You Can't Judge the '30s Without Understanding the '20s

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In the middle of 1921 banks in the United States began to exchange funds through an overnight process of check clearing. Banks that were members of the relatively new Federal Reserve System would exchange a Reserve check for a clearinghouse check from a non-member bank. The Reserve check would clear immediately, due to the fact that it was drawn on the member's reserve account. The non-member bank's check would clear in one day's time.

Because of this one-day time difference, the Reserve member bank essentially loaned the non-member bank excess funds overnight. With the member bank acting as a supplier of reserves in a check exchange, the loan was self-extinguishing. Since the reserves were supplied by a member of the Federal Reserve System, they became known as federal funds.

By the mid-1920's, this exchange/lending process was fully marketable, and by 1930, banks were also using wired funds. But it was a decision in September 1928 that proved to be most beneficial to the new federal funds market. The Federal Reserve issued a ruling granting borrowed federal funds nonreservable status. That meant borrowing funds in this manner was not subject to reserve requirements, making it a relatively efficient manner for managing liquidity.

The rationale for the decision was the comparison to borrowing at the Discount Window. In that age it was not atypical for banks to borrow continuously from the Discount Window, which the Fed appeared little interested in directly discouraging. An alternate, indirect means of reserve management was welcomed.

In addition to regular use of the Discount Window, banks before the federal funds market also used the call money market as a means to manage excess reserves. Typically, a bank would contract with a broker or securities dealer for overnight call money in which the broker would pledge stocks or bonds as collateral. This was the early prototype of the private repo market.

Banks in this hybrid system, then, had the opportunity to borrow excess overnight deposits that could be closely matched to either longer-term loans or temporarily placed in other highly liquid outlets. With a smooth flow of funding between banks and with the Federal Reserve System through Reserve accounts, this financial evolution devalued the physical currency limitations that had previously restricted the creation of credit. It also removed physical limitations since interbank movement of liquidity in this fashion could be highly mobile.

The call money system had arisen out of the mechanics of securities markets. The markets in New York were arranged so that accounts were settled daily. That meant that no matter how many purchases and sales a particular brokerage firm made on behalf of clients or its own accounts, it would settle all accounts at the end of every business day. That meant a need for short-term liquidity was always present.

The collateralization took place as part of the delivery of margin to brokerage customers. Customers could deposit 20% of the purchase amount and receive margin for the remaining financed through the call money market. The securities purchased, though titled in the name of the brokerage customer, would remain in possession of the call money lender (whichever bank was lending excess reserves). Since call money loans were overnight in term, this led to the need for a clearinghouse of collateral securities.

By the mid-1920's, when federal funds became far more accessible, margin arrangements had risen to 90% of security purchases. Customers needed only 10% "equity" to finance security speculation, and the lending requirements and standards for meeting this 10% threshold were greatly reduced.

Call money rates throughout the 1920's exceeded, meaning a durable positive spread, to both the discount rate and the quoted federal funds rate. That meant the Federal Reserve System was directly subsidizing the call money market, and therefore stock margin buying, due to an imprecise and overly "stimulative" discount rate. The undesirability of the discount rate owed to the preference for "sterilizing" gold flows in the "gold exchange" period of the 1920's - the Fed was no longer allowing gold to initiate price changes to alleviate monetary imbalances. Instead, credit would pile up so that imbalances would be semi-permanent.

In 1926, call money balances were about $2 billion. By the end of 1928, they had spiked to $3.9 billion, and by the crash in October 1929 an incredible $6.4 billion.

Sterilization was accomplished in a couple of ways. In some cases that meant leaving gold bullion in overseas accounts and warehouses, off the official books. But it mostly meant that the Fed had to reduce the balances in its open market account to "buy" the inflow of gold. This was diametrically opposed to the old "rules of the game" of the traditional gold standard.

By the recession of 1927, the Fed's open market account was down to $100 million in securities. That meant the Fed had very limited "dry powder" to reduce inflationary pressures building in bank reserve balances. The open market account was the store of securities the Fed used to trade for excess reserves, thus removing excess from the interbank marketplace. Without an ability to replenish securities, the Fed was without significant means to reduce speculative lending, including the pipeline between its own reserves system into call money margin for stocks.

To provide the system with some room, the Fed purchased an additional $180 million in securities and reduced the Discount rate to 3.5%. The move was stated as a measure to counter the recession, but there is little debate that a strong motivation came from intentions to stop the flow of gold from London.

By the middle of 1928, the Fed had again reduced its open market account, this time in a vain effort to drain excess reserves. The Fed increased its discount rate several times but the demand for "money", including call loans as stock prices were in the grips of the mania phase, overshot any interest rate attempt at reducing credit growth. The spread of call money over the Discount rate was a persistent 1.5%, which meant that no matter how high the Fed pushed the Discount rate banks could obtain overnight funding cheap enough and circulate it through either federal funds or call money at a profit and without reserve requirement.

By 1929, the Fed was limited in its options. Without a serious increase in its open market account, there was little it could do to prevent credit speculation. Use of the Discount rate was inefficient since it was a blunt tool that was unsuitable for narrowing the spread to either call money or commercial lending. In addition, a higher Discount rate would lead to more gold flowing into New York, an action that the Fed was increasingly unable to sterilize.

The Fed resorted to "unconventional" means to talk banks down from speculation, the moral suasion tactic where the central banks get the banking system to work on its behalf without actually committing scarce resources. By the middle of 1929, member banks were $1 billion in debt to the Fed, a striking amount for that age. Prior to that time, $500 million was considered the upper limit for the system. With an amount double the "upper limit", the pyramid of money creation was undoubtedly immense from there on outward.

The Fed's actions were partially effective in the first half of 1929. Banks reduced call money and brokers' loans by about a third, but other channels simply arose to fill the void. Call money rates were reaching the teens and as high as 20%, allowing private investors to borrow from the banks and lend into the stock frenzy.

The amazing run of market interest rates and stock prices had attracted capital and money from all over the world. The easy and free flow of reserves, margins and call money (and the ease of interplay between them) made it a desirable location for speculation from financial firms and private investors. Foreign loans from US lenders, for example, were 50% less in 1929 than 1928. By late July, the US wrote off 61% of French war debts due to the disruption of global capital flow. Because of the attraction of New York, interest rates throughout Europe were rising and getting dangerously depressive.

By September 1929, the British were considering an increase in their discount rate to 6.5% as gold reserves were at a low. The British were desperate to attract capital back from New York and Paris, and markets began to sense that the frenzy was reaching its zenith.

The problem at that point was the interconnection of financial flows and security arrangements. Collateral sufficiency in a 90% margin arrangement is obviously lacking, meaning a greater need for additional collateral with only minor incremental price changes. At the time that meant investors were pledging securities that had never been pledged before, but it was never going to be enough. By the dawn of October 1929, call money and call loans amounted to about 10% of the entire value of the stocks on exchange in New York. There was simply no way to unwind it all.

Clearly the US had experienced an real upswing (aging) due to technology and innovation. However, due first to the British adherence to the wrong price of gold (the pre-war parity target) the Federal Reserve was "sterilizing", thus changing the banking system away from real money (gold) and toward fungible money (bank reserves). By the time the French piled on in 1927, the US banking system increasingly transformed the monetary nature of banking away from gold toward "reserves" (due to the Fed's sterilization performing a transformation of monetary character and content, along with preferences for a liquid, short-term flow system of fungible reserves).

Gold formed the pillar of credit for the rural banking system that transmitted money through credit throughout the interior away from NYC. Monetary policy pre-1925 and pre-Fed was about managing the very seasonal flow of gold to and from the interior to NYC for export/import. As less gold remained for dispersal, reserves began to concentrate in NYC, particularly into those collateralized call loans and such. The recovery in the real economy out of the recession of 1927 was lackluster, as were economic conditions in other parts of the world where money was leaving. Equities and asset prices, however, flew to ridiculous proportions because of the changing content of banking "money".

During 1927-28, total Federal Reserve credit (fungible reserves) grew from about $1.2 billion to $1.6 billion, an increase of about 28% in just a year's time. A lot of it was due to the recession backdrop against French and British demand for gold. In 1927-28, total monetary stock of gold fell by about the same amount, from $4.5 billion to $4.0 billion (the net difference was absorbed by a change upward in things like bills discounted, ie, what we would consider reverse repo operations today). Overall money stock was exactly as the Fed intended - no real discernible change - meaning sterilization had done its job.

But as I mentioned above, the cost of sterilization was not neutral. The changing content of bank reserves away from gold meant an increase in concentration into the "wrong" segments of credit markets, made easier by technological innovation that wasn't appreciated by monetary policy. So the US ended up where stock prices go parabolic while the real economy domestically does not keep up at all (Milton Friedman and Anna Schwartz in their 1963 book estimate real income growth of 2.5% for the period 1923-29, far below the average pace of expansion previously). Contemporary academics view it as a period of slow steady growth, absent the normal volatility of depression in the pre-Fed periods, and thus a Golden Age of monetary competence to be emulated and improved.

In reality, the new interbank system and its relationships simply changed the content of money so that it would increasingly focus on things other than the real economy - money changed from a medium of exchange into a means to pyramid credit in exactly the wrong places through exactly the wrong means at exactly the wrong time.

It didn't last but a few more years because the gold standard was increasingly being re-imposed across Europe, finally enforcing some measure of restraint that popped the bubble. Perhaps the overall pace of increase in money stock was "measured" and stable, but there has to be some account for changing proportions and content of that stock. So the 1920's saw gold reserves become ledger money bank "reserves" at the Fed, including vital interbank trade. This was similar to the 1990's that saw the traditional banking system (based on physical currency) replaced by wholesale money in the shadow banking system (under the Basel rules). The end result in both cases is nearly identical, and that is not coincidence.

To a monetarist, money is money is money, just like aggregate demand, it's all uniform without consequence to source or content. This uniformity is nonsense and is characteristic of childlike simplicity rather than a passable means for formulating an extremely important foundation of "control".

That is what, in its most basic case, this is all really about. How to control the economic system, through truly free markets of dispersed control (gold or commodity money) or through PhD's (the Golden Age and the Great Moderation). Can the people be trusted to make the most basic monetary decisions or do we need benevolent central planners to do it for us? The lesson of the 1930's for the monetarists was definitive in favor of mistrust of the people, while those, like me, see the 1930's through the 1920's - monetarism is definitively flawed and will always lead to failure. The people should not be penalized for responding to prior monetary distortions.

You simply cannot judge the 1930's without investigating and explaining the 1920's, yet mainstream academic thought is conspicuously incurious about the 1920's; the volume of research on the 1930's, by contrast, is absolutely immense. The conclusions of this selective focus are that free markets should trade free mechanics in favor of central bank-driven "stability". But as the focus on "money" growth showed in the 1920's, that stability is an illusion caused by ignoring nuance and complexity. Some things never change.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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