A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  6. Tugwell was an economist and Moley a political scientist at Columbia University. Along with Adolf Berle, a lawyer, they were the principals of Roosevelt’s campaign “brain trust.” Moley coordinated campaign policy statements. His specialty was crime and the administration of justice, but he worked on all domestic policy issues during the campaign (Fusfeld 1956, 210–15). Tugwell was the main advocate of planning and a tax on undistributed corporate profits that the administration later tried. Berle was a student of economic concentration. He believed that corporations must serve not just stockholders but the community, a view that appears periodically in the literature critical of the modern corporation. Although he shared some of Tugwell’s views, he was more favorable to antitrust as a solution to the economy’s problem. Instead of forming cartels under government supervision, Berle favored breaking up large firms.

  A second group wanted reductions in government spending and a balanced budget. During the campaign Roosevelt had promised a balanced budget, except for emergency relief, in a campaign speech in Pittsburgh, and he had criticized Hoover repeatedly for running deficits. In the first one hundred days Congress passed the Economy Act, reducing government employees’ salaries by 15 percent and reducing veterans’ pensions. Balancing the budget remained an unrealized goal of the administration until the 1938 recession, when the goal changed. Prominent advocates of balanced budgets, as a means of restoring confidence, included many economists and businessmen. Within the administration, the leaders of this group were Henry Morgenthau, who followed William Woodin as secretary of the treasury, serving from late 1933 to 1946, and Lewis Douglas, the first budget director.

  A third group took the opposite position. This group included Marriner Eccles, Lauchlin Currie, Harold Ickes, and Harry Hopkins. Eccles and Currie, separately, developed the idea of countercyclical fiscal policy that later became identified with Keynes’s General Theory.8 Eccles, like Keynes, wanted not just spending but government investment to replace private investment during recessions. Roosevelt took this approach in 1938, but his change of view was partly, possibly mainly, a political decision about the 1938 election.

  The fourth group wanted antitrust policy to break monopolies. Adolph Berle, an early adviser, was the leading proponent for many years, but he was supported in 1938 by the staff of the antitrust division of the Justice Department led by Thurman Arnold. As part of this policy, the Temporary National Economic Committee conducted a massive study of monopolies, trusts, and business practices beginning in 1938.

  Fifth was the concerted effort to supplement NIRA codes of fair pricing by increasing the gold price and buying silver. These monetary operations to raise the price level are discussed more fully below.

  Both the Democratic and Republican platforms, prepared for the 1932 campaign, called for an international conference to consider monetary questions. Both platforms mentioned silver explicitly, in deference to political pressures from western states. Both urged reform of bank supervision and action to prevent the use of credit for speculation (Krooss 1969, 4:2692–93). Both are short on specific recommendations.

  7. Weinstein 1981 is a careful study of the macroeffects of NIRA. The act, signed by the president in June 1933, gave the administration power to regulate production in cooperation with business and labor unions. These groups adopted “codes” of conduct that had the force of law. In total, 557 codes were adopted (plus 188 supplementary codes), covering 95 percent of industry. The codes increased wages, reduced hours of work, and set “fair” prices (Arndt 1966, 42).

  8. Keynes first advocated the plan (with Hubert Henderson) during the 1929 British election. Eccles and Currie did not seem to know that Keynes’s advocacy predated their own. As Laidler (1999) shows, deficit finance had many advocates before Keynes, Currie, or Eccles.

  The depression years were the beginning of the end of the international gold standard. Increasingly, domestic concerns dominated international concerns. Roosevelt had not committed to maintaining the gold standard during the campaign or after. He had not decided to devalue, either. In retrospect, July 1933 is the turning point, the time when the administration chose domestic recovery and an end to deflation over commitment to a fixed gold price. The Federal Reserve had sterilized gold flows in the past to achieve domestic objectives, but sterilization did not alter the commitment to a fixed exchange rate. Although the Roosevelt administration attempted to stabilize exchange rates by international agreement in 1936 and again in 1944, neither agreement required the Federal Reserve to subordinate domestic to international monetary objectives.

  REOPENING THE BANKS

  Most of the banks in the country had been closed before the national banking holiday in March 1933 as a defense against further bank runs. Federal Reserve staff had considered how to restore banking services. The administration, however, had no plan for reopening banks, and no program for what would come next. It had not planned whether the United States would leave the gold standard or reopen the reserve banks and pay out gold as necessary. On March 9 the Emergency Banking Act resolved the administrative issue by authorizing the secretary of the treasury and the state banking authorities to license banks. Implementing the program proved time consuming.9

  The Federal Reserve had been indecisive and incompetent as the banking problem became a crisis. The Board now took a backseat.10 The Treasury and the new president made the policy decisions. Ogden Mills stayed on to assist the new secretary, William Woodin. The Board’s senior staff took a leading role in drafting proposals to reopen the banks in stages. It also drafted legislation that became the Emergency Banking Act, based on earlier work. George Harrison came to Washington on March 5 to work with Mills, Woodin, Senator Carter Glass, Congressman Henry Steagall, the acting comptroller, Francis Awalt, Adolph Berle, one of the Columbia professors advising Roosevelt, Treasury staff, and others. Later, Adolph Miller joined the group.

  9. Case describes procedures at New York (interviews with J. Herbert Case, CHFRS, February 26, 1954, 3–4). The New York district had 1,200 banks, of which 30 percent had problems. Leslie Rounds, a vice president, and his staff screened each bank. The directors met all day, every day, during the bank holiday to consider his recommendations. In some cases, the RFC purchased preferred stock to restore capital and permit reopening.

  10. One active participant blames Meyer for the lack of leadership. Meyer did not get along with Roosevelt and resigned in May 1933 (CHFRS, interview with Edward Smead, June 14, 1954). Smead was head of Reports and Statistics at the Board. Smead claims that Ogden Mills took control of the banks’ reopening. Awalt (1969, 361–63) also credits Mills with a leading role even though his term had ended. He reports that Meyer insisted on a stenographic record of all his conversations (and his staff’s) with Secretary Woodin. Woodin refused to speak to him or the staff. Awalt (368) attributes this behavior to concern about future embarrassment.

  The group could not reach a conclusion. Some wanted to guarantee all bank deposits. Others wanted to print currency and pay it out to all depositors. Glass shifted from favoring an end to gold payments to a proposal that they pay gold on demand without regard to the statutory reserve. The proposal to issue currency is the only mention of a readily available Bage-hotian solution to the currency drain. Harrison opposed the proposal as inflationary, and it did not get much consideration (Harrison Papers, Memo to the Files, file 2010.2, March 12, 1933).

  The discussion went on most of Sunday without reaching a conclusion. Woodin appointed a small subset to work out a plan. On Monday, this smaller group proposed to guarantee bank deposits either up to 50 percent or on a sliding scale depending on the bank’s assets, but the administration, especially the president, opposed a guarantee.11 They agreed to open the strongest banks first but could not agree on how to open the weaker banks without renewing bank runs or offering guarantees.12 Finally Roosevelt decided to make all government bonds, $21 billion, convertible into currency on demand at par. Full conversion would have doubled the money stock,
currency, and demand deposits. Mills and Harrison were aghast. Harrison regarded it as “completely destructive of government credit, such an inflation of the currency as to destroy the currency and offer no means of contraction” (ibid., 7).

  The crisis got the Federal Reserve to do what it had failed to do earlier—relax its rules governing currency issues and credit expansion. To head off the president’s proposal, Mills and Harrison proposed that the administration reopen the sound banks, reorganize those that could survive and support many of them in exchange for preferred stock held by the Reconstruction Finance Corporation (RFC), and close the rest. The Federal Reserve (1)would lend to any member bank that opened based on its sound assets and weaken the links between gold and note issue by (2) issuing Federal Reserve bank notes backed only by portfolio assets (not gold), and (3) would broaden the definition of eligible paper backing the new notes to include direct obligations of individuals and firms that borrowed from Federal Reserve banks against government securities. The president accepted the proposal, and it became part of the Emergency Banking Act (Harrison Papers, file 2010.2, March 12, 1933).13

  11. Harrison describes Adolph Miller at these meetings as “impossible . . . making long harangues—many of them quite academic and not pertinent.” Miller refused to take a position because he was there unofficially (Harrison Papers, Memo to the Files, file 2010.2, March 12, 1933, 5).

  12. Harrison proposed that individuals, corporations, and others that held government bonds be allowed to borrow currency against this collateral at Federal Reserve banks. This was a major departure from precedent, but it did not solve the larger problem of reopening banks.

  Federal Reserve banks reopened on March 10 and 11 to provide cash for payrolls and to lend on government securities. Harrison told his directors that the new law “greatly extends the powers of the Reserve banks, and adds to their responsibilities and the risks, which they may incur” (Minutes, New York Directors, March 9, 1933, 172). They could now lend more freely and greatly expand the note issue. Since the objective was to prevent reopened banks from failing, “the Federal Reserve banks become in effect guarantors of the deposits of reopened banks” (172).14

  In his first “fireside chat” to the public on March 12, the president explained the plan for reopening banks. Licensed banks in Federal Reserve cities reopened on Monday, March 13. On Tuesday, licensed banks reopened in 250 cities with clearinghouses. Reopening continued for months. The Federal Reserve banks sent the Treasury lists of banks recommended for reopening, and the Treasury licensed those it approved.15 As late as October, bankers wrote to complain about the slow pace of re-openings (Board of Governors File, box 2185, October 2, 1933).

  13. Joseph Dreibilbis gives principal credit to Walter Wyatt, the Board’s counsel, and to various ideas that “had been thought up previously.” He does not mention Harrison by name (CHFRS, Dreibilbis, March 9, 1954, 2). Awalt (1969) also credits Wyatt and Mills. Roosevelt’s refusal to consider deposit guarantees may have been motivated by unwillingness to endorse Hoover’s main proposal or by his belief that guarantees would increase risk.

  14. A liberal reopening policy meant the reserve banks would have to lend to relatively weak banks but deflation would end. A conservative policy would leave many areas without banks; the shrinkage of money and credit would pose a risk. The directors chose a liberal reopening policy but wanted to restrict the public’s access at first to 50 percent of its deposits, gradually increasing the percentage. The Treasury wanted 100 percent of the deposits available and agreed to indemnify the reserve banks against losses (Minutes, New York Directors, March 11, 1933, 179). Out of 5,938 national banks, 5,300 reopened on March 9 (Awalt 1969, 360–61, 367).

  15. Authority for the secretary to license banks continued until April 1947, and some banks continued to operate under Treasury license in the 1940s. Government intermediaries such as the Reconstruction Finance Corporation, the Home Loan Banks, Intermediate Credit Banks, and Land Banks reopened on March 13. Some states permitted all banks to open at once, so there were wide differences in availability of banking facilities in the country.

  Approximately 4,000 banks did not reopen.16 This was nearly 40 percent of the banks that closed between June 1929 and June 1933. The Midwest was hit particularly hard, losing 2,500 of the 4,000 banks. The Cleveland Federal Reserve bank sent a telegram to the Board expressing concern about “many banking institutions the present condition of which precludes their reopening with governmental support . . . or otherwise” (telegram, Decamp to Meyer, Board of Governors File, box 2158, March 11, 1933). Other reserve banks wired concern about too few or too many banks being opened.

  The president’s announcement had assured the public that only sound banks would be reopened. Recognizing that the public would not distinguish between member and nonmember banks, Congress allowed state nonmember banks to borrow from Federal Reserve banks on acceptable collateral. This power expired after one year.17

  Many of the banks that did not immediately reopen had borrowed from the Federal Reserve. Nearly nine hundred unlicensed and closed banks owed $125 million, almost 30 percent of outstanding borrowing in early April. Chicago had the largest number of such banks, 13 percent of the total, but Philadelphia, New York, and Cleveland each held about 20 percent of the now illiquid loans (Board of Governors File, box 1297, April 8, 1933).

  The April meeting of the Governors Conference considered the many problems encountered in reopening and licensing banks. A week after the meeting, a committee of governors drafted a statement reporting the unanimous opinion that “if any member bank which had been licensed to reopen, is permitted to fail, it will prove a serious shock to the confidence of the public, . . . and may well precipitate a banking crisis even more critical than the recent one” (Governors Conference, April 19, 1933, memo dated April 26, 1933).18 The governors accepted a share of the responsibility for avoiding failures, but they were concerned that their efforts would reduce the capital and surplus of the Federal Reserve banks if banks failed while in debt to the reserve banks. The governors’ subcommittee recommended that the Federal Reserve banks “adopt a liberal loan policy and be prepared to make loans on sound assets with little or no margin in cases where it is necessary to keep a bank open.” To reduce risk to the reserve banks, the subcommittee urged that the Reconstruction Finance Corporation take over loans after an agreed period (ibid., 2–3).19

  16. Data from Board of Governors of the Federal Reserve System (1943, 16) show a decline of 3,871 in the number of banks (including mutual savings banks) between December 1932 and June 1933. Friedman and Schwartz (1963, 423–27) give a detailed accounting. They report only 2,132 banks closed, suspended, or liquidated between March 15, 1933, and December 31, 1936. An additional 500 banks terminated during the bank holiday to March 15. Part of the discrepancy results from differences in the definition of a bank, but the main difference arises from the difference in dates; 1,334 banks reopened between June 1933 and December 1936.

  17. The banks had to meet reserve requirements and other Federal Reserve regulations while in debt to a reserve bank. The history of this bill gives insight into the way government functioned during the crisis. The Federal Reserve learned about the bill by chance, when one of its senior staff overheard a conversation between the budget director and a treasury undersecretary. The Board believed the legislation unnecessary because the Reconstruction Finance Corporation could make the necessary loans or could purchase preferred stock under the Emergency Banking Act. Senator Huey Long (Louisiana) wanted to admit all banks to the Federal Reserve System, so the Board proposed to amend the pending bill by making state banks meet the reserve and other requirements of member banks. The Board notified Senator Glass, however, that it continued to oppose the legislation.

  The subcommittee also suggested an alternative. The Federal Reserve could lend to the RFC, and the RFC could lend to the banks. The RFC’s debentures carried a government guarantee, so the Federal Reserve would be protected against
losses. The subcommittee wanted authorization to negotiate an agreement to this effect with the Treasury.

  The remarkable feature of the memo is that, except for the guarantee, it recalls a proposal made by Secretary Mellon in 1931. At that time President Hoover and Secretary Mellon sought a nongovernment solution to prevent bank failures. Large banks were asked to underwrite a new intermediary, the National Credit Commission, that would buy up some of the assets of failing banks. The effort failed in part because the Federal Reserve refused to accept obligations of the proposed intermediary as eligible paper if the subscribing banks faced insolvency or illiquidity. If the earlier proposal had been implemented, many of the bank failures and the resulting financial crisis could have been avoided.

  No less remarkable is that the subcommittee recommending the financial safety net had three members, George W. Norris, George Seay, and George L. Harrison, who had served throughout the decline. Norris was an especially strong proponent of real bills and an opponent of credit expansion by the Federal Reserve. It is hard to avoid the conclusion that the governors were not just chastened by their experience but were also fearful of the legislation that the new Congress and administration would support if they failed to cooperate with the recovery program.

  The proclamations and orders closing and reopening banks also changed the role of gold in the monetary system. On March 6 banks were ordered not to pay out gold or gold certificates in connection with the few transactions authorized with foreigners during the bank holiday. After March 10, reopened banks or financial institutions could not pay out gold or gold certificates without authorization by the secretary of the treasury. The Board ordered the reserve banks to compile lists of all persons who purchased gold from the reserve banks after February 1 and had not redeposited the gold in a bank before March 13 (later extended to March 27).