A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  236. If nothing was done, they “would get instead a transcontinental highway or $8 billion of extraordinary expenses” (Blum 1959, 405).

  237. This implied an annual rate of base growth of 4 percent. The Anderson and Rasche 1999 measure of the base increased 4.6 percent for the quarter; all of the change occurred in March. Morgenthau checked the plan with the British (under the Tripartite Agreement discussed below). The British agreed but asked why the United States did not reduce reserve requirements.

  238. On April 5, Roosevelt told the cabinet: “The situation was bad not only for the country but also for the Democratic Party, which might lose the fall election if conditions continued as they were” (Blum 1959, 418). The reaction of the stock market was probably more closely related to foreign than to domestic conditions. The Harrison Papers (file 2140.3, March 21, 1938) discuss growing concerns about a European war after Hitler annexed Austria that month.

  239. This program is cited as the first United States example of a planned increase in spending and the deficit to stimulate the economy. Some writers describe the decision as a major change in Roosevelt’s thinking about fiscal policy (see Stein 1969, 109–14). Stein does not mention the political argument for spending. Currie, who served as Roosevelt’s economic adviser during the war, does not share Stein’s view. He claimed (1971, 3) that Roosevelt understood compensatory changes in spending and taxes only in 1940. I am indebted to Roger Sandilands for a copy of Currie’s letter. Currie and others may have based their view on Roosevelt’s opposition to increased spending in the 1939 budget, but it is also true that, in the fall of 1938—possibly to placate Morgenthau—Roosevelt appointed a conservative businessman, John W. Hanes, as undersecretary of the treasury, responsible for fiscal decisions (Blum 1965, 15–16).

  240. The preliminary draft of the announcement stated: “While there were ample excess reserves to meet any probable needs . . . many people were under the impression that the Board’s action . . . increasing reserve requirements was unduly deflationary; . . . the System is in a position, in the opinion of a substantial portion of the public at least, of resisting the recovery program; and that for that reason the Board could not be motivated exclusively by the economic factors in the situation and disregard the psychological factors” (Policy Records, Board of Governors File, box 291, April 15, 1938). All this was eliminated in the final draft, which talked about a “concerted effort by the Government.” It appears, however, in the FOMC minutes for April 21 (7), which described the reduction of reserve requirements as “in the best interests of the Federal Reserve System.”

  Discussion of the effects of the 1937 reserve requirement increases was highly contentious. In February, Goldenweiser was relieved of all other duties and ordered to rewrite the annual report to make the discussion of reserve changes more appealing to the Board (Board Minutes, February 25, 1938). The FOMC rejected Williams’s report on reserve requirement changes three times.

  The Federal Reserve was reluctant to permit all the sterilized gold to increase reserves at once; the Treasury felt otherwise. The Treasury wanted to issue gold certificates in exchange for Federal Reserve deposits, then use the deposits to retire Treasury bills as they came due. This would increase excess reserves quickly, pressuring the banks to expand credit. The Federal Reserve preferred to have the Treasury use its deposits to pay for gold purchases, thereby spreading the increase in excess reserves over a longer period. On April 19 the executive committee of the FOMC agreed to present its case to Morgenthau in terms of disorderly debt markets. Reducing the stock of short-term government securities would reduce yields and could create disorderly markets. The Treasury dismissed the argument.

  The president’s announcement of the new program sparked a rally in the Treasury market. Already low yields on short-term securities fell to zero out to a maturity of eighteen months (Minutes, FOMC, April 21, 1938, 7). Desterilization and the reduction in reserve requirements appear to dominate any effect of a larger deficit; the market viewed the monetary ease as more than sufficient to absorb any additional debt resulting from the deficit or increased private spending and borrowing.

  The FOMC’s April 21–22 meeting gave most attention to the problem of replacing Treasury bills and notes with market yields at zero or below.241 With a large increase of excess reserves currently and prospectively available, yields on Treasury securities had fallen at all maturities. The FOMC’s principal concern was “disorderly markets”; rates had declined rapidly and could reverse.242 The members did not want either to criticize the administration’s program or to accept responsibility for correcting disorderly markets.

  Eccles told Morgenthau about these problems. He reported to the FOMC that Morgenthau was sympathetic but would not agree to stop retiring $50 million in Treasury bills a week. The most he offered was to reconsider the subject later. Divided and uncertain about what to do, the FOMC voted to replace maturing Treasury bills with notes out to a two-year maturity, if it could be done without paying a premium (negative yield).243

  241. Treasury bills have large denominations that make them useless in transactions. At an equal nominal rate of zero, the real yield on currency—the own or nonpecuniary yield—is the higher of the two. Also, Cecchetti (1988) shows that the negative yields were the price paid for “exchange privileges.” Certain coupon securities carried rights to purchase new issues of these securities. Adjusted for this option, rates on notes are positive but close to zero. Treasury bills did not have the exchange privilege. Bankers urged their customers to withdraw deposits and buy bills (even with very low yields) to save the cost of deposit insurance, one-twelfth of 1 percent.

  242. Yields on long-term government securities declined from 2.62 in April to 2.51 in May and June (Board of Governors of the Federal Reserve System 1943, 471).

  The following week the committee reconsidered the same issues. Harrison wanted authority to replace maturing issues with longer-term securities if useful for maintaining orderly markets and authority to purchase or sell securities to prevent disorderly markets. Eccles opposed sales as counter to the administration program. He proposed to continue replacing securities as long as yields were not negative. Harrison’s motion was defeated eight to three; Eccles’s proposal then passed unanimously.244 Unlike the situation in the 1920s, the Board had control.

  In September, long-term Treasury yields rose as the economy recovered and despite foreign buying of United States securities at the time of the Czech (Munich) crisis. The Treasury bought $37 million of notes and bonds. The Federal Reserve made smaller purchases, offset by sales of bills. Pressure from the Treasury to keep yields low lessened a bit after the Munich agreement. With Eccles absent, Harrison urged the executive committee on September 15 to let up to $700 million in bills run off without replacement if necessary. This would have reversed the April reduction in reserve requirements and offset Treasury purchases to hold rates down. The committee defeated the proposal. It voted instead to replace government bonds with Treasury bills to put the System in a position to offset monetary expansion without taking portfolio losses.245

  The December meeting reconsidered the same issue, the problem of replacing bills as they matured without paying a premium to buy bills. The FOMC asked Morgenthau to increase the size of weekly bill issues, but he preferred to encourage lower bond yields by keeping bill yields near zero. Over Eccles’s objection, the FOMC voted to let bills run off without replacement if they could not be replaced without paying a premium. A background memo prepared for the December 30 meeting showed the problem worsening. The System had to buy an increasing amount of notes to prevent a decline in its portfolio. In its announcement after the December 30–31 meeting, the FOMC noted that its portfolio might show some fluctuation solely because the System was unable to replace maturing bills. The committee assured the public that “no change in Federal Reserve policy is contemplated at this time” (Press Release, FOMC, Board of Governors File, box 1452, December 31, 1938).246

  243. Failure
to replace maturing securities reduced the open market portfolio. The System was reluctant to offset or cancel the reserves released by the reduction in reserve requirements so as not to appear in opposition to the president’s recovery program.

  244. At the May 31 meeting, the FOMC decided that meetings with the secretary of the treasury were not official FOMC meetings, so they did not have to be reported in the minutes.

  245. The September 15 meeting accepted the resignation of W. Randolph Burgess as manager of the System Open Market Account. Burgess resigned as vice president of the New York bank on September 13 to become vice chairman of National City Bank. He returned in the 1950s as treasury undersecretary in the Eisenhower administration. Allan Sproul became account manager. Appointment of a new manager led to a brief discussion of the conduct of open market operations. Harrison mused that “he had come to question whether the Committee had not gone into the market too frequently to try to moderate movements which, in some cases, were merely temporary. . . . He suggested that better results might be obtained in the future if the Committee were less responsive to minor fluctuations.” The suggestion had no visible effect. The System continued and later intensified its concern for short-term changes. Governor Ransom suggested that the System “enter the market in the early stages of a situation which might develop into a disorderly rise or fall.” He offered no suggestion about how that perennial problem could be solved (Minutes, Executive Committee, FOMC, September 15, 1938, 3).

  GOLD AND EXCHANGE RATES, 1935–40

  Gold and exchange rate policies, culminating in the 1934 devaluation, provided the main stimulus to domestic recovery in the first two years of the Roosevelt administration. The permanent increase in the gold price to $35 an ounce permitted gold holders to exchange gold for United States goods and assets on more favorable terms. As gold flowed to the United States, the principal countries remaining on the gold standard—France, Belgium, Italy, and Switzerland—came under increasing deflationary pressure.

  By 1935 advocates of stable exchange rates, to revive international trade, had become more active. In the Treasury, Jacob Viner argued that side. Harrison favored allowing the British Exchange Equalization Account to buy and sell gold directly with the Treasury to help stabilize the pound.247 These ideas appealed to Morgenthau, who wanted to build a democratic alliance against Hitler and hoped that monetary cooperation would help achieve that goal (Blum 1959, 140–41). But Morgenthau hesitated, because Roosevelt was suspicious of British intentions and believed Harrison was influenced too much by the British.

  246. In December the staff considered means of improving operations of the government securities market. The suggestions included allowing each reserve bank to deal in government securities in its own district (a return to conditions in the early 1920s), making open market operations continuous instead of intermittent, and having the manager report directly to the executive committee of the FOMC instead of to the New York reserve bank, an issue that would return many times (Board of Governors File, box 1433, December 9, 1938). The committee’s use of press releases, and its concerns about market reactions, contrasts with its traditional secrecy. The System became aware of anticipations as a strong influence on markets without explicit recognition of why these changes could be helpful.

  247. Under Treasury rules, only countries that remained on the gold standard could deal with the Treasury. This excluded Britain.

  The dollar weakened early in 1935 when the Supreme Court was about to decide the gold clause cases. United States gold clause bonds went to a premium. Harrison discussed with Morgenthau and Undersecretary T. J. Coolidge what actions the Treasury planned or had under way through the Exchange Stabilization Fund.248 He wanted the Treasury to develop a policy instead of operating from day to day. Morgenthau agreed to talk to Roosevelt, who controlled the decision (Harrison Papers, file 2012.6, February 18, 1935).

  At about this time, Morgenthau asked John H. Williams to suggest a policy. Williams proposed informal discussions with the British. Something had to be done, he believed, because United States gold and silver policies drained gold and silver from all other countries, making both standards untenable. Harrison agreed. Morgenthau relayed the conversation to the president, but Roosevelt would consider cooperation only if the British asked for help (Harrison Papers, file 2013.2, March 2, 1935).249

  With the pound continuing to weaken against the dollar and the franc, the Bank of France proposed to extend credit of $330 million (Fr 5 billion) if the British would agree to defend the pound and would state, informally, the level they intended to hold. The French asked the New York reserve bank to join in the support operation if the French government approved. Morgenthau discussed the issue with the president, who was ambivalent. The United States offered “sympathetic support” and expressed hope that the pound would not go below $4.86, the old parity (Harrison Papers, Memo J. E. Crane to Files, file 2012.6, March 6, 1935).

  The pound continued to fall, reaching $4.776 on average for March. Morgenthau did not pursue the issue of support operations. Instead, he invited some advisers on foreign exchange and domestic prices to dinner on March 5. The topic was further devaluation of the dollar against gold to raise commodity prices. Former governor Eugene Meyer was in favor, but he gave no reason.250 George Warren and Herman Oliphant favored devaluation. Oliphant wanted the president to announce a price level objective. Harrison, Williams, Viner, and undersecretary Coolidge opposed. Viner and Harrison argued that the administration’s objective should be to increase business activity and reduce unemployment. Profits, not just prices, were the key to recovery. Williams supported this position and warned against further competitive devaluations. With his council divided, Morgenthau did not pursue the idea.

  248. T. J. Coolidge served as special assistant to the secretary from March to May 1934 before he became undersecretary, where he served until February 1936. The Treasury had been selling pounds to buy French francs, while the British did the opposite, selling francs and buying pounds.

  249. Harrison urged a conversation among technical central bank experts to avoid politics. The Treasury responded that those days were gone; exchange policy was now run in the Treasury (Harrison Papers, file 2013.2, March 2, 1935, 5).

  250. Eccles was governor at the time but was not present. Meyer was no longer in the System. J. E. Crane was a deputy governor of the New York reserve bank concerned with foreign exchange operations. He was present at the dinner and summarized the discussion in a memo to Harrison, who was present also. Herman Oliphant was the Treasury counsel at the time and one of Morgenthau’s principal advisers.

  The next move, again, came from France. Still wanting to stay on the gold standard, and willing to deflate as necessary, the Bank of France requested permission to sell gold to the United States.251 Morgenthau agreed to buy up to $150 million on May 31 and to release the dollars for immediate use in New York or Paris (Harrison Papers, file 2012.5, June 3, 1935). This support helped to convince the French government that the United States would cooperate.

  Conversations with the British and the French continued sporadically throughout 1935. Roosevelt, who did not trust the British, was particularly wary of Neville Chamberlain, then chancellor of the exchequer. He blamed Chamberlain for the system of empire preference that gave British exports an advantage in British colonies. And he blamed the British for the failure of the London Monetary and Economic Conference. They blamed him (Blum 1959, 141). Despite these antipathies, Morgenthau remained eager to engage the British and the French in stabilization measures as a means of strengthening democratic governments against Hitler. He believed that exchange rate stability would improve prospects for expansion in all three countries. By 1936 the United States economy was expanding rapidly, attracting gold from the rest of the world; faster expansion abroad would slow the inflow.252

  Late in April 1936 Poland, one of the remaining members of the gold bloc, imposed exchange controls and embargoed gold, effectively leaving the gold stan
dard. The pound fell slightly. Morgenthau used the opportunity to convince Roosevelt to permit him to begin conversations with the British about stabilization. Since the president’s authority to devalue had expired at the end of January, the United States was less able to threaten independent action. The British eventually replied to his overture, and to Morgenthau’s insistence on greater transparency in their actions, by stat

  251. One reason for pressure on the franc-gold price was the continued gold drain to the United States. The more immediate cause was the crumbling of the Latin Monetary Union, the last gold bloc. Belgium devalued in April. Italy, the Netherlands, and Switzerland did not devalue until the following year, 1936, but Italy adopted extensive exchange controls, contrary to gold standard rules.

  252. Contemporary Federal Reserve explanations of the inflow gave primary responsibility to relatively strong United States expansion and uncertainty about devaluation by the gold bloc countries. It did not mention the $35 gold price (memo, Despres to Sproul, Sproul Papers, December 5, 1935).