A History of the Federal Reserve, Volume 1
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A second explanation attributes the decline in money to the operation of the gold standard, to the desire to maintain the gold reserve, or to the desire to maintain convertibility of foreign currencies. This argument takes various forms. One claim is that under the conditions of the period, gold and international reserves flowed toward the countries with surpluses on current account of the balance of payments, principally the United States and France. This forced contraction in the deficit countries without producing expansion in the surplus countries.
154. For the four years December 1929 to December 1933, the total note issue increased $1.17 billion. Currency held by the public increased $1.04 billion. The Chicago district had by far the largest absolute and percentage increase.
Eichengreen (1992) makes this argument forcefully. His descriptive statement is correct, but it does not explain why both deficit and surplus countries behaved as they did. Temporary or long-lasting suspension of gold convertibility had occurred under the gold standard many times and in many countries. Great Britain had suspended convertibility several times in the nineteenth century. Yet most deficit countries chose to deflate and protect their gold reserves rather than suspend convertibility. One reason is that policymakers in many of these countries also believed that contraction and deflation were the inevitable consequences of the speculative excesses that had gone before.
The French government was not immune to this view. Far more important, it disliked the gold exchange standard. The French preferred to hold gold rather than foreign exchange as an international reserve, an attitude and policy that reappeared under the Bretton Woods system in the late 1960s. Eichengreen and others point out that the Bank of France was prohibited from undertaking open market operations. This claim fails to recognize that the bank engaged in open market sales of foreign exchange as part of its policy of holding only gold reserves. Under this policy, France sterilized a large part of its gold inflows.
The Federal Reserve did not depend on foreign central banks and governments and did not follow gold standard rules. The large inflow of gold in spring and summer 1930 did not expand bank reserves or the monetary base. With a few exceptions, such as the British suspension, gold flows received little attention in the minutes for the period.155
Concern about the size of the gold reserve relative to the reserve requirements for currency and bank reserves—the problem of “free gold”—has limited applicability. Goldenweiser (1951) argued that the Federal Reserve “could not proceed to buy securities in the market because member banks were likely to use the proceeds to reduce their indebtedness to the Federal Reserve Banks. These banks would then have to put up more gold as collateral against notes and there would soon not be enough gold to meet the requirements against deposits.”156 Harrison and others mentioned free gold at times during summer and fall 1931, but after the fact Harrison recognized that free gold had not constrained action. Nevertheless, the Open Market Policy Conference waited for the passage of the Glass-Steagall Act in 1932, permitting government securities to serve as collateral for notes, before beginning large-scale purchases. However, the argument is not credible as an explanation of the System’s inaction between January 1930 and October 1931. During these months the System’s reserve ratio never fell below 75 percent, was always above the average for the decade of the twenties, and generally was more than twice the required ratio. Open market purchases had been made in 1924 and again in 1927 when the reserve ratio was similar to or lower than that in 1930 and most of 1931.
155. Much the same can be said about the failure of international cooperation. Earlier in the chapter, Oliver M. W. Sprague, an adviser to the Bank of England, is quoted as saying that when cooperation was desirable, central banks could agree (Board of Governors of the Federal Reserve System, Weekly Review of Periodicals, June 2, 1931, 1–2). Clarke (1967, 42) makes a more accurate statement. “Monetary policy could be brought into play [for international cooperation] only when the central bank’s international aims happened to coincide, or at least not conflict, with its domestic ones.” Eichengreen (1992, 247 ff.) also uses “deflationist” views as an explanation of Federal Reserve actions in 1929–31. As discussed earlier, “deflationist” views arose because the Federal Reserve permitted an expansion based on speculative credit.
The greater puzzle about the reserve ratio or alleged “free gold” problem is that traditionally countries suspended the reserve ratio whenever a fall in the ratio would have prevented a central bank from acting against an internal drain. Bagehot’s dictum, “lend freely at a high rate,” had been the unstated policy of the Bank of England through most of the nineteenth century. The bank had suspended its gold reserve requirement rather than force contraction. The Federal Reserve followed a similar policy in 1920, suspending reserve requirements for the New York bank rather than forcing the System into a more contractive policy. Other reserve banks had avoided suspension during and after the war only by selling acceptances and rediscounting commercial paper with other reserve banks.157 This option remained open throughout the period. Although Boston and Chicago refused to participate in open market purchases, Boston had offered to rediscount for New York during the summer of 1932 if New York continued the purchase policy of the previous spring.
Even if “free gold” had prevented purchases of government securities, it did not prevent monetary expansion. An aggressive policy of acquiring some of the outstanding commercial paper and acceptances would have provided eligible paper and freed up gold for use as a reserve against currency issues. Nor does the free gold argument account for the failure to redefine eligible paper to include notes secured by high-grade corporate bonds or even the bonds themselves or to press for a change in legal requirements.158
156. Emanuel Goldenweiser was director of research at the Board of Governors. Anderson (1965, 67–69) repeats this argument.
157. Chandler (1958, 184–85) shows that in October 1920 eight of the Reserve banks remained below the required reserve ratio, some by more than twenty percentage points.
158. In spring 1930, W. P. G. Harding, governor of the Boston bank until April 1930, proposed redefinition of eligible paper to permit discounts secured by high-grade bonds. See Harris 1933, 1:304. There is no record of a System response.
The most that can be said for the “free gold” argument is that it was one of a number of reasons Harrison and others used to delay the start of the purchase program in January and February 1932. The “free gold” position cannot explain the System’s failures to pursue expansive policies during 1930 and most of 1931 or during the fall of 1932. To explain these we must look elsewhere.
The third explanation of Federal Reserve inaction is lack of knowledge. Bach (1967, 346–56) and Stein (1969, 15) suggest that the System either lacked information about contemporary movements or acquired information too slowly to act in time to prevent a catastrophe. The discussion and tables in the chapter give only a few of many examples showing that the members knew about gold movements, currency changes, interest rate movements, changes in bank earning assets, industrial production, and employment. The minutes and memos of the time frequently contain accurate estimates of current gold flows, the volume of currency “hoarded” by the public, changes in industrial production, and commodity prices. The severity of the crisis would have been lessened if the governors had allowed the monetary base to rise by the full amount of their estimate of the increased demand for currency. Information on output, employment, prices, and lending is available in the minutes, in the Federal Reserve Bulletin, in the Board’s annual reports, and in speeches by officials at the time. Intelligence gathered within the System and available at the time was entirely adequate for the improvement in policy that would have substantially reduced the severity of the contraction or eliminated it entirely. Much the same can be said for the available theories. Indeed, if the System had done no more than follow the principles established in the nineteenth century, it would have prevented the internal drain and the greater part o
f the monetary crisis.
There can be no doubt that most of these principles were known at the time. Some of the governors refer to Bagehot’s work. Keynes (1930, 2:225–26) describes as the “first necessity of a Central Bank” the control of the deposits created by the member banks. The way to control the deposits, he said, was to control the total stock of money, currency and deposits, by controlling the monetary base. Within the system, several of the New York directors, W. Randolph Burgess, and Eugene Meyer often favored purchases, opposed sales, and at times pointed out the consequences of the System’s policies for employment, prices, and production. Outside the System, Seymour Harris (1933, 2:175–92) criticized the central relation of the Riefler-Burgess analysis—that the Federal Reserve controlled member bank borrowing by open market operations—and pointed out that the analysis neglected changes in currency, Treasury operations, and gold movements.
From his detailed examination of various periods during the twenties, Harris concluded that the inverse relation between borrowing and open market operations was much weaker than Riefler, Burgess, and Strong claimed.159
A fourth explanation is that the monetary system collapsed because the Federal Reserve lacked leadership. With the death of Benjamin Strong, leadership of the Federal Reserve Bank of New York passed to George Harrison. According to Friedman and Schwartz (1963, 411–19), Harrison lacked Strong’s ability to lead and was unable to get other members of the Open Market Policy Conference to follow his suggestions.160
There is ample reason to believe that Strong would have regarded the policy action from August 1929 to the summer of 1931 as an “easy policy.”161 His statements on open market operations repeatedly emphasized the importance of the volume of member bank borrowing as the most important indicator of the desirability of purchases and sales. His March 1926 statement, quoted earlier, uses $500 million to $600 million as a tight policy at the start of a recession.
Strong approved of the policy of selling securities during the winter of 1928 and the increases in the discount rate during the spring, despite the very slow rate of increase in money and the slow decline in the monetary base during the recovery from the 1927 recession. We know that Strong approved of the deflationary policy of 1920–21, but this decision antedates his understanding of the role of open market operations.
Burgess changed his views after 1930, arguing for expansion. Burgess was a main proponent of continued expansion in summer and fall 1932. Clearly, Burgess put aside the Riefler-Burgess framework. It seems probable that Strong would have done the same. On this point, Fisher and Friedman and Schwartz seem correct. Strong was by far the most knowledgeable and thoughtful of the governors or Board members.
159. Harris comes close to recognizing that the Federal Reserve must control the monetary base. His criticism of Keynes (Harris 1933, 2:192–95) for insisting that a central bank must control the stock of money, however, shows that he did not fully understand this point. Instead, he reached a conclusion that the System was only too willing to adopt later; the Board members and governors had less control than they claimed. Harris had access to the Board’s files and internal memorandums, and his discussion gives an excellent account of the changing views of the Board members.
160. Wheelock (1992) notes that this view goes back at least to Irving Fisher. He quotes Fisher’s testimony in hearings on the Banking Act of 1935 that if Strong had lived, “we would have had a different situation”—stable prices (12). Fisher (1946) repeated his view in a letter to Clark Warburton, dated July 23, 1946, 3. I am grateful to Wayne Angell for providing a copy of the letter.
161. We know that Strong used the Riefler-Burgess framework and paid no attention to monetary aggregates in conducting policy during the 1923–24 and 1926–27 recessions. See table 5.30 above. In his 1926 testimony to the House Committee on Banking and Currency, reprinted in Strong 1930, 257–58, Strong described the elimination of indebtedness of the New York banks as the main objective of the 1924 purchase policy. He listed six aims of monetary actions including, as number five, assisting when possible “the recovery of sterling and the resumption of gold payment by Great Britain.” Then he added, “I think the guide, looking back now, was whether the New York banks were completely out of debt or not, or whether they still owed us a small amount as a regulator.”
Would Strong have succeeded in persuading a majority of the committee? After April 1930, the five-member executive committee included a majority—McDougal, Norris, and Young—who insisted that deflation was an inevitable consequence of the speculative boom that had gone before. These governors, and others, blamed Strong for the expansive purchases in the fall of 1927 when member banks were only $400 million in debt. And they repeatedly cited the real bills interpretation of the tenth annual report to support their position. Some of them had opposed Strong’s policies in 1927. McDougal in particular was hostile to Strong’s policy of reducing the discount rate and acted only after the Board forced the reduction.
The recalcitrant governors made an internally consistent argument. Moreover, they could appeal to the intent of the Federal Reserve Act. Carter Glass, who never tired of pointing out that he had written the act, shared their view. Even Eugene Meyer believed that “the New York bank had built up its power entirely out of proportion with the intent of the Act” (CHFRS, Meyer, February 16, 1954, 4).162
Even when the OMPC voted to purchase, Boston and Chicago did not always participate in purchase programs. One reason New York stopped purchases in 1932 was that it lost gold reserves to other banks. Unless Strong could have persuaded McDougal and Young to participate, or convinced the Board it should force other banks to sell gold to New York, Strong would have faced a loss of gold and a fall in the gold reserve ratio. Although Meyer at times favored continuing purchases, he was unable to get the Board to insist on a System program. Miller, often joined by Hamlin, opposed purchases. Strong would have faced the same resistance.
Many of the other governors and Board members blamed Strong’s policies in 1924 and 1927 for starting the speculative expansion. The contraction was an “inevitable consequence” of the expansion. When speculative credit expansion produced a boom, a collapse must follow. Despite a falling price level before the collapse and an accelerating price decline after, there is far more concern about potential inflation than about deflation. Strong would have had to convince his colleagues that another round of speculative credit expansion could succeed.
162. Meyer refers to “ill feeling between the Board, New York and Chicago,” no doubt a contributing factor in the inability to reach agreement (CHFRS, Meyer, February 16, 1954, 4).
Quite independent of the role Strong might have played, there is little evidence that Harrison generally favored an expansive policy. The two strongest pieces of evidence Friedman and Schwartz present to suggest that Harrison favored such a policy fail to support that interpretation when examined more closely. Although Harrison received little support for his proposal to purchase, sent to all the governors in July 1930, there is no evidence that he intended to steadily expand the portfolio or the stock of money. In a reply written to the governors of the other reserve banks in mid-July, Harrison noted that there had been an unanticipated increase of $100 million in the bill portfolio and that the money market banks had reduced their borrowing from the reserve banks. This, he said, removed the necessity for purchases. In summer 1931 Harrison, urged on by Meyer and his directors, again tried to persuade the other governors to expand the executive committee’s authority to purchase $300 million. Other members of the Open Market Policy Conference opposed and authorized purchases of $120 million. Another improvement in money market conditions occurred shortly after the meeting, and Harrison failed to use the more limited authority given to the executive committee.
In September 1930 W. Randolph Burgess, Carl Snyder, and several members of the Board supported purchases; Harrison opposed.163 In January 1931 Harrison favored a policy of sales. In January and February 1932 he talked about the ne
ed for delay and the danger of wasting ammunition. On these and other occasions, Harrison’s views do not differ from the views of the other governors. The minutes provide some evidence that the majority of the committee would not have opposed Harrison if he had encouraged them to continue the purchase program during summer and fall 1932, as Burgess wished. But those who opposed strongly would not have taken their share of the securities. The sample of his views, quoted throughout the chapter, does not show Harrison as repeatedly rebuffed. More often, Governor Meyer of the Board, or some of the New York directors, urged a cautious Harrison to expand.
Harrison’s behavior, and the behavior of most of the other governors, is consistent with their understanding of the Riefler-Burgess framework. If, on the Federal Reserve interpretation, the market was “easy,” purchases were not authorized or made. Because the governors believed monetary policy was best judged by money market variables, most of them believed they had done all that could be done to prevent a collapse of the monetary system. They did not regard the declines in money and bank credit as consequences of their actions. On their interpretation, the demand for credit had fallen as a “natural” result of the previous speculative boom. This reduced the demand for reserve bank credit. In 1932 they tried a policy that many of them described as credit inflation, and it failed to revive the economy, as several of them expected it would.
163. In a revised edition of his book, published in 1946, Burgess comments that during the depression borrowing, interest rates, and bank lending responded to Federal Reserve actions but the economy didn’t respond. See Wheelock 1990, 415.