A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The Board was piqued at Harrison and the New York bank for undertaking purchases without prior approval (as was customary), but decided to defer discussion of Harrison’s assumption of responsibility until later. Instead, the discussion turned to action that “might appropriately [sic] be taken.” Cunningham suggested, and the majority agreed, that it would be best to reduce the discount rate at the New York Bank from 6 to 5 percent, “with the understanding that the System will suspend, for the time being, any purchases of government securities, pending further developments in the credit situation as a result of the rate reduction, and further consideration and approval by the Federal Reserve Board.”

  Harrison then called to inform the Board that he had purchased an additional $65 million, a total of $115 million for the day. There was no further discussion of policy at the Board meeting.

  On the following day, October 30, Young reported to the Board on his conversations with Harrison and James B. McDougal (Chicago). Young’s position was classical; the System should encourage discounting by member banks, and he had told McDougal that “while he could not commit his board, he thought loans should be made freely and liberally.” The conversation with Harrison had apparently been lengthy, owing to a difference of opinion between New York and Washington on the policy that was appropriate for the day. Harrison informed Young that he was planning further purchases of securities. Young reported to the Board that he had advised Harrison that further purchases would “probably lead to the eventual promulgation of a regulation on the subject” by the Board.

  The difference of opinion between New York and Washington was another round in the dispute about who had responsibility for decisions. Young reported that he had “advised Governor Harrison that he would not hesitate about lending to a member bank.” He told the Board that “he would go farther and purchase government securities liberally using any resource that the System has in an attempt to minimize the effects of conditions that may develop.” Other members of the Board—Edmund Platt, Hamlin, and Miller—agreed with Young’s position and urged him to communicate these views to the reserve banks.

  Young informed Harrison on October 31 that the Board was in favor of reducing the discount rate at New York from 6 to 5 percent and that the “majority appeared to have changed their views with respect to coupling the reduction in the discount rate with an agreement to suspend purchases of government securities for the time being, feeling that the Federal Reserve banks should be prepared to pursue a liberal policy.”

  The positions now reversed. Banks had reduced their discounts by more than $150 billion since the cyclic peak. The gold stock had increased, and banks continued to lend on commercial paper, real bills, with only modest changes in interest rates. Harrison told the Board that he had made no purchases on October 30, that he did not plan to make any purchases that day, and that he could see no reason for additional purchases, “although it might become necessary to take on additional amounts later.” His directors had adopted a resolution, unanimously, “that, in the interest of maintaining business and employment, the policy .. . for the coming weeks should be to keep a plentiful supply of money in the market . . . in order that discounts of the Federal Reserve System may be reduced and at the proper time a further reduction of the discount rate effected with the objective of securing lower interest rates for business throughout the country.”

  The prompt and rapid response by the New York bank undoubtedly prevented the rapid decline in stock prices from affecting interest rates in the money market. The monthly data show a slight rise in the interest rates on short-term Treasury notes and longer-term corporate bonds and a substantial decline in the rate charged for new stock exchange call loans. Weekly data on open market rates for the last week of October 1929 show a slight rise in the rate on new stock exchange call loans and a decline in other quoted market rates. Commercial banks in New York made the largest volume of new loans to brokers and dealers shown in any week up to that time and offset to a large extent the reduction in call loans by banks outside New York. Although the average of daily figures in table 5.2 shows the Federal Reserve as a net seller of government securities for the month as a whole, the System purchased $157 million of government securities during the last week of the month, more than doubling the size of its portfolio of governments. In addition, the discounts of member banks with the System increased by $200 million for the week.

  Although the Board was in favor of continuing the policy Harrison had started, the committee made no purchases in the following week. On November 1, New York reduced its discount rate to 5 percent and also reduced the buying rate on banker’s acceptances. The monetary base declined by $50 million, almost one-sixth of the increase in the previous week. Open market rates changed very little, and both the market and the System appear to have decided that the crisis had passed. The Board did not press New York to make further purchases. During the rest of 1929, the Board met almost every day, generally discussed routine matters, and rarely mentioned open market policy.

  The Board’s minutes for the week of the crisis make it clear that the members were slower than the New York bank to recognize the desirability of large-scale open market purchases. But the lag, or delay, was at most two days. By October 31, Governor Young and most of the Board members wanted further purchases to offset rising discounts, while Harrison and the directors of the New York bank, knowing that the panic had not affected the money market, favored a less aggressive approach.

  Part of the dispute about whether the System should act through open market operations or by discounting reflects the entrenched “real bills” doctrine. Those who favored discounting as a means of supplying reserves generally wanted to leave the initiative with the member banks and favored using the “needs of trade” as a guide to appropriate policy. Even in periods of crisis, their discussion contains repeated references to the “demand for Reserve bank credit,” in contexts suggesting that the Federal Reserve should supply the quantity of reserves demanded to meet the “needs of trade” but should avoid using open market operations to supply “redundant reserves” that would generate “speculative excesses.”

  The reactions in New York and Washington are consistent with the Riefler-Burgess view. The pressure on the commercial banks in New York became intense at the time of the stock market decline, in large part because banks outside New York reduced their loans to the call money market. The security purchases by the New York bank undoubtedly prevented both a sharp rise in interest rates during the week and additional borrowing from the Federal Reserve by banks in New York and other large cities. Since the Open Market Investment Committee had decided at the September 24 meeting to reduce borrowing, by open market purchases if necessary, the response by the New York bank is not a deviation from the prevailing policy or from the concentration on interest rates and money market conditions. The reluctance to continue purchasing once borrowing and upward pressure on interest rates declined is further evidence that its behavior at the time was consistent with the Riefler-Burgess framework.20

  Friedman and Schwartz (1963, 367) offer a different interpretation of these events. Their discussion, based on Harrison’s papers, makes no mention of the change in responses by Washington and New York after October 29. In their view, New York stopped purchasing securities because of the strong reaction at the Board. More important, they suggest that this episode had a permanent effect on Harrison and that thereafter he was reluctant to engage in open market operations without the consent of the Board or the Open Market Investment Committee. The Board’s records suggest, on the other hand, that the Board members conceded Harrison had been correct in making large-scale purchases of government securities and in encouraging the additional discounts that the Board had urged from the start as a means of meeting the crisis. They disliked New York’s decision to act alone.

  20. Harrison made a very similar point on November 13 in a letter to Governor Black of the Atlanta Federal Reserve bank. “We had only commenced operatio
ns at the rate of $25 million a week in accordance with the recommendation of the Open Market Investment Committee, when the severe collapse in stock prices at the end of October and the consequent immense shifting in loans to the New York City banks made it imperative that we purchase very substantial sums of Governments to minimize the risk of an up-swing in rates.” He now (mid-November) favored a policy of continuing the “purchases of Governments as rapidly as opportunity offers in order that we may avoid any further large increase in the total volume of discounts in the System and, if possible, to facilitate the reduction of those discounts” (Harrison Papers, Letters and Reports, vol. 1, November 13, 1929).

  The dispute was mainly about procedure, not about substance. Nor was the procedural issue a new one. The Board and the New York bank had differed about the division of responsibility and particularly about the Board’s role in open market policy from the very first years of the System and particularly after 1923, when the importance of open market operations increased. The Board had discussed reorganization of the committee responsible for policy recommendations at meetings in 1928 and 1929.

  Harrison wrote to Young on November 7. The New York directors had voted that day to purchase government securities if they did not acquire sufficient acceptances. Their aim was to provide a seasonal increase in reserves while reducing the volume of discounts and open market rates. His letter mentions the directors’ concern “that there may be a greater danger of recession in business with consequent depression and unemployment, which we should do all in our power to prevent” (Open Market, Board of Governors File, box 1435, November 7, 1929).

  No purchases were made. Between September 24 and November 8, the System account increased $80 million, by purchases of $30 million and acquisition of $50 million purchased by New York during late October. New York increased its holdings (net) by $108.8 million. Only seven reserve banks participated in the purchases.21

  John U. Calkins, president of the San Francisco reserve bank, explained his reasons for not participating in open market purchases.22 He was not “in entire sympathy with the course of open market policy.” He was opposed to the view that “artificial conditions should be created for the purpose of promoting a bond market.. . . We can not see that this policy can be continuously followed without unfavorable results” (Letter Calkins to Harrison, Board of Governors File, box 1435, January 7, 1930).

  Calkins then commented on Strong’s 1927 purchases: “We are unable to see that the 1927 experiment, now quite generally . . . admitted to have been disastrous, contributed very materially to the welfare of this country by providing or supporting a market for our exports. . . . [T]he purpose of the Federal Reserve System is to provide and assure adequate finance for trade . . . at a cost conducive to stability” (ibid., 2; emphasis added).

  21. Cleveland, Richmond, Minneapolis, Kansas City, and San Francisco did not participate. These banks had lower gold reserve ratios than several of the participating banks, but the ratios ranged from 52 percent to 66 percent (Board of Governors File, box 1436, November 12, 1929).

  22. Calkins served as governor of the San Francisco bank from May 1919 to February 1936, when he was required to retire after passage of the Banking Act of 1935. Governor Seay (Richmond) expressed similar views. At the December meetings of the Governors Conference, the governors voted on whether they agreed with the OMIC’s policies. Governor Talley (Dallas) voted no, and Norris and Calkins abstained.

  This letter, written within a few months of a major financial panic and at a time of deepening recession, represented a substantial body of opinion within and outside the Federal Reserve System. To these real bills advocates, Strong’s 1927 policy had failed on the narrow grounds of expanding exports, on which it had been offered, but it also had been a main cause of the increase in stock prices and brokers’ loans. They wanted no more. They believed that crises and recession were inevitable after speculative lending; they had to be endured to reestablish a sound basis for expansion.23

  The data in table 5.3 are for the end of November, hence they overstate somewhat the changes that had taken place at the time the committee met. The sizable reduction in the money supply is a reversal of the very large rise in deposits in the last week of October. At the time of the meeting, industrial production was 5 percent below its level at the peak, and by month’s end it was more than 7 percent below the August peak. Short-term interest rates and wholesale prices had continued to decline, but member bank borrowing was higher on average than in the preceding month.

  The committee noted that a turning point had occurred and that there had been a “severe liquidation of credit against securities under circumstances which constitute a serious threat to business stability at a time when there were already indications of a business recession.” The time had come for the Federal Reserve System to “do all within its power toward assuring the ready availability of money for business, at reasonable rates.” In the Riefler-Burgess framework, the committee’s statement meant that the discounts of member banks should be reduced. The governors voted to do just that by purchasing bills (acceptances) and, if necessary, by purchasing government securities. At Harrison’s suggestion, the committee changed the limit on purchases from $25 million per week to a total of $200 million between the November and January meetings.

  This meeting, within three months of the turning point, showed little disagreement about the interpretation to be placed on the events that had occurred or on the proper means of meeting the expected recession. The committee clearly regarded the fall in security prices and the decline in the public’s wealth as factors intensifying a recession that was already under way. The record in 1929, as at the start of most subsequent recessions, is inconsistent with the often-repeated view that the Federal Reserve is slow to take countercyclical action because it is slow to recognize the onset of a recession. The reluctance to take expansive action that many of the governors showed at subsequent meetings of the committee cannot be explained as a misinterpretation of the then current economic conditions or a failure to recognize that the economy had turned from expansion to recession.

  23. Calkins’s letter suggested a $150 million (16 percent) reduction in the open market portfolio.

  At first the Board refused to approve the committee’s decision. Young wrote to Harrison on November 13 that the Board was willing to authorize purchases for emergencies but would not grant authority to purchase up to the $200 million approved by the committee. Harrison’s memo, recording his subsequent conversation with Young, makes it clear that he viewed the Board’s objection as an opposition to the grant of discretion, not to the purchase policy. He accused Young of wanting to have a central bank operating in Washington and was surprised when Young agreed (Harrison Papers, Conversations, vol. 1, November 15, 1929).

  To obtain approval of the purchase program, Harrison offered a temporary solution to the procedural issue. New York agreed to stop purchasing for its own account if the Board approved the committee’s decision without qualification. The Board accepted on November 25. In the first three weeks of December, the System purchased $207 million of securities and $52 million in acceptances. In the remaining weeks of December, market rates fell, acceptances came to the bank at a faster rate, and the System sold nearly $50 million of government securities. The initial crisis was over.

  Response to Recession

  Changes in many of the monetary variables at the time of the January meeting are not markedly different from the changes that characterize other recessions.24 Gold and bank loans had fallen, the latter partly a reflection of the reduction in stock exchange credit. The monetary base had fallen also, but more of the base was held as bank reserves, so the money supply had increased. Short-term interest rates were below the levels reached at the peak and had declined since the previous meeting; the term structure sloped up. (The term premium between Aaa rates and ninety-day acceptances had increased from 0.57 to 0.72.) Member bank borrowing was 50 percent below its peak, the lowest level s
ince early 1928.

  The January meeting was the first meeting after issuance of the Board’s order replacing the OMIC with a new Open Market Policy Conference (OMPC) on which all reserve banks would serve. Although all governors participated in the January meeting, there was substantial disagreement about the new procedure, and it was not adopted until March 31.25

  24. See Cagan 1965. An exception is the decline in currency, which began earlier than the average for the cycles up to 1960 that Cagan studied.

  The new committee recognized that “a business recession has taken place, the extent or duration of which is not yet possible to determine” and that “liquidation is progressing in an orderly fashion.” However, the members were divided about the policy that should be pursued in the coming months. Governor Eugene R. Black (Atlanta) “desired a continuation of credit ease,” arguing that neither business nor the mental attitude of businessmen in his district was conducive to expansion. At the other pole, “Governor McDougal (Chicago) indicated that an easing policy would be worth considering if it would benefit business, but he felt present rates were not restrictive.” “Governor Norris (Philadelphia) believed that open market operations had been carried far enough, that the object of the November policy had been achieved, and he would rather see lower interest rates come of their own accord than as a result of Federal Reserve interference.”

  Governors Lynn P. Talley (Dallas), William McChesney Martin Sr. (St. Louis), and John Calkins (San Francisco) joined Norris and McDougal. Calkins noted that there had been “more than the usual liquidation in his district,” but he could see no reason for further changes in interest rates. Others took intermediate positions, several favoring Harrison’s proposed reduction in the buying rate for acceptances.26 No one argued for a program of substantial or even moderate open market purchases. It was “the judgment of the Committee that no open market operations in government securities are necessary at this time either to halt or expedite the present trend of credit.”