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To Mr. Eccles
Prom Mr. Edmiston


In the large volume of writing about "unemployment insurance schemes
of various types it is rather surprising that there has "been relativelylittle attention paid to the question of how the reserves are to " e
handled and what effects upon the economic system might " e expected from
different uses of the reserve funds. There are three types of proposed
schemes for handling reserves,which will be discussed "below.
Investment of Reserves in Government Securities*
In the first place, the reserves might be invested in securities, particularly in Government securities, as these provide the maxim-urn safety and
availability and probably for political reasons would be the only type of
securities in which the funds can be invested

under any compulsory "un-

employment insurance plan that requires the fund to be handled by some
Governmental agency whether it be the national Government or the Governments
of the several States.
If Government securities are to be used for investment of reserves the
handling of the fund requires considerable management.

In a period of in-

creasing business activity it is to be expected that payments would normally be coming into the fund at a faster rate than benefits are being made.
If this excess amount were used to purchase Government securities the funds
would go into the hands of the holders of these securities who sold them
to the trustees of the fund.

These individuals or institutions would then

be able to use the funds as they saw fit. They would probably either
purchase other securities, purchase commodities or leave deposits in the
hands of banks. As the original payments into the fund came as a result
of the sale of some of the above types of assets the net effect from these

- 2 -operations would entail no change at all upon the volume of bank deposits
or purchasing power if no other factors entered into the picture.
If, on the other hand,the source of the original payments into the
reserve fund came as a result of an expansion of bank creditf indicating
the prospect of greater profits and an increase in business activity so
that bankers were willing to advance new funds and were able to do so,
either because they had previously accumulated excess reserves or were
willing to borrow at the Federal Reserve^ the operations of the reserve
fund by purchase of Governments would provide no check whatsoever to this
expansion of bank credit.
In fact it lias been argued by some that by purchasing Governments the
price of those securities would be kept high with the tendency to provide
ease in the money market, thus the general level of interest rates would be
kept down, providing an impetus to further expansion of bank credit as the
cost of credit to entrepreneurs would be low, thereby increasing the spread
between selling prices and costs and consequently increasing the margin of
The reason why the inflationary aspects of the use of unemployment reserves in a period of accumulation is looked upon by many as dangerous is
because of the growing lack of confidence in the ability and the willingness of the Federal Reserve authorities to apply sufficient check to credit
expansion and to exert control over the speculative use of bank credit.
This is a real problem as I have pointed out in previous memos and danger
is undoubtedly present under the existing organization of the Reserve system.
However, it seems to me that the situation should be reformed directly by
changing the set-up of the Federal Reserve System rather than by superi&pos-

- 3 -

ing an "unemployment reserve scheme which attempts incidentally to correct
the abuses that now exist in the agency of credit control•
S*uch a plan of handling reserves has exactly the same effect on securities markets as the customary Treasury operations of retiring bonds
which mature or become callable during periods when reserves exceed expenr
ditures. The only difference is that operations in Government securities
would be somewhat greater when the unemployment reserve fund is added to the
normal Treasury operations.
In a depression period the problem is more difficult.

In mild de-

pressions the tendency in the past has been for Governments to strengthen
from the levels at which they were quoted in the later stages of the previous boom, with its attendant high interest rates. Thus if the vol*ume of
liquidation from the reserve fund's holdings of Governments is not too
great there would be no loss or difficulty in selling out securities.
However, if the depression deepens, heavy sales of Governments would
tend to have unfortunate aspects.

In a time of general deflation of bank

credit, declining business activity, and falling prices to have Government
credit weekened unnecessarily is unfortunate because it has repercussions
throughout the whole financial and economic system.
If Government securities tumble in price the bond market generally
has the tendency to follow suit. With a weak bond market new corporate
issues become impractical and refunding is handicapped. Corporations
with maturities approaching try to get liquid and/acc-unrulate cash. They
lower standards of maintenance and delay necessary repairs. These actions
result in decreased employment and purchases which tend to accumulate over
the economic system as a whole. Commodity markets feel the effects, con-

- 4 traction of "bank credit ensues and a cycle of deflation is engendered.
This process continually makes government securities harder to liquidate
without severe losses as time goes on.
In order to preserve Government credit and to halt deflation generally it is important to have the close cooperation of the Federal Eeserve

If the Federal puts new funds out by purchasing the "bonds that

the trustees of the unemployment reserves find it necessary to sell, the
price of Governments can be maintained and the unemployment reserve fund
will show no appreciable losses•
The funds find their way into commercial "banks almost immediately
(assuming hoarding of currency and gold exports do not take place) with the
result that "banking stress is eased and pressure for continued deflation
lessened as reserve balances are built up. Again, the fact should be mentioned that early action by the Reserve system is essential before depression psychology sets in and deflation lias been carried to such lengths that
even large excess reserves do not provide an incentive to new lending by
the banks of the country.
Holding the Reserves as Deposits in the Banking System
A stiggestion has been made in some quarters that instead of investing
the unemployment reserve funds in securities they be placed fJeHly in the
commercial banks of the country as demand deposits. The individuals who
advocate this course are generally those who have very little faith in the
effectiveness of control measures which might be taken by the Federal Reserve and therefore want to connect a form of monetary and credit management with the handling of unemployment reserves.
The effect of this type of operation is that it would sterilize cer-

- 5 -

tain bank deposits at the time when there is likely to " e excessive credit
expansion, and on the other hand would provide for a shift of funds from
inactive to active accounts in a period of depression*
In periods of expanding "business activity the payments which the fund
trustees receive would be placed in the commercial banks to remain there
simply as idle deposit accounts that would not be checked against. These
funds have been received from accounts which pres"umably have been active
previously, and would continue to be so if not disturbed.

Thus, there

would be a decreasing of the velocity of circulation of bank deposits by
the operations of the reserve fund and to this extent the incipient boom
is undermined*

It remains true of course that there can be an expansion

of bank credit provided the bank reserves allow it and conditions are favorable.

These new fionds that are created in the banking system might have a

very rapid velocity so that in total amount debits to individual deposits
might increase at a rapid rate.
In periods of depression, on the other hand, it is normal to find a
slackening in the turnover of bank deposits as many corporations and individuals find themselves without suitable channels to use their money and
therefore they simply hold them as idle deposit accounts in the hands of
the banks. In such a period the benefit payments from the reserve fund
would be increasing, and hence the former sterilized deposits would now become active, as the benefit payments would be made to individuals who
would put the funds to use immediately by purchasing necessary goods and
services. Of co-urse only one turnover of the funds is all that can be
guaranteed, because the funds might then go into the hands of individuals
and corporations who would have no pressing use for the funds and in view

- 6 -

of depressed conditions would prefer to allow them to remain idle.
This method of simply placing reserves in commercial banks,therefore,
does have some merit in tending to stabilize the business cycle. However, ,
it seems to me to be going outside of their proper field of activity for
trustees of an unemployment insurance fund to be attempting credit management, even though in this case^ there would be no descretionary action on
their part as they would simply be following the specific mandates of the
legislative branch of the Government• Personally, I am a believer in having one agency held responsible for maintaining sound credit conditions and

absolute control over the credit and monetary base. These powers

of management should in no way be confused or hampered by the operations of
any unemployment insurance fund*
Placing Unemployment Beserves in the federal Reserve Banks
A third method of handling unemployment insurance reserves is to have
the funds placed as deposits in the Federal Reserve banks by the trustees
of the fund.

The proponents of such a plan are even more pessimistic about

the effectiveness of Reserve authorities in controlling the credit situation
than those who advocate the previous plan.

They take the attitude that

the Federal Reserve system by its very composition finds itself unable to
prevent an excessive expansion of bank credit diaring periods of increasing
business activity.

Therefore, they propose that in periods when funds are

piling up in the unemployment reserves there should be an immediate withdrawal from banks and the funds placed as deposits in the Federal Reserve
Banks, Thus, the reserve balances of member banks would be immediately
drawn down, and in order to replace them, the banks would either have to
contract credit, thereby decreasing deposits and hence the amount of reserves

- 7 -

required, or would have to "borrow from the federal Reserve•

This situa^-

tion would mean a tightening of credit, a tightening of money rates and
therefore an effective check to further credit expansion*
It may " e that contraction at such a time would have too great an efb
fect in checking a desirable increase in legitimate "business activity.


this was deemed to be true then the Federal Reserve authorities could
counteract the effects of the operations of the uaemployment reserve fund
by lowering rediscount rates and purchasing Government securities, thus
replacing funds in the market and making accommodations cheaper.

In other

words, it is a reversal of the normal operations of the Federal Reserve
Board in controling the situation during a boom period.

The view is taken

however that the Reserve authorities are too lax in placing checks to unwise credit expansion and therefore it is better to have pressure applied
on them to ease conditions in a boom, with the main reliance for keeping
market conditions tight placed upon the automatic operations of the unemployment reserve fund*
The reverse situation would appear in a time of depression. As
benefit payments from the unemployment reserve fund exceeded current receipts the trustees would simply draw checks upon the Federal Reserve banks,
thereby placing funds in the hands of member banks relieving the pressure
of liquidation, building up excess reserves, tending to make market rates
low, and credit conditions easy. All of which would be desirable in such
a period. Furthermore, the funds would be placed immediately in the hands
of spenders and thus in addition to there being created an absolute increase in the volume of purchasing power there would be every expectation
that this purchasing power would be used immediately in the commodity mar-

- 8 kets of the country.
While it is true that in a depression period the fund if operated in
this way would be very "beneficial to business immediately, there is no
guarantee that funds would stay in circulation*

It is quite possible that

the individuals who receive the funds after the first turnover would simply
be willing to maintain unused deposit balances in the hands of commercial
banks, thereby effectively sterilizing the funds from future circulation.
Also, it is not beyond the realm of possibility as definitely shown in the
present depression that the mere existence of excessive reserves provides
no one incentive for banks to lend when conditions in the business world
make the prospect of profits unfavorable*
It is true that this plan of handling unemployment reserves has some
merit when we consider that the operations of the Federal Reserve Board
have left much to be desired in the past. But this plan goes too far to
the other extreme and I would definitely be opposed to it.

In the first

place, here again the duties of trustees of an unemployment reserve fund
are combined with powers for monetary and credit control.

I think this is

an unwarranted ass-umption of po7/ers which should only be placed in the
hands of an especially designated and qualified body. Even worse in its
probable effects is the method which this plan sets up of specifically
directing the trustees of the unemployment reserve fund to deposit at the
Federal Reserve in a period of increasing business activity.

I am not one

who argues for a passive attitude on the part of the body charged with
credit control and recognize that an unwise expansion of bank credit leads
to greater difficulties later on. However, it is important to realize that
credit expansion in itself is not an evil.

Growing business activity must

- 9 -

" e supplied with new funds if employment and production are to be maintainb

I fear that the automatic drawing down of member bank reserves in such

a period would be too severe and that in spite of compensatory action by
the Federal Reserve banks, it would check desirable increases of production
and business activity. Moreover, there would be too large a shift from
week to week of reserve balances and it would be expecting too much of the
central banking authority to maintain sound credit conditions when the
volume of member bank reserves is shifting at such a rapid and unpredictable
Tims, while the aims of this plan are commendable in that they seek to
prevent excessive expansion of bank credit in boom periods and also attempt to prevent serious contraction of credit by automatically forcing
funds out into the market and into the hands of spenders in a period of
depression, the methods which the plan employs to attain these ends are
too drastic and would probably tend to introduce instability into the economic system to a greater degree than the stabilizing influence which they

The cure is in effect 7/orse than the disease.