America’s Money Machine

THE YEAR 1926 ended with an extraordinary spectacle on the floor of the New York Stock Exchange. During the final hour, a bull rally was going as floor traders sought to fill orders that poured in from a confident public; but their shouts were drowned by the blare of a band, and their finger wagging was hidden in a shower of confetti. Trading came to a standstill as the band played, balloons floated in the air, and stock brokers danced on a floor littered with ticker tape and confetti. Members with more agile feet entertained the packed galleries with exhibitions of the Black Bottom, the current ball room rage. Just before three o’clock the band moved from the gallery to the trading floor and the final gong sounded in the midst of songs and revelry.

There seemed ample reason for rejoicing. It had been a prosperous year—probably the most prosperous in the nation’s history. Prices of goods were stable, the public debt was steadily diminishing, gold was flowing to these shores, factories were humming, jobs were plentiful, profits were good, and investors were reaping the rewards of their shrewdness and thrift.

Such a year would not return soon, and when business did again revive, following the worst stock market panic in history, and after an exhausting war, the profits of business were no longer its own, nor its decisions. There would be an immense public debt and interest to pay; there would be an enormous defense cost to meet; taxes on corporate enterprise would now drain over half the profits, and corporate managers, in addition to the internal revenue auditor looking over their shoulders, would find their affairs under the continual scrutiny of dozens of other bureaucratic and regulatory agencies. Under the system of forced savings instituted under the Keynesian Theory, that individuals should be relieved of concern for old age in order to be encouraged to spend all they earned, social security taxes alone were destined to take more from the wage earner than formerly his total income tax bill.

Whether the post-war prosperity reached its climax in 1926 or 1927 depends upon which series of statistics is used to measure prosperity; those who gained their livelihood in the stock market were swimming in profits until toward the middle of 1929; the year 1929 was to record more income tax payers with incomes in excess of $1 million (513) than in any year of the next thirty-six.1 Nevertheless, by 1926, signs were beginning to indicate that the bloom was off the boom, and that a tiredness was overtaking the economy. Chief of these was the divergence that had appeared in the two main branches of the economy—production and financing, and their parallels, raw materials prices and prices of securities. We can give only fragmentary indications, and their value as direction pointers is highly relative. Still, they possess some historical interest. Thus, production of steel ingots and castings, the primary substance of industrial civilization, had climbed steadily, with only one pause, from 19.8 million tons in 1921 to surpass in 1925 the wartime peak of 45 million tons and to reach 48.3 million tons in 1926. Here there was a pause and a sharp fall off in 1927 to 44.9 million tons, though followed by a recovery to 51.5 million tons in 1928 and 56.4 million tons in 1929—a figure not again to be reached until World War II. Meantime there had been an actual decline going on in new investment in blast furnace capacity, that had reached a wartime peak of 53.7 million tons, and had steadily increased to 59 million tons in 1925, but that thereafter began to fall off and did not again pass the 59 million ton figure until 1942.

Investment in residential construction, and consumer purchases of new automobiles and other “durable” goods, had also begun to fall off, reflecting an exhaustion of individual purchasing power. Construction of urban dwellings reached a peak in 1925, and began to drop sharply, to less than half by 1929.2 Production of motor vehicles dropped from $2.5 billion value in 1926 to $1.97 billion in 1927, but recovered to reach $2.57 billion in 1929.

The movement of wholesale prices also reflected an incipient lassitude in business. The index—using the Bureau of Labor Statistics data for 1947–49 as a base of 100—had recovered from the unprecedented 1920 break, and had risen from 62.8 in 1922 to 67.3 in 1925. At that point it “peaked” as the statisticians say, and then began a slow but certain decline that accelerated after the stock market crash, and eventually reached a low of 42.1 in 1932.

The fact—recognized then as now—was that an unwholesome amount of the country’s liquid resources were being drawn into speculative channels. Early in the decade there was a great boom in Florida real estate, but figures are lacking to trace its influence statistically. That frenzy collapsed in 1926, but the significance of the collapse was ignored by the stock market. The volume of stock sales in the New York Stock Exchange increased from 259 million in 1922 to 451 million in 1926, and more than doubled in the next two years with over 1,125 million shares traded in 1929.

These happenings, let us remark, did not go unnoticed by the authorities of the Federal Reserve System; but whether they misinterpreted their significance, or appropriately reasoned that it was neither their function nor responsibility to intervene and to attempt to direct the course of credit, may well be argued. In 1927 the authorities began to take notice of a similar scissors movement in credit. The calm, impersonal, judicial view which they took of this development is reflected in the language of the Board’s report for 1927, which we quote:

In consequence of a somewhat smaller volume of production and employment in 1927 the demand for bank credit to finance trade and industry was no larger than the year before. There was nevertheless a rapid growth of member bank credit, total loans and investments of all member banks increasing by $2,783 million, and that of reporting member banks in leading cities by $1,673 million, or 8.4 per cent. This compares with 2.1 per cent in 1926 and 5.2 per cent in 1925. That the growth of Reserve bank credit has not been due to demand for loans for industry or trade is indicated by fact that all other loans, which comprise loans for agricultural and industrial purposes as well as commercial loans, actually decreased during the year.

The Report went on to comment that loans on securities meantime had increased 15.8 per cent, and that “the decrease in other loans would have been larger but for the real estate loans, which increased $276 million, while commercial loans proper decreased $230 million.”

During 1927, the Federal Reserve, to counter the business decline that had begun, had adopted a moderate “easy money” policy, made effective through authorizing reductions in the discount rate and increasing the System’s open market purchase of securities. The discount rate was reduced in August from 4 per cent to 3 1/2 per cent; open market purchase of securities rose from $210 million at the end of June to $392 million at year end, but this was less significant than it appears, for ordinarily the end of June figures ran substantially less than end of year figures.

Actually, the actions of the Reserve authorities to modify the diversion of credit to the security markets remained, in accordance with their stated policy, tentative and modest until early in 1929. On February 7 of that year, the Board addressed the member banks by letter, stating:

During the last year or more the functioning of the Federal Reserve System has encountered interference by reason of the excessive amount of the country’s credit absorbed in speculative security loans. The volume is still growing. . . . The matter is one that concerns every section of the country and every business interest. . . .

For a less formal and more intimate statement of the theory and convictions upon which Federal Reserve policy moved, we have an illuminating article written by Owen D. Young for Review of Reviews for September, 1928. Mr. Young was at this time chairman of the board of General Electric Company and of the Radio Corporation of America, two of the largest business enterprises of the country, and was also deputy chairman of the Federal Reserve Bank of New York. Explaining the Board’s action in 1927 in reducing the rediscount rate from 4 to 3 1/2 per cent, he wrote:

In the summer of 1927, the European exchanges were weak, just at the time that our fall crop movement was coming on. The export of our agricultural surplus was the most important factor of our domestic economic problem. It was obvious that the buying power of Europe for our agricultural products, and to some extent for our manufactured products, would be greatly curtailed if the foreign currencies were at an abnormal discount. . . .

In August, 1927, the rediscount rate of the Federal Reserve Bank of New York, and of the other banks generally throughout the System, was 4 per cent. Had not this foreign situation existed, it would probably have remained at 4 per cent, but the administrators of the Federal Reserve System concluded to make the rediscount rate 3 1/2 per cent in order that so far as the rate could influence the money market, money in New York might be cheap as compared with the rates in London, Paris, Berlin, Amsterdam, and other financial centers.

This disparity would tend to strengthen the foreign exchanges and increase the buying power of Europeans for our cotton, wheat, and other food supplies, and at the same time provide cheap domestic money for the movement of the crops. It was most important, not only in the interest of our farmers, but in the economic interest of the whole country that our surplus should be exported, rather than be left to depress the domestic price.

That action, which I believe was wisely taken, had the desired effect; and the recent improvement in our agricultural situation as well as the continued export of our manufactured goods has been aided, in my judgment, by that action of the Federal Reserve System. . . . It was also apparent that our domestic business was slowing down, and that as a result we would, in the normal course, have increased unemployment in the winter. Insofar as the Federal Reserve System could stimulate business with a low discount rate it was clearly wise both from the standpoint of our exports and our domestic consumption.

Mr. Young went on to observe that the policy misfired, that business, already financed, did not make use of this credit, and it was instead largely absorbed in the stock market.

“During the late autumn of 1927,” he continued,

the question of whether the rate should be restored to 4 per cent was frequently discussed, but that was not done until February 3, 1928.

It may be that the Federal Reserve System could have—without danger to our export situation and our domestic business situation—and therefore should have, advanced the rate to 4 per cent earlier than it did. But it was wise, I am sure, to have resolved the doubt in favor of our export and domestic business situation even if, as a collateral consequence, too much credit was going into the stock market.

The European exchanges being strong, and the European countries being in need of more gold to ballast their currencies, it was quite natural that a gold flow should start out of this country. Looked at in a large way, that was to be desired, because it would reduce the temptation to uncontrolled inflation. Since November, 1927, something like $500,000,000 in gold has been exported. One would have thought that speculators and financial people generally would have given immediate attention to this movement and realized that it would increase proportionately the rediscounts at the Federal Reserve banks. As a matter of fact, no attention was paid to it. Brokers’ loans rapidly increased in the face of it, and credit became still further expanded.

The Federal Reserve System thereupon began to sell securities from its portfolio to the market, which would have the effect of tightening money rates. As a result of the gold exports and these sales, the banks borrowed additional sums from the Federal Reserve banks, and in order to discourage borrowing the rate was advanced in New York to 4 1/2 per cent on May 17, 1928.

As a result of all of these factors, rates for call money on the Stock Exchange went up, and as might be expected, in a highly speculative atmosphere they fluctuated widely and abruptly. The result was that although the member banks endeavored to call their loans and reduce the amount of credit in the stock market, private individuals and large corporations withdrew their surplus funds from deposit with the banks, and put them directly on call. This had the effect of taking control of the money market, to some degree, out of the hands of the banks and out of the Federal Reserve System.

The banks are now borrowing over a billion dollars from the Federal Reserve. This amount is double the borrowing of the same banks from the System a year ago, largely because of gold exports and Federal Reserve sales of securities. The banks are trying to pay off some of these loans, because they quite properly believe that Reserve credit should be used only to meet seasonal and other temporary needs. If the banks are to pay off the Federal Reserve they must seek funds to that purpose by restricting their loans both at home and abroad.

Following this narration of Reserve actions, Mr. Young went on to a spirited defense and explanation of Federal Reserve policy and philosophy, as it was then understood:

“Now,” he declared,

I would not have any one think from what I have said that the Federal Reserve System has its eye on the stock market. That is the last thing that enters into its consideration. The System has its eye on the business interests of the United States. It desires to contribute to stability in the purchasing power of our money, and to provide proper credits for business at reasonable rates without wide fluctuations.

When, however, it became apparent that Federal Reserve credit, created primarily for business and made cheap to aid business, is being principally used for speculative purposes, then it becomes the duty of the Federal Reserve System to limit that credit to our commercial needs. It is not its purpose to control prices on the Stock Exchange but it is true that as a consequence of adjusting credit to commercial needs, prices on the Stock Exchange may be affected.

There are some who believe that when the Federal Reserve System knew that its member banks were permitting credit in large amounts to go into the stock market, it should have refused the credit. Also, it has been suggested that if the Federal Reserve System will not undertake the responsibility, then a law should be passed penalizing, through taxation, the use of credit for speculative purposes which Congress might from time to time think undesirable.

I have grave doubts about the wisdom of such action. It is a tremendous power to pass over to a few men in a central bank to determine in specific instances the purposes for which their credit shall be used. . . .

As to Congress using the limitless power of taxation in the assignment of credit, that seems to me to be fraught with much greater danger than the evils which it is designed to cure.

A central bank, as I see it, should be influenced in its action only by the economic conditions of the country as a whole. It cannot determine the size of the pot of credit, nor can it determine the price; but it can, in some measure, influence both; and that influence should be exercised in the light of economic conditions as a whole.

Whether the pot of credit should be used for one thing or another should, in my judgment, be left to competitive economic forces uncontrolled by political interference either directly by law or indirectly through a quasi-governmental institution, such as the Federal Reserve System.

Then, too, it must be remembered that call money on the Stock Exchange is now being supplied in substantial measure by others than the member banks of the Federal Reserve System. Large corporations and wealthy individuals are withdrawing their money from deposit and putting it on call. I suspect even that individuals are borrowing at their banks and putting the money on call, scalping the margins.

All this shows that if we take the member banks out of the call loan market by arbitrary controls, it will not be long before the banks and the Federal Reserve System will have no direct control of the call market whatever. Their influence right now is relatively small. The large New York banks have called a very large percentage of their loans, but the vacuum created by their call has in many instances been filled by their own depositors withdrawing deposits, which again has forced the banks, even against their wills, into the Federal Reserve bank. This development of companies and individuals, and even mutual savings banks, putting money direct into the market is a new one, which is outside the control of the Federal Reserve System.

I think the creation of the Federal Reserve System was a great piece of constructive legislation, and I believe that by and large its administration has been wisely handled in the interest of all the people of the United States. . . .

Owen D. Young’s analysis is significant not only as a reflection of the views of the men who were at the time dominant in the determination of monetary policy, but as a revelation of the awareness, on the part of the business community, of the extent and nature of the security speculation then gripping the country, and of its potential for disaster.

As Mr. Young conceded, however, the Federal Reserve was as powerless before this phenomenon as a lone cowhand to stem a stampede of maddened cattle. Too much money was awash in the economy, and it was flowing in to the stock market through a hundred channels other than the banks.

Despite this brave appraisal of the importance of the Federal Reserve System and sage defense of its restricted policy, the fact remained that the Federal Reserve was the ultimate source of this flood of credit.

The Federal Reserve, indeed, was no more than the sorcerer’s apprentice, whose witless meddling in his master’s absence conjured his disaster.

Before tracing the final movements of the tragedy of 1929, let us look again at the changes in the monetary system introduced by the Federal Reserve Act, and how they provided the leverage for the greatest credit boom in modern times.

_______________

3In 1965,646 taxpayers reported adjusted gross income in excess Of$1 million. Between 1967 and 1976, the number hovered between 800 and 1,300.

4The David M. Blank index dropped from 208.1 in 1925 to 100 in 1929 (1929= 100).

• 1*In 1965,646 taxpayers reported adjusted gross income in excess Of$1 million. Between 1967 and 1976, the number hovered between 800 and 1,300.
• 2†The David M. Blank index dropped from 208.1 in 1925 to 100 in 1929 (1929= 100).
• 3Whether the post-war prosperity reached its climax in 1926 or 1927 depends upon which series of statistics is used to measure prosperity; those who gained their livelihood in the stock market were swimming in profits until toward the middle of 1929; the year 1929 was to record more income tax payers with incomes in excess of $1 million (513) than in any year of the next thirty-six.* Nevertheless, by 1926, signs were beginning to indicate that the bloom was off the boom, and that a tiredness was overtaking the economy. Chief of these was the divergence that had appeared in the two main branches of the economy—production and financing, and their parallels, raw materials prices and prices of securities. We can give only fragmentary indications, and their value as direction pointers is highly relative. Still, they possess some historical interest. Thus, production of steel ingots and castings, the primary substance of industrial civilization, had climbed steadily, with only one pause, from 19.8 million tons in 1921 to surpass in 1925 the wartime peak of 45 million tons and to reach 48.3 million tons in 1926. Here there was a pause and a sharp fall off in 1927 to 44.9 million tons, though followed by a recovery to 51.5 million tons in 1928 and 56.4 million tons in 1929—a figure not again to be reached until World War II. Meantime there had been an actual decline going on in new investment in blast furnace capacity, that had reached a wartime peak of 53.7 million tons, and had steadily increased to 59 million tons in 1925, but that thereafter began to fall off and did not again pass the 59 million ton figure until 1942.
• 4Investment in residential construction, and consumer purchases of new automobiles and other “durable” goods, had also begun to fall off, reflecting an exhaustion of individual purchasing power. Construction of urban dwellings reached a peak in 1925, and began to drop sharply, to less than half by 1929.† Production of motor vehicles dropped from $2.5 billion value in 1926 to $1.97 billion in 1927, but recovered to reach $2.57 billion in 1929.