A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The New York directors proposed three changes to avoid further tightening when seasonal demands appeared: relax qualitative controls to permit banks to borrow freely; end the Board’s policy of opposition to collateral loans (secured by marketable securities); and allow reserve banks to expand credit if needed.

  The Board met with several New York directors on June 5. Each side appeared willing to compromise but unwilling to fully abandon its previous position. New York stressed that it wanted to increase the discount rate. The Board stressed that any relaxation of its direct action policy would be “merely a suspension” (Riefler 1956, 316). A week later the Board proposed temporarily suspending the direct action program during the months in which banks would be discounting heavily to market the harvest, and it recognized that purchases of acceptances and possibly governments might be needed if discounts increased substantially.174

  172. In all, New York voted nine times to raise the discount rate. Leslie Rounds, the first vice president at New York, explained the persistence as an effort by Chairman McGarrah to “show the bank had been on the job and had done what it could, but perhaps he did not sense how great a calamity was building up” (CHFRS, Rounds, May 2, 1955, 13).

  173. A week later, the Federal Advisory Council changed sides also, recommending a 6 percent rate.

  By July 10 the System’s acceptance portfolio had declined to $66 million, more than $100 million below the previous year and the lowest level since the 1924 recession. Call loan rates reached 11 percent in the first week of July. Responding to the pressure, New York lowered its acceptance buying rate by 0.25 percent to 5.25 percent. Acceptance rates in the market quickly fell to 5.125 percent, where they remained until mid-October. New York followed, reducing by 0.125 percent on August 9. Acceptance purchases now began to add reserves.

  Harrison met with the Board on August 2 to discuss a discount rate increase. Business now “appears to be on a sound basis.” “The time has passed for the adoption of a policy of higher rates.” Nevertheless, he proposed combining an increase in the discount rate to 6 percent with a small reduction in the acceptance rate to help finance domestic business and exports (Harrison Papers, Board Meetings, August 2, 1929). George R. James, a member of the Board, suggested a preferential rate for commodities. The only agreement was to call a meeting of all governors for August 7 and 8.

  The governors accepted Harrison’s proposal by a vote of eleven to one. Their resolution looked forward to supplying the seasonal increase by buying acceptances and explicitly ruled out a general increase in discount rates at reserve banks outside New York. The Board approved the resolution and a 6 percent discount rate at New York. No other bank followed.

  The reasoning behind the policy action was confused, its effect modest. In the Board’s view, which New York accepted to reach the seasonal compromise, credit allocation mattered. Acceptances were real bills, whereas discounts could support speculative credit. Hence encouraging acceptance purchases while reducing discounts helped commerce and agriculture and discouraged speculation. In contrast, under Riefler-Burgess, a reduction in discounts was a move toward easier policy, since banks borrowed reluctantly, not for profit.

  174. After the Board relaxed its policy of direct action in June, Seay (Richmond) wrote to Harrison: “It is a rather strange or mixed course or procedure which the Board expects Federal Reserve banks to follow. Having told member banks that they were not within their reasonable rights for rediscounts while they are lending under certain conditions, we are now not to abandon that position but to temper it . . . then if they overdo the matter, we are to tell them that they have overdone it and resume pressure. It is difficult to pilot the ship with such a variable compass” (Seay to Harrison, June 27, 1929; quoted in Chandler 1958, 469).

  The Board communicated the agreement in a letter to each of the reserve banks. The letter described its earlier decision to take direct action as deliberate, its current position as holding fast to its belief that it was necessary. The present suspension was temporary to assist banks “that have not found it practicable to readjust their position in accordance with the Board’s principle.”

  Banks responded to the rate switch by lowering their costs. In the ten weeks from August 16 to the stock market break on October 23, discounts declined and acceptances increased. The net effect was $29 million in additional Federal Reserve credit, far below the $200 million estimated as the required seasonal increase through October (OMIC Minutes, Board of Governors File, box 1436, September 24, 1929).175

  The discount rate increase had little effect on market rates. Bond yields increased at first but then reversed. After six weeks, Harrison reported very small effects on rates except abroad. Britain continued to lose gold to France and Germany. New York bought sterling bills to stabilize the pound.

  The National Bureau of Economic Research puts the peak of the expansion in August. At the September 24 OMIC meeting, Harrison reported that though business was at a “high level. . . [t]here has been a declining tendency in a number of basic industries.” The committee proposed open market purchases of acceptances and, if necessary, up to $25 million of short-term government securities each week. The aim was to prevent an increase in borrowing if acceptance purchases proved insufficient for seasonal expansion. A week later the Board approved the resolution, noting in its letter that the approval should not be seen as a change in Board policy. No purchases were made in the month before the stock market break.

  The OMIC did not meet again until November, after the market break. For the week ending October 12, call loan rates were below 6 percent, for the first time in more than a year, and half the level reached in early May. October 24 was “black Thursday,” a day of climactic decline in share prices. The Board approved a reduction in the acceptance rate to follow the market but rejected New York’s request to lower its discount rate to 5.5 percent.

  Acceptance rates continued to fall as banks scrambled for short-term liquid assets. On October 28 New York told Young that “there has been a large reduction in brokers loans and that corporations and bankers in the interior are calling such loans and investing in bills, Governments and commercial paper” (Riefler 1956, 355). To meet the demand, New York banks borrowed heavily from the reserve bank. With the market rate down to 4.625 percent, New York asked for a further reduction in its acceptance buying rate. The Board refused: “No further reductions in the bill rate should be made at this time as the easing program of the System seems to be progressing satisfactorily.” Riefler added: “At this time, conditions in the money market were threatened by reason of drastic liquidation in the securities markets” (Riefler 1956, 356).

  175. The full seasonal swing from early August through the end of December was estimated at $500 million (OMIC Minutes, Board of Governors File, box 1436, September 24, 1929). The actual was half the estimate.

  The Federal Reserve was established, in part, to prevent a panic in the money market. The Board’s response to New York ignored the scramble to reduce loans to the call market then in progress. Table 4.5 shows the large changes in lending as the stock market fell.

  In the week ending October 30, the New York reserve bank opened its discount window. System discounts rose $200 million for the week. By October 28 the New York directors, tired of haggling with the Board, gave Harrison discretion to purchase governments without any limit.

  Harrison informed the Board but began purchases of $50 million before the stock market opened on October 29. The Board accepted the result reluctantly, since the purchases had been made before its meeting, but it noted that New York had not consulted the OMIC or the Board.176 In all, New York purchased $133 million, $25 million for the System account and $108 million on its own.

  Later in the day Harrison telephoned to hear the Board’s response to a proposed reduction in the discount rate to 5 percent. The Board agreed to the reduction if New York would suspend open market purchases. On November 1, New York’s rate went to the 5 percent rate maintained at other
reserve banks.

  The decline that became the Great Depression was under way. Balke and Gordon (1986) show real GNP rising only 0.5 percent in the third quarter before falling at an annual rate in excess of 11 percent in the fourth quarter. After rising at an 11 percent rate in the first nine months, industrial production (as reported at the time) declined in the fourth quarter (Reed 1930, 171).177 Although the initial decline in output was steep, it was less steep than at the start of the 1920–21 recession. Federal Reserve documents in October noted the beginning of the decline within two months of the NBER peak. The rapid fall in stock prices in late October suggests a rather sudden shift in anticipations about future profits and economic growth.

  Knowledge of events was not a problem at the time or later. Misinterpretation, incorrect analysis, lack of agreement, and concern about letting the discount rate rise without limit—not ignorance of events—prevented action. The Board was unwilling to accept the political cost of raising rates to levels that would renew the concerns and criticisms in 1920–21. Young asked repeatedly how much Harrison and the other governors proposed to increase discount rates. The answers did not reassure him or other Board members.178

  176. The Board regarded New York’s action as a violation of the 1923 agreement establishing the OMIC. The following week the Board approved a resolution denying Federal Reserve banks the right to buy or sell government securities without Board approval. Counsel advised them that there was considerable doubt about its legality, so it did not become effective (Riefler 1956, 359).

  177. For the period 1922 to 1929 as a whole, the Board’s contemporary measure of industrial production rose at a compound average annual rate of 7.5 percent (Miller 1935, 443, chart 1). The Miron-Romer data show a growth rate above 8 percent from January 1922 to February 1929, the peak in their data. Extended to August, their average is close to the Federal Reserve data. Recent Federal Reserve data (base 100 in 1982) show a peak in July 1929 and a 3.3 percent decline in the next three months (a 13.5 percent annual rate). These data show industrial production doubling between the 1921 trough and the 1929 peak, a 9 percent compound annual rate of increase.

  CONFLICTING INTERPRETATIONS

  Ambiguity in the Federal Reserve Act was one reason for the policy conflict. Lines of authority and responsibility between the individual reserve banks and the Board were unclear, hence a source of the periodic frictions and disputes. At a deeper level was the conflict over how policy operated and what it should and could accomplish.

  This conflict showed through in the Board’s tenth annual report. As noted earlier, although the report was the work of Walter Stewart, Adolph Miller had considerable influence on the drafting. Yet New York praised the report at the time. The reason for this anomaly was that the report, like the Federal Reserve Act, had two policy conceptions that had not been reconciled. One was the real bills doctrine, calling for the control of speculation and restrictions on the use of credit to encourage commerce, agriculture, and industry. The other was first the gold standard and later the Riefler-Burgess doctrine. Under Riefler-Burgess, the volume of discounts replaced the gold reserve ratio as the principal signal for expansive or contractive action.

  Both policy rules or procedures had the same objective—to prevent inflation by changing the amount of bank credit (and money) as output changed. Proponents of real bills saw the financial system as largely self-regulating. If banks created credit only on real bills, they believed it would grow or decline with production and trade. Adherents of Riefler-Burgess agreed that money (bank credit) should grow at the same rate as output in the long run, but they regarded the short-run relation of money to output as highly variable. They wanted to manage the relation by using open market operations to control the volume of member bank borrowing.

  178. The Board prepared a summary (unsigned) that appears to have been written by Young based on his personal records. The summary contrasts the Board’s direct action with New York’s policy, which it characterized as a request for repeated increases in rates. The summary quotes an April 9, 1929, letter from Harrison: “The discount rate would be employed incisively and repeatedly, if necessary” (Discount Rate Controversy, 21, Board of Governors File, box 1246, undated). Several other quotations from Harrison and McGarrah’s comments refer to higher rates, even 8 percent or more (22).

  Miller was the System’s most outspoken proponent of real bills, but he was not alone. Several of the bank governors—Norris, McDougal, Seay, and Calkins—held similar views, and they were joined by some, perhaps most, of the Board.179 They had strong support in Congress, from Carter Glass and others, and in much of the financial press. No less important, they had the text of the Federal Reserve Act with its injunctions against the use of credit for speculation and its emphasis on discounting real bills.180

  Although the real bills advocates agreed on the importance of preventing speculation, they did not agree on the means. For example, Norris wrote: “This whole process of ‘direct action’ is wearing, friction producing, and futile. We are following it honestly and energetically, but it is manifest beyond the peradventure of doubt, that it will never get us anywhere. . . . Our 5 percent [discount rate] is equivalent to hanging a sign over our door ‘Come In’ and then we have to stand in the doorway and shout ‘Keep Out.’ It puts us in an absurd and impossible position” (Norris to Hamlin, April 2, 1929; quoted in Chandler 1958, 467–68).

  Strong, and others at New York, did not disagree that preventing speculation was part of their mandate. Like Norris, they believed that persuasion or direct action was unavailing without an increase in interest rates. Strong went further. He had learned from the experience of 1919–20 that qualitative control could not work because there is no way to identify how additions to reserves and loans would be used at the margin. Repeatedly New York explained that the collateral used for loans from a bank or from a reserve bank bore no relation to the purchase or loan financed by the addition to reserves and that the bank had no way to discover how credit was used in practice. The only effective way to prevent credit expansion, New York said, was to reduce the total by open market sales or discount rate increases. But it never stated, and perhaps did not recognize, that the rise in stock prices was at least partly a response to the policy of inaction181 and the robust economic expansion.182

  179. Leslie Rounds remarked that “without Miller there never would have been any great difference of opinion. I don’t think anybody else down there would have . . . trusted their own judgment enough to take such a stand” (CHFRS, Rounds, May 2, 1955, 6).

  180. In the 1960s, Clay Anderson (1965, 57) gave these same reasons for reliance on “direct action” in 1929 and added concern that an increase in rates would harm commerce and agriculture. Anderson was an officer of the Philadelphia reserve bank.

  Another part of the controversy was as old as the Federal Reserve. The Board’s first annual report (Board of Governors of the Federal Reserve System, Annual Report, 1914, 53) discussed limiting discounts by the purpose of the loan and concluded that it was not possible to know what each bank did with its loans. The issue arose again after World War I when the Treasury, opposed to higher market rates, had the Board ask the reserve banks to ascertain which banks were borrowing on government securities for speculative purposes. In 1925, as again in 1929, the Board was reluctant to increase rates when faced with increased borrowing. The 1925 annual report, however, recognized the futility of qualitative control: “It was seldom possible to trace the connection between borrowings of a member bank at the Reserve bank and the specific transactions that gave rise to the necessity for borrowing” (Annual Report, 1925, 16). It is only in the 1929 report that we find: A bank is not “within its reasonable claims for rediscount facilities” when borrowing to make or maintain speculative loans (Annual Report, 1929, 3). This statement is unobjectionable as a comment on the intent of the law; however, it does not make a case for the effectiveness of direct action.

  The legal basis for the Board’s “di
rect action” was unclear. In 1925 Miller justified his proposed policy on the grounds that “the use of credit for speculative or investment purposes is precluded by specific provisions of the Federal Reserve Act” (quoted in Harris 1933, 1:225). He later modified the position, finding support for direct action in the references to real bills as the proper collateral for discounts. The Board’s legal counsel found support for the February 1929 letter to member banks in section 13, which made rediscounts subject to the restrictions and regulations of the Board.183

  181. One month after announcement of the policy of direct action, National City Bank offered to lend $25 million to the call market while borrowing from the Federal Reserve. The president of the bank was a Federal Reserve director. He justified the policy as necessary to prevent panic in the money market. His defiance made the System appear weak even to those who understood that direct action could not prevent credit expansion. Neutral observers saw loans at rates of 20 percent or more financed by borrowing at 5 percent.

  182. Strong agreed that the problem was “speculation” in Florida land in 1925 and in stocks in 1927–28. Like the others, he saw these more as manias than as endogenous responses to strong economic growth and low inflation. See, for example, Chandler 1958, 460–61.

  183. Burgess (1964, 224) suggested a different reason for the program—reluctance to raise interest rates after the 1920–21 experience: “The disagreement was not as to the dangers of the situation but as to the methods of dealing with it. . . . Back of this was, I believe, reluctance to take the responsibility for decisive action, having in mind the criticism incurred by the Board for increasing the discount rate in 1920.”