View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

C

ni

j'lDENTIA

June 23, 1937
Desterilization and
Reserves on Foreign Deposits

Since the end of January 1934, the inflow of gold to this country has
amounted to five billion dollars. This inflow has only to a minor extent
represented a favorable balance of commodity trade and during the past year
the gold inflow has been in large volume while commodity imports have been
in excess of exports*

The reason for this inflow has been a large-scalo

movement of capital from foreign countries to America.
It is not infrequently stated that the reason for the flow of gold to
this country is the high price that the United States Government pays for gold.
Taken literally, this statement is incorrect, because the price of gold is
essentially the same throughout the world and cannot be different so long as
there are international exchange dealers or arbitrageurs who take advantage
of any differentials between prices of gold in different markets. If the
statement is intended to mean that an ounce of gold would buy more goods if
converted into dollars than if converted into sterling or into francs, it is
questionable.

But even if that were so, it is clear that it is not the reason

for the movement of gold here, because, as already stated, we have bought more
goods abroad during the past year than we have sold to foreign countries.
Gold is coming here because thoro is a large demand for dollar exchange,
and this demand in turn is duo to the fact that holders of funds throughout
the world aro inclined to move a part of thorn to America. They are doing
this partly because they think that the money is safor hero and partly bocause the American security market is moro attractive than tho socurity markets
abroad.




c

- 2 -

The fact that in rocont months the inflow of capital has taken the form
of a growth in idle balances has been duo to a combination of circumstances.
There have been rumors of a reduction in the price of gold, or interference
with the gold market which have led private holders of gold in London to dishoard on an extraordinary scale* A substantial part of the proceeds of this
gold dishoarding has come to the United States. Neither the pound nor the
franc was regarded by dishoarders as being in as strong an exchange position
as the dollar, the pound having been pushed to what appeared to be an unusually
high level in April which might ultimately prove difficult to maintain, while
—v

the franc has recently been subjected to a new crisis. Dishoarded funds
coming to the United States have not gone into the stock market, because for
the last three months the market has shown a declining tendency*
There is, therefore, a combination of fundamental economic reasons and
technical market circumstances for the large increase in the gold movement
to this country in recent months and for the fact that this movement has
created bank balances instead of being invested in American securities.
As a consequence of these developments, the Treasury and the Federal
Reserve System are confronted with a serious situation. The Board has
exhausted its power to raise reserve requirements against deposits and has no
means of absorbing reserves except through disposing of its portfolio. It is
true that the portfolio amounts to $2,500,000,000, but selling it now involves
the possibility of interfering with Treasury financing and with the market for




- 3 -

Government obligations and raises the question at what point the portfolio will
cease to be sufficient to give the System the necessary control over credit
in case an inflationary development should occur.
The System, therefore, has only one instrument of control at its command,
and is reluctant to dissipate it. The Treasury, in turn, is also facing a
serious problem. "When the Treasury undertook to sterilize gold at the end of
December 1936, it did not contemplate that the amount that it would sterilize
by borrowing in the market would exceed a billion dollars. This limit has
been passed in less than six months. It is true that it is only costing the
Treasury perhaps $5,000,000 a year to sterilize this gold, but nevertheless
the Treasury is reluctant to continue sterilization at the rate of a possible
$100,000,000 to 0150,000,000 a month. There is objection in Congress to
paying interest on borrowed money for the purpose of burying gold in Fort Knoxj
the Administration does not like to see an increase in the public debt caused
by gold purchases; and the problem of issuing securities for new money at a
time when it is not needed for any purpose except to sterilize gold and when
the country is becoming increasingly apprehensive about a growing public debt,
makes the Treasury feel that it is not willing to go above a billion dollars
in its sterilization program.
At the time sterilization was undertaken, it was understood that the
Treasury could discontinue the policy at any time, but that before tho policy
was changed tho Treasury would consult tho Federal Reserve System and give it
an opportunity to be hoard.




.. 4 -

It is clear, in view of those circumstances, that something should bo
done to moot tho immediate gold situation, even though the program may
consist only of a device for gaining time while tho broader problem is
being worked out. This broader problem is not one that can be settled
in a hurry or by this country alone. It involves a restoration of political
stability in France and of better prospects of peace in Europe. It involves
also a vdllingness on the part of England and other countries to do something
about the gold problem. At the present time

England is satisfied with

the situation. The gold mines owned by the British are yielding large
dividends; the gold reserves of England are not extravagant, though large;
and the United States is holding the bag. This broader problem is not the
direct responsibility of the Federal Reserve System, which by itself can
do nothing about it, except study it and be prepared to give its advice,
if asked.

One of tho advantages of undertaking some immediate action about

gold is that it may cause a larger amount to go to England, thus increasing
the pressure on England and possibly making it moro willing to consider
plans for an ultimate solution of the problem.
The more immediate question before the Federal Reserve System is
what can be done at once to meet the current domestic situation. It has
been suggested that one way to increase this country^ ability to absorb
reserves arising out of gold imports would be to give the Board of Governors
power to raise reserve requirements against foreign deposits here. There




9
*

c
are at present $1,800,000,000 of such deposits. These deposits are
for the most part hold by 26 banks in New York City, Presumably
the reserves now held against them are somewhere in the neighborhood
of $500,000,000. There are, therefore, perhaps $1,300,000,000 of
those doposits in excess of oxisting reserves against them. This
is approximately the maximum amount -which could be frozen if the
Board had power to raise reserve requirements against foreign deposits up to tho full amount of tho deposits.
There are many difficulties in tho way of this proposal,
(l) It is not easy to define foreign doposits or to so draft legislation as to prevent evasion.

(2) Tho deposits, as already stated,

are at the present time at an exceptionally high level and may at any
time diminish, not through export, which would help solve tho problem,
but through conversion into domestic deposits by being invested in
American securities, bankers1 acceptances, or Treasury bills. Idle
deposits held by foreigners are tho most unstable form of capital and
afford but a precarious footing for a policy of control.

(3) Objections

may be raised to the plan because it may interfere with tho maintenance
of necessary working balances in connection with international trade and
finance

o



(4) There is also a strong prejudice among bankers against

#

•

0

- 6 -

c
anything approaching 100 porcont reserves, so that even if only applied
to foreign deposits, the dread spectro of 100 percent will be raised*
(5) A largo difference between reserves against foreign and domestic
deposits is undesirable, because it would load to the banks* imposing
service charges on the foreign deposits, part of which would then bo
converted into short-term investments, and this transfer would reduco
the reserve requirements back to 26 percent and reopen the question
of excess reserves*
Nevertheless, and notwithstanding these considerations, it would
be helpful for the Board to have the power to raise reserve requirements
against foreign deposits because a certain volume of them is in all
probability going to remain here as minimum working balances, and
increased requirements against them would in any case absorb a substantial
amount of gold. Administration of the new system will be easier if small
accounts can be exempted.

Probably exemptions should be optional with

the Board, with possibly an indicated maximum, and could be made to be
different for savings accounts, for time deposits other than savings
accounts, and for demand deposits. These exemptions could eliminate
from the operation of the higher requirements a large number of the accounts without reducing the aggregate volume materially, and would make
it easier for the banks to comply with the request, as well as easier for
the authorities to enforce the law. It has also been suggested that the
amount of foreign balances which were held by a bank prior to some designated date could be exempted from the increased reserve requirements«




c

f

- 7 -

In order to be effective, however, the power of the Board to raise
reserve requirements on foreign balances should be coupled with an effective program of taxation of foreign capital.

It is not necessary here

to discuss this program in detail, but such a tentative program is in
process of preparation, including both a substantial tax on income earned
by foreigners on American investments and a capital gains tax on American
securities held by foreigners*
A move to obtain authority to raise reserve requirements imposes
on the Board an implied duty to use this authority effectively.

If the

Board should obtain the authority, and if gold should continue to come
in undiminished volume and take the form of investments in securities,
as it is likely to do if the market should become more favorable, then the
System might find itself swamped with excess reserves with an entirely
inadequate means for coping with the situation. For this reason, it is
important that the request for additional authority be coupled with a
proposal for taxation of foreign capital, which would discourage capital
from coming to this country and at the same time would diminish the inducement for balances that are already here to be invested in American
securities*
A tentative draft of a bill to authorize the Board to raise reserve
requirements on foreign deposits and to provide that foreign central banks
and governments be required to hold all their American deposits with
the Federal Reserve banks ie attached. The essential parts of this bill

c

are contained in sections 2 and 3 on pages 3 and 4.

One feature of the

proposal that requires comment is that it is applicable to nonmember




- 8-

I
banks as well as member banks. That, of course, is essential, because
otherwise the balances would be transferred to private banking firms
and would escape the reserve requirements. Making the law applicable
to nomnember banks raises both a political and a constitutional question.
The political question is not so serious when the banks are large moneymarket banks as it would be if they were small banks scattered throughout
the country. Aside from the money-market banks themselves, which do not
have much political following, the political objection could only tako
the form of considering this an entering wedge for unification, to which
there is strenuous political objection. On the other hand, there is a
precedent in that the Board now has authority to impose margin requirements
on security loans made by nonmember banks. To meet the constitutional
question, the draft of the bill connects the power to raise reserve requirements with safeguarding the country's monetary eystem and with promoting international trade, both of which are considered to be subject
to Federal jurisdiction*
No satisfactory alternative for this proposal has been developed.
There is a plan under which the amount of funds that would be permitted
to count as reserves might be limited by the Board, But this plan has
not been adequately explored, and in any case would not be feasible
»
without unification of banks.
If it be assumed that a satisfactory bill for increasing reserve
requirements on foreign balances has been drafted,. and that it is
accompanied by effective tax legislation in relation to foreign capital,
there would still be the problem of working arrangements with the
Treasury in regard to the actual mode of procedure under the new powers.



V

- 9 -

The Treasury, for example, might wish to desterilize at once all
or a large part of the billion dollars which it now holds in the inactive
account.

It would then spend the proceeds, which would create excess

reserves, and the Federal Reserve System would be confronted with the
necessity of absorbing this billion of excess reserves, together with
such additional reserves as might be created by further gold imports.
It is clear that such a procedure would be undesirable, because the powers
under the supposed legislation would not be sufficient to enable the
Board to absorb the billion dollars and the further imports. As already
stated, at its maximum the power comprises only around $1,300,000,000
and this amount may diminish at any time by the conversion of the foreign
into domestic deposits. The greater the increase made by the Board,
furthermore, the greater the probability of such conversion, because high
reserves against foreign deposits would necessitate the imposition of
service charges by the banks and would, therefore, encourage the foreigners
to hold their American funds in some form other than idle deposits.
Another reason why the desterilization of a billion dollars at once
would be Tindesirable is that it might result in serious repercussions
in the money market. The inorease in reserve requirements would all be
in the money—market banks, while the expenditures of the proceeds of
desterilization would be scattered all over the country. The money
market banks, therefore, would be under the necessity of disposing of
earning assets at least temporarily and this might result in a repetition
of the March and April situation.

c



I

- 10 -

C
For these reasons it would be better if the Treasury would agree to
continue to hold an inactive gold account of approximately one billion
dollars. This is an amount which the Treasury contemplated when it
entered upon the program and it is probable that, if the Treasury needed
to borrow no additional funds for the purchase of gold, there would be
no serious pressure on the Treasury from Congress. After all, the cost
of carrying the billion is negligible and the danger of inflation arising
from dosterilization is realized by many.
A plan could be worked out by which the Treasury would agree to keep
approximately a billion dollars in its

inactive account with a revolving

fund either above or below this amount to be desterilized from time to
time. To make this more specific, let us say that the Treasury now has
a billion dollars of inactive gold. When another $100,000,000 comes in,
it could deposit this with the Federal Reserve banks and spend the resulting balances. The Board could then raise requirements sufficiently to
absorb $100,000,000 of reserves. The Treasury could then accumulate another
$100,000,000 and then desterilize it, whereupon the Board could raise
requirements by another notch. This plan would involve less disturbance
in the money market, and it would reduce the Board's problem to manageable proportions • It would be coupled with some understanding that the
amount the Board is willing to handle in this way should not exceed all
told a billion dollars and after the first half billion the problem
should once more be reconsidered.
If the plan as just outlined were adopted, there would be two possible

c

ways to proceed. One would be for the Board to agree to raise reserve




- 11 !
requirements on foreign balances automatically from time to time by an
amount approximately equaling the gold currently desterilized by the
Treasury. Another way would be for the Board to let the Treasury desterilize a given amount when it is accumulated and then leave it to the
Board to handle the situation in accordance with current banking and money
market conditions. It might decide to absorb these reserves by letting some
bills run off from its portfolio*
ments.

It might decide to raise reserve require-

Or it might decide to permit the reserves to remain with the banks.

Its decision would depend on circumstances. This would give the Board
the freest hand and is the correct procedure in principle, because the
Board should never commit itself in advance to any course of action and
should keep a free hand to use any, all or none of its instruments of
control, as the situation may demand*
The argument for automatic advances is that they would keep the
Treasury in the picture more definitely in connection with gold.

It would

also make it easier for the Board to take action that may be unpopular,
if it was definitely understood that this action is merely a means of
absorbing gold imported from abroad and released by the Treasury,
Details of the arrangements to be made with the Treasury, however, can
be worked out later. It will be sufficient at this time for the Board to
determine:
1. Whether it favors a request for authority to raise reserve




requirements against foreign deposits and to require that
deposits of foreign central banks and governments be held
with Federal Reserve banks.

c

•4

- 12 2, If it does, whether it thinks that this should be coupled
with a foreign capital tax proposal, and
3« Whether the Treasury should be requested to agree to maintain




an inactive gold account of approximately $1,000,000,000.

.