America's Great Depression (23 page)

Period VII (November 1925–October 1926) was the first time after Period III that uncontrolled factors acted to
increase
reserves.

But, in contrast, this time, the Federal Reserve failed to offset these factors sufficiently, although the degree of inflation was very slight (only $2.4 million per month).

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115

In Period VIII (October 1926–July 1927), the degree of inflation was still small, but, ominously, the Federal Reserve stoked the fires of inflation rather than checked them; controlled factors increased, as did the uncontrolled. The culprits this time were the U.S. Government’s Securities ($91 million) and Other Credit ($30

million).

Period IX (July 1927–December 1927), was another period of accelerated and heavy inflation, surpassing the previous peaks of latter 1922 and 1924. The per-monthly reserve increase in latter 1927 was $42.0 million. Once again, uncontrolled factors declined, but were more than offset by a very large increase in controlled reserves, emanating from Bills Bought ($220 million), U.S. Government Securities ($225 million), and Bills Discounted ($140 million).

Period X was the sharpest deflationary period (in
reserves
) in the 1920s. Uncontrolled factors rose, but were more than offset by a controlled decrease. Bills Discounted rose ($409 million), but the deflationary lead, was taken by U.S. Government Securities (-$402

million) and Bills Bought (-$230 million). The decline of over $200 million in reserves generated a decline of about $600 million in member bank demand deposits. Time deposits rose by over $1

billion, however, and life-insurance reserves by $550 million, so that the total money supply rose substantially, by $1.5 billion, from the end of 1927 to mid-1928.

With the boom now well advanced in years, and developing momentum, it was imperative for the Fed to accelerate its deflationary pressure, if a great depression was to be avoided. The deflation of reserves in the first half of 1928, as we have seen, was not even sufficient to offset the shift to time deposits and the other factors increasing the money supply. Yet, disastrously, the Fed resumed its inflationary course in latter 1928. In Period XI, a tendency of uncontrolled reserves to decrease, was offset by a positive and deliberate increase ($364 million of controlled reserves, against -$122 million of uncontrolled). The culprit in this program was Bills Bought, which increased by $327 million, while all the other reserve assets were only increasing slightly. Of all the periods
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America’s Great Depression

of the 1920s, Period XI saw the sharpest average monthly rise in Bills Bought ($65.4 million).

In the final Period XII, the tide, at last, definitely and sharply turned. Uncontrolled factors
increased
by $390 million, but were offset by no less than a $423 million decrease in controlled reserves, consisting almost wholly of a reduction of $407 million in Bills Bought. Total reserves fell by $33 million. Member bank demand deposits, which also reached a peak in December, 1928, fell by about $180 million. Total demand deposits fell by $540 million.

So far, we have seen no reason why this deflation should have had any greater effect than the deflation of Period X. Indeed, total reserves fell by only $33 million as against $228 million in the former period. Member bank deposits fell by less ($180 million as against $450 million), and total demand deposits fell by about the same amount ($540 million against $470 million). The crucial difference, however, is this: in Period X, time deposits rose by $1.1

billion, insuring a rise in the nation’s total currency and deposits of $600 million. But in Period XII, time deposits, far from rising, actually fell by $70 million. Total deposits, therefore, fell by $510

million, while the total money supply rose very slightly, impelled by continued growth in life insurance reserves. Time deposits no longer came to the rescue, as in 1923 and 1928, and total money supply rose only from $73 billion at the end of 1928, to $73.26 billion in mid-1929. For the first time since June 1921, the money supply stopped increasing, and remained virtually constant. The great boom of the 1920s was now over, and the Great Depression had begun. The country, however, did not really discover the change until the stock market finally crashed in October.

TREASURY CURRENCY

An increase in Treasury currency played a considerable role in the inflation in the early years from 1921–1923. It is unusual for Treasury currency to change considerably, as we see from its behavior over the rest of the 1921–1929 period. The surprising increase in 1921–1923 consisted almost exclusively of
silver
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117

certificates
, representing silver bullion held in the Treasury at 100

percent of its value. (Of the $225 million increase in Treasury currency during Periods I–III, $211 million was silver certificates.) In 1918, the Pittman Act had permitted the United States government to sell silver to Britain as a wartime measure, and the silver stock of the Treasury, as well as the silver certificates based 100

percent upon them, was reduced as a consequence. In May, 1920, however, in accordance with its obligation under the Act to buy silver bullion at the inflated price of one dollar per ounce until its stock had been replenished, the Treasury began to buy silver bullion, and this subsidy to domestic silver miners swelled bank reserves. This silver purchase policy effectively ended by mid-1923. The Treasury was forced to embark upon the silver purchase program by the terms of the Pittman Act of 1918, the responsibility of the Wilson administration. The Harding administration, however, could have repealed the Pittman Act if it had had the desire to do so. It must therefore bear its share of the blame for the silver purchase policy.16

BILLS DISCOUNTED

We have seen the important role played by discounted bills in spurring the inflation. In 1923, 1925, and 1928, bills discounted came to the rescue of the banks at periods when the Fed was trying to exert anti-inflationary pressure by selling government securities, and, in 1923 and 1928 at least, reducing its holding of acceptances. In each instance, bills discounted was responsible for continuing the inflationary surge. The main trouble lay in the Federal Reserve’s assumption of the role of “lender of last resort,” more or less passively waiting to grant discounts to any banks that apply. But this was a policy adopted by the Fed, and it could have been changed at any time. The Fed allowed itself to affect discounts merely by setting and changing its rediscount rate.

16For the Pittman Act, see Edwin W. Kemmerer,
The ABC of the Federal Reserve
System
(9th ed., Princeton, N.J.: Princeton University Press, 1932), pp. 258–62.

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America’s Great Depression

The bulk of discounts consisted of rediscounted business paper (including commercial, agricultural, and industrial), and advances to banks on their promissory notes secured by U.S. government securities as collateral. When our period began, maximum legal maturity on discounts was 90 days, except for agricultural paper, which could be discounted for six months. In March, 1923, Congress extended the special privilege to agricultural paper to nine months, and the Fed was also granted authority to rediscount agricultural paper held by the newly established Federal Intermediate Credit Banks. More important, the FRB changed its original idea of making careful credit analyses of the original borrowers, and instead relied on the apparent solvency of the discounting banks, or else directly bailed out banks in distress.17 This relaxation permitted a greater quantitative level of rediscounts.

If the Federal Reserve induced changes in discounts through the rediscount rate, it should certainly have always set it at a

“penalty rate,” i.e., high enough so that the banks would lose money by borrowing from it. If a bank earns 5 percent on its loan or investment, for example, and the Reserve sets its rediscount rate above that, say at 8 percent, then a bank will only borrow in the direst emergency when it desperately needs reserves. On the other hand, if the rediscount rate is set below the market, the bank can make a pleasant career out of borrowing, say, at 4 percent and relending the money at 5 percent. To discourage bank discounting, then, a permanent penalty rate above the market is essential.

There was considerable opinion in the early 1920s that the FRB

should maintain penalty rates in accord with British central banking tradition, but unfortunately the proponents only wanted rates above the lowest-yielding loans—prime commercial paper. Such a penalty rate would have been rather ineffectual, since the banks could still profit by discounting and relending to their riskier borrowers. A truly effective penalty rate would keep the rediscount rate above the rates of all bank loans.

17H. Parker Willis, “Conclusions,” in H. Parker Willis, et al.
,
“Report of an Inquiry into Contemporary Banking in the United States” (typewritten ms., New York, 1925), vol. 7, pp. 16–18.

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Opinions clashed within the government in the early years on proposals for a mild penalty rate above prime commercial paper.

The three main centers of monetary power were the Treasury, the Federal Reserve Board, and the New York Federal Reserve Bank, the latter two institutions clashing over power and policy throughout our period. At first, the Federal Reserve leaders favored penalty rates, and the Treasury was opposed: thus, the annual Federal Reserve Board report of 1920 promised establishment of the high rates.18 By mid-1921, however, the Federal Reserve began to weaken, with Governor W.P.G. Harding, Chairman of the Federal Reserve Board, shifting his views largely for political reasons. Benjamin Strong, very powerful Governor of the Federal Reserve Bank of New York, also changed his mind at about the same time, and, as a result, penalty rates were doomed, and were no longer an issue from that point on.

Another problem of discount policy was whether the Federal Reserve should lend
continuously
to banks or only in emergencies.19

While anti-inflationists must frown on either policy, certainly a policy of continuous lending is more inflationary, since it stokes the fires of monetary expansion continuously. The original theory of the Federal Reserve was to promote continuous credit, but for a while in the early 1920s, the Reserve shifted to favoring emergency credit only. Indeed, in an October, 1922 conference, FRB authorities approved the proposal of New York Federal Reserve Bank official, Pierre Jay, that the Federal Reserve should only supply seasonal and emergency credit and currency, and that even this should be restrained by the necessity of preventing credit inflation.

By early 1924, however, the Federal Reserve abandoned this doctrine, and its Annual Report of 1923 supported the following disastrous policy:

The Federal Reserve banks are the . . . source to which the member banks turn when the demands of the business community have outrun their own unaided

18See Seymour E. Harris,
Twenty Years of Federal Reserve Policy
(Cambridge, Mass.: Harvard University Press, 1933), vol. 1, pp. 3–10, 39–48.

19Ibid.
,
pp. 108ff.

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resources. The Federal reserve supplies the needed additions to credit in times of business expansion and takes up the slack in times of business recession.20

If the Federal Reserve is to extend credit during a boom
and
during a depression, it follows quite clearly that the Reserve’s policy was frankly to promote continuous and permanent inflation.

Finally, in early 1926, Pierre Jay himself repudiated his own doctrine, and the “emergency” theory was now dead as a dodo.

Not only did the FRB, throughout the 1920s, keep rediscount rates below the market and lend continuously, it also kept delaying much needed raises in the rediscount rate. Thus, in 1923 and in 1925 the Fed sabotaged its own attempts to restrict credit by failing to raise the rediscount rate until too late, and it also failed to raise the rate sufficiently in 1928 and 1929.21 One of the reasons for this failure was the Federal Reserve’s consistent desire to supply “adequate” credit to business, and its fear of penalizing “legitimate business” through raising rates of interest. As soon as the Fed was established, in fact, Secretary of the Treasury William G.

McAdoo trumpeted the policy which the Federal Reserve was to continue pursuing throughout the 1920s and during the Great Depression:

The primary purpose of the Federal Reserve Act was to alter and strengthen our banking system that the enlarged credit resources demanded by the needs of business and agricultural enterprises will come almost automatically into existence and at rates of interest low enough to stimulate, protect and prosper all kinds of legitimate business.22

Thus did America embark on its disastrous twentieth-century policy of inflation and subsequent depression—via a stimulation of legalized counterfeiting for special privilege conferred by government on favored business and farm enterprises.

20Federal Reserve,
Annual Report, 1923,
p. 10; cited in ibid.
,
p. 109.

21See Phillips, et al.,
Banking and the Business Cycle,
pp. 93–94.

22Harris,
Twenty Years,
p. 91.

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121

As early as 1915 and 1916, various Board Governors had urged banks to discount from the Federal Reserve and extend credit, and Comptroller John Skelton Williams urged farmers to borrow and hold their crops for a higher price. This policy was continued in full force after the war. The inflation of the 1920s began, in fact, with an announcement by the Federal Reserve Board (FRB) in July, 1921, that it would extend further credits for harvesting and marketing in whatever amounts were legitimately required. And, beginning in 1921, Secretary of Treasury Andrew Mellon was privately urging the Fed that business be stimulated, and discount rates reduced; the records indicate that his advice was heeded to the full. Governor James, of the FRB, declared to his colleagues in 1926 that the “very purpose” of the Federal Reserve System “was to be of service to the agriculture, industry and commerce of the nation,” and no one was apparently disposed to contradict him.