A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  18. The minutes of the April 19 Governors Conference also considered matters “of such a confidential nature that a written record seems to be undesirable.”

  19. Calomiris and White (1994) point out the importance of an agreement between Roosevelt and the RFC regarding deposit insurance as one of the key steps in the reopening process by reducing concerns of the reserve banks.

  The administration had not formulated a gold policy. Among those whose advice the president sought, Professors Irving Fisher, George Warren, and John R. Commons were the main proponents of devaluation or abandoning the gold standard. Roosevelt made no decision at the time, so it was not known whether the restrictions on gold payments would remain or prove temporary (Barber 1996, 24–25).

  The banking position was a decisive factor in the decision to leave the gold standard. On April 5, the president forbade domestic gold holding. All gold coin, certificates, and bullion were ordered sold to the Federal Reserve banks by May 1.20 On April 18 the president announced that the Treasury would cease issuing licenses to export gold (except to settle claims of foreign governments made before the moratorium).

  The April 18 order took the country off the gold standard and ended any deflationary threat from adherence to gold standard rules. The president’s announcement did not explain what would happen next. The president was no less obscure the next day, when he explained that he wanted to raise commodity prices and get the world back on the gold standard. This was followed on June 5 by a joint resolution abrogating the gold clause in all public and private contracts. Payments could be made only in legal tender.

  The gold drain did not require a ban on domestic gold holding or repudiation of the gold clauses in private and public contracts. The president’s April 18 decision would have stopped the gold outflow by making the dollar inconvertible into gold, a decision President Nixon made in 1971. This would have permanently removed the deflationary pressure that the embargo had ended temporarily. Banning private gold holdings and abrogating the gold clauses transferred the profit on the devaluation to the federal government. These steps seem unnecessary interventions into private contracts and asset decisions. Their purposes were mainly political, to show that bankers and wealthy individuals would not gain from the policy.

  20. Awalt (1969, n. 6) reports that Miller considered leaving the gold standard in the fall of 1932. Also, he notes that Adolph Miller discussed a gold embargo in June 1932. The discussion never went further. The Treasury agreed to repay the Federal Reserve for the expenses incurred in reopening the banks. Roosevelt had insisted on frugality, so the Treasury would not pay for the costs of shipping gold and for losses from abrasion. Some commercial banks refused to ship gold to the reserve banks unless the reserve banks paid for freight, insurance, and abrasion (memo to Morrill, Board of Governors File, box 745, October 10, 1933). The following April, the Treasury agreed to reimburse the reserve banks.

  Since the United States held about one-third of the gold in all central banks, these moves puzzled Europeans and generated suspicion and distrust of United States policy in the negotiations leading up to the London economic summit scheduled to be held that summer. The suspicions remained when the administration later changed course and sought cooperation to stabilize the dollar exchange rate against the pound and the franc.

  MONETARY AND OTHER LEGISLATION, 1933

  The Hoover administration had done little to correct the perceived flaws in financial regulation. The Glass-Steagall Act granted authority to use government securities as collateral for the note issue as a temporary measure, later made permanent. Likewise the Reconstruction Finance Corporation started as a rescue operation for banks, insurance companies, and railroads, but initially loans had to have full collateral backing. The RFC had very limited resources. After Congress required release of the names of banks it helped, banks hesitated to ask the RFC for assistance. Mason (1994) notes that the RFC’s constructive role in reorganization began in 1933, when it gained the power to acquire preferred stock in weak or failing banks.

  Congress held hearings on reform proposals during 1931 and 1932 without reaching agreement or passing legislation.21 The information collected proved useful, however. In 1933 the banking committees could proceed without new hearings. Their major problem was to avoid some of the more populist measures such as those calling for issuing greenbacks, coining silver, devaluing the dollar, and compensating depositors for part of their losses from bank failures.22 Some of these proposals had considerable public support and support in Congress.

  21. The 1931 hearings focused on branch, group, and chain banking. Congress could not agree on what regulation was needed. National banks were permitted to follow state rules on branching in 1927.

  22. One bill (S. 806) abolished the Federal Reserve System. All deposits would be placed in a bank (with branches) authorized to issue $2 billion of new credit (approximately 25 percent of the monetary base at the time). The bank would be charged with restoring the price level to the 1915–25 range, a range that included wartime inflation (Woodin to Fletcher, Board of Governors File, box 136, May 3, 1933). The Home Loan Bank Act passed on July 16, 1932, permitted issuance of $917 million in national banknotes. Only $120 million was issued in the next year. On the same date legislation authorized Federal Reserve loans directly to individuals and businesses.

  The Thomas Amendment

  The wholesale price index, as recorded at the time, reached a low of 59.6 (base 100 in 1926) in early February and again in March. By early April the index had increased only one point. This was far too slow for many farmers and ranchers, hence for their representatives. They wanted prices for crops and livestock increased in time for the harvest.

  Senator Burton Wheeler (Montana) offered an amendment requiring the Treasury to coin silver in the ratio of sixteen to one to gold. When Roosevelt threatened to veto the bill, Senator Elmer Thomas (Oklahoma) offered a substitute amendment to the Agricultural Adjustment Act (AAA) that permitted the Federal Reserve to purchase up to $3 billion of securities directly from the Treasury upon authorization by the president; gave the president discretionary authority to issue $3 billion in currency (United States notes or greenbacks) if the Federal Reserve refused to make direct purchases of Treasury securities; and permitted the president to devalue the dollar against gold and silver up to 50 percent of its value.23 The amendment also permitted the Federal Reserve Board to raise or lower required reserve ratios by declaring an emergency, on a vote of five members and with the approval of the president, and it authorized silver purchases of up to $200 million (Krooss 1969, 4:2719–22).24

  Roosevelt and his advisers did not agree about the amendment. Opponents believed it was inflationary and likely to raise concerns about the administration’s direction. Roosevelt saw the issue in political terms. The amendment authorized action but did not require it. If he opposed the Thomas amendment, Congress could pass mandatory legislation to inflate. The hesitation suggests that the administration had not decided whether to return to the gold standard at the old parity, devalue, or inflate. When Roosevelt announced on April 18 that he would accept the amendment, his budget director, Lewis Douglas (a gold standard advocate), is reported to have said, “This is the end of western civilization” (Kindleberger 1986, 200).

  The Federal Reserve did not participate in discussions with the president about the Thomas amendment (Todd 1995, 26). Nor did it raise objections or point out that prices of most agricultural products were set in world markets, so that any benefit to farmers resulting from inflation would be temporary, reversed by devaluation of the dollar and a rise in the prices farmers paid.

  23. Originally the bill had no time limit. In January 1934 the Gold Reserve Act limited the authority to two years.

  24. The legislation became part of the Agricultural Adjustment Act because the act sought to raise farm prices by restricting output. The Thomas amendment added a demand side policy to raise farm prices. The amendment passed the House 307 to 86 and the Senate 64 t
o 21, more than enough to override a veto.

  Meyer did not approve of the administration’s direction and had limited contact with its officials. On May 10, he resigned. His replacement as governor was Eugene R. Black, governor of the Federal Reserve Bank of Atlanta since early 1928. Black had the shortest tenure as governor of the Board to date; he served only fifteen months before returning to the Atlanta bank. He died in December 1934, four months after his return.25 Roo-sevelt also appointed J. F. T. O’Connor as comptroller and, ex officio, a member of the Board.

  The Banking Act of 1933

  As a senior member of Congress, Carter Glass had his choice of the chairmanship of two Senate committees—Appropriations and Banking. If Glass chose Banking, Kenneth McKellar (Tennessee) would be chairman of Appropriations. McKellar was a machine politician and, for this and other reasons, unattractive to the incoming administration as chairman of a key committee. The president prevailed on Glass to take the Appropriations post but, de facto, he retained control of banking legislation (Hyman 1976, 162).26

  The 1933 act was the first major revision of the Federal Reserve Act. Glass submitted his first bill in December 1930. Shortly after, he appointed H. Parker Willis as technical adviser to the committee.27 Willis had worked with Glass in 1913 and shared his views about the real bills doctrine, speculation, and decentralization. Hearings began in January 1931. Glass and Willis used the hearings to question Harrison, Case, Miller, and others about what had gone wrong, whether speculation and the power of the New York bank in dealings with foreign central banks had contributed to bank failures, deflation, and depression, and whether the Board should have more control of open market operations.28

  25. Black knew Roosevelt from Roosevelt’s frequent trips to Warm Springs, Georgia. He did not intend to stay in Washington and went on leave from the Atlanta bank. His salary at the Board was about half his salary at Atlanta, and though he opposed deflation, he did not favor the administration’s “inflationary policies.” Unlike Meyer, he favored expansion, so he resumed open market purchases, but he opposed devaluation of the dollar (Katz 1992, 14–24).

  26. Duncan Fletcher (Florida) became chairman of Banking and Currency, but power and authority rested with Glass. Glass became chairman of a subcommittee with authority to formulate banking and monetary policies. All members of the committee were also members of Glass’s subcommittee, and all legislation affecting banking and the Federal Reserve went through his subcommittee. In the House, Henry Steagall remained as chairman of the Banking and Currency Committee. Before the 1932 election, the Republicans controlled the Senate but not the House after 1930. Senator Peter Norbeck (South Dakota) was chairman of the banking committee, but he allowed Glass to chair the subcommittee on banking legislation (Patrick 1993, 42–43).

  27. Chester Morrill, for many years the Board’s secretary, reports that bankers strongly opposed Willis’s draft legislation. Early in 1932, “Meyer exposed his weakness as a draftsman.” Willis resigned (CHFRS, interview with Chester Morrill, May 20, 1954, 4–5).

  A second attempt to write a bill, in 1932, strengthened the Board’s power over open market operations. All operations had to have the approval of the open market committee and the Board. The Board argued that that was too rigid.29

  The 1933 act established a deposit insurance fund that became the Federal Deposit Insurance Corporation (FDIC), separated deposit and investment banking, restricted member banks from dealing in investment securities, and placed supervision of bank holding companies under the Board.30 The act also lengthened the terms of the six appointed Board members to twelve years, increased the Board’s power to remove bank officers or directors who violated banking laws, prohibited interest payments on demand deposits, and gave the Board power to set ceiling rates on time deposits.31

  The Federal Open Market Committee, with all twelve banks as members, acquired legal status. Reserve banks could engage in open market operations only under Board regulations (Krooss (1969, 4:2725–69). To retain local directors’ authority, the act permitted a reserve bank to refuse to participate in an open market operation on thirty days’ notice to the Board and the committee (Kennedy 1973, 210). This was a step away from the idea of semiautonomous reserve banks, but it did not abandon local option.

  Glass believed the New York bank and the secretary of the treasury had too much power. He blamed New York, particularly Strong, for the expansion of speculative credit after 1927. He was suspicious of the relation between the New York bank and the Bank of England and determined to prevent relations of this kind from affecting the growth of credit. The act reduced New York’s role in foreign transactions by shifting control to the Board. Glass also wanted to remove the treasury secretary from the Board, but the secretary objected strongly, and Glass did not prevail.

  28. The reference to “foreign central banks” referred mainly to Strong’s assistance to the Bank of England, which Glass regarded as violating the principles of the Federal Reserve Act. Parts of the colloquy are summarized in chapter 4. Miller supported Glass’s argument for greater Board supervision and responsibility for open market operations but did not argue for the Board’s taking responsibility for relations with foreign central banks (Senate Committee on Banking and Currency 1931, 159).

  29. In his letter to Congress about the proposed bill, Meyer offered a strange proposal suggesting that reserve requirements be based on deposits and deposit turnover—debits to deposit accounts. The intention was to penalize speculative credit by taxing overnight or short-term borrowing and repayments (Board of Governors File, box 142, March 29, 1932). The proposal penalized a bank for its customers’ decisions.

  30. One-bank holding companies were inadvertently omitted. This omission was corrected in 1956.

  31. Restrictions on interest payments reflected the belief that banks had made speculative and unsound loans to increase earnings and pay interest. Benston (1964) shows there is no evidence for this belief. The Board opposed the prohibition of interest payments as a major change whose consequences could not be foreseen. Glass told them he did not need their views, since he knew them (Board Minutes, April 10, 1933, 24; April 13, 1933, 16).

  The act also eliminated the double liability of directors of national banks, specified in the National Banking Act.32 Despite much testimony arguing that reserve banks could not control the use of credit, Glass inserted a provision that the banks must keep informed about “whether undue use is being made of bank credit for the speculative carrying or trading in securities, real estate or commodities” (Krooss 1969, 4:2726). The intent was to limit discounting and prevent financial speculation. Since discounts remained low in the 1930s, the provision had no effect. Glass also included a provision making the System’s goal the accommodation of commerce, industry, and agriculture.

  Writing at the time, Westerfield (1933, 727) reports that Glass believed the Federal Reserve had been dominated by the Treasury and had permitted securities speculation. The Board had been timid and vacillating. Power had shifted to New York. The Board, on its side, considered most of the legislation unnecessary. It wanted only an amendment clarifying its power of supervision over open market operations and relations with foreign banks (732).

  Glass had larger plans. He wanted most of all to strengthen commercial lending by separating commercial and investment banking. Some bankers supported this change, among them Winthrop Aldrich, chairman of the Chase National Bank (Harrison Papers, Conversations, file 2500.1, March 8, 1933).33 He wanted banks to retain powers to underwrite only municipal, state, and federal government bonds. After the Pecora investigation of investment banking exposed the alleged misdeeds of banks’ investment affiliates, other bankers wrote to Roosevelt or Glass supporting separation (Kennedy 1973, 222–23).34

  32. Kane and Wilson (1998) show that elimination of double liability helped shareholders of large banks during the recovery.

  33. Winthrop Aldrich was the son of Senator Nelson Aldrich, who played a leading role in establishing the Feder
al Reserve. He had become chairman of Chase by opposing financing through an affiliate and favoring conservative banking. At Chase, he replaced Albert Wiggins, a longtime director of the New York reserve bank.

  34. As noted above, Benston (1990) shows that there was little if any evidence to support the charges. Calomiris (1997, 11) summarizes research as showing “that securities underwriting by banks prior to 1933 was at least as honest as securities underwriting outside of banks.” Securities operations diversified bank risks, hence lowering risk. See also Rajan (1992), who points out that banks realize informational economies by combining lending and underwriting securities. If there is conflict of interest, this gain could be a loss to customers.

  Section 20 of the Banking Act, known as the Glass-Steagall Act, gave banks one year to choose between commercial and investment banking, prohibited investment banks from taking deposits, and banned interlocking directorates for commercial and investment banks. Glass regarded this as the most important feature of the 1933 act. It took more than sixty years to reverse the mistake.

  Henry Steagall (Alabama) had proposed some type of deposit insurance or guarantee for several years. The insurance provisions were his main contribution to the Banking Act.35 Public pressure to get partial recompense for banking losses helped to move the legislation toward passage.