America’s Money Machine
15. When to Reef Sail
DURING THE FINAL DAYS of debate in Congress on the Federal Reserve Act, it will be recalled, the distinguished Senator from New York, Elihu Root, rose to make one of the most brilliant, devastating, and significant attacks on the bill that had been heard in the Senate. Speaking on December 13, 1914, Root had declared that the bill was inflationary and dangerous.
“It provides,” he had said, “an expansive currency, but not an elastic one. It provides a currency which may be increased, always increased, but not a currency for which the bill contains any provision compelling reduction.”
He had gone on to survey the historical experience of inflation in Europe:
With remarkable prescience, Senator Root foretold exactly what would happen six and a half years later: “You cannot contest the operation of these laws,” he had declared.
As against the working of that law, your raising the rate of interest, or your attempting to sell government securities, will be just as effective as Mrs. Partington’s mop against the Atlantic Ocean, because you do not bring into operation your forces until the damage is done. When confidence is lost, you can raise the rate of interest to the roof, but you do not bring the money until you restore confidence. . . .
The Senator’s analysis was an admirable blueprint for the post-war collapse. After the Armistice merchant shipping that had been concentrated on the shortest Atlantic crossings now scattered throughout the world seeking cargo. Wool that had been piling up in Australian warehouses for want of means to get it to market, now clogged the London and Boston docks.
Meantime, prices were continuing to rise, to the mounting concern of everyone, from housewives trying to fill the market baskets with the lagging wages of their spouses, to industrialists faced with the profit squeeze of narrowing margins between costs and sales, to the authorities of the Federal Reserve Board, anxious over the “overstrained situation resulting from excessively high prices and wages.”
While high prices of necessaries were obviously chargeable to inefficiency and underproduction to a large degree, the Board reported in its summary of business conditions for April, it advanced the belief “that the already high costs of production were aggravated by the added expense of obtaining capital,”—that is, the high interest rates prevailing.
Actually, of more concern to the authorities was the continually increasing demands for goods, which by their very urgency increased dislocations in industry. A railroad strike for higher wages, combined with a shortage of freight cars, had reduced coal mining in Eastern mines to 30 per cent of normal, and in Southwestern mines to about two-thirds of normal, the Federal Reserve Board reported, while sporadic strikes in the manufacturing industries, notably textiles, interrupted production and aggravated unrest. It reported also an acute shortage of labor on farms. Wages, the Board found, apparently were falling behind advances in prices and the cost of living.
In the light of all these factors the Board prognosticated no general reduction of prices, though it suggested somewhat Delphicly that changes in prices that had already taken place might be the basis for a more far- reaching alteration in the essential price structure.
Meantime, as a measure to discourage excessive use of Federal Reserve credit to finance expansion the Board obtained from Congress an amendment to the Federal Reserve Act (April 13, 1920) to permit Reserve banks to vary or graduate the discount rate charged member banks, based upon the total amount of their borrowing from the Reserve. (Section XIV, 5)
“In this way,” explained Governor Harding, “it would be possible to reduce excessive borrowings of member banks and induce them to hold their own large borrowers in check without raising the basic rate. The Federal Reserve banks would thus be provided with an effective method of dealing with credit expansion, more nearly at the source than is now practicable, and without the unnecessary hardship to banks and borrowers who are conducting their affairs within the bounds of moderation.”
At this juncture Senator Owen, champion of easy money, launched an attack upon the Federal Reserve’s high rediscount rate, charging the Board with responsibility for a $3 billion depreciation in the $26 billion of government bonds outstanding.
“I do not think it wise, I do not think it just, I do not think it decent or ethical,” he declared, “for the government agencies to pursue a policy which causes a loss of $3 billion to their patriotic bondholders.”
The Federal Reserve Board, in its review of April business, revealed its mounting concern over the price situation. It said:
The existence of the Federal Reserve System does not relieve a single banker from his individual responsibility to do his share in checking further expansion by exercising a stricter control of the credit he creates; for, except in its limited open market purchases of bankers’ acceptances, the Federal Reserve System does not act directly on the volume of credit, but acts only indirectly, through the banks, on whom the primary responsibility rests.
Clearly, the present is not an appropriate time to extend business merely for the sake of increased volume of profits. This applies not only to producers and distributors, but to bankers as well, for the present opportunities to take on new borrowing accounts and to reloan borrowed money at a profit are tempting to many. Nor is it a time for public or private improvements not absolutely necessary for health and efficiency.
With a shortage of goods and labor, the necessity of conserving both is as great as it was during the war, and requires an even higher self-restraint on the part of bankers, producers, distributors and consumers, since government control no longer exists. Accordingly, the more clearly the banker keeps in mind the conservation of labor and goods for necessary purposes as the object of his control the more clear will be his course in exercising such control.
On May 11 the Chicago Tribune reported that Secretary of the Treasury David Houston and the Federal Reserve Board were convening a conference of leading bankers to consider “how to halt the orgy of spending on luxuries and other non-essentials”:
The principal suggestion to be discussed will be . . . how to curtail the advance of credit for the production of non-essentials in an effort to stem the wave of extravagance, on the theory that people will stop spending where there are no luxuries to buy and capital will be forced into the production of necessaries when denied the more profitable field of non- essentials.
The despatch went on to state that “farmers are unable to procure nails, wire and other articles of iron because of the prodigious demand for steel in the automobile industry”—the automobile industry then assumed to be a luxury, and the cry reminiscent of the later complaint of John Kenneth Galbraith against automobiles with fins, and his ultimatum that automobile styles should be government regulated. The author of the despatch (Arthur Sears Henning) went on, however, to point out the difficulties of regulating credit with such ends in view:
There are numerous difficulties to be faced by the conference, however, in dealing with the curtailment of the production of luxuries and increasing production of essentials.
The impression prevails that such action as may be taken along this line must necessarily be of a general nature. Beyond blanket power to restrict loans, the Federal Reserve Board has no specific authority by law to define essential industries and non-essential industries.
There will also be a discussion of the present rediscount rates, but beyond a modification of those now in effect general increases are not anticipated.
Officials here believe the results of the application of graduated rediscount rates in the Kansas City district have been successful in restraining unnecessary use of credit.
In the midst of these deliberations, on May 20, 1920,wool quotations suddenly plunged from 65 cents a pound to 20 cents a pound, and the absence of buyers forced a closing of the wool exchange. Wheat quotations, also affected by Australian and Argentine supplies coming into the market, felt the shock in August. From an average price of $2.46 a bushel in June, and $2.43 in July, quotations dropped to $2.16 in August and to $1.46 by the end of the year. By the end of 1921 wheat was selling for less than a dollar a bushel, or about where it sold before the war.
How responsible was the Federal Reserve for this price debacle?
These measures, as Senator Root had predicted, were ineffectual in curtailing the amount of bank credit and money in circulation. Total Reserve credit outstanding (the sum of bills discounted for member banks, and the Reserve banks’ own purchases of bills and securities) rose from $2.4 billion just before the Armistice to $3.2 billion by the end of 1919 and $3.3 billion just before the May break in prices. Most of this increase was due to member banks rediscounting paper with their Reserve banks, but oddly, in view of the official policy, Reserve bank purchases of bills and securities also continued to increase, adding to the available credit in the banking system. Total Reserve credit continued to increase until October, 1920, flowing in an opposite direction to that of prices, and it was not until November that the movement was reversed, and Federal Reserve credit began to drop in response to business contraction.
Partly the continued increase in Reserve credit in 1920, after prices began to break, was due to the attempt to shore up prices by injection of purchasing power into the economy. This is a device which we shall examine in more detail in relation to the depression following the Great Crash of 1929. In short, the Federal Reserve was using credit much as the country woman used butter on boiled eggs—it was good to soften them when they were too hard, and to harden them when they were too soft. When business activity was rising, credit flowed into the economy to assist business to expand; when business activity was falling, credit was injected to restrain the fall.
Thus, on June 17, 1920, at the suggestion of the Governor of the Federal Reserve Board, W. P. G. Harding, a conference of Western bankers and sheep ranchers convened in Chicago to discuss means of raising $100 million to aid wool growers—and their creditors. Boston bankers, with their portfolios full of doubtful wool paper, were in no position to assist further, and there seemed to be some idea that Chicago might take over the burden of financing distressed holders of wool, and in the process shift the wool trade center to that city. It was announced a few days later that accommodation would be available through rediscounting wool drafts with the Federal Reserve banks, the only requirement being a bill of lading from a railroad company showing that the wool was being shipped. No eventual buyer was required to endorse this paper. The grower simply drew upon his bank, and the bank need only accept the draft. Naturally, the draft would cover only such portion of the value of the wool as the bank considered realizable under forced sale, and such value would be based upon the deflated prices of wool then prevailing. The operation helped the grower to realize some cash on his crop, but it did not raise the market value of the crop. There still remained the painful gap between what the rancher got for his wool, and what he was obligated to pay out in interest on his mortgaged ranch and livestock that had been bought on a basis of much higher wool prices.
The unanswered question that continued under debate among economists is whether the collapse of 1920 was due to economic or monetary causes, whether it was simply a return to “normalcy,” a readjustment of livelihood activities to the more ordinary requirements of peace, or a plunge into an economic abyss from the push of artificial manipulation of credit. Again, did the rise in intrest rates precede or follow the rise in rediscount rates, and did the rise in interest rates project or simply reflect the maladjustments of business? The difficlties in reaching any conclusion are illustrated in the accompanying chart of the rediscount rates and prime commercial paper rates in New York City for the years 1917 through 1921.
FEDERAL RESERVE AND MARKET RATES OF INTEREST PER CENT PER ANNUM
|
||
| Date | Rediscount rate New York Federal Reserve Bank | Market rate1 |
|
||
1917 |
||
Jan. |
4 | 3.98 |
Feb. |
4 | 4.47 |
March |
3 1/2 (21) | 4.50 |
April |
3 1/2 | 4.63 |
May |
3 1/2 | 5.28 |
June |
3 1/2 | 5.28 |
July |
3 1/2 | 5.25 |
Aug. |
3 1/2 | 5.19 |
Sept. |
3 1/2 | 5.44 |
Oct. |
3 1/2 | 5.63 |
Nov. |
3 1/2 | 5.69 |
Dec. |
4 (5) | 5.75 |
|
||
1918 |
|
|
Jan. |
4 | 5.83 |
Feb. |
4 | 5.88 |
March |
4 | 6. |
April |
4 | 6.08 |
May |
4 | 6.13 |
June |
4 | 6.03 |
July |
4 | 6.10 |
Aug. |
4 | 6.22 |
Sept. |
4 | 6. |
Oct. |
4 | 6. |
Nov. |
4 | 6. |
Dec. |
4 | 6. |
|
||
1919 |
|
|
Jan. |
4 | 5.25 |
Feb. |
4 | 5.13 |
March |
4 | 5.50 |
April |
4 | 5.38 |
May |
4 | 5.25 |
June |
4 | 5.38 |
July |
4 | 5.38 |
Aug. |
4 | 5.38 |
Sept. |
4 | 5.38 |
Oct. |
4 | 5.25 |
Nov. |
4 3/4 (4) | 5.25 |
Dec. |
4 3/4 | 5.88 |
|
||
1920 |
|
|
Jan. |
6 (23) | 6. |
Feb. |
6 | 6.38 |
March |
6 | 6.88 |
April |
6 | 6.88 |
May |
6 | 7.38 |
June |
7 (4) | 7.88 |
July |
7 | 8.13 |
Aug. |
7 | 8.13 |
Sept. |
7 | 8.13 |
Oct. |
7 | 8.13 |
Nov. |
7 | 8.13 |
Dec. |
7 | 8. |
|
||
1921 |
|
|
Jan. |
7 | 7.88 |
Feb. |
7 | 7.63 |
March |
7 | 7.63 |
April |
6 (15) | 7.63 |
May |
6 | 6.88 |
June |
6 | 6.75 |
July |
5 1/2 (21) | 6.38 |
Aug. |
5 1/2 | 6.13 |
Sept. |
5 (23) | 6. |
Oct. |
5 | 5.88 |
Nov. |
4 1/2 (4) | 5.50 |
Dec. |
4 1/2 | 5.13 |
|
||
2 Prime commercial paper, 4–6 months, New York City. Figures in parentheses indicate day new rate became effective.
Source: Federal Reserve Board. Banking and Monetary Statistics. 1941.
The Federal Reserve authorities managed to take an optimistic view of the fall in prices and reported at the end of September that “business conditions are now definitely on the road to stability of as great and confirmed a nature as the disturbed position of the world at large permits,” and added: “Continuance of the process of readjustment in business and industry has been an outstanding feature of the month. This has been accompanied by price reductions and by the resumption of work in branches of industry where hesitation as to the future outlook has led to suspicion.” The Board went on to comment on the change in the labor situation: “A notable change appears to have taken place in the efficiency of labor—twenty-one out of thirty-one of the largest corporations in the country reporting improvement, while none report any decrease. Improved railroad operation has resulted in much better marketing of goods. . . . Stock market conditions have partially recovered. . . .”
Meantime, the Board came under attack by Senator Owen, leader of the easy money and fiat currency wing of the Congress. In a letter to Governor Harding on October 22 he charged the Board with responsibility for what he termed the “psychological effect of the policy of deflation” which he asserted originated with New York bankers. The Board, he went on to assert, had by its action destabilized the credit of the United States, assisted in producing industrial unrest and lack of confidence, which had checked production and brought commodity prices below the point at which legitimate supply and demand would fix them.
Senator Owen’s letter continued:
The need for the alleged policy of deflation rests on the premise that the entire country is suffering from inflation, which is fundamentally untrue. Legitimate borrowing and lending for legitimate purposes is not inflation.
We have the greatest crop in the history of the country. The productive and machine power of America and its capacity for organization is greater than ever before in its history. The tremendous demand for credits is justified by these conditions and the credits ought to be extended by the Reserve banks and by the member banks.
The banks are exercising, naturally and properly, a discrimination against the speculator and the profiteer, but the man who produces and the man who distributes is entitled to credit against the value of the commodities which he handles.
You have the power under the Reserve Act to suspend the reserve requirements.
Without suspending the reserve requirements as to the reserve note you could issue additional reserve notes equal to the amount outstanding without violating the statute. In other words, you could increase the credits of the Reserve banks and the member banks three billions immediately, not only without harm, but with the beneficent effect of immediately restoring the confidence of the country which has been impaired by the terrible policy of so-called deflation.
Out of the 1920 debacle and the controversy that it generated began to emerge the issue of the central function of monetary policy, and the direction of public policy. The issue was fairly stated in an editorial in the Times commenting upon the debate between Owen and Harding and their respective parties:
The first duty of banks is to keep themselves liquid. In excess of patriotism the banks financed the Treasury rather than trade, and thus got into the frozen condition from which they are retrieving themselves in the interest of all concerned. It is the duty of business to finance the banks as well as of the banks to finance business. The reciprocal discharge of all obligations is the duty of all.
