At least one of the directors was dissatisfied with the policy of delay and hesitation. He urged purchases of at least $100 million, and in a prophetic statement he made it clear that Harrison’s was not the only view.39 “Unless the banks take initiative in affording the relief of very cheap money, however, he foresaw a relatively long period of business depression and severe unemployment. The first step in the program, as he viewed it, might be to get the call money rate down to a dramatically low level.”
The decline in short-term market rates and the return of borrowing to the level of mid-May helped to convince the Boston and Cleveland banks that no further purchases should be made. They now sided with Philadelphia and Chicago, so the vote in the executive committee on June 23 was four to one against the purchase program. Harrison was the lone dissenter, arguing as before that there was a maldistribution of credit between short-and long-term markets and that further purchases of securities would lower long-term rates, increase loans to foreigners, and thus stimulate exports. Harrison’s argument—which he attributed to the directors of the New York bank—repeated the directors’ earlier statements about “lack of purchasing power in various parts of the world.” Prices had fallen because countries “are not in a position to purchase commodities.” Reversing the position he had taken at the directors’ meeting, he now argued that the effect of recent purchases of securities had been offset by a decline in the System’s bill holdings (see table 5.7).
39. Adolph Miller was present at the June 5 meeting in New York. He favored a reduction in the discount rate in lieu of additional purchases. He viewed the current recession as part of a long-term postwar readjustment to lower prices following wartime inflation.
Unfortunately, Harrison failed to respond to the main points raised by some of the other members on the committee. They argued that “easy money” and the low interest rates on the short-term markets had not had any effect on longer-term markets. The term spread had continued to widen. Some now interpreted the purchases in early June as an experiment that had failed to lower long-term rates. Harrison agreed that the short-term money market was “easy.” He told the group “that he did not want to leave the thought that there is any feeling in New York different from that expressed by the other members of the Committee that there is an adequate supply of short-term credit available for business. This is not the difficulty today, . . . and it has not been for months” (Board Minutes, June 23, 1930).
Governor Fancher (Cleveland) pointed out that since short-term rates had fallen, there was very little more that the System could do. Money would flow from the short-term market to the bond market as soon as banks attempted to increase their earnings. This would revive the bond market and lower long-term rates. Early in June he had favored a purchase program (to reduce short-term rates), but he now believed that additional purchases would accomplish little.
McDougal and Norris led the opposition to purchases in the executive committee with support from a letter that Governor Calkins wrote to Governor Young explaining why San Francisco did not share in the June purchases. The basis of their position was that “credit is cheap” and that nothing could be gained by making it cheaper. Further increases would not stimulate production, but a large security portfolio would make the committee hesitant to purchase when an opportune time came.
Harrison’s opponents agreed on one point—no further purchases should be made. McDougal wanted to sell securities and allow the acceptance portfolio to run off. Norris told the executive committee that he opposed the purchase program because the recession was due to excess capacity and overproduction that had caused a fall in the price of commodities. His examination showed that “the commodities on which the reduction of prices had been most marked disclosed in almost every case a specific reason which has nothing to do with credit.” Easier money, by which he meant lower interest rates, “might lead to further increases in productive capacity and further overproduction.” On the same day, he told the Board that he opposed a reduction in the discount rate at the Philadelphia bank because the only effect of a reduction would be “to increase the margin of profit for those banks which are chronic borrowers . . . and make it more difficult for the well managed bank to show any earnings at all.” As for open market purchases, Norris said that he and other members of the executive committee “cannot bring themselves to believe that a further purchase of government securities would help, but feel that such purchases would be an interference with the natural effect at this time and would not be productive of any good, and might be embarrassing at the time when business starts to pick up, at which time this System would find itself with a large amount of government securities and low discount rates.” The majority of the executive committee could not see any benefit to be derived from “affirmative action” (Harrison Papers, Office Memoranda, vol. 2, June 1930).
Harrison consistently evaded the question of how or why the policy of relatively small weekly purchases would work. He agreed that short-term funds must be regarded as “abundant,” since short-term rates were in the lowest ranges reached in previous recessions.40 Several of the other members—despite their differences—believed that recovery would not come until there was an increase in member bank borrowing and an increased demand for bank loans to finance trade and other productive activities. Harrison appears to have shared large parts of this real bills view. He made no effort to present an alternative.
Three days later, on June 26, Harrison discussed the response to the OMPC’s decision with the New York directors. They could wait for a change in sentiment at the other banks; withdraw from the OMPC and purchase for their own bank; or attempt to persuade the boards at other reserve banks by circulating a statement of their position. The bank’s officers favored the third proposal. The directors were reluctant to agree because they believed delay was “tantamount to retarding business recovery. . . . [T]hey indicated their belief in the power of credit to bring about a revival in the bond market and, through it, to bring about an improvement in business” (Minutes, New York Directors, June 26, 1930).
Harrison put the issue sharply. Was the bank “so firmly convinced of the soundness of its position as to be willing to withdraw from the System Open Market Policy Conference?” He preferred delay. He was not convinced of “the power of cheap and abundant credit, alone, to bring about improvement in business” (ibid., 2). New York either had to act alone or had to persuade other banks to change their position. He was unwilling to do the first, unable to do the other.
Those who argue that Harrison saw the need for more expansive policy but was prevented from carrying it out by the other members of the conference and by the Board point to the events of this period to support their position. The claim is more true of the New York directors than of Harrison. Harrison seems pushed and pulled by the opposing views of his directors and his colleagues on the OMPC. He showed no intention of seeking a sustained rate of increase in money or bank credit. He had the much more limited aim of offsetting an increase in short-term rates and planned to stop purchases once he achieved this objective.
40. By June the wholesale price index used by the Board had fallen 11 percent since August 1929, a 13 percent annual rate of decline. Ex post, short-term real rates were approximately 15 percent.
After the June 26 meeting, he wrote to the other governors suggesting that the Federal Reserve resume purchases of $25 million a week. The letter described the situation in the economy and in the money and bond markets in enough detail to convince even the most skeptical that the failure to act cannot be explained by lack of information. Commodity prices had suffered the most severe and rapid decline since 1921. These prices, he said, were now 12 percent below the previous year, and the decline had accelerated (see table 5.7). Profit margins and purchasing power had fallen, and many people were facing unemployment and distress. Although money market rates had come down, the long-term bond market had not eased sufficiently: “Purchases of securities which had been made thus far have aided i
n relieving the member banks from a pressure of indebtedness at the Reserve banks and in a measure had provided the market with surplus funds available for use on the bond and mortgage market. But to a large extent these purchases . . . had been offset by declines in rediscounts and in the bill portfolios of the Federal Reserve Banks so that the total Federal Reserve credit has shown a net decline, even making allowance for gold imports.” Emphasizing that the opinions he expressed were those of his directors, Harrison recommended that the System resume purchases and concluded, “While there may be no definite assurance that the market operations and government securities will of themselves promote any immediate recovery, we cannot foresee any appreciable harm that can result from such a policy” (Harrison Papers, Correspondence, July 3, 1930).
This weak proposal brought some strong responses. Calkins (San Francisco) wrote that his bank’s executive committee believed that “the volume of credit forcibly fed to the market up to this time has had no considerable good effect. . . . [E]very time we inject further credit without appreciable effect, we diminish the probable advantage of feeding more to the market at an opportune moment which may come” (Harrison Papers, Correspondence, July 10, 1930, 2).
At the July 10 New York directors’ meeting, Harrison discussed the Board’s response to New York’s proposal. At first Vice Governor Platt indicated that the Board would approve a recommendation by the New York directors to purchase $50 million for the bank’s own account. Later Platt suggested that New York should wait until it received replies from the other governors. Harrison said he agreed with Platt’s suggestion to await replies from the other banks because they had been able to accomplish at least part of what they hoped to achieve by their operations in the acceptance market.41
A week later Harrison told the directors that an unanticipated increase in the offering of acceptances had enabled the bank to increase reserves by approximately $70 million: “This increase in the System’s holding of bills had, in considerable measure, accomplished what we had hoped to accomplish by further purchase of government securities.” He did not believe New York would be justified in “forcing further funds upon the market.” Then Harrison made a clear statement of the Riefler-Burgess doctrine to explain his reason for first favoring and now opposing purchases: “If the program of purchases of government securities advocated by this bank at the beginning of July had been approved by the Federal Reserve System, that approval would not have resulted in further purchases of government securities in view of the money market conditions which later developed” (emphasis added).
The next day, Harrison sent a letter to all the other governors repeating this position.
Since the end of June, even since my letter of July 3, conditions in the money market have changed with rapidity. . . . The principal New York City banks have paid off all their discounts here and at present have a surplus of reserves. Thus, the condition which we have desired, and for the attainment of which we believed purchases of government securities might be necessary, has been achieved during the past ten days in the natural course of developments in the bill market which could hardly have been anticipated. . . . As we pointed out in our letter of July 3, we believe that the important thing to be achieved in present circumstances is that the money center banks should be substantially out of debt and that there should now be some surplus funds available. As just stated, this condition now exists largely as a result of the increase in the System bill portfolio. (Minutes, New York Directors, July 17, 1930)
41. The bill purchases reflected mainly changes in market rates relative to the posted acceptance rate. Harrison summarized the governors’ replies in a memo included as part of the minutes of the directors’ meeting of July 17. An example of the importance given to real bills and the need to avoid “speculative” credit is the letter Harrison received from Governor Talley of Dallas (Harrison Papers, Letters and Reports, vol. 1). Talley wrote that “if rediscount rates are reduced beyond their natural point and open market transactions are used to force the rediscount rate below that point to which it would naturally fall, then reserve credit would be forced into illegitimate channels and the total amount of credit, based upon the excess reserve credit released, would find its way into a long-term investment where it does not belong, and the tendency would be for another period of inflation to ensue without stopping at the natural point of readjustment from which recovery would proceed in the natural way.”
The committee did not meet again during the summer of 1930. On August 7 the executive committee and the conference agreed by telephone, without much dissent, to purchase $25 million so as to offset part of the gold export. At the end of August it approved $50 million of additional purchases by telephone to reverse the money market effect of a seasonal increase in member bank borrowing or a further decline in the gold stock if these should occur.
The Board granted the authority but, still concerned about prerogatives, noted that the Open Market Policy Conference had not held a meeting as required by the resolutions it operated under. Harrison replied that the purchase program had been entirely for seasonal purposes. He had consulted members of the executive committee of the conference, and “we are all in agreement that at the moment there does not appear any need to purchase government securities.” He explained that the demand for currency and credit for the Labor Day weekend had subsided; the New York City banks had reduced their indebtedness to $8 million; reserves were in excess of requirements. “Money” was easy.
On August 30 Governor Young expressed the same opinion in a letter to President Hoover tendering his resignation as governor of the Federal Reserve Board to accept appointment as governor of the Boston bank: “Now, however, it is clearly evident that the credit structure of the country is in an easy and exceptionally strong position” (Young to Hoover, Board Minutes, August 30, 1930).
Young did not give the basis for this claim. The data show a further decline in June for the sum of banker’s acceptances and commercial paper. In fact, both had fallen, while loans at reporting member banks had increased. Although table 5.7 shows commercial paper and banker’s acceptances outstanding above the August 1929 level, the peak occurred in January 1930. By June, acceptances and commercial paper were 13 percent below the January total, while bank lending had increased 1.3 percent since January and was slightly above the level at the cyclic peak in August 1929. However, member bank borrowing and short-term market rates were in the range considered easy.
Bernanke (1983, 1994) and Calomiris (1993) claim the decline in bank lending was an independent cause of the economic decline that supplemented the decline in the money stock. They argue that small firms that depended most on banks for credit were forced to contract by the decline in bank lending. Bank failures increased the costs of intermediation, making credit more difficult to obtain for borrowers too small or too risky to use open credit markets.
A cursory examination of the data in table 5.7 seems to support this claim. Bank loans, acceptances, and commercial paper increased in the first ten months of recession, but the cumulative increase in open market lending far exceeds the increase in bank loans. This is misleading. Most of the increase in open market lending occurred from August to November 1929. Loans at weekly reporting banks also rose in this period, but by a smaller amount. In the first half of 1930, Bernanke’s hypothesis fails. From January 31 to June 30, commercial paper outstanding fell by 12.6 percent, while loans at weekly reporting banks rose by 1.3 percent. Weekly reporting member banks are above average size and lend to larger customers. For all member banks, call data on December 31, 1929, and June 30, 1930, show a decline of 3.6 percent in total loans, much less than the decline in commercial paper.
Changing Character of the Decline
By the next OMPC meeting, more than a year had passed since the cyclical peak. Industrial production had fallen 25 percent, and the stock of money and the monetary base had fallen 4 to 5 percent. Member bank borrowing had fallen $850 million from the peak and was at a compar
atively low level, and short-term interest rates were less than half the levels of the previous year. Long-term interest rates on Aaa bonds had fallen much less, as is typical in a cyclical downswing (table 5.8).
A new element appeared for the first time in the September data: the spread between Aaa and Baa rates widened. Baa rates rose while Aaa fell, so the risk premium increased from both ends, suggesting flight to quality. In June the risk spread was the same as at the August 1929 peak; in September it was wider by 0.27 percent.
A comparison of the decline in money, output, and prices during the first year with the changes in later years shows how the character of the contraction changed. At first, industrial production declined by a much larger percentage than the stock of money or the price level. After the first year of contraction, industrial production was midway between peak and ultimate trough; the stock of money and the price deflator were no more than a quarter of the way from peak to trough. A severe deflation now combined with a severe contraction. Even on the Federal Reserve’s interpretation that the contraction was brought on by the speculative excesses of the late twenties, it is clear that the speculative excesses had been obliterated after one year by the precipitous decline in output. From this point on, output declined at a slower rate; money and prices declined faster. During the next thirty months, the average percentage declines in money, industrial production, and prices were more nearly the same.
Most of the policymakers regarded the substantial decline in short-term market interest rates and the attendant decline in member bank borrowing as the main—and perhaps the only important—indicators of the current position of the monetary system. On the Riefler-Burgess view, policy was “easy” and had never been easier in the experience of the policymakers or of the Federal Reserve System. However, table 5.8 makes clear that the decline in interest rates was not principally a result of Federal Reserve operations. The Federal Reserve had partially offset the decline in interest rates resulting from the reduction in the public’s currency holdings, the demand for loans and other forms of bank credit, and deflation.
A History of the Federal Reserve, Volume 1 Page 46
