Economic History Association

Answers to Stock Questions: Fed Targets, Stock Prices, and the Gold Standard in the Great
Depression
Author(s): Gerald Epstein and Thomas Ferguson
Source: The Journal of Economic History, Vol. 51, No. 1 (Mar., 1991), pp. 190-200
Published by: Cambridge University Press on behalf of the Economic History Association
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Answers to Stock Questions: Fed Targets,

Stock Prices, and the Gold Standard in the
Great Depression
GERALD EPSTEIN AND THOMAS FERGUSON

Theseartificiallylow rates are of no benefitto anyone ...

the banks are no longer able to employ their funds to
advantage, and hence get no proper compensationfor
their services. Such rates are, in fact, ruinous, and
inasmuch as they do not allow the banks to earn an
adequateprofit,must in the end impairthe stabilityof the
banks if not actually involve them in ruin.
-Commercial and Financial Chronicle,July 9, 1932
Ourearlierstudy concurredwith the judgmentsof manycontemporaneousobservers
and participantsthat the FederalReserve essentiallyabandoneda highlytouted planfor
reflationin the summerof 1932. Philip Coelho and G. J. Santoni have disputed this,
pointingto steady growthin the supplyof "high-powered"money all throughthe period
in question.'
In supportof their skepticism, they profferedresults of two econometrictests, both
of which assume a strong version of the "efficient markets" argumentthat was so
fashionable before the 1987 stock market collapse. Their first test related weekly
measures of high-poweredmoney to similarlygraduatedindexes of bank share prices
and the Dow Jones Industrialaverage;the second, relyingon dailydata, investigatedthe
relation between T-bills (a proxy, as they explained, for high-poweredmoney), the
Dow, and an index of share prices for banks in New York and Chicago. Coelho and
Santoni discovered that bank stocks in both cities "moved with generalmovementsin
the market" and rose with additions to high-poweredmoney.2 These results, they
claimed, show that monetarystringencycould not have been helpingthe banks and tell
against our argumentthat portfolio differencesbetween the banks in New York and
Chicago placed them at loggerheadsover reflation.
Only one of theirclaims was on target-that our analysis of the 1932episode is highly
germane to current discussions of how the Fed should be restructured.Coelho and
Santoni began by seriously oversimplifyingour plainly stated account of why the Fed
abandonedits program.Our article showed that not one but three separate strandsof
causality were involved in the decision to kill the reflationprogram.One, of course,
concernedthe desire to protectbankmarginsthat so exercised Coelho and Santoni.But
the other two involved the role of gold and the gold standard.
At the time we wrote, the mainstreamview of MiltonFriedmanand Anna Schwartz
The Journal of Economic History, Vol. 51, No. 1 (Mar. 1991). ? The Economic History
Association. All rightsreserved. ISSN 0022-0507.
GeraldEpsteinis AssistantProfessorof Economics,Universityof Massachusetts,Amherst,MA
01003; Thomas Fergusonis Professorof Political Science and Senior Associate at the John W.
McCormackInstituteof Public Policy, Universityof Massachusetts,Boston, MA 02125-3393.
The authorsare gratefulto Ben Bernankeand, especially, to PeterTeminfor helpfulcomments;
and to Emily Kawanofor researchassistance.
' The quotationis from the Commercialand Financial Chronicle,July 9, 1932, p. 168. See
Gerald Epstein and Thomas Ferguson, "Monetary Policy, Loan Liquidation,and Industrial
Conflict:The FederalReserve and the Open MarketOperationsof 1932,"this JOURNAL, 44 (Dec.
1984), pp. 957-83; and Philip R. P. Coelho and G. J. Santoni, "RegulatoryCapture and the
MonetaryContractionof 1932:A Commenton Epstein and Ferguson," this JOURNAL, 51 (Mar.
1991).
2

Coelho and Santoni, "RegulatoryCapture,"p. 188.

190
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Reply to Coelho and Santoni

191

denied that gold, or concern for the gold standard,importantlyconstrainedthe Fed in

this period. We showed that this was false, not only as a generalproposition,but as it
bore on the 1932episode. We also demonstratedthat not only the amountof gold but its
distributionamong the various Federal Reserve districts mattered.3
This failure to discuss or even to mention the other two-thirdsof our case led our
critics to misinterpretseriously their own evidence. By neglectinggold and the gold
standard, and using one bad economic theory (monetarism, with its emphasis on
high-poweredmoney) to supportanother(the combinationof rationalexpectationswith
Walrasianmarket clearing that defines the "efficient markets" approach), they produced a retrospectiveon the dramaticevents of 1932that is an almostperfect inverse of
reality. They directed attention to a variable-high-powered money-that few, if
anyone, at the time consideredvery importantor, probably,even conceptualizedin the
relevant terms.
A serious analysis of Fed monetary targets and instrumentsin the Depression is
extremelycomplicated.It requiresa carefulstudy of primarysources, a deliberateeffort
not simply to projectcurrentviews backwardin time, and a sensitivityto rapidchanges
in context. By January 1932, for example, the social order in both America and the
world was visibly quaking. Steady policy failure, particularly,as we observed in our
earlierarticle, the pressures on even the big New York banks (principallythroughthe
decliningvalues of bonds in their portfolios)in the wake of the interest-ratehikes that
followed the Britishabandonmentof the gold standardwere drivingincreasingnumbers
of top policy makers(we used this termto referto leadingfiguresin both the privateand
the publicrealms)to contemplatepolicies thatliterallyhadbeen unthinkablea few years
previously. And some, includingan influentialminorityat the very highest levels of
policy making,were beginningto reappraiselong-heldtheoreticalviews. Bankersat J.P.
Morgan& Co., for example, were openly promotingthe Fed's open marketcampaign
for explicitly macroeconomicreasons and deridingthe existing Fed collateralrequirements for Federal Reserve notes.4
In this transitionperiodpolicy makersproposed,discussed, and evaluatedall sorts of
targets and indicatorsfor the Fed. These includedforeign balances, bank suspensions,
gold earmarked for foreigners, bank reserves, currency in circulation, industrial
production,bond prices, exchange rates, excess reserves, the gold stock, as well as a
host of others, includingwages and prices.5
In this slowly buildingatmosphereof almost Wagneriangloom, fixingexclusively on
one particulartarget or indicatorfor very long became impossible, even if anyone had
wanted to do it, which, by 1932,few did. For this, there were essentially two reasons.
First, as we earlierdocumentedin detail, the various parts of the business community
had begunto polarizein variousconfusingways over policy. Farfrombeing an exercise
in cool, technocratic reasoning, debates over targets and indicators thus became in
reality prime means of advancingone's viewpoint in that rapidlyevolving conflict.
Second, however, was the simple fact-by then obvious even to many former
advocates of "real bills," not to mentionWinfieldRieflerand W. RandolphBurgess(the
survivingeponymousheroes of the mythical"Riefler-Burgess-Strong
Doctrine")-that
simple rules of thumbrelatingone traditionalFed targetor instrumentto anotherwere
3 See Epstein and Ferguson, "MonetaryPolicy," especially pp. 968-77. More recently, Peter
Temin, in Lessons of the GreatDepression(Cambridge,MA, 1989),has emphasizedthe broadrole
of the gold standard.
4 See Epstein and Ferguson, "MonetaryPolicy," for example, p. 966.
S The list comes fromvariousminutesof eitherthe Fed or the New YorkFed of the period;from
papersin the OgdenMillsor EugeneMeyerpapersat the Libraryof Congress;the HerbertHoover
PresidentialLibraryin West Branch,Iowa; or papersof various privatebankerscited in Epstein
and Ferguson, "MonetaryPolicy."

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192

Epstein and Ferguson

9

Money Multiplier
4.5

4.0
6
3.5

Credit Multiplier

3.

1932
J

F M A M J

A S 0

N D J

1933
F M A M J J

A S 0

N D

FIGURE 1

CREDITMULTIPLIERAND MONEY MULTIPLIER,1932-1933

(High-PoweredMoney = Reserves and FederalReserve Notes)
Note: The credit multiplieris on the left-handscale, and the money multiplieris on the right-hand
scale.
Sources and Definitions: See Appendix 1.

becoming grotesquely incognate with reality.6 As bank runs waxed and waned, the
currency ratio (currency as a percentage of bank deposits) fluctuated wildly.7 And as
Figure 1 demonstrates, by 1932, so did the traditional (and modern) credit and money
multipliers.
In such a climate, a focus on high-powered money (including, notably, the proxy that
Coelho and Santoni sometimes relied on, bank reserves plus Federal Reserve notes) for
purposes of making monetary policy made about as much sense as reliance on geometric
multiples of the Great Pyramid. The notion simply did not have any stable implication
during the period in question. Note that during roughly the same time period Coelho and
Santoni indicated that high-powered money was growing at 17 percent, the money and
credit multipliers were falling approximately 25 percent.8
6 See Epsteinand Ferguson,"MonetaryPolicy," p. 961, on W. RandolphBurgessand Winfield
Riefler.Strongappearsnever to have subscribedto the doctrine,either, thoughthe point exceeds
the scope of this reply.
7 Appendix 1 contains a full account of our sources of data and definitions.For the currency
ratioin this period,see MiltonFriedmanand AnnaJ. Schwarz,A MonetaryHistoryof the United
States, 1867-1960(Princeton,1963),pp. 802-3, table B-3, and p. 333, chart 31.
8 The precise value of course dependson the time period;the appropriate
time period, in turn,
dependson one's view of the time horizonthatpolicy makerswouldhave reliedon in formingtheir
views. From Aug. 31, 1931,to Mar. 1933, both the money and credit multipliers,no matterhow
measured, declined about 44 percent. Because policy makers surely required some time to

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Reply to Coelho and Santoni

193

Policy, however, still had to be made-which meant that it had to be formulatedin

termsof somethingobservable.Now, as TreasurySecretaryOgdenMills admittedat an
Associated Press luncheon at the time, the advocates of reflationpreferredmonetary
expansionto other possible vehicles, such as "fiatcurrency"or "unbalancedbudgets"
for the same reasons conservative policy makers always have-because central bank
control was more secure than legislative or other forms of intervention.9Once they
decided to use monetarypolicy, open marketoperationswere the only avenue readily
availablefor action that was potentiallybig enough to make much difference.
Whateverultimatepolicy disagreementsexisted amongthe reflationists,the practical
measure of the Fed's programduring its entire life inevitably became precisely the
variablewe tested and thatall contemporarydocuments(privateand public)reveal to be
crucial: the amount of government securities and bills bought within a given time
period.'0This was how the programwas announced,evaluated, and debated in public
and in private.Had the Fed persistedandbroughtthe economyback to life, it is possible
that one could search its behaviorfor finerclues to its moreultimatetargets.In the end,
however, it scarcely matteredwhether,as in the case of at least some Morganpartners,
the grandobjective was general macroeconomicimprovement,or as with many other
policy makers,it was (long-term)bonds or industrialproduction.Withthe economy so
far down, very large open marketoperations-lasting, Russell Leffingwellat Morgan
claimed to think, for a year or more-were clearly requiredin all reflationistviews."
Our earlier article was therefore correct in stating that "something had changed"
when "at the June 16 meeting of the executive committee of the Open MarketPolicy
Conference" Harrison"declined to press for increases in the open marketprogram,"
proposinginstead that the Fed aim to "maintainthe excess reserves of memberbanks
at a figure somewhere between $250,000,000and $300,000,000until there was some
expansion of credit which would make it desirableto reconsiderthe program."''2The
open marketprogramwas being scaled back; indeed, it was ending.
Coelho and Santoni's mistaken treatmentof Fed targets and indicatorsduringthis
periodhas importantimplicationsfor the use they madeof theirstock marketdata, since
one of their regressionsemployed high-poweredmoney as a right-handvariable. Since
neitherinvestors nor policy insiderswere relyingon it as either a targetor an indicator,
changes in it (that is, "unexpected changes," as required by the efficient markets
theory) cannot be expected to measurethe Fed's effect on stock prices.
This, however, is scarcely the only problemwith theirdiscussionof the stock market
during this period. First, there is the blunt fact, which Coelho and Santoni never
acknowledged,that a growingmass of evidence tells heavily againsttheirblithelystated
conviction that stock marketsreflect the workingsof efficientmarketsfor all available
assimilatechanges, this earlierbase point is perhapsthe most reasonable.Using other base points
and periodsyields a varietyof very unstableanswers:fromAug. 31, 1931,to Dec. 1932,the decline
is about 31 percent;from Jan. 1932to Mar. 1933(the periodof our critics' graph),the decline is
approximately32 percent;fromJan. to Dec. 1932,the decline is about 16 percent.The results do
not change whetherone calculatesmoney or credit multipliersor varies definitions.
9 See his remarkabledefense of the open marketprogram,quotedin Commercialand Financial
Chronicle,Apr. 30, 1932,p. 3142.
0 There were very few bills boughtduringthis periodbecause there were comparativelyfew to
buy. The Fed, for example, could also purchase trade acceptances. But with the collapse of
internationaltrade, there were simply not enough of these available. Accordingly,the practical
measureof the programbecame the numberof governmentsecuritiespurchased.
" The question of exactly who thoughtwhat and when is too complicatedto discuss here in
detail. Various documents are quite clear that differentadvocates of reflationexpected lags of
various durations. Moreover, Russell Leffingwellat Morgan and others were not uniformly
consistent later in recallingtheir own views at the time.
12
Epstein and Ferguson, "MonetaryPolicy," p. 976.

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194

Epstein and Ferguson

information.On the contrary,as John MaynardKeynes and others have observed, real
stock markets display strong evidence of fads, fashions, and other forms of human
action that fall markedlyshort of economists' ideals of rationality.
In such a world, tests of the type Coelho and Santoni proposed often make little
sense, for opportunitiesare unlikely to be arbitragedaway with sufficientspeed. As
RobertShillerhas recentlycautioned,"such fashionsor fads may not create spectacular
profitopportunitiesif the future paths of the fashions or fads are not very predictable.
If there exist only modest (anduncertain)profitopportunitiesfor smartmoney, then the
tendency to accumulatewealth throughprofitabletradingmay be a slow one. ...13
This warningseems particularlyapt for a situationlike that of 1932.Here, uncertainty
was overwhelming. Risk was enormous. Traditional "theories" and views were
breakingdown entirely, while new conceptions evolved literallyby the day-virtually
the polar opposite of the world describedby the single, true, universallyheld theory
presumed by rational expectations theorists. Also, many markets were very thin, a
hostile or dubious Congress was scrutinizingmargin loans, various institutions or
groups were already supportingindividualstock prices, and banks long considered
pillarsof the communitywere going down like nine pins. We are thus inclinedto doubt
that a sufficientnumberof arbitragerswould have found bank stock purchasesa royal
road to riches.
Nevertheless, there is certainly no harm in trying to discover whether bank stocks
moved in response to the reflationprogramor not. The appropriatetests, however, are
not those performedby Coelho and Santoni.'4Their dependentvariableattemptedto
measuremarkettrends over a long period of time. Not only does this run well-known
risks of omittingimportantvariablesthat can confound the equation, it must contend
with another problem:a now-vast literatureargues that if marketsare efficientin the
relevant sense, stock prices should adjust instantaneouslyto unanticipateddevelopments. In practicalterms, this meansthat one properlytests hypothesesaboutthe stock
marketin terms of the methodologyof "event analysis."'5 Essentiallyone attemptsto
assess how a discrete event-for example, the unveiling by the Fed of its vastly
increased program of open market purchases (April 13, indicated as day zero in
RobertShiller, Market Volatility (Cambridge,MA, 1989),p. 52.
It also appearsthat their sampleof Chicagobanks has some serious flaws. It excludes what
even they wouldpresumablyconcede was one of the classic regulatoryfailuresof Americanhistory
(in which ReconstructionFinanceCorporationChairCharlesDawes resignedto accept what wags
called the "second Dawes Loan": a giganticbailoutof his CentralRepublicTrustCo.-at the time
probablythe thirdlargestbankin the city-from the agency he was exiting, while his stock opened
at 50, fell to one, and then closed at what was almostcertainlya stronglysupportedfour bid and
six asked). See, for example,F. CyrilJames, TheGrowthof ChicagoBanks(New York, 1938),vol.
2, pp. 1037ff.Note thatCoelhoand Santoni'sChicagosampleincludesfive banks,so thatomission
of such a large, ill-fatedbank matters.There is also the fact that some bank stocks were being
artificiallysupportedduringthis periodin both New YorkandChicago,and this may cause serious
problems with "efficient markets" approaches. Furthermore,another bank in their sample,
ContinentalIllinois,hadto be rescuedfrombankruptcynot longafterthe pointwheretheiranalysis
stoppedfollowingthe stock. Added to CentralRepublic,this implies that two of the three largest
banksin the city folded. We are also puzzledthat TheNew YorkTimes,which Coelhoand Santoni
indicatedas their source for weekly stock quotations,stoppedquotingpricesfor the stocks of the
Chicagobanksfor two weeks duringthis period;we are unclearwhat this means.
15 A classic reference is Eugene Fama et al., "The Adjustmentof Stock Prices to New
Information,"InternationalEconomicReview, 10 (Feb. 1969),pp. 1-21. For review, see William
Schwert, "Using Financial Data to Measure Effects of Regulation," Journal of Law and
Economics, 24 (Apr. 1981),pp. 121-58. Most tests focus on stock returns,which in additionto
changes in stock prices, includedividendsand other payments.Given Coelho and Santoni'sfocus
on stock prices and the likelihoodthat over the month-longperiod of our test most changes in
returnsare accountedfor by changes in stock prices, we use stock prices as an approximation.
13

14

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Reply to Coelho and Santoni

195

Appendix2's table of residualsfor our event analysis)-differentially affectedtrendsof

the various stocks in which one is interested.
Curiously,Coelho and Santonidid not runsuch a test, which has the additionalvirtue
of being much less affectedby omittedvariables.(They also did not botherto arguethat
their second set of regressions,on T-bills, actuallyreflectunexpectedhappenings;this,
too, is another virtue of the "event" approach, since one is dealing virtually by
definition with a new occurrence at a definite moment in time.) While we are not
partisansof efficientmarkets-we hold unreservedlyto the cautions noted above-we
have run the requisite "event analysis." Reportedin Appendix2, its conclusions were
unambiguous:in accord with our view, but contrary to what Coelho and Santoni
claimed, announcementof the Fed's reflationprogramdrove Chicagobankstock prices
down relative to the market,while drivingNew York stock prices up (in line with the
general market),with the differencesbetween them highly significant.'6
What of the overarchingstock markettrend they identify-the fact that the market
moved down as the Fed commenced open marketexpansion, and rose as it tapered
off?'7 At first glance this indeed appearsdifficultto reconcile with our analysis. How
could monetaryease help New York (and similarlycircumstanced)banks but hurt the
stock market?This paradoxis easily explained.Coelho and Santonifailed to note that
the marketreactions they presupposeare regime specific-and that the regimeof 1932
was the (dying)gold standard.'8
At that time, for the modalinvestorboth in and out of the United States-as opposed
to the relative handful of insiders championing a carefully controlled (by them)
monetaryperestroika-' inflation" representedan act of ultimatefolly. Appearingto
these investorsas Act V of a tragedywhose otheracts had successively consisted of the
Kreditanstalt,the Standstill Agreement, the British Abandonmentof Gold, and the
ensuingAmericanGreatDeflation,the new Fed policy signaledthe abandonmentof the
time-tested Rx for depression:deflationand wage reductions.
16 As indicatedby the significantresultsfor Apr. 13in the columnof T-Differences.Note thatthe
effect we are discussing concerns the announcementof the program.It is possible that a similar
effect also could be detected for its terminationin June. We ourselves have not run this test,
becauseof the comparativelyenormousamountof datathatsuch tests require.(For this reason,for
our tests we used a sampleof seven very large New York banks, as listed in Appendix 1.) A test
in June, however, might run afoul of the truly gigantic bank runs that were then occurringin
Chicagoand the anxieties about gold that were rife in the New York banks.
Appendix 2's table for the event analysis also reports a test designed to see if relaxing the
requirementthat marketsclear "instantaneously,"in favor of an approachthat allow them some
days to assimilatefully the impactof the news would prove fruitful.It did-as can be seen by the
resultsfor the pooledresidualsfor the rest of the week (reportedbelow the maintablefor the event
analysis in Appendix2).
17 Their analysis is also flawed by its reliance on a model of the stock market's valuationof
equitiesderivedfrom PaulSamuelson'sold paperon asset duration.Ourearlierarticle'spointwas
that such an approachis insufficientfor analyzingbanks in a situationlike 1932. It is not enough
that the weightedsum of futureprofitsadd to some positive number-one has to reckon with the
possibilitythat some partof the streamsinks low enoughto throwthe firminto bankruptcy.As we
arguedthere, the question is indeed an empiricalone. Samuelson,however, abstractedfrom this
possibility, while our analysis underscoredthe role that liquidity,bank runs, and balance sheet
compositionsplay in situationssuch as that of 1932.See Paul Samuelson,"The Effect of Interest
Rate Increaseson the BankingSystem," AmericanEconomicReview, 35 (Mar. 1945),pp. 16-27.
The originalwork on asset durationwas done by F. R. McCauleyin the 1930s;our discussion of
his and other contributionshad to be deleted fromthe publishedversion of our articlefor reasons
of space.
18 On the role of exchange-rateregimes, see, for example, Peter Temin and BarrieWigmore,

"The End of One Big Deflation," Explorations In Economic History, 25 (Oct. 1990).

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196

Epstein and Ferguson

In that regime, accordingly, expectations worked precisely opposite to how they

would now. As they watched the Fed begin buying bonds, these investors did not buy,
they sold, and many took flight to gold. As one of the best known and most influential
of all the market operators of the period declared:
I feel impelledto say that I do not agree with the presentpolicy of inflation,or shall I say,
"controlledinflation"of the FederalReserve System. It seems to me that it will have the
very opposite effect from what is intended-i.e., it will create furtherlack of confidencein
our monetarysystem. This will surely occur unless there is put into effect a real cut in the
present four billion dollar budget and unless there is a real increase from new sources of
taxation.... I go a little furtherin my opinion. I believe that if all the energy was toward
the balancingof the budgetthat morereal money-sound moneyand plentyof it-would be
available than there would be under the present apparentlynew policy of the Federal
Reserve. Huge sums of currency,huge bankdeposits and largeamountsof hiddengold are
there waiting to go back into circulation,into action, waitingonly for a sound fiscal and
monetarypolicy by our governments
The speculator's references to the budget highlight another set of reasons for the
market's otherwise anomalous behavior, variables that, because they were omitted from
Coelho and Santoni's equations, underscore the vulnerability of their econometric
evidence: the spring of 1932 was not normal. Indeed, it was as far from "normalcy" (as
Republicans fondly used the term) as any point in American history. The Bonus Army
was on the march. Bills for real inflation, of the type abominated by Morgan, Mills &
Co., had major-if finally insufficient-support in Congress. And any number of
schemes for cartelization, regulation, and public works were also gaining support.20
Not surprisingly, with basic property rights up for grabs and the Fed pressing ahead
with "inflation," a major gold drain as well as a fall in the stock markets started. The
French, many other foreigners, and a substantial number of Americans began taking
gold in large quantities. In our previous article we analyzed in detail how this weakened
support for the open market campaign; here we only need to note that in late June
Congress adjourned (having failed to pass or override President Herbert Hoover's
vetoes of various inflationary bills) and the Fed eased off on its reflation program. The
gold drain turned around (amid some rumbles from the British and others) and the stock
market abruptly moved up (not gradually, as one might expect had the upturn come
about through a gradual expansion of high-powered money).
But here, again, Coelho and Santoni's analysis inverts causality and the real situation.
Because they took no account of the regime specific expectations of inflation, they did
not realize that virtually throughout the reflation program, this loss of gold was an
endogenous result of the Fed's program-a result confirmed by both archival evidence
and Granger tests for causality.2' Once the program was abandoned, however, the gold
drain reversed-again, as both the archival evidence and the Granger tests suggest, in
9 BernardBaruch to Owen D. Young, Apr. 16, 1932 (Baruchpapers, Seeley Mudd Library,
PrincetonUniversity).Baruchduringthis periodpracticedwhat he preached:he was buyinggold.
Duringthe FranklinRoosevelt administrationhis effortsto hangon to his hoardbecame a minor
scandal.
20 See ThomasFerguson,"Normalcyto New Deal: IndustrialStructure,PartyCompetition,and
AmericanPublic Policy in the Great Depression,"InternationalOrganization,38 (Winter1984),
pp. 79ff.
21 The results of those tests are presented in Appendix 2. Note that under a gold standard,
expansionaryopen marketoperationscan normallybe expected to triggera gold loss; this point is
separablefrom anyone's views about what was desirable economic policy and what the stock
marketitself was doing.

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Reply to Coelho and Santoni

197

part because of the policy change. As The New York Times trumpeted at the time, in
reference to the rise in the stock market, "primarily the change has come in result of the
discovery that the United States is securely anchored to the gold standard, and is not at
the mercy of the shifting winds of fortune."22
This is why their regression shows that falling T-bill rates push the market downexactly what we would expect under a (fading) gold standard. For essentially the same
reasons, their criticism that we were unaware that in the second half of the year, after
the program had ended, the Fed deliberately let incoming gold swell reserves is also
invalid. We have always believed it did exactly that, as it had earlier been forced to try
compensating (at least partially) for gold losses with security purchases.
We therefore reject entirely Coelho and Santoni's criticisms. Governor McDougal's
devastating letter of July 9-which they concede is inconsistent with their case-was
not a quixotic gesture or eccentric flourish.23 The Fed did stop reflating in part because
of opposition from bankers trying to keep up their margins. And, in due course, bank
margins in Chicago (and other Fed districts) were indeed severely strained, falling, for
example, in Chicago from $0.43 per hundred dollars of loans and investments in June to
$0.23 in December.24 To the extent they can be measured, bank profits also fell (and so,
in due course, did bank stocks-indeed, the entire financial system eventually collapsed), though the deepening economic crisis and very limited government interventions to snatch particular institutions from the jaws of death makes it difficult to sort out
according to efficient markets models.25 The Chicago Tribune was not inventing a fairy
tale when it reported that
Chicagobanks,it was learnedyesterday,are in open revoltagainstthe artificialeasy money
policy of the FederalReserveBoard.... One leadingChicagobankhas stoppedbuyingany
"Governments" at all, and actually has cash representingnearly 55% of its deposits,
excludingGovernmentbonds and other liquid assets. Ratherthan buy Treasurybills and
certificatesyieldingless thanone-tenthof 1%perannum,bankspreferto keep cash. "When
the yield of 'Governments'get down below a quarterof 1%per annum,the clerical labor
requiredto put them on the books costs more than the interest yield," said one bank
executive yesterday.26
22
TheNew YorkTimes,July 29, 1932;the discussionis about the "cumulativeevidence of the
great change which has occurred in financialsentimentsince the atmosphereof gloom seemed
all-pervasivetwo monthsago."
23 McDougalhad served in his post almost two decades and had originallybeen tapped for it
because of his reputationas one of the most able and experienced of Chicago's bankers. In
addition,as our articlenoted, his was not the only voice complainingaboutthe impactof rates on
profitabilitywithin the bankingcommunity.Indeed, a careful study of the Depressionwill show
that issue surfacingagainand again. For McDougal,see James, ChicagoBanks, vol. 2, p. 877;for
other governors, see the remarksof Governor Norris of Philadelphia,quoted in Epstein and
Ferguson, "MonetaryPolicy," p. 982. Though it exceeds the scope of this reply, the issue of
excess reserves simmeredthroughoutthe early New Deal; see, for example,the briefdiscussionin
Ferguson,"Normalcy," pp. 90-91, of the 1936election, in whichafterthe FederalReserve Board
raised the reserve requirement,the outgoing president of the American Bankers Association
endorsedRoosevelt's re-electionbid.
24 Appendix1 describesthe sourcesfor our calculationsof bankmargins.Note thatthe full effect
of the plungein T-billrates shows up only some monthsafter the initialfall, as older bills paying
morerunoff, and the money has to be reinvested.See Epsteinand Ferguson,"MonetaryPolicy,"
pp. 970-72.
25 Estimatesof bank profitsduringthe periodin questioncan be found in the Federal Reserve
Bulletin, Feb. 1938, pp. 102-26, especially p. 116, table 1.
26 Our quotationfollows the Commercialand Financial Chronicle,Jan. 7, 1933, p. 3, which
reprinted the Chicago Tribunestory of "Saturday last"; we have regularizedminor bits of
punctuationin accord with more modernusage.

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198

Epstein and Ferguson

Appendix 1: A Note on Sources

Sources for data used in this article are Boardof Governorsof the FederalReserve,
Bankingand MonetaryStatistics (Washington,DC, Nov. 1943);Milton Friedmanand
Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (Princeton,

1963);Boardof Governorsof the FederalReserve, Federal ReserveBulletin(Washington, DC, 1927-1932,semiannually);and The New YorkTimes.
Definitionsand sources for variablesused are as follows. BANK RESERVES: monthly
averagesof daily figures,millionsof dollars,are fromBankingand MonetaryStatistics,
p. 371, table 101. BANK STOCK INDEXES are as calculatedin Coelho and Santoni (see
their table 1 notes); each bank index tracks a $100 portfolio invested equally in each
stock in the base period. Daily data are from TheNew YorkTimes. The base period is
Mar. 28, 1932. There are seven banks in each index. The New York banks are Chase
National Bank, First National Bank, NationalCity Bank of New York, Manufacturers
Bank, BankersTrust, ChemicalBank, and GuarantyTrustCo. The ChicagoBanks are
CentralRepublic Bank and Trust, ContinentalIllinois Bank and Trust, First National
Bank, Harris Trust and Saving, NorthernTrust Co., Peoples Trust and Saving, and
Straus National Bank. COMMERCIAL LOANS AND INVESTMENTS: total loans and investments, weekly reportingbanks, millionsof dollars, monthlydata, are fromBankingand
MonetaryStatistics, pp. 144-45, table 48. CREDIT MULTIPLIER: commercialloans and
investments divided by bank reserves and Federal Reserve notes. FEDERAL RESERVE
NOTES: FederalReserve notes in circulation,monthly,millionsof dollars, end-of-month
figures,are fromBankingand MonetaryStatistics, p. 412, table 110.GOLD STOCK: U.S.
gold stock, millions of dollars, weekly data, Wednesdaydata, are from Banking and
MonetaryStatistics, pp. 386-87, table 103.GOVERNMENT SECURITIES: those held by the
Federal Reserve, millionsof dollars, weekly data, Wednesdaydata, are from Banking
and Monetary Statistics, pp. 386-87, table 103. MONEY MULTIPLIER: money supply
divided by bankreserves and FederalReserve notes. MONEY SUPPLY: currencyheld by
the public plus demand and time deposits, billions of dollars, monthly data, are from
Friedman and Schwartz, A Monetary History, pp. 713-14, table A-1, col. 8. NET
INTEREST MARGINS: interest received less interest paid less non-interestexpenses per
$100 of loans and investmentsfor all memberbanks, by FederalReserve District. The
margins are calculated from various issues of the Federal Reserve Bulletin. STOCK
MARKET INDEX is from The New YorkTimes, 25 industrialsand 25 railroads,reported
in the business section, first day of each month, daily figures.

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Reply to Coelho and Santoni

199

Appendix 2: Statistical Tests

TABLE 1

RESIDUALS IN NEW YORK AND CHICAGOSTOCKPRICESAND THE DIFFERENCES

BETWEENTHEM AROUND APRIL 13,1932

Apr. 13

Days

New York

-12
-11
-10
-9
-8
-7
-6
-5
-4
-3
-2
- 1

0.007
-0.014
-0.002
-0.001
0.002
0.005
-0.017
0.009
-0.006
0.010
0.000
-0.006

T-New York Chicago T-Chicago Difference T-Difference

0.547
-1.149
-0.125
-0.041
0.194
0.378
-1.393
0.718
-0.481
0.814
-0.026
-0.505

0.015

1.175

?1

-0.020

-1.630

?2
?3
+4
+5
+6
+7
+8
+9
+10
+11
+12
+13

0.026
0.031
0.007
-0.016
-0.011
-0.008
0.010
0.001
-0.007
-0.010
-0.010
-0.001

2.1l9b
2.468b

0.542
-1.324
-0.927
-0.615
0.821
0.078
-0.567
-0.782
-0.786
-0.116

-0.006
0.009
-0.002
0.000
0.002
0.001
-0.005
-0.003
-0.016
-0.006
0.010
-0.001

-0.524
0.767
-0.140
-0.038
0.213
0.133
-0.449
-0.235
-1.479
-0.538
0.858
-0.059

-0.024

- 2.170b

0.039

2.544b

-0.015

-1.323

-0.006

-0.364

0.026
0.001
0.015
0.008
0.003
0.003
0.003
0.002
0.001
0.019
-0.023
0.000

2.344b

0.133
1.345
0.678
0.292
0.315
0.299
0.203
0.087
1.669
-2.062a
-0.040

0.000
0.029
-0.008
-0.024
-0.015
-0.011
0.007
-0.001
-0.008
-0.028

0.018
1.916a
-0.540
-1.575
-0.970
-0.732
0.451
-0.085
-0.526
-1.857a

0.013
-0.023
0.000
0.000
0.000
0.003
-0.012
0.012
0.010
0.016
-0.010
-0.006

0.013
-0.001

0.829
-1.498
0.001
-0.006
0.002
0.211
-0.809
0.758
0.688
1.057
-0.648
-0.369

0.865
-0.065

+14
0.008
0.614
-0.003
-0.281
0.011
0.706
a Significantat 10 percent level in two-tailedtest.
b Significantat 5 percent level in two-tailedtest.
Notes: The sum of the differencesin residualsover the periodApr. 13 to 16 is significantat the 5
percentlevel, with a t-statisticequalto 2.07. The New Yorkcolumndataare the residualsfromthe
regressionof the New Yorkindexon the stock marketindex. The T-NewYorkcolumndataare the
t-statistics on the New York residuals. The Chicago column data are the residuals from the
regressionof the Chicagoindex on the stock marketindex. The T-Chicagocolumn data are the
t-statisticson the Chicagoresiduals.The Differencecolumnis the differencein residualsbetween
New Yorkand Chicago(New Yorkless Chicago).The T-Differencecolumndataare the t-statistics
on the differences.
The event analysis is based on the regression estimates of equations 1 and 2, below,
using daily data from Mar. 30 to Apr. 29, 1932. The endpoints of the regression were
determined by the lack of data on Chicago banks before Mar. 28, 1932, and the
interruption in reporting of prices for Peoples Bank and Central Republic after Apr. 29,
1932.
The dependent variable is the change in the log of the New York Index or Chicago
Index. The independent variable is the change in the log of the stock market index.
Both equations were adjusted for first-order serial correlation. But the results are
similar if no autocorrelation adjustment is made and if changes, rather than changes in
logs, are used.

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200

Epstein and Ferguson

New York: 0.001 + 0.628 Index
(0.51) (6.4)
Adjusted R2 = 0.63, Durbin-Watson = 2.0, AR(1)

(1)
=

- 0.27

Chicago: -0.004 + 0.19 Index

(2.3)
(-2.1)

(2)

AdjustedR2 = 0.14, Durbin-Watson= 2.1, AR(1) = -0.27

The T-statisticsare in parentheses.
GRANGER TEST

We performedsimple "GrangerCausality"tests to determinewhetherchanges in the

stock of gold predicted changes in open market operations or vice versa. Applying
standardtechniques, we regressedleads and lags of changes in governmentsecurities
held by the Federal Reserve on changes in the gold stock. Statisticallysignificantlags
imply that open marketoperations"Granger-cause"gold flows. Statisticallysignificant
leads implythat gold flows "Granger-cause"open marketoperations.If both leads and
lags are significant,"Grangercausation" operates in both directions.
The dependent variable is the change in the stock of gold, and the independent
variableis four lags and leads of the changein governmentsecuritiesheld by the Federal
Reserve. The regressionis based on weekly data from Jan. to Dec. 1932.
A test of the hypothesisthat all lags are equalto zero generatedan F-statisticof 3.24,
with 4 and 43 degrees of freedom, so that the hypothesis that changes in government
securities do not "Granger-cause"changes in gold could be rejected at the 5 percent
level in a two-tailed test. A test for the hypothesis that all leads are equal to zero
generatedan F-statisticof 0.81, which cannot rejectthe hypothesisthat changes in gold
do not Granger-causechanges in governmentsecurities held by the Federal Reserve.
When the sample was split in June, the tests suggest that "causation"goes both ways.

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