A History of Money and Banking in the United States: The Colonial Era to World War II

by Murray N. Rothbard

  The Chicago Fed, however, balked at lowering its rates, and Strong got the Federal Reserve Board in Washington to force it to do so in September. The isolationist Chicago Tribune angrily called for Strong’s resignation, charging correctly that discount rates were being lowered in the interests of Great Britain.88

  After generating the burst of inflation in 1927, the New York Fed continued, over the next two years, to do its best: buying heavily in prime commercial bills of foreign countries, bills endorsed by foreign central banks. The purpose was to bolster foreign currencies, and to prevent an inflow of gold into the U.S. The New York Fed also bought large amounts of sterling bills in 1927 and 1929. It frankly described its policy as follows:

  We sought to support exchange by our purchases and thereby not only prevent the withdrawal of further amounts of gold from Europe but also, by improving the position of the foreign exchanges, to enhance or stabilize Europe’s power to buy our exports.89

  If Strong was the point man for the monetary inflation of the late 1920s, the Coolidge administration was not far behind. Pittsburgh multimillionaire Andrew W. Mellon, secretary of the Treasury throughout the Republican era of the 1920s, was long closely allied with the Morgan interests. As early as March 1927, Mellon assured everyone that “an abundant supply of easy money” would continue to be available, and he and President Coolidge repeatedly acted as the “capeadores of Wall Street,” giving numerous newspaper interviews urging stock prices upward whenever prices seemed to flag. And in January 1928, the Treasury announced that it would refund a 4.5-percent Liberty Bond issue, falling due in September, in 3.5-percent notes. Within the administration, Mellon was consistently Strong’s staunchest supporter. The only sharp critic of Strong’s inflationism within the administration was Secretary of Commerce Herbert C. Hoover, only to be met by Mellon’s denouncing Hoover’s “alarmism” and interference.90

  The motivation for Benjamin Strong’s expansionary policy of the late 1920s was neatly summed up in a letter by one of his top aides to one of Montagu Norman’s top henchmen, Sir Arthur Salter, then director of Economic and Financial Organization for the League of Nations. The aide noted that Strong, in the spring of 1928, “said that very few people indeed realized that we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis.”91 Similarly, a prominent banker admitted to H. Parker Willis in the autumn of 1926 that bad consequences would follow America’s cheap-money policy, but that “that cannot be helped. It is the price we must pay for helping Europe.” Of course, the price paid by Strong and his allies was not so “onerous,” at least in the short run, when we note, as Dr. Clark pointed out, that the cheap credit aided especially those speculative, financial, and investment banking interests with whom Strong was allied—notably, of course, the Norman complex.92 The British, as early as mid-1926, knew enough to be appreciative. Thus, the influential London journal, The Banker, wrote of Strong that “no better friend of England” existed. The Banker praised the “energy and skillfulness that he has given to the service of England,” and exulted that “his name should be associated with that of Mr. [Walter Hines] Page as a friend of England in her greatest need.”93

  On the other hand, Morgan partner Russell C. Leffingwell was not nearly as sanguine about the Strong-Norman policy of joint credit expansion. When, in the spring of 1929, Leffingwell heard reports that Monty was getting “panicky” about the speculative boom in Wall Street, he impatiently told fellow Morgan partner Thomas W. Lamont, “Monty and Ben sowed the wind. I expect we shall all have to reap the whirlwind.... I think we are going to have a world credit crisis.”94

  Unfortunately, Benjamin Strong was not destined personally to reap the whirlwind. A sickly man, Strong in effect was not running the Fed throughout 1928, finally dying on October 16 of that year. He was succeeded by his handpicked choice, George L. Harrison, also a Morgan man but lacking the personal and political clout of Benjamin Strong.

  At first, as in 1924, Strong’s monetary inflation was temporarily successful in accomplishing Britain’s goals. Sterling was strengthened, and the American gold inflow from Britain was sharply reversed, gold flowing outward. Farm produce prices, which had risen from an index of 100 in 1924 to 110 the following year, and had then slumped back to 100 in 1926 and 99 in 1927, now jumped up to 106 the following year. Farm and food exports spurted upward, and foreign loans in the United States were stimulated to new heights, reaching a peak in mid-1928. But, once again, the stimulus was only temporary. By the summer of 1928, the pound sterling was sagging again. American farm prices fell slightly in 1929, and agricultural exports fell in the same year. Foreign lending slumped badly, as both domestic and foreign funds poured into the booming American stock market.

  The stock market had already been booming by the time of the fatal injection of credit expansion in the latter half of 1927. The Standard and Poor’s industrial common stock index, which had been 44.4 at the beginning of the 1920s boom in June 1921, had more than doubled to 103.4 by June 1927. Standard and Poor’s rail stocks had risen from 156.0 in June 1921 to 316.2 in 1927, and public utilities from 66.6 to 135.1 in the same period. Dow Jones industrials had doubled from 95.1 in November 1922 to 195.4 in November 1927. But now, the massive Fed credit expansion in late 1927 ignited the stock market fire. In particular, throughout the 1920s, the Fed deliberately and unwisely stimulated the stock market by keeping the “call rate,” that is, the interest rate on bank call loans to the stock market, artificially low. Before the establishment of the Federal Reserve System, the call rate frequently had risen far above 100 percent, when a stock market boom became severe; yet in the historic and virtually runaway stock market boom of 1928–29, the call rate never went above 10 percent. The call rates were controlled at these low levels by the New York Fed, in close collaboration with, and at the advice of, the Money Committee of the New York Stock Exchange.95 The stock market, during 1928 and 1929, went into overdrive, virtually doubling these two years. The Dow went up to 376.2 on August 29, 1929, and Standard and Poor’s industrials rose to 195.2, rails to 446.0, and public utilities to 375.1 in September. Credit expansion always concentrates its booms in titles to capital, in particular stocks and real estate, and in the late 1920s, bank credit propelled a massive real estate boom in New York City, in Florida, and throughout the country. These included excessive mortgage loans and construction from farms to Manhattan office buildings.96

  The Federal Reserve authorities, now concerned about the stock market boom, tried feebly to tighten the money supply during 1928, but they failed badly. The Fed’s sales of government securities were offset by two factors: (a) the banks shifting their depositors from demand deposits to “time” deposits, which required a much lower rate of reserves, and which were really savings deposits redeemable de facto on demand, rather than genuine time loans, and (b) more important, the fruit of the disastrous Fed policy of virtually creating a market in bankers’ acceptances, a market which had existed in Europe but not in the United States. The Fed’s policy throughout the 1920s was to subsidize and in effect create an acceptance market by standing ready to buy any and all acceptances sold by certain favored acceptance houses at an artificially cheap rate. Hence, when bank reserves tightened as the Fed sold securities in 1928, the banks simply shifted to the acceptance market, expanding their reserves by selling acceptances to the Fed. Thus, the Fed’s selling of $390 million of securities was partially offset, during latter 1928, by its purchase of nearly $330 million of acceptances.97 The Fed’s sticking to this inflationary policy in 1928 was now made easier by adopting the fallacious “qualitativist” view, held as we have seen also by Herbert Hoover, that the Fed could dampen down the boom by restricting loans to the stock market while merrily continuing to inflate in the acceptance market.

  In addition to pouring in funds through acceptances, the Fed did nothing to tighten its rediscount market. The Fed discounted $450 million of bank bil
ls during the first half of 1928; it finally tightened a bit by raising its rediscount rates from 3.5 percent at the beginning of the year to 5 percent in July. After that, it stubbornly refused to raise the rediscount rate any further, keeping it there until the end of the boom. As a result, Fed discounts to banks rose slightly until the end of the boom instead of declining. Furthermore, the Fed failed to sell any more of its hoard of $200 million of government securities after July 1928; instead, it bought some securities on balance during the rest of the year.

  Why was Fed policy so supine in late 1928 and in 1929? A crucial reason was that Europe, and particularly England, having lost the benefit of the inflationary impetus by mid-1928, was clamoring against any tighter money in the U.S. The easing in late 1928 prevented gold inflows from the U.S. from getting very large. Britain was again losing gold; sterling was again weak; and the United States once again bowed to its wish to see Europe avoid the consequences of its own inflationary policies.

  Leading the inflationary drive within the administration were President Coolidge and Treasury Secretary Mellon, eagerly playing their roles as the capeadores of the bull market on Wall Street. Thus, when the stock market boom began to flag, as early as January 1927, Mellon urged it onward. Another relaxing of stock prices in March spurred Mellon to call for and predict lower interest rates; again, a weakening of stock prices in late March induced Mellon to make his statement assuring “an abundant supply of easy money which should take care of any contingencies that might arise.” Later in the year, President Coolidge made optimistic statements every time the rising stock market fell slightly. Repeatedly, both Coolidge and Mellon announced that the country was in a “new era” of permanent prosperity and permanently rising stock prices. On November 16, the New York Times declared that the administration in Washington was the source of most of the bullish news and noted the growing “impression that Washington may be depended upon to furnish a fresh impetus for the stock market.” The administration continued these bullish statements for the next two years. A few days before leaving office in March 1929, Coolidge called American prosperity “absolutely sound” and assured everyone that stocks were “cheap at current prices.”98, 99

  The clamor from England against any tighter money in the U.S. was driven by England’s loss of gold and the pressure on sterling. France, having unwillingly piled up $450 million in sterling by the end of June 1928, was anxious to redeem sterling for gold, and indeed sold $150 million of sterling by mid-1929. In deference to Norman’s threats and pleas, however, the Bank of France sold that sterling for dollars rather than for gold in London. Indeed, so cowed were the French that (a) French sales of sterling in 1929–31 were offset by sterling purchases by a number of minor countries, and (b) Norman managed to persuade the Bank of France to sell no more sterling until after the disastrous day in September 1931 when Britain abandoned its own gold-exchange standard and went on to a fiat pound standard.100

  Meanwhile, despite the great inflation of money and credit in the U.S., the massive increase in the supply of goods in the U.S. continued to lower prices gradually, wholesale prices falling from 104.5 (1926=100) in November 1925 to 100 in 1926, and then to 95.2 in June 1929. Consumer price indices in the U.S. also fell gradually in the late 1920s. Thus, despite Strong’s loose money policies, Norman could not count on price inflation in the U.S. to bail out his gold-exchange system. Montagu Norman, in addition to pleading with the U.S. to keep inflating, resorted to dubious short-run devices to try to keep gold from flowing out to the U.S. Thus, in 1928 and 1929, he would sell gold for sterling to raise the sterling rate a bit, in sales timed to coincide with the departure of fast boats from London to New York, thus inducing gold holders to keep the precious metal in London. Such short-run tricks were hardly adequate substitutes for tight money or for raising bank rate in England, and weakened long-run confidence in the pound sterling.101

  In March 1929, Herbert Clark Hoover, who had been a powerful secretary of commerce during the Republican administrations of the 1920s, became president of the United States. While not as intimately connected as Calvin Coolidge, Hoover long had been close to the Morgan interests. Mellon continued as secretary of the Treasury, with the post of secretary of state going to the longtime top Wall Street lawyer in the Morgan ambit, Henry L. Stimson, disciple and partner of J.P. Morgan’s personal attorney, Elihu Root.102 Perhaps most important, Hoover’s closest, but unofficial adviser, whom he regularly consulted three times a week, was Morgan partner Dwight Morrow.103

  Hoover’s method of dealing with the inflationary boom was to try not to tighten the money supply, but to keep bank loans out of the stock market by a jawbone method then called “moral suasion.” This too was the preferred policy of the new governor of the Federal Reserve Board in Washington, Roy A. Young. The fallacy was to try to restrict credit to the stock market while keeping it abundant to “legitimate” commerce and industry. Using methods of intimidation of business honed when he was secretary of commerce, Hoover attempted to restrain stock loans by New York banks, tried to induce the president of the New York Stock Exchange to curb speculation, and warned leading editors and publishers about the dangers of high stock prices. None of these superficial methods could be effective.

  Professor Beckhart added another reason for the adoption of the ineffective policy of moral suasion: that the administration had been persuaded to try this tack by the old manipulator, Montagu Norman. Finally, by June 1929, the moral suasion was at last abandoned, but discount rates were still not raised, so that the stock market boom continued to rage, even as the economy in general was quietly but inexorably turning downward. Secretary Mellon once again trumpeted our “unbroken and unbreakable prosperity.” In August, the Federal Reserve Board finally agreed to raise the rediscount rate to 6 percent, but any tightening effect was more than offset by the Fed’s simultaneously lowering its acceptance rate, thereby once again giving an inflationary fillip to the acceptance market. One reason for this resumption of acceptance inflation, after it had been previously reversed in March, was, yet again, “another visit of Governor Norman.”104 Thus, once more, the cloven hoof of Montagu Norman was able to give its final impetus to the boom of the 1920s. Great Britain was also entering upon a depression, and yet its inflationary policies resulted in a serious outflow of gold in June and July. Norman was able to get a line of credit of $250 million from a New York banking consortium, but the outflow continued through September, much of it to the United States. Continuing to help England, the New York Fed bought heavily in sterling bills from August through October. The new subsidization of the acceptance market, mostly foreign acceptances, permitted further aid to Britain through the purchase of sterling bills.

  A perceptive epitaph on the qualitative-credit politics of 1928–29 was pronounced by A. Wilfred May:

  Once the credit system had become infected with cheap money, it was impossible to cut down particular outlets of this credit without cutting down all credit, because it is impossible to keep different kinds of money separated in water-tight compartments. It was impossible to make money scarce for stock-market purposes, while simultaneously keeping it cheap for commercial use.... When Reserve credit was created, there was no possible way that its employment could be directed into specific uses, once it had flowed through the commercial banks into the general credit stream.105

  DEPRESSION AND THE END OF THE GOLD-STERLING-EXCHANGE STANDARD: 1929–1931

  The depression, or what nowadays would be called the “recession,” that struck the world economy in 1929 could have been met in the same way the U.S., Britain, and other countries had faced the previous severe contraction of 1920–21, and the way in which all countries met recessions under the classical gold standard. In short: they could have recognized the folly of the preceding inflationary boom and accepted the recession mechanism needed to return to an efficient free-market economy. In other words, they could have accepted the liquidation of unsound investments and the liquidation of egregiously un
sound banks, and have accepted the contractionary deflation of money, credit, and prices. If they had done so, they would, as in the previous cases, have encountered a recession-adjustment period that would have been sharp, severe, but mercifully short. Recessions unhampered by government almost invariably work themselves into recovery within a year or 18 months.

  But the United States, Britain, and the rest of the world had been permanently seduced by the siren song of cheap money. If inflationary bank credit expansion had gotten the world into this mess, then more, more of the same would be the only way out. Pursuit of this inflationist, “proto-Keynesian” folly, along with other massive government interventions to prevent price deflation, managed to convert what would have been a short, sharp recession into a chronic, permanent, stagnation with an unprecedented high unemployment that only ended with World War II.

  Great Britain tried to inflate its way out of the recession, as did the United States, despite the monetarist myth that the Federal Reserve deliberately contracted the money supply from 1929 to 1933. The Fed inflated partly to help Britain and partly for its own sake. During the week of the great stock market crash—the final week of October 1929—the Federal Reserve, specifically George Harrison, doubled its holding of government securities, and discounted $200 million for member banks. During that one week, the Fed added $300 million to bank reserves, the expansion being generated to prevent stock market liquidation and to permit the New York City banks to take over brokers’ loans being liquidated by nonbank lenders. Over the objections of Roy Young of the Federal Reserve Board, Harrison told the New York Stock Exchange that “I am ready to provide all the reserve funds that may be needed.”106 By December, Secretary Mellon issued one of his traditionally optimistic pronouncements that there was “plenty of credit available,” and President Hoover, addressing a business conference on December 5, hailed the nation’s good fortune in possessing the splendid Federal Reserve System, which had succeeded in saving shaky banks, had restored confidence, and had made capital more abundant by reducing interest rates.