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Monetary Policy, Loan Liquidation, and Industrial Conflict: The Federal Reserve and the Open Market Operations of 1932

Published online by Cambridge University Press:  03 March 2009

Gerald Epstein  and
Thomas Ferguson
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Abstract

Early in 1932 the Federal Reserve System made a serious attempt to reverse the “Great Contraction” throught expansionary open market operations, but abandoned it a few months later. In this paper we offer an interpretation of the episode that throws new light on the Fed's behavior during the Depression. Key are the attitude of private bankers, Britain's abandonment of the gold standard, and the brief open market campaign. To protect bank profits the Fed abandoned the program which set the stage for the complete financial collapse of the United States in early 1933.

Type
Articles
Information
The Journal of Economic History , Volume 44 , Issue 4 , December 1984 , pp. 957 - 983
Copyright
Copyright © The Economic History Association 1984

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References

1 Keynes, ' remark is in his “A Note on the Long Term Rate of Interest in Relation to the Conversion Scheme,” Economic Journal, 42 (09. 1932), 421–22.CrossRefGoogle Scholar

2 This “Glass-Steagall Act” should not be confused with a law passed a year later bearing the names of the same two legislators that mandated the separation of investment from commericial banking.Google Scholar

3 Josephson, Mathew, The Money Lords (New York, 1973), p. 101.Google Scholar Josephson was then in fairly close touch with top Fed officials. See his Infidel in the Temple (New York, 1967), p. 21.Google Scholar

4 SeeFriedman, Milton and Schwartz, Anna, A Monetary History of the United States 1867–1960, Princeton, 1963);Google ScholarBrunner, Karl and Meltzer, Allan H., “What did we learn from the Monetary Experience of The United States in the Great Depression,” Canadian Journal of Economics, 1 (05 1968), 334–48;CrossRefGoogle ScholarMeltzer, , “Monetary and Other Explanations of the Start of The Great Depression,” Journal of Monetary Economics, 2 (1976), 455–71;CrossRefGoogle ScholarTemin, Peter, Did Monetary Forces Cause The Great Depression? (New York, 1976);Google ScholarWicker, Elmus R., “Federal Reserve Monetary Policy, 1922–1933: A Reinterpretation,” Journal of Political Economy, 73 (08 1965), 325–43;CrossRefGoogle Scholar and Federal Reserve Monetary Policy, 1917–1933 (New York, 1966).Google Scholar See also the essays in Brunner, K., ed., The Great Depression Revisited (Boston, 1981)CrossRefGoogle Scholar and Trescott, Paul, “Federal Reserve Policy In The Great Contraction: A Counterfactual Assessment,” Explorations in Economic History, 19 (07 1982), 211–20.CrossRefGoogle Scholar

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7 p. 195.Google Scholar

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9 See for example, Meltzer, “Monetary And Other Explanations,” p. 465.Google Scholar

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11 Our discussion here summarizes the more detailed analysis in our “Monetary Policy, Loan Liquidation, and Industrial Conflict: The Federal Reserve and The Great Contraction,” available from the authors.Google Scholar

12 Meltzer's table is presented in his “Monetary and Other Explanations,” pp. 465–67. Our continuation of the table is available from either of us.Google Scholar

13 See Stigler, George, “The Economic Theory of Regulation” in his The Citizen and the State (Chicago, 1971),Google Scholar and Posner, Richard, “Theories of Economic Regulation,” Bell Journal of Economics, 5 (Autumn 1974), 335–58. For one attempt at applying the economic theory of regulation to the Federal Reserve SystemCrossRefGoogle Scholar see Epstein, Gerald, “Monetary Instability and the Political Economy of the Federal Reserve,” in Stone, Alan, ed., The Political Economy of Public Policy (Beverly Hills, 1983). Pressures from other sectors strongly affect the treatment of the Fed as a creature of a single industry. Note that Wicker, and Friedman and Schwartz, though they did consideratble research in archives, gathered very little material on the private sector. Of course, what the Fed needs to do to raise bank profits depends on the state of the economy and, as we discuss later, on the condition of bank portfolios. In regard to the latter question,Google Scholar see Fisher, Lawrence and Weil, Roman L., “Coping with the Risk of Interest Rate Fluctuations: Returns to Bondholders From Naive and Optimal Strategies,” Journal of Business, 44 (10, 1971), 408–31;CrossRefGoogle Scholar and Flannery, Mark, “Market Interest Rates and Commercial Bank Profitability: An Empirical Investigation,” Journal of Finance, 36 (12. 1981), 1085–1101.CrossRefGoogle Scholar

14 The previous two paragraphs primarily rely on Friedman and Schwartz, Monetary History, pp. 363–71. Note that opposition to the New York Fed's initiatives helped lead to a reorganization of the Open Market Committee.Google Scholar

15 See Harrison, “Report of the Chairman of the Open Market Policy Conference to the Governors Conference” of April 27, 1931, for a review of policy to then. This and the other Harrison papers quoted can be found in the George L. Harrison Papers, Rare Books and Manuscript Library, Columbia University. The papers there are often said to be duplicates of those in the Federal Reserve Bank of New York archives.Google Scholar

16 The stock market crash initially threatened banks in New York to a greater extent than those in other districts. Almost 50 percent of the loans of central reserve city member banks in New York were loans on securities, over a third of them to brokers and dealers in New York City. This compares to less than 40 percent for all member banks with only 10 percent of those to dealers and brokers in New York. Moreover, much of the pressure of withdrawals of bank deposits following the crash was concentrated in New York banks.Google Scholar See Board of Governors of the Federal Reserve System, Banking and Monetary Statistics (Washington, D.C., 1943), p. 76, 83; in regard to the directors see the quotation in Meltzer, “Monetary And Other Explanations,” p. 463.Google Scholar

17 Treasury Secretary Andrew Mellon, quoted in Koskoff, David, The Mellons, (New York, 1978), p. 265; Koskoff in turn is quoting from the report in Hoover's memoirs.Google Scholar

18 See the sources discussed at greater length in our “Monetary Policy.”Google Scholar

19 For Hoover's efforts, see the entry in the Stimson diary of April 4, 1931 (which discusses the policies Hoover implemented soon after the crash), Henry Stimson Papers, Sterling Library, Yale University, and Rothbard, Murray, America's Great Depression (Princeton, 1963).Google Scholar See also Baily, Martin, “The Labor Market In The 1930,” in Tobin, James, ed., Macroeconics, Prices and Quantities (Washington D. C., 1983).Google Scholar

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21 Goldenweiser, E. A., Meeting With Federal Reserve Board, Jan. 3, 1930 from Goldenweiser Papers, Library of Congress, Box 1, quoted in Friedman and Schwartz, Monetary History, p. 401. For other evidence on how seriously the Fed viewed the gold question, see Minutes of Meetings of The Open Market Policy Conference, April 29, 1931, in the Harrison Papers.Google Scholar

22 Miller. for example, clearly relied on real bills in his statement cited in the main text to the previous footnote. The true meaning of real bills during this period is complicated by the Fed's enthusiasm for liquidation. During much of the early Depression the brunt of deposit withdrawals, runs, and suspensions fell on smaller, generally state-regulated banks. As a consequence, deposits had a discernible tendency in some Fed districts to leave such banks for larger ones regulated by the Fed. Because a bank that gained deposits probably had less need to borrow from the Fed and real bills advocates frequently relied on such borrowing to gauge how tight policy was, a plea in favor of real bills by larger banks was equivalent to a request for a policy that transferred the assets of their marginal competitors to them. Note that our regression results, reported below, indicate that for the Depression as a whole, the Fed did not respond to bank failures and that the Fed was frequently criticized in this period for its alleged hostility to small banks.Google Scholar

23 Goldenweiser, E. A., memo on Meeting With Federal Reserve Board, January 3, 1930, Goldenweiser Papers. Harrison's forceful advocacy of the reduction of collateral requirements mentioned below, shows that he agreed with Goldenweiser, and is incompatible with a real bills doctrine. In 1932 when the Glass-Steagall Act passed, Thomas W. Lamont of Morgan was also openly attacking older, restrictive notions of “elegibility.” See Lamont to Walter Lippman, Memorandum, dated Feb. 11, 1932, Lippman Papers, Sterling Library, Yale University.Google Scholar

24 Certain brief, anomalous aspects of Fed behavior during 1931 cannot be considered here.Google Scholar

25 Friedman and Schwartz, Monetary History, p. 316.Google Scholar

26 p. 322; they also note Hoover's interest in other assistance for banks.Google Scholar

27 U. S. Board of Governors of the Federal Reserve, Banking and Monetary Statistics (Washington, D.C., 1943) pp. 468, 475, 478. Lower grade bonds had plunged earlier. Note that actual failures continued to be concentrated among smaller banks.Google Scholar

28 See the striking letter of Morgan partner Russell Leffingwell to Senator Carter, Glass, January 8, 1932; Leffingwell Papers, Box 3, Yale University, Sterling Library. Leffingwell's views had been very different only a few months before, and he now emerged as a leading lobbyist for the program.Google Scholar

29 The portfolio changes discussed here can also be expressed more technically as an analysis of changes in the “duration” of bank assets and liabilitiesw as, for example, in Samuelson, Paul, “The Effect of Interest Rate Increases on the Banking System,” American Economic Review, 35 (03 1945), 16–27. See note 38 of our “Monetary Policy.”Google Scholar

30 See the discussion in Ferguson, Critical Realignment.Google Scholar

31 Minutes of the Meeting of the Open Market Policy Conference, Washington, D.C., January 11 and 12, 1932, p. 7; Harrison Papers. Friedman and Schwartz do mention the issue of railroad wage cuts, p. 383, but do not indicate its importance. Wicker does not mention it. The report of an official communication (New York Federal Reserve, January 20, 1932, from J. E. Crane to Confidential Files, Bank of France telephone conversation; report on talk of Harrison with Lacour-Gayet) underscores the importance of the railroad wage cuts.Google Scholar

32 Letter from Burgess to Harrison, February 16, 1932, Federal Reserve Board of New York archives (hereafter FRBNY). This memo is also an excellent indication that Burgess has abandoned (if he ever held) the “Riefler-Burgess-Strong” doctrine.Google Scholar

33 See Ferguson, Critical Realignment.Google Scholar

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35 Preliminary Memorandum for Executive Committee of The Open Market Policy Conference, April 5, 1932, Harrison Papers.Google Scholar

36 Preliminary Draft, Minutes of Meeting of the Executive Committee of the Open Market Policy Conference, April 5, 1932, Harrison Papers.Google Scholar

37 Meeting of Joint Conference of The Federal Reserve Board and The Open Market Policy Conference, April 12, 1932; Washington, D.C., Harrison Papers. Note that even Miller, previously a champion of real bills, supported reflation.Google Scholar

38 All issues of the Federal Reserve Bulletin in this period present comparative data for the various Federal Reserve banks. In the 1920s controversies between the Chicago and New York Federal Reserve banks had been acute; for a particularly striking example, see Ferguson, “Normalcy to New Deal,” p. 72.Google Scholar

39 McDougal and Young, for example, had opposed the program at a Feb. 24 and 25 meeting of Governors. See Minutes of the Meeting of Governors held at Washington, D.C., Feb. 24 and 25, 1932, Harrison Papers. Minutes of the Boston Fed, for various dates in 1932, now held in the Federal Reserve Bank at Boston, indicate that the Boston bank, nevertheless, sometimes bought securities.Google Scholar

40 Meeting of Joint Conference, April 12, 1932, Harrison Papers, p. 21. Harrison's answer indicates what he thought was animating the critics and seems to rule out an appeal to belief in real bills as an explanation for their behavior. After questioning the programs as “inflationary,” McDougal finally voted with the majority. No significance should be attached to this move, however. Both before and after this meeting, McDougal, whom Harrison later descrined as ‘always a reluctant follower” of the reflation program, vigorously attacked open market expansion. (See Harrison's comments at the June 23, 1932, meeting of the directors of the New York Fed, Binder 50, Harrison Papers.) Note also that bureaucratic pressures, to close ranks once the outcome of a decision was cleat, were very strong and led losers to say frankly on several occasions that they would not vote formally against what they lacked the strength to halt.Google Scholar

41 See the figures for the period in Federal Reserve Bulletin (Feb. 1938), pp. 123–24.Google Scholar

42 The Federal Reserve volume, Banking and Monetary Statistics, actually has a record of negative values for short-term interest rates in Oct. 1932, p. 460.Google Scholar

43 By 1933 some banks were refusing deposits because they were losing money on them. See Commercial and Financial Chronicial, Feb. 11, 1933.Google Scholar

44 The data on net earnings are from Federal Reserve Bulletin (Feb. 1938), p. 119. Table III of our “Monetary Policy” breaks down bank expenses for “salaries and wages” and other categories during the early 1930s. The data for this table, on which our discussion here is based, are from various issues of the Federal Reserve Bulletin.Google Scholar

45 These figures are drawn from Table 4 of our “Monetary Policy” paper, which calculates net margins for banks in each Federal Reserve district from 1927 to 1932. The data come originally from various issues of the Federal Reserve Bulletin. Net margin equals interest earned less interest paid less other expenses per $100 of loans and investments. Note that margins vary considerably over the whole five-year period.Google Scholar

46 Report of Open Market Operations to Meeting of the Executive Committee of the Open Market Policy Conference Held at Federal Reserve Bank of New York on April 5, 1932, Harrison Papers.Google Scholar

47 James, F. Cyril, The Growth of Chicago Banks, (New York, 1938), Vol. 2, pp. 1062–63. After the declaration of the Banking Moratorium, when it was too late, the Chicago bank finally did agree to rediscount for the New York Fed.Google Scholar

48 For statistics on each bank's notes and gold holdings, see Federal Reserve Bulletin for 1932 and 1933, various issues; remember that each bank desired a safety margin. Note also that opponents of reflation soon began arguing that the system-wide nature of the program was very important, if it were to be done at all, while the New York Fed feared the wrath of the provinces if it tried to go it alone.Google Scholar

49 Board of Governors of the Federal Reserve System, Banking and Monetary Statistics, p. 574.Google Scholar

50 For statistics of the gold loss, see. The much-disputed question, whether French Prime Minister Laval made a promise to President Herbert Hoover, is discussed in Ferguson, Critical Realignment.Google Scholar

51 See Allan Sproul (E. M. Despres) to Crane and Burgess, June 8, 1932 (a retrospective on gold in recent months), in FRBNY archives. For Fed-Bank of England communications in this period see the file for the Bank of England in the Archives of the Federal Reserve Bank of New York. For the Bank of England's efforts to lower interest rates in the spring of 1932, see the Monthly Newsletter of the National City Bank of New York, May 1932, p. 69;Google Scholar see also Howson, Susan, “Sterling's Managed Float,” Princeton Studies in International Finance (Princeton, 1980) concerning the conflict between the British Treasury and the Bank of England.Google Scholar

52 Leffingwell, R., “Memorandum,” April 2, 1932, Box 3, Leffingwell Papers, Yale University.Google Scholar

53 Federal Reserve Bank of New York, May 26, 1932, telephone conversation with Mr. Cariguel, Banque de France. From L. W. Knoke, reporting on a call from Cariguel to Crane of the staff of the New York Fed. See also Howson, “Sterling's Managed Float,” p. 15, which suggests that the Bank of England had been buying dollars in May, but was selling them in June and July; and Goldenweiser, untitled memo for June 10, 1932, Goldenweiser Papers.Google Scholar

54 Woodlief Thomas to Mr. Sproul; Subject: “Gold Movements and System's Open Market Policy,” June 9, 1932, reporting the comments of several investment bankers, FRBNY archives. Note that many, perhaps most, lower-ranking New York Fed officials supported the reflation program.Google Scholar

55 Harrison to Confidential Files, from Governor Harrison, June 2, 1932, Subject: “The Dollar in England, President's meeting May 30, balancing budget, etc.,” Harrison Papers, which discusses a meeting with various industrialists and a U.S. senator to put pressure on Hoover and the leaders of Congress.Google Scholar

56 See Ferguson, Critical Realignment. Among primary sources, see especially the Charles Hamlin diary for May and June 1932, at the Library of Congress. It is also worth mentioning that currency hoarding worried some Fed officials, as did the prospect that this could develop into a domestic gold run.Google Scholar

57 For example, the memoranda referenced in fn. 54. In May and June some Fed staffers who supported reflation had attempted to minimize the significance of the gold outflow. But the bankers who were losing the deposits and the high Fed officials responsible for policy took a more serious view of the situation. Gold cover problems in individual Fed banks also continued.Google Scholar

58 Minutes of the Meeting of the Executive Committee of The Open Market Policy Conference, June 1932, Harrison Papers.Google Scholar

59 J. B. McDougal to Harrison, July 9, 1932, FRBNY archives. Note that falling interest rates could, and in districts like Chicago where many banks were already collapsing, almost certainly did increase chances that depositors would withdraw their funds.Google Scholar

60 The “pool” was a corporation in which different financial groups could buy shares. See Ferguson, Critical Realignment, and contemporary references such as the Journal of Commerce and Finance, (June 8, 1933), 780.Google Scholar

61 Our “Monetary Policy” reports a regression on bank stock data indicating that falling prices of bank stocks, but not industrial production, influenced the Fed. We have only limited confidence in this equation, however, and so do not discuss it here.Google Scholar

62 See, for example, Goldfeld, S. and Blinder, A., “Some Implications of an Endogenous Stabilization Policy,” Brookings Papers on Economic Activity, 3 (1972), pp. 585–640. The problem of “selective attention” is particularly worrisome.CrossRefGoogle Scholar

63 See the literature on currency substitution, for example, Girton, L. and Roper, D., “Theory and Implications of Currency Substitution,”, Journal of Money, Credit, and Banking, 13 (02. 1981) 12–30, and the discussion in the Federal Reserve Bulletin (Jan. 1932).CrossRefGoogle Scholar

64 Given the traditional posture of central banks and discussions of the time, one might expect that the Fed would respond to inflation. We found, however, in our statistical work that the Fed did not respond to inflation in this period, contrary to conventional wisdom.Google Scholar

65 Minutes of The Meeting of the Open Market Policy Conference, Jan. 4, 1933, Harrison Papers. McDougal of Chicago also expressed a desire to “make open market money rates firmer.”Google Scholar

66 See Ferguson, Critical Realignment.Google Scholar