Monetary Policy Was Born Out of a Mistake

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Modern monetary policy as it is conducted operationally was born out of a mistake, discovered by accidental action. One of the primary doctrines of the early Federal Reserve System was that it needed to be self-sufficient, thus no taxpayer funds were to go to its support. Each individual reserve bank thus needed a manner in which to accumulate "earnings" to pay staff and cover operational costs. To do so required the reserve branches to hold a portfolio of securities in which they could "earn" interest in sufficient quantity as to hold to that early doctrine.

In October 1921, each of the Reserve banks began to seek out additional sources of "earnings." Though each branch acted in individual considerations on their own singular volitions, collectively they had accumulated $400 million in government bonds by May 1922. That amount seemed insignificant owing in no small part to the massive ledger of government debt left over from World War I, yet the banking system complained of disruptions to credit flow, particularly in the treasury market.

That initiated a series of steps designed to ensure that branches were not "competing with themselves" and thus creating disruptions other than when absolutely necessary. By early 1923, that initial committee of governors from the Eastern Reserve branches was folded into a wider Open Market Investment Committee for the Federal Reserve System.

While the initial impetus behind the interest in open market operations ran back through bank "earnings", they had through experience noticed a peculiar effect in each manner of operation. Credit and liquidity in the banking system tended to rise when Reserve banks bought bonds, and tended to contract when they sold them. Thus was born the idea of an open market policy to influence through a channel not limited to reserve banks. That was one of the insights given to the new Open Market Committee as a means to try to influence financial behavior.

It became the great challenge of that time, as the Fed was not at all sure what its central role was to be. There was no shortage of debate about how active a role the central bank should, or even could, take on over economic affairs. The idea was more or less settled in that the more mechanical functions of Federal Reserve monetary policy were to be surpassed by some manner of active management.

In its influential Tenth Annual Report of 1923, the Fed noted what would become a doctrinal assertion that remains pretty much in force today.

"The reason for variable Federal reserve discount rates is the necessity of adjusting rates to these changes in business and credit conditions.

"The experience of the Federal reserve banks, notwithstanding that brief period of their active operation on a considerable scale has been one of disturbed economic and financial conditions, is demonstrating that there is sufficiently close connection between changes in Federal Reserve bank rates and changes in rates charged their customers by member banks on a sufficiently large volume of customer borrowings to make Federal reserve rates an important and at times a leading influence on money centers. In that sense the Federal reserve bank rate may be said to be effective. Its effectiveness and the range of its influence have been promoted in no inconsiderable degree in recent years by the increasing fluidity of the American credit system - that is, by the ease with which credit flows between the larger financial centers and the interior of the country."

That passage highlights what was thought in 1923 as total harmony between more active approaches that were then being tested, such as open market influences, and the main monetary responsibility of that day and age. There was tremendous seasonality in monetary flows, depending in full part on geography of agriculture. Money flowed as crops flowed, a process as old as the Republic itself. That did not change much even as industry replaced agriculture in terms of monetary volume.

Essentially money flowed from the interior to city banks, usually via small country banks, and from there to central reserve cities (NYC and Chicago, later St. Louis). The process reversed upon payment, thus creating a tremendous potential strain upon the monetary system at certain calendar points.

Almost every major bank panic of the nineteenth century took place in either September or October: Panic of 1857 started in September when the sinking of the SS Central America failed to deliver gold that was needed in the seasonal money flow; Panic of 1873 when Jay Cooke & Company could not market sufficient Northern Pacific bonds, leading to a ten day closure of the NYSE beginning September 20; the Panic of 1907 began with irregularities at United Copper that October. The exception to that pattern was the Panic of 1893 which was more widespread across the calendar, having it roots in the February failure of Philadelphia and Reading Railroad, culminating in separate stock and bank panics that May and July.

Thus the mechanical need for a central system to offset any structural weaknesses in the credit flow system was paramount in the creation of the Federal Reserve itself. Seasonal money flow was a primary factor in directing no shortage of resources to mitigating any effects. By 1923, then, the Fed had seemed more than content in that role, the "increasing fluidity of the American credit system."

By law, country banks in the National Banking Era were required to hold reserves equal to 15% of all outstanding bank notes, but "reserves" were somewhat fungible. A full 60% of those required reserves could take the form of deposits in reserve city banks, tying closely the country banks to the reserve city banks. A drain on deposits would necessarily lead to a drain on resources of reserve city banks. The reserve city banks were specified via Congressional statute, situated in major cities (other than the central reserve cities). Reserve city banks themselves were subject to a 25% requirement.

As with country banks, reserve city banks had a depository option in the next step up the banking hierarchy. They could hold half of these required reserves in the form of deposits with central reserve city banks. That made the reserve city banks essentially an intermediary step in what was a nascent interbank market for deposit liabilities. The deposits gathered by the country banks were shipped upward to end up with the larger "money center" banks in Chicago and New York (and later St. Louis, though most volume flowed to NYC), functioning as a de facto branch system coupled to an interbank liability market.

The money center banks in New York thus had high levels of liquidity that fluctuated greatly with this structural, seasonal flow of the early national economy. That meant a great deal of central reserve city bank assets tended to be short-term in nature, unable to perform any maturity transformations themselves due to the flow structure. The terminus in New York also provided the central capacity of international trade and finance, as it served as the vital link to London and other financial centers. Mechanically speaking, it was a true system of intermediation.

Depending on the source, it has been estimated that central reserve city banks placed about 75% of their loans to brokerage houses. Again, the need for shorter durations on the asset side meant that central reserve city banks had to be able to liquefy with reasonable speed. Thus these loans to brokerage houses were callable on demand of the bank, giving rise to the terminology of "call loans."

The concentration of brokerage and central reserve city liabilities in New York City meant that the New York branch of the Federal Reserve subsumed responsibility for the monetary activities of call loans and central reserve city bank suitability. In regulating the call loan rate, the New York branch took advisement from a committee formed of NYSE members themselves. That was standard procedure, as the New York branch itself was subscribed from the very central reserve city banks themselves. There were no illusions about the nature of the Federal Reserve system on this level, it was designed as an organ of the banking system (money elasticity).

It was, however, these new authorities and responsibilities that created no shortage of tension. It was assumed, as it is today, that the needs of banks were very closely aligned with the needs of the real economy. Serving one thus provides the "proper" approach to the other.

In May 2013, I noted this disparity as it reached the epic heights of the 1929 crash:

"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."

The "durable positive spread" between call money rates and the discount rate was exactly this tension. The Fed could not follow its 1923 "rules" of taking an active role without, in its calculations, setting the discount rate to sterilize gold movements. That intersected, of course, in New York with the central reserve city banks. Thus the call rate was itself determined as a function of what those banks saw, in close cooperation with the brokerage houses' collective desires for "liquidity", as a necessary condition for the mechanical operation of structural monetary flow.

As noted in the quote above, that natural tension between mechanical needs and policy desires for active economic management rendered a massive monetary imbalance that carried out in the form of an asset bubble of historical proportions. That was not the only expression of this imbalance, as credit had penetrated in areas unseen to that point, but the stock market apex was the most visible signal of monetarism gone awry. Another primary source of credit imbalance flowed into mortgages, particularly commercial, as debt in that form had been largely untapped.

The Federal Reserve itself had been interested in exactly this kind of imbalance going back to its first observations about open market operations. Again, in the Tenth Annual Report, the Fed mentioned on several occasions the dangers of speculative accumulations.

"The extension of credit for purposes ‘covering merely investments or issued or drawn for the purpose of carrying or trading in stocks, bonds, or other investment securities, except bonds and notes of the Government of the United States,' is not permitted by the Federal reserve act. The Federal reserve system is a system of productive credit. It is not a system of credit for either investment or speculative purposes. Credit in the service of agriculture, industry, and trade may be described comprehensively as credit for productive use."

"The problem in good administration under the Federal reserve system is not only that of limiting the field of uses of Federal reserve credit to productive purposes, but also limiting the volume of credit within the field of its appropriate uses to such amount as may be economically justified - that is, justified by a commensurate increase in the Nation's aggregate productivity."

This passage, and others like it, committed monetary policy, even in its activist approach, to the real bills doctrine. In other words, as long as credit and money were used to finance real economic demand for production and trade, imbalance potential was exceedingly limited. However, it was also recognized that keeping to the real bills doctrine in anything approaching a realistic fashion was extraordinarily difficult. There was no clear-cut method of discernment and definition between what constitutes true productive uses and what is purely speculative. In reality, the line between the two often blurs in the same transaction.

Throughout the 1920's, that point was argued but with inconsistent results. Walter Stewart, the author of the 1923 Annual Report, was reported in 1925 to have urged Benjamin Strong, Governor of the New York Branch, to assert "direct pressure" on member banks in light of what was believed to be "overborrowing." Governor Strong refused, as that would have meant an increase in both the discount rate and call rate, leading to a "rationing of credit."

Such views spilled into politics, becoming a hardened position of national economic policy. In a campaign speech in October 1924, Calvin Coolidge reassured "business" that, "It has been the policy of this administration to reduce discount rates." In March 1927 as a mild recession was in process, Treasury Secretary Mellon proclaimed, "There is an abundant supply of easy money which should take care of any contingencies that might arise."

In a July 2013 speech "celebrating" the first hundred years of the Fed, then-Chairman Ben Bernanke described this period as,

"Federal Reserve notes were redeemable in gold on demand, and the Fed was required to maintain a gold reserve equal to 40 percent of outstanding notes. However, contrary to the principles of an idealized gold standard, the Federal Reserve often took actions to prevent inflows and outflows of gold from being fully translated into changes in the domestic money supply. This practice, together with the size of the U.S. economy, gave the Federal Reserve considerable autonomy in monetary policy and, in particular, allowed the Fed to conduct policy according to the real bills doctrine without much hindrance."

To conclude that the Fed was following the real bills doctrine aside its interference with money market rates is beyond misleading. What the Fed actually followed was a prescribed political path to create and foster business expansion solely predicated on credit expansion. That is the opposite of the real bills doctrine. In other words, the demand for money is superseded by this supply canon where credit and money is believed the (sole) impetus for any and all marginal business expansion. Any reference or determination of uses of credit for speculative purposes is simply ignored.

This is not to say that there should be any part of the Federal Reserve engaged in determining what constitutes speculation. That is a fool's errand; and there is no shortage of legitimate uses of speculative credit. However, it leaves off the mechanical functions of the Fed in the wake of the activist approach. The market demand for money is determined mechanically by structural factors, but the Fed does not allow those to take place or at least overwashes them in this desire to continually "stimulate" marginal production through marginal credit. That has been constant since the first discovery of open market influence, through all sorts of political alignments and formulations.

What this disparity between monetary mechanics and monetary activism produces amounts instead to a subsidy of speculation of the kind witnessed in the latter 1920's. The corollary of the real bills doctrine is the natural rate of interest, which we know from close experience has been left out of the American equation going back decades. The Federal Reserve itself, taking any action outside of any mechanical monetary nature, is an imposition on the natural rate of interest, and then by definition creates an impropriety in the credit system.

The warm and politically-driven cuddle of activism is axiomatically a disturbance upon "productive uses of credit." It can produce nothing but imbalance of the sort that has been occurring since its inception. The mechanical nature of the banking system has been changed by ledger money and the modern economy, but the true scale of imposition has reached such proportions upon only full recognition of the removal of all traditional bank limitations (removing money as property and replacing it wholesale with a system of financial securities from the ground up).

Despite all the modern alterations to the mechanical nature of financial flow, it is curious to see that more recent incarnations of panic also occur exclusively in September and October (1987, 1997 and especially 2008). That cannot be a random occurrence, suggesting that buried within the banking system are artifacts of that earlier and far simpler age. While that might strike against sensibility, the probabilities, on a random basis, would be infinitesimal. That would seem to suggest a fractal nature, a self-similarity embedded in the financial system that has gone unnoticed because of this assertion and primacy of activist doctrine.


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

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