8. Open-Market Purchases in the 1920s

The Federal Reserve generated a monetary expansion averaging approximately 7% per annum in the great boom years from 1921 to 1929, an expansion propelled by an average annual increase of member bank reserves of 6% per year.[56] By far the most important factor in generating the increased reserves was open-market purchases by the Federal Reserve Bank of New York. The purchases came in three great bursts: in 1921–22, in 1924, and in the latter half of 1927. In the first surge, the Fed tripled its holding of government securities from $193 million in November 1921 to $603 million in June 1922. This was the Fed’s famous “discovery” of the inflationary effect of open-market purchases, a discovery that the authorities were delighted to make. Before the war, there had been little government securities available on the market and almost no short-run floating treasury debt. There was therefore little scope for open-market operations as a deliberate expansionary or restrictive policy even if this method had been discovered. After World War I, however, there was suddenly a large mass of short-term floating debt on the market that needed to be rolled over.[57] The Federal Reserve purchased the massive amounts in 1921–22 largely to acquire income-earning assets during the era of business recession. It then saw to its delight that a new and powerful instrument of monetary expansion and inflation had been discovered.

That this discovery was, to an extent, anticipated by Benjamin Strong is indicated by a letter he wrote on April 18, 1922, to Undersecretary of the Treasury S. Parker Gilbert, who had wondered about the Fed’s unusually large purchases of government securities. Strong explained that the policy had been designed not only to add to the Fed’s income-earning assets but also “to establish a level of interest rates, or at least to maintain rates at a level, which would facilitate foreign borrowing in this country” and thus would assure “more stable conditions and [would] facilitate business improvement.” This indicates that, at least to some degree, Strong bought the securities in order to push interest rates lower, to expand money and credit, and to stimulate an economic upturn.[58]

The expanded open-market operations led Governor Strong to reconvene the governors conference on a regular and systematized basis. In May 1922, the conference set up an executive committee that would henceforth centralize and execute open-market operations for the entire system; Benjamin Strong was, not coincidentally, made chairman of this governors committee.[59] From that point on, and particularly from the time of the second committee meeting in October 1922, Strong was conducting open-market purchases and sales for the entire system, instead of merely functioning as an agent and processing orders from other regional Reserve Banks.

Strong fell ill in February 1923 and was out sick until October. Shortly after, in April, the Federal Reserve Board in Washington, prodded by Adolph Miller, took steps to try to take dominance of the system away from the absent Strong. The board dissolved the extralegal governors committee and reconstituted a new one—the Open Market Investment Committee—strictly under the control of the board. With Strong temporarily gone, the board managed to force the New York Fed to sell most of its remaining government securities, for Miller, and the treasury as well, had continued to be uneasy at the large open-market purchases the Fed had made the previous year. Strong was furious both at the loss of his power and at the sale of securities, which he feared would cause a recession. In November, however, Strong came roaring back, seizing control of the Federal Reserve from that point until his final illness in the spring of 1928. Regaining his power over the Open Market Investment Committee, Strong, as chairman, created a Special System Investment Account at the New York Fed into which committee purchases and holdings were put. He also let it be known that he would expand such purchases whenever any economic downturn loomed: “The Reserve System should not hesitate to resume open-market purchases, thereby again reducing bank borrowings and easing money rates, rather than permit an unwarranted state of mind alone to disturb the even course of the country’s production and consumption.”[60]

The next big burst of inflationary credit expansion came in 1924. Shortly after Strong’s return, he began to purchase securities on a massive scale, buying $492 million from October 1923 through 1924. The overriding reason was the determination to help Britain and Montagu Norman return to gold at its overvalued par. To do so, the United States had to embark on an inflationary, cheap money policy to lower interest rates and raise prices relative to Britain so that Britain would not lose gold to the United States. In 1922, Norman had hailed the easy credit and drop in interest rates to match Britain’s credit expansion. During that and the following year, Norman continued to pepper Strong with appeals and demands for further extensions of credit in the United States. But Strong felt that the time was not yet ripe.

Finally, in 1924, with Britain’s return to the gold standard looming the following year, Strong felt that the time was ripe, and the massive open-market purchases began. Furthermore, the pound sterling, which had risen to $4.61 by the end of 1922 with news of the impending return to gold, had fallen sharply to $4.34 by mid-1924. Only massive inflationary pressure in the United States could raise the pound to $4.86.

Strong set forth his basic policies in a lengthy letter on May 27, 1924, to Secretary of the Treasury Andrew Mellon:

There still remains the serious problem of the disparity of price levels in the different countries due to monetary disturbances and currency inflation, the correction of which must be undertaken before a return to actual gold payment will be safe. This may be illustrated by the case of British prices and our own. The pound sterling is, roughly, at 10 percent discount measured in our gold currency ...

At the present time it is probably true that British prices for goods internationally dealt in are as a whole, roughly, in the neighborhood of 10 percent above our prices and one of the preliminaries to the re-establishment of gold payment by Great Britain will be to facilitate a gradual readjustment of these price levels before monetary reform is undertaken. In other words, this means some small advance in prices here and possibly some small decline in their prices. ... No one can direct price changes. They will be to a certain extent fortuitous, but can be facilitated by cooperation between the Bank of England and the Federal Reserve System in the maintaining of lower interest rates in this country and higher interest rates in England so that we will become the world’s borrowing market to a greater extent, and London to a less extent. The burden of this readjustment must fall more largely upon us than them. It will be difficult politically and socially for the British Government and the Bank of England to force a price liquidation in England beyond what they have already experienced in face of the fact that their trade is poor and they have over a million unemployed people receiving government aid.[61]

The inflationary open-market purchases led to a fall of interest rates in the United States below Britain by mid-1924. Sterling rose again, reaching $4.78 by the spring of 1925. Britain resumed the gold standard at the prewar par by the end of the year. This resumption was further aided by the New York Fed’s loan of a line of credit of $200 million to Britain, accompanied by a similar credit of $100 million to Britain by J.P. Morgan & Co.[62]

The final great burst of inflation, and the most intense of the 1920s, came in the latter half of 1927, when the Federal Reserve purchased $225 million of government securities and $220 million of banker’s acceptances, adding $445 million to bank reserves from these two sets of purchases alone.[63]

The problem was that Britain’s return to the gold standard quickly proved an unhappy one. The sharp rise in the value of sterling put great pressure on Britain’s already depressed exports, especially on the coal industry. Britain’s chronic depression intensified and rigid wage rates intensified unemployment. A general strike and a lengthy coal mine strike in 1926 were the direct consequence of the return to gold at an overvalued par. Instead of deflating, therefore, to validate the $4.86, Britain insisted on inflating in a vain attempt to relieve the depression. Prices rose, the Bank of England lowered its discount rate, and the balance of payment deficit and the resulting gold outflow became much worse. The pressure on the sterling intensified. Unwilling to stop inflating and tighten credit, Montagu Norman turned to Benjamin Strong, his old ally.

Benjamin Strong purchased some sterling bills to reverse the dollar flow from Britain and also sold France $60 million in gold to forestall French demands for redemption of sterling. But these were just temporary expedients. So Strong invited three top central bankers for a highly secret conference in New York in July 1927. So secret was the conclave that Strong, in his usual high-handed fashion prevented Gates W. McGarrah, chairman of the board of the Federal Reserve Bank of New York, from attending the meeting, and the Federal Reserve Board in Washington was also kept in the dark.[64] In addition to Norman, the other European representatives were Professor Charles Rist, deputy governor of the Bank of France, and Hjalmar Schacht, governor of the German Reichsbank. Strong and Norman tried hard to get Rist and Schacht to agree on a concerted and massive four-country cheap credit and inflation, but the Europeans vigorously refused, expressing alarm at the inflationary trend. While Rist and Schacht sailed for home, the Anglo-American combine stayed to weld their pact for inflation, expanded credit, and lower interest rates. Before Rist left, however, Strong told him buoyantly that he was “going to give a little coup de whiskey to the stock market.”[65]

President Coolidge and Secretary Mellon endorsed the new inflationary policy, the only high-level objectors being Adolph Miller and Herbert Hoover. The Federal Reserve authorities stayed silent about the reasons for their sudden expansion in late 1927, with only Governor W.J. Bailey of the Kansas City Federal Reserve Bank repeating the line that Strong had told him: that the cheap credit policy—including the open-market purchases, the lowering of rediscount rates, and the lowering of Fed buying rates on acceptances—was being pursued to “help the farmers.” Helping Britain—not a very popular policy in the American heartland at the time—was kept under wraps as the major reason for the inflationary surge.[66]

The importance of helping Britain in the inflationary policy of the 1920s is seen in Benjamin Strong’s comments to Sir Arthur Salter, secretary of the League of Nations and a Norman associate, in Paris in May 1928. Rejecting the idea of a formal meeting of the world’s central banks, Strong cited the political hostility in the United States. Then, as an aide summarized:

To illustrate how dangerous the position might become in the future as a result of the decisions reached at the present time and how inflamed public or political opinion might easily become when the results of past decision became evident, Governor Strong cited the outcry against the speculative excesses now being indulged in on the New York market and the criticism of the Federal Reserve System for its failure to curb or prevent this speculation. He said that very few people indeed realized that we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis.[67]