The decision to purchase $50 million, made at the June meeting of the executive committee, went into effect at once. The System made additional purchases of $30 million after Harrison conferred with other members of the executive committee. In July excess reserves stopped rising, and member bank borrowing declined. Both long- and short-term interest rates fell during the month. By the usual money market indicators, the money market was easier during July than in June, and no purchases were made between July 8 and early August.
Harrison told his directors that Meyer wanted to make additional purchases. Harrison opposed because the System was likely to extend additional credit to foreigners. He favored waiting (Minutes, New York Directors, July 23, 1931). The following week the directors approved purchase of $125 million of prime commercial bills, endorsed or guaranteed by the Bank of England, for three months.68
67. The lower-quality bonds were mainly railroad bonds that banks held. At the time, banks’ bond portfolios were marked to market value under examination rules. As railroad earnings fell, many railroad bonds became ineligible for bank portfolios. In anticipation of the ineligibility expected to occur when railroads released their 1931 earnings reports, the banks sold bonds, lowering their price. Bank examiners, using the market value of the bonds to value the bank’s assets, found many banks insolvent. The minutes record that 222 banks were threatened with insolvency. Harrison favored methods of revaluing the bonds and changes in the examination procedures used by the state and the Comptroller of the Currency.
Harrison’s response to the domestic banking crisis was very different from the response of Owen Young, one of his directors. At the August 10 meeting, Young noted that “the country looked to the Federal Reserve System and not to the Comptroller of the Currency to assume leadership in banking crises.” His suggestion for a series of strong measures to assist the banks appears to have been ignored. On August 13, Harrison told his directors that “the events of the past year have made bank examiners much more critical and have brought to light weaknesses in management and in assets which previously were not so apparent.”
Contrast with insurance companies suggests what might have been done. The National Association of Insurance Administrators agreed not to revalue the bonds in life insurance portfolios by the full decline in price if the bonds were not in default. As a result, many fewer insurance companies failed.
68. The Bank of France made an identical purchase, so in total the Bank of England received $250 million. Owen Young, a New York director, urged making a larger purchase. He argued that the larger the credit, the more effective it would be because announcement of a large credit would deter speculation. Harrison then talked to Meyer. Meyer doubted the Board would approve more than $125 million. He “thought that England’s present difficulties were so fundamental that much of the help needed should be obtained through a Government loan in this market” (Minutes, New York Directors, July 30, 1931).
Purchases resumed early in August. Harrison explained the August purchases by first noting that the banks in New York had held excess reserves of $60 million to $80 million during the past two months: “In the past few days, due to currency withdrawals and the action of the Bank of France in allowing Treasury bills and bankers bills to run off, this excess had been wiped out and the banks had been obliged to borrow at the Reserve bank from $40 to $80 million. . . . In view of this sudden and unusual change, and to avoid a disturbance to the money situation, the New York Reserve Bank had made purchases on August 10 and 11, for its own account, of $50 million of government securities.”69
The Open Market Policy Conference held a lengthy discussion of open market policy. Harrison described the economic situation and talked of the prospect of economic, social, and political upheavals and of the high rate of unemployment expected in the winter. He introduced a motion to authorize the executive committee to buy up to $300 million “when they thought it was necessary,” but he indicated that the time for purchases had not yet come because “the attitude of the banks and the investors was such that funds thus made available” would be held idle. Authority to purchase up to the larger amount was necessary he thought, because of the currency drains and the recent action of the Bank of France.70 Calkins introduced an amendment reducing the authorization to $120 million, an amount equal to the estimated autumn seasonal. Harrison and Young (Boston) opposed the amendment, the latter because he opposed further purchases. The amended motion passed, Governor Young dissenting.
A preliminary memorandum prepared for the meeting explained that in the typical seasonal pattern currency reached a low point near the end of July. The memo noted that the increase in currency during the autumn months would be superimposed on the estimated hoarding, $500 million in currency, and that there would be further increases in the demand for currency. Harrison, Meyer, and Black wanted authority to offset the currency drain and the seasonal movement if it developed. The other governors raised two related arguments, both of which were answered to no avail.
69. These purchases are not shown in table 5.13 because they came after the end of July. On August 6, Leslie Rounds reported on bank failures in the district. Owen Young asked: “Must we stand by and see these banks fail?” Harrison replied that “there is no alternative” (Minutes, New York Directors, August 6, 1931).
70. The memo prepared for the August 11 meeting refers to 166 bank failures in the country in June, the largest number since January. Total deposits in failed banks reached $218 million, the largest since December 1930. A table showed the number of suspended banks and their deposits from January 1930 through July 1931. The big months are November and December 1930, January and June 1931. Totals for 1930 were 273 and $865 million, and for 1931 through July, 773 and $498 million. The memo concluded, however, that financial difficulties abroad were more severe than the difficulties at home. The principal concerns abroad were the loss of $150 million in gold from the London market and the suspension of debt payments by South American countries.
Governor Calkins argued that not all the reserve banks could participate in the purchase program, hence not all would benefit from the higher earnings if the System undertook large-scale purchases. Gold holdings were not distributed in the same proportion as the liabilities of the System, so not every bank had reserves to cover its share of the additional deposits and currency. The second argument was about the System’s volume of “free gold.” Governor Meyer presented a detailed analysis showing over $800 million of “free gold” was available and that the key problem was not gold but currency hoarding and bank failures.71
Once again the Board favored a more expansive policy than the Governors Conference. Meyer and other Board members expressed disappointment at the small volume of purchases authorized and urged the members to undertake an effective program of purchases. This discussion was in vain. Money market pressures did not increase during the month, the System’s holdings of acceptances increased slightly, and the inflow of gold slowed. Despite the continued increase in currency held by the public, the System did not use its authority to purchase securities.
Although Harrison argued for a more expansive policy than the OMPC approved, he made it clear that he did not plan to put the purchase program into effect even if approved. His argument for standby authority is very
71. The Federal Reserve defined free gold in terms of the excess gold reserves of the reserve banks. Two definitions were sent to all the reserve banks in 1930. “Excess reserves: deduct from cash reserves the thirty-five percent required reserves against deposits and the forty percent against Federal reserve notes in circulation. Free gold: deduct from excess reserves the amount by which gold required as collateral against outstanding notes and for the Gold Redemption Fund exceeds forty percent of the notes in circulation.”
On August 21, Harrison followed up Meyer’s discussion of “free gold” in a letter to McDougal. With the letter, Harrison sent a memo showing the effect of $300 million in purchases on the ability of the System to maintai
n gold reserves sufficient for the additional note issue. The memo showed that after the purchase, there would be $600 million of “free gold” and that the amount could be increased to $900 million by reducing the amount of Federal Reserve notes issued but not in circulation. (These notes were held at reserve banks and could be canceled.) The memo argued that with the increased demand for currency, the banks would discount eligible paper that could replace gold as collateral for outstanding notes.
The “free gold” problem is similar to the problem the Bank of England periodically encountered during the nineteenth century. Friedman and Schwartz’s useful discussion of the “free gold” problem in 1931–32 suggests that the problem had not been discussed before the thirties. Traditional central bank concern with the gold reserve ratio and with the effect of monetary expansion on the demand for currency shows that the issue was an old one. During the twenties, the Board used the “free gold” position to argue against expansion in 1928, and Burgess had discussed the “free gold” position in a published paper. For references to these discussions, see Harris 1933, 1:377–81. See also Friedman and Schwartz 1963, 399–406.
similar to the statements he made in his discussion with Governor Miller of the Board almost a year earlier. A program of purchases would not be effective, in his view, if it added to the excess reserves of the member banks. He did not see any prospect that reserves would be used to purchase securities or to expand credit, and he did not urge the executive committee to make the limited volume of purchases that the OMPC authorized.
Friedman and Schwartz gave considerable attention to this meeting. On their interpretation, Harrison desired a more expansive policy but was unable to convince the other members to support his position and therefore failed to carry out the expansive policy that Governor Strong would have followed had he lived. In fact, Governor Meyer made the case for expansion.72 Harrison’s statements at the meeting and his actions during the summer show little interest in an expansive policy. He told the other governors that he did not intend to undertake large-scale purchases based on the increased authority to purchase; he desired standby authority to offset the effect of larger than usual demands for currency and renewed gold flows that he expected because of the weakened position of many of the banks and the repeated crises in the markets for foreign currencies.
When Harrison discussed the OMPC report with the New York directors on August 20, he complained only about procedure. The Board and the OMPC had agreed to a procedure under which the Board approved a general program proposed by the governors, and the executive committee of the Governors Conference decided on the timing and amount of purchases or sales. This time the Board had not approved the program but had delegated to Governor Meyer the right to approve purchases (but not sales) recommended by the executive committee. Meyer was present in New York and replied that the OMPC had not presented a program. The Board would have approved a “real program” of purchases but was opposed to sales and did not approve the OMPC report because it permitted the executive committee to buy or sell at its own discretion without limit as to time. Harrison’s complaints about the difficulty of obtaining the agreement of the other governors seem hollow in view of his failure to carry out or even recommend a regular program of monetary expansion.
72. Charles Hamlin, a member of the Board, testified about the August decision: “Governor Meyer . . . went before the committee for 2 hours explaining that under existing conditions nothing but a major stroke would help the situation, and perhaps that would not; but that it was vitally important that the System should make a bold stroke and buy, say, 300 millions or 400 millions of Government securities hoping that might turn the tide. For 2 hours he discussed the math with the governors. We then came together in a conference and we found, after their meeting by themselves, . . . [they] cut the power from $300,000,000 to $120,000,000. The $20,000,000 was an unexpended balance. . . .[This] naturally would destroy the effect because it would cease to be a major operation” (Senate Committee on Banking and Currency 1935, 945–46). In September Meyer told the New York directors they should raise interest rates but purchase securities to show that policy had not changed (Harrison Papers, Memorandum, September 3, 1931).
Why did Harrison fail to press for purchases under the August decision? He told the executive committee of his directors on September 1 that he expected the seasonal requirements for credit to be small, but he anticipated a continued demand for currency. In keeping with Riefler-Burgess doctrine, he saw no advantage in making purchases unless an expansion of member bank credit would result; he had discussed the matter with bankers, and they indicated that any increase in excess reserves would remain idle. There would be no increase in real bills, hence no reason to provide reserves.
In fact, Federal Reserve credit increased $200 million during August as banks sold bills to obtain currency. Harrison at first favored purchases to offset any increase in market rates, but after listening to several directors argue that higher rates might be interpreted as a sign of recovery, he concluded—inconsistently—that “no action should be taken . . . to prevent such a seasonal firming of money rates.”
At the next two directors’ meetings, attention shifted to the prospects for selling the $50 million in securities that the New York bank had acquired early in August. Both Harrison and Meyer opposed the sale, fearing misinterpretation of any move toward tightness. Meyer added, “The opinion was being expressed by substantial people that the System had not taken sufficiently aggressive action to maintain the volume of credit as a support for the commodity price level,” an indication of congressional attention that introduced a new element, fear of “inflationary legislation,” into the Federal Reserve’s discussions during the winter of 1932.
FROM THE BRITISH DEVALUATION TO THE BANKING HOLIDAY
Two years had passed since the cyclical peak, but the end of the decline was not in sight. Two events were about to happen that permanently changed beliefs and attitudes. First came the British decision to leave the gold standard. In less than two years, most gold standard countries followed.73 In retrospect, these decisions led a majority of the public, economists, and eventually central bankers to reconsider the alleged virtues of the gold standard, by first questioning the gold exchange standard and later the gold standard in its various forms.
73. The British Empire and all British dominions except South Africa followed Britain. Three Scandinavian countries also suspended gold payments immediately. By the end of the year, they were joined by Portugal, Egypt, Bolivia, Finland, and Japan. Several South American countries had suspended gold payments in 1929 and 1930.
Second, in many countries, including the United States, government took more responsibility for managing the economy through regulation and controls. In the United States the first steps came within a few weeks of the British devaluation. Concerned about a renewed wave of bank failures, President Hoover pressed for the formation of a public-private partnership, the National Credit Corporation, to support the banks by supporting the bond market. This was a forerunner of the Reconstruction Finance Corporation.
Britain Leaves the Gold Standard
Britain had remained on the gold standard for most of the preceding two hundred years. The Bank of England had suspended specie payments in crises but had always returned to convertibility at the former gold price. After the Napoleonic Wars and again after World War I, the government and the bank engineered socially costly deflations to restore gold parity. The decision to suspend gold payments and allow the pound to float was therefore a climactic event for Britain and, given Britain’s important international role in lending and borrowing, a major event for the world economy.
Conventional opinion at the time criticized the government and the bank for offering only a weak defense. Bank rate had remained at 4.5 percent. In many previous crises the bank had raised the discount rate to 10 percent to attract gold.74 Many of these comments reflected the prevailing orthodoxy—suspension was evidence of failure to follow pr
oper policies. The freedom to end deflation, gained by suspension, represented the choice of inflation over sound, proper policies.75
Although the Bank of England did not raise its discount rate, Britain had not been idle. The British announcement on September 20 came after six months of recurrent payments difficulties that started in Austria and Hungary, then shifted to Germany and later to London. Resort to exchange controls and blocked balances on the Continent increased the magnitude of the problem confronting the Bank of England by freezing British balances abroad.
74. Harrison reported a comment by officers of the Bank of France, who described “tremendous feeling in Paris” against the weak British action (Harrison Papers, Memoranda, September 3, 1931); memo, Consequences of the British Suspension of Gold Payments, Minutes, New York Directors, October 15, 1931). There was no mention of the severe deflation or the very high real interest rate then in effect.
75. Kindleberger (1986, tables 12 and 19) permits comparison of the depreciation of the pound (relative to the French franc) and the change in French and British prices as recorded during this period. Between August and December, the pound exchange rate in France fell 31 percent, and British prices rose 37 percent relative to French prices. These data suggest that Britain did not “beggar its neighbor.” It was able to lower its interest rate and stop deflation.
During the two months from July 23 to September 19, Britain paid out $972 million of reserves. To finance the reserve loss, the Bank of England borrowed $650 million in New York and Paris during July and September. The Federal Reserve, with the approval of the Board, agreed to lend $125 million on July 30, and the Bank of France lent a similar amount. Throughout August and into September, Harrison negotiated with the Bank of France and acted as intermediary for the Bank of England with the New York bankers to find a set of terms for a one-year private loan (Clarke 1967, 201–8).
A History of the Federal Reserve, Volume 1 Page 50
