Harrison supported the recommendation and argued against a proposal to sell $150 million provided excess reserves did not fall below $250 million. No strong support for sales developed, so the committee postponed discussion of sales until the next meeting, scheduled for January 1933.
104. The bank’s head was General Charles G. Dawes, author of the Dawes Plan for German reparations and vice president of the United States in the Coolidge administration. Dawes was a prominent citizen who received the Nobel Peace Prize for his work on German reparations. But Dawes had been administrative head of the RFC until June 1932. A few days after leaving the RFC, the RFC made its largest loan to Dawes’s bank. To embarrass Hoover and Dawes, the Democrats in Congress forced the RFC to publish the names of banks that received assistance to show that Dawes’s bank received the largest loan up to that time. Publication of names weakened the listed banks and made banks reluctant to apply for RFC assistance.
105. Hoover had asked Congress to appropriate $500 million and permit the RFC to borrow an additional $3 billion. Congress set initial borrowing authority at $1.5 billion. After the Chicago failures, on July 21, 1932, it increased borrowing authority to $3.3 billion. In March 1933, Congress increased the RFC’s powers and permitted it to acquire preferred stock in weak or failing banks.
In the last two weeks of July and the first weeks of August the System made its maximum authorized purchase ($15 million) when discounts increased and its minimum required purchase ($5 million) when discounts fell. After mid-August, the requirement to purchase expired. Since member bank discounts were near the level of the previous autumn and continued to decline, the Riefler-Burgess framework suggested that the market had returned to the “degree of ease” prevailing before Britain left the gold standard. After mid-August, the acceptance portfolio remained unchanged. The System did not undertake any additional purchases even though the executive committee had not yet made all the purchases authorized in May. Short-term open market rates remained below the levels of summer 1931. On the Riefler-Burgess interpretation, there was no reason to purchase.
Riefler-Burgess reasoning was not the only motivation for ending purchases. As is often the case in committee decisions, no single argument appealed to all the members. That the program did not trigger a rapid expansion in bank credit, however, strengthened the opponents and weakened the supporters. Governor Young of Boston had opposed the program from the start, and Norris of Philadelphia had voted for the program without any belief that it would succeed. Boston and Chicago refused to participate in further purchases. Although Harrison recognized that purchases had offset a gold outflow, permitted member banks to repay borrowing, and greatly reduced the rate of decline in bank credit, the demand for credit had not increased. Foreign governments had sold their United States securities and taken gold. Continued purchases would have a more expansive effect. Harrison told his directors that he was willing to continue purchasing provided that other banks, particularly Boston and Chicago, participated and that the RFC liberalized its operations so as to stop further bank closings (Minutes, New York Directors, July 7, 1932). Since Harrison knew neither condition would be met, his proposal seems disingenuous, more an effort to placate some of his directors than a program for open market purchases.
Harrison wanted to protect New York’s gold reserve. The New York bank had taken 55 percent of the System’s purchases between April 13 and July 13, slightly more than twice its standard allotment. Boston, Richmond, Kansas City, and Dallas had taken much less than their standard allotment. One result was that New York had the second smallest gold reserve ratio in the System even after selling securities worth more than $164 million to other reserve banks for gold. Table 5.23 shows these data.
On July 9 McDougal wrote to Harrison to explain his bank’s decision not to purchase. He noted that between February and June, Chicago and New York had taken a much larger share of the securities than required by the allotment formula. This was particularly difficult for the Chicago bank, which had an “abnormally large amount of circulation . . . over 25 percent of the entire [currency] circulation of all the Reserve banks.”106 McDougal then expressed concern about the integrity of the note issue and the dangers that might arise because of reliance on the provisions of the Glass-Steagall Act permitting the reserve banks to use government securities as collateral.
The Chicago bank had faced an increased demand for currency after the Chicago bank failures. The failures may have convinced a skeptical and reluctant McDougal to stop participating in the purchase program. Harrison told his directors on July 25 that McDougal feared the newly issued currency would later return to the banks, producing excess reserves that would flow to New York. Chicago would have to settle the balance with New York in gold. McDougal did not want to further reduce Chicago’s gold reserve by increasing currency (Harrison Papers, Memoranda, New York Executive Committee, July 25, 1932).
106. Letter dated July 9, 1932, from McDougal to Harrison. McDougal supported his argument with data showing that in the Chicago district, member bank reserves were only about one-third of the note issue, whereas in New York, member bank reserves were more than 1.4 times currency outstanding. The implicit point was that his bank was more vulnerable because the demand for currency was much greater in his district. In fact, Chicago also had a much higher ratio of gold to monetary liabilities than New York. The Glass-Steagall Act had removed the requirement that currency had to be backed by real bills and gold, but as noted in the text, McDougal did not want to use government securities as backing for the note issue. Epstein and Ferguson (1984) argue that commercial banks wanted purchases to end because lower interest rates reduced their profits. Coelho and Santoni (1991) dispute this claim by showing that Federal Reserve purchases did not contribute to lower bank profits.
Concern at the New York and Chicago banks about their gold reserves represents another failure of the Federal Reserve Act. Chicago acted as banks had acted before the act. The Federal Reserve Board did not force banks to pool their reserves, as the act intended. Knowing that it could not rely on support from other banks, New York also acted to protect its gold reserve by first limiting, then ending, open market purchases.
By late June, Harrison’s interest in purchases had become conditional on actions by Chicago and Boston and more aggressive efforts by the RFC. On July 11 he reported to his directors on his conversation with Meyer.107 Meyer agreed that the RFC had been “defensive” but made no commitment about future policies. Meyer wanted the System to continue the purchase program: “If for no other reason, it is politically impossible to stop at this particular time. . . . If the program were terminated just as Congress adjourned, we would be crucified next winter.”108
A decline in excess reserves early in July proved to be temporary. By late July, excess reserves were again above $250 million. With the rise in excess reserves, Harrison’s interest in the purchase program disappeared. He told the executive committee of his directors that the “need for further purchases is subsiding.” Purchases ended in early August.
The rise in excess reserves reflected the return flow of gold during July, a flow that continued throughout the fall. After August, excess reserves generally remained above $400 million, member bank borrowing was less than excess reserves, and short-term interest rates remained below the discount rate and in the range traditionally regarded as “low.”
Results of the Purchase Program
In the year following the British decision to suspend gold payments—from September 1931 through August 1932—the System’s balance sheet showed the following changes:
107. Eugene Meyer, governor of the Federal Reserve Board, served ex officio as first director of the Reconstruction Finance Corporation until July 1932, when he asked to be replaced at the RFC for health reasons. This is one of several examples of a Federal Reserve governor or (later) chairman taking an active role in economic policy. Federal Reserve directors also served on regional branches of the RFC (Todd 1994, 16).
108. Congress had considered, but not passed, legislation to reflate, principally the Goldsborough bill mandating a return to the 1920s average price level. The Federal Reserve opposed it, as it had opposed similar efforts by Congressmen T. Alan Goldsborough and James A. Strong to stabilize the price level in the 1920s. Congress approved issuance of $500 million in Federal Reserve banknotes (greenbacks) at the discretion of the president.
Expressed in terms of a change in the monetary base, the data show that the monetary base increased approximately $400 million. The sources of the increase were the excess of security purchases over the gold outflow ($213 million) and the change in “other,” mainly a decline in deposits of nonmember banks at Federal Reserve banks.
Chart 5.1 shows that the gold outflow followed open market purchases after a brief lag. This was the classical reaction, substitution of domestic assets for gold on the central bank’s balance sheet. Substitution was incomplete, however. During March, gold flows were small and positive. From March 30 to early July, the period of large-scale open market purchases, gold losses were more than half the size of open market purchases. The gold flow reversed before purchases ended. By mid-January 1933, the Federal Reserve’s gold holdings had returned to the level reached before the British devaluation.
Gold losses did not force an end to the purchases program. The System’s gold reserve ratio did not fall below 56 percent, well above the minimum requirement. To a limited extent, individual reserve banks transferred security holdings to others to meet the gold reserve requirement.
Reductions in discounts and advances were the other main offset to purchases. These also remained far below the volume of open market purchases. During the peak purchase period, from March to July, member bank discounts declined $133 million, 14 percent of open market purchases. Together gold and discounts offset 64 percent of purchases. With discounts reduced and many foreign balances withdrawn, the offset would have fallen had purchases continued. Economic recovery would have reversed the gold flow and the reduction in member bank borrowing.
As these comparisons suggest, seasonally adjusted data show that the stock of money—currency and demand deposits—increased during the summer and fall (Friedman and Schwartz 1963, table A-1). Output responded to the increase in money. After falling to 47 in July, the seasonally adjusted index of industrial production (August 1929 = 100) rose to 53 in October, an increase of more than 12 percent.109 It seems likely that had purchases continued, the collapse of the monetary system during the winter of 1933 might have been avoided.110
109. The index went from a 20 to 30 percent annualized rate of decline in the winter and spring to a 50 percent annualized rate of increase from July to October. Growth stopped in November, and decline resumed in December.
The Federal Reserve recognized the improvement at the time. At the August 11 meeting of the New York directors, Meyer described the rise in commodity and security prices as the best in nearly three years. He then dismissed “those who think things are going too fast; they are not going fast enough.” Meyer saw a continued rise in commodity prices as the chief hope for banks and the economy.111
The Federal Reserve’s purchase program was not the only factor working toward improvement in the financial system and the economy. From the date of its inception, January 22, 1932, to the end of August, the Reconstruction Finance Corporation authorized loans of $784 million to more than 4,000 banks as compared with only $155 million lent to 575 banks by the National Credit Corporation in the three months ending January 1932. Under the impact of monetary expansion and RFC lending, the bank failure rate declined markedly. The improvement was so great that by October 1932, repayments to RFC exceeded new loans. The improvement did not last, however. In December the number and deposits of suspended banks rose once again.112
110. A memo prepared for the July 14 meeting of the OMPC compared the current recession with previous deep recessions. Previous deep declines in industrial activity, 1873–78, 1892–94, 1920–21, and 1923–24, measured 24 to 34 percent from peak to trough. The current decline was 56 percent from June 1929 to June 1932. Payrolls had fallen by more than two-thirds in several durable goods industries, where employment had fallen by 50 percent or more. Unemployment had increased to 10 million, a rise of 3 to 4 million in a year. The memo mentions the threat of social disturbance and radical legislation. It also recognizes some signs of improvement—the nearly complete withdrawal of foreign short-term balances, an end to domestic gold hoarding, passage of tax increases to balance the budget (sic), and expanded powers for the RFC. Banks had stopped reducing credit, “since the Reserve System began its policy of vigorous purchases of government securities” (Open Market, Board of Governors File, box 1452, July 14, 1932). The OMPC did not use this analysis as a reason for continuing purchases.
111. The index of common stock prices (base 100 in 1935–39) confirms Meyer’s statement. The low point of the index is 35.9 in June 1932. By August the index reached 56.3, more than 50 percent above its low point. The performance of the index of railroad stocks is even more dramatic. After reaching a low of 37.5 in June, the index rose to 91.5 in September. None of the common stock indexes ever returned to the June 1932 low point. Bond yields also reversed direction. Moody’s corporate bond yields reached 8.01 in June, then declined to 6.45 in August and 6.08 in September. Yields on lower-quality Baa bonds declined more than one-third, from 11.63 in May to 7.61 in September, in part a result of Reconstruction Finance Corporation activities.
At the July 1932 meeting, a majority of the reserve banks were in favor of continuing the purchase program on a limited scale. Only one governor, George Seay of Richmond, joined Young and McDougal in opposing purchases.113 It seems likely that if Harrison had urged continued expansion, he would have had the support of the smaller banks and the Board. Harrison failed to continue the program, ostensibly because he did not have the support of two banks that had taken less than 20 percent of the previous purchases. To protect New York’s reserve, he did precisely what Bagehot had warned central bankers to avoid.
THE FINAL COLLAPSE
The standard seasonal pattern called for an increase in reserves to prevent a seasonal increase in interest rates. With little upward pressure on interest rates and declines in November and December, the System was inactive throughout the fall. The main discussion was the timing of sales.
Gold continued to flow in, adding to excess reserves. The System remained passive despite a resumption of banking failures, the beginning of state or area bank closures, and the renewed gold outflow during the winter. Despite requests for assistance from President Hoover, it remained almost passive as the financial system collapsed, stirring itself only at the very last moment.
112. In the four months through January 1932, deposits of suspended banks exceeded $1 billion. In the remaining eleven months of 1932 deposits of suspended banks declined to just under $500 million. See Federal Reserve Bulletin, December 1933, 664.
113. The vote differs from Harrison’s report to the executive committee of his directors (July 9) that the majority of the executive committee of the OMPC would like to stop purchases but that they were not able to do so without a vote of the full committee. At the time, he described McDougal and Young as opposed to further purchases and Norris (Philadelphia) as “lukewarm.” The other members of the committee were Fancher (Cleveland) and Harrison. Philadelphia voted with the majority in mid-July.
Open Market Policy Discussions
Once the purchase program ended in August, Harrison showed no interest in a new program. Burgess spoke in favor of continuing the purchase program in early August, but Harrison preferred to rely on the gold inflow to maintain excess reserves and talked about the prospects for reducing System holdings of government securities by allowing Treasury bills to run off. In September and October, Burgess proposed additional purchases; Harrison discussed the appropriate time for sales.114 Governor Norris expressed the view of many when he told the New York directors on September 1
3, “The only question to be decided is when and how we shall reduce our portfolio.” Harrison agreed that securities should be sold but was uncertain about the appropriate timing. He was concerned that “too large an amount of excess reserves would mean that the credit situation might get out of control” (Harrison Papers, Meeting of the Officers’ Council, September 13, 1932). His discussion presages the deflationary policy action later in the decade, when the System raised reserve requirements.
Burgess responded, opposed sales, and argued for additional purchases. The Federal Reserve should “keep on all possible upward pressure in order to stimulate business improvement.” There was “plenty of time for us to turn around” because there would be no sudden upsurge that would restore employment and output. He thought recovery would take months and perhaps years, so he favored continued purchases.115 Governor Norris was present at the New York meeting and expressed the dominant opinion. He could not “see that it would be worthwhile to burden the city banks much longer with large accumulations of excess reserves.”
The November meeting of the Open Market Policy Conference considered a proposal to sell up to $150 million of securities provided that excess reserves remained above $250 million. There was general agreement that the recent election, the choice of a new Congress, and other uncertainties made it appropriate to delay sales. The OMPC voted to reopen the question during the first week of January after defeating a motion by Governor Seay, supported by McDougal, to reconvene in December. The only action was to ask Congress to extend the Glass-Steagall provisions for a second year.
A History of the Federal Reserve, Volume 1 Page 54
