The Phelan Act of 1920 sounded simple in principle. It authorized the various Federal Reserve Banks, at that time twelve district branches operating independently, to charge progressive interest rates on the rediscounting activities at their respective windows (the discount rate was the interest charged to obtain collateralized funds from the various reserve banks). Private banks in each district were given a set credit line to be used in the regular course of business. Any borrowing above that amount would be subject to rate gradation according to the Phelan Act.
The rationale for doing so from the perspective of the Federal Reserve was twofold. The banking system was coming off its WWI inflationary boom which would be a strain on liquidity and credit. The reserve system had to be sensitive to that development, but also wished to remain true to Bagehot’s so-called golden rule to lend freely but at a high rate. Thus, if a bank wished to borrow in excess it could, but it had to be prepared to pay up for it.
Each 25% increase in borrowing beyond the set limit would cost an additional one half of one percent above the prior effective rate. If the amount in the previous period was at or below the limit, it would be a penalty rate above policy discount rate. For further excessive amounts, the escalated cost would be added in addition to whatever marginal rate previously in effect.
The mechanics of liquidity aside, the purpose of the Federal Reserve in the first place was to provide currency elasticity that its designers believed the United States sorely lacking. They blamed the seemingly frequent bank panics and subsequent depressions on the shortcomings of a private only banking system that would at times exacerbate monetary shortages (hoarding). One such founder believing fervently in this principle was Senator Robert Owen.
Owen’s background was banking but not Eastern banking. He was from Oklahoma and therefore from the rural, agricultural type. As a bank owner with mostly farmers as customers, depositors, and borrowers, his business was often seemingly at odds with the high finance taking place in far off reserve city banks in Chicago and New York. The latter types were all gold and deflation if necessary, while for Owen it meant the agricultural interior that would get hit the hardest.
His experience in the 1893 panic convinced him of the need for a centralized liquidity apparatus if for no other reason than to protect middle American farm mortgagors from Wall Street ups and downs that didn’t appear to have anything to do with them. Traveling through Europe in the later 1890’s, Owen visited many of the European central banks, including the Bank of England, that had been in business for centuries. Though their management and operative conditions were quite often vastly different from one another, their common purpose made them all the more compelling as adaptable to the American experience.
Rising to prominence in the Democratic party as one of its Populist faction members, Robert Owen claimed to have convinced William Jennings Bryan at the 1896 nomination convention to add a plank to the party’s platform on the idea of elasticity. He would write in his memoir:
I strenuously urged a plank pledging the Democratic Party to protect the country from financial panics but failed to obtain support. I advocated, as a resolution before the Committee on Resolutions, that United States bonds might, in times of threatened panic, be made convertible into Treasury notes to serve as currency as a source of quick supply of money to offset the withdrawal of currency for hoarding by frightened depositors.
He never gave up on the idea, and after the Panic of 1907 the country finally seemed to have had enough of panics. Liquidity even if in the form of a central bank was finally reaching palatability (though it is as much likely that uniform national currency was the deciding factor). Having played a central role in creating the Fed in 1912 and 1913, along with Carter Glass, Paul Warburg, and several others, Owen was shocked at what it was only a few years later.
In 1921, Robert Owen was mad. Not just angry, but beside himself with rage over what had become of the institution he helped create. Perhaps more than anyone else in Congress, Owen, as Chairman of the Senate Committee on Banking and Currency, had not only shepherded the Federal Reserve into existence, he had contributed perhaps more than anyone to what it actually became. So in the Depression of 1920-21 when the Federal Reserve was again appealing to “deflation”, Owen could not tolerate such a course since the system he designed and crafted was created with the explicit idea that it would never do so.
To restore price parity after WWI inflation, the System had raised the discount rate to 7% by June 1920 (there was, again, no single rate, so the rate set for the New York branch which did most of the monetary business in the system was as close to a policy rate as might have been possible). And as liquidity conditions faltered in the forming depression, it was none other than the agricultural heartland that was hit hardest yet again. The Phelan Act meant that as it became increasingly difficult to hold on as interior, rural banks, they would have to pay the progressive scale for additional liquidity in the face of rapidly gaining hardship.
The Fed system has provided very little elasticity for what Robert Owen at least wished to achieve. In fact, the tenth Fed district for Kansas City, the one that included his native Oklahoma, would not recover from the depression, struggling even throughout the whole Roaring Twenties. Other areas of the country, New York prominently, had little trouble progressing past the contraction and were therefore yet again of seemingly another world altogether (chart below extracted from KC Fed history).
Economic and monetary history from the perspective of the 21st century always seems to have begun in October 1929. Left largely unexamined is the period leading up to that great calamity. It isn’t wrong to focus on the Great Depression, but it is to the exclusion of everything else.
The first chapter in the Fed’s history is alive with parallels. Monetary evolution, often by the necessity of World War I, was rampant throughout the 1910’s and 1920’s, and so was central bank policy experimentation. In my view, there is no more closely resembling past period to the 1990’s and 2000’s than the 1910’s and 1920’s.
I have admittedly reduced considerably this review due to the format. There are a number of other complications to consider and factor in reviewing the Depression of 1920, and not just the discount rate or the role of the Phelan Act. But in simple terms, Robert Owen worked almost his whole adult life to prevent deflationary currency from so devastating his homeland again. He was so successful in reaching that goal to be one of, if not the most important, founders of the Federal Reserve System.
It was designed with currency elasticity as its first legal task and it failed as a matter of both policy as well as mechanics. Owen’s Fed was supposed to be a shining example of how to do it right. The mistakes, of course, would not end with the relatively brief 1920 contraction, colossal as it was, soon to be overshadowed by another even more terrifying liquidity event. Monetary evolution played a prominent role in leading to both no matter how sound the institution was taken for ahead of each. If Owen voiced no concerns in 1919, practically no one was sounding alarms in the mania years of 1927 and after.
The lesson, if there is to be just one, is as old as governments. Bureaucracies are slow to adapt and often are only able to do so long after it’s all over. The Fed has several times in its history displayed perhaps too much this tendency. One primary reason is as universal, as Milton Friedman wrote in A Monetary History describing the 1920’s Fed in which he characterized as its “high tide”:
In years of prosperity, monetary policy is said to be a potent instrument, the skillful handling of which deserves credit for the favorable course of events; in years of adversity, monetary policy is said to have little leeway but is largely the consequence of other forces, and it was only the skillful handling of the exceedingly limited powers available that prevented conditions from being even worse.
A more comprehensive review of the Federal Reserve stitched together from so many of these anecdotes from then as well as now argues clearly and forthrightly for the central bank to never be so central.
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