul Warburg wrote in the American Banker for January 20, 1931, “The way to avoid a depression (or lessen its severity and duration) is to ‘sit on the bulge’ during an excessive upward swing. Once acute over-expansion has taken place, acute overcontraction must follow with inexorable certainty. Unfortunately, it would seem politically impossible for any government to use its influence toward checking a wave of prosperity, even though it was clearly a fake prosperity destined to end in a crash” (Weekly Review, January 27, 1931, 5).

  These were not the only views, but they were common views of central bankers. M. H. deKock of the South African Reserve Bank thought that the “maintenance of pronounced monetary ease for any length of time almost inevitably leads to inflation and speculation in one form or another” (Weekly Review, February 3, 1931). In the same report, the noted British economist Lionel Robbins argued against the view that there was a worldwide shortage of gold. Like most others, he failed to distinguish between real and nominal interest rates: “If insufficiency of gold is the main cause of depression, why is there a depression in America. And with a 2 percent discount rate in New York, it is hard to contend that credit conditions are stringent” (2–3).

  Robbins also mentioned the maldistribution of the gold stock, a common complaint at the time. However, he assigned more importance to the unhealthy character of the boom in 1928. Money rates had been held too low for too long.13

  Charles S. Hamlin shared the view that speculative excesses had to be purged from the financial system and the economy. On November 8, 1929, shortly after the 1929 stock market break, he told a group of New England bankers:

  The present crisis through which we are passing is typical of the kind of crisis that the framers of the Federal Reserve Act had in mind. The Act was designed to prevent the close dependence or interdependence of American industry upon speculative activity throughout the community. . . . The Federal Reserve System was designed to break up the vicious circle under which a speculative orgy accompanied every forward step of industry. . . .

  The success of the Federal Reserve System is apparent today. . . . These events [losses] are deplorable, but they were of course inevitable and could not have been avoided. (Federal Reserve Bank of Boston 1929, 28)

  The opinions of bankers and central bankers at the time are similar to the statement of Federal Reserve policy in the tenth annual report (Board of Governors of the Federal Reserve System, Annual Report, 1923). As Friedman and Schwartz note, the statement was compatible with two interpretations. One, the “real bills” or “productive credit” view of policy, required the Federal Reserve to provide “credit” for the “needs of trade” but not for “speculative” uses. The second interpretation is that the Federal Reserve would attempt to counteract inflation and deflation by countercyclical open market operations.

  Only the first interpretation, the real bills view, appears in the minutes of the Open Market Policy Conference for the early thirties and in the statements of bankers and central bankers above. It is possible that the references to statements in the tenth annual report were made to justify views that were held for other reasons. Even if this was true, however, it is striking that none of the governors objected to the interpretation or presented an alternative. Even more striking is the absence, at most of the meetings of the OMPC, of any statement favoring an expansive policy. Even those governors who occasionally pressed for open market purchases and reductions in the discount rate expressed doubt that monetary (or credit) policy alone would have much effect on output. They too appear to have been greatly influenced by the notion that the prevalence of low nominal interest rates and low borrowing showed that policy was “easy.”

  13. J. M. Keynes is quoted in the February 3, 1931, Weekly Review as opposing reductions in money wages. Keynes blamed low investment, which he attributed to uncertainty, high interest rates, high-risk premiums, and borrowers’ fears. Keynes also noted that falling prices increased the burden of outstanding debts.

  Benjamin Strong shared many of these interpretations. He often relied on the volume of member bank borrowing as a measure of ease or restraint.14 Nothing in either the Riefler-Burgess doctrine or the real bills doctrine distinguished between real and nominal rates of interest or recognized that the level of borrowing depends on anticipated income and inflation.

  The minutes of the Open Market Investment Committee, the Federal Reserve Board, and the Conference of Governors of the Reserve Banks, considered below, show that most of the policy decisions remained consistent with the Riefler-Burgess and real bills frameworks. This should not suggest that everyone slavishly followed a formula. Many other inherited notions, mentioned in the minutes, contributed to the Federal Reserve’s failure to act or justified inaction. Concerns about “redundant reserves” or “excessive liquidity in the banking system” are variations on the real bills theme but may have other origins. Whatever the source of these ideas, many of the policymakers opposed expansive policy action because they believed that expansive action was inappropriate. Concern about future inflation caused several governors to hesitate to act, to regard deflation as the inevitable consequence of previous speculative excesses, for much the same reasons that Strong and others had viewed the severe deflation of 1920–21 as a consequence of inflationary wartime policies and a necessary prelude to the price stability of the middle twenties. Speculative credit and nonreal bills had to be purged. This was the message of Hamlin, Warburg, Robbins, Sprague, and many other bankers and central bankers.

  Once borrowing and short-term market rates had fallen below the range familiar to governors and commercial bankers, policy was “easy.”15 They saw no reason for further additions to reserves and further reductions in market rates. Expansive policy would finance speculative credit and become the source of a future inflation that, once under way, would be difficult to stop. The System’s holdings of government securities were much smaller than the level of member bank borrowing during much of the twenties and were not substantially larger than the level of borrowings in the early thirties. Not having enough securities on hand to prevent a future inflation had been a recurring concern since the start of the Federal Reserve System. The concern seems a ludicrous reason for not expanding, but it appeared very real to several of the governors at the time. Since nominal interest rates had been reduced to levels that were comparatively low by the historical standards or experience the governors and members relied on, they saw little reason to increase speculative credit and accept the risk of inflation.

  14. “As a guide to the timing and extent of any purchase which might appear desirable, one of our best guides would be the amount of borrowing by member banks” quoted in Chandler 1958, 239–40.

  15. The range usually mentioned for the United States was aggregate member bank borrowing of $500 million to $600 million in recession. During the deflation after 1870, the Bank of England never adjusted the discount rate to prevent continued deflation once the discount rate reached 2 percent.

  Some officials either did not fully share the dominant view or differed about particular events. At times some showed clear understanding of the role the System might play, although they did little to promote their views against the dominant view in the System. Included in this group are two members of the Federal Reserve Board—Eugene Meyer and Adolph Miller—who at times questioned Harrison and the other members of the open market committee about their reasons for not pursuing a more expansive policy. W. Randolph Burgess at the Federal Reserve Bank of New York urged more expansive policies at critical times, with support from the directors of the New York bank.
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  The policy problems of the early thirties were not unique. Books discussing the appropriate means of handling these problems were known to some of the members of the open market committee or their staffs. The effect of changes in the quantity of money had been discussed for more than a century, and many outstanding economists had contributed to the analysis. Some, like Henry Thornton (1965) and Walter Bagehot (1962), whose works are discussed in chapter 2, had described the appropriate response of a central bank to a crisis. Both Thornton and Bagehot suggested some of the principal reasons for large-scale currency withdrawals, and both had indicated that during a currency drain the central bank should expand.

  Three of Thornton’s recommendations to the Bank of England are particularly relevant to—and contrast sharply with—the behavior of the Federal Reserve during the thirties. First, he argued repeatedly that there was rarely any reason for reducing the quantity of money (Thornton 1965, 259). Second, he urged the governors of the bank to meet an increase in the demand for currency by temporarily increasing the bank’s liabilities (259). Third, he recommended that the bank use the quantity of money—and not the volume of commercial bank borrowing from the central bank or of private borrowing from commercial banks—as a measure of its policy and the influence it would have on prices and output (271).

  It is possible, but unlikely, that Thornton’s work was entirely unknown.16 However, there is no doubt that officials knew Bagehot’s work, since references to his book, Lombard Street, appear in the OMPC minutes. Bagehot had demanded repeatedly that the Bank of England acknowledge publicly that it served as lender of last resort, and subsequently the bank had done so. And Bagehot had discussed fully why it was a mistake for a central bank to seek to protect its gold reserve by failing to lend during a run on commercial banks.

  Numerous other writers had analyzed the effects of changes in the quantity of money and the responsibilities of central banks in a crisis. Two of the most able monetary economists of all time, Irving Fisher (1920, esp. chap. 4) and John Maynard Keynes (1930, 1931), had argued in scholarly books, in pamphlets, and in newspaper articles of the period that a decline in the quantity of money would first affect the level of output and employment and only later affect the price level.17 Neither the absence of relatively simple, comprehensible alternative theories, nor the absence of facts about developments in the economy, nor the absence of strong leadership can explain the dismal record. The main reason for the failure of monetary policy in the depression was the reliance on an inappropriate set of beliefs about speculative excesses and real bills. This set of beliefs, embodied in the Riefler-Burgess framework, directed attention to short-term market interest rates and member bank borrowing and encouraged their use as indicators of the magnitude and direction of monetary stimulus.

  THE FIRST YEAR OF DECLINE: POLICY FROM AUGUST 1929 TO SEPTEMBER 1930

  To show how policy responded to the economic decline, the discussion comments on each meeting of the Open Market Investment Committee and its successor the Open Market Policy Conference, or their executive committees, between the peak of the expansion in August 1929 and the trough of the recession in March 1933. A series of twenty tables shows some of the information available at each meeting. Three types of data suggest the direction of monetary policy and the levels or changes in other variables that the committee discussed from time to time at its meetings or that influenced its decisions. One type of data shows cumulative change from the peak of the expansion to the nearest month. A second type, called “recent changes,” shows the change in various measures between meetings. The third group shows the levels of variables that are of interest, again dated to the nearest month.18 Data for the money supply were not available at the time, but currency and demand deposits were available separately.

  16. Jacob Viner, a distinguished economist of the period, had paid considerable attention to Thornton’s work. See Viner 1924.

  17. In the Treatise, Keynes argued for sizable open market operations in the United States. See Keynes 1931, 2:371–74 and 304–37. Charles Rist (1940, 404–6) points out that by 1840 the Bank of France had recognized the responsibility of a central bank to act as lender of last resort.

  Responses to the Financial Panic

  At the peak of the cycle in August 1929, the level of member bank borrowing exceeded $1 billion, the highest level reached since 1921. The interest rate on new stock exchange call loans was 8.15 percent, more than 1.5 percent below the high for the year in March. Other short-term market rates had passed their peak, while long-term rates were generally at the highest levels of the expansion. The seasonally adjusted monetary base was 1 percent below the peak reached more than a year earlier.

  In the first six weeks the policy, agreed on in August, worked as planned; the System provided seasonal credit expansion by lowering the acceptance rate while raising the discount rate. Harrison told the Board that the total seasonal increase was about average. The acceptance portfolio increased $162 million, more than offsetting the $130 million decline in discounts. In addition the System purchased $20 million in the open market. Harrison asked for an OMIC meeting in September to consider open market purchases to supplement acceptance purchases (Board of Governors File, box 1435, November 12, 1929; these are minutes of the September meeting).

  Brokers’ loans continued to increase. Banks used all the reserves obtained from sales of acceptances to the reserve banks to repay discounts, so total bank credit remained unchanged. Interest rates changed little.19

  18. Most of the data are taken from Banking and Monetary Statistics (Board of Governors of the Federal Reserve System 1943). An index of industrial production is available in the Federal Reserve Bulletins at the time, but I have used the revised index of industrial production from Industrial Production 1957–59 Base (Board of Governors of the Federal Reserve System [1962?], 5–149). These data are seasonally adjusted. Data on money supply are from Friedman and Schwartz 1963. The money supply is the sum of currency and demand deposits of the public. The monetary base is from Anderson and Rasche 1999. The base is the sum of total currency and reserves outstanding adjusted for changes in reserve requirement ratios. In addition to the changes in the monetary base, I present data on changes in some of the principal sources of the base: changes in government securities held in the Federal Reserve portfolio, changes in bills bought (acceptances), and changes in the gold stock. These data are from Banking and Monetary Statistics. Data on wholesale prices are from various issues of the Federal Reserve Bulletin for the period. Other data that were available regularly include department store sales and inventories, money rates abroad, and a breakdown of member bank loans and investments. See data sources, pp. 761–64.

  19. The report notes that England continued to lose gold reserves to France and Germany. Pressure from high rates “is becoming constantly more intense and is tending to retard industrial and business developments” (Open Market, Board of Governors File, box 1435, November 12, 1929, 7). The report (written for the September 24 meeting) also notes a more than seasonal drop in exports and declines in several basic industries.

  At the September 24 meeting, the governors expressed concern about the levels of discounts and rates of interest. To reduce both while acting against an impending recession, the committee voted to purchase up to $25 million of government securities weekly, if acceptances could not be obtained at the posted buying rates of 5.125 percent. When presenting the proposal to the Board, Harrison, the chairman of the OMIC, noted that “some reduction in this [member bank] indebtedness would be a necessary prerequisite to any further easing of interest rates,” as implied by Riefler-Burgess. The Board delayed accepting the proposal until its members returned from vacation. On September 30 Harrison wrote to Governor Roy A. Young at the Board to report the favorable response of the New York directors to the purchase program and again stressed the importance of reducing interest rates.

  The Board approved the committee’s recommendations on October 1. In his reply to Harri
son, however, Young noted that the Board’s approval was mainly for seasonal reasons, not a reversal of prevailing policy. There was no suggestion in the monetary indicators the Board and the committee watched, and no recognition in their discussions or letters, that the financial system was about to experience the first of a series of shocks in the following weeks. The committee made no open market purchases until the week of October 30.

  The indexes of prices on the New York Stock Exchange reached peaks in September and plummeted in the last week of October. The Federal Reserve lowered the buying rate on banker’s acceptances by 0.125 percent (to 5 percent) on October 25. By October 28, with the decline on the stock exchange continuing, the members of the Board were of the opinion that “no further easing of the bill rate should be made at this time as the easing program of the system seems to be progressing satisfactorily.” The next day the market plunged downward on volume in excess of 16 million shares, nearly five times the average daily volume.

  The following day Governor Young reported on his conversation with Harrison. Harrison informed him that the directors of the New York bank had given him authority to purchase government securities for the bank’s account without any stated limit, and he had used this authority to purchase $50 million. Inasmuch as the purchases had been completed, Young concluded: “There was nothing before the Board at that time requiring immediate action.”