CHAPTER 3
Taking the year (1923) as a whole and regarding it in the perspective of the after-war readjustment period, there is abundant evidence that, so far as the United States is concerned, economic readjustment has been proceeding at a rapid rate and is now nearing completion.
Tenth Annual Report of the Federal Reserve Board Covering Operations for the Year 1923.1
World War I had set off a torrid economic expansion in the United States. In 1920 that boom came to an end, and in 1921 the country experienced a severe but short-lived depression. When that depression ended in early 1922, the monetary disruptions unleashed by the war finally ceased. This chapter describes the significant impact the Depression of 1921 had on the Fed's balance sheet. It also highlights the relative calm the Fed enjoyed during the rest of the decade.
The Balance Sheet
Assets
Between October 1920 and the end of 1930, the Fed's total assets contracted from $6.6 billion to $5.3 billion, as shown in Chart 3.1. Notice, however, that all of the contraction occurred between October 1920 and January 1922. During that time, the Fed's total assets fell by 27%. Afterwards, they remained more or less stable during the rest of the decade.
The Fed's assets declined during 1921 because the commercial banks sharply curtailed their borrowing from the Fed. This is reflected on the Fed's balance sheet by the plunge in bills discounted from $2.8 billion in October 1920 to only $414 million in January 1922 (see Chart 3.2).
CHART 3.1 The Fed's Total Assets, 1914 to 1930
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
Two factors drove the commercial banks' decisions to repay their loans from the Fed. First, a large amount of gold entered the United States during 1921, as the country's allies began to repay some of the money they had borrowed from the United States during the war. That year the country's gold reserves rose by $734 billion, or 28%. When this gold entered the United States, it was deposited into the commercial banks. They used the gold to repay part of their loans from the Fed. The 1921 Annual Report of the Federal Reserve Board attributed 44% of the decline in Fed's “loan account” to these gold inflows.2 The Fed's gold holdings increased by 50% that year from $2 billion to $3 billion, as shown in Chart 3.2.
CHART 3.2 A Breakdown of the Fed's Major Assets and Liabilities, 1914 to 1930
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
The Depression of 1921 is the second reason the commercial banks repaid their loans from the Fed. The postwar economic boom ended with a commodity price crash in 1920, followed by a severe economic slump. During 1921, the total loans and investments of the 800 reporting member banks in leading cities contracted by nearly 11%.3 The combination of ample gold reserves and weak loan demand meant the commercial banks simply did not need to continue borrowing from the Fed.
The banks repaid the Fed by redeeming the bills they had offered to the Fed as collateral. The bills discounted on the asset side of the Fed's balance sheet fell 85% between October 1920 and January 1922. That explains the 27% contraction in the Fed's total assets during that period despite the large increase in the Fed's gold holdings.
Altogether, Federal Reserve Credit contracted by nearly $1.8 billion during 1921, as shown in Chart 3.3.
CHART 3.3 Federal Reserve Credit, Annual $ Change, 1915 to 1930
Source: The Federal Reserve4
Chart 3.4 shows that total Federal Reserve Credit, represented in the top line in dark gray, contracted 70%, from a peak of $3.4 billion in November 1920 to a low of $1 billion in August 1922.
This collapse was due entirely to the reduction in the Fed's bills discounted. By comparison, changes in the other two components of Federal Reserve Credit, government securities and bills bought, were much less significant during those years, as well as throughout the rest of the decade.
The large inflow of gold and the steep contraction in Federal Reserve Credit resulted in gold once again overtaking assets acquired with Federal Reserve Credit as the largest component within the Fed's total assets. Chart 3.5 shows that gold surpassed the assets acquired with Federal Reserve Credit in mid-1921 and remained the dominant component throughout the rest of the decade.
CHART 3.4 Federal Reserve Credit and Its Components 1914 to 1930
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
CHART 3.5 The Fed's Total Assets: Gold vs. Assets Acquired with Federal Reserve Credit, 1914 to 1930
Source: Data from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
Liabilities
On the liabilities side of the Fed's balance sheet, Federal Reserve Notes also contracted sharply between late 1920 and early 1922, by approximately $1.2 billion or 35%. This was another significant development over which the Fed had no control. Once the war ended and the war-induced economic boom came to an end, the public no longer needed or wished to hold as much cash. They deposited it into their accounts at the commercial banks, and the commercial banks returned the unwanted Federal Reserve Notes to the Fed. As the Fed received the cash, in exchange, it credited those banks' reserve accounts at the Fed.
Chart 3.2 shows that the Fed's Federal Reserve Note liabilities shrank as currency was retired. Had no other factors been at play, Bank Reserves would have increased one for one with the decrease in Federal Reserve Notes. However, two other factors were at play. The second factor added to Bank Reserves, while the third factor reduced Bank Reserves.
The second factor, which was discussed above, was the gold inflows into the United States during 1921. When the commercial banks deposited that gold into their reserve accounts at the Fed, it increased the Fed's gold holdings on the asset side of the Fed's balance sheet and it increased the member banks' Reserves on the liabilities side of the Fed's balance sheet.
Therefore, the reduction in Federal Reserve Notes and the gold deposits made by commercial banks both added to Bank Reserves. However, a third factor had the opposite effect. In 1921, when the commercial banks repaid the Fed the credit they had borrowed from the Fed during the war, the Fed took payment by simply debiting the reserve accounts those banks held at the Fed by the amount of the loans repaid, thereby reducing the size of member banks' reserves on the liabilities side of its balance sheet.
The two factors adding to Bank Reserves, the reduction in Federal Reserve Notes and the gold deposits made by commercial banks, were more or less completely offset by the one factor deducting from Bank Reserves: the repayment of the commercial banks' loans from the Fed. As a result, Banks Reserves were little changed between late 1920 and early 1922.
It is also important to note that the reduction in Federal Reserve Notes outstanding, combined with the large additions to the Fed's gold holdings, resulted in an impressive improvement in the Fed's gold coverage ratio. Chart 3.6 shows the ratio of the Fed's gold reserves to notes and reserve liabilities increased from 43.2% in October 1920 to nearly 80% by mid 1922, eliminating, for the time being at least, any concern that the Fed would lack sufficient gold to meet its statutory reserve requirements.
CHART 3.6 Gold Coverage Ratio, 1914 to 1930
Source: Data from Ratio of Reserves to Note and Deposit Liabilities, Federal Reserve Banks for United States, St. Louis Fed., 1914 to 1948
Conclusion
The monetary disruptions that had begun with the outbreak of World War I finally came to an end in February 1922. The Fed had never been intended to be the source of long-term credit. It had been created to supply short-term loans to prevent temporary liquidity shortages from developing into full-blown banking panics. Therefore, the contraction in Federal Reserve Credit during 1921 occurred in full accordance with how the Fed was designed to function. The Fed had supplied Federal Reserve Credit on a large scale as an emergency measure to help finance the war effort. Therefore, the contraction in Federal Reserve Credit during 1921 simply returned the size of the Fed's balance sheet back to a level much closer to where it would have been had World War I never occurred.
During the rest of the 1920s, the Fed functioned as the passive institution that its architects had designed it to be. The Fed periodically responded to commercial bank demand for liquidity through discounting operations. Otherwise, the Fed was largely inactive. There were no significant additional gold inflows from abroad, so the Fed's gold holding remained relatively flat. The amount of Federal Reserve Notes outstanding remained relatively stable and Bank Reserves expanded only gradually. Up through the end of 1930, the Fed's total assets grew little and Federal Reserve Credit grew even less.
The Fed's operating procedures began to evolve during the 1930s. World War II not only radically altered the way the Fed functioned, it radically altered its purpose as well. Afterwards, the Fed never returned to the role set out for it in the Federal Reserve Act of 1913. Chapters 4 and 5 detail how the Great Depression and the World War II transformed the Fed.
Notes
1. Tenth Annual Report of the Federal Reserve Board Covering Operations for the Year 1923, Washington Printing Office, February 15, 1924, p. 1.
2. Eighth Annual Report of the Federal Reserve Board Covering Operations for the Year 1921, Washington Printing Office, 1922, p. 6.
3. Eighth Annual Report of the Federal Reserve Board Covering Operations for the Year 1921, Washington Printing Office, 1922, p. 22.
4. Data for 1914 to 1917 from “The Federal Reserve System’s Weekly Balance Sheet Since 1914” and accompanying spreadsheet. Johns Hopkins University, SAE/No.115/July 2018. See Bibliography.
Data for 1918 to 1930 from The Fed’s 2017 Annual Report, page 306