12/5/06 - foreshadowing the depression

In today's excerpt - the Federal Reserve Bank, newly created in 1914 and influenced by the personality of New York bank governor Benjamin Strong, displays significant structural weakness and confusion in the recession of 1921-22. Its authority versus the U.S. Treasury is unclear, its theories are largely untested, including a belief in the necessity of deflation even if that deflation is in excess of 20%, and, most egregiously, it has little ability to gather information about the U.S. economy -- so much so that it cannot even determine what interest rates are. It is this disarray that will later lead the Bank to contract the money supply in the early 1930s and turn an economic recession into the Great Depression:

"Strong [stated] that deflation was an inevitable consequence of the previous [World War I] inflation: 'No one could have stopped it, and no one could have started it. In our opinion it was bound to come.' Governor George W. Norris (Philadelphia) supported him. Ignoring the effect of the gold standard, he said deflation was not confined to the United States. All countries had inflated during the war, and all must deflate. ... Measured by either the [GNP] deflator or the consumer price index, prices fell after midyear 1920; the rate of deflation remained between 20 and 30 percent from the fourth quarter 1920 through second quarter 1921. ...

"At the October [1921] Governors Conference, the Board asked the governors to state how interest rates should be set. Governor Norris expressed the confused state: 'No two of us would write exactly the same essay ... The only thing we could agree on would be absolutely nothing.' ...

"The Board's 1921 annual report clearly conveys its inability to find a satisfactory explanation for the movement in member bank earning assets and member bank borrowing during the recession. ... [According to the Board of Governors Annual Report, 1921], it is 'exceedingly difficult to determine just what current market rates are.' "


Allan H. Meltzer


The History of the Federal Reserve: Volume I 1913-1951


The University of Chicago Press


Copyright 2003 by The University of Chicago Press, Ltd.


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