A History of Money and Banking in the United States: The Colonial Era to World War II (42 page)

The answer made by representatives of business to the charge of socialism is that in all great emergencies, war for example, governments have always thrown themselves into the breach, because only they can organize and mobilize the whole strength of the nation. In war every country becomes practically a dictatorship and every man’s resources are at its command; the country is now in an equally great emergency.38

The RFC certainly paid off for these favored business groups. The excuse for the secrecy was that public confidence would be weakened if the identity of the shaky business or bank receiving RFC loans became widely known. But of course these institutions, precisely because they were in weak and unsound shape,
deserved
to lose public confidence, and the sooner the better both for the public and for the health of the economy, which required the rapid liquidation of unsound investments and institutions. During the first five months of operation, from February to June 1932, the RFC made $1 billion of loans, of which 60 percent went to banks and 25 percent to railroads. The theory was that railroad bonds must be protected, since many of these securities were held by savings banks and insurance companies, alleged agents of the small investor. In practice, the bulk of these RFC railroad loans went 38Theodore Knappen, “The Irony of Big Business Seeking Government Management,” in
Magazine of Wall Street
49 (January 23, 1932): 386–88, cited in Olson,
Herbert Hoover
, pp. 45–46. See also ibid., pp. 39–46; and the excellent article by William E. Leuchtenburg, “The New Deal and the Analogue of War,” in
Change and Continuity in Twentieth-Century America
, John Braeman, Robert H. Bremner, and Everett Walters, eds. (New York: Harper and Row, [1964] 1967), pp. 81–143.

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A History of Money and Banking in the United States:
The Colonial Era to World War II

to repaying debt. About a third of these loans went to repaying railroad debts to banks. Thus, one of the first RFC loans was $5.75 million to the Missouri Pacific Railroad to repay its debt to J.P. Morgan and Company, and an $8 million loan to the B and O Railroad to repay its debt to Kuhn, Loeb and Company. One of the main enthusiasts for this policy was Eugene Meyer, who touted it as “promoting recovery” by “putting more money into the banks.” It certainly did the latter, at the expense of the taxpayers and of propping up inefficient banks and businesses. The loan to Missouri Pacific was a particularly egregious case, for as soon as Missouri Pacific performed its task of repaying its debt to Morgan, it was gently allowed to go into bankruptcy.

Another consequence of RFC bailout loans to railroads was to accelerate the socialization of the railroad industry, since the RFC, as a large-scale creditor, was able to place government directors on the board of the railroads reorganized after bankruptcy.39

While the Democrats in Congress had their way after August in forcing the RFC to report to Congress on its loans, President Hoover had
his
way in finally persuading Congress to transform the RFC into a bold, “positive” agency empowered to make new loans, to engage in capital loans, to finance sales of agriculture at home and abroad, and to make loans to states and cities, instead of being merely an agency defending indebted banks and railroads. This amendment to the RFC

Act, the Emergency Relief and Construction Act of 1932, passed Congress at the end of July, and increased the RFC’s authorized capital to $3.4 billion. Eugene Meyer, suffering from exhaustion, persuaded Hoover to include, in the amended bill, the separation of the ex officio members from 39Thus, see Arthur Stone Dewing,
The Financial Policy of Corporations
, 5th ed. (New York: Ronald Press, 1953), 2, p. 1263. On the Reconstruction Finance Corporation in this period, see Rothbard,
America’s Great
Depression
, pp. 261–65.

From Hoover to Roosevelt:

293

The Federal Reserve and the Financial Elites
the RFC. But Meyer’s double-duty work was greatly appreciated by Felix Frankfurter, soon to be one of the major gurus of the Roosevelt New Deal. Frankfurter telegraphed Meyer’s wife that “Gene . . . has been the only brave and effective leader in [the Hoover] administration in dealing with depression.”40

Free-market financial writer John T. Flynn had a very different assessment of the year of the Hoover-Meyer Reconstruction Finance Corporation. Flynn pointed out that RFC loans only prolonged the depression by maintaining the level of debt.

Income “must be freed for purchasing by the extinguishment of excessive debts. . . . Any attempt to . . . save the weaker debtors necessarily prolongs the depression.” Railroads should not be hampered from going into the “inevitable curative process” of bankruptcy.41

In the meantime, Eugene Meyer was promoting more inflationary damage as governor of the Federal Reserve. Meyer managed to persuade both Hoover and Virginia conservative Carter Glass, leading Democrat on the Senate Banking Committee, to push through the Glass-Steagall Act at the end of February, which allowed the Fed to use U.S. government securities in addition to gold as collateral for Federal Reserve notes, which were of course still redeemable in gold.42 This act enabled the Federal Reserve to greatly expand credit and to lower interest rates. The Fed promptly went into an enormous 40Pusey,
Eugene Meyer
, p. 226.

41John T. Flynn, “Inside the RFC,”
Harper’s Magazine
166 (1933): 161–69, quoted in Rothbard,
America’s Great Depression
, pp. 263–64. See also J. Franklin Ebersole, “One Year in the Reconstruction Finance Corporation,”
Quarterly Journal of Economics
(May 1933): 464–87.

42The Glass-Steagall Act of 1932 also contributed to inflation of bank credit by broadening the description of what assets were eligible for banks to rediscount at the Fed. Pusey,
Eugene Meyer
, pp. 227–31; and Susan Estabrook Kennedy,
The Banking Crisis of 1933
(Lexington: University Press of Kentucky, 1973), pp. 46–47.

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A History of Money and Banking in the United States:
The Colonial Era to World War II

binge of buying government securities, unprecedented at the time. The Fed purchased $1.1 billion of government securities from the end of February to the end of July, raising its holdings to $1.8 billion. Part of the reason for these vast open market operations was to help finance the then-huge federal deficit of $3 billion during fiscal year 1932.

Thus, we see the grave error of the familiar Milton Friedman-monetarist myth that the Federal Reserve either deliberately contracted the money supply after 1931 or at least passively allowed such contraction. The Fed, under Meyer, did its might-iest to inflate the money supply—yet despite its efforts, total bank reserves only rose by $212 million, while the total money supply
fell
by $3 billion. How could this be?

The answer to the mystery is that the inflationary policies of Hoover and Meyer proved to be counterproductive. American citizens lost confidence in the banks and demanded cash—Federal Reserve notes—for their deposits (currency in circulation rising by $122 million by the end of July), while foreigners lost confidence in the dollar and demanded gold (the gold stock in the United States falling by $380 million in this period). In addition, the banks, for the first time, did not fully lend out their new reserves, and accumulated excess reserves—these excess reserves rising to 10 percent of total reserves by mid-year. A common explanation claims that business, during a depression, lowered its demand for loans, so that pumping new reserves into the banks was only “pushing on a string.” But this popular view overlooks the fact that banks can always use their excess reserves to buy existing securities; they don’t have to wait for new loan requests. Why didn’t they do so? Because the banks were whipsawed between two forces. On the one hand, bank failures had increased dramatically during the depression.

Whereas during the 1920s, in a typical year 700 banks failed, with deposits totaling $170 million, since the depression struck, 17,000 banks had been failing per year, with a total of $1.08 billion in deposits. This increase in bank failures could give any bank pause, especially since all the banks knew in their hearts
From Hoover to Roosevelt:

295

The Federal Reserve and the Financial Elites
that, as fractional reserve banks, none of them could withstand determined and massive runs upon them by their depositors.

Second, just at a time when bank loans were becoming risky, the cheap-money policy of the Fed had driven down interest returns from bank loans, thus weakening banks’ incentive to bear risk. Hence the piling up of excess reserves. The more that Hoover and the Fed tried to inflate, the more worried the market and the public became about the dollar, the more gold flowed out of the banks, and the more deposits were redeemed for cash.

Professor Seymour Harris, writing at the time and years before he became one of America’s leading Keynesians, concluded perceptively that the hard-money critics of the Hoover administration might have been right, and that it might be that the Fed’s heavy open market purchases of government securities from 1930 to 1932 “retarded the process of liquidation and reduction of costs, and therefore have accentuated the depression.”43

Herbert Hoover, of course, reacted quite differently to the abject failure of his inflationist program. Instead of blaming himself, he blamed the banks and the public. The banks were to blame by piling up excess reserves instead of making dangerous loans. By late May, Hoover was “disturbed at the apparent lack of cooperation of the commercial banks of the country in the credit expansion drive.” Eugene Meyer’s successor at the RFC, former Ohio Democratic Senator Atlee Pomerene, denounced the laggard banks bitterly: “I measure my words, the bank that is 75 percent liquid or more and refuses to make loans when proper security is offered, under present circumstances, is a parasite on the community.” Hoover also went to the length of getting Treasury Secretary Ogden Mills to organize bankers and businessmen to lend or borrow the surplus 43Seymour E. Harris,
Twenty Years of Federal Reserve Policy
(Cambridge, Mass.: Harvard University Press, 1933), 2, p. 700. See also Rothbard,
America’s Great Depression
, pp. 266–72.

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A History of Money and Banking in the United States:
The Colonial Era to World War II

credit piled up in the banks. Mills established a committee in New York City on May 19 headed by Owen D. Young, chairman of the board of Morgan’s General Electric Corporation, and the Young Committee tried to organize a cartel to support bond prices, but the committee, despite its distinguished personnel, failed dismally to form a cartel that could defeat market forces.44 The idea died quickly.

Not content with denouncing the banks, President Hoover also railed against the public for cashing in bank deposits for cash or gold. Stung by the public’s redeeming $800 million of bank deposits for cash during 1931, Hoover organized a hue and cry against “traitorous hoarding.” On February 3, 1932, Hoover established a new Citizens’ Reconstruction Organization (CRO) headed by Colonel Frank Knox of Chicago. The cry went up from the CRO that the hoarder is unpatriotic because he restricts and destroys credit. (That is, by trying to redeem their own property and by trying to get the banks to redeem their false and misleading promises, the hoarders were exposing the unsound nature of the bank credit system.) On February 6, top-level antihoarding patriots met to coordinate the drive; they included General Charles Dawes, Eugene Meyer, Secretary of Commerce Robert P. Lamont, and Treasury Secretary Ogden Mills. A month later, Hoover delivered a public address on the evils of hoarding: “the battle front today is against the hoarding of currency,” which prevents money from going into active circulation and thereby lifting us out of the depression.

President Hoover later took credit for this propaganda drive putting a check on hoarding, and it is true that cash in circulation reached a peak of $5.44 billion in July 1932, not rising above 44The Young Committee included Walter S. Gifford, head of AT&T

(Morgan), Charles E. Mitchell of the National City Bank (Rockefeller), Alfred P. Sloan of General Motors (DuPont-Morgan), and Walter C.

Teagle of Standard Oil of New Jersey (Rockefeller). Rothbard,
America’s
Great Depression
, pp. 271–72.

From Hoover to Roosevelt:

297

The Federal Reserve and the Financial Elites
that until the culminating bank crisis in February 1933. But if true, so much the worse, for that means that bank liquidation was postponed for a year until the final banking crisis of 1933.

THE NEW DEAL: GOING OFF GOLD

The international monetary system that the House of Morgan helped Great Britain cobble together in 1925 lay in ruins when Britain hastily abandoned the gold-exchange standard in late September 1931. The Morgans tried desperately to keep Britain on gold in 1931, and afterward tried to get their bearings in the newly chaotic monetary arena. By the time of Roosevelt’s accession to power in the spring of 1933, the Morgans had thrown in the towel on the American gold-coin standard; indeed, the Morgan-oriented leadership at the Treasury, Mills and Ballantine, had been agitating for going off gold considerably earlier.45 But the overriding Morgan concern was always their associates and colleagues in England, and they hoped for a rapid return to some kind of fixed-exchange-rate relation to Britain, and perhaps, by extension, to the other major European currencies as well. The Morgans wanted to reconstruct a regime of monetary internationalism as soon as possible.

But for the first time since the turn of the century, the Morgans were no longer dominant over the monetary thinking of American financial and business elites. In the midst of the cauldron of depression, a new economic and monetary nationalism, a desire for domestic inflation untrammelled by international monetary responsibilities, began to take hold. Backed by proto-monetarist and proto-Keynesian economists eager to spur inflationist federal policies to cure the depression, the shift of business groups toward inflation centered in farm and agribusiness groups, which had been agitating for higher farm prices since the early 1920s, and in industrialists making products for the retail market, who wanted government to pour new money into 45Chernow,
House of Morgan
, pp. 330–36, 358–59; Rothbard,
America’s
Great Depression
, p. 289.