A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  114. Harrison called a meeting of the principal New York officers on September 13 to discuss when sales should begin. He said that the traditional indicator of the monetary situation, the rate of increase in bank credit relative to business activity, did not suggest the need for sales. Some of the officers challenged the use of that indicator, suggesting that it had misled them. Burgess defended it. “If we had acted in the light of the bank credit-business activity index in the past, we would have acted promptly enough for our purposes and in the right direction” (Harrison Papers, Meeting of the Officers’ Council, September 13, 1932, 2). Harrison expressed concern about the risk of inflation. Burgess pleaded for an expansive policy, citing “the fact that we are approaching a terrible winter from the standpoint of unemployment and widespread social distress” (3).

  115. A month later, Burgess expressed very similar views at a meeting of the New York directors. He declared that “the time has not yet come for a reversal of our System open market policy.” He then analyzed the policy of the previous year as one that had encouraged people to switch from cash or liquid assets to short-term securities. By continuing to purchase, they could now force a switch from short- to long-term securities. This would lead to the employment of men and machinery.

  Harrison and Meyer stated the prevalent arguments for and against sales at a meeting of the New York directors on December 22. Harrison rested the case for selling on two main points. In both, he treated excess reserves as a redundant surplus and ignored Burgess’s earlier argument. (1) The purchase program had accomplished the objective of stopping a “drastic deflation” but not the secondary and “unavowed objective” of stimulating business recovery. However, it was unclear whether the $700 million to $800 million of excess reserves was any more effective in stimulating recovery than $400 million. (2) The accumulation of excess reserves created a risk: “We do not have real control as contrasted with psychological control until member banks are forced to borrow at the reserve banks. If excess reserves pile up, . . . we must remember that we are relinquishing a lever of immediate control.”

  Meyer’s response emphasized political as well as economic factors. The inflationists in Congress were looking for a reason to inflate. Sales would be interpreted as deflationary and would fly in the face of predominant congressional sentiment. Also, sales would attract a gold inflow by raising interest rates. The present inflow was “embarrassing”; a further inflow generated by a deliberate policy of raising interest rates was hard to justify to foreign governments.116

  It is impossible to reconcile Meyer’s statement that sales would raise interest rates with Harrison’s treatment of excess reserves as a redundant surplus. Meyer’s comments on the level of excess reserves correctly interpret the increase as a response to expected System policy. He suggested that the variability of excess reserves was as important as the level and that the banks had failed to use the excess reserves as a basis for expansion of deposits and earning assets because of uncertainty about future Federal Reserve policy.117 The banks expected sales, and Meyer did not strongly oppose selling. He believed that if sales were to be made, the time for it would be January, when currency would return to the banks.

  116. Owen Young, a director, offered a succinct statement of a major problem. “There is deflation in the country which loses the gold and no inflation in the country which receives it” (Minutes, New York Directors, December 22, 1932, 2).

  117. Meyer’s statement is in the minutes of the directors’ meeting. At the time, Treasury bill yields had been driven almost to zero—an average of 0.085 percent for the month. “Concerning the most effective pressure of excess reserves, Governor Meyer said that if the banks knew that there is going to be a constant amount of excess reserves over a long period, the amount can be relatively small and still be more effective than a much larger but uncertain amount. To be effective, he said, the pressure of excess reserves has to enter into the calculations of people who are going to use the money over a period of time. We have not obtained the full effect of recent large excess reserves because of uncertainty as to our future policy” (Minutes, New York Directors, December 22, 1932).

  The background memo for the January 4, 1933, OMPC meeting showed that bank credit (loans and investments) was 2 to 3 percent above the July low point, but growth had stopped in October. Loans at weekly reporting banks were below the July level (table 5.24). Member bank borrowing had fallen about $600 million. Excess reserves, mainly at New York and Chicago banks, continued to increase. Most of these funds came from regional and rural banks seeking investment in the New York and Chicago markets. The memo noted also that the rise in commodity prices and industrial production during the spring and summer had reversed.118

  The OMPC members had different interpretations of excess reserves, but there was general agreement on a policy of purchases or sales to maintain the level of excess reserves no higher than $500 million, slightly less than the amount that prevailed at the time of the meeting. Seay and McDougal wanted the System to reduce excess reserves by $125 million at once, but they voted for the resolution and it passed unanimously.

  During the next few weeks New York followed the instructions almost to the letter. It sold approximately $60 million and maintained the banks’ excess reserves close to $500 million. By early February, currency drains had reduced excess reserves below the target. Burgess wanted to return to the target, but Harrison was cautious and limited purchases to $25 million. After February 8, the committee ignored the instructions. Purchases failed to offset the increase in currency, so excess reserves fell. Between mid-February and the banking “holiday” of early March, weekly purchases did not exceed $25 million. On February 16, New York reduced its acceptance rate to 0.5 percent and purchased $27 million.

  The final bank runs had started. Harrison told his directors on February 16 that the OMPC could not meet because reserve bank governors could not leave their districts. New York might have to purchase securities for its own account, offering participation to other reserve banks later. He reported increased gold withdrawals by domestic residents and foreigners. In the second half of February, Michigan, New Jersey, Missouri, Maryland, Ohio, Pennsylvania, Indiana, and Kentucky either authorized banks to close as required or declared bank holidays.119

  118. A table in the memo compared levels of excess reserves in previous deep recessions back to 1884–85. The table showed that in previous recessions excess reserves had been larger relative to requirements, that business activity lagged six to eighteen months behind the increase in excess reserves, and that there was little risk of a sudden rise in commodity prices.

  Once again, the Federal Reserve watched events take place and failed to respond as long as the level of market interest rates remained low. Once again, when market interest rates rose the System responded by discounting “freely” at a higher rate, by raising the acceptance rate at the New York bank, and by purchasing very little in the open market. Even Governor Meyer shared the dominant view. He told the Board on February 27 to follow gold standard rules: “Continued purchases of government securities at the present time would be inconsistent from a monetary standpoint . . . the New York money market should protect itself against the higher rates abroad by increased rates and not through open market purchases of governments by the Federal Reserve Banks. . . . Any reasonable amount of open market purchases at this time would prove to be ineffective and appear to be a vain attempt to prevent a readjustment of rates which is inevitable.”

  Renewed currency demand, “hoarding of gold coins in aggravated form,” weakness in the foreign exchanges, and foreign demand for gold produced almost no response.120 During February, reserve bank credit increased only $284 million, mainly by bill purchases in the last week. In the same period, currency circulation increased by almost $400 million. Table 5.25 shows some principal financial measures at the end of February and the changes from the August 1929 peak.

  Final Currency and Gold Drains

  The banki
ng crisis was not a sudden, unanticipated event. It developed over months, spreading from state to state, and when it was left unattended, spread fear throughout the country. Failure to stop the growing crisis arose at many levels. Boston and Chicago would not participate in purchases, so New York did not ask for a System policy. The Board would not insist on a Systemwide program. It watched passively while its staff prepared for a financial collapse. The political system was in transition from Hoover to Roosevelt. Without Roosevelt’s agreement, Hoover would not take responsibility for actions whose legality he suspected. Roosevelt would not accept responsibility until he was inaugurated and had authority to act. Clearinghouse banks would not issue currency substitutes, scrip or clearinghouse certificates, because they believed the crisis differed from the crises in the 1890s or 1907, when they had last issued clearinghouse certificates.121

  119. Rockoff (1993, table 2) lists the restrictions by date and state beginning in October 1932. He notes that restrictions had begun earlier. His data are from the Commercial and Financial Chronicle (1933). See also his table 3, showing the restrictions in place on Sunday, March 5, just before the national bank holiday.

  120. The only major action discussed in the minutes was purchase of Treasury securities to prevent “violent price fluctuations” when the Treasury had to borrow $350 million and refinance $650 million on March 15. Harrison urged his directors to agree to support the Treasury market during the sale if needed. One director dissented but changed his vote to make the decision unanimous (Harrison Papers, New York Executive Committee, February 27, 1933).

  Roosevelt was elected without commitment to a specific program. His advisers included people with known views, but these views covered several different policies. Roosevelt would not commit to balance the budget or maintain the gold value of the dollar during the four months between his election and inauguration on March 4, 1933. Several senators and congressmen proposed legislation to raise prices by increasing money. The proposals, if enacted, would have made devaluation a likely outcome.122 These proposals, speculation about Roosevelt’s plans and intentions, a congressional mandate requiring the RFC to publish the names of banks it assisted, and the long delay between election and inauguration heightened uncertainty, adding to the crisis.

  121. The three main arguments were that the crisis was not caused by a shortage of currency (as in the past) but by insolvent banks; that scrip would exchange at a discount against Federal Reserve notes; and that checks payable in scrip could not be transferred through Federal Reserve banks. At best such checks would be noncash items, but only if they contained the words “payable in scrip” on their face (Memorandum re: Proposed Plan for the Issuance of Secured or Unsecured Bank Scrip, Board of Governors File, box 2222, February 15, 1933). The source contains analyses of the programs used in 1890, 1893, and 1907 and for the possible use of scrip in 1907 and 1914.

  122. Eichengreen (1992, 327) cites press accounts at the time showing recognition of the threat to the dollar’s gold value. The proposals included calls for stabilizing the price level at the 1920s level and for printing greenbacks. See discussion of the Thomas amendment in chapter 6. Federal Reserve discussions did not distinguish between proposals to raise the price level and to print fiat money.

  Between February 1 and March 4, the demand for Federal Reserve notes and gold increased $1.43 billion and $320 million respectively. In the same period, foreigners moved $300 million in gold into earmarked accounts, $200 million in the week before the inauguration (Eccles 1951, 115).123 The public’s increase in note and gold holdings was about one-third of the outstanding stock at the end of December 1932, the gold loss, 6 percent of the December 1932 stock.

  These data suggest that most of the gold purchases were made by foreigners, including foreign central banks. If we attribute all or most of the currency drain to domestic demand, foreigners account for about 10 percent to 20 percent of the run on the monetary system in early 1933 and about the same percentage in the climactic two weeks from February 22 to March 8, when currency outstanding increased $1.55 billion and the gold stock fell $2.7 million (Board of Governors of the Federal Reserve System 1943,387).

  Bagehot (1962) describes the remedy for an internal and external drain as lending freely at a high rate. The Federal Reserve continued to ignore this advice. Banks therefore could not meet demands for currency and gold. In the four months between election and inauguration, the Hoover administration tried unsuccessfully both to activate the Federal Reserve and to cooperate with the incoming administration.

  Burdened by its history of crises, a lame duck administration, Federal Reserve inaction, and Roosevelt’s silence, the financial system collapsed. By inauguration day, thirty-five states had declared bank holidays, closing all banks. Closings typically were for limited periods, but some were indefinite. In the states without declared holidays, withdrawals were severely restricted; often no more than 5 percent of deposits could be withdrawn (Board of Governors File, box 2166, March 1933).

  123. These data are not entirely consistent, as is shown by the comparisons of Eccles’s and the board’s estimates of currency withdrawals. Combining the end of January data and weekly data ending March 8, official figures show a $310 million fall in the gold stock and a $41.9 billion increase in “money in circulation” (Board of Governors of the Federal Reserve System 1943, 376, 387). The latter figure includes vault cash. Gold sales are close to Eccles’s claim, so I use his numbers with Federal Reserve data for Federal Reserve notes, gold coin, and gold certificates (412). These items show a combined increase of $850 million in the month of February, suggesting that the demand for Federal Reserve notes, gold coins, and currency increased $580 million in the critical days of early March. New York reserve bank estimates show an increase of $162 million in gold coin between January 11 and March 4 and $172 million in gold certificates from February 8 to March 4 (Sproul Files, memo E. Despres to Burgess, March 18, 1933).

  Weekly data on earmarked gold are not available. Monthly data show transfers to earmarked gold in early 1933.

  The final crisis did not come suddenly. In November, Harrison and Secretary Mills discussed a likely December default on intergovernmental debt payments. Greece had defaulted earlier in the month; Britain wanted an international meeting to discuss intergovernmental debt payments and had asked to postpone its December payment. Harrison and Mills thought Roosevelt would probably not accept a private invitation to discuss problems with President Hoover. The best available course was an open letter, discussing the problems and inviting cooperation. The letter appeared on November 3, 1932. Roosevelt accepted the invitation the following day, but the meeting achieved nothing.124

  In late November, Harrison warned Mills about the beginning of flight from the dollar. Although the gold stock continued to increase, Harrison explained that Britain had stopped buying dollars and started using them to strengthen its exchange rate against the French franc. This involved selling dollars for francs in Paris and selling francs for pounds in London.

  By December the staff began informing the New York directors about the number of banks in the United States that had closed since the previous week. In mid-February Michigan joined the several states that had declared banking holidays, closing all banks. Michigan’s action closed the Detroit banks.125 To avoid loss of deposits, corporations moved their balances to New York banks, thereby draining reserves from small and medium-sized cities. New York made a feeble effort to relieve the pressure by lowering the buying rate for bills to 0.5 percent on February 16. The directors approved purchases of $20 billion to $25 billion of government securities a week during February and bought $350 million in commercial bills for the month.

  124. The campaign had been bitter, so there was not much spirit of cooperation. Mills’s discussion shows that the administration believed the election repudiated its program, so it was reluctant to act alone and uncertain about how a Democratic-controlled Congress would receive its proposals (Harrison Papers, Conversation
s with Ogden Mills, November 11, 13, 14, 1932).

  125. Awalt (1969) describes negotiations with Henry Ford before the failure of one of the large Detroit banks. Ford’s company was a large depositor, and members of the Ford family were principal stockholders in one of the banks. Ford believed the collapse was “inevitable” (354). He refused to subordinate his deposit liability in exchange for additional capital from the RFC. Instead he threatened to withdraw $7.5 million in deposits from the trust company, forcing it to close, and $25 million from one of the banks, putting it at risk. The secretary of commerce warned him that his actions would cause a run on other Michigan banks, force bank closures, and cause great distress. Ford persisted, so the governor of Michigan closed the banks before they opened on February 14, 1933. Awalt was the acting comptroller of the currency in 1932–33. He participated in meetings in Detroit with Henry Ford, Secretary Roy D. Chapin, and others.

  In mid-February, President Hoover wrote to Roosevelt to inform him about capital flight, currency drains, and the threat to the exchange rate and the gold standard. Hoover’s letter blamed the problem on agitation to tinker with the financial system, publication of RFC loans, and the like. The letter asked Roosevelt to commit to a policy based on the gold standard and a balanced budget and to reassure the public that the country would recover if the government followed sound policies. Roosevelt replied that “mere statements” would do nothing to stop the runs (Moley 1939, 141–42).126