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Form No.

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131
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1

Ofhce Correspondence

FEDERAL RESERVE

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Governor Eccles

Subject: The Federal Advisory Council

From

Mr* JEklmiston AJLr^-

recommendation on JL» R> noAe collaterals

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16—852

The proposal of the Federal Advisory Council with regard to collateral requirements for Federal Reserve notes indicates a complete lack
of understanding of this provision of the pending banking bill. To take
the position that the present method of issuing Federal Reserve notes
provides an elastic currency that is responsive to the needs of commerce,
industry, and agriculture is ludicrous. The United States is primarily
a deposit using country and the volume of currency in circulation at any
given time is not related to the volume of commercial loans made by commercial banks. Large fluctuations in the volume of notes outstanding
have been due to the disposition of the public to hoard or dishoard currency. The Federal Reserve System should be given maximum freedom to aid
the banks of the country to meet such emergency situations and thereby
prevent the disastrous effects that such movements may have upon the
whole banking structure of the country.
I doubt seriously that the Council would argue their position on
the basis of experience with movements of note circulation. A more likely explanation of their proposal is that the Council hopes by this indirect method to limit the ability of the Federal Reserve System to purchase
government securities by decreasing the volume of excess reserves of the
Federal Reserve banks. There is no doubt that this decrease of excess
reserves of the Federal Reserve banks would restrict severely the system's
potential opeiMnarket operations. The exact extent to which it would do
so, however, depends upon many factors that cannot be forecast in advance.
At the present time if all notes in circulation were legally required to
be backed 100J6 by gold because of the lack of commercial paper, the excess
reserves of the Federal Reserve banks would be cut to about $700 millions.
On the assumption that no new gold certificate reserves are received, no
gold exports made, and no increase of currency in circulation, the Reserve
banks would then be able to purchase government securities and increase
member bank deposits only in the amount of about #2,000 millions before the
legal reserve limits would be reached. By paying a 5% tax and putting up
a #1,000 million of government securities behind notes in circulation the
potential power to buy governments would be increased to -*••. over #5,000
millions. Because of the unlikelihood of a large increase of currency
in circulation or of large gold exports in the near future the Council's
suggestion would not be immediately effective as a brake on government
security purchases.
As a long run proposition, however, it would be a highly undesirable provision because it would tend to prove restrictive to the System at
the very times when curtailment is undesirable. If member banks were losing reserves by gold exports or currency hoarding the reserves of the
Federal Reserve banks would be depleted and the System would, therefore,
be unable to engage in open-market operations designed to stem the course




-z of the deflation that would ensue. Undoubtedly under such circumstances
the law would be amended just as it was in 1932 by the Glass-Steagall
Act. But the damage would probably already be done before legislative
action were taken.
In view of the probable need o& conserving our gold stocks in
the future in order not to have a continually falling price level it would
certainly be unfortunate to have incorporated in the law a provision of this
type which wastefully ties up gold to back currency circulation.
The general memorandum on the Council's suggestions contains additional points of opposition to the proposals with regard to note collateral
requirements.