A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  85. Banking and Monetary Statistics (Board of Governors of the Federal Reserve System 1943) shows the decline at weekly reporting banks as more than $3.7 billion (20 percent) from August 1929 to December 1931 and an additional $374 million (20 percent) in commercial paper and acceptances. Call reports show nearly $7 billion (26 percent) decline in total loans at all member banks from October 4, 1929, to December 31, 1931. Weekly reporting banks gained relatively, no doubt influenced by fewer failures.

  86. Harrison later revised this view. See below.

  The directors did not accept Harrison’s answer. But Harrison held firm and urged delay so that actions could be synchronized with the passage of Reconstruction Finance Corporation legislation (passed at the end of January), the (downward) adjustment of railroad wages, and other pending changes. Then they could reduce the discount rate to encourage borrowing and begin open market operations.

  Delay during the fall allowed a large part of the banking system to fail. In two months, September and October 1931, the deposits of suspended banks rose to $705 million, as much as in the entire year 1932 yet to come. Nearly 30 percent of the bank suspensions between August 1929 and February 1933 came in the last four months of 1931.

  Member bank borrowing had fallen at the time of the January meeting from the seasonal peak at the end of December, and short-term open market rates had fallen also. As borrowing fell, the Federal Reserve sold some of the securities acquired in December. The amount of borrowed reserves and market rates on both short- and long-term securities remained high relative to the recent past. The money stock continued to decline, reflecting the additional increase in demand for currency and the contractive policy of the Federal Reserve.

  In the six months between June and December 1931, the money stock fell about 6 percent and industrial production about 14 percent. The risk premium on bonds rose nearly four percentage points above their level at the peak of the expansion in 1929, and even rates on Aaa bonds were above the August 1929 level. With wholesale prices 11 percent below the December 1930 level, real yields on Baa bonds were above 20 percent. The risk spread was above five percentage points.

  The gold outflow stopped in November and reversed in December. The Open Market Policy Conference decided that the time had come for a reduction in bill rates and in discount rates. Much of the discussion at the meeting concerned the government’s budget and the desirability of a balanced budget as a means of reducing pressure on market interest rates. The members apparently continued to favor a reduction in member bank borrowing brought about by a continuation of gold inflows. They hoped the currency drain would reverse.

  Despite his statements at the directors’ meetings earlier in the month, Harrison neither urged open market purchases on the other governors nor advocated any other expansive action. Nor did he urge the directors to reduce the discount rate when he returned to New York. When two of the directors, Clarence M. Woolley and Theodore F. Whitmarsh, pressed for immediate action at the January 14 meeting, Harrison advocated caution and delay. Again, on January 21, Whitmarsh urged Harrison to reduce the discount rate, and again Harrison urged delay and caution. The following week Owen Young joined Whitmarsh and Woolley in urging Harrison to take some expansive action, but Harrison pointed to the “free gold” position as a reason for delay. Young was not deterred and pressed Harrison to purchase $50 million while maintaining the discount rate unchanged to stem any outflow of gold. The only concessions Harrison made were an agreement that purchases would be considered in an emergency and that a change in the discount rate would be reconsidered the following week. At the next meeting, February 4, the gold outflow had stopped temporarily, and the “foreign situation” was no longer an excuse for inaction. Harrison now cited a “bad banking situation on the Pacific Coast” as a reason for delaying any decision to reduce the discount rate.

  At each weekly meeting with his directors, Harrison urged delay. Before Congress passed the RFC legislation, he argued for an expansive program to accompany congressional approval of the RFC. Later he wanted to wait for the Glass-Steagall Act, or similar legislation removing the restrictions on the assets eligible for discount and the use of government securities as collateral for the note issue. Once such legislation appeared likely to pass, he favored delay because the proposed legislation might alarm foreigners. When Owen Young pointed out that Harrison had offered a variety of reasons for postponing action and urged an end to the “ruinous” decline in bank credit, Harrison modified his position and agreed that, once the Glass-Steagall Act passed, they could both reduce the discount rate and buy government securities.

  Free Gold

  One of the reasons given for delay was that the System either lacked free gold or was at risk of doing so.87 The Board made this argument in its 1932 annual report, and Goldenweiser (1951), Thomas (1941), Burgess (1964), and other Federal Reserve officials used the argument later to explain delay and inaction.88 As noted earlier, Eichengreen (1992) accepted the System’s argument, but Friedman and Schwartz (1963) rejected it. The next two sections present the case for and against the importance of free gold as a reason for delaying open market purchases.

  the case for free gold Harrison cited the free gold position several times in the four months between the British suspension and the passage in February 1932 of the Glass-Steagall Act, removing the free gold problem. Most of these citations are in months with relatively large gold outflows, October 1931 and January 1932.89 Taken alone, these statements support the Federal Reserve’s explanation of its inaction.

  With the benefit of hindsight, Harrison rejected the argument he made at the time. A year later he told Gates McGarrah that when the Glass-Steagall Act passed, the System “had around $350 million of excess gold; that even if there had been a further drain, the $350 million did not represent the maximum of our capacity to export gold since additional borrowings would have been forced upon the banks which would have given us additional collateral which would have released gold”90 (Harrison Papers, Confidential Files, Telephone Conversation with Mr. McGarrah, October 10, 1932).

  87. Free gold was the amount of gold held by reserve banks that was not required as a reserve against outstanding base money. Note issues required 40 percent gold and 60 percent eligible paper as backing. In addition, reserve banks had to hold 5 percent of the difference between notes outstanding and notes in circulation (Harris 1933, 2:770). The decline in borrowing and the rise in currency more than exhausted the stock of eligible paper, so reserve banks substituted gold as backing. This reduced free gold. As noted earlier, each reserve bank met the requirement from its own resources (but could borrow gold from other banks). For the System, the ratio on February 28, 1932, was 71 percent, implying free gold of about $300 million. This number is approximate because each reserve bank had its own free gold. As noted in the text below, Federal Reserve banks could have increased the amount by canceling notes in their vaults.

  88. Thomas’s statement is ambiguous (1941, 33): “Had the Reserve banks bought Government securities . . . then it would have been necessary to substitute gold as collateral, and there might not have been sufficient gold.”

  89. Harrison Papers, Open Market, October 5, 1931: “He considered the gold position of the System paramount at this time, and on that account would not be inclined to purchase government securities.” Ibid., January 4, 1932: “His only hesitancy in recommending such a program at the moment, he said, was on account of the relatively small amount of free gold.” January 28, 1932: Governor Harrison pointed out that our free gold position must still be considered in relation to further purchases of Government securities.” All references are to Harrison’s statements to the New York directors.

  To reconcile these contradictory statements, note that Harrison made the last statement months after the event. His expressions of concern about free gold came when the gold outflow was large, and no one could predict how long the outflow would last or how large it would be. These were real concerns at the time. Between
late September and late February, the Federal Reserve’s gold stock declined by 8.7 percent, reversing the entire inflow received since the August 1929 peak.

  The free gold problem affected New York, Chicago, Boston, and Philadelphia. By November 1931, reserve banks in Richmond, Atlanta, Dallas, Minneapolis, and Kansas City together had sold almost $50 million of securities to other reserve banks to meet gold reserve requirements.91 In addition, several of the regional banks stopped participating in the System’s acceptance (bill) purchases, thereby shifting purchases to the other reserve banks.

  the case against free gold Section 10c of the Federal Reserve Act permitted the Board to suspend any reserve requirement for thirty days followed by an additional fifteen days if needed. Suspension of the gold reserve against note issues required the reserve bank to pay a small tax; for reductions from 40 to 32.5 percent, the tax rate was 1.5 percent. Miller (1925a) referred to this provision.

  This was not the only recourse. The System could have reduced the discount rate on acceptances to increase its holdings of the $1 billion of acceptances outstanding in November 1931 (Board of Governors of the Federal Reserve System 1943, 465). It could have canceled currency in its vaults to save a 5 percent gold reserve against unissued notes. It could have speeded the return of notes issued by other reserve banks.92 It could have issued other currency not subject to a gold reserve. It could have asked Congress to suspend gold reserve requirements, as Britain often did in the nineteenth century.

  More important, free gold can explain inaction for only a very short period, October 1931 to March 1932. The Federal Reserve had ample gold to support expansion before the British suspension, and the constraint was not binding after February. Further, the Federal Reserve did not find it necessary to invoke the Glass-Steagall Act when it began large-scale purchases in March.

  90. The commercial banks would lose reserves, so they would borrow from the reserve banks, increasing eligible paper (real bills).

  91. New York took more than half of the acceptances. Its relative size was about 30 percent at the time.

  92. Until 1954, a reserve bank paid a tax for reissuing notes of other reserve banks, so it returned these notes. The notes in transit were considered outstanding, thus subject to the 40 percent gold reserve requirement and, under prevailing conditions, the substitution of gold for eligible paper.

  Did the free gold problem delay open market purchases? The answer is certainly yes. Harrison gave several reasons for delay, and several governors opposed purchases generally, so the System might have delayed in any case. Nevertheless, the many references to free gold as a reason for delay, and the initiation of purchases as soon as the Glass-Steagall Act passed, support the case if only in the limited sense that passage of Glass-Steagall put the administration and Congress, including Senator Carter Glass, on record as favoring purchases. The System could not ignore the message in this action.93

  THE 1932 PURCHASE PROGRAM

  Passage of Glass-Steagall temporarily suspended the collateral requirement for notes by permitting reserve banks to substitute government securities for commercial paper or real bills.94 Though intended to be temporary, this was a major retreat from the principles underlying the Federal Reserve Act. Passage of the 1932 legislation recognized that the real bills doctrine did not provide the flexibility (elasticity) to expand the note issue or prevent the crisis from deepening.95

  Despite worsening business and financial conditions, only two banks reduced discount rates between the meetings on January 11 and February 24. In late January, Richmond and Dallas lowered their rates from 4 percent to 3.5 percent. The system took no other expansive action despite a 20 percent decline in loans of member banks, a 35 percent decline in open market paper outstanding, and a 15 percent increase in the public’s currency holdings during the last six months of 1931. The buying rate on acceptances remained below the market rate, so the bill portfolio declined.

  93. Harrison gave three reasons for not using the authority to purchase that had been agreed on at the January OMPC meeting: “various elements in the domestic situation had developed more slowly than had been anticipated, . . . gold withdrawals to Europe, and . . . the limited amount of free gold held by the System” (Harrison Papers, Open Market, February 24, 1932).

  94. Congress renewed the temporary provision several times before making it permanent.

  95. Glass recognized what had happened. He told Burgess: “You tell George Harrison that I am now just a corn-tassel Greenbacker” (Burgess 1964, 226). The act was prepared mainly by Walter Wyatt, the Board’s general counsel.

  The Glass-Steagall Act

  The Glass-Steagall Act relaxed Federal Reserve collateral requirements in three ways. First, government securities became eligible as collateral for note issues, as discussed previously. Second, reserve banks could lend on previously ineligible commercial paper at a rate 1 percent above the discount rate. This provision permitted banks to borrow against a much broader range of assets. Third, groups of five or more banks could borrow on the group’s credit. This provision permitted clearinghouses to borrow directly and encouraged the formation of county clearinghouses in rural areas.

  Exchange rates and bond yields responded almost at once to the new provisions and the start of the RFC. The dollar weakened against the pound, falling 5 percent between December and February and an additional 8 percent by its trough in April. Yields on government bonds rose between December and February, but yields on corporate bonds fell, particularly on lower-rated bonds, as perceived risks declined. Both changes suggest that markets interpreted the change as a less deflationary policy.

  Glass-Steagall was a temporary change, scheduled to last a year. Several New York directors criticized the one-year limit. Some noted that if the gold outflow continued, the System would be in crisis at year end, unable to replace government securities with gold or commercial paper. Harrison responded that he hoped hoarded currency would return to the banks, releasing gold reserves (Minutes, New York Directors, February 11, 1932).

  Permitting banks to borrow on ineligible paper alarmed the governors: “A number of governors pointed out the dangers in the Federal Reserve System’s becoming loaded down with loans of this sort” (Governors Conference, February 24, 1932, 2). Talk shifted to ways of limiting the volume of ineligible paper. Governor Meyer suggested a 5.5 percent rate, the rate charged by the RFC (4); Governor Black (Atlanta) warned against thwarting the will of Congress.

  Purchases Begin

  By the time the Open Market Policy Conference met late in February, it had become clear that neither a decline in the demand for currency nor an inflow of gold could be counted on to reduce the level of member bank borrowing and short-term market interest rates. As table 5.19 shows, gold flowed out during January and February, and the demand for currency again increased. In fact Harrison told the members of the OMPC to expect additional reductions in the gold stock of about $50 million a month. Further, he thought “it seemed unnecessary for the banking position to be subjected to severe strain” because of the hoarding of currency. The Glass-Steagall Act, which Congress was about to pass, gave them the power “to purchase government securities to relieve the banks of some of their indebtedness to the Reserve banks.”

  As on most previous occasions, the OMPC followed Harrison’s recommendation. By a vote of ten to two, it approved purchases of $250 million; the executive committee, three to two, authorized purchases at the rate of $25 million a week. The Board approved immediately. The magnitude of the operation, though small compared with the decline in money, bank loans, output, or prices, should not be underrated. At the time the decision was taken, the Federal Reserve held $741 million in securities, so the decision permitted the System’s security holding to increase by one-third. The addition to the security portfolio during the next few weeks was equal to 50 percent of the securities purchased during the two and one-half years since the August 1929 peak in economic activity.

  Many of the banks that voted to p
urchase did not take part in the program. Only four banks—New York, Philadelphia, Cleveland, and Kansas City—participated in the initial purchases, with New York taking 80 percent of the first $70 million.96 Some banks had sold part of their portfolio to others, but Chicago and Boston did not participate because they opposed purchases. James B. McDougal (Chicago) said the new legislation encouraged borrowing, so there was no reason for purchases. George W. Norris (Philadelphia) preferred to wait until “all serious troubles are behind us. . . . [H]e feared further possible bank failures, further commercial failures and possible municipal defaults” (Harrison Papers, Open Market, February 24, 1932, 6). He voted for purchases after being assured that New York would buy most of the securities but that the money would flow all over the country. If he had voted against, a majority of the five-person executive committee would not have supported purchases.

  Why did the System finally decide to act in a way that, at the time, seemed bold? There are at least three reasons. First, the action was consistent with the Riefler-Burgess framework. Member bank borrowing and short-term rates had not declined. Borrowing was well above the $500 million range considered high in an ordinary recession and was almost back to the 1929 peak. A program to reduce the volume of borrowing by undertaking purchases was consistent with the dominant view that credit markets could be eased by forcing a reduction in the System’s portfolio of real bills. The preliminary memorandum prepared for the meeting talks about the deflationary effect of the large volume of member bank borrowing and compares the borrowings of banks outside principal money market cities with the amount borrowed in 1929 when the “Reserve System was exerting the maximum pressure for deflation.” Gold flows to the United States or a return of currency to banks had not occurred, so borrowing had remained high. System action would not be seen as inflationary.