How a Great Power Falls Apart
Decline Is Invisible From the Inside
THE policy of Central Banks, and the international implications of what they do, plainly have become matters of intense public interest during the past year -- and not, unfortunately, altogether in a manner to promote sound judgments and just conclusions.
In the United States the policy and performances of the Federal Reserve System have become the subject of controversy in financial circles, on the floors of Congress and in the press. The debate has been acrimonious and the System clearly has lost prestige. On the one hand, it has been accused of exercising arbitrary power in an attempt to depress the stock market; on the other, it has been criticized severely for following too timid and hesitant a policy. Congressmen have declared that our central banking system is being operated not for our own good but for the convenience of England; while in London one school of observers has declared that the Bank of England was forced to advance its rate because the Federal Reserve authorities would not act to control their domestic situation, and has asked, "Why should we be the catspaw that removes American chestnuts from the fire?" J. M. Keynes publicly regretted that the Governor of the Bank of England was unable (so he assumed) to persuade the Federal Reserve Board to reduce its rates during last February, and hoped that the Governor at least secured an understanding that American discount rates would be raised no further. At the very same time other Englishmen complained of a "lack of coöperation" by the Federal Reserve authorities in refusing to raise rates sharply and promptly in order to crush speculation and so bring a return of a more normal money market. Meanwhile, the Bank of England's stock of gold having been brought down close to the minimum, the Bank of France, because of its huge sterling and dollar balances, holds a whip hand over the London money market; and European central banks generally have been forced to advance their rates because of high call money rates in Wall Street. In addition, the reparations experts have envisaged a new bank for international settlements that shall provide better machinery for coöperation between existing central banks. Central banking is plainly a matter of acute international interest.
In approaching the subject we may do well to recount briefly certain fundamental changes in the situation that occurred during the war period. When the war closed the world had been forced off the gold standard. The United States had been transformed into a great creditor nation with a surplus of capital and the Federal Reserve System had been created and put into operation. The world-wide post-war inflationary wave, and the consequent deflation, gave the banking authorities of all countries an abundance of concrete financial problems that pressed for solution. The economists were busy with theories. Many of them, misreading the implications of the quantity theory of money, proclaimed, during the inflationary wave, that commodity prices were firmly established on a new and permanently higher level. These theorists were entirely discredited by the events of 1920 and 1921. Another school advocated premature revaluation of currencies. Others came out strongly for "managed currencies". They believed that central banks could and should control commodity prices. They advocated the abandonment of the gold standard and the stabilization of prices through regulation of the volume of money in accordance with the movement of statistical indices. Strongly opposed to the "managed currency" school were the realists who put their trust in the time-tried gold standard. The views of the realist group were re-phrased in the report of the Cunliffe Committee whose recommendations were followed in restoring specie payments in England.
Governor Montagu Norman of the Bank of England resolutely advocated the restoration of the gold standard, and found a ready collaborator in the late Benjamin Strong of the New York Federal Reserve Bank. These two, with the eventual aid of other central bank heads, labored steadily and successfully for the return to gold and are entitled to the gratitude of the world for their vision, wisdom and energy. They would have none of the "managed currency" doctrines. Actually they managed currencies during the period of restoration; but they did so in order to restore the gold standard and thereby reduce management of currencies to a minimum. They fought a "war to end war" of their own. They worked to restore the prewar situation in which free money markets were interrelated and correlated by the free international movement of gold. They labored to restore a situation in which central banking would be as nearly as possible automatic; in which the demand for and supply of credit in the various money markets would be regulated by the free play of money rates and the free movement of gold. They realized the shortcomings of human knowledge and judgment and put their reliance in the workings of the law of supply and demand.
The United States has the distinction of having been the first country to return to the gold basis after the war. With remarkable courage the Treasury Department raised the embargo on export of the metal on June 7, 1919. With praiseworthy fortitude it watched $400,000,000 worth of gold flow from the country in the ensuing twelve months. This action gave the world an excellent lead. One by one the important countries of Europe fell into line. What might be described as the spectacular climax of the program for restoration of the sound money basis throughout the world came in the last half of 1927. On July 29 the Kansas City Federal Reserve Bank reduced its rate to 3½ percent; and this action was followed by all the other regional banks within two months. In addition the system bought bills and government securities freely; by the end of the year it had increased the supply of its credit at the disposal of the money market by approximately $500,000,000. Under these circumstances a vigorous gold export movement was started that ran from September 1927 to June 1928, and resulted in a net outflow of approximately half a billion dollars worth of the metal. By this action the restoration of the gold standard in France and Italy was accelerated while the gold position of several other countries was materially strengthened. At the end of 1928, few of the principal countries of the world remained on a paper money basis. In this respect, the policy followed was a spectacular success. It must be noted, however, that what actually was secured in many of the countries was a gold exchange and not a real gold standard. It must also be noted that the large-scale injection of credit into our money market during the autumn of 1927 was a daring move and naturally stimulated activity in the stock market.
With the beginning of 1928 Federal Reserve policy was reversed. During January the System withdrew about $200,000,000 from the money market by the sale of securities. Discount rates were moved up from 3½ to 4 percent. Stock market activity slackened; the Reserve banks stopped selling securities and the Governor of the Federal Reserve Board made a reassuring statement before a Congressional Committee. The rest of the first seven months of the year was featured by a great revival of stock market strength and by two additional half-of-one-percent advances in discount rates. Brokers loans increased rapidly and the Board, inaugurating its "warning" policy, failed to achieve its ends. The firm touch of Benjamin Strong, soon to die, already was missed; and months were to pass before his capable successor was to be installed as governor of the New York bank.
In August another change of policy became apparent. The System, which had been trying, fruitlessly, to secure contraction, began to buy acceptances heavily. Before the year ended, one of its representatives told the bill dealers, in intimating that the Reserve Banks' ten-year subsidy of the bill market had ended, that in order to protect the bill market during the autumn the System had put credit into the market $100,000,000 in excess of commercial requirements. Naturally the bull party in stocks welcomed this assistance. The stock market rose to new high records and the Federal Reserve System ended the year extending credit aggregating approximately $1,900,000,000. This represented an increase of $300,000,000 during the year and was the largest amount of credit extended by the system since 1921. Clearly 1928 was a year of Federal Reserve failure. Aiming to secure a contraction of credit and a damping down of speculative activity, the authorities actually allowed their resources to be drawn on in even larger measure and at the same time had to watch the greatest year of stock market activity on record. Having lost the vigorous leader who had guided the System since the post-war inflation, the Board embarked on a futile "warning" policy which provided a convenient basis for attacks by the System's enemies and which invited controversy.
With the start of 1929 it was apparent that Strong's death and the delay in appointing his successor had furnished the Reserve Board, elements of which had been jealous of Strong's leadership, with an opportunity to exert authority which it, or some of its members, would not allow to escape. The "warning" policy was continued, with increasing ineptitude. In addition it became clear that the Board was not prepared to allow the Reserve Banks to employ the classic method of advancing discount rates to control the volume of credit. Instead it substituted a policy of "direct action" -- pressure on member banks to reduce existing loans on securities and to deny fresh loans of this kind. This policy apparently went so far as to indicate to member banks that they could not use the rediscount privilege if they were making call loans on securities. The Board apparently had persuaded itself, or a majority of its members, that it could keep money cheap for business and so keep business going up, and at the same time make money dear for the stock market and so make the stock market go down. A substantial liquidation in brokers' loans (which had increased approximately one and a half billion dollars in the last year), and a curbing of speculative activity, evidently were the objects of the policy.
Again the results were very different from those the Board anticipated. Literal application of its direct action policy in the Chicago district brought a one-day panic on the Chicago Stock Exchange that was reminiscent of Berlin's "black Monday" when the same policy was tried there, and sufficiently indicated the dangerous possibilities of the policy. However, credit was obtained from other sources and the situation at Chicago was restored. Meanwhile from the start of the year the System steadily reduced its holdings of government securities and acceptances purchased in the open market, confirming its abandonment of the ten-year subsidy in the bill market. This abandonment constituted the bright aspect of the situation.
The result of these developments was a fantastic call money market with rates fluctuating between 6 and 20 percent, and a time money market with rates rising higher than at the peak of the post-war inflation, although the reserve ratio of the Federal Reserve system stood at approximately 75 percent as against about 40 percent at the earlier period. Another result was a severe strain on the foreign exchanges. This forced a general rise in foreign bank rates and started an influx of gold which resulted in a net gain of some $145,000,000 during the first five months of the year. Indeed the effects of the deflationary policy were more disconcerting to foreign money markets than to the stock market, which after suffering a sharp break when 15 percent call money first appeared rallied back to fresh high levels, although, when allowance is made for new listings, on a diminished volume of trading. The high call money rates proved far more damaging to the foreign exchanges than higher rediscount rates would have, and attracted capital to the call money market from all over the country and from foreign countries. As for brokers' loans in New York City, a moderate decline of $368,000,000 in March and April was followed by fresh advances that brought the mid-May total back within $228,000,000 of the peak. Meanwhile trade and profits in industry reached record proportions and a pretty clear demonstration was had of the fact that the stock market cannot be counted on to decline because of high call money as long as business continues on the up-grade. The System did succeed in reducing the volume of its credit employed by about $700,000,000 during the first five months of the year. Although part of this contraction was seasonal, by mid-May the volume had been brought down to about $1,200,000,000 or to approximately $200,000,000 less than that of mid-May, 1928, and to about the average level, since the post-war deflation, for that time of year. But it failed to drive down stock prices or to obtain any substantial liquidation in brokers' loans.
An interesting and important question raised by the experiences of the past spring is that of the scope and seriousness of the disease which our credit doctors have set themselves to cure. No one claims that the disease, or supposed disease, involves anything but the stock market. Admittedly there is no inflation of commodity prices, no loss of efficiency in industry, or any other convincing signs of the business congestion which indicates the approach of a crisis. Business admittedly is in a remarkably healthy condition. With regard to criticism of the stock market, there is on the one hand the quick assumption that the large increase in brokers' loans in New York City is a reflection merely of an unprecedented increase in speculative activity on the Stock Exchange, with its corollary that the high call money rates are purely a result of that speculation. This school of thought is greatly impressed with the magnitude of the rise in stock prices as suggested by the movement of spectacular individual stocks and by the "averages." It considers self-evident the proposition that there is no longer any rational relationship between stock prices and underlying values. It refers positively to a "diversion" of credit from business to speculative purposes.
On the other hand it is pointed out that the increase in brokers' loans in New York represents to a considerable extent a rapid increase in listings of additional securities on the New York Exchange; and it is a fact that in four years the number of shares listed has increased 50 percent. This, it is held, corresponds to a legitimate change in the ownership of American industry and in the method of financing it. It also is pointed out that another part of the increase is due to whatever justified advance in prices has occurred because of the striking growth in size and earning power of American enterprises during the past several years. As for the rise in stock prices, it is pointed out that the movement of the "averages" is somewhat misleading because they are heavily weighted with "leading" stocks that have risen much more than average; in fact, the president of the Stock Exchange has stated that if all listed shares are taken, the average share increased in price only 18 percent in 1928 and only 66 percent in the four years 1925-1928. With regard to the relation between prices and values, it is pointed out, and with considerable justification, that the critics know little about values -- that they have made little study of values of shares of individual enterprises. As for a diversion of credit to speculative purposes, the reply is that no commercial demands have gone uncared for and that it has been the relative lack of commercial demands for credit that has supplied brokers' loans with an opportunity to act as a safeguard in providing safe employment for surplus funds and so of avoiding the more dangerous inflationary possibilities involved in the great expansion of Federal Reserve credit in the autumn of 1927. As for speculative activity being responsible for the rise in money rates, defenders of the stock market declare that it is the Federal Reserve System's contraction of credit and its discrimination against stock market collateral that is responsible.
Just where the truth lies in this matter is difficult to determine. An impartial and scientific examination of the various aspects of the problem still seems to be lacking. The extravagant claims of some of the "bull" operators are foolish. On the other hand, some of the Federal Reserve pronouncements reflect a strong bias or even resentment over the System's failure to have its way, while some seem propaganda more than reasoned statements of facts. Other critics of the market have introduced a moralistic note into the discussion which fails to recognize the economic functions of speculation and which assumes that speculation in stocks is on a lower plane than that in real estate and other forms of business. However, most well-informed persons agree that the question of the height of stock prices is not of evidential value in fixing banking policy. The prime criterion is whether or not there is a dangerous absorption of credit in speculative loans, or an absorption that is detrimental to general business.
On this point the evidence is not conclusive. The mere fact that brokers' loans placed in New York City have risen sharply leaves the question open, as it fails to take account of transfers of loans from other districts to New York when new shares are listed and of the change in the method of financing American business in favor of stock issues. The argument really comes down to the claim that there is too much money in brokers' loans rather than that business is being deprived of funds. It is admitted that the member banks as a whole have not been diverting their funds to the call money market; the year's increase in brokers' loans is almost entirely accounted for by the increase in the money placed in the market for the account of "others." In fact, the member bank statements do not furnish evidence of inflation. Perhaps the best-sounding argument that has been advanced by the critics of the situation is that the increase in brokers' loans represents money that would have been deposited in the banks and money against which no reserve is required. But the idea that these brokers' loans are a potential bank liability is not a convincing one. The president of the Stock Exchange maintains, and some bankers join in the view, that the new money in brokers' loans is capital as distinct from bank money. The president of the Exchange also maintains stoutly that the brokers' loans are financing industry as truly as any other form of loan. In any event, it seems clear that the official policy of discriminating against brokers' loans, with the resultant high rates for call money, has served to attract funds to this market from all over the world.
Judging from the behavior of the stock market itself, one would conclude that the extent and seriousness of current speculation has been exaggerated by its critics. The market has been subjected to severe tests both in the way of high money rates and of sharp declines (as on the 8¼ million share day of last March); and has acquitted itself well. A tendency to disorderly liquidation, such as would be expected if there was a preponderance of ignorant and weakly-protected speculators, has been noticeably absent. Quick reactions involving considerable declines in prices have not brought on continuing liquidation but have been followed by a diminution of activity and a tendency to rally. As a matter of fact, brokers have lifted their margin requirements for customers progressively during the last year or two until they are now at relatively high levels. Thirty percent is now a common general requirement and fifty percent is required on the leading speculative issues. These increased requirements correspond to the very conservative margins that banks now require from brokers on their call loans. Whatever its size, the present speculation probably is the best-backed one in our history.
Even more important than an exact understanding of the existing situation is a clear conception of what does and what does not constitute sound central banking policy -- both as to aims and as to methods to be employed in controlling credit.
Certainly the "warning" method of attempting to control credit has proven a complete failure during the past year. The result is not surprising because in theory the method has little to recommend it and much to condemn it. As employed by the Federal Reserve Board it has consisted partly in speeches by officials and partly in the issuing, as press releases and with more or less preliminary publicity, of extracts from essays on credit conditions contained in forthcoming numbers of the Board's Monthly Bulletin. Neither the speeches nor the essays have had much to recommend them as regards clearness of thought, consistency or point. Instead of contributing to the System's prestige they have decreased it. Meanwhile these speeches and essays have "written a book" and so provided the enemies of the System, and the demagogues, with a convenient record on which to base attacks. They have helped greatly to make the System and its operations a matter of public controversy. They have been and are likely to continue to be an embarrassment to the System. One cannot escape the conclusion that the way to conduct a banking business is through banking operations -- by the management of discount rates and portfolios -- and not through the newspapers. An excellent example to follow is that of the Bank of England, which goes quietly about its business, acting vigorously when necessary and never talking in public. One is tempted to say that in central banking, as in many other fields, "silence is golden." The publication of comprehensive statistical statements of fact bearing on the condition of finance and trade is well within the functions of central banking authorities; but the drawing of inferences from these facts in public would better be left to others.
The "direct action" policy of the Reserve Board is as unsound as the "publicity" policy and raises much more dangerous issues. Reference has been made to its panic-producing possibilities. If applied vigorously enough it could precipitate a stock market panic of first-rate proportions. It cuts squarely across the principle that money should always be available -- at a price. It substitutes the principle, as far as stock exchange collateral is concerned, of no money at any price. It destroys the right that goes with the ownership of property of being able to borrow on that property. Nothing like it was contemplated in the framing of the Federal Reserve Act. The power it represents is a most dangerous one to be assumed by a politically-appointed board. In addition, it discriminates against one of the most liquid forms of bank investment. And, as a practical matter, it has failed to achieve the end sought -- the liquidation of brokers' loans. This attempt to starve out the stock market has failed because the high rates forced in call money have attracted capital from all over the world. It also has failed because business has maintained so high and profitable a rate of activity -- which is the other object that the Board had in mind. Not until the end of May, when misgivings began to be felt as to the business outlook, and when weakness in farm products had become acute, did the share market show vulnerability.
This experience with the "direct action" policy confirms the classic theory that central banks can best exercise a useful influence by applying their efforts to control the total volume of credit, and its price, rather than by trying to control its distribution. Money and capital are too fluid, and human judgment is too fallible, for a central banking organization to be able to direct the relative flow of funds into the different branches of business. The law of supply and demand and the natural processes of adjustment and compensation would better be left to perform that function. The idea of attempting to make business and stocks move in opposite directions is an artificial and unworkable one. It may arise from a disposition to be too considerate of business, or from a bias against the stock market, or from both. If business activity and profits are high, and if signs of a business recession are not apparent, strength in stocks must be expected. On the other hand if speculation really is excessive, there is a presumption that the pace of business is very rapid and that a higher price for money and for business purposes is in order. Under normal gold standard conditions, as business becomes active money naturally becomes dearer and finally acts as a curb on both the stock market and business, producing the cyclical recessions that have a purging and cleansing effect on both. The net conclusion is that our central banking authorities would be well advised to go back to first principles and use their discount rates and portfolios if bank resources are being unduly drawn on and credit abused.
However, granting that the discount rate policy embodies the correct method of credit control, the question of when and how sharply rates should be advanced remains. For example, during the past winter one wing of the discount rate protagonists was positive that rates should be jumped progressively and quickly to 8 percent or higher, if necessary, in order to bring down the stock market and secure liquidation. The theory was that a sharp quick purge would kill off speculative spirit and so permit an early lowering of discount rates and a return of cheap money. In reply to the suggestion that a major liquidation seemed unlikely unless business declined, this school held that in such an event rates should be put up until business suffered. To take this attitude would seem to imply a great deal of confidence in one's own knowledge and judgment. It implies that one knows, even in the absence of unhealthy symptoms in general business and of encroachment on bank reserves (the System's ratio was fluctuating around 75 percent), that the time had come to give the country a set-back. It is reminiscent of the attitude of the advocates of managed currencies.
A more natural and reasonable method of managing the discount rate would be to move it up with reference to the demands for Federal Reserve credit. Thus as business became more and more active money would tend to become firmer and demands for Federal Reserve credit would increase. Under those circumstances the Reserve banks properly would lift their discount rates in accordance with conditions in the open money market and to prevent their resources from being drawn on unduly. In this fashion they would retain control of the money market -- which is something they have failed to do under the policies of the past year. They would also free themselves from the danger inherent in attempts to make money inordinately cheap for business and so of promoting an unnatural expansion of business, which is the thing that promotes unreasonable speculation.
In addition, it is highly desirable that the Board abandon its attempt to initiate and direct the policies of the System. The Board should realize that its proper function is that of a supervisory and regulatory body to review the actions taken, after due deliberation, by the directors of the Reserve banks. The Board should leave to the Reserve banks, which are familiar with local credit conditions and which are conducting banking operations, the initiative as to the appropriate measures to be taken to control credit in their districts. It should withhold approval of changes in rates voted by the directors of the regional banks only with the greatest hesitation and reluctance. If the Board were to continue its attempt to dictate the operations of the Reserve banks, which the Federal Reserve act designed as autonomous institutions, the directorates of the banks might as well be abolished and the System frankly recognized as a highly centralized organization operated by a politically appointed board at Washington. Most of the troubles of the past year have, in fact, arisen from the Board's assumption of active authority over the Reserve banks and from the unsound and meddlesome policies which it has adopted. The principal banks themselves have displayed a capacity for sound leadership that has been thwarted by the Board. A return to the normal function of the Federal Reserve System and to the classic policies of central banking should resolve any present difficulties.
In reviewing the international activities and influences of the Federal Reserve System since the war, we find that in the first instance they were to the highest degree constructive. The sound principle of the gold standard was adopted and a great coöperative effort was entered upon to put the gold standard in operation throughout the world. Effective aid was extended to foreign countries that desired to return to gold payments. At the same time the position of the United States as an exporting country was improved. As for the credit expansion of the autumn of 1927, it was at its worst a well-intentioned mistake; at its best it was an exaggeration of a proper effort to hasten the normal course of economic events. Quite possibly the wiser policy would have been to wait until Europe was able to command the gold through the equation of exchange. The point is debatable.
The hesitations and the further credit expansion of 1928 were misfortunes from both the domestic and international standpoints; they illustrate the dangers inherent in unsound policies. During the present year there has been an unfortunately distracting concentration of attention and energy upon the struggle between the Reserve Board and the Reserve banks over policy and upon the campaign against brokers' loans and the stock market. While occupied with these issues, the System has been withdrawing credit on a scale comparable to that of the 1927 expansion. The total volume of credit extended by the Reserve banks in mid-May was, we have seen, $700,000,000 (or 37 percent) smaller than at the close of 1927. What is even more pertinent, it was $200,000,000 smaller than in mid-May a year before, and this despite the fact that business was considerably more active than at the earlier date.
This is deflation. Its effects are seen in the imports of gold, which have not had their normal effects because of the deflationary policy, and in the behavior of the foreign exchanges. Recent marked weakness in commodity prices probably also is more than a coincidence. One cannot help wondering how far the authorities intend carrying this deflationary policy. If it is the Board's intention to retrace all the ground covered in the autumn of 1927, further downward revision of the domestic general price level and further gold imports seem inevitable. Such an inflow of gold would be precisely what the Federal Reserve authorities two years ago set out to reverse. Continuance of the deflationary policy also would restrict further our granting of foreign credits, which aid in the reconstruction of Europe and stimulate our export trade, and would place additional strain on foreign money markets and so curb world trade. Bearing in mind the great international settlements left in the train of the war, such as reparations and Allied debts, an active deflationary policy in the United States certainly seems ill-suited to the needs of the world. In addition, a large-scale injection of Federal Reserve credit in 1927, to be followed by an equal deflation in 1929, cannot be regarded as a contribution to stability in world finance and trade. Such a performance would put the Federal Reserve System in the position of rushing from one extreme to the other and of exaggerating instead of diminishing the fluctuations in financial and business activity. It may be hoped that the authorities will keep in sight the broader aspects of the problem; that they will not be unduly distracted by the emotional reactions raised by the stock market and brokers' loans controversies; and that control of the money market will be regained through a transition to a sound rate policy unaccompanied by further deflationary activity.
And, finally, one may hope for a general return to the real gold standard as distinct from the gold exchange standard, and so to that more nearly automatic working of central banking machinery which will relieve central bankers of their present excessively heavy responsibilities and which will diminish the dangers arising from the fallability of human judgments.