A History of the Federal Reserve; Chapter 4: New Procedures, New Problems, 1923-29

The years 1923-1929 are often described as the best period in Federal Reserve history. Inflation though highly variable from quarter to quarter, averaged about zero for the period as a whole. Economic growth was variable but robust. The economy grew at a 3.3% average rate despite two recessions in six years. The Federal Reserve developed much more activist procedures than envisaged by the authors of the Federal Reserve Act or practiced in earlier years. The Reserve banks, particularly New York, gained more control of decisions, raising issues and disputes over substance, power and personalities. Policy actions intended to serve three principal aims: (1) reestablish the international gold standard, (2) maintain price stability, and (3) prevent or slow growth of speculative credit, particularly credit extended to carry securities traded on the New York Stock Exchange. The three aims were incompatible with economic conditions at home and abroad. The restoration of the gold standard (as a gold exchange standard) increased the demand for gold, forcing a decline in commodity prices. Britain returned to gold in 1925 at an overvalued exchange rate but was unwilling to deflate further. France returned in 1927-28 at an undervalued exchange rate, but was unwilling to inflate. The U.S. received large amounts of gold but was unwilling to inflate also. Both France and the United States sterilized gold inflows, forcing deflation on the rest of the world. French and U.S. policies were incompatible with the gold standard. Either their policies had to change, or the gold standard would break down. With hindsight, we know the answer: Britain, followed by many others, abandoned the gold standard after 1931. Canada left the standard in 1929. Three distinct groups coexisted within the Federal Reserve system. One, led by member of the Board but including several Reserve bank governors, accepted the real bills doctrine. They believed that speculative credit--including loans to brokers, dealers or customers to purchase shares on the New York Stock Exchange--was inflationary and must be prevented. Despite slowly falling prices, they worried most about inflation after 1927. A second group, led by Benjamin Strong of the New York bank, abandoned the real bills doctrine. In its place, they put the framework developed in pathbreaking books by Winfield Riefler and Randolph Burgess. Their framework emphasized the role of member bank borrowing as an indicator of the banks' position. Increased borrowing indicated increased tightness of the money market; reduced borrowing meant greater ease. Open market operations, by removing or augmenting reserves, were said to force banks to borrow or encourage repayment. This group regarded the high level of borrowing in 1929 as evidence that money was "tight". They wanted to raise the discount rate to force repayment and ease the money market. The third group included Governors of several Reserve banks. This group was concerned mainly with the earnings of the Reserve banks. Strong could gain their votes for his policy by increasing their banks' earnings. Despite the deflationary policies of the late 1920s, Federal Reserve officials wanted to tighten. They could not agree on the means. By the time they moved, world recession had started in Germany and Britain. The Federal Reserve entered the depression divided on personal and substantive issues. The rise in stock prices from 1927 to 1929 was driven by a comparable rise in corporate earnings. Market capitalization remained relatively high in these years; the capitalization rate fluctuated but did not generally rise. A large rise in capitalization rates occurred earlier, in 1926. As in 1966-68 and 1996-97, the rise seems to have been driven, at least in part, by a belief that the Federal Reserve had learned to control inflation and mitigate recessions.