A History of the Federal Reserve, Volume 1
Page 51
The Federal Reserve’s assistance to the Bank of England and its earlier assistance to the Austrian, German, and Hungarian central banks showed an ability to respond promptly to events it understood.76 Treasury Secretary Andrew Mellon, who served ex officio as chairman of the Federal Reserve, at first opposed aid to European banks, but he changed his views as the crisis spread from Austria and Hungary to Germany (Todd 1994, 8). Perhaps as a result, policy toward international and domestic troubled banks differed markedly. Harrison and other central bankers lent money to support Credit Anstalt, a private Austrian bank. Under the leadership of Gates McGarrah, a former chairman of the New York bank who had become president of the Bank for International Settlements, central banks in June had made available a second $14 million credit to the Austrian National Bank contingent on an agreement by the Austrian government to negotiate a $21 million, two- to three-year foreign loan to strengthen the position of Credit Anstalt. Yet the Federal Reserve was unwilling to take any new steps to prevent the failure of United States banks.
The Federal Reserve’s first response to the international monetary crisis was to raise the buying rate on acceptances to 1.25 percent on September 25 and to purchase $14 million in the open market. On October 8 the New York directors approved an increase in the discount rate of 1 percent (to 2.5 percent).77
Harrison gave two reasons. First was the gold export. Second was his conversation with Governor Clement Moret of the Bank of France. Moret complained that rates were too low; this contributed to a lack of confidence.78 Harrison explicitly dismissed a shortage of “free gold,” the argument subsequently used by Federal Reserve officials to explain policy inaction. He “pointed out that the amount of free gold held by the System had not been materially affected by the recent loss of gold, so that there was still considerable leeway for purchases of Government securities (Discount Rate Advance, Minutes, New York Directors, October 8, 1931). A week later the bank set the rate at 3.5 percent and the System sold the purchased securities.79 Before the second increase, New York’s rate had been the lowest in the System. Once New York put its rate at 3.5 percent, the other reserve banks followed. Table 5.14 shows some of the principal money market changes during the period.
76. Harrison remained cautious toward countries with structural problems. “Governor Harrison raised the question as to what this bank could best do. . . . He expressed the opinion that this bank should not dissipate its resources by making loans to various countries to help them stay on the gold standard when it appeared doubtful whether such loans would be adequate for the purpose” (Consequence of the British Suspension of Gold Payments, Minutes, New York Directors, September 24, 1931). The countries mentioned are Uruguay, Bolivia, and Colombia. These central banks needed more than short-term credits so, Harrison said, they should borrow from commercial banks.
77. A comparison of the loans made to the United Kingdom in the weeks before suspension and open market operations casts doubt on Eichengreen’s argument about lack of cooperation. In July the Federal Reserve and the Bank of France each lent £25 million (approximately $120 million). Later J. P. Morgan and a French bank each lent $200 million additional, a total of $640 million. Federal Reserve open market purchases for the two years following the August 1929 peak were only $519 million (table 5.13).
The Federal Reserve responded to the gold outflow by increasing interest rates. It ignored the currency drain and the banking failures. Again, a main reason for the difference is that the gold stock fell, market interest rates rose, and the money market indicators the governors relied on revealed the changes accompanying the gold and currency movements. As table 5.14 shows and as Harrison’s comment made clear, market interest rates rose slowly at first. Not until late October did the market rate on banker’s acceptances rise above the posted acceptance rate. The increase in the market rate forced the System to buy bills or raise its buying rate.
Start of the Reconstruction Finance Corporation
Alarmed by spreading failures and continued declines, President Hoover called a meeting of nineteen bankers at Secretary Mellon’s apartment in Washington on October 4 to discuss steps that might be taken to prevent bank failures. A memo read at the meeting noted that 1,215 banks with $967 million in deposits had failed in the first nine months of the year, most of them during the summer. The memo interpreted these and other data on currency hoarding and bank failures as showing that bankers and the public had lost confidence in the banking system. Then Hoover’s memo continued: “Prior to the establishment of the Federal Reserve Bank System, it [the banks’ demand for liquidity] would probably have been met through the relationship between the banks in the principal centers and their out of town correspondents, but, with the establishment of the Federal Reserve System, there grew up a tendency to feel that it was to the Federal Reserve System rather than to the banks in central reserve cities that all other banks should look” (Harrison Papers, Miscellaneous Letters and Reports). President Hoover then proposed a central organization, the National Credit Corporation (NCC), to rediscount assets not legally eligible for discount at the Federal Reserve banks and purchase marketable assets of insolvent banks.80 To provide capital, commercial banks would subscribe $500 million. The corporation would have the power to borrow an additional $1 billion.
78. From England, W. Randolph Burgess cabled recommending against any action to increase rates. Harrison read the cable to the directors, but it had no effect.
79. Meyer was at the meeting. He said that “the advance in the rate was called for by every known rule, and believed foreigners would regard it as lack of courage if the rate were not advanced. . . . [H]e did not see how it could affect depositors in this country” (Discount Rate Advance, Minutes, New York Directors, October 15, 1931, 2).
The New York clearinghouse bankers agreed on the following day to subscribe $150 million of the $500 million. Harrison notified the president on October 7 that “there was quite general and enthusiastic support throughout New York for your proposal, not merely to the formation of a $500 million corporation but also to the enlargement of the rediscount facilities of the Reserve System.” Support in the Federal Reserve was more restrained. Harrison’s report on Hoover’s proposal to the executive committee of his directors on October 5 mentions his own proposal to increase the market value of railroad bonds by raising railroad freight rates or reducing railroad wages but does not record his opposition to broader lending powers for Federal Reserve banks. However, he had made his opposition to such proposals clear on October 1, and at an October 26 meeting he firmly opposed any plan that allowed Federal Reserve banks to acquire assets that were not self-liquidating (Harrison Papers, Miscellaneous Letters and Reports, October 5, 1931). The NCC was organized without a Federal Reserve commitment.81
80. Railroad bonds posed the main problem. During the 1920s, small banks with insufficient local loan demand bought railroad bonds to increase earnings. Also, many banks invested savings deposits in bonds (CHFRS, Rounds, May 2, 1944, 20). Interest payments became uncertain as railroad earnings declined, so bond prices fell. Examiners priced the bonds according to a scale based on bond ratings. If the average (dollar weighted) rating fell below 80 (a BBB bond), the bank could be declared insolvent (ibid.). The examiner closed the bank and sold the bonds, depressing their prices. At the October 4 meeting, Harrison proposed raising freight rates to increase earnings. President Hoover dismissed that proposal as not likely to help. Railroad unions opposed wage reductions on the grounds that employed workers contributed 20 percent of their income for relief of unemployed members. The president then suggested that the NCC buy bonds from solvent but illiquid banks and pay depositors of insolvent banks. He proposed also making NCC obligations eligible for discount at the reserve banks and increasing the capital of the Farm Loan banks (Minutes, New York Directors, October 5, 1931).
Hoover proposed the NCC as a temporary measure during the emergency.82 Once Congress reconvened in December, he intended to ask it to broaden the pow
ers of the Federal Reserve to discount paper secured by government securities (Hoover 1952, 84–88). In January Congress passed the Reconstruction Finance Corporation Act, and in February it extended Federal Reserve powers to discount in the first Glass-Steagall Act.83 The Treasury provided $500 million as capital for the Reconstruction Finance Corporation. The RFC could borrow $1.5 billion either from the Treasury or from private sources. In July 1932 Congress increased the borrowing line to $3 billion.
Return to Inaction
Monetary and economic conditions deteriorated considerably between the July OMPC meeting and the executive committee meeting on October 26 (table 5.15). Industrial production fell 12 percent, the index of stock prices more than 25 percent. Bank loans and money also fell by $1 billion. The risk spread was one percentage point higher than in July as bank failures and the currency drain returned.
81. Todd (1994, 11–13) reports that Eugene Meyer was one of the principal proponents of the NCC and later of the Reconstruction Finance Corporation. Todd credits Meyer with obtaining the support of the commercial bankers. Meyer became chairman of the new organization while remaining governor of the Board. The only other instance of a Federal Reserve chairman accepting an administration position while remaining chairman came with Arthur Burns in the 1970s.
82. The NCC advanced only $15 million between October and mid-December, an inconsequential amount in relation to the shrinkage of capital values (see table 5.17, p. 352) The data on advances are from a cable Harrison sent to Governor Moret of the Bank of France. The French feared that Congress was about to pass “inflationary legislation.” The cable restates Harrison’s opposition to making obligations of the National Credit Corporation or the proposed Reconstruction Finance Corporation eligible for discount at the reserve banks.
83. Hoover’s report of the meeting with congressional leaders recalls a past era. “The group seemed stunned. Only Garner [Speaker of the House] and Borah [Senate majority leader] voiced approval. The others seemed shocked at the revelation that our government for the first time in peacetime history might have to intervene to support private enterprise” (Hoover 1952, 90, as quoted in Todd 1995, 7).
In the five weeks following the British suspension, new member bank borrowing offset 85 percent of the direct effect of the gold outflow. Although the OMPC had approved purchases of up to $120 million, Harrison saw no reason to undertake any large volume of purchases, and none was made. McDougal, supported by a telegram from Calkins, favored sales.
The preliminary memorandum prepared for the October 26 meeting and the minutes of the meeting pay far less attention to the British decision than to the renewed bank failures and currency “hoarding.” Harrison noted that four hundred banks closed during the first three weeks of October. Banking problems are described as “the most important” problems facing the System, and the preliminary memorandum suggested that all actions be considered in terms of their effect on bank failures.84
What action was appropriate? The consensus of the meeting was that “everything should be done to persuade the (city) banks to adopt a liberal policy” of lending to banks in difficulty and rediscounting at the Federal Reserve banks. Despite the references to bank failures in the minutes, the Federal Reserve gave less assistance to the banking system than it had arranged for the Bank of England. Nor did it contribute the type of support for the commercial banks that it and other central bankers had urged the Austrian government to give to Credit Anstalt.
Within a month, the Federal Reserve allowed acceptances to run off. The preliminary memorandum prepared for the November meeting conveyed the sense of satisfaction about the System’s response to the “largest gold export. . . and a heavy domestic withdrawal of currency continuing a movement of almost a year’s duration.” The memorandum described the response as “classic” and, to reinforce the point, quoted heavily from Bagehot. By lending freely at an increased discount rate, the System had followed Bagehot’s advice for central banks confronting a crisis. The preliminary memorandum referred to the fact that Federal Reserve credit had expanded by $1 billion during the weeks of the crisis. The maximum amount outstanding, more than $2 billion in the week ending October 14, was the largest total in more than ten years, and the rate of increase—doubling in less than two months—was the largest change in Federal Reserve credit in any two-month period up to that time. Bank failures and currency movements received little attention.
84. Harrison explained that the receivers of closed banks liquidate marketable assets quickly, depressing the bond market. The Comptroller had proposed that certificates backed by the assets of closed banks be eligible for rediscount. Harrison opposed because the assets were not self-liquidating (memo, Executive Committee, Minutes, OMPC, October 26, 1931).
The immediate crisis had passed without reliance on open market purchases, and the governors expressed little interest in a purchase program during the following months. Miller’s suggestion that they start a bold program received very little support. The data on member bank borrowing show that at last an increase in real bills could be used to justify open market purchases. Harrison argued for delay, although he recognized that the volume of borrowing had increased substantially and expected the New York banks to borrow heavily during December. Others saw no reason to keep New York and Chicago banks out of debt.
The OMPC gave the executive committee authority to purchase up to $200 million in securities during December to be sold after the start of the year. Clearly intended as a seasonal adjustment, the authority was used in precisely that way. The weekly figures show changes ranging from +$200 million to –$150 million during December and early January and a net increase of less than $50 million during the month.
Why was the increased borrowing ignored? Harrison made his position clear at meetings with his directors in November and December. His first argument opposed purchases because the gold flow had reversed. Gold had come into the country during November, but the reduction in Federal Reserve credit exceeded the gain in gold mainly because acceptances had run off and had not been replaced. This showed “disinclination on the part of member banks to use Federal Reserve credit for the purpose of extending credit to their customers.” Several of the directors urged purchases; Owen Young pointed out that it was the end of the year and a “bad time to impose any further load of indebtedness on member banks.” Harrison dismissed this argument, and when Young persisted in urging purchases, Harrison offered a whole catalog of arguments purporting to show that the purchases would be badly timed and would do no good.
A month later, on December 24, Harrison showed the directors a chart of the relation between bank credit, business activity, and the price level. Based on past relations, he predicted a further deflation and “commented on the serious aspects of any further deflation of prices.” Still, he urged no purchases because of the “present free gold position and the potential demands which may be made on us at home and abroad.” Some of the directors pointed out that the New York City bankers were almost unanimous in opposing purchases. After a brief discussion, the directors agreed to wait until after the first of the year and to observe the progress of the bill to replace the privately financed National Credit Corporation with a publicly financed Reconstruction Finance Corporation (RFC).
Again, Harrison’s discussion shows that he knew the crisis had deepened. He referred to the decline in bank credit as the largest in the history of the country and reported that his staff had estimated its size at $5 billion in the first two years of contraction. Further, he noted that the rate of decline had increased during the fall.85 He was aware, also, that the effect of a further decline would be a further contraction in business activity and further deflation, and he discussed these problems with his directors. Moreover, he had received a confidential memo in early December showing the position of the banks in the New York Federal Reserve district (Harrison Papers, Memoranda, December 24, 1931). Table 5.17, taken from the memo, points up that he knew, in considerable detail, how much
the position of the banking system had deteriorated between November and the first week of December. However, yields on lower-rated bonds increased during the autumn, as shown by the yield spread in table 5.16. The estimated “shrinkage” of capital funds in table 5.17 is the amount the banks lost mainly as a result of the decline in the market value of their bond portfolios. The memo notes that 300 of the approximately 800 banks had losses nearly equal to their capital funds and that an additional 150 to 200 had some capital impairment. The table included all banks in the New York district except 23 money market banks.
On January 4, Harrison again discussed purchases with his directors. He believed the time had come for the Federal Reserve to consider substantial purchases of government bonds: “His only hesitation in recommending such a program . . . [was] . . . the relatively small amount of ‘free gold’” (Minutes, New York Directors, January4, 1932).86 Congress was considering legislation that would permit the Federal Reserve to pledge all of its assets as collateral for the note issue. Once the legislation passed, it would be able to supplement the legislative program by taking action in the open market.
One of the directors (Clarence M. Woolley) asked Harrison whether there was nothing that so great an organization could do to stem the tide of disaster. He was not satisfied with the usual answer that the banks would not make use of the reserves created by the purchase of government securities. Harrison pointed to the “free gold” position. “We must,” said Harrison, “be on relatively safe ground before we embark on a program of government security purchases, which is not the case at the moment when banks are failing by the score, the renewal of currency hoarding is a probability, and substantial gold withdrawals by foreign holders of dollars are quite possible.”