WEBVTT NOTE Controlled and Uncontrolled Reserves at the Federal Reserve, 1921-1933 1 00:00:00.000 --> 00:00:03.360 As we'll see later today, it's the 50th anniversary 2 00:00:03.360 --> 00:00:05.640 of Rothbard's America's Great Depression, 3 00:00:05.640 --> 00:00:09.160 and it's also the 50th anniversary of Millen Freeman's 4 00:00:09.160 --> 00:00:11.080 and Anna Jacob Schwartz, a monetary history 5 00:00:11.080 --> 00:00:12.520 of the United States. 6 00:00:12.520 --> 00:00:16.680 The latter was enormously influential in economic history, 7 00:00:16.680 --> 00:00:20.200 especially monetary history and the general mainstream 8 00:00:20.200 --> 00:00:22.640 interpretation of the Great Depression. 9 00:00:22.640 --> 00:00:27.000 Rothbard did not receive the same attention. 10 00:00:27.000 --> 00:00:35.040 As anyone who's sort of read either book, you can tell that they're different. 11 00:00:35.040 --> 00:00:39.600 If you read Rothbard's first, just to look at a couple titles in the book, you look at 12 00:00:39.600 --> 00:00:45.480 his part two and it's called The Inflationary Boom from 1921 to 1929. 13 00:00:45.480 --> 00:00:49.920 You look at it and so Rothbard, you read and he says, all right, the 1920s was a bad decade 14 00:00:49.920 --> 00:00:50.920 for monetary policy. 15 00:00:50.920 --> 00:00:54.680 The Federal Reserve was very inflationary, it tried to increase the money supply for 16 00:00:54.680 --> 00:01:01.000 for various reasons, and this was one of the contributing factors to the Great Depression. 17 00:01:01.000 --> 00:01:05.600 You read Freeman and Schwartz, and the same title for that period, the 1920s, they called 18 00:01:05.600 --> 00:01:12.840 it the high tide of the reserve system, 1921 to 29, and for them it was a great, if not 19 00:01:12.840 --> 00:01:18.840 the greatest decade for Federal Reserve monetary policy. Price level was stable, output growth 20 00:01:18.840 --> 00:01:23.800 was good, unemployment was low, the stock market boomed, there's actually some papers 21 00:01:23.800 --> 00:01:40.800 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. 22 00:01:40.800 --> 00:01:45.800 And so, yeah, so for Freeman and Schwartz, the 1920s was a good decade for monetary policy. 23 00:01:45.800 --> 00:01:51.800 And you can also see this similar sort of vast difference. 24 00:01:51.800 --> 00:02:10.800 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. 25 00:02:10.800 --> 00:02:12.480 and of course the waterfalls. 26 00:02:12.480 --> 00:02:16.320 Okay, so why the difference? 27 00:02:17.440 --> 00:02:19.400 Now the reason I'm concentrating here, 28 00:02:19.400 --> 00:02:22.480 obviously Rothbard used Austrian Business Cycle Theory, 29 00:02:22.480 --> 00:02:23.600 Milton Friedman did not. 30 00:02:23.600 --> 00:02:26.240 There's definitions on the money supply, on inflation, 31 00:02:26.240 --> 00:02:29.520 whether or not to be related to the money supply or prices 32 00:02:29.520 --> 00:02:32.660 and there's relative prices versus the price level. 33 00:02:32.660 --> 00:02:33.920 But I'm gonna concentrate on here, 34 00:02:33.920 --> 00:02:37.400 on the view on Federal Reserve credit outstanding. 35 00:02:37.400 --> 00:02:44.800 And for this, this represents the loans and investments that the Fed in the 1920s had to its member banks. 36 00:02:44.800 --> 00:02:49.000 So Rothbard said that the Fed actively tried to increase controlled reserves. 37 00:02:49.000 --> 00:02:53.000 And so the thesis of this working paper is that Rothbard is right. 38 00:02:53.000 --> 00:02:59.500 And I'll try and build on his analysis that he gives in America's Great Depression 39 00:02:59.500 --> 00:03:05.900 and also sort of try to provide an updated Rothbardian analysis of this time period 40 00:03:05.900 --> 00:03:09.180 and contrast it with recent interpretations 41 00:03:09.180 --> 00:03:11.740 because obviously with the Great Recession, 42 00:03:11.740 --> 00:03:13.780 there's been a huge new research 43 00:03:13.780 --> 00:03:16.020 and emphasis on the Great Depression. 44 00:03:16.020 --> 00:03:18.100 So in Freeman and Schwartz on the other hand said 45 00:03:18.100 --> 00:03:20.740 the Fed stabilized Federal Reserve credit outstanding 46 00:03:20.740 --> 00:03:23.800 or could even be considered deflationary at times. 47 00:03:23.800 --> 00:03:26.960 And they do mention this and that's the view 48 00:03:26.960 --> 00:03:31.960 supported by most monetary, if not all, monetary economists. 49 00:03:32.560 --> 00:03:34.620 So all right, here's a picture from Freeman and Schwartz 50 00:03:34.620 --> 00:03:44.780 Federal Reserve Credit Outstanding from 1921 to 1929, roughly right before October. 51 00:03:44.780 --> 00:03:50.140 And so in June 1921, which is also when Rothbard starts, Federal Reserve Credit was roughly 52 00:03:50.140 --> 00:03:51.140 $2 billion. 53 00:03:51.140 --> 00:03:57.260 On October 23rd, right before the stock market crash, it was $1.37 billion. 54 00:03:57.260 --> 00:04:02.160 So there's a decline in $720 million, roughly 34%. 55 00:04:02.160 --> 00:04:06.240 So you're thinking, what's Rothbard talking about? 56 00:04:06.240 --> 00:04:13.280 I mean, you just simply look at it and if you start from 1921, it was deflationary. 57 00:04:13.280 --> 00:04:17.520 If you just start right at the bottom of that sharp decrease, all right, it looks like they 58 00:04:17.520 --> 00:04:23.320 stabilized it and it's slightly increased at the end. 59 00:04:23.320 --> 00:04:28.840 So this is sort of supporting the Friedman and Schwartz view. 60 00:04:28.840 --> 00:04:33.920 So just to sort of go into what Federal Reserve credit outstanding was at the time, it consisted 61 00:04:33.920 --> 00:04:36.160 of bills bought, which were acceptances. 62 00:04:36.160 --> 00:04:40.680 They were used to guarantee payment of goods in transit, mostly used internationally. 63 00:04:40.680 --> 00:04:50.960 The Fed sort of created this market in the 1920s by deliberately subsidizing it. 64 00:04:50.960 --> 00:04:55.720 Flow very minor, unimportant, it's just from the temporary increase in reserves to the 65 00:04:55.720 --> 00:05:00.160 Check, the way the checks were cleared, there were government securities, open market operations, 66 00:05:00.160 --> 00:05:04.820 this is all what we know the Federal Reserve does now, and then there were bills discounted, 67 00:05:04.820 --> 00:05:09.880 which, and this is the big difference as I'll sort of go into how they view Federal Reserve 68 00:05:09.880 --> 00:05:10.880 credit. 69 00:05:10.880 --> 00:05:15.200 So to go into bills discounted, this is a simple picture I'll go into later, it consisted 70 00:05:15.200 --> 00:05:18.380 of advances and rediscounts. 71 00:05:18.380 --> 00:05:21.480 Advances were when the Federal Reserve, I mean the member banks would basically borrow 72 00:05:21.480 --> 00:05:31.480 This is primarily what the discount window is used for now, even when it is used. It's not used that much. 73 00:05:31.480 --> 00:05:37.480 Rediscounts, or what should really be called rediscounts, were really what the discount window was used for back then. 74 00:05:37.480 --> 00:05:42.480 And this is when a commercial bank would rediscount eligible paper at the Fed. 75 00:05:42.480 --> 00:05:47.480 So the way this would work, just to sort of go into how commercial bank worked back then, 76 00:05:47.480 --> 00:05:52.160 The way it worked back then, a borrower, the stick figure, would have a promissory note, 77 00:05:52.160 --> 00:05:57.880 such as commercial paper, saying he'll pay $1100 in one year, and at say a going interest 78 00:05:57.880 --> 00:06:06.880 rate of 10%, the Newman Bank, that's me, would discount it and say, okay, I'll give you $1000 79 00:06:06.880 --> 00:06:07.880 now. 80 00:06:07.880 --> 00:06:12.480 And then the bank, we'd have to pay it back, and it'd just be a simple loan like that. 81 00:06:12.480 --> 00:06:16.600 So traditionally, in the Bank of England, and what the Federal Reserves are going to 82 00:06:16.600 --> 00:06:20.840 and the later was actually modeled after, it was supposed to be a penalty rate. 83 00:06:20.840 --> 00:06:27.880 So this is echoing Walter Baggett in 1873, his walk on Lombard Street, the policy of 84 00:06:27.880 --> 00:06:30.480 lend freely at a high rate. 85 00:06:30.480 --> 00:06:34.500 So it's sort of supposed to separate the insolvent banks from the illiquid banks. 86 00:06:34.500 --> 00:06:38.680 So if there's a run on the bank and the Newman Bank, let's say the same day, it's really 87 00:06:38.680 --> 00:06:43.200 unlucky, the Newman Bank, I got to get reserves, meet depositors, so I'm going to discount 88 00:06:43.200 --> 00:06:44.200 it at the Fed. 89 00:06:44.200 --> 00:06:49.000 And let's say the discount rate is 15%, so he's going to discount it again and I'm going 90 00:06:49.000 --> 00:06:50.840 to get $950. 91 00:06:50.840 --> 00:06:55.160 So it's less than the $1000 I started with, but at least it's something. 92 00:06:55.160 --> 00:07:00.560 So it's the idea that it's a penalty rate, it is a penalty, so you're not going to borrow 93 00:07:00.560 --> 00:07:07.480 from the Fed in normal times because it's higher than, you know, prime commercial paper 94 00:07:07.480 --> 00:07:09.760 and you're not going to be able to re-discount it again. 95 00:07:09.760 --> 00:07:39.760 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 96 00:07:39.760 --> 00:08:03.760 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. 97 00:08:03.760 --> 00:08:11.200 And during the Fed, since it also, I might have time to go into this, it also implicitly allowed continuous borrowing. 98 00:08:11.200 --> 00:08:15.680 The policy is not really lend freely at a high rate, it's lend freely at a low rate. 99 00:08:15.680 --> 00:08:21.960 So Rothbard's insight, and this is the kicker, this is what distinguishes him from Freeman and Schwartz, 100 00:08:21.960 --> 00:08:26.120 at least when they view these controlled reserve figures, is that when banks repaid, 101 00:08:26.120 --> 00:08:33.120 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, 102 00:08:33.120 --> 00:08:37.840 and, but they're deliberately choosing to shun a profitable opportunity. 103 00:08:37.840 --> 00:08:42.400 So Rothbard splits it down the middle and he says, okay, bill is discounted, it's going 104 00:08:42.400 --> 00:08:47.280 to be controlled then because the Fed is choosing to lend money, they could not, they could decide 105 00:08:47.280 --> 00:08:50.440 not to discount it, but when bills were repaid it was uncontrolled. 106 00:08:50.440 --> 00:08:54.880 So it was like if the public decided to take money out of their banks, an increase in currency 107 00:08:54.880 --> 00:09:01.380 in the hand of the public, that's uncontrolled, the Fed can't directly influence that just 108 00:09:01.380 --> 00:09:18.380 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. 109 00:09:18.380 --> 00:09:30.380 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. 110 00:09:30.380 --> 00:09:36.980 if not the biggest differential during this period. So just a brief history of 111 00:09:36.980 --> 00:09:40.540 the penalty rate and this comes from Alan Meltzer's A Monetary History of the 112 00:09:40.540 --> 00:09:44.420 Federal Reserve. The Fed, I'll go through this quickly, the Fed was originally 113 00:09:44.420 --> 00:09:48.820 designed of a penalty rate. It conflicted with Fed treasury goals. There was a mild 114 00:09:48.820 --> 00:09:53.140 1914 recession. Fed wanted to increase bank earnings and then the Treasury 115 00:09:53.140 --> 00:09:56.980 needed to finance the war so they pretty much coerced the Fed. There's an 116 00:09:56.980 --> 00:09:59.340 interesting story behind this, I can't really go into this, into setting a 117 00:09:59.340 --> 00:10:04.820 Preferential Rate on Discounting Government Securities, just to get banks to buy the government securities. 118 00:10:04.820 --> 00:10:08.580 Post-war, the Fed wants to return to a penalty rate, the Treasury does not. 119 00:10:08.580 --> 00:10:14.540 1920 to 1921, during that recession, Benjamin Strong and the Fed, they won a penalty rate. 120 00:10:14.540 --> 00:10:17.620 Benjamin Strong, he's the famous central banker in the 1920s. 121 00:10:17.620 --> 00:10:22.740 At the beginning, he, in the early 1920s, he wanted to liquidate, he wanted a penalty rate. 122 00:10:22.740 --> 00:10:29.060 However, Treasury, the presidency, Congress do not, and Strong and the Fed, they quietly drop this 123 00:10:29.060 --> 00:10:36.060 The Treasury, everyone wanted the political considerations, especially upcoming congressional elections. 124 00:10:36.060 --> 00:10:40.060 They wanted in their agricultural districts, they wanted low rates. 125 00:10:40.060 --> 00:10:43.060 So here's just a quick quote. This comes from Meltzer. 126 00:10:43.060 --> 00:10:49.060 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. 127 00:10:49.060 --> 00:10:55.060 He continued to favor a penalty rate in principle, and he said money market conditions hardly justified making a further reduction. 128 00:10:55.060 --> 00:10:58.300 However, he said, classical methods were, quote, 129 00:10:58.300 --> 00:11:00.780 not always the wisest and there were political considerations 130 00:11:00.780 --> 00:11:02.660 brought about by the change of administration. 131 00:11:02.660 --> 00:11:04.500 So as we all know, when it comes to government, 132 00:11:04.500 --> 00:11:06.620 it all comes down to politics. 133 00:11:06.620 --> 00:11:10.380 And the idea of the penalty rate was dropped. 134 00:11:10.380 --> 00:11:15.300 So I was able to go back into Federal Reserve interest rate 135 00:11:15.300 --> 00:11:16.460 and I was able to get this data. 136 00:11:16.460 --> 00:11:19.980 And so here the blue line is the discount rate. 137 00:11:19.980 --> 00:11:23.060 And the red line is commercial paper rate 138 00:11:23.060 --> 00:11:53.060 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 139 00:11:53.060 --> 00:11:58.260 There's an inverse relationship between government securities bought or sold and bills discounted or repaid. 140 00:11:58.260 --> 00:12:06.060 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. 141 00:12:06.060 --> 00:12:12.060 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. 142 00:12:12.060 --> 00:12:15.060 So the Fed could influence bills repaid through open market operations. 143 00:12:15.060 --> 00:12:18.060 And so this is sort of contrary to what Rothbard was talking about. 144 00:12:18.060 --> 00:12:21.060 So maybe it's not completely uncontrolled, like he was saying. 145 00:12:21.060 --> 00:12:26.340 Well, just to sort of quickly go to some problems with the scissors effect, it relied on banks 146 00:12:26.340 --> 00:12:30.540 not borrowing for profit when in reality the discount rate really was a lend freely at 147 00:12:30.540 --> 00:12:31.540 a low rate. 148 00:12:31.540 --> 00:12:33.620 In 1928, they're what? 149 00:12:33.620 --> 00:12:37.980 Over moral suasion, some of the dealing with the stock market, they did try and clamp down 150 00:12:37.980 --> 00:12:40.100 on continuous borrowing but it didn't work. 151 00:12:40.100 --> 00:12:45.780 Throughout the 1920s, they turned the other way and they still let it happen. 152 00:12:45.780 --> 00:12:49.020 Banks were still ultimately in control because despite the increase in reserves, they still 153 00:12:49.020 --> 00:12:51.980 still could on the net increase or maintain borrowing. 154 00:12:51.980 --> 00:12:58.380 And this is what happened, especially in 1927 when the Fed bought government securities, 155 00:12:58.380 --> 00:13:00.500 banks increased their bills discounted. 156 00:13:00.500 --> 00:13:04.300 And this was completely against what the doctrine would say and the proponents of it, they were 157 00:13:04.300 --> 00:13:06.280 sort of quiet on this issue. 158 00:13:06.280 --> 00:13:10.940 Another more important thing is that during these giant spurts of bills being repaid, 159 00:13:10.940 --> 00:13:14.780 bills repaid often began before, not after the increase in securities. 160 00:13:14.780 --> 00:13:24.880 So in June 1921 to December 1921, bills discounted, declined 34% while government securities remained 161 00:13:24.880 --> 00:13:26.060 the same. 162 00:13:26.060 --> 00:13:33.100 And so this was before, this was even when the Fed had this policy, but this was before, 163 00:13:33.100 --> 00:13:36.980 so this is the fact that it wasn't, the idea was that first government securities would 164 00:13:36.980 --> 00:13:42.140 increase and then bills would be repaid, when often it was the opposite. 165 00:13:42.140 --> 00:13:47.880 So the conclusion is that Rothbard's view of the discount rate is one of the main differences 166 00:13:47.880 --> 00:13:51.820 between his and Freeman's account of Federal Reserve monetary policy in the 1920s, and 167 00:13:51.820 --> 00:13:52.940 I happen to think he's right. 168 00:13:52.940 --> 00:13:53.620 So thank you for your time.