Economics and The Public Welfare

Chapter 35

The Year 1931 Continued—The First Foreign Run on the Gold of the United States

First Austria, then Germany, then England went under. The Germans did not surrender the nominal gold parity of the mark. Rather, the government blocked payments and took control of foreign exchange transactions, limiting drastically the volume of mark exchange that could be offered on the markets. The British, leaving the exchanges free, frankly abandoned the gold standard, and the pound dropped drastically on the foreign exchange markets. Foreign holders of mark balances with German banks found, for the most part, that they could use them only inside Germany, and faced an increasing number of restrictions upon the ways in which they could employ them. Holders of sterling balances with British banks were free to draw checks and sell them for what they would bring, but found that they had heavy losses as they did this.

A great fear ran over the world regarding foreign balances in all countries and regarding the value of all currencies. If sterling was not good, was anything good? Was the Swedish crown good? Was the Dutch guilder good? Were Swiss francs good? Were French francs good? Was the dollar good? Switzerland and the Netherlands had handled themselves well and their liabilities in foreign hands were not excessive. They stood, as did Belgium and France. France was so strong in gold and in foreign balances that no serious question rose regarding the ability of the French financial authorities to protect their currency in the foreign exchanges.

Sweden Abandons Gold Reluctantly. Sweden proved a weak spot, because of her losses in sterling. On September 27 Sweden (accompanied by Norway) also abandoned the gold standard. The Swedish crown followed the pound sterling downward.

There have been some misapprehensions regarding this. It has been supposed by some that this was a matter of deliberate policy on Sweden’s part, and there has even been a beautiful myth developed that the Swedes by very skillful manipulation have worked out the first scientific system of money in the history of the world, thereby keeping the commodity price level stabilized.1

After Failing to Get Loan in New York. The fact is that the Swedes were most reluctant to abandon the gold standard, and that they sent a delegation to New York to negotiate a loan or a bank credit with which to defend the gold standard. They had heavy losses on sterling when England abandoned gold, and their position was greatly weakened thereby, but if they could borrow dollars they would hold the fort. This delegation from Sweden, chiefly bankers, representing the government and the central bank, met a friendly reception in New York, but did not get the needed money. Most of the New York banks were ready to go along in joint action, had all the big banks joined. But the New York banks had large holdings in foreign countries, and especially had large holdings in Germany. There was apprehension by this time in New York that American depositors might question the action of American banks if they extended their commitments in foreign countries. If all acted in concert this danger would be overcome, but it was impossible to get concerted action. One of the largest of the New York institutions refused to join, and the others reluctantly advised the Swedish bankers that New York could not help. It was an unduly timid course for New York to have taken. It was only after the failure of this effort to get a loan or bank credit that Sweden yielded.

Foreign Run on America’s Gold Immediately Follows England’s Collapse. With dramatic suddenness there came a foreign run on the gold of the United States. The run began immediately when England abandoned the gold standard. The figure for our monetary gold stock 2 on September 16, 1931, stood at $5,015,000,000. The next available figure is that of September 23, two days after the abandonment of the gold standard by England. By that date the figure had dropped to $4,897,000,000, showing a loss of $118,000,000 of gold, practically all of which took place in two days. The drop was steady thereafter down to October 28, on which date the figure stood at $4,287,000,000, meaning a loss of gold of $728,000,000 from September 16. The next two weeks showed improvement. The figure for November 7 rises to $4,311,000,000, and the figure for November 11 to $4,346,000,000.

The American Gold Tradition Held. The country and the Federal Reserve banks met the shock with calm incredulity. We were very strong in gold. We had a record of paying gold. Our whole financial tradition rested on the principle that we would pay gold. Grover Cleveland in the middle 1890’s had defended our currency with gold payments under very much more adverse conditions. On February 12, 1895, the net gold in the Treasury dropped to $41,300,000, but he continued to pay gold. That was what the gold was for. President Cleveland called upon the bankers of the United States to get him more gold. They did it. Mr. Henry W. Cannon, former President of the Chase National Bank, and a Director of that institution, once told of sitting up all night with other bankers in New York as they cabled London, negotiating a gold loan for Cleveland, and of the exultation with which, weary and bleary-eyed, they were able to turn over to the newspapers early in the morning the news that a ship in New York harbor with a cargo of gold destined for London would be unloaded, and the gold returned to the United States Treasury, and that a ship was being loaded with gold in London to be sent to New York. This was Cleveland’s low point. His courage in paying gold when his gold stock grew low, his determination to maintain the gold standard, brought to his rescue the gold resources of American banks and of London, and the gold in the United States Treasury never fell to so low a point again. He had $108,000,000 in gold in the Treasury at the end of the year.3

We had met a sudden call for our gold at the outbreak of World War I, as we have seen in an earlier chapter. Unable to ship gold to London because of German cruisers on the sea, we had made arrangements with the Bank of England that the gold might be received in Ottawa. And we had exported gold and pulled down the price of the pound sterling to a figure within the gold points and restored the dollar to its normal position in the foreign exchanges.

That the outside world should question either our ability to pay gold or our determination to pay gold aroused incredulity. We paid, of course. There was no question about it.

No Domestic Gold Hoarding. During this foreign run on our gold, domestic hoarding of gold in the United States was absolutely negligible. There was a great deal of gold hoarding among the people of Europe, especially in France. France was not subject to a foreign run; rather, France was pulling gold out of the United States. It is proper to add that the Bank of France itself behaved very well, in the opinion of the Federal Reserve authorities at the time.

Our own people did not hoard gold. In one Federal Reserve district the total hoarding of gold was $5,000. In another, one of the largest, it was less than $100,000. The total for all Federal Reserve districts was less than $20,000,000, and of this, $6,000,000 was accounted for by two known transactions which involved, not domestic hoarding, but hoarding by domestic agencies of foreign concerns.

Our people were in many cases doubtful about the goodness of individual banks, but they had no doubt whatever of the soundness of our gold standard and the good faith of the Government and the Federal Reserve banks with respect to redeeming paper money in gold.

Federal Reserve Money Market Policy. The Federal Reserve banks and the member banks had a further problem to meet while the foreign run on our gold was going on. Between July 31 and December 31, 1931, there was an increase in money in circulation in the United States of $810,000,000. The impact, both of the drain on our gold and of the increased money in circulation, fell in first instance upon the reserves of the member banks of the Federal Reserve System. And it was necessary either to replenish these reserves or to have an immense liquidation of bank credit.

The reserves were in part replenished by rediscounting with the Federal Reserve banks, but not all the banks had assets of the kind which the Federal Reserve banks could take, in sufficient amount. The Federal Reserve banks could rediscount commercial paper, and the Federal Reserve banks could lend against Government securities. They could not lend against real estate mortgages or installment finance paper or loans secured by stocks and bonds. Rediscounts rose from $169,000,000 (a very low figure) for the daily average of July, to $774,000,000 as the daily average for December, a figure high enough to make real money market pressure. This figure rose to $848,000,000 in February of 1932.

Acceptance Policy. The Federal Reserve banks could also aid in replenishing member bank reserves by open market purchases of acceptances. They did buy acceptances in large amounts during the actual foreign run on our gold, the figure rising from $79,000,000 in July, 1931, to $768,000,000 in the week of October 24. They accomplished this by holding their buying rate for acceptances somewhat below the market rate as interest rates rose in the course of the run. They then raised the official buying rate on October 24, and their acceptances holdings fell off rapidly, dropping to $36,000,000 by the end of March, 1932. This was partially ameliorated by Federal Reserve bank purchases of acceptances for foreign correspondents, which rose from $99,000,000 at the end of October, 1931, to $335,000,000 by the end of March,4 1932.

The buying of acceptances helped greatly in the meeting of the foreign run on our gold, but the decline in acceptance holdings of the Federal Reserve banks after the week of October 24 intensified the pressure on member bank reserves which the continuing increase in money in circulation involved.

Federal Reserve Banks Had Previously Exhausted Ability To Buy Government Securities. It was unfortunate that the Federal Reserve System was unable to make use of the device of buying Government securities in moderating the shock to the money market of the first foreign run on our gold. We have pointed out earlier how helpful it was that the Federal Reserve banks did increase their holdings of Government securities by slightly over $150,000,000 in the stock market panic week, October 23-30, 1929. But the Federal Reserve banks could not do this in late 1931 because they had previously exhausted this resource in making the artificially cheap money and the renewed bank expansion of 1930-1931, as we shall see.

The Bank of England has been criticized in a previous chapter for the buying of government securities in July, August, and September, 1931, to offset the withdrawal of gold, and to prevent the withdrawal of gold from tightening the British money market. The difference between the British position in meeting this foreign run and that of the Federal Reserve System in meeting our foreign run was a very simple one. We had enough gold. We could pay the foreigners all that they were able to take. The Bank of England did not have enough gold, and its only recourse, if it were going to defend the gold standard, was to submit to a radical tightening of its money market, and indeed, to take the first step in such a tightening by raising Bank Rate to a panic level. But the Federal Reserve System had gold enough so that it would have been well justified in expanding the purchases of Government securities to ease off the strain, had it not previously exhausted its ability to do so.

Government Security Purchases and “Free Gold.” The inability of the Federal Reserve System to increase Government security purchases in the midst of the foreign run on our gold, and in the midst of domestic runs on our banks in that winter of 1931-1932, was due to a technical point, which must be understood if we are to grasp the significance of the Glass-Steagall Bill of early 1932, which eased the situation.

The term “free gold” has a technical meaning. For the purpose of redeeming Federal Reserve notes, or for the purpose of honoring checks against deposits with the Federal Reserve banks, all the gold in the Federal Reserve System is free gold. That is what the gold was for. For the purpose of permitting credit expansion by discounting for member banks or by buying acceptances of member banks, all the gold of the Federal Reserve System was free gold. The legal reserve requirements were 40% gold reserve against Federal Reserve notes, and 35% and lawful money (including greenbacks and silver dollars) against deposits; and the gold reserves of the Federal Reserve banks stood high above these legal reserve ratios at the worst point of the foreign run on our gold. If the legal reserve ratio had been reached, the System would have just begun to fight, and would still have had the power and the duty to pay out gold in redeeming notes or in honoring checks against deposits, though it would have been subjected to a progressive tax as the reserves went lower and would have been under obligation to raise the discount rates as the reserves went lower.

But the term “free gold” does not relate to the ability of the Federal Reserve System to meet its demand liabilities in gold. It relates rather to the ability of the System to make an artificial ease in money by buying Government securities. The technical point is as follows. The Federal Reserve System was designed to be a commercial paper system. When the Act was passed in 1913, the total of the Federal Government debt outstanding was approximately one billion dollars, and about three-quarters of this was pledged to secure National Bank notes. A good deal of the rest was tied up in trust funds. The floating supply was very small. The Federal Reserve System was given the power to buy Government securities as an incidental matter, but its main work was intended to be rediscounting paper from member banks to meet seasonal needs for additional currency and to meet crisis needs. Federal Reserve notes were to be issued against the rediscounting of commercial paper and were to be retired as these discounts were paid off. Federal Reserve notes were to be elastic, expanding and contracting in volume with the needs of trade.

Moreover, Federal Reserve notes were not created by the Federal Reserve banks, though practically they were intended to be bank notes. In legal theory they were obligations of the Government of the United States issued not by but through the Federal Reserve banks. They were issued to the Federal Reserve banks by the Government, and then by the Federal Reserve banks to the member banks, and through the latter to the people. But when the Government issued Federal Reserve notes to the Federal Reserve banks it had to receive collateral in exchange for them. This collateral could consist, in the first instance, of 60% commercial paper and 40% gold. Later, in 1917, the law was changed so that it might consist of 100% gold, without commercial paper. But in any case gold or commercial paper had to be given by the Federal Reserve banks to the Federal Reserve Agent representing the Government when notes were issued. The term “commercial paper” for this purpose included not only commercial paper in the strict sense (including acceptances bought), but also bills of the member banks secured by Government obligations. It did not, however, include the Government obligations themselves.

As long as the Federal Reserve System had plenty of rediscounts and acceptances, the problem of issuing Federal Reserve notes was a simple one. Notes could expand as rediscounts expanded. The only gold requirement was the 40% legal reserve requirement.

In the crisis of 1920-1921 there was a very great expansion of Federal Reserve notes, but there was a simultaneous great expansion of discounts with the Federal Reserve banks, and the Federal Reserve banks always had plenty of collateral to give the Federal Reserve Agent without unnecessarily locking up gold.

A different situation arose, however, when the Federal Reserve banks had been putting out their credit, not through rediscounts, but through the purchase of Government securities. As they put out their credit in this form, several things happened. First, immediately, there was an increase in member bank reserves. Second, the major part of this increase was used by member banks in paying off rediscounts, though part of it remained in the hands of the member banks as a basis for additional bank expansion. Third, as rediscounts declined in the Federal Reserve System, the Federal Reserve banks were obliged to substitute gold for commercial paper as collateral against Federal Reserve notes with the Federal Reserve Agent.

With the renewal of Government security purchases in 1930, the time came on August 27, 1930, when Federal Reserve notes were secured by 104.9% in gold.5 Gold actually segregated to secure Federal Reserve notes stood at $1,575,000,000 on that date, as against Federal Reserve notes in actual circulation of $1,337,000,000. The gold required by law to be held behind Federal Reserve notes on that date was $1,402,000,000, which is 104.9% the Federal Reserve notes in actual circulation. This excess above 100% is to be explained by the fact that, in order to be able to issue Federal Reserve notes freely and quickly, the Federal Reserve banks themselves maintained “counter cash” in Federal Reserve notes over and above the notes in actual circulation.

A reversal of the Federal Reserve policy would, of course, free this gold very rapidly. If the Federal Reserve banks chose to sell Government securities and to force the member banks to rediscount thereby, they could substitute rediscounts for gold in the collateral with the Federal Reserve agents, and thereby free the gold held as collateral. But this meant tightening the money market and raising interest rates.

Reckless Buying of Government Securities in 1930 Made for Money Market Tension in Winter of 1931-1932. It was this consideration which made not a few responsible men in the Federal Reserve System apprehensive of the renewal of artificially cheap money which came in 1930. Late in December, 1929, one found the conviction among them that monetary ease would have to wait for a substantial liquidation of the volume of bank credit outstanding, secured by stocks and bonds. We were strong enough at that time to have gone through an orderly liquidation. But early in 1930 Federal Reserve policy quickly veered in the other direction, and the purchase of Government securities was resumed. The Federal Reserve System was gambling, using dangerous devices to stave off an unpleasant liquidation, and hoping for a return of the prosperity which was “just around the corner.” They succeeded in making cheap money. They succeeded in bringing about a further expansion of bank credit against securities. (p. 264)

But the Federal Reserve System also succeeded in bringing the banking system of the United States into an extremely vulnerable position, tragically revealed when the foreign run on our gold came in late 1931, and when depositors, fearful of individual banks, were taking cash out of these banks and hoarding it. Had the Federal Reserve banks been able, in the autumn and winter of 1931-1932, to buy the $290,000,000 of Government securities which they had previously bought between November 13, 1929 and August 20, 1930, they could have eased the strain a great deal.

Reporting Member Bank Credit Outstanding (In millions of dollars)
Date	Total deposits	Total loans and investments	Investments in securities	Loans on securities	All other loans	Loans on securities plus investments to total loans and investments
Aug. 28, 1929	19,787	22,405	5,456	7,521	9,429	57.92%
Oct. 23, 1929	20,328	22,895	5,395	7,920	9,580	58.157%
Aug. 27, 1930	21,091	23,122	6,329	8.377	8,416	63.6%

The Great Liquidation of Bank Credit, 1931-1932. As it was, we met the foreign run, but we went through a terrific liquidation of bank credit. Between June 30, 1931, and December 31, 1931, the deposits of the member banks of the Federal Reserve System dropped $5,522,000,000, while the loans and investments dropped $3,347,000,000. The process of liquidation went further in the months that followed. The table on page 265 shows the history of the member banks of the Federal Reserve System with respect to this point.

Many Interior Banks Unable to Lend to Good Customers. A new factor came into our economic situation at this time. There had been no shortage of bank reserves in 1930 or the first half of 1931. There had been excess reserves, and interest rates had been very low. There had been no inability on the part of the banks generally to supply good customers with adequate loans. There had rather been a reaching out by the banks for good loans. There had been progressive questioning of individual credits, and there had been a progressive realization of the unsatisfactory quality of a good deal of the credit, but there had been no limitation on quantity of credit to anybody who was good. We had had, incidentally, a complete demonstration of inability of abundant and superabundant money and credit to offset deterioration in the quality of credit, and to reverse a decisive down trend in business.

But now there came a new factor. In the autumn of 1931 and the winter of 1932 we had real money pressure. Great banks in New York continued through the whole of this period to lend adequately to all good customers, but there were important parts of the country where this was not done. There were important parts of the country where good merchants had their loans reduced or even cut off because the banks themselves were short of money. There came, too, an attitude of fear on the part of the banks. In many cases, banks able to make loans were afraid to do so through fear that their depositors might suddenly make runs upon them.

Deposits, Loans, and Investments of Member Banks of the Federal Reserve System (Millions of dollars)
Weekly Reporting Member Banks			All Member Banks
	Deposits (time, demand, and U. S.)	Total loans and investments		Total deposits	Total loans and investments
1927
Feb. 16	18,908	19,538	Mar. 23	33,756	31,949
July 6	19,700	20,584	June 30	35,398	32,756
1928
Feb. 29	20,344	21,328	Feb. 28	35,375	33,688
July 3	20,601	22,314	June 30	36,060	35,061
1929
Feb. 27	20,302	22,338	Mar. 27	36,799	35,393
			Oct. 4	36,694	35,914
1930
Feb. 26	19,822	22,003	Mar. 27	35,836	35,056
June 25	21,051	23,140	June 30	38,139	35,656
Sept. 24	21,213	23,297	Sept. 24	36,364	35.472
Oct. 29	21,540	23.495
1931
Feb. 25	20,969	22,647	Mar. 25	36,000	34,729
June 24	20,764	22,343	June 30	36,268	33,922
July 29	20,807	22,296
Sept. 30	20,378	22,107	Sept. 29	33.480	33,073
Dec. 30	18,127	20,532	Dec. 31	30,746	30,575
1932
Mar. 30	17,073	19,354
Apr. 27	17,006	19,033
May 4	17,272	19,277
May 25	17,102	18,994
June 29	16,807	18,754	June 30	27,836	28,001
July 27	16,411	18.334
Aug. 31	16,796	18,539	Sept. 30	28,417	28,045
Oct. 19	17,672	19,121	Dec. 31	28,690	27.469

Reverse Side of Low Reserve Ratios—Multiple Contraction of Bank Credit. One factor of special significance in connection with the severity of this liquidation was the excessively low legal reserve requirements set in the Federal Reserve wartime legislation of 1917. We have previously discussed this. The legal reserves for demand deposits were set at 13% for the central reserve cities, 10% for the other reserve cities, and at 7% for the country banks, while the reserve requirements for time deposits everywhere was 3%. This, as we have seen, made multiple expansion of bank credit on the basis of increasing reserves move with startling rapidity. On the other hand, decreases in reserves meant multiple contraction of bank credit to a startling degree when the pressure came. We had created a highly vulnerable situation. The first foreign run on our gold touched off the testing of our unsound internal credit situation. We easily met the foreign run on our gold. The standard of value was safe. But the fabric of domestic credit was also tested, and much of it was precarious.

The Federal Reserve banks were designed to take only the cream of the paper held by the other banks. This was sound central bank policy and our laws with respect to it were well devised. For the rest, when small banks needed an additional credit and did not have the kind of paper that the Federal Reserve banks required, the usual practice was to go to the correspondent banks in the great cities, and these correspondent banks tided them over. Indeed, country banks very often borrowed from city correspondents in preference to borrowing from Federal Reserve banks, even when they had collateral which suited the Federal Reserve banks.

The National Credit Corporation. But the pressure of liquidation called for further remedies. President Hoover called upon the strong banks of the country to create a special fund for the rescue of weaker banks. The great banks responded, receiving the assurance of the President that when Congress assembled he would ask the Congress to create an emergency Government corporation which could take over the load. The great banks were to create a temporary emergency corporation to fill in the gap. On October 8 a plan was adopted for the creation of The National Credit Corporation by an organization appointed by the Governor of the Federal Reserve Bank of New York. This corporation received $500,000,000 of funds subscribed by the participating banks. It was to lend to banks under pressure, upon the basis of sound assets which were not legal for rediscount at the Federal Reserve banks. There was further a provision for the issue of debentures to obtain additional funds. The National Credit Corporation functioned, aiding the situation greatly, and ceased to function when the Reconstruction Finance Corporation, created by the Congress on the recommendation of President Hoover, took over the work. It performed a vitally needed service in a critical time.

• 1This point will be discussed at length in Chap. 34.
• 2I have not been able to find that this article was ever published. However, the reader will find much of it in two books by Veblen: Imperial Germany and the Industrial Revolution, New York, 1915; and The Nature of Peace and the Terms of Its Perpetuation, New York, 1917.
• 3See my book The Effects of the War on Money, Credit and Banking in France and the United States, published by the Carnegie Endowment for International Peace, Oxford University Press, New York, 1919. For London, see the interesting articles by Mr. J. M. Keynes in the British Economic Journal in late 1914.
• 4O. M. W. Sprague: “Crisis of 1914 in the United States,” American Economic Review, September, 1915; H. G. S. Noble: “The New York Stock Exchange in the Crisis of 1914,” Garden City, N. Y., Country Life Press, 1915. These two papers are classics of permanent value.
• 5The figures of all the State and National banks and trust companies appear only once a year in the Comptroller’s report as of approximately June 30. For dates other than June 30, it is necessary to make estimates. During the war period these estimates are made on the basis of variation in the National Bank figures.