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When an outflow of gold was taking place, central banks would frequently sell foreign bills of exchange upon the market in order to affect exchange rates, or would redeem their note and deposit liabilities in light-weight gold coins, and, in some instances, would refuse to pay out gold excepting upon receipt of a premium. To encourage imports of gold central banks then and now granted interest-free advances to the amount imported. The pre-war gold standard required management by central banks.

Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 424 STABILIZATION The Bank of England did not and could not pay attention to the direct or indirect effect of changes in the discount rate upon the general level of prices of commodities, although it was known, since the bullion report of 1810, that a raise of the rate tended to reduce business activity and thereby reduce the prices of commodities, and a lowering of the rate stimulated business and helped to raise prices.

These industrial and price effects were, indeed, the instruments through which the discount rate became effective over the export and import of gold, yet they had to be subordinated to the purpose of protecting the gold reserve.

Since the World War, however, in order not only to protect her gold reserves, but also to acquire enough gold to restore the gold standard, the Bank of England has been compelled both to retire paper currency and, for the past several years, to maintain generally a higher discount rate than the rates in gold standard countries, which, with other circumstances, has resulted in a long-continued depression of business, unemployment, and reduction of prices. This depression was not, however, necessary during the year 1919-20, when the United States was lending to Europe nearly $4,000,000,000 at low rates of interest. Here was the period when the Federal reserve system learned its first lesson respecting the psychological effect of low discount rates in increasing the demand for credit by foreign and American business men, and the resulting rise of prices.

This lesson shows that the administrators of the Federal reserve system learn only by experience and not by theory, just as the Bank of England learned after 1847, and just as every banker, every business man, and, indeed, everybody learns only by experience.

Through the greater part of 1919 the discount rate at New York Reserve Bank was kept at what was then a low rate of 4% per cent, on loans secured by Government collateral, which constituted nearly 90 per cent of the immense borrowings of member banks from the reserve banks. (See Chart No. I l l, Commons: Federal Reserve Bank Holdings of Bills Discounted, p. 77.) Prices began rapidly to rise in March, 1919, and continued to rise notwithstanding large net exports of gold ($407,216,000 from Ma,y, 1919, to March, 1920), which were more than offset by increases in Federal reserve credit.

Labor became fully employed and, indeed, exceedingly scarce by July, 1919, but the maximum of production in manufactures was not reached until February, 1920 (Woodlief Thomas, of Federal Reserve Board, Journal of American Statistical Association, September, 1927), after labor had been drawn from agriculture and other sources by the high industrial wages. Any further rise in prices and wages could not call forth more production nor more labor.

Hence, with the low rate of discount, it was found that prices and wages, and to a lesser extent, factory production and employment, kept on increasing until May, 1920.

What stopped further inflation in 1920 was the realization that the gold reserve of the system was rapidly approaching the legal minimum of 35 and 40 per cent. This realization forced the system rapidly to raise the rates of discount in 1920, finally reaching, in June, 6 per cent on Government collateral and 7 per cent on commercial paper (Chart No. IV, p. 78, Commons: Bond Yiejds in Relation to Commercial Rates, Rediscount Rates, and Stock Yields), with the resulting collapse of production, employment and prices, not only Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis STABILIZATION 425 in America but in all countries which did not continue to inflate their paper currency. The raise in discount rates, in America, was not based on a policy of preventing the rise in prices, but on the pre-war policy of preventing a further deflation of gold reserve, after permitting, as a matter of course, a surplus gold reserve to be used for expansion of bank credit.

Furthermore, the illusion was generally accepted in 1919 and 1920 that the rise of prices was not due to monetary policy but was due to a world scarcity of goods, caused by the war, over which the reserve system had no control. Yet it is now admitted that this world scarcity of goods was largely mythical, especially in the United States, and, in any case, could not have raised prices had it not been for the supporting abundance of credit furnished at low rates by the Federal reserve system. Demand is only effective if backed up by purchasing power, and this was provided by a skyrocketing increase in money and credit.

The discount policy of the system had not been directed, in 1919, toward preventing a rise in prices, but was directed toward maintaining the price of Government securities which had been issued at low rates of interest. These Government issues were made at 4% per cent (Chart No. I I, Commons, p. 77, Money Rates at New York), at a time when the bond yield on the best private bonds was 5 to 514 per cent, so that, in order to support the par value of Government securities, the discount rate at the reserve banks, when secured by Government collateral, had to be kept at 41/4 per cent.

Had the discount policy been directed toward preventing a rise of prices in 1919 beyond the point where production, trade and employment were at their maximum, the rate of discount, as learned by later experience, would have been raised as early, perhaps, as March, 1919, when business was hesitating, instead of waiting until the end of 1919 and the early part of 1920, when business demand for credit was expanding, not for production, but solely in expectation of higher prices. And public warnings would have been given out, not that there was a world scarcity of goods, requiring increased production, over which the reserve system had no control, but that there was a menace of excessive inflation of prices and wages beyond the needs of productive credit, which the reserve system could and would prevent, if necessary, by raising the discount rates.

How high the rate of discount needs to be raised in order to prevent further increases in prices is a matter of which much may be learned through experience. Experience has taught the reserve system that if they wait too long, until a frenzy of commodity speculation is running headlong, it requires an excessive rise of the discount rate, like the 7 per cent rate on commercial paper in June, 1920, to check the further optimism of business and rise of prices. But if they begin early, when business activity is hesitating, then a very sligh^ increase will prevent a further rise of prices. Doctor Miller, of the Federal Eeserve Board, estimated, on the basis of experience, that a raise of only three-fourths of 1 per cent—that is, from 4*4 to 5 per cent—if taken as early as the middle of 1919, would have prevented any considerable rise of prices thereafter. If this estimate is accurate, then a very slight increase in the discount rate as early as April, 1919, when member banks were in debt to the reserve banks and business was beginning to recover, but was still hesitating, would have accom

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point of 42.4 per cent, and there was little menace in that direction, so that a timely but gradual reduction of the rate would have changed the pressure of credit policy from that of driving down prices to that of mitigating and slowing up the general fall of prices. While the excessively high rate of 7 per cent in June, 1920, was probably justified as a means of protecting the gold reserve when once it had been reduced to its legal limit by the excessively low rates of discount of 1919, yet the continuance of that high rate during 11 months of rapid depression of business can be explained only by the illusion that monetary policy had no effect on prices or by the determination to penalize producers for their previous overproduction and inflation of prices, although these had been stimulated by the low discount policy of the system itself in 1919.

At any rate, there was no guiding principle of stabilizing the purchasing power of the dollar, either by preventing the general rise of prices by higher rates of discount early in 1919 or of cushioning the fall of prices by low rates soon after the fall had begun in June, 1920.

Extreme liquidation was, indeed, temporarily delayed by renewing frozen loans, but this was done at such high rates of interest that it could do little more than postpone the bankruptcies inevitable on account of the excessive fall of prices.

After the depression of 1921 a new problem came to the front, not present in 1919, namely, that of the open market purchases of the Federal Reserve banks. In the latter part of 1921, the Federal reserve banks, when the demand for commercial credit was at its minimum, began separately to use their excessive gold reserves for the purchase of Government securities, and purchased, up to May, 1922, about $410,000,000 of such securities. This turned out to be equivalent to the importation of that much gold, and, to gether with the large imports of gold itself accumulated during the latter part of 1920 to the end of 1922 ($1,083,000,000) and recovery of business owing to scarcity of goods, helped to reduce the rates of discount to 4 per cent in New York (Chart No. II, Commons, p. 77, Money Bates at New York) and to encourage borrowings by the business public. The combined effect began to show itself on general prices in January, 1922, which rose 12 per cent within six months.

This new problem of open-market purchases by the 12 reserve banks competing with each other was taken in hand in May, 1922, by joint action of the governors of the reserve banks, who then, for the first time, instituted a centralized control of open-market operations. They sold securities to the amount of $511,0p0,000 from May, 1922, to October, 1923, proceeding at a particularly rapid rate from March to October, 1923. This compelled member banks to rediscount in large amounts, to raise commercial rates and, together with increases in the rates of rediscount following these increased in commercial rates, to aid in restraining the rise of prices. The volume of production, trade and employment, however, continued toward their peak until March and April, 1923, followed by a decline in prices, production, trade, and employment, which reached bottom in June and July, 1924.

There arose, in 1922 and 1923, within the system itself, two conflicting theories, not as to the economic effects of the open-market operations and rediscount rates, but as to their timeliness and amount.

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to the amount of $511,000,000 from May, 1922, to October, 1923, it had purchased securities to the amount of, say, $500,000,000; and instead of raising its rates of discount in February, 1923, it had lowered its rates earlier below the preceding level of 4 per cent.

And, instead of the publicity advising caution, suppose there had been a continuance of the publicity advising greater production and expansion. It is wholly unlikely that the rising price movement would have been checked in the early part of 1923, as it actually was checked.

The inflation would probably have continued, much as it was expected to continue by those who were alarmed at the rapid rise of prices in

1922. Faced by the choice of these alternative policies and probably different results on prices, it becomes evident that it required considerable dogmatism and evasion to contend that Federal reserve credit policy had little or no effect on the happy outcome of 1923.

A better explanation, and more creditable to the system, would be the one that it had learned by the experience of 1919-20 and later, not to use its powers of open-market operations, rediscount rates, and publicity to stimulate an already rapid expansion of business and rise of prices beyond the needs of lull production and full employment, but had learned somewhat how to begin early enough, and in the right degree and amount, to use its powers to check that overexpansion and rise of prices beyond the limits of production and safety.

These considerations apply to the fall in the index number of wholesale prices from 159 in March, 1923, to 145 in June, 1924, a 9 per cent decline, accompanied by the above-mentioned decline in production, employment, and trade. This fall proceeded in part from nonmonetary considerations, especially the fall in agricultural prices. But it does not follow that the extreme fall was due solely to nonmonetary causes. The rate of discount was maintained at 41/2 per cent throughout 1923 into 1924 from May to October, at the different reserve banks. This was a relatively high rate at this time, when the increased savings of the country had brought a rise in bond prices so that the bond yield had fallen to slightly under 5 per cent (Chart IV. Commons, p. —, Bond Yields, etc.) In 1919, the discount rate 01 4% per cent had been a low rate compared with the bond yield of 5.01 to 5.35 per cent, but in 1923 the discount rate of 4% was a much higher rate compared with the lower bond yield which ranged from 4.77 to 4.94 per cent. (Chart IV.) Whether a discount rate is low or high is not to be measured absolutely in itself but relatively to other rates of interest, especially to the bond yield which represents mainly the rate on savings. Accumulated savings were scarce in 1919, so that bond yields were high, but became more abundant in 1923, with a marked fall in bond yields.

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