The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
FEDERAL ADVISORY COUNCIL May 20, 1940 Under date o f A p ril 27, 1940, the Federal Reserve Board, through it s Secretary, asked the follow ing QUESTION "The Council has urged upon the Board the ♦modification o f the policy of extreme easy money*. The Board would lik e to have the opinion o f the Council as to the more im portant causes of the ’ easy money* conditions; as to what actions within the power o f the Board o f Governors would bo desirable and e ffe c tiv e in the public in terest; and as to the probable consequences o f such action s." ANSWER I - Causes In the unanimous opinion o f the Council, the more important causes of extreme "easy money" are: 1. The adoption by the Federal Reserve Board o f "easy money" as a guiding policy, and it s continuous advocacy in annual reports, other publications, at Congressional hearings, in advice to the Exec u tiv e , and in public addresses and press interviews. The Board should not underestimate the influence it has exercised, or the re sp o n sib ility i t has assumed before the public, the Congress, and other governmental agencies, by repeatedly defining "easy money" as the o f f i c i a l monetary objective o f the highest responsible monetary authority in the land. The follow ing quotation from it s 1939 report to the Congress is one o f many which define that objective. -2 - MIn recent years it has been the policy of the Government and of the Federal Reserve System to encourage the expansion of credit. This has constituted the so-called policy of monetary ease, which has been directed at keep ing banks supplied with an abundant volume of reserves, 30 as to encourage them to expand their loans and investments. This policy has been one of the factors in the creation of the existing large volume of deposits in the hands of business enterprises and of individual and corporate in vestors, and has resulted in reducing interest rates to the lowest level in history.**** "Nor is there any immediate reason for considering a reversal of this policy,” (Report submitted January 27* 1939) As far as the Council is aware, the Board still advocates the doctrine of "easy money" and is taking no steps to set up warning signals against the evil effects of the extreme to which it has been carried and of the dangers of its continuance, nor to evolve any long range plans to eliminate some of its causes or to counteract its con sequences. The Council believes that this policy has failed after years of trial to bring about its pre-announced objectives— namely the expansion of private borrowing, the stimulation of business and the re duction of unemployment and that the dangers of the extreme to which it has been carried are now so apparent that the Board should publicly ad vocate its modification. 2. The expansive open market operations of the System be ginning toward the end of 1929» continuing for several years, and never reversed in principle. June 18, 1937.) (Note Annual Report of the Board dated -33. The too long delayed reduction of the p o rtfo lio o f Gov ernment b i l l s thereby forcing in terest rates on b i l l s to the vanishing point. The rep etitio n o f that process in the case o f the Government bonds acquired la s t autumn and retained (except fo r some r e la t iv e ly small sa le s) in the face of a market that roso steadily u n t il a few days ago— despite the fa c t that so great a volume was not needed fo r the maintenance of the System. As hitherto stated, when repeatedly advising sa le s, the Council i s o f the opinion that i t was and i s un healthy fo r the central monetary authority to retain as a fix ed policy a la rg e volume o f Government o bligatio n s. 4. The unprecedented spending program o f the Federal Gov ernment, which necessitated borrowing and inevitably induced the au th o ritie s to exercise th eir influence in the direction o f keeping in terest rates at a minimum. D e fic it financing and o f f i c i a l pressure fo r "easy money" go hand in hand. Furthermore, to the extent that the Government has borrowed from commercial banks, and dispersed tho funds, an increase in the aggregate o f deposits has resulted, intensifying the pressure upon in terest ra te s. 5. A series o f other p o lic ie s o f the Federal Government tending to increase the supply o f funds or the volume o f excess re serves, or both, such as: (a ) The increase in the d o lla r price of gold, therety encouraging the production o f that metalj (b ) The discontinuance o f the practice of s t e r iliz in g incoming gold; -4 - (c) The policy of purchasing silver far above its world price and issuing silver certificates there for on the basis of the artificial Valuation; (d) The creation of scores of lending agencies which, avowedly established for emergency purposes, are apparently perpetuating themselves, and are lend ing taxpayers' funds at progressively lower rates, often in competition with the taxpayer himself j (e) The Johnson Act and the "cash-and-carry" provisions of the neutrality laws upon the merits of which the Council does not express an opinion but which, in effect, are impelling most of the leading foreign powers to ship us gold or to go without indispensable supplies. 6. The series of policies of the Federal Government tending to decrease the demand for funds on the part of business enterprise. The Council has no wish to appear to enter into the field of political controversy, and therefore contents itself with stating, purely objec tively, that it is its belief that the concept of more and more state interventionism, expounded Ly many Government officials as a universal remedy, and the growing practice of it, have exercised and are exercis ing a depressant effect upon new capital demand in many fields, with the result that even at the prevailing low money rates, relatively little new industrial borrowing for other than refunding purposes has taken place. (7) The developments abroad that have led to the repatria tion of American capital and have caused huge shipments of gold to this country by foreigners,— both operations that have vastly contributed to our excess reserves, t h e r e a f f e c t i n g the interest rato structure. The Council believes that we should continue to accept incoming gold, but notes that no steps are being taken to attempt to offset this in fluence upon our credit structure. The Council has mentioned this important cause last, not be cause it does not recognize its dominant influence, but bccause it feels that this cause should not be permitted to overshadow the many other important causes, enumerated above, or to create any misconcep tion that "easy money" has been thrust upon the responsible monetary authorities against thoir wills. II - Action to Be Taken In the opinion of the Council, there is no more important public service which the Board and its members can perform than to use their influence in every direction possible to bring an end to the pe riod of extreme "easy noney". Among the steps to that end that might be taken are: 1. Let the Board publicly announce that in the light of events, it is modifying its former policy of extreme "ea^y money" and will exer cise its powers, particularly those of counsel and persuasion, to reverse the trend. This does not mean credit stringency or high interest rates, -6but means only a recognition of the fact that extremely "easy money" is reducing the purchasing power of millions of American citizens, and is creating hardship without compensating advantage in stimulating business or reducing unemployment. 2. Reduce the Government portfolio at the earliest oppor tunity and adhere consistently to the policy of purchasing Governments only to offset manifestly disorderly or paniclcy markets and to dispose of such purchases as soon as circumstances permit. 3. Exert the Board's influence with the Treasury, directly and through the Open Market Committee, against the choice of methods of Government financing which would tend to make money rates still lower or to increase excess reserves ty the use, for example, of silver seigniorage "profits" or similar "funds" to avoid the debt limit. In deed there should be public opposition to all such devices that can but create more excess reserves and more extreme low rates. 4» Exert its influence upon the Treasury toward the estab lishment of a policy in offering Government securities which would encourage their purchase as far as possible by investors— such as in dividuals, life insurance companies, trusts, etc.— rather than by the commercial banking system. 5. Accept the rol3 customarily exercised by the central monetary authority of "keeper of the Government's financial conscience", and in that capacity actively and openly insist upon the elimination of the several menaces to the financial structure, many of which, among other things, would still further increase excess reserves, such as the power to issue greenbacks, further to devalue the dollar, etc. 6. Consider plans, on a long range basis, which may at the proper time be recommended for the purpose of coping with the gold and silver problems, such as the question of reestablishing a full gold stand ard with the resumption of specie payment, readopting sterilization (any such sterilized gold to be released only with the approval of the Open Market Committee), reconsidering the silver program, alteration of the legal reserve requirements, and use of existing legal powers in these re spects. With reference to the adoption of any of the foregoing measures the Council recognizes that the prevalence of war conditicnsmay make the matter of timing one of extreme importance. 7. If the Board is unprepared to take any or all of the fore going steps, we urge that it enter upon the study of the probable long range consequences of the extreme "easy money” policy, which the Council recommended to the Board in February of last year, when it expressed the belief that the probable fundamental consequences of this policy had not been fully appreciated. The Board then replied, in effect, that it considered that such a special independent study was not required. The Council cannot share this view. Last June it detailed what, in its judgment, had been some of the evil consequences of extreme "easy money", and expressed the opinion that present tendencies contained grave threats for the future. here. It is unnecessary to repeat this lengthy resolution No answer has been received by the Council, and the Council is -8 - still unaware as to how far, if at all, the Board shares its views. Such a study is clearly within the power of the Board and the Council believes that it is highly desirable in the public interest. It seems to the Council that the Board should make the dif ficult effort of projecting itself five to ten years into the future and reach conjectures, assuming a continuation of the present extreme »»easy money” conditions, as to the then probable economic results. For example: 1. What will be the condition of the commercial banks? 2* What will have happened to the mutual savings banks and to the principal and interest of the millions who have entrusted their hard-earned savings to the care of such institutions? 3. What will have happened to the cost of life insurance and the return therefrom, and to the income received, or to be re ceived, by the beneficiaries of the sixty million persons who are paying for life insurance or annuities? 4. What will be the aggregate debt burden of Federal and local governments? 5. What will be the position of the operations, and staff of our great private and semi-public hospital, educational, religious, and charitable institutions throughout the land, dependent in large measure upon income from the generous endowments that private enter prise has contributed in the past? 6. What will have happened to the purchasing power of the army of the hard-working and thrifty who have set something aside for their old age or a rainy day? 7« What will be the effect on additional unemployment, arising out of the inability of persons whose incomes from investments are reduced, to continue their usual purchases of goods and services? Is not this whole class being subjected to a veiled fona of taxation if the rates of interest are artificially forced, say ono per cent, below what would otherwise be operative? 8. What are the probable advantages to offset the imperil- ment of our commercial banks, our savings banks, our assurance funds, our endowment funds, and the hardship to those who live on their sav ings, to widows and children of those deceased? This enumeration of questions ic merely illustrative of many more, III - Consequences The Council believes that in the long run the consequences of action in the direction of a reversal of the policy of extreme '•easy money” would be beneficial to our economy and would help toward a partial restoration of confidence in the future of private enter prise, which is the condition precedent to sustained recovery and which represents the only alternative to state socialism or worse. The Coun cil believes that thè Board might take a leaf from the book of British experience since the beginning of the depression. While believing in, and practicing, a policy of ”easy money", tho British authorities were careful to avoid the pitfall of extreme "easy money", because they -1 0 - re cognized that "easy money" is a destructive influence if pushed too far. Thus, for example, the authorities collaborated with the market in preventing the ninety day bill rate from falling below one half of one per cent. What relation this sounder administration of the policy of "easy money" had to the British recovery, which was much more rapid and complete than here, is a matter of opinion, but its objective of protecting the banking system, and investment generally, is manifest. The Council maintains no argument for high interest rates, as such. Indeed, in an atmosphere of confidence and given sound underlying con ditions, low interest rates often have a beneficial effect upon busi ness and the economy generally. But abnormally low interest rates, due in part to the persistent efforts of Government interventionism, create uncertainty and have a depressing effect upon the economic structure. They are certainly not a natural accompaniment of a situation where enonaous Government deficits are piling up and more are frankly pre dicted, where taxes are steadily mounting, accumulated wealth steadily being consumed, and business confidence fundamentally lacking. In expressing the view that the consequences of a change of trend would be of a beneficial character, the Council recognizee that existing complexities of the economic and political situation are such that confident prediction as to the consequences of any single remedial step is hardly warranted. The failure of prices to respond, except fleetingly, to the change in the gold content of the dollar, the breakdown of the "pump priming" experiment, the failure of -li the policy of stimulating spending by taxing undistributed earnings, the failure of the "easy money" policy as a stimulant to new private borrowing, are all illustrations of the dangers of definite prediction in a world where the normal operations of economic laws are frustrated ty one artificial device after another. It cannot be expected, there fore, that damage done by a single policy will be instantly remedied ty a modification of that policy alone, but the Council does believe that a change in the policy is necessary before a sound economic struc ture can be restored, and that in the long run the Board will have rendered great servico to the country by modifying publicly, definitely, and actively its previous policy, by taking all steps within its power to correct the situation, including therein the potent ones of advice, warning, and popular education, and to oppose all measures of our Gov ernment, the natural consequences of which are to maintain extreme "easy money", or to drive rates still lower. tue banks aijd Q C N m m m m B01©S A SUGGESTED SOLUTION FOR A l3EIIACIIfl> SITUATIOH Memorandum in reference to United States Government bonds now owned by the Foderai Reserve System and its member banks and suggestions concerning a refunding and ohange in form thereof which -would appear bo be in the interest of the Treasury, the Federal Reserve System, the member banks, the Federal Deposit Insurance Corporation and the public generally venose money is deposited in the member banks* Liay 7th, 1940 * As of December 31st, last, the Federal Reserve System itself and all member banks held, respectively® 2.5 and 11.2 billions of direct obligations of the United States Govormaont# In addition thereto, member banks hold 3.1 billions of bonds and notes guaranteed by the United States Government, 2*7 billions of tho obligations of states and their political subdivisions and 3.0 billions of other securities* Those vast aggregates totaling 22.5 billions have, when considered as a -whole , been acquired within the banking system at extremely high market levels and at excessively low yields. (inasmuch as many individual banks may have purchased certain of their securities prior to the advent of extreme easy money, this statement may be challenged by those banks and "should bo verified by a factual study of actual reports on file of examination of all member bonks Trj the national Bank and Federal Reserve Examiners). Tiie net -working capital of all member banks (i.e., gross capital loss capital permanently tied up in benk premises, furniture and fixtures and other non-oonvortible items) is approximately 4.4 billions. (This total inoludes a substantial amount of preferred stock mmed by tho Government and not as yet redeemed). The United States Government, in public estimation, substantially guarantees the safety of deposits in member banks through its Federal Deposit Insurance Corporation« * (Since this memorandum was prepared statistics have beoome available as of June bo inserted. The substitution of later figures would but 30, 1940, and should magnify the problem« In 1920 vfoen the total Government debt was less than 25 billions of dollars, Fourth 4~l/4$ Liberty Loan bonds sold in the middle 80*5, approximating a Q% yield to maturity and in the same year the Government offered one year certificates at interest* The net yield of Federal obligations has recently ranged between less than 0% for the shortest maturities and 2 ^ for the longest maturities. latter has fallen to this level from 4 Tho return on tho in 1932 in the face of the fact that the national debt has substantially doubled since that date* An advance in tho yield on a 10 to 15 year bond selling on a Z&ibasis to even a 4% basis v/ould cause its market value to decrease approximately 1SJ&. A lb% decrease in the investment account of all Dumber banks rcould wipe out approximately two «thirds of their net capital. This net capital must also absorb all losses arising from some 14 billions of loans* In particular reference to the Government securities now owned by member banks * during the past several years the carrying value of these bonds has in effect been steadily written up through the process of selling one issue for profit and buying another at the same market levol and often of substantially tho same maturity. Early issues of higher ooupon rates have boen paid off and issues of progressively lower coupon rates have taken their plaoes. Thus the present carrying values v/ill approximate tho existing extremely high market values« It has been conclusively demonstrated that the market for Government securities promptly disappears viioncvcr any general selling movement occurs exoept insofar as the Federal Reserve System is willing to support a declining market and by sc doing further increase the System investment in Government securities viiioh is already in excess of ZOfo of the reserve deposits of its member banks* TIIE mSTIilG HOLDINGS OF 11*2 BILIIOIIS OF DIRECT UIJITED STATES GOTERirJSIJT SECURITIES COIISTITUTE 23$ OF THE AGGREGATE DEPOSITS OF ALL MLiliBER BANKS. In. viov; of tho clangers inhei’ont in tho situation above outlined, I would recommend for the serious consideration of the Federal authorities that 1« The Treasury issuo and sell at par to the Federal Reserve System account and to all member banks* indebtedness of the United States Government in the form of consols of no maturity in tho aggregate amount of 13«? billions* all for the purpose of refunding the System account of 2*6 billions and tho me&ber banks1 account of 11*2 billions* i«o», tlioxr present holdings of direct United States Government securities« la payment for consols at pur the Treasury to accept from the System account end from member banks cash and/or their present holdings of direct United States Government securities at the average daily opening market value of each issue so tendered for a reasonable period immediately preceding the conversion* or from the offering date on issues sold mthin that period# The said oonsols to be subject to call at par by the Treasury proportionately from all holders and until called to bear a rate of interest substantially equal to the present yield of iiie System port .2 l«3/^ya* folio * i.e The ownership of consols to be restricted to the Federal Reserve System and its member banks* 2* Concurrently with (1) above the legal reserve requirements of all member banks to be inoreased by an average of 23%t \foioh increased reserves shall be held in United States Government oonsols. The said increase averaging ZZ% shall be proportioned in the seme moaner and to the same relative degree as cash reserves are nay; proportioned bet-ween Central Reserve City banks* Reserve City banks* and country banks, and betpjeen demand and time deposits as follows! - 3 » miAiiD DEPOSITS Central Res« ReSöCity City Banks Banks Required cash reserve Required consol All Banks AVERAGE All Banks 22-3/4$ 17~¿$ 12$ 5$ 135» 40 31 $ 21$ rMhtrfcw 9$ 23% 48^ 33$ $ 62-3/4?; 3« TILIB DEPOSITS Country Banks u% 36% The System account to purchase from each member bank daily at par all consols held in excess of reserves required to be so held and to sell daily at par consols to eaoh member bank sufficient to fill reserves required to be so held« Since consols would be held in safe-keeping by Federal Reserve banlas, ownership could bo transferred from one member bank to another by book entry* 4« The Treasury to rodean consols at par Taken total outstanding exoeo&s 2 A ? billion (System account) plus the required reserves of all member banks to be held in consols (i.e., in caso of a shrinkage in the total of all deposits in member banks)« 5. The Treasury may at its option sell additional consols at par to the System when total outstanding is less than 2*6 billions (system account) plus the above required reserves of all member bonks to be held in consols (i.e., in case of an increase in the total of all deposits in member banks.) In case the Treasury failed to avail itself of said option the reserves of member banks required to bo held in consols shall be automatically proportionately so reduced« Under a National emergency and possibly in any event for flexibility, it is possible that the Secretary of the Treasury and the Board of Governors of the Federal Reserve System, acting jointly, should have some discretion, but in apy event within definite fixed limits, to increase the consol reserves above 25$ (being the $ of member bank deposits now iavestod in the direct obligations of Government.) On the one hand, the Treasury has full authority to redeem oonsols. It is obvious that if the Treasury and the Board of Governors, acting jointly, had the authority to increase the average consol reserve abc^e the existing 23$ average to an average of 25$, it would give the Government a further call upon the deposits of the public in member banks of approximately 1 billion dollars« 6. At such tamo as the Treasury is retiring the national debt and at its option calls proportionately from all holders all or any part of its then outstanding oonsols, reducing the total of 2.5 billions (System account) plus the above required reservos of all member benks to be held in oonsols, to a lesser total, the reserves of member banks required to be hold in consols shall first and to that extent be automatically proportionately so reduced and thereafter applied to reduce the System account* 7* The aggregate of consols hold within the System in its own and member bank accounts shall not exceed a total nhieh is not covered, as are all other rasmber bank reserves, by 35$ in gold or lawful money» 8» Total gold or lawful money required to be held in vaults of System or subject to its sole order would then be as follows* 99 40$ to cover circulation of 4*9 billions dfc 2* 35$ to cover member banks* cash reserves £ 4» 35$ tc cover member banks* consol reserve ± 4* Total gold or lawful money required by System ± 10o Total gold now held by Federal Reserve System ± 16* Llember banks desiring to do so would be permitted to hold say other United States Government securities but at free market risk in addition to their required reserves in consols« This procedure should be desirable from the Treasury viewpoint because it m i l «1« Effect a permanent refunding of 32$ of the total Federal debt without increasing the total thereof outstanding except as offset by subsequent saving in interest« - 5 - 2. Beduce prosent cost of interest to the Treasury on 1102 billions of direst debt ovvnod by member banks* (This statement should be verified frcra reports of Examiners* It is believed that the average ooupon rate of member bank holdings; exceeds that of the System account) a 3* Stabilize the market for all Government issues by removing the constant threat of bank selling of bonds held against demand deposit liabilities* Other holders of balimc© of public debt such as life insurance companies# corporations* trusts, savings and other individuals ere generally investors of term funds not subject to mass -withdrawal and therefore more stable holders* Balance of public debt so held as more permanent investment reduced to ^ 28*6 billions« 4* natural investment level of premier security of world could be better maintained viien freed from threat of mass selling frcsn banks* 5» Protect the deposits of the public and particularly the Federal Deposit Insurance Corporation guax*antee* This procedure should be desirable from the Central Bank or System viewpoint because it will « 1« Increase purely monetary and credit controlSo 2* Increase reserve requirements substantially without adversely effecting oash loan or other investment position of member banks a£ jx whole (llote that the increased requirements of smaller and country banks are much less than of large banks in Reserve cities* See table on Page <*») 3« Trill not decrease existing System revenue« 4« Remove member bank speculation in Government bonds « switching* gambling on conversion rights, etc* 5. Reno to necessity r* supporting markets on totals of 42 billions of United States Government securities to protect 11*2 £2*5 or 13«7 billions held within the Federal Reserve System* 6* Further justify present gold acquisition policy by requiring that gold be held by Federal Reserve System to secure all reserves of member banks# 7* Best promote interests of agrioulture and industry and every other objective of the Federal Reserve System by centering attention on -ways and roeans protecting the member banks and hence the money of the public on deposit therein* illis procedure should be desirable from the individual member bank viexvpoint because it tdll « I« Eliminate the danger of capital impairment due to market fluctuation of existing Government securities -which are at times “frosen" and unsalable«. 2o Eliminate the possibility of market manipulation by large holders at expense of small holders » So Assure moderate earnings on reasonable proportion of required reserves« 4« Divert banking attention to banking needs of public and a m y from specula tive interest in Government bond markets. This procedure should be desirable frcei the public viewpoint because it 7d.ll ~ 1« Better proteot the money of the iimerioan people in member banks, restoring the principle of diversification of risk in all forms of loans and investments -which are subject to market fluctuation and risk* xfaen made -with depositors 5 money largely subject to demand* 2* Increase the courage and confidence of bank management and, free of th© threat of capital impairment# encourage freer lending* 3* Avoid further dangerous and destructive extremes of easy money and tend to arrest the diminishing returns on capital« Condition of All IJember Bonks In Billions of Dollars 12 30/30 / Loans Capital Surplus & Undivided Profits 14» ) ) State and Municipal Bonds Other Securities 2.7)19.7) ) ) 3.0) ) ) U.S.Gov*t Securities - Direct 22.1 Demand Deposits ) Demand Interbank 3*1 Exoess Vault 6 .4 ) )11«6 ) 5.2) .8) ) Other Banks In process of collection .scellaneous assets (Bank premises,bank furniture end fixtures, etc#) 8.5 ) 37.4 3*1) Demand Foreign Federal Reserve Cash - Required 28.2 ) 11.2 ) U.S.Gcv*t Securities - Guaranteed 5.5 Time Deposits ) ) Timo Interbank 08 j 11.7 ) ) 11.3 •1 ) ) 19.7 Cash ) 8.5) 8.1) I 1.8) 4:9 «2 ) i«i 54.8 54*8 U.S.Gov’ts*(direct) of 11.2 are 23$ of member bank deposits* ” tT n in System account are 2«6 additional yielding avg* of 1*72$ Federal Reserve notes in circulation are 4«9 Member Bank deposits -with Federal are 11 «6 Gold & lawful money now required by System Gold now held by System 40$= 2*0 35$= 4*0 6*0 16.0 Excess Reserves 5.2 Correspondents* balances excessive by 1*8 Loans & other investments of 22*8 could rise 30$ before banks would have to rediscount. 19.7 oasli-flla2 Direct Gov’ts*=30*9 of Cash & Direct Govrts* or 63$ of total member bank deposits« Capital Ratio 1* Net capital— gross capital of 5*5 less misc* bank premises, etc.. of 1*1, or 4.4 ould not be 2« Loans 1 4 . + State & Llunio.Bds. 2 . 7 + other bonds 3.04- U.S.guaranteed?c Wbween capital & 3*1= 22*8 — loans & investments placed at risk by member bank deposits but between management (excluding U* S* Direct) net capital & money at risk* . . 0<50 . _ „ 4*4t 22*8 as It 5*2
@FedFRASER