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"Understanding the Great Depression
 & Failures of Modern Economic Policy"
 by Dan Blatt - Publisher of FUTURECASTS online magazine.

 Explaining the Great Depression and failures of "New" Keynesian interest rate suppression policy without ideological clap trap, theory confirmation bias or political spin.

Table of Contents & Introduction
?

A History of the Federal Reserve, Vol. I (1913-1951)
by
Allan H. Meltzer

Part II: The Engine of Deflation (1923-1933)

Page Contents

Monetary policy objectives (1923-1933)

Destruction of gold standard

Monetary policy during Great Depression

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Vol. 10, No. 7, 7/1/08

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E) Conflicting Objectives

Confusion:

 

The reputation of the System soared, but its ambiguities left policy and control uncertain and frequently sharply in dispute.

  The Federal Reserve System (the "System") seemed to have gotten its act together during the half dozen years before 1929. The nation prospered and the business cycle was moderated.  The reputation of the System soared, but its ambiguities left policy and control uncertain and frequently sharply in dispute, Alan H. Meltzer explains in his excellent work, "A History of the Federal Reserve, vol. 1 (1913-1951)."  See, Meltzer, "History of Federal Reserve, vol. 1," Part I, "The Search for Monetary Stability (1913-1923);" and Meltzer, "History of Federal Reserve, vol. 1," Part III, "The Engine of Inflation (1933-1951)."
 &

  The key policy officials in the System, their policy disagreements, doubts and the struggle for control over policy between the Federal Reserve Board (the "Board") and the Federal Reserve Banks, especially the N.Y. Federal Reserve Bank (the "N.Y. Fed") are sketched by Meltzer.

  "Many of the principals responsible for policy in the 1920s, and during 1929 to 1933, were weak men with little knowledge of central banking and not much interest in developing their knowledge. There were a few strong-minded individuals, but they were often at loggerheads. Policy decisions became a contest of wills between [Benjamin] Strong and [Adolph] Miller and later between Miller, [Eugene] Meyer, and [George L.] Harrison or [W. Randolph] Burgess."

  The dominant officials prior to 1929 were Miller, a member of the Board, and Strong, governor of the N.Y. Fed.

  "To Strong and other [reserve] bank governors, the System was an association of reserve banks supervised by the Board. To Miller and others in Washington, the Board was responsible for directing the System to a common policy goal and steering away from bankers' interests. As open market operations increased in importance and discount policy declined, Miller tried repeatedly to shift control of open market policy from Strong and his colleagues to the Board. He was unsuccessful while Strong was alive."

  Meltzer goes at some length into the uncertainty, disputes and shifts in System monetary policy after the 1920-21 depression. By concentrating on conditions in credit markets, particularly on discounts and interest rates and the level of member bank borrowing from the reserve banks, System policy moves trailed by as much as nine months cyclical turns in the economy. Poor crops abroad coinciding with a large U.S. crop and higher exports and prices in 1924 probably did more to end the 1923-24 recession than System monetary policy. Substantial gold inflows helped ease credit conditions during the recession, in line with gold standard theory expectations.
 &
  The System ultimately did increase its portfolio by $500 million, thus increasing the basic money supply. Strong wanted the System to increase its assets sufficiently so that it could reduce the circulating money stock by sales from its portfolio to combat any inflationary surge.  The System now had that substantial portfolio of securities.  He did not want a repeat of the 1919 inflation. He continuously viewed the uncontrolled inflow of gold as a major inflation threat.
 &

Reestablishment of the gold standard proved impossible as the System preferred price stability and intervened to prevent the price fluctuations vital to gold standard functioning.

  The System's several objectives proved to be inherently in conflict. Reestablishment of the gold standard proved impossible because price stability was in practice an even higher priority. The System intervened to prevent the price fluctuations vital to gold standard functioning. Prevention or deterrence of the growth of speculative credit, particularly for investment in the New York Stock Exchange, proved impossible because the System feared to risk the wrath of Congress by raising its discount rates and feared to repeat the policy moves that contributed to the 1920-21 depression. "Qualitative" controls - moral suasion and efforts to ration credit - predictably failed.
 &

F) The Search for an Administered Alternative

Gold sterilization:

 

&

  To maintain price stability, the System "sterilized" the gold inflows by such means as leaving gold in European depositaries and selling securities from its portfolio to withdraw money from public circulation.
 &

  An increase in System interest rates was not an attractive option since that would draw in even more gold, undermining British efforts to get back on the gold standard. Meltzer explains:

  "At a more basic level was the conflict between price stability and restoration of the world gold standard. In part to maintain price stability, the Federal Reserve System sterilized gold inflows and, reversing its earlier policy, put gold and gold certificates into circulation. This policy reduced the monetary expansion resulting from the gold inflows, thereby shifting more of the burden of adjustment to Britain and other countries seeking to reestablish and sustain a type of gold standard. Once Britain returned to the gold standard, it had to raise interest rates and deflate to defend its exchange rate. A more classical gold standard policy of lowering United States interest rates and allowing the country's prices to rise in response to gold inflows would have reversed some of the gold flows and reduced the need for deflationary policies abroad, at the cost of higher inflation in the United States." (Of course, that inflation would have been temporary - cyclical - rather than chronic as at present.) 

  Gold in System reserves was more expansive than gold in circulation because Federal Reserve notes could be issued with just 40% gold backing. The policy had previously been to retire gold certificates and replace them with Federal Reserve notes in order to centralize gold reserves in case of need. Now, $800 million in new gold certificates were issued from 1922 to 1926. In addition, as much as $200 million in gold was left in Europe so it wouldn't count as System reserves. Together, these practices reduced official gold reserves by 25% at their peak.
 &
  France similarly sterilized gold inflows, preventing the price increases that would have permitted the gold standard to function.
 &

Human administration of monetary policy was substituted for the discipline and automatic business cycle flows of the gold standard - with disastrous results.

  Instead of simple responses to gold flows, policy was to be guided by an impressive intellectual effort to gather and analyze a vast and growing array of business and financial statistics. Human administration of monetary policy was substituted for the discipline and automatic business cycle flows of the gold standard - with disastrous results.

  With the advent of the New Deal, and even after WW-II and still to this day, the result of human administration of monetary policy is chronic inflation where none had existed under the gold standard. Commodity prices on London markets, for example, fluctuated broadly due to such events as wars, crop failures and gold discoveries, but stayed within a level band for over three centuries. During that time, England rose to economic and financial prominence and broad based prosperity using gold as money, bank reserves, and as the international medium of exchange. Moreover, as Meltzer points out, the 19th century was a period of persistent price deflation in the U.S. at modest rates a bit less than the rate of productivity increase. This was a period when the U.S. economy prospered and the U.S. became an economic powerhouse. 
 &
  Inflation in the U.S. reached ruinous levels with vicious cyclical swings in the 1970s and early 1980s. Predictably, inflation is returning to ruinous levels in the current period beginning in 2006, and the U.S. is again about to experience increasingly severe cyclical swings. It is apparent that, without gold standard or similar disciplines, policies leading to ruinous levels of inflation are politically irresistible. The nation's gallant legislators are simply the boys and girls "who can't say no" to even the most unaffordable spending schemes. The Federal Reserve System is thus forced to monetize increasing amounts of public and private debt to keep interest rates from rising to restrictive levels - a classic formula for a debased currency, chronic inflation, and increasing economic instability.

Only the N.Y. Fed seemed concerned with executing a national monetary policy.

 

Discount rate policy was reduced to a supporting role due to the bluntness of its impact and to the political criticism of high rates.

  The development of active open market operations as a tool of monetary policy is covered by Meltzer. Among many other things, there were problems in coordinating the open market purchases and sales of the twelve reserve banks, and conflicts with discount policy and Treasury financing activities that had to be resolved. There was a persistent struggle for control of policy between the Board and the reserve banks, especially with the N.Y. Fed. There were conflicts between policy needs and the basic need to hold sufficient assets to cover reserve bank operating expenses. With the federal budget in substantial surplus, the Treasury was rapidly retiring its securities and didn't want to have to compete with the reserve banks for purchases of government securities.
 &
  An executive committee of five governors led by Strong as chairman was formed to coordinate open market policy operations and to avoid interference with Treasury operations. However, the individual reserve banks retained their discretionary authority to buy and sell government and commercial securities for their own purposes. Their predominant concerns were retention of sufficient earning assets to cover expenses, and accommodation of the needs of their member banks. Only the N.Y. Fed seemed concerned with executing a national monetary policy.
 &
  In March of 1923, the Board took supervisory control of the executive committee, now called the Open Market Investment Committee (the "OMIC"). It was to be "governed with primary regard to accommodation of commerce and business, and to the effect of such purchases and sales on the general credit situation." The reserve banks successfully fought off further centralization of policy authority in the Board. Miller and the Board exercised their supervisory authority by repeatedly delaying, altering or refusing to approve OMIC decisions, much to the annoyance of Strong.
 &
  The battle was over control of open market operations, now recognized as the primary tool of monetary policy. Discount rate policy was reduced to a supporting role due to the bluntness of its impact and to the political criticism of high rates. Rather than a penalty rate for use as a tool of monetary policy, discount rates tended to follow market conditions at an average level. For the bulk of the 1920s, they stayed within a narrow 3.5% to 4.5% range at New York.
 &

Without the guidance of the gold standard, examination of the host of economic and financial statistics still left policy dependent on judgment.

  The Board's Tenth Annual Report (1923), written mainly by Walter Stewart, the director of the Board's research office, with Miller's support, was the most important policy statement of the decade. It decisively moved away from reliance solely on the gold standard and real bills doctrine. It favored active open market operations involving government as well as commercial securities in response not just to current but also to anticipated changes in credit markets. It recognized that "qualitative" policies alone were insufficient. "Credit is fungible." "Quantitative" open market and discount rate moves were required as well as qualitative policies.
 &
  However, without the guidance of the gold standard, examination of the host of economic and financial statistics still left policy dependent on judgment. Nor was price stability alone an adequate guide, since price fluctuations reflected myriad impacts outside the money and credit system. The System had no control over shifts in monetary velocity. Thus, the Report "does little more than sketch a new framework for monetary policy."
 &

  The Tenth Annual Report was not widely welcomed among the governors. Meltzer provides a blow-by-blow account of the disagreements within the System when the N.Y. Fed, supported by Miller and the Board, tried to move the System's discount rates down during the 1924 recession. Miller wanted the System to be viewed as equally concerned with mitigating recessions as with constraining speculative surges. Several governors were more concerned that reduced discount rates would threaten their own earnings, and there was doubt over the impact on financial demand of changes in discount rates.
 &
  Economists, including Keynes, widely applauded the Tenth Annual Report despite their criticism of its continued support for qualitative and real bills policy. Reliance on an active open market policy promised rational management of economic conditions.
 &

Total member bank borrowing from the System of between $500 million and $600 million was believed by many System authorities, including Strong, to be the normal level.

  System economists Winfield Riefler and W. Randolph Burgess tried with limited success to flesh out the Report's policy framework. Their work fell short of explaining how System money, credit, interest rates, and borrowing would link with income and the price level. There was no recognition of the difference between nominal and real interest rates.

  "It was an easy, but invalid, inference to rely on member banks' borrowing [from the System] or a market interest rate as the proper measure of the thrust of monetary policy. If borrowing and interest rates were low, policy was easy; if the two were high, policy was tight. By the mid-1920s, high and low borrowing were defined as member banks' borrowing above and below $500 million."

  Total member bank borrowing from the System of between $500 million and $600 million was believed by many System authorities, including Strong, to be the normal level. If member banks were borrowing more, that indicated great demand for funds that the System should meet by extending funds into the economy. Member bank borrowing substantially below this range indicated there was little demand for funds, so funds should be withdrawn by the System by open market sales of securities from its portfolio.
 &
  These were viewed as indicators, not commands and were in any event applied loosely. However, especially in times of uncertainty, they did heavily influence the views of System monetary authorities.
 &

There was great doubt that the System could influence broad economic trends while maintaining the purchasing power of the currency.

  The System was otherwise passive. With a recognized exception for dealing with financial panics, broad economic and financial events were not its responsibility and were outside of its control. The System under this view was responsible only for money and member banks, and did not attempt to micromanage the economy.
 &
  Indeed, there was great doubt that the System could influence broad economic trends while maintaining the purchasing power of the currency. (The two objectives would inevitably come into conflict in the 1970s and in this first decade of the 21st century.) Worse, without a functioning gold standard mechanism and flexible markets for international trade, System monetary policy was entirely pro-cyclical. It expanded the money supply, stimulating the economy even as the economy was growing, and contracted the money supply, restraining the economy even when the economy was declining.
 &

  Congress was considering legislation to make price stabilization an official system objective. The mix of monetary policy views among economists and System officials is revealed in the extensive excerpts that Meltzer provides from their testimony. Strong opposed the legislation, proposed changes that fudged the price stabilization objective, and the legislation was killed in committee.
 &
  Whatever the defects of an official price stabilization objective, Meltzer asserts that System focus on stable dollar purchasing power would have substantially mitigated the Great Depression and prevented the great inflationary surges of the 1960s and 1970s.

  Meltzer clearly overestimates the extent of the System's capacity to mitigate the Great Depression and maintain its own independence. Money certainly matters. However, because money is the subject of this book, there is perhaps a natural tendency for the author to overstate the importance of monetary manipulation. It must carefully be acknowledged that there are many other complex factors at work in the economy. He does briefly mention the tariffs several times, but most of those other factors the author deigns to mention only once and briefly.
 &
  The non-monetary factors involved in the Great Depression included, among many other things, the huge WW-I war debts and the 1920s trade war tariffs that made it impossible for debtor nations to earn the wherewithal to service those debts. Protectionist tariffs naturally encouraged increasingly dangerous levels of overcapacity. There were huge farm surplus carryovers just before and during the Great Depression. See, Great Depression Facts & Mythology.
 &
  Considering the increasing budgetary deficits of the 1960s and thereafter, care must be taken not to exaggerate the capabilities of even ideal monetary policy - if it can be agreed upon as to what that might have been - to deal with the circumstances of the 1970s. Also, the real world limits to System independence must be kept in mind. The U.S. was, after all, involved in a serious military conflict during the 1960s and early 1970s, and the Lyndon Johnson and Richard Nixon administrations insisted that the System churn out the dollars needed for immediate military and domestic expenses, regardless of the longer term consequences. These consequences became manifest during the 1970s and the beginning of the 1980s in the vicious swings of the business cycle and ultimately in the concurrent double digit miseries of unemployment, inflation and interest rates.

  Meltzer accepts the relevance of the high tariffs in undermining international commerce, and especially for the farm states and their banks dependent on the vast agricultural sector of the 1930s U.S. economy. However, he confines this to a brief footnote. He acknowledges in that footnote that most research suggesting a small effect "ignores the pronounced effect on farm exports, distress, bankruptcies, and bank failures in farm states."

  The author misplaces the 1930 Smoot-Hawley Tariff in 1929, and ignores the cumulative impacts of the trade war levels of U.S. tariff protection already in place since 1922. It is hornbook economics that markets are moved by events at their margins, and the collapse of international commodity markets and the vast U.S. agricultural sector from the spring of 1930 onwards was hardly just a marginal event. See, Great Depression, "The Collapse of Agriculture (end 1930)."

Without the discipline of the gold standard, there would be incentives for governments at times to undertake various types of paper money expedients and inflation.

  There remained a great commitment to the gold standard, and widespread fear of the consequences of abandoning it. Without the discipline of the gold standard, Montague Norman, governor of the Bank of England warned, there would be violent fluctuations in currency exchange rates and the devaluation of currencies. There would be "an incentive to all of those who were advancing novel ideas for nostrums and expedients other than the gold standard to sell their wares; and incentives to governments at times to undertake various types of paper money expedients and inflation." (These fears have proven and are being yet again proven absolutely accurate!)
 &

The demise of the gold standard:

 

&

  The "sterilization" of gold flows to prevent them from having their normal impact on the monetary base and on cyclical price inflation was - and has been - widely criticized. Meltzer points out that the sterilization policy was most evident after Britain returned to the gold standard in the second quarter of 1925. However, even before that time, compliance with gold standard rules was weak.
 &

  Getting back on the gold standard for most WW-I belligerents meant currency devaluations - a form of national bankruptcy where creditors and ordinary people lose a percentage of the purchasing power of their currency and income. The franc was devalued to 20% of its previous gold price, so creditors lost 80% on the value of French franc bonds.
 &
  England once again chose to restore the pound to its prewar level of $4.86 per pound. This required it to deflate its economy as after previous major conflicts. It thus attempted to restore its credit but imposed an immediate burden on the English people. To assist in this effort, the System extended a $200 million two year standby loan to England. The loan expired without ever being drawn upon.
 &
  Under the Dawes Plan, $190 million was loaned to Germany to facilitate its payment of reparations which in turn facilitated payment of the war loans extended by the U.S. to its allies. Private lenders also flooded Germany with funds so that ultimately Germany received more in loans than it paid out in reparations, but collapsed under the weight of its interest obligations as the Great Depression undermined all financial plans.

  Perhaps if its exports were not blocked by trade war levels of protectionist tariffs, Germany could have earned enough to pay its reparations obligations without having to borrow so much. It might not have collapsed and fallen into Hitler's hands. But that's another story.

  More substantively, the System lowered interest rates in 1924 to help Britain and France get back on the gold standard and to help other nations get back on a gold exchange standard based on the pound or dollar. That the U.S. was in recession at the time provided another reason for the interest rate reduction, and was the reason endorsed by most System policy officials. The spread between short term rates in New York and London turned sharply in favor of gold flows to London.
 &

With memories of the 1919-21 inflation and deflation cycle still in mind, domestic price stability was the most important consideration.

  However, domestic policy considerations remained paramount, and rates were increased in 1925 as the domestic economy revived. With memories of the 1919-21 inflation and deflation cycle still in mind, domestic price stability was the most important consideration. It was more important than Britain's efforts to get back on the gold standard and even more important than the rules for U.S. conduct under the gold standard.
 &
  In 1926 and 1927, Strong met with and concerted action with the central banks of Great Britain, France, and Germany to prevent the unraveling of international exchange rates. A general strike tied the hands of the Bank of England. The British public would tolerate no more deflation. Interest rates would have to come down in the U.S. and France because they could not go up in Britain to stop the outflow of British gold. With the U.S. again in recession, rates were reduced in the U.S., again favoring gold flows to London and restoring exchange rate stability for a time. However, the franc remained undervalued and the pound overvalued, so there was no long term solution.

  "A choice had to be made between parity changes and price level changes. Both were ruled out politically. Neither France nor Britain was willing to adjust its exchange rate. Britain was unwilling to deflate further; France and the United States were unwilling to inflate. Temporary United States interest rate reductions, United States loans to Europe, or French decisions to buy gold in New York rather than in London, as in 1927, could postpone but not prevent a long-term solution. If governments maintained the misalignment, the only issue was when financial markets would begin to force price level or parity changes."

  France strove to increase its gold holdings after its return to the gold standard. Even worse than the U.S., it implemented policies that undermined the normal flows of the gold standard. It drained gold from Britain and the rest of the world. "Rescue" loans from surplus currency nations kept the system afloat for awhile, but that arrangement couldn't last. "Without a willingness to permit price levels and exchange rates to adjust, crises seem to be the inevitable, but costly, means of adjusting exchange rates." (European finance was embroiled in crises throughout the 1920s. See, James, "The End of Globalization.")
 &

It wasn't the gold standard that failed, it was nations like France and the U.S. that refused to play by the rules.

  The markets triumphed - as they always do - viciously, when Britain was forced to devalue in 1931. The markets would similarly triumph again - this time against U.S. monetary policy failures - in the 1970s. Meltzer asserts that the "misalignment" of exchange rates were the underlying problem in both the 1920s and 1960s, not the short term gold flows, or "shortage" of gold supplies.

  However, Meltzer, too, doesn't carry the analysis deep enough. He doesn't consider the monetary policies - in the 1960s, the Keynesian monetary policies - that caused the misalignments in the first place. Currency realignment without a disciplined monetary policy is at best just a temporary fix and at worst just an accommodation of inflationary policies.

  Meltzer quotes a London Times explanation of the gold standard collapse in September, 1931. It wasn't the gold standard that failed, it was nations like France and the U.S. that refused to play by the rules. The Times also (properly) highlighted the role of prohibitive tariffs in creditor nations that left debtor nations no way to earn the wherewithal to service their debts and forced them to pay with gold until they had none left and had to default. (Even before the infamous Smoot-Hawley tariff of 1930, U.S. tariffs were the highest in the world except for those of Spain.)
 &


By sterilizing gold inflows and ignoring the impacts of real interest rates, the System had made itself an engine of deflation.

  Like generals preparing to fight the last war over again - in this case, the inflationary boom and deflationary bust cycle of 1919-21 - the System marshaled its forces against price inflation - including the temporary price inflation of the ordinary business cycle. By sterilizing gold inflows and ignoring the impacts of real interest rates, it had made itself an engine of deflation.

  Because of the great WW-I financial obligations of the European belligerents, and because of the trade war levels of tariffs that made it impossible for them to earn the wherewithal to service those debts, System policies made it an engine of deflation worldwide.

G) The Great Depression

Boom:

 

&

  Stock market margin credit and the N.Y. call money market were already a concern for System monetary policy authorities in 1925. Strong expressed doubt that anything could be done to directly influence margin credit.
 &

  Failure to keep the discount rate at penalty levels  had as feared induced several member banks to borrow continuously from the reserve banks. After all, it was an easy and secure profit to borrow from the System to lend at a higher rate through the commercial paper and call money markets.
 &
  By 1926, the stock market was booming and money was flowing into New York to meet the demand for speculative credit. It was also flowing into Florida real estate among other things. Restriction of System credit in these two markets would not have helped since money was simply flowing in through commercial markets from all around the country and even from abroad. Four European nations - Britain, Switzerland, Germany and Holland - had just resumed gold payments, but the gold standard system remained very shaky.

  "The problem was not, as is often suggested, lack of cooperation or unwillingness to cooperate. The failure was a failure of a managed system operating under inconsistent objectives on both sides. Forecast errors about short-term responses added to the problem, but these errors were minor compared with the inconsistent objectives: restoring the prewar gold standard at prevailing exchange rates without additional adjustment of the relative prices of traded goods on both sides of the Atlantic. European countries wanted to lower the real cost of exports, and the United States wanted to avoid inflation. All of them wanted the gold standard, but none (sic) wanted more gold. Coordination could not solve this problem; the countries' objectives were incompatible with the international monetary system they had adopted." (Moreover, trade war tariff levels made the whole system rigid and brittle.)

The reserve banks could not control the uses of credit "once it leaves our doors."

  • 1926 was an uneventful year for the System. As the economy hesitated, the stock market fell back until May and then renewed its climb.

  Concern about abuse of the discount privilege continued. A report indicated that about 900 banks had borrowed continuously from the System for at least a year, but some were distressed banks as bank failure rates remained high, and some were in process of paying down large seasonal or other legitimate loans. Member bank borrowing rose to $650 million in the fourth quarter, about 30% of total reserves. The Board pressed the reserve banks to act against such borrowing, but they generally refused and resented the intrusion on their business. The N.Y. Fed explained that the reserve banks could not control the uses of credit "once it leaves our doors."

As the stock market boom took off, many would criticize Strong for placing international interests ahead of domestic interests.

  • 1927 brought economic recession but higher stock prices with increased margin speculation. The former required lower rates, the latter higher rates. The pound, too, was under pressure. System gold was accumulating rapidly, but was held off the books - "earmarked" - in Europe.

  Strong wanted lower rates, both to deal with the recession and reverse the gold inflow from Britain. Opposition to lower rates was not overcome until May and rates were reduced late that summer - long after the recession had begun. However, the recession was short and mild and hardly put a dent in stock market speculation.
 &
  Efforts to sterilize gold drained the open market account to only about $100 million. Once again, there were too few securities available for sale in the event the System had to reduce the monetary base to dampen an inflationary surge or to sterilize future gold inflows. To restore the open market account, $180 million in securities were purchased that spring.
 &
  When rates were reduced in August - to 3.5% - the recession was noted as the reason. However, all indications were that the reduction was primarily due to Strong's concern about the pound. Gold was flowing out of London, and lower rates in N.Y. might stop that flow without Britain having to increase its own rates. The gold flow did indeed reverse.
 &
  However, as the stock market boom took off, many would criticize Strong for placing international interests ahead of domestic interests. The rates stayed low for most of the rest of 1927. The  gold stock declined $460 million. The total return on common stocks was 98% for 1927 and 1928 and brokers loans for margin speculation soared.

  "The Board and the reserve banks faced a question that has often plagued central bankers: Should they respond to large increases in asset prices or confine their attention to prices, output, money, or foreign exchange rates?"

  • In 1928, a booming economy and stock market pushed up loan demand. Market interest rates kept rising further above the System's discount rate. Economic and price level stability was the primary policy objective. There was little concern for the functioning of the gold standard, which required an unconstrained price and business cycle. The System was losing control. Increasingly ill, Strong died in October, 1928, leaving the System without anyone who could provide decisive leadership.

  The rapid expansion of commercial bank credit - by 8% in 1927 - and its flow into stock margin accounts and other speculative investments, became the primary immediate concern of the System. Banks encouraged depositors to shift into time and savings accounts for which reserve requirements were considerably lower than for demand - checking - accounts. Interest rates offered for time deposits rose. With commercial rates rising, banks could find increasingly profitable investments for every dime they could lend.  The profitability of borrowing from the System for 3.5% to lend at the rising commercial rates was becoming irresistible.
 &
  The discount rate was raised to 4% in the first quarter of 1928. This was supplemented by sales of securities to drain money from the economy. The System was thus tightening although there was no sign of price inflation. Price levels were thus actually declining despite the booming economy, and nobody was willing to let prices rise when gold flowed in.
 &
  By the second quarter of 1928, the discount rate was at 4.5% but call money rates were at 5%. The System had now sold off all but about $100 million of its open market account securities and had little left to effectively engage in further restrictive open market sales. The reserve banks had about another $150 million, but that was held for income.
 &
  The N.Y. Fed raised its discount rate again, but call money rates remained about 1.5% higher so money just flowed in from other districts and from private sources, increasingly including large corporations. By summer, seven of the reserve banks were at 5%, but call money rates were 10% and member bank borrowing from the System soared above normal levels. (Margin rates were generally about 1% to 1.5% above call money rates.)
 &
  Pressure was eased that summer by a substantial break in stock market prices and a decline to 5% in call money rates. But member banks remained $1 billion in debt to the System - twice what System economists Riefler and Burgess - and Strong - had considered the upper limit for normal operations. Strong, increasingly ill, was no longer an active participant.

Gold was again flowing in, but was so effectively sterilized that the monetary base actually declined 1.3% in the year ending June, 1929. At a time of record breaking economic growth and a substantial gold inflow, System policy was clearly a cause of domestic price deflation.

  •  That fall, 1928, the System was torn between its inconsistent objectives. It had to ease credit to meet seasonal agricultural demands - and tighten credit to constrain the renewed stock market boom. Margin rates were again rising - to almost 9% - but a Treasury refinancing of WW-I Liberty Bonds required the System to keep interest rates low. The System bought $300 million in acceptances to peg that rate at 4.5% and keep long term rates unchanged through the fall, but the bull stock market was roaring.
  • In the first half of 1929, the  domestic economy was expanding exuberantly, but without price inflation. London was again losing gold. High commercial rates in New York were sucking in capital from all over the world. Rates would have to rise abroad - to levels too high for economic prosperity, forcing deflation abroad. Gold was again flowing in, but was so effectively sterilized that the monetary base actually declined 1.3% in the year ending June, 1929. At a time of record breaking economic growth and a substantial gold inflow, System policy was clearly a cause of domestic price deflation.

  "The Federal Reserve considered policy expansive, based on the 43 percent increase in stock prices in 1928, the use of credit to support leveraged positions, faster growth of credit than of output, and the large volume of member bank borrowing. Misled by its indicators, it believed the challenge as 1929 started was to restrain 'speculation.' Disagreement, though sharp, was limited to how this could be best accomplished -- how monetary policy should be tightened. All parties ignored the deflation."

The Board repeatedly denied N.Y. Fed requests for discount rate increases, preferring instead direct action efforts to ration credit away from speculative uses.

 

The high call money rates - spiking as high as 20% - were sucking the financial life blood out of the economy here and abroad.

  George L. Harrison was the new governor of the N.Y. Fed. Roy A. Young was the new governor of the Board. Miller remained an influential member of the Board. With Strong out of the way, Young moved immediately to tighten Board control of monetary policy at the reserve banks, and Harrison did not actively contest the issue.
 &
  The focus of monetary policy in 1929 shifted
of necessity to the discount rate as the amount of securities available for open market sales fell to only $50 million. However, discount rate increases were a blunt instrument that would affect the entire economy and even international markets, not just the securities markets. And high interest rates were politically very unpopular, especially in agricultural states. The Board thus repeatedly denied N.Y. Fed requests for discount rate increases, preferring instead direct action efforts to ration credit away from speculative uses.
 &
  The reserve banks expressed their doubts, but Harrison said the N.Y. Fed would try. However, the N.Y. Fed, along with Boston, Philadelphia and Chicago reserve banks, were soon requesting 6% discount rates. Several of the smaller reserve banks remained opposed to any increase, but by May there was a uniform 5% discount rate throughout the System.
 &
  The N.Y. Fed pushed its acceptance rate to 5.5%, above its 5% discount rate, so money expanded through bankers acceptances while discounts declined. The Board continuously insisted on jawboning, which remained spectacularly ineffective. The bull market charged through Wall Street  and commercial interest rates soared to double digit levels - drawing gold and private capital from abroad and broadly forcing interest rate increases except in France, which was also sterilizing gold inflows.
 &
  Although N.Y. banks responded to moral suasion be reducing their brokers loans by 33% and other banks reduced brokers loans by 18% in the first quarter of 1929, credit simply flowed through other channels. Nonbank lending for brokers loans soared 27%, so total brokers loans increased 6%. Clearly, private interests were profiting by borrowing from banks to lend at higher rates for brokers loans. The high call money rates - spiking as high as 20% - were sucking the financial life blood out of the economy here and abroad.
 &

The Crash of '29:

 

&

  The monetary base continued to decline as high commercial rates caused a runoff of bankers acceptances and the System sold most of the remaining securities in its open market account. France, too, was still sterilizing gold inflows, and the financial situation in Germany was at crisis proportions. (The Great Depression had already begun throughout Central Europe.)
 &

As a looming crisis became increasingly apparent, officials were posturing. The N.Y. Fed requested rate increases it knew would be refused, and the Board insisted on credit rationing just to give the impression it was doing something when it didn't know what else to do.

  The Board continued to refuse requests for discount rate increases. Instead, it publicly listed member banks that borrowed continuously from the System while lending to securities brokers and dealers. As a looming crisis became increasingly apparent, officials were posturing. The N.Y. Fed requested rate increases it knew would be refused, and the Board insisted on credit rationing just to give the impression it was doing something when it didn't know what else to do. Despite System efforts to ration credit, brokers loan figures soared upwards that summer. The Board would not risk the political heat that it could expect for 6% discount rates.
 &
  After a reversal that May, the stock market was off again for its final spectacular summer surge. (This was hardly irrational, given that crops failed in Argentina and Australia and were reduced by drought in North America, substantially pushing up grain prices and exports. The usual seasonal business slowdown failed to appear that summer.) With commercial interest rates again in double digits and seasonal demands for credit fast approaching, the Board finally relented. Something had to be done.
 &
  The result was a strange policy mix. The N.Y. Fed was allowed to raise its discount rate to 6%. However, direct action against member bank discounting with the System was relaxed so that the harvest could be accommodated, and the acceptance rate was lowered to 5.25% to help finance domestic business and exports. No other reserve bank raised its discount rate to 6%.

  "The reasoning behind the policy action was confused, its effect modest. In the Board's view, which New York accepted to reach the seasonal compromise, credit allocation mattered. Acceptances were real bills, whereas discounts could support speculative credit. Hence, encouraging acceptance purchases while reducing discounts helped commerce and agriculture and discouraged speculation."

  With discounts declining and acceptances increasing, the net effect was just a $29 million addition to System credit - far below the $200 million estimated as needed for seasonal fall agricultural needs.
 &

The System was designed to prevent financial panics, and on this occasion the panic was successfully confined to the stock markets due to the action of the N.Y. Fed and its member N.Y. banks.

    A blow-by-blow account of System monetary policy from August, 1929, is provided by Meltzer. There was no OMIC meeting scheduled for October as the stock market, already in turmoil, headed for the abyss.  There was no recognition of the impending crisis by the Board, which was only concerned with seasonal demands. The Board approved some further loosening through the acceptance market, but Harrison was on his own at the N.Y. Fed as the stock market followed a tumultuous week by crashing on Monday and Tuesday, October 28 and 29. See, Great Depression, "The Crash of '29."
 &
  In the week to October 30, money was fleeing New York. Out-of-town banks withdrew over $1 billion from the call money market. However, N.Y. banks stepped into the breach, almost doubling their commitment to just over $2 billion. They were supported by $133 million in open market purchases by the N.Y. Fed and $200 million in discounts authorized by Harrison on his own to extend reserves into the banking system. Harrison was unanimously supported by the directors of the N.Y. Fed. The Board grudgingly ratified Harrison's "liberal" measures on October 31.
 &
  There is no indication that the other reserve bank governors were slow to perceive the economic threat or take counter-cyclical action. The OMIC immediately acknowledged the seriousness of the situation and supported Harrison by approving a further $200 million in open market purchases. The System purchased another $260 million in securities and acceptances before Christmas. "The initial crisis was over."
 &
  The System was designed to prevent financial panics, and on this occasion the panic was successfully confined to the stock markets due to the action of the N.Y. Fed and its member N.Y. banks. By all measure - and under the harshest of conditions - the System had achieved a spectacular tactical success, but solely because of measures initiated by Harrison.
 &

  The System was not supposed to be an engine for speculative and inflationary excess. The System was supposed to finance just real commerce. A single penalty discount rate was inappropriate for all the different reserve banks, and it was politically untenable at any rate. It was thus impossible to prevent the discount facility from becoming an engine for speculation. Once System credit was out the door, there was no way to control its use. "Limiting rediscounts to real bills does not change the marginal loan at member banks or the volume of credit outstanding," Meltzer points out. Open market activities could be more finely tuned, but they had similar problems.
 &
  Miller subsequently tried to place most of the blame on the dead Strong for the System failures leading up to the 1929 Crash. Meltzer goes at some length into the factual errors, inconsistencies, and dubious theory in Miller's 1935 American Economic Review article.
 &

Bust:

 

&

  Left wing myths about the Crash of 1929 and its economic impacts are convincingly shredded by Meltzer. The figures clearly do not support the myth created by Keynesian economists such as  John K. Galbraith and Charles P. Kindleberger that the stock market boom and bust that year was grossly irrational.
 &

  The economy had indeed been remarkably prosperous and stable for four years and seven months into August of 1929. There was no sign of inflation. There was growing confidence that the System could mitigate the business cycle. The federal budget was in substantial surplus throughout the decade and tax rates were repeatedly reduced by substantial amounts. There was much talk of a "new era" in economics, and the thought was hardly outlandish. Prior to 1929, even abroad, foreign currencies were returning to gold convertibility or to pound or dollar convertibility and there was growing prosperity.
 &
  The stock market had indeed doubled in relation to net corporate profits, but this surge in the capitalization rate had occurred before 1928. The stock market surge in 1928 and the first eight months of 1929 was matched and rationally justified by the surge in profits, industrial activity, exports and other measures of prosperity. The doubling of the capitalization rate in 1926 and 1927 is readily justified by perceptions of reduced risk, greater stability and expectations of the prosperity subsequently realized. through the summer of 1929.
 &
  That the Crash itself did not precipitate the Great Depression is proved by the extent of the economic downturn that began the previous August. Trouble abroad was evident by the beginning of 1929.

  Stock market prices had pushed up to dangerously high levels of optimism in relation to yields - which fell below 3% in September, 1929. Dividends were an important part of return on investment in those days before high marginal tax rates. However, dividends were increasing at an accelerating rate.
 &
  Economic decline clearly preceded by more than two months the stock market Crash at the end of October, 1929, and a substantial stock market rebound through the first quarter of 1930 did not end the economic decline. The stock market reflected economic events, it clearly did not determine them.

With the U.S. and France aggressively sterilizing gold flows (and trade war levels of tariffs constraining trade flows), all gold standard nations were maintaining deflationary monetary policies as they strove to maintain gold reserves at desired levels.

  Meltzer again points an accusing finger at System monetary policy. The monetary base actually declined about 2% during the two year period of rapid commercial expansion through June, 1929. Ambiguity is introduced by expanding the analysis to broader measures of monetary aggregates such as M2. Banks were aggressively encouraging expansion of time and savings deposits that required lower reserve ratios.

  It is another Keynesian myth that deflation is inconsistent with prosperity. Productivity growth justifies modest levels of deflation, and these naturally increase purchasing power and provide powerful healthy economic stimulation unless an economy is deeply in debt. The U.S. enjoyed declining price levels in eight of the ten decades of the generally prosperous 19th century, excepting only the decades of the gold rush and Civil War period.

  With the U.S. and France aggressively sterilizing gold flows (and trade war levels of tariffs constraining trade flows), all gold standard nations were maintaining deflationary monetary policies as they strove to maintain gold reserves at desired levels. The economic downturn began abroad at least by the spring of 1929, and began in the U.S. that summer.

  "By the spring of 1929, recession had started abroad. It was probably too late to stop a worldwide recession, but there was ample time to stop the severe deflation that followed."

  Automobile production, home construction and exports were declining rapidly from booming first quarter levels, but otherwise there were no signs of domestic economic trouble until agricultural prices started declining in the middle of August.

  The author concludes that a less restrictive monetary policy that avoided deflation "would have ameliorated or possibly prevented the 1929 recession."

  An end to sterilization and acquiescence with a functioning  gold standard would certainly have performed better and mitigated the Great Depression. However, the 1920s would have been far less "stable" for the U.S., and without an end to trade war levels of tariffs and other protectionist measures, the Great Depression could not have been avoided or even shortened. Indeed, the highly protectionist forces in both parties in Congress would probably have responded to any increase in imports with even greater tariffs and increases in other protectionist measures. The trade war had already resulted in vast overcapacity in agricultural and industrial commodity markets that made collapse in these markets inevitable.

Failure of the administered alternative:

  A blow-by-blow account of System monetary policy up to the advent of the New Deal is provided by Meltzer. Only the highlights are provided in this review.
 &

  At the January, 1930 meeting of reserve bank governors, there was general recognition that a recession was in progress affecting some regions more than others, and general satisfaction that the immediate crisis had been handled. The inclination was to let the process run its course and that the natural decline in interest rates would suffice. "No one argued for a program of substantial or even moderate open market purchases." The governors took a sanguine view of conditions.

  "Since short-term market interest rates had fallen and were expected to fall further as member bank discounts declined, most governors saw little reason for the Federal Reserve to 'interfere' or to hasten the decline in rates. Words like 'artificial stimulus' and 'inevitable decline' reflect the dominant view that speculative excesses had to be purged. Once that happened, the economy would recover, and the System would be able to expand based on rediscounting of real bills."

  The Board took another step in gaining control of monetary policy in 1930 by replacing the 5 member OMIC with an Open Market Policy Conference (the "OMPC") consisting of all 12 reserve bank governors with a 5 person executive committee to carry out instructions. The Board did not succeed, however, in its efforts to include Board members on the OMPC.
 &
  The minimum buying rate for bills was reduced by the Board several times that first quarter of 1930. It was down to 3% in March. Discount rate cuts were also approved. However, unrecognized was a wholesale price decline of 7% in seven months that meant that real interest rates had risen more than nominal rates had fallen. Thus, the System's holdings of both acceptances and discounts were declining precipitously.
 &
  Meltzer notes - but understates - the economic and stock market recovery that first quarter of 1930. See, Great Depression, "Rebound from Crash of '29 (1929-30)." He argues that if the governors had used money stock statistics instead of nominal interest rates as a measure of monetary conditions, they would not have concluded that monetary policy was "easy." Open market purchases could have contributed to the economic expansion at that time. Instead, contraction of the money stock contributed to the subsequent decline and ultimate financial collapse.

  As Meltzer notes, money was flowing into time and savings deposits that were paying as much as 4.5% interest - an excellent return on investment during a period of sharp deflation. Savings account funds were generally made immediately available to depositors as a matter of bank policy. If they are included in the "money stock" figures, and especially if we consider the M2 instead of just the M1 money supply, we get a substantially different picture.

  The Board rejected further rate decreases towards the end of April, but within a week it was induced to begin rapidly reducing System rates.

  All economic factors were tumbling sharply with a general collapse of commodity prices. Vast surplus overhangs in numerous commodities had accumulated - something monetary policy had no capacity to deal with. See, Great Depression, "The Collapse of Agriculture (end 1930)."

That summer, an adverse credit shift began as spreads widened between various grades of debt and business entities saw their credit ratings decline.

 

Only the directors of the N.Y. Fed actively supported an aggressively expansive monetary policy. They were struggling with the financial difficulties of the Great Depression every day in their own commercial activities.

  The governors were sharply divided as to what to do. Substantially lower System rates were not being reflected in long term rates, which declined only modestly. That summer, an adverse credit shift began as spreads widened between various grades of debt and business entities saw their credit ratings decline. The governors decided to do nothing but stand ready to react to further developments. No one mentioned the rapid two month decline in demand deposits - of more than $1 billion - that was reducing the money stock.
 &
  Only the directors of the N.Y. Fed actively supported an aggressively expansive monetary policy. They were struggling with the financial difficulties of the Great Depression every day in their own commercial activities.
 &
  There is no sign of broad policy disputes between Harrison and the other reserve bank governors who readily acquiesced that the N.Y. Fed should have broad monetary policy discretion subject only to Board approval. Harrison's occasional ventures into expansionist open market operations were aimed at dealing with short term monetary conditions.  He failed to develop any long-term program. Modest experiments with open market purchases had no observable economic impact and strengthened opposition to further open market efforts. There was widespread belief that the worsening recession had causes totally unrelated to monetary policy. (This belief was largely but not entirely correct.)
 &
  Harrison specifically doubted "the power of cheap and abundant credit, alone, to bring about improvement in business." His aim was to have sufficient monetary ease so that the money center banks would be out of debt to the reserve banks and would have sufficient excess reserves to be ready to meet loan demand. By July, 1930, this objective had been achieved. Money was now "easy." However, with wholesale prices declining about 14% on an annual basis, real interest rates were about 16%. Who could afford to borrow at such real rates?

  However, because there are risks and administrative costs to extending loans, commercial interest rates cannot go to zero in any event no matter how rapid price deflation may be. Would 15% real interest rates have been any better than 16% real interest rates?

The System attributed as a main cause a lack of purchasing power - domestic and international. It still did not appreciate the implications of high real interest rates. Low nominal rates and low member bank borrowing from the System was interpreted as evidence of monetary ease. The banking system had all the money it could use at low nominal interest rates.

  After one year from the August, 1929, economic peak, it was clear that all the "speculative excess" had been squeezed out of the economy. And yet the downturn had over 2-1/2 years to go. The rate of contraction in prices and the money stock accelerated even as the rate of contraction in industrial production eased back so that the three were now declining at the same great rate.
 &
  The System now recognized that the Great Depression was already one of the worst in the nation's history. It attributed as a main cause a lack of purchasing power - domestic and international. It still did not appreciate the implications of high real interest rates. Low nominal rates and low member bank borrowing from the System was interpreted as evidence of monetary ease. The banking system had all the money it could use at low nominal interest rates.
 &
  Correspondence reveals widespread doubts that further reductions in interest rates could bring recovery and fear that current levels of monetary ease might already have gone too far. The notion of forcing extra funds into the banking system through open market purchases was widely rejected as ineffective and dangerous. The problem remained economic overcapacity, not under-consumption.
 &

  The System should remain pro-cyclical - ready to add credit when needed by business expansion and acting to soak up the slack when business was declining, in line with the policies in the Board's Tenth Annual Report. This would occur naturally if the "real bills" doctrine of confining discounting to commercial paper were followed since that rose and fell with the business cycle. As one memo explained:

  "We have been putting out credit in a period of depression when it is not wanted and cannot be used, and we will have to withdraw credit when it is wanted and can be used."

  By this time, however, Adolph Miller at the Board and some officers and staff at the N.Y. Fed were arguing for an aggressive open market program of securities purchases to push additional funds into the banking system. Harrison and other System officials rejected this as dangerous. It would be futile and would just cause a gold outflow until the System was drained of gold reserves. The purchase program would thus eventually prove unsustainable, and would have little impact since there was already ample funds available for borrowers in the banking system. (What was lacking was sufficient profit prospects to induce borrowing and investing, and business conditions that supported credit worthiness.)
 &
  With real interest rates above 16%, member bank borrowing from the System had already fallen below the levels of the previous two recessions.

  "The System had purchased more than $500 million of securities and acceptances in the previous twelve months. Short-term rates were at historical lows. [Member bank borrowing at considerably less than $500 million] suggested that policy was easy. The real bills doctrine implied that the correct policy was a passive one. Most governors had always held these views; Harrison shared many of them."

Gold lying sterile in U.S. vaults was not performing its assigned function.

  However, gold standard rules dictated an expansion of the money stock that reflected the System's bulging gold reserves precisely to induce price increases and a reversal of gold flow back to the nation's that needed it. Gold lying sterile in U.S. vaults was not performing its assigned function.
 &
  The Great Depression reached the banking system early in its second year, highlighted by the failure of the Bank of the United States in New York in December, 1930. Efforts to save the bank were halfhearted and fell through.
 &
  Public confidence in its national banking system - previously strong - was suddenly shattered. Demand deposits were drawn down and held as currency, which expanded substantially by $300 million - about 7.5% - mostly supplied by the N.Y. Fed. The N.Y. Fed bought $100 million in securities and $75 million in acceptances before Christmas and made similar purchases during the Christmas week to assure adequate funds in the New York region. Risk spreads widened even further and member bank lending fell by $500 million in two months.
 &
  The N.Y. Fed quickly unwound its emergency positions after the risk of panic subsided. The trend towards greater public holding of currency and wider risk spreads continued from this point as the Great Depression deepened. "Excess reserves" began to pile up in the banking system  - doubling to $100 million - as banks became more cautious about the course of events. Member bank loans had declined almost $1 billion in the four months through January, 1931.
 &

  At last, the impact of the trade war in general and the Smoot-Hawley tariff in particular was noted by the reserve bank governors. (These factors were increasingly being debated in the press. See, Great Depression, "Debate Begins, (beginning 1931)." Europe was planning to reduce its imports from the U.S. because the U.S. wouldn't buy their exports and they couldn't continue to pay the difference with gold. The N.Y. Fed repeatedly tried to help by buying sterling bills in London, but this was a poor substitute for trade.

  North American grain exports - generally well in excess of 200 million tons - were cut to substantially less that 100 million tons in 1930 as Europe's tariff protected agricultural sector became able to fill all Europe's needs. This - not monetary policy - was undoubtedly the primary reason for the failure of the promising business revival in the spring of 1930. Similar worldwide collapse occurred throughout 1930 in cotton, silver, copper and other commodities. It was far too late for mere monetary manipulation, no matter how aggressive, to materially impact these events.
 &
 
Left wing economists have ever since attempted to disparage the importance of the trade war as one of the several primary causes of the Great Depression. After all, they emphasize, foreign trade at that time was only 8% of GDP. They strive instead to support a host of anti-capitalist myths. However, facts are hard things. It is hornbook economics that markets move on their margins - and the huge agricultural segment of the U.S. economy in the 1930s was hardly just a marginal factor.
 &
  Wheat export surges and ebbs alone
had been the major factors in three swings in the business cycle for the entire economy within the prior half century. Failed wheat crops abroad had led to export and economic surges in 18791882, 1891-1893 and 1897-1899 that turned to export busts that were transmitted to the rest of the economy when foreign crops recovered. See, Friedman and Schwartz, "Monetary History of U.S. (1867-1960)" Part I, Greenbacks and Gold (1867-1921)" at segments on "The Adjustment Process of the Gold Standard " (boom of 1879-1882), "End of free silver movement" (boom of 1891-1893) and "Gold inflation" (boom of 1897-1899). Indeed, wheat price declines approaching $1 per bushel had become a primary economic indicator - a red flag - for Wall Street.

The catastrophic levels of capital flight from Europe induced Pres. Hoover, on June 19, to propose a moratorium on intergovernmental payments for war debts and reparations.

  The money stock continued to decline as the System sold its government securities and its acceptances and discounting continued to fall. Harrison and most other governors were still more concerned with inflation risks because they doubted the effectiveness of aggressive open market monetary policy. However, by the April, 1931 governors conference, the gold inflow at last convinced the governors to favor up to $100 million in open market purchases.
 &
  A gold inflow was supposed to reduce interest rates and expand the money stock. Interest rates were at record lows, but the money stock remained in rapid decline. In May, the reserve banks yet again lowered their acceptance and discount rates. Nevertheless, System holdings of bankers acceptances continued to fall because market rates were even lower - now less than 1% - and  discounts remained low. Even though gold continued to flow in, the money stock continued to decline, and the public continued to demand increasing amounts of currency as faith in banks continued to evaporate.
 &
  Declining bond prices - especially for the railroads - were eating into bank reserves and accelerating the rate of bank failures. Bank lending declined at a 20% annual rate during the first half of 1931. Wholesale and agricultural prices were collapsing. The political breakdown in Germany and throughout Central Europe was now of increasing concern. The catastrophic levels of capital flight from Europe induced Pres. Hoover, on June 19, to propose a moratorium on intergovernmental payments for war debts and reparations.

  In response to the Hoover Moratorium call there was a major stock market rebound that added almost $5 billion - over 10% - to values on the NYSE that June. This is strong proof that businessmen, investors and politicians were acutely aware that the reparations payments, war debts, tariffs and other trade war phenomena played a major role in the tremendous collapse of world trade, domestic business and finance of the Great Depression. Yet little more was done, and nothing was admitted.
 &
  The inference most apparently to be drawn from this is that the widespread vengeful emotions surrounding the Great War and its financial obligations and the effect of these emotions on democratically elected political leaders was actually one of the root causes of the Great Depression. While a perfectly understandable outcome of a horrific conflict, they condemned the world to continued and worsening economic suffering and perhaps also to WW-II. See, Great Depression, "Collapse of International Finance (end 1931)."

Panic:

 

 

&

  The gold inflow - about $170 million with more on the way in the six weeks before the June 1931 executive committee meeting, finally induced the governors to favor open market purchases. The gold flow simply had to be reversed because capitalist markets were collapsing throughout Europe and Latin America. Board governor Eugene R. Black and Board member  Eugene Meyer strongly favored such open market purchases. Hoover's moratorium proposal had to be supported by System actions.
 &
  Substantial loans to tottering European banks were arranged, but they were mere spit in the torrent of capital flight. These efforts drew criticism because the System was doing more to relieve financial distress abroad than in the U.S. However, Harrison still felt helpless to intervene more forcefully. He still felt that nobody had any use for additional System funds. (In the event, these interventions abroad proved spectacularly ineffective.)
 &

Harrison had repeatedly asked for standby authority in case of need, but always seemed to feel the need lacking or found other excuses to remain on the sidelines.

  The Depression plumbed unknown depths in every respect that summer. Capital was fleeing Britain and Latin American nations were defaulting on their loans. By August, the governors were finally  convinced to authorize substantial open market purchases. The Board wanted far more open market purchases than did the governors. Meyer argued strenuously for a bold stroke involving $300 million in purchases. The governors authorized $120 million.
 &
  Meltzer convincingly demonstrates the fallacy of Milton Friedman's opinion that Harrison was being held back by the criticism of Board and other System policy officials. See, Friedman & Schwartz, "A Monetary History of U.S. (1867-1960," Part II, "Roaring Twenties Boom - Great Depression Bust (1921-1933)," at segment on "Paralysis of the Federal Reserve System." "Despite the continued increase in currency held by the public, the System did not use its authority to purchase securities." Harrison had repeatedly asked for and received standby authority in case of need, but always seemed to feel the need lacking or found other excuses to remain on the sidelines. However, now, Meyer was conveying discontent with System inaction that was building not just in the public but with Congress as well.
 &

The bonds that banks had invested their reserves in - predominantly railroad bonds - were declining in price and rating as railroad income collapsed, throwing banks into insolvency.

  European financial collapse swept through Austria, Germany and Hungary and culminated in the spectacular collapse of the British pound on September 20, 1931. Loans from the U.S. and France to troubled nations could not alter the fundamental problems faced by those nations.

  Only trade with the U.S. could balance their imports with exports and provide them with the dollars needed to service their dollar debts, and that was blocked by U.S. protectionist tariffs.

  The initial impact in the U.S. was a gold outflow. No paper currency was safe any more. The System responded by quickly raising its discount rate in two steps from 1.5% to 3.5%. Acceptance rates were similarly boosted, but market rates surged higher by the end of October and acceptances were allowed to run off.
 &
  Over 1200 U.S. banks with almost $1 billion in deposits failed in the first three quarters of 1931, with most of the failures occurring in the third quarter. The bonds they had invested their reserves in - predominantly railroad bonds - were declining in price and rating as railroad income collapsed, throwing banks into insolvency.
 &

  Pres. Hoover called a bankers meeting to propose an emergency National Credit Corporation ("NCC"). Its capital would be $500 million subscribed from the major banks, and it would have authority to borrow an additional $1 billion, with which to rediscount bank assets not legally eligible for discount by the System. The NCC would function until Congress reconvened in January, 1932, when Hoover intended to propose a permanent Reconstruction Finance Corporation ("RFC") for this and other financial support purposes. He could no longer tolerate the lack of such action on the part of the System, and so was making other arrangements.
 &
  In the event, the NCC had, by the middle of December, advanced only $15 million. The RFC was funded by the government with $500 million and had authority to borrow $1.5 billion more from the Treasury or private sources.
 &

  The Great Depression decline accelerated in the last quarter of 1931 after the collapse of the pound. Industrial production and stock market prices collapsed, bank loans and money stock declines accelerated and risk spreads widened alarmingly. Although the System had authority for $120 million in open market purchases, it made none.
 &
  Four hundred banks closed in the first three weeks in October. Liquidation of their marketable assets drove bond prices even lower. The governors recognized the bank failures as their most pressing problem, but could not think of anything to do. Meltzer notes again that they had done more to support foreign banks (unsuccessfully) than they were willing to do for domestic banks.
 &

New York bankers were almost unanimous in opposing open market purchases, as were most of the System governors. Thus, as they kept score on the rapidly collapsing economic and financial situation, the System took no action.

  However, the System had responded to the pound devaluation crisis in the classic fashion advised by Bagehot. It had raised discount rates to stem the gold outflow and currency drain, but lent freely to prevent panic. System credit outstanding had doubled in two weeks - to $2 billion - the fastest rate of expansion on record to that time. The gold outflow reversed, but faith in the nation's banks had been fatally undermined. The rate of bank failures accelerated and the public withdrew currency from the banking system. Even interest rates of Aaa rated bonds were rising as their prices declined. The risk spread was 5% - 4% higher than in 1929.
 &
  Open market operations were limited to seasonal adjustments. Harrison had authority for an open market purchase program and was urged to initiate it by his directors and staff at the N.Y. Fed and by Miller and Meyer at the Board, but he adamantly refused, insisting it would do no good. Member banks were not using System credit for loans to customers. New York bankers were almost unanimous in opposing open market purchases, as were most of the System governors. Thus, as they kept score on the rapidly collapsing economic and financial situation, the System took no action.
 &

Desperate measures:

 Congress forced action in February, 1932, by passage of a Glass-Steagall Act that temporarily - for one year - suspended the eligible paper collateral requirement for Federal Reserve System notes. It permitted the substitution of government securities.
 &

   Paper that had previously been ineligible could now be discounted or bought by reserve banks at a rate 1% above the discount rate. This allowed banks to discount a wider variety of their assets. Banks could also group together to borrow on the group credit, encouraging the formation of county clearinghouse banks.
 &
  The RFC was established that January and began immediately extending credit. The 1932 election year had begun, and Congress was desperate to do something - anything - to deal with the worsening tragedy. All manner of radical currency schemes were in the legislative hopper. (However, with a few notable exceptions, the legislators adamantly refused to reconsider their precious tariffs.)
 &

  That spring, the System pumped $1 billion into the banking system. The N.Y. Fed did most of the heavy lifting under the System's purchase program as the Boston and Chicago reserve banks refused to participate. However, France and other nations responded by withdrawing gold, so gold reserves declined $500 million. Discounts dropped $400 million, so these aggressive open market purchases increased reserve bank credit outstanding by only $100 million.
 &
  The spring business revival in 1932 was practically non-existent and the economy was again contracting rapidly by May. See, Great Depression, "Collapse of WW-I Financial Obligations (beginning 1932)." The gold reserves of the N.Y. Fed were down to about 50%. With nothing to show for this major open market effort, Harrison drastically slowed the purchase program. In Chicago, banks began dropping like flies. The City of Chicago could no longer pay its bills, and the utilities holding company of Samuel Insull collapsed.
 &
  There were a variety of reasons why the purchase program came practically to a standstill in the summer of 1932, but the failure to achieve any noticeable results was paramount. Harrison was loath to have the N.Y. Fed carry a load not shared by the other reserve banks. Foreign governments, alarmed by the purchase program, had withdrawn significant amounts of gold from New York during the program. The Great Depression was still perceptibly worsening, and reserve bank authorities wanted to retain sufficient reliable resources - now only gold - to meet further emergencies. System gold reserves dropped below 56%.
 &
  With the end of the purchase program, gold began to flow back into the System. With market rates below both the discount and acceptance rates, member bank borrowing from the System remained low. The decline in the money stock resumed in the fall.
 &

  However, June, 1932, was a low point in the Great Depression in some - but certainly not all - respects. The stock market rebounded vigorously off its bottom - more than doubling in two months - (perhaps the sharpest bull market in history). The bond market also recovered, with spreads for lower grades narrowing significantly. Industrial production surged that summer from its very low base.
 &
  Meltzer attributes much of this revival to the purchase program and concludes that its continuation would have supported recovery from that point or at least would have prevented the collapse of the next winter. The RFC had also been instrumental, Meltzer notes, lending $784 million to troubled banks and sharply reducing the rate of bank failures.

  However, the author is guilty of confirmation bias, here. He totally ignores the non-monetary factors behind the summer stock market and business upsurge, and the continued collapse of the market for U.S. exports that caused the final collapse of grain prices that fall. He looks only at the facts he wants to find. He ignores how narrow the summer recovery was.
 &
  The summer, 1932 surge was clearly an agricultural market phenomenon that lasted only so long as supported by crop reports. The economic surge spread to textiles, but little else. The Farm Board had stepped aside in defeat. The surge in commodity and stock market prices began precisely  when the resulting drastic reductions were reported in U.S. grain and cotton crops. It came to an end that October as European reports indicated another bumper European wheat crop sufficient to meet all European needs.
 &
  All of the most important economic indicators remained flat at low levels throughout the summer despite the great surge in the stock market and in agriculture and textiles. With the exception of a recovery from the July 4 holiday week dip, steel production remained flat through the entire summer. Electric power experienced a few sharp spikes but remained within a flat range, and automotive activity declined sharply throughout the summer. Railroad car loadings remained flat until September when they began to rise in response to the usual fall business season  upturn. But the fall business season upsurge turned out to be short and grossly disappointing, With the exception of agriculture and textiles, there is absolutely no proof of an economic bottom in the summer of 1932.
 &
  Monetary factors might have helped in the spectacular summer rally in agriculture and textiles and the stock market, but there is actually no real evidence to that effect. It is mere conjecture. Further monetary expansion would not have increased grain exports by a single bushel into Europe's tariff protected markets. Monetary expansion could not have made a dent in the cotton carryover that by this time exceeded a full year's domestic consumption. See, Great Depression, "Collapse of Governments (end, 1932)."

H) Collapse of the Federal Reserve System

Paralysis:

 

&

  As the final collapse developed, the System resumed its passive policy response. The N.Y. Fed would have to take the lead in any open market purchase program. Although support for such purchases had now grown among all but a few of the System governors, Harrison was again doubtful of its effectiveness and wary of expending N.Y. Fed reserves.
 &

Hoover, with increasing urgency, asked the Board what action should be taken. However, the Board admitted it had no idea what action might be effective in the circumstances.

  The System meetings in the period leading up to the bank holiday are covered in detail by Meltzer. Open market activity remained passive - concerned only with the technical aspects of maintaining free reserves within a range that was considered appropriate. The nation tumbled into ultimate banking collapse without the central banking system thinking there was anything it could do. Banks were failing and closing in increasing numbers, people were withdrawing currency and foreigners were withdrawing gold.
 &
  Also, the nation was between presidents. Franklin D. Roosevelt had been elected in November but would not take office until March 4, 1933. He refused to give assurances as to his intentions, so matters continued to flow downhill. Pres. Hoover, now a lame duck, tried without success to get the System to act and to get FDR to  cooperate. Meltzer relates the disjointed responses of the government officials as the situation spun totally out of control.

  "Burdened by its history of crises, a lame duck administration, Federal Reserve inaction, and Roosevelt silence, the financial system collapsed. By inauguration day, thirty five states had declared bank holidays, closing all banks. Closings typically were for limited periods, but some were indefinite. In the states without declared bank holidays, withdrawals were severely restricted; often no more than 5 percent of deposits could be withdrawn."

  Hoover, with increasing urgency, asked the Board what action should be taken. However, the Board admitted it had no idea what action might be effective in the circumstances. With gold draining from the N.Y. Fed to both domestic and foreign interests, and a vast demand for Federal Reserve notes to meet currency demands, gold reserves at the N.Y. Fed plummeted to 24%, although it stayed above the required 40% for the System as a whole.
 &
  The Bank of England was very active in draining gold from N.Y. In March, the Board suspended the gold reserve requirement, but the N.Y. Fed was still losing gold to foreigners. On March 4, at the request of the N.Y. Fed and the N.Y. clearinghouse banks - which remained solvent through the crisis - N.Y. State governor Herbert Lehman declared a banking holiday. Illinois, Pennsylvania, Massachusetts and New Jersey followed suit.
 &

Aggressive open market purchases without uniform System support would have drained N.Y. Fed gold not only abroad but internally as well to the nonparticipating reserve banks.

  The System was still sharply divided, with many officials openly critical of the assumption of monetary policy powers by the N.Y. Fed. Two of the largest reserve banks - in Chicago and Boston - frequently refused to participate in monetary policy actions. Aggressive open market purchases without uniform System support would have drained N.Y. Fed gold not only abroad but internally as well to the nonparticipating reserve banks.

  "Despite a falling price level before the collapse and an accelerating price decline after, there is far more concern about potential inflation than about deflation. [Even if Strong had lived,] he would have had to convince his colleagues that another round of speculative credit expansion could succeed." (But it couldn't possibly have succeeded!)

  The Board remained indecisive to the end. It did direct other regional reserve banks on March 7 to rediscount securities from the N.Y. Fed in return for gold. The N.Y. Fed quickly obtained $245 million in gold, raising its reserves to 41.5% when it reopened on March 9. It repaid its borrowings in mid-April at a rediscount rate of 3.5% and a $10,200 fine for violating the 40% gold reserve requirement.
 &
  Pres. Roosevelt closed all the banks
from March 6 to March 11, 1933, first using the dubious authority of the WW-I Trading With the Enemy Act and then the Emergency Banking Act passed on March 9.

I) Conclusion

Impacts of monetary policy:

  Meltzer concludes that the primary errors in monetary policy were an acceptance of the real bills doctrine, failure to act as lender of last resort, and failure to distinguish between real and nominal interest rates.
 &

  He recognizes that deflation increased "real" money balances and thus significantly stimulated spending. This worked during the subsequent recessions of 1937-38 and 1947-48 as it had during the prior recessions of the 1920s. However, real interest rates rose above 10% in 1930 and stayed there. One reason was that the money stock declined so fast. He sums up the monetarist view of the Great Depression.

  "If the Federal Reserve had prevented the decline in money, falling prices would have raised real balances, created an excess supply of money, stimulated spending, and limited or ended the decline when the economy began to recover in spring 1930; rising real balances and an excess supply of money would have increased aggregate spending. Or if the Federal Reserve had followed the gold standard rules, the gold inflow would have increased nominal and real money balances from 1927 to 1929 and from 1929 to the British devaluation in the fall of 1931."

  The author recognizes - without any analysis - that there were many non-monetary factors involved. He notes correctly that the Great Depression was a complex phenomenon with no single dominant cause. Nevertheless, the monetary factors - especially the failures of System monetary policy - are viewed as the most influential of those that might have prevented the Great Depression or brought it to a swift conclusion during the first half of 1930. (As pointed out above, this view totally ignores the collapse of international commodities markets starting during that time.)
 &

The effort to substitute human administered alternatives in place of the automatic gold standard market mechanism had proven to be an unmitigated disaster.

  Meltzer is clearly correct, however, that the failure to follow gold standard rules - adherence to the pro-cyclical "real bills" doctrine - misunderstandings of the nature of real interest rates and the indicators of monetary "ease" - and the persistent fear of inflation had transformed the System into an engine of deflation - worldwide. The effort to substitute human administered alternatives in place of the automatic gold standard rules based market mechanism had proven to be an unmitigated disaster. See, Meltzer, "History of Federal Reserve, vol. 1," Part I, "The Search for Monetary Stability (1913-1923);" and Meltzer, "History of Federal Reserve, vol. 1," Part III, "The Engine of Inflation (1933-1951)."

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