Between 1929 and 1933, the Federal Reserve System,
which is the central bank of the United States, monetarily starved the
country into the worst economic crisis it has ever experienced. Markets,
and the market system generally, did not fail, and nothing was
inevitable about the collapse that occurred. Rather, the monetary system
was so mismanaged that even a healthy and vigorous market system could
not correct the disequilibrium that resulted.
The popular application of "market failure" to describe
the economy during the years of the Great Contraction, 1929-1933, is
wrong. Market actions in that era made the politically inspired crisis
less severe than it otherwise would have been. Furthermore, "market
failure" is a term people often apply to events when they cannot
understand the complexities of economic processes that result from
illconceived government policies. The operations of just about any
monetary system, and especially one with a central bank, are always
puzzling to the layman. Consequently, when things go wrong owing to
monetary mismanagement by central bankers or some other political
intervention, the instigators can ring in "market failure" as an excuse
for their personal failures to make the right decisions.
Failure in other aspects of human endeavor often
generates learning that subsequently leads to correction and eventual
success.1Federal Reserve policy failure in 1929-1933,
however, led only to federal legislation that increased the number and
power of federal government agencies. The Republican Hoover
administration, for example, initiated the expensive Reconstruction
Finance Corporation in 1932 to carry out lending policies that the
elaborately structured Federal Reserve System had failed to undertake.
The Roosevelt administration then took control of the political
machinery in 1933 and began a program of federal intervention and
bureaucratic propagation that is mind-boggling even today.
Two items of Roosevelt-era legislation markedly
affected the U.S. banking and monetary system. The first was the
so-called Gold Reserve Act of 1934. This legislation gave the president
the unconstitutional power to call in all privately owned gold for
deposit in the U.S. Treasury. It also gave him the unconstitutional
power by his fiat to revalue the price of gold (devalue the dollar) by
as much as 60 percent.
Congress's constitutional power to "regulate the value
of money" was a power that could not be delegated to the executive.
Furthermore, "regulate" did not mean a massive change in the monetary
values of either gold or silver. Its sole purpose was to provide a means
for congressional housekeeping control over the coinage system. Properly
used, it allowed Congress to make incremental changes in the legal
tender value of either gold or silver so that both metals would stay in
circulation. It was put into the Constitution to counteract Gresham's
Law. Otherwise, changes in the market value of one or the other metal
would result in what had now become the cheaper metal going to the mint
and the other, dearer, metal going into the markets as a commodity.
2
A New Central Banking Measure
The other piece of legislation, the Banking Act of
1935, was more momentous than the original Federal Reserve Act passed in
1913. In fact, the Act of 1935 might better have been labeled "The
Central Banking Act of 1935," because it virtually rewrote the earlier
Act.
A central bank, like a gold standard, can assume many
institutional forms that differ markedly from one another. The 1913 Fed
Banks, for example, were regionally autonomous; the Board in Washington
was relatively powerless. Board members were treated and paid on a scale
similar to government employees in the US. Treasury, while the
presidents of the regional Fed Banks commanded salaries comparable to
those of executives heading major corporations. The Fed Banks' gold
reserves severely restricted their lending policies, as was proper under
an operational gold standard. Finally, the real bills doctrine was
supposed to furnish the grounds for Fed Banks' accommodation of credit
to their client member banks.
The Banking Act of 1935 changed the whole paraphernalia
of monetary control. It vested the Federal Open Market Committee (FOMC)
with complete discretionary control to determine the stock of money in
the United States. Regional Fed Bank presidents still had five of the 12
seats on the FOMC, but the Board was now a seven-man majority. From that
time on, the FOMC has fashioned monetary policy by authorizing the
purchase (or sale) of U.S. government securities in the open market, an
operation that the Fed Bank of New York conducts week by week.
When the FOMC buys the U.S. securities that the
Treasury has previously sold to pay the government's bills, it does so
by creating money. This new money is either commercial bank reserves or
Federal Reserve note currency. Clearly, if a 12-person board is
determining the quantity of money that exists, the quantity of gold in
the system has little or nothing to do with the money. Either a gold
standard specifies the quantity of money in the economy, or a central
bank does. A marriage of the two never lasts longer than an unhappy
weekend.
The Gold Reserve Act of 1934 was the final divorce
decree between gold and the monetary system. After January 31, 1934, no
private household, bank, or business was allowed to own or hold more
than a trivial amount of gold. Gold coin was forbidden for monetary
purposes. This Act also authorized the president, Franklin Roosevelt, to
raise the price of gold by 60 percent. Roosevelt, however, did not use
all the power given him only 98 percent of it. In early 1934, he
increased the official mint price of gold, which had been $20.67 per
ounce for 100 years, to $35 per ounce. The Treasury gold stock, valued
at $4,033 million in January 1934, became $7,348 million in February
1934, an increase of $3,405 million by the decree of one man.
3 The federal government had also, unconstitutionally,
repudiated all gold clauses in its contracts and debts, so it did not
have to share any of its newfound wealth with the private sector. In one
month Congress and Roosevelt, by their legislative and administrative
fiats, created seigniorage revenue from gold equal to one year's
ordinary tax revenues. In contrast, the federal government of 1834-1837,
when it realized one year's extraordinary revenue from land sales,
returned that surplus to the state governments to be used or distributed
as those sovereign governments saw fit. 4
President Roosevelt rationalized this usurpation of
private property rights in gold in one of his notorious fireside chats.
"Since there was not enough gold to pay all holders of gold
obligations," he claimed, "the Government should in the interest of
justice allow none to be paid in gold." 5
This rationalization of government confiscation was
fatuous pretension. Gold in banks was then and had always been a
fractional reserve against outstanding obligations. When the banks were
on their own, they had adequate means to protect their reserves-gold,
silver, or other legal tender. The Fed Banks and the U.S. Treasury -
government institutions - also held only fractional reserves against
their outstanding currencies. Use of gold as a recognized fractional
reserve always precluded immediate liquidation of all monetary
obligations into gold. So in effect Roosevelt was saying, "Since there
was not enough gold to pay all holders of gold obligations, . . . the
federal government should expropriate and keep all of the gold."
The increase in the dollar price of gold, though other
countries had gone off the gold standard or had also raised the price of
gold in their own currencies, started a massive inflow of gold to the
United States. Political apprehension in Europe and elsewhere also
contributed to the U.S. accumulation. By 1940 the US. gold stock totaled
$20 billion, or almost 20,000 tons! The contrast was notable between a
government awash in gold and a depressed economy denuded of money and
functioning with a shell-shocked banking system.
Fed Banks and the Treasury still accounted new gold
coming into the U.S. system as though the gold were a monetary asset.
The Treasury issued "Gold Certificates"- currency notes in $100,000
denominations accounted at the new gold price of $35 per ounce, which it
"deposited" in Federal Reserve Banks. Fed Banks then debited their
"Treasury deposit" liability account, and credited their "Gold
Certificates." Whoever had received a check for the gold from the
Treasury, however, had by now deposited that check in a commercial bank
that in turn sent it to the Fed Bank for clearance. The Fed Bank cleared
the check against the "Treasury deposit" account and debited the deposit
reserve account of the client bank by the same amount. No one could get
the gold out of the Treasury, or touch it, or see it, or use it. (It was
now a criminal act to use gold for monetary purposes!) Nonetheless, the
gold provided an accounting medium for increasing the basic money stock
of bank reserves and Federal Reserve note currency.
The Treasury in Control - The Fed Plays Ball
With all of the new gold coming into the system, the
FOMC did not need to use its newly legislated powers. From 1933 to 1936,
the M2 money stock grew at annual rates of 9.5, 14.0, and 13.0 percent.
6 In fact, so much gold was coming into the Fed-Treasury's
coffers that sentiment in both the Fed and Treasury leaned toward
monetary restriction.
The Fed had active hands-on control of monetary policy.
Not only did it have the power to initiate open-market operations in
government securities through the FOMC, but the Banking Act of 1935 also
gave the Fed Board extensive control over member bank reserve
requirements. Prior to the Banking Act, reserve requirements were
statutory at 7, 10, and 13 percent-not based on the size of the bank,
but on the size of the city in which the bank was located. The larger
the city the higher the legal reserve requirement. 7 The
Banking Act of 1935 used the existing set of reserve requirements as the
lower end of a new range of requirements: 7-14, 10-20, and 13-26
percent. Board of Governors' decisions in Washington were to specify the
precise set of requirements in force at any time. Thus Fed policy could
be restrictive by mandating an increase in requirements. 8
Banking Act or not, the Treasury was still very much in
the monetary picture. Treasury Secretary Henry Morgenthau, Jr., had
recommended to President Roosevelt the appointment of Marriner Eccles to
be chairman of the Federal Reserve Board. Eccles outspokenly favored
lots of federal spending and fiscal budget deficits. By his stance, he
effectively signed over monetary policy to the Treasury. (Morgenthau had
recommended Eccles for this reason.) The upshot of the arrangement was
that Morgenthau ran the show. Both men favored a dominant fiscal policy
that had Federal Reserve support. Although the new Banking Act took the
secretary of the Treasury off the Fed's Board of Governors (he had been
the ex officio chairman), he now had a surrogate as chairman. He was
more than satisfied to see his purposes served from behind the throne.
Even a surrogate position was not enough for
Morgenthau. The realized seigniorage from the gold devaluation had given
the Treasury a $2 billion windfall, accounted in an Exchange
Stabilization Fund, that the Treasury was supposed to use to "stabilize"
the dollar price of foreign currencies. The Treasury thus had a gold
"position" and license for conducting gold policy.
Federal Reserve policy directed the first increase (50
percent) in reserve requirements in August 1936-from 7, 10, and 13
percent to 10½, 15, and 19X percent. A few months later the Treasury
initiated its own gold sterilization policy-the same policy the Fed had
fostered in the 1920s. Its purpose was "to halt the inflationary
potentialities [sic]" of all incoming gold. Beginning December 22, 1936,
the Treasury placed its gold purchases in an "inactive" account, Instead
of issuing gold certificates and depositing them in Fed Banks to raise
the necessary credit balance to pay for the gold, the Treasury paid for
the gold by selling government securities in financial markets. By this
means, it carried out its own open market operations - sales in this
case - with its own "FOMC." This way the gold remained stockpiled but
unnionetized in the Treasury.
Besides neutralizing the gold inflows, the policy was
further deflationary because it brought more government securities into
markets to compete with consumers' and investors' dollars. It thereby
tended to raise interest rates as it inhibited general spending. In
March and May of 1937, the Fed complemented this generally deflationary
policy by increasing reserve requirements to the maximum allowable
percentages: 14, 20, and 26 percent. Fed-Treasury policy makers had
acted deliberately and purposively. They believed in human management of
the monetary system. Just before he was appointed Fed chairman, Eccles
had boldly stated that the Fed should "support expansionary fiscal
policy through discretionary monetary policy." 9
Unfortunately, the discretionary monetary policy now being practiced was
anything but expansionary. It was, in fact, extremely repressive.
Unprecedented Depression
However, the rest of the economy, unlike politically
prosperous Washington, was moving at an unprecedentedly slow rate. Never
before had a recession-depression been so tenured or so intense. By late
1936 business was picking up, but the price level was still 18 percent
below its 1929 value, and unemployment was still 16 percent of the labor
force. Nonetheless, the great concern in the Treasury and Federal
Reserve was the danger of inflation! Fed and Treasury officials looked
at the overhang of excess legal reserves in the banking system and
imagined what would happen if the commercial banks expanded all those
reserves into an avalanche of checkbook money. Monetary mismanagement
had just provoked the most disastrous hyper-deflation in history. Yet,
before all the foreclosures had been properly settled, the government's
monetary managers were contriving to counteract the inflationary
potential that they had systematically built into the monetary
machinery.
Secretary Morgenthau announced in a press release,
dated December 20, 1936, that Treasury gold policy was coordinated with
the Fed's reserve requirement increases.10 By mid- 193 7
"inactive" gold in the Treasury was $1,087 million, or about 9 percent
of total Treasury gold.
Meanwhile, the banking system and the private economy
foundered in a new recession. If one were to write a script that
chronicled the end of free-enterprise capitalism, the events of
1929-1938 would logically serve the purpose. Since few people understood
the nuances of Fed-Treasury monetary policies, the common perception was
that the Recession of 1937-1938 posed yet another failure of the market
system. Dozens of tracts, novels, plays, and newspaper editorials
reflected this notion.
The appearance of the depression-recession evidently
convinced Morgenthau that the "danger of inflation" was passed. In
September 1937 he released $300 million of gold from the inactive
account thereby restarting the machinery of gold monetization. Gold
certificate accounts at Fed Banks responded and gave rise as usual to
increases in monetary base items in Fed Banks' balance sheets. Finally,
on April 19, 1938, Morgenthau announced the discontinuance of the
inactive gold account altogether.
The time span of the Treasury's gold policy was 16
months-December 1936 to April 1938, while the Fed's reserve requirement
increases occurred in August 1936 and March-May 1937, and continued in
force with little change until after World War II. Treasury policy cut
off new gold at the initial point of monetization; Fed policy
effectively smothered the money-creating potential that old gold had
already provided. For the next three years the economy stagnated. By
1941 the price level was still 14 percent below its 1929 value, and
unemployment was still 10 percent of the labor force. Treatises appeared
analyzing "the stagnant industrial economy." The Keynesian notion of
less-than-full-employment equilibrium seemed documented beyond
reasonable doubt.
Fed-Treasury methods in the mid-1930s reflected the
prevailing notion of the times - that someone had to run the show, that
operations without the rule of men were destined to be "chaotic, "
Economists and financial gurus were just as convinced of this argument
as politicians and political scientists. One economist, Gove Griffith
Johnson, commented in his contemporary book on Treasury policy: "One may
be skeptical of the wisdom with which monetary instruments will be used,
but the possibility of abuse extends throughout the whole sphere of
governmental activity and is a risk which must be assumed under a
democratic or any other form of government."
The Treasury's gold policy, Johnson continued, "was an
essential instrument for producing desired political aims." Congress had
given over the Fed's powers of monetary regulation to the Treasury
because the central bank had proven ineffectual. These powers had become
more democratic because "they were now exercised by politically
responsible officials ... [and] would eventually be subject to review by
the electorate.... In large part," he concluded, "the [Federal Reserve]
System has served merely as a technical instrument for effecting the
Treasury's policies." 11
Clearly, the awesome monetary powers the Fed-Treasury
had wielded were not the product of either "wisdom" or scientific
analysis. They were simply discretionary, seat-of-the-pants responses,
sometimes politically motivated, by political authorities who faced no
responsibility for their decisions. Furthermore, the "risk of abuse" did
not need to be "assumed" under a democratic government suitably
restrained by the rule of law. Finally, the electorate knew less about
these policies than it knew about Sanskrit, and it had no power at all
either to pass judgment on them or to change them.
Under a true rule-of-law gold standard, the Treasury
would not have had a "gold policy." The gold standard Itself would have
been the gold policy and would have been self-regulating through the
concerted actions of thousands of households and businesses that bought
and sold goods and services in hundreds of markets. The gold, more
important, would not have been stockpiled in Treasury vaults unavailable
and illegal for human use, like some dangerous drug or weapon. It would
have been in commercial banks primarily, serving its conventional
function of securing bank-issued money.
The monetary mismanagement chronicled here should serve
as the all-time example of the failure of discretionary monetary policy.
Although a gold standard was still on the books, it was nothing more
than a facade for Fed-Treasury manipulations. First the Fed by itself in
the 1920s, then the Treasury ten years later, simply fit this "gold
standard" into their other hands-on policies. Both agencies saw to it
that the gold was safely tucked away where it could do no one any good.
Approximately seven thousand banks failed in the early 1930s for want of
reserves while the stockpiling went on. Congress then gave the executive
the power to enact an unprecedented increase in the price of gold, and
added as well significant new powers to the Federal Reserve's authority.
By 1936 the Fed-Treasury managers, fearing they had overdone monetary
expansion, decided to put on the brakes by again sterilizing gold and
doubling bank reserve requirements. The result was a virtual paralysis
of the monetary system and the economy.
Had the banks held their own reserves or had them
available in their own clearinghouses, as they did before the coming of
the Fed, bank and clearinghouse executives (who were often the same
people) would have parlayed the gold into strategic trouble spots where
it would have prevented failures of healthy banks and general monetary
destruction. Gold to be effective cannot be declared illegal and buried
in the ground where no one can get it. If that is the best that
civilization can do, we might as well have left the gold in California,
the Klondike, Australia, and South Africa.
At the time of the original publication, Richard
Timberlake was a professor of economics retired from the University of
Georgia and author of Monetary
Policy in the United States: An Intellectual and Institutional History
(University of Chicago Press, 1993).
1. See, Dwight R. Lee and Richard McKenzie, Failure and
Progress: The Bright Side of the Dismal Science (Washington, D.C.: Cato
Institute, 1993).
2. For further discussion of this issue, see Richard H.
Timberlake, Gold, Greenbacks, and the Constitution (Berryville, Va.: The
George Edward Durell Foundation, 1991), pp. 8-9.
3. Board of Governors of the Federal Reserve System,
Banking and Monetary Statistics (Washington, D.C.: Government Printing
Office,1943), p. 537.
4. See my Monetary Policy in the United States: An
Intellectual and Institutional History (Chicago: University of Chicago
Press, 1993), chapter 5.
5. James D. Paris, Monetary Policies of the United
States (New York: Columbia University Press, 1938), p. 18.
6. Milton Friedman and Anna J. Schwartz, A Monetary
History of the United States, 1867-1960 (Princeton: National Bureau of
Economic Research and Princeton University Press, 1963), p. 544.
7. This pattern of law reflected the flawed notion that
banks in larger cities were more subject to "speculative" influences and
were more likely to make risky loans than banks in the "country."
8. In next month's issue of The Freeman, I will treat
the reserve requirement episode in more detail.
9. Donald F. Kettl, Leadership at the Fed (New Haven:
Yale University Press, 1986), pp. 49-53.
10. U.S. Treasury, Press Releases, nos. 9 20, December
20, 1936.
11. Gove Griffith Johnson, The Treasury and Monetary
Policies, 1933-1938 (Cambridge, Mass.: Harvard University Press, 1939),
pp. 205-111 223; emphasis added.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
May 1999, Vol. 49, No. 5.
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