Credit Policies of the Federal Reserve System

CHAPTER VII

THE RESERVE BOARD AND THE STOCK MARKET: THE TECHNIQUE OF CONTROL

As has been noted elsewhere, one of the primary purposes in the minds of many of those who participated in the formulation of the Federal Reserve Act was to discourage speculation, or at least to curtail the use of bank credit to finance stock exchange operations. The Federal Reserve Act provides that the Federal Reserve Banks may discount notes, drafts, and bills of exchange arising out of commercial transactions, “but such definition shall not include notes, drafts, or bills, covering merely investments or issues drawn for the purpose of carrying or trading in stocks, bonds, or other investment securities except bonds and notes of the government of the United States.”1 Stocks and bonds of corporations are not included among the securities eligible for purchase in the open market, and securities used as collateral for direct advances to member banks must be such as are eligible for rediscount or purchase by Federal Reserve Banks.

Throughout the life of the Federal Reserve system there has been a wide variety of views among both its representatives and its critics as to what is the proper responsibility of the System toward speculation in securities, and also with regard to the efficacy of proposed methods of exercising control over the speculative markets.

With regard to objectives, the most popular theory holds the System responsible for conservation of the limited supply of credit for other uses which are deemed more important than is the speculative use. This was the dominating view among the framers of the Act and has apparently been the most important strand of thought in the Reserve Board itself.2 But in more recent discussions precisely the opposite line of argument has been used to support a similar conclusion. It is held that speculative booms make it unduly easy for industrial concerns to obtain capital through the issuance of securities, and that the over-expansion of certain types of business is thereby fostered. That there has been little consciousness of the contradictory character of these two points of view is evidenced by the following quotation from an address made by an official of the Federal Reserve system in 1925:

Neither are the operations of the stock market the concern of the Federal Reserve system, except when the stock market is absorbing credit that is needed in general business, as was the case in the fall of 1919, or when the activity of the market and the rapid advance of many stocks threatens to breed a speculative fever which is liable to spread to commodities.3

Finally, there is the view that the influence of the Reserve system should be thrown against speculation because of ethical and social reasons. This view has had little weight in Federal Reserve circles but has frequently been brought forward by Congressional critics of Reserve system policies. Opposition has also been voiced on the ground that the distribution of speculative profits leads to extravagance.

In the following pages we shall trace the dealings of the Reserve system with the problem of control of speculation. As in previous chapters, we shall first trace the record of stated policies and of actual practice, then appraise the merits of the policies which have been pursued.

In the early post-war period Reserve authorities expressed official opposition to the use of Reserve credit for security speculation. The necessity for the Federal Reserve Board to define its attitude toward a speculative boom first arose in a serious way in 1919. The Board’s attitude at this time was expressed in a letter to the Federal Reserve agents, dated June 10, 1919, which read as follows:

The Federal Reserve Board is concerned over the existing tendency towards excessive speculation, and while ordinarily this could be corrected by an advance in discount rates at the Federal Reserve Banks, it is not practicable to apply this check at this time because of government financing.4

Again on July 9 the Board said:

It is not the function of the Treasury nor of the Federal Reserve Banks or the banking institutions of the country to provide cheap money for stock speculation, and the Board feels that the reflex action of the rates for call money on stock collateral upon the government’s financial program and the requirements of commerce and industry has greatly decreased, . . . and will continue to decrease as it becomes better and better understood that the true function of the banking institutions of the country and of the Federal Reserve system, acting in their aid, is, subject to the temporary requirements of the government, to finance commerce and industry. . . .5

In the succeeding months the Board repeatedly called attention to the dangerous speculative tendencies which it believed to be prevalent, but it was not until the end of the year that it found itself at liberty to give money market conditions precedence over Treasury requirements in determining its own policy.6 When rates were first advanced in November the Federal Reserve Bank of New York issued the following statement:

The reason for the advance in rates announced today by the Federal Reserve Bank of New York is the evidence that some part of the great volume of credit, resulting from both government and private borrowing which war finance required, as it is released from time to time from government needs, is being diverted to speculative employment rather than to reduction of bank loans. As the total volume of the government’s loans is now in course of reduction, corresponding reductions in bank loans and deposits should be made in order to insure an orderly return of normal credit conditions.7

For a number of years little attention was paid to keeping credit out of the stock market. After the collapse of the boom in 1920 the question of the relationship between Federal Reserve credit and speculation did not again come to public attention until the fall of 1925, when the upswing of stock prices and the increase of speculative activity which had started in the summer reached such a point as to call forth renewed expressions of apprehension lest the Federal Reserve system might be allowing its resources to be drawn upon for speculative purposes. There was much opinion to the effect that the advances in discount rates which were made in the fall of 1925 were motivated in part by a desire to keep the stock market speculative situation in check, but this was not the official explanation.8 At this time, however, the dominating point of view in Federal Reserve circles was unfriendly to any serious effort to control the use to which member bank funds were put so long as the provisions of the law covering the issuance of the credit was observed.9

The changes in rates which were made in 1926 appear to have been intended to support the stock market rather than to check speculation. As was noted on page 46, 4 per cent rates prevailed during the year 1926 except for a reduction of the New York rate to 3 1/2 per cent in April, and its restoration to 4 per cent in August. Likewise, the only change in open market policy was the purchase of 65 million dollars worth of securities in the spring, and the sale of 75 million dollars worth in the early autumn. The easing of the money market in the spring and the restoration of the old rate and the old policy of open market holdings in the fall were never explained by Federal Reserve authorities with the fullness which usually characterizes Federal Reserve publicity. The annual report of the Board for 1926 stated that the reduction was made “at a time when there was a large volume of liquidation of bank loans in New York City, a decline in open market money rates, and an apparent slowing down in some lines of business activity.” The increase in August was described as having occurred “when there was a rapid growth in security loans, an advance of money rates in the open market and an increase in the volume of Reserve Bank credit outstanding.”10

This characterization of the business situation in 1926 is correct as far as it goes, but it reads like Hamlet with the Prince of Denmark left out. The outstanding facts in the credit history of the year are that the New York Bank rate was reduced and 65 million dollars of government securities were purchased in response to a sudden decline of 10 per cent in the average of stock prices, and that the rates were restored and the securities sold when the stock market had made back the lost ground. Up to that time, and in fact up to the time of the stock panic of 1929, Federal Reserve authorities consistently denied any responsibility to support the stock market, but any one who was at all cognizant of the business and financial situation in 1926 could hardly doubt that the most important cause of the rate manipulation of that year was the stock market recession and not the trifling recession of business activity.

In 1927, as has been noted elsewhere, the Reserve system committed itself to an extremely vigorous easy money policy, motivated in part by an interest in the business situation and in part by a desire to support the European exchange. By the end of this year, however, the stock market boom, which had not been checked by the mild depression, became so violent that Reserve authorities agreed, apparently without serious dissent, that steps must be taken to damp it down. Agreement as to the end was not, however, accompanied by agreement as to the means. The unity of purpose only brought to light a long-standing disagreement concerning the most effective technique of Reserve operations. This issue we must consider before we carry the story further.

Two divergent views of the power of the Reserve Banks can be traced through the post-war history of the System. One view, which for convenience we shall call the New York theory, holds that the only way in which it is practicable for the Reserve system to exert any important influence over the credit situation is by direct or indirect control of the volume of reserve available as a basis for member bank credit. In accordance with this viewpoint the Reserve Banks cannot discriminate between applicants for credit, so long as these applicants present eligible paper for rediscount or satisfactory collateral, but can only influence the situation by adjusting the rates upward and downward or by open market operations. The other viewpoint, which may be called the Washington theory, stresses qualitative control. It holds that it is the duty of the Reserve Banks to look back of the collateral offered by the prospective borrower and take cognizance of the purpose for which the borrower proposes to use the funds, discriminating against speculative and in favor of “productive” demands. The first of these views is associated especially with the name of Governor Benjamin Strong of the Federal Reserve Bank of New York; the latter with that of Adolph C. Miller of the Federal Reserve Board. The two views can be traced from the early post-war period to the hearings on the Glass bill in 1931, though there was no open clash over the issue, nor any public debate on it before 1929.11

Governor Strong said in 1926:

I hope this discussion has some sympathetic reception by the members of the committee from this point of view—that the most that the System can do is to exercise influence as to the quantity of the whole volume of credit, what the total sum of it shall be, and what it shall cost. That is the influence we exert.12

After sketching an illustrative case in which a transfer of funds from a bank to a trust company resulted in an increase of stock market loans on the part of the trust company and an increase in borrowing at the Federal Reserve on the part of the bank, Governor Strong went on to say:

You may say that is $2,000,000 of Federal Reserve funds gone into the speculative market. As a matter of fact, that is what will happen despite anything that we may do. If we create an addition to the volume of credit by our open market operations or by our discounts the banks which get it pass it along through all the channels through which credit circulates in our banking system—and we can not control what happens to it. Some of it will go in one direction and some of it will go in another, and the nature of the use of our funds is perfectly impossible to control. . . .

To carry your question a little further, suppose this bank “A” on a certain day makes a loan of $100,000 on Pennsylvania Railroad stock, also buys $100,000 of foreign exchange, also buys $100,000 of banker’s bills representing a movement of commodities, and buys $100,000 of government bonds, and sustains net loss of $100,000 of deposits. There is $500,000 of funds that it has paid out. It has $300,000 of its loans repaid. That leaves it still $200,000 short in its reserve, and it must borrow it from us. . . . Shall we say that the $200,000 borrowed from us was used for buying Pennsylvania Railroad stock or buying government bonds or buying foreign exchange or buying banker’s bills representing movement of commodities or to make good a loss of $100,000 of deposits. There is no way of telling. It is all in the way you look at it.

Mr. Wingo. In other words, you can control the volume and price of credit, but you can not control the purpose for which the persons getting that credit use it?

Governor Strong. It can not be done.13

Likewise Burgess wrote in 1927:

It is thus impossible for a Reserve Bank to dictate how its credit shall be put to employment. It cannot, for example, restrict loans on the stock exchange and at the same time encourage loans to the farmer. Reserve Bank loans to a farming community bank may, and often do, find their way promptly to the stock exchange money market. The specific use of credit is the business of the individual member and non-member bank, and the Reserve system is no substitute for sound banking practice. . . .

It is the business of the Reserve system to influence the amount of credit in use, and try to bring about a proper adaptation of the total volume of credit to the volume of business.14

This view was still held by representatives of the New York Reserve Bank in 1931, as is shown clearly by the statement submitted by that Bank in response to a questionnaire which was sent out by the Senate Committee on Banking and Currency in connection with the hearings on the Glass bill, and by Governor Harrison’s testimony before that committee.15 The contrary doctrine, namely that it is the responsibility of the Reserve Banks to be guided in the extension of credit by the purpose for which it is proposed to use the funds, found expression as early as 1919. The following statement is quoted from the Federal Reserve Bulletin of July 1 of that year:

On June 10 the Board sent a letter to all Federal Reserve agents asking for information concerning the purposes for which funds obtained by rediscounting were being used by member banks. This letter was made public and one effect of it was apparently that of leading some banks to hesitate about making application for rediscounts where the funds were unquestionably intended for speculative purposes. . . . It is well to reiterate the fact that the funds of the Federal Reserve system are in no sense intended for the support of speculation and that member banks should bear this in mind when arranging for the extension of accommodation to borrowers.16

After the collapse of the stock market boom of 1919 the issue did not arise again until 1925, when, as has been noted, the “New York doctrine” was in the ascendancy. Mr. Miller, however, expressed the contrary view at that time:

. . . It [the Federal Reserve system] is a system of liquid productive credits. The use of Federal Reserve credit for speculation or investment purposes is precluded by specific provisions of the Federal Reserve Act. It is clear, therefore, that no bank has a proper status as an applicant for Reserve Bank accommodation which is supplying credit for speculative uses. It is the duty of the Federal Reserve Banks to hold true to the course plotted for them in the fundamental provisions of the Federal Reserve Act. . . .17

The theory that the only feasible control of the Federal Reserve over the money market is through the volume of credit outstanding, and not through its allocation to particular uses, continued to be the official standard of Federal Reserve policy down to the end of 1927.18

During this period, however, there was growing pressure for a change of policy. There were strong arguments on both sides. On the one hand, the steadily rising tide of speculation and the unprecedented upward sweep of stock prices suggested that the Federal Reserve policy was unduly liberal. On the other hand, the wish to co-operate in the maintenance of the new gold standard currencies in Western Europe, the state of our gold reserves, the apparent absence of swollen inventories, and the considerable volume of unemployment, suggested a policy of easy money. Among critics of Reserve policy there was much difference of opinion as to the relative weight to be given to these factors, and no doubt there was likewise disagreement within Federal Reserve circles which was not made public.19

In 1928 Reserve policy was directed to controlling speculation by curtailing the total amount of Reserve credit in use. In January of that year the Reserve system abandoned the theory that the soundness of the credit situation can be gauged by statistical measures of production, employment, inventories, and prices, and recognized the stock market boom as the crucial element in the situation with which the Reserve system had to deal.20 For a year and a half the market was subjected to strong pressure in an effort to curb the volume of speculation, or at least to curtail the contribution of Reserve credit to the supply available for its use.

In the first half of 1928 pressure was exerted in the traditional way, by open market sales and advancing rediscount rates. From December 31, 1927 to June 30, 1928 holdings of government securities were reduced from 617 million to 235 million dollars. Rediscount rates, which were 3 1/2 per cent at all Banks at the end of the year, had been advanced by March 1 to 4 per cent at all Banks, by June 7 to 4 1/2 per cent, and by August 1 to 5 per cent at eight Banks. It would be expected that under these conditions the flow of gold would be inward; as a matter of fact there was one of the most rapid outward movements which has occurred since the Reserve system was established.

The combination of an outflow of gold and a decrease in open market holdings made necessary a rapid increase in rediscounts; hence the efficacy of discount rates in curtailing the credit operations of the banks was tested under unusually favorable conditions. Open market money rates promptly showed the effect of the pressure. Call loan rates advanced from an average of 4.24 per cent in January 1928 to 6.05 per cent in July, and other open market rates generally advanced during the same period by about 1 per cent. Meanwhile, the member banks reduced their reserve balances by about 100 million dollars (partly a seasonal decrease) and money in circulation fell by 38 million (also partly a seasonal change). Brokers’ loans, however, continued to advance, a decrease of 521 million dollars loaned by banks (from January 4 to July 25) being more than offset by an increase of 926 million in the advances of non-banking lenders.21 Stock prices (as measured by the Standard Statistics index) remained about steady through the first three months of the year, advanced by fully 15 per cent during April and May, and then during June and July lost about half of the previous advance.

In short, there was no clear indication that the stiffening of money rates had yet had any dampening effect on the buoyancy of speculative sentiment. Nor was there any indication that the business community was being so handicapped as to make a reversal of the policy advisable. Business prosperity and speculation continued to advance together. Nevertheless, during the last half of the year the repressive policy was relaxed. The holdings of government securities were only slightly changed; rediscount rates remained unchanged at all Reserve Banks; but there was distinctly more than the usual seasonal increase in the holdings of acceptances.22

At the same time the restrictive effect of the measures already taken was mitigated by a reversal of the gold flow. Between July and December the monetary gold stock increased by 23 million dollars. Rediscounts also continued to increase.

The result of the combination of gold inflow, increased rediscounts, increased acceptance buying, and stable holdings of government securities was to restore to member bank reserves about two-thirds of the funds which had been squeezed out in the first half of the year. The net decrease in member bank reserves for the year, therefore, was only 32 million dollars. This, of course, was a sharp change from the usual trend,23 but no such drastic curtailment as had been foreshadowed in the first half of the year. Call rates continued to soar, averaging 8.6 per cent in December; other open market rates also advanced but not so rapidly as at first. The stock market continued its remarkable advance, the high call and time rates bringing forth an abundance of funds for brokers’ loans, both from banking and from nonbanking sources. For the year as a whole, brokers’ loans of New York banks showed a decrease of 168 million dollars; for out-of-town banks there was an increase of 306 million; and for “others” an increase of 1,334 million.24

In 1929 Reserve authorities abandoned the doctrine that control can be exercised only over the quantity of credit outstanding, and attempted qualitative control. It was clear by that time that the measures of restriction undertaken in 1928 were not adequate to accomplish their purpose. There was tacit agreement on the necessity of a further attempt to restrict speculation, but there was very grave difference of opinion as to the means to be used. The directors of several Reserve Banks favored further effort along traditional lines; that is, putting rediscount rates still higher. The Board, or a majority of its members, believed that such action would be injurious to business and agriculture, and initiated an attempt to restrict the amount of credit available for the stock market without either a further contraction of the total amount issued or an increase in its cost to the business community. The holdings of government securities were sold down to about 100 million dollars, and the four Reserve Banks which still had 4 1/2 per cent rates were allowed to come up to 5 per cent, but all requests for permission to put rates above this level were denied. The New York Bank was particularly insistent in urging the need of a higher level, and a bitter quarrel developed on the subject between New York Bank and Reserve Board authorities. Advances to the 6 per cent level were also voted repeatedly in the spring by the directors of the Reserve Banks at Boston and Chicago;25 these were in each case vetoed by the Board.

In place of credit restriction there was instituted in February a new device called “direct pressure.” This policy consisted of a refusal of the rediscount privilege to those banks which maintained a volume of speculative security loans in excess of that deemed reasonable by the Reserve Banks.

In a circular dated February 7, 1929, the Board said:

The Federal Reserve Act does not, in the opinion of the Federal Reserve Board, contemplate the use of resources of the Federal Reserve Banks for the creation or extension of speculative credit. A member bank is not within its reasonable claims for rediscount facilities at its Federal Reserve Bank when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans.

The Board has no disposition to assume authority to interfere with the loan practices of member banks so long as they do not involve the Federal Reserve Banks. It has, however, a grave responsibility whenever there is evidence that member banks are maintaining speculative security loans with the aid of Federal Reserve credit. When such is the case the Federal Reserve Bank becomes either a contributing or a sustaining factor in the current volume of speculative security credit. This is not in harmony with the intent of the Federal Reserve Act, nor is it conducive to the wholesome operation of the banking and credit system of the country.26

It is impossible to state how far the Reserve Banks as a whole co-operated with this policy. Governor Harrison of the Reserve Bank of New York testified in 1931 that his Bank refrained from action on the recommendation, both because of lack of sympathy with the measure and also because the direct stock market loans made by New York banks in the spring and summer of 1929 were in fact comparatively few.27

The Reserve Banks of Atlanta, Boston, Chicago, Dallas, Philadelphia, and St. Louis report favorably on the use of “moral suasion,” several of them stating that they believe it to be more effective in keeping money out of speculative channels than is the discount rate. The management of the Cleveland Bank appears to agree with the New York position that the sphere of usefulness of moral suasion is in preventing member banks from borrowing too much or too continuously, rather than in controlling the specific use made of the funds that the banks command.28

During the spring of 1929 business activity reached a considerably higher pitch29 and the question began to be raised in numerous circles whether industry and trade, as well as speculation, might not benefit by some measure of restraint. Throughout the spring, as has been stated, there was a vigorous controversy between the Reserve Board and the Federal Reserve Bank of New York. The position of the Bank was that direct pressure was impracticable, and that rate increases were needed in order to deflate the stock market. Governor Harrison later stated the case thus:

The effective way to do it [to “put the brakes on”] is to put a rate control into effect which will invariably result in a liquidation of those loans least desirable first; in other words, if you are a borrowing bank and we put the pressure of a 6 per cent rate on you, and you want to get out of our debt, you will not call the commercial customers’ loans, but the least desirable loans or the most liquid loans or call loans, which are used as secondary reserves. When the rate pressure begins to work in New York, the first loans that begin to go are the call loans. Why? The banks trying to get out of debt will look at the collateral loans and will pick out the least desirable of the call loans and then, if the pressure is still too great, they will go up to the second level of call loans. That is where they adjust their position first.30

Mr. Hamlin (a member of the Federal Reserve Board) gives the following interpretation of the reasons given by the New York Bank for its recommendation of higher rates:

. . . that speculation had injured business by increasing interest rates; that high interest rates prevented the flotation of foreign securities in the United States, that the purchasing power of Europe was thereby lowered, and that the high call loan rates were drawing gold from Europe.31

The Board’s position, as explained later, was that the time had passed when it was possible to control the situation by moderate advances in discount rates; that the 6 per cent advance would have to be followed by a series of further advances,32 and that such advances would be a serious burden to other lines of business and would probably bring on a panic, whereas direct pressure would keep funds out of the stock market regardless of the willingness of speculators to pay rates which would be prohibitive for other types of business.33

The Reserve Board was supported at first by the Federal Advisory Council, which had recommended in the previous autumn that the situation be handled by “cooperation” and which on February 15 adopted the following resolution:

The Council believes that every effort should be made to correct the present situation in the speculative markets before resorting to an advance in rates.34

The resolution was not made public, however, until after the next meeting of the Council, that of April 15, at which time the Council decided that direct pressure had not been effective and recommended that Reserve Banks be allowed to raise their rates and “to maintain a rate consistent with the cost of commercial credit.” This recommendation was renewed on May 21.35

In the last week of March a combination of Reserve credit restrictions, seasonal expansion of commercial borrowing, the shifting of funds in connection with income tax payments, and preparation for April 1st dividends, resulted in a very tense money market situation in New York which threatened to bring about a stock market collapse and to precipitate a major crisis in the fight for control of the Reserve system.

The call rate jumped to 20 per cent on Monday, March 25, and stock prices broke.36 There was much talk of an impending panic. In this emergency the National City Bank took the leadership by throwing 25 million dollars into the call money market (being at the same time a heavy borrower at the Federal Reserve Bank of New York). Other banks followed and after two days of 15 per cent call money the rate sagged back to 8 per cent and the stock market recovered by Thursday to 217. The incident, which was admittedly a direct violation of the principles laid down in the February warning of the Federal Reserve Board, derived particular interest from the fact that Mr. Charles E. Mitchell, president of the National City Bank, was a director of the Federal Reserve Bank of New York.37 Mr. Mitchell was quoted in the newspapers of Wednesday as saying: “So far as this institution is concerned we feel that we have an obligation, which is paramount to any Federal Reserve warning, or anything else, to avert, so far as lies within our power, any dangerous crisis in the money market.”38 It is noteworthy that the position taken by Mr. Mitchell is exactly that which was taken by the management of the System, apparently without dissent, at the time of the stock market collapse which ensued in the autumn of 1929.39

The issue between the Board and the New York Reserve Bank came to a crisis in May 1929. On the first day of that month the Board addressed a letter to the Bank in which were listed certain New York member banks that were borrowing continuously or frequently and also were carrying a considerable volume of collateral loans, with a pointed request that the Reserve Bank deal with these banks in accordance with the policy laid down by the Board in its February “warning.” After ten days the Bank replied with what appears to have been a flat refusal (the correspondence has not been published); stating that banks have a right to loan on collateral, that the Reserve Board has no way to determine whether collateral loans are in fact speculative, and that the right of a bank to borrow on eligible paper ought not to be prejudiced by the fact that it is exercising its legal lending powers. Three weeks later (perhaps even before June 1) the policy of direct pressure was abandoned.40

On August 8, the rediscount rate at New York was at last raised to 6 per cent. This, however, was not at all a measure of restraint. For simultaneously the buying rate on acceptances was lowered from 5 1/4 to 5 1/8 per cent. As the supply of acceptances always increases greatly with the oncoming of the harvest season, the effect of putting the discount rate above the acceptance buying rate was merely to bring about a shift from rediscounting to the sale of acceptances. The important thing about this action was that after keeping its credit substantially out of the acceptance market for a number of months, the Reserve Banks once more gave to that market the full measure of their support. As was anticipated, acceptance holdings jumped up (from 74 million at the end of July to 176 million at the end of August, and to 292 million at the end of September), while rediscounts fell off by only about half as much. Market rates of interest showed little change until later in the fall, after the stock market decline was under way, but funds were available in plenty at rates around 8 and 9 per cent for borrowers who had stock market collateral.41

Direct pressure achieved no greater success as a stock market sedative than did rate pressure. The price averages remained fairly stable throughout the first half of the year 1929, though the stability was due to the more or less accidental compensation of big advances in certain groups of stocks and big declines in others. In the third quarter there was a final tremendous upward movement, followed by the memorable collapse of October and November.

In this crisis there was no thought of discrimination in credit policy against the stock market. On the contrary, the Federal Reserve Banks came to the aid of the member banks with heavy purchases of government securities, and the funds thus released were poured by the banks into the stock market, largely through security affiliates.42

In the spring of 1930 it appeared that the tests set up in 1928-29 had been abandoned. Stock prices far higher than those of early 1928 caused no alarm. Nothing was heard of the increase in the proportion of security loans and investments to total loans and investments. No alarm was expressed because brokers’ loans were heavier than they ever had been before 1929. No complaint was uttered because Federal Reserve credit was used to support stock market speculation. The peak of 1929 had been so high that it dwarfed all lesser peaks, and the fear of depression outweighed all anxiety lest the stock market absorb too much credit.

Since the second collapse of stock prices, in the late spring of 1930, down to May 1932, the issue of damping down a stock market advance has not arisen. There have been no advances of such violence as to create anxiety.

Federal Reserve policy was successful in keeping down the direct use of Reserve Bank credit in the stock market, but not in stabilizing the stock market itself. One’s judgment of the success of the Federal Reserve policy of 1929 depends on one’s conclusion as to what objectives were deemed most important. If the main purpose was to check the growth of speculative activity,43 both the experiment of direct action and the use of credit restriction must be acknowledged failures. The market was able to go ahead because it was able to finance itself—by imports of gold and by borrowing from “others”—with a diminishing supply of Federal Reserve credit, and to pay rates which no Reserve organization would have dared to impose upon commercial borrowers. I see no reason to doubt that the course of the market would have been much the same if the Reserve system had increased rediscount rates even more sharply, or had restricted call lending by banks more successfully. Nor was the final stock market liquidation forced by the credit situation. The basic fact was the rise of a general conviction that it was time to “get out from under.” Speculation is based in part on faith in ultimate values, but also in large part on the hope of more speculation. No credit policy is adequate to stem the flood of liquidation when, after a stock market advance, the conviction takes hold of the public that there is no prospect of a further advance. There is no real reason to believe that Reserve Bank policy played a significant part in bringing about the decline.

If, however, we limit the responsibility of the Reserve system to keeping down the amount of Reserve credit used directly in the stock market, we must concede that it achieved a considerable degree of success. Though Reserve credit increased in 1928, the expansion was not enough to offset the outflow of gold so that the volume of member bank reserve deposits actually declined. During the first nine months of 1929 they still showed no increase, though the System recovered all the gold that had been lost in 1928. There was a small increase in member bank loans and investments in the latter year, but this was much more than covered by the increase of capital and surplus and was represented entirely by loans not secured by stocks and bonds. The Reserve system can, therefore, be acquitted of any responsibility for financing the last year and a half of the stock market boom.

In 1929, before the Reserve system relaxed its policy of withdrawing Federal Reserve credit from banks which were making stock exchange loans, the situation of the banks which were financing the security markets was not essentially different from what it would have been had there been no Federal Reserve system. Without a Reserve system, the market, after taking up the slack in American banks’ reserves, would have had two resources to fall back on—namely, foreign credits and the credit of domestic lenders. Foreign credit could have been obtained through gold imports arising either from bank operations, or through foreign participation in loans by “others.” Domestic loans by “others” would not have created new reserves but would have eased the pressure on the banks by leading to a cancellation of deposits.

These sources of aid were exactly as accessible with the Federal Reserve system in operation—regardless of whether its policy was to encourage or to discourage stock market activity—as they would have been otherwise. The creation of the Federal Reserve system had merely added another potential resource, the credit of the Reserve Banks. To the extent that this new resource was now cut off by “direct pressure,” the market was thrown back on its old resources, non-banking credit and bank credit supported by newly imported gold.

In so far as the idea was merely to insure that there should be a reservoir of Federal Reserve credit available for rescue purposes whenever the boom might collapse, complete success was attained.44 As has been noted elsewhere, the stock market crash of 1929 was differentiated very sharply from previous stock market collapses by the fact that in 1929 the last line of defense had been reached. Bank credit was available in abundance and there was no forced selling except on account of the exhaustion of margins. This fact must be placed to the credit of the Reserve system. Under the old form of organization of American credit the banks could have supported the market only to the extent that they could have replenished their reserves by imports of gold. There was no reserve supply of unused lending capacity, and the banks which made up the system were too numerous to make it possible to maintain such a reserve by mutual agreement. One of the most important things for which a Reserve system is needed is to pool the resources of the banks in such a way that a margin of lending capacity is held in reserve, with the cost automatically distributed over the whole System. And this is just what the System did in this case. Had this resource not been in existence the crisis would have been serious indeed, for no such abundant resources of foreign gold were available as existed in 1907 and 1920.

It must be admitted, however, that under the conditions of 1928-29 this was not an extraordinary achievement. The surplus reserves in the Reserve Banks were so large when the boom started in 1924 that even if the Reserve Banks had pursued a flagrantly shortsighted expansionist policy, there was not the slightest danger that a stock market boom would run so far as to exhaust the Reserve Banks’ lending power before toppling of its own weight, unless there occurred also a boom in commodity markets. The fact that the Reserve Banks were in a position to bring aid to the market in November 1929 was the result of the policies adopted in 1923 in the face of the great gold imports, rather than of those adopted for the first time in 1928 and 1929 to deal with the stock market.

According to the Board’s spokesmen, however, the solicitude of the System to keep credit out of the stock market was not based merely on a desire to keep the Reserve Banks free to come to the rescue when the inevitable crash came (inevitable at least in retrospect), but on a purpose to keep the stock market from absorbing more than “its share” of the credit in the common reservoir, to the detriment of business and agriculture. From this standpoint, the policy of the Reserve system must be adjudged a failure. The discount rate and open market policies of 1928 and the “direct pressure” of 1929 may perhaps have kept down the amount of Reserve credit which went into use through the stock market, but if so it was because they kept down the total amount available for all uses, and not because agriculture and business gained at the expense of the stock market.

Assuming for the moment that there was real danger that the stock market would absorb so much credit45 as to work a hardship on agriculture and business, there were two possible ways of guarding against it. One was the traditional method: make credit so expensive for all comers as to bring about a stock market liquidation even at the risk of bringing on a commercial liquidation; then make it cheap again in the hope that agriculture and business will revive and expand their use of credit before a stock market revival runs far enough to create fresh pressure on the banks. The other alternative, which was an innovation, was to try to shut credit out of the stock market by direct action while keeping it available and not prohibitively dear for other lines of business. In 1928 the first alternative was adopted; in 1929 the second.

Unfortunately, neither experiment was carried out with such thoroughness as to settle the question of its usefulness. Rate control was abandoned with rates at 5 per cent; possibly 6 per cent or 7 per cent rates supported by a refusal to buy acceptances or government securities might have been more successful, though it does not appear likely. On the other hand, if dependence was to be placed on direct action and money kept cheap for business, rediscount privileges should have been freely extended at low rates to banks which kept out of the stock market lending business. This policy, coupled with open market sales to mop up the floating supply of Reserve Bank credit would, if the theory of direct action was correct, have kept money cheap for industry and agriculture and at the same time have conserved the resources of the System for their use. Instead, all rediscounting was penalized with a 5 per cent rate, and acceptance rates—contrary to all precedent—were kept above rediscount rates. Commercial paper rates were actually forced up by nearly 2 per cent. All this was at a time when the Reserve Banks had abundant reserves, when no evidence of business inflation had been detected,46 when undesired gold was flowing in, and when the stock market was not getting its funds from banks.

Nevertheless, the experience of 1929 does not support the position of those who deny the possibility of discriminating in the allocation of credit. The attempt to give “commercial” demands priority over “speculation” was partially successful. Though open market rates for commercial paper advanced, rates on collateral loans advanced much more. Though the banks have usually given a preference to commercial loans, in 1928-29 there was probably more discrimination than there would have been in the absence of the special propaganda directed to that end.47 Credit was not kept in water-tight compartments but the flow to the stock market was to a certain extent obstructed.

So far in our discussion we have not considered the validity of the objectives at which the Reserve system was aiming in 1928 and 1929. Indeed, in all this controversy the one thing on which all parties were able to agree was the desirability of checking the stock market boom. Because spokesmen for the Federal Reserve Board, representatives of the Reserve Banks, and Congressional investigating committees were unanimous in regard to this aspect of policy, the reasons for its acceptance have received but little attention. Interest has centered almost exclusively in the technique of control, Yet the really important thing about the whole episode, and the thing which differentiates it from almost all recorded central banking history at home and abroad,48 is not the methods used but the objects aimed at. In Chapter VIII, therefore, we shall consider the principal reasons which have been offered in justification of the attack on speculation, and try to arrive at a judgment as to their soundness.

“The Chairman: You felt that the international situation should have more bearing than the effect of speculative activity?”

“Mr. Miller: I think that is what the Board felt; I felt the reverse.”

“Governor Harrison. Senator, we never did it . . . for two reasons: In the first place, the so-called brokers’ loans of the New York banks were not going up. They were staying stable at the figure at which they rested even before the period of speculation began and, in the second place, our directors felt from the beginning the proper method of breaking such expansion, if it occurred, was through the rate rather than through a particular admonition to particular banks.” (Hearings on S. res. 71, Part 1, pp. 55-56. See also Part 6, p. 725.)

It is to be noted, however, that there were newspaper reports in the early spring of 1929 to the effect that the Federal Reserve Bank of New York did discourage rediscounting by member banks which were lending freely on the call money market. The New York Journal of Commerce for Feb. 25, 1929 said: “A number of banks in this district have received a letter indicating that further rediscounting would not be permitted unless their brokers’ loans were reduced. . . . Federal Reserve Banks in three western cities—Minneapolis, Kansas City and Dallas—have applied such a policy for a long time past. In the New York District, however, active adoption of a similar policy has only taken place since the warning was issued.”

• 1The distinction between “banking policy” and “credit policy” is taken from Annual Report of the Federal Reserve Board, 1928, pp. 9-10.
• 2Compare pp. 132-40.
• 3This is, of course, in substance the position of the Banking School in the British banking controversy of the early nineteenth century.
• 4“. . . When increased credit demands can be met only by recourse to the Federal Reserve Banks, the volume of Reserve Bank lending is a sensitive indicator of credit conditions. . . .” (Federal Reserve Bulletin, 1923, Vol. 9, p. 411).
• 5Annual Report of the Federal Reserve Board, 1923, p. 10 (quoted below, pp. 79-80); Federal Reserve Bulletin, 1928, Vol. 14, p. 6.
• 6The omission of reference to price changes in the text is intentional and without prejudice. I believe that there is need of a thorough reexamination of the orthodox statement of the influence of gold movements on price changes and the extent to which in pre-war days changes in price levels were caused by gold movements and operated to check the gold movements.
• 7For fuller discussion of these points, see Chap. IX; compare also B. H. Beckhart, The Discount Policy of the Federal Reserve System, Chap. II.
• 8The cash balance carried in the United States Treasury was occasionally drawn upon to meet seasonal or crisis demands, either through the depositing of funds in banks or through the purchase of bonds by the Treasury, but the device was very crude and there was no continuity of policy in its management.
• 9Compare chart, p. 35.
• 10The possibility of temporary nullification of a central bank’s control through the mobilization of fresh resources is illustrated by an action of the Midland Bank, which in 1927 bought securities so heavily as to lower its own reserve ratio by several per cent. The amount involved was small enough so that the Bank of England was able to offset it. The net result was simply to increase the earning assets of the Midland Bank and decrease those of the Bank of England; not to ease the market.
• 11Compare p. 231.
• 12Annual Report of the Federal Reserve Board, 1927, pp. 10, 16.
• 13See pp. 104-05.
• 14Annual Report of the Federal Reserve Board, 1927, p. 11.
• 15The 4 1/2 per cent rate was charged on all maturities of less than 90 days, such paper making up the great bulk of the transactions.
• 16As reported by the New York Stock Exchange.
• 17At least such a policy was promulgated by the Board. It is difficult to say how far the Reserve Banks went in carrying it out. Apparently the New York Bank did not give much heed to it; alleging, truly, that New York banks were not loaning heavily in the stock market. Compare p. 133.
• 18Indexes of Standard Statistics Company.
• 19This increase is not altogether due to the rate change, as the supply of acceptances is always increased by autumn exports. The increase in 1929 was much more than seasonal, however.
• 20See 70 Cong. 1 sess., Brokers’ Loans, Hearings on S. res. 113 before Committee on Banking and Currency.
• 21See testimony of Cassel, Fisher, and Foster in Hearings on H.R. 78955 William T. Foster and Waddill Catchings, “Is the Reserve Board Keeping Faith?,” Atlantic Monthly, July 1929, Vol. 144, pp. 93-102.
• 22From July 31 to December 31 the increase in acceptances held was 327 million dollars. In no other years except 1924 and 1929 has the increase exceeded 235 million dollars, and usually it has been below 200 million (in 1924, 363 million dollars; in 1929, 329 million). Computed from data published in annual reports of the Federal Reserve Board.
• 23From the beginning of 1922 to the end of 1927 member bank reserve balances had shown an increase in every year, the average gain being 120 million dollars, or about 6 per cent.
• 24Monthly averages, December 1927 compared with December 1928.
• 25Hearings on S. res. 71, Part 6, pp. 753-63.
• 26Federal Reserve Bulletin, 1929, Vol. 15, p. 94.
• 27“The Chairman. . . . It is the business of the Federal Reserve Bank to know what the borrower is doing and for what purpose he is doing it. If that is not the meaning of this Act why should they feel—your board of directors ever feel, in any sense or degree—warranted in admonishing member banks in New York to reduce their loans to brokers?
• 28Hearings on S. res. 71, Part 6, pp. 724-25.
• 29The production index of the Standard Trade and Securities Service for the first half of 1929 averaged 131 as compared with 120, 120, and 119 for 1926, 1927, and 1928 respectively.
• 30Hearing’s on S. res. 71, Part 1, pp. 56-57. It should be added that Governor Harrison explained the failure of discount rate advances to check the speculative movement in 1928 as a result of the loans on account of “others.”
• 31Ibid., p. 172.
• 32“The Federal Reserve Board was asked to approve an increase to 6 per cent on the understanding that that was to be the first step, and then other increases were to follow, if necessary. As a matter of fact, rates as high as 7, 8, and 9 per cent were discussed at conferences in the Board as being possible under such a drastic increased rate policy.” (Testimony of Mr. Hamlin, ibid., p. 174).
• 33“When a speculative mania is once under way you can not do anything with it by the use of higher discount rates; when speculation was beginning, higher rates might have been effective. But when you came to 1929, the period we were considering, it would have no effect whatsoever. The speculators, I believe, wanted us to approve the 6 per cent rate. Six per cent meant to those men easy money, because it meant, as they hoped, a discontinuance of direct pressure and permission to borrow all the money they wanted if they would merely put up good collateral and pay the increased discount rate. A 6 per cent rate would have been to the speculator a relief.” (Ibid., pp. 175-76.)
• 34Annual Report of the Federal Reserve Board, 1929, p. 218.
• 35Ibid.
• 36The Standard Statistics Company daily index of industrial stock prices dropped from 214.6 on Saturday to 208 on Monday; on the 16th it had stood at 223.5.
• 37An interesting sidelight on the question was a debate between Senator Glass and former Senator Owen, the chief official authors of the Federal Reserve Act. Senator Glass declared that the Reserve Board ought to ask for Mitchell’s resignation as a director of the Federal Reserve Bank of New York, while Mr. Owen took the position that speculation on the stock market is legitimate business and that the National City Bank had not only a legal right but a distinct obligation to see that the market was supplied with the funds necessary to prevent a collapse.
• 38It may be added that Mr. Mitchell defended his position entirely on the basis of the emergency situation and did not express a general dissent with the theory underlying the Reserve Board’s warning. In the National City Bank Letter for August 1928 it was stated that “if funds borrowed upon eligible collateral are diverted to the security markets, the law is violated in the spirit if not in the letter.”
• 39Compare p. 54.
• 40Hearings on S. res. 71, Part 1, pp. 169-71.
• 41The low point of call rates in every month of 1929, through September, was 6 per cent; in October, 5; in November and December, 4 1/2. The high point was 20 in March, 16 in April, 15 in May and July, 12 in August, 10 in June, September, and October, and 6 in November and December.
• 42For data concerning these operations see below, pp. 158-60.
• 43This seems to be implied in the passage quoted below (p. 149) from the Report of the Secretary of the Treasury.
• 44“. . . the course adopted by the Board resulted in a substantial conservation of the credit resources of the banking system of the country, and particularly of the Federal Reserve Banks, for essential needs which arose later in the year.” (Annual Report of the Federal Reserve Board, 1929, p. 4.)
• 45Compare pp. 132-33. We consider in Chap. VIII the extent to which such absorption is possible.
• 46“Distribution of commodities to consumers kept pace with production and there was no evidence of a general accumulation of stocks at distributing points or of inventories at factories or commercial establishments.” Federal Reserve Bulletin, January 1929, p. 1.
• 47At the peak of money rates in September 1929, the yield of 90-day time loans on stock market collateral averaged in New York 2.81 per cent higher than prime commercial paper; at the peak in August 1920 the difference was 0.72 per cent. (Averages computed by the Standard Statistics Company from rates quoted weekly in the Commercial and Financial Chronicle.)
• 48The attack on the Bourse by the Reichsbank in May 1927 presents a parallel case, though the technique employed was entirely different.