America’s Money Machine

THE WAR did to the Federal Reserve what battle did to men; it revealed the institution’s frailties and imperfections; it changed its character, and wounded it in vital parts. We have surveyed generally the main drift of the economic consequences of the monetary policies pursued during the war; we may now take a closer look at some of the changes in the structure and operations of the System. These changes were not all generated by the war; their origins are to be traced to the misconceptions of the framers of the act as to the realities of the business world which the new banking system was designed to serve; the war was the incubator that hastened their exposure.

Probably no better assessment of these changes is offered than that by H. Parker Willis, who, next to Paul Warburg, was the most influential technician in fashioning the System, and the profoundest authority on its operation. Willis had been a professor of finance in various institutions, and at the time the Democrats came into control of Congress in 1910 was dean of the College of Political Sciences of George Washington University in Washington, D. C. He was appointed expert to the House Ways and Means Committee and later an expert on the House Banking and Currency Committee, to draft the Federal Farm Loan Act. When Wilson was elected in 1912, Carter Glass employed Willis to assist in drafting the banking bill that eventually became the Federal Reserve Act. Later Willis became the secretary of the newly organized Federal Reserve Board and subsequently its director of research, a position he held until 1922.

The first notable defect of the System of which he makes mention was that of the ineffectuality of the rediscount rate. It had been Paul Warburg’s theory, as we have noted, that changes in the System’s rediscount rate would be the principal moderating influence upon the general interest rate structure of the economy, since the central bank’s lending rate was in effect the ultimate, or marginal, cost of money to which all other rates would be related. This was the famous theory first popularized by Walter Bagehot, in his Lombard Street, a classic first published in 1873, that had already gone through thirteen editions by 1913 when Federal Reserve legislation was being debated. Bagehot had demonstrated to the delight and fascination of bankers how a central bank, by manipulating its lending rate, could stimulate or retard the state of business, the movement of merchandise in trade and of gold in and out of the country, all mainly by making the price of money cheaper or more costly, and conversely the price of goods more costly or cheaper. It is an ingenious theory, supported by a vast amount of data from British experience, in which central banking authorities still put faith and on which hang most of their operations to this day, despite the testimony of Willis and the tragic experience of the 1929 stock market crash, as well as numerous later evidences to the contrary.

“The outstanding fact,” Willis wrote, “is that there has been no time when the System could be said to be really the leader of the market, or be able to make its discount rate ‘effective’ for any considerable period.”

During the first two years of the System’s operations, Willis explained, the banks of the country were too well provided with funds and too little inclined to resort to the Reserve banks for accommodation to permit the discount rates of the latter to be of serious importance. This was due in part to the expansion of the note issue at the outbreak of the war, under the emergency note provision of the Aldrich-Vreeland Act. It was also due to the lowering of the cash reserve requirements for national banks which the Federal Reserve Act authorized. The effect of this “release of reserves,” Willis pointed out, was to place in the hands of the banks a very large lending power which they were able to use in expanding their operations. The banks were not slow to take advantage of this power and did increase their lending, and with this broader power of operation it was not necessary for them to do any rediscounting. Some of this slack was taken up shortly before the United States entered the war, and some observers thought that for a few months, early in 1917, the System was able to exercise an influence upon the money market by its discount policy—but this period, Willis declared, was not for long.

With the coming of war, a fundamental question in the financial world was the rate at which the government could borrow. Despite the great propaganda campaign to buy “Liberty” bonds, as they were called, and the patriotic appeal of the propaganda, it was recognized that the discount rate would govern the price at which the bonds could be sold, for buyers promptly used them as bank collateral to put themselves in funds again, a transaction that really meant that the banks were indirectly lending to the government. It was considered essential by the authorities that the rediscount rate correspond with the coupon rate of the war bonds.

The first Liberty loan, as we have already noted, was sold with 3 1/2 per cent coupon, which paralleled the 3 1/2 per cent rate on notes secured by such bonds. As subsequent issues came on the market, the difficulty of placing them increased and a higher coupon rate was necessary. The higher coupon rates were matched by a corresponding advance in the discount rate.

It was not until the war was over, and had been succeeded by a period of inflation which had brought the country close to disaster, Willis reported, that the discount rate again began to play much part in the control and direction of credit. But he went on to say, “Deflation which set in as a result of a world-wide revolution in demand and prices largely threw the System out of alignment with the commercial credit market, and once more rendered its rates relatively ineffective.”

“Today,” he continued, speaking of conditions in 1922, “they have practically no relation to, or effect upon, current short-time commercial rates. Reviewing the whole experience and concentrating attention upon the two periods of a few months each, during which the Federal Reserve discount rate was a real factor in current finances, the conclusion to be drawn must be very adverse to the success of the System as a leader of the market or as a moulder of credit.”

Confirmation of the appraisal made by H. Parker Willis is found also in the views of Adolph C. Miller, a member of the Federal Reserve Board, who wrote in the American Economic Review for June, 1921, as follows:

Although the war was over in 1918, in a fighting sense, it was not over in a financial sense. The Treasury still had enormous obligations to meet, which were eventually covered by a Victory loan. The main support in the market again was the Federal Reserve. Throughout 1919 discount rates were maintained at artificially low levels.

In 1920, the Reserve finally undertook to develop a policy of control by means of discount rates. The consequence, whether because the Reserve’s action was too late, or inherently ineffectual, was the debacle we have already described.

Following the business revival that began in 1921, accompanied by a new upward movement in prices, the Reserve took another look at its functions in regard to the discount rate.

The Federal Reserve Board’s annual report for 1923, its tenth, reviewed its ten years’ history, beginning with a discussion of the responsibility of the System to fix discount rates, as the act stipulated, “with a view to accommodating commerce and industry.”

Discussions, the Board pointed out, were usually addressed to the question of the relationship that should exist and be maintained between Federal Reserve bank rates and the rates in the open market. The view most widely held was that the Federal Reserve bank rate “should move in sympathy with general money rates, rising as they rise and falling when they fall.”

The Board went on to say, however, that a development of this theory was that the Federal Reserve banks should assume leadership in the money market. It is at this point that the departure in policy appears.

The Board was careful to point out, by a series of tables, that the wide variety of conditions geographically and as to the quality and character of notes made impossible any 1 to 1 correspondence between the official rediscount rate and the open market rate.

The year 1922 marks, in a way, a turning point in Federal Reserve policy. Henceforth the Reserve began quietly to abandon reliance upon the discount rate as a modifier of the economic climate and to put its faith and money into open market transactions in which, instead of relying upon the ebb and flow of commerce to bring expansion or contraction of bank credit, it attempted to influence that ebb and flow by forcing credit into the economy—or conversely, withdrawing it—by going into the market and either bidding for paper or offering it for sale.

Closely connected with the failure of the Federal Reserve to develop as a financial leader during these earlier years, through the use of the discount rate, was the withering of the acceptance as a financial instrument. The trade acceptance—that is, the draft drawn by a seller of goods upon the buyer, and accepted by him—simply did not fit the American way of doing business and it never developed to any degree. In its place it was hoped that the banker’s acceptance would prove more popular, and considerable effort was devoted to promoting this form of paper, and the Federal Reserve banks, in their eagerness, went to numerous questionable practices, including favoritism and straining their authority. The banker’s acceptance differed from a trade acceptance in that the acceptor was a bank rather than the buyer of the goods. It was objectionable in the eyes of many authorities on the subject, principally for the reason that it permitted a weak creditor, or a creditor using funds for purposes that were not for business or commercial purposes, to obtain the funds through the credit of a bank; and encouraged banks, by the temptations of profit, to lend their credit beyond their capacity.

In 1922, a committee of bank examiners filed with the Comptroller a scathing report, listing the abuses that had come to their attention. The effect of this report was decisive. From an estimated maximum of around $1 billion in acceptances outstanding at the height of their use, the volume dropped to around $400 million in 1923. Much of this drop, of course, was due to the business recession.

Subsequently, during the boom just preceding the stock market crash of 1929 the volume of bankers’ acceptances rose to around $1 1/2 billion, but thereafter declined to less than $150 million at the end of 1941 just before the U. S. became involved in World War II.

After 1937 the Federal Reserve practically ceased to buy or rediscount such paper, but following World War II the use of bankers’ acceptances revived. The average amount outstanding during 1962, for instance, was around $2 1/2 billion—a figure still insignificant in comparison to total bank credit outstanding—but the maximum held by the Federal Reserve banks never exceeded $100 million until toward the end of 1962.

The expansion of acceptance banking that occurred thereafter will be discussed further on in relation to the disappearance of silver coinage, the suspension of gold convertibility and the uncontrollable inflation that began in the 1960s and accelerated through the 1970s. Here we may note that the failure of the acceptance to obtain status during the formative years of the System led the Reserve authorities to seek some other mechanism by which to exercise the latent powers conferred upon them. This they found in the market for short-term government bonds—the official bill market.

The promotion of the banker’s acceptance in a generally indifferent market was the first major step in substituting finance in the abstract for finance in the concrete. Backing for the note issue would no longer consist of physical things, particularly goods in the course of production or trade, along with gold, but it would consist increasingly of evidences of debt, of uncertain character and duration, and a declining amount of gold. At first this debt was that of the commercial banker, in the form of the banker’s acceptance, whose assets did not consist of physical goods (beyond the bank premises, and the small change in his cash till) but of other evidences of debt. As we have noted, the original character of the banker’s acceptance as an instrument representing a further guarantee upon an obligation derived from goods in trade, and having an early maturity corresponding to the time required to deliver or dispose of the goods in the market, had given way to that of an instrument representing an obligation secured by goods in warehouse and not actually in trade, and having an indefinite, or a continually renewed maturity.

The next step was to substitute, for the banker’s acceptance, the short-term obligations of the Federal government, which represented often the unliquidated balance of past fiscal deficits, the cost of wars long fought and forgotten, and other consumption activities of the state. This development will be followed in more detail as our story proceeds.

The third major change in central bank theory which the customs of commerce, the independence of trade, and the exigencies of politics forced upon the Federal Reserve System, was in relation to the price level—the notion that somehow the movement of prices should be controlled by the state.

The operations of the Federal Reserve System, as originally constituted, were to be directed to a money and credit supply that served “to accommodate commerce and business.”

Adolph C. Miller, the Board member whose opinions we have already cited, raised the curtain on the issue in his American Economic Review article which we have already quoted. He said:

As an abstract proposition, the proposal to substitute a price indicator for the reserve ratio as a guide to discount policy has much economic merit. The rigors of the recent price readjustment process through which the United States, in common with the rest of the commercial world, has been passing, have emphasized the value of price stability. Price disturbances not originating from inevitable natural causes are bad and costly alike to producer and consumer. . . .

. . . As a theoretical proposition, therefore, it is entirely conceivable that the discount policy of the Federal Reserve System might be governed by indications of impending price changes, with a view of mitigating their cyclical fluctuations. While such an undertaking would raise some new and difficult problems of credit administration, no doubt in time the technique of a plan of credit regulation based on price indices could be worked out and made administratively practicable if public sentiment demanded. But there is now no warrant in the statute under which the Federal Reserve banks are organized for undertaking to regulate their credit operations on any such basis. . . .

It is noteworthy of these early managers of the Federal Reserve that they uniformly resisted the idea that price regulation was a central bank function. The 1923 Report discussed the theory of price regulation at some length and concluded:

Entirely apart from the difficult administrative problems that would arise in connection with the adoption of the price index as a guide and entirely apart from the serious political difficulties which could attend a system of credit administration based on prices, there is no reason for believing that the results attained would be as satisfactory as can be reached by other means economically valid and administratively practicable. . . . Price fluctuations proceed from a great variety of causes, most of which lie outside the range of influence of the credit systems. No credit system could undertake to propose the function of regulating credit by reference to prices without failing in the endeavor.

The price situation and the credit situation are no doubt frequently involved in one another, but the entire relationship of prices and credit is too complex to admit of any simple statement, still less of a formula of invariable application.

The Board then proceeded to analyze in detail some of the difficulties in establishing any cause and effect relationship and to analyze the task of administering credit with a view to “accommodating commerce and business.”

Nevertheless, despite its reservations, it was not long before monetary policy had made a complete turn. No longer was the question to be one of “elastic money” but a stable price level, and in the morass of price statistics the Federal Reserve has been mired ever since.