A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  Later statements of the reasons for the failure of the 1932 purchase policy differ little from the reasons given in fall 1932 to justify ending the program of open market purchases: “The success of the enlarged open market program (in 1932) depended on the use of excess reserves by member banks” (Anderson 1965, 71). “In October [1933], there was a full-scale review of policy. Excess reserves were about $760 million, member bank indebtedness to the Reserve banks was at the lowest level since August, 1917, and short-term interest rates were at an all-time low. There was general agreement that additional purchases were not needed for monetary reasons” (73).

  Federal Reserve officials were not alone in their acceptance of the real bills doctrine. Seymour Harris (1933, 1:365) describes “the heroic efforts made by the Reserve banks in the years 1929–32 to stimulate the expansion of bank credit and (later) to stop the decline.” Mints (1945, 264) quotes a 1935 statement by sixty-nine members of the Economists’ National Committee on Monetary Policy opposing liberalization of the rediscount provisions of the Federal Reserve Act. The statement expresses concern about illiquidity and inelasticity if the Federal Reserve issues “notes against frozen or illiquid assets.” The committee argued that “the supply of noncommercial paper eligible for rediscount should be further restricted, not enlarged.”

  Looking back on the experience at the end of the 1930s, a Federal Reserve Bulletin described the 1929–33 collapse as caused by the speculative situation that developed between 1921 and 1929. The experience also showed that the price level does not respond to the cost of money: “When the cost of money was so drastically cut, prices went down by about one-fourth” (quoted in Mints 1945, 273–74, from the 1939 Federal Reserve Bulletin, 363–64).

  Wicker (1966) concluded that Federal Reserve officials were ignorant of the proper role of a central bank. This is correct but incomplete. A more complete statement is that most of the governors accepted the real bills doctrine, failed to function as lender of last resort, and failed to distinguish between nominal and real rates of interest.

  Ex post real interest rates rose in 1930 and 1931 and remained at historically high levels in 1932. Chart 5.4 compares real interest rates to growth of the real money stock.164 In the previous deflation, 1920–21, falling prices raised real balances and stimulated spending despite relatively high real interest rates. Falling prices also attracted gold, increasing money balances. (See chart 3.1.)165

  The principal difference in 1929–33 is that the falling money stock more than offset the expansive effect of falling prices on real balances. If the Federal Reserve had prevented the decline in money, falling prices would have raised real balances, created an excess supply of money, stimulated spending, and limited or ended the decline when the economy began to recover in spring 1930; rising real balances and an excess supply of money would have increased aggregate spending. Or if the Federal Reserve had followed gold standard rules, the gold inflow would have increased nominal and real money balances from 1927 to 1929 and from 1929 to the British devaluation in the fall of 1931.

  The minutes of the period, statements by Federal Reserve officials, and outside commentary by economists and others do not distinguish between real and nominal interest rates. Surprisingly, even Irving Fisher did not insist on this distinction. Although Fisher pointed to the decline in demand deposits in conversation with Meyer, his preferred explanation of the prolonged decline was the asymmetric effect of deflation on debtors.

  164. The rate of inflation is common to both series. Ex post real rates are computed using long-term bond yield minus four-quarter moving average inflation. Growth of real money balance is a four-quarter moving average using M1 as the measure of money. The large currency drain makes the monetary base misleading for this period.

  165. The same mechanism, deflation, worked subsequently in the deflation of 1937–38 and 1947–48 to raise real balances.

  Not every official of the Federal Reserve slavishly followed the real bills doctrine or the Riefler-Burgess version of that doctrine. Nor did they all interpret the doctrine in precisely the same way. Some would have preferred a more deflationary policy. Some believed the time for expansion would come in the future, when credit increased and banks offered discounts to the reserve banks. All could agree, much of the time, that purchases should not be made.

  In his memoirs many years later, President Hoover expressed his frustration and anger. The Federal Reserve, he wrote, “was indeed a weak reed for a nation to lean on in time of trouble” (Hoover 1952, 212). This was not the accepted view at the time. So certain was the System about the correctness of its actions and its lack of responsibility for the collapse that I have found no evidence the Board undertook an official study of the reasons for the policy failure. Legislative action expanded and centralized the Board’s authority. The Riefler-Burgess framework continued as a general guide to policy action and interpretation for many years, and return to the gold standard remained the accepted goal of governments everywhere.

  APPENDIX A: DEMAND FOR MONEY

  The equations for ln M/p and ∆ ln M/p are from Meltzer and Rasche 1994.

  APPENDIX B: CROSS-SECTION RESPONSE OF REAL INCOME GROWTH TO GROWTH OF REAL BASE, BASE VELOCITY, AND CURRENCY-DEPOSIT RATIO, 1929–32

  The twenty countries are Austria, France, Germany, Italy, Netherlands, Norway, Sweden, United Kingdom, United States, Bulgaria, Czechoslovakia, Denmark, Finland, Greece, Hungary, Spain, Yugoslavia, Mexico, Brazil, Canada. Data are from Mitchell 1992, 1993. Canada appears to be an outlier in the sample, so estimates were made with and without Canadian data. All data are percentage changes for the period. The wholesale price index is the available deflator. Standard errors are in parentheses.

  six

  In the Backseat, 1933 to 1941

  The Federal Reserve took few policy actions from 1933 to 1941. The open market portfolio and the discount rate rarely changed. Changes in the monetary base during these years reflect principally changes in the gold stock and the devaluation of the dollar against gold; after the gold standard broke down the United States more closely followed gold standard rules for the money stock.

  Congress and the Treasury made the important decisions about gold, silver, and banking legislation. Early in the administration, President Roosevelt took an active part in setting gold policy and making decisions about gold and silver purchases and exchange rates. The Federal Reserve had a subsidiary role—the backseat. New York transacted for the Treasury, as fiscal agent, but the Board had little influence on the decisions and was often uninformed about Treasury actions and plans.

  The Banking Act of 1935 permanently changed the Federal Reserve’s structure and laid the foundation for the postwar Federal Reserve System. Out went the legal basis for semiautonomous, regional banks, each controlling its own portfolio. Reorganization shifted power and authority over the reserve banks to the Federal Reserve Board in Washington, where it remained. Although the Treasury controlled most decisions until after World War II, the 1935 act made possible the centralized system that developed once the Federal Reserve became free to pursue an independent policy.

  Reorganization was mainly the work of Marriner S. Eccles, a Utah banker, aided by Lauchlin Currie, a young economist at the Treasury and later at the Board and in the White House as a presidential adviser. Eccles became governor of the Federal Reserve Board in November 1934 and, after reorganization, the first chairman of the Board of Governors in 1936. He was a strong proponent of government investment spending as a countercyclical policy and believed that the Federal Reserve should keep market rates low to facilitate private spending and government finance during a depression. He called his program “controlled inflation.”

  Despite these strongly held views, Eccles and the Board became convinced after 1935 that the growing volume of reserves at member banks posed the threat of future inflation. The Board’s principal policy action in these years increased reserve requirement ratios as a preemptive act against inflation. Between August 19
36 and May 1937, the Board doubled these ratios, thereby contributing to a steep recession in 1937–38.

  Until 1937, recovery from the depression proceeded rapidly. In the four years following the trough in March 1933, using Balke and Gordon’s (1986) data, real GNP rose at a compound annual rate of almost 12 percent. After a sharp decline in the 1937–38 recession, growth resumed in mid-1938. Real GDP did not reach its 1929 value until 1941, however, and per capita consumption did not regain its 1929 peak until 1942.1

  Prices rose during the recovery, in part a result of deliberate policy to devalue the dollar so as to raise agricultural and commodity prices. The GNP deflator and the consumer price index remained below their 1929 levels, however, when the United States entered World War II.

  Despite the strong recovery, many contemporary observers, including prominent administration officials, regarded President Roosevelt’s New Deal as unsuccessful. The principal reason is that 8 million people, more than 14 percent of the labor force, were unemployed in 1940. In fact, the number employed in 1940 was the same as in 1929, and hours worked were lower. Viewed one way, there was a substantial increase in productivity, but part of the measured increase was a substitution of capital for labor to avoid costly New Deal legislation. These measures sought to raise wages, reduce hours of work, and encourage the growth of trade unions. Militant unionism, particularly in manufacturing industries such as autos, steel, and rubber, reduced current and expected profits in those industries and deterred investment.

  Labor legislation was one part of President Roosevelt’s New Deal. The period 1933–41, particularly the early years, was a time of intense legislative activity. The New Deal restructured society, permanently changing the role of government and the public’s attitude toward the responsibilities of government. Lasting changes were made in the financial system and the Federal Reserve.

  1. GNP came very close to the 1929 peak in 1937, before the recession. Balke and Gordon’s (1986) quarterly data (in billions) have a peak of $329.7 in third quarter 1929 and $329.3 in first quarter 1937. Annual data (in 1958 prices) show $203.6 billion for 1929 and $203.2 for 1937. The annual data in 1958 dollars pass the 1929 peak in 1939.

  Much of the period’s financial legislation reflected the judgments reached by the authors of the new legislation, often shared by much of society at the time, that speculation was responsible for financial collapse and the Great Depression. Taken as a whole or separately, much of the new financial legislation sought to prevent or limit speculation in common stocks, restrict banks from financing securities, and centralize authority and responsibility for monetary policy.2 The Securities Exchange Act (1934) gave the Federal Reserve Board authority to set margin requirements in the belief that general monetary powers, such as open market operations or discount rate changes, cannot prevent a speculative boom in stock prices without harming the so-called legitimate needs of trade.3 Parts of the Banking Act of 1933, generally referred to as the Glass-Steagall Act, separated commercial banking from investment banking. This section of the Banking Act was mainly the work of Senator Carter Glass. A leading proponent of the real bills doctrine, Glass was convinced that the boom and bust had been caused by commercial bankers’ financing investment banking activities and other nonreal bills.4

  In retrospect, the period marks the beginning of the decline in the importance of the real bills doctrine at the Federal Reserve. The 1932 Glass-Steagall Act permitted government securities to serve as backing for the note issue. Conceived as a temporary step, lack of discounts during the depression required renewal of temporary authority, later made permanent. At the end of the period, the beginning of wartime expansion restructured the Federal Reserve’s balance sheet. Government securities became the principal source of reserve bank credit. Growth in the size of the balance sheet and wartime inflation made it less costly to reduce, and later eliminate, reserve requirements behind the note issue and the monetary base than to shrink the base and force postwar deflation.

  2. President Hoover partly shared this belief. In 1930 he asked the officers of the New York Stock Exchange to reform their rules to eliminate excessive speculation. He did not believe there was constitutional authority for legislation (Fusfeld 1956, 224).

  3. Several studies, beginning with Moore 1966, find that margin requirements are ineffective and have little effect on stock prices or trading. Although not recognized by the financial community at the time, some of the legislation contributed to the development of financial markets. The 1933 Securities Act improved both the quantity and the quality of information about companies, thereby encouraging widespread ownership of common stocks after growth resumed in the postwar years.

  4. Benston (1990) documents the charges made against bankers, including claims of criminal activity and disregard for the public. In a superb book, he shows that the claims were either false or unsupported by evidence. At the time, each citation of evidence of wrongdoing referred to previous citations, so a reader could believe that the changes had been thoroughly researched and documented. After World War II, the United States imposed a similar system on Japan. Congress repealed these provisions in 1999 after a major bank merged with an investment bank and an insurance company.

  Other legislative changes reshaped the Federal Reserve by reducing the power of the New York Federal Reserve bank domestically and internationally. Glass and others believed that Benjamin Strong’s assistance to Britain in 1924 and, even more, in 1927 initiated the speculative boom that ended in the collapse. A widely shared view held that the collapse was an inevitable consequence of previous speculative excesses and departures from real bills principles. Unorthodox policies, such as the Hoover budget deficits and Britain’s departure from gold, sustained and deepened the collapse. Hence the remedy was to reduce the influence of those like Strong whose ideas, they believed, had failed.

  None of this was lost on Adolph Miller. Miller, a friend of both Glass and Roosevelt, saw the Banking Acts of 1933 and 1935 as a vindication of his views (Miller 1935). He believed that by centralizing power in the Board, and eventually restoring the gold standard, the Federal Reserve would return to its original conception. In this he was mistaken.

  A contemporary reader finds it difficult to reconstruct the prevailing orthodoxies of the past or to see events as they were seen at the time. Bernard Baruch, a financier who advised many presidents, perhaps typifies the views of the more articulate and influential bankers and financiers of the period. In testimony before the Senate Finance Committee in February 1933, Baruch blamed the depression on four factors, all the effects of war: inflation, debt and taxes, national self-containment, and excess productive capacity (Baruch 1933, 1). The “chief barrier” was wartime inflation. Only in 1933 could prices be said to have fallen to the 1913 level. Reflation by monetary means to restore prices to the 1929 level was the wrong policy. Prices could not be raised by increasing money: “If there is no confidence, no amount of tinkering with the currency can raise the price level. . . . Deficits and the finance of them by ‘bank money’ inflation. . . impair confidence and drive money deeper into hiding” (9). A main task of government was to reduce public spending. Although he favored relief of human suffering, he believed that “reduction in public expense is indispensable for recovery” (2). Reductions in spending and the budget deficit instill confidence and “the working of natural processes” (4). Baruch’s views are similar to the views of the Economists’ National Committee on Monetary Policy, a group that included prominent academic economists.

  Views like these were not just wrong, they were influential. They appealed to beliefs that were widely shared. They called for more deflation and contraction in the mistaken belief that the 1913 price level (or some other) was correct. Restoration of that price level would somehow right whatever was wrong, but the proponents could not say how or why that would happen.

  Not all financial legislation and action corrected past mistakes and alleged misdeeds. Roosevelt had campaigned as a financial conservat
ive, critical of the Hoover administration’s deficit spending, but he also wanted to end the depression and stop the fall in prices. He promised to balance the budget, except for emergency relief, but he offered few specific proposals during the 1932 campaign and had no coherent plan for the economy when he took office.5 During the campaign, Roosevelt described himself as an advocate of experimentation: “The country needs and, unless I mistake its temper, the country demands bold, persistent experimentation. It is common sense to take a method and try it. If it fails, admit it frankly and try another. But above all, try something” (quoted in Sumner 1995, 1).

  Between 1933 and the beginning of defense and war mobilization in 1940, the Roosevelt administration experimented with five main types of economic policy. The Supreme Court declared some of these actions unconstitutional. Some conflicted with others, for example, establishing cartels to fix prices and later strengthening antitrust action against price fixing. Roosevelt encouraged some advisers to advocate policies that others opposed so that he could gauge public reaction. He chose between them, tired of the policies when they did not work or were unpopular, and went to something different.

  One group led by Agriculture Secretary Henry Wallace and two of Roosevelt’s campaign advisers, Rexford Tugwell and Raymond Moley, wanted national planning.6 In the administration’s first months, Congress passed the National Industrial Recovery Act (NIRA) and the Agricultural Adjustment Act. Both were declared unconstitutional within three years.7

  5. Much of his campaign was an attack on Hoover’s policies. His main charges were that the Hoover administration had encouraged speculation and overproduction, misled the public about the gravity of the collapse, blamed other countries for our problems, and delayed relief and forgotten reform (Fusfeld 1956, 223). During the campaign Roosevelt favored a larger measure of “social planning” but did not elaborate (204).