10. From Boom to Depression

In the spring of 1928, with Benjamin Strong ill and absent after mid-May, the Federal Reserve became alarmed by the now exploding stock market and tried to put an end to the inflationary boom. The Fed managed to contract reserves by selling securities, but its efforts were partially offset by large increases in rediscounting spurred by the Fed’s failure to raise rediscount rates sufficiently and by the banks’ shifting of credit from demand to time deposits, which required far less reserves. Still, the contraction of reserves took hold from May through July, and as a result, the rate of money growth leveled off sharply.[79] Stock prices rose far more slowly than before, and the gold drain out of the United States began to reverse.

The boom could have ended in mid-1928, and the resulting contraction could have been mild. But this was not to be. Instead, the Fed’s massive purchases of acceptances increased reserves in the latter half of the year, and the money supply growth rose again. One reason for the Fed’s failure to stay its relatively less inflationary course was the great pressure it received from Europe. The short-run “benefits” of the inflationary injection of 1927 in Europe had already dissipated: The pound was sagging again, gold was flowing out of Britain, and interest rates were again higher in the United States than in Britain. With the exception of France, Europe clamored against any tighter money in the United States, and the Fed’s aggravation of inflation in late 1928 eased the flow of gold from Britain.[80] And Benjamin Strong, though ill and traveling in Europe, kept up a stream of pressure for easier money. In mid-July, Strong looked back on his handiwork and found it good. In a letter to S. Parker Gilbert, he wrote that his policy since 1924 had

enabled monetary reorganization to be completed in Europe, which otherwise would have been impossible. It was undertaken with the well recognized hazard that we were liable to encounter a big speculation and some expansion of credit. ... Six months ago we faced the new year with practically all the European nations in a strong position in monetary matters. ... Our course was perfectly obvious. We had to undertake it. The conditions permitted it, and the possibility of damage resulting abroad were [sic] at a minimum.[81]

Strong went on to express his concern at the “very high rates” then prevailing in New York and looked forward to rate reductions in the fall. On his return to the United States in August, Strong continued to express concern, not over the inflationary boom and the runaway stock market but over what he considered excessively high interest rates. He clearly wished to resume his old inflationary policy.

After Strong’s retirement in August, his faithful followers tried to tread the same path. His successor as governor, George L. Harrison, led the Open Market Committee to worry about excessively high rates and asked and obtained the board’s permission for the authority to engage in massive open-market purchases.

The end of Strong’s reign (he died in October 1928) led to indecisive splits and fragmented power within the Federal Reserve System. Although Harrison attempted to emphasize open-market purchases, the majority of the board wanted the Fed to buy far more acceptances. Each faction wanted its own version of inflationary credit expansion.

One reason for the Fed’s emphasis on acceptances was the increasing adoption in Washington of the curious theory of “moral suasion,” which was to plague efforts to end the inflationary boom during the latter half of 1928 and through 1929. Until the end, President Coolidge was still trying to boost the stock market. But the new President Hoover and Governor Roy Young of the Federal Reserve Board had a different theory: that credit could remain cheap and easy for “legitimate” business but be restrictive toward the stock market. As soon as Hoover assumed office, he tried moral suasion by intimidation, sending an old banker friend, Henry M. Robinson of Los Angeles, to New York to try to persuade the banks to restrict stock loans and calling a meeting of editors and publishers to warn them of high stock prices.[82] Moral suasion was abandoned by June 1929. The Federal Reserve, after finally shutting off the acceptance window in March by raising its buying rate above the discount rate, delayed raising the rediscount rate under pressure from Hoover. Finally, it raised the rate in August, but typically the Fed offset this check to the boom by lowering the acceptance rate at the same time. As a result of this unprecedented “straddle,” large Fed purchases of acceptances from July to October drove the stock market to new heights. These acceptances were largely sterling bills purchased by the New York Fed once again to help Britain. Great Britain was trying to inflate and pursue cheap credit in the midst of a worsening depression, and the Fed was trying to stem the renewed outflow of gold in the United States.[83]

With all eyes on the stock market, however, the great American boom of the 1920s was already over. For despite, or perhaps because of, the waffling and confusion of the Fed, the money supply remained level from the peak at the end of 1928 through September 1929. A recession was now inevitable.

Unbeknownst to most Americans, the economy started turning downward around July 1929. Three months later, on October 24, the great stock market crash brought the shift from boom to depression to the attention of everyone.

The Federal Reserve did not meet the crash with any idea of laissez-faire or of allowing the economy to liquidate the malinvestments of the boom. On the contrary, its inflationist attitude during the boom was matched by a similar and even more aggravated outlook during the depression. In an unprecedented act, the Fed inflated reserves wildly in one week—the week of the crash. In the last week of October, the Fed doubled its holdings of government securities and discounted $200 million for member banks, adding $350 million to total bank reserves. Almost all of these increased reserves were poured into New York in order to prevent liquidation of the stock market and to induce New York City banks to take over the brokers’ loans that nonbank lenders were in the process of unloading. As a result, member banks expanded their deposits during that fateful last week in October by $1.8 billion—a monetary expansion of nearly 10% in one week. Almost all of this amount, totaling $1.6 billion, came from increased deposits in New York City banks. The Federal Reserve at the same time sharply lowered its rediscount and acceptance rates.

By mid-November, the great stock market break was over and, stimulated by artificial credit, began to rise again. Total bank reserves then fell, so that at the end of November they had reached precrash levels. This contraction stemmed from a decline in discounts and acceptances, a gold outflow, and increased money in circulation; the Fed tried to offset this in vain by purchasing more securities. If we compare October 23, the day before the crash, with the situation at the end of 1929, we find that bank reserves controlled by the Fed—all government securities—tripled in size. This expansion was offset by such uncontrolled factors affecting reserves as a decline in gold and an increase in cash in circulation brought on by falling public confidence in the banks and in the dollar itself. The Fed had done its best to inflate in the last quarter of 1929, but its efforts were thwarted by seasonal cash outflows and the exigencies of the gold standard. The result was that the total money supply remained level in the final quarter of 1929.

President Hoover was proud of his experiment in cheap money and, in a speech to a White House conference of several hundred business leaders in December, hailed the nation’s good fortune in possessing the magnificent Federal Reserve System, which had succeeded in saving banks, restoring confidence, and lowering interest rates. Hoover also revealed that he had done his part for the cause by personally urging the banks to rediscount more extensively at the Federal Reserve. Secretary of the Treasury Mellon issued one of his by now traditionally optimistic pronouncements, stating that there was “plenty of credit available.” And William Green, head of the American Federation of Labor, hailed the Federal Reserve for its success in ending the depression. On November 22, 1929, Green opined: “All the factors which make for a quick and speedy industrial and economic recovery are present and evident. The Federal Reserve System is operating, serving as a barrier against financial demoralization. Within a few months, industrial conditions will become normal, confidence and stabilization of industry and finance will be restored.”[84]

Apparently, many leading Federal Reserve officials were disposed, at the end of 1929, to “let the money market ‘sweat it out’ and reach monetary ease by the wholesome process of liquidation.”[85] But this laissez-faire policy was not to be. Instead, Governor George L. Harrison, head of the New York Fed, led a policy of massive easy money. Rediscount rates at the Fed, buying rates on acceptances, and the call loan rate all fell drastically. At the end of August 1930, Governor Roy Young of the Federal Reserve Board resigned and was replaced by a thoroughgoing inflationist, Eugene Meyer, Jr.[86] Total bank reserves rose during the year, chiefly through large Fed purchases of government securities. But all this inflationism was to no avail, since a wave of bank failures struck toward the end of the year, and shaky banks had to contract their operations. The net result was that the total money supply remained level throughout the year. For a while stock prices rose again, but they soon fell sharply, and production and employment kept falling steadily.

Meanwhile, the New York Fed continued to lead collaborations with foreign central banks, often against the wishes of the federal administration. Thus, the new “‘central bankers’ bank,” the Bank for International Settlements (BIS), was instigated by Montagu Norman, and much of the American capital for the BIS was put up by J.P. Morgan & Co. The BIS treated the New York Fed as America’s central bank, and Governor Harrison made a trip abroad in late 1930 to confer with European central bankers. Chairman of the BIS’s first organizing committee was Jackson E. Reynolds, a director of the New York Fed, and the first president of the BIS was Gates W. McGarrah, who resigned as chairman of the board of the New York Fed to assume the post. Yet there was no legislative sanction for U.S. participation in the bank.

Despite the administration’s and the Fed’s systemic attempts to inflate and provide cheap money, the inflationists were not satisfied with the course of events. In late October, Business Week thundered against the supposed “deflationists in the saddle,” supposedly inspired by the large commercial and investment banks.[87]

In contrast, in the same month Herbert Hoover apparently felt that the time had come for self-congratulation. In an address to the American Bankers Association, he summed up the multifaceted intervention of the preceding year. He hailed the Federal Reserve System as the great instrument of promoting stability and called for an “ample supply of credit at low interest,” which he pointed out was now available “through the cooperation of the banks and the Federal Reserve system.” Hoover proceeded to point out that the Federal Reserve was the locus of a vast system of cartelization:

The reserve system and its member banks and the Treasury participation in fact form a widespread cooperative organization, acting in the broad interest of the whole people. To a large degree it can influence the flow of credit. Bankers themselves are represented at each stage of management. And, in addition, the various boards and advisory committees represent also industry, agriculture, merchandising, and the Government. The reserve system therefore furnished an admirable center for cooperation of the banking business with the production and distribution industries and the Government in the development of broad and detached policies of business stability.[88]

Moreover, these broad and detached policies of cooperation had succeeded in combating the depression:

We have all been much engaged with measures of relief from the effect of the collapse of a year ago. At that time I determined that it was my duty, even without precedent, to call upon the business of the country for coordinated and constructive action to resist the forces of disintegration. The business community, the bankers, labor, and the Government have cooperated in wider spread measures of mitigation than have ever been attempted before. Our bankers and the reserve system have carried the country through the credit storm without impairment.[89]

The rest is history.