Academic journal article Journal of Money, Credit & Banking

Member Bank Borrowing and the Fed's Contractionary Monetary Policy during the Great Depression

Academic journal article Journal of Money, Credit & Banking

Member Bank Borrowing and the Fed's Contractionary Monetary Policy during the Great Depression

Article excerpt

The influence of the reserve banks upon the volume of credit is felt not directly, but indirectly through the member banks. The reserve banks do not "push" credit into use. Benjamin Strong, U.S. House of Representatives, 1926

INTRODUCTION

THE CONTRIBUTION OF "INEPT" FEDERAL RESERVE monetary policy to the length and severity of the Great DepressiOn is now well understood. In their MonetaryHistory of the United States, Friedman and Schwartz (1963) demonstrate the importance of monetary forces in the Depression. And recent studies by Bernanke (1983), Field (1984a,b), and Hamilton (1987) emphasize further the importance of restrictive monetary policy on economic activity from 1929 to 1933. However, the reasons why the Fed failed to respond vigorously to the Depression are not so clear. Were the Fed's failures the product of leadership or other organizational changes? Or, were they caused by the pursuit of a flawed strategy, and thus independent of the System's structure?

Friedman and Schwartz (1963, pp. 407-19) contend that the death of Benjamin Strong, Governor of the Federal Reserve Bank of New York, in 1928, and a subsequent reorganization of the Open Market Committee caused a major change in the Fed's responsiveness to economic conditions. They argue that under Strong's leadership in the 1920s the Fed had used open-market operations effectively to limit fluctuations in economic activity. But those officials who gained power after Strong's death did not understand the role of monetary policy and permitted widespread bank failures and collapse of the stock of money during the early 1930s.

Two aspects of the Friedman and Schwartz interpretation of Federal Reserve behavior have been challenged. Their view that monetary policy was used effectively during the 1920s has been challenged by Miron (1988), Toma (1989), and Wheelock (1989). Miron shows that output was less stable following the Fed's founding in 1914 than it had been previously. Wheelock finds evidence that the Fed did attempt to stabilize output, but that its operation had no impact on the volume of Federal Reserve credit outstanding. And Toma demonstrates that the Fed's open-market operations had no effect on the supply of money. Since these studies suggest that the Fed's policies were not successful during the 1920s, they imply that the failure of monetary policy to revive the economy during the Depression might not have resulted from a substantial change in Fed behavior.

Wicker (1966) and Brunner and Meltzer (1968) argue that indeed Fed errors during the Depression are traceable to policy during the 1920s. Wicker contends that the Fed had little understanding of how monetary policy should be used to stabilize economic activity. He argues also that the Fed's operations in the 1920s were made in response to international events, not to stabilize the domestic economy (Wicker 1966, pp. 77-94, 106-16). Brunner and Meltzer (1968) and Meltzer (1976) argue that the Fed did not respond vigorously to the Depression because officials believed that low nominal interest rates and little member bank borrowing signaled exceptional monetary ease. Brunner and Meltzer contend that the Fed had been guided similarly by interest rates and bank borrowing during the 1920s and hence that there was no change in Fed behavior.

During the 1920s the Fed developed a reserve position strategy in which it used open-market operations to target" (1) borrowed reserves. The current Fed procedure of using borrowed reserves as an operating target is quite similar. And, as Thornton (1988, p. 33) describes, "strict adherence to the borrowings procedure will not provide effective money stock control." In this paper I argue that during the 1920s and early 1930s the System's operating tactics caused monetary policy to be ineffective, even destabilizing. The Fed's strategy did not lead to effective money stock control. And the borrowed reserves procedure was particularly inappropriate during the Depression because of instability in borrowed reserve demand induced by financial crises. …

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