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In Support
Pmident,

of Price Stability

Statement by
Roberzt P. Black
Federal Reseme Bank of Richmond

EDITOR'S NOTE: Rep. Stephen Neal of North Carviina has intmduced House Joint Resoh&m 409,
dim&g
the Federa/ Reserve to reduce inflation to zem within jive years and maintain price
stabz’ thereafter. On Febmary 6, Mr. Block and thme o&r Federai Reseme Bank presidents
@v
testz>ed in support of the Resolution before the Subcommittee on Domestic Monetary Polity of tire
U.S. House of Representatives Committee on Banking, Finance, and Urban Af/‘
airx Following
is Mr. Blacks testimony.

Mr. Chairman, I am delighted to be here today
to testify in favor of H.J. Resolution 409, which would
instruct the Federal Reserve to achieve price stability
within five years. I believe passage of the Resolution by Congress would significantly improve the
overall framework in which monetary policy is conducted and increase our chances of achieving price
stability and steady economic growth in the years
ahead.
I have been associated with the Federal Reserve
Bank of Richmond for over thirty-five years and have
attended at least some of the meetings of the Federal
Open Market Committee for about thirty of those
years. For seventeen years, I have been the Richmond Bank’ official representative at those meetings.
s
My work with the Committee has convinced me that
price stability should be the primary long-run objective for monetary policy and that the Federal Reserve
can make its greatest contribution to the economic
health of our country through pursuit of that
objective.
The Case for Making Price Stability the
Overriding Objective of Monetary Policy
The case for making price stability the primary
objective of monetary policy is a compelling one, Mr.
Chairman. First, inflation imposes pervasive costs on
our society, especially if it is not anticipated. Inflation distorts the signals that prices send in our market
economy, which leads to serious inefficiencies in the
allocation of resources. These distortions and inefficiencies reduce the long-run rate of growth of the
economy below its full potential. In a similar way,
inflation disrupts the functioning of our financial
markets and on balance discourages saving and
investment. Moreover, its volatility increases the
FEDERAL

RESERVE

risk associated with particular. business decisions.
Finally, inflation redistributes income and wealth in
arbitrary ways, which creates dissatisfaction within
the social and economic groups whose incomes and
wealth are adversely affected.
Although many of these costs are hard to measure,
there is good reason to believe that they are significant in the aggregate. First, there is a negative
correlation between inflation and long-term economic
growth across different countries. Second, our
citizens have repeatedly made it clear that they
strongly dislike inflation. Finally, persistently high
rates of inflation in peacetime in the U.S. have frequently been associated with relatively low rates of
real economic growth.
Inflation is still a major problem today, despite the
belief in some quarters that it has been conquered.
It disturbs me to hear people talk as if inflation were
dead when we have been experiencing an underlying inflation rate in the neighborhood of 4 to 4%
percent. The current rate is clearly an improvement
over the very high rates prevailing in the late 1970s
and early 198Os, but it is not a particularly low rate
when judged by longer-run historical standards. As
you may know, the consumer price index rose at an
average annual rate of 1.5 percent between the end
of the Korean War and 1965. What is now considered
by some to be moderate inflation was regarded as
an intolerable condition only a few years ago. President Nixon imposed a comprehensive price and wage’
control program on the economy in August 1971
when the rate of inflation was even lower than the
rates of recent years.
Moreover-and
issues addressed
well reaccelerate
BANK

OF RICHMOND

I believe this is one of the critical
by the Resolution-inflation
may
in the absence of a clear signal to
3

the public that Congress fully supports the Federal
Reserve’ commitment to reduce it further. As we
s
all know, the System is under constant pressure to
“do something” with monetary policy in the short run
to improve the economy’ performance or deal with
s
some other current problem. In the past ‘
such
pressures have, at times, led the System to take
actions that have eventually contributed to an acceleration of inflation. There is obviously a risk that
history will repeat itself unless an effort is made to
reduce these pressures.
I say this even though I believe the present
members of the Federal Open Market Committee
as a group are especially strongly committed to
fighting inflation and the public still has vivid
memories of the rampant inflation of the late 1970s
and early 1980s. The composition of the Federal
Open Market Committee will change, and the
memories of double-digit inflation will gradually fade,
but the pressures on the Federal Reserve to make
its monetary policy decisions on the basis of shortrun considerations without adequate regard for the
long-run inflationary consequences of. these decisions
will surely persist in the years ahead.
One problem the Federal Reserve faces in conducting monetary policy currently, in my view, is that
our mandate is too broad. A clear and attainable
objective is a necessary condition for the success
of any policy strategy. Unfortunately, current law
does not provide the Federal Reserve with such an
objective. Instead, our current mandate instructs us
to consider a wide range of economic conditions in
carrying out monetary policy. Specifically, Section
2A of the Federal Reserve Act requires the System
to take account of “. . . past and prospective
developments in employment, unemployment, pro.duction, investment, real income, productivity, international trade and payments, and prices. . . .” in
setting its annual objectives for the growth of the
monetary and credit aggregates.
A mandate that instructs the Federal Reserve to
consider such a broad range of economic conditions
may not be the strongest foundation for an effective
strategy for monetary policy. Faced with the requirement’ take account of all these conditions, policy
to
choices necessarily are made in a discretionary manner which gives substantial weight to current eco‘
nomic and financial conditions and prospects for the
near-term future. This approach to policy fosters the
notion that the Fed can fine-tune the economy even
though both actual experience and much of the most
important recent research in macroeconomics argue
4

ECONOMIC

REVIEW,

persuasively to the contrary. It also encourages
special interest groups to try to pressure the System
to pursue the particular goals they consider important. These circumstances tend to impart an inflationary bias to monetary policy.
The Resolution would help us overcome these
problems by specifying clearly a single, feasible
objective for monetary policy and instructing the
Federal Reserve to achieve that objective. Price
stability is obviously an appropriate objective for any
central bank. Further, it is a feasible objective since
there is no question that the System can achieve price
stability over the long run by controlling the rate of
growth of the monetary aggregates.
Moreover, I believe price stability is really the only
feasible objective for monetary policy. Some might
argue that increasing long-run economic growth or
fine-tuning economic .activity .in the short run are
alternative objectives. Most economists now agree,
however, that the long-run rate of real economic
growth is determined by nonmonetary factors such
as population growth, increases in productivity, and
the rate of saving and investment. Accordingly, most
conclude that expansionary monetary policies can
raise the growth rate only temporarily, if at all. There
is also a growing consensus that the System could
make its greatest contribution to long-run economic
growth by fostering price stability so that economic
decisions could be made on the basis of reliable
information on both current and future prices.
There also is very little evidence that the Federal
Reserve can use monetary policy to fine-tune the
economy in the short run. Monetary policy affects
the economy with both long and variable lags. These
lags, in conjunction with the inability of economists
to forecast future economic conditions with much
confidence, make it very difficult for the System to
determine what.policy actions it should take today
to produce a particular result at some point in the
near-term future. Moreover, as I indicated earlier,
focusing too narrowly on relatively short-run
economic conditions tends to give monetary policy
an inflationary bias. This is not to say that the
Federal Reserve should ignore extraordinary events
such as the stock market crash in October 1987. But,
as I believe we demonstrated
in late 1987, the
System can react to such shocks to the economy
without weakening its long-run commitment to price
stability.
One might argue, of course, that price stability has
always been one of the System’ primary objectives
s
JANUARY/FEBRUARY

1990

and therefore that the Resolution is not needed since
it simply instructs the Federal Reserve to seek an
objective it is already pursuing. I strongly disagree
with this view. Despite our best intentions, prices
have not yet stabilized, as evidenced by the fourfold
increase in the price level since 1964. Moreover,
surveys of expected inflation consistently indicate
that the public does not expect the Federal Reserve
to make much further progress in reducing inflation
in the future, let alone achieve price stability.
Confidence in the System’ commitment to price
s
stability suffers because its policy decisions are
necessarily influenced by numerous other considerations. Passage of the Resolution would send an
unambiguous signal to the public and the financial
markets that price stability is the overriding goal of
the Federal Reserve. The credibility of the System’
s
efforts to reduce inflation would therefore rise. This
increased credibility would, in turn, lower the public’
s
expectations of future inflation because these expectations would be less influenced by the relatively high
inflation rates in the recent past. Further, lower
expected inflation would tend to reduce the costs of
achieving price stability in terms of any temporary
loss of output and employment. This reduction would
occur in part because producers, when faced with
monetary restraint, would be more inclined to reduce
prices, or raise them at a slower pace, and less
likely to reduce output and employment. Similarly,
workers would be more inclined to ,restrain their wage
demands. It is worth emphasizing that a truly clear
and unambiguous Congressional mandate to eliminate
inflation would play a vital role in this process.
Responses to Some Likely Arguments
Against the Resolution
The major arguments that will be made against the
Resolution are fairly predictable, and I would like to
say a few words about them. One argument obviously
concerns the potential transitional cost of implementing the Resolution. Specifically, some will argue
that trying to eliminate inflation altogether would risk
a recession. It is impossible to predict the future, so
we cannot dismiss this argument out of hand. In
evaluating the argument, however, we should not
simply extrapolate from our experience in dealing
with past inflationary episodes such as the ones in
1973-74 and 1979-81. In those periods, the System
acted forcefully in a crisis atmosphere to reduce the
rate of inflation over a short period of time and
economic activity contracted sharply. In contrast,
Resolution 409 would require a gradual reduction
in inflation over a relatively long period of time
FEDERAL

RESERVE

following an extended period in which substantial progress has already been made. As I indicated earlier,
there is good reason to believe that passage of the
Resolution would enable us to achieve such a reduction in inflation with relatively small costs to the
economy. Moreover, it is very important to weigh
any short-run costs of achieving price stability as provided by the Resolution against the longer-run costs
of not achieving it. These latter costs could be particularly great if, at some future time, the Federal
Reserve were forced to follow policies resulting in
a recession in order to rein in an accelerating rate of
inflation.
A second possible argument against the Resolution is that it would prevent the Federal Reserve
from reacting appropriately to unanticipated “shocks”
to the economy, such as the stock market crash in
October 1987. As I suggested a moment ago,
however, there is simply no reason why shocks that
may affect the System’ actions in the short-run
s
should prevent us from achieving price stability over
a period as long as five years. This would be especially true if the policy had credibility in the eyes of
the general public and financial market participants,
as I believe it would if the Resolution were enacted.
In evaluating this argument, it is also important to
distinguish between temporary adjustments in our
policy instruments
or intermediate
targets 2nd
changes in our ultimate policy objectives. Adjustments in our policy instruments or intermediate
targets do not require us to alter our long-run objettives. Following the stock market crash in 1987, for
example, the System temporarily supplied additional
reserves to meet the greater demand for liquidity
induced by the crash, but this action did not change
our longer-run policy goals.
Implementation

of the Resolution

A final question regarding the Resolution concerns
how it would be implemented. I realize the Resolution leaves this matter to the Federal Reserve. Nevertheless, in evaluating the Resolution I think it is
important to appreciate that from a technical standpoint the System is quite capable of achieving price
stability over a five-year period and that pursuing this
objective would require at most minor changes in our
current procedures. Recent research both at the
Board of Governors and at the Richmond Reserve
Bank has provided strong evidence that the public’
s
total demand for balances included in the monetary
aggregate M2 has remained stable since the early
195Os, despite the substantial amount of financial
BANK

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5

innovation in recent years. This innovation has affected the behavior of the components of M2, but it
has had little effect on the behavior of total M2.
Consequently, the velocity of M2, which is simply
current-dollar GNP divided by M2, has not exhibited
any trend either upward or downward in this period.
This constancy in the velocity of M2 over time implies that the System could bring the trend rate of
inflation to zero within a five-year period by gradually lowering the trend rate of growth of M2 to the
longer-run potential rate of growth of real GNP.
It is worth noting that implementing the Resolution would not require any major change in the
Federal Reserve’ operating procedures, since we
s
already set annual targets for M2 and announce
them to Congress. Under the Resolution we would
simply have to reduce these targets gradually and
persistently until they declined to the trend rate of
growth of real GNP, which is probably somewhere
in the neighborhood of 2% to 3 percent a year.
One fairly straightforward change in our procedures
that I would favor would be to establish multi-year
targets for M2 rather than the one-year targets we
currently set. Under the current procedure, growth
in M2 above or below the target for a given year ‘
is
effectively forgiven at the end of the year. Thus, the
base for the next year’ target is the actual level of
s
M2 at the end of the current year rather than the
targeted level. As a result of this “base drift” in M2,
the price level can drift up or down over time even
though the individual annual M2 targets may be consistent with a zero rate of inflation. Consequently,
I believe the likelihood of achieving true long-run
price stability would be increased if we eliminated
base drift by setting a multi-year path for M2.
This last point raises a corresponding point regarding how, in practice, the System would pursue
the price stability objective mandated by the Resolu-

6

ECONOMIC

REVIEW,

tion. One approach would be to seek to hold the price
level at a particular permanent level on average over
the long run. A second approach would be to try to
maintain the price level at its current level at any
point in time irrespective of any past movements in
the level. Under the first approach, the System would
act to bring prices back to their permanent target level
if they moved away from that level in response, for
example, to an unanticipated change in M2 velocity. Under the second approach, the System would
not attempt to offset the one-time effects of such
shocks on the price level, but would simply try to
hold the price level at its then current level. We
prefer the first approach, although we recognize
that it might take considerable time to reattain the
permanent objective in some instances in order to
avoid significant transitory disruptions
to real
economic activity. Under the second approach, the
price level would almost certainly change permanently from time to time, and it is not unreasonable
to expect that political and other pressures would tend
to bias these movements upward.
Conclusion
In conclusion, Mr. Chairman, I strongly support
Resplution 409 and its objective of achieving price
stability in five years. The costs of the persistent
inflation in this country are substantial. Without a
significant change in the framework in which
monetary policy decisions are made, inflation is likely
to continue to be a serious problem in the years
ahead, and it is entirely possible that the rate of inflation could reaccelerate. Resolution 409 goes to the
heart of the policy problem, which stems to a large
extent from the Federal Reserve’ overly broad curs
rent mandate. Price stability can and should be the
overriding objective of monetair policy. Achieving
and maintaining price stability is the best contribution monetary policy can make to the successful performance of the economy over the long run.

JANUARY/FEBRUARY

1990

The FedeA
Governor

Reserve

Bank of .Richmond:

Seay and the Issues of the Early Years
James Patihemos *

The choice of Richmond as a Federal Reserve
city was greeted with jubilation by the civic leaders
of the old capital of the Confederacy.
For three
months they had waged a carefully orchestrated campaign to convince the Reserve Bank Organization
Committee, established to select the sites for the new
Reserve Banks, of the superiority of Richmond’
s
claims over those of such competing cities as
Washington, Baltimore, Charlotte, and Columbia.
The chief architect of that campaign was George J.
Seay.
For %ay, the choice of Richmond, announced on
April 2, 1914, was a great personal triumph. He had
worked tirelessly in the campaign to bring the
Reserve Bank to Richmond. The city’ petition to
s
the organization committee and its supporting brief
were largely his work. He had made the principal
oral presentation before the committee in January
19 14 and had prepared the revised written brief
presented to the committee in the following month.
With other Richmond leaders, he had toured the
Carolinas in an effort to mobilize support among
bankers and business leaders in those states. He had
prepared an extensive brief countering efforts by
Baltimore leaders to reverse the choice of Richmond.
Seay’ contributions were recognized and lauded,
s
even among the leaders of rival campaigns. The compelling arguments presented in his brief to the
organization committee were widely credited as the
crucial factor in the decision to locate the Reserve
Bank in Richmond.
George J. Seay was born in Petersburg, Virginia,
in March 186’ He was educated in the public
2.
schools of Petersburg, winning first honors on graduation from high school. Seay had no college training. At 17, he accepted employment as a runner at
the Petersburg Savings and Insurance Company. His
talents were quickly recognized, and he rose rapidly
Mr. Parthemos retired in 1985 as Senior Vice President and
Director of Research, Federal Reserve Bank of Richmond. This
article appeared in the 1989 Antzua~Repwt of the Federal
Reserve Bank of Richmond.
l

FEDERAL

RESERVE

in the organization. He served that institution for
24 years,lthe last nine as cashier. In 1902, he was
elected president of the Virginia Bankers Association.
He resigned from the Petersburg institution in 1903
to become a partner in the Richmond banking house
of Scott and String-fellow. He remained in that post
until 1909, leaving in that year to devote himself to
independent study of banking reform arid railroad
finance, subjects that had commanded his interest
for most of his adult life.
Seay was especially interested in the movement
for banking reform at the turn of the century and had
followed closely the various reform proposals. He
published a pamphlet on the Fowler and Aldrich bills
and was said to have “devoted many months’ study
to the Federal Reserve Act during its progress in Congress.” While the record indicates that he retired in
1909, at the age of 47, it is likely that he maintained some connection with one or more local
businesses between 1909 and 19 13, perhaps in a consultative capacity. On December 28, 1913, he was
retained by the Committee on Locating a Federal
Reserve Bank in Richmond to put together a case
for the city’ petition to the organization committee.
s
Following the choice of Richmond as a site for one
of the Reserve Banks, Seay, amid plaudits for his contributions, was widely regarded as a likely candidate
for a high post in the new institution. He was recommended by a former employer as a man “. . . of
absolute integrity and high character, perfect habits
and of great industry and energy, with an efficiency,
capacity and ability in banking matters which I have
never seen surpassed, an! rarely equalled in many
men of his age.” This employer deemed him
“eminently qualified” for the position of manager of
the Reserve Bank.
The Richmond Reserve Bank was incorporated on
May 18, 1914. On the same day, representatives of
some 2 10 banks from the Fifth District met in Richmond to discuss procedures for electing three Class
A directors, representing the banking community,
and three Class B directors, representing industry,
BANK

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7

commerce, and agriculture. This gathering was
without authority to elect directors, but it nevertheless proceeded to offer a preferred slate of candidates which included Seay’ name as a Class B
s
director. This slate was later elected through the
elaborate election procedure prescribed in the Federal
Reserve Act. While in January Seay had indicated
to the organization committee that he had “no
business or financial connection,” in executing the
oath of office as director, in August he described
himself as “Vice Pres’ U.S. Tobacco Co. and RR
t
and Financial Statistician and Expert.”
Selected with Seay in the Class B category were
David R. Coker of.Hartsville, South Carolina, and
James F. Oyster of Washington, D.C. The Class A
directors were Waldo Newcomer of Baltimore, J. F.
Bruton of Wilson, North Carolina, and Edwin Mann
of Bluefield, West Virginia. Three Class C directors,
representing the general interest, were appointed later
by the Federal Reserve Board. They were William
Ingle of Baltimore, designated Chairman and Federal
Reserve Agent, James A. Moncure of Richmond,
designated Deputy Chairman and Deputy Federal
Reserve Agent, and M.F.H. Gouveneur of Wilmington, North Carolina. At its first meeting, on
October .5, the board of directors elected Seay to
be the Bank’ first governor, as the chief executive
s
officer was then called. It also named him the Fifth
District’ representative
s
to the Federal Advisory
Council.
Seay served as governor of the Richmond Bank
until 1936..His tenure covers the Federal Reserve
System’ formative years. This formative period
s
embraces two distinct chapters, the first dominated
by World War I and the second by the vicissitudes
of the .world economy in the decade following. The
second chapter ended unhappily, with the great stock
market crash of 1929 followed by a collapse of the
banking system that led to a restructuring of the
Federal Reserve.
The early years-the period from 1914 to the end
of 1929-posed
a number of key issues the resolution of which was important in the development of
effective monetary policy mechanisms as well as an
efficient payments system. First, there was the basic
issue of the distribution of authority between the
‘
Reserve Banks and the Reserve Board. This issue
remained in abeyance during the war years when the
Banks were preoccupied with war financing and were
largely under Treasury domination. Second, there
were issues of credit policy involving the forging of
effective policy tools and their application to the
8

ECONOMIC

REVIEW,

problems of the time. Third, there were issues and
problems involved in a broad effort to improve the
nation’ payments arrangements, especially in the
s
area of check collection. The Richmond Bank, under
Seay, played an important role in the System’
s
efforts to confront these issues constructively.
Financing

World War I

The entry of the United States into the First World
War in April 1917 presented a special challenge to
the Reserve Banks. As fiscal agents of the federal
government,
they were called on’ to serve the
Treasury in planning and implementing a program
to finance the war effort with minimal disturbance
to the nation’ financial markets. Seay and the other
s
Reserve Bank governors participated in the planning sessions.
The Banks’ services to the Treasury in this regard
began in March, just before the country’ entry into
s
the war. At that time the Banks distributed for the
Treasury $50 million of certificates of indebtedness
issued in anticipation of income tax receipts due in
June. The Richmond Bank was allotted $Z’
million
of this issue;which it placed promptly.
Then followed the first of five multi-billion-dollar
bond issues aggregating more than $24 billion, an
unprecedented
magnitude of borrowing. The socalled First Liberty Loan, announced on May 14,
was a $2-billion, 30-year issue dated June 15, with
interest at 3% percent. An elaborate effort was
mounted to market this issue. Secretary McAdoo led
the effort, touring the country in what he later
described as a “. . . great movement that vibrated
with energy and patriotism and swept the country
from coast to coast in the greatest bond-selling campaign ever launched by any nation.”
The marketing effort centered heavily on the
Reserve Banks. In accordance with detailed plans
provided by the Treasury, each Bank established a
closely structured, Districtwide network for promoting sales. The Reserve Bank governors were
designated chairmen of District committees made up,
in turn, of the chairmen of state committees; who,
in their turn, appointed county and local committees.
In the Richmond District, a Liberty Loan bureau was
set up in every bank, and each was advised of its “proportionate amount of the loan, based on its total
resources.” An executive staff, reporting directly to
Governor Seay and including teams of field directors, coordinated the effort. Seay considered the
JANUARY/FEBRUARY

1990

Liberty Loan drives to be his most important duty
and threw himself wholeheartedly
into each
.campaign.
The premise of the financing program was that the
war should be financed to the extent possible by the
real savings of the public. Bank credit, and in particular Reserve Bank credit, was to be relied on
only residually with every effort made to hold the
residual to a minimum, in keeping with the prevailing view in banking circles that bank credit should
be directed primarily at financing production and
accommodating trade, not at accommodating government. Hence a large promotional effort was directed
at placing the bonds with the nonbank public.
Seay approached the financing task with a fervor
bordering on the religious and worked untiringly to
match or excel the best efforts of the other Reserve
Banks. Writing in 1923, he noted the District’
s
“remarkable record” in 1917, 1918, and 1919, when
the actual purchases of all types of war securities by
the people of the Fifth District reached “the stupendous aggregate of $1.1 billion!” It was his “deliberate
and mature judgement that but for the existence of
the Federal Reserve System . . . Germany would
have won.” He also believed that “the bringing
of the Federal Reserve System into being and enabling it to perform such a signal service for civilization was nothing less than an act of Providence.”
As the apparatus of wartime controls expanded,
the Reserve Banks were given a variety of additional
duties in the areas of foreign exchange trading, gold
export controls, and surveillance over the capital
issues of corporations and municipalities. Much of
the added work fell directly on Seay, who was already
heavily preoccupied with perfecting the District’
s
organization for handling the Liberty Loans. The
work burden contributed to a breakdown in his health
in the autumn of 1918. At the height of the influenza outbreak of that year, he fell dangerously ill
and was bedridden for more than.a month. Subsequently, at the insistence of the Bank’ directors, he
s
underwent a convalescence of several months before
returning to work.
For the five drives, subscriptions nationwide totaled
just over $24 billion. The slightly more than $1 billion
handled by the Richmond Bank thus accounted for
roughly 4 percent of the total. At that time, the nation’ financial wealth was heavily concentrated in
s
the large centers of the Northeast. The New York,
Boston, and Philadelphia Districts accounted for
FEDERAL

RESERVE

nearly half the total subscriptions, with Chicago and
Cleveland accounting for an additional 25 percent.
The Richmond District stood seventh in subscriptions, behind San Francisco.
Seay and the Richmond Bank won plaudits
throughout the District for their efforts. The work
of all the Banks was widely appreciated and the
System emerged from the war with great prestige.
It had won its spurs, so to speak, and was widely
accepted as the institution at the heart of the nation’
s
financial system.
The Reserve Banks and the Reserve

Board

1. The Issue of Authority A major issue in the
early years of the System was the question of the
division of authority between the Reserve Banks and
the Federal Reserve Board. The question was particularly contentious until the banking acts of the
middle 1930s buttressed the authority of the Reserve
Board in several areas. For most of the decade of
the 192Os, however, the Banks offered a distinct
resistance to the Board’ dictates and relations were
s
marked by a continuing tension.

By common agreement, the new System, when
launched, was .a regional arrangement envisaging
substantial autonomy for the individual Reserve
Banks. But the lines were not sharply drawn. Broad
supervisory and coordinating authority was vested in
the Reserve Board by the-Federal Reserve Act. The
view was widely held, however, that the Board’ role
s
should be constraining and coordinating, not coercive, leaving the Banks latitude for independent
action to cope with credit and payments-system
problems peculiar to their respective Districts. There
was a general reluctance to describe the System as
a “central bank,” as though the term might undermine the emphasis on regionalism.
The Richmond Bank’ directors sought from the
s
beginning to reach an understanding on the scope
of their authority. They sent a delegation to the Board
early in 1915 to discuss the matter but received
little satisfaction. Immediately afterward, a sharp
dispute with the Reserve Board erupted over the
issue of Governor Seay’ salary. The Richmond direcs
tors had set his annual salary at $15,000 only to have
the Reserve Board reduce it to $10,000. There
followed a sharp exchange of letters in which the
Board rebuked the Bank’ directors and peremptorily
s
asserted its right to approve salaries at all levels. The
directors acquiesced, but the episode left scars.
BANK

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9

The entry of the United States into the World War
had an important effect on the distribution of authority in the System. Until the end of 1919, the
exigencies of Treasury borrowing for the war effort
subordinated
both the Reserve Board and the
Reserve Banks to the Treasury’ mandate. But the
s
practical knowledge and experience that the Treasury
required in its debt management and financing operations were heavily concentrated
in the Reserve
Banks, especially the New York Bank. As a result,
Treasury
officials tended increasingly to work
directly through the Reserve Bank governors and to
bypass the Reserve Board. Governor Harding of the
Boston Bank, who had served earlier as a member
of the Reserve Board, once remarked that for this
reason members of the Reserve Board frequently felt
left out of important deliberations.
As matters developed in the 192Os, the governors
of the Reserve Banks, acting through conferences
that met semiannually,
were able to establish
themselves as a major factor in shaping System
policies and practices. At these conferences, the
governors discussed and analyzed in detail the full
range of problems, confronting the System. The
discussions were comprehensive, frequently lasting
four days or more and including sessions with the
Reserve Board and with Treasury officials. Standing
committees kept major issues, including credit policy
and payments-system
problems, under continuing
study.
Compared with the members of the Reserve
Board, the Reserve Bank governors were much closer
to the day-to-day problems in the banking system
and in credit markets. For the most part, they were
seasoned bankers with hands-on experience of the
technical details of both the payments system and
credit operations of commercial banks. This gave the
Conference of Governors an important advantage in
the give-and-take that determined the degree of
autonomy of the Reserve Banks. Under the leadership of Benjamin Strong, governor of the New York
Reserve Bank, the Conference of Governors became
the dominant forum in the System in the 1920s with
Strong emerging as.the leading figure in the System.
trws Seay was a major contributor to
2. Seayk l4’
the deliberations of the Conference? He was chairman of the committee on discount rate policy and
also chaired a special advisory committee to the
Federal Reserve Board on legislation.
Like most of his colleagues, Seay had an aversion
to the term “central bank.” He was a vigorous
10

ECONOMIC

REVIEW,

defender of regionalism and favored a high degree
of autonomy for the Reserve Banks. He argued, in
particular, that the Banks, as the best judges of credit
conditions in their respective Districts, deserved
broad latitude in setting discount rates. Because of
what he perceived as wide disparities of basic credit
conditions among Districts, he opposed requiring
uniformity of discount rates. He also insisted on the
right of individual Reserve Banks to buy and sell
government securities.
Yet Seay was a team player. To him, autonomy
defined a relationship between the Reserve Board
and the Banks and did not preclude close cooperation among the Banks. He thought that the governors of the Banks should discuss discount rate policy
every 60 days and that such discussions should
become an important factor in discount rate decisions. He thought that transactions in government
securities should be managed with similar cooperation among the Reserve Bank governors and was
prepared to limit, though not to deny altogether,
independent operations by the Banks.
In other areas of the Reserve Banks’ activities, Seay
was inclined to’
favor Systemwide uniformity of practice. This was especially the case for such fiaymentssystem functions as check collection and clearing and
noncash collections: He sought uniformity of practice in such technical details as the timing of debits
and credits to reserve accounts in the course of checkcollection operations, the treatment in reserve accounting of coin and currency en route to the Reserve
Banks from members, and penalties for reserve deficiencies. Questions involving these and other important details were not definitively settled in the 192Os,
and for much of the decade practices differed among
the several Districts.
Yet close cooperation among the governors was
the general rule. The Conference of Governors,
under the leadership of Governor Strong, was protective of the rights of the individual Banks and resistant to broad interpretations of the Reserve Board’
s
authority. Strong’ death in October 1928 marked
s
the,beginning of a shift of power away from the Banks
and toward the Reserve Board, away from regionalism and toward centralization. The stock market
crash of 1929 and the banking collapse of the
1930-33 period accelerated that shift. The Banking
Acts of 1933 and 1935 ratified it in many respects.
For virtually all of the decade of the 192Os, however,
the Reserve Banks were able to hold centralization
at bay and to realize a high degree of autonomy.
JANUARY/FEBRUARY

1990

Credit Policy Issues of the 1920s
I.
Gen~alBackgmnd
The decade of the 1920s
presented a variety of challenges to the System. It
was, in general, a period of rapid economic growth,
fueled by the intensive development of new industries-the automobile, radio, major appliances-and
by innovations in the organization of production.
Public confidence in the economy’ capacity to
s
generate high levels of prosperity ran high and
translated soon into a strong speculative mood that
constituted an important element in the backdrop
against which the Reserve Banks operated. Prosperity
was by no means comprehensive,
however. The
agricultural sector remained depressed for the entire
decade. Large numbers of bank failures occurred
almost every year. Serious problems existed, too, in
the international area. A large fraction of the world’
s
monetary gold had lodged in this country and its
orderly redistribution became a key condition for the
restoration of the international gold standard, a prime
objective of U.S. policy. The vexatious issue of war
reparations and resurgent economic nationalism in
the world at large were also complicating factors.

Early in the decade, the economy slipped into a
severe recession for which the System was widely
blamed. Milder recessions occurred in 1923-24 and
1927. Combined with the continuing bank failures
and widespread farm sector discontent with credit
conditions, these interruptions seriously eroded the
System’ prestige, which reached a low point in the
s
financial disturbances at the end of the decade and
in the early 1930s.
2. Seay’ Appmach to Credit Pohy During the war
s
years, credit policy was dominated by the U.S.
Treasury. The discount rate was determined by the
interest rate the Treasury placed on its offerings of
securities. Moreover, to facilitate the Treasury’ finans
cings, the Reserve Banks offered preferential rates
on their loans when government securities were
offered as collateral. Such loans were made at rates
slightly below the nominal rate on the Liberty bonds,
with the result that they rose sharply and, while the
Reserve Banks bought only small amounts of government securities, they held large amounts as collateral.

Seay shared a widespread conviction that extensive use of bank credit to finance the war would pose
a problem in the war’ aftermath. At this stage, he
s
adhered strictly to the commercial loan (or real
bills) theory, holding that bank credit should be extended to finance only self-liquidating loans arising
FEDERAL

RESERVE

out of the production or distribution of goods. Credit
extended for any other purpose, including even the
holding of government securities, represented unsound banking practice and multiplied the risk of
destabilizing price movements. Seay would purchase
only those government bonds that were eligible for
use as collateral for national bank notes and this
only for the purpose of retiring all such notes in
order to leave the issue function exclusively with the
Reserve Banks.
Like most of his contemporaries, Seay had no idea
of using Federal Reserve credit policies in any
countercyclical way. He attributed the burst of
rising prices in 1919 and 1920 to the large amounts
of government securities in the banking system. Like
most of his colleagues, he failed to envisage using
open market operations in government securities as
a policy instrument. Rather, he felt that the inflation
problem had to be met with discount rate action that
would force banks to disgorge their government
securities. Following the lead of Strong, he recom-‘
mended and the Richmond directors voted successive increases in the discount rate from 4 percent in
late 1919 to 6 percent in mid-1920.
The discount rate increases in this period created
some friction in relations with the Treasury, which
operated in the market for government securities on
a virtually continuing basis at the time. Since discount
rate increases tended to hamper its operations, the
Treasury favored a program of direct controls on
credit expansion administered by the Reserve Banks
instead of rate increases. This view also found some
support at the Reserve Board. The Reserve Bank
governors for the most part felt, as did Strong and
Seay, that credit expansion could not be controlled
effectively without discount rate action.
When the economy slipped into a sharp recession
in the spring of 1920, Seay and the Richmond directors saw little reason to reduce the discount rate
promptly. Indeed, the Reserve Banks generally were
slow to take any easing action. In the face of a sharp
break in commodities prices, rising unemployment,
and a severe depression in the farm sector, the
System came under criticism by a number of groups,
especially by governors and legislators from farm
states. Under pressure from the Treasury, the Boston
and New York Banks began reducing their discount
rates in the spring of 192 1. But the Richmond Bank
continued to hold out, waiting until November to
reduce its rate from 6 percent to 5% percent and
until December to reduce it to 5 percent.
BANK

OF RICHMOND

11

colleagues in noting that sales from such holdings
could prove useful in offsetting excessive easing in
markets resulting from large gold imports. This
adjustment in Seay’ attitude was probably influs
enced in part by the indifferent success of the
System’ efforts to establish an acceptance market
s
of significant dimensions. Seay had been a strong
supporter of such efforts and of arrangements for
coordinating operations in acceptance markets.

In public addresses, Seay staunchly defended the
action of the System in the recession of 1920-Z 1.
He argued that the basic problem was the earlier
credit inflation caused by sizable holdings of government securities in the banking system. The solution
lay in moving these securities out of the banking
system and into the hands of the nonbank public.
He considered the resulting reduction in bank credit,
with its accompanying
setback to business, a
necessary and inevitable part of the nation’ adjusts
ment from a wartime to a peacetime economy.
Seay also argued that an overriding objective of discount rate policy had to be the protection of the gold
reserves of the Reserve Banks. At the depth of the
1920-Z 1 recession, the gold reserve ratio of the Richmond Bank had fallen to 34 percent and the ratios
of five other.Reserve Banks were substantially lower,
far below the legal limit of 40 percent. These low
reserve ratios were clearly a factor in the tardiness
of the Richmond and other Reserve Banks in reducing the discount rate. Seay’ view, widely held at the
s
time, was that the System’ main concerns had tos
be the soundness of bank credit, the prevention of
financial panics, and the preservation
of gold
payments. Systematic control of the money supply
and positive action to moderate cyclical swings in
business were not part of his agenda.
3. Changing Views on Operations in the Government
Securities Market The decade was an extended

learning experience for the entire System. Seay’
s
views on credit policy underwent significant changes,
as did those of most other System personnel involved with policy. Credit policy was discussed at
length in the semiannual meetings of the Conference
of Governors and in the sessions with the Reserve
Board. These discussions, and especially the trenchant observations of Governor Strong, had a major
influence on Seay’ thinking. There were other ins
fluences as well. One was an increasing appreciation
of the potential usefulness of systematic operations
in the market for government securities. Another was
the iarge contemporaneous
swings in gold exports
and imports, which tended to upset conventional
notions regarding the relationship between the gold
reserve ratio and the discount rate.
In any case, in the early 192Os, Seay modified his
views on the holding’ government securities by the
of
Reserve Banks. At a conference of the governors in
March 1923, he observed that a stock of governments held by Reserve Banks would give the System
“a better hold upon the market.” He joined several
12

ECONOMIC

REVIEW,

Among the Banks, attitudes toward investing’
in
government securities were affected by a sharp reduction in their earning assets .in the recession of
1920-Z 1. As rediscounts declined and the supply of
acceptances diminished, most of the Banks turned
to the government securities markets for investments
in order to be able to cover costs and pay the dividend provided for by the Federal Reserve Act.
Purchases and sales were of sufficient magnitude to
interfere with Treasury operations in the market and
hence aroused the opposition of the Treasury. The
matter was discussed in detail by the Conference in
May 192’ At that time, all the Banks except
2.
Atlanta and Richmond were buying and holding
governments. The governors of all, including Richmond and Atlanta, vigorously defended their right
to do so at their discretion.
The Conference was confronted with the problem
of reconciling the Treasury’ apprehensions and the
s
Reserve Banks’ need for earning assets. The Banks
were reluctant to accept any restrictions on their
right to invest as they deemed necessary. The
Treasury for its part insisted that the Banks refrain
from purchases and sales whenever it was engaged
in market operations.
Under Strong’ leadership and after extended
s
discussion, a compromise was reached. Each governor agreed to recommend to his directors that investments in government securities be limited to
“
. * . such amount as is required, over a period of time,
to meet . . . expenses and dividends and necessary
reserves.” It was also agreed that purchases and
sales would be coordinated to avoid interference
with the Treasury’ activities in the market. To pros
vide this coordination a.Committee on Centralized
Execution of Purchases and Sales of Government
Securities by Federal Reserve Banks was established, composed of the governors of the New York,
Boston, Philadelphia, and Chicago Banks. Later the
governor of the Cleveland Bank was added.
This committee, under the chairmanship of Governor Strong, operated until March 1923 when, on

JANUARY/FEBRUARY

1990

orders of the Federal Reserve Board, it was disbanded and replaced by an Open Market Investment
Committee. The change, however, made little difference in practice, amounting to little more than a
formal response to the Reserve Board’ assertion of
s
authority over open market operations. The new
committee was composed of the same governors as
the old and included no member of the Reserve
Board. Like its predecessor, it allowed the Banks a
wide latitude of discretion with respect to their participation in the new committee’ purchases and sales.
s
Moreover, no limits were placed on the Reserve
Banks’ transactions in government securities with
member banks of their respective Districts.
The arrangements
for dealing in government
securities were satisfactory to Seay and the Richmond
directors. The Richmond Bank had no earnings
problem in that period and consequently no need to
rely on government securities as a source of earnings. Accordingly, Seay was not as exercised over
the issue as some of his counterparts and could take
a longer-term view of the implications of the new arrangement. While he was fiercely defensive of the
Banks’ rights to buy and sell securities, he agreed with
Strong that coordination of purchases and sales was
highly desirable. He argued that open market operations should not be geared to the earning needs of
the Reserve Banks but rather to the “overall
credit requirements” of the economy.
Along with many of the other governors, Seay
recognized limitations on the practical usefulness of
open market operations. Through much of the
decade, large operations had to be undertaken to
offset gold movements and these often had a major
impact on the Committee’ portfolio without a cors
responding effect on bank credit. Moreover, doubts
soon developed that the government securities
market was sufficiently large to accommodate the
magnitude of operations that domestic and international considerations might require. The Treasury
was actively retiring debt over much of the period
and, while the Committee operated in acceptances
as well, that market contracted in periods of slack
business.
Recognition
of this limiting factor
strengthened Seay’ conviction that the discount rate
s
had to be the System’ chief policy instrument.
s
4. Coordinating Open Market and Discount Rate
PohXes The System’ move toward systematic open
s

market operations had implications for the manner
in which discount rate policy was implemented.
These implications were quickly recognized by Seay
and others of the governors. In 1924, Governor
FEDERAL

RESERVE

Strong noted that the “. . . belief of the Governors
‘ been uniformly for some years past that the opera-’
has
tions of the Open Market Committee are designed
. . . to exert some influence on matters preliminary
to the possible need for changes in discount rates.”
In the same year, Seay observed that the Committee’ purchases led member banks to reduce their
s
borrowings at the discount window and, with
diminished dependence on the Reserve Banks, to
step up their efforts to make loans. This put
downward pressure on loan rates, setting the stage
for discount rate reductions.
Seay appreciated the relationship between discount
rate policy and gold movements but seemed reluctant to use the discount rate to help restore the
international gold standard. When in the late
summer of 1927 the Reserve Board, largely at the
initiative of Governor Strong, undertook to orchestrate a general reduction in discount rates in order
to help Great Britain solidify its return to the gold
standard, the Richmond Bank followed, cutting the
discount rate from 4 percent to 3 % percent. But Seay
expressed sympathy for the position of the Chicago
Bank, which refused to reduce its rate, with the
result that the Reserve Board fixed it at 3 ‘ percent
/2
at that Bank. This action by the Board ran counter
to Seay’ conviction that the initiative for rate
s
changes should come from the Banks. But Seay
appears also to have entertained doubts about
giving international considerations precedence over
domestic conditions. When this controversial rate action was discussed at the meeting of the Conference
of Governors in November, he argued that the rate
should be higher to reflect “true market forces instead of international conditions.”
The stock market speculation of the later years of
the decade troubled Seay. He met with groups of
District bankers on several occasions and urged them
to limit stock market loans. But to him the problem
went beyond stock market loans and was not likely
to be solved by moral suasion. The basic problem
was excessively easy credit and had to be addressed
by effective tightening action on both the open
market and discount rate fronts. The excessive ease,
he argued, resulted largely from the arbitrary
reclassification of demand deposits as time deposits
by member banks, which created large amounts of
excess reserves.
In March 1928 and again in April, the Richmond
directors conveyed to the Open Market Committee
their conviction that the Committee should be selling securities. In an April 1929 communication to
BANK

OF RICHMOND

13

the Reserve Board they argued that, from the national standpoint, a strong reason existed for raising
the discount rate to 6 percent, noting, however, that
Fifth District conditions could not justify such an
action. Rather, they believed that the rate should be
raised first in the New York District since the stock
exchange loan problem was centered there, with the
other Banks following later. Actually, the rate at the
Richmond Bank, which had been raised in successive
steps from 3 ?4 to 5 percent in 1928, was not raised
further in 1929.

Payments

System Issues

Seay held strong convictions regarding the role of
the Reserve Banks in the nation’ payments system.
s
In his view, the Reserve Banks should have the exclusive issue ,privilege and ‘
also be the principal
managers of the nation’ facilities for check-collectioe
s
and check-clearing operations.
2. 7Xe Currency Regarding the currency, Seay
considered the Federal Reserve note, anchored to
gold to ensure its soundness and to eligible commercial paper to ensure its “elasticity,” the ideal currency. He urged that it be allowed to displace all other
forms of currency, including legal tender notes and
silver certificates. These last two forms he believed
to have taken on the character of “reserve money,”
and, along with gold and gold certificates, should be
impounded in the Reserve Banks to support Federal
Reserve credit as represented’ in Federal Reserve
notes and member bank reserves. He was unalterably
opposed to the issue of national bank notes and
urged that they be completely eliminated from the
circulation, by legislation if necessary. This stance
reflected his continuing Aversion to linking the’
currency to government
securities. On the same
grounds, he opposed the issue of Federal Reserve
Bank notes, which, unlike Federal Reserve notes,
were backed only by government securities.
With such views, Seay often found himself at odds
with both the Reserve Board and the Treasury. He
was critical of a Reserve Board ruling requiring the
Reserve Banks to pay out currency in a priority ordering with national bank notes first, followed in order
by Federal Reserve Bank notes, silver certificates,
legal tender notes, Federal Reserve notes, gold certificates, and gold. He argued that, pending the retirement of national bank notes and Federal Reserve
Bank notes, Federal Reserve notes should be third
in the priority ordering.
14

ECONOMIC

REVIEW,

Seay also opposed proposals by the Treasury and
the New York Reserve Bank to encourage the circulation of gold certificates in periods of heavy gold
imports. He was also cool to a Treasury request for
Reserve Bank cooperation in an effort to encourage
temporary use by the public of silver dollars to allow
the buildup of an inventory of one-dollar bills in
the months before the introduction of a newly designed, smaller-sized currency in the summer of
1929.
2. The Collection Function Seay’ concern over
s
the quality of the currency was part of a more general interest in improving the efficiency of the country’ payments system, which he considered to be
s
a major objective of the Federal Reserve Act. The
introduction of the Federal Reserve’ leased wire
s
system in 1918 was a welcome innovation to Seay,
and he favored Reserve Bank absorption of the cost
of wire transfers of funds by member banks.

The major effort to improve the payments system
in the 1920s centered on check-collection operations.
Few System activities in the 1920s commanded
as much attention. One of the first standing committees of the Conference of Governors was the
Standing Committee on Collections and Clearings.
John S. Walden, Jr., an assistant to Seay and a senior
operating officer of the Richmond Bank, served on
this committee during the entire decade. Through
Walden, Seay contributed to the standing committee’ work. He was especially interested in promoting
s
uniformity of procedures and practices among the
Banks and in pressing for effective measures to
ensure collection at par, that is, with no levy of
exchange charges by drawee banks.
The committee devised in this period the system
of symbols, printed in the upper right-hand corner
of checks, identifying the dratiee bank and the
Federal Reserve office through which the check
would be collected. This system quickly became of
inestimable value to banks in sorting and routing
checks. The committee also faced the daunting
task of working out a satisfactory arrangement for
timing debits and credits to the reserve accounts. of
drawee banks and depositing banks and dealing with
the effect on member bank reserves of arrangements
that involved other than simultaneous debits and
credits. Only after long experimentation
was .a
satisfactory time schedule with a system of deferred
credits put in place.
In the war period, as part of the Board’ general
s
promotion
JANUARY/FEBRUARY

of membership,
1990

the Banks began collect-

ing for member banks such noncash items as notes,
drafts, and acceptances. Member banks were quick
to avail themselves of this noncash-collection service,
which soon became a major activity at all the Reserve
Banks. When many of the Reserve Banks were experiencing earnings problems in the early 192Os,
sentiment for eliminating the service began to
develop. Such sentiment was especially strong’ the
in
geographically large Districts of the South and the
West-Atlanta,
Dallas, Minneapolis, Kansas City,
and San Francisco-where
distances were great and
transportation and communications costs relatively
high.
Seay, however, insisted on uniformity. He had had
misgivings about offering the service, but once it was
instituted, he favored continuing it. The System had
much to lose, he thought, if it were perceived as
arbitrarily turning its services off and on in response
to earnings changes. Moreover, noncash-collection
services were consistent with Seay’ expansive views
s
of the services the Reserve Banks should offer to
members. Citing the nonpayment of interest on
reserve balances, he argued that Reserve Banks
should offer to member banks all the services they
could expect from city correspondents.
3. Pmblem Areas: Par Colhction, Bank Faihm, and
Mernberxhip Efforts to improve the collection pro-

cess were hampered in the period by a continuing
wave of bank failures and by a running and often
acrimonious disagreement with state-chartered banks
over exchange charges. In the ensuing controversy,
the System found itself confronting the hostility of
state legislatures and banking commissions as well
as of many state-chartered banks. The Reserve Banks
sometimes found to their consternation that member
banks, especially the large-city correspondents, gave
them little or no support in this impasse. In any case,
the large number of bank failures, among members
as well as nonmembers, in combination with the parcollection controversy, tended to diminish public
confidence in the System and to contribute to a
steady erosion of membership in the period.
From the outset, exchange charges on checks were
recognized as a major obstacle to membership in the
System by small, state-chartered institutions. The
Reserve Board took advantage of the patriotism
generated during the war period to mount a campaign
to encourage universal par remittance on a voluntary
basis. So-called par lists were established, and the
Reserve Banks succeeded in placing on these lists
the great majority of the nation’ banks. Yet substans
tial groups of state banks in rural areas of the South,
FEDERAL

RESERVE

West, and Midwest stubbornly resisted. Many soon
found that they could take advantage of the System’
s
collection facilities through city correspondents
without becoming members and giving up exchange
charges.
Acting on a Reserve Board interpretation that the
Federal Reserve Act gave the System authority to
collect all checks at par, the Reserve Banks met this
resistance with a concerted effort to present the
checks of nonpar banks at the counter for cash payment. This action by the Reserve Banks brought
the issue to a head. It touched off extended litigation that seriously embittered relations with small,
state-chartered
banks over much of the nation.
The Reserve Banks most immediately involved in
the litigation were Richmond, Atlanta, Cleveland,
Minneapolis, and San Francisco.
In its annual report for 1920, the Richmond Bank
noted “. . . marked progress toward the establishment of universal par collection.” All District states
except South Carolina were reported on a par basis.
Of 2,210 banks in the District, only 334, all in South
Carolina, refused to remit at par. In view of
developments in the following year, this report probably gave an inaccurate evaluation of progress toward
universal voluntary par remittance. Data for subsequent years suggest strongly that the par list for 1920
included many involuntary par remitters at whose
counters the Richmond Bank was presenting checks
for cash payment.
On February 5, 1921, the North Carolina legislature passed “An Act to Promote the Solvency of
State Banks,” in which it affirmed the right of state
banks to charge exchange when remitting for checks
sent to them by mail. It provided, moreover, that
state banks were not required to pay in cash for
checks presented at their counters by the Reserve
Bank or any of its agencies but could pay with a draft
drawn on a correspondent unless the drawer of the
check had made a notation to the contrary. Finally,
it forbade notaries public to protest checks when payment had been refused solely because it had been
demanded in cash.
The Richmond Bank deemed the act to be unconstitutional and continued to present checks on
nonpar banks at the counter for cash payment. On
February 9, 13 nonmember banks brought suit
against the Richmond Bank in the Superior Court
of Union County, North Carolina, and obtained a
restraining order forbidding the return as dishonored
of checks that the plaintiff banks had refused to pay
BANK

OF RICHMOND

15

in cash. More North Carolina banks joined the suit,
and 230 were on the injunction list by December.
The Richmond Bank refused to handle the checks
of these banks and from time to time published their
names along with the names of other banks the
checks of which, for various reasons, it would not
handle. At the end of 192 1, of 2,195 banks in the
District, 580 refused to remit at par. All these were
in North Carolina (254) and South Carolina (326).
At trial, the Superior Court ruled the North
Carolina act constitutional. The Richmond Bank
appealed the decision to the North Carolina Supreme
Court, which reversed the Superior Court. The plaintiff banks, however, took the case to the U.S.
Supreme Court, which in June 1923 reversed the
North Carolina Supreme Court and ruled the act constitutional. The banks of the state thus retained the
right to charge exchange and to refuse cash payment
for checks presented by the Reserve Bank at the
counter.
Paralleling this case against the Richmond Bank
were significant cases against the San Francisco,
Atlanta, Cleveland, and Minneapolis Banks. As a
result of the decisions in the several cases, the
System ,ended up well short of its desired goal of
universal par collection.. At the direction of the
Reserve Board, the practice of presenting checks for
cash payment at the counters of nonpar banks was
discontinued. The System adopted a policy of refusing to handle checks on nonpar banks. In the years
that followed, the number of banks on the par list
fell sharply.
In the Richmond District, the U.S. Supreme Court
decision in 1923 was quickly followed by a large
reduction in the number of banks on the par list.
Three banks in West Virginia and, 57 in Virginia
promptly removed themselves from the list. The list
fell rapidly over the remaining years of the decade,
from 1,494 in 1923 to 1,091 in 1929. The decline
was slightly more rapid than the drop in the total
number of banks. At the end of 1929, nearly a third
of the banks in the District were not remitting at par.
These were concentrated heavily in the Carolinas and
Virginia. In North Carolina, some 70 percent (294
of 4 19) of all banks were nonpar; in South Carolina,
almost half (67 of 139); and in Virginia, nearly a
quarter (104 of 468). There were nine nonpar banks
in West Virginia but none in Maryland or the District
of Columbia.
While the nonpar banks were mostly small banks
in rural areas, the volume of check operations for
16

ECONOMIC

REVIEW,

the group was significant. Their refusal to remit at
par left an important gap in the Federal-Reservebased payments arrangement that the System was
so eager to establish. The outcome was especially
disappointing to Seay.
The par-collection issue affected membership. In
the Fifth District membership reached a peak of 634
in 1922 and then declined in each remaining year
of the decade. At the end of 1929 it totaled 525.
The number of state members fell from 68 to 45.
Over the same span, the number of national banks
declined from 566 to 480.
The total number of banks in the District fell from
2,210 in 1920 to 1,637 at the end of 1929, a reduction of 573. Much of this decline was accounted for
by failures, which totaled 431 for the period. The
failures were heavily concentrated in the farming areas
of the District, with South Carolina accounting for
225, North Carolina for 119, Virginia for 45, and
West Virginia for 34. There were only eight failures
in Maryland and none in the District of Columbia.
Among the failures were many‘
national banks and
state member banks, which accounted for much of
the decline in membership. A handful of state members merged with national banks during the period,
but the decline in state membership was due almost
entirely to liquidations and voluntary withdrawals.
Concluding

Observations

In their first five years, the Federal Reserve Banks
were immersed in problems associated with financing the First World War. Not until 1920 were they
able to come to grips with issues they were designed to resolve. To a significant extent the experience of the 1920s represented efforts by the
Banks and the Reserve Board to fill gaps and resolve
ambiguities in the Federal Reserve Act, which was
amended ten times in the 1920s. The original act
described only a skeletal outline of a system of
banking control. Many crucial questions of detail were
left unaddressed. It remained for the Reserve Board
and the Banks, in the course of practice and experience, to put flesh on the skeleton.
For the entire decade, the division of authority
between the Reserve Board and the Banks remained at issue. While the act clearly gave the Board
broad authority, certain sections implied substantial
autonomy for the Banks. The new system had been
treated all along as a regional system, not a central
JANUARY/FEBRUARY

1990

bank, and it was widely assumed that the Board’
s
authority over the Banks would be limited to a
monitoring and coordinating function. This divas
clearly the view of Seay. It was frequently expressed by the governors of the other Banks and
seems to have been acquiesced in by some Reserve
Board members as well. In any case, it is clear from
the history of the period that the governors of the
Banks, as a group under the leadership of Benjamin
Strong, were able to maintain a high degree of
autonomy and to play a major role in shaping the
System’ early development.
s

System, problems that dwarfed in both magnitude
and complexity any that had been confronted up to
that time. The banking collapse in the three years
that followed and the onset of the Great Depression
led to a drastic restructuring of the System. The result
was a less ambiguous centralization of authority in
a newly constituted Reserve Board, renamed the
Board of Governors of the Federal Reserve System,
and a substantial reduction in the autonomy of the
Reserve Banks.

Epilogue
As noted, Seay and the Richmond Bank were
vigorous defenders of the autonomy of the Reserve
Banks. They were also major contributors to the
efforts of the governors to develop an effective
mechanism
of credit control and an efficient
payments system. In the credit-policy area, Seay
favored cooperative action by the Banks’ governors,
coordinated through the Conference of Governors,
over Reserve Board leadership. He was a firm supporter of Governor Strong’ efforts to forge an
s
effective policy tool out of the Banks’ purchases and
sales in the market for government securities. In
addition, he chaired the Conference of Governors’
committee to establish basic principles that should
be followed in setting discount rates.
In the payments-system area, the Richmond Bank
was in the forefront of the effort to universalize
collection of checks at par. Seay and Walden were
major contributors to the work of the Conference of
Governors’ Standing Committee on Collections and
Clearings. The Richmond Bank was also involved
in one of the key court cases that questioned the
authority of the System to require par remittance for
checks.
The stock market crash at the end of the decade
of the 1920s signaled the end of an important
chapter in the history of the Federal Reserve Banks.
It ushered in a new set of problems for the entire

FEDERAL

RESERVE

The major reforms of the mid-1930s, along with
important amendments enacted since that time, have
produced a system fundamentally different, both in
structure and in approaches to money and credit control, from the original. In every respect, the Federal
Reserve System has become undeniably a central
bank or, more precisely, a central banking system.
The System today retains, however, sufficient
vestiges of its pristine form to continue to be described as unique among the world’ central banks.
s
In particular, in the face of increased centralization
of power in the hands of the Board of Governors,
the regional Reserve Banks continue to play an important role. Their operations are crucial to the
maintenance of an efficient payments system. Their
information services constitute useful inputs into decisions of businesses, large and small, and of governments. Their role in monetary policymaking has been
restructured to bring it into closer conformity with
radically revised views regarding techniques of
monetary and credit control, but it is no less significant. The boards of directors of the Reserve Banks
continue to take the initiative in setting the discount rate. More important, the executive heads
of the Reserve Banks, now styled presidents instead
of governors, serve actively on the Federal Open
Market Committee,
the System’ chief policys
making body.

17

BANK OF RICHMOND

:

.~ . .

The Lender
Alternative

of Last Resort:

Views and Historical

Experience

Michael D. Bordo *

I.INTRODUCTION
Recent liquidity assistance to failing savings and
loans and banks (some insolvent and some large) in
the U.S. and similar rescues abroad have prompted
renewed interest in the topic of the lender of last
resort. Under the classical doctrine, the need for a
lender of last resort arises in a fractional reserve
banking system when a banking panic, defined as
a massive scramble for high-powered
money,
threatens the money stock and, hence, the level of
economic activity. The lender of last resort can allay
an incipient panic by timely assurance that it will
provide whatever high-powered money is required
to satisfy the demand, either by offering liberal
access to the discount window at a penalty rate or
by open market purchases.
Henry Thornton
(1802) and Walter Bagehot
(1873) develop&d the key elements of the classical
doctrine of the lender of last res‘
ort (LLR) in
England. This doctrine holds that monetary authorities in the face of panic should lend unsparingly but
at a penalty rate to illiquid but solvent banks.
Monetarist writers in recent years have reiterated and
extended the classical notion of the LLR. By contrast, Charles Goodhart and others have recently
posited an alternative view, broadening the power
of LLR to include aid to insolvent financial institutions. Finally, modern proponents of free banking
have made the case against a need for any’ public
LLR.
The remainder of this paper is organized as follows:
Il. The LLR’ role in preventing
s

banking panics

Ill. Four views of the LLR: central propositions
Research for this article began while the author was a Visiting
Scholar at the Federal Reserve Bank of Richmond in Summer,
1988. Thanks go to the following for help on this paper and
on an earlier draft: George Benston, Marvin Goodfriend, Bob
Hetzel, Tom Humphrey, Allan Meltzer, Anna Schwartz, and
Bob Graboves. Paulino Texeira orovided valuable research
assistance. The views expressed are those of the author and not
necessarily those of the Federal Reserve Bank of Richmond or
the Federal Reserve System.
l

18

ECONOMIC

REVIEW,

IV. Historical evidence:
Incidence of banking panics and LLR
actions, U.S. and elsewhere
Alternative LLR arrangements in the U.S.,
Scotland, and -Canada
Record of assistance to insolvent banks
V. Lessons from history in the context
four views of the LLR
II.

of the

BANKINGPANICSANDTHE
LENDEROFLASTRESORT

The need for a monetary authority to act as LLR
arises in the case of a banking panic-a widespread
attempt by the public to convert deposits into currency and, in response, an attempt by commercial
banks to raise their desired reserve-deposit ratios.
Banking panics can occur in a fractional reserve
banking system when a bank failure or series of
failures produces bank runs which in turn become
contagious, threatening the solvency of otherwise
sound banks.
Two sets of factors, some internal and some external to banks, can lead to bank failures. Internal
factors, which affect both financial and nonfinancial
enterprises, include poor management, poor judgment, and dishonesty.
External factors include
adverse changes in relative prices (e.g., land or oil
prices) and in the overall price level.
Of the external factors, changes in relative prices
can drastically alter the value of a bank’ portfolio
s
and render it insolvent. Banking structure can
mitigate the effects of relative price changes. A nationwide branch banking system that permits portfolio diversification across regions enables a bank to
absorb the effects of relative price changes. A unit
banking system, even with correspondents,
is considerably less effective. The nearly 6000 bank failures
that occurred during the decade of the 1920s in the
U.S. were mostly small unit banks in agricultural
regions. Canada, in contrast, had nationwide branch
JANUARY/FEBRUARY

1990

banking. Consequently, many bank branches in those
regions closed, but no banks failed (with the exception of one, in 1923, due to fraud).
A second external factor that can lead to bank
failures is changes in the overall price level (Schwartz,
1988). Price level instability (in a nonindexed system)
can produce unexpected changes in banks’ net worth
and convert ex ante sound investments into ex post
mistakes. Instability means sharp changes from
rising to falling prices or from inflation to disinflation. It was caused by gold movements under the
pre-1914 gold standard, and, more recently, by the
discretionary actions of monetary authorities.
Given that bank liabilities are convertible on
demand, a run on an insolvent bank is a rational
response by depositors concerned about their
ability to convert their own deposits into currency.
In normal circumstances, according to one writer,
bank runs serve as a form of market discipline,
reallocating funds from weak to strong banks and constraining bank managers from adopting risky portfolio strategies (Kaufman, 1988). Bank runs can also
lead to a “flight to quality” (Benston and Kaufman
et al., 1986). Instead of shifting funds from weak
banks to those they regard to be sound, depositors
may convert their deposits into high-quality securities.
The seller of the securities, however, ultimately will
deposit his receipts at other banks, leaving bank
reserves unchanged.
When there is an external shock to the banking
system, incomplete and costly information may
sometimes
make it difficult for depositors to
distinguish sound from unsound banks. In that case,
runs on insolvent banks can produce contagious runs
on solvent banks, leading to panic. A panic, in turn,
can lead to massive bank failures. Sound banks are
rendered insolvent by the fall in the value of their
assets resulting from a scramble for liquidity. By
intervening at the point when the liquidity of solvent
banks is threatened-that
is, by supplying whatever
funds are needed to meet the demand for cash-the
monetary authority can allay the panic.
Private arrangements can also reduce the likelihood of panics. Branch banking allows funds to be
transferred from branches with surplus funds to those
in need of cash (e.g., from branches in a prosperous
region to those in a depressed region). By pooling
the resources of its members, commercial bank clearing houses, in the past, provided emergency reserves
to meet the heightened liquidity demand. A clearing house also represented a signal to the public that
FEDERAL

RESERVE

helo would be available to member banks in time
of panic. Neither branch banking nor clearing houses,
however, can stem a nationwide demand for currency
occasioned by a major aggregate shock, like a world
war. Only the monetary authority-the
ultimate supplies of high-powered money-could
succeed. Of
course, government deposit insurance can prevent
panics by removing the reason for the public to run
to currency.1 Ultimately, however, a LLR is required
to back up any deposit scheme.
1

III.

ALTERNATIVE VIEWS ONTHE
LLR FUNCTION

Four alternative views on the lender of last resort
function are outlined below, including:
l

The Classical View: the LLR should provide
whatever funds are needed to allay a panic;

* Goodfriend and King: an open market operation
is the only policy required to stem a liquidity
crisis;
l

Goodhart (and others): the LLR should assist
illiquid and insolvent banks;

* Free Banking: no government
needed to serve as LLR.
The Classical

authority

is

Position

Both Henry Thornton’ An Enqhy into th Eficts
s
of the Paper Cmdit of Great Bri%ain (1802) and Walter
Bagehot’ Lombard Street (1873) were concerned with
s
the role of the Bank of England in stemming periodic
banking panics. In Thornton’ time, the Bank of
s
England-a
private institution which served as the
government’ bank-had
s
a monopoly of the note
issue within a 26-mile radius of London, and Bank
of England notes served as high-powered money for
the English banking system.2 For Thornton, the
Bank’ responsibility in time of panic was to serve
s
i In theory private deposit insurance could also be used. In practice, to succeed in the U.S., such arrangements would require
the private authority to have the power, currently possessed by
the FDIC, to monitor, supervise, and declare insolvent its
members. Also the capacity of the private insurance industry
is too limited to underwrite the stock of government-insured
deposits. (Benston et al., 1986, ch. 3). Alternatives to deposit
insurance include requiring banks to hold safe assets (treasury
bills), charging fees for service, and one hundred percent
reserves.
r Bank of England notes served as currency and reserves for
the London banks. Country banks issued bank notes but kept
correspondent balances in the London banks. From 1797 to
1821, Bank of England notes were inconvertible into gold.
BANK

OF RICHMOND

19

stability in the United States (also see Cagan, 1965).
According to them, the peculiarities of the nineteenth
century U.S. banking system (unit banks, fractional
reserves, and pyramiding of reserves in New York)
made it highly susceptible to banking panics. Federal
deposit insurance in 1934 provided a remedy to this
vulnerability. It served to assure the public that their
insured deposits would not be lost, but would remain
readily available.

as LLR, providing liquidity to the market and discounting freely the paper of all solvent banks, but
denying aid to insolvent banks no matter how large
or important (Humphrey, 1975, 1989).
Bagehot accepted and broadened Thornton’ view.
s
Writing at a time when the Bank had considerably
enhanced its power in the British financial system,
he stated four principles for the Bank to observe as
lender of last resort to the monetary system:
Lend, but at a penalty rate3: “Very large loans
at very high rates are the best remedy for the
worst malady of the money market when a foreign
drain is added to a domestic drain.” (Bagehot,
1873, p.56);
Make clear in advance the Bank’ readiness
s
lend freely;

to

Accomodate anyone with good collateral (valued
at pre-panic prices);
Prevent illiquid but solvent banks from failing.4*5
Recent monetarist economists have restated the
classical position. Friedman and Schwartz (1963), in
AMonetary History, devote considerable attention to
the role of banking panics in producing monetary

3 Bagehot distinguished between the response to an external
gold drain induced by a balance of payment deficit (raising the
Bank rate) and the response to an internal drain (lending freely).
4 Bagehot has been criticized for not stating clearly when the
central bank should intervene (Rockoff, 1986), for not giving
specific guidelines to distinguish between sound and unsound
banks (Humphrey, 1975), and for not realizing that provision
of the LLR facility to individual banks would encourage them
to take greater risks than otherwise (Hirsch, 1977).
5 In part, Humphrey’ summary of the Classical position is:
s
‘
6
The lender of last resort’ responsibility is to the entire
s
financial system and not to specific institutions.”
“The lender of last resort exists not to prevent the occurrence
but rather to neutralize the impact of financial shocks.”
“The lender’ duty is a twofold one consisting first, of lending
s
without stint during actual panics and second, of acknowledging beforehand its duty to lend freely in all future panics.”
“The lender should be willing to advance indiscriminately to any
and all sound borrowing on all sound assets no matter what the
type.”
“In no case should the central bank accommodate unsound borrowers. The lender’ duty lay in preventing panics from spreading
s
to the sound institutions, and not in rescuing unsound ones.”
“All accommodations would occur at a penalty rate, i.e., the central bank should rely on price rather than non-price mechanisms
to ration use of its last resort lending facility.”
“The overriding objective of the lender of last resort was to prevent panic-induced declines in the money stock. . . .” (Humphrey, 1975 p.9)

20

ECONOMIC

REVIEW.

Friedman and Schwartz highlight the importance
in the pm-FDIC system of timely judgment by strong
and responsible leadership in intervening to allay the
public’ fear. Before the advent of the Fed, the New
s
York Clearing House issued clearing house certifi- _
cates and suspended convertibility, and, on occasion,
the Treasury conducted open market operations. In
two episodes, these interventions were successful;
in three others, they were not effective in preventing severe monetary contraction.
The Federal
Reserve System, established in part to provide such
leadership, failed dismally in the 1929-33 contraction. According to Friedman and Schwartz, had the
Fed conducted open market operations in 1930 and
1931 to provide the reserves needed by the banking system, the series of bank failures that produced
the unprecedented decline in the money stock could
have been prevented.
Schwartz (1986) argues that all the important fmancial crises in the United Kingdom and the United
States occurred when the monetary authorities
failed to demonstrate at the beginning of a disturbance their readiness to meet all demands of sound
debtors for loans and of depositors for cash. Finally,
she views deposit insurance as not necessary to prevent banking panics. It was successful after 1934 in
the U.S. because the lender of last resort was
undependable. Had the Fed acted on Bagehot’ prins
ciples, federal deposit insurance would not have been
necessary, as the record of other countries with stable
banking systems but no federal deposit insurance
attests.
Meltzer (1986) argues that a central bank should
allow insolvent banks to fail, for not to do so would
encourage financial institutions to take greater risks.
Following such an approach would “separate the risk
of individual financial failures from aggregate risk by
establishing principles that prevent banks’ liquidity
problems from generating an epidemic of insolvencies” (p. 85). The worst cases of financial panics,

JANUARY/FEBRUARY

1990

according to Meltzer, “arose because the central bank
did not follow Bagehotian principles.“6
Goodfriend-King and the Case for
Open Market Operations
Goodfriend and King (1988) argue strongly for the
exercise of the LLR function solely by the use of
open market operations to augment the stock of highpowered money; they define this as monetary policy.
Sterilized discount window lending to particular
banks, which they refer to as banking policy, does
not involve a change in high-powered money. They
regard banking policy as redundant because they see
sterilized discount window lending as similar to
private provision of line-of-credit services; both
require monitoring and supervision, and neither
affects the stock of high-powered money.7 Moreover,
they argue that it is not clear that the Fed can provide such services at a lower cost than can the private
sector. Goodfriend (1989) suggests that one reason
the Fed may currently be able to extend credit at
a lower cost is that it can make fully collateralized
loans to banks, whereas private lenders cannot do
so under current regulations. On the other hand, the
availability of these fully collateralized discount window loans to offset funds withdrawals by uninsured
depositors and others may on occasion permit delays
in the closing of insolvent banks8 Goodfriend regards
government-provided
deposit insurance as basically
a substitute for the portfolio diversification of a
nationwide branch banking system. By itself, however, deposit insurance without a LLR commitment

6 Meltzer (1986) succinctly restates Bagehot’ four principles:
s
“The central bank is the only lender of last resort in a monetary
system such as ours.”
“To prevent Squid banks from closing, the central bank should
lend on any collateral that is marketable in the ordinary course
of business when there is a panic . . .”
“Central bank loans, or advances, should be made in large
amounts, on demand, at a rate of interest above the market rate.”
“The above three principles of central bank behavior should be
stated in advance and followed in a crisis.” (Meltzer, 1986, p. 83)
7 Like Goodfriend and King, Friedman (1960) earlier argued
for use of open market operations exclusively and against the
use of the discount window as an unnecessary form of discretion which “involves special governmental assistance to a particular erouo of financial institutions” (D. 38). Also see Hirsch
(1977)&d’
Goodhart
(1988) for the &gum&t that Bagehot’
s
rule was really designed for a closely knit/cartelized banking
system such as the London clearing banks.
8 Cagan (1988) in his comment on Goodfriend and King makes
the case for retention of discount window lending in the case
of “a flight to quality”. In that case, the discount window can
be used to provide support to particular sectors of the economy
which have had banking services temporarily curtailed.
FEDERAL

RESERVE

to provide high-powered money in times of stress
is insufficient to protect the banking system as a
whole from aggregate shock.
The Case for Central
Insolvent Banks

Bank Assistance

to

Charles Goodhart (1985, 1987) advocates temporary central bank assistance to insolvent banks. He
argues that the, distinction between illiquidity and
insolvency is a myth, since banks requiring LLR support because of “illiquidity will in most cases already
be under suspicion about . . . solvency.” Furthermore “because ‘ the difficulty of valuing [the disof
tressed bank’ assets, a Central Bank will usually
s]
have to take a decision on last resort support to meet
an immediate liquidity problem when it knows that
there is a doubt about solvency, but does not know
just how bad the latter position actually is” (Goodhart,
1985, p. 35).
He also argues that by withdrawing deposits from
an insolvent bank in a flight to quality, a borrower
severs the valuable relationship with his banker. Loss
of this relationship, based both on trust’
and agentspecific information, adds to the cost of flight,
making it less likely to occur. Replacing such a connection requires costly search, a process which imposes losses (and possible bankruptcy) on the borrowers. To protect borrowers, Goodhart would have
the central bank recycle funds back to the troubled
bank.
Solow (1982) also is sympathetic to assisting insolvent banks. According to him, the Fed is responsible for the stability of the whole financial system.
He argues that any bank failure, especially a large
one, reduces confidence in the whole system. To
prevent a loss of confidence caused by a major bank
failure from spreading to the rest of the banking
system, the central bank should provide assistance
to insolvent banks. However, such a policy creates
a moral hazard, as banks respond with greater risktaking and the public loses its incentive to monitor
them.
Free Banking:
The Case against Any Public LLR
Proponents of free banking have denied the need
for any government authority to serve as lender of
last resort. They argue that the only reason for banking panics is legal restrictions on the banking system.
In the absence of such restrictions, the free market
would produce a panic-proof banking system.
BANK

OF RICHMOND

21

According to Selgin (1988, 1990) two of the most
important restrictions are the prohibition of nationwide branch banking in the U.S. and the prohibition
everywhere of free currency issue by the commercial banking system. Nationwide branch banking
would allow sufficient portfolio diversification to
prevent relative price shocks from causing banks to
fail. Free note issue would allow banks to supply
whatever currency individuals may demand.
Free banking proponents also contend that contagious runs because of incomplete information would
not occur because secondary markets in bank notes
(note brokers, note detectors) would provide adequate information to note holders about the condition of all banks. True, such markets do not arise
for demand deposits because of the agent-specific
information involved in the demand deposit contract-it is costly to verify whether the depositor has
funds backing his check. But, free banking advocates
insist that clearing house associations can offset the
information asymmetry involved in deposit banking.
According to Gorton (1985), and Gorton and
Mullineaux (1987), clearing houses in the nineteenth
century, by quickly organizing all member banks into
a cartel-like structure, established a coinsurance
scheme that made it difficult for the public to discern
the weakness of an individual member bank. The
clearing house could also allay a panic by issuing loan
certificates which served as a close substitute for gold
(assuming that the clearing house itself was financially
sound). Finally, a restriction on convertibility of
deposits into currency could end a panic. Dowd
(1984) regards restrictions as a form of option
clause.9 In an alternative option (used in pre-1765
Scotland) banks had the legal right to defer redemption till a later date, with interest paid to compensate for the delay.
For Selgin and Dow& the public LLR evolved
because of ti monopoly in the issue of currency. The
Bank of England’ currency monopoly within a
s
26-mile radius of London until 1826 and its extension to the whole country in 1844 made it more
difficult than otherwise for depositors to satisfy their
demand for currency in times of stress. This, in turn,
created a need for the Bank, as sole provider of high9 A restriction of convertibilityitself could exacerbate a panic
becausethe public,in anticipating
such restriction,demandscurrency sooner.
22

ECONOMIC

REVIEW,

powered money, to serve as LLR.lO In the U.S.,
bond-collateral restrictions on state banks before
1863 and on the national banks thereafter were
responsible for the well-known problem of currency
inelasticity. Selgin and Dowd do not discuss the case
of a major aggregate shock that produces a widespread demand for high-powered money. In that
situation, only the monetary authority will suffice.
In sum, the four views-classical, GoodfriendKing,
Goodhart, and free banking-have
considerably different implications for the role of a LLR. With these
views as backdrop, the remaining paragraphs now
examine evidence on banking panics and their resolution in the past.

IV. THEHISTORICAL RECORD
In this section, I present historical evidence for a
number of countries on the incidence of banking
panics, their likely causes, and the role of a LLR in
their resolution. I then consider alternative institutional arrangements that served as surrogate LLRs
in diverse countries at different times. Finally, I
compare the historical experience with the more
recent assistance to insolvent banks in the U.S.,
Great Britain, and Canada. This evidence is then
used to shed light on the alternative views of the
lender of last resort discussed in section III.
Banking Panics

and Their Resolution

The record for the past 200 years for at least
17 countries shows a large number of bank failures,
fewer bank runs (but still a considerable number) and
a relatively small number of banking panics. According to a chronology compiled by Anna Schwartz
(1988), for the U.S. between 1790 and 1930, bank
panics occurred in 14 years; Great Britain had the
next highest number with panics occurring in 8 years
between 1790 and 1866. France and Italy followed
with 4 each.
An alternative chronology that I prepared (Bordo,
1986, Table 1) for 6 countries (the U.S., Great
Britain, France, Germany, Sweden, and Canada) over
the period 1870-1933 lists 16 banking crises (defined as bank runs and/or failures), and 4 banking
lo Selgin (1990) argues that the Bank Charter Act of 1844 exacerbated the problem of panics because it imposed tight constraints on the issue of bank notes by the Issue Department.
However, the Banking Department surely could have discounted
commercial paper from correspondent banks without requiring
further note issue. That is one of Bagehot’ main points in
s

Lombard Street.
JANUARY/FEBRUARY

1990

panics (runs, failures, and suspensions of payments),
all of which occurred in the U.S. It also lists 30 such
crises, based on Kindleberger’ definition of finans
cial crises as comprising manias, panics, and crashes
and 7 1 stock market crises, based on Morgenstern’
s
(1959) definition.
I
The similar failure rates for banks and nonfinancial firms in many countries largely reflect that individual banks, like other firms, are susceptible to
market vagaries and to mismanagement.
Internal
factors were important, as were the external factors
of relative price changes, banking structure, and
changes in the overall price level. The relatively
few instances of banking panics in the past two centuries suggests that either (1) monetary authorities
in time developed the procedures and expertise to
supply the funds needed to meet depositors’ demands
for cash or (2) the problem of banking panics is
exaggerated.
A comparison of the performances
of Great
Britain and the U.S. in the past century serves to
illustrate the importance of the lender of last resort
in preventing banking panics. In the first half of the
nineteenth century, Great Britain experienced banking panics when the insolvency of an important financial institution precipitated runs on other banks, and
a scramble for high-powered money ensued. In a
number of instances, the reaction of the Bank of
England to protect its own gold reserves worsened
the panic. Eventually, the Bank supplied funds to
the market, but often too late to prevent many
unnecessary bank failures. The last such panic
followed the failure of the Overend Gurney Company in 1866. Thereafter, the Bank accepted its
responsibility as lender of last resort, observing
Bagehot’ Rule “to lend freely but at a penalty rate”.
s
It prevented incipient financial crises in 1878, 1890,
and 19 14 from developing into full-blown panics by
timely announcements and action.
The United States in the antebellum period experienced 11 banking panics (according to Schwartz’
s
chronology) of which the panics of 1837, 1839, and
1857 were most notable.” The First and Second
Banks of the’
united States possessed some central
banking powers in part of the period; some states
11 Selgin (1990), based on evidence by Rolnick and Weber
(1986), argues that the episodes designated as panics in the
antebellum Free Banking era are not comparable to these in the
National Banking era because they did not involve contagion
effects. Evidence to the contrary, however, is presented by Hasan
and Dwyer (1988).
FEDERAL

RESERVE

developed early deposit insurance schemes (see
Benston, 1983; Calomiris, 1989), and the New York
Clearing House Association began issuing clearing
house loan certificates in 18.57. None of these arrangements sufficed to prevent the panics.
In the national banking era, the U.S. experienced
three serious banking panics - 1873, 1893, and
1907-08. In these episodes, the Clearing Houses of
New York, Chicago, and other central reserve cities
issued emergency reserve currency in the form of
clearing house loan certificates collateralized by
member banks’ assets and even issued small
denomination hand-to-hand currency. But these
lender of last resort actions were ineffective. In
contrast to successful intervention in 1884 and 1890,
the issue of emergency currency was too little and
too late to prevent panic from spreading. The panics
ended upon the suspension of convertibility of
deposits into currency. During suspension, both
currency and deposits circulated freely at flexible
exchange rates, thereby relieving the pressure on
bank reserves. The panics of 1893 and especially
1907 precipitated a movement to establish an
agency to satisfy the public’ demand for currency
s
in times of distrust of deposit convertibility. The
interim Aldrich-Vreeland Act of 1908 allowed ten or
more national banks to form national currency
associations and issue emergency currency; it was
successful in preventing a panic in 1914.
The Federal Reserve System was created in 19 14
to serve as a lender of last resort. The U.S. did not
experience a banking panic until 1930, but as Friedman and Schwartz point out, during the ensuing three
years, a succession of nationwide banking panics accounted for the destruction of one-third of the money
stock and the permanent closing of 40 percent of the
nation’ banks. Only with the establishment of federal
s
deposit insurance in 1934 did the threat of banking
panics recede.
Table. I compares American and British evidence
on factors commonly believed to be related to banking panics, as well as a chronology of banking panics
and banking crises for severe NBER business cycle
recessions (peak to trough) in the period 18701933 .r2 The variables isolated include: deviations
from trend of the average annual growth rate of real
output; the absolute difference of the average annual
rate of change in the price level during the preceding
12 For similar evidence for the remaining cyclical downturns in
this period, see Bordo (1986, Table 6, 1A). ’
BANK

OF RICHMOND

23

Table

Banking
Deviations

Panics

from Trend

of Average

Absolute

Difference

I

(1870-1933):
Related
Annual

Real Output

of Average

Deviations

Annual

from Trend
Change

Growtha

in Money

Incidence,

and Resolution

(peak to trough)”

Rate of Price

of Average

Level Change

Annual

Monetary

due to Change

Banking

Reference
cycle

Factors,

(trough

Growthb

to peak minus
(specific

in Deposit-Currency

CrisisC **

Banking

cycle
Ratio

Panicd
Existence

peak to trough)’
peak to trough)”

(specific

cycle

of Clear

and Credible

Trough

United

I
1873

I
1879

States

1882

1885

-3.2%

- 12.2%

1893

1894

-9.5%

-9.0%

-9.3%

-4.3%

7193

1907

1908

- 14.7%

-6.1%

- 1.7%

-2.7%

10107

1920

1921

-7.6%

1929

1932

I
0.5%

-4.7%

-7.1%

2.6%

-56.7%

5.2%

-2.5%

l

I
Clearing

Houses/Treasury

Successful

LLR

Clearing

Houses/Treasuly

Restriction

of Payments

Clearing

Housesilreasury

Restriction

of Payments

Clearing

Houses/Treasury

No
No

l

Restriction

Yes

2.0%

*

Agency*

NO

5184

*

(7)
1930,1931,1932

- 12.5%
- 11.7%
-27.4%
- 16.7%
--__----_--------------------------~----------~----------------------

--__---__--

II,
at73

2.7%

LLR Policy”’

of Payments

Resolution’

Peak

peak to trough)*”

**

1933

No

Great

1873

1879

Britain

1883

1886

1890

1894

-0.2%

-4.4%

1907

1908

-4.7%

- 13.6%

1920

1921

-6.9%

- 68.0%

-5.1%

4.5%

1932

-3.7%

-7.9%

-4.3%

- 1.3%

Federal

LLR

Resew

Yes

1929

Unsuccessful

Yes

-7.1%

-3.1%

5.2%

Yes

- 5.4%

0.9%
- 1.2%

-2.8%

2.3%

Yes

-2.2%

Notes:

(a)

See Data Appendix

in Bordo

See Data Appendix

in Bordo

Yes

Judgmental,

on this paper

Bank of England

Successful

Yes

(1986).

l l

*

The trend

growth

the natural

based

rates of real output

logs of real output

(b)

The trend

(c)

Banking

crisis-runs

(d)

monetary

Banking

panic-runs,

growth
and/or

were 3.22%

in terminal

rates were
failures.

failures,

and other

research
for the U.S.

and initial

(1870-1941)

years divided

5.40%

for the U.S.

Source

and

by the number

(1870-1941)

1.48%

for Great

Britain

(1870-1939).

Each was calculated

as the difference

between

of years.
(1870-1939).

Bordo (1986).

suspension

of payments.

and 2.71%

for Great

Britain

Each was calculated

as in footnote

(a).

Ibid

trough to peak and the current peak to trough as a
measure of the effect of changes in the overall price
level; deviations from trend of the average annual rate
of monetary growth; and the percentage change in
the money stock due to changes in the depositcurrency ratio. l3
The table reveals some striking similarities in the
behavior of variables often related to panics but a
remarkable difference between the two countries in
the incidence of panics. Virtually all six business
cycle downturns designated by the NBER as severe
were marked in both countries by significant declines
in output; large price level reversals, and large
declines in money-growth. Also, in both countries,
falls in the deposit-currency ratio produced declines
in the money stock in the three most severe
downturns: 1893-94 (U.S.); 1890-1894 (G.B.);
1907-08; and 1929-32.
I3 In relating the changes in the money stock to changes in the
deposit-currency ratio, we hold constant the influence of the other
two proximate determinants of the money supply: the depositreserve ratio and the stock of high-powered money. It is
calculated using the formula developed in Friedman and Schwartz
(1963). Appendii B.
24

1 l/90

(1981).

*

*

Sources:

Crisis

,- 1.0%

l

Data

Baring

-2.5%
- 1.6%

,

ECONOMIC

REVIEW,

However, the difference in the incidence of panics
is striking-the U.S. had four while Britain had none.
Both countries experienced frequent stock market
crashes (see Bordo, 1986, Table 6.1). They were
buffeted by the same international financial crises.
Although Britain faced threats to the banking system
in 1878, 1890, and 1914, the key difference between
the two countries (see the last three columns of
Table I) was successful LLR action by the British
authorities in defusing incipient crises..
Similar evidence over the 1870-1933 period for
France, Germany, Sweden, and Canada is available
in Bordo (1986). In all four countries, the quantitative variables move similarly during severe recessions to those displayed here for the U.S. and Great
Britain, yet there were no banking panics. In France,
appropriate actions by the Bank of France in 1882,
1889, and 1930’
prevented incipient banking crises
from developing into panics. Similar behavior occurred in Germany in 1901 and 193 1 and in Canada
in 1907 and 1914.
One other key difference was that all five countries had nationwide branch banking whereas the U.S.
JANUARY/FEBRUARY

1990

had unit banking. That difference likely goes a long
way to explain the larger number of bank failures in
the U.S.
Alternative

LLR

Arrangements

In the traditional
view, the LLR role is
synonymous with that of a central bank. Goodhart’
s
explanation for the evolution of central banking in
England and other European countries is that the first
central banks evolved from commercial banks which
had the special privilege of being their governments’
banks. Because of its sound reputation, position as
holder of its nation’ gold reserves, ability to obtain
s
economies by pooling reserves through a correspondent banking system, and ability to provide extra cash
by rediscounting, such a bank would evolve into a
bankers’ bank and lender of last resort in liquidity
crises. Once such banks began to act as lenders of
last resort, “moral hazard” on the part of member
banks (following riskier strategies than they would
otherwise) provided a rationale for some form of
supervision or legislation. Further, Goodhart argues
that the conflict between the public duties of such
an institution
and its responsibilities
to its
shareholders made the transition from a competitive
bank to a central bank lengthy and painful.
Though Goodhart (1985 Annex B) demonstrates
that a number of central banks evolved in this fashion,
the experiences of other countries suggests that alternative arrangements were possible. In the U.S. before
the advent of the Fed, a variety of institutional arrangements were used on occasion in hopes of allaying banking panics, including:
Deposit insurance schemes: relatively successful
in a number of states before the Civil War (Benston, 1983; Calomiris, 1989);
A variety of early twentieth century deposit insurance arrangements which were not successful
(White, 198 I);
Clearing houses and the issue of clearing house
loan certificates (Timberlake,
1984; Gorton,
1985);
Restriction of convertibility of deposits into currency by the clearing house associations in the
national banking era;
Various U.S. Treasury operations between
and 1907 (Timberlake, 1978);
The Aldrich-Vreeland

1890

Act of 1908.

Two countries which managed successfully for long
periods without central banks were Scotland and
FEDERAL

RESERVE

Canada. Scotland had a system of free banking from
1727 to 1844. The key features of this system were
a) free entry into banking and free issue of bank notes,
b) bank notes that were fully convertible into fullbodied coin, and c) unlimited liability of bank
shareholders.
Scotland’ record under such a system was one of
s
remarkable monetary stability. That country experienced very few bank failures and very few financial
crises. One reason, according to White (1984), was
the unlimited liability of bank stockholders and strict
bankruptcy laws that instilled a sense of confidence
in noteholders.r4 Indeed, the Scottish banks would
take over at par the issue of failed banks (e.g., the
Ayr bank, 1772) to increase their own business. A
second reason was the absence of restrictions on bank
capital and of other impediments to the development
of extensive branching systems that allowed banks
to diversify risk and withstand shocks.r5 Faced with
a nationwide scramble for liquidity, however, Scottish banks were always able to turn to the Bank of
England as a lender of last resort (Goodhart 1985).
Although Canada had a competitive fractional
reserve banking system throughout the nineteenth
century, no central bank evolved (Bordo and Redish,
1987). By the beginning of the twentieth century,
though, virtually all the elements of traditional central banking were being undertaken either by private
institutions or directly by the government.
By 1890, the chartered banks, with the compliance
of the Government, had established an effective selfpolicing agency, the Canadian Bankers Association.
Acting in the absence of a central bank, it succeeded in insulating the Canadian banks from the
deleterious effects of the U.S. banking panics of 1893
and 1907. It did so by quickly arranging mergers
between sound and failing banks, by encouraging cooperation between strong and weaker banks in times
of stringency, and by establishing a reserve fund to
be used to compensate note holders in the event of
failure.
In addition, the nationwide branch system overcame the problem of seasonal liquidity crises that
characterized the United States after the Civil War,
I4 Sweden from 1830 to 1902 had a system of competitive note
issue and unlimited liability. According to Jonung (1985), there
is evidence neither of overissue nor of bank runs.
I5 Switzerland also had a successful experience with free banks
1826-1850 (Weber. 1988) but like Scotland’ dependence on
s
the Bank of‘
Englanb, she’
depended on the Bank-of France as
lender of last resort (Goodhart, 1985).
BANK

OF RICHMOND

25

characterized the United States after the Civil War,
thus lessening the need for a lender of last resort.
However, the Bank of Montreal (founded in 18 17)
very early became the government’ bank and pers
formed many central bank functions.
Because Canadian banks kept most of their
reserves on “call” in the New York money market,
they were able in this way to. satisfy the public’
s
demand for liquidity, again precluding the need for
a central bank. On two occasions, 1907 and 1914,
however, these,reserves proved inadequate to prevent a liquidity crisis and the Government of Canada
had to step in to supplement the reserves.
The Finance Act, passed in 19 14 to facilitate wartime finance, provided the chartered banks with’ a
liberal rediscounting facility. By pledging appropriate
collateral (this was broadly defined) banks could borrow Dominion notes from the Treasury Board. The
Finance Act clause, which was extended after the
wartime emergency by the Amendment of 1923, provided a discount window/lender of leastresort for the
Canadian banking system.
In sum, though Canada, Scotland, and several
other countries did,not have formal central banks
serving as LLRs, all had access to a governmental
authority which could provide high-powered money
in the event of such a crisis.
LLR

Assistance

to Insdvent

Banks

The classical prescription for LLR action is to lend
freely but at a penalty rate to illiquid but solvent
banks. Both Thornton and Bagehot advised strongly
against assistance to insolvent financial institutions.
They opposed them because they would encourage
future risk-taking without even eradicating the threat
of runs on other sound financial institutions. Bagehot
also advocated lending at a penalty rate to discourage
all but those truly in need from applying and to limit
the expansion in liquidity to the minimum necessary
to end the panic.
Between 1870 and 1970, European countries
generally observed the classical strictures. In the
Baring Crisis of 1890, the Bank of England successfully prevented panic. It arranged (with the Bank
of France and the leading Clearing Banks) to advance
the necessary sums to meet the Barings’ immediate
maturing liability. These other institutions effectively
became part of a joint LLR by guaranteeing to cover
losses sustained by the Bank of England in the pro26

ECONOMIC

REVIEW,

cess (Schwartz, 1986, p. 19). The German Reichsbank in 1901 prevented panic by purchasing prime
bills on the open market and expanding its excess
note issue, but it did not intervene to prevent the
failure of the Leipziger and other banks (Goodhart,
1985, p. 96). The Bank of France also followed
classical precepts in. crises in 188 1. and. 1889.
The Austrian National Bank, however, ignored the
classical advice during the Credit Anstalt crisis of
193 1 by providing liberal assistance to the Credit
Anstalt at low interest rates (Schubert, 1987). Then,
a run on the Credit Anstalt and other Viennese banks
in May 1931 followed the disclosure of the Credit
Anstalt’ insolvency and a government financial
s
rescue package. The run degenerated
into a
speculative attack on the fixed price of gold. of the
Austrian Schilling.
’
The U.S. record over the same period is less
favorable than that of the major European countries.
Before the advent of the Federal Reserve System and
during the banking panics of the early 1930s LLR
action was insuffrcient to prevent panics. By contrast,
over the past two decades, panics may have been
prevented, but LLR assistance has been provided
on a temporary basis to insolvent banks and, prior
to the Continental Illinois crisis in 1984, no penalty
rate was charged. In the U.S. on three notable occasions, the Fed (along with the FDIC) provided
liberal assistance to major banks whose solvency was
doubtful at the time of the assistance: Franklin
National in 1974, First Pennsylvania in 1980, and
Continental Illinois in 1984. Further, in the first
case, loans were advanced at below-market rates
(Garcia and Plautz, 1988). This Federal Reserve
policy toward large banks of doubtful solvency
differs significantly from the classical doctrine.
The Bank of England followed similar policies in
the 1974 Fringe Bank rescue and the 1982 Johnson
Matthty affair. In 198.5, the Bank of Canada arranged for the major chartered banks to purchase the
assets of two small insolvent Alberta banks and
fully compensate all depositors. In contrast to the
Anglo-Saxon experience, the German Bundesbank
allowed the Herstatt Bank to be liquidated in 1974
but provided LLR assistance to the market. Thus,
although the classical doctrine has been long
understood and successfully applied, recent experience suggests that its basic message is no longer
always adhered to.
JANUARY/FEBRUARY

1990

..

V. CONCLUSION:
SOMELESSONSFROMHISTORY
One can draw a number of conclusions from the
historical record.
(1) Banking panics are rare events. They occurred more often in the U.S. than in other countries. They usually occurred during serious recessions
associated with declines in the money supply and
sharp price level reversals. The likelihood of their
occurrence would be greatly diminished in a diversified nationwide branch banking system.
(2) Successful LLR actions prevented panics on
numerous occasions. On those occasions when panics
were not prevented, either the requisite institutions
did not exist or the authorities did not understand
the proper actions to take. Most countries developed
an effective LLR mechanism by the last one-third
of the nineteenth century. The U.S. was the principal exception.
(3) Some public authority must provide the lender
of last resort function. The incidence of major
international financial crises in 1837, 1857, 1873,
1890-93, 1907, 1914, 1930-33 suggests that in such
episodes aggregate shocks can set in train a series
of events leading to a nationwide scramble for highpowered money.
(4) Such an authority does not have to be a central bank. This is evident from the experience of
Canada and other countries (including the U.S. experience under the Aldrich-Vreeland Act in 1914).
In these cases, lender of last resort functions were
provided by other forms of monetary authority, including the U.S. Treasury, Canadian Department of
Finance, and foreign monetary authorities.

FEDERAL

RESERVE

(5) The advent of federal denosit insurance in
1934 solved the problem of banking panics in the
U.S. The absence of government deposit insurance
in other countries that were panic-free before the
1960s and 1970s however, suggests that such insurance is not required to prevent banking panics.
(6) Assistance to insolvent banks was the exception rather than the rule until the 1970s.r6 The
monetary authorities in earlier times erred on the side
of deficiency rather than excess. Goodhart’ view is
s
certainly not a description of past practice. The recent experience with assistance to insolvent banks
is inconsistent with the classical prescription. Liberal
assistance to insolvent banks, combined with deposit
insurance which is not priced according to risk, encourages excessive risk-taking, creating the conditions for even greater assistance to insolvent banks
in the future.
In sum, the historical record for a number of countries suggests that monetary authorities following the
classical precepts of Thornton and Bagehot can
prevent banking panics. Against the free banking ’
view, the record suggests that such a role must be
provided by a public authority. Moreover, contrary
to Goodhart’ view, successful LLR actions in the
s
past did not require assistance to insolvent banks.
Finally, the record suggests that the monetary
authority’ task would be eased considerably by allows
ing nationwide branch banking and by following a
policy geared towards price level stability. Under such
a regime, as Goodfriend and King argue, open market
operations would be sufficient to offset unexpected
scrambles for liquidity.
16 Although in the U.S., the policy of purchase and assumption
carried out by the FDIC and FSLIC before that date incorporated elements of public subsidy.

BANK

OF RICHMOND

27

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