The 1920s were years of growing prestige for the Federal Reserve System. Table 22.6 shows that after the sharp but brief recession of 1920-1921, the economy advanced smoothly. Real income rose steadily year after year, as did the stock of money. Prices for the most part were stable.
What influenced the Fed’s policy during these years? Surprisingly, one fact that did not influence policy was the large number of bank closings. Suspensions numbered in the hundreds each year, reaching a peak of 975 banks in 1926. The Federal Reserve concluded that these banks (mostly small banks in rural areas) were plagued by bad management, unrealistic loans to farmers made during the war boom, and increased competition due to the rise of the automobile. (The automobile increased the ability of borrowers and depositors to shop for favorable terms.) It followed that simply allowing these banks to close strengthened the banking system as a whole. Although it is difficult to imagine the Fed taking such a callous position today, its analysis probably contained a good deal of truth. Unfortunately, this policy was carried into the 1930s when high numbers of bank failures under very different economic conditions undermined confidence in the banking system.
An important series of papers by Eugene White (1981, 1984, 1986) clarified the nature of the weakness in the rural banking system and its role in the breakdown of the banking system in the early 1930s. To a large extent, the problem stemmed from legislation that prohibited branch banking. Small unit banks were unable to diversify their loan portfolios and had no resources to draw on during periods of temporary illiquidity. The states tried various deposit insurance schemes to protect their systems, but these ended in failure. Eventually, most states began to eliminate crippling prohibitions against branch banking, but by then the damage had been done, and it was too late to build a system that could withstand the deflation of the 1930s.
The Fed, however, was deeply concerned about the growing speculation on Wall Street. Brokerage houses were lending money to their customers so they could buy stocks, and the brokerage houses were in turn borrowing from the banks in the form of call loans—loans that had to be repaid on demand, that is, when “called.” Speculation, the Fed believed, diverted capital from more productive investments, and the inevitable retrenchment might cause widespread disturbances in the economy. But it was not clear how to slow the flow of funds to the stock market without simultaneously restricting the total supply of credit, thus risking a recession. At first, the Fed tried “moral suasion,” pressuring the New York City banks into making fewer call loans. This policy was partly effective, but other lenders quickly moved into the gap left by the banks. Finally,
Frustrated by its inability to cool the market in any other way, the Fed raised its discount rate from 4.5 to 5.5 percent on August 9, 1929. The discount rate was still well below the call loan and other bank lending rates, so the increase itself did not remove the incentive to borrow, but it did signal the Fed’s intention to restrict the supply of credit. Other central banks were taking similar actions: The Bank of England raised its discount rate from
5.5 to 6.5 percent in September. Perhaps as a result of these widespread harbingers of tighter credit, American stock prices reached their peak early in September. The exact role of the Fed’s policy in subsequent events is a matter of considerable debate, as we will read in chapter 23. During the 1930s, however, the Fed was given the power to set margin requirements on stock purchases because it was recognized that the Fed’s monetary policy had been distorted in the late 1920s by its efforts to control the stock market.
World History
