A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  96. At the time, New York owned 33 percent of the System portfolio and was expected to buy 27 percent under the formula used to allocate System securities to individual reserve banks (Board of Governors File, box 1452, March 16, 1932).

  Second was passage of the Glass-Steagall Act on February 27, 1932, and the start of Reconstruction Finance Corporation purchases on February 2, 1932. Third was the threat of additional legislation, particularly the passage of two bills that had been introduced in Congress, one calling for a soldiers’ bonus, the other for an issue of paper currency, or “greenbacks.” When some directors expressed concern about the inflationary effect of the purchase program, Harrison replied that “the only way to forestall some sort of radical financial legislation by Congress” was an expanded program of purchases.

  The New York directors had urged Harrison to purchase for weeks. Woolley was enthusiastic and urged purchases of $100 million a week instead of $25 million. Roy A. Young (Boston) expressed fears that an inflationary policy would drive the country off the gold standard, but after receiving assurances from Treasury Secretary Ogden Mills that the next budget would be balanced unless Congress passed the bonus bill, Young conceded that “by working toward controlled inflation we would be working against uncontrolled inflation by the Congress.” He then shifted his position and urged Harrison to double the weekly rate of purchase and get an agreement from the other governors to purchase $500 million at a rate not less than $50 million a week. “If we are going into this program,” he said, “the more vigorously and promptly we act, the less we shall have to do.”97

  Harrison’s principal concern was that Congress would approve “inflationary policies” before Federal Reserve purchases could help the economy. During the Coolidge administration, the government had promised a bonus to World War I veterans, payable in 1945. One group in Congress wanted to pay the soldiers’ bonus at once. Another group, led by Senator Thomas, wanted to print $2.4 billion of Federal Reserve banknotes, collateralized by 2 percent government bonds sold to the Federal Reserve banks. Neither group could get its bill passed, but the two groups had started to work together. Their plan was to use Federal Reserve banknotes to pay the bonus. This would stimulate spending. Senator Elmer Thomas, author of the bonus bill, told Harrison that “if his bill is not favorably received, even more radical proposals will be forthcoming from Congress” (Minutes, New York Directors, April 4, 1932).

  97. Both Young’s use of “we” and his demand for a more expansive program contrast with his bank’s failure to participate in the purchase program.

  Political concerns accomplished what economic disaster could not. The Thomas bill, and the threat of other legislation, aroused Harrison to action. He told his directors, “The only way to forestall some sort of radical financial legislation . . . is to go further and faster with our own program” (ibid., 2).98 He proposed purchasing $500 million in the next month, an extraordinary amount and rate of purchase and completely out of character for Harrison.

  Although the purchase program had been in effect for five weeks when the OMPC met in April, System policy had not yet become expansive. The money supply fell during March, as table 5.20 shows. The preliminary memorandum prepared for the April 5 meeting of the executive committee noted, on Riefler-Burgess grounds, that the “program of security purchases has been even more successful than had been hoped . . . as member bank indebtedness has been reduced by more than $200 million.” The memorandum correctly noted the contribution made by the reversal of the currency flow and by the small gold inflow. Moreover, the risk premium had fallen two percentage points since the end of 1931.

  On April 5, the OMPC’s executive committee unanimously approved continuing the purchase program. Even McDougal and Young, who had opposed the program when it started in February, voted to continue purchasing because they did not believe that the executive committee should stop a program adopted by the full Open Market Policy Conference. But the executive committee did not accept Harrison’s argument to expand the program. It deferred action pending a meeting of the full OMPC the following week.

  The New York directors wanted a more aggressive program. At their meeting on April 7, they talked about a “race against time” and urged Harrison to take “dramatic action,” to make “emergency purchases” for their own account immediately, and to “go it alone” without waiting for the other reserve banks. When Harrison reported that Senator Thomas had told him he “might be satisfied not to press for congressional action [on the bonus bill] if the System would proceed more vigorously,” one of the directors urged an immediate purchase of $100 million.

  98. He seemed to describe himself. “There will always be some reason for postponing action, and we shall never do the courageous thing if we wait for absolutely clear skies” (Board of Governors File, box 1452, March 16, 1932, 2). He then described four difficulties: System approval would be needed; New York might have to buy most of the securities; New York would have to invoke the Glass-Steagall provision; and the critics would call New York’s policy inflationary. He did not mention the loss of gold, a major offset to the expansion. France held approximately $80 million in short-term acceptances. By late March it had adopted a policy of withdrawing $12.5 million in gold each week. Governor Moret of the Bank of France wanted to increase the rate. Harrison told him that the New York bank did not object to any gold purchase and export program he chose.

  Thus prodded by Senator Thomas and his directors, Harrison introduced a resolution at the April 12 OMPC meeting calling for purchases of up to $500 million in addition to the unexpired authority under the February 24 decision. Purchases were to be made as rapidly as practicable with at least $100 million purchased in the current week. The OMPC approved the program ten to one, and the Board added its approval on the same day.

  Governor Young of Boston was the main opponent. His argument was very similar to the argument made by Governor Norris eighteen months earlier. A purchase program could not be successful unless the commercial bankers approved. Previous programs had failed; he saw little point in continuing the program.

  Meyer replied to each of Young’s arguments. The country was not in a favorable position to take advantage of the funds made available. He believed the program would inspire confidence and would not be opposed by the banks. Governor Harrison reinforced this view: “The uncertainty as to the budget and bonus legislation had constituted obstacles,” but it was not necessary to wait for these questions to be resolved. He believed the success of the program depended on the use member banks made of their excess reserves, but he thought the wisest course was vigorous action by the Federal Reserve.

  Several governors said they regarded the purchase program as a success, supporting their statements with references to various measures. The minutes note that open market rates had fallen, that government security prices had fallen markedly, and that banks had reduced borrowing and accumulated excess reserves. Some hoped that the decline in member bank loans and investments had ended, as suggested by the data for weekly reporting banks early in May.99

  Purchases Slow

  The signs of improvement quickly disappeared. The data in table 5.21 show that by the end of May the risk premium had risen to the highest level experienced in the depression. Despite open market purchases of more than $100 million a week, Aaa rates were back to the December level, and Baa rates were at a new high. The gold outflow to Europe, mainly to France, increased during the spring. The gold stock was now below the level at the previous peak in 1929, one of the few times this had occurred during the downswing. Perhaps influenced by the new rules for collateral or fear of congressional action, the members of the OMPC paid little attention to the gold movement and authorized additional purchases of $500 million, at a reduced weekly rate.

  99. Seasonally unadjusted data show a small increase in loans and investments for the week ending May 4. Loans declined at a slower rate (Board of Governors of the Federal Reserve System 1943, 145).

  Bank lendi
ng, commercial paper, and acceptances continued to fall. Industrial production fell five percentage points in May to a level nine percentage points (15 percent) below the December 1931 level and 50 percent below its value at the 1929 peak. Wholesale and consumer prices continued to decline; the wholesale price index reached 64 (base 100 in 1926). The index of farm prices was 16 percent below the previous December level, a 38 percent annual rate of decline.

  Governors Young and Martin could find no beneficial effect of the past purchases. Both thought that the Reconstruction Finance Corporation had helped but that open market purchases had had no effect. Adolph Miller also believed the purchase program had failed. McDougal favored slowing the program down until the large excess reserves were put to work.100 He hoped there would be no specified amount of security purchases fixed in advance, and he expressed his fears that the System would dissipate its resources and not be in a position to meet a crisis.

  Pulled in different directions by opposition within the OMPC, concerns about congressional and public reaction, and his characteristic indecisiveness, Harrison took a position midway between McDougal and the New York directors. On May 5 he opposed the proposal by one of his directors, supported by Burgess, that the System buy longer-term securities. A week later he talked about setting an objective, a terminal point such as a specific level of member bank reserves. He again opposed proposals to purchase longer-term securities and a suggestion that New York reduce its discount rate from 3 percent to 2.5 percent. On May 16, with Harrison absent, Burgess told the executive committee of the directors that the System was trying to find an objective for the purchase policy, perhaps by tying the volume of purchases to the volume of reserves. He expressed his own view that after a long period of credit contraction, credit expansion required larger reserves than in normal times.

  Bank reserves had increased by $725 million between February and May, mainly as a result of System purchases. Member banks had reduced borrowing or increased excess reserves by almost $600 million. When Harrison reported to his directors on May 26, he favored a slower rate of purchase. He reasoned that the “best policy would be to keep our program alive for a considerable period rather than to fire all of our ammunition at once.” In the previous two weeks, the rate of purchase had declined from $100 million to $86 million and then to $58 million. Currently, he thought, $50 million to $60 million was sufficient to offset gold exports, month-end and holiday currency withdrawals, and other demands for reserve bank credit. On June 9 he opposed the proposal by one of the directors to increase the rate of purchase, again stressing the importance of stretching out the program instead of using up “ammunition.”

  100. More than one-third of the $600 million purchased in April and May was held as additions to excess reserves at the end of May.

  The rate of purchase continued to slow after the May meeting. By the June meeting of the executive committee purchases had fallen to about $40 million a week. Some governors claimed they had achieved the aims of the purchase program. The volume of member bank borrowing was $350 million below the late February level. Although the risk premium had risen to more than six percentage points, short-term market interest rates had fallen. At the end of June, loans at weekly reporting member banks were 13.5 percent lower than at the start of the year. Late in June the Federal Reserve lowered the buying rate on acceptances from 2.5 percent to 1 percent and set the discount rate at New York at 2.5 percent. The Federal Reserve’s discount on acceptances remained above the market’s discount, so the System did not expect acceptance holding to increase.

  All the accustomed indicators of Federal Reserve policy showed that policy was “easy” and suggested to the governors that the time had come for a less active policy. At the June meeting of the executive committee, Governor Meyer noted that the weekly telephone discussion about the volume of purchases could be avoided by agreeing on a policy target. He suggested that member bank excess reserves be kept between $250 million and $300 million, approximately the amount held by banks at the time of the meeting. The committee decided that the System should continue to purchase securities so as to avoid any indication that policy had changed. The purchases, however, were to be as small as required to maintain the volume of excess reserves.

  Another reason for slowing purchases was the absence of a System policy. Most of the reserve banks did not accept their allotment of securities, and some did not participate at all. New York took more than half, at times 75 to 80 percent of purchases. Gold exports to Europe drained New York’s gold reserves disproportionately, and banking problems in the country drained correspondent balances of New York banks. With his gold reserves falling, Harrison became reluctant to continue purchases without more support from other reserve banks, particularly large banks such as Boston and Chicago: “Given the comparative reserve positions of the two banks, he said, it is difficult to see why we should pump funds into the market which will then be siphoned off to Chicago” (Minutes, New York Directors, June 23, 1932, 2).101 A new round of bank failures in Chicago made him hesitant to stop purchases entirely, so the directors agreed to purchase up to $30 million in the last week of June.

  The following week, Owen Young described the purchase program as having “served to check a contraction of credit rather than stimulate an expansion of credit. We have been clearing away for action, rather than taking action.”102 Harrison agreed, citing the decline in borrowing “to a minimum” and the withdrawal of gold by France and other large holders. He added that “our program is only now getting a real test as an agency for recovery” (Minutes, New York Directors, June 30, 1932).

  That test did not come. Harrison favored continued purchases, possibly at a higher rate, only if “the program be made a real system program and that the Federal Reserve banks of Boston and Chicago, in particular, give it their affirmative support” (ibid.). Further, he wanted to transfer securities to these banks to acquire gold, and he wanted the Federal Reserve Board to get Chicago and Boston to agree.103 In response to a director’s question, he proposed a $250 million to $300 million target for excess reserves, as much as $80 million above the prevailing level.

  Chicago Banking Problems

  Bank failures continued in the Chicago district throughout June, rising to a peak in the last full week of June, when twenty-six banks failed (Calomiris and Mason 1997). Fearing that the crisis would spread, the public withdrew deposits from some of the leading banks that held relatively large portfolios of municipal warrants, real estate mortgages, or loans to electric utilities, particularly those associated with Samuel Insull’s collapsed holding company. The City of Chicago had stopped paying interest on its bonds, paid wages and salaries intermittently, and sold illiquid tax warrants to local banks to finance payments to suppliers and some creditors (ibid.).

  101. New York had a 50 percent gold reserve ratio compared with 58 percent for the System and 75 percent for Chicago. Excess reserves of the Chicago reserve bank were now larger than New York’s (Minutes, New York Directors, June 23, 1932).

  102. He based his statements on a report showing that $1 billion of purchases had offset a gold loss of $500 million, reduced discounts by $400 million, and increased reserve bank credit by $100 million.

  103. It is difficult to know whether this was a serious recommendation or simply a response to those New York directors (and Burgess) who wanted to continue or expand the purchase program. Harrison knew that Young and McDougal opposed the program and that Boston (Young) had not participated at all. Harrison then added the condition that the RFC become more active in stopping bank failures. He accused it of being too cautious. On the other hand, Charles Hamlin probably described this meeting in testimony several years later: “The Governor delivered an oration worthy of Demosthenes. He nearly drew tears to my eyes, when he told us it was the duty of the Board to force Boston and Chicago into line. I agreed with him entirely.” Hamlin promised to try to get the Board to either force the two banks to purchase or rediscount for New York (Senate Committe
e on Banking and Currency 1935, 948). Hamlin gives the date as the fall of 1933, but that is clearly incorrect.

  The Central Republic Bank was one of the threatened banks.104 On Sunday, June 26, Harrison, Burgess, and Meyer talked with Treasury and RFC officials. These officials reported that the bank was insolvent, an assessment some Chicago bankers did not share. Afraid to close the bank for fear of additional runs, the RFC lent $90 million (and Chicago banks lent $5 million), sufficient to cover all the Central Republic Bank’s deposits. This was the largest loan by the RFC to that time. It permitted the bank to pay its depositors and go into voluntary liquidation (see Upham and Lamke 1934, 158–60).105

  Purchases End

  In the month following the June meeting of its executive committee, the System purchased less than $150 million. The July meeting of the Open Market Policy Conference authorized purchases of at least $5 million a week for four weeks and no more than $15 million per week until the time of the next meeting. The OMPC agreed unanimously to hold excess reserves at approximately $200 million and limit total purchases between July and January to the $207 million remaining from the authorization given at the May meeting.