Monetary Policy Surrounding The Great Depression

From Secrets of The Temple by William Greider, pp. 296-303.

Ben Strong, the dominant central banker in America during the Fed's first formative decades, understood the political advantage in blurring the central bank's influence over prices and the economy. The Fed would always be caught between the conflicting interests of consumers and producers, between finance and farmers, between lenders and borrowers. "There you are," he said, "between the devil and the deep sea."

"It seems to me that if the Federal Reserve System is recognized as a price regulator," Strong explained, "it is going to be somewhat in the position of the poor man who tried to stop a row between an Irishman and his wife. They both turned in and beat him.^„16

Benjamin Strong died in October 1928, and one year later, the Fed­eral Reserve System suffered its historic disgrace. The stock market crashed and the American economy collapsed with it. The "new era” of permanent properity was abruptly demolished, followed by the Great Depression with unemployment at 25 percent and desperate poverty for tens of millions of Americans. Tens of thousands of busi­nesses were bankrupted, and the panic of bank failures also returned —destroying more than forty percent of all American banks. The Fed­eral Reserve was blamed for failure to act on both sides of the Great Crash—first for letting it happen, then for failing to reverse the dev­astation. The Fed's defenders liked to imagine that had Benjamin Strong lived, maybe the worst of the disaster could have been averted. It sounded like wishful thinking in hindsight.

Certainly, Strong saw the outlines of the gathering crisis before others did. In the summer of 1928, three months before his death, he warned a colleague that banks and investors were caught up in a dangerous frenzy of speculation, borrowing heavily to make specula­tive stock-market forays, bidding up prices so high that the rosy ex­pectations could not possibly be fulfilled. The nation was giddily enjoying the Republican prosperity. The New York Fed was privately worrying about its collapse.

"The problem now," Strong wrote, "is so to shape our policy as to avoid a calamitous break in the stock market, a panicky feeling about money, a setback to business because of the change in psychology, and at the same time accomplish if possible some of the purposes enumerated above." The Reserve Banks, he said, must dampen credit and restrain the speculative lending, but without setting off that "ca­lamitous break."

This was a tricky business, though Strong thought it could be done. After his death, his successors tried fitfully and failed. They applied "moral suasion," pleading with commercial banks to stop making loans for stock-market speculation. When that failed, they argued among themselves. Without Strong to impose his will, the Reserve Banks and the Federal Reserve Board were stalemated through most of 1929. Belatedly, they voted a modest Discount increase in August, intended to slow down the rapacious bank lending. The speculative bubble continued. Stock-market prices went higher and higher.

On October 24, 1929—Black Thursday—the bubble burst, the "ca­lamitous break" that Strong had feared. Within a matter of days, the Standard and Poor's composite index of stocks fell from 245 to 162, wiping out more than one-third of the stock market's value. Something on the order of $7 billion in bank loans to financial investors was rendered worthless. A "panicky feeling about money," as Strong had called it, swept the nation and the world.

In the tendentious postmortems over what exactly caused the Crash of '29, Strong was himself blamed for the debacle. Adolph Miller of the Federal Reserve Board, among others, charged that Strong had personally engineered the major easing of credit in the summer of 1927—Discount-rate reductions and open-market purchases of $340 million—that pumped excessive liquidity into the banking system and permitted the artificial investment boom to take off. Strong's easy-credit policy in 1927, Miller said later, "was father and mother to the subsequent 1929 collapse."

The 1927 error, if it was an error, was at least motivated by Strong's desire to aid the real economy. When he had leaned on his colleagues at the other Reserve Banks to reduce their Discount rates, he was worried. Employment was slipping, wholesale prices were declining again and business appeared to be sliding back into recession. The easier credit was intended to avert another contraction. But Strong had another more controversial motive—helping out the central banks of Europe. Presiding at the New York Fed, Ben Strong regularly col­laborated with the central bankers of England and the Continent, trying to stabilize things so the gold standard could be restored inter­nationally. The great international banking houses, from Morgan to Rothschild, had always worked closely with one another, borrowing and lending capital among themselves to balance out the worldwide demands for credit. From the start, Strong discreetly assumed the same role for himself—personal responsibility for representing Amer­ica in global financial coordination, in an era when most Americans still thought of their nation as totally independent.

In mid-1927, Montagu Norman of the Bank of England called on Strong and urged him to ease U.S. credit. Strong promptly agreed to do it. The Fed would provide excess liquidity for the American bank­ing system and that money could flow abroad, through foreign loans, to ease credit in the European financial markets, where tightening conditions threatened to push up interest rates. If rates rose sharply in London and Paris and Vienna, that would depress business and perhaps set off a general contraction. The explanation would certainly have rankled citizens of the United States if they had known it. World War I had left a great tide of isolationism in its wake. The suspicion that the Federal Reserve secretly served the needs of international banking at the expense of domestic interests would become a peren­nial source of resentment.

As Strong himself argued, however, the U.S. assistance was also self-interested—what damaged European business would in time also damage America's. If Europe's economies contracted, for instance, then Midwestern grain farmers would find no buyers for the surplus crops they exported. Like it or not, the world's industrial economies were already closely interlocked, through both finance and produc­tion, long before the Federal Reserve came into existence. The "global economy" celebrated by modern commentators was different only in the degree of complexity, the volume and speed of international trans­actions. Despite his autocratic manner, Strong was ahead of his time in his internationalism.

Strong's maneuver, in any case, did not work. It backfired. Given the weakened state of the real economy, the flush of excess liquidity he had pumped into the banking system was not needed for transac­tions in real commerce or production. The surplus of money flowed, instead, into financial markets—artificially inflating financial values and fueling the run-up of stock prices that ended abruptly in the autumn of 1929.

After the crash, the Federal Reserve System did nothing. If Ben Strong had been alive and in charge, perhaps he would have acted to stop the collapse. At least, when he was expressing his fears of a ^"calamitous break" back in 1928, Strong understood that the Federal Reserve could quickly reverse such a disaster.

I think you realize, as I do [Strong had written to a colleague], that the very existence of the Federal Reserve System is a safeguard against any­thing like a calamity growing out of money rates. Not only have we the power to deal with such an emergency instantly by flooding the street with money, but I think the country is well aware of this and probably places reliance upon the common sense and power of the System. In former days the psychology was different because the facts of the banking situation were different. Mob panic, and consequently mob disaster, is less likely to arise.

Strong was mistaken about the "mob" and its faith in the Fed. When the market broke, the same psychology that had driven banking panics in 1907 and earlier took hold, swept across America and Eu­rope, and ultimately destroyed 9,800 U.S. commercial banks over the next five years. But Strong was making a more fundamental point: the Federal Reserve had ample power to stop such a crisis almost instantly "by flooding the street with money."

That is what his successors failed to do. At first, they accepted the ruinous deflation as a natural, even desirable outcome. As the contrac­tion deepened, they bickered among themselves about the correct reponse. Finally, rather late in the crisis, they tried briefly to reverse the decline, then abandoned the effort before it had a chance to suc­ceed.

Money disappeared on a massive scale. As billions of dollars of bank debt were liquidated by defaults and bankruptcies in the economy, involving farmers and businesses along with the stock-market specu­lators, the process naturally extinguished money and the supply of money contracted. From 1929 to early 1933, U.S. money shrank in volume by more than one-third. The Federal Reserve could have in­tervened to reverse the contraction. It could have reduced interest rates sharply to stimulate renewed borrowing and business activity. More importantly, it could have purchased millions or billions in gov­ernment securities—pumping new money into the banking system to reverse the price deflation and restart the dead economy. Instead, as President Herbert Hoover lamented, the Fed became a "weak reed for a nation to lean on in time of trouble." ¹⁷

Long afterward, the 1929 debacle left the general impression in political circles that it could never happen again. The Fed would not permit it. If another similar collapse ever occurred, the central bank would simply begin pumping up the money supply, creating new money abundantly until the crisis was reversed. When the Great Crash occurred, it was said, the failure stemmed from the Federal Reserve's ignorance and impotence. Fed officials lacked sufficient knowledge of the economy to understand what was happening. They lacked the proper monetary tools to intervene successfully.

Comforting as the mythology was, it was not quite right. It was not that Federal Reserve governors lacked the tools to reverse the waves of failure after 1929. They could have pumped money into the econ­omy by open-market purchases—"flooding the street," as Strong had said—and that would have restarted the economic engine. But the governors argued among themselves over whether to use these powers to halt the collapse—and they decided against it. The Federal Re­serve's failure was a failure of human judgment, not the mechanics of money. Unless one assumed that the Fed had subsequently become all-wise, such decisive errors would always still be possible.

The central bankers of 1929 did not view the economic collapse as an unfolding tragedy, at least in its opening phases. On the contrary, they regarded it as a normal correction to excess. Ten months after the stock-market crash, amidst soaring unemployment, collapsing prices and an ominous new wave of bank failures, George W. Norris of the Philadelphia Fed sounded almost pleased by developments.

The consequences of such an economic debauch are inevitable [Norris told his fellow Reserve Bank officers]. We are now suffering them. Can they be corrected or removed by cheap money? We do not believe that they can. We believe that the correction must come about through re­duced production, reduced inventories, the gradual reduction of consumer credit, the liquidation of security loans and the accumulation of savings through the exercise of thrift. These are slow and simple remedies, but just as there is "no royal road to knowledge," we believe that there is no shortcut or panacea for the rectification of existing conditions.

The leading commercial bankers who advised the Fed agreed. The Federal Advisory Council urged the central bank to let nature take its course. "The present situation will be best served if the natural flow of credit is unhampered by open-market operations," the council de­clared in November 1930.

Andrew Mellon made the same case with chilling clarity. The way out of the Depression, he confided to President Hoover, was more failure and unemployment, more liquidation. "Liquidate labor, liqui­date stocks, liquidate the farmers, liquidate real estate," Mellon de­clared. The Treasury Secretary believed, and many other Fed officials agreed, that panic and recession were good for people. "It will purge the rottenness out of the system," Mellon explained. "People will work harder, live a more moral life. Values will be adjusted and enter­prising people will pick up the wreck from less-competent people."

Hoover was not so sure this was the answer, but the President had little influence over the independent leaders of the Federal Reserve System. Herbert Hoover, of course, became the political scapegoat for their failure; his name would be invoked by a generation of Demo­cratic orators as the symbol of Republican indifference to human suf­fering.

As the Depression deepened, the Federal Reserve persisted in its passivity in part because the Fed's money principles—the "real bills" doctrine—called for passivity. Again and again, in their private min­utes and memoranda, the Reserve Bank officials insisted that the Fed's role was merely to provide Discount loans to the commercial banks that asked for them—accommodating the credit needs of the economy. Of course, almost nobody was asking for new loans in 1930 or 1931. The economy was contracting and the banking system did not need expanded credit from the Fed. On the contrary, banks found themselves floating in an excess of reserves—a pool of surplus lending capacity—because they could find no customers who wanted to borrow.

When others urged the Fed to inject more money into the financial system, Norris of the Philadelphia Fed reminded his colleagues of the operating principle thay had formally adopted in 1923 on the System's tenth anniversary: "The Federal Reserve supplies the needed addi­tions to credit in times of business expansion and takes up the slack in times of business recession." That was the whole idea of an "elastic currency"—expanding or shrinking the money supply in response to business demands for credit. Norris complained that even the modest steps the Fed had taken on its own initiative would be regretted. "We have been putting out credit in a period of depression, when it was not wanted and could not be used," he warned, "and will have to withdraw credit when it is wanted and can be used."

Logical as it sounded, the theory was fatally flawed. The "real bills" approach meant the Federal Reserve would always be passively fol­lowing the direction of the economy and exaggerating its cycles on both the upside and the downside—providing more and more new money to banks during a period of expansion and withdrawing more and more money during an economic recession. Thus, the Fed's be­havior deepened the great contraction through its self-imposed stance of impotence. The Discount rate, its principal means of control, was like an empty sail on a becalmed sea.

What was needed, as some Fed officials recognized, was an activist money policy that pulled against the economic tide rather than drifting with it—a countercyclical policy, economists would say, rather than the procyclical policy implicit in the "real bills" doctrine. In short, the Fed must be willing to inflate the currency on its own initiative—"flooding the street with money"—in order to counteract the natural forces of deflation and contraction that were under way. The Federal Reserve System had neither the desire nor the courage to do that.

Federal Reserve officers had another reason not to act—a rather ugly reason considering the human suffering abroad in the land. Reserve Bank presidents held back because they were anxious to protect the earnings of private commercial banks. That sounded callous and narrow-minded, but political scientist Thomas Ferguson and econo­mist Gerald Epstein found confirming evidence in their research of the central bank's archives—blunt private statements by the Reserve Bank presidents that no more additional money should be supplied because it was hurting the important banks in their districts.

For two years, some Fed officials, including the board chairman in Washington, Eugene Meyer, had pleaded with their colleagues to in­ject massively through open-market purchases. That would pull down interest rates and get prices and wages rising again, restimulating economic activity. In October 1931, the Reserve Banks actually did the reverse—raising the Discount rate by two percentage points in two weeks. Industrial production fell another 26 percent in the next six months. The money base shrank by another $90 million.

Finally, by April of 1932, Meyer and others prevailed, supported by the Morgan bank and important Wall Street financiers. They per­suaded the Reserve Banks' open-market committee to pump up the money supply and quickly. The New York Fed began buying Treasur­ies on an unprecedented scale—$100 million a week for eleven weeks, $1.1 billion in additional reserves. If the campaign had continued, it would have produced a turnaround in the economy.

But, in early summer, the Reserve Banks abruptly abandoned the initiative. The bold experiment was over. When the contraction re­sumed a few months later, a third wave of bank failures swept the country, more severe than the first two. Another five thousand banks would close.

James McDougal of the Chicago Fed was among the Reserve Bank presidents who objected to the Fed's attempted activism. Major banks in the Chicago district, he complained, were suffering an earnings squeeze because of the Fed's easy money. The expanded money sup­ply drove down interest rates on government securities to a minuscule level, and in these slack times, the banks held large portfolios of government securities as their principal source of income. "We be­lieve that the additional (open-market) purchases made were much too large," McDougal wrote a colleague, "and have resulted in creating abnormally low rates for short-term government securities."

Norris of the Philadelphia Fed agreed: "Further increases in excess reserves would adversely affect bank earnings. . . ." Owen D. Young of the Boston Fed, who had voted against the open-market initiative in the first place, was "apprehensive that a program of this sort would develop the animosity of many bankers." ¹⁸ All in all, the episode was perhaps the starkest evidence in support of historian Gabriel Kolko's estimate of the Federal Reserve as a political institution: it was cre­ated to serve the most important banks and, in this instance, it did, despite the horrendous losses it was to cause the nation at large.

The Federal Reserve backed off. The infusions of new money were halted. And nature followed its course to a climax of destruction. By early 1933, as Franklin D. Roosevelt awaited his Inaugural, a new wave of collapsing banks was under way, accompanied by still higher unemployment and many more business failures. As Democrats came to power, the national economy was ruined and the American banking system was ruined with it. Also destroyed was the reputation of the Federal Reserve System.

The Land of Makebelieve