A History of the Federal Reserve, Volume 1

by Allan H. Meltzer

  The policies failed. French industrial production had increased 9 percent in the year ending March 1936. Under the Popular Front, production fell; increased costs of production, particularly labor costs, aborted a recovery that was under way, much the same as happened in the United States under the NIRA in summer 1933. Prices rose, requiring devaluation. The agreement postponed devaluation, delaying adjustment. A floating rate would have devalued the currency to reflect the cost increase; the fixed rate forced the adjustment to come through changes in prices, output, and employment.265

  The agreement had two basic flaws. The first was failure to distinguish between real and nominal exchange rates. Fixing nominal exchange rates forced adjustment of misalignment through price changes. The discussions leading up to the agreement, and after, show no recognition of this central point. Second was the belief that international cooperation was a viable alternative to exchange rate adjustment. Exchange rates and prices were misaligned in the mid-thirties, just as at the end of the twenties. Belief in the gold standard remained strong, however. Prominent economists like Viner and Williams, who advised Morgenthau, and many businessmen and politicians believed that fixing exchange rates under some type of gold standard was evidence of adjustment and a source of stability. What better way to restore stability than to fix exchange rates?

  In retrospect, we know now that the agreement ended the major principle of the gold standard—that countries should avoid devaluation as a means of adjustment whatever the cost. If the British devaluation was the first step, the French, Dutch, and Swiss devaluations represent rejection of the principle by the last countries with strong commitments to the gold standard. After 1931–36, devaluation was no longer unthinkable.

  264. They did not fully agree on what the Tripartite Agreement required. As late as December 1937, Sproul and Siepmann exchanged views on such basic questions as the size of permissible fluctuations, responsibility for maintaining stability of the bilateral rate, and the conditions requiring gold shipments (Siepmann to Sproul, Sproul Papers, Bank of England, December 15, 1937).

  265. France is the only major country in the 1930s, and possibly the only country, that saw output fall after devaluation. This suggests the extent of misalignment in countries such as the United States, Belgium, and Britain.

  As a political measure, the agreement had greater merit. Morgenthau was eager to show the Germans and Italians that the democracies would work together toward a common goal. And Roosevelt overcame some of his suspicions about the British, so he was better prepared to cooperate in a wartime alliance.

  POLICY AND WAR PREPARATIONS, 1939–41

  The probability of a European war rose and fell in the late 1930s. The first explicit mention of preparations by the reserve banks came at the time of the Munich agreement, on September 8, 1938. The New York directors discussed their policy toward loans on government securities in the event of a war. They reached no decision, but they reopened the subject at the Conference of Reserve Bank Presidents (Presidents Conference) later that month. The main issues were the rates at which the reserve banks would lend on government securities and whether the rates would be higher for nonmember banks, individuals, and corporations. The presidents recommended making their discount rates (1 percent to 1.5 percent) the applicable rates for member banks but using a slightly higher rate for nonmember banks and others (Board Minutes, September 21, 1938, 1–2). The political problem in Europe eased, so they did not make a decision.

  By early 1939, real GNP rose above its prerecession peak, with prices slowly falling. Falling prices and economic recovery, plus the threat of a European war, increased the gold flow from $113 million in the first half of 1938 to $1.3 billion in the second half. More than $3 billion followed in 1939.266 Sterilization had ended, so the monetary base rose 23 percent in 1938 and 20 percent in 1939. Interest rates and risk premiums fell as excess reserves rose.

  At the end of 1938, excess reserves were above $3 billion, higher than in August 1936, when the System first increased reserve requirements. A year later, excess reserves were above $5 billion. The gold reserve percentage reached 83.5 percent, the highest level since World War I, but not yet a peak. Although excess reserves were again greater than the open market portfolio, the Federal Reserve remained inactive.267

  266. People shipped gold by parcel post. Many of the shipments came from France, although the sender may have lived elsewhere. The Bank of England tried to stop or slow the shipments by getting insurance companies to raise insurance rates, but the insurance business shifted to Swiss companies. In 1938 shipments averaged £1 million per month. By February 1939 shipments reached £4 million per month (telephone conversation with the Bank of England, Sproul Papers, Bank of England, March 13, 1939).

  Conflict continued between the Treasury and the Federal Reserve over whether to increase the size of the weekly Treasury bill auction. The System wanted a higher bill rate so it would not have to extend portfolio maturity. It hoped that an increased supply of bills would lower the price and raise the yield. Higher short-term rates were expected to raise long-term interest rates, permitting the System to reverse the approximately $100 million (4 percent) increase in the portion of its portfolio with five years or more to maturity.268 The Treasury opposed. Morgenthau liked the low yields on Treasury bills, so he turned down the request. To prevent a fall in long-term rates, Morgenthau sold $10 million from the Treasury trust accounts. He invited the System to participate in the sale, but it declined because markets were not disorderly. The “strength of the market was due to fundamental causes which would not be reached by the action suggested” (Minutes, Executive Committee, FOMC, March 13, 1939, 2). The fundamental causes were the government’s silver purchase policy and the gold inflow at the time of the March 1939 German occupation of western Czechoslovakia.269

  Concerns about a European war remained high. Pressed by the Treasury for a policy to prevent market disorder in the event of war, the executive committee agreed to share purchases equally with the Treasury until the Treasury had invested all of the balances in the trust accounts, approximately $100 million. After that, the System would purchase on its own up to $500 million, a 20 percent increase in its portfolio.

  Eccles made his reasoning clear. After the Treasury exhausted the trust funds, any additional Treasury purchases would come from the Exchange Stabilization Fund, “which would create in the Treasury an open market portfolio of Government securities. . . . This would be undesirable” (Minutes, Executive Committee FOMC, March 14, 1939, 2). He preferred to operate alone, after consultation with the Treasury (3).

  Harrison, cautious as usual, agreed to the proposal but asked for a commitment to sell the securities after the emergency passed: “There should be no objection . . . solely on the ground that no sales should be made before conditions warranted a change in the present easy money policy” (ibid., 3–4). The committee agreed only to keep an open mind about sales.270 The following week, the full FOMC authorized the proposed purchase policy.

  267. In March the New York bank acknowledged defeat in its efforts to establish a bill market comparable to the London market, as Strong and Warburg had planned. The directors abolished the bill department and merged bill and securities (governments) operations (Minutes, New York Directors, vol. 45, March 2, 1939, 21).

  268. The Federal Reserve did not want to take the risk of a rise in longer-term yields, but it also did not want to sacrifice income.

  269. A background memo suggested that the decline in long-term rates resulted from $390 million of purchases by New York banks. The banks wanted to increase their income, so they sold notes and bills and purchased bonds (Board of Governors File, box 1452, March 17, 1939).

  The presidents and governors again discussed discount policy in the event of a European war. Late in April, the reserve banks agreed to make loans to member and nonmember banks at the discount rate, if collateralized by government securities valued at par. The New York rate was 1 percent, with 1.5 percent at all
other banks. The Board approved the policy but agreed not to announce it until a war began.271 This changed as war approached in late August; the Board wanted to announce the policy as part of a general statement describing its powers and its willingness to serve as lender of last resort. Only the Cleveland bank objected to not waiting for the war to start. By the time the discussion finished, war had started. The Board issued the statement on September 1.

  Gold flows increased. As war approached, safety of capital and, later, payment for war materials supplemented the United States gold price as a driving force. By the end of 1940, the United States Treasury owned almost 80 percent of the world’s monetary gold (Schwartz 1982, tables SC6 and SC8). The inflow would have slowed without policy action as Treasury gold holdings approached 100 percent of the world’s monetary gold stock.

  Policy changed first. In March 1941 Congress approved “lend-lease,” under which countries allied against Germany or at war with Japan could obtain materials in the United States on loan from the United States.272

  Before lend-lease, Britain purchased supplies by selling $2.5 billion in gold and United States securities formerly held by British citizens. To appease Congress, Morgenthau insisted that they also sell direct investments in United States companies. Lend-lease substituted United States government debt for gold as payment for war material.

  270. After this discussion, the committee discussed how to maintain an orderly market in the event of a major disturbance. Committee members were aware of some dynamic effects of policy. Harrison argued against fixed, or pegged, interest rates because they would encourage market participants to “dump their holdings,” since most of them had profits. He proposed an adjustable peg, under the current market. Each day a new price would be set. He did not consider, however, why the adjustable peg would not generate the same expectations and sales by market participants. The committee agreed to the procedure (Minutes, Executive Committee, FOMC, March 14, 1939, 4–5).

  271. Only Chicago opposed; it wanted a 4 percent rate for nonmembers. Federal Reserve officials regarded these rates as low, as they were in an absolute sense. Rates on prime commercial paper and banker’s acceptances were lower still. The System had inadvertently returned to a penalty rate.

  272. The act was initially an amendment to the Neutrality Act, but hostility to foreign aid was strong in the Foreign Relations Committees, so the majority leaders introduced the bill (Blum 1965, 216–17). The act also contained a section authorizing negotiations about the postwar economy. Discussions leading to the Bretton Woods Agreements began under this title.

  Almost immediately, the gold inflow slowed. After rising at a 22 percent annual rate from the start of the European war to first quarter 1941, the base fell at a 4 percent rate for the next three quarters.273 The banking system’s excess reserves reached a peak of $6.5 billion in January 1941. By December, excess reserves had fallen to $3.4 billion.

  Criticism of Easy Money

  With the economy expanding strongly in the spring of 1939, excess reserves far larger than the (stagnant) open market portfolio, and interest rates on Treasury bills at 0.25 percent or less, the Federal Reserve began considering what it could or should do. Harrison raised the possibility of open market sales in discussions with the New York directors. The directors believed that sales were appropriate (Minutes, New York Directors, vol. 45, June 1, 1939, 94).

  Earlier, the Federal Advisory Council had asked the Board at its February meeting to reexamine the effects of “cheap money.” The Board rejected the suggestion on grounds that there had been many studies, so not much more could be learned. The council was more forceful in June. The easy money policy, in effect since 1929 (sic), they wrote, expected to stimulate business by making borrowing cheap. The policy had failed. The reasons were that low interest rates reduced saving, weakened the capital position of the banks by reducing their earnings, and made the public and Congress indifferent to the size of the government’s debt. The council urged the Board to abandon the policy of extreme easy money (Board Minutes, June 6, 1939, 6–7).

  Governor Ransom asked what the council wanted the Board to do. One member proposed open market sales and increased reserve requirements to raise interest rates: “Nothing would be more effective than the resumption of the coinage and circulation of gold and . . . no further devaluation of the dollar.” He said that the System should advocate this policy (ibid., 7). Other members agreed on the importance of higher interest rates and pointed to the British agreement to have a minimum 0.5 percent rate on Treasury bills at auctions. Several participants urged open market sales of $100 million to show that the System recognized that rates were too low.

  273. Since gold flows had been the driving force in growth of the monetary base, base growth turned negative in second quarter 1941. Despite rising government expenditure, the economy slowed in the second half of 1941. The Federal Reserve made no open market purchases. In the fourth quarter, industrial production, real GNP, and stock prices fell.

  Goldenweiser gave the Board’s view. Policy had not forced easy money. Low rates had been brought about by an active policy in 1932. Since that time the System had been passive, except for the increase in reserve requirements in 1936–37. This was “not a policy of restraint, but a preliminary precautionary action to bring the System in touch with the market” (ibid., 12–13). Low rates reflected gold flows, silver policy, and business conditions. The System could make some minor adjustments, but even if the FOMC sold its entire portfolio, excess reserves would be plentiful and would continue to increase: “The System would be deprived of its ability to do anything in the future. . . and would have no source of income with which to pay its expenses” (14).

  Goldenweiser’s defense of inaction did not convince the bankers. They differed only on the rate at which securities should be sold. Several emphasized that market participants believed long-term rates would continue to fall, so they saw little risk in buying bonds. A signal that the System disapproved of the easy money policy, or was concerned about low bank profits, would change perceptions. Some expressed concern about bank losses and possible failures if war in Europe raised rates in the United States.

  The bankers’ arguments were largely self-serving, the search for an argument to justify higher portfolio earnings. Goldenweiser’s response again showed the persistence of the Riefler-Burgess framework. The Federal Reserve could do nothing. With total member bank borrowing below $5 million and excess reserves above $4 billion and rising, the System was “disconnected” from the market.

  Both sides shared a “lending” approach. Neither suggested an aggressive policy of buying long-term bonds, corporate bonds, and other securities to change the relative prices of assets and output and encourage expansion.274 The bankers would have opposed purchases of long-term securities because, temporarily, their earnings would have declined.

  The meeting authorized reductions in the open market portfolio to maintain orderly market conditions. This action was in the direction the bankers wanted. Between June 21 and August 16, the FOMC sold $100 million. Bond yields rose by 0.1 percent. These were the first net sales in any week since March 1933.

  274. Eccles came closest to this position. He wanted the Treasury to stop the sale of long-term bonds not only to avoid capital losses at banks but to force investors to buy corporates “and thus encourage the private capital market” (memo Harrison to Rouse, Harrison Papers, file 2140.4, August 16, 1939).

  War Starts

  As Europe moved toward war at the end of August 1939, the Federal Reserve at first was alert to market disturbances, but not active. On August 25 Britain suspended gold payments, formally ending the Tripartite Agreement.275 The pound fell from $4.53 to $4.44, but the bond market opened unchanged. Harrison met with city bankers to urge them not to sell bonds. During the week to September 1, the System purchased $6.8 million as rates fell.

  Eccles reminded Harrison that they had authorization to purchase up to $500 million in the event of a disturban
ce if war started. This pledge had been made to the president, and he wanted assurance that Harrison would carry it out. Harrison was characteristically hesitant to take decisive action or to disagree with Eccles. With yields at 2.27 percent, they agreed that bonds would not fall below par, about 2.75 percent—a decline of approximately $6 per bond (Harrison Papers, file 2140.4, August 30, 1939, 5–7). On September 1 and 2, the System purchased $139 million as prices fell (System Open Market Account, Board of Governors File, box 1452, September 13, 1939).

  Bond prices continued to fall. On September 5 Harrison talked to an excited Eccles, who shifted between proposals to let the market fall and to support it on the way down. Harrison proposed buying at declining yields, pointing out that bondholders were shifting to the equity market and that corporate bonds had fallen more than governments, so governments were out of line.276

  Between August 30 and September 13, the FOMC bought $800 million, half for the Treasury accounts. Bond yields rose about 0.5 percent. The Federal Reserve continued the policy of following market prices down until, at a meeting in the Treasury on September 12, Morgenthau urged it to let prices “go down faster and with less expenditure of money.” He had to sell some new issues soon, and he wanted the market to reach bottom (Harrison Papers, file 2140.5, September 16, 1939).277