America's Great Depression (26 page)

51
Hearings, Operation of Banking Systems,
Appendix, Part 6, pp. 847, 922–23.

52Yet not wholly unexpected, for we find Governor Strong writing in April, 1922 that one of his major reasons for open-market purchases was “to establish a level of interest rates . . . which would facilitate foreign borrowing in this country . . . and facilitate business improvement.” Benjamin Strong to UnderSecretary of the Treasury S. Parker Gilbert, April 18, 1922. Chandler,
Benjamin
Strong, Central Banker,
pp. 210–11.

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If the Reserve authorities had been innocent of the
consequences
of their inflationary policy in 1922, they were not innocent of intent. For there is every evidence that the inflationary result was most welcome to the Federal Reserve. Inflation seemed justified as a means of promoting recovery from the 1920–1921 slump, to increase production and relieve unemployment. Governor Adolph Miller, of the Federal Reserve Board, who staunchly opposed the later inflationary policies, defended the 1922 inflation in Congressional hearings. Typical of Federal Reserve opinion at this time was the subsequent apologia of Professor Reed, who complacently wrote that bank credit “was being productively employed and that goods were being prepared for the consumer at least as rapidly as his money income was expanding.”53

Open-market policy was then well launched, and played a major role in the 1924 and 1927 inflationary spurts and therefore in the overall inflation of the 1920s.

The individual Reserve Banks at first bought the securities on their own initiative, and this decentralized policy was resented by the Treasury. On the initiative of the Treasury, and seconded by Benjamin Strong, the Governors of the various Reserve Banks formed an Open-Market Committee to coordinate Reserve purchases and sales. The Committee was established in June, 1922. In April, 1923, however, this Governors’ Committee was dissolved and a new Open-Market Investment Committee was appointed by the Federal Reserve Board. Originally, this was a coup by the Board to exert leadership over open-market policy in place of the growing power of Strong, Governor of the New York Bank. Strong was ill throughout 1923, and it was during that year that the Board managed to sell most of the FRB holdings of government securities. As soon as he returned to work in November, however, Strong, as chairman of the Open-Market Investment Committee, urged purchases of securities without hesitation should there be even a threat of business recession.

53Harold L. Reed,
Federal Reserve Policy, 1921–1930
(New York: McGraw–Hill, 1930), pp. 20, and 14–41. Governor Miller agreed “that though prices were moving upward, so was production and trade, and sooner or later production would overtake the rise of prices.
”
Ibid., pp. 40–41.

The Inflationary Factors

135

As a result of Strong’s new accession to power, the Federal Reserve resumed within two months a heavy purchase of government securities, and the economy was well launched on its dangerous inflationary path. As Strong’s admiring biographer puts it:

“This time the Federal Reserve knew what it was doing, and its purchases were not earnings but for broad policy purposes,” i.e., for inflation. Ironically, Benjamin Strong had now emerged as more powerful than ever, and in fact from that time until his retirement, the FRS’s open-market policy was virtually controlled by Governor Strong.54 One of Strong’s first control devices was to establish a “Special System Investment Account,” under which, as in the case of acceptances, Reserve purchases of governments were made largely by the New York Bank, which then distributed them
pro rata
to those other Reserve Banks that wanted the securities.

Another new and important feature of the 1920s was the maintenance of a large volume of floating, short-term government debt.

Before the war, almost all of the U.S. debt had been funded into long-term bonds. During the war, the Treasury issued a myriad of short-term bills, only partially funded at a later date. From 1922

on, one half to one billion dollars of short-term Treasury debt remained outstanding in the banks, and had to be periodically refinanced. Member banks were encouraged to carry as much of these securities as possible: the Treasury kept deposits in the banks, and they could borrow from the Federal Reserve, using the certificates as collateral. Federal open-market purchases also helped make a market in government securities at low interest rates. As a result, banks held more government debt in 1928 than they had held during the war. Thus the Federal Reserve, by employing various means to bolster the market for Federal floating debt, added to the impetus for inflation.55

54See Chandler,
Benjamin Strong, Central Banker,
pp. 222–33, esp. p. 233. Also see Hardy,
Credit Policies,
pp. 38–40; Anderson,
Economics and the Public Welfare,
pp. 82–85, 144–47.

55See H. Parker Willis, “What Caused the Panic of 1929?”
North American
Review
(1930): 178; and Hardy,
Credit Policies,
p. 287. Tax exemption on income from government bonds also spurred the banks’ purchases. See Esther Rogoff Taus,
Central Banking Functions of the United States Treasury, 1789–1941
(New York: Columbia University Press, 1943), pp. 182ff.

5

The Development of the Inflation

We have seen how the leading factors in the changing of reserves played their roles during the boom of the 1920s. Treasury currency played a considerable part in the early years, due to the silver purchase policy inherited from the Wilson Administration. Bills discounted were deliberately spurred throughout the period by the Federal Reserve’s violation of central banking tradition in keeping rediscount rates below the market.

Acceptances were subsidized outrageously, with the Federal Reserve deliberately keeping acceptance rates very low and buying all the acceptances offered at this cheap rate by the few leading acceptance houses. Open-market purchase of government securities began as a means of adding to the earning assets of the Federal Reserve Banks, but was quickly continued as a means of promoting monetary expansion. We may now turn from the
anatomy
of the inflation of the 1920s, to a
genetic
discussion of the actual course of the boom, including an investigation of some of the reasons for the inflationary policy.

FOREIGN LENDING

The first inflationary spurt, in late 1921 and early 1922—the beginning of the boom—was led, as we can see in Table 7, by Federal Reserve purchases of government securities. Premeditated or not, the effect was welcome. Inflation was promoted by a desire to speed recovery from the 1920–1921 recession. In July, 1921, the
137

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America’s Great Depression

Federal Reserve announced that it would extend further credits for harvesting and agricultural marketing, up to whatever amounts were legitimately required. Soon, Secretary Mellon was privately proposing that business be further stimulated by cheap money.1

Another motive for inflation was one we shall see recurring as a constant and crucial factor in the 1920s: a desire to help foreign governments and American exporters (particularly farmers). The process worked as follows: inflation and cheap credit in the United States stimulated the floating of foreign loans in the U.S. One of Benjamin Strong’s major motives for open-market purchases in 1921–1922 was to stimulate foreign lending. Inflation also helped to check the inflow of gold from Europe and abroad, an inflow caused by the fiat money inflation policies of foreign countries, which drove away gold by raising prices and lowering interest rates. Artificial stimulation of foreign lending in the U.S. also helped increase or sustain foreign demand for American farm exports.

The first great boom in foreign borrowing therefore coincided with the Federal Reserve inflation of latter 1921 and early 1922.

The fall in bond yields during this period stimulated a surge in foreign lending, U.S. government yields falling from 5.27 percent in June 1921 to 4.24 percent in June, 1922 (corporate bonds fell from 7.27 percent to 5.92 percent in the same period). Foreign bond flotations, about $100 million per quarter-year during 1920, doubled to about $200 million per quarter in the latter part of 1921.

This boom was helped by “a deluge of statements from official, industrial, and banking sources setting forth the economic necessity to the United States of foreign lending.”2

The 1921–1922 inflation, in sum, was promoted in order to relieve the recession, stimulate production and business activity, and aid the farmers and the foreign loan market.

1Seymour E. Harris,
Twenty Years of Federal Reserve Policy
(Cambridge, Mass.: Harvard University Press, 1933), vol. 1, p. 94.

2Robert L. Sammons, “Capital Movements,” in Hal B. Lary and Associates,
The United States in the World Economy
(Washington, D.C.: Government Printing Office, 1943), p. 94.

The Development of the Inflation

139

In the spring of 1923, the Federal Reserve substituted credit restraint for its previous expansion, but the restraint was considerably weakened by an increase in Reserve discounts, spurred by the rediscount rate being set below the market. Nevertheless, a mild recession ensued, continuing until the middle of 1924. Bond yields rose slightly, and foreign lending slumped considerably, falling below a rate of one hundred million dollars per quarter during 1923. Particularly depressed were American agricultural exports to Europe. Certainly part of this slump was caused by the Fordney–

McCumber Tariff of September 1922, which turned sharply away from the fairly low Democratic tariff and toward a steeply protectionist policy.3 Increased protection against European manufactured goods delivered a blow to European industry, and also served to keep European demand for American exports below what it would have been without governmental interference.

To supply foreign countries with the dollars needed to purchase American exports, the United States government decided,
not
sensibly to lower tariffs, but instead to promote cheap money at home, thus stimulating foreign borrowing and checking the gold inflow from abroad. Consequently, the resumption of American inflation on a grand scale in 1924 set off a foreign lending boom, which reached a peak in mid-1928. It also established American trade, not on a solid foundation of reciprocal and productive exchange, but on a feverish promotion of loans later revealed to be unsound.4

Foreign countries were hampered in trying to sell their goods to the United States, but were encouraged to borrow dollars. But afterward, they could not sell goods to repay; they could only try to borrow more at an accelerated pace to repay the loans. Thus, in an indirect but nonetheless clear manner, American protectionist policy must shoulder some of the responsibility for our inflationist policy of the 1920s.

3See Abraham Berglund, “The Tariff Act of 1922,”
American Economic Review
(March, 1923): 14–33.

4See Benjamin H. Beckhart, “The Basis of Money Market Funds,” in Beckhart, et al.,
The New York Money Market
(New York: Columbia University Press, 1931), vol. 2, p. 70.

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America’s Great Depression

Who benefitted, and who was injured, by the policy of protection
cum
inflation as against the rational alternative of free trade and hard money? Certainly, the bulk of the American population was injured, both as consumers of imports and as victims of inflation and poor foreign credit and later depression. Benefitted were the industries protected by the tariff, the export industries uneconomically subsidized by foreign loans, and the investment bankers who floated the foreign bonds at handsome commissions. Certainly, Professor F.W. Fetter’s indictment of America’s foreign economic policy in the 1920s was not overdrawn:

Producers in those lines in which foreigners were competing with us were “taken care of” by high tariffs, promises of still higher tariffs from the Tariff Commission if “needed,” and those interested in foreign trade were told how the Department of Commerce was going to open up huge foreign markets. Foreign loans were glorified by the same political leaders who wanted bigger and better trade restrictions, entirely oblivious to the problems involved in the repayment of such loans. .

. . A tremendous volume of foreign loans made possible exports far in excess of imports . . . and Secretary Mellon and other defenders of this tariff policy pointed the finger of ridicule at those who had prophesied that the Fordney–McCumber Act would have an injurious effect upon our foreign trade.5

The Republican administration, often wrongly considered to be a “laissez-faire” government, actually intervened actively in foreign lending throughout the 1920s. Foreign loans had been rare in the United States before the World War, and the United States government had no statutory peacetime authority to interfere with them in any way. And yet the government did intervene, though 5Frank W. Fetter, “Tariff Policy and Foreign Trade,” in J.G. Smith, ed.,
Facing the Facts
(New York: G.P. Putnam’s Sons, 1932), p. 83. Also see George E.

Putnam, “What Shall We Do About Depressions?”
Journal of Business
(April, 1938): 130–42, and Winthrop W. Aldrich,
The Causes of the Present Depression and
Possible Remedies
(New York, 1933), pp. 7–8.

The Development of the Inflation

141

illegally. On May 25, 1921, President Harding and his cabinet held a conference with several American investment bankers, at the instigation of Secretary of Commerce Hoover, and Harding asked to be informed in advance of all public flotations of foreign bonds, so that the government “might express itself regarding them.”6

The bankers agreed. The state had been set for this meddling at a Cabinet meeting five days before, where:

The Cabinet discussed the problem of favoring exports and the desirability of the application of the proceeds of foreign loans made in our own financial markets for the purpose of exporting our commodities.7