Blaming the Money Managers

I

IN the old days the human mistakes which may have generated business depressions were regarded as acts of God. Modern depressions are recognized as man-made. And, if there is one thing which they have in common, it is that they must all be equipped with a scapegoat. That is the mundane penalty for a mundane phenomenon. The present depression is no exception. On the bread line it is difficult to keep from devilhunting; yet few even among those farthest removed from the bread line seem capable of refraining from this latest of indoor sports. Among them Mr. B. M. Baruch, who says there is enough blame to spread around, stands out. But most of us prefer to invoke particular devils according to our particular prejudices.

A subsidiary devil on Capitol Hill and elsewhere is the Federal Reserve System. As set up again in the Banking Act of 1935, the Reserve System was widely hailed as the Supreme Court of Money. In 1935 the legislature endowed it with new influence in respect of the supply and the cost of money available to the community. For, thanks to the great deflation of 1929-1932, there was a magic associated with money control. ‘Money,’ said Tom Paine, ‘is the right of action,’ and to some of the lay theoreticians who flourished under sundry Pied Pipers in the reform era the controller of money assumed the function of controller of economic activity. I am thinking of a diversity of folk, from money-minded business men to Father Coughlin’s congregation. It was those who had thought in such terms who in particular turned upon the Federal Reserve System as the responsible agent for the 1937 breakdown.

Two questions arise as a result of this failure of the Federal Reserve to prevent the debacle. Was it ever proper to think of the Federal Reserve System as possessing omnipotent powers over economic activity? Has the Federal Reserve System exercised its powers wisely? The questions are not necessarily related. But an answer to the first question is a necessary preliminary to the examination of the second. For, if we find that the System is not omnipotent, then the actions — or lack of them — of the Federal Reserve System must lose some of their potency in our minds.

Actually our economic system is run by the multitudinous decisions of millions of free individuals, particularly risk takers and investors. Money may give them the ‘right’ of action. But action is not necessarily realized either by the availability or by the cost of money. The history of the New Deal proves it. Between the second quarter of 1933 and the second quarter of 1935, money increased by 50 per cent and corporate profits doubled. Yet there was an increase in factory output of only 10 per cent. In the same period an increase of 60 per cent in factory pay rolls was accompanied by only a 30 per cent increase in retail sales. Such comparisons show what the Harvard Committee on Research into the Trade Cycle calls ‘the enormous amount of “play” in our economy.’ By this is meant the lack of automatic influence of money stimuli upon economic action. No mechanistic theory can account for human phenomena.

In fact, the Federal Reserve System has not even played the decisive money rôle in the history of the New Deal. In 1935 the central bank was entrusted with broad powers which enable it to affect the volume and the cost of money available to the community. The word ‘ affect ’ is the way that the System itself puts its authority. And there is nothing unduly modest in this phraseology. For it is obvious that for years past the Treasury has had far more influence than the Federal Reserve System in affecting the volume and the cost of money. This it has exerted by selling its bonds to the commercial banks for the purpose of covering government deficits. When commercial banks buy government bonds, they create a deposit to the account of the Treasury, which thereupon checks out the deposit to contractors, reliefers, and others. Money is cheapened by the plethora of it which the Treasury thus creates. Even the cost of money is affected directly by the Treasury’s stabilization fund in buying and selling its bonds on the open market.

Nor can the Federal Reserve System do anything about the number of times the dollar is turned over. Turnover is that recipe of prosperity so dear to the Townsen elites known as velocity of circulation. By 1936, deficit financing had reflated the volume of money to a figure above the figures for 1929. But the index of work which the dollar was supposed to do remained subnormal. The dollar turned over about fifteen times a year, compared with thirty times in 1929. Nothing that the monetary authorities could do could influence this velocity of circulation. It is a psychological factor, pure and simple. This factor reënforces the proof that the reflation of money is not the same as the reflation of work — that psychological deflation can coexist with monetary reflation.

Even the cheapening of abundant money by the monetary authority does not necessarily increase its availability. Neither the Treasury nor the Federal Reserve Banks can make the commercial banks lend. Nor can they make business men borrow. Usually cheap money and easy money go together, but in the New Deal recovery they parted company. The rates for short money and for prime bonds have been the lowest in history. In twenty-seven Southern and Western cities the rates on customers’ loans have fallen steadily till they are now 4.15 per cent. In 1929 they were 6.16 per cent. Yet, according to W. Randolph Burgess, vice president of the Federal Reserve Bank of New York, speaking at the last meeting of the American Statistical Association, ‘because of a feeling of uncertainty as to the future, the position of the borrower is scrutinized with the utmost care, and money is not easy to obtain for any but prime borrowers.’ Here is another illustration of the limitations of the power of the central bank to influence the effective supply of money.

So that the Federal Reserve System is omnipotent neither as an economic nor as a monetary controller.

II

At the same time the monetary weapons of the Federal Reserve System are powerful. They are of two kinds. One set is destined to accelerate economic activity by increasing the supply of money and putting down its cost. Another is destined to brake that activity by doing just the reverse. It was to the ‘braking’ function of the Federal Reserve System that economist and banking eyes were turned in 1935. The reason has just been stated. The Treasury had been engaged both in knocking down the cost and in increasing the volume of money by unbalancing the budget. To many watchers the process had in it all the makings of an inflationary rise in the cost of living. Therefore the Federal Reserve System was expected to help to stabilize economic society when this ‘reflation’ had been completed.

The brake of most interest in the System’s brand-new armory was the power to ‘change the requirements as to reserves to be maintained against demand or time deposits or both by member banks’ in order ‘to prevent injurious credit expansion or contraction.’ It is the use of this particular brake that has come into question in blaming the money managers for the breakdown of 1937.

The meaning of these banking terms will not be taken for granted in view of their importance in the economic history of 1936-1937. Reserves that banks must maintain with their local Federal Reserve Bank are ratios of their customers’ deposits. I have already explained how deposits are created in favor of the Treasury. They are creat ed in the same manner for private individuals. It sounds odd to say that deposits can be created by prior loans and investments. At least it sounded odd till the SocialCrediters popularized the explanation. Nevertheless it is a fact. H. D. Macleod, in his classic Elements of Banking, says: —

When it is said that a great London joint stock bank has £25,000,000 of deposits, it is almost universally believed that it has £25,000,000 of actual money to lend out, as it is erroneously called. But these deposits are not cash at all; they are nothing but an enormous superstructure of credit.

The hen of a loan (or investment) comes before and creates the egg of a private deposit with the antecedent loan (or investment). For the loan finds its way by one route or another into somebody’s checking account.

The condition of a bank’s reserves is the limiting factor on this process of money creation. And these reserves are kept in the Federal Reserve System. Requirements vary with the type of deposit, whether time or demand. They also vary with locality, whether city or country. In 1935 they averaged, roughly, 10 per cent of customers’ deposits. Thus for every ten dollars of customers’ deposits a bank had to have one dollar in backing with a Federal Reserve Bank. Obviously if the Federal Reserve System is empowered to increase reserve requirements at will, it can exert a powerful drag upon the commercial banks’ lending ability. Suppose the banks were ‘loaned up.’ If the Federal Reserve made the reserve requirement two dollars instead of one dollar per ten dollars of deposits, then the banks would have to contract their loans, and the economy to that extent would be deflated.

In 1935 the banks’ lending ability on the basis of their existing reserves was by no means exhausted. This in spite of the heavy drafts on it from the Treasury. There were, in fact, about three billion dollars of ‘excess’ reserves. On the basis of one dollar reserve requirement for every ten of deposits, the banks, therefore, could have lent another thirty billion dollars, or much more than the total money (demand deposits and currency) then in use. The reasons for this money amplitude were the stretching of the gold supply by devaluation and the inflow of gold from abroad. It requires no economic knowledge to appreciate that an ‘injurious credit expansion,’ or inflation, was at least potential on the basis of those ‘excess’ reserves.

The key to the employment of this thirty billion dollars was the development of a buoyant commercial feeling in which business wanted to borrow and banks wanted to lend. That would have spelled an ‘injurious credit expansion,’ or inflation. In 1935 and 1936 authoritative opinion talked and wrote as if this inflation were just around the corner. Among the economists E. W. Kemmerer was the leading calamity howler; among the bankers Winthrop W. Aldrich, head of the Chase National Bank. Mr. Aldrich described the excess reserves as so much ’explosive material awaiting the match.’ Successive meetings of the Federal Advisory Council, which is composed of one important banker from each of the twelve Federal Reserve districts, issued solemn warnings that excess reserves must promptly be reduced ‘in order to obviate the probability of an undue and dangerous credit inflation.’ On few subjects have the bankers been more sure. Of all the bankers only one firm, to my knowledge, refused to endorse the Advisory Council’s proposal. This was J. P. Morgan and Company. Speaking through the late S. Parker Gilbert, the Morgan firm thought that ‘ the proposed increase in reserve requirements might do more harm than good by administering a severe check to recovery and setting in motion new forces of deflation.’ Prophetic words, if you think that the Federal Reserve can administer ‘severe checks.’

The Federal Reserve System turned a deaf ear to this authoritative and clamant demand. Chairman Marriner S. Eccles, indeed, remained one of the leading and consistent reflationists in Washington. Even as late as March 15, 1937, we find him saying: —

I have been and still am an advocate of an easy-money policy and expect to continue to be an advocate of such a policy so long as there are large numbers of people who are unable to find employment in private industry, which means that the full productive capacity of the nation is not being utilized. Under such conditions, to restrict the available supply of capital and thus to make it difficult, if not impossible, to employ these people would not only be antisocial but uneconomic.

If Mr. Eccles held these views in March 1937, he certainly held them before that date. And yet he and the majority of his colleagues on the Board of Governors in Washington subscribed to action to satisfy in part the banking demand upon them. In mid-year of 1936 the Board ordered a 50 per cent increase in the reserve requirements to take effect on August 15. That is, instead of an average of one dollar of reserves to ten dollars of deposits, a dollar and a half was now required.

This was a landmark in New Deal history. Till then the standing order had been ‘full steam ahead’ in reflating the money stream. That had been more than accomplished by mid-1936. Total money (demand deposits and currency) outstanding had reached twenty-one billion dollars. In the lush days of 1929 the corresponding figure was only eighteen billions. When, therefore, the Federal Reserve System put on the brakes, one was justified in assuming that the Board thought (1) that depression was a thing of the past; (2) that monetary policy should henceforth be directed toward the prevention of undue, or inflationary, expansion.

And yet there was nothing actually deflationary in the Board’s action. There was no mopping up of necessary reserves for the continued financing of recovery. Consequently, the commercial banks were put under no need to contract their loans or investments in building up their reserves to the new ratio. All that was done was to transfer the excess, or unused, reserves to the active, or used, reserves column. This left an ‘excess’ still remaining of nearly two billion dollars, which, so far from involving any credit strain, was sufficient, if the need arose, to increase customers’ deposits under the new dispensation by about fifteen billion dollars, or three quarters of the total money (demand deposits and currency) then in circulation.

Thus the Federal Reserve System might be said to have ‘tested’ its new brakes, rather than to have used those brakes. Clearly it could not essay any control over either money volume or money cost while the banks possessed so much surplus lending power. That surplus kept the System at a distance from active control. All that the August 15 change did was to narrow the distance so that, to quote one of the governors, the System could be placed ‘ in a position where it can more easily prevent an injurious expansion if it should threaten to develop.’

Finance, however, does not stand still. Later in the year, bank imports of gold added to reserves, and reasserted the original distance between the banks and the Federal Reserve credit controllers. To offset this building up of excess reserves the Treasury, on December 21, began to impound the incoming gold. Then the Federal Reserve System, on January 30, 1937, once more stepped on the brakes. It announced that it would raise reserve requirements by the full 100 per cent permitted by law. On the average this ruling would, therefore, require two dollars instead of one in reserves for the support of every ten dollars in customers’ deposits.

The increase was not to take place all at once. One half of it was to go into effect on March 1, and the other half on May 1, at the end of which time, it was calculated, the banks would still possess ‘excess’ reserves of around one billion dollars, or five billion dollars excess lendability — a figure which, as events turned out, was almost reached.

III

Yet something happened to the economy, after the March 1 increase in reserve requirements, which apparently had not been expected. Coincidentally New York City banks started dumping government bonds on the market. As a result, government bonds suffered a total loss of 41/2 points from the high level. When bonds fall, the yield on them increases, and this puts up the cost, of further accommodation to the government. Yields on Treasury bonds with more than five years’ maturity advanced from 2.10 per cent to 2.58 per cent, an increase of nearly 23 per cent, and never regained the former abnormally low level. Certainly the bond market suffered a crack.

Some commentators refer to this break as the handwriting on the wall of what one writer calls ‘the reflation deadlock,’ or the new depression. Certainly the new capital-issues market went to a new low in April, and new issues constituted the key of success or failure of pump priming. They had been stagnant in the depression, when the government was the great capital spender. In 1936 the new issues had moved up to $4,200,000,000, as compared with $2,600,000,000 in 1935, $696,000,000 in 1934, and $230,000,000 in 1933. In the late twenties they were anywhere from eight to ten billion dollars. It is perhaps unfair to pick on that period as a yardstick. That was a period of over-capitalization, unhealthy socially and economically. Still, after so much stagnation, the 1936 record was subnormal, and healthy prosperity required a much bigger amount of capital building. Such a hope lingered on after the falling off in underwriting. The sag in April was succeeded by three fair months; then the bottom fell out of the market, and it has since Iain utterly prostrate.

From what we now know, the 1936 demand for capital goods was merely for replacement purposes. It made up for deferred maintenance. And, when that necessary job — which cannot be put off indefinitely — had been completed, there was not the long-term willingness either to demand or to supply the means for those additions to capital equipment which are the sine qua non of capitalistic progress.

So the economy ran down. Industrial production had already passed its peak in December 1936, when the index stood at 121 per cent of the 1923-1925 average. It dropped to 114 in January 1937, and pursued a side movement up to September, when the sharpest falling off in history occurred, the year closing at 84, a decline of 26 per cent.

A coincidence between the use of Federal Reserve brakes and the running down of the economy is evident. Personally I do not think that the coincidence was a case of cause and effect. For reasons already stated, I do not share the view current in some quarters that the Federal Reserve System is omnipotent.

An English economist, D. H. Macgregor, in an invaluable book, Enterprise, Purpose, and Profit, concludes an investigation of the business cycle with the observation that ‘enterprise has had priority over the other primary indices, and the changes upward or downward have depended on the prescience of enterprisers.’ To be enterprising you must be hopeful of a future that will yield a profit, and other events besides Federal Reserve ‘anti-inflation’ action could be cited with equal force and more reason as signaling a breakdown in longterm enterprise.

To particularize: in 1936-1937 the budget was on the way to a balance by the reduction in emergency payments and the increase in receipts from social security taxes. This was anti-inflationary in itself. The pump, moreover, remained unprimed, partly because of the advance in wages and prices, particularly in the construction industry. Residential building, for example, had priced itself clean out of the market, to adopt Robert H. Jackson’s phraseology. Industry was in the throes of digesting New Deal taxation of a kind which put a discount on long-term business initiative. Strikes were common, and the epidemic of sit-down strikes, coupled with the ambiguous response from government, created almost a condition of civil war in some of the main centres of business activity. These situations, superimposed upon the general calamity howling about inflation, caused a good deal of forward buying which could not be sustained. Finally, there was the Supreme Court Plan, sprung upon a startled country on February 5, 1937.

Any one of these events depressed the business mind in the winter of 1936-1937 much more than any Federal Reserve tinkering with the money brakes.

The second reason for my feeling there was no cause-and-effect relation between the testing of Federal Reserve brakes and the running down of the economy is that the actions of the Federal Reserve System were deflationary neither in intent nor in effect. Chairman Eccles’s views have already been quoted. He and the members of the Board saw alike in wanting definitive reflation. Indeed, one governor, John K. McKee, was so doubtful that such a goal had been reached that he was the only dissentient from the January 30 action. For this reason the System tried to counter the March setback immediately. Having just treated the economy for an excess of funds, it proceeded to pump funds back again with another control weapon, an action which, while testifying to its surprise over the repercussions of the March 1 step, evidenced also its antipathy to deflation.

The effect of the reserve requirement action, moreover, was not to cause deflation. In testimony before the Senate Committee on January 4, 1938, Chairman Eccles explained how the System creates deflation: —

The way that the Reserve System would influence the use of credit on the part of the public, through the banks, would be to put the banks in a position where they had to borrow from the Reserve System in order to extend credit, and then the Reserve System could raise the discount rates; so that in effect the restraining action would have to be brought about largely by extinguishing any excess reserves, putting the banks then in a position where, if they extended credit, they would have to go to the Reserve System to get it, the Reserve System, in turn, raising the discount rate, so as to discourage the banks from borrowing from the Reserve System and, hence, discouraging them from making loans.

At no time during the experiments with the brakes were the affected New York City banks deprived of ‘excess’ reserves, or lendability. At the height of the bond selling they were down to fifty million dollars. But this was still a plus sign. And the Federal Reserve System quickly eased the position for them by using other weapons in its armory of accelerators which reëxpanded excess reserves. Nor were the New York banks scared into putting the screws on their customers. I quote Robert B. Warren, of Case, Pomeroy, and Company, in the 1937 annual review issued by the New York Sun: —

At no time was this tension so severe that the banks had any occasion to refuse sound commercial loans — indeed, during most of the period the customers’ loan rates in representative cities were progressively falling, as loan rates were more attractive to banks than the rates attainable on many types of government securities.

And there was no decline in the lendability of the banking system as a whole. Last year-end total money in circulation amounted to more than the total on August 15, 1936.

Mr. Warren, a leading authority on the banking system, points to two additional factors in explaining the March break. He speaks about interior bank repatriation of funds from correspondent banks in New York City because of the need for financing better conditions. Then he mentions the shortage of capital on the part of New York City banks. Both of these factors would explain New York’s liquidity preference at a time when its reserves also were being contracted.

As to the first point, the reasoning is prima facie; but the second, which has now become of great importance in view of the absorption of government securities expected of the banks under the new pump-priming programme, deserves examination. A sort of unwritten rule is that the ratio of deposits to capital should be ten to one. But in June 1937, according to information for which I am indebted to Mr. J. H. Riddle, economist of the Bankers’ Trust Company, the ratio was less than seven to one. Accordingly the deposits of the banks as a whole could have expanded more than twenty billion dollars on the basis of their existing capitalization before reaching a ten-to-one ratio. This shows a better position than Mr. Warren implies, and throws more importance upon the interregional shifts which were going on simultaneously with Federal Reserve action.

Still, the Federal Reserve action must have added its mite to the general longterm uncertainty. So that the braking of the Supreme Court of Money was badly timed. With the benefit of hindsight (we could all be good central bankers after the event) we may say that the testing of the brakes found the central bank wanting in two respects. First, the true inwardness of the banking situation seems to have been wrongly evaluated; and, secondly, the psychology of the business situation appears to have been miscalculated.

The prophecy of S. Parker Gilbert has been thrown into high relief by the events in early 1937. He questioned whether the method of changing reserve requirements was well adapted for use as a regular measure of control. In 1935 he said: —

The banks of the country, if they are to do business and respond to the needs of industry, agriculture, and trade, must know with some degree of assurance what their reserve requirements are. Otherwise it becomes inherently difficult for them to carry on their normal operations, and if the requirements are to be changed from time to time as a measure of control, the tendency will be to restrain their lending activities and perhaps create again an exaggerated device for liquidity.

More or less the same stand seems to have been taken by Governor McKee. With Chester C. Davis, he dissented in 1936 from the testing of the credit brakes. He was the lone dissentient in 1937. At that time he felt that some braking should be done, but that the implement to be used should not be the brake on bank reserve requirements. In post hoc evidence before the Senate Committee, Chairman Eccles agreed that the weapon was not ‘a flexible instrument’; for in the use of it there can be no particularizing among the banks according to the condition of their individual reserves. The braking in both 1936 and 1937, to be sure, was not done without a careful review of reserve conditions in general; and it was found on both occasions that reserves were well distributed. And yet the dumping overboard of bonds by the New York banks in March 1937 revealed border-line cases in New York City.

The lesson of the first ‘controlling’ done by the Federal Reserve System under its new setup is that this weapon of changing reserve requirements is illadapted to the American system of unit banks. It revealed once again, moreover, the structural weakness of the system of unit banks as compared with a widespread branch-banking system. Nevertheless, to judge from the new pumppriming announcement, the System intends to persevere with this weapon. On April 14 of this year the President himself said that the Federal Reserve Board would reëstablish the reserve requirements effective prior to May 1, 1937. This, with the desterilization of gold, would boost excess reserves to nearly four billion dollars, or by far the highest figure in history.

The brakes were used, furthermore, before it became clear to most observers that the pump had been primed. Colonel Ayres has lately evolved an index of confidence. Surely we have such an index at hand in the index of bank debits.

The annual rate of turnover of demand deposits in 101 cities, including New York, is given in the following table in percentages of the 1919-1925 average: —

By comparison, the rate of turnover in New York City in 1929 was 192.5, and in a hundred other cities was 124.8. In other words, the recovery rate of money turnover never recovered to more than half the 1929 rate! Clearly the chill has never been taken off the circulation of money since the Great Depression. That is as good a sign as any that the reflation of money did not reflate the confidence necessary before business could take over the responsibility of recovery from the pump primers. The notion that the money doctors nipped this confidence in the bud would be more tenable if that confidence had ever budded.

IV

No one cause is responsible for business depressions. Mechanistic causes in particular may be discounted in this very human field of economic activity. Surely this is obvious from the change of vocabulary that takes place when boom turns into slump. In booms we talk mechanistically about ‘controls,’ ‘brakes,’ ‘accelerators,’ ‘pump priming,’ and devices in general. As soon as a slump arrives, ‘depression,’ ‘hope,’ ‘confidence,’ ‘fear,’ are the chosen words — a sudden change from mechanics to psychology. Logically there must be psychological roots in booms as well as slumps. In economic society, as Professor Pigou says, there is ‘a certain measure of psychological interdependence,’ and when the border line between boom and slump occurs, there comes into play a ‘quasi-hypnotic system of mutual suggestion.’ A strike of capital, indeed!