138. Hamlin was on vacation in Massachusetts and so ineligible to vote. Platt’s letter identifies Crissinger, James, and Comptroller Joseph W. McIntosh as favoring action, but James subsequently reversed his position, making action unlikely. Cunningham and Miller were on vacation also.
With New York’s rate below the rates in other financial centers, regional banks borrowed in New York and lent at home. These actions, and the normal seasonal pattern, drained New York’s gold reserve by $120 million through mid-August. On August 19, Strong wrote to Crissinger about the higher discount rates in Philadelphia and Chicago but added “that is a matter for them to decide” (Strong to Crissinger, Open Market Policy, Board of Governors File, box 1434, August 19, 1927, 24).
The August 19 letter is the only mention of Chicago’s rate in Strong’s many letters to the Board during August. He wrote directly to Norris and McDougal, making the case for rate reductions in terms of the benefits achieved abroad by lower rates in New York.139 If the gold drain from New York to the districts with higher rates continued, New York would have to raise rates to stop it. Strong concluded with an argument that appealed to Norris’s and McDougal’s views about commerce and industry: “That orgy [stock market speculation] will always be with us and if the Federal Reserve System is to be run solely with a view to regulating stock speculation instead of being devoted to the interests of the industry and commerce of the country, then its policy will degenerate simply to regulating the affairs of gamblers. I have no hesitation in expressing my impatience with such a view of our role” (quoted in Chandler 1958, 444).
McDougal replied on August 24, saying that Chicago would decide by itself when it was appropriate to change rates. Strong responded, now citing issues that were important to the Chicago district—the benefits to crop movements and the need for System policy—but McDougal and the Chicago directors were not persuaded. On August 29, for the third time in a month, they voted to retain the 4 percent rate (ibid., 445–46).
Chicago’s inaction angered Crissinger. He demanded that Chicago reduce its rate by September 2 or the Board would act without a recommendation. Chicago’s chairman, William A. Heath, asked for a delay until September 9, when the Chicago directors would meet again. Heath explained that only the directors could act, not the executive committee, and they would not meet until September 9.
Although Crissinger waited for Philadelphia and San Francisco, he would not wait any longer for Chicago. At a September 6 Board meeting, Vice Governor Platt argued that the Board could not disapprove an existing rate. Crissinger overruled him. A motion was made to reduce Chicago’s rate to 3.5 percent effective the following day, September 7. Hamlin moved to substitute continuation of the 4 percent rate until September 9 to give Chicago time to reconsider. The substitute failed on a three to three vote with Miller abstaining and Mellon absent. The Board voted four to three to reduce the rate, with Platt, Hamlin, and Miller voting no and Cunningham, James, and McIntosh supporting Crissinger.140 By the same one-vote margin, the Board then voted to notify San Francisco to reduce its rate. By the middle of September, all rates were 3.5 percent.
139. The benefits included postponement of rate increases abroad and a strengthening of sterling that permitted New York to sell some of the sterling bills held in London.
The Board had seized power from a reserve bank despite the bank directors’ opposition. Strong wrote to Senator Carter Glass expressing concern about the strengthening of a central bank in Washington, subject to political control (Chandler 1958, 449). Glass disliked the Board’s action. He dismissed its argument that it acted on the principle he had established in 1919, claiming that his earlier decision, and the supporting opinion of the acting attorney general, was not the correct interpretation of the Federal Reserve Act.141 But Glass was more concerned about New York’s role than about the board’s action. In a letter to Hamlin, he expressed most concern about “the New York Bank being regarded [as] the Central bank of the Reserve System, with the other eleven banks merely branches” (Glass to Hamlin, Board of Governors File, box 1434, September 29, 1927).142 Congress took no action.
The gold flows reversed after the rate reduction. In the next year, the gold stock declined more then $460 million to the lowest level in five years. By October, Strong suggested to the Board that an increase in the discount rate might soon be advisable. He also asked for the views of foreign central bankers. Governor Gerard Vissering of the Netherlands Bank urged caution (Board of Governors File, box 1434, October 20, 1927). The Board took no action; the 3.5 percent rate remained for the rest of the year. In November, New York proposed to set interest rates in relation to Europe that would allow newly mined gold to flow abroad “where the reserves are most in need of reinforcement” (OMIC Minutes, Board of Governors File, box 1436, preliminary memo for November 2, 1927, 11).
140. According to Hamlin, Crissinger did not report to the Board that Mellon had asked to delay a decision until he returned to Washington on the following day. Strong took no part in the decision. Although he wanted the rate reduced, he disliked the Board’s action (Chandler 1958, 449).
141. Glass wrote in 1927: “Neither the spirit nor the text of the Act sanction[s] interferences by the central board except in unusual circumstances” (quoted in Warburg 1930, 2:493).
142. Warburg (1930, 2:493–95) shows that the only support for reserve bank autonomy with respect to discount rates in 1914 was in an amendment offered by Senator Owen that was not included in the final bill. He criticized Owen, Glass, and Parker Willis for taking opposing positions on what the act intended. The final wording was “subject to review and determination” by the Federal Reserve Board. In the early days, reserve banks resubmitted rates weekly, so the Board could influence changes by rejecting a submission (ibid., 491). This practice resumed in the 1930s.
conflict about stock prices Crissinger resigned as governor on September 15, 1927, to accept private employment. Roy A. Young succeeded him as governor. Young had been governor of the Minneapolis bank for eight years.143 Strong quickly wrote to foreign central bankers to assure them that Crissinger’s resignation was unrelated to the Chicago controversy (Chandler 1958, 450).
Chandler reports that Strong was enthusiastic about the appointment (ibid., 450). If so, it was a mistake. Young shared Strong’s enthusiasm for the gold standard but little else. He had sided with McDougal in the rate controversy, and he would later side with Miller in relying on direct action. Nothing in his record as governor of the Board suggests that he shared Strong’s enthusiasm for a systematic policy to moderate deflation. He was, first and last, a real bills advocate with a good understanding of banking and little appreciation of the role that the Federal Reserve could have taken to alleviate the depression by preventing deflation.
By mid-1927, stock exchange speculation began to take a more prominent place in policy discussions. Common stocks returned 37.5 percent in 1927, one of the largest returns on record. Returns in 1928 were larger still, 43.6 percent, so the compound total return for these two years was 98 percent. Between July and November 1927, loans to brokers and dealers in New York increased more than $300 million. The Board and the reserve banks faced a question that has often plagued central bankers: Should they respond to large increases in asset prices or confine their attention to prices, output, money, or foreign exchange rates?
At Strong’s request, Burgess prepared a background memo on the stock market for a meeting of the Governors Conference and the OMIC early in November.144 The memo showed that security loans had increased modestly as a percentage of total loans, rising from 25 percent in 1922 to 1924 to 28 or 29 percent in 1926–27. The stock market increase occurred worldwide, but United States stock prices rose somewhat more than prices abroad (OMIC Minutes, Board of Governors File, box 1436, November 2, 1927).
143. Young served until April 1930, when he became governor of the Boston bank. Young started in banking as a bank messenger but rose quickly. In 1927 he supported McDougal in the rate controversy a
nd was the last to lower his discount rate. He had extensive experience with agricultural credit and had handled many defaults, so he was welcomed by the farm bloc as an antidote to eastern (New York) influence.
144. The meeting had been discussed for more than a month. In late September Strong asked the members of the OMIC if they wanted to meet. Opinions differed. All favored a meeting and approved sterilizing gold outflows. Norris and McDougal expressed concern about stock market speculation. Harding and Fancher favored seasonal purchases to be reversed in January. Strong favored seasonal purchases also. At the time, the System held about $375 million. Strong expected purchases of an additional $25 million, made to offset sales of sterling bills, to bring the account to $400 million, far above the authorized $325 million. However $95 million of the total had been purchased to offset gold outflows.
Earlier, Strong had written to Governor Young sending a draft of Burgess’s memo and commenting on the longer-term growth of bank credit. In the past three years, Strong wrote, bank credit had increased by about $5 billion, with about $3 billion at member banks, while the gold stock had increased only $18 million. The System had supplied about $200 million of additional reserves, a credit multiplier of fifteen. The large multiplier had been achieved by a reduction in the average reserve requirement ratio resulting from more rapid growth of time and savings deposits relative to demand deposits.
Some favored security sales and higher interest rates to reduce stock exchange lending. Strong opposed using an argument that the Board used later against New York: “I have not felt that such a policy was justified by the facts, that any effort through higher rates directed especially at stock speculation would have an unfavorable effect upon business generally, and that this would be particularly unfortunate at a time when we are producing a surplus of exportable farm products which cannot be marketed abroad unless the country remains a free loaning market for the rest of the world” (Strong to Young, Board of Governors File, box 1436, October 19, 1927).
The Governors Conference coincided with the end of the mild recession. Newspapers at the time commented on the “low rate policy” and urged the Federal Reserve to tighten. Others expressed concern about the loss of gold to Argentina, Brazil, and Canada (Reed 1930, 124–26).
Although all banks had reduced their rates to 3.5 percent and the Board had urged or forced some of the reductions, the governors grumbled but agreed to keep open market rates unchanged until March and to offset gold movements by open market purchases and sales. George Seay (Richmond) said: “I think it is too low a rate, and I thought so from the beginning.” Maximillian B. Wellborn (Atlanta) said he was compelled to lower rates because Kansas City, St. Louis, and Dallas had lowered theirs. Even Willis J. Bailey (Kansas City), who had been the first to reduce the rate (at Strong’s urging), wanted to return to the 4 percent rate. McDougal, of course, favored an increase (Governors Conference, November 2–3, 1927, 31–46).
The committee endorsed three policy guidelines: member bank borrowing, the general level of interest rates, and the movement of foreign exchange rates, the last as a guide to future gold movements. Adolph Miller proposed making all purchases or sales of foreign exchange subject to prior approval by the Board. The Board rejected his motion and accepted the OMIC proposal. Strong now had authorization to offset gold flows without limit, and he moved quickly. In the following two weeks, the System partially sterilized large gold movements to France and Argentina and from Brazil and Poland. The net effect was an increase in the System account but little change in the money market. When New York stopped sterilizing gold losses, discounts rose to more than $600 million for the month. Despite the increased discounting, the monetary base continued to fall. By year end, call money rates began to increase.
The November meeting shows both Strong’s ability to get approval for his policies and the growing restlessness of several governors and Board members. Miller was, as usual, opposed to giving Strong discretionary authority. McDougal and Norris wanted higher rates and a tighter policy. They were now joined openly by governors of smaller banks, who wanted to increase their earnings. Strong had answered, but not satisfied, the critics of his policy, who blamed him for the increase in loans to the stock market and in speculative credit.
Thus the discount rate and open market decisions of 1927 further divided the System’s policymakers. Those, like Strong, who favored a System policy that took account of domestic and international objectives were generally pleased by the outcome.145 International cooperation, though restricted by domestic considerations, had prevented a threat to the gold exchange standard. Strong now recognized more clearly the weaknesses in that system: any central bank holding a large stock of dollars or pounds instead of gold could precipitate a crisis or a serious problem by calling for gold.
Miller later blamed Strong for the easy policy. In congressional testimony and elsewhere, he described the 1927 actions as the beginning of an inflationary policy that produced an “inevitable” reaction culminating in the “breakdown of the autumn of 1929” (Miller 1931, 124; 1935). He described the policy in harsh words as based on an illusion that the Federal Reserve could correct “the maldistribution of gold in the world. . . . It is one of the most misleading illusions that any body of men charged with the responsibility of administering the fundamental credit mechanism of the country could allow to enter its mind” (Miller 1931, 134): “In my judgment [the policy] resulted in one of the most costly errors committed by it or any other banking system in the last 75 years” (134).
The mistake, according to Miller, was to expand reserves when there was no demand for additional reserves. Banks don’t hold idle reserves. The money flows into the stock market and brokers’ loans in the call money market.146
145. Strong’s background memo for the November Governors Conference remarks that “the positions agreed upon in July have so far been successful.” Miller also described the first effects as successful—“a brilliant exploit” (Miller 1935, 447). The problems came later.
Miller’s statement reflected the theory he and others relied on. His statement is correct when it claims that the additional reserves would not remain idle, but the implication he drew was incorrect. Monetary expansion encourages stock purchases and raises stock prices by changing expected (nominal) earnings and lowering interest rates. This was part of the transmission process, as Miller recognized. He was wrong to oppose monetary expansion for this reason and to assert the real bills position that the Federal Reserve should respond only to banks’ increased demand to borrow on real bills.
Miller’s statement conflicted also with Strong’s Riefler-Burgess views. That analysis was flawed also, as events at the time, fall 1927, suggest. Discounts rose in December despite increased open market purchases of acceptances and securities. Contrary to Riefler-Burgess, banks did not show the reluctance to borrow that Strong’s interpretation relied on. Borrowing to buy shares had become unusually profitable. By holding rates down seasonally and to help Britain, the System permitted market rates to rise above the discount rate. The central problem of the next two years had begun.
Thus the System entered 1928–29 with divided views about its responsibilities and mistaken ideas about the appropriate course of action. Strong was now terminally ill. The Board had new, but weak, leadership in Young. Miller was an active critic, eager to take control but without much ability to persuade. Most of the others lacked an understanding of central banking and financial markets. They agreed on the desirability of an international gold standard, but they were unwilling to permit domestic prices to rise when gold flowed in, and they all seemed unaware, or at least never mentioned, that falling United States prices from 1926 to 1929 signaled that the gold exchange standard had a serious inconsistency.147
Hesitant and Uncertain Direction
Net gold exports continued in early 1928. The Federal Reserve sterilized part of the net outflow and allowed part to balance the seasonal reduction in bank reserves. Deputy Governors Case and Har
rison kept the Board informed about the ebb and flow and the size of open market purchases and sales.
146. Kettl (1986, 34) reports on a 1934 letter from Miller to Herbert Hoover claiming that Montagu Norman exerted great influence on Strong. I have found nothing in the record that contradicts Strong’s statements that he cooperated only to the extent that it did not conflict with domestic objectives. United States prices had fallen at the time of the July 1927 agreement.
147. Burgess (1964, 224) mentions discussions in the twenties about the desirability of United States inflation to help Europe recover. Strong was opposed.
The OMIC met in mid-January. The preliminary memo described the 8 percent growth of bank credit in 1927 as the largest in three years and, despite the recession, 2 percent above “normal” growth. Loans on stocks and bonds showed the most rapid increase.148
The recession appeared to have ended. Also, system policy was now “much more independent of the European situation.” The current problem was to control credit expansion without harming business. The OMIC proposed, and the Board approved, authorization to sell securities to offset gold movements (OMIC Minutes, Board of Governors File, box 1436, January 12, 1928). In the three weeks ending January 25, the System sold $80 million and reduced advances to dealers by $76 million. Those actions offset the seasonal decline in currency. Market rates declined, so the OMIC voted to tighten by selling an additional $50 million.149
A History of the Federal Reserve, Volume 1 Page 34
