America's Great Depression (20 page)

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America’s Great Depression

1920s amounted to a few hundred million dollars at most; the bulk of consumer credit was extended by non-monetary institutions.9

As we have seen, inflation is not precisely the increase in total money supply; it is the increase in money supply
not consisting in
, i.e., not covered by, an increase in gold, the standard commodity money. In discussions of the 1920s, a great deal is said about the

“gold inflation,” implying that the monetary expansion was simply the natural result of an increased supply of gold in America. The increase in total gold in Federal and Treasury reserves, however, was only $1.16 billion from 1921–1929. This covers only a negligible portion of the total monetary expansion—the inflation of dollars.

Specifically, Table 2 compares total dollar claims issued by the U.S. government, its controlled banking system, and the other TABLE 2

TOTAL DOLLARS AND TOTAL GOLD RESERVES*

(billions of dollars)

Total Dollar

Total Gold

Total Uncovered

Claims

Reserve

Dollars

June, 1921

44.7

2.6

42.1

June, 1929

71.8

3.0

68.8

*“Total dollar claims” is the “total money supply” of Table 1 minus that portion of currency outstanding that does
not
constitute dollar claims against the gold reserve: i.e., gold coin, gold certificates, silver dollars, and silver certificates.

“Total gold reserve” is the official figure for gold reserve
minus
the value of gold certificates outstanding, and equals official “total reserves” of the Federal Reserve Banks. Since gold certificates were bound and acknowledged to be covered by 100

percent gold backing, this amount is excluded from our reserves for dollar claims, and similarly, gold certificates are here excluded from the “dollar” total. Standard silver and claims to standard silver were excluded as not being claims to gold, and gold coin is gold and a claim to gold. See
Banking and Monetary Statistics
(Washington, D.C.: Federal Reserve System, 1943), pp. 544–45, 409, and 346–48.

9On the reluctance of banks during this era to lend to consumers, see Clyde W.

Phelps,
The Role of the Sales Finance Companies in the American Economy
(Baltimore, Maryland: Commercial Credit, 1952).

The Inflationary Factors

95

monetary institutions (the total supply of money) with the total holdings of gold reserve in the central bank (the total supply of the gold which could be used to sustain the pledges to redeem dollars on demand). The absolute difference between total dollars and total value of gold on reserve equals the amount of “counterfeit” warehouse receipts to gold that were issued and the degree to which the banking system was effectively, though not
de jure
, bankrupt. These amounts are compared for the beginning and end of the boom period.

The total of uncovered, or “counterfeited,” dollars increased from $42.1 to $68.8 billion in the eight-year period, an increase of 63.4 percent contrasting to an increase of 15 percent in the gold reserve. Thus, we see that this corrected measure of inflation yields an even higher estimate than before we considered the gold inflow.

The gold inflow cannot, therefore, excuse any part of the inflation.

GENERATING THE INFLATION, I:

RESERVE REQUIREMENTS

What factors were responsible for the 63 percent inflation of the money supply during the 1920s? With currency in circulation not increasing at all, the entire expansion occurred in bank deposits and other monetary credit. The most important element in the money supply is the commercial bank credit base. For while savings banks, saving and loan associations, and life insurance companies can swell the money supply, they can only do so upon the foundation provided by the deposits of the commercial banking system. The liabilities of the other financial institutions are redeemable in commercial bank deposits as well as in currency, and all these institutions keep their reserves in the commercial banks, which therefore serve as a credit base for the other money-creators.10 Proper federal policy, then, would be to tighten monetary 10As McKinley says:

Just as the ultimate source of reserve for commercial banks consists of the deposit liabilities of the Federal Reserve Banks, so the ultimate source of the reserves of non-bank institutions consist of the deposit liabilities of the commercial banks. The
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America’s Great Depression

restrictions on commercial banks in order to offset credit expansion in the other areas; failing, that is, the more radical reform of subjecting all of these institutions to the 100 percent cash reserve requirement.11

What factors, then, were responsible for the expansion of commercial bank credit? Since banks were and are required to keep a minimum percentage of reserves to their deposits, there are three possible factors—(a) a lowering in reserve requirements, (b) an increase in total reserves, and (c) a using up of reserves that were previously over the minimum legal requirement.

On the problem of excess reserves, there are unfortunately no statistics available for before 1929. However, it is generally known that excess reserves were almost nonexistent before the Great Depression, as banks tried to keep fully loaned up to their legal requirements. The 1929 data bear out this judgment.12 We can safely dismiss any possibility that resources for the inflation came from using up previously excessive reserves.

We can therefore turn to the other two factors. Any lowering of reserve requirements would clearly create excess reserves, and money supply [is] . . . two inverted pyramids one on top of the other. The Federal Reserve stands at the base of the lower pyramid, and . . . by controlling the volume of their own deposit liabilities, the FRBs influence not only the deposit liabilities of the commercial banks but also the deposit liabilities of all those institutions which use the deposit liabilities of the commercial banks as cash reserves.

“The Federal Home Loan Bank,” p. 326. Also see Donald Shelby, “Some Implications of the Growth of Financial Intermediaries,”
Journal of Finance
(December, 1958): 527–41.

11It might be asked, despairingly: if the supposedly “savings” institutions (savings banks, insurance companies, saving and loan associations, etc.) are to be subject to a 100 percent requirement, what savings would a libertarian society permit? The answer is: genuine savings, e.g., the issue of shares in an investing firm, or the sale of bonds or other debentures or term notes to savers, which would fall due at a certain date in the future. These genuinely saved funds would in turn be invested in business enterprise.

12
Banking and Monetary Statistics,
pp. 370–71. The excess listed for 1929 averages about forty million dollars, or about two percent of total reserve balances.

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97

thereby invite multiple bank credit inflation. During the 1920s, however, member bank reserve requirements were fixed by statute as follows: 13 percent (reserves to demand deposits) at Central Reserve City Banks (those in New York City and Chicago); 10 percent at Reserve City banks; and 7 percent at Country banks. Time deposits at member banks only required a reserve of 3 percent, regardless of the category of bank. These ratios did not change at all. However, reserve requirements need not only change in the minimum ratios; any
shifts
in deposits from one category to another are important. Thus, if there were any great shift in deposits from New York to country banks, the lower reserve requirements in rural areas would permit a considerable net overall inflation. In short, a shift in money from one type of bank to another or from demand to time deposits or
vice versa
changes the
effective
aggregate reserve requirements in the economy. We must therefore investigate possible changes in
effective
reserve requirements during the 1920s.

Within the class of member bank demand deposits, the important categories, for legal reasons, are geographical. A shift from country to New York and Chicago banks raises effective reserve requirements and limits monetary expansion; the opposite shift lowers requirements and promotes inflation. Table 3 presents the total member bank demand deposits in the various areas in June, 1921, and in June, 1929, and the percentage which each area bore to total demand deposits at each date.

We see that the percentage of demand deposits at the country banks declined during the twenties, from 34.2 to 31.4, while the percentage at urban banks increased, in both categories. Thus, the shift in
effective
reserve requirements was
anti
-inflationary, since the urban banks had higher legal requirements than the country banks. Clearly, no inflationary impetus came from geographical shifts in demand deposits.

What of the relation between member and
non
-member bank deposits? In June, 1921, member banks had 72.6 percent of total demand deposits; eight years later they had 72.5 percent of the total. Thus, the relative importance of member and non-member
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America’s Great Depression

banks remained stable over the period, and both types expanded in about the same proportion.13

TABLE 3

MEMBER BANK DEMAND DEPOSITS*

Central

Date

Reserve City

Reserve City

Country

Total

(in billions of dollars)

June 30, 1921

5.01

4.40

4.88

14.29

June 30, 1929

6.87

6.17

5.96

19.01

(in percentages)

June 30, 1921

35.7

30.8

34.2

100.0

June 29, 1929

36.1

32.5

31.4

100.0

*
Banking and Monetary Statistics
(Washington, D.C.: Federal Reserve Board, 1943), pp. 73, 81, 87 93, 99. These deposits are the official “U.S. Government” plus “other demand” deposits. They are roughly equal to “net demand deposits.”

“Demand deposits adjusted” are a better indication of the money supply and are the figures we generally use, but they are not available for geographic categories.

The relation between
demand
and
time
deposits offers a more fruitful field for investigation. Table 4 compares total demand and time deposits:

13
Banking and Monetary Statistics
, pp. 34 and 75. The deposits reckoned are

“demand deposits adjusted” plus U.S. government deposits. A shift from member to non-member bank deposits would tend to reduce effective reserve requirements and increase excess reserves and the money supply, since non-member banks use deposits at member banks as the basis for their reserves. See Lauchlin Currie,
The Supply and Control of Money in the United States
(2nd ed., Cambridge, Mass.: Harvard University Press, 1935), p. 74.

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99

TABLE 4

DEMAND AND TIME DEPOSITS

(in billions of dollars)

Percent

Demand

Time

Demand Deposits

Date

Deposits

Deposits

of Total

June 30, 1921

17.5

16.6

51.3

June 29, 1929

22.9

28.6

44.5

Thus, we see that the 1920s saw a significant shift in the relative importance of demand and time deposits: demand deposits were 51.3 percent of total deposits in 1921, but had declined to 44.5 percent by 1929. The relative expansion of time deposits signified an important
lowering
of effective reserve requirements for American banks: for demand deposits required roughly 10 percent reserve backing, while time deposits needed only 3 percent reserve.

The relative shift from demand to time deposits, therefore, was an important factor in permitting the great monetary inflation of the 1920s. While demand deposits increased 30.8 percent from 1921

to 1929, time deposits increased by no less than 72.3 percent!

Time deposits, during this period, consisted of deposits at commercial banks and at mutual savings banks. Mutual savings banks keep only time deposits, while commercial banks, of course, also provide the nation’s supply of demand deposits. If we wish to ask to what extent this shift from demand to time deposits was
deliberate
, we may gauge the answer by considering the degree of expansion of time deposits at commercial banks. For it is the commercial banks who gain directly by inducing their customers to shift from demand to time accounts, thereby reducing the amount of required reserves and freeing their reserves for further multiple credit expansion. In the first place, time deposits at commercial banks were about twice the amount held at mutual savings banks.

And further, commercial banks expanded their time deposits by 79.8 percent during this period, while savings banks expanded
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America’s Great Depression

theirs by only 61.8 percent. Clearly, commercial banks were the leaders in the shift to time deposits.

This growth in time deposits was not accidental. Before the establishment of the Federal Reserve System, national banks were not legally permitted to pay interest on time deposits, and so this category was confined to the less important state banks and savings banks. The Federal Reserve Act permitted the national banks to pay interest on time deposits. Moreover, before establishment of the Federal Reserve System, banks had been required to keep the same minimum reserve against time as against demand deposits.

While the Federal Reserve Act cut the required reserve ratio roughly in half, it reduced required reserves against time deposits to 5 percent and, in 1917, to 3 percent. This was surely an open invitation to the banks to do their best to shift deposits from the demand to the time category.