Economics and the Public Welfare. Benjamin M. Anderson
3,762,104,551
[print edition page 69]
From this table it is clear that we met almost all of our adverse trade balance with the non-European world with shipments of gold and silver. We more than made up the rest by shipments of Federal Reserve notes, chiefly to Cuba, although Federal Reserve notes also went to Santo Domingo, some to the northern parts of South America, and in minor amounts to other countries.
[print edition page 70]
The Causes of the Crisis of 1920
The Quantity Theory of Money Stops Analysis of Causes. With the turn in the tide of commodity prices in the spring of 1919 there came into vogue a ready-made explanation which gave great comfort and confidence to the speculators and to the business community as the boom of 1919-20 proceeded. It was the explanation afforded by the quantity theory of money. Money in circulation and bank credit in the United States were enormously expanded as compared with the prewar situation. Commodity prices were enormously higher. But the prices, according to this theory, were higher because of the expansion of money and credit, and the prices were consequently safe, and adequately explained. Professor Irving Fisher was the leading advocate of this view in the United States. The formula of the quantity theorists is a monotonous “tit-tat-toe”—money, credit, prices. With this explanation the problem was solved and further research and further investigation were unnecessary, and consequently stopped—for those who believed in this theory. It is one of the great vices of the quantity theory of money that it tends to check investigation of underlying factors in a business situation.1
[print edition page 71]
The quantity theory of money is invalid.2 It was clear as early as May 1919 that the boom was thoroughly unsound, that the commodity prices prevailing were dangerously high and very precarious, and that the longer the boom lasted, the more violent the reaction would be.3 The basic cause of the boom was in the factors which we have previously considered, notably, the one-sided export trade to Europe first financed by the government, and, second, the going on the basis of unfunded private credits. We cannot accept a predominantly monetary general theory either for the level of commodity prices or for the movements of the business cycle.
Money and credit have their place in the explanation of both of these problems, but they are only a part of the explanation and often are a very minor part. The role of bank credit in particular is very frequently secondary and passive. Bank credit usually adapts itself to the underlying factors, rather than forcing the pace. Very notable exceptions, as we shall see, appeared in the period 1922-29, and in the period 1897-1903. The monetary forces provide the primary explanation of our Civil War prices, when our currency was the irredeemable greenback. Monetary forces may well dominate our price situation following World War II. The inflowing gold and the resultant ease with which the expansion of bank credit could go on were contributory factors of great importance in the rise of commodity prices in 1916 and the first part of 1917.
Money and Credit as Factors in the 1919-20 Boom. The factor of money and bank credit was not the dominating factor in the postwar boom, 1919-20, despite the fact stated above, that bank loans and investments in the United States expanded 25.4 percent between April 11, 1919, and April 9, 1920. This expansion was, on the whole, a reflex rather than a cause of the other phenomena. We were losing gold from April 1919 through April 1920. Our gold stock stood at $2,890,000,000 in April 1919 and at $2,554,000,000 in April 1920, a decline of $336,000,000, or 12 percent. Interest rates rose steadily and to very great heights. Open market commercial paper which had sold at 5.5 percent at the beginning of 1919 sold at a 7 percent rate in early 1920, reaching a peak of over 8 percent in the third quarter of 1920. Prime customers’ loans at the great city banks did not rise as high as this, but they rose steadily, and 7 percent was a very common rate for strong corporations before the boom was over.
Federal Reserve Rediscount Rates Below the Market. It must be recognized, however, that the handling of the Federal Reserve rediscount rate permitted the expansion to move faster and to go further than would otherwise have been the case. That rate was held at 4 percent through the greater part of 1919 despite the rising rates of interest in the money market.
[print edition page 72]
The explanation appears to be that the Federal Reserve authorities did not wish to raise their rate until the government had got over the peak of its borrowings. That peak was reached, however, in August 1919, whereas the rise in the Federal Reserve rate was delayed until November 1919. The New York Federal Reserve Bank suddenly found itself with a reserve deficiency and was thus obliged under the law to raise its rate. The rate went to 4.75 percent on November 4, 1919, to 6 percent on January 23, 1920, and to 7 percent on June 4, 1920. The other Federal Reserve banks followed New York in these moves, though only three of them went to 7 percent in June. It is thus true that down to January 23, 1920, it was definitely profitable for a member bank to rediscount at a Federal Reserve bank and relend to its customers. Too many of them did this, and too many of them found themselves heavily indebted to the Federal Reserve banks when the crisis came. The head of one great trust company, early in January 1920, put this question to an economist: “How much longer is it safe for me to go on borrowing at the Federal Reserve bank to relend at a profit?” He was shocked and startled when the economist replied that he had already gone much too far, that he had borrowed twice his reserves, and that it was essential for him to pull up. He did pull up and let some profitable business go to some other institutions, and took good care of his customers when the crisis came in autumn 1920.
The great New York banks in general were very reluctant to borrow from the Federal Reserve bank when the system was first inaugurated. Banks in general were disposed to feel that it was a sign of weakness if they rediscounted with the Federal Reserve banks, though banks in the Dallas district, where there is an immense pressure in the cotton-moving season, very early learned to do so. But it was not until the coming of war finance or shortly before this that the great New York banks rediscounted. They did so at the request of the Federal Reserve