A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  There can be no doubt that the Federal Reserve was aware of the severity of the depression. The preliminary memorandum prepared for the September meeting compared the then current depression to the depression of the 1880s, described it as one of the worst in the country’s history, and named lack of purchasing power as a main cause. The memorandum also referred to the cautious approach being taken by the banks, particularly banks in New York, a reference to the fact that member banks’ borrowing had fallen.

  At the September meeting, Harrison again described the monetary and economic situation, called attention to the fact that most central banks had increased their gold reserves during the year, and for the first time mentioned the reduction in the monetary base. The ratio of gold to central bank liabilities had increased because of the “very substantial” decline in note and deposit liabilities.42

  Traditionally, the committee devoted much of its attention in the early fall to the seasonal increase in bank credit and bank reserves. This year, however, member bank borrowing and short-term interest rates had fallen, contrary to the seasonal pattern, so the governors considered selling securities. After some discussion, the committee approved Harrison’s motion that “it should be the policy of the System to maintain the present easy money rate position in the principal money centers . . . that . . . no further easing of such money rates would be advisable and that no firming of rates would be desirable whether because of seasonal requirements, gold exports, or other causes.” The OMPC approved this motion nine to two with one abstention.43

  42. “For the past year, this country has been in a business recession. At first it was hoped that the recession would be relatively brief reflecting the temporary disturbance of the stock market inflation and decline. But in recent months the recession was extended until, even if the bottom has now been reached, it will rank as one of the country’s major business recessions both in extent and duration. The duration of the recession has already been as long as any recession since the 1880s. The causes of the recession are deep seated and broad in their scope and involved, in part at least, a serious shortage or working capital and curtailment of purchasing power in a number of countries and some over-production in basic world industries accompanying under-consumption. . . . The end of the recession does not yet appear by any concrete evidence to be definitely in sight though there have been of late some indications of a check in the downward movement. Generally speaking the banks have pursued an extremely cautious lending and investment policy seeking to keep themselves in the most liquid position” (Harrison Papers, Open Market, September 25, 1930).

  The minutes then refer to a general discussion between the members of the OMPC and the Board at which members of the Board asked why the conference had not requested authority to engage in substantial purchases so as to force more credit on the country.44

  Governor McDougal restated his position at length. He was opposed to maintaining the present low rates that prevailed in the market because they were “artificial,” “too low.” Banks were now unwilling to pay a 2 percent rate to buy new Treasury issues on credit because money was not worth 2 percent. In an apparent reference to the open market purchase of $50 million the previous spring, which he had opposed, he reminded the governors that easy money had been tried, and while it could not be said that the policy had achieved nothing, “it has not done what we hoped.” And he added, “We are all in agreement that nothing should be done to make things easier.”

  Governor Calkins explained that he had voted against the resolution for reasons he described as “trivial.” He had written the background memorandum, but he opposed the section, added at the meeting, authorizing purchases or sales of $100 million instead of $50 million. He did not want any action to ease the money market, but he could not agree with Governor McDougal that this was an opportune time to “firm the money market.” “We have every reason to anticipate the usual seasonal increase, and I think we should go through that period, the remainder of this year, before we take any action to bring about a less sloppy condition.”

  Governor Norris voiced an opinion similar to McDougal’s: “I think the large majority felt that money conditions were unduly and unwholesomely easy and that there might be some little hardening in some rates without doing any harm and possibly doing some good.” He had voted for the resolution as Harrison presented it, because he did not want to take responsibility for a firmer policy at that time in view of the seasonal problem. His views were more fully expressed in a memorandum from the directors and officers in Philadelphia that he had read to the conference. The memo restated the dangers of low interest rates and argued that low interest rates could not bring about recovery. The problem, as they saw it, was one of excess capacity and not one of underconsumption.

  43. The conference also voted to raise the limit on purchases and sales by the executive committee from $50 million to $100 million without further approval of the conference. Governor Calkins believed this would be interpreted as a move to greater ease, so he voted against the resolution. Governor McDougal gave the other negative vote. He explained that “he thought some firming of rates might be advisable.”

  44. The details of this discussion are not contained in the minutes, but they are available from the Board’s correspondence. They reveal most clearly the positions, beliefs, and attitudes held by leading members of the System. The quotations and source material that follow in the text are from a letter to Eugene Meyer, dated September 30. Meyer had replaced Young as governor of the Federal Reserve Board. He served from 1930 to 1933. The memo notes that the remarks are not verbatim.

  The Philadelphia memo appealed to the real bills doctrine that most of the governors regarded as their guiding principle:

  We have always believed that the proper function of the System was well expressed in the phrase used in the Tenth Annual Report of the Federal Reserve Board—“The Federal Reserve supplies needed additions to credit and takes up the slack in times of business recession.” We have, therefore, necessarily found ourselves out of harmony with the policy recently followed of supplying unneeded additions to credit in a time of business recession, which is the exact antithesis of the rules stated above.

  The suggestion has been made that we should be prompt to “go into reverse” and dispose of these governments when business picks up. This is a complete and literal reversal of the policies stated in the Board’s Tenth Annual Report, already quoted. We have been putting out credit in a period of depression, when it is not wanted and cannot be used, and we will have to withdraw credit when it is wanted and can be used. (Open Market Policy Conference, Board of Governors File, September 25, 1930)

  Norris and his directors believed that “correction must come about through reduced production, reduced inventories, . . . and the accumulation of savings through the exercise of thrift.” The burden was on those who wished to deviate from the established principles of policymaking to show that some benefit would result. None of the members of the Open Market Policy Conference openly disagreed with Norris’s interpretation of the policy statement in the Board’s tenth annual report. None of them offered an alternative interpretation or argued that he had misinterpreted that report, as Chandler (1958) has suggested.

  Adolph Miller of the Board urged the members of the committee to consider a more expansive policy and stated the case for countercyclical policy as clearly as it was ever done in the minutes for the period. He began by asking whether the governors’ recommendations related to the economic situation and to the depressing conditions the System faced. He questioned whether they misinterpreted money market conditions because they relied on a faulty indicator:

  Is this your program for handling whatever problems of a financial or credit character that originate in this present condition of depression? I ask that because in times of depression, particularly, a money rate is a very imperfect indicator of the true state of credit. . . .You have lower rates precisely because business is stagnant. . . . I expected the Comm
ittee might come along with a proposal not to maintain the existing program, but to alter the situation by a bold buying away from the public or banks 50 million or 100 million dollars of bonds and make them turn around and look for some other avenue of investment.

  After an exchange with Harrison, Miller continued:

  The fellow who sells me his corporate bonds which I buy with the money the Reserve bank has given me in exchange for my government bonds turns around and eventually has got to find something in the field of some new undertaking. I think the real meat of this matter is that in a condition of this kind the fellow who is tempted to sell a security, a government bond in the first instance, does it because he sees somewhere an opportunity where he can replace his investment to his own advantage. In the meantime you have started a movement which causes a revision of the relative scale of investment desirability and values which may work some benefit in a stagnant situation. (Open Market Policy Conference, Board of Governors File, September 25, 1930)

  In reply, Harrison argued that Miller’s policy was the policy of deliberate inflation, a policy that was “fraught with a great many dangers.” There were “some in the organization of the New York bank,” who wanted to pursue the policy Miller now urged upon them, but the governors had not considered this alternative. One of the great dangers in this policy was that it would fail to generate much expansion but would instead cause a gold outflow. After they used all their reserve bank credit, they “would be stumped.”

  Harrison’s reference to “some in the organization of the New York Bank” is to two officers of the New York bank, Carl Snyder and W. Randolph Burgess, and perhaps to some of the directors. At a meeting of the officers’ council on September 17, Snyder urged Harrison to support an aggressive policy of expansion.45 Snyder pointed out that the call report data for June 30 showed that the volume of bank credit at all member banks was the same as in 1928, and that credit had actually declined compared with 1929. The city member banks had reported an increase during this period so, he reasoned, the approximately eight thousand nonreporting member banks must have curtailed the amount of credit outstanding. In his opinion this was deflationary. He favored an aggressive policy of purchases to stimulate business and avoid the winter of depression that now seemed likely.

  45. At the New York directors’ meeting on October 23, Harrison mentioned again that a majority of the officers of the New York bank favored additional purchases. Harrison opposed on grounds that the market was easy and the OMPC would not agree (Minutes, New York Directors, October 23, 1930).

  Harrison replied that since the banks borrowed only minimum amounts from the Federal Reserve, additional purchases would force them to invest in securities instead of real bills. The dangers of such an inflationary policy were “great” and the advantages “doubtful.”

  Burgess argued that the attempt to correct a previous deflation was not inflationary. He believed that New York should favor a policy that involved more than merely maintaining easy money rates and keeping the New York City banks out of debt. By increasing the pressure on the banks to employ their surplus funds, open market policy could give a little impetus to business recovery. Later, if inflation developed, there would be ample opportunity to slow it down.

  Harrison replied that the present economic difficulties could no more be remedied by a “heavy dose of easy credit” than by the small dose that had already been administered. He repeated the stock argument: when the New York City banks are continuously out of debt to the reserve bank over any considerable period of time, it means a very easy reserve position. Harrison added that most of the other Federal Reserve Banks would not agree to additional purchases (Harrison Papers, Discussion Notes, “Credit Policy in the Business Situation”).

  At the OMPC, Governor Meyer agreed with Harrison that any increase in reserve bank credit beyond what he called the “status quo” would lead to a gold outflow. Miller then urged that they at least consider an exploratory operation, but he was unable to counter the arguments of Harrison and Meyer that the proposed policy was inflationary, that the conference felt it had “gone too far.”

  Norris closed the discussion with the type of argument that often appeals to “practical men.” He had talked to a partner of Morgan and Company, who assured him they had “no trouble at all in selling high grade bonds but that there was difficulty in selling second grade bonds, because buying was institutional.” Further purchases by the Federal Reserve would succeed in marking bond prices up only temporarily; as soon as the purchases stopped, prices would fall, and the customers would be disgruntled.

  Summary: Policy in the First Year

  The September meeting was the last scheduled meeting of the full Open Market Policy Conference in 1930 and the last opportunity the Federal Reserve had to prevent the wave of bank failures and currency drains that started late in the year. With the exception of Miller’s plea for a more expansionist policy and the Snyder-Burgess suggestions a few weeks earlier, there had been no serious consideration of an alternative to the existing policy. Of those present at the OMPC meeting, only Miller appears to have dissented from the view that “ease” was best measured by member bank borrowing and short-term market interest rates, and only Miller questioned the notion that policy could do nothing more until there was an increase in the demand for credit. No one suggested that the severe deflation had increased real rates.46

  As usual, the quixotic Miller did not convert others to his view. It seems unlikely, however, that the more persuasive Strong would have succeeded if he had lived. The dominant view among the governors was that open market purchases and easy money had failed to revive the economy. The System had purchased more than $500 million of securities and acceptances in the previous twelve months. Short-term rates were at historical lows. The Riefler-Burgess doctrine suggested that policy was easy. The real bills doctrine implied that the correct policy was a passive one. Most governors had always held these views; Harrison shared many of them.

  The economies of the United States and much of the rest of the world became victims of the Federal Reserve’s adherence to an inappropriate theory and the absence of basic economic understanding such as that developed by Thornton and Fisher (chapter 2 above). The alternative interpretation, that monetary policy failed because no one suggested the appropriate action to take, is contradicted by the arguments that Miller, Burgess, and Snyder advanced at the September meetings in New York and Washington and by the arguments of several New York directors in May and June.

  Although Harrison mentioned a future loss of gold as a reason for not expanding, gold movements had little impact on policy decisions and actions. In the year to September, bank reserves had increased by less than the increase in gold stocks and the monetary base had declined, so gold standard reasoning supported expansion.47

  46. Snyder and Burgess continued their efforts. At the October 23 meeting of the New York directors, Harrison reported that the officers were in favor of further purchases. One of the directors urged Harrison to make these views known to the Board. Harrison again referred to the very low level of member bank borrowing but now argued that “he was doubtful of the advisability of forcing more funds into the market where they might back up and cause an unwise inflation of credit.” In a letter to Governor McDougal written at about this time, Harrison interprets the 1928–29 experience as “speculative excess” with insufficient credit restraint, the view taken by Strong’s critics.

  47. On both October 9 and October 30, New York voted to purchase $25 million of sterling bills for its own account. New York acted to strengthen the pound, but discussion of the assistance to cotton exports may have influenced some directors (Minutes, New York Directors, October 9 and 30, 1930).

  The discussion at the September 1930 meeting shows that the Federal Reserve’s decisions followed the real bills doctrine, as expressed in the tenth annual report, and failed to distinguish between real and nominal interest rates. Consumer and wholesale prices had fallen 14 to 15 per
cent in the year to September, so the 3.25 percent reduction in acceptance rates, the 3.5 percent reduction in the discount rates at New York, and other rate reductions left short-term real interest rates more than ten percentage points above the level of the earlier year.

  Eichengreen’s (1992) claim that lack of international coordination prevented expansion finds no mention in the discussion. With few exceptions, the governors, members, and officers of the Federal Reserve believed they had acted appropriately—that any additional purchases would fuel speculative growth. They did not look to foreign central banks for guidance or leadership, and they did not consider coordination necessary for expansion.

  In the year since the peak, the Federal Reserve had purchased $442 million of government securities and acquired $73 million of acceptances. Borrowing had declined $854 million and was well below the minimum levels reached in the 1923–24 and 1926–27 recessions. To a modern observer, these changes suggest that the Federal Reserve had failed to offset the decline in borrowing. The Riefler-Burgess doctrine provided a different interpretation: Federal Reserve purchases had permitted the banks to repay borrowings. The financial system was in a position to expand if the private sector wanted to borrow.