phillips - banking and the business cycle; a study of the great depression in the u. s. (1937)

BANKING AND THE BUSINESS CYCLE A Study of the Great Depression in the United States C. A. PHILLIPS, PH.D. Dean, the College of Commerce, State University of Iowa T. F. McMANUS, PH.D. College of New Rochelle, New York R. W. NELSON, PH,D. Síaíe University of Iowa NEW YORK THE MACMILLAN COMPANY 1937 COPTRIOHT, 1937, Br THE MACMILLAN COMPANY ALL· SIGHTS BE8EBVED—NO PAST OF THIS BOOS MAT BB BEFRODUCED IN ANT FORM WITHOUT PERMISSION IN WRITING FROM THE PUBLISHER, EXCEPT BT A REVIEWER WHO WISHES TO QUOTE BBIEF PASSAGES IN CONNECTION WITH A BEVIEW WRITTEN FOB INCLUSION IN MAGAZINE OB NEWSPAPÏB Published March, 1937 SET UP AND ELECTBOTTPED BT T. MOBET * SON PRINTED IN THE UNITED STATES Or AMEBICA "* * * reckless inflations of credit—the chief cause of all economic maL·ise * * *" Alfred Marshall u * * * ¿fø recen t world-wide fall of prices is best described as a monetary phenomenon which has occurred as the result of the monetary system failing to solve successfully a problem of unprece- dented difficulty and complexity set it by a con- junction of highly intractable non-monetary phenomena." The Macmillan Committee Report PREFACE The task that is attempted in this book is a contribution to an understanding of the banking and financial events of the War and post-War period as the underlying causes of the Great Depression in the United States. There were many causes which contributed to this collapse; among others, mention might be made of misguided tariff policy, war debts, monopolistic practices. Our failure to accord certain non-monetary phenomena special treatment is not to be construed as disregarding their influence; we have pre- ferred to focus attention upon those causes which we believe to be predominantly basic. There is good reason for this belief. In no previous de- pression have all of the same non-monetary phenomena been present; in no previous depression have the monetary phenomena been absent. The financial mistakes of the past two decades are not dissimilar to those of England during and following the Napoleonic Wars, and the inflation of the Civil War and the depression of the 'seventies bear striking resemblance to the recent upheaval; the follies of the ages are repeated again and again. It is a melancholy fact that each generation must relearn the fundamental principles of money in the bitter school of experience. The inflationists, it would seem, we always have with us. It is nevertheless a duty of economists to devote attention to periodic reiteration of the ancient truths of monetary science; it is necessary to make as familiar as possible the workings of the financial machinery if further errors are to be avoided in the future. It is to the mismanagement of the monetary mechanism that most of our recent troubles are chiefly ascribable. And with the juggernaut of another inflationary boom already upon us, emphasis upon the monetary causes of the last depression, to the neglect of others, is not only warranted viii PREFACE but needful if progress toward an understanding of business cycles is to be expected. The scope of this study we have endeavored to explain fully in the introductory chapter. It remains for us here to indicate our obligations to those who have aided in one way or another in the constructive part of the work. Theorists in the field of business cycle causation owe a permanent debt of gratitude to the work of Robertson, Hayek, and Keynes; ours will be sufficiently obvious in the pages which follow, but we would emphasize it at this point. Our purpose has been in large part that of developing the underlying theo- retical portion of their works into an explanation of the depression in this country. Of American economists writing before the event, Dr. B. M. Anderson, Jr. and Professor H. Parker Willis were perhaps most conversant with the nature of the post-War banking developments leading up to the 1929 panic, and our own knowledge has been en- riched by their analyses. Professor Ralph A. Young's study for the National Industrial Conference Board, The Banking Situation in the United States, proved an invaluable guide. Finally, Professor T. E. Gregory has unknowingly aided in smoothing several knotty points. We are indebted to Professor James Washington Bell of Northwestern University and to Dr. Howard Bowen of the State University of Iowa for direct and personal interest while the work was in preparation. Professor Bell read the manuscript in entirety, and made suggestions as to organiza- tion and placement of emphasis which have been incor- porated. Dr. Bowen was an interested and friendly critic during the earliest stages, and aided in clarifying several theoretical questions, especially in Chapter V. But no amount of acknowledgment to others can shift responsi- bility for any faults which may inhere in the volume. C. A. P. T. F. M. R. W. N. February 28, 1937 TABLE OF CONTENTS CHAPTER PAGE I. INTRODUCTION 1 II. GENERATING THE GREAT DEPRESSION . 11 Points of Departure 11 Inflation and Its Causes 13 Banking in Relation to War Finance 14 Utilization of Surplus Reserves Through Govern- ment Borrowing Productive of Manifold Deposit Expansion 15 Extent of Inflation 19 Forces Underlying Inflation 20 Credit "Slack" in the United States 22 Reduction of Reserve Requirements an Inflation- istic Step 23 Reserve Banking Inherently Inflationistic 24 Issue of Federal Reserve Notes Favored Inflation . 28 The Federal Reserve Act and Time Deposits . . 29 Unequal Credit Expansion of Member and Non- Member Banks 29 Banks' Purchase of Government Securities a Potent Cause of Credit Expansion 33 Post-War Price Levels Abnormal 34 Post-War Depression Inevitable 35 Proximate Versus Ultimate Causes of the Great De- pression 35 III. THE ROLE OF GOLD 37 "Popular" Explanations 37 Erroneous Explanations of Depression Indict Gold 38 Critical Examination of Warren-Pearson Conten- tions 40 Importance of Location of Gold Is Pivotal . 44 Bearing of Gold Exchange Standard 48 Significance of Gold Bullion Standard 49 Increasing Use of Checks Effects Gold Economy 49 Cessation of Gold Production Would Have Resulted in No Shortage 50 ix x TABLE OF CONTENTS CHAPTEB PAGE The Question of Maldistribution of Gold 51 Maldistribution Merely Symptomatic 51 Conditions Requisite to Satisfactory Operation of Gold Standard 53 Toppling of Prices Was Last Stage of Decline from Heights of War Inflation 55 IV. OVERPRODUCTION, UNDERCONSUMPTION, AND MALDISTRIBUTION OF INCOME AS CYCLICAL FORCES . 57 The Underconsumption Theory 57 Variants of the Underconsumption Theory . . 58 Overproduction Contrasted with Ill-Assorted Pro- duction 59 Price, the Key-Log 61 Enlarged Production Constitutes Enhanced Demand 62 Overproduction Apparent, Not Real 63 Technological Unemployment 64 Excessive Credit Expansion Leads to Misap- plication of Capital 67 The Underconsumption Contention 69 Underconsumption Idea May Have Partial Validity Temporarily 69 Refutation of Underconsumption Theory , . 70 Maldistribution of Income as a Possible Cyclical Force 73 Banking Policy a Disturbing Factor 76 V. POST-WAR DEVELOPMENTS IN AMERICAN BANKING 78 Unprecedented Expansion and Contraction of Capital Credit 79 Factors Underlying Credit Expansion 79 Effects of Investment Credit Inflation 81 The Extent of Inflation 82 The Initiating Source of the Inflation 85 Open-Market Purchases Significant 88 Facilitating Factors in the Inflation 91 Disproportionate Growth of Time Deposits Re- sulted in Progressive Decline in Average Reserve- Deposit Ratio 95 TABLE OF CONTENTS xi CHAPTER PAOB Bank Credit Expansion Versus Direct Saving as Affecting Growth of Time Deposits 98 Payment of Interest on Time Deposits a Factor in Their Expansion 100 Federal Reserve Board Cognizant of Time-Deposit Developments 100 The Paradox of Increasing Member Bank Credit Combined with Rising Reserve Ratio of Federal Reserve Banks 101 The Nature of the Inflation 103 Commercial Loans Strikingly Stable . . . 105 Effects of the Inflation 106 Liquidity of Banks Impaired 107 Two Aspects of Liquidity 108 Decline in Ratio of Gold to Deposits Suggests Declining Liquidity 110 Credit Extension by Indirection Ill An Inherently Instable Boom 112 VI. THE FUNDAMENTAL CAUSES OF THE GREAT DEPRESSION 115 Developments in Business Cycle and Monetary Theory 115 An Integrated Explanation . . . . . . . 116 Dominating Explanatory Considerations . . . 118 Complexity of Present-Day Competitive Economic Order 119 Inherent Disequilibrating Forces 119 Oscillation Greatest in Capital Goods Indus- tries 120 Production of Iron and Steel as "Trade" Barometers 122 Constructional Activity in United States during Pre-Depression Period Pro- digious 124 Production of Machine Tools an Indicator of Variations in Production of Capital Goods 126 Production of Consumption Goods Relatively Stable 126 Disparity Between Investment and Saving Causes Cyclical Swings in Business Activity 128 Genesis of Saving and Investment Disparities . . 129 xü TABLE OF CONTENTS CHAPTER PAGE Oscillation of Market Rate of Interest About Natural Rate Supplies Condition for Divergence Between Rate of Investment and Rate of Saving 129 Manufacture of "Bank Money" Creates Disparity Between Market and Natural Rates of Interest and Alters Structure of Production 132 Pivotal Importance of Degree of Stability in Rate of Increase of Investment 135 Bank Credit Expansion Accelerates Rate of In- vestment Increase 135 "Created" Purchasing Power Enhances Profits in Circular Fashion 137 Exaggerated Character of Recent Cycle Attributable to Central Banking Operation 139 Foregoing Analysis Compatible with Explanation of Earlier Cycles 140 The Immediate, Inciting Cause of Decline . . . 142 Both Market Rate and Natural or Productivity Rate of Interest Vary Toward Convergence . . 143 That Natural Rate of Interest Varies Is Peculiarly Important 144 Sound Theory Essential to Accurate Forecasting . 146 Recent Cycle Theories Diversely Deficient . . . 147 VII. THE FUNDAMENTAL CAUSES OF THE GREAT DEPRESSION (Continued) 149 Forecasters Led into Error by Previous Cycle Pat- terns 149 Neglected Factors 150 Percussive Character of Stock Market Crash. . . 151 Stock Market Boom, with Its Fleeting Profits, Sustained Consumer Demand, Delayed and Intensified Disaster 153 Stock Market Boom Stimulated by Rapid Re- tirement of Federal Debt and Mushroom Growth of Investment Trusts 153 Stock Prices in Relation to Corporate Earnings 155 Bank Credit Directly Underlay Stock Market Advance 158 Chronological Aspects of Production Decline in Relation to Stock Market Collapse 160 Prolonged Process of Investment Deflation . . . 160 TABLE OF CONTENTS xiii CHAPTEB PAGE How Shrinkage in Security Values Repressed Pro- duction Activity 161 Shaken Confidence Reflected in Drastically Cur- tailed Construction Notably in Capital Goods Industries 162 Impact on Income 164 Entanglement of Banks with Depression 167 Bank Failures Dealt Disruption 168 The Equilibrium Theory of the Business Cycle . . 170 Equilibrium View Essential 172 VIII. BANKING POLICY AND THE PRICE LEVEL . 175 Misleading Behavior of Post-War Price Level . . 175 Unjustified Criticism of Federal Reserve Board . . 176 Stable Price Level and—Ensuing Depression! . . 177 Did Federal Reserve Board Deliberately Attempt Price Stabilization? 178 Currency Management Difficult—But Not New . 181 Rediscount Rate Changes and Open-Market Opera- tions as Instruments of Control 182 Motivation of Adoption of Price-Stabilization Policy 184 Historical Analogy Prompts Skepticism as to Fullness of Post-War Price Recession 184 Unprecedented Technical Progress Indicated Falling Prices Normal 186 Parallelism Between Growth of Bank Credit and Productivity 188 Absence of Inventory Inflation 189 Effects of Inflation Best Measured Where Use of Credit Most Active 190 Why Stabilization of Price Level Is an Improper Objective of Banking Policy and an Inadequate Guide 191 Artificial Support of Price Level Resulted in "Relative "Inflation 193 Bearing of Cycle Theory upon Control Policy . . 195 Theoretical Foundations of Federal Reserve Policy 196 Some International Consequences of "Easy Money" Policy of the United States 197 Currency Management the Offspring of War Finance 199 Policy of Stabilization of Price Level Tends Toward Its Own Collapse 200 [...]... analysis is irrefragable, as far as it goes, but Withers here does not take account of the nature and significance of central banking in relation to the War-time inflation The operation of the machinery of bankers' banking made possible the creation of the greater portion of the credit by means of which both the United States and England financed the War It was not the effect of such transactions as... attempting to harmonize the various conflicting views, nor to give a precise and formal definition of inflation 14 BANKING AND THE BUSINESS CYCLE form of inflation which will be discussed in the main here, as it was resorted to on an extensive scale by all countries participating in the War, and it was the predominant type of inflation in the case of the United States BANKING IN RELATION TO WAR FINANCE... that followed after the dislocations caused by war The ultimate causes of the depression are traceable to the War; just as the late war was the Great War, the recent depression was the Great Depression But the more immediate causes of the depression grew out of the post-War inflation of bank credit in this country It is sought to show that the main cause of the dislocation in trade and industry was,... FINANCE The World War was probably the worst-financed war in history from the viewpoint of sound fiscal policy Less of the monetary costs of the War was financed by taxation and more by inflation of one form or another than any of the wars of the nineteenth century Mr Hartley Withers estimates that 17ì per cent of the cost of the War to England was covered by taxation,1 and Sir Josiah Stamp states that... correlated with the banking and financial situation in the United States during the post-War years into an explanation of the causes of the Great Depression "Causes" is used advisedly, it being "at once evident that no general or single theory is valid for so varying and varied a phenomenon as crisis." 2 And, as Professor Clark states,3 most "theoretical studies give us causes that are too few and too... understanding of what was taking place in American banking during the post-War years is therefore essential to a thorough analysis of the causes of the depression The reader should be warned, however, that this is not a history, either of the entire post-War banking situation in this country, or of post-War American economic life, or of the depression itself in its entirety: rather, the emphasis is upon an... upon an analysis of those factors in banking and economic development which were basically causal to the Great Depression As the depression has been denominated primarily a central banking phenomenon, it will also be desirable to attempt to unravel some of the changes caused in the structure, organization, and operation of the American banking system by the establishment of the central banking system... fixing of a lower reserve ratio against time than against demand deposits, and the general reduction of reserve requirements contained in the original Act as well as the further reductions effected as an aid to war financing by the Amendment of June 21,1917 Through the purchase of investments commercial banks impart a positive upward impulsion to the business cycle Coming in as a marginal determining... 22 BANKING AND THE BUSINESS CYCLE sharp increase in Federal Reserve credit outstanding began, and it was with the increase in deposits in the latter part of the year that the real rise in prices started It is not denied that a contributing cause of this price inflation was found in the huge quantities of gold thatflowedinto this country from Europe during the early years of the War But in spite of these... reserve base came about simply as a result of the creation of a central banking system This is because of the fact that a system of central banking operates to dilute cash, so that reserves in effect go further In a system devoid of bankers' banking, reserves consist of lawful money in the vaults of individual banks; in a system incorporating central banking, legal reserves for the member banks of the system . com- monly supposed. An understanding of what was taking place in American banking during the post-War years is therefore essential to a thorough analysis of the causes of the depres- sion. The. BANKING AND THE BUSINESS CYCLE chain of causation and explains the origin of the boom; the structural view, with its emphasis upon the changes in the structure of production and the disequilibrium. Report PREFACE The task that is attempted in this book is a contribution to an understanding of the banking and financial events of the War and post-War period as the underlying causes of the Great Depression