In working on my forthcoming book dealing with the Great Depression, I noticed something intriguing about the discount rate of the Fed. Oh wait, I should first clarify — I’m talking about the New York Federal Reserve Bank, because the Fed banks had more autonomy in the beginning, and so you couldn’t talk of “the Fed’s” discount rate.
What I noticed is that from the time it opened its doors in November 1914, all the way through 1931, the New York Fed charged its record-low rates at the very end of this period. The “discount rate” was the interest rate the Fed banks would charge on collateralized loans made to member banks. For the New York Fed, rates had bounced around since its founding, but they were never higher than 7 percent and never lower than 3 percent, going into 1929.
This changed after the stock-market crash. On November 1, just a few days following Black Monday and Black Tuesday — when the market dropped almost 13 percent and then almost 12 percent back to back — the New York Fed began cutting its rate. It had been charging banks 6 percent going into the Crash, and then a few days later it slashed by a full percentage point.
Then, over the next few years, the New York Fed periodically cut rates down to a record low of 1 ½ percent by May 1931. It held the rate there until October 1931, when it began hiking to stem a gold outflow caused by Great Britain’s abandonment of the gold standard the month before. (Worldwide investors feared the United States would follow suit, so they started dumping their dollars while the American gold window was still open.)
The Fed Hiked Rates During the Depression of 1920–1921
So far my story doesn’t sound unusual. “Everybody knows” that the Fed is supposed to slash rates to ease liquidity crunches during a financial panic. It helps to ease the crisis, and provides a softer landing than if the supply of credit were fixed.
But guess what? Throughout the period we are considering, the highest the New York Fed ever charged banks was 7 percent. And the only time it did that was smack dab in the middle of the 1920–1921 depression.
Although you’ve probably never heard of it, this earlier depression was quite severe, with unemployment averaging 11.7 percent in 1921. Fortunately, it was over fairly quickly; unemployment was down to 6.7 percent in 1922, and then an incredibly low 2.4 percent by 1923.
After working on these issues for my book, it suddenly became obvious to me: the high rates of the 1920–1921 depression had certainly been painful, but they had cleaned the rot out of the structure of production very thoroughly. The US money supply and prices had roughly doubled during World War I, and the record-high discount rate starting in June 1920 was a pressure washer on the malinvestments that had festered during the war boom.
Going into 1923, the capital structure in the United States was a lean, mean, producing machine. In conjunction with Andrew Mellon’s incredible tax cuts, the Roaring Twenties were arguably the most prosperous period in American history. It wasn’t merely that the average person got richer. No, his life changed in the 1920s. Many families acquired electricity and cars for the first time during this decade.
Why Central Banks Should Raise Rates in a Panic
In contrast, during the early 1930s, the Fed’s rate cuts “for some reason” didn’t seem to do the trick. In fact, they sowed the seeds for the worst decade in US economic history.
Now let’s be clear, I am not merely arguing from historical correlations. There is a perfectly good theoretical explanation for why the record-high rates in the early 1920s were the right policy, while the record-low rates in the early 1930s were the wrong policy. We quote from Lionel Robbins, who wrote from a 1934 vantage point and applied the Mises-Hayek business-cycle theory to the world collapsing before his eyes:
Now in the pre-war business depression a very clear policy had been developed to deal with this situation. The maxim adopted by central banks for dealing with financial crises was to discount freely on good security, but to keep the rate of discount high. Similarly in dealing with the wider dislocations of commodity prices and production no attempt was made to bring about artificially easy conditions. The results of this were simple. Firms whose position was fundamentally sound obtained what relief was necessary. Having confidence in the future, they were prepared to foot the bill. But the firms whose position was fundamentally unsound realised that the game was up and went into liquidation. After a short period of distress the stage was once more set for business recovery.
It’s actually easier to see if you forget about a central bank, and just pretend that we were living in the good old days when banks would compete with each other and there was no cartelizing overseer. Now in this environment, when a panic hits and most people realize that they haven’t been saving enough — that they wish they were holding more liquid funds right this moment than their earlier plans had provided them — what should the sellers of liquid funds do?
The answer is obvious: they should raise their prices. The scarcity of liquid funds really has increased after the bubble pops, and its price ought to reflect that new information. People need to know how to change their behavior, after all, and market prices mean something.
But in more modern times, thanks not just to Keynes but, more important, to Milton Friedman, central bankers now think that during the sudden liquidity crunch, they are supposed to shovel their product out the door. But in order to do that, of course, they have to water down its potency. It’s as if a wine dealer suddenly has a rush of customers for a rare vintage of which he only has 3 bottles, and his response is to put the vintage on sale but then dilute it with 9 parts water to 1 part wine. That way he can sell to all the eager customers and not pick their pocket at the same time.
Now I know there is a big dispute in the Austrian-libertarian academic world over whether banks in a legitimately free market would have 100% hard-money reserves in the vault, or if banks would be allowed to lend out some of their customers’ checking-account deposits to other customers. I’m not taking a stand on that here.
What I am saying, though, is that if we decide banks ought to be able to engage in fractional-reserve lending — so that the total supply of credit can be expanded if the banks want to stretch their reserves thinner — then we still agree that the unit price of that expanded credit issue ought to be higher.
If the owner of a trucking company experiences a huge rush for his services, he might decide to postpone essential maintenance on his fleet, to take advantage of the unprecedented demand. But during this period he will be charging record shipping prices to make it worth his while to deviate from the normal, “safe” way of running his business. He will only be willing to bear the extra risk (either to the safety of his drivers or just the long-term operation of the trucks) if he is being compensated for it.
The same is true for the banks. Just as every other business during a recession wants to bolster its cash reserves, so too with the business that rents out cash reserves. If there’s a hurricane, the stores selling flashlights and generators should raise the prices on those essential items, to make sure they are rationed correctly. The same is true for liquidity — the moment after the community realizes they are in desperate need of it.
Conclusion
It was a good thing for Americans that Herbert Hoover — regardless of his other disastrous policies — did not want the United States to abandon the gold standard. Because its gold reserves were plummeting, the Fed had no choice but to reverse its disastrous course in late 1931. The next two years were awful, but that was because so much capital had been squandered in the boom and then in the easy-money collapse.
FDR was sworn into office in March 1933. Had he followed the same pattern as Warren Harding and Calvin Coolidge — i.e., had he basically kept the federal government out of it — Americans might have looked back at the Great Interruption, referring to the three-year gap between the Roaring Twenties and the Zooming Thirties.
Switching to today, the sad fact is that Ben Bernanke and the other central bankers of the world do not have any feedback on their behavior. There is no dwindling stock of gold reserves to signal to them that they are doing something horribly wrong. Like all central planners, they are groping in the dark, as Mises said.
Although the dollar is no longer tied to gold, that will not stop the dollar price of gold from exploding when more investors realize that no one, not even a sharp guy like Ben Bernanke, ought to hold the fate of the world’s economy in his hands.
