Monetary Mischief 9780231886727

Citation preview

MONETARY MISCHIEF

MONETARY

MISCHIEF

BY

GEORGE BUCHAN ROBINSON

NEW YORK: MORNINGSIDE HEIGHTS

COLUMBIA U N I V E R S I T Y PRESS 1935

COPYRIGHT

1935

COLUMBIA U N I V E R S I T Y

PUBLISHED

PRINTED

IN THE

UNITED

PRESS

1935

STATES

OF

AMERICA

THE PLIMPTON PRESS, NORWOOD, MASSACHUSETTS

To H. PARKER WILLIS WHO, OF ALL MEN WITHIN THE LIMITS OF MY O B S E R VATION, UNDERSTOOD MOST CLEARLY THE CIAL EVENTS OF THE I 9 2 0 ' s

FINAN-

AS THEY UNFOLDED.

CONTENTS INTRODUCTION

IX

I . T H E M O N E T I Z A T I O N OF COMMON STOCKS

.

.

.

I I . T H E A B N O R M A L CREDIT CONDITION OF 1 9 2 9

3 19

I I I . FEDERAL R E S E R V E POLICY

29

IV.

41

F E D E R A L R E S E R V E POLICY I N T H E S U M M E R OF 1 9 2 9

V . CORPORATION F I N A N C E AND T H E I N C O M E T A X .

59

V I . T H E R E C K O N I N G FROM CORPORATION F I N A N C E .

74

V I I . T H E R A C E T R A C K AND T H E STOCK E X C H A N G E .

84

VIII. IX. X. XI. XII. XIII. XIV. XV.

SHORT S E L L I N G

96

A BOOM P R I C E

100

T H E INVESTMENT

TRUSTS

108

BONDS AND/OR STOCKS, 1 9 3 4

117

B A N K FAILURES GUARANTEED

122

" P R I N T I N G PRESS M O N E Y "

129

T H E G O V E R N M E N T ' S M O N E T A R Y POLICIES, 1 9 3 3 - 3 4

141

T H E D E B A S E M E N T OF T H E D O L L A R

160

INDEX

179

I N T R O D U C T I O N

complex may be the nature of our present economic distress, certain of its origins were clearly monetary, using that word in its broadest possible sense. It appears also that these monetary considerations are not being given sufficient weight in many of the diagnoses of our troubles which are now current. So many of these, indeed, seem to be based upon a mere examination of the patient, without any taking of the history of the case. Judgments on such evidence are too easy, in economics as in medicine, and are seldom correct. In either field they are likely to be panicky, and the recommendation is immediate major surgery. Before we shall proceed to major economic surgery we need to examine the evidence of our monetary errors, and to ascertain if they will not go so far in themselves toward explaining our industrial débâcle that it would be clearly unwise and unnecessary to conclude at this point that any of the more extreme proposals is tenable. It is being widely said that capitalism is on trial. Granted that our monetary mistakes have arisen as phenomena of the capitalistic scheme, we need to know if they represent fundamental aspects thereof, or merely unhealthy growths to be cured or excised. HOWEVER

In its simplest form capitalism is a scheme of economic life which is based upon the conception that individuals should and will produce as generously as possible, and live on something less than they produce, in order that they may possess a remainder, in the form of property, to insure greater comfort, to support retirement and old age in some security, and to bequeath to their children. Unhappily, the matter is not so simple as this, because the individual's excess of production over consumption, of grain, or motor cars, or whatnot, must be translated into property through a monetary machinery. The farmer is not willing to have his property in the form of stored grain, because it will rot. Mr. Ford would not have been willing to have his surplus in the form of Model T's, because he knew they would go out of vogue. The

X

INTRODUCTION

monetary machinery must be available at every moment, first to turn these surpluses into money capital, and then to translate such capital into property. When it is considered that this task is additional to its much larger function of providing a mechanism of exchange for all production which does not consist of the surpluses of individuals, but merely of their contributions to the common pool of production in return for their livelihoods, something of the vast importance of the monetary machinery becomes clear. It is a very delicate mechanism. It must be treated as such, and never managed recklessly. There is much evidence that it has been managed both recklessly and ignorantly since 1917. Our concern herein is with that evidence. If capitalism were as simple as its simplest conception, as described above, there would be very few dissenters in America. But it has become exceedingly complex. How very complex it is can be illustrated by the fact that the oversubscription of another bond issue was recently hailed with gratification at the Treasury, though the reality of the matter was only that this generation had succeeded in borrowing another billion dollars for its children to pay. Meanwhile, we are being offered socialism as the alternative to the present course. But under socialism we should have a monetary problem, assuming that socialism does not contemplate barter as its maximum effort at exchange. Barter will not suffice a modern socialist state; it might perhaps operate in the first stages only, say, to transfer our surplus grain to our automobile makers. We should still have to have money, to serve its classical uses as a medium of exchange, and a standard and measure of value, and of deferred payments. For example, given any form of money, the device of borrowing for the next generation to pay would still remain to us. It would still be possible for one generation to impose on the next. And surely we may reasonably suspect that the present Treasury problem would exist under socialism, if socialism had waged a foreign war, had lent vast uncollectible sums to other socialist states, had made very serious mistakes in planning its economy, had erected new industries which destroyed old ones, had ex-

INTRODUCTION

xi

ported vast quantities of goods in return for monetary acknowledgments, had speculated, of course socially, but nevertheless unwisely, particularly in terms of the burden placed upon the future. And after socialism, what, if meanwhile we should not have conquered the modern manifestations of the monetary science? There is a vast area for compromise between the gangster capitalism of 1 9 2 4 - 2 9 and the simple conception under which individuals transfer their surplus production into property for the private possession and enjoyment thereof. This area needs to be explored in the light of the knowledge to be gained from consideration of our mistakes. " High finance" is a phenomenon which we cannot again afford, and speculation on the old scale is one which we dare not tolerate. Attempts to revive either can only end in defeat and distress. But capitalism must do more than abolish these old prerogatives. It must again permit people to produce, and provide a mechanism of exchange for such production. It must perfect and maintain a monetary system which will not allow capital and credit to be confused; that is to say, which will regulate, the more automatically the better, the total of the new capital investment, at approximately an amount which equals the sum of the net savings of individuals, without any assistance from credit to be " coined " by banks, or by the government. It was widely believed at about the time of the establishing of the Federal Reserve banks that we possessed such a monetary system, but that system, unhappily, was destined not to be managed in accord with the intent of its authors. It was destined instead to encounter a foreign war and to be diverted from its purpose; and finally it was to do the very thing it was established to prevent, namely to confuse credit with capital, and in the process completely to upset the delicate mechanism of the capitalistic scheme. The following pages deal with aspects of the monetary mischief of the past eighteen years, beginning with April, 1 9 1 7 , when America declared war. The relation of each chapter to the central theme may not always be entirely clear, but it has seemed that any contributory force which has to do with the origins of the boom, or the speculative phenomena of the boom, or with our monetary efforts to end the depression, is entitled to inclusion.

zii

INTRODUCTION

T o exclude these matters, indeed, would be to ignore the obvious fact that new phenomena have arisen in our economy, which are not accounted for in classical monetary reasoning. W e use bank credit, that is to say, checks against bank deposits, for 90 percent of our money work. These bank deposits have their true origin in bank loans. Dating from 1917, we vastly increased our bank deposits, and therefore our money supply, preponderantly by the making of two kinds of bank loans, first, loans to the United States, and second, loans on securities, largely common stocks. These circumstances definitely bring within the scope of the monetary problem all matters dealing with banking, stock speculation, corporate finance, government finance, taxation, etc., as these factors operated to bring on the boom and its inevitable collapse. Chapter I, " The Monetization of Common Stocks," sketches the relationship of stock speculation to the deposit currency, and hence to the monetary problem. Chapters II, I I I and IV deal with the Federal Reserve policies of the boom period, in respect to their effects on the money supply. Chapters II and I I I were published in The Annalist, July 9 and July 23, 1929, respectively. I believe that those papers contained a correct appraisal of the monetary condition of that time and that they may therefore be of interest to students of that incredible period, as well as to persons who do not yet know exactly what struck them. Chapters V and V I deal with another origin of the boom, with another source of monetary mischief, namely the Internal Revenue Act, more specifically with how that law perverted corporation finance into its orgy of stock dividends, sell outs, rights to subscribe, etc., and caused great damage thereby. T h e middle portion of the book (Chapters V I I - X I ) contains a somewhat different type of discussion. These five chapters deal with speculation and investment. Chapter I X ( " A Boom Price " ) was written in 1930 and is included here to serve as an illustration of the extreme credulity of the stock market. I am hopeful that here and there in this portion of the book may be found sound counsel for such persons as attempt stock speculation without full knowledge of its risks, and for those persons who gamble recklessly, but unwittingly, under the name of investment. So

INTRODUCTION

xiii

very many persons did these things during the boom that the aggregate result was colossal damage to the banking and monetary systems. I confess to some degree of fear that regulation of speculation by a commission may not prove any more successful in the long run than did regulation of bank credit by the Federal Reserve Board, and therefore believe that a better understanding by present and potential stock traders, investors, and business men, of both the fundamental risks and the economic meaning of stock speculation, might constitute a helpful auxiliary force. I should like to contribute something toward such a better understanding. The remaining chapters consider critically three important national problems: ( i ) Banking; (2) The financing of both war and depression by the sale of United States bonds to banks; and (3) The monetary policies of the United States, 1933-35. In the criticisms herein I do not defend, or even spare the bankers at times, but neither do I charge them with exclusive, or even preponderant responsibility for our monetary mistakes. It seems to me, indeed, and I think this book shows, that in this matter Washington is a great glass house. For example, the Constitution of the United States assigned to Congress the power (and duty) " to coin money, regulate the value thereof "; and this power was abdicated (and this duty avoided) long before the banking generation which is now under fire attained banking age. The banking system was permitted by Congress " to coin " 90 percent of our effective money (the deposit currency) and also largely to " regulate its value " by controlling its supply. When i t " coined money " too freely and carelessly, it was the Federal Reserve Board, composed of presidential appointees, which ignored the recommendations of the Federal Reserve Council, composed of active bankers, that the discount rate should be raised.1 It was Congress which 1 The Hon. Charles S. Hamlin, testifying (January 23, 1931,) before a subcommittee of the Committee on Banking and Currency, United States Senate, Seventy-first Congress, Pursuant to S. Res. 71 said: " The Federal Advisory Council after thoroughly approving our plan on February 15, 1929, changed its view, and on April 19, and again on M a y 21 at their meeting stated they now thought the rate should be increased to 6 percent." — Hearings, Part I, p. 173. T h e Federal Reserve Board not only did not follow this recommendation, but within about ten days after M a y 21 abandoned its own restrictive policy of " direct pressure." This subject will be considered in detail in Chapter I V .

xiv

INTRODUCTION

weakened the banking law (1917) to promote the sale of the war loans; 1 which lent such vast sums to our Allies, and has made such stupid efforts at collecting them. It is Washington now which is burdening the country with debt; which has converted the banking system into a paper money shell of its old self; which has become the new seat of high finance. The monetary mischief has not ended. Let these illustrations suffice, however, though there are many more, because it is so futile to allocate discredit when there is plenty of it to go around, and when there is so little chance to repair the premises until the stone-throwing stops. We need to get at the evidence of our blunders. Let us look at the record. GEORGE BUCHAN

ROBINSON

LAUREL HILL IRVINGTON-ON-HUDSON NEW YORK

April 1, 193S 2 First Liberty Bond Act, approved April 24, 1917, and Second Liberty Bond Act, approved September 24, 1917.

MONETARY MISCHIEF

I THE MONETIZATION

OF C O M M O N

STOCKS

IT is an interesting circumstance that from the date of the establishment of the Federal Reserve banks (1914) to the end of 1929, there was so little curiosity about, or interest in, the theory of money. Perhaps it is a fact that interest in the theory of money tends to vary inversely with interest in the acquisition of money, and we were very busy during those years with what then appeared to be acquisition. But now that in so many cases even very successful past acquisition has proved chimerical, and that present acquisition even to the point of livelihood is so very difficult when it is not impossible, the minds of men have turned again to the theory of money, in the hope that they may ascertain, and then correct, what they suspect has been done to them in this regard. It is interesting to recall, in view of the tremendous interest in the subject now, that it was mentioned only in passing in the presidential campaign of 1932. Of course a monetary crisis is not an unprecedented phenomenon in the United States. Our last one occurred in 1907, and our last important one in 1893. William Jennings Bryan said, " You shall not crucify mankind upon a cross of gold." 1 Though for almost thirty years Mr. Bryan's monetary reasoning appeared to have been repudiated and forgotten, it has come to life again with great vigor. Thus history repeats itself. Mr. Bryan's demand for the coinage of silver sprang from the circumstance that the agricultural West was heavily in debt; now after forty years the West is again in debt, and so are the East and the North and the South, so that the issue this time is not sectional. Nevertheless, it seems only reasonable to believe that before we shall turn away permanently from the gold standard, we need to make much more sure than we are now that it is the gold standard which has been responsible for our troubles. 1

A t the Democratic National Convention, Chicago, Illinois, June, 1896.

4

MONETIZATION

OF C O M M O N

STOCKS

N o other public question is so important as this money question at this moment, because, unless it shall now be solved correctly, w e shall only take it with us unsolved, whether our government shall go toward the right or left, and unsolved it will ruin our course in either direction. Even Russia uses money and has a monetary problem, best evidenced by the circumstance that rubles cost fifty cents in Russia and two cents or so outside of Russia. T h e purpose of this chapter is to contend that we were not " crucified upon a cross of gold," but upon a cross of uncontrolled bank credit. T h e relationship of the gold stock in the United States to the total monetary liabilities (bank deposits plus money in circulation), from 1890 to 1932, has been shown by Mr. Henry R . Bowser in The Review of Economic Statistics of Harvard Economic Society, Inc., for M a y 15, 1933. 2 From 1890 to 1909, the " gold percentage " {i.e., the ratio of gold to total monetary liabilities) ranged from a high of 12.8 to a low of 9.2 percent, and averaged well above 10 percent. From 1910 to 1915, the high was 9.3 and the low was 8.4. There followed thereafter a gain to 10.6 in 1 9 1 7 ; then a decline to 6.6 in April, 1920; another high of 9.5 in M a y , 1924; and a new low of 6.5 in January, 1929. In England the " g o l d percentage" held consistently above 15 from 1890 to 1914. It then dropped sharply to a low of 7.2 in 1918; rallied to 10.2 in 1920; and declined very gradually to 6. in December, 1932. These figures, as to the United States, contain the story of our undertaking to make gold more efficient. Despite the circumstance that our gold percentage ( 1 8 9 0 - 1 9 1 3 ) was, on the average, 33 percent below England's, we undertook in the Federal Reserve Act ( 1 9 1 3 ) , ( 1 ) to reduce the reserve requirements of the banks; and (2) to substitute for " gold and other lawful money " as bank reserve, the single item, credit at the Federal Reserve banks, which in turn need be gold-secured only to the extent of 40 percent, while the remaining 60 percent could be commercial paper and United States bonds. T h e reasons for these changes appear worthy of note at this point; and also, the respects in which the reasoning 2 The Review 1933. PP- 82-96.

of Economic

Statistics of H a r v a r d E c o n o m i c Society, Inc., M a y 15,

MONETIZATION

OF

COMMON

STOCKS

5

of the Federal Reserve Act was so very soon to be affected by events. The Congress of 1913 appears to have been willing to reduce the reserve requirement of the banks, on the ground that prime commercial paper, arising out of transactions in goods, was as good as gold as a base for money, and in many respects better than gold. Obviously it was more economical, because of the cost of gold, and it was considered to be much more elastic, in that the volume of the deposit currency would ebb and flow with the volume of such paper — that is to say, the volume of money would be directly and immediately responsive to the demands of business. It appears to have been chiefly for these reasons also that the Congress was willing to enact that Federal Reserve notes should bear the promise of the United States to pay them in gold on demand. Though the Federal Reserve Act provided for loans on United States bonds, and for open-market purchases of United States bonds, there was, at that date (1913), no expectancy of the vast extent to which Federal Reserve credit would thus become based on United States bonds, inasmuch as the supply of such bonds was then very small. Their use came with the War and the financing of it. At the end of the Liberty Loan campaigns, our banks held very large amounts of United States bonds and it was their habit thereafter to use these as security for Federal Reserve credit 3 when they wanted it, in preference to rediscounting commercial paper. One advantage to the banks was convenience. Another was that some banks disliked to return to borrowers canceled notes which indicated that they had been under rediscount. It took the exigencies of the War to convince many bankers that they should use the lending and rediscount facilities of the Federal Reserve banks. The difficulties in this situation were these: ( 1 ) that the United States bonds were not, like the prime commercial paper, due to be liquidated by the natural process of consuming goods and 8 For the purpose of clarity, the term " Federal Reserve credit" is used throughout this book to refer to credit at the Federal Reserve banks. Its constituent parts are Federal Reserve notes and member bank balances. The term will not be used to refer to the assets held by the Federal Reserve banks to secure their liabilities, though that appears to be the Federal Reserve practice in the matter.

6

MONETIZATION

OF COMMON

STOCKS

paying for them, and (2) that the United States had agreed to pay in gold on demand an indeterminate amount of Federal Reserve notes, without itself holding specifically any gold whatever against the guaranty, and against which the Federal Reserve banks might under the law hold only 40 percent of gold, and for the remaining percentage might hold chiefly long-term United States bonds. The promise of the United States on the Federal Reserve notes, however, was to pay gold on demand.4 Concerning this promise, Senator Elihu Root, speaking on the Glass-Owen bill 5 in 1 9 1 3 , had said that the proposed bill would lead to an extraordinary inflation, and that " if this bill passes as it stands, America stands to lose all that we saved when Grant vetoed the Inflation Bill, all we saved when Grover Cleveland abolished the Silver Purchase, all the gold Democrats saved when they helped in the repudiation of the vital principle which has been put into this bill." The Federal Reserve currency would be, in his opinion, " merely greenbacks or fiat money, for the redemption of which the faith of the nation would be pledged." He declared, " This bill proposes to put in pawn the credit of the United States; and when your time of need comes it is the United States that is discredited by the inflation of its demand obligations which it cannot pay." When Senator Root so spoke, he probably did not think that the day to which he referred would be as late as March 4, 1933, or that in the meantime, through the ability to inflate thus about to be acquired, the United States would not only finance its own participation in a European war but also much of the participation of its Allies. Nevertheless, he came much closer to the facts of 1933 in 1913 than Senator William G. McAdoo did in 1 9 3 1 , when in his book, Crowded Years, he quoted these remarks of Senator Root with the comment " that his speech was unworthy of his fine intellect," " a mass of erroneous promises, non-sequiturs, and illogical conclusions." 8 4 " The United States of America will pay to the bearer on demand . . . dollars. Redeemable in gold on demand at the United States Treasury or in gold or lawful money at any Federal Reserve bank." 5 Enacted as the Federal Reserve Act. • William G. McAdoo, Crowded Years ( 1 9 3 1 ) , p. 256. Referring to Senator Root's speech of 1913, Mr. McAdoo also said : " T h i s was more than seventeen years ago. None of Senator Root's emphatic predictions has been realized." They were destined to be realized, however, on March 4, 1933.

M O N E T I Z A T I O N

OF

COMMON

STOCKS

7

The amount of the guaranty, moreover, was indeterminate in respect to the fact that as long as any bank remained open, depositors presumably might have Federal Reserve notes for their deposits, and that any bank in turn might obtain Federal Reserve notes, first, for its deposit credit at the Federal Reserve bank, and second, for every dollar, presumably, of eligible paper a n d / o r United States bonds it might possess. If, in the process of paying off depositors with borrowed Federal Reserve credit, a bank should exhaust its reserve, it must replenish it or fail; but if, in the process of fulfilling the banks' demands, the Federal Reserve banks should force the gold ratio dangerously below the legal ratio, they would, no doubt, have to refuse rediscount facilities. That day was to come on March 4, 1933. It so happened also that at the very time when it was considered desirable to increase the qualifications of United States bonds to serve as security for Federal Reserve credit (Glass-Steagall bill, 1932), 7 they had become, because of the exigencies of the Treasury, much less desirable instruments than ever before for that purpose. From 1920 to 1930, although it was never considered that United States bonds were self-liquidating like commercial paper, it was nevertheless a fact that they were being paid off at the rate of only slightly less than one billion dollars per annum, at which rate, in 1930, another sixteen years would have paid them all. Since 1930, however, they have increased by more than ten billions, completely destroying, for the immediate future at least, the earlier expectancy of automatic, though slow, liquidation out of taxes. We have said that the use of United States bonds, both as security for loans to the member banks, and as investments by the member banks, came with the War, and the financing of it. It is a great pity they were not legislated or administered out of use at the first opportunity after the War. We would have had less of boom and presumably would have done less financing of foreign nations; because if United States bonds, of which the banks had a vast supply, had not been good for Federal Reserve credit, rediscounts would have been restricted to commercial notes, and open-market purchases to acceptances, both of which arise only 1

Enacted as an amendment to the Federal Reserve Act, February 27, 1932.

8

MONETIZATION

OF C O M M O N

STOCKS

from transactions in goods. Certainly it seems reasonable to believe that if member banks had not been able to borrow on securities, (i.e., United States bonds) they would not have been so willing to lend on securities (i.e., stocks and bonds). As for the open-market policy, it was dictated almost invariably by the theory that trade would be responsive to Federal Reserve policy, instead of that Federal Reserve policy should be responsive to trade, and accordingly was on the expansive rather than the restrictive side, almost without variation of any consequence. When it is considered that Federal Reserve policy largely determines the volume of the money supply — that is to say, of the deposit currency — it will appear how far we departed from our earlier conception, the very basis of the Federal Reserve Act, that the money supply should be elastic, expanding with more business but also contracting with less business. It seems clear enough that it was not generally understood that under our banking laws and the Federal Reserve policy of the time, our banks were not mere lenders of money, but actual creators of money. The common excuse advanced by bankers for the most important change in banking practice of the last decade — namely, from commercial to stock loans — was that a sufficient volume of commercial loans was no longer offered, and that they must perforce use their money (sic) in loans on securities. This conception of the case failed completely to take into account the fact that banks create new or additional deposit currency whenever they make new loans. This deposit currency, being the sum of our bank deposits, does most of our money work — perhaps go percent. It vastly exceeds, both in amount and importance, all other forms of money which we use; indeed these other forms, such as Federal Reserve notes, national bank notes, treasury notes, silver certificates, etc., have become in our economy merely convenient means for transferring bank deposits from one person to another, as when individuals draw checks " to cash " and spend the cash, which then goes back to bank to the credit of another depositor. There are many people who go to banks only to deposit (or withdraw) money which they have earned, or the proceeds of

MONETIZATION

OF C O M M O N S T O C K S

9

goods which they have sold. Such deposits do not represent a new creation of deposit currency, but merely a transfer of previously created currency. It may not be doubted that that circumstance has confused many bankers as well as depositors, the former having had the experience of noting that their deposits increased, though they were not making new loans. But in this case some other bank had been lending, or there had been a mere shifting from one bank to another. A single transaction accomplished with deposit currency effectively divorces it from all connection with its origin, which, with the exception of the deposit with a bank of newly minted or imported gold, is invariably the making of a loan by a bank. An easy demonstration of this (if one is needed) is to break down a consolidated bank statement of all the banks in the United States by the assumption that if on a given day all loans made by the banks (and all securities held, these being merely longterm loans) should be paid by checks drawn on banks (this being the normal way to pay loans) as far as the deposits would last, the deposit currency would entirely vanish in the paying of the loans, and the banks would be left with an amount of loans and securities representing capital and surplus. Thus the deposit currency vanishes by reversing the process of its creation. It is this matter of origin through bank loans and only through bank loans which makes the total of our bank deposits so immaterial and unreliable a figure in appraising the condition of the country. If a bank deposit represents stored credit for an individual, the counterbalancing loan also represents the liability of someone else, and the country is no better off, and frequently much worse off, if these sums are large than if they are small. This was the fallacy which in 1930 underlay the reasoning of those who expected a prompt revival of stock and commodity prices and trade on the theory that there was as much money in the country as before.® 8 In 1934 we again witnessed a large increase in the volume of bank deposits. It is clear that this increase was due to the sale of United States bonds to the banks. The increase is accordingly a purely monetary phenomenon, and is not a reliable index of condition. Inasmuch as in this case the Treasury is the borrower, the major consideration is the condition of the Treasury, in respect to its promise for the future.

IO

MONETIZATION

OF C O M M O N

STOCKS

The all-important considerations at all times are the character and quality of the loans. If bank deposits are high because loans have increased to finance the production, transport and consumption of goods, we might then reasonably believe that the high bank deposits indicated a happy state of affairs. When business should slow down, loans obviously would be paid — that is to say, when goods were consumed and not so many produced — and deposits would decline correspondingly. Under these circumstances the volume of the deposit currency would be directly responsive to the needs of business. But assume, instead, that we have high bank deposits of which a large part have come into existence because of loans on things which are never to be consumed, such, for example, as common stocks. Leaving out of consideration the fact that common stocks fluctuate greatly in price, usually, moreover, in unison, we should have contributed to corporation endeavor a vast amount of bank credit in lieu of investment capital which presumably the borrowers at bank did not possess. There can be no more dangerous occurrence in a capitalistic world than widespread confusion between investment capital and bank credit. We should, under these circumstances, have created an additional supply of the deposit currency, which would not be in the least responsive to the demands of commerce, but would rise and fall with the trend in speculation. This new deposit currency would be certain to have a bullish effect on prices, chiefly, no doubt, on the prices of common stocks; and in this circumstance there may be an explanation for the fact that commodity prices lagged far behind stock prices, in the years 1924-29. Even if such a situation should not lead ultimately to collapse, as it did in 1929, we should, nevertheless, have a case in which the deposit currency which we were using in trade had been increased in volume by loans on stocks and, to whatever extent such a condition existed, common stocks would have been " monetized," in the sense that deposit currency predicted upon common stocks would be doing a portion of our money work. To illustrate this process, let us say that an individual went to his bank in 1929 with one hundred shares of United States Steel com-

MONETIZATION

OF C O M M O N

STOCKS

n

mon stock, and asked a loan thereon of $15,000. The stock had a market value of $25,000. Such a loan would have been granted by almost any bank, and without regard for the purpose for which the money was wanted. The borrower gave the bank his note for $15,000, deposited the stock with the bank as collateral, and his checking account was credited with $15,000. Here was a complete banking transaction except for the circumstance that it might be necessary for the bank to increase its reserve at the Federal Reserve bank by 7 , 1 0 , or 13 percent (depending on its classification) of the amount of the new deposit of $15,000, all of which was easily accomplished by sending its note to the Federal Reserve bank, accompanied by the required amount of United States government bonds, of which almost every bank possessed a preponderant supply. The deposit currency — that is to say, the money supply of the country — had increased $15,000 by this transaction. Doubtless the individual had borrowed for some purpose; presumably he wanted to buy something; probably he wanted to buy more shares of stock, and we will say that he did buy shares of American Telephone and Telegraph Company. We will presume that he did so at once, and to make this first step very simple, that he bought from a depositor in his own bank. He paid by check, and the bank merely transfered the deposit credit from buyer to seller. Presumably the seller of the stock would have something which he wanted to do with his new cash, and this time we will assume that he bought a piece of real estate from a depositor in another bank in the same city. This transaction is not so simple as the first, because it involves payment by the first bank to the second and a shifting of reserve requirements. In actual fact, however, during the late boom at least, it was quite simple, because there was so much of this easily created bank credit in circulation that this transaction was very likely to be balanced before the end of the day between the two banks by a similar transaction in the opposite direction — that is to say, some depositor of the second bank had bought something from a depositor of the first bank. Now, in all probability, the seller of the real estate, who may

12

MONETIZATION

OF C O M M O N

STOCKS

have been trying to sell it for a long time, had something which he wanted to do with his new $ 1 5 , 0 0 0 . Perhaps he bought a Rolls Royce, or improved his house, or bought land in Florida. In any case, this $ 1 5 , 0 0 0 of bank-created deposit currency had done already a considerable amount of money work. It might go to Florida and come back; it would in all probability get split up into fractions of the original sum; it might be paid out in wages and flow back to banks again; but as deposit currency, as part of the supply of the intangible promises which it is our habit to use for money, it would not go out of existence except when, as, and if. the original borrower of the $ 1 5 , 0 0 0 should pay his note by a check on a bank. And in 1 9 2 9 we had $17,000,000,000 of this sort of money. E v e r y dollar of it was divorced by a single transaction from any trace of its origin in a bank loan on common stocks. It is small wonder that trade was good. Banks would lend one day, and expect withdrawals, only to receive a deluge of money the following day — few asked or understood wherefrom. Examining this hypothetical transaction further, we have assumed that the second man in the chain sold American Telephone and bought real estate, and that the third man sold real estate and perhaps bought an automobile. There is obviously nothing undesirable in such trades; indeed, it is a happy circumstance that these men were enabled to get what they wanted in place of what they did not want. E a c h had sold something he owned, before he bought something he wanted, which is always sound finance. T h e original borrower, however, was not on such safe ground, for he had been unwilling to sell his United States Steel before he bought American Telephone. There is a buyer and a seller in every such business transaction. Whenever, therefore, some persons are buying without selling anything, there must be others who are selling without buying. N o t everyone was crazy, much evidence to the contrary notwithstanding. Persons who buy without selling tend to become the chief borrowers at bank, whereas persons who sell without buying tend to become the chief depositors at bank. Referring to our illustration of the manner in which the total deposit currency theoretically could be destroyed b y using it to pay all the bank loans at a given

MONETIZATION

OF C O M M O N

STOCKS

13

moment, it is obvious that for this to be possible, the borrowers would have to be prepared to pay their notes by being depositors of sufficient sums, which is never the state of affairs. Whenever the banking condition approaches this position, however, the banks are obviously very liquid; and whenever it swings away far enough so that relatively few borrowers are depositors of sums equal to their loans, and their ability to pay has become dependent upon anything other than the daily and constant consumption of goods, not only have the banks become frozen, but the borrowers are embarrassed and the market for whatever collateral they have posted for security is in for trouble. There can be little doubt that there was some such spread between the identity of borrowers and depositors in the summer of 1929. If the total of the deposit currency of that year had had its origin in loans made for the purpose of permitting the borrower to buy goods which were destined for consumption, payment for the goods b y the consumer would have paid the loans. T h e borrower would have returned to the status of a depositor in sufficient amount as soon as he had sold and collected, and could then have paid his note at maturity. That is the reason for having and supporting a commercial banking system. T h e borrower on stocks in 1929, however, was in no such state. Nothing which he owned was destined to be consumed and paid for. This country uses many millions of dollars worth of merchandise each day; yet the only portion of our millions of family budgets which said stock borrower could hope to invade for his market was that small fraction devoted to savings, for which competition was more than ever rife from all species of investment bankers, and which had in so many cases been spent in advance. T o the extent that he did not possess a counterbalancing deposit, and it may be fairly presumed that few such borrowers did, because obviously they had bought more stocks than they could pay for, he was dependent upon selling his collateral in the market for ability to pay his loan. And the price he would receive was to depend chiefly on two factors — first, competition from fellow borrowers; and second, the collective judgment as to stock prices and values of those persons whose names were at that moment on the

14

MONETIZATION

OF COMMON

STOCKS

other side of the banks' ledgers, namely, the persons who in one way or another had become possessed of all the deposit currency which had come into existence b y the making of the seventeen billions of stock loans as well as all other loans, who, in the main, by the very possession of that bank credit at that moment had indicated that they were not committed either to investment or speculation in stocks at that price level. Obviously, there are not ever two distinct groups of people. Individuals shift from one side to the other daily. T h e banks, however, remain always between — the creditors of one side, debtors to the other. I t is their function in the economic process to translate the promises to pay of the business community which, though sound, cannot circulate as money, into their own promises to pay — i.e., bank deposits, which do circulate as money. They accordingly temporarily monetize whatever they accept as security. As long as they accept only notes which will be paid when goods are passed on through the channels of manufacture, distribution, and consumption, they will have issued merely an amount of deposit currency which is delicately responsive to the volume of trade which is taking place. When they go beyond this, and similarly monetize for borrowers, common stocks, real estate, or other such capital assets, they create a volume of deposit currency which cannot be contracted, in any considerable amount, without bringing about a collapse in the going prices of such capital assets. Then loans have become dependent upon a market, which means mere shifting either from person to person, or bank to bank, and not at all upon consumption, which means final and extinguishing payment out of the incomes of the people who consume to live. T h e reason that the banks generally did not have a true perspective of the situation they were creating, in the years 1 9 2 4 - 2 9 , seems clear enough. Being engaged in business for profit, they were eager, as always, to increase both loans and deposits. This was true even of those sound banks whose primary motivation was the safety of loans rather than profit, because the form which the major portion of the expansion took — namely, loans on stocks — presented a false appearance of safety. I t is natural enough for bankers to think in terms of their individual banks. T o

MONETIZATION

OF COMMON

STOCKS

15

the individual bank, loans on stocks were a far safer venture than they were to the banking system. For many months, when any single bank wanted to collect ten or twenty millions of its call loans on stocks, it could do so in a single day without market disturbance, but always for the reason that some other bank was willing to lend as much as was withdrawn. But with so many banks trying to keep themselves liquid by lending on stocks, the result was a commitment on the part of the banking system to the stock market, so vast as to make it inevitable that the day would come when the calling of loans would exceed the new funds offered. It was then that the market crashed, because the only ways other than the above-described process of substitution, by which call loans could be collected in any volume, were by forcing the sale of the collateral or the posting of additional margins. T h e latter method seems to have been tried first, as margin requirements were advanced in 1929 until they reached 40 percent. This was said at the time to be an indication of the strength of the market; instead it was the exact opposite, because it meant that all new buyers on margin had to furnish an unusually high percentage of the purchase price. Thus by advancing margin requirements, the banks strengthened their own positions somewhat, but weakened the stock market upon which they relied. It was the only possible policy, however, for self-preservation, though to have been effective it must have been done before speculation had reached the heights. B y then, individual borrowers were paying at least 7 percent 9 on $17,000,000,000 10 of loans ($1,190,000,000 per annum) for the privilege of claiming ownership of $24,000,000,000 of stocks (at market value), yielding in cash income not more than 3 percent 1 1 on such market value ($720,000,000 per annum). Their interest 9 The average renewal rate for call loans for July, 1929, as reported by the Federal Reserve Bulletin, August, 1929, was 9.23 percent. 1 0 This estimate was made by using a formula set forth in the Federal Reserve Bank of New York's Monthly Review of Credit and Business Conditions, Second Federal District, M a y , 1929, p. 33. 1 1 Standard Statistics, Inc. gives the dividend yield of " 90 stocks combined " as having been 3.16 percent for July, 3.01 percent for August, and 2.92 percent for September (1929).

i6

MONETIZATION

OF

COMMON

STOCKS

loss was accordingly at the rate of about $470,000,000 per annum. By then the fate of the market had been sealed. In concerning themselves with its individual banks without due regard for what its policies were doing to the banking system, bank management undermined the foundation upon which the system rested. The banks also monetized large amounts of installment paper with a somewhat similar effect. They considered such loans to be safe, and it is said that they have proved to be. Safety for the individual bank, however, is not by any means the paramount consideration. B y this policy they monetized the future earning and paying power of individuals, and increased the money supply each time they made such a loan. The greatest harm was not done to the speculators, who reasonably may always be considered to have due notice of the hazards inherent in their trades, but to the business men intent upon their own affairs who had no fair notice that the money {i.e., deposit currency) which was circulating so madly about, was not money which had its origin in production, but in speculation, and was, therefore, as unreal as stock prices themselves. It was bank-created money, and would be destroyed by the banks whenever they should undertake to collect their loans in volume. With all the prejudice which has existed in this country against what is commonly termed fiat money, it is astounding that such an uncontrolled franchise to create the medium which we chiefly use as money was ever permitted to develop by the Congress. It was not, of course, the intent of the Federal Reserve Act to grant such a franchise. Notes which arose from transactions in stocks were specifically excluded from rediscount in the following words: " but such definition shall not include notes, drafts, or bills covering merely investments or issued or drawn for the purpose of carrying or trading in stocks, bonds, or other investment securities, except bonds and notes of the Government of the United States." 1 2 But at that date (1913) our twenty billions of United States bonds had not been issued, nor had the vicious practice of discounting eligible paper for the purpose of making stock loans been 12

The Federal Reserve Act.

MONETIZATION

OF

COMMON

STOCKS

17

invented. We strayed far indeed from the intent of the Federal Reserve Act. It was not the intent of the Act that we should maintain and support a commercial banking system which is geared to supply deposit currency to everyone who wants it and can present and hypothecate some evidence of wealth or property, or ability to pay. If a man owns a farm or a factory, and wants bank credit for the purpose of raising crops or producing goods, it seems proper that he should have it from commercial banks; but there is no good reason why he should expect it for the purpose of permitting him to buy a second farm or a second factory. For such accommodation he should go to the capital market, to savings banks, insurance companies, investors, who do not, in the manner described, create money in the process of lending it. T h e Constitution of the United States gives to Congress the power " to coin money, regulate the value thereof." Under this constitutional authority, Congress had designated a dollar as being 23.22 grains of gold. As before related, it had accepted for the United States a full commitment to pay all Federal Reserve notes in gold on demand, though it held no gold specifically against that promise, and had been duly warned by Senator Root. The total supply of the various kinds of money thus coined by the United States had reached about $5,000,000,000 in 1929. T h e banking system meanwhile had " coined " about $55,000,000,000 of deposit currency. Moreover, it had gone far toward " regulating the value thereof " by regulating its supply. It had increased all prices (i.e., decreased the value of money) by monetizing common stocks, etc. (1924-29) and was about to decrease prices (i.e., increase the value of money) by " demonetizing " them, through the calling and paying of loans. T h e functions of money are to provide a standard of value — a standard for deferred payments — a medium of exchange. Through the functioning of the banking system we had greatly increased the volume of the medium of exchange, and we were soon to learn that it is impossible to do this, in a ratio of fifteen of monetized property of various sorts, against one of gold, without very seriously affecting the functioning of gold as a standard of value, and

18

MONETIZATION

OF

COMMON

STOCKS

particularly a standard for deferred payments. We increased the money supply and thus raised the price level. Then we entered into long-term contracts which were based on the advanced prices. Then we reduced the money supply, and accordingly prices, and thus made these long contracts difficult or impossible to perform. It seems clear enough that, except technically, we had in effect abandoned the gold standard long before April, 1933, and had accepted in its place a sort of combination standard of gold and monetized property. We had also monetized the credit of the United States to the extent of the more than $11,000,000,000 of United States bonds which were then owned by the banks. This process had begun in 1 9 1 7 . It will be discussed at length in another chapter ( " Printing Press Money " ) . Its results were at least as influential as the monetizing of common stocks, and between them we set aside the old gold standard. We should not, therefore, blame the gold standard, but our own administration of it. In July, 1929, I reviewed 13 the credit condition of that time, and charged that Federal Reserve policy was largely responsible for the inflation which existed. The mistakes involved therein constituted our most destructive monetary error. These two papers accordingly comprise the next two chapters, and, with a third chapter following, tell the story of the failure of the Federal Reserve system to stop the monetization of common stocks. May I be forgiven if I point out here that each of the four risks described in Chapter I I I as then existing (July, 1929) developed into actuality within fifteen months of that date? My excuse for calling attention to this circumstance is that I would like to show that these risks should have been foreseen and guarded against by the Federal Reserve authorities. 13

In The Annalist, July 9 and July 23.

II THE ABNORMAL

CREDIT

CONDITION

OF i 9 2 9 1 So far, in the discussion regarding the current banking situation in the United States, comment has dealt chiefly with the Federal Reserve Board, without serious attempt to examine the entire banking structure, or at least the entire Federal Reserve system including the member banks. The condition of the member banks, however, is always the most important aspect of the banking situation. It would accordingly seem to be a proper starting point in any consideration of the broad questions involved. What is the condition of the member banks? Does inflation of bank credit appear to exist? If so, to what extent has it been caused by stock speculation, and to what extent is such inflation being maintained by the use of Federal Reserve credit? Is contraction necessary or advisable? What mistakes have been made? Do suggestions of actual danger exist? Has the Federal Reserve Act failed, or men in its administration? Has a new day come when the law should be amended? What is the real meaning of this episode considered as monetary history? Does inflation of bank credit appear to exist? The evidence that it does exist is as follows: ( i ) Bank reserves are low. The going rate in New York for " Federal funds " 2 has lately been 6 percent, against a rediscount rate of 5 percent. Under the practice of loaning and borrowing " Federal funds," banks which have surplus reserves, lend to banks which presumably would otherwise show a deficit in reserves. This practice amounts to a bootlegging of bank reserves and renders bank statements quite valueless as showing their reserve positions. (2) Of the bank reserves of member banks on June 26, 1929, 46 percent consisted of borrowed Federal Reserve credit. (3) The ratio of gold to bank credit, accepting the figures of the Cleveland Trust Company (Col. Leonard Ayres, 1 2

From The Annalist, J u l y 9, 1929. " Federal funds " and " member bank balances " are synonymous terms.

ABNORMAL

20

CREDIT

CONDITION

Vice President) is at the lowest point in history, being below 7 to 100, against 8 to 100 in the deflation of 1921. 3 In this very important matter we are accordingly in an uncharted area. (4) Periods of inflation of bank credit are invariably accompanied by inflation of commodity prices, or of the prices of capital values, or of both. In the present case we have an inflation of capital values, that is to say, of stocks. Again accepting the figures of the Cleveland Trust Company, current stock prices value each dollar of industrial and public-utility earning power at twice the figure of 1924. 4 (5) T h e New York Times price average of industrial stocks advanced, during the year ended July 1, 1929, by approximately 55 percent. 5 Assuming that the average margin requirement of the banks is 40 percent of market value, it would appear that the sums now being loaned on stocks are approximately equal to their full market values of one year ago. T h e " loans on securities " of member banks are $9,000,000,000. This means that $9,000,000,000 of our deposit currency has come into existence through such loans. It constitutes more than one-fourth of the total deposit currency. When bank reserves are low, and 46 percent of them are borrowed ; when the ratio of gold to bank credit is so low that in that regard we are in an uncharted area; when the investment yield of stocks is not more than 3 percent, at a time when the United States Government must pay 5 % percent for nine-months' loans; a when, upon such prices, even with large margins, there has been erected a structure of loans and deposit currency which runs to such a sum as $9,000,000,000; it would appear that it may reasonably be said that bank credit is inflated. T h e manner and extent to which such inflation has been produced by stock speculation, and the extent to which it is being maintained by use of Federal Reserve credit, are the next con3

T h e C l e v e l a n d T r u s t C o m p a n y , Business

Bulletin,

M a y 15, 1929.

4

T h e C l e v e l a n d T r u s t C o m p a n y , Business

Bulletin,

A p r i l 15, 1929, s t a t e d : " T h e

line

(referring to a graph)

twice as m u c h

s h o w s t h a t a t the close of

for a share of s t o c k

w a s w i l l i n g t o p a y in 1924, o r 1925, o r 5

The

A'fU'

York

Times

average

1928 t h e p u b l i c

paying

1926."

for

t w e n t y - f i v e industrial

stocks

o n J u l y 2, 1 9 2 8 , a n d 3 9 4 . 1 4 o n J u l y 1 , 1 9 2 9 ( c l o s i n g p r i c e s ) . 6

was

r e p r e s e n t i n g e a r n i n g s o f a g i v e n a m o u n t , as i t

$400,000,000 C e r t i f i c a t e s o f I n d e b t e d n e s s , d a t e d J u n e 15, 1929.

was

254.23

A B N O R M A L

CREDIT

CONDITION

21

siderations. For aid in their consideration it is desirable to examine closely the sources, or at least the chief source, of bank credit. The chief source of bank credit, that is to say, of bank deposits (we mean the same thing when we speak of the amount of money in the country) is bank loans. 7 When a depositor borrows $100,000 he gives his note for that sum, and his account is credited with the proceeds. Loans are then up $100,000 and deposits are up $100,000, less the discount. If the bank has a sufficient excess reserve (deposit credit at the Federal Reserve banks is now the only legal form of reserve) at the time it makes this loan, the banking transaction is complete. If it does not have excess reserve, it must obtain the required reserve. T h e average reserve requirement of the three classifications of member banks is 10 percent of demand deposits. T o obtain the required reserve against the $100,000 deposit, the bank must obtain Federal Reserve credit of $10,000 (or $13,000 or $7,000, depending on its classification). There are three ways in which the bank can in effect borrow Federal Reserve credit to supply this reserve. First, it can rediscount eligible paper or borrow on government bonds; second, it can sell government bonds to the Federal Reserve bank if the Federal Reserve bank is then buying bonds; third, it can sell its own acceptances to the Federal Reserve bank if the Federal Reserve bank is then buying acceptances. In each case the Federal Reserve bank extends credit to the member bank. In any consideration of the matter, it is accordingly necessary to take the sum of these three items in the Federal Reserve bank statements (rediscounts, plus government bonds owned, plus acceptances owned) as balancing the amount of Federal Reserve bank credit outstanding. This amount at present is $1,200,000,000 plus. On the theory that this has long been " a billion dollar country," this amount seems harmless enough, but its true significance arises from the fact that the extension of this credit to the member banks has furnished the member banks with the required reserves to support approximately ten times that amount of deposits and to permit ten times that amount of loans. T h e member banks do not 7

This process was more fully described in Chapter I.

22

ABNORMAL

CREDIT

CONDITION

borrow mere money. T h e y borrow bank reserves. 8 Approximately $12,000,000,000 of deposits and loans of member banks accordingly rest on Federal Reserve credit. It is interesting to note that this sum ($12,000,000,000) is approximately identical with the amount of member bank credit which is now being loaned on securities, being $9,000,000,000 for the accounts of the banks plus $3,000,000,000 for the " account of others." While it is evident that practically all banks are lending on securities, it is b y no means evident that all banks are rediscounting; indeed, the evidence is conclusive that many are not. It is obvious that if all banks were rediscounting and were also lending on securities, both in average amounts, it could be charged that the $12,000,000,000 of security loans rests entirely on Federal Reserve bank credit. A s this is not the case, it is necessary to search further for evidence of the extent to which it does so rest, and if that m a y not be appraised precisely, to raise a question of presumption, which only the facts, now available to the 8 Despite this fact: namely, that the banks do not borrow, and the Federal Reserve banks do not lend mere " money " but bank reserve, the authority to lend of the Federal Reserve banks was enlarged by amendment to the Federal Reserve Act (June 29, 1934) to permit direct loans to industry. Such loans are similar to loans to member banks, in that they consist of Federal Reserve credit, and Federal Reserve credit is bank reserve. Moreover, when such a " direct loan " shall be paid, payment will have to be translated into Federal Reserve credit by whatever bank the check tendered in payment is drawn upon. Thus industrial borrowers at the Federal Reserve banks can both augment and invade the reserve positions of individual member banks, and the total reserve position of all member banks, by the making and paying of direct loans at the Federal Reserve banks. Inasmuch, moreover, as the Federal Reserve banks may lend to industry for any term not longer than five years, a class of paper which the member banks themselves may not buy because of its long maturity is now permitted partly to secure the most inviolate of all bank assets, namely, bank reserve. Though this seems to be merely another step in a long deteriorative process, in respect to the quality of bank reserve, it also constitutes a first step toward removing from the banks full authority over the amount of their reserves, as indicated above. The Hardy-Viner report (Report on the Availability of Bank Credits in the Seventh Federal Reserve District. Submitted to the Secretary of the Treasury by Charles O. Hardy and Jacob Viner. Preliminary Edition, December, 1934.) though it recommends " that the Federal Reserve banks be relieved of the responsibility of making direct loans to industry " bases this conclusion on other grounds, and does not mention the circumstance here described. It would appear, however, that this single circumstance: namely, that the Federal Reserve banks, by the nature of their organization and function, cannot lend mere money, but must lend Federal Reserve credit, or bank reserve, because that is all they possess and can lend, should now suffice, even if there were no other reasons, to persuade Congress to countermand the authority it thus granted.

ABNORMAL

CREDIT

CONDITION

23

Federal Reserve authorities alone, will answer. T h e following points bear directly on this matter: ( 1 ) T h e banks which are not rediscounting have been the beneficiaries of Federal Reserve policy, many of them equally with those which are, through the medium of sale to the Federal Reserve banks of government bonds and acceptances. ( 2 ) Banks which have neither rediscounted nor sold government bonds or acceptances have benefited from Federal Reserve policy, owing to the tendency of deposits, once created by loans, to become disseminated rapidly through the banking system, and to lose speculative identity if they originally possessed it. Referring to the $100,000 loan heretofore described, assume that it was made on the security of 1,000 shares of United States Steel, and that the resulting deposit was used at once for the purchase of additional shares of United States Steel. The bank deposit was checked out in payment and became a deposit in another bank to the credit of the seller, entirely free in that bank from any suggestion of its speculative origin. T h e bank deposits of the country, however, have not been affected by this second transaction. They have gone down in the first bank and up in the second. There has been also a shifting of reserve requirements, and of Federal Reserve balances between the two banks, but merely a shifting, not a change. Bank deposits in the aggregate will not go down until the note which created the $ 1 0 0 , 0 0 0 deposit has been paid. ( 3 ) It cannot be denied that the financial reward to those banks which have rediscounted heavily and/or have sold bonds and acceptances to the Federal Reserve bank, indeed, to all the banks, directly or indirectly, has been very great. Interest at 6 percent on $12,000,000,000 of loans permitted by $1,200,000,000 Federal Reserve credit is $720,000,000 per annum. The cost of this credit in the aggregate has been the rediscount rate of 5 percent on $1,200,000,000, or $60,000,000 per annum, plus whatever interest the banks pay on deposits. A n increase in the discount rate from 5 to 6 percent would increase the cost of the credit by only $12,000,000. Are not these factors — ( 1 ) the magnitude of the profit involved at any discount rate, ( 2 ) the manner in which bank

ABNORMAL

24

CREDIT

CONDITION

deposits once created are diffused through the banking system, (3) the part played in the expansion of deposits and loans generally throughout the system by the purchase of government bonds and acceptances by the Federal Reserve banks, and (4) the close coincidence between the volume of speculative credit and the volume of bank credit supported by Federal Reserve credit — of sufficient significance to justify a reasonable presumption that the entire speculative structure of $12,000,000,000 of loans on securities is being supported directly or indirectly, but preponderantly if not exclusively, by Federal Reserve credit, and to place a definite burden on the Federal Reserve Board to prove, if it can, that this is not the case? But what if it is, we are being asked by speculators and politicians, and the president of the New Y o r k Stock Exchange 9 has even suggested that speculative paper should be admitted to rediscount. 10 It must be confessed that there would be some advantage in the direct discount of such paper as compared with the present scheme of indirect discount, that is to say, of presenting eligible paper for rediscount, but using the reserves thus obtained to create or maintain speculative loans. But it seems, instead, that there are too many holes in the arguments presented and too much evidence of self-interest in some of them to guarantee reliability, when to accept them would be to depart completely from banking principles which through long experience are definitely known to be sound. T h e basis of these arguments is that conditions have so changed that the provisions of the Federal Reserve Act itself are obsolete, that a new day has come when corporations prefer to raise new capital through the sale of stock instead of borrowing from the banks, that the supply of commercial paper has greatly diminished and tends toward disappearance, that banks must become financial rather than commercial institutions, etc. T h e president of the N e w York Stock Exchange has even expressed alarm over what the banks will do for rediscountable paper some fifteen years hence when the national debt has been retired. 11 It seems quite absurd Mr. E. H. H. Simmons. In a speech at the annual dinner of the Chicago Stock Exchange, M a y 9, 1929, as reported in E. H. H. Simmons, Financing American Industry and Other 1 1 Ibid., p. 237. Addresses, p. 237. 9

10

ABNORMAL

CREDIT

CONDITION

25

that the New York Stock Exchange should need to be reminded that stocks represent capital values, that paper based thereon is no more properly rediscountable at a central bank than paper based on any other capital values, real estate, farms, buildings or what not, which in any such case depends for its liquidation on the sale of property instead of the flow of goods to consumption. It is possible that stock speculation has become an essential industry, but certainly it has not to the extent claimed by Mr. Simmons, in spite of the evidence that so many people have been making their livings these recent years selling stocks to one another. There exists, on the other hand, convincing evidence that quite the greatest threat against national well-being is speculation carried to an extreme in any field, whether that extreme has or has not been reached at this moment in the case of stocks. T o create a high price for anything, make it easy to buy on credit. Make stocks easy to buy on credit, and prices will inevitably reach an extreme sooner or later. While stocks are going up, millions of dollars are made (or acquired) in the market, which millions go to increase the demand for goods for consumption. When the market no longer advances, but instead holds level or begins to decline because it has finally exhausted the imaginations of even the most credulous, the flow of money from speculation into business ceases and business itself recedes. If in the meantime stock speculation has possessed itself of any considerable percentage of the banking resources of the country, the bank credit necessary to sustain declining business and to permit an orderly retreat from an extended position will be very hard to obtain. We may be very sure that at such a time there will be an entirely adequate supply of commercial paper for rediscount. If the business retreat of 1 9 2 0 21 had been complicated by as vast a structure of stock speculation as exists today, one could not picture the result. Or if the 1 9 2 0 - 2 1 condition had been complicated by the admission to rediscount of paper based on farm loans, the same would be true; though it was unquestionably the fact that a great amount of such paper had been admitted to rediscount by indirection, in the same manner that stock paper has been today, and that it did very serious damage and, together with the speculation in land which was

26

ABNORMAL

CREDIT

CONDITION

predicated upon it, was the origin of the demand for farm relief which has persisted ever since.12 For the structure of stock speculation today is vast indeed. The sum of $12,000,000,000, being the loans on securities of member banks and others, does not tell the whole story. The Federal Reserve Bank of New York, in its Monthly Review of Credit and Business Conditions for May, 1929, estimated the total of loans on securities by all banks and others at $15,000,000,000. To reduce this colossal figure within, or at least toward, our comprehension, it can be expressed in terms of the number of shares indicated to be represented in these loans. The average market value of the stocks listed on the New York Stock Exchange was $80.87 11 on April 1. Assuming an average margin requirement of 40 percent, the average amount being loaned per share was accordingly under $50. The sum being loaned ($15,000,000,000), divided by the sum loaned per share ($50), gives the approximate number of shares being carried on margin, namely 300,000,000. The extent to which these security loans and investments in securities have absorbed the banking resources of the country is best appraised by the statement of the Federal Reserve Board, in its fifteenth annual report,14 that at the present time, of the total volume of nearly $35,700,000,000 of loans and investments of member banks, more than 57 per cent are either in investments or in loans on securities. Securities thus underlie considerably more than half of the outstanding volume of member bank credit.

It is true that many corporations have taken advantage of this period of high prices for stocks to obtain permanent capital, and that, having the capital in hand, have retired temporary capital (or credit) which had been borrowed at the banks. And to furnish permanent capital to the corporations, many stockholders have borrowed at the banks. These facts are admitted, indeed asserted, in support of the view that a " new day " has come. It is probable 1 2 Not only did this demand for " farm r e l i e f " persist until 1929, as stated above, but it has not subsided as of the present date ( J a n u a r y , 193s). 13 New York Stock Exchange figures. 1 4 Report for the year 1928.

ABNORMAL

CREDIT

CONDITION

27

that the part played by such transactions in reducing commercial loans is not so great as is asserted, because such financing, even though it includes several notable examples, does not comprise a considerable percentage of recent stock financing. Apparently there have been dozens of companies financed whose commercial loans would not have been acceptable to the banks. The organization of investment trusts, of which there has been a deluge, does not reduce the supply of commercial loans. The United States Steel financing did not reduce the supply of commercial loans. N o doubt it has added to stock loans. A vast amount of the stocks added to the listings in the last two years represents sales by the owners of enterprises rather than by corporation treasuries, a procedure which does not lessen commercial borrowing in the least. Acceptance credit has replaced commercialpaper credit in very considerable volume. But strictly as to those cases which represent the sale of stock to stockholders, with or without the retirement of commercial loans, it is by no means clear that this procedure is good for us. First, it looks as if in the aggregate the corporations have obtained more capital than they need in their businesses (witness the stock loans for the accounts of others) from stockholders who could not afford to contribute it (witness the growth in loans on securities). In any such single transaction, there are three parties involved — the corporation, the banks and the stockholders. Such a financial operation may be good for the corporation or it may not, depending on the use it makes of the permanent capital. Certainly it is not good for the stockholder who has to borrow at present rates 16 to protect his equity, even though marketwise it may appear to be. And very certainly it is not good for the banks. For the prime note of a first-class company, to be liquidated out of the proceeds of the sale of goods, there has been substituted a note which represents a chattel mortgage on an equity. It is no longer a prime obligation, and it is not liquid. There is no process of manufacture, distribution and consumption which will provide payment. From the point of view of the individual bank, such notes have the appearance of liquidity, but in the aggregate for all 15

See Chapter I, p. 15, footnote 9.

28

ABNORMAL

CREDIT

CONDITION

the banks such loans are not liquid because they can be paid only b y the sale of the collateral; and if one bank sells it out, another bank must furnish the money for the buyer. T h e present volume of the collateral, moreover, is about 300,000,000 shares, and it is all being carried for an advance in price. Unfortunately, when an advance comes, as it has come time after time in the last three years, no liquidation in the aggregate takes place; only a shifting between speculators, with the aggregate of the loans and the strain on the banks steadily increasing. T h e experience of recent months, moreover, indicates that these loans are paid in part only at such times as sharp breaks in the market occur. Certainly this is not adequate liquidity for a banking system, when in the aggregate the banks have to liquidate stocks to collect their notes. In the present situation one more point requires examination here. It has been said that, given a quiet market for a time, the power of the country to absorb the loans on securities out of current savings will m a k e itself evident. It is earnestly to be hoped that this will prove to be the case, but at least two powerful forces are operating against it. One force is the avalanche of new offerings of stocks, which will continue as long as there is a strong market; the other is the interest loss involved in carrying 3 percent stocks at an average interest cost of not less, certainly, than 7 percent. Four percent on $15,000,000,000, is $600,000,000 per annum. W e m a y y e t find that an industrial structure with less invested capital, backed b y a strong banking system able to furnish bank credit for all legitimate temporary commercial needs, able, in the words of the Federal Reserve A c t , to " afford means of rediscounting commercial p a p e r , " means a stronger nation than an industrial structure able to loan its billions on demand through the banks to its own stockholders w h o have not yet paid fully for their stocks. Such utter confusion of capital and credit is a dangerous adventure.

Ill F E D E R A L

R E S E R V E

P O L I C Y

1

IT is obvious then, that contraction of bank credit is advisable and necessary, and equally obvious that it can be accomplished in volume only by the calling of speculative loans. Whatever the Federal Reserve Board may or may not do in the matter of the discount rate, it seems very evident that the member banks, the Federal Reserve banks and the Federal Reserve Board are at last aware that speculative credit must be withdrawn, that the only matter in question is the manner of doing it, and the only matter in doubt is the duration of resistance by the stock market in the matter of liquidation. But when the liquidation has occurred and when banking is back to normal, and when business and the investing public have suffered all that they are sure to suffer, it will be definitely clear that colossal mistakes were made which could have easily been avoided. It will not be the first time that the Federal Reserve Board has been severely criticized in and out of Congress. Having permitted an easy-money policy during the war years and immediately thereafter (the wisdom of this is not being questioned here) to build a very high price level in farm lands and commodities, Federal Reserve credit had to be deflated in 1920-21. There was a prompt outcry from all concerned, chiefly the agricultural interests, against the contraction of credit. Only eight years passed, a new easy-money policy succeeded that liquidation, and Federal Reserve credit went to inflate stock prices. At the first warning by the Federal Reserve Board (February 7, 1929) Wall Street speculators and publicists began the identical protest against contraction which had come from the farmers in 1920. The parallel is most interesting in its manifestations to this date, nor has it yet ended. Farm relief after 1920; tariff relief after 1928; much of the latter will be to help industrial stockholders, who have paid too much for their stocks. 1 From The Annalist, July 23, 1929. This chapter is a continuation of the previous chapter.

30

FEDERAL

RESERVE

POLICY

Popular outcry never rises against the inflation of credit, but always against its contraction. T h e mistake, however, is in ever permitting the inflation which makes the contraction necessary. It appears in the present case that the Federal Reserve Board has permitted a speculative spree, which was already out of hand by August, 1928, to grow progressively worse until July, 1929. In its issue of August 4, 1928, the Commercial Chronicle said editorially:

and

Financial

Strained credit conditions with excessive borrowing of member banks at the Federal Reserve institutions, mostly for the purpose of loaning out on the security of stocks and bonds (or in the vernacular of the day, to employ in making broker's loans), have continued to be the uppermost subject of discussion in the financial community the present week and also the uppermost matter of concern. Member bank borrowings were then $1,085,000,000, against $445,000,000 on August 3, 1927. Total Federal Reserve credit was $1,463,808,000, against $1,031,835,000 a year earlier. Gold reserves had declined during the year from $3,010,027,000 to $2,599,538,000. Note circulation had declined b y $60,000,000 and member banks reserve account was down b y $6,000,000. T h e gold ratio was 64.7, against 74. T h e greatest change during the year was in respect to the percentage of member bank reserves which had been borrowed, by rediscounting and selling acceptances. It had been 26 percent in 1927 and was 53 percent in 1928. This ratio is quite as important as the gold ratio itself, because it goes so far to portray the position of the member banks. T o assume that the banking position is strong at any moment because the gold ratio of the Federal Reserve banks is high is to ignore the fact that always the most important consideration is the condition of the member banks themselves in relation to their reserve position, and how it has been obtained. There are no published Federal Reserve exhibits which show the surpluses or deficits in reserves. T h e Federal Reserve Bank of New Y o r k in its Monthly Review of Credit and Business Conditions for July, 1928, said: Conservative bankers are not content to continue long in a position where they can balance their books only by borrowing money. While

FEDERAL

RESERVE

POLICY

31

funds from the reserve banks are available to meet seasonal and unusual needs, it is not regarded as sound banking for a bank to be continuously dependent upon the use of such funds. M o r e o v e r , as previously stated, the banks were not then borrowing merely $1,250,000,000 of " m o n e y , " 2 but $1,250,000,000 of bank reserves, out of their total reserves of $2,343,000,000. B r o k e r ' s loans as of A u g u s t 1, 1928, were $4,259,396,000, or some $17,000,000 larger than they had been on July 12, when the discount rate of the Federal Reserve B a n k of N e w Y o r k had been raised from 4 ^ to 5 percent. T h e r e was no sign during A u g u s t of any liquidation of loans on securities, and b y mid-September a further increase in the discount rate was expected b y many observers, brokers' loans in the meantime having attained a total of $4,470,476,000. Instead of an increase in the discount rate, however, there came on September 20, from Governor R o y A . Y o u n g of the Federal R e s e r v e Board, in a speech at Indianapolis, the following reassurances regarding the situation:

3

If, after January, 1929, the banks still owe the system approximately $1,000,000,000 in rediscounts, I personally will feel that the situation has been handled admirably, and I shall have no cause for concern because, with the tradition which the member banks have about borrowing continually from the Federal Reserve System, a debt to the system of $1,000,000,000 will have a more moderating effect upon the too rapid growth of bank credit than any other single condition I can think of. A f t e r stating that the loans on securities of all banks were approximately $13,000,000,000, he said: There has been some complaint of late that investment and speculative credit have not received their proportion of the bank credit available, but it seems to me from these figures that these forms of credit have been treated liberally by the banks. I t is to be noted that no qualification whatever as to the use of the credit, nor the percentage of bank reserves to be supplied b y such rediscounts, accompanied the first statement above quoted; and that the second quotation can be read only as a defense of 2 The distinction between " money " and " bank reserve " has been considered in Chapter II, p. 22, footnote 8. • As reported by the New York Times, September 21, 1928, p. 13, col. 2.

32

FEDERAL

RESERVE

POLICY

Federal Reserve policy for not actually encouraging further loans on securities. T a k e n together, they amounted to an announcement of a hands-off policy until January, and were accepted as such b y W a l l Street. Governor Y o u n g w a s obviously not concerned at the volume of stock loans at that time. It is interesting to note that b y January 25, 1929, rediscounts were below the $1,000,000,000 specified b y Governor Y o u n g as being satisfactory. In the meantime, however, the increase in speculative loans which had inevitably followed Governor Y o u n g ' s reassurance of September 20, 1928, had alarmed the board to the point of issuing the " warning " of February 7, 1929. This statement said: " A member bank is not within its reasonable claims for rediscount facilities at its Federal Reserve B a n k when it borrows either for the purpose of making speculative loans or for the purpose of maintaining speculative loans." Inasmuch as the Federal Reserve A c t specifically forbids the rediscounting of speculative paper, it is clear that this statement referred to the practice of rediscounting eligible paper at a time when a bank holds speculative paper, that is to say, loans on stocks. T h e practice amounts to an indirect method of rediscounting speculative paper. In the opinion of the Board, this practice is beyond the " reasonable claims " of the banks. It is clear enough, however, that since the date of this statement many banks have continued to make the very sort of claims for loans proscribed b y the warning, and that these claims have been met b y the Federal Reserve banks. T h e evidence on this point is as follows: Referring to the high call rate on the Stock E x c h a n g e of April 26, the Federal Reserve B a n k of N e w Y o r k s a i d : 4 The New York banks, with their heavy borrowing at the Reserve Bank were reluctant to put out funds except in case of extreme necessity to avoid a breakdown of the market. Under such circumstances very tight money and high rates are from time to time inevitable. T h e statements on M a r c h 26-27, of Charles E. Mitchell, president of the National C i t y B a n k , had similar import. M r . Mitchell stated, according to the New

York

Telegram,

* Federal Reserve Bank, New Y o r k , Monthly Review Conditions, Second Federal Reserve District, M a y , 1929.

that on T u e s d a y of Credit and

Business

F E D E R A L

R E S E R V E

POLICY

33

and Wednesday, March 26-27, the National City Bank increased its call loans by more than $25,000,000, and that on Tuesday, March 26, it called on the Federal Reserve Bank for about $25,000,000. Mr. Mitchell was directly quoted as follows: " So far as this institution is concerned we feel that we have an obligation which is paramount to any Federal Reserve warning, or anything else, to avert, so far as lies within our power, any dangerous crisis in the money market." Mr. Mitchell has been severely criticized by Senator Glass 5 for his action and statement, but there is much which can be said in support of Mr. Mitchell's position. First, it was then entirely clear that in spite of its statement of February 7 the board continued to permit the Federal Reserve banks to meet the claims it had inferentially proscribed, such as Mr. Mitchell's bank presented. It was clear that in its statement of February 7 the Federal Reserve Board had taken a position which, while entirely correct, was at the moment untenable if it should be strictly enforced. To have enforced it strictly, immediately after it was announced, would have precipitated the " dangerous crisis " which M r . Mitchell foresaw. Moreover, it was a Federal Reserve policy of long standing, namely, that of entire complacence with inflation in bank credit through stock loans, which was fundamentally responsible for the position of Mr. Mitchell's bank, with its obligations to thousands of depositor-borrowers who had been led into the market by a money policy which for many months had been invariably easy as to volume and usually as to rate. It should be noted that the only construction which can reasonably be placed on the board's statement of February 7 is that a bank which is lending any money whatever on stocks (except presumably to distributing dealers) should not demand rediscount facilities, but should, instead, call its stock loans. The statement means this, if it means anything. The practical difficulty in suddenly issuing such a ukase and then enforcing it is that when banks call the stock loans of their own depositors they do not in most cases obtain Federal Reserve credit, but checks on them6

The Hon. Carter Glass, Senator from Virginia.

34

FEDERAL

RESERVE

POLICY

selves, which do not help them much if they want Federal Reserve credit. Bank reserves improve very slowly by this process — that is to say, only by the amount of the reserves which are released by the decline in deposits, which is approximately in the ratio of one of reserves to ten of deposits. Inflation of bank credit can be cured only by deflation, and the latter is either a slow and painful or a quick and disastrous process. But if the board's statement of February 7 is taken literally, it must be the fact that very few banks are entitled under it to rediscount facilities at the present time, and that to restore their facilities in agreement with the statement a very considerable liquidation of security loans must sooner or later be accomplished. The opinion that the statement is entitled to the above interpretation is enforced by the following quotation from an address made by the Hon. Adolph Miller (member of the Federal Reserve Board), at Boston in 1925.6 Dr. Miller said: The use of Federal Reserve credit for speculative purposes is precluded by specific provisions of the Federal Reserve act. It is clear, therefore, that no bank has a proper status as an applicant for reserve bank accommodation which is supplying credit for speculative uses.

It is clear enough at this moment that speculative Wall Street believes that the position taken on February 7 has already been modified, or that the board did not then " mean " what it said. This conclusion, which is proved by the continued strength of the market, has been based upon a series of incidents which have occurred since February 7. These incidents have given the speculative pools an opportunity to rally the market in the hope that at some later date and at some higher price they may be able to distribute their stocks to a public whose fears have been allayed by constant reiteration of the accusation that the scarcity of credit is an artificial condition created largely by Federal Reserve whim or inefficiency. The incidents referred to are as follows: Speaking at Cincinnati on March 16, Governor Roy A. Young said: T 6 As reported by The Commercial and Financial Chronicle, New Y o r k . Vol. 121, No. 3153, N o v . 28, 1925, pp. 2593-4. 7 As reported by the New York Times, March 17, 1929, p. i , col. 3.

FEDERAL

RESERVE

POLICY

35

Another group believes that the system should resort to the orthodox and traditional method of correction by a rediscount rate which they think will accomplish the results desired. In making such a suggestion, however, they overlook the fact that the high money rates may not deter the speculator when he is optimistic, but if they continue long may depress trade and industry. It is for this reason that the system believes that it should first use every effort to accomplish the desired results by other means, though it may be compelled in the end to resort to higher discount rates. Given an " orthodox and traditional method " b y the F e d e r a l Reserve A c t itself, the Federal Reserve Board has chosen not to employ it except as a last resort. It would appear that in so choosing, the Board has taken on its shoulders a vast responsibility. If they shall fail without having tried the time-proved expedient which the law intended they should employ, it will not be a failure of the law, but of its administration. Or if they shall be forced to try it as a last resort, they will have admitted the failure of their substitute expedient and of their judgment. O r if, on the other hand, they succeed in liquidating stock loans without raising the rate, and are able to get the banks back on a basis where they are entitled to rediscount facilities in accord with the statement of F e b r u a r y 7, the risks to industry and commerce from the liquidation will h a v e been exactly the same as if the liquidation had been induced in the normal manner. T o consider in 1 9 2 8 29 that they know a better method than the " orthodox and traditional method " provided for b y law in 1913, is to substitute experiment for experience, and flouts the entire history of central banking at home and abroad. I t is worthy of note here that the " loans on securities " of member banks in 101 cities were $93,000,000 greater on June 26, 1929, than they had been on January 30, 1929, the date of the latest statement prior to the " warning " of February 7. C l e a r l y enough, the raising of the discount rate b y any central bank should a l w a y s be the mildest and most natural of expedients, instead of a last resort. In the present case the discount rates should have been raised in the autumn of 1928;

8

had this

8 " I agree with what was said yesterday that ' it might have been better if by July 13, 1928 we had raised discount rates to 6 percent instead of 5 percent, and I

36

FEDERAL

RESERVE

POLICY

been done, it would have found business at a lower level and the banking position much less extended. T h e amounts being loaned on many stocks today are larger than their total market values of a year ago, and it would be necessary only to liquidate stock prices back to the level of June, 1928, to make millions of our people believe that they had experienced a financial panic. It may be pointed out here that the gold ratio of the Federal Reserve banks, which has improved during this period from 65 in August, 1928, to 75 in June, 1929, is not a measure of the member banking position. It is only a measure of the gold position of the Federal Reserve banks and of the ability of the Federal Reserve banks to exert pressure on the member banks. T h e Federal Reserve banks can improve the ratio at any time b y increasing pressure, and can weaken it by relaxing pressure. Its improvement since August, 1928, does not constitute evidence that the banking position has improved in the least. T h e condition of the member banks in relation to their reserve requirements, the degree of liquidity of their loans, not only as individual banks but as a banking system, the percentage of their reserves which are being borrowed from the Federal Reserve banks, their right to claim Federal Reserve credit without transgressing the intent of the law, are at any moment and at all moments more important considerations than any gold ratio of the Federal Reserve banks which remains within the range of the last five years. 9 T h e Federal Reserve Board made a supplementary statement on April 4. A f t e r noting that progress in readjustment of brokers' loans had been made during the seven weeks ending M a r c h 27, the Board said: Continued developments in this direction, indicating a definite reversal of recent trends, would release an increasing amount of credit for the use of trade and would lead to an easing in the money situation. In case the desired readjustment is not brought about by voluntary cooperation, however, the Federal Reserve System may adopt other methods of influencing the situation. believe there might h a v e been a chance that such a rate might h a v e curbed speculation without injuring b u s i n e s s . ' " — T h e H o n . Charles S. Hamlin, M e m b e r of t h e Federal Reserve B o a r d . Hearings before a Sub-Committee of the. Committee on Banking and Currency, Seventy-first Congress, P a r t I ( J a n u a r y 23, 1 9 3 1 ) , p. 166. 9 T h e high ratio w a s 83.7 on M a y 21, 1924, and the l o w w a s 61.6 on D e c e m ber 28, 1928.

FEDERAL

RESERVE

POLICY

37

On April 9 the following statement from a Washington dispatch by Carter Field 10 to his paper, the New York Herald Tribune, did not bring any denial or explanation from the Federal Reserve Board. In referring to the above-quoted statement of the Federal Reserve Board, Mr. Field said: Actually, it develops this statement was written by an employee of the board, and while proofs of it were submitted to all members and none took exception, it did not result from a formal discussion. The warning does represent the views of a majority if not all the members of the board, but the possibilities behind it are not as menacing as some imaginative minds in New York and elsewhere have painted it.

It would appear from this incident that it requires what Mr. Field calls an imaginative mind to believe that the Federal Reserve Board means what it says. In any case, Wall Street believed that Mr. Field had been correctly informed, and the trend of brokers' loans was upward for five weeks thereafter. Governor Roy A. Young was quoted by the Evening World (New York) on April 12 as having said: " So far I have been able to observe no signs of inflation." It is worthy of note that on that date the following conditions existed: ( 1 ) The ratio of gold to bank credit in the United States was at approximately the lowest point in history, being below 7 to 100; (2) the percentage of member banks' reserve which consisted of borrowed Federal Reserve credit (rediscounts plus acceptances) was 48.2; (3) loans on securities of member banks were $9,000,000,000, coincident with the existence in the money market of sufficient Federal Reserve credit to support $9,000,000,000 of bank deposits and to have permitted said $9,000,000,000 of bank loans. If the governor of the Federal Reserve Board did not see any signs of inflation in these circumstances, is it in the least strange that Mr. W. C. Durant should demand still further expansion of Federal Reserve credit, and that thousands of small investors should believe that money rates would now be low except for artificial pressure from the Federal Reserve authorities? The Whaley-Eaton Service, Washington, D. C., has lately published 1 0 M r . Carter Field, then Washington correspondent of the New York Tribune.

Herald

FEDERAL

38

RESERVE

POLICY

a pamphlet entitled What About Me? The Small Investor Asks a Question. The author is one of many thousands who has this point of view. Referring to the restriction of credit, the pamphlet states: I have said we had a fear there was a trap prepared for us. We bank on a continuation of American prosperity and on the least possible interference of government with business. We believe that this theory extends to finance, which Mr. Mitchell has called the handmaiden of business. The trap is wholly artificial restriction of credit for purposes which are not fully explained. If it can be shown that such artificial restriction is absolutely necessary for the present well-being of American industry and American agriculture, we are only too glad to agree, even though the measures taken may touch our pocketbooks for a time. If it is not necessary for such purposes, it seems to us that it is wholly unjustified and is in itself an unwarranted restriction on American business and American prosperity.

The public believes that the situation cannot be serious or the board would raise the discount rate, and Wall Street's agencies of publicity will not permit it to believe otherwise. In this they have had frequent and powerful aid from Washington reassurances. The Federal Reserve Act, in its own language, was an act " to provide for the establishment of Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States and for other purposes." The discussion which accompanied and preceded its enactment, dating back as far as the report of the Monetary Commission 11 (1898), does not contain the slightest suggestion that the facilities of the new system would be susceptible of use during normal times for the permanent augmenting of the resources of member banks, with or without a vast volume of speculative loans. Such facilities were obviously known to exist, but were intended for emergency use, national and seasonal. The first opportunity to use them in any volume came with the declaration of war by the United States in April, 1917. The total rediscounts of all the Federal Reserve banks as of that date were under $25,000,000. By the end of 1917 they were about $1,000,000,000, and at the end of 1918 they had 11

The Report

of the Indianapolis

Monetary

Commission.

FEDERAL

RESERVE

POLICY

39

reached $1,749,000,000. In the meantime a war had been financed. Here was a national emergency, and the system functioned as intended by its founders. The next emergency was one of business, 1920-21. Here again Federal Reserve credit was furnished to member banks, to ease the liquidation of business from an extremely extended position. Is there an emergency at present? If there is, the Federal Reserve Bank of New York described it when it said: The New York banks with their heavy borrowings at the reserve bank were reluctant to put out funds except in case of extreme necessity to avoid a breakdown of the market. Under such circumstances very tight money and high rates are from time to time inevitable. 12

But such an emergency is primarily one of speculators and of those banks which are heavily involved. It is not a national emergency. The great risk that the Federal Reserve Board is taking is that there may be superimposed upon the present situation some real national emergency. It need not be another war. It might be a crop failure, or a collapse of grain prices, or unhappy events abroad, or an important recession in business at home. To treat bank credit as investment capital has always been one of the most certain ways to bring on the last-mentioned phenomenon. What is the meaning of the entire incident, considered as monetary history? Business has confidently believed for many years that the " sound money " victory of 1896 and the establishment of the Federal Reserve banks have given the country a financial system which is panic-proof. The free-silver movement of the nineties was a demand from the then debt-ridden West for a greater volume of the circulating media, in which prices should be expressed and debts could be paid. The conservative East called it financial heresy. How strange it is that in 1929 there should come from Wall Street, now itself debt-ridden, this identical demand for a greater volume of the circulating media in the further extension of Federal Reserve credit, more loans, more deposit currency. 1 2 In Federal Reserve Bank, New Y o r k , Monthly Review of Credit and ness Statistics, Second Federal Reserve District, M a y , 1929, p. 34.

Busi-

40

FEDERAL RESERVE

POLICY

T h e Federal Reserve system, like all banking systems, has its human limitations, and can lose for the country in maladministration all that was gained in its establishment. The Federal Reserve system was founded on the belief that the working capital of the country (the deposit currency) must be protected against absorption in speculation. It has now departed far from this intent; it has been used as an agency for a greater stock speculation than ever occurred before. Business meanwhile does not know what to make of the credit situation and cannot learn under the present circumstances. One matter, however, is clear enough, and that is that when the stock market and the loans on securities have finally been liquidated from the present or some higher level, the effect thereof on business will measure only the quality of recent banking and Federal Reserve policies and management, and not in the least the merits of the system as intended in its establishment by law.

IV FEDERAL

RESERVE SUMMER

POLICY OF

IN

THE

1929

I T will be noted from Chart I that following the Federal Reserve Board warning of February 7, 1929, the stock market declined, then rallied, then declined again through late April and M a y , to reach a low at the end of M a y of 178 against a high in February of 201. On June 1 another advance began, which was to continue C H A R T 1. S T O C K P R I C E S , B U S I N E S S A C T I V I T Y AND COMMODITY PRICES 240

CANNAUST

INDICES)

160

125

without important interruption until the all-time high of September 3 (232). Chart I indicates that on June 1 both the volume of commerce and commodity prices were approaching their high points, and that from that date on they did not rise commensurately with stock prices. It is frequently claimed that a valuable function of stock specu-

42

F E D E R A L R E S E R V E POLICY IN

1929

lation is to discount, and therefore ameliorate, changes in the trend of business; that is to say, that changes of trend in the stock market precede similar changes in business volume, and that business men thus have notice of impending reversals of trend and can protect themselves to an extent. If the stock market had so functioned in this instance, the advance of early June, if there had been one, would have flattened out at some point below the high of F e b r u a r y ; that is to say, the advance would have been merely a rally in a bear market which had begun in the traditional manner in February, about four months prior to the reversal in the business trend. The stock market, however, did not so function, but instead staged an exceedingly abrupt, very broad and extensive rise which continued to September 3. It is probable that this rise ( J u n e to September) deluded more business men, investors and speculators into acceptance of the " new-era " philosophy than had any previous advance of equal extent or duration. The reasoning, indeed, was very simple, apparently in more than one sense of that word, namely, that the market was going up when obviously it should be going down, and that therefore a money millenium was at hand. In any case, consideration of the magnitude of the rise, taken in conjunction with the coincident increase in " loans on securities " (from $ 7 , 1 1 2 , 0 0 0 , 0 0 0 to $7,632,000,000) suggests that no other three-months' period in the entire bull market could possibly have equaled this period in damage to the banking position. Can this very extensive and entirely abnormal rise be explained? And what part in it, if any, was played by Federal Reserve policy? Our contemporaneous inquiry into this subject, reproduced in the preceding chapter, ended with the Federal Reserve statement of April 4, and the published comment thereon of M r . Carter Field. For the most authoritative information regarding subsequent developments, the chief sources are the Hearings1 bejore a Subcommittee of the Committee on Banking and Currency of the United States Senate ( 1 9 3 1 ) . Before referring to this testimony, however, two circumstances require mention: ( 1 ) that on or about February 14, 1929, the Federal Reserve Bank of N e w 1

Pursuant to S. Res. 71.

F E D E R A L R E S E R V E P O L I C Y I N 1 92 9

43

Y o r k requested permission of the Federal Reserve Board to raise its discount rate, was refused, and repeated this request ten times thereafter until M a y 2 3 ; and ( 2 ) that on August 9 the Federal Reserve Bank of New Y o r k raised its discount rate from 5 percent to 6 percent and at the same time reduced its acceptance rate from 6 percent to 5 percent. The testimony before the Senate Committee indicates that the controversy between the Federal Reserve Bank of New Y o r k and the Federal Reserve Board, in the matter of the discount rate, was not only protracted but was sharp. T h e New York bank requested an increase ten times, and was denied ten times. T h e reason given for refusal appears to have been invariably that a higher discount rate might, presumably would, affect business unfavorably. The business statistics of the time, however, indicated clearly enough that a vast amount of the business then current was springing from capital expenditures which ( 1 ) were based on the expectancy of even more business in the future, and ( 2 ) were being financed by the banking system through loans on stocks. Certainly it did not require of the Federal Reserve Board any considerable financial genius to understand that if this or any country crowded into a single year an expenditure of capital for increasing plant account, that is to say, for new factories, new roads, new offices, new homes, which was far in excess of such expenditures for former years, and particularly if such expenditures were financed by bank credit, this vast activity must later be compensated, through the resulting overproduction of such facilities, by a period of slackened activity. This postulate had been part of the economic knowledge of the world since, at least, the building of the last of the pyramids. Thus, in refusing the requests of the Federal Reserve B a n k of New York that it be permitted to raise its discount rate, the Federal Reserve Board not only disregarded both the intent of the Federal Reserve Act and all the experience of central banking, but ignored, in the reason given for its refusal, the business statistics of the time, and one of the most elementary facts of economic knowledge. During the three months, March through M a y , offerings of new securities ( N e w York Stock Exchange figures) aggregated

FEDERAL

44

RESERVE

POLICY

IN

1929

$ 2 , 7 8 7 , 0 0 0 , 0 0 0 a n d h u n d r e d s of m i l l i o n s of a d d i t i o n a l c a p i t a l e x penditures were planned b y industry from which retreat w a s later i m p o s s i b l e . T h e s e v a s t e x p e n d i t u r e s , m a n y of t h e m n o w d e m o n s t r a b l y u n w i s e b e c a u s e t h e y e n l a r g e d an a l r e a d y

overextended

p l a n t a c c o u n t , w e r e t h u s m a d e a n d p l a n n e d a t this t i m e b y b u s i ness d i r e c t l y u n d e r t h e a e g i s of the F e d e r a l R e s e r v e B o a r d . T h e f o l l o w i n g t e s t i m o n y b e f o r e the S e n a t e S u b c o m m i t t e e indic a t e s t h a t this m a t t e r w a s m u c h b e t t e r u n d e r s t o o d a f t e r t h e f a c t : Governor Harrison [George L . Harrison, Governor, Federal Reserve B a n k of N e w Y o r k ] : W e first requested the board's approval of an increase in the rate on, I think it was, February 14, 1929. . . . T h e directors of the Federal Reserve B a n k ( N e w Y o r k ) voted unanimously for the increase in rate week after week until the end of M a y , I think it was. . . . I do not think there ever was a time when the reasons that prompted our directors to act were more clear, or to them more convincing, than during this period of 1929. T i m e after time we discussed the propriety of the action and the need for the action. 2 The Chairman:3 Y o u say your own view is that excessive speculation is to be controlled b y the operation of the discount rate? Did your board ever give to the Federal Reserve Board as a reason w h y you wanted to raise the rate, the desire to repress excessive speculation? 4 Governor Harrison: I think what we did — and we were careful to do it that w a y — was to advise the board that we wanted to raise the rate to control the continued rapid expansion in the country's credit structure which was contributed to primarily by the demand for loans upon stock exchange collateral. The Chairman: Y o u would not be willing to modify that expression b y saying exclusively instead of primarily? Governor Harrison: Well, you could not say it was exclusively because there were periods when we had real estate speculation in Florida and elsewhere that contributed to it. Furthermore, when I look backwards, I cannot help but be convinced that indirectly business was getting too much credit for its own good at that time, not only through commercial borrowing, but through capital funds with which, for instance, they built up factories which tended to overcapacitate them. . . . Mr. Owen D. Young [Chairman, General Electric Company, and Director of the Federal Reserve B a n k of N e w Y o r k ] , on the same subject: A s a matter of fact, I have a strong feeling that business at that 2 3 4

Hearings, Part I (January 22, 1931), p. 84. The Hon. Carter Glass, Senator from Virginia. Hearings, Part I (January 22, 1931), p. 84.

FEDERAL

RESERVE

POLICY

IN

1 92 9

45

time [circa February, 1929, and later] needed a check, as well as speculation. 5 . . . The Chairman, to Governor Harrison: Did the Federal Reserve Board ever give you any reason for its refusal to sanction your increased discount rate? a Governor Harrison: Senator, I think perhaps that is a question they can answer better than I. 8 . . . I t m a y be well to note, before quoting f r o m the testimony of the Hon. Charles S. Hamlin, member of the F e d e r a l

Reserve

B o a r d , on this and other matters, that although it is v a s t l y to the credit of the F e d e r a l R e s e r v e B a n k of N e w Y o r k that it saw clearly during these weeks from m i d - F e b r u a r y to late M a y , it is nevertheless the f a c t that that was the first and last time that it did so, because ( 1 ) the rate should have been raised long b e f o r e F e b r u a r y (as previously s t a t e d ) ; and ( 2 ) at the end of M a y the b a n k sharply reversed its position, requesting extension instead of restriction of Federal R e s e r v e credit. M r . Hamlin's testimony brings out the interesting circumstance that the action taken b y the Federal R e s e r v e B a n k of N e w Y o r k on A u g u s t 9 and duly sanctioned b y the F e d e r a l R e s e r v e B o a r d (this action consisting of raising the discount rate f r o m 5 percent to 6 percent, and at the same time reducing the acceptance b u y i n g rate from 6 percent to 5 percent) w a s intended to be in respect to b a n k credit, an expansive rather than a restrictive move. I f accordingly it shall be conceded that the three increases in the rate of the N e w Y o r k bank which were m a d e in 1928, each being of one-half of one percent, constituted such v e r y mild action as not to appear in the least restrictive ( e a c h time, and also in A u gust, 1929, the stock m a r k e t so interpreted these a c t i o n s ) , it is the unhappy fact that the Federal R e s e r v e B o a r d saw the stock m a r k e t and business boom through f r o m beginning to end w i t h o u t a n y positively restrictive action w h a t e v e r . E v e n t h e threat of action contained in the board's statement of F e b r u a r y 7, and repeated on April 4, w a s abandoned almost as soon as it w a s announced (and the stock m a r k e t w a s informed of i t ) , and b y late M a y the board w a s content that the policy had proved effec5 6

Hearings, Part II (February 4, 1931I, p. 357. Hearings, Part I (January 22, 1931), p. 85.

46

FEDERAL

RESERVE

POLICY

IN

1929

tive and that an increase in rate, or any other restrictive measure, was no longer necessary or desirable. C h a r t 2 indicates on a graph of stock prices the dates of the three increases of one-half of one percent each during 1928 and the date of the anomalous action of A u g u s t 9, 1929.

Mr. Hamlin: A great deal has been said in the press about this socalled controversy between the Federal Reserve Board and the Reserve Bank of New York in the matter of raising the discount rate. It is not proper to call that a controversy. . . . Each party was acting under its lawful right, the bank to initiate the rate, and the Federal Reserve Board to review the rate. . . . There is another misapprehension that has formed the basis of a great deal of the criticism made of the Federal Reserve Board throughout this so-called difference of opinion. It seems to be almost universally assumed that the difference between the board and the New York bank began February 14th when that bank asked to increase its rate to 6 per cent, and continued until August 9th, when the

FEDERAL

RESERVE

POLICY

IN

1929

47

board, it is claimed, reversed itself, and agreed to the increased rate of 6 per cent. I think that is one of the fundamental errors that has been going around through the press and the minds of many bankers, and I want to say emphatically that the so-called policy of direct pressure began February 7th, when the board issued its warning, and was suspended by the board early in June, and a formal note to that effect was sent to the Federal Reserve Bank of New York on June 12 th. But as a matter of fact, it was practically suspended, or agreed to be suspended, the very latter part of M a y or, at the latest, very early in June, for on M a y 22nd, the Governor and Chairman of the Federal Reserve Bank of New York came before the board, and on M a y 31st the Chairman, Mr. McGarrah, 7 wrote the board a letter, in which he said that under the so-called direct pressure the banks were really afraid to borrow at all and that there was coming a time very soon when there would be an absolute necessity for more Federal Reserve credit — I think he intimated perhaps $100,000,000 or more; and that as to the discount rate, while they still would like to have it advanced, yet that had become relatively unimportant as compared with reaching some understanding with the board toward easing our discount policy. . . . From that time on the discount rate divergence of policy practically went out of existence. As I have said, the board practically agreed then that it would suspend direct pressure for the purpose of enabling the banks to get the credit that they needed. That was not made public for obvious reasons. It, however, got into the public press through an article by Mr. David Lawrence. I do not know how he got his facts, but his facts were essentially correct — that the board was satisfied with the result of direct pressure, and it determined that it would be wise for the present at least to suspend it. 8 . . . On June 3rd, and again on July 16, 1929, Mr. Mitchell [Mr. Charles E. Mitchell, Chairman, National City Bank, New York] came down and favored a more liberal discount policy, the discount rate to remain at S per cent barring excessive speculation. [In view of later events, it would be interesting to know what amount of speculation Mr. Mitchell would have considered to be excessive.] On August 2nd, Governor Harrison came before the board. He favored an easing policy because, as he said, there was need for more Federal Reserve credit. He asked to have the discount rate increased to 6 per cent and that was done, as you remember, three days later, on August 9, 1929. The increase was not made, however, to curb speculation. That increase was part of an easing policy. We determined to ease by lowering acceptance rates. . . . It was not any new change of the policy of the Federal Reserve Board. Since 7 Mr. Gates W . McGarrah, Chairman of the Board of Directors, Federal Reserve Bank of New Y o r k . 8 Hearings, Part I (January 23, 1931), pp. 164-65-

F E D E R A L R E S E R V E P O L I C Y IN

48

1929

the ioth or 12 th day of June, the board had been in harmony with the policy of New York. . . . What was the real issue between the Federal Reserve Board and the Federal Reserve Bank of New York? The majority of the Federal Reserve Board thought that the 5 per cent rate should not be increased, but that pressure should be brought to bear on the banks to cut down unnecessary borrowings, reduce speculative loans and investments, and adjust their position in accordance with our warning. . . . Most people apparently believe that the only issue before our board was whether the rate, which was then 5, be made 6. There never was a greater mistake than that. The position of the New York Bank was that, beginning at 6 per cent, we should start in on an affirmative rate policy of repeated increases of discount rates until the situation should be corrected.9 The Chairman: What situation? 9 Mr. Hamlin: I have been asked that a great many times. I think it meant until the stock market was liquidated. . . . As a matter of fact, rates as high as 7, 8 and 9 per cent were discussed at conferences in the board as being possible under such a drastic increased rate policy.9 Mr. Hamlin said further: Now, I am not going to interpret what New York meant by favoring a drastic increase in rates. I am going, however, to quote what the English paper, The Manchester Guardian, said as to what such an increase meant. This paper did not approve our wish to keep the discount rate down to 5 per cent. I quote from its edition of March 4, 1929: " There appeared to be some slender hope that the Federal Reserve authorities were meditating action drastic enough to precipitate the crisis in Wall Street, which, in the opinion of most monetary students, must come sooner or later." That was the opinion of that journal, as I understand it, of the effect of that drastic policy which the New York bank at that time favored. Our board, as I have said, did not want to precipitate any crises. We wanted to get our Federal Reserve credit back where it belonged. And, as I have said, had we yielded to a drastic series of increases in rates, I think we would have brought on the crash which even then I hoped could have been staved off. I think we would have simply precipitated the crash which came in October.10 It may be well to interrupt the quoted testimony before the Senate Committee at this point to recall the circumstance that our main purpose in this chapter is to inquire into the responsibility of the Federal Reserve Board and the Federal Reserve banks for the overextended credit situation, both as to the banks and the stock market, of September, 1929. We have no interest in the responsibilities, or in the mistakes of judgment, of indi9

Hearings,

Part I (January 23, 1931), pp. i73~74-

10

Ibid.,

p. 175.

FEDERAL

RESERVE

POLICY

IN

49

1 92 9

viduals. Mr. Hamlin's testimony is being examined here solely for the reasons that ( 1 ) despite a disclaimer that he was stating only his own opinions, it appears throughout to be a statement of the position and reasoning of the majority of the board (no portion of it having been denied or questioned by any other member during the hearings), and that (2) in toto it amounts to a blanket defense of the board's acts, without admission of substantial error, though made after fifteen months of unhappy experience with the results of said acts. What a mercy it would have been if both the banks and the stock market had been liquidated, or as Mr. Hamlin puts it, the " crash precipitated," from the level of March 4 (the date of the Manchester Guardian statement quoted by Mr. Hamlin), instead of collapsing of their own weight from those of September 3! Reference is again made to Chart 2, on which these dates have been noted. The following table shows the prices of eight active stocks at these dates and the percentages of advance during this period: Price M^rch 4

Stock

United States Steel American Can D u Pont New York Central General Electric American and Foreign Power American Telephone and Telegraph . . Consolidated Gas

Price Percentage Sept. 3 Gain

. .

186

2ÖI

40

. .

HQ

l8l

••

183

217

51 18

•• ••

195 238

256

••

115

396 164

••

215

304

no

183

31 66 42

41 66

The following are the changes in banking figures during the same period: Brokers' Loans " Loans on Securities " ... .

March

September

$5,647,000,000 7,563,000,000

$6,354,000,000 7,632,000,000

The above quoted testimony of Governor Harrison and Mr. Hamlin appears to indicate:

5o

FEDERAL

RESERVE

POLICY

IN

1929

( 1 ) That from February 7 to about M a y 23 both parties to the controversy desired to restrict speculative bank credit, but disagreed as to the best method, the bank desiring " an affirmative rate policy of repeated increases of discount rates until the situation should be corrected " and the board desiring only to continue its policy of "direct pressure." There appears to have been no realization on either side, until after the fact, that there existed great need for restricting credit to business as well as to speculation. ( 2 ) That at the end of May the bank sharply reversed its position, abandoning its requests for a rate increase, in favor of requests for extension of Federal Reserve credit. The testimony does not clearly explain this reversal. Mr. McGarrah wrote to the board on M a y 3 1 that "under the so-called direct pressure the banks were really afraid to borrow at all and that there was coming a time very soon when there would be an absolute necessity for more Federal Reserve credit " (Mr. Hamlin). 1 1 It seems only reasonable to assume, however, that the necessity for more Federal Reserve credit at the end of M a y , or later, in New Y o r k was in part if not wholly a result of the failure of the board to authorize previously the affirmative rate policy so often requested by the bank. From March through M a y new security offerings had aggregated $2,787,000,000 and it was well known that much of this money was being borrowed by stockholders from the banks. If this assumption is correct, the explanation of the reversal appears to rest in the circumstance that the bank had become impressed with the necessities of its member banks in caring for the vast volume of new financing. " Direct pressure" had reached only the banks, probably only a portion of the banks, and had not reached, could not reach, individual or corporate borrowers, because banks under pressure presumably were reluctant to talk much about it. Can it be reasonably doubted, on the other hand, that these borrowers would have been discouraged, and much of their unhappy financing would have been estopped, by the alternative " affirmative rate policy," when it is considered that this meant successive increases of one percent if necessary? 11

As heretofore quoted.

FEDERAL

RESERVE

POLICY

IN

1 92 9

51

(3 ) That at the end of M a y the Federal Reserve Board reversed its position quite as much as the New York bank did. It abandoned " direct pressure," but " that was not made public for obvious reasons." " The board was satisfied with the result of direct pressure." The controversy accordingly seems to resolve into these facts, that at first board and bank favored restriction of credit, but differed as to method, and that in late M a y both C H A R T 3.

9

LOANS ON SECURITIES, REPORTING MEMBER BAN KS 9

8

8

nemHG

7 10 5 6 -I 8 >

/

DIM. KU tmsoMi SITTUHID -

o J 3 J in

z

7 6

I