Controlled and Uncontrolled Reserves at the Federal Reserve, 1921-1933

0:00As we'll see later today, it's the 50th anniversary of Rothbard's America's Great Depression, and it's also the 50th anniversary of Millen Freeman's and Anna Jacob Schwartz, a monetary history of the United States. The latter was enormously influential in economic history, especially monetary history and the general mainstream interpretation of the Great Depression. Rothbard did not receive the same attention. As anyone who's sort of read either book, you can tell that they're different. If you read Rothbard's first, just to look at a couple titles in the book, you look at his part two and it's called The Inflationary Boom from 1921 to 1929.

0:45You look at it and so Rothbard, you read and he says, all right, the 1920s was a bad decade for monetary policy. The Federal Reserve was very inflationary, it tried to increase the money supply for for various reasons, and this was one of the contributing factors to the Great Depression. You read Freeman and Schwartz, and the same title for that period, the 1920s, they called it the high tide of the reserve system, 1921 to 29, and for them it was a great, if not the greatest decade for Federal Reserve monetary policy. Price level was stable, output growth was good, unemployment was low, the stock market boomed, there's actually some papers The Federal Reserve screwed up by raising the discount rate, and that's what sort of caused the Great Depression, and then the Federal Reserve didn't do anything in the Great Depression.

1:40And so, yeah, so for Freeman and Schwartz, the 1920s was a good decade for monetary policy. And you can also see this similar sort of vast difference. There's a series of articles between Joseph Salerno and Richard Timberlake from 1999 to 2000 in the Freeman, and it's the same type of deal where one of them is telling one of these stories and the other is telling the other. I'll let you figure out which one is telling which story. and of course the waterfalls. Okay, so why the difference? Now the reason I'm concentrating here, obviously Rothbard used Austrian Business Cycle Theory, Milton Friedman did not. There's definitions on the money supply, on inflation, whether or not to be related to the money supply or prices and there's relative prices versus the price level.

2:32But I'm gonna concentrate on here, on the view on Federal Reserve credit outstanding. And for this, this represents the loans and investments that the Fed in the 1920s had to its member banks. So Rothbard said that the Fed actively tried to increase controlled reserves. And so the thesis of this working paper is that Rothbard is right. And I'll try and build on his analysis that he gives in America's Great Depression and also sort of try to provide an updated Rothbardian analysis of this time period and contrast it with recent interpretations because obviously with the Great Recession, there's been a huge new research and emphasis on the Great Depression. So in Freeman and Schwartz on the other hand said the Fed stabilized Federal Reserve credit outstanding or could even be considered deflationary at times.

3:23And they do mention this and that's the view supported by most monetary, if not all, monetary economists. So all right, here's a picture from Freeman and Schwartz Federal Reserve Credit Outstanding from 1921 to 1929, roughly right before October. And so in June 1921, which is also when Rothbard starts, Federal Reserve Credit was roughly $2 billion. On October 23rd, right before the stock market crash, it was $1.37 billion. So there's a decline in $720 million, roughly 34%. So you're thinking, what's Rothbard talking about? I mean, you just simply look at it and if you start from 1921, it was deflationary.

4:13If you just start right at the bottom of that sharp decrease, all right, it looks like they stabilized it and it's slightly increased at the end. So this is sort of supporting the Friedman and Schwartz view. So just to sort of go into what Federal Reserve credit outstanding was at the time, it consisted of bills bought, which were acceptances. They were used to guarantee payment of goods in transit, mostly used internationally. The Fed sort of created this market in the 1920s by deliberately subsidizing it. Flow very minor, unimportant, it's just from the temporary increase in reserves to the Check, the way the checks were cleared, there were government securities, open market operations, this is all what we know the Federal Reserve does now, and then there were bills discounted, which, and this is the big difference as I'll sort of go into how they view Federal Reserve credit.

5:10So to go into bills discounted, this is a simple picture I'll go into later, it consisted of advances and rediscounts. Advances were when the Federal Reserve, I mean the member banks would basically borrow This is primarily what the discount window is used for now, even when it is used. It's not used that much. Rediscounts, or what should really be called rediscounts, were really what the discount window was used for back then. And this is when a commercial bank would rediscount eligible paper at the Fed. So the way this would work, just to sort of go into how commercial bank worked back then, The way it worked back then, a borrower, the stick figure, would have a promissory note, such as commercial paper, saying he'll pay $1100 in one year, and at say a going interest rate of 10%, the Newman Bank, that's me, would discount it and say, okay, I'll give you $1000 now.

6:07And then the bank, we'd have to pay it back, and it'd just be a simple loan like that. So traditionally, in the Bank of England, and what the Federal Reserves are going to and the later was actually modeled after, it was supposed to be a penalty rate. So this is echoing Walter Baggett in 1873, his walk on Lombard Street, the policy of lend freely at a high rate. So it's sort of supposed to separate the insolvent banks from the illiquid banks. So if there's a run on the bank and the Newman Bank, let's say the same day, it's really unlucky, the Newman Bank, I got to get reserves, meet depositors, so I'm going to discount it at the Fed. And let's say the discount rate is 15%, so he's going to discount it again and I'm going to get $950. So it's less than the $1000 I started with, but at least it's something.

6:55So it's the idea that it's a penalty rate, it is a penalty, so you're not going to borrow from the Fed in normal times because it's higher than, you know, prime commercial paper and you're not going to be able to re-discount it again. Alright, but let's say it was a non-penalty rate, which happened in the 20s for most of the Fed's founding, so then I could discount it at the Fed, and the Fed would discount it, and they'd give me $1,050 now, so I get a $50 increase in reserves, so I'm pretty happy, you know, because now I can lend that out, I just got $50 more, let's say, you know, this is at a 5% interest rate, and so then, in this scenario, banks can borrow from the Fed for profit, because they're actually The idea here, and this is what Rothbard touched on, is when the discount rate is less than prime commercial paper, and prime is just relatively, if not the market, very riskless, the discount rate is easy, it's no longer a penalty rate.

8:03And during the Fed, since it also, I might have time to go into this, it also implicitly allowed continuous borrowing. The policy is not really lend freely at a high rate, it's lend freely at a low rate. So Rothbard's insight, and this is the kicker, this is what distinguishes him from Freeman and Schwartz, at least when they view these controlled reserve figures, is that when banks repaid, it was uncontrolled and against the wishes of the Fed, because the banks could still on the net be in debt to the Fed by discounting additional bills, and, but they're deliberately choosing to shun a profitable opportunity. So Rothbard splits it down the middle and he says, okay, bill is discounted, it's going to be controlled then because the Fed is choosing to lend money, they could not, they could decide not to discount it, but when bills were repaid it was uncontrolled.

8:50So it was like if the public decided to take money out of their banks, an increase in currency in the hand of the public, that's uncontrolled, the Fed can't directly influence that just So when we look at it like this way, then controlled reserves increased by $1.775 billion over this period, whereas uncontrolled reserves decreased, and this is solely from bills being repaid, by $2.495 billion. So that's where you get the 720 decline. And the sharp decrease at the beginning in 1920-1921, there was a massive amount of bills being repaid, even when this discount rate was extremely easy. if not the biggest differential during this period. So just a brief history of the penalty rate and this comes from Alan Meltzer's A Monetary History of the Federal Reserve. The Fed, I'll go through this quickly, the Fed was originally designed of a penalty rate. It conflicted with Fed treasury goals. There was a mild 1914 recession. Fed wanted to increase bank earnings and then the Treasury

9:53needed to finance the war so they pretty much coerced the Fed. There's an interesting story behind this, I can't really go into this, into setting a Preferential Rate on Discounting Government Securities, just to get banks to buy the government securities. Post-war, the Fed wants to return to a penalty rate, the Treasury does not. 1920 to 1921, during that recession, Benjamin Strong and the Fed, they won a penalty rate. Benjamin Strong, he's the famous central banker in the 1920s. At the beginning, he, in the early 1920s, he wanted to liquidate, he wanted a penalty rate. However, Treasury, the presidency, Congress do not, and Strong and the Fed, they quietly drop this The Treasury, everyone wanted the political considerations, especially upcoming congressional elections. They wanted in their agricultural districts, they wanted low rates.

10:40So here's just a quick quote. This comes from Meltzer. He's talking to Norman, Montague Norman, who was the head of the Bank of England at the time, and I'll just sort of go through it really quickly. He continued to favor a penalty rate in principle, and he said money market conditions hardly justified making a further reduction. However, he said, classical methods were, quote, not always the wisest and there were political considerations brought about by the change of administration. So as we all know, when it comes to government, it all comes down to politics. And the idea of the penalty rate was dropped. So I was able to go back into Federal Reserve interest rate and I was able to get this data. And so here the blue line is the discount rate. And the red line is commercial paper rate from the four to six month and the average difference is half a percent which I mean it wasn't as different as big as I made it last time but that certainly provides an opportunity for profit and so other explanations I really wanted to get some time to go to this so this is the the scissors effect and that's what sort of Friedman and Schwartz call it and this is the rifler Burgess doctrine that's what Meltzer calls it there's a picture of scissors and it helped explain this so they noticed after the 1920-1920 recession

11:53There's an inverse relationship between government securities bought or sold and bills discounted or repaid. So the idea is that if the Fed were to buy government securities, banks would use some of this increase in securities to pay their debt to the Fed. So you might read this as, okay, if you give someone money, they're going to spend some of that money and repay their debt. So the Fed could influence bills repaid through open market operations. And so this is sort of contrary to what Rothbard was talking about. So maybe it's not completely uncontrolled, like he was saying. Well, just to sort of quickly go to some problems with the scissors effect, it relied on banks not borrowing for profit when in reality the discount rate really was a lend freely at a low rate. In 1928, they're what? Over moral suasion, some of the dealing with the stock market, they did try and clamp down on continuous borrowing but it didn't work.

12:40Throughout the 1920s, they turned the other way and they still let it happen. Banks were still ultimately in control because despite the increase in reserves, they still still could on the net increase or maintain borrowing. And this is what happened, especially in 1927 when the Fed bought government securities, banks increased their bills discounted. And this was completely against what the doctrine would say and the proponents of it, they were sort of quiet on this issue. Another more important thing is that during these giant spurts of bills being repaid, bills repaid often began before, not after the increase in securities. So in June 1921 to December 1921, bills discounted, declined 34% while government securities remained the same.

13:26And so this was before, this was even when the Fed had this policy, but this was before, so this is the fact that it wasn't, the idea was that first government securities would increase and then bills would be repaid, when often it was the opposite. So the conclusion is that Rothbard's view of the discount rate is one of the main differences between his and Freeman's account of Federal Reserve monetary policy in the 1920s, and I happen to think he's right. So thank you for your time.