Now as to the limitations which the Federal Reserve Act seeks to impose as to the character of the paper which a Reserve bank may discount. When a member bank’s reserve balance is impaired, it borrows to make it good, and it is quite impossible to determine to what particular purpose the money so borrowed may have been applied. It is simply the net reserve deficiency caused by a great mass of transactions. The borrowing member selects the paper which it brings to the Reserve bank for discount not with regard to the rate which it bears, but with regard to various elements of convenience. . . . [S]uppose a member bank’s reserve became impaired solely because on a given day it had made a number of loans on the stock exchange; it might then come to us with commercial paper which it had discounted two months before. . . . If it were the design of the authors of the Federal Reserve Act to prevent these funds . . . from being loaned on the Stock Exchange or to nonmember state banks or in any other type of ineligible loan, there would be only one way to prevent the funds from being so used, and that is by preventing member banks from making any ineligible loans whatsoever, or deny it loans if it had.
The eligible paper we discount is simply the vehicle through which the credit of the Reserve System is conveyed to the members. But the definition of eligibility does not effect the slightest control over the use to which the proceeds are put. (Chandler 1958, 197–98)
Important as the policy issues were, they were not the only problems. The Federal Reserve Act left the lines of authority unclear. Political trading had not resolved the dispute between those who wanted a central bank modeled as closely as possible on the Bank of England and those who wanted the political authorities to protect the public against bankers. Lines of authority were unclear not only between the Board and the reserve banks, but between Washington, New York, and the other banks. Early conflicts did not resolve the issue. Throughout the early 1920s letters and memorandums from the reserve banks complained that the impression in the districts was that discount rates were set in Washington and that the Board controlled discount policy. The Board, in turn, complained that the reserve banks leaked information about rate changes before they had been approved by the Board. In addition, personal antipathies between Strong and Miller, or between Strong and Glass, sometimes affected judgments and decisions.
The long delay in reducing interest rates provided a test of two longstanding conceptions about monetary policy. Nominal interest rates were higher at the trough of the recession than at the preceding peak, the only time this has occurred in Federal Reserve history to date. With prices falling at the trough, real interest rates rose more than nominal rates during the contraction. The economy recovered in large part because falling prices combined with an inflow of gold to increase real money balances. The rise in real money balances overcame the effect of high real interest rates, increasing spending and output. This experience contrasts with experience in the early 1930s when real balances fell as real interest rates rose.
Although there were many mistakes, the first eight years produced some successes as well. The System was able to pool the gold reserve and to make interdistrict loans when the gold reserve ratio fell. Although more banks failed in 1921 than in the recessions of 1893 or 1907 and 1908, there was no banking panic. Also, the Federal Reserve pressed the banks, particularly rural banks, to establish par collection. It improved the system for issuing currency, eliminated the effects of seasonal swings in currency demand, and nurtured a market in banker’s acceptances with the aim of reducing the influence of the stock exchange and the call money market on the banking system.
The System had survived its first mistakes. The central task of developing a policy framework and useful operating guides remained.
four
New Procedures, New Problems, 1923 to 1929
The years 1923 to 1929 are often described as one of the best periods in Federal Reserve history. Inflation, though highly variable from quarter to quarter, averaged close to zero for the period as a whole. Economic growth was variable but robust. The economy grew at a 3.3 percent average rate, despite two recessions in six years.1 Labor productivity in manufacturing rose 4 percent a year, and the index of stock prices rose 20 percent a year.
Whether judged by money growth or by interest rates, Federal Reserve policy avoided the sharply inflationary and deflationary actions of earlier and later years. Interest rates on both long-term Treasury bonds and commercial paper averaged about 4.5 percent. The monetary base rose about 1.5 percent a year. Although the United States was on the gold standard for the period as a whole, variations in money growth were not much affected by gold movements.
Membership in the Federal Reserve System was far from complete. Fewer than 10 percent of state banks were members. The number of state member banks declined, but deposits of member banks increased both absolutely and relative to deposits of nonmember banks.
The Federal Reserve developed much more activist procedures than envisaged by the authors of the Federal Reserve Act or practiced in earlier years, and policy actions became more centralized. The reserve banks, particularly New York, gained more control over decisions, but disputes about the locus of power continued and at times became intense.
1. Real growth is computed from third quarter 1923 through third quarter 1929 to omit the recovery early in 1923 and the start of the 1929 recession. Using annual data, growth is 4.7 percent for the seven years 1923 through 1929. The difference is due principally to the strong recovery reported for second quarter 1923. Quarterly and annual data for inflation give very similar results.
The problem was partly personal, partly substantive. Adolph Miller, the dominant personality at the Board, was indecisive, inclined to shift his position in debate, and unwilling to take responsibility. Miller envied the power and influence of Benjamin Strong and the New York reserve bank that Strong headed. As the only economist in a decision-making position, he expected Strong and others to defer to him on economic issues. Strong was decisive, commanding, and eager to exercise leadership. Intended ambiguity in the Federal Reserve Act, a result of the compromise President Wilson crafted, heightened the personal controversy. To Strong and other bank governors, the System was an association of reserve banks supervised by the Board. To Miller and others in Washington, the Board was responsible for directing the System to a common policy goal and steering away from bankers’ interests. As open market operations increased in importance and discount policy declined, Miller tried repeatedly to shift control of open market policy from Strong and his colleagues to the Board. He was unsuccessful while Strong was alive.
Substantive differences also reflected problems in the Federal Reserve Act. Miller and the Board emphasized control of the quality of credit by discounting real bills. The act supported their position; this was the intent of Carter Glass and others who drafted the act. Strong held this view before the 1920–21 recession, but the policy failures of that period and the political response to interest rate increases changed his mind. Further, unlike Miller and the Board, he recognized that the type of credit instrument discounted by the borrowing bank did not restrict the volume of borrowing or give information about the use of new loans. He saw that under the real bills doctrine, money and credit would expand as long as banks had eligible paper and could discount profitably. To be effective, the System had to control the quantity of credit.
Initially, policy action responded to the gold reserve ratio. A decline in the ratio signaled that interest rates should rise, a rise that rates should decline. With few countries on the gold standard during and after the war, the signal was less reliable.
What should replace it? The Board’s annual report for 1923 set out the new operating framework. By carefully sifting through the responses to open market purchases and sales, economists at the New York bank and the Board developed a new set of signals to guide operations. I call this analysis the Riefler-Burgess doctrine. The doctrine played a major role in the 1920s and beyond.
Governor Strong’s efforts to support
the British by easing policy in the summer and fall of 1927 brought differences between New York and the Board into sharp focus. Under Strong’s leadership, the open market committee lowered United States interest rates by buying government securities after member bank borrowing declined. Advocates of real bills, such as Miller, criticized the action as inflationary, by which they meant that the increased credit was not backed by productive assets. They, and most others, believed that inflationary credit expansion, like wartime expansion, must inevitably be followed by contraction and deflation. For the real bills advocates, the deflation and depression that started in 1929 were the inevitable consequence of Strong’s policies in 1927.
Conflict between New York and the Board reached new heights in 1928 and 1929. New York, operating on Riefler-Burgess rules, favored a higher discount rate to reduce member bank borrowing and the quantity of credit. On their interpretation, reduced borrowing would indicate greater ease. The Board, fearful of a return to the high discount rates at the start of the decade and wanting to limit credit to stock market speculators, favored controlling the quality of credit by moral suasion, direct pressure, and exhortation against speculation. It opposed increases in discount rates. The result was delay and inaction; the more serious problem on both sides was failure to recognize that monetary policy was deflationary.
The Federal Reserve had three principal aims during the 1920s: to reestablish the gold standard as an international exchange system; to maintain price stability at least as well as if the country remained on the prewar gold standard; and to prevent or slow the growth of speculative credit, particularly credit used to carry securities traded on the New York Stock Exchange. A fourth aim, though rarely stated, was present also: the Federal Reserve wanted to avoid a return to the level of interest rates and deflationary policies of 1920–21 that had damaged agriculture and commerce and heightened criticism of the System.
The different aims often gave conflicting signals. Higher interest rates to prevent growth of stock exchange lending exposed the System to renewed criticism and attracted gold. Mindful of those criticisms, some officials preferred to rely on exhortation or qualitative control instead of quantitative control. This produced conflict within the System.
At a more basic level was the conflict between price stability and restoration of the world gold standard. In part to maintain price stability, the Federal Reserve System sterilized gold inflows and, reversing its earlier policy, put gold and gold certificates into circulation. This policy reduced the monetary expansion resulting from gold inflows, thereby shifting more of the burden of adjustment to Britain and other countries seeking to reestablish and sustain a type of gold standard. Once Britain returned to the gold standard, it had to raise interest rates and deflate to defend its exchange rate. A more classical gold standard policy of lowering United States interest rates and allowing the country’s prices to rise in response to gold inflows would have reversed some of the gold flows and reduced the need for deflationary policies abroad, at the cost of higher inflation in the United States.2
French policy added to the problems faced by Britain and others. France returned to the gold standard in 1927 at a rate that undervalued the franc; Britain returned in 1925 at an exchange rate that overvalued the pound. Under the rules of a full gold standard, gold would have flowed from Britain to France, the United States, and perhaps elsewhere. The countries receiving gold would have allowed prices to rise, and British prices would have fallen. But France and the United States were as reluctant to permit prices to rise as Britain was to let them fall. Without this mechanism, or a substitute, the gold standard could not work to adjust gold stocks and prices.
In practice, after 1927 the United States and France pursued mildly deflationary policies that drained gold from Britain, Latin America, and elsewhere. The collapse of the gold standard came in the 1930s, foreshadowed by the policies of the 1920s.
The result was failure to achieve three of the four aims. Qualitative controls failed to prevent a rise in stock prices and brokers’ loans. The international gold (or gold exchange) standard collapsed, never to be restored. And the relative stability of the 1920s was followed by severe deflation and economic depression throughout the world.
NEW PROCEDURES
A more activist policy required more and better information, new procedures, and a new framework for deciding on policy actions. The procedures began to take shape after 1921, and though they evolved through the first half of the decade, the System had the main outlines in place by the end of 1923.
The prewar gold reserve had served as a signal for timing changes in the thrust of policy. That signal was now muted. During the first part of the decade, the United States was the only major country on the gold standard. The governors agreed that they could not rely on the gold standard mechanism to maintain price stability until currencies became convertible and countries restored the international standard. They favored restoration and worked toward that end, but until countries readopted the gold standard, they needed a new guide for policy. Hence they developed the research function, first in New York and later at the Board, to provide indexes of industrial production, prices, interest rates, credit, and other measures of current and prospective economic activity.3 These measures, and the volume of discounts, replaced the gold reserve ratio as guides to policy action.
2. Between 1922 and 1926, the United States share of the world monetary gold stock rose from 43.3 percent to 45.5 percent, while the share held by the Treasury and Federal Reserve fell. The difference is explained by gold and gold certificates in circulation (Schwartz 1982, vol. 1, tables SC8 and SC10).
Development of Open Market Policy
Section 14 of the Federal Reserve Act authorized open market operations to make discount rates effective. The section reflected the belief that if banks were out of debt to the reserve banks, changes in discount rates would be ineffective.4 By selling in the open market, the reserve banks could reduce bank reserves and force banks to borrow, thereby restoring the effectiveness of discount policy.
Open market operations were not new. They had been known for at least one hundred years in England. As early as 1822, the Bank of England purchased and sold government securities to assist the Treasury in refunding the public debt by maintaining a particular market rate (Wood 1939, 5).5 After 1830, the bank bought and sold Exchequer bills at its own initiative on a limited scale.6
3. Adolph Miller, the only economist on the Board, urged creation of a statistical office. The office was located in New York mainly to accommodate Parker Willis, its director. It began publication of the Federal Reserve Bulletin in 1914. Willis took charge in 1918 after he resigned as secretary of the Board. The New York bank started its own publication, the Monthly Review of Credit and Business Conditions, and in 1920 it hired W. Randolph Burgess as its first editor. New York also had a statistics department led by Carl Snyder. In 1922 the Board’s research office moved to Washington, D.C., when Walter Stewart was appointed director in July. See Burgess 1964 and Yohe 1982. Stewart left the Board in 1926 to enter private business, but he continued to serve as an adviser to Strong until Strong’s death. He then served as economic adviser to the governor of the Bank of England from 1928 to 1930, where he initiated construction of statistical series similar to his work at the Board. During this period, the Board’s staff developed the statistical data for the table called “Member Bank Reserves and Related Items.” The “Index of Industrial Production” first appeared in 1922 as the “Index of Production in Basic Industries” and later (1927) as “A New Index of Industrial Production.” Between 1922 and 1925, the statistical section of the Federal Reserve Bulletin introduced, among others, series on department store sales, agricultural movements, department store stocks, wholesale trade, factor employment, factory payrolls, and building contracts (House Committee on Banking and Currency 1926, 698). Yohe (1990) discusses the early history of the Research Division.
4. The House report on the Glass bill mentions tw
o reasons for open market operations in “the classes of bills which it is authorized to rediscount” (Krooss 1969, 3:2318). The first is to make the discount rate effective. The second is to provide an outlet for investment of funds “when it was sought to facilitate transactions in foreign exchanges or to regulate gold movements” (ibid.).
5. Before 1819, the bank seldom bought Exchequer bills except at the Treasury’s request (Wood 1939, 5). Other bills were bought, however.
6. Keynes (1930, 2:170, 229) is misinformed when he writes that in 1890 “open market policy had not been heard of.” Sayers (1957, 49) claims that before 1914 the bank purchased but never sold. Hawtrey (1932, 151) cites the 1847 experience when the bank sold current bills for specie and bought forward bills, thereby removing cash from the market at a time of stress. Testifying before the Lords in 1797, Thornton said it was immaterial whether the bank relieved market strain by discounting or by purchasing government securities.
Open market purchases and sales were also well known in the United States before 1920. A few weeks after the reserve banks began operations, the Board authorized them to purchase government securities “within the limits of prudence as they might see fit” (Board of Governors of the Federal Reserve System, Annual Report, 1914, 16). The first Governors Conference in 1915 discussed whether each reserve bank should purchase and sell independently or as part of a coordinated effort.7 The reserve banks retained the right to purchase independently but agreed to combine operations in government securities and acceptances under New York’s supervision.
A History of the Federal Reserve, Volume 1 Page 21
