Government spending continued to exceed revenues at the end of the war, so the Treasury’s problem of financing the deficit continued through the winter and spring of 1919. This was one source, but not the only source, of contention between the Treasury and the Federal Reserve and within the Federal Reserve. Carter Glass, who replaced McAdoo as treasury secretary in January 1919, preferred qualitative controls and moral suasion to rate increases as a means of controlling credit. In the first of many differences about qualitative controls, governors of many of the Federal Reserve banks argued that exhortation or moral suasion would work, if at all, only if rates increased.54 Missing from the discussion of qualitative controls, as from Hamlin’s proposal to ration credit, was the role of interest rates in resource allocation. Wartime expenditures required a shift of real resources equal to almost 20 percent of GNP. Several Board members and Treasury officials seem unaware that their proposals raised the cost of the transfer and added to the burden of financing the war.
In addition to deficit finance, the Treasury faced the problem of rolling over the outstanding stock of short-term certificates. Before leaving office, McAdoo had sent a letter to all banks urging them to purchase short-term Treasury certificates. Glass continued this policy of moral suasion. Moreover, to sell the Fourth Liberty Loan (in September and October 1918), national banks had promised as part of the borrow and buy program to lend at 4.25 percent for ninety days with renewal guaranteed for a year at the 4.25 percent rate. These commitments did not expire until the end of October 1919. And to sell the Victory Loan, in April–May 1919, banks had offered customers installment loans at a 4.25 percent rate for six months.
53. A few months later, Governor Joseph A. McCord (Atlanta) wrote to Harding warning that banks were recycling fifteen-day paper to avoid the 0.5 percent difference between fifteen- and ninety-day paper. The Federal Reserve ignored evidence of this kind when it decided that there was a tradition against borrowing for profit.
54. No one pointed out that urging a bank to repay borrowing could shift the borrowing to another bank.
The shorter period for financing the Victory Loan reflected a telegram from the Board to the reserve banks on April 16 suggesting that member banks be discouraged from “leaving the situation with respect to loans secured by Government bonds entirely clear after November” (Board Minutes, April 16, 1919, 297).
The Board and the reserve banks were parties to the borrow and buy policy. As heads of the Liberty and Victory Loan committees, the governors had wanted this commitment to make the bond drives successful and to avoid large changes in money and interest rates following Treasury bond drives. Treasury took the position that honoring the commitments took precedence over credit and monetary control (Board Minutes, April 16, 1919). With this stance, the Treasury also hoped to fund its outstanding short-term debt at the prevailing interest rate.
Behind the subsequent struggle lay the governors’ concern about independence. Wartime policy had prevented Strong and other governors from establishing an independent institution that was free of political control. A strong Board subject to political pressures, or dominated by the Treasury, was a long-standing concern.
In January Strong took another leave to rest and recuperate from tuberculosis. The Board approved a three-month leave with full pay. Strong was away from the bank during January and February and in Europe from mid-July to late September. He participated in the discussion only by letter. Early in February he wrote to Adolph Miller and to Russell Leffingwell, the undersecretary of the treasury, about the need to liquidate the banks’ borrowings secured by Treasury certificates. In his letter to Miller he is undecided about the speed with which the Federal Reserve should act and the consequences of a rapid liquidation. The letter to Leffingwell is more decisive about the need to deflate, although he recognized that “the process of deflation is a painful one, involving loss, unemployment, bankruptcy, and social and political disorders” (Chandler 1958, 138–39).
When the Governors Conference met with the Federal Reserve Board on March 20–22, three main considerations were the forthcoming sale of the Victory Loan, the French and British decisions to allow their currencies to depreciate against gold and the dollar, and the end of the gold embargo with the expiration of the Trading with the Enemy Act in June.55 Discussion of the size and pricing of the Victory Loan presumed that discount rates would remain unchanged. Large foreign balances had built up during the war, currency exports had increased, and there was concern that a higher discount rate would be needed to slow the gold export.
Leffingwell argued that Europe lacked effective demand. Although the gold reserve ratio had fallen from 61 percent to 49 percent in the year to March and seven reserve banks including New York and Philadelphia had recourse to interbank loans to supplement their reserves, he did not “see anything in the international situation to justify an apprehension about the protection of our gold reserves” (Governors Conference, March 20, 1919, 156). He would soon reverse that forecast. Strong responded that British and French devaluations effectively raised prices in the United States, so it was equivalent in its effect on spending to an increase in the discount rate. He feared that raising the discount rate would cause too rapid liquidation of inventories (162).
The next day the Conference voted to maintain the discount rate until after the Victory Loan was placed and “for such reasonable period thereafter as will permit a considerable liquidation of such borrowing [to buy the bonds] without imposing undue penalties upon the banks” (Governors Conference, March 21, 1919, 354–55). It would soon regret this decision. The Conference also voted to recommend a 5 percent interest rate on the Victory Loan.56 The Treasury set the rate at 4.75 percent.
The inflation rate increased sharply during the summer and fall of 1919. Part of the increase is mainly measurement, the release of prices that had been controlled in wartime, but this explains only a small part of the surge in the inflation rate. Balke and Gordon’s (1986) estimate of the deflator rose from 4.3 percent annual rate in first quarter 1919 to 15.8 percent for the last two quarters. The consumer price index shows an even larger increase.
Interest rates on government bonds and commercial paper remained steady through the spring and summer. The Treasury continued to support the bond price by purchasing in the open market. From June to year end, the Treasury purchased $500 million, with more than half the purchases in late November and early December (Wicker 1966, 35).
55. Some of the meetings in this period included outsiders. Present on the first day of the meeting were members of the executive committee of the Federal Advisory Council and two senior members of Congress, Senator Robert Owen, chairman of the Senate Banking Committee, and Congressman Edmund Platt, the ranking minority member of the House Banking Committee. Platt subsequently became a member of the Board.
56. The conference agreed also to hold the buying rate on acceptances below the discount rate to encourage the market for dollar acceptances. This policy, favored by Strong, later infuriated Glass.
By June, an outflow of gold and rising inflation revived interest in eliminating the preferential rate for Treasury securities and raising the discount rate. On June 9 the Treasury removed the embargo on gold exports. Despite the subsequent gold outflow, bank reserves and currency continued to rise in response to member bank borrowing. Rising monetary liabilities and falling gold stock reduced the ratio of gold to monetary liabilities from 50.6 percent in June to 47.3 percent in September. The fall in the gold reserve ratio was the traditional signal to raise interest rates. The Federal Reserve had urged an end to the wartime embargo so that the United States would lose gold. Adolph Miller describes the decision as helping “to bring nearer the day when the Federal Reserve must be permitted to resume their normal relations to the money market and to exercise control through discount rates” (1921, 182).
The Treasury was in charge, and it continued to oppose a rate increase. In July, Boston requested a general increase in its discount rates. The Bo
ard rejected the request as “inadvisable from the point of view of Treasury plans.” Government debt outstanding reached a peak in August, but the Treasury was not yet ready to raise rates. At a September 4 meeting with the Board, Leffingwell explained that he shared the view that rates must rise. He was not primarily interested in borrowing money cheaply for the government. His purpose, he said, was to refund the debt and eliminate the Treasury certificates that were subject to the preferential discount rate. He thought that higher rates would make that task more difficult in two ways. First, Liberty and Victory bonds would fall below 90, and if this occurred, Congress might require the Treasury to refund the entire debt and absorb the loss. Second, banks were obligated to renew loans to carry securities at unchanged rates. A rise in rates would put more of the debt into the banking system, so speculative credit expansion would increase at the expense of commercial and agricultural credit. This he viewed as contrary to real bills principles, hence inflationary.
In response to a question from Governor Harding, Leffingwell indicated that the Treasury did not oppose an increase in rates on commercial loans: “I ask that you do not increase your rates on paper secured by Government obligations” (Board Minutes, September 4, 1919).
Despite Leffingwell’s comment, some of the differences at the meeting reflected the commitment to keep rates unchanged at least until November. A second issue concerned debt management. Strong wanted the Treasury to borrow at market rates, in smaller amounts, more frequently. His reasoning was that Treasury borrowing created a large volume of Treasury deposits not subject to reserve requirements. When the Treasury spent the proceeds, private deposits increased. Banks borrowed at the prevailing preferential discount rate to meet the reserve requirement. The Treasury’s view was that the reserve banks should discourage borrowing by the banks without raising rates. Strong, supported by several of the reserve banks, argued that inflation could not be controlled as long as borrowing at the preferential discount rate remained profitable.57
At an October 28 meeting, Strong urged the Board to approve an increase in the minimum discount rate to 4.5 percent. Leffingwell objected that such a move would hurt the Treasury’s planned refunding. He again favored higher rates for commercial and agricultural borrowers and greater use of moral suasion to prevent “speculation.” Secretary Glass strongly favored moral suasion and opposed rate increases.58
Glass, and others, argued as if demand were completely inelastic. By raising rates, the reserve banks would encourage commercial banks to raise their rates with no effect on the amount borrowed. He agreed, however, to increase the rate for borrowing against Treasury certificates to 4.25 percent and voted for the increase at the November 1 Board meeting.
Table 3.4 shows the interest rates prevailing during the years 1919 and 1920. In October 1919, just before the first increase in discount rates, short-term rates were above long-term rates. Both had changed little during the year; bond prices, on average, had remained in a narrow range below par, 91.3 to 92.9, sustained in part by Treasury purchases.
At the end of October 1919 the outstanding debt was $26 billion, with $3.7 billion in certificates of indebtedness subject to a preferential rate. At the nearest call date, November 17, member banks held $3.5 billion in United States government obligations, mainly Treasury certificates, and had borrowed $2.2 billion from Federal Reserve banks, mainly at preferential rates (Board of Governors of the Federal Reserve System 1943).59 An important change had occurred, however. Commercial bank commitments to lend at a fixed rate on the Fourth Liberty Loan and the Victory Loan issues had expired.
57. For example, Governor Perrin (San Francisco) wrote to the Board on September 16 to report that his directors favored a gradual increase in discount rates, first eliminating the preferential rate for Treasury certificates, then “fixing higher rates for loans based on government securities than for those growing out of commerce.” Harding replied that “it was not advisable to make any change in rates until after Christmas” (Board of Governors File, box 1239, September 16 and 24, 1919).
58. The chairmen of the reserve banks, who also served as Federal Reserve agents, met in conference periodically. The views expressed at their October 1919 meeting suggest the ambivalence that prevailed at the time. The chairmen concluded: “The normal check [against inflation] . . . is a higher discount rate. But in the opinion of your Committee the conditions prevailing at home and abroad are so abnormal as to render this method not wholly effective of itself. . . . Some increase in bank rate, however, seems the necessary first step in any program for the restraint of undesirable credit expansion” (Federal Reserve Agents Conference, October 1919, 6). The agents favored a small increase in rates accompanied by a campaign to moderate speculative uses of borrowing (7). Talk of “special conditions” and the problems of refinancing debt produced a very similar lack of response after World War II.
On November 3 the directors of the New York bank voted to increase the discount rate by 0.25 percent, putting the discount rate for borrowing on certificates (4.25 percent) equal to the rate on the certificates. The discount rate on commercial paper increased by 0.75 percent to 4.75 percent and to 4.5 percent on paper secured by Liberty Loans. However, the Bank retained the preferential rate for borrowing collateralized by Treasury certificates, so the new minimum effective rate was 4.25 percent for up to fifteen days maturity.60 This was the first increase in the discount rate for more than a year. The Board immediately approved increases at New York, Boston, and Chicago and, on the next day, at Kansas City. Other banks followed later.
Member bank borrowing continued to increase, but government bond yields rose and stock prices fell. The monthly index of common stock prices, at 80.5, was close to a peak in October. It did not pass the monthly October level in the next five years. Loans to brokers and dealers on the New York Stock Exchange declined, suggesting reduced demand for “speculative” credit. The rate of inflation increased, however.
Although Glass voted for the increase in rates, he was far from enthusiastic about the decision. He had always favored the real bills doctrine, and he now forcefully urged the reserve banks to rely on qualitative control. On November 5 he wrote a five-page letter to Governor Harding arguing that the Federal Reserve could not rely on interest rates alone. In principle he accepted that discount rates should be above commercial rates, but these were difficult times. A rise in Federal Reserve rates would only raise other rates. Wartime embargoes remained, so gold would not be imported. Higher rates would curtail domestic production, raise prices, and stimulate speculation. Then he added:
59. Reserve bank holdings are available for June 30 and December 31, 1919. On these dates, 86 percent and 68 percent of borrowings were secured by Treasury obligations. The December data came after the increase in discount rates, so they probably understate the importance of Treasury debt at the October meeting.
60. The preferential rate remained until June 1921.
We cannot trust to copybook texts. Making credit more expensive will not suffice. . . . The Reserve Bank Governor must raise his mind above the language of the textbooks and face the situation which exists. . . .
Speculation in stocks on the New York Stock Exchange is no more vicious in its effect upon the welfare of the people and upon our credit structure than speculation in cotton or in land or in commodities generally. But the New York Stock Exchange is the greatest single organized user of credit for speculative purposes.” (Board of Governors File, box 1239, November 5, 1919)
Glass praised the Federal Reserve for accepting Treasury leadership during the war. Now the Board must provide the leadership. Governor Harding replied that he was “in hearty agreement” with the letter. The Board sent a copy to each of the reserve banks “with the injunction that the policy outlined be carried into effect” with reliance on direct action to prevent excessive borrowing and improper use of “bank credit.”61 The emphasis on direct action continued. As late as April 1920, the Board commented on the use of credit for sp
eculation.62
61. Leffingwell stated the Treasury’s case for moral suasion as a solution to the wartime and postwar problem at a symposium held at the American Economic Association meeting in December 1920 (Leffingwell 1921). Wartime inflation reflected excess demand and the waste of those goods in a wartime “debauch.” “To control credit through rates would have been futile” (31). The Treasury would have had to pay higher rates. Since gold movements were controlled by all governments, this would have had no effect unless rates were so high that “we would have lost the war and would have to inflate afterwards to pay the indemnity which Germany would have imposed” (31). The same conditions continued after the war. Invoking an argument reinvented after World War II, he argued: “You cannot have credit control with an unmanageable floating government debt” (32). “An increase in rates would operate solely on the domestic situation, and with painful results” (34). Leffingwell concluded that the Federal Reserve was “bound to make the effort to deal with the problem by direct action” (34). In fact, the failure of higher rates to attract a gold inflow because foreign governments were off the gold standard, if true, would have helped, not hindered, Federal Reserve control of inflation. In fact, deflation soon attracted a gold inflow despite restrictions abroad.
A History of the Federal Reserve, Volume 1 Page 15
