America's Great Depression (24 page)

Also in 1926, Dr. Oliver M.W. Sprague, economist and influential advisor to the Federal Reserve System, prophesied no immediate advances in the rediscount rate, because business had naturally been assuming since 1921 that plenty of Federal Reserve credit would always be available. Business, of course, could not be let down.23 The Federal Reserve’s very weak discount policy in 1928

and 1929 was caused by its fear that a higher interest rate would no longer “accommodate” business sufficiently.

An inflationary, low-discount-rate policy was a prominent and important feature of the Harding and Coolidge administrations.

Even before taking office, President Harding had urged reduction of interest rates, and he repeatedly announced his intention of reducing discount rates after he became President. And President Coolidge, in a famous pre-election speech on October 22, 1924, declared that “It has been the policy of this administration to reduce discount rates,” and promised to keep them low. Both Presidents appointed FRB members who favored this policy.24 Eugene 23Oliver M.W. Sprague, “Immediate Advances in the Discount Rate Unlikely,”
The Annalist
(1926): 493.

24See H. Parker Willis, “Politics and the Federal Reserve System,”
Banker’s
Magazine
(January, 1925): 13–20; idem, “Will the Racing Stock Market Become
122

America’s Great Depression

Meyer, chairman of the War Finance Corporation, warned the banks that by advertising that they do not discount with this farm loan agency, they were being “injurious to the public interest.”25

While such men as the head of the Merchants’ Association of New York warned Coolidge about Federal Reserve credit to farmers, others pressed for more inflation: a Nebraska congressman proposed loans in new Treasury Notes at one-half percent to farmers, Senator Magnus Johnson urged a maximum rediscount rate of 2

percent, and the National Farmer–Labor Party called for the nationalization of all banking. Driven by their general desire to provide cheap and abundant credit to industry, as well as their policy (as we shall see below) of helping Britain avoid the consequences of its own monetary policies, the Federal Reserve sought constantly to avoid raising discount rates. In latter 1928 and 1929, with the need clearly evident, the FRB took refuge in the dangerous qualitative doctrine of “moral suasion.” Moral suasion was an attempt to keep credit abundant to “legitimate” industry, while denying it to “illegitimate” stock market speculators. As we have seen, such attempts to segregate credit markets were inevitably self defeating, and were mischievous in placing different ethical tags on equally legitimate forms of business activity.

Moral suasion emerged in the famous February, 1929, letter of the FRB to the various Federal Reserve Banks, warning them that member banks were beyond their rights in making speculative loans, and advising restraint of Federal Reserve credit speculation, while maintaining credit to commerce and business. This step was A Juggernaut?”
The Annalist
(November 24, 1924): 541– 42; and
The Annalist
(November 10, 1924): 477.

25The War Finance Corporation had been dominant until 1921, when Congress expanded its authorized lending power and reorganized it to grant capital loans to farm cooperatives. In addition, the Federal Land Bank system, set up in 1916 to make mortgage loans to farm associations, resumed lending, and more Treasury funds for capital were authorized. And finally, the farm bloc pushed through the Agricultural Credits Act of 1923, which established twelve governmental Federal Intermediate Credit Banks to lend to farm associations. See Theodore Saloutos and John D. Hicks,
Agricultural Discontent in the Middle West,
1900–1939
(Madison: University of Wisconsin Press, 1951), pp. 324–40.

The Inflationary Factors

123

taken in evasive response to persistent urging by the New York Federal Reserve Bank to raise the rediscount rate from 5 to 6 percent, a feeble enough step that was delayed until the latter part of 1929. Whereas, the New York Bank was the more inflationary organ in 1927 (as we shall see below), after that the New York Bank pursued a far more sensible policy: general credit restraint, e.g., raising the rediscount rate, while the Federal Reserve Board fell prey to qualitative credit fallacies at a peculiarly dangerous period—1929. The FRB went so far as to tell the New York Bank to lend freely and abundantly for commercial purposes.26 The late Benjamin Strong had always held that it was impossible to earmark bank loans, and that the problem was quantitative and not qualitative. The New York Bank continued to stress this view, and refused to follow the FRB directive, repeating that it should not concern itself with bank loans, but rather with bank reserves and deposits.27

The refusal of the New York Bank to follow the FRB directive of moral suasion finally drew a letter from the FRB on May 1, listing certain New York member banks that were borrowing continuously from the Federal Reserve, and were also carrying “too many” stock loans, and requesting that the New York Bank deal with them accordingly. On May 11, the New York Bank flatly refused, reiterating that banks have a right to make stock loans, and that there was no way to determine which loans were speculative. By June 1, the FRB succumbed, and dropped its policy of moral suasion. It did not raise the rediscount rate until August, however.28

26See Harris,
Twenty Years,
p. 209.

27Charles E. Mitchell, then head of the National City Bank of New York, has been pilloried for years for allegedly defying the FRB and frustrating the policy of moral suasion, by stepping in to lend to the stock market during the looming market crisis at the end of March. But it now appears that Mitchell and the other leading New York banks acted only upon approval of the Governor of the New York Federal Reserve Bank and of the entire Federal Reserve Board, which thus clearly did not even maintain the courage of its own convictions. See Anderson,
Economics and the Public Welfare
, p. 206.

28See Charles O. Hardy,
Credit Policies of the Federal Reserve System
(Washington, D.C.: Brookings Institution, 1932), pp. 122–38. Dr. Lawrence E.

Clark, a follower of H. Parker Willis, charged that Mr. Gates McGarrah, Chairman of the New York Federal Reserve Bank at the time, opposed moral
124

America’s Great Depression

Apart from the actions of the New York Bank, the policy of moral suasion failed, even on its own terms, for non-bank lenders used their bank-derived funds to replace bank lenders in the stock market. This inevitable result surprised and bewildered the qualitativists, and the stock market boom continued merrily onward.29

While stock market loans are no worse than any other form of loan, and moral suasion was a fallacious evasion of the need for
quantitative
restriction, any
special
governmental support for a certain type of loan is important in two ways: (1) government encouragement of one type of loan is apt to swell the overall
quantity
of bank loans; and (2) it will certainly overstimulate the particular loan and add to its readjustment difficulties in the depression phase. We must therefore examine the important instances of particular governmental stimulation to the stock market in the 1920s.

While not as important as the increase in reserves and the money supply, this special aid served to spur the quantitative increase, and also created particular distortions in the stock market which caused greater troubles in the depression.

One important aid to stock market inflation was the FRS policy of keeping call loan rates (on bank loans to the stock market) particularly low. Before the establishment of the Federal Reserve System, the call rate frequently rose far above 100 percent, but since its inception, the call rate never rose above 30 percent, and very rarely above 10 percent.30 The call rates were controlled at these suasion because he himself was engaged in stock market speculation and in bank borrowing for that purpose. If this were the reason, however, McGarrah would hardly have been—as he was—the main force in urging an increase in the rediscount rate. Instead, he would have been against any check on the inflation. See Lawrence E. Clark,
Central Banking Under the Federal Reserve System
(New York: Macmillan, 1935), p. 267n.

29The moral suasion policy was searchingly criticized by former FRB

Chairman W.P.G. Harding. The policy continued on, however, probably at the insistence of Secretary of the Treasury Mellon, who strongly opposed any increase in the rediscount rate. See Anderson,
Economics and the Public Welfare,
p. 210.

30See Clark,
Central Banking,
p. 382. The call rate rarely went above 8 percent in 1928, or above 10 percent in 1929. See Adolph C. Miller, “Responsibility for Federal Reserve Policies: 1927–1929,”
American Economic Review
(September, 1935).

The Inflationary Factors

125

low levels by the New York Federal Reserve Bank, in close cooperation with, and at the advice of, a Money Committee of the New York Stock Exchange. The New York Fed also loaned consistently to Wall Street banks for the purpose of regulating the call rate.

Another important means of encouraging the stock market boom was a rash of cheering public statements, designed to spur on the boom whenever it showed signs of flagging. President Coolidge and Secretary of Treasury Mellon in this way acted as the leading “capeadores of Wall Street.”31 Thus, when the emerging stock market boom began to flag, in January, 1927, Secretary Mellon drove it onward. The subsequent spurt in February leveled off in March, whereupon Mellon announced the Treasury’s intention to refinance the 43 percent Liberty Bonds into 32 percent notes the next November. He predicted lower interest rates (accurately, due to the subsequent monetary inflation) and urged low rates upon the market. The announcement drove stock prices up again during March. The boom again began to weaken in the latter part of March, whereupon Mellon once more promised continued low rediscount rates and pictured a primrose path of easy money. He said, “There is an abundant supply of easy money which should take care of any contingencies that might arise.” Stocks continued upward again, but slumped slightly during June. This time President Coolidge came to the rescue, urging optimism upon one and all. Again the market rallied strongly, only to react badly in August when Coolidge announced he did not choose to run again. After a further rally and subsequent recession in October, Coolidge once more stepped into the breach with a highly optimistic statement.

Further optimistic statements by Mellon and Coolidge trumpeting the “new era” of permanent prosperity repeatedly injected tonics into the market.
The New York Times
declared on November 16

that Washington was the source of most bullish news and noted the growing “impression that Washington may be depended upon to furnish a fresh impetus for the stock market.” 31Ralph W. Robey, “The Capeadores of Wall Street,”
Atlantic Monthly
(September, 1928).

126

America’s Great Depression

BILLS BOUGHT–ACCEPTANCES

Tables 7 and 8 show the enormous importance of Bills Bought in the 1920s. While purchase of U.S. securities has received more publicity, Bills Bought was at least as important and indeed more important than discounts. Bills Bought led the inflationary parade of Reserve credit in 1921 and 1922, was considerably more important than securities in the 1924 inflationary spurt, and equally important in the 1927 spurt. Furthermore, Bills Bought alone continued the inflationary stimulus in the fatal last half of 1928.

These Bills Bought were all
acceptances
(and almost all
bankers’

acceptances
), and the Federal Reserve policy on acceptances was undoubtedly the most curious, and the most indefensible, of the whole catalog of Federal Reserve policies. As in the case of securities, acceptances were purchased on the open market, and thus provided reserves to banks outright with no obligation to repay (as in discounting). Yet while the FRS preserved its freedom of action in buying or selling U.S. securities, it tied its own hands on acceptances. It insisted on setting a very low rate on acceptances, thus subsidizing and indeed literally
creating
the whole acceptance market in this country, and then pledging itself to buy all the bills offered at that cheap rate.32 The Federal Reserve thus arbitrarily created and subsidized an artificial acceptance market in the United States and bought whatever was offered to it at an artificially cheap rate. This was an inexcusable policy on two counts—

its highly inflationary consequences, and its grant of special privilege to a small group at the expense of the general public.

In contrast to Europe, where acceptances had long been a widely used form of paper, the very narrow market for them in this country, and its subsidization by the FRS, led to the Reserve’s becoming the predominant buyer of acceptances.33 It was a completely 32Acceptances are sold by borrowers to acceptance dealers or “acceptance banks,” who in turn sell the bills to ultimate investors—in this case, the Federal Reserve System.

33Thus, on June 30, 1927, over 26 percent of the nation’s total of bankers’

acceptances outstanding was held by the FRS for its own account, and another 20

percent was held for its foreign accounts (foreign central banks). Thus, 46 percent
The Inflationary Factors

127

Federal Reserve-made market, and used only in international trade, or in purely foreign transactions. In 1928 and 1929, banks avoided borrowing from the Fed by making acceptance loans instead of straight loans, thus taking advantage of the FRS market and cheap acceptance rates. When the Federal Reserve bought the acceptance, the bank now acquired a reserve less expensively than by discounting, and without having to repay. Hence the inflationary role of acceptances in 1929 and its sabotaging of other Federal Reserve attempts to restrain credit.

In addition to acceptances held by the FRS on its own account, it also bought a large amount of acceptances as agent for foreign Central Banks. Moreover, the Reserve’s buying rate on acceptances for foreign account was
lower
than for its own, thus subsidizing these foreign governmental purchases all the more. These holdings were not included in “Bills Bought,” but they were endorsed by the FRS, and, in times of crisis, such endorsement could become a liability of the Federal Reserve; it did in 1931. The Reserve’s acceptances were purchased from member banks, non-member banks, and private acceptances houses—with the bills for foreign account bought
entirely
from the private dealers.34