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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. .