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Ralph E. Flanders

October 21, 1937


The Problem of Business Stability
Money, Banks, and Bank Credit
Composition and Quality of the Sources of Deposits
The Business Cycle
Objectives and Criteria of Business Control
The Means of Control
The Dangers of Inflation and Debt
Survey and Summary

Chapter V
What is it that we wish to stabilize, and what do we
mean by stability?
Y e wish to stabilize business, and by business we mean
the production and distribution of goods and the rendering of

These are the activities which provide the people of

the nation with the things which they wish to use and to enjoy;
while the varied occupations which make this provision furnish
the wages, salaries, profits, rents, crop returns, dividends, and
interest with which the goods and services are purchased by the
The variety of these necessary occupations is very

It includes more than the simple manufacture of a radio,

for instance.

It includes the production of raw materials from

the soil and their extraction from the earth and from the sea.
It includes transportation of raw materials and of finished goods
and the buying, selling and distribution of the same.

It includes

the mobilization of savings {and a -feefeia^return to those who save)
so that the necessary buildings, machinery, and equipment may be
built and assembled into a manufacturing and selling organization.
It includes the other necessary financing and banking facilities,
for the initiation and operation of• the enterprise.

It includes

•the necessary engineering and technical training, skill and experience, and the financing of engineering training and research.
It includes a proportionate share in the

maintenance of an

ordered civilization, under which alone our present and prospective scale of living is possible.
All of this and more is included in the term "business"
as it will be used in this document.

But there are other activi-

ties which have at times been considered as belonging to "business"

V - 2
which we must exclude from that honorable designation*
There is a group of activities which thrives on business without making any important contribution to it. These are
activities which it is fair to designate as being parasitical
on true business• They are for the most part related to useful
operations of the sort which we call "financial"; indeed they
are often found to be closely entwined with legitimate and necessary activities. They include such operations as, in general,
are directed toward the realizing of future profits in the present, particularly when those profits are fallacious and misrepresented, or when the whole situation has been built up to a
general hysteria of optimism. In short, the mechanism of the recurring boom, whether in real estate, commodities or securities,
is not "business" in our sense. Similarly the process by which
inside officials profit from the buying and selling of securities
of their own companies on the basis of inside information is not
It must be admitted that the distinction is not clear
and sharp. The border line cases defy classification.

It may

even be that a certain small percentage of the activities excluded in our definition are unavoidable or even necessary. But
the great mass of desirable business activity is so far removed
from this border line that identification is not difficult•
. f t f i definition of business is important because it
must in considerable measure determine our policies. Vfliile we
may properly give short shrift to parasitical growths on business,
we will be careful of disturbing business itself, which is the
process of providing ourselves with what we want. We will try
to improve it, to expand it, but not to cripple it. Business

V - 3
in ouff .sense is the life blood of svery citizen and to choke its
flow is to attacfe( his social health and well-being.

Our use of the wofd "stability11 also needs definition.
We do not infer that it is possible or even desirable to keep
industrial production, or the general price level, or foreign
trade, or any other economic factor - even employment - on an
absolute dead level*
We could not do this if we would*

There are new factors

continuously being injected into our social mechanism —
ventions, crop failures, wars and rumors of wars —

new in-

which require

readjustment of the whole mechanism of production and distribution*

Some of these slow down activity; others speed it up.


are not wise and skillful enough to foresee these disturbances or
tofl compensate for them accurately.
More than this, perhaps we should not attain absolute
stability even if we could.

There is no analogy in the world

around us or within which leads us to believe that an unchanging
state is desirable.

Day and night, the moon and the tides, the

succession of the seasons, the very intake and exhalation of
our breath, and the expansion and contraction of our hearts -all these are immemorial symbols of life, health, and energy.
Yet too great alternations bring not life, but death; and in our
alternations in business, in employment, and in consumption we
have been perilously near the death and destruction of our social

I/hat we seek is not absolute, but relative stability.
Nor is this all.

We are not content with the present

standard of living for the mass of our fellow-citizens.


more it is right that we should be discontented, for that standard

V - 4
is lower than it needs to be in view of our natural resources
and present technical development.
can raise it still higher*

Current technical progress

There are no physical obstacles,

Y/hat the political and economic obstacles may be we will examine
in later pages*

But it is clear that, we are justified in seek-

ing an expanding stability as well as a relative stability.
Whenever, therefore, the word "stability" is used in
this section, an expanding, relative stability is to be understood*

The phrase is too clumsy for repeated use and the word

must be recognized as comprehending the phrase*

Our concern with financial policy in this part resolves itself into two phases*

The first part of our task con-

cerns the banking and monetary system itself.

In any objective

appraisal of economic instability, the banking system must
bear a considerable burden of responsibility.

In modern times,

a large proportion of our total money supply has been supplied
by the banks*

In fact, some nine out of every ten dollars em-

ployed in the general business of the country originates in
the banking system.

This supply of bank-made money shows a

tendency to wide fluctuations.

Thus in 1929, as measured by

demand deposits in all banks in the United States, it amounted
to somewhere in

the neighborhood of twenty-six billion dollars.

In 193*3, it sank to the low of around seventeen billion dollars.
The causes of this fluctuation may have been the result of
The ratio of currency to bank money or deposits has tended to
decrease. James W* Angell, "The Behavior .of Money," McGraw-Hill,
1936, Chart II.
Annual reports, Comptroller of the Currency, 1929 and 1933* These
are "unadjusted11 figures. "Adjusted" net deposits are shown on
Chart IV, page
of this book.

V - 5
business factors quite apart from any actions of the banks; but
again the possibility arises that there were strains and pressures
from the banking system which brought about, or at least exaggerated, this expansion and contraction in the supply of bankmade money.

If this be so, we have a destabilizing factor in

our economic system which should be the cause for real concern*
It is necessary to consider the ways and means by which such a
variation may, if possible, be controlled*
Or, to suggest another aspect of the problem, the boom
stages which have preceded all, or nearly all, of the serious
depressions in modern times have been periods of intense speculative activity.

The peculiar characteristic of speculation is

that it must be either building itself up or collapsing; and
collapse as we know has a blighting effect on business that may
be far removed from the immediate area of speculation•


speculation must be financed if it is to continue. Money must
be provided for the speculator if he is to speculate*

Is it

possible that our banking arrangements have been such that it
is a particularly easy matter to finance a speculation?
how can it be made less easy?

If so,

If speculation can be checked by

proper financial controls, one is disposed to think that an imIT

portant element of instability can be removed.
It would be a mistake to limit any consideration of
banking and financial mechanisms to the purely negative sphere
of a search for stabilizing elements* A depression can be
—The difficulty of drawing a sharp line between true business and
parasitical speculation should again be noted. Security exchange
transactions on a large scale are useful. A "market" is needed
by the security holder. Future purchases of grain by the miller
are, not speculative, but the reverse. They actually remove the
speculative element from his business. The markets must be kept
open. Some harmful activity will occur. But a scale large
enough to be harmful can be recognized and can be controlled*

V - 6
defined in many different ways.

One of the most useful ways to

state the problem of depressions is in terms of fluctuations in
spending —

spending both by producers and consumers.

We are

concerned with the possibilities which the banks and the banking
system may have for contributing a positive stability to this

This is a matter which has been much discussed in

recent years.

It brings us face to face with the armory of federal

reserve control —

the interest rate, open-market operations,

margin controls, reserve requirements and moral suasion.
The first stage then of our consideration of the problem of financial stability is one of considering the extent to
which we can look to Federal Reserve policy for a positive contribution to stabilized business and private spending, and thus
minimize the causes of unemployment and the necessity for expanded governmental spending.

As the second phase of our task, we must concern ourselves with the financial aspects and implications of the flexible
budget as proposed in Part I.

There we have recommended that the

government adopt as a permanent policy the taking care of the
greater part of the able unemployed in regular useful public work*
Over certain periods, we are disposed to think that this expenditure, as well as perhaps a part of normal government expenditure,
should be financed by public borrowing*
We recognize that this violates what for many decades,
even centuries, has been considered a canon of sound public

The laymen, the newspaper editor, and even the economist

have been accustomed to think that age-old maxims for the guidance
of the individual constitute a wise financial policy for the state.
In general,

these maxims center around the idea

that -going

V - 7
into debt is foolish and dangerous —

as indeed it often is. Yet

the whole structure of modern business is based on indebtedness
to banks or to security holders; and many an individual has
borrowed wisely as, for instance, to gain an education.


are, however, differences between public and private borrowing
which put them in different categories, and it is one purpose
of these chapters to bring out those differences.
Even those who have paused to consider that there may
be some difference between personal finances and the finances
of the state have observed that an unbalanced budget has frequently been a prelude to inflation.

States, for example, that

have been pressed by wartime or reconstruction expenditures have
not infrequently found it impossible to keep revenues abreast of

This has resulted in considerable increase in

price levels and, in some notable cases, in runaway inflations.
We do not consider for a moment that the state should
adopt the policy of a permanently unbalanced budget.

It does

appear, however, that it may be wise to operate at times with
an unbalanced budget and at other times with an overbalanced

So far as the danger of inflation is concerned, it can

be shown that there are very important differences between conditions of depression when we recommend that a budget be unbalanced and conditions of high production and employment when
we recommend that the budget be overbalanced.

Except in the final

stages of*the.runaway variety, inflation and a depression and
unemployment do not occur at the same time, nor has runaway inflation occurred when governmental receipts exceeded expenditures.

The second task of this section, therefore, is to

V - 8
define and explore the foregoing matters more carefully*


recognize that the financial policies which we believe should
accompany the flexible budget are ones that are not without danger•
We hope to examine with equal care both the policies and the

Chapter VI
It is desirable first of all to sketch in some of the
outlines of our money system.
factually complete.

This treatment is in no sense

It presents only those characteristics of

the monetary system and the banking processes which are necessary
for the subsequent discussion.
The business of the country is done —
and services is made —

purchase of goods

with two kinds of money.

these we call common currency.

The first of

It consists of the ordinary bills

and coins with which we are all familiar.

The second and much

more important kind of money -is that for the supply of which the
banks are responsible. It takes the form of bank deposits and in
some sense also/bank notes. The bank deposits are transferred
from one individual to another by bank checks.

However, it is

rather important to keep in mind that it is the deposit which
serves the function of money —

not the check which is actually

transferred from one owner to another.
What we have called common currency derives historically
from many sources.
precious metals —

However, its most important ancestors are the
gold and silver*

For many centuries individuals

have used these metals in the ordinary processes of consumer transactions.

At an early stage governments undertook to mint definite

weights of these metals into what we call coins.
In the evolution of common currency the gold (and in
the main also silver) coin has given way to paper money.

At one

stage paper was merely a convenient substitute, and an equivalent
amount of gold was deposited for safe-keeping by the issuing bank
or government.

However, as people became accustomed to using

paper currency, it was found that everyone did not demand gold at
the same time.

Thus, it was found possible to issue a larger

VI - 2
amount than could be covered by the gold held in reserve, and
still the exchange value of the paper money did not vary from
that of the gold coin it represented.

The gold equivalents of

the various national currencies set a practically constant exchange rate between them so long as governments gave gold freely
for the paper when demanded.

V e have here crude outlines of the

unmodified gold standard.
At the present time the government still takes gold
and gives paper money in exchange.

If the gold is to be exported,

it also takes paper money and gives gold at the same rate, at
present an ounce of gold for each $35 in paper money.


gold has now been withdrawn from domestic circulation and the
latter is made up exclusively of paper money together with a
smaller volume of subsidiary coins or change.

We have, in other

words, a modified metallic base currency against which metallic
reserves are held but without free domestic convertibility.
The second main element in our monetary system is bankcreated money.

This is by far the more important of the two

In fact, as was stated in the previous chapter, the

common currency makes up only about one-tenth of the total under
what we are accustomed to consider as normal conditions•


under modern methods of doing business, could it be much more important than this. Currency alone is wholly unadaptable to present
methods of making payments and conducting business transactions.
It is with bank money that v/e are most concerned and
we must scrutinize its generation most closely*

The fundamental

fact about bank money or its largest component, bank deposits,
is that it has originated by indebtedness largely generated in the
ordinary process of doing business.

In fact, if every bank debt —

VI - 3
private, business, and governmental —

were suddenly paid up, most

of the money supply in the country would disappear.
the banks sold their investments, the rest would go.

If, in addition,
That is to

say, bank deposits would practically disappear and only the metallic
and currency reserves would remain•

Business, it seems safe to

say, would be at a virtual standstill*
The process of generating bank deposits or bank money
is somewhat as follows: A manufacturer has an order for goods for
the making of which he has not enough money to buy the materials
and pay his workers.

In anticipation of receiving payment from

his customer, he borrows from the bank to cover his payments for
materials and pay rolls.

The bank as a part of the process of

making him the loan sets up a deposit against which he draws
checks to pay his workers and those from whom he purchases supplies*
The deposit so set up is in every sense money.

By the time he re-

ceives payment for the order, he has used up his deposit and the
payment goes to liquidate his loan.

That payment, in turn, the

merchant to whom he sold the goods may have borrowed; so that it
was a new deposit set up in a bank which he transfers to the
manufacturer, and which the manufacturer uses to liquidate his

Bank money it will be seen has financed all of these trans-

It is desirable that a clear-cut description of this
process be kept in mind through the succeeding discussion.


this reason we are including at this point a somewhat longer description of the process which has been prepared by Professor
Sumner Slichter:
"When a bank lends on a promissory note or a bill of exchange, it does not usually advance cash. It is
more convenient to both bank and borrower for the bank
"Modern Economic Society," pp. 234-7.

VI - 4
to give credit on its books in the form of a deposit account
against which the borrower can draw checks* From his
standpoint, of course, a checking account is equivalent* to cash* This custom of giving checking accounts
instead of cash for promissory notes and bills of exchange seems a trivial detail and yet probably no
practice in the conduct of modern business has more
momentous consequences.
"It creates, for example, a peculiar relationship between the deposits of a bank and its loans• The man
in the street is accustomed to think that banks lend
out their deposits, that they lend money which has
been deposited in them for safe-keeping or convenience*
To some extent, this is done, but it is more accurate
to say that banks lend in their deposits, because deposits are mainly the results instead of the sources
of loans. A bank buys a promissory note for $1,000
payable in four months. It pays $980 for it, giving
the seller a checking account for that amount. On the
asset side of the bankfs balance sheet, the item floans
and discounts1 is increased by $1,000 and on the liability side, the,it em Tdeposits1 is increased by §980. The
difference between the two is credited to fprofit and
loss*1 When the balance sheet is drawn up, the profit g
balance in this account'appears as fundivided profits*fBecause of this dependence of deposits upon loans, it
will be found on examining the balance sheets of commercial banks that, as business activity indreases or
decreases, loans and deposits rise or fall together.
Because too of this relationship between loans and deposits, a law requiring banks to maintain a minimum reserve against deposits limits the amount which banks
may lend*
"But far overshadowing all other results of the practice of giving checking accounts in exchange for promissory notes and bills of exchange, is its effect upon
the volume of currency. If banks simply lent the
money deposited in them by their customers, the extension of credit would not increase the number of dollars
in circulation. But when banks grant credit by creating
or adding to deposits subject to check, more is involved
than a transfer of dollars already in existence. New
dollars are created* Suppose, for example, that a number of banks possess a total of $1,000*000 in cash. If
every borrower insisted upon taking with him the money
which he borrowed, it would obviously be impossible for
the loans of these banks to exceed $1,000*000. But if
borrowers are willing to accept checking accounts instead of cash, the way is paved for the banks to lend
more than they possess* Assume that the banks lend
|5,000,000 giving the borrowers checking accounts for
that amount and keeping their $1,000,000 in reserve to
'Present-day bank bookkeeping modifies this process somewhat, but
the end result is the same*

VI - 5
meet demands for cash. Evidently there has been a net
increase of four million in the number of dollars* It
is true that the new dollars are not stamped out of
gold. They are credit dollars and they are created by
the stroke of the pen rather than by dies and stamping
machines, but their purchasing power is no:; less than
that of the dollars coined at the government mint* In
other words, the principal way in which dollars are
created Tn modern economic society is by borrowing.
This means that the number of dollars in existence at
any particular time depexjds upon the willingness and
ability of banks to lend*The volume of purchasing
power fluctuates with men f s state of mind; the growth
of pessimism may suddenly throw millions of men out of
work or the growth of confidence may create thousands
of jobs over nigjit.
"But by what sleight of hand is it possible for banks
to create dollars by the stroke of the pen? Let it be
repeated that it can be done only because borrowers are
willing to accept checking accounts instead of cash. But
why does this make it possible? Will not the borrowers,
by drawing checks against their accounts, quickly exhaust the bankfs funds? It is true that the borrowers
soon draw against their accounts, but their checks do
not necessarily cause the bank to lose cash. For the
recipients of the checks, in many cases, prefer a checking account in a bank to cash in their own possession.
Hence, instead of cashing the checks, they deposit
them in the bank. Every bank, therefore, is constantly
having checks drawn against it but is also receiving
from its customers checks drawn in their favor. To
illustrate how the disbursement of cash is avoided, let
us suppose that A borrows $1,000 from his bank and receives, as a result, a credit for that amount on its
books. He drav/s a check to pay a debt of §1,000 which
he owes B. B happens to have his account at the same
bank. He deposits the check which A has given him, the
bank debits A on its books for #1,000 and credits B
with the same amount. Simply by entries in the books,
A has been able to use his loan to pay his debt, and the
bank has not been compelled to advance a cent of cash.
"The process is essentially the same if A and B keep
their money in different banks. B deposits the check
in his bank which credits him with the amount and presents it to A f s bank for payment.. But A f s bank does not
necessarily give B T s bank cash for the check.
In all
probability, it has received from its depositors many
checks drawn against B f s bank. Each bank presents all
the checks which it holds against the other, and the
difference, usually a small fraction of the total, is
settled in cash."
It will be seen from the foregoing statement that loans
and consequently deposits and the volume of the purchasing medium
And of safe borrowers to borrow (R.E.F.)

VI - 6
go up and down with the volume of business, and not only with
business, as we have defined it, but with speculation as well.
The question arises when there is an unlimited demand for loans,
is there any limit to the volume of loans that

the banks may

make, thereby creating new deposits and new purchasing power?
In other words, could we have an unlimited expansion of the money
supply within the banking mechanism?
The limit is set by the legal requirement that the banks
keep a certain percentage of cash or common currency against
their deposits.

The law now requires that member banks keep the

following percentages of reserve against deposits:


Country banks
Reserve city banks



Central Reserve city banks



This is an increase over the percentages formerly required. In the beginning, these reserve requirements were conceived as a device for forcing the banks to keep enough cash on
hand to meet any conceivable demands on their deposits. V/hile
this function of the reserve still remains, its importance is
overshadowed by another consideration.

At the present time, pro-

fessional students of money and banking regard the reserves almost exclusively in their role as a limitation on the amount of
possible expansion of loans and deposits•
For the sake of completeness, it should be pointed out
that there is a class of common currency which originates in the
banking system.

This is the federal reserve note, which consti-

tutes a large" fraction of our hand-to-hand currency.
The federal
The national bank notes, now largely withdrawn from circulation,
and the Federal Reserve Bank notes also fall in this general

VI - 7
reserve note is issued by federal reserve banks and by law must
be secured by gold certificates, warehouse receipts for gold, U.S.
Government bonds, and notes rediscounted for the member banks. In
precisely the same way as the member banks must keep cash reserves
against deposits, the Federal ReserveJ^anks must keep a 40$ reserve of gold certificates against their outstanding federal reserve notes.

Owing to our enormous gold supply at the moment

of writing (October, 1937), the federal reserve banks have title
to $8,838,000,000 in gold against outstanding notes of $4,184,000,000
Bank loans, however, are not the only source of deposits —

that is, of bank money.
Banks may purchase government or private bonds or

other types of securities.

In so doing, new deposits are created

in the amount of the purchase, which normally go to some bank,
if not to the purchasing institution, and thus serve to build
up the aggregate volume of bank money•

Conversely, the selling

of investments by the bank lowers deposits and decreases the
total of bank money.
Y l e new bond issues are involved, whether governmental
or private, their purchase by the bank is of the same nature as
the ordinary bank loan previously discussed, except that the loan
is for a longer term.

If stocks or other equities are involved,

the operation diverges further from the typical loan but retains
the deposit generating feature.

In this respect the purchase

and sale of securities by a bank differs from purchase and sale
by an individual.

If an individual buys securities out of savings

or other existing funds, deposits are simply transferred from his
account to that of the seller without any increase in the total


2>et*tttne/ J> tijoit-f-s- AH



? 10




Federal (\e*>erire

VI - 8
of deposits.

If l e sells, the transfer is in the other direci

tion and again without change in total deposits.

But should he

buy on margin, the amount he borrows above his margin is, of
course, new money.
Investments tend to increase in importance and loans to
decrease as the generating basis of bank deposits.

This is par-

ticularly evident if investments and loans on securities, real
estate, etc., are compared with business loans.
•When the processes by which bank deposits are generated
are clearly seen, there is no difficulty in understanding why
they vary so much, since business varies in its activity and since
security prices vary to reflect business co^iingpi «> expectations.
The upper curve in Chart I, Demand Deposits and Velocity, shows
this variation for all member banks of the Federal Reserve System.
The unprecedented increase in deposits in the last four years has
been due to purch&sw of Government Bonds rather than to loans or
other investments, and will have our particular attention a little
The lower curve in Chart I shows the rate of turnover
of demand deposits, as distinguished from time or savings deposits.

It is arrived at by dividing the total amount of money

checked out of individual deposits in a year ( see Bank Debits,
Chart III) by the sum of the net demand deposits of the reporting
banks (see Chart IV)*,

The velocity of bank money v/ill be seen

to vary fully as much as the amount, being nearly down to
of its 1929 peak in the period from 1933 on.


James W. AnggJb, "The Behavior of Money," pp. 170, 171.


Chapter VII
As we have seen, the bank deposits with which most of our
business is done are generated by the making of loans or the purchase of investments by banks. When loans and investments increase, deposits or bank money increases.
money decreases.

When they decrease, bank

There are a number of types of loans and of in-

vestments, each with its own characteristics.

The character of the

whole structure, which is the aggregate of the characteristics of
its components, will depend upon the varying amount of each type
in that structure*
In addition to this question of the general composition,
there is the question of the quality of each element in the whole
structure —

the safety of each individual loan —

the net worth,

earning power, and future prospects of each individual investment.
While composition and quality are related, they are not quite the
same thing, as will be seen from the succeeding analysis.
Among the kinds of loans which compose the supporting
structure for bank deposits, the following are the most important.
1. The financing of current production and distribution
by short term paper.
of bank loan.

This is the traditional and orthodox foxm

It involves borrowing for seasonal requirements

or for large orders, when these make necessary a temporary expansion in working capital.

It may be applied to agriculture,

manufacturing, or merchandizing.

It is subject to abuse as when

used for the financing of unwisely swollen inventories.
types of business —

as for instance general contracting, and

the warehousing and merchandizing of seasonal commodities
make a large use of credit for this purpose.



On the whole,

VII - 2
however, the tendency of late years has been for substantial
businesses to increase their working capital from earnings and
to carry idle balances in slack seasons instead of borrowing during the busy season.

This has diminished the importance of this

conventional source of de&$§its.

It still remains an important

element in agriculture.
2* The financing of a permanent expansion of working

It has usually been considered good financial practice

for a firm to provide for its working capital either from operations or from an issue of securities.

This principle has been

at times more respected in the breach than in the observance, and
a certain volume of bank loans outstanding at any time provides
long period working capital for business enterprises*
3. The finane ing of fixed capital.

Like the preceding

class, this is also frowned upon by orthodox banking theory except where temporary pre-financing of large projects is involved.
This sort of loan on an' unsecured, short term basis with repeated
renewals, is considered unsuitable as an asset for the ordinary
commercial, bank with its high liquidity requirements.

The pur-

chase of marketable bonds as an investment is in a different

The financing of securities purchased on margin.

This involves the loaning of funds against stock market collateral
for the purchase of the securities which are posted as collateral.
So far as the individual bank is concerned, this is a safe and at
times remunerative way of extending credit. As will be noted
presently, there are reasons for believing that it seriously impairs the stability of th£ whole economy.

This is a case in

which the quality of every individual loan may be safeguarded

VII - 3
while the price and volume of the total collateral of this sort
in the whole banking structure may be highly dangerous.


illustrates the difference between composition and quality.
This case has other important aspects as well.

If the

loan is for the purchase of a newly issued security whose proceeds are applied to capital expenditure, it constitutes and indirect but real application of credit and new deposits to capital,
and so is classified under type 2 or 3.

As it is bought and sold

it so remains until some purchaser, out of savings or existing deposits, retires the amount of the original loan.

Any remaining

loan, based on an enhanced market value, retains the characteristics
of type 4.
5. The financing of consumer purchases.

In recent

decades a considerable volume of bank credit has been employed
in the financing of consumer installment purchases including,
besides' houses,, a considerable volume of other durable consumer1 s

This may be done by loans to the buyer, to the seller,

or to specialized finance companies.

If our economy can be so

stabilized that this component can be kept stable also, if the
amount borrowed by the individual does not exceed a reasonable
fraction of his income, if the terms do not add unreasonably to
the cost of the goods purchased, and if the installments are arranged to liquidate the loan well within the useful life of the
goods purchased —

then this component can be a very useful part

of the credit structure, perhaps making up for the diminishing
volume of short-term paper.

Experience has shown its quality to

be high.
6. Indirect government financing.

Iii the financing

of the World War, the banks of the country made loans on the
notes of individuals who were willing to apply the funds thus

VII - 4
generated to the purchase of government securities.

By this

devious route many billions of dollars of new deposits of purchasing power were placed at the disposal of the government for the
conduct of the war.

For certain reasons this resulted in inflation

and serious attendant ills which will be described later.
7. Direct government financing.
being carried out on a large scale*

This is a process now

The banks purchase bonds or

short-term paper from the government and give the government a
checking account in return.

This is a shorter and more direct

process than the one described above and has been used in recent
years on a scale comparable to that of war-time financing.
The last two cases are on the border-line between loans
and investment.

In the case of indirect financing the paper ac-

quired would show as an asset under the item of loans. For direct
government financing the paper acquired would be listed under investments.

Yet their effects as components of the deposit struc-

ture j s practically identical.

A main purpose of this whole dis-

cussion is to examine the usefulness and danger of credit extended
to the government, whether directly or indirectly.
While government financing, direct or indirect, constitutes
a particular component of the credit structure with characteristics
of its own, it may be applied to activities served by other components*
It may go into commercial credit for financing agriculture through the
Federal Land Bank.

It may go into real estate or equipment loans

through the Federal Housing Administration. It may appear as a capital
loan through the Public Works Administration. There are many ways in
which the new deposits are put to work in the fields of other components of the credit structure•
There are still other forms of credit, but of no great importance in their total volume, such as personal, two-name, or secured*
Jtaiong the kinds of investments whose purchase expands the
volume of deposits are the following:

VII - 5
8. Bonds of federal, state, and local governments. Besides
financing governmental expenditures by direct or indirect purchase
of new issues, it is possible to expand deposits by the purchase in
the open markets of existing issues.

In effect, the purchasing bank

opens a deposit account for the seller, thus balancing its new
asset with a corresponding liability. The deposit may find its way
into another bank with which the seller does business, but in either
or any event the total volume of deposits is increased. Federal bonds
notably, most state bonds, and many local bonds are highly liquid
and comparatively stable in value.

Their yield is, of course, cor-

respondingly low. V/hen open market purchases are made by the Federal
Reserve banks a different and most important result takes place. The
resulting deposit by the seller i i his bank is in the form of a
credit on the Federal Reserve Bank v/hich increases the member bank's
reserves, increases the deposits it is entitled to accept or to
generate by loans or investments, and thus raises the limit for expanding the volume of bank money.
9. Industrial and railroad bonds, preferred stocks, etc.
The purchase of new issued by the banks is a direct application of
bank credit to capital expenditure.

Similar purchase of old issues

in the market is an expansion of bank deposits for whatever purpose
the seller may elect. These assets are usually liquid at some figure,
but, of course, not always at the purchase price.

In a period of

severe liquidation they are liable to join the .group of frozen assets.
10. Real Estate mortgages. Under prudent management this
is a safe, but not necessarily liquid, investment.
of inflation the market for real estate, even at

After periods

prices, becomes stagnant, and the underlying mortgages depreciate.*
The inflation of real estate values in a speculative market is
financed in part by mortgages based on unjustified values, and in

part on loans

made on other collateral.

In states and institutions

VII - 6
where it is not illegal, there is even a large volume of second
and third mortgages talc en by banks.

In a period of general liquida-

tion this type of security becomes a principal component of the
body of frozen assets.
11* Foreign Bonds. A proper extension of credit where
assurance of repayment is given.

The funds realized are not

ordinarily transferred to the borrowing country.

Instead, the

resulting deposits are applied to the production of goods for export abroad.

Unless provision is made for a counterbalancing

import of goods, services, or gold, the bonds depreciate in value
and become frozen assets.
There are many other types of investment on which deposits are based, but these are the most important.

Their pur-

chase by banks expands deposits; their sale to private holders
decreases deposits.

We now have at hand most of the important elements of
the problem of progressively stable production and distribution of
goods and rendering of services, and of the provision of deposits
or purchasing power for maintaining that flow of business.
must, however, add at least one more item —


the general price level*

The general price level is an abstraction, but it is
a useful t>ne. Price levels are usually expressed as "price indexes" which may roughly be described as an average price for
the commodities and services for which they are calculated. Chart
II shov/s two examples.

One is a price index of the


cost of living, including all the usual necessary family expenses.

The other is an average by statistical processes of the

prices of the principal commodities entering into the wholesale

VII - 7

This includes such divergent elements as sugar, iron,

leather, and cotton*

Attempts have been made to devise an in-

clusive price index, which would combine rents, security prices,
and other financial factors, as well as goods and services.
The volume of goods made and distributed and the volume
of services rendered is the thing which we wish to increase and

Indexes for this volume are also made by statisticians,

and one of them (the index of General Trade and Production of the
New York Federal Reserve Bank) is also shown in Chart II.


properly devised and constructed such an index should show the
general state of prosperity of the people of the country, allowing for variations of distribution between localities, classes,
and individuals.
Furthermore, an inclusive price in&ex, multiplied by
an inclusive index of volume of business activity ought to be
an index of the rate of spending, and should, therefore, follow
the variations in the rate at which checks are drawn on bank

Since check transactions constitute the most important

method of payment, with the much smaller cash payments roughly
following them in volume, the curves for bank debits in Chart III
indicate the current rate of spending.
All this may be put in the- following form:
The volume of trade activity times the inclusive price
index equals the rate of spending of which bank debits is a reliable indicator.

If P is the price index, and T the volume of

trade, we may put this in the concise form, PT - rate of spending
%s indicated by bank debits.
Now the rate of spending can also be described in money
terms, as well as in terms of volume of trade and prices.


VII - 8
rate of spending is also the amount of money multiplied by its
rate of turnover, the latter being the average number of times
that each dollar is used in the course of a year.

Using net

demand deposits as a measure of the volume of money, this may be
stated as follows:
The volume of deposits times its rate of turnover or
velocity equals the volume of bank debits, which is an indication
of the rate of spending.

If M is the amount of deposit money,

and V is its velocity, then MV = bank debits and indicates rate
of spending.
If M includes currency as well as deposits, and V is
the average velocity of both combined, then MV is* the rate of

But so was PT*


This is an elementary formula in monetary theory, which
we v/ill find to be valuable if not used too mechanically.
use we will try to avoid.


One aspect of this formula is that

it reveals the intimate connection between business and money.

Volume of trade and the price level are then the important elements on the business side; and amount and velocity of
money on the financial side.

But something more than the mere

physical volume of business transactions needs to be considered
before we can accept T as a measure of the well-being
the nation.

Of what kind are these transactions?


Do they

consist in the useful production and distribution of desired
goods and the rendering of desired services, or do they consist merely in the rapid passing from hand to hand of titles to
securities, commodities, and real estate in ways which do


]TII - 9
contribute to the flow of goods and services into consumption.


a word, we are interested in the composition of trade at any given
We have an indicator of the composition of trade aside
from detailed trade statistics*

As might be expected from the

intimate relationship between business and money, it is found in
the composition of the sources of bank deposits, which was examined
earlier in this chapter*

When the speculative and other purely

financial components of loans and investments are high, the nonconsumable elements in the total volume of spending are also high,
and bank debits —

or the rate of spending —

is not a reliable

index of the general welfare.
Likewise, as" we shall see, when the quality of loans
and investments is low, the maintenance of the volume of deposits
and therefore of the rate of spending is threatened with collapse.
To sum up these matters, we may say that the desideratum
is large and increasing flow of goods and services to consumers.
The necessary business elements in this flow are volume and composition of trade and the general price leve.

The necessary

elements in deposits or purchasing power are the volume, composition, quality and velocity of money, which for most practical purposes means of bank deposits.
We will next proceed to see how these various elements
are affected by the business cycle.

Chapter VIII
The terra "business cycle" is an inclusive one which
covers raany kinds of fluctuations in business activity and, consequently, in the volume of spending which is made for producers1
and consumers* goods.

In our view there is no one reason wjiy

business oscillates from good times to bad.

It is quite pos-

sible that the reasons for two successive oscillations may be
very different.

In fact, it seems likely that they will be.

Therefore, we have no intention of setting forth here a conclusive theory of the business cycle.

It is beyond the scope of

this work to attempt to bring together all of the different explanations of business fluctuations, much less assign to each
a specific weight as causes of variations in activity*
However, the problems with which we are dealing are
problems which are given point by the existence of business

We cannot discuss the problem of financial stabil-

ity, for example, without knowing the points of contact between
monetary or banking policy and the consequences of boom and depression in business.

Therefore, it is the purpose of this chap-

ter to canvass some of the factors which combine to produce
fluctuations in business spending so that we can relate to them
the changes and improvement in financial mechanism which we are
We will consider in turn some of the business, governmental, and speculative elements which initiate or aggravate the
fluctuations in production, spending, consumption, and enjoyment
which we call the "business cycle." At the same time we will
examine the attending monetary phenomena.

The business element

is itself subdivided into agriculture on the one hand and in

VIII - 2
dustry and trade on the other.
As the great basis of business, agriculture is a major
factor in general business prosperity.

When farmers are prosperous

they are good purchasers so that industry and trade tend to flourish

When farmers are impoverished the market for industrial goal s

diminishes and trade slows down.

But the relationship between the

two great branches of business is a reciprocal one; for if influences outside agriculture increase or diminish the activity of
industry and trade, the farmers1 markets are expanded or diminished
Agriculture is nevertheless one initiator of business instability, and the weather is the great unstabilizer.

Y/hen weather

is favorable, there may be such a surplus of crops that the market
price for the farmer is below the cost of production.

At the

other extreme, severe drought may destroy his crops and leave him
without income.

The happier conditions of ample crops and profitable

prices also occurs.
With crops whose prices are made in world markets it may
happen that crop failures and high prices abroad may accompany a
bumper crop here.

The business recession in 1924 in the United

States apparently was checked by just such a coincidence.
Agricultural prosperity depends less on man-made conditions-*
such as the amount of working capital invested in the season's operations —

and more on conditions beyond human control —

such as the

There is, therefore, less primary correspondence with loans,

investments, and deposits than is the case with other human activities.

A large secondary effect results, of course, from the impor-

tance of farmers as consumers —

a point which already has been men-

VIII - 3
Industry, transportation, and trade represent the other
branch 9f productive business.

Here are found certain other in-

stabilities, not due to natural phenomena like the weather, but due
to certain enduring traits of human nature.

Examples are to be

found in housing, the automobile industry, the size of inventories
carried by businesses under different conditions, and in the demand
for capital goods•
For instance, the construction of residences does not normally proceed at an even pace.

If we grant the existence of some

cyclical variation to begin with, the individual who is experiencing
an improving income will first take care of any pressing personal
needs of himself and his family*

He will provide more expensive

food and will replenish his depleted wardrobe.

He will replace a

shabby automobile and will begin buying new household furniture* If
his favorable income situation continues and if the foregoing needs
are fairly well satisfied, he will begin to think about better housing*
He will either start looking for a larger apartment, in which case
his requirements added to those of his fellow-beings will lead to a
rising level of rents and a consequent revival of apartment-house
building; or, if otherwise situated, he will start planning for a
house of his own.

Since much of this house building is brought about

because a considerable proportion of the population is similarly circumstanced, the. period of large-scale house construction will tend
to be compressed within one particular range of time*
If, by the time this body of construction is well along,
there chances to be a business recession in other areas, there
will be a check to new contracts*

Upon the completion of

existing contracts, the housing industry will also recede and
will add force to the recession elsewhere in progress*
much the same thing would be true even if




VIII - 4
activity did continue.

The first period of revival in residential

construction is concerned with making up an accumulated deficiency*
After that deficiency is made up, the matter of normal requirements for obsolescence and population growth causes building to
proceed at the lower rate.

The total volume of building activity

thus tends to decrease absolutely.

This tendency to waves we

may call a-1"natural instability," and we must not expect that it
will be easily counterbalanced.
Another factor to which it seems possible to assign a
position of ©offl&^importance is the movement in inventories. Again
granting that some initial disturbance forces businesses to decrease inventories, this decrease must be conceded to have an
important influence in decreasing production.

Thus, an effort by

wholesalers and retailers, for example, to cut inventories by
10$ may be reflected back to the manufacturer in the form of a
vastly greater percentage cut in orders.

Likewise, on the upswing,

efforts to replace depleted inventories may be magnified several
times before reaching the manufacturer.

The business income paid

out by the manufacturer is subject to a like magnification.


is of importance to our problem that both the unavoidable pressure
to decrease inventories and the financial provision for increase
in inventories may come from the banking system^*
The production of capital goods in general —

such as

factories, machinery and equipment «—• is subject to large natural

Capital goods do not have to be made and installed

at an even rate year in and year out.

As depreciation grows and

obsolescence appears, buildings, machinery, and equipment are replaced if "times are good*"
they are.

If times are not good, we wait until

Thus periods of business depression are accentuated

VIII - 5
by the near-stoppage of the capital goods industries, while
periods of business activity are accentuated by the feverish attempt to make up for lost time in replacing buildings, machinery,
and equipment. &***t


Much the same condition of feast and famine occurs in
the durable consumer goods industries, such as automobiles and

Anything whose purchase can be deferred adds its un-

balance to the swing of the business pendulum.

Only the goods

currently consumed, like food, clothing, and fuel, add to the
stability of the business mechanism.
A number of these points are well summed up in a letter
recently received by the author from Dr. J. Frederic Dewhurst of
the Twentieth Century Fund. He says:
It seems to me that capital goods and inventory together, explain the sensitivity of our capitalistic
system. It is the entrepreneur rather than the consumer who is unstable in his buying habits. He is
essentially a speculative buyer in the sense that
the volume of his buying is affected very largely
by his expectation of the future trend of prices. If,
as during the past year, he foresees a substantial
rise in the prices for raw materials, he buys far in
advance of current needs and if he gets panicky after
accumulating large stocks, he uses what he has without replenishing them. *
"Thus, we have an economic system in which agricultural
producers at one end go on producing whether prices
are high or low since they are constantly under the
pressure of overhead cost represented by their own
time and idle acres. At the other end, the consumer
goes along buying pretty steadily, unthinking of future
price changes until his own income has been affected#
In between are the producers and fabricators whose buying policies reflect not a steady purchase fabrication,
and resale in accordance with consumer demand, but a
sort of reservoir which is constantly being filled up
at a more rapid rate than it is being emptied, or is
being emptied more rapidly than is is being filled*
Consequently, it has a far more drastic effect on the
functioning of the rest of the system than any other

This passage well describes the sensitive elements in

VIII - 6
The variations of international trade have wide-spread

A development of particular importance was the attempt

in the 1920*s continuously to export more than we received in goods
and services.

Such a permanent excess of exports could only be

bought on credit, and in consequence we loaned hundreds of millions
to foreign countries to support our export trade.

Since we were

unwilling to accept imports and there was not gold or international
services enough to settle the balance, there was no way provided
to pay these debts.

In consequence the bond values collapsed,

thus helping on the general debacle in 1929 and 1930.

Of course,

we did not actually export money under these conditions. V e
shipped goods without assuring ourselves of the means of payment.
These variations and maladjustments in business are
reflected in the corresponding loan and investment operations by
which they are financed.

The composition of business is reflected

in the composition of deposits.

In the following summary the

various monetary components are numbered to agree with the list
given on pages VII - 1 to - 6,
Housing variations are reflected in construction loans
(1) and mortgages (2), Automobile sales and consumer credit (5)
tend to rise and fall togehter.

An undue expansion of inventories

is reflected in short-term loans (1 and 2) made for the purpose.
The purchase of capital goods is financed by short-term loans (3)
stock margin loans for new issues (4) and the purchase of securities by the banks (9), where the funds are not provided in

VIII - 7
the normal way out of the savings of firms and individuals.


international trade overbalanced on the export side is financed
for a creditor country by the sale of foreign bonds and other
securities (11)•

Besides the maladjustments in business, there are others
due to the operations of government which have most serious effects
on business stability and the personal well-being of its citizens.
Perhaps the most disastrous is war, with its attendant financing,
When a nation resolutely sets out to wage war, it is not long
before the whole structure of agriculture, industry, and trade is
reorganized to this end.

The demand for some crops becomes limit-

less; other crops can scarcely find a market.

Some industries

are expanded to the limit of available labor, material, and equips
ment; others are closed down or-changed to furnish new products.
Millions of men are withdrawn from agriculture and industry for
service in the army, and other millions of boys, old men, women,


unemployablesM are set to work producing the materials of war.
The resoux^ces of government finance (6, 7, and 8) pro-

vide unlimited funds.

The needs of the army provide an unlimited

Workers and equipment are limited.

These are the con-

ditions under which a price inflation is bound to develop, and
develop it does.

The price rise occurs not merely in war materials,

but in consumer goods as well; for the workers on v;ar materials
are well paid, while the volume of consumer goods they wish to
purchase has been decreased by diversion of productive activity
toward war.

This condition of large earnings and small supply

of goods to be bought starts the pyramiding of prices which continues so long as war financing and war production continue•

VIII - 8
Vflien the war ends, the conditions disappear*

There is no flood

of new deposits from war financing; there is an ample labor and
equipment supply, and prices tumble•

The war boom is over,

A similar maladjustment can occur from large peace-time
expenditures by the government*

Should limitless

funds be pro-

vided by governmental financing (6, 7, and 8) for peace-time
governmental work, and should the funds and work be ample enough
to absorb available labor and bid up wages, there would be the
same application of expanded purchasing power to a market whose
supply of goods and services was kept at a/.low level by the maintenance of business activity in governmental operations of the type
we are proposing for the Flexible Budget,

This is a fair description

of the mechanism of the German inflation, for instance, except that
fiat money instead of fiat credit was the financing means.
should not be difficult for us
/ o avoid a similar catastrophe*

Tfa It

On top of these business and governmental activities,
wise and unwise, there always exists the possibility of speculation

In times past speculation has become rife whenever other

maladjustments operate to furnish a foundation for optimism, however flimsy*

Indeed speculation sometimes seems to need no

cause or foundation whatever, appearing to spring full-fledged
from the ashes of its most recent holocaust*
In practically no recorded instance has there been an
extended boom period without serious speculative activity of
some sort.

The speculation may occur at different times in dif-

ferent places —- sometimes in commodities, sometimes in real estate, sometimes in securities, and sometimes in all three.


VIII - 9
is true, of course, that there are localized examples of speculation to be found at almost all times, borne of these, such as
the Florida land boom in 19S6, do not coincide with a major boom
movement generally; but whenever we- have had a major boom followed by a major collapse, a major speculative movement of some
sort has always been involved.

In 1920 the speculation occurred

in inventories and commodities generally.

In the period ending

in 1929, the securities market and urban real estate were the
important areas of speculation.
Speculation is in many respects a logical result of
the inarch of events which leads a recovery period into a boom

Gains are being taken in inventories with advancing

prices, shortages are developing, and a class of buyers enters
to take advantage of the price increases.

It is a fair general-

ization that any speculative increase in prices must be followed
by a collapse.
However, we are not so much concerned with the mechanics
of the speculative movement as we are with the fact that speculation must be financed.

Speculations are financed with particular

ease under our economic system because of the possibility of
creating bank deposits from which the funds are provided.


the spell of optimism which drives forward a speculative market,
thousands of individuals borrow money to purchase commodities,
real estate, securities or the other subjects of speculation.
The security and commodity markets being organized for quick
sale, the security from the bank's point of view is excellent
and banks are as willing to loan as borrowers are to borrow.
Something of the same sort of thing is true of real estate while

VIII - 10
the market is active, although a conservative banker is likely
to be somewhat more cautious in this. area.

This same borrowing

is accompanied by the setting up of the bank deposits which are
the means by which the speculation is financed.

In other words,

we have a banking system which operates to facilitate speculative
A vicious circle is here in operation.

First stock

prices go up and provide a larger base for borrowing so that
more money can be spent for securities, which forces their prices
still higher.

Thus the boom is self-generating.

A study of the collapse ofIthe boom and of the speculation which accompanies it is almost equally instructive.


when it became evident in 1929 that baseless optimism had driven
prices and real estate development higher than could be justified by earnings prospects over a long period of years, the collapse
of the market forced the banks to protect their loans by selling
the underlying collateral.

The very act of selling securities or

real estate to protect underlying loans depresses the market. This
requires that still more holdings be liquidated, that there be
further sales and a further collapse in prices.

Thus, in the same

way that the banks provide the facilities for an expansion for the
promotion of a speculative flurry, so they also are forced to apply
the pressure for its contraction; and all past history teaches that
a broad speculative collapse shortly contaminates productive business.

The two are too closely intertwined to be separated, both in

the monetary field and in personal relationships.
The point which this presentation seeks to make is
this —

that in the mechanism for the generation and retirement

of bank deposits as at present operating, we have a mechanism
which tremendously intensifies the variations in speculative
expansion and contraction.


might be normal and healthy

VIII - 11
business variations are magnified into waves of such violence that
they endanger the fabric of society.

As Professor Slichter has

said, "Indeed, if we were living in a cash economy and desired
for some strange reason to make that economy highly susceptible
to violent fluctuations, we could scarcely do better than to invent the present credit system,'t^
^Commodity speculation cannot be carried on without collateral and general loans (1 and 2).

Real estate speculation cannot

be carried on without mortgages (10), Security speculation requires margin loans (4) and other collateral notes.

The initiation

and progress of a speculative market can be observed directly if
we wish, or it can be followed by a study of the composition and
quality of the banking operations which support it.
Such a study of the supporting credit for speculation,
and for other maladjustments as well, should do more than keep
us informed of current conditions.

If we can develop the tech-

nique for the purpose, this study should furnish a clue to control as well, for control of credit is a powerful means of control of the activities for whose sake the credit was generated.

But before we proceed to the subject of credit control,
and intervening point should be cleared up.

In our list of

natural business instabilities which are elements in the business
cycle, prominence was given to the wide fluctuations in the
capital goods industries.

We must make clear that this prominence

is not necessarily an endorsement of the theory that depressions
are caused by over-saving or over-investment.

See "TowardsStability," pp. 23.

VIII- 12
A wide variety of explanations both of cyclical movements and of the intensification of the cycle hinges on the view
that there is an improper distribution of income.

It is believed

by many, for instance, that a period of prosperity is brought to
a destructive crisis by the condition of-an undue volume of
profits as compared to wage and minor salary distributions*
arguments here vary*


One is that while the total volume of wages,

salaries, rents, interest, dividends, and undistributed profits
is admittedly great enough to purchase the goods produced, yet
too large a part goes in the form of profits and salaries into
the hands of those who have sufficient consumable goods and are
only interested in investing in the hope of further profits.
This presumably results in an excessive production of new factories
and capital equipment, and an increasing difficulty in selling
the goods which are produced by these factories*

A consequent

cessation of capital construction may choke off payments which
are flowing through to consumers by this route and lead to a
destructive collapse.

A variant of this argument is that not all

of the income going to the higher bracket recipients is invested
or spent for goods or services in any form, and that consequently
payments to consumers are insufficient to buy back the volume of
consumables produced.

This v/ould seem to be true where income

is hoarded, or is kept in idle bank balances, or is applied to
security inflation.
But this leaves out a most important consideration.
The expanded investment of. the boom period is by no means derived
exclusively from achieved income or existing deposits in the first instance.

The facilities of bank credit make available for in-

vestment sums enormously greater under boom conditions than those

VIII - 13
immediately available from existing deposits.

To these sunis must

be added the immense deposits generated by direct bank investments
(see component 9),

Until we have some better measure and under-

standing oil these processes it will be difficult to say whether
present rates of profit from normal business operations are or
are not sufficient for the optimum rate of investment.
There is quite evidently some theoretical optimum in
the division of . . h returns from industry between the stream
which goes on the one hand to consumers and that stream which,
on the other hand, goes to savers and investors.

The consumer

stream cannot be too great in proportion to the total or the demand for goods will tend to exceed the productive capacity*
Prices will rise and production will be expanded only against
the pressure of interest rates.

On the other hand, the funds

seeking investment may be so large as to produce some variant
of the conditions described above.
But if oversaving is to be held responsible for some
part of business fluctuations, it is none the less important to

&**«%.& Ur&&C Ajt*3fa*<As ffer*~ jz^n--1^




recognize that our economic system does require a large and growing volume of savings.

The volume of savings must be great

enough to equip society for a growing population.

"While the rate

of growth is decreasing, the population is still growing and
will continue to grow for some decades to come.
calls for some expansion in equipment.

This in itself

Furthermore, there must

be enough saving to equip a rising standard of living; that is to
say, there must be new and increased facilities for a larger volume
of goods and services made and distributed to people; an increase
in consumer buying requires anv increase in investment also.


part of this rising standard of living, provision must be made

VIII - 14
for shorter hours, if shorter hours are to be an element in our
social objective.

This requires increased provision of improved

labor-saving equipment as well as simply adding new equipment*
Likewise the day shift must be provided for, unless night work is
to be considered a desirable element of the more abundant life.
To reduce working hours to the day shift will make necessary a
larger supply of machinery,

equipment, and facilities than is

required by two- or three-shift operation.

Finally there must

be enough saving to finance the research and experimentation
which will insure progress toward new products, better products,
higher efficiency and shorter hours.
In view of the impressive requirements for saving in
our society it appears clear that we must not risk too.-Sharp a
curtailment of the supply.

There are indeed some evidences that

the profit; from true "business" in our sense is no more than
sufficient for the needs outlined above.

The Census of Manu-

factures of the Department of Commerce indicates that in the
manufacturing industries as a whole the profits on invested
capital scarcely exceed 5 percent, year in and year out.
years they are much less, some years, much more.


Some individual

companies have much greater returns; others suffer losses for
many successive years.

But this is the average profit from which

the needs for capital must largely be satisfied.
it the amount does not seem unduly large.

On the face of

These figures, of

course, exclude the winnings of speculation and other parasitical
elements in the social order.

It is the profits of tine business

vtfiich do not seem unduly letrge for the needs of society, and
until some conclusive evidence to the contrary is presented,

VIII - 15
the writer of this section cannot recoiumend policies directly or
indirectly based on the oversaving and overinvestment theories.
In calling attention to the fact that a large proportion of the sums available for investment are not provided in
the first instance by savings from profits or other existing
deposits, we are not saying that investments in capital goods can
ultimately be made without savings.

Modern economic theory is

much concerned with the relation between saving and investment,
and by a somewhat abstruse course of reasoning .tends to the belief that saving and investment are simultaneous; and this saving
under many conditions becomes a "forced saving^,*1 made necessary
by the investment, especially when financed on bank credit under
boom conditions*
May it not be that voluntary saving of receipts from
true business is no greater than is needed to serve society?


it not be that the winnings of business parasites and the forced
saving drawn from us by the application of credit to investment
are the real evils in the whole situation?

If so, credit control

is our first duty, rather than experimentation with the detailed
control of business or the radical reduction of true business


Chapter IX
The objectives which we seek, in the arrangement of the
financial side of our economic system are fairly clear and there
is also a good deal of agreement as to what they are. As in the
case of the other measures suggested in this document, our aim is
toward a condition of stable employment, production, consumption,
and enjoyment, with provision for expansion.

The controversy

in financial policy arises not over the ultimate objectives but
over the criteria by which we judge whether or not these objectives are being served.

It is the task of this chapter to

examine some of these criteria and to see whether or not they
are satisfactory as guides in financial policy.
In recent times at least, the most common criterion set
up for financial policy, is the maintenance of a stable price
level which, for most champions of this policy, means the wholesale price level.

A considerable group, no doubt, has looked

upon the stable price level as an end in itself.

But even many

who have not, have argued that if prices generally could be
stabilized, then production and employment would likewise be

In consequence, they conclude that it is the task

of the government and of the Federal Reserve system to concentrate
its attention on keeping prices stable.
Taking a long view of the course of prices and of business activity over the last century, it is true that periods of
stable or rising prices have been periods of good employment,
a high level of production, and of general prosperity.

It is

likewise true that depressions have usually accompanied periods
of falling prices.

It is this broad, statistically observed,






0-f LlVH


* Federal


(hank of /Yew



IX - 2
relation which has given most support to those who argue that if
prices are stabilized, then other things will be stable as well*
However, stable prices as a criterion of financial policy do not stand close examination.

In the first place, it ap-

pears that falling prices on a wide front are in their first
appearance a sympton rather than a cause of instability, and
that the symptom appears after the instability is well established.

A recent example of this is the collapse of 1929.


dustrial production had begun to slow down some months before
prices broke into a rapid decline.

Any policy which awaited

the falling prices would have been too, late.
Moreover price movements are illusory.

For example,

there was a long slow drop in the general commodity price level
from 1925 on.

This on the simple quantity theory of money would

have indicated the necessity for a continuous expansion of credit
and deposits during that period to counterbalance the drop. But
& large-scale expansion of the velocity of deposits was in fact
getting under way.

This expansion was of sufficient magnitude

and occurred in such kinds of credit that it ultimately contributed to disaster.
indication of this.

The wholesale price level gave little

These points are brought out by Chart II

where the slow decline in the price level from 1926 on is compared
with the New York Federal Reserve Bank's

index of the physical

volume of production and trade„
It may be urged that if the index employed for the
period from 1925 on had included prices of real estate and
securities, it would have given warning in time to bring desirable action.

But this actually

leads to another reason for

This is not to be sought for in Index of General Trade and Production in Chart II, where retail and wholesale^ trade^, transportation and many other elements are included-in addition to

IX - 3
distrusting the price level as a criterion of financial policy.
The price level is not a single uniform honogeneous thing.

It is

made up of *the px^ices of many different things which respond differently to different conditions.

Some elements respond quickly

and violently and others more sluggishly.

Some may even move in

a direction opposite to the general course.

Consequently, to

watch a general index of prices may be to neglect important


locations which may be occurring in the component parts of that

But when attention is given to movements in all of the

component parts, then, of course, the idea of general stability in
price level is abandoned.

As an indication of the varied behavior

of price indexes of varied construction, the cost of living index
in Chart II may be compared with that for wholesale prices.
We are disposed to think that if financial policy is
successful, the result will be a considerable degree of stability
in various classes of prices; or, as a long-time result, perhaps
an imperceptibly rising price level may be desirable, which would
exert a constant mild stimulation on business.

But it is worth

emphasizing that we look upon a stable or gently rising price
level largely as a long-time result and not as an immediately
operable cause of stability.

Another, and in some respects an even simpler criterion
of financial policy, is the variation in foreign exchange rates.
To say almost the same thing, to be controlled by this criterion
means so arranging monetary and banking policy as to maintain the
gold standard.

From the point of view of the orderly develop-

ment of international trade and a stable and secure environment
for international lending and borrowing,

no one

would deny

IX - 4
the advantages of stable exchanges.

In a generally peaceful

world, the gold standard has operated as the most effective mechanism of international exchange which has yet been devised and
put into practice*
However, we do not endorse the gold standard or stable
foreign exchanges as the central purpose of financial policy*
Successfully to achieve this objective, there are times when we
must be willing to sacrifice internal stability to this end.


particular, if a rigid gold standard is to be maintained, its
very maintenance requires that there be fluctuation in domestic
prices and incomes to keep the various countries in the gold
standard community in equilibrium*

During the late 1920^3

England was unwilling to undergo the deflation necessary to maintain the gold standard.

During the same period, we in the

United States were unwilling to have the increase in prices which
our huge gold stock implied and which maintenance of the international gold standard demanded.

It seems doubtful if in the

future we will be more willing to sacrifice domestic policy for
the gold standard; and considering the relative importance of
internal and external trade, it is even more doubtful if we would
be wise to do so*
All this does not deny the usefulness of the gold

It can be left and returned to, and any

conception of it recognizes this fact*


Its good qualities are

When economic conditions are healthy, it is the best system

we know of for handling foreign exchange*

When conditions are

such that continued adherence to it would produce social hardship, this is a sure indication of internal or external disorders
which need to be remedied*

IX - 5
Within recent years international trade has shown some
ability to accommodate itself to considerable exchange movements.
Or, to put the matter in a slightly different way, it seems likely
that a sufficient measure of stability of the international exchanges can be obtained to permit international trade to be pursued on a practical basis while at the same time there is little
sacrifice of domestic objectives.

Within the last year some

progress has been made along the lihes of just such a policy as
At certain times, it has been suggested that the rate
of interest is a desirable criterion for Federal Reserve and
national monetary policy, with a stable rate as the objective.
It is difficult, however, to see how the interest rate could be
anything but a means to some further end.

As .we shall see in

the next chapter, the ends which we would consider desirable
seem to be best achieved through positive movements in the interest rate, as well as by other means.
Within recent times a number of students have suggested
the volume of money as a criterion of financial policy, and a
stable volume as an immediate but not ultimate objective.

By a

stable volume of money is meant a stable volume of both hand-tohand or common currency and bank deposits combined, as measured
on a per capita basis.

The view that a very slowly growing

volume of money would be a useful objective arises from the
view that the changes which now occur in the money supply
through the mechanism of bank credit expansion and contraction
have much to do with intensifying business fluctuation.


not agreeing completely with all the proposals of this sort which

IX - 6
have been set forth, we are inclined to concur in this as a
broad principle, though with important reservations relating to
the importance of velocity, as will later be set forth*
Of the various aspects of the monetary problem central
banking policy is most effective in controlling the volume of
currency and bank credit in circulation.

It is not a new idea

as a primary criterion for Federal Reserve control*

It was sub-

stantially that followed by Governor Strong and Dr. Carl Snyder
during the period when Governor Strong was very influential in
the Federal Reserve System —, roughly, between 1924 and

the first half of 1928. Had the net demand deposit curve in
Fig. 2 been carried back four or five years earlier, it would
have shown that this was a period of nearly stationary volume of

It was also a period of stable commodity price level

although a stationary price level was not the end directly

We thus have evidence tending to substantiate the state-

ments previously made as to the price level being a possible result of effective central bank management, even if it is not
the immediate aim.
Another proponent of the volume-of-credit criterion
is Dr. Lionel Edie, who has explained the idea at length.
Another writer who has recently called attention to volume


a criterion, though not the sole criterion, is Dr. Laughlin


now in a responsible position on the staff of the Board

of Governors of the Federal Reserve System in Washington.
These three authorities do not necessarily agree in

"The Banks and Prosperity.n

This book unfortunately is out of

The Supply and Control of Money in the United States," Harvard

IX - 7
other respects or in all the details of this particular subject,
They differ, among other things, with respect to the method by
which they would measure the volume of credit outstanding.

The conclusion from this brief survey of possible
criteria of financial policy is that there is no one simple
criterion which is a serviceable operating formula.

We cannot

take prices or foreign exchanges or the interest rate and
assume that if one or another is kept stable, all will be well*
The criterion which most nearly fits our needs is that of the
volume of money.

Even this, as we shall see, requires atten-

tion to the velocity of its circulation.

The facts are that

we have no substitute for our ultimate objective of more stable
employment, more stable spending to maintain that employment
and the provision for such expansion as will be consistent
with greater stability in employment and spending.

It is ap-

parent that the financial policy must look all the way through
to the requirements of stable employment and spending or what
we may call a better ultimate stability.

It is the task of

the next chapter to see what weapons there are in the armory
to promote this ultimate stability on an expanding basis.

Chapter X
Having reached the decision that there is no single
simplifying formla to guide us in financial policy, the question
arises as to what means we have for achieving our ultimate objective of stable employment, production, and consumption.

To do

this we must first of all see what the relation is between vfoat
the banks and the government can do on the one hand and how business
behaves in response to these actions on the other.
Some idea of this relationship can be gained by reference
to the monetary formula MV = PT, which has already been described.
In this formula H is the amount of money (currency and bank deposits)
in circulation; V is the velocity of circulation of dollars or the
turnover; P is the level of prices; and T is the physical volume
of transactions.

Each of these terms may be subject to extended

analysis by anyone writing a definitive treatise.

For our purposes

they represent an obvious truism, since each side of the equation
is equal to the current rate of spending and, therefore, the two
sides of the equation are equal to each other*
It is plain first of all that it is T in which we are
ultimately interested.

T is the physical volume of business and

upon T depends the volume of employment and consumption.

Our gen-

eral objective could be described as a stable T with, provision for
its increase in accordance with an increased population and an increasing standard of living.

V/e must not be afraid of setting this

value of T at a fairly high level.

Its volume for 1929 was well

within our physical possibilities and these have increased since

But it is equally important that we do not attempt to reach

a high level too suddenly, lest we set up maladjustments v/hich may
foil the endeavor*

It is also apparent that M is a primary point or contact with this equation through action of the Federal Reserve
System or the government • But whatever the Reserve System and
the government do through changing the amount of M, or money,
must, if possible, be done so as to prevent offsetting changes
in V, or the rate at which money is spent, and in P, or the
amount of money which it takes to complete any given transaction.
Let us first consider what the Federal Reserve System
can do and secondly what it is possible for the government to do*
We will in each case direct our attention first to what can be
done during a depression period to keep T or the volume of trade
from declining unduly and in the second place we will consider
what can be done during the prosperity period to keep it under
a proper degree of control.
The Federal Reserve System has five particular tools
for monetary control;
1.. Rediscount rate control

Open market operations


Examination, moral suasion, removal of officials,


Variable legal reserve requirements


Control of margin requirements for security

The presumption behind the use of rediscount rate control during a depression is ishat by decreasing the rate at which
the banks borrow from the reserve banks, the banks themselves will
lower their rates.

At these low rates there will be additional

borrowing, or any tendency to decrease borrowing will be checked.
Bank deposits will consequently be maintained, likewise the rate

X - 3
of spending and the level.of transactions*
Plainly the importance of changes in interest rates
may be attacked on both theoretical and practical grounds.


particular if the outlook for business is poor, low interest
rates may be insufficient to give a stimulus to expansion.


such times perhaps not even an interest rate of Ofo would attract

If the business outlook is such that there is no

prospect of earning any return in investment, then there will
be no incentive to borrow even if it costs nothing to do so; or,
if there is borrov/ing, say by the builder, it will be for some
future engployment of the funds, and. while the amount of money
in the form of bank deposits will be increased, this increase
will be offset completely by the fact that it has zero velocity.
Consequently there will be no effect on T, our ultimate objective.
In general, it may be said that in periods of swiftly
falling prices the interest rate would have to be negative to
stimulate borrowers to borrow and spend at once.

A negative

rate is out of the question unless banks could charge their depositors for the privilege of holding deposits and pay borrowers
a subsidy; and if this were done, people would withdraw their
balances as long as the banks1 cash lasted and keep them at home or
in safe deposit boxes.
The interest rate does have some importance, however,
for long term loans and bonds for businesses which, unlike manufacturing or general merchandising, can forecast more or less
accurately their profit possibilities and, as a result, operate
on a closer margin.

Where the margin is close and1calculable,

the interest rate is important•

Perhaps the best example of

this in the past has been the case of operating companies among

X - 4
the public utilities which were able to forecast demand and estimate cost and in consequence were accustomed to build with reference to favorable borrowing conditions.

It has been charged that

this situation has been altered by the present uncertainty of governmental policy•

Apartment-house and residential construction is

another area in which interest rates have been a detenaining factor
of some importance.

In any event the long-term interest rate is

not directly or immediately affected by the controlled short-term
It is, therefore, fairly clear that the interest rate
is a slender reed.

While low interest rates may create a favor-

able situation for other classes of action, it is not considered
that they are of any great importance as a measure of control during

The second tool of federal reserve control is open market

These are often regarded as being a mere adjunct

to interest rate control;

that is to say,

if the reserve system

wishes to raise interest rates, the rediscount rate is put up.
But if the member banks have surplus reserves and are


borrowing from the reserve banks, they may be under no pressure
to raise interest rates.

But if the reserve banks then sell

bonds which are purchased by depositors of the member banks,
then cash is transferred from the menber banks to the reserve

Member banks1 reserves are in this fashion decreased,

and if enough bonds are sold, the member banks v/ill be forced to
borrow from the reserve banks at the higher rediscount


This and the following paragraph are paraphrased from J. P«
Y/ernette, "Money, Business & Prices,11 page 85.

X - 5
This is supposed to induce the member banks to increase their
own lending rate*

Such in brief is what might be called the

original theory of open market operations.
It is becoming increasingly clear, however, that open
market operations constitute an important central bank tool wholly
apart from and indeed without changes in the rediscount rate.
Member banks in the United States have aimed to keep out of debt
to the Federal Reserve banks.

Hence if the Federal Reserve banks

sell bonds, the member banks tend to contract their loans in
order to avoid borrowing.

The reserve position of the member

bank in other words affects its general lending policy more than
does the rate at which it can borrow from the Federal Reserve
During the period of depression, the obvious policy for
the Federal Reserve banks to follow is to buy securities.


increases the cash and deposits at the disposal of the member banks
and puts them in the position where they are able to accommodate

Again, however, the increase in borrowing and the

consequent increase in deposits and spending depends on the willingness of borrowers to borrow,

ilven if the banks stand willing to

lend, if the prospects of return to borrowers are poor, then
there will be little or no borrowing*

So again in the case of

open market operations as in the case of interest rate control,
the action of the banking system to increase spending and the
volume of transactions is only permissive and requires that other
things be favorable.
The third tool, moral suasion, consists in the Reserve
System cajoling, persuading, or threatening mildly the member
banks, in order to get them to execute a credit policy desired

X - 6
by the reserve authorities.

This method was tried in 1929, for

example, in the effort to reduce stock market loans. Likewise,
during the depression the banks were encouraged to increase their
loans to private business. Until recently the weapon of moral
suasion has been comparatively ineffective.

Of late years, how-

ever, moral suasion and the power of removal has become a very
effective means of credit control in its qualitative aspect.


here again we meet with limitations so far as concerns quantity.
For eyample, even if the banks can be persuaded to loan during'
a depression, it is still another matter to get safe borrowers to

And, unless there is borrowing, there is no favorable

effect from the banks1 action,,

In suggesting policies for the

future, much greater emphasis will be placed on this weapon.
The fourth weapon in the armory of the Federal Reserve
controls was added in 1935 when the Board of Governors was given
authority to raise or lower within limits the legal minimum reserve ratios of the member banks —

in other words, the amount

of cash they are required by law to hold against their deposit

Variation of reserve requirements accomplishes directly

what open market operations accomplish indirectly —

the de-

termination of the amount of excess reserves or excess loaning
power in the banking system.

Plainly, excess reserves can be

decreased and increased as readily by raising and lowering the
legal minimum reserve requirement as by selling and buying government bonds•
So far as depression conditions are concerned, the
of decreasing reserves or buying bonds
result/would only be to create a favorable possibility of

X - 7
borrowing rather than borrowing itself.
The fifth and final tool of control rests in the power
to alter the margin required of individuals borrowing for securities purchases.

Of the several tools for control, this

probably has the least application to depression conditions.


viously, if borrowers do not regard the stock market outlook as
favorable, they will not increase their borrowings in order to
buy securities on margin, no matter how favorable the margin requirements may be.
Referring particularly
•Turning now to the use of these several tools during
periods of prosperity we have a somewhat different picture.


is fair to suppose that all of the measures suggested have a
more potent effect when used to check undue borrowing and deposit

Thus, the reserve banks by putting up the rediscount

rate and draining away member banks1 cash by selling securities
can cause the member banks to choose among the would-be borrowers
and restrict the total amount of lending.

To the aid of such

a policy can be brought increases in the reserve requirements, and
specific control of securities speculation can be affected to
some degree by sharp increases in margin requirements•
There are, of course, situations in which Federal Reserve action migjit be ineffective or possibly thwarted*


case would be if excess reserves were very large and the reserve
banks held few bonds and had already raised reserve requirements
as far as permitted.

However, this could be corrected by legis-

lation permitting further or perhaps even unlimited increase in

X - 8
reserve requirements.

Another situation where control is dif-

ficult comes when a speculative furore is well started and borrowers may insist on borrowing no matter how high the Interest

At such times, private and corporation funds may come

into a speculative market to supplement bank borrowings*


would be difficult if the speculation were primarily in commodities, margin control of brokers would seem to be an effective
resource in a security boom*
The foregoing suggests an important point which applied
both to prosperity and depression action on the part of the
Federal Reserve System,

In both prosperity and depression periods,

early action may be far more effective than delayed action.
Prompt and vigorous action to lower interest rates and ease borrowing conditions may have an altogether different effect in
maintaining spending than action which is delayed until a depression situation is well established.

Stringent borrowing

conditions and ivc reases in interest rates that may serve to check
Q speculative boom that is just beginning may be entirely ineffective once it is well along.

And if the preceding boom has

not been allowed to go too far, prompt and vigorous action at
the beginning of a depression to lower interest rate's and ease
borrowing conditions may have an altogether different effect in
maintaining spending than action which is delayed until a depression situation is well established.

All of the tools of Federal Reserve action as we have
discussed them are pointed at the control of the total volume of
money and through that it the total volume of spending.

As sug-

gested in Chapter VI, we are disposed to think that there is

X - 9
some reason to differentiate between different classes of bank
borrowing as they contribute to the supply of money.

In particular

it would appear that bank loans for financing securities speculation and for the financing of fixed capital requirements are
more conducive to instability than bank loans for the provision
of, for example, seasonal working capital requirements.


suasion is the only resource for controlling this situation. It
may be here remarked that the effectiveness of this tool has been
greatly increased by the inspections of the Federal Deposit Insurance Corporation, and a correlation of effort with the Federal
Reserve Bank would extend its range and usefulness.
We may conclude at this point that the Federal Reserve
System has an armory of weapons which are fairly effective in
meeting boom conditions, but which are not in themselves capable
of taking care of conditions met with during a depression.


a sense, the Federal Reserve System in relation to the supply
of money, the volume of spending and of business, may be likened
to a rope tied to a balloon.

During recovery and boom, the

balloon has a tendency to go up and the rope serves very well
to restrain it, provided at least it is restrained in tiem.
During depression, the balloon has a tendency to come dov/n. The
rope, no matter how much it is slackened, will not hold the
balloon up in the air.

However, the slackening is of some im-

portance, for if something else can be found to keep the balloon
up, then the slack in the rope at least penaits it to stay there.

Keeping in mind the possibilities, and above all the
limitations, of federal reserve measures for control of business
fluctuations, let us now turn to see what the government can do.

The chief
Federal Reserve Bank of St. Louis

requirement is that during a depression the volume of

X - 10
borrowing from the banks be maintained and that the deposits
created in this process take up the slack in spending created
by the decline in private borrowing and spending.

In other

words, if the government sells bonds which are purchased by the
banks and the proceeds are credited to the government, and if
the government spends these proceeds, we will have an increase
in M from the borrowing and in T from the spending which will
compensate for the decrease resulting from the curtailing of
private borrowing and spending•
It is our view that if the flexible budget, as discussed in Part I, is financed by public borrowing, it will have
this effect*

The supply of money and the current rate of spend-

ing will be maintained.

This spending, or at least a major

part of it, will be for different things than were the borrowing
and spending by private individuals•

But we have satisfied our-

selves that this public spending will serve a useful purpose;
and so far as the maintenance of the supply of money is concerned, the results should be about the same as if private
borrowing were responsible for the activity.

In terms of the

metaphor we have just used, we have provided a supply of
helium to keep the balloon in the air.
If, after a boom which has not gotten out of hand,
government spending is begun promptly enough when private spending is ebbing, we are disposed to think that the private
spending will decrease much less than otherwise might be expected.

At the same time through lowered rediscount rates,

open market operations and lowered reserve requirements the
permissive controls of the Federal Reserve System should give
business full latitude to continue or maintain its own borrowing*

X - 11
In short, we see the flexible budget properly financed
and applied as a well-synchronized part of a program for maintaining financial stability.
During the recent depression the public works program
and the large public deficits were in a very real sense the first
test of the sort of program we have just been outlining. However,
in subsequent depressions, we are disposed to think, that the
plan will work more effectively than it has during the -recent

Aside from such obvious matters as the need for preplanning

of the works program and the need for starting it promptly when
a recession is under way, there is a great advantage in having a
program such as this regarded as a familiar line of policy. Should
this new departure become a regular organized feature of public
business controls, we may expect that its deterrent effect on
people's willingness to spend will be greatly diminished.
We have been talking so far about the effect of public
borrowing as a stabilizing factor during depression.

Does this

policy have any counterpart during periods of prosperity?


consider that this policy has a most important counterpart during the prosperity period.

It is that public expenditures be

diminished, public revenues increased, and public indebtedness

This, if properly carried on, should be an important

supplement of federal reserve action in controlling undue boomtime expansion.

During a boom, private enterprise is borrow-

ing extravagantly from the banks with consequent expansion of
loans and deposit money.

If, at such times, the government is

repaying its loans and canceling a similar amount of deposits,
we have an influence working against a dangerous trend in private industry.

How important this repayment of indebtedness

X - 12
will be as a factor in controlling the boom it is, of course,
impossible to say.

Unfortunately, we did not have the courage

to continue and increase it in the late twenties.

It is im-

portant, however, that it does work with, rather than against,
the course of Federal Reserve policy during the boom period*
So much for the discussion of combined Federal Reserve and governmental efforts to smooth out business fluctuations.

The role that we have suggested for the government in

this is not an easy one. Moreover it is one that is widely
recognized as involving certain dangers * some of them serious^.
We turn now to a consideration of these dangers•

Chapter XI
In endorsing policies which have been described on
the preceding pages, we wish particularly to avoid blinding ourselves to the dangers which may be involved.

It is fair to

suppose that it is the danger of certain unfortunate results
which would be most likely to deter people from accepting such
proposals as the flexible budget financed by public borrov/ing
during depression, with repayment during good times.
There are dangers in the policies which we are suggesting.

These, so far as they can be seen in advance, are of two


In the first place, there is the danger of inflation*

This may come about as a fairly direct consequence of the operation of the flexible budget supported by public borrowing, provided that certain

highly important safeguards are not recog-

The second danger is that of a permanent disproportion

or unbalance between government debt on the one hand and government revenues on the other.

The result of this would be

a weakened economic tax-paying morale and eventually also inflation.

Let us examine these two dangers in some detail.

To understand and appraise the danger of inflation,
we must first of all undertake to define the term.

Perhaps no

other word has such a variety of conflicting uses.

In common

usage the term "inflation" applies to any monetary expansion
which in the mind of the observer seems to carry possibilities
of getting out of control.

This is too vague a distinction to

be used in serious discussion.
terms —

It seems wise to apply two

"inflation11 and "expansion" —

for purposes of estimat-

ing the degree of danger involved in any particular policy or

XI - 2
To define what we have in mind by inflation and expansion, let us refer again to our formula, KIT = FT,

MV is ob-

viously the rate at which money is spent, and this rate may increase as the result of either an increase in M or an increase
in V or both; it may even occur as a matter of fact when either
M or V is decreasing, provided that the other is increasing
rapidly enough to increase the product of the two. Any increase
in MV has its counterpart on the other side of the equation.


may be an increase in T the volume of transactions, or in F the
general level of prices.

V e are now ready for our definitions.

When an increase In MV shows only in an increase in T and leaves
P undisturbed, we have pure production expansion.

When an in-

crease in MV, or spending, raises P without increasing the
volume of transactions T, we have pure price inflation.


both P and T increase with an increase in MV, which is the
usual condition, we have mixed expansion and inflation.


corresponding terms for a decreased rate of spending are contraction
and deflation, pure or mixed.
From 1929 to 1932-33 the process of depression was accompanied by a general mixed contraction and deflation*


such a period, the road to recovery lies normally along the
route of a general mixed expansion and inflation.

To inveigh

against inflation, meaning by the term as many do, any rise in
the price level, is to inveigji against recovery itself; for the
natural means by which the volume of production and of goods distributed is increased is by a stimulation of an increase in prices,

XI - 3
or P, resulting from increased demand.
We must not lose sight of the fact that it is the
pansion of T, the production and distribution of goods and services, with which we are concerned.

Inflation is helpful or harm-

ful to the extent that it hinders or assists a continuous and
stable expansion of T. As suggested in our discussion of criteria of financial policy, it is not an evil or good in itself*
We have said that the normal process of business recovery is a mixed price inflation and expansion*

It may be said

as a broad generalization that the larger the element of inflation
relative to expansion, the more likely is the situation to be an
unstable one. Such a price increase breeds speculation, unjustified optimism, and in general a subsequent collapse*
It is apparent that inflation as we have defined it
can come about in two ways.

In the first place, it may be pre-

ceded by expanded bank loans with the accompanying creation of deposits and a speed-up of the velocity of the circulation of money.
This may happen apart from and independent of any action of the
government „
In the second place, it may come from government action.
For this, the first requirement is usually an unbalanced budget
with the accompanying deficit financed by some form or other of
created money.
may be created.

There are four important ways in which this money
The first and crudest method is to run the print-

ing presses and turn out what is usually called fiat money.


second method, which has been regarded as somewhat more reputable.
The definition and analysis of inflation presented in the three
foregoing paragraphs is adapted from J. P. Wernette, "Business
Cycles," in "Essays in Honor of T. N. Carver," N.B. Hines, Editor.

XI - 4
is to create the money by borrowing directly from the central



The third method of creating money is through government

borrowing from the commercial banks.

This method has been ex-

tensively used during the present recovery.

The fourth method,

which was widely employed during the World War, is to sell bonds
to private individuals who in turn borrow the money to pay for
them from the commercial banks.

The last three methods have al-

ready been discussed as means of increasing deposits or bank
All of the last three methods must be distinguished from
the case where the government sells its bonds to the private investor*

In this case the individual turns his savings or exist-

ing deposits over to the government to spend rather than to a
private concern.

There is no net increase in spending unless it

is at a time when the alternative for the individual would be
the hoarding of his deposits.

During a depression, of course,

this is not an unlikely situation and while it does not increase
the total amount* of money in existence, it does have the same effect through increasing the amount of money which is actually in

This effect would show as an increase in velocity•
For many the fear of inflation arises primarily from the

fear that the government will directly create paper money*

As far

as its purely monetary aspect goes, this method of creating money
differs little from the allegedly more reputable method of borrowing from the banks, although it may be considered to imply a
r example, the Federal Reserve banks. This method is illegal
in the United States but it is accomplished in practice nevertheless. When the government sells bonds to the member banks
and these are in turn purchased by the Federal Reserve System, the
results of the process are identical with those described, whatever the psychological differences may be.

XI - 5
state of mind, an infirmity of purpose, which invites disaster.
It should be said also that most of those who think of this class
of money creation think of the creation of a great deal of money.
They assume that this process means that the printing presses will
" e run day and night, as, for example, in post-war Germany,
So much for the idea of inflation*

It is plain first

of all that we may rule out the danger of a wild orgy of papermoney inflation.

As a practical matter, these are rather rare*

While almost every country, certainly every one that has entered
into a major war, has increased its supply of money by the printing-press method, there have been only three xunaway, inflations before 1914.

These were the continental currency of the

American Revolution, assignats of the French Revolution, and the
currency of the Confederacy.

In each case the currency was

issued by a revolutionary government new to fiscal administration
and engaged in desperate warfare.
there was no runaway inflation.
following the War.

Even during the World War,

There were, of course, several

The currency issued ran to astronomical

amounts and the very word inflation was a frightening one.


countries affected were Germany, Austria, Russia, Poland, Roumania,
Bulgaria, and Czechoslovakia.

Several of these countries were

the remnants of or the successors to the defeated central powers.
Each had a new government or a new form of government.

No parallel

can be drawn between the conditions obtaining in these countries
in the immediate post-war period and the economic problem with
v/hich we are here faced*
Let us turn now to consider the more subtle ways of increasing the supply of money which are part of our present proposals,

XI - 6
Do they hold a danger of inflation?

Let us confine our attention

to price increases not of the runaway variety, but of the more
moderate yet still dangerous varieties, which are likely to involve a certain amount of suffering in themselves and portend a

subsequent collapse•
So far as a depression period is concerned, we can say
categorically that there is at that time no immediate danger of

The creation of new money during this period by the

government does not in itself affect the creation of money by
the banks for private use, which would be part of a general process of recovery.

Moreover, in a depression situation the effect

of increased spending through increase in the money supplied will
usually be on T rather than on P.

This is for the simple reason

that a manufacturer running at 50^ capacity does not boost his
prices proportionately to every increase in orders.

He only be-

gins to think of price increase when business begins to approach
more or less closely to full levels of production.

To put the

matter in general terms, rapid price rises occur normally only
when output is approaching the limit of the available labor supply, or of the available raw material sup-oly, or of the avail-

able production equipment/
Dangerous price increases may appear as the depression
stage nears its end or as recovery begins.
for this.

There are two reasons

First of all, as we have just noted, the tendency is

e*g* The war inflation whose first collapse in this country
occurred in 1920, and from whose effects*agriculture has suffered until recently.
rk broad upward price movement may likewise occur as a result of
extensive artificial*or subsidized price controls, or of wage
advances greater than the profit margins of the industries involved; but these factors fall outside our discussion.

XI - 7
to increase prices instead of output as plants or labor supply
near their capacity, and in the second place, capacity is not
approached evenly in all lines of production.
It is when bottle necks appear that the danger of inflation arises, particularly when we reach the stage where v e
have fairly full employment or where bottle necks in the labor
supply or perhaps in certain raw materials begin to be numerous
and restrictive in their effects. Unless these bottle necks are
relieved by population shifts, vocational training, and other
remedies, we may run into inflation in the face of considerable
remaining unemployment•

Professor Slichter has proposed in

this connection a division of "bottle-neck research1* in the
federal government.
V e may insert here the observation that there is a
need for meeting this problem of persisting unemployment that
goes beyond any mere counting of the unemployed.


ments are (l) current figures continually revised by the United
States Employment Service to show the amount, location, and kind
of unemployment; (2) a periodic census of employment and unemployment to act as a baseline and check on current compilations;
(3) a corresponding analysis of current industrial development
and developing labor shortages; and (4) the establishment of
policies of information, vocational training, and population
shift which will so far as possible fit the pattern of unemployment to the pattern of expanding opportunity.
It is here that a critical question arises in connection with our proposal.

Unless government expenditures are

See his article, "Must V/e Have Another Boom11.
April, 1937, page.605.

Atlantic Monthly,

XI - 8
decreased at mid-stage we have the spending engendered by the
public policy added to the increase in private spending attendant upon recovery conditions.

If the two continue side by

side, we have an expanded demand for consumer goods and an inadequate supply of those goods, due to the continued diversion
of labor and funds towards governmental work, and to the
accumulating bottle necks•

We thus risk a boiling up of prices;

and while we do not run any serious danger of runaway inflation,
there is the possibility of a more moderate forward movement
which is still large enough to be self-destructive*
As a safeguard, when production approaches capacity
or as the bottle necks become more numerous, government expenditures must decrease in favor of private expenditures•


is in fact a vital part of the program we are here proposing.
It is partly for this reason that we suggest conservatism in
setting the index figure of unemployment by which the flexible

is consulted.

We suggested at the beginning of this chapter that the
second main danger in those proposals is that governmental expenditures and public debt might get permanently out of line.
This danger cannot be focussed so easily and sharply as the
danger of inflation.

Consequently we must deal with it in some-

what more general terms.
The question is —

how great is the danger that the

government may gradually accumulate a volume of indebtedness which
is beyond the powers of a workable tax system to service.


this condition occur, inability to levy further taxes and the inability to get people to pay taxes that have been levied may
force the government into an unrestrained sale of its securities,
perhaps to the central bank; or it may even force it to resort
to paper money.
The policies which we are suggesting are not ones which
a government carrying a heavy burden of debt could easily undertake.

The security of credit advanced to the government rests

on the peculiar power of the government to tax the whole productive resources of the nation.

However, there are limits to this

taxation, as to all things; and if a limit is being approached
where even in good times taxpayers and tax-paying morals are beginning to weaken, or the tax burden is beginning to strangle production and private employment, then the policy would be unwise.
It does not appear that in the United States we need
of necessity face a situation such as that just described.


Table I we present figures of the national debt, carrying charges
per capita: etc., for the United States, England, and


-.. ....

.. ',...: ;
National Government Debt


.... , .

#99,000,000,000 15,600,000,000

Annual Interest Jhargea on Nat'l.

Oovera m* I


4«r Capita K a t ' l . iov»t. i obt


,050,000,000 #



761 &

J er Oaplta ainual Int.JljarQea
« Kat*l. Gov't. ebt
tal Inooiaa of I oople


. Gov*t. ©bt,
to Total Annual Inooioo of



#80,000,000,000 ^,400,000,000


Batio, a t » l . OovU, Tax Heoolpta
to uinuai I n t . Jha



160 •

3*0 tiir,*£» int.

3.9 ttems int.


orcentage, l«at'l. Sov*t. Tax
eoeifjt£>» to Total Annual
Income of People
Total *xibllo uobt
(Xnoludls s t a t e s , o l t i e t 9etc•)
I Oapita Total .ublic i^obt









, :

904 #

jroenta^i., ?otal Jollo i>ebt, to
otal Annual Inoo, .o of people
Percentage, Total itiblio
i t ' l , -.ealt

ebt to

, ^{l Y o - ••• > 1
tcriber 23, 1936. Twentieth Geatoi
; ; .... t ;goul,ti 01M torn 3 , 4, and 5. ~terline figures

beec o ; verted it .00; frano i'i. v:.r»s 1 0.0466.

XI - 10

We also show the ratio between the government debt and

the annual national income of the three countries*

However, com-

parisons of national debt alone are by no means precise, since
the debt of states, departments, cities, etc*, are larger in proportion in this country than they are abroad.

We have, therefore,

included data as to the total public debt of the three countries*
In the United States it is probably the federal debt which arouses
the greatest concern in the public mind*
Despite the difficulties in comparison, the relative
figures for the three national governments are of some significance*
Not only is the per capita national debt of the United States well
below that of England and France, but our national a much
smaller percentage of our total national income.

Likewise where

our total federal tax receipts in 1930 were seven times the amount
of the federal interest charges, they were only 3.6 times interest
charges in England and approximately four times interest charges
in France*

Comparing our position, for example, with Great Britain

and considering the notable stability of the British governmental
finance, it appears that we would have little cause to worry, if
our budget ha® comparably careful management.

The qualification

is, however, a serious one.

We may conclude from the foregoing that the United
States need not be a danger-line country, where policies of the
sort we are recommending must be foresworn*

On the contrary,

it would appear that we have sufficient margin or leeway so that
the financial resources of the government can be used, if used
wisely, to stabilize the national income, or, more fundamentally,

XI - 11
national production and expenditure.

We have more to fear so far

as financial stability is concerned from another drop in national
income from eighty billions to half that amount than we have from
the much smaller public expenditures which, if wisely applied,
may be made to sustain a volume of business which will maintain
our national income in the neighborhood of eighty billions.
With respect to the security of the governmental
financial structure, as with inflation it is important that the
policy we are suggesting be adhered to in prosperity as well as
in depression.

Insecurity in public' finance would appear, and

doubtless within a relatively short span of years, if we have
not the self-restraint to relate taxes and expenditures in such a
way as to balance the budget at some midway point between depression and prosperity, and retire debt during prosperity periods.
If we are right in assuming that we have a certain working margin
of revenues in relation to public debt at the present time, it is
none the less important that we protect that margin by appropriate
policies during the prosperity period.

So far as we have followed

measures during the present recovery similar to ones we have outlined here, there is cause for concern at the present time (November,
1937) that the federal deficit is still as large as it is.

There is another aspect of the twin dangers of debt and
inflation which cannot safely be ignored.

This is the possibility

that conditions may be unfavorable to the transfer of workers
from governmental to private employment, so that large governmental
expenditure remains as a continuing condition.
This condition might be expected to occur if the expectation of business profit is too severely limited by excessive
or unwise taxation, by unwise and unpredictable governmental

XI - 12
restraints on business, by unreasonable labor demands which too
greatly narrow the profit margin in important industries, by destructive industry competition, or from other causes now existing,
or which may be brought into existence by unwise policies in the
The phrase "better business sentiment" is often used
to define a prime essential for business recovery.
needs a more precise definition*

The idea

What is needed is a "reasonable

expectation of profit" in the business world in general.


a reasonable expectation is needed, not assurance; for the profit
system is really a profit and loss system and losses are an
essential element in its mechanism*
There are great advantages in governmental expenditure
as a balancing element in an unstable economy*

Not the least ad-

vantage is that new purchasing power is immediately put to work
in wages and in the purchase of materials made for wages.


might be expected that the consumer demand created by government
borrowing would act as an imperative force for business expansion.
As we shall see in the next chapter, however, this has not
happened in fact so completely as was hoped for.
to rest in idle bank balances.

Funds tend to come

And these idle funds are those

from the lower incomes as well as from the rich, for savings banks
and insurance companies have as much difficulty in finding profitable investment as does private capital*
It is, then, an essential element of the hopeful group
of policies we are discussing that governmental policies toward
business should be purposefully directed toward the maintenance
of that reasonable hope of sufficient profit to assure the maintenance and expansion of private employment, and the continual
flow of purchasing power through the hands of the great mass of

our fellow
Federal Reserve Bank of St. Louis



br/< and ifO


A Measure o{ the Rcttt. o{
5o\ine - Fedtral


Bank o\ tfeu/ York.

Chapter XII
As we have observed a number of times, the policies
we are recoiamending have already been put in force in several
important details*

The unbalanced budget and governmental

borrowing and spending have been vigorously pursued, and there
is hope that the second period of overbalancing, reduced expenditures, and repayment is close at hand.

It, therefore,

seems opportune to survey our progress to date, particularly
with reference to monetary policy with which this part is concerned.

We shall begin our survey with the predepression years*

In making criticisms and suggestions on control, particular
emphasis will be given to the newer types in actual use, or to
those suggested herein as desirable.

Our social aim is stability in employment, production,
distribution, and consumption on a rising scale.

This finds

its statistical counterpart in the Index in General Trade and
Production in Chart II. When this is low, there is unemployment
and distress.

When this is as high as in the predepression

years there is relatively high employment and consumption.
The monetary counterpart of General Trade is to be
found in Bank Debits as shown in Chart III.

These curves show

the total - * M M f of checks drawn monthly on the principal banks
and spectilatit/0'
of the country, and are, therefore, a good index of business/
activity of all sorts*

It is a record of our rate of spending

of bank money or deposits for all purposes.

If the Index of

General Trade and Production included all transactions including
such items as the purchase of securities and the payment of
rents and taxes, and if an inclusive price level for all these

XII - 2
transactions were stable, then the Index of Trade would correlate
perfectly with the sum of bank debits and cash payments.


one would represent PT in the money equation and the other, MV;
and both are the rate of spending.
We are not seeking mathematical accuracy in this correlation, but useful guides for action.

Within the limits of

error of the most skillful analysis, no serious difficulty will
be found in eliminating the cash transactions which are difficult
to estimate.

The price level, as shown by the tv/o indexes in

Chart II,very evidently does vary and must be considered.


us for the moment, however, examine the remaining element of nonconformity, the fact that all business operations are not included in the Index of General Trade, while most of them are in
the curve for bank debits.
It is an evidence of the close relation between monetary
phenomena and business that these differences are clearly seen in
the monetary data.

Chart III gives bank debits or the rate cf

spending for Hew York, for the 140 principal cities outside New
York, and for all combined.

The difference between the curves

for New York and the outside cities is immediately visible. Where
the rate of spending-in New York has varied nearly 6 to 1, that
for the outside cities has been scarcely 3 to 1.

The greater

volume of New York transactions in the pre-depression period
gave its character to the whole.

During the depression and

since that time, our financial capital has meekly followed the
rest of the nation.
What was New York doing in those years from 1926 to
1929, inclusive, that resulted in that inflation of activity?


A// Member



New YerK





red, ftes. bulletin.

XII - 3
The answer is not far to seek.

It was engaged in real estate

and security operations on an increasingly furious scale, and
it is the monetary transactions connected with this activity and
centered there which set the city apart from the rest of the

It is the more recent dampening of these activities

which has kept New York in line.
This rudimentary analysis of Chart III shows two things.
The first is that an inclusive curve or set of data may conceal
important facts which are revealed when the material is examined
in detail; the preponderant effect of New Yorkfs speculative
activity is not revealed in the combined curve (shown also on
Chart Ij).

The second is that monetary activity is not a good

index of business in the sense in which we have defined the word
and are using it.

The curve of general trade and production

in Chart II is a far better one; it does show a fair correlation
with bank debits for the outside cities, indicating that monetary
transactions outside New York have been a better index of productive business.

In Chapter IX we gave a qualified approval to the idea
that observed changes in the quantity of money is one criterion
of financial control, and that an objective might be sought in a
stable volume of deposits.

Certain dangers in this as a sole

objective are clearly shown in Chart IV.
already appeared in Chart L)

(The combined curve has

The figures given for


Bank debits show the rate of spending in dollars. Ultimately we
are interested in the rate of purchase of goods and services and
should, therefore, divide bank debits in Chart III by some inclusive price index. The result would be that the depression of
spending (or purchasing) would not appear quite so low in 1933 nor
would the recovery with its rising price level appear quite so great,

XII ~ 4
demand deposits11 are not available before the latter part of 1928.
The total of deposits kept approximately constant until
the end of 1930, when it started a long decline to a point more
than 25$ lower in the middle of 1933.

Since then, under the lm-

pulse of governmental borrowing and spending (&&u&&tep alongthe
lines we have been recommending) it has risen to unprecedented
heights —

far beyond amounts previously needed to finance even

boom time conditions.

What is the significance of this phenomenon?

First let us break down this curve also into two components, one
for New -York banks and the other for outside banks. Again we
find significant differences between conditions in the metropolis
and the country at large.
Throughout the boom and to the bottom of the depression
the banks of New York City are remarkable for the steadiness in
the volume of their deposits.

Its great speculative activity in

the boom was evidently financed by velocity of turnover rather
than by greatly increased funds.
later in Chart V.

Evidence of this will be seen

Its maintenance of this volume nearly un-

impaired throughout the depression is by most observers accounted
for on the supposition that outside depositors withdrew their
accounts from home banks and transferred them to the stronger
New York institutions as bank difficulties increased.

The drop

in total deposits is almost entirely a drop in deposits in
outside banks.

Since the summer of 1933 New York and the cities

outside have risen in about the same proportion, indicating, as
in Chart III, that whether for good or for ill, the Metropolis
is now in step with the rest of the country.

One cannot, however, examine Chart IV and feel sure


ft/of Adj't/s+ed ^OK Seas<ji4al

: Federal fiesewe Bank of W

XII - 5
that all is well and nothing is ill.

The volume of deposits has

risen to unprecedented heights without corresponding effect on
the rate of spending of all sorts, speculative included, as shown
in Chart III.

It has not financed a corresponding volume of

general business and employment as represented by the index of
trade in Chart I, as it might be expected to do if not shortcircuited in speculation.

These discrepancies will, of course,

be more plainly revealed in an examination of the corresponding
curves for velocity, which are shown, in Chart V.
All cities show some rise to 1929 and a subsequent drop
to the bottom in 1933.

That speculation is primarily a matter

of rapid turnover of funds is shown not only by New York's rise
culminating in 19S9, but also by the rise in all cities, which
supported the short-lived speculation early in the sumaer of 1933*
New York's variations are more in velocity than in volume* Outside
cities vary more in-volume than velocity.

But all cities show

failure to recover anything that might be considered normal velocity
in the face of enormous increases in the volume of deposits.
There is nothing new in having velocity of circulation
go down during a depression. Y/hat seems to be new is the depth of
its drop and the/slowness of its recovery in this depression. The
writer has been furnished, by courtesy of the staff of the Board
of Governors of the Federal Reserve Bank, with, figures for velocity
calculated on a somewhat different basis from that used in Fig. 4,
which show the difference in the case of two cycles.

Depression 1921




XII- 6
The contrast is evident.

In 1926, after five years,

we had regained one-third of our velocity; in 1936, after four
years, we had regained scarcely 8$ of our velocity*

We cannot

make so definite a comparison v/ith earlier and more severe depressions, such as that following the Civil War, because the
corresponding data are not available.
Of course, we must bear in mind that we do not wish
to return to the peak velocity of 1929, since we are determined
to control the speculative fever on which this.high velocity
was based.

Perhaps 60 rather than 160 is our new normal*


so our bank deposits are too large and their rate of turnover
is too low for the business we are doing*

One cannot be sure of the causes of this situation,
but a number of suggestions may be made.
For one thing, the whole recovery emphasis, whether
for employers or employees, has been placed on security rather
than on enterprise.

Play safe, don't risk!

That is the busi-

ness atmosphere of the day, reflecting current political doctrines.

In practical application these doctrines have sought

to destroy speculation.

With the thought that uncurbed specula-

tion is the most dangerous disease to which the business of the
nation is exposed, this document is in complete sympathy.


question now raised is as to whether restraints and controls
have not gone beyond the border line of speculation and encroached on productive enterprise.

Among the many elements in-

volved are difficulties in the way of floating new security
issues,, interest rates and profit margins so low that hoarding
seems preferable to the risk of investment, and the difficulties

211 - 7
put in the way of business expansion, added employment and consumption by the undistributed profits tax*
Another factor producing the current stagnation in deposits is the premium put on liquidity of funds by estate taxes
and the undistributed profits tax.

The preparation for these

taxes tends temporarily to draw funds away from use in active
business and employment into inactive liquid deposits, so that
they may be realized on at a moment1s notice.

At any given

moment the funds thus withdrawn must be sizable in the aggregate*
As a last consideration which by no means exhausts the
list, we have to reckon with the lack of understanding and cooperation between business and government —

the responsibility

for which the present writer feels constrained to lay for the
moment at the door of government, in view of the complete power
over business destinies which now lies in the hands of the
federal administration.
In brief, the unfortunate possibilities described in
the concluding paragraphs of the preceding chapter are, perhaps,
the actualities of the current situation*

This whole document

as presented by the writer and his associates is an endeavor
to remove misunderstanding and promote cooperation in one large
area of the relationship between government and business.


business man must be lead to see that the multitudinous and unorganized recovery policies of the government can be unified
and organized into a mechanism which will again propel the nation
forward, in more steady fashion, on its course of economic and
social progress*

On its part the government must resolutely

organize its policies to that end —

and the next step is the

fostering and encouragement of private employment, production,

211 - 8
and distribution*
Perhaps the writer may be permitted to elaborate a
homely figure.,

It is as if a farmer had two horses hitched to

the plow, of which one was named Business and the other Speculation.

Speculation bolted, dragged Business with it, lamed his

mate, and wrecked the plow.

Speculation was caught, hobbled

fore and aft and tied to a tree with a short rope*

The farmer

then put a curb bit in the mouth of Business, cut himself a
tingling switch, and by rapidly alternating and sometimes simultaneous application of whip and curb attempted to proceed with
his plowing*
The plowing is being badly done, the crop will be
short, and the family will suffer*

V/ith the data of the charts in mind, we now undertake
the difficult task of suggesting the policies which might have
been followed in the boom and through the depression, and which
now should be followed in the current recovery, giving particular
emphasis to the new controls, some of which did not exist prior
to 1933.
The objective is stable employment, production, distribution, and consumption.

XII - 9
The criteria are the unemployment index, various wage
and pay roll indexes, price indexes, trade indexes including
general indexes like that in Chart II, current market reports,
monetary data as in Charts III, IV, and V, and detailed information from the banking system as to the composition of the credit
structure which is the basis for deposits.
The tools of control: are the older ones of rediscount
rate and open market operations, and the newer ones of variable
reserve ratios, variable stock margin requirements, and moral

The latter should be applied both to the composition

and to the quality of a bank's loans and investments; and it
should be reinforced and unified by putting under the jurisdiction
of the Board of Governors of the Federal Reserve Back both the
Federal Deposit Insurance Corporation and the powers of examination and control for National Banks now vested in the Comptroller.
An additional requirement is the intelligent cooperation
of business and of government.
Supposing these conditions, when the rapid rise in
velocity and bank debits in New York and the slower rise outside
became evident, an examination of the composition and quality of
the assets of the banks would be called for.

Quality alone would

not tell the story, for the safety of a margin loan on securities
is high under ordinary circumstances.

A large increase in such

loans, whether directly or through "others", is a danger signal
and calls for the raising of margin requirements.
Similarly, real estate or commodity speculation can
be identified in the bank portfolio and kept within limits.


Florida boom and collapse could not have occurred under FDIC controls now available if wisely applied, nor would the less* intense

XII - 10
but larger and more wide-spread boom in urban real estate, which
spread over the country later, have talc en place,

questions of

quality are more important in the real estate portfolio, where
second and third mortgages are liable to make their appearance
toward the peak, as well as first mortgage loans at inflated
It is not argued that these controls should have been
applied in an endeavor to keep the situation on an even keel
without expansion or contraction.
no desirability even —

There is no human possibility

of such close control*


But there was in

fact no control of obvious excesses, and it is only such control
that is suggested.

The control of obvious excesses would still

have permitted a mild boom and the beginnings of a recession.
That is to be expected.
As trade indexes fall and Specifically, as unemployment
appears to approach the critical point established for action,
the flexible budget should be put into effect, at such points and
in such operations as will best meet the emerging unemployment.
If this policy is known and understood beforehand, this move
will be accepted with confidence by the business world; the new
funds put into circulation will be kept in use; and it may be
expected that normal velocity will be maintained.
This matter of business temper is all-important.


community which has worked itself up into a hysteria of speculation will not calm down into an assurance of normalcy as the
positive controls are applied.

Nor will the experience of seeing

its government on a preceding^ occasion unwilling or unable to
decrease its expenditures and balance its budget as prosperity
returned, permit the business community to view without justifiable

XII - 11
alarm the initiation of a new period of spending•
It is for this reason that we gave as essentials the
cooperation of government and business*

If "business does not co-

operate willingly, on the upswing at least it can be forced into
line by banking control*

If government does not cooperate, no

force can be applied to it except the votiiig strength of an intelligent electorate.
Under normal conditions the banking system will willingly be absorbing the new governmental loans at low rates. When
productive business falls off and commercial credit declines,
such a means of generating new deposits has the great advantage,
as we have seen, of making deposits and putting them to work in
the selfsame process.

The older expedients, such as open market

buying and lowered rediscount rates made borrowing easier and
generated new deposits, but did not insure the primary turnover
of new money, as does government borrowing and expenditure*
As government borrowing and spending increases in accordance with the increasing unemployment, the Board of Governors
will be watching its total of deposits, its debits, the price
level and the rate of turnover —

particularly the latter.


the new deposits become stagnant, they v/ill search for the cause
and bring it to public attention, if it can be located.

It may

be undue business pessimism as a reaction to undue optimism.


may be governmental restrictions or tax policies which hinder the
expansion of private enterprise and employment.

It may be labor

policies which prevent profitable operation and employment*


there are no maladjustments discoverable which account for the
stagnation, it will be in order to consider taxation policies

All - 11-A
directed specifically to this problem of idle balances, taking
care that these policies do not lead toward the hoarding of
If the corner is turned and the unemployment figures
decrease, it will then be the duty of the government to decrease
its expenditures, in such places and in such work as,will release men of the kind needed where a shortage of workers is

XII - 12
This involves a decrease of' borrowing.

Should unwise governmental

policies gain control and spending and borrowing continue, it will
be in order for the banking system to leave government financing
to the open investment market; and should private borrowing reappear inlarge volume and the beginnings of a boom return, the
Reserve Banks would take the further step of selling their government paper in the open market,
Houghly, this is the type of. control which we foresee*
It is general and not specific, except as to evident errors in
quality of loans and investments.

It does not try to control too

closely or for too immediate results.

It allows ample margin for

elasticity and automatic controls.
It does not seek direct management of business details,
but sets monetary limits to business excesses, and furnishes
actual orders for business to work on in depression by means of
the expanded budget.

This distinction between direct control and

indirect monetary control within generous limits is important.
Some businesses must be controlled because they are natural
monopolies, or for other reasons.

In our judgment they can be

controlled only because the mass of business remains relatively

Were more direct and detailed controls to be applied to

the majority of business activity the undertaking would become

The design and manipulation of a rigid business

structure in a nation of unregimented consumers we believe to be
beyond the limits of human ingenuity, or of the most arbitrary
and unrestrained political power.

It may easily be argued —

it has been argued —

authority as we propose to confer on the

that such

Board of Governors is

XII - 13
also beyond human will and capacity.
lightly dismissed.

This criticism cannot be

There will be required, we believe, some re-

organization of the present system.
No powers are needed beyond those now existing.

But there

need to be transferred to the Board of Governors the powers of
banking control now residing in the Comptroller of the Currency
and in the Federal Deposit Insurance Corporation,
unity of control and of policy.

This will insure

It will also give some of the ad-

vantages of chain banking without destroying our individual system.
We*must expect that the Board of Governors will have in
great measure to learn its job by doing it, no matter how experienced its members may be.

The job is a new one.

Careful selec-

tion and secure tenure are both needed.
As a part of the mutual self-education of business, the
banking system, government and the Board itself, they should explain and justify their acts publicly and in detail. It
yto have
wholesome/^? dissenting members make public statements of their
reason for dissent.

This will be a condition for the most ef-

fective cooperation of the banks themselves in building up the
technique of control and in applying it to themselves without compulsion.
The Board of Governors should be independent of government,
banks, and business in the execution of the duties assigned to them
independent of everything except enlightened public opinion and the
results of their own acts.

This general statement is subject to

the following obvious qualifications:

They must act under laws

passed by Congress; they must be appointed by the President by and
with the consent of the Senate; they must be impeachable
tablished and orderly process for malfeasance in office.

by es-


XII - 14
These conditions would seem to be met by a Board of seven
men, varied in experience, but combining the fields of banking, busipolitical parties &
ness, agriculture, labor and economics and drawn from diverse/rergions.

Rotating in fourteen-year terms with a new appointment

every two years, each presidential term would permit two appointments.

On the scale of governmental salaries, they should be

highly paid for the fourteen years1 service and should be pensioned
on retirement.

It should not be necessary for them to look beyond

their term for success, for power, or for profit•

It is natural for us when strain is released to grow lax
in our thought and preparation for the next emergency.

As the

depression recedes into the distance, what is more natural than to
live in the business problems and achievements of the present?
V/hat is more natural, and what is more dangerous?
It was by a very narrow margin that we escaped social and
political disintegration in the early 50 f s.
experience still burden us.

The results of that

Indeed the issue is not yet decided

as to whether a democratic government can continue to exist and
maintain an economic mechanism which will continuously transform
useful labor into high living standards for its people.

It is our

belief that another severe depression would make this impossible•
It is our further belief that we have not done all within our
power to prevent such a recurrence of depression —

&nd that some

of our policies are a hindrance rather than a help to the desired
Holding these beliefs we offer no apologies for presenting the best proposals we are able to offer.

If there are better

XII - 15
ones, we will gladly turn to them.

For ourselves, the attitude

we cannot accept is that of thoughtlessness and inaction.