Tuesday, March 16, 2010

Own the Fed, Part V: The Crisis of 1920

With the end of World War I, the United States faced a series of problems that threatened to destabilize the economy. Admittedly, the depression that followed the end of the war did not last very long — even though a different, less restrictive definition of the dreaded D word was in use. By April 1919, there was an upswing in business, the economy having been given the chance to switch back to peacetime production after the demands of the war. As the existing accumulations of savings had been drained off by the Liberty Loan drives and, after the war, the Victory Loan drive, commercial banks turned to the Federal Reserve to provide an adequate money supply, as intended by the framers of the Act and as provided for in the design of the institution.

Unfortunately, much of the demand the commercial banks experienced for additional liquidity did not come from qualified industrial, commercial, and agricultural investment. As is usually the case in a period of business expansion, there was also a great increase in speculation on the secondary market. This caused commercial banks to extend credit and create money for speculation, diverting their resources (necessarily limited by the fractional reserve requirement) away from productive investment. The increased demand for money and credit for speculative purposes was, in fact, a significant part of the increased pressure for the Federal Reserve to provide additional liquidity to the private sector. (Financial Organization and the Economic System, op. cit., 392.)

That, of course, was impossible. Out of the fear that the money creation powers of the system would be diverted to just the sort of non-productive speculation that had led to the Panic of 1907, the Federal Reserve Act of 1913 clearly specified that bills drawn on equity issuances would not qualify for rediscounting. (H.R. 7837, § 13.) The Federal Reserve could, of course, rediscount qualified paper issued by the commercial banks. There was, effectively, an unlimited supply of credit for productive purposes, but hat would not have satisfied speculative demand.

Adding to the problem was the fact that during the war any company that had not been able to demonstrate that the goods and services it produced were essential to the war effort had, in general, not been able to obtain loans to finance capital expansion. This was due principally to restrictive legislation as well as the efforts of the Capital Issues Committee. During the latter part of the war, the Committee had managed to prevent the flotation of any securities that were not deemed necessary for prosecuting the war. With the Armistice, however, and the removal of the restrictions, a phenomenal number of new loans were made.

Another factor was the depletion of the remaining reserves in the system by the demands of the trade imbalance with the Orient and South America. Despite the name, "World War," the Orient and South America, by and large, had not been directly engaged in the conflict. There had been some sporadic efforts in Africa, disastrous for both sides in the conflict, but, except for the Japanese six-day siege of Tsingtao in China, and minor engagements at Bita Paka and Toma in German New Guinea, the war in the Pacific was nearly bloodless, while South America's direct involvement primarily dealt with the seizure of German warships in neutral ports that had overstayed the 24-hour limit.

This meant that the productive capacity of the Orient and South America for consumer goods was intact, and had not changed over to war production to any significant degree. Raw materials were a different story. The demand for nitrates and other raw materials shrank considerably with peace, causing widespread unemployment, especially in Chile. A large number of the unemployed workers joined communist organizations. Some authorities credit this with beginning the spread of Marxism on the continent.

In any event, with the domestic restriction of non-war related production, if the United States wanted consumer goods, a large amount of those goods had to be imported. Consequently there was a large outflow of gold reserves from the United States to South America and the Orient as "boot" in unequal exchanges and to fund a growing trade deficit. The United States was not producing anything the Orient and South America wanted in any quantity — war material having a somewhat limited market — so, instead of exchanging commodities and finished goods, the United States had to pay in gold. Under the fractional reserve banking mandated by partial adherence to the tenets of the Currency School, for every dollar in gold transferred to a foreign country, the domestic money supply was potentially reduced by approximately twenty dollars. In the United States financial system as a whole, reserve requirements in gold amounted to approximately 5% of outstanding claims against cash. (Harold Moulton, Financial Organization and the Economic System, op. cit., 392.)

As a result, reserve ratios across the country declined. Recall that, in contrast to today's artificial redefinition that restricts "reserves" to mean cash, demand deposits at the Federal Reserve, and, effectively, government securities, under the original Federal Reserve Act of 1913, "reserves" included qualified industrial, commercial, and agricultural paper as well as gold. Ratios declined from the recommended level of approximately 50% to less than 45% by the end of 1919.

The decline in reserves raised an issue that had plagued the United States for decades in the debate over whether or not a central bank should be established. A central bank is, by theory and practice, intended to establish and maintain a stable currency by regulating the supply of money and credit to the private sector directly primarily by rediscounting qualified paper and supplemented with open market operations to ensure that no money is created that is not backed by hard assets in the form of the present value of existing or future marketable goods and services. The problem was that, using a confused definition of reserves and misunderstanding the meaning and role of interest, the amount of gold in the system could decline to the point where it was insufficient to cover the demand for convertibility into specie.

The obvious solution was to suspend convertibility domestically and encourage the rediscounting of loans made for qualified industrial, commercial, and agricultural purposes. The outflow of gold would then have made little difference, and the trade imbalance would have been corrected by increased exports as American industry, commerce, and agriculture became productive once again. By using a definition of reserves that excluded such qualified paper, and the enormous increase in money creation for speculation instead of productive purposes, however, the country found itself in serious difficulties.

Unfortunately, business leaders and policymakers at the time were in a self-imposed "Catch-22" situation. There was an apparent business "boom," but it was largely speculative, not true investment in sound capital projects. The country needed to rebuild its peacetime capacity to produce marketable goods and services, a policy that would have the added benefit of reversing the drain of gold out of the country and thus replenishing commercial bank reserves. This called for a low discount rate at the Federal Reserve to encourage productive investment. With financial resources of commercial banks diverted into speculative projects, however, it seemed as if the economy was fast becoming, in today's terminology, "overheated." Authorities contended that the need was for the Federal Reserve to raise the discount rate.

The federal government, however, was initiating the process of floating its "Victory Loan" issue of $4.5 billion. The Treasury Department needed to keep the interest rate on the bonds as low as possible to keep costs down for the taxpayer. This appeared to mandate a low discount rate. Further, the Treasury Department had already announced that the interest rate on the Victory Loan would be low, and bankers throughout the country had set policies and made loans based on that assumption. To raise the interest rate would have meant breaking faith with the bankers, and cause them substantial losses. The interest rate was kept low.

Commercial banks did not, however, return the favor. Bankers found it much more profitable to make new loans for speculative purposes out of existing accumulations of savings and by creating money by discounting, than to extend loans for properly vetted industrial, commercial, and agricultural investment that qualified for rediscounting at the Federal Reserve. The interest rate on qualified loans was kept down due to the low discount rate and the low risk typically associated with blue chip securities, thereby lowering potential profits. The profit potential on loans made for speculative purposes was much greater due to 1) no fee paid to the Federal Reserve for rediscounting unqualified paper, 2) the higher interest rate typically charged for lending existing accumulations of savings, and 3) the high risk premium associated with speculative loans.

What authorities even today fail to realize is that raising the discount rate made no difference. The discount rate did not, and does not apply to "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." (H.R. 7837, § 13.) Regardless of the discount rate, commercial banks would have gone on creating money through their own discount powers, not rediscounting "notes, drafts, or bills" that didn't qualify for rediscounting in any event, and pocketing the huge profits that result when speculation is successful.

Ironically, the only thing in the system providing a check on the creation of money for speculative purposes was the fractional reserve requirement. Commercial banks had to make a certain percentage of genuinely productive loans (that counted as reserves) to increase their reserves in order to make the speculative loans (which did not count as reserves). A 100% reserve requirement that included notes, drafts, and bills drawn for trading in properly vetted and collateralized investment in stocks, bonds, and other securities in the definition of reserves that qualified for rediscounting would have solved the problem, but rediscounting such securities was specifically prohibited by the Federal Reserve Act. The Federal Reserve therefore had no power to affect the dealings of commercial banks in speculative securities except indirectly by manipulating reserve requirements and the interest rate — which (as history has demonstrated) has a tendency to backfire and inhibit or prevent productive investment and, paradoxically, promote speculative and unsound lending in the hope of making large profits to make up for the paucity or reduced attractiveness of financially feasible sound investment.

In addition to the decline in the trade balance already mentioned, two other factors contributed to the seriousness of the situation. One, the rail system was disrupted. This caused the transportation system to break down and, eventually, led to the Great Railroad Strike of 1922. Businesses could not get raw materials or move their finished goods, and had to obtain extended credit to cover them until normal operations could resume. Moulton commented that this led to a new term, "frozen credit," to describe the situation in which businesses had to secure credit for longer periods and for greater amounts than would otherwise have been the case. (Financial Organization and the Economic System, op. cit., 395.)

Two, the inflation induced by the decision to finance the war by borrowing rather than by taxation was having its effect. As Moulton explained the situation,

The steady rise in commodity prices during 1919 and the first months of 1920, accompanied as it now was by substantial increases in rents, had finally reached a point where it was forcing a curtailment of consumptive demand. Whatever may have been the case earlier, it had by this time certainly become true that the net annual wages of labor, generally speaking, as well as the income of the salaried classes, were failing to keep pace with advancing prices, with the result that the real purchasing power of the rank and file of the people declined. The "peak" of prices was reached in the spring of 1920, among other reasons because consumptive demand was not sufficient to absorb the existing volume of production at the prices for which goods were then being offered. Popular hostility to the continuous marking up of prices is also believed by many to have finally led to a voluntary reduction of purchases. (Ibid.)
The suicidal solution of increasing consumer credit to stimulate the economy was not considered anything other than insane, as the tremendous number of contemporary articles about "dollar-a-day slavery" in the form of loan sharking attest. To try and maintain some control over the situation and stabilize the economy, then, the Federal Reserve issued an official warning in the early summer of 1919. Commercial banks and Wall Street speculators were informed that it was necessary to curtail loans made for speculative purposes, especially when loans were extended for speculative purposes at the expense of truly productive loans extended to finance capital formation.

The warning was ignored. It wasn't until the middle of October and the situation had become extremely serious that the Federal Reserve repeated its warning. The situation was so bad by then that the banks in New York actively cooperated with the Federal Reserve Board. The commercial banks drastically raised the rates on call money (i.e., loans made for purchases on the margin) and put a cap on the amount that brokers could borrow. As a result, stock values collapsed. This ended the bull market that had been in effect since the spring.

While the restrictions on speculation caused a significant drop in the stock market, this did not have a material effect outside Wall Street. Most people did not have equity investments, and did not, in general, engage in speculation. Curtailing speculation halted the diversion of financial capital and lending capacity from productive purposes, and damped down some of the inflationary pressure on the economy, but it did not eliminate it. The price level was still higher than either the productive capacity or the consumptive capacity of the economy could justify.

Consistent with the thinking of the day, and repeating the policy that had appeared successful following the Civil War, still in living memory, the solution to inflation seemed obvious. To counter the inflation caused by government borrowing and the creation of money for non-productive purposes, induce deflation, or a constriction of the money supply.

Deflation, however, causes its own problems, not the least of which is that a policy of tight money tends to affect the productive sector adversely. This is particularly true for any business (including farms) that borrowed "cheap money" during the inflationary period, and has to repay the loan with expensive money. Induced deflation usually leaves the prime causes of inflation — government borrowing and private speculation — untouched, and can even, in certain circumstances, encourage massive non-productive money creation.

This is because creating money for productive purposes, per the real bills doctrine of the Banking School, is non-inflationary. It makes no sense to deprive industry, commerce, and agriculture of financing to “cure” inflation. In periods of deflation and falling prices, however, speculation tends to run rampant as even people who would not otherwise have engaged in speculation are drawn by necessity or greed to the prospect of high, if extremely risky profits. This was the case especially in the latter half of the 19th century, when the United States tried to correct the financial folly of Salmon Chase in borrowing to finance the Civil War with the counter-folly of deflating the currency. Further, the State, unable to derive sufficient revenue from a declining tax base in deflationary periods, frequently resorts to additional borrowing, countering the deflation with additional inflation by creating money backed by government debt, making a policy of deflation self-defeating.

Despite the faulty logic, the Federal Reserve began raising the discount rate. It had no effect except to raise the costs of doing business, and fortunately did not cause the expected deflation. Because of the high price level, businesses were able to generate sufficient profits to make borrowing even at high interest rates pay. As Moulton described the situation,
The several increases in interest rates that were made during the autumn and winter of 1919-1920 apparently had little, if any, effect in restraining business activity. Before an outright curtailment of loans was undertaken, the other factors to which reference has been made — transportation difficulties, rising living costs, a restriction of consumption, and falling prices of raw materials, etc. — were operating to bring about a price and business readjustment. (Financial Organization and the Economic System, op. cit., 396.)
The bottom line to the Crisis of 1920 was that the Federal Reserve can be given credit for staving off what had the potential to be a financial meltdown. This would not have been anywhere near the scale of what was going on in Germany and Austria-Hungary at the same time, but it would have been extremely serious, as the events of ten years later were to prove.

What puzzles the economists and policymakers, however, is that the Federal Reserve, at one and the same time, both caused the crisis, and remedied it — even though the remedy could not have worked in any event, and was not implemented in any effective manner. The inflation was caused in large measure by the decision to finance the war through borrowing rather than taxation, while the proposed deflation would have wrecked the economy. How, then, did the Federal Reserve resolve the crisis? Through public confidence in the Federal Reserve itself, an intangible that, as Charles Morrison explained in 1854 in his Essay on the Relations Between Labour and Capital, has the power to keep an economy on an even keel. As Moulton explained,
The Federal Reserve system, however, undoubtedly prevented a panic in 1920. Beginning about the middle of May, the credit tension became of the acute variety that had in the past characterized the weeks immediately preceding a financial collapse. Just as soon as the decline in prices, with the concurrent slackening of industry and backing up of the speculative water, began, great numbers of businessmen were panic stricken much as would have been the case in former times. The cancellation of business orders, the failure of creditors to meet their obligations promptly, the recurring slumps in inventory values, and the uncertainty as to the whole future trend of events developed a veritable business crisis — accompanied by the usual insistent pressure upon the banks for loans with which to tide over the interval of readjustment. There was one noteworthy difference, however, between this and similar occasions in the past. Widespread confidence in the Federal Reserve system proved a powerful sedative. There was no panic and no suspension of specie payments. (Financial Organization and the Economic System, op. cit., 396.)
Thus, even though the Federal Reserve had done the wrong thing by allowing itself to be diverted from its primary mission in order to finance the war, and even though the proposed remedy of induced deflation would have been disastrous, the very fact that the Federal Reserve existed and was doing something restored public confidence and averted a financial meltdown. Unfortunately, it also convinced economists and policymakers that inducing inflation or deflation, as well as manipulating reserve requirements and interest rates were effective tools in controlling the economy, as opposed to setting the standard of value, regulating the currency, and maintaining its stability, as is a proper role of the State, and thus delegated to the Federal Reserve.

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