>>Why do you believe that?<<
This speech by Allan Meltzer gives a good overview of the policies that guided the Federal Reserve in the 1920's and 1930's - start with page 5. He's been doing research in the Fed's archives. He discusses the high real rate of interest after the Crash. Excerpt:
>>The Federal Reserve refused to follow gold standard rules if
they required inflation. Instead of letting gold inflows raise prices, it, too, followed deflationary
policies. The Treasury ran budget surpluses equal to about 20% of tax revenues. The Federal
Reserve ran a tight monetary policy. U.S. policy tried to achieve two incompatible objectives: a
stable price level and stable exchange rates. It failed on both counts.
French and U.S. policy misjudgments and failures to inflate are only part of a fascinating
episode in monetary history. Another major part is the stock market and economic boom in the
second half of that decade. The Federal Reserve believed the 1920s stock market boom was
inflationary. (This sounds too much like current Federal Reserve statements for comfort.)
Unlike the 1990s, their reasoning reflected the strong hold of the real bills doctrine.
As many central bankers, bankers, and economists saw the problem, productive credit---
discounting real bills that financed trade and production---could not cause inflation. Inflation
was caused by the financing of speculative credit--the stock market, government bonds, and real
estate mortgages are examples. These assets are not self-liquidating in the short-term. Wars
financed by debt are inflationary, under this doctrine, because credit expands without any change
in production. Notice that it is not the increase in money that matters; it is the increase in credit
not matched by an increase in output.
The U.S. stock market boom in 1928 and 1929 seemed to fit this description. Most
remarkable for me is the intense concern about inflation with the U.S. price level falling
modestly, but falling nonetheless. The real bills proponents at the Federal Reserve knew that the
price level was falling, but they did not believe that inflation was a problem of prices and money;
it was the use of credit for speculative purposes that mattered most. This was evidence of future
inflation.
All Federal Reserve officials did not share this view, but most did. The main exceptions
were at the New York Reserve bank. Benjamin Strong, the New York Governor, one of his
deputies, W. Randolph Burgess, and a few others had recognized earlier that (1) they had no way
to control the composition of credit, and (2) the composition of credit was less important than its
volume. Unfortunately, they measured monetary ease or restraint by the volume of member
bank borrowing. They interpreted large borrowing as easy, low borrowing as restrictive.
Borrowing adds to reserves so, on this set of beliefs, higher reserves resulting from increased
borrowing is evidence of monetary restriction.
Note the peculiar reasoning. Increased borrowing, cet. par., increases the monetary base;
repayment of borrowing lowers the monetary base. The officials, at the time, ignored the
monetary base. Monetary base growth showed no evidence of inflation. On New York's
interpretation of borrowing, monetary conditions were easy; using growth of the base, policy was
tight. The decline in the base was mainly the result of open market sales by the Reserve banks,
supplemented by a loss of gold during a few months of 1928.
There was intense controversy within the Federal Reserve System. Real bills proponents
wanted banks to restrict speculative credit for the stock market, but they opposed an increase in
the discount rate because that would reduce productive credit. Perhaps in their minds, also, was
the political controversy set off by the discount rate increases in 1920-21. They did not want to
repeat that experience or to arouse the populists in the Congress and the country.
On the other side were those who wanted a higher discount rate to reduce bank borrowing
at the Reserve banks. We would regard that as a more restrictive policy, a policy that would lead
to further deflation.
The correct policy under gold standard rules was to reduce the discount rate so that
money and credit would expand as gold flowed in, especially in 1927, 1929, and after.
There are two additional surprises about policy in this period. First, no one in authority
proposed allowing gold inflows to increase prices, as required under gold standard rules.
Second, no one distinguished between real and nominal rates, an important distinction with
prices falling. Even when prices fell by 10% a year or more in the early 1930s, no one
mentioned the effect on real rates. Irving Fisher was alive and active at the time, but I have not
found that he insisted that real rates were high. Later, he urged reflation, particularly in the
1930s, to restore the price level to its previous level.
The rest of the history of this period is, I think, well known. The Federal Reserve raised
the discount rate in August 1929, the very month that the National Bureau of Economic Research
calls the peak of the expansion. Germany and the U.K. were in recession, a consequence of their
own deflationary policy under gold standard rules. This was the start of the Great Depression.
The Great Depression did not break the intellectual hold of the real bills doctrine. I will
recount two anecdotes to show how doctrine affected policy.
The first occurred during one of the few attempts to expand growth of money and credit.
Several of the Reserve bank Governors opposed. One explained that an expansive policy not
backed by real bills would increase credit when business did not need it and would require a
reversal when they did. This was only true on real bills logic.
The second event was an attempt by Irving Fisher, in 1930, to convince Governor Eugene
Meyer of the Federal Reserve Board to expand money. Fisher told Meyer that demand deposits
had fallen. Meyer asked: What are they? He was so uninformed about money, he did not know
the principal monetary aggregates.<<
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