The January rise in the discount rate did not change the minimum borrowing rate. Bank lending and reserve bank discounts continued to increase, and the gold reserve ratio continued to fall. At the end of February the minimum discount rate increased to 5 percent. In March, Boston, New York, and Cleveland asked to raise the minimum rate (collateralized by Treasury certificates) to 5.5 percent. The motion was tabled by the Board, with Harding and Miller opposed (Board Minutes, March 9, 1920, 250–51). The reserve banks continued to lose gold, so the Federal Reserve Board approved an increase in the discount rate at New York, Chicago, and Minneapolis to 7 percent on commercial credit and from 4.75 to 5.5 percent on Treasury certificates at seven banks effective June 1. Boston soon followed. This increase in interest rates, and the start of deflation in July, reversed the gold flow.
To supplement the increase in rates, Congress passed the Phelan Act in April 1920. The act authorized progressive discount rates on a member bank that borrowed relatively large amounts from its reserve bank. In districts that adopted progressive rates, each bank was given a line of credit, or normal rediscount. The governors agreed in principle that a member bank’s contribution to the lending power of the System increased with its reserve deposits and paid-in capital. They could not agree on a formula to apply the principle, so the choice of formula was left to the reserve banks (Governors Conference, April 1920, 388). Borrowing in excess of the normal line was subject to progressively higher discount rates.
76. On October 12, 1920, four of the reserve banks had $231.8 million in loans outstanding to the other reserve banks. Banks in the South and West did most of the borrowing; Cleveland, Boston, and Philadelphia were the principal lenders. Other unusual arrangements included counting deposits abroad as part of reserves and including deposits of silver from the Treasury’s holdings. The Federal Reserve Act authorized interdistrict lending at rates set by the Federal Reserve Board.
77. The monthly average reserve ratio fell to 56.3 percent in July 1932 and 51.3 percent in March 1933 (Board of Governors of the Federal Reserve System 1943, 348–49). New York had a reserve deficiency in early March 1933.
78. Several of the governors and Board members served in both periods.
There was considerable difference of opinion about how and when to use the new powers. Governor Wellborn (Atlanta) wanted progressive rates to be applied in all districts. Others wanted these rates used only as a last resort, mainly to reinforce efforts to discourage banks that borrowed heavily. A resolution to that effect was defeated at the April Governors Conference, in part because several governors opposed any effort to bind their directors or limit local authority over discount rates (Governors Conference, April 1920, 269, 279).
Rates were considerably higher in agricultural districts. The reserve banks in these districts saw that their members could lend at rates of 10 or 12 percent or more, so they would not be deterred by discount rates of 5 to 6 percent.79 Unable to get an agreement to use a progressive rate, the four agricultural districts in the South and West—Atlanta, St. Louis, Dallas, and Kansas City—acted on their own. The details of the formulas for computing borrowing lines differed, but in each of the districts the progressive rate was tied to the member’s reserve position, stock in the reserve bank, and the amount borrowed. Loans on government securities were excluded.80 Each 25 percent above the borrowing line was subject to a progressive or marginal rate of 0.5 percent a month. A bank with a borrowing line of $150,000 and excess borrowing of $150,000 subject to progressive rates would pay 2 percent above the standard discount rate for agricultural paper on borrowing above $112,500 and up to $150,000.
The aim of the program was to make the discount rate “effective” and penalize banks that borrowed heavily.81 Although Congress had authorized the program, it did not like its application. Since only banks in agricultural regions used progressive rates, the program seemed to confirm populist claims that a central bank would be run for the benefit of eastern bankers, especially Wall Street. Congress and the press pointed to marginal rates as high as 81.5 percent charged by the Atlanta Federal Reserve Bank on agricultural paper (Board of Governors File, box 1240, 1920).82 The System was also criticized for not applying the progressive rate at all reserve banks.
79. “The margin of profit to a member bank in the western regions of this district . . . is so great as to tempt even the most conservative bankers to make loans which they know their bank is not able to carry” (R. L. Van Zandt [Dallas] to Governor Harding, Board of Governors File, box 1470, December 8, 1920). Richard L. Van Zandt was governor at Dallas. The letter goes on to recognize that a penalty rate should be based “on the rate actually received by the member bank from its customers on the identical item.” This was a rare recognition of differences in risk.
80. If a bank with a borrowing line of $100,000 borrowed $400,000 with $150,000 secured by government securities, the amount subject to a progressive rate was $400,000 – $100,000 – $150,000 = $150,000.
81. The annual report (Board of Governors of the Federal Reserve System, Annual Report, 1921, 3) reports that 906 member banks had borrowed 494 percent of their basic lines, while all member banks borrowed 40 percent of their basic lines.
Political issues aside, progressive rates applied selectively shifted borrowing from reserve banks with high rates to those with lower rates. Member banks in an agricultural district could borrow from correspondent banks in other districts to repay their borrowing at the district reserve bank. Often the correspondent bank then borrowed from its reserve bank. The Board was aware that this kind of substitution took place, and the Joint Commission of Agricultural Inquiry gave examples, but the Board made no systematic effort to estimate the extent of the problem.83
Progressive rates remained in effect from six to fifteen months depending on the district. The main lessons the System learned were to be wary of political criticism of high marginal rates and to avoid the appearance of favoring financial over agricultural interests. Progressive rates were never used again. In March 1923 Congress repealed the provisions of the Phelan Act authorizing progressive rates.84
Glass left the Treasury early in 1920 and was elected to the Senate. His successor for the remaining months of the Wilson administration was David Houston and, after the presidential election, Andrew Mellon.85 Houston adopted Strong’s earlier plan of selling and refunding certificates more frequently, so in smaller volume. The Treasury intervened in the Board’s policy much less. For the first time in its brief history, the System had control of its policy and sufficient resources to carry it out. But it lacked enough determination and coherence of views to act. Although several governors complained about the preferential rate for Treasury securities, the April 1920 Conference voted nine to three to retain the preferential rate.
For nearly a year after the June 1920 increase in rates, the Federal Reserve did very little. Minimum borrowing rates on Treasury certificates remained at 5.5 percent in New York, Boston, and most other banks. Several reserve banks, however, kept the minimum, preferential rate on Treasury certificates at 5 percent until January or February 1921, when it was raised at all banks to 5.5 or 6 percent. Large-scale borrowing by member banks continued in 1920. Not surprisingly, much of the borrowing was at the minimum rate. Continuing the preferential rate severely reduced the effect of discount rate increases for commercial borrowers.
82. The borrowing bank had a small reserve position, hence a small borrowing line. The 81.5 percent rate applied to a loan of $112,000 for two weeks. Maximum rates at St. Louis, Dallas and Kansas City were 16 percent, 7 percent, and 22.5 percent, respectively, all on relatively small amounts for short periods (Board of Governors File, box 1240, December 1, 1920).
83. To mute criticism of the effect on agricultural districts, the Board did a study of borrowing rates at the twelve reserve banks. The study compared average rates charged in New York with the average rates charged in the four districts with penalty rates. The study ignored differences in marginal rates and foun
d similar average rates.
84. Progressive rates were not the only problem. Congressional criticism of the System’s policy was followed by bills in December 1920 and April 1921 to impose ceiling rates of 5 percent. Senator Robert Owen (Oklahoma), an author of the Federal Reserve Act, took a leading role in criticizing policy and urging lower rates (Board of Governors File, box 1246, November 1919, October 1920).
85. Houston was the secretary of agriculture in 1914, so he had served on the organizing committee for the System.
Table 3.5 shows the amount borrowed by type of collateral in the first two postwar years. The table makes clear that it was profitable for banks to borrow even at the higher rate on commercial paper.86
The gold reserve percentage continued to increase throughout the summer and fall, but it did not reach 50 percent until March 1921. Rates on commercial paper reached a peak early in January 1921 and remained above the 7 percent discount rate until late April. The Federal Reserve watched and waited but did not begin to reduce rates until open market rates began to fall.87 It made no effort to restore a penalty rate but followed the market, reducing the discount rate on commercial paper to 6.5 percent in May and 6 percent in June. Rates in New York were now uniform for all collateral.
86. Banks in the largest cities did most of the borrowing, so the discount rates at New York are a useful benchmark. For example, at December 30, 1920, all member banks had borrowed $3.04 billion, of which $2.1 billion was for banks in 101 leading cities. New York banks owed more than one-quarter of the total outstanding (Board of Governors of the Federal Reserve System 1943, table 48). Friedman and Schwartz (1963, 233) neglect the 5.5 percent borrowing rate on Treasury certificates and conclude that banks continued to borrow at a loss. This leads them to overstate the role of the 7 percent discount rate and the lag in response to discount rate increases during this period.
87. The October 1920 Governors Conference voted to eliminate the preferential rate on Treasury certificates, but the Board did not act. In place of policy discussion, the governors considered, at length, the development of an acceptance market in each district. The discussion brings out the rivalry between reserve banks. With Strong on leave, Acting Governor J. Herbert Case argued that New York’s purchases should “unreservedly” bind other banks to participate in the purchase. Chicago and Boston were unwilling, and Boston argued that if New York wanted to limit purchases, it could raise it rate and let acceptances go to other markets. Charles A. Morss (Boston) accused New York of being too protective of the buyers and too hesitant to change buying rates: “We think you protect them too much; that they do not take any chances at all” (Governors Conference, October 14, 1920, 65). The Conference voted, however, to establish a centralized committee on acceptances, with a secretary in New York. The committee was to develop uniform policies, suggest buying rates, and receive weekly reports on activity from each reserve bank. Much of the discussion foreshadows issues that arose about the management of the open market account.
The National Bureau of Economic Research (NBER) chose January 1920 as the peak of the postwar expansion. Industrial production reached a peak in that month, but consumer prices continued to increase until July. Using this measure of the start of recession, the recession was a year old before the Federal Reserve acted to stem the decline.
POLICY IN RECESSION AND RECOVERY
Virtually every statistical indicator shows the 1920–21 recession as a sharp decline. The measured unemployment rate rose from a 4 percent average for 1920 to 12 percent in 1921. The Federal Reserve Board’s index of industrial production (base 100 in 1947–1949) fell 23 percent, from 39 in 1920 to 30 in 1921 before returning to 39 in 1922. Agricultural production fell from 83 to 71 between 1920 and 1921, a much more severe decline than in the early years of the 1929–33 depression.88 The Bureau of Labor Statistics wholesale price index (base 100 in 1947–1949) fell 37 percent, a much sharper percentage decline than in any single year of the 1929–33 depression and a total percentage decline of comparable magnitude. Yet throughout the period the Federal Reserve maintained and even raised its discount rates.89
In its annual report for 1920, the Board defended the sharp rise in discount rates as necessary to “maintain the strength of the Federal Reserve Banks, which are the custodians of the lawful reserves of the member banks,” a reference to the gold reserve ratio. It denied that Federal Reserve policy had been the cause of the contraction (Board of Governors of the Federal Reserve System, Annual Report, 1920, 12–14). The dominant view, which reappears again in 1929–33, was that the deflation was an inevitable consequence of the previous inflation. Federal Reserve officials defended the deflationary policy as a means of reversing the effects of the previous inflation and restoring the gold standard at the prewar gold price.
Since prices had risen in virtually every country, a less costly means of restoring the standard would have been to adjust exchange rates to reflect differences in recorded rates of inflation. The United States, as the principal gold standard country, was in a position to negotiate buying and selling prices that would have avoided much of the adjustment of domestic and foreign prices. Although several European countries devalued against gold, there is no evidence that the Federal Reserve discussed devaluation or any other alternative to domestic deflation. To the governors and board members, gold standard rules called for a fixed gold price.
88. Comparable figures for 1929–33 show agricultural production relatively flat from 1929 through 1932, then falling from 80 to 58 between 1932 and 1934.
89. Balke and Gordon 1986 shows a 27.5 percent peak to trough decline in the GNP deflator. The wholesale price index available at the time, base 100 in 1913, declined 44 percent from May 1920 to January 1922.
Both Strong and the governor of the Bank of England, Montagu Norman, regarded the restoration of the prewar gold standard as a necessary condition for reestablishing international stability. To restore “stability,” they were willing to deflate, just as the governors of the Bank of England had been willing to deflate to achieve resumption a century earlier and the United States had accepted deflation as necessary for resumption after the Civil War. However, there are few clues to why Strong, Norman, and others believed that both countries should deflate to restore prewar exchange rates.
Strong knew there were real costs of deflation. He predicted that the deflation would be “accompanied by a considerable degree of unemployment, but not for very long, and that after a year or two of discomfort, embarrassment, some losses, some disorders caused by unemployment, we will emerge with an almost invincible banking position, prices more nearly at competitive levels with other nations, and be able to exercise a wide and important influence in restoring the world to a normal and livable condition” (letter to Professor Kemmerer, February 1919, quoted in Chandler 1958, 122–24).90 There is no suggestion in his writings or speeches that the goals Strong sought to achieve required adjustment of the relative rates of inflation and not a reduction of the absolute price levels to their prewar values.
The size of the deflation during 1920–22 shows the extent to which the Federal Reserve saw the problem of restoring the gold standard as a problem of reducing the absolute price index to its prewar level. There had been two periods of rising prices in the United States between 1914 and 1920. The first, mainly due to gold movements, ended early in 1917; the second, mainly due to the Federal Reserve policy of assisting Treasury debt operations, continued until 1920. The prevailing view of the gold standard and the real bills doctrine treated these price increases very differently. Only the increases in price level resulting from the wartime and postwar policies had to be rolled back by eliminating the effects of speculative credit based on government securities or stock exchange loans.
90. This was very much the conventional view. At the time, Keynes was a strong proponent of rapid deflation in the United Kingdom. He favored a 10 percent bank rate for up to three years to eliminate inflation (Meltzer 1988, 45–46). At the time, Keynes also
favored a return to the prewar gold parity for Britain on grounds of national prestige and confidence (49).
Table 3.6 shows the values of the wholesale price index during the period. By 1921–22, the wholesale price level was approximately the same as the average for the years 1916–17.91 The United States gold stock was slightly higher than it had been at the start of the war, and at 70 percent the gold reserve ratio was within a few percentage points of its April 1917 value. If the Federal Reserve intended to eliminate the effects of wartime inflation, these indicators suggest that the policy was successful. The effect of the policy, however, was to reduce the United States price level relative to the price levels in other trading countries, so the commitment to fixed exchange rates became a commitment to deflation abroad as well as at home.92
The 1920–21 recession is one of the few recessions in which published market interest rates were higher at the NBER trough (by three-eighths to three-quarters of a percentage point) than at the previous peak. As long as market rates remained above the discount rates, many Federal Reserve officials opposed reductions in discount rates. Their arguments are very similar to the arguments put forward in England a half century earlier. Any attempt to encourage expansion by reducing discount rates or allowing discount rates to remain below market rates was an encouragement to borrowing for profit, speculation, and therefore was inflationary.93 They believed the discount rate should be a penalty rate.
A History of the Federal Reserve, Volume 1 Page 17
