The Board’s hostility to the Governors Conference and the demands of wartime finance ended the first coordination effort. Although San Francisco, Chicago, and Cleveland continued to coordinate actions with New York in the acceptance market, the System did not have a common policy (D’Arista 1994, 82). After the war, the reserve banks renewed efforts to coordinate operations at the March 1919 Governors Conference. New York proposed centralization of acceptance purchases in New York and rules for reserve bank operations. New York wanted a no resale rule for acceptances, to avoid competition with member banks, and common rules for purchases made outside a reserve bank’s home market to restrict competition. Nothing happened. A year later New York tried again, this time urging a common program in which everyone would share and all would be obligated “unreservedly.” Boston argued for developing local markets, and Chicago argued that New York held acceptance rates too low, reducing reserve bank earnings.
The governors could not agree at the time on rules for allocating acceptances purchased commonly. The main decision in 1920 was to appoint a committee to develop a basis for dividing costs and income from joint operations in the acceptance market. A year later the committee recommended a uniform purchase rate and urged that purchases be made only from dealers and only after bills had been endorsed.8
Coordinated operations in acceptances laid the groundwork for coordinated government securities purchases. Three factors worked to force the next step. First, the New York bank, as the main fiscal agent, was responsible for distributing and refunding government debt. The Treasury complained that uncoordinated market activity by the reserve banks interfered with debt management operations, and some commercial banks complained about competition from the reserve banks in the debt market. Second, the reserve banks purchased heavily in 1921–22 to replace income from discounts during the recession and recovery. The Treasury objected both to the timing of purchases and to the magnitude of the reserve banks’ holdings. Third, the New York bank observed that when the regional reserve banks purchased, New York member banks repaid some of their borrowings. The result was a transfer of earnings to the regional reserve banks at New York’s expense.
7. The Federal Reserve Act gave each reserve bank responsibility for its own portfolio. Without voluntary agreement, the System could not have a common policy.
8. The committee included Governors Morss and Fancher and Edwin Kenzel, New York’s expert on acceptances and one of the first appointments Strong made in 1914. The recommendations were not entirely welcome at several of the reserve banks, so frictions about acceptance market practices continued.
The main impetus for coordination came from the Treasury following the large-scale purchases by the reserve banks. Between October 1921 and May 1922, the reserve banks added almost $400 million to their holdings of government securities as partial replacement for the $900 million reduction in discounts during the same period. Purchases were particularly heavy in February and March, when the reserve banks purchased $200 million, doubling their holdings.9
The desire to avoid losses overcame scruples about real bills (Parthemos 1990, 12). In 1920, with high discount rates and heavy discounting, the reserve banks added $83 million to surplus after paying a franchise tax of $60.7 million and dividends of $5.6 million. In 1921 the addition to surplus fell to $16 million after similar franchise tax and dividend payments. By early 1922 all the reserve banks recognized that income would not be enough to cover their banks’ expenses, franchise tax, and dividends. The volume of acceptances had declined along with discounts and discount rates, reducing earnings. Even with the large increase in their government portfolios early in the year, some of the reserve banks had to pay dividends in 1922 from their accumulated surplus.10
Secretary Andrew Mellon asked the Federal Advisory Council in November 1921 to recommend a policy for the reserve banks. On April 29, 1922, he sent Governor Harding the council’s recommendations, opposing any use of the Federal Reserve System “for the purpose of carrying the Government’s obligations” and recommending that the reserve banks confine their purchases to bills of exchange and acceptances (Governors Conference, May 1922, 13–14). Undersecretary Parker Gilbert pursued the issue with great force in 1922 by writing and speaking to the governors, rejecting their argument about covering expenses, and repeatedly urging them to sell their holdings (Board of Governors File, box 1441, January, March, and April 1922).
9. Purchases were not uniform. New York, Chicago, Cleveland, Boston, and Kansas City were heavy buyers (Board of Governors File, box 1441, March 8, 1922).
10. Inflation and expanded operations had greatly increased expenses. By 1921–22 the reserve banks’ expenses were close to $50 million, nearly ten times expenses in 1916. The general price level was about 50 percent higher, so in constant dollars expenses had increased about sevenfold while the number of member banks increased by 30 percent.
Strong undertook three main tasks at the May 1922 governors’ meeting. He wanted to coordinate purchases and sales and centralize responsibility in his hands and away from the Board. He had to satisfy the Treasury that the reserve banks would not interfere with fiscal operations and would reduce their holdings. And he had to satisfy the other governors that their autonomy and earnings would be maintained. The governors regarded government securities as a substitute for discounts and acceptances, hence subject to decisions by their directors.
At the May 1922 Conference, Strong read a letter from Secretary Mellon to Governor Harding, dated April 25, objecting to reserve bank purchases. The Treasury’s policy was to not ask Federal Reserve banks for assistance. Mellon’s letter recognized the desire for earnings, but policy was more important: “I should regard it as particularly unfortunate if incidental questions of expenses and dividends were to be permitted to control on questions of major policy” (Governors Conference, May 1922, 519). He reminded the governors that the reserve banks were not created to make a profit.
Treasury Undersecretary Gilbert wanted the reserve banks to liquidate all their current holdings of governments. To partially compensate for the reduced income, he offered to pay the reserve banks for their fiscal services. And he reminded them that the attorney general had ruled that they could pay dividends out of accumulated earnings when they had insufficient current income.
Most of the governors admitted they were investing for earnings. George W. Norris (Philadelphia) favored buying longer-term bonds to increase yield. Others argued, incorrectly, that since they bought mainly from district banks, they had no effect on the national market. David C. Biggs (St. Louis) reported that one of the reasons his directors agreed to purchase Treasuries was to keep the gold reserve ratio from rising.
Although New York was by far the largest investor in Treasury debt issues, Strong used the Treasury’s complaints to advance his program. The reserve banks were fiscal agents of the Treasury. And, he insisted, the Treasury’s complaints were correct. The reserve banks had a legal right to purchase securities, but the Treasury wanted a policy of noninterference.11 Not only was it their duty to meet these demands, Strong said, but the Federal Reserve Board could require them to do so.
James McDougal (Chicago) resisted centralization as an attack on the regional character of the System. Open market purchases were local decisions to be decided locally. If the Treasury was in the market, the reserve banks would stay out if notified. He offered a resolution expressing willingness to work with the Treasury but retaining local decision making (Governors Conference, May 1922, 113, 129).
Strong had no interest in solving the problem so simply. He saw the opportunity for a coordinated policy under his guidance. He wanted to build a portfolio that they could use later to prevent a repeat of the 1919–20 (or 1915) experience: “The first thing we know we will suddenly break into a run-away market such as occurred in 1919, with no means of checking it. It is not the intention of this bank to let go its hold upon the situation at the present time, and we would regard ourselves as derelict in our duty
were we to do so” (quoted in Chandler 1958, 211).12
The main concern of most governors was their banks’ earnings, not System policy. McDougal moved, and the Conference agreed, that “each governor recommend to his directors that it be the policy of the bank to invest in Government securities only to the extent it may be necessary from time to time to maintain earnings in amounts sufficient to meet expenses including dividends and necessary reserves” (Board of Governors File, box 1434, May 2–4, 1922). The governors also agreed to allow their investment accounts to decline at maturity until they had eliminated earnings in excess of expenses and dividends.
Strong was able to gain approval for creation of a committee that would execute centrally all orders to buy or sell for the account of any of the Federal Reserve Banks. He saw this as a way of laying “a foundation for an investment policy” (ibid., 497). The banks were to draw up statements of projected earnings and expenses including dividends. All agreed to stay out of the market when the Treasury issued or redeemed securities. This was the beginning of what was later called an “even keel” policy—keeping interest rates unchanged during Treasury operations.
11. The Treasury’s policy seems a reversal of typical government finance. A reason for the Treasury’s desire to keep the reserve banks from buying or holding governments was that the Treasury had started to run surpluses in fiscal year 1920 and continued to run large budget surpluses throughout the decade. (At its peak in 1927, the budget surplus was 28 percent of Treasury receipts.) The Treasury used the surplus to retire debt. Between June 30, 1922, and 1929, the gross debt declined $6 billion, 26 percent of the amount outstanding in June 1922. Hence the Treasury had no interest in having the Federal Reserve banks bid for and raise prices on outstanding debt that it would buy. The Treasury did not invoke the real bills view that the central bank should hold gold and real bills.
12. Strong added: “I would view the future with apprehension were we to commence now to liquidate the $150 million or $160 million of investments” (Chandler 1958, 211). These amounts refer to holdings at New York. The System held over $500 million but began to liquidate in June when prices started to rise. Within a year, System holdings were less than $100 million.
The agreement did not satisfy McDougal, Norris, and Charles A. Morss (Boston). Chicago had nurtured a local market for government securities. A central committee in New York would favor the New York market. Strong offered to buy and sell in all active markets and suggested that decisions to purchase and sell be controlled by a committee consisting of himself, McDougal, Norris, and Morss. The governors voted to establish the Committee of Governors on the Centralized Execution of Purchases and Sales of Government Securities with the four members Strong had proposed. In October the committee added Governor Elvadore R. Fancher (Cleveland). Governors of these banks continued to serve as the executive committee during the 1920s.
As the committee’s name suggests, its role was limited to recommendations and to execution of orders sent by the reserve banks. Responsibility for decisions remained with the individual banks and their directors, who retained the right to purchase and sell at their discretion and to buy directly from member banks in their districts.
At the first meeting, the committee elected Strong chairman, with Deputy Governor J. Herbert Case of New York as his alternate. The committee began coordinated sales of securities in response to the Treasury’s request to reduce holdings and the reserve banks’ agreement to limit holdings to cover expenses. The sales occurred at a time of recovery and expansion. The Board’s index of industrial production rose 35 percent in 1922, and GNP increased at a 13 percent average annual rate for the four quarters of 1922, despite a decline at the start of the year. In June Boston, New York, and San Francisco responded to the continuing decline in open market rates by reducing their discount rates by 0.5 percent to 4 percent despite the expansion.
Undersecretary Gilbert wrote to Strong in mid-September, again urging that the reserve banks liquidate all their government securities. Sales would permit increased member bank borrowing, he said, expressing what was soon to be the System’s policy view. The reserve banks should reduce discount rates to encourage the additional borrowing. Further, he complained that even with the Committee on Centralized Purchases and Sales, reserve banks were purchasing independently to increase earnings. Strong replied that since May the reserve banks had sold $150 million, one-third of the account. The committee had no power to do more than act as agents for the individual reserve banks. And, Strong added, he opposed a reduction in the discount rate, since additional borrowing might prove to be inflationary (Board of Governors File, box 1434, September 13 and 15, 1922).
When the governors met in October, Gilbert continued to press for reductions in reserve bank holdings to be carried out without disturbing Treasury operations (Governors Conference, October 10–12, 1922, 425). The governors recommended no further purchases and modified their objectives.13 Henceforth they would conduct open market operations with less attention to earnings and dividends and more to the effects on the money market. Governor McDougal, though a member of the Committee on Centralized Purchases and Sales, spoke against the recommendation as a radical departure from practice and from the principle that made directors responsible for portfolio decisions. George J. Seay (Richmond) also objected. He was hesitant to give any committee the power to override the judgment of the individual reserve banks. Strong replied, perhaps disingenuously, that nothing of that kind was intended. The committee would make recommendations to the individual banks. The reserve banks’ directors would make portfolio decisions. The committee had a “purely ministerial function”; it would not decide policy.14
The governors also took a major step away from the original plan for semiautonomous banks and toward a unified System. The Committee on Centralized Purchases and Sales now had responsibility for recommending to the reserve banks the advisability of purchases and sales.15 Decisions remained with the individual banks; they could refuse to participate, so centralization had not yet been realized. This is clear from the responses to a letter sent by Vice Governor Edmund Platt of the Federal Reserve Board early in February 1923.16 The letter asked each governor to explain his bank’s policy with respect to purchases of acceptances and governments.17
13. An exception to the decision allowed reserve banks to purchase so-called Pittman Act securities that the Treasury wanted to withdraw. Richmond, Atlanta, and Dallas purchased only these securities. Pittman Act securities had been issued under an April 1918 act that permitted the Treasury to withdraw silver certificates from circulation and replace them with Federal Reserve banknotes backed by Pittman Act certificates. The Treasury sold the silver to Britain to support India’s silver standard. After the war, the Treasury repurchased silver and reissued silver certificates, and the reserve banks reduced Pittman Act certificates and the corresponding currency issues (Friedman and Schwartz 1963, 217n).
14. Strong recognized, however, that unless the directors objected, an individual reserve bank would receive securities under the formula for allocating purchases and sales. Hence a bank’s portfolio would change with decisions by other banks, including particularly the decisions by the five largest banks, whose governors constituted the committee. But he did not mention this point in response to Seay.
15. Burgess (1964, 220) cites Strong’s discussion of “credit control” at Harvard in October 1922, in which he does not mention open market operations, as evidence that there was no open market policy. The May and October 1922 meetings, however, show that Strong was clearly aware of the opportunity. The only coordinated action to that point had been sales at the behest of the Treasury.
The question is surprising. The reserve banks, by unanimous vote, had adopted a common policy statement at the October 1922 Governors Conference. The statement said that discount policy and “open market operations should be administered in each district in such manner as to assist the system in discharging, as far as it may be able, its national
responsibility to prevent credit expansion from developing into credit inflation.” The statement was included again in the minutes of the Committee on Centralized Purchases and Sales on February 5, 1923, when it decided not to make further purchases (Board of Governors File, box 1434, February 5, 1923). Except for New York, none of the responses to Platt’s letter referred to the policy statement. The eleven banks gave no recognition to systemic or market effects. There were three types of responses.
Several banks reported that they executed all their purchases through the centralized committee. There were not many discounts, so purchases were made to increase earnings. Chicago acknowledged that the System’s policy was to assist the Treasury by buying acceptances instead of governments. However, “the volume of bills. . . is at times inadequate to supply the Federal Reserve Banks with sufficient investments” (Board of Governors File, box 1434, February 7, 1923). Relying only on acceptances would depress rates and drive the commercial banks out of the market. A few banks wrote that they did not participate in the governors’ centralized purchases. They bought governments from district member banks, at prices quoted in New York, as an accommodation because there was no market in their district. Only New York wrote that purchases were made as part of a policy of keeping the volume of credit as stable as possible after allowing for seasonal demands.18
16. Edmund Platt served as a member of the Board from June 1920 to September 1930 and was vice governor after July 1920. Platt trained as a lawyer but had worked as a journalist and an editor. In 1912 he was elected to Congress as a Republican when his opponent died. He voted against the Federal Reserve Act. In 1919 he became chairman of the Banking Committee (Katz 1982, 216–17). Platt was the senior operating official of the Board from August 9, 1922, when Governor Harding’s term as a Board member ended, to May 1, 1923, when Congress confirmed Daniel R. Crissinger as governor. The most likely reason for the change was that Governor Harding was a Democrat, appointed by President Wilson. The New York Times wrote at the time that “his forced retirement would give a shock to the financial community,” a comment repeated about many of his successors (Kettl 1986, 28). Subsequently, Harding became governor of the Federal Reserve Bank of Boston, where he served from 1923 to 1930.
A History of the Federal Reserve, Volume 1 Page 22
