A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The commission was organized in response to a request by the Board to consider charges against the Board and Strong by John Skelton Williams, the comptroller of the currency in the Wilson administration and an ex officio member of the Board until March 1921. Williams claimed that the Federal Reserve had deliberately created a deflation to the detriment of farmers and small banks.

  In December 1920, with the election over and his term about to end, Williams wrote a letter to the Board advocating lower rates. After an exchange of letters with Governor Harding, he brought his proposals before the Board on January 25 (Board Minutes, January 3, 13, 17, and 25, 1921). His principal motion, at the time, called on the Board to prepare a press release showing the unused lending power resulting from gold inflows and stating the Board’s intention to reduce interest rates. The motion was defeated five to one, with Secretary Houston absent. A second motion, to suspend progressive rates, was tabled at Williams’s request when the Board produced a letter from the Dallas bank suspending its progressive rate.

  On February 26 the Board considered some additional motions and charges.110 This time Williams demanded discount rate reductions to 6 percent at all reserve banks effective March 1 and the elimination of the remaining progressive rates. (Six banks were at 7 percent, the others at 6 percent.) Ignoring its own precedent, the Board objected that discount rate policy actions should be taken by reserve bank directors. Williams also moved that 4.5 percent Liberty bonds be purchased at par if the money was used for “essential purposes.” None of the proposals was approved.

  110. This meeting was considered so confidential that the Board’s copy of the minutes is written in longhand. The minutes for the meeting were stored in Governor Harding’s office and never transcribed. These are the only handwritten minutes I have found.

  Williams charged that the New York bank had lent to the Chase National Bank and that Chase had made “unsafe and improper advances to the officers of the member bank and to companies and corporations in which such officers were interested” (Board Minutes, January 25, 1921, 173). New York had continued the policy after the comptroller’s examinations in October 1919 and August 1920.

  Strong was present for this part of the meeting and replied that there was nothing in the comptroller’s 1919 report to warn the Federal Reserve bank. A report of the August 1920 examination had not been received until January 1921. Moreover, the comptroller was required by law to make two examinations a year but had made only one.111

  Williams’s charges and the complaints of farmers and small businessmen were aired by the Joint Commission at the first congressional hearing on Federal Reserve policy. Strong acted as the System’s principal witness. In three days of testimony, he defended the deflationary policies and urged the commission to accept that deflation was an inevitable response to the previous excessive expansion. The System had been unable to control the expansion because of wartime exigencies and subservience to the Treasury. “Nature” had brought on the deflation, and there was little the Federal Reserve could have done to prevent it.112 The reserve banks had been willing to lend on real bills. Without the reserve banks, there would have been liquidation and financial panic, as experience before 1914 showed. In the same hearings, Harding denied that the Federal Reserve had anything to do with the deflation and could not have prevented it (Joint Commission of Agricultural Inquiry 1921, 363).

  The commission accepted most of Strong’s argument and concluded that the Federal Reserve was most at fault when it yielded to Treasury pressure during the summer and fall of 1919. The commission argued, correctly, that the System should have been more concerned about inflation and less concerned about Treasury refunding operations. To a considerable extent the final report reflects Strong’s ability to shift responsibility from the Federal Reserve to the Treasury, as well as the absence of any witness for the Treasury and perhaps the commission’s desire to dispose of the issues by blaming the previous Democratic administration. The System’s case was strengthened because the Treasury could have invoked the Overman Act and had threatened to do so. Moreover, the hearings came at the end of the deflation and the beginning of recovery. On the indexes used at the time, industrial production rose from 75 (1919 = 100) in the summer of 1921 to 87 by January 1922 and 100 by September 1922 (Reed 1930, 16).113

  111. Williams sent copies of his charges to some members of Congress but refused to give the Board their names (Board Minutes, March 2, 1921, 184). The Board and the reserve banks retaliated by asking the Treasury to transfer the comptroller’s functions to the Board (Board Minutes, March 11, 1921, 205).

  112. Strong’s testimony is reprinted in Strong 1930; see esp. 135–38. The claim about inevitability was widely held at the time. See, e.g., Sprague 1921, 20–22, or Miller 1921. The same claim returns at the end of the decade. “Nature” in this case is the combination of the real bills doctrine, the gold standard, and agricultural production. The Federal Reserve and the Bank of England wanted to restore the prewar gold standard at unchanged gold parities. The Federal Reserve also wanted to eliminate speculative credit as collateral for discounts to banks and to eliminate most Treasury securities from the portfolios of borrowing member banks. They did not achieve the last objective.

  The commission led to only one important change in the Federal Reserve’s structure—the addition of one member to the Board to represent agricultural interests. Beginning in 1923, the Board had six appointed members plus two ex officio members. The first appointee to the new position died after eight days. He was replaced by Edward H. Cunningham, a farmer, leader of the Iowa Farm Bureau, and a Republican legislator. Cunningham served until his death in November 1930.

  The problem of when to change the discount rate and the more basic problem of how to conduct monetary policy had not been resolved. Studies by Federal Reserve staff concluded that member banks borrowed for profit or at least profited while borrowing. The 1921 annual report compared the average rates charged on rediscounts at each Federal Reserve bank with the average rates charged by member banks on the paper used as collateral during December 1921. At a time when discount rates at the reserve banks ranged from 4.5 percent in the large eastern centers to 5.5 percent at Dallas and Minneapolis and rates on open market paper at New York were between 4 and 4.5 percent, the rates on the rediscounted paper ranged from 4 percent to 12 percent. Instead of a net cost, or penalty, the data show an average net return to the borrowing banks ranging from 1.27 percent (Cleveland) to 2.87 percent (Kansas City). Almost one-third of the items rediscounted had rates of 8 percent or above, and on 20 percent of the items the reported rates were at least 10 percent, almost twice as high as the highest rate of discount at any of the reserve banks. The study made no allowance for differences in risk on the different rediscounts. Further, the highest rates of recorded profit appear to have been on relatively small items, so the data overstate the marginal net return from borrowing by neglecting the cost of arranging and collecting loans and depositing collateral at the reserve banks.114

  113. The recent Federal Reserve index shows a more rapid initial recovery from 6.03 in July 1921 to 6.53 in January 1922 followed by a 26 percent increase to 8.22 in September 1922. Miron and Romer (1989) have a very different pattern, based on a smaller sample.

  114. More than 80 percent of the total volume of rediscounts carried rates of 6.5 percent or less, but this volume was accounted for by only 25 percent of the number of items rediscounted. The average value of the notes rediscounted during the month was about $14,000; the average value of the notes bearing 6 percent interest was about $40,000; the average size of notes bearing 10 percent interest was about $1,000.

  A second type of evidence on the effect of rediscount rates on member bank borrowing came from a study of progressive discount rates. Although only four of the reserve banks used progressive discount rates, all of them accumulated information on the number of banks borrowing in excess of their basic line and the average amounts borrowed.115 These data showed that during th
e contraction of 1920–21 the volume of borrowing in excess of basic discount lines rose at first, then declined as the larger banks reduced their borrowing. But the number of banks borrowing in excess of their lines continued to increase—from 1,800 in May 1920 to 3,000 in December 1921—and the increase was particularly great in the agricultural sections (Board of Governors of the Federal Reserve System, Annual Report, 1921, 67). These data furnished the main empirical basis for the conclusion that the use of a penalty discount rate did not reduce borrowing in the agricultural and rural sections of the country. Yet the report offered no analysis of the effect on borrowing of removing the progressive rates and made no effort to separate the volume of borrowing secured by Treasury securities that, during most of the period, could be used by banks subject to progressive rates to obtain discounts at a preferential rate. Perhaps most important of all, the Board’s report made no attempt to compare the marginal rates on loans at banks subject to progressive rates with marginal rates at other banks. Data collected in December 1921, long after the peaks in borrowing and interest rates, showed that lending rates on eligible paper rose to 12 percent or more, suggesting that marginal loan rates at the peak were well over 12 percent. The borrowing data, on the other hand, showed that fewer than 250 banks paid progressive rates of 10 percent or more (Wallace 1956, 61). Nevertheless, the Board concluded that progressive rates were not effective, and this conclusion has been repeated in subsequent System studies (see Anderson 1966, passim).

  A third source of evidence came from examining the effect of removing the preferential discount rate for borrowing secured by government obligations. The elimination of the preferential rate at various times during 1921 was reflected in a rapid decline in the volume of borrowing secured by such obligations, but total borrowing continued to rise, and as late as May 1921, borrowing was above the level at the start of the recession. The Board’s 1921 annual report clearly conveys its inability to find a satisfactory explanation for the movements in member bank earning assets and member bank borrowing during the recession. After noting that the principle of maintaining central bank discount rates above market rates was well established, the report compared the Bank of England and the Federal Reserve System. The Bank of England accepted only one class of paper for rediscount—bills of exchange. Federal Reserve banks accepted a wide variety of paper, so that it is “exceedingly difficult to determine just what current market rates are” (Board of Governors of the Federal Reserve System, Annual Report, 1921, 30). Neither the studies nor the discussion suggested setting the penalty rate in relation to the rate changed for the loan.

  115. Most of the reserve banks computed the borrowing lines by taking 65 percent of the balances maintained with the reserve bank, adding the amount paid in subscription to the reserve bank’s capital stock, and multiplying the total by 2.5.

  To many in the System, the 1920–21 experience showed the need to replace or supplement the discount rate as a main instrument of Federal Reserve policy and to speed the process by which policy changes reduced market interest rates. Using the discount rate as a penalty rate, applying the Bank of England’s system under American conditions, did not seem to work in the way they had expected. The System had tried progressive rates, nonuniform rates, uniform rates, preferential rates, and moral suasion. None of these methods seemed to them to be an effective means of controlling member bank borrowing. Years later Ralph Young, a director of research at the Board, summarized the experience: “The broad conclusions of System experience in the ’20’s, the record shows, was that in this country it was not feasible to attempt to make the discount rate function as a penalty rate. Our banking conditions were too unique. It was more practical to rely on the bankers’ tradition against borrowing and reluctance to remain continuously in debt” (Minutes, Federal Open Market Committee, August 23, 1955).116

  The political attacks on the Board and the System for the high rates charged at a few banks during the period of progressive discount rates, and also the criticisms of the Board and the System for having caused a decline in agricultural prices and incomes, must be viewed against the background of hostility to high interest rates in the South and West, where the highest rates were charged, and the long debate before Congress agreed to establish the Federal Reserve System. Fears of political reprisal, combined with doubts about the effectiveness of the penalty rate policy, stimulated the search for a new approach to policy.117

  116. The Board’s tenth annual report comments that the outlook for credit regulation would be “unpromising . . . if the Reserve banks had no other means than discount rates to regulate the volume of their credit” and had to rely on penalty rates (Board of Governors of the Federal Reserve System, Annual Report, 1923, 9).

  117. The 1920–21 experience and its political repercussion helps to explain why the Board was reluctant to raise interest rates above 6 percent during the stock market boom at the end of the decade.

  CONCLUSION

  The first annual report of the Federal Reserve Board, published within six months of its founding, saw the role of the Federal Reserve as preemptive. Its duty was “not to await emergencies but, by anticipation, to do what it can to prevent them” (Board of Governors of the Federal Reserve System, Annual Report, 1915, 17). Practice was far from that intent. In its early years the Federal Reserve financed the war by indirectly monetizing the Treasury’s debt. It was too weak politically to slow or stop the postwar inflation and too uncertain about the political consequences of its actions to act decisively when the Treasury allowed it to act. Thereafter the Federal Reserve pursued a deflationary policy throughout the deep postwar recession.

  Wartime political weakness is certainly part of the explanation for the inauspicious beginning. Beliefs, or theories, also had a large role. Notwithstanding the intention to be preemptive, expressed in the first annual report, the policy conception embedded in the Federal Reserve Act and in the minds of the principals was passive. The gold standard was expected to maintain long-term price stability. The discount rate was a penalty rate that followed the market and the gold reserve. The principal asset, other than gold, was the discount portfolio. The real bills doctrine gave the borrowers responsibility for deciding on the volume of discounts.

  This conception proved inadequate in the early years, particularly in the 1920–21 recession. Freed of Treasury controls in 1920, the Federal Reserve soon found its policy guides giving directions it did not wish to follow. The gold reserve rose, signaling a reduction in the discount rate at a time when member banks remained heavily in debt to the Federal Reserve, when member banks held large portfolios of Treasury securities, and when the penalty discount rate had not been restored. The real bills doctrine required higher interest rates and a reduction in borrowing. The gold reserve ratio sent the opposite signal.

  In the event, political considerations tipped the balance in favor of lower discount rates. Secretary Mellon and the new Republican Congress were eager to show improved economic conditions, particularly before the 1922 congressional elections. Congressmen from agricultural areas, particularly in the South and West, were highly critical of the higher discount rates in those regions. Bills were introduced limiting the System’s ability to increase rates. The Federal Reserve yielded to this political pressure by lowering discount rates. More important for the recovery, however, was the gold inflow and the rise in real money balances resulting from almost two years of severe deflation.

  The experience convinced the Federal Reserve that the original policy conception was flawed: the Bank of England’s use of the discount rate as a penalty rate and its limitation on discounts to one type of eligible paper were not the model for the United States. This conclusion appears to have been based more on conjecture than on careful analysis, the conclusion itself being as much political as economic. The discount rate worked “too slowly,” hampered by the diversity of the economy, by the alleged profitability of borrowing, and by the many types of paper eligible for discount. The evidence, such
as it was, came from comparing average gross returns to banks on a wide variety of risky loans with the risk-free rate and from the fact that discounts had continued to rise long after the recession began. This suggested to the governors that much larger increases in discount rates would be needed during recessions. The political response to such rates was not something they wanted to experience.

  Bank portfolio choices appeared to support the conclusion. There was no sign of a return to real bills. In both January 1920, when the discount rates were raised, and June 1922, when the rates were reduced, the 101 weekly reporting banks held $2 billion in government securities and $4 billion or more in total investments. Loans on securities had fallen by less than $1 billion. In fact, the low point for bank investment in “speculative” instruments and loans on securities had come in summer 1921, at the trough of the recession. The prospect of shifting portfolios of borrowing banks mainly to real bills by discount rate policy appeared unattainable.

  By the end of 1922, in a speech at Harvard, Strong recognized that the real bills doctrine provided no effective limitation. He had seen early on that a bank may use its borrowings for many purposes. Now he saw clearly that the doctrine was flawed. Although he did not fully recognize the distinction between an individual bank and the banking or financial system, he was far ahead of his contemporaries on the Board and at the other banks.