Financial Panics, the Seasonality of the Nominal Interest Rate, and the Founding of the Fed By JEFFREY A. MIRON* After the founding of the Fed in 1914, 1 the frequency of financial panics and the size of the seasonal movements in nominal inter- est rates both declined substantially. Since the Fed was established in part to "furnish an elastic currency," 2 it is natural to hypoth- esize that the Fed caused these changes in the behavior offinancialmarkets. There were, however, a number of other major changes in the economy and in the financial system during this period including World War I, the shift from agriculture to manufacturing, 3 and the loosening of the gold standard. 4 Moreover, Robert Shiller (1980) has ex- amined the effect of the Fed's founding on the seasonal in real interest rates and has concluded that the Fed's actions had little or no effect. This paper investigates the relationship be- tween financial panics, seasonal movements in nominal interest rates, and the open market operations of the Fed after 1914. The paper establishes that the Fed, by carrying out the seasonal open market policy that eliminated the seasonal in nominal interest rates, caused the decrease in the frequency of * Department of Economics, University of Michigan, Ann Arbor, MI 48109. I thank Stanley Fischer, Larry Summers, Peter Temin, Olivier Blanchard, Milton Friedman, Steve Zeldes, Steve O'Connell, Sue Collins, Robert Clower, and two anonymous referees for helpful comments on earlier drafts of this paper. 1 The Federal Reserve Act was passed by Congress on December 23, 1913. The Board of Governors took office and began planning the organization of the System on August 10, 1914. The twelve banks opened for business on November 16, 1914. 2 This quote is from the preamble to the Federal Reserve Act. 3 The share of agriculture in Gross Domestic Product fell from 24 percent in the period 1897-1901 to 12 percent in 1922. See Historical Statistics of the United States,... (1976, Series F125-129, p. 232). 4 During World War I, several countries (including Great Britain) left the gold standard, so the United States was less affected by external conditions. panics. Since seasonal movements are antic- ipated and financial panics are probably real events, the results show that an anticipated monetary policy had real effects on the econ- omy. The issue of whether anticipated monetary policy can affect real variables, which is at the heart of monetary economics, has re- ceived much recent attention following the well-known contributions by Robert Barro (1977, 1978). His results have been subjected to a barrage of critical review, much of it supporting his finding that only unantic- ipated changes in money have real effects (for example, Barro and Mark Rush, 1980; Robert Litterman and Lawrence Weiss, 1985; Robert Lucas, 1973; Shiller; Christopher Sims, 1980), 5 some of it arguing that the evidence rejects the neutrality of anticipated money (for example, Robert Gordon, 1982; Frederic Mishkin, 1982, 1983). 6 The gener- ally inconclusive nature of the debate reflects the difficulty of determining whether policy caused or responded to changes in the econ- omy and of distinguishing anticipated from unanticipated policy actions. Thomas Sar- gent (1976), when describing the possible observational equivalence of classical and nonclassical models, suggested that identifi- cation would be aided if it were possible to draw data from two different policy regimes. 5 The approach to testing neutrality in Barro and Rush is the same as in Barro (1977, 1978). Litterman- Weiss and Sims use vector autoregressive techniques and base their conclusions on the failure of money to be Granger causally prior for real income. Lucas shows in a cross section of countries that the variance of money shocks is negatively correlated with the variance of output movements. 6 Barro (1978) introduced the use of cross-equation restrictions into this literature. This more powerful way of testing neutrality has been exploited extensively by Mishkin (1982, 1983), who has usually found that the data reject neutrality, contrary to the results of Barro. 125 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis
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Financial Panics, the Seasonality of the Nominal Interest Rate,and the Founding of the Fed
By JEFFREY A. MIRON*
After the founding of the Fed in 1914,1
the frequency of financial panics and the sizeof the seasonal movements in nominal inter-est rates both declined substantially. Sincethe Fed was established in part to "furnishan elastic currency,"2 it is natural to hypoth-esize that the Fed caused these changes inthe behavior of financial markets. There were,however, a number of other major changes inthe economy and in the financial systemduring this period including World War I,the shift from agriculture to manufacturing,3
and the loosening of the gold standard.4
Moreover, Robert Shiller (1980) has ex-amined the effect of the Fed's founding onthe seasonal in real interest rates and hasconcluded that the Fed's actions had little orno effect.
This paper investigates the relationship be-tween financial panics, seasonal movementsin nominal interest rates, and the openmarket operations of the Fed after 1914. Thepaper establishes that the Fed, by carryingout the seasonal open market policy thateliminated the seasonal in nominal interestrates, caused the decrease in the frequency of
* Department of Economics, University of Michigan,Ann Arbor, MI 48109. I thank Stanley Fischer, LarrySummers, Peter Temin, Olivier Blanchard, MiltonFriedman, Steve Zeldes, Steve O'Connell, Sue Collins,Robert Clower, and two anonymous referees for helpfulcomments on earlier drafts of this paper.
1 The Federal Reserve Act was passed by Congress onDecember 23, 1913. The Board of Governors took officeand began planning the organization of the System onAugust 10, 1914. The twelve banks opened for businesson November 16, 1914.
2 This quote is from the preamble to the FederalReserve Act.
3 The share of agriculture in Gross Domestic Productfell from 24 percent in the period 1897-1901 to 12percent in 1922. See Historical Statistics of the UnitedStates,... (1976, Series F125-129, p. 232).
4 During World War I, several countries (includingGreat Britain) left the gold standard, so the UnitedStates was less affected by external conditions.
panics. Since seasonal movements are antic-ipated and financial panics are probably realevents, the results show that an anticipatedmonetary policy had real effects on the econ-omy.
The issue of whether anticipated monetarypolicy can affect real variables, which is atthe heart of monetary economics, has re-ceived much recent attention following thewell-known contributions by Robert Barro(1977, 1978). His results have been subjectedto a barrage of critical review, much of itsupporting his finding that only unantic-ipated changes in money have real effects(for example, Barro and Mark Rush, 1980;Robert Litterman and Lawrence Weiss, 1985;Robert Lucas, 1973; Shiller; ChristopherSims, 1980),5 some of it arguing that theevidence rejects the neutrality of anticipatedmoney (for example, Robert Gordon, 1982;Frederic Mishkin, 1982, 1983).6 The gener-ally inconclusive nature of the debate reflectsthe difficulty of determining whether policycaused or responded to changes in the econ-omy and of distinguishing anticipated fromunanticipated policy actions. Thomas Sar-gent (1976), when describing the possibleobservational equivalence of classical andnonclassical models, suggested that identifi-cation would be aided if it were possible todraw data from two different policy regimes.
5 The approach to testing neutrality in Barro andRush is the same as in Barro (1977, 1978). Litterman-Weiss and Sims use vector autoregressive techniques andbase their conclusions on the failure of money to beGranger causally prior for real income. Lucas shows in across section of countries that the variance of moneyshocks is negatively correlated with the variance ofoutput movements.
6 Barro (1978) introduced the use of cross-equationrestrictions into this literature. This more powerful wayof testing neutrality has been exploited extensively byMishkin (1982, 1983), who has usually found that thedata reject neutrality, contrary to the results of Barro.
125
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the loans made by private banks should havebecome less seasonal.
Section II examines empirically the impli-cations of the model and the hypotheses itsuggests about the behavior of the Fed. Theseresults come from a simple model, but theydo not depend on the particular assumptionsmade in order to keep the analysis simple.11
The model presented above is the most com-plicated one that can be tested empirically; itis not possible to test the additional implica-tions of more complicated models because ofdata limitations.
II. The Evidence
A. Historical Background: The NationalBanking System and the Founding of the Fed
The period from 1863 through 1913 isknown as the period of the National BankingSystem because the provisions of the Na-tional Banking Acts of 1863, 1864, and 1865determined the banking and financial struc-ture in several critical ways. The NationalBanking Acts were both a response to prob-lems of the financial system that existed be-fore the Civil War and a measure designed toraise revenue for the North during the war.The Acts successfully generated revenue andcured some prewar financial ills (notably themultiplicity of note issue). During the Na-tional Banking Period, however, those inacademia, the banking community, andgovernment still regarded the financial sys-tem as fundamentally flawed because of the"perverse elasticity of the money supply"and the high frequency of financial panics.
The term perverse elasticity of the moneysupply referred to the tendency of the moneysupply to contract in precisely those periodswhen it was "needed" most. This occurred inthe spring and fall of each year when sea-sonal increases in loan and currency demandforced interest rates up and reserve-depositratios down. These seasonal movements inloan and currency demand were attributed
11 Appendices A and B to ch. IV of my disserationshow that the conclusions are still valid if one allows fora pyramided banking system, or for the general equi-librium interactions of the economy.
mainly to the need for both currency andcredit by the agricultural sector of the econ-omy in the spring planting season and thefall crop-moving season, and to the need forcurrency and credit by the corporate sectorfor quarterly interest and dividend settle-ments. Additional currency was needed be-cause the volume of transactions was higherin these periods. Credit demand was highbecause farmers borrowed to finance theplanting and harvesting of the crops.12
The financial panics that occurred in thisperiod were combinations of bank failures,bank runs, and stock market crashes. A typi-cal panic began after an individual bank washit by either an unexpectedly large depositwithdrawal or a large loan default. If thebank had a small amount of reserves, itwould need to call in some of its loans. Thismight concern other banks enough so thatthey would call in some of their loans, manyof which were in stock market call loans, andthe cumulative effect of loan recall by manybanks tended to depress the stock market. Atthe same time, the fact that banks were call-ing in loans caused the nonbank public toincrease its desired currency-deposit ratio,and this could cause either individual bankfailures or runs on many banks. Eventuallythe process either reversed itself or ended ina suspension of convertibility.13
There were, of course, differences in thedynamics of various panics. Some began inNew York as the result of a large loan de-fault at a New York bank and then weretransmitted West as New York banks triedto acquire additional reserves from the coun-try banks. Others started in the West whencrop failures damaged the liquidity positionsof country banks who then tried to recall
12 E. W. Kemmerer (1910, pp. 223-24) mentions in-creased rail and barge activity during warm weather andholiday seasons as additional reasons for seasonal activ-ity in the financial markets. A. Piatt Andrew (1906)discusses the influence of agriculture on economic activ-ity during the pre-Fed period, and J. Laurence Laughlin(1912, pp. 309-42), discusses the seasonal cycle in gen-eral economic activity. See also O. M. W. Sprague(1910), C. A. E. Goodhart (1969), and John James(1978, pp. 127-37) for discussions of the seasonal flowswithin the country that accompanied the seasonalchanges in interest rates and reserve positions of banks.
13 Sprague (pp. 1-225).
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130 THE AMERICAN ECONOMIC REVIEW MARCH 1986
balances from reserve cities. Nevertheless,the key element of a panic was the same inall of the major episodes. This key elementwas a generally increased demand for re-serves that could not be satisfied for allparties simultaneously in the short run.
The likelihood that an event such as alarge loan default would precipitate a panicdepended on the initial position of the bank-ing system. If such an event happened at atime when loan demand was high or depositdemand was low, so that the reserve-depositratios of banks were low, then the costsimposed by the loan default were higher.Since there were seasonal movements in loanand deposit demands that produced seasonalmovements in reserve-deposit ratios, panicstended to occur in the fall and spring, whenhigh-loan demand and low-deposit demandproduced low reserve-deposit ratios. Thus theproblems of perverse elasticity and theaccompanying financial panics were partly aresult of and coincided with the seasonalmovements in asset demands.
The academics, bankers, and governmentofficials of the time understood this phenom-enon. J. Laurence Laughlin, a professor ofeconomics at the University of Chicago,commented in detail on this relation betweenpanics and seasonality in his 1912 treatise onreform of the banking system (pp. 309-42).Paul Warburg, a Wall Street banker wholater served on the Federal Reserve Board,wrote in 1910 that "there can be no doubtwhatever that the basis for healthy controlby a central bank must exist in a countrywhere regular seasonal requirements cause,with almost absolute regularity, acute in-creased demand for money and accommo-dation" (1930, p. 156). Leslie Shaw, Secre-tary of the Treasury from 1902 to 1906,actively attempted to accommodate the sea-sonal demands in financial markets, althoughthe funds available to him were not sufficientto allow him to be successful.14
The panic of 1907 precipitated sufficientconcern about panics and elasticity that
14See Andrew (1907, p. 559), and Richard Timber-lake (1978, p. 181). See Andrew (1907) also for aninteresting analysis of Shaw's other activities andTimberlake (1963) for a critique of Andrew's analysis.
Congress passed the Aldrich-Vreeland Act of1908. This Act addressed the problems of thebanking system by granting certain emer-gency powers to New York City banks andby creating the National Monetary Commis-sion. This Commission was assigned to un-dertake a detailed study of the U.S. bankingsystem. Its Report, published in 1910, con-tained in depth examinations of every aspectof banking theory and practice in the UnitedStates and abroad.
Two parts of the Report deserve particularnotice. O. M. W. Sprague, a professor ofeconomics at Harvard, wrote History of CrisesUnder the National Banking System. Thisbook examined in detail the operation of thebanking system during five of the worstfinancial crises (1873, 1884, 1890, 1893, and1907). Sprague wrote that "with few excep-tions all our crises, panics, and periods ofless severe monetary stringency have oc-curred in the autumn" (p. 157). E. W.Kemmerer of Cornell contributed the volumeSeasonal Variations in the Relative Demandsfor Money and Capital in the United States.He noted that "the evidence accordinglypoints to a tendency for the panics to occurduring the seasons normally characterized bya stringent money market" (p. 232). Thustwo parts of the Report mentioned explicitlythe tendency for panics to occur in certainseasons of the year.
The Federal Reserve Act established theFederal Reserve System in 1913, three yearsafter the publication of the Commission'sReport. The preamble to the Act states that itis "an act to... furnish an elastic currency."It was to be expected, therefore, that the Fedwould try to eliminate panics by accommo-dating the seasonal demands in financialmarkets.
B. Evidence of the Changes inFinancial Markets
I now document the two facts cited in theintroduction: the frequency of financial pan-ics diminished after the founding of the Fed;and the size of the seasonal fluctuations innominal interest rates diminished also.
Table 1 shows the starting dates of thefinancial panics that occurred during theperiod 1890-1908 according to Sprague and
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TABLE 1—STARTING DATES AND CLASSIFICATION OFFINANCIAL PANICS ACCORDING TO
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(1929, 1930, 1932) while two were in thespring (1931, 1933).20 Thus the recurrence ofpanics during this period corroborates thehypothesis that the Fed caused the reductionin the frequency of panics after 1914.
The decreased accommodation of the Sea-sonals in asset demands was probably theresult of a generally restrictive open marketpolicy that the Fed initiated in late 1928.21
During much of the 1920's, there was fearthat speculation by participants in the stockmarket was "excessive," and those who ob-jected to the speculation most encouragedthe Fed to restrain the growth of credit,particularly loans by banks to stock marketbrokers. The officials at the Fed differed intheir view of how much to restrain credit. Onbalance, however, they opposed restrainingspeculation so much that it might adverselyaffect general business activity.
This policy changed toward the end of1928. Stock market speculation had beenespecially virulent, and the Fed respondedwith a strongly restrictive policy. The ex-planation for the change in policy is thatBenjamin Strong, the governor of the NewYork Fed, died in October of 1928.22 Duringthe period 1915-28, Strong was a dominantforce in the Federal Reserve System and inthe entire financial community. In the wordsof his biographer, Lester Chandler, Strongwas "one of the world's most influentialleaders in the fields of money and finance.During the first fourteen turbulent, formativeyears of the Federal Reserve System, his wasthe greatest influence on American monetaryand banking policies" (1958, p. 3). Strongintensely disliked stock market speculation,but was an outspoken critic of restrainingspeculation at the cost of causing a recession.His death allowed the balance of opinion atthe Fed to shift toward greater restraint, anda highly restrictive policy resulted. One of
the manifestations of this policy was theincomplete accommodation of the seasonaldemands in financial markets.
F. The Real Effects of Financial Panics
The final issue discussed in this section iswhether financial panics had real effects onthe economy. It is not possible to test anexplicit model of the real effects of panicsbecause of data limitations.23 It is possible,however, to demonstrate support for theproposition that panics had real effects if oneis willing to make assumptions about whatthese effects might have been. I assume herethat panics affected the distribution of out-put by decreasing the average level of realactivity, increasing the variance of real activ-ity, and increasing the length of businesscycles.24
In the context of this paper there are twoimplications of the proposition that panicswere real events. First, the distribution ofoutput in the pre-Fed period should havebeen worse in panic years than in nonpanicyears; second, the distribution of outputpost-Fed should have been better than thatpre-Fed.
Table 5 shows the mean and variance ofthe rate of growth of annual real GNP forthe period 1890-1908 and for this periodminus the years in which panics occurred(Kemmerer's major panic definition). Theaverage level of GNP growth is higher andthe variance of real growth lower for non-panic years, so these facts support the hy-pothesis that panics altered the distributionof output. They do not, of course, prove thathypothesis, since panics might be the resultof negative output shocks. Nevertheless, thefacts in the table lend plausibility to theproposition that panics changed the distribu-tion of output during the pre-Fed period.
2 0 See F r i edman and Schwartz (pp. 305, 308, 313,324).
21 See Paul Trescott (1982) for a more detailed ex-aminat ion of this aspect of Fed policy.
22 F r i edman and Schwartz (pp. 4 1 1 - 1 9 and pp .692-93) discuss in detail the effects of Strong's death onthe power s tructure of the Fed.
23 The data in Gordon are interpolations.24 See Ben Bernanke (1983) for an analysis of the
effects of the financial crises dur ing the Grea t Depres-sion, Cagan for a discussion of the real effects of panicsdur ing the p re -Fed period, and Gor ton (1983) for workon the general relat ion between panics and businesscycles.
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Average for Pre-Fed Period = 17.5 monthsAverage for Post-Fed Period = 14.25 months
Length
1118191924149
191514
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VOL. 76 NO. 1 MIRON: FOUNDING OF THE FED 139
above does not necessarily imply that con-tinued elimination of interest rate Seasonalsis desirable. The analysis does show that animportant aspect of Fed policy is its seasonalbehavior, and it demonstrates that this aspectof policy can have substantial real effects onthe economy.
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