The problem with the Federal Reserve in the 1920s — if "problem" is the correct term for having an incomplete understanding of money, credit, and banking — was that Federal Reserve policy had by then almost completely changed over from the principles of the British Banking School to the tenets of the British Currency School. "Money" was no longer anything that could be used in settlement of a debt, but a special creation of the State. As such, the Federal Reserve believed it could not directly affect the money supply by rediscounting real bills — the Currency School did not admit that money could be so created. Instead, the Federal Reserve became self-limited to manipulating what it presumed were existing supplies of money — existing accumulations of savings, the only money recognized by the Currency School as money — by changing reserve requirements and artificially raising and lowering interest rates. "Interest," as we explained in a previous posting in this series, was no longer a share of profits, but the cost of money, that is, the price of bank credit.
Bank credit itself changed from a system of promises that "lubricate" the economy and results in the creation of new money, to a commodity. Construed as a commodity, credit was presumed to be limited in supply, completely dependent on the amount of existing savings, rather than based on the present value of existing and future marketable goods and services in addition to existing accumulations of savings, expanding and contracting in direct response to the actual needs of the economy. As Louis Kelso put it, the financial community became "preoccupied with the monetary shadows of reality, rather than reality itself." As Kelso explained,
This assertion should not be taken lightly. The wide discrepancies between the solutions to economic problems arrived at through monetary thinking and their real-life results, in terms of enabling people peacefully and rationally to produce and consume general affluence, must be attributed to the ease with which symbols are confused with the physical realities for which they stand. Money is not a part of the visible sector of the economy; people do not consume money. Money is not a physical factor of production, but rather a yardstick for measuring economic input, economic outtake and the relative values of the real goods and services of the economic world. Money provides a method of measuring obligations, rights, powers and privileges. It provides a means whereby certain individuals can accumulate claims against others, or against the economy as a whole, or against many economies. It is a system of symbols that many economists substitute for the visible sector and its productive enterprises, goods and services, thereby losing sight of the fact that a monetary system is a part only of the invisible sector of the economy, and that its adequacy can only be measured by its effect upon the visible sector. (Louis O. Kelso, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967, 54.)To put it more succinctly, "money" is a derivative of the present value of existing and future marketable goods and services. "Currency" — coin and paper money (and, depending on your paradigm, demand deposits) — is a derivative of money, a symbol of a symbol. Money is thus a means of exchanging claims back and forth, whatever specific form it takes. It is based on private property, and thus cannot be treated as if it were a special creation of the State or a commodity without, in effect, abolishing private property (Fisher, loc. cit.) — yet that is how the Keynesian, Monetarist, and Austrian Schools view money. This is a paradoxical and self-defeating understanding that only leads to more confusion, unnecessary acrimony, and ineffectual remedies to economic problems.
By rejecting the reality that commercial banks create money by discounting bills drawn on the present value of existing and future marketable goods and services, and limiting the definition of money to coin, currency, and demand deposits, the Federal Reserve unconsciously encouraged the widespread belief that you could get something for nothing — for that is what it appeared the financial system and the money markets were doing as the decade of the 1920s progressed. Without realizing it — for clearly that was not the intention of either the government or the central bank — by using the wrong definition of money and adhering to the tenets of the Currency School (especially the new definition of interest), the Federal Reserve actually encouraged the speculative frenzy and the misuse of money and extension of credit for non-productive uses that it sought to discourage.
This was inevitable within the framework of thought bounded by the assumptions of the Currency School. Denying the reality of the real bills doctrine and Say's Law of Markets, the contradictions built into the system sooner or later necessarily force an economy into crisis. As just one example, putting money and credit creation — not just regulation — under the State means that what should be purely an economic decision in direct response to the actual needs of private sector business engaged in the production of marketable goods and services (i.e., how much money to create or cancel), becomes a political decision, often determined by the whim of the person in charge.
As a case in point, the depression of the 1830s, "Hard Times," had its origin in President Andrew Jackson's dogmatic beliefs that only gold and silver were "real" money, that banks (except for those run by his friends) were frauds, and that sound economic growth could only be financed by a return to "real" money. Similarly, Amity Schlaes in her book, The Forgotten Man, relates how President Franklin Roosevelt arbitrarily changed the price of gold, often picking the amount out of thin air: "One morning, FDR told his group he was thinking of raising the gold price by twenty-one cents. Why that figure? his entourage asked. 'It's a lucky number,' Roosevelt said. 'because it's three times seven.' As Morgenthau later wrote, 'If anybody knew how we really set the gold price through a combination of lucky numbers, etc., I think they would be frightened.'" (Amity Shlaes, The Forgotten Man: A New History of the Great Depression. New York: Harper Perennial, 2008, 148.)
Still, the reorientation of the Federal Reserve from being an institution based principally on the precepts of the Banking School, to being a tool of the State to implement Currency School policies and programs was a symptom, not the cause of the fundamental change in how people viewed investment in activities intended to produce marketable goods and services. While it seems paradoxical — especially in light of the fact that the purpose of production is consumption — under the reign of the Currency School genuinely productive activity tends to become secondary to manipulating derivatives of production, especially money, credit, and corporate equity issues.
Nowhere was this more evident than in the financial frenzy that led to the Crash. By any standard, the Federal Reserve's policy of discouraging loans for speculation was the right thing to do. The problem was that the Federal Reserve had, in essence — by denying that commercial banks create money — stripped itself (or allowed itself to be stripped) of any direct regulatory control over the creation of money and extension of credit. Only conscious direct regulatory control, not the presumed indirect management that they assumed they were exercising, would have ameliorated in some measure both the scope and the character of the Crash and the subsequent depression.
Shifting Federal Reserve policy from increasing the money supply directly by rediscounting qualified industrial, commercial, and agricultural paper, to affecting the money supply indirectly by manipulating reserve requirements and the interest rate took away a very powerful tool of the central bank. The only direct action the Federal Reserve could take in the late twenties, when commercial banks, hand-in-glove with their investment banking divisions, were creating money at a tremendous rate to finance speculation in stocks on Wall Street, was to refuse to create money for speculative purposes — which the institution was forbidden to do in any event.
The Federal Reserve had rendered itself powerless to do anything substantive about the buildup to the Crash of 1929. The central bank had redefined itself as a different institution than the one established in 1913 specifically to avert such financial panics by directly regulating the amount of money in the economy through the operation of the real bills doctrine. By effectively denying that commercial banks create money by discounting — even while carrying out rediscount operations — the Federal Reserve could not admit that money was being created at an incredible rate in a way the officials running the institution and the policymakers in the government refused to recognize.
Money was being created to finance speculation through misuse of commercial banks' discount powers. The situation was exacerbated by the inappropriate links between commercial banks and investment banks, which were often combined in a single institution — in effect, giving the chicken thief the key to the henhouse, or (perhaps more accurately) a drug addict access to an unlimited supply of heroin. Regardless how bad the situation got, the best the Federal Reserve could do under its Currency School assumptions was to try and engage in indirect management of the money supply by implementing ineffectual changes in reserve requirements and manipulating the interest rate. As Moulton explained,
The Federal Reserve authorities were subjected to some criticism during the period from 1924 to 1927 on the ground that the comparatively easy money policy being pursued was encouraging excessive stock speculation. In the light of the criteria which had been adopted as a guide to Reserve policy, it did not seem to the Reserve officials at the time that stock speculation was having a deleterious effect upon business — for if such were the case the statistics of business should have revealed the fact. As one of the officials state: "The operations of the stock market are not the concern of the Federal Reserve system, except when the stock market is absorbing credit that is needed in general business, as was the case in the fall of 1919, or when the activity of the market and the rapid advance of many stocks threatens to breed a speculative fever which is liable to spread to commodities." [George W. Norris, quoted by George E. Roberts, "Federal Reserve Control of the Money Market," American Bankers Association Journal, December 1925, Vol. XVIII, No. 6, p. 448.] (Financial Organization and the Economic System, op. cit., 405.)In other words, the official policy of the Federal Reserve — dictated by the tenets of the Currency School and bound by its assumption that only existing accumulations of savings can be used to extend credit for any purpose — assumed as a given that bank credit was a commodity, limited in supply. Within this policy framework, the only circumstance that should cause problems was if the massive speculation began draining the existing supply of this commodity away from the productive sector to the detriment of "general business." The possibility — reality, actually — that commercial banks were not drawing on some existing "inventory" of credit, but creating money for both productive investment and speculation at will without causing any kind of diminution in the amount of credit available does not appear to have been considered.
Consequently, when Federal Reserve officials woke up and decided that the speculative boom in the stock market was a matter for serious concern, they attempted to put the brakes on. This was the right thing to do, but since they approached the problem from the wrong analytical framework, they employed the wrong tools. As Moulton described the situation,
By 1928, however, the Reserve officials began to express genuine concern over the stock market boom. In the first half of the year pressure was exerted toward restraining speculation by open market sales and advancing rediscount rates. At the same time, the credit situation was tightened as a result of a large outflow of gold. Call loan rates advanced from an average of 4.24 per cent in January, 1928 to 6.05 per cent in July. There was, however, no appreciable effect upon speculative sentiment. Moreover, business prosperity and speculation continued to advance together. (Financial Organization and the Economic System, op. cit., 405.)By refusing to recognize that commercial banks were creating money for both productive uses and speculation at the same time, and that the amount of money created for one did not necessarily affect the amount of money created for the other, the Federal Reserve boxed itself in. By adhering to the tenets of the Currency School, the two obvious ameliorative actions that could have been taken did not even suggest themselves: immediate imposition of a 100% reserve requirement on commercial banks (being careful to define reserves as they were in the original Federal Reserve Act of 1913), and mandatory separation of commercial banking from investment banking. This would have left a number of weaknesses in place (e.g., the power to monetize government deficits and the inclusion of government securities in the definition of reserves), but would have given the Federal Reserve the power to stop commercial banks from creating money for speculative purposes, at least for the time being, and restrict speculative loans to being made out of accumulated savings.
Within its self-imposed constraints, however, the best the Federal Reserve could do was resort to an ineffectual half measure. Coming from the orientation of the Currency School, the Federal Reserve would not, of course, impose a 100% reserve requirement even as an emergency measure. Using the wrong understanding of the role of the central bank, it simply would not occur to the officials that they could thereby eliminate, even if only temporarily, the ability of commercial banks to create money for stock market speculation. Instead, as Moulton described the actions of the Federal Reserve,
In February, 1929, the Reserve officials conceived a new method of exercising control over the stock market. Instead of merely increasing the cost of credit, hoping thereby to curtail its use, they devised a policy of "direct pressure." This involved a refusal of the rediscount privilege to banks having a volume of speculative security loans in excess of an amount deemed reasonable by the Reserve banks. During the ensuing months, however, there was a vigorous controversy between the Reserve officials and those of the Federal Reserve Bank of New York. The bank held that direct pressure was impractical and that the only effective means of control was to "put the brakes on" by raising discount rates, the first effect of which would be to restrict loans of a speculative character. The Reserve officials felt, however, that "advances would have to be so sharp — far beyond six per cent — that other lines of business would be severely affected and that a crisis might in consequence ensure." The Federal Advisory Council supported the position of the Reserve officials. However, the New York Reserve bank refused to cooperate, and in June the policy of direct pressure was abandoned. (Financial Organization and the Economic System, op. cit., 406.)The actions by both the Reserve officials and the Federal Reserve Bank of New York reveal a fundamental misunderstanding of what was going on. Convinced that a fixed pool of savings was available, the "direct pressure" policy tried to make it more attractive for commercial banks to extend loans for productive investment instead of speculation. Similarly, the New York Federal Reserve assumed that raising the rates would make speculative loans (and, by extension, all loans) less attractive.
Both approaches, however, failed to take into account the fact that the commercial banks could continue to create money at will for both purposes, without having to choose between them. Refusing rediscount to commercial banks simply meant the commercial banks would keep the qualified paper on hand as reserves, rather than changing it into reserves in the form of demand deposits at the Federal Reserve. As for raising the discount rate, that would merely increase a cost that would be passed through to the borrower.
Again, a 100% reserve requirement, even if imposed only as a temporary emergency measure, would have stopped money creation for speculation. It would not have had any effect on speculation carried on using existing accumulations of savings, but that by definition was a risk borne by people who could well afford the loss. It is money creation for non-productive spending and speculation that was the problem, not the misallocation of a presumably fixed pool of savings between productive investment and speculation. The Crash of 1929 was probably inevitable, both to adjust share prices on the secondary market to a more reasonable level and to drain "morbid capital" out of the economy. From the orientation of the Banking School, however, there was no good reason why the Great Depression should have occurred in the first place, or for the recovery to have been so difficult, and, ultimately, ineffective.