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..
394:
•
X-3090
Released for publication
Jut~_e_l~__ }..:..9,gi
(Note: As this article has been prepared for publication in the June
number of the American Economic Review~ credit should be given to that
Review in printing any portion o! the article in other publications).
FEDERAL RESERVE POLICY
by
A. C. MILLER
Member, Federal Reserve Board
X-3090
TABLE OF CONTENTS
Introduction
L
PP• 1-4
Past Policy Qi Federal Reserve Banks
L
Gold Policy
2~
Currency Policy
3-
Credit Policy
4-31
PP· 5-9
S-12
12-25
4. 'Consideration of certain criticisms of
past discount policy of Federal Reserve
Banks
II. Considerations
l.
25-30
~
Future Faderal Reserve
Poli~y
.
31-48
Reserve Bank ratios must be made more
sensitive indicators of ch~nging credit
conditions than they new are
31
2~
The example of the Bank of England
32-33
3.
Important bearing of currency regulation upon
the reserve ratio and credit policy
34-39
4.
Bank-note convertibility as protection
against over-expansion considered
5. Proposal for changes in future
Federal Re•
serve policy regardin~ gold and currency in
their relation to credit policy
39-41
41-48
'
396
I
X-3090
F.EDER.AL RESERVE POLICY.
~he
acute distress and tLe economic taxdship resulting from the
business-
and price-recession movements of t:C.e past eight
month~?,
wl:.ic.::. tava been experienced in all sections of the country, bave
drawn attention to
t~e
Federal Reserve System to a degree not
to experienced and Lave made the operations and'methods of
eral Reserve .Banks a matter of widespread public interest.
bit~er
t~e
Fed-
The
;rowin; appreciation of the fact in the past few months, even in
sections of the country w'.ilare a strong disposition was manifested
last autumn to charge tLe Federal Reeerve System with responsibility
for the collapse of prices, that t~e recent li~dation movement
bas, in the main, proceeded from world-wide economic ca'J.ses and is
incident to the general economic readjustment made necessary by the
profound economic disturbances worked by the war, bas done_ much to
· clarify the atmosphere and to make the moment favorable for a review
and discussion of Federal Reserve policy and practice.
W"llile t:b.ere
is every reason to believe that the first and worst stage of the
post-war econondc readjustment is near its close. there is enough
li~lih9od.
of further periods of economic difficulty and. strain in
the process of completing the general readjustment to make it a matter of great public concern to consider tow the Federal Reserve
System my
nes~
of
t~e
be~t
function in assistins the industry, trade, and busi-
country through sucL furtLer periods of uncertainty and
pres sure as may occur.
397
X-3090
-2-
It is but little more than six years since the Federal Reserve
be~an
System was or6anized and
operations on a modest scale.
In
tbat brief period of time it tas had to meet a greater variety of
coniitions
an~
problems
serve bdnkinJ.
Since
t~ ~ve
t~e
ever cvnfrvnted any system of re-
Armistice it Las Lad to cope with economic
and financial problems of unprecedented maenitude and great complexity.
It has rendered continuously
t~e
;reatest assistance to
t.i.:.e Tred.Sury in makinG s.r..ort term borrcAvin:;s.
credit basis for
financin~
our
eno~ous
It is primarily to its steadyin:; and
It l:a.s provided tte
exports on credit to Europe.
moderatin~
influence that the
irop in prices durin:; tl:.e past ei:;:;.t montl:s did not eventuate in
a. complete and disastrous CJllapse.
accomplis:;.ed
t~e
wit~out
All of
ever for a moffient
t~ese
puttin~
tl.:.in.:;s l.:a.ve been
tl.:.e maintenance of
;old standard, or the solidity and integrity of our
tern, in jeopardy.
Tl:.ese tl:in;:s augu.r well for tlle future of
serve banking in tLe United. States.
met its first
credit-$~
searc~n~
The fact, moreover,
t~t
tests on
in tLe
T:.:e Federal Reserve System ::as
t~e w~ole wit~
~eat
r~
remarkable success.
of a presidential campaign,
in w::icl: t::.e attitude and metl:od.s of the Federal Reserve System
were fre9Uently tl:e subject of bitter attack in sectivns of
Vi~ic~
t~e
country
felt in a peculiarly hig:C. de;;ree ti.:.e impact of tt.e price-re-
cession movement, it did not yield to sectional or political pressure of any
expressed at
c~racter, ~s
t~e
done
muc~
to set at rest
inception of the System, as to
~e
wLet~er
doubt, often
any system
398
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X-3090
of reserve bankin: under Governmental supervision could be fully
successful in tt.e United. Sta.tes because of ''politics.
A great
11
system is not, :.:....:wever, to be re.;arded as a.
bankin~
reaiy-made contrivance.
T~e le~islator
can frequently foresee much,
and tl:.e law can do n:uc:.:, to make provision for future contingencies
and
establis~
safe
o~ris
asainst future temptations, but
w~en
all
is done t:t.at can wisely be done by legislative prescription ani le::;isla.tive safeguards, it still remains true t::a.t a ::;reat banldn::; system
must be largely
t~e
result of growt:t. and development in the course
of sbapin-; its policies, devisin;: mett.ods, promoting practices, and
adapt in::_- its operations to t:::.e exi;encies of differin:; situations
as they arise.
Sue~
is peculiarly the case at the present time.
The
Federal Beserve System must learn its ways and t;et its gait in a
world more profoundly disturbed financially, economically, socially,
and politically than ever before.
Severe, tnerefcre, as are
t~
tests which the System Las already bad to meet, t:...e developmmta.l
stage may not yet be said to be over.
Traditiunal mett.ods of reserve
banking, developed in the experience of Europe, cannot be
mec~cally
adopted in t:.W administration .:>f t::..e Federal Reserve System.
Mu.c).;..
pioneer work in blazing new patbJ mu.st therefore needs be done by those
who are gUiding its development, and tl:ey will need all the t.elp they
can get from enlightened discussion and larGe-mdnded consideration of
their problems.
Recallinc Bagehot 1 s penetratinG
observa~ion
ttat "the
abstract thinkirl£ of the world is never to be expected from persons
399
X-3090
-4-
in high places1 ' *, and recalling a.lso .how much
t.l:le
development of the
English banking system in the 19th century owed to scientific
economic discussion, it is much to be desired that American econorrdsts
who are in teres ted in probhms of credit and ba.nking 10 or in the
bearing of credit administration upon economic conditions, should
give close thought to Federal Reserve problems.
It is for this reason
that Dr. 0. M. W. Sprague' s/~j~g~i examination of the discount policy
of tte Federal Reserve Banks # is :r;articularly welcome.
serves well as a point of
de~arture
His paper
for (1) a review of Federal
Reserve FJlicy in the past, and for (2) a consideration of factors
and difficulties that will b.a.ve to be reckoned wi tll in adjusting the
methods and operations of ti:.e Federal Reserve Banks in the future to
new conditions and altered circumstances.
I~
Leavin; out of. consideration t:Jany oinor, but by no rr..eans un..,.
important, features of Feieral Reserve policy in order to concentrate
attention upon more
fund~..ental
aspects, it way be said
t~t t~e
three
chief elements of the policy of a central bank or system of reserve-
* Reference: "Lombard Street", by Walter Bagehot, p. 1?9. The w~le
passage wit~ reference to t~e early wanacerrant of the reserve of the
Bank of En,;land is worth quoting:
"---the directors of the Bank of England were neither acquainted
with riglit principles, nor were they protected by a. judicious routine·
They could not be expected themselves to discover such principles.
The abstra.ct thinking of the world is never to be expected from persons
in high places; the adndnistration of first-rate current transactions
is a most engrossing business, and those charged with them are usuallY:
but little inclined to think on points of theory, even ·~hen such thinktbg
most nearly concerns those transactions.
No doubt wben men's own
fortunes are at stake, the instinct of the trader does soffiehzyN anticipate
the conclusions of the closet.
Dut a board has no instincts when it i&
not getting an income for its members,. and when it is only discharging
a duty of office. 11
# In the American Economic Review for March, 1921, p. 16.
X-3090
holding institutions are best d.i:.>closed in connection ·;.ri.th the attitude
adopted. to·-;ard
(1-) Gold;
( 2) Cur rene y;
(3) Credit.
'\''".aile t:C.us separately enumerated, however, the policies pursued
-'Jith respect to gold, currency and. credit by the Federal Reserve Banks
are not to be reg~rd.ed as sepdrate and. \U~related policies, but as
closely .co~;~~nta~/ .;U.d. i:...t0gral pa.rt;; of Feicral Ros0rvc fOlicy.
It
\
vmuli perhaps
oc
nearer t~e truta. to s.::~.y trut tne policy pursued wi tb.
respect to gold and the policy pursued ,..,i t.u respect to currency are
elements in the policy pursued.
Hit!l
respect to credit, tne regulation of
t:Ue flow and volumlil of credit being in tb.e last a.na.lysis the primary
function of t~e Federal Reserve Eanks.
\~natever policy
the Federal Reserve
System. may pursue with respect to_ either goli or currency must take its
color a.nd occasion from the policy pursued '-?i th respect to creii t, and
suc:U bas been the case in the past.
1.
Gold Polio~
The first pAase of the Federal Reserve Systam 1 s
policy wi t.D. referen~e to goli was developed in connecdon wit~ t~e hea..vy
influx: of gold ·;.tt:ic!l set in toward our snores soon after the be.:inning of
tte European War, and \7.Qich up to the end. of tile year 1916 added
approximately 1200
~ullions
of dollars to our
r.atior~l
monetary
stoc~
Th9 Feieral nGserve Banks at this ti~~ not being possessed of any ready or
adequate icethod of impounding this redundant gold, the Feder'-il :Ueserve
:Soc:i.rd recommended in 1916 .:m e:.menkent to our ca.nkint;; st""tute giving the
Doard t.l::..e power to raise the reserve re'.luirer.:.ents of member banks.
The
object sou?,ht was to prevent, wAen ~d as it seemed. desirable, the new
401
-6-
X-3090
golJ. wC.ich was accumulating in the vault reserves of n:t"Jmoer banks fro::l
becoming the basis of an undesirable expansion of credit.
It will be
recalled taat ~t tcis tixe the Federal Reserve Banks were operatin~
w~der
t.ae terThs of tne Reserve Act as
ori~inally
enacted, the required
raserves of member banks oeing carried partly with reserve banks .... s
ba.L:..nces, partly in the va.ults of mer.Jber banks, the rerr.a.inder
t't.t
tbe
option of t.ae :-.:.ember banks being carried ei tiler ir.. tJleir own vaults or
wi tb the Reserve .Danks.
It was hoped that a. sufficient number of tbc
leading member banks '-"'uld appreciate the need of cooperation '-vi th the
.3oa.rd' s purposes in preventing the abnormal increase in our gold supply
from providin3 a basis of inflation, to secure their support for this
arnen:ir::;ent.
T.O.is dmendn:ent fe:dled, but in Septe;:;J.:;er, 1 916, the Reserve
Act was amended so as to permit rremter banks, at their option, to carry
the whole of tt.eir req1.1ired. reserves as bald.llces v•i tb. the Federa.l :2eserve
Banks.
The object of· t.i:lis .ame~d,ment wasto concentrate a larger portion
of tb.e actual s-oli reserves of meober banks in the bands of the Fe1eral
Iieserve Ednks.
In brief, tnese first phases of the Federal Reserve
System's gold policy ievelo:9ed out of its credit policy .:.ts
e:t.
method of
restraining unJ.ue cmd. unnecessary expansion of credit at a time when
tne ::eserve :d::1nks had not yet attained a position Yhere they could
exercise dllJ' effective control over t.ae course of the country's credit
operations by discount rates.
The follo'.l.i ng table, ;vtich sets forth cmnges in the leading items
of t..:..e Fed.er.;:1,1 Reserve :Janks' condition, snows the cb.:m.ges in t:Ue Syste~n• s
gold position to the en.:l of
T~.;...;;:c:C.,
1921:
:.-
GOLD MOVEMENT ~D CHANGES IN RESERVE
POSITION OF TBE FEDERhL RESERVE BANKS
...
( IN MILLIONS OF DOLLARS)
:·Gold Reserves: Total cash :Net de- :
:Net Imports r:: General
Gold in U.s.
reserves of:posits :Re3erve
of
:(+) or
· stock of
other than
F.R.
Banks :and note:
Exports (-): gold in
F. R. Banks
gold reserves
:liabili-: R::.tio
of Gold
u. s.
of F.R.Banks
:ties
(a)
(a
a
·~
1,335
1,607
228
262
252
104.2
3,089
3,092
2, 662
3,001
2,151
904
727
779
938
2,138
1,935
2,222
947
2,255
2,057
2,437
1,065
4,350
4,821
4,535
89.0
51.8
·-+2. 7
53·1
+1,254
+ 544
+ 710
+ 685
+ 313
-}5.2
+
-1,247
+1,250
+1.308
+3 ,285
·37·2
117
253
198
+ 471
November 27 1 1911+
End
End
End
End
.J-V
of March, 1917
of ~~ay, 1919
of March, 1920
of March• 1921
Changes for Period
Nov. l, 1914 to end of
March, 1917
End of March, 1917 to
end of M.ay, 1919
End
May I 1919 to
end of Varch, 1920
End of March, 1920 to
end of March, 1921
+ 1,139
29
of
404
+
376
3
430
+
339
.
·•
+
52
+
287
+
380
(a) Bank figures relate to the last Friday of the month, except those of March, 1921,
which a:c·e as of March 31, deposit liabilities and reserve :percentages have been figured
on a uniform basis throughout the table.
.. -
9·1
236 : + l0.4
X-3090
-7-
The next phase of the Federal Reserve System's gold policy carr.e
with our entry into the war in 1917.
The note issue provisions of
the Federal Reserve Act were then liberalized so as to permit tLe
direct issue of the Federal Reserve notes against gold as collateral
security, the gold thus held as security in the Federal Reserve Agent's
Department being counted as reserve required against Federal Reserve
notes, and the provisions concerning member banks 1 reserves were changed,
first by reducing their
re~uired
reserves, and second by requiring that
their reserves should all be carried as cash balances with Federal
Reserve Banks.
The object o:· these 0.::~auges wM to enable the Federo.l
Reserve System to strengthen itself against the credit demands which
it was foreseen the war into which we were entering would occasion.
The policy, in brief, was to impound as much of the stock of monetary
gold in the country as possible in the Federal Reserve System, where it
would supply, as circumstances made it necessary,
basis for an enlarged issue of Federal Reserve
-~
note~,
adequate gold
and reserve de-
posit credit in connection with the vast loan and financial operations
of the war.
Here again the gold policy of the Federal Reserve System
is to be interpreted in the light of its attitude toward credit conditions and needs.
Just as in the first phase of its gold policy its
objective was to restrain credit expansion at a time when such expansion was not necessary, so now its objective was to provide an ampler
base for credit expansion in view of the changed situation and its
credit requirements.
The next importam; J--..'lase of the gold policy o:f the :Federal Res;:;rvs
System came in 1919 with the lifting of the enbargo on the exportation
.,.
l
X-3090
-8-
of gold in June of that year on the recomrrendation of the Federal Reserve
Board.
The embargo on gold was not originally imposed at the instance of
the Federal Reserve Board, although the Board was charged with the responsibility of administering it.
When one form after another of the
various controls which had been set up over industry, trade, transportation,
fuel, etc., began to fall away in
1919, the Federal Reserve Board re-
commended a lifting of the gold embargo, although the Federal Reserve
System was still confronted with the credit problems of the Treasury and
had not yet, on accotmt of the Treasnry financing, regained a normal control
of its discount operations and its .discount policy.
At a time When it was
virtually helpless to influence the course of the money market by the
adjustment of discount rates to actua.l conditions, it sought to exercise
what influence it could over the expansion of banking credit in the year
1919 by perrrdtting the exportation of gold, and thus exposing the gold
reserve of the Federal Reserve System to depletion by foreign drains.
The loss of gold from the country thus occasioned to the end of the year
1919 amounted to 322 millions of dollars.
The loss occasioned to the
Federal Reserve System amounted to 125 millions of dollars, and helped
to bring nearer the day when the Federal Reserve Banks must be penni tted
to resume their normal relation to the money market and to exercise a
control through discount rates.
Thus again it appears that the gold
policy of the Federal Reserve Board was a reflection of its attitude
toward credit conditions, although an important consideration in the
lifting of the gold embargo was, also, the desire to rraintain and upbuild American financial prestige by restoring to the .Aiterican ma.Iket
the character of a free gold market.
•
I
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X-3090
There was little occasion, during the first
years of the Federal Reserve System, for the Federal Reserve Board to
develop a currency policy.
According to the original conception of the
Federal Reserve Act, and in view. further, of the fact that at the time
of the organ.iza.tion of the new system the country was SU"'plied with a
large volume of currency in the form of national bank notes, the Federal
Reserve note was regarded as a means of satisfying seasonal or emergency
requirements for additional circulation.
When the great gold influx set
in, in 1915, the Federal Reserve System pursued the policy of issuing
Federal Reserve notes in exchange for £Old, and the Federal Reserve note,
up to the time of our entry into the war in 1917, was in effect a gold
certificate.
The object sought in this policy, especially in view of the
extraordinary character of the shifting of the world's stocl: of monetary
gold then in "Orogress as an incident of tbe war, was to treat tre Reserve
Ba:nl- s
as repositories of gold
a~ains t
tl:G
day when it see;:r.ad reas enable
to e.x-r:ect that tl"le largest portion of cur new acq,uisi tions of "old would
flow back to Europe, and was also in furtherance of the early credit
· policy of the 'Board. already described.
Under the
ter~s
of tt-e Feder&l
Reserve Act, Federal Reserve notes were not available as legal reserve
money to n.errber ban1::s.
One of t'f-_e practical effects, therefor::;, of t'l:':·::;
issue of Federal Reserve notes in exchanee for gold w.::s the .-i tt-drawal
of this gold from ordinary banldng use, p?..rticularly from nenber bank
reserves» where its accurr.ulation was already beginning to work an undue expansion of credit.
In brief, currency policy was
develo~ed
upon lines
parallel ling the Federal Reserve Syste;- 1 s credit policy. wt.ich, as already
- 10 -
X-3090
stated, was airred, at this tirre, at a control
of credit expansion, the
dtuation not yet having develored to a point where the traditional rrethod
of the control of expansion by n:eans of discount rates could be trade
effective.
During the -period between the end of November, 1914, and the end
of March, 1917, net imports of gold into the United States amounted to
1189 ndllions of dollars, while the increase in the gold held by the
Reserve Banks
and the Reserve Agents was about 710 millions.
The dif-
ference between these two amatmts represents additions to the gold
holdings of national, non-national, and private banks, to gold held earmarked for foreign account, and to geld in circulation.
It appears,
therefore, that even before the ent.-y of the United States into the
war, the larger part of the gold coming into this country found its
way into the Federal Reserve Bariks and was
i~ounded
there.
After we entered the war and the Federal Reserve Act was liberalized
in its note issue provision, the Board systematically continued the
policy, already noted in connect5.on with the discussion of its gold
policy, of impounding gold in exchange for Federal Reserve notes.
It
was expected that the gold thus acquired would be needed in the process
of providing
and in
th~
credit facilities needed in
tBkin~care
~e
financing of the war
of the extraordinary requirements of business
occasioned by the war.
It was of course recognized that the degree of credit assistance
that the Federal Reserve :Sanks might be called upon to extend to their
member banks in the process of floating the Govemrr.ent's war loans
might easily reach the point of producing a considerable inflation of
I
~
-11-
credit.
X-3090
"But the theory upon which the Board proceeded with rc:>}lect to
tile issue of
~eral
Reserve notes was that the currency. as such,
would not promote inflation, and that restriction of note issues by
Federal Reserve Batiks in resnonse to the requirerr.ents of the
was not therefore advisable or
neco~~ary.
corr~unity
On more than one occasion,
as the volurre of Federal Reserve notes in circulation showed substantial
increase, the Beard stated its view that the increased issues were
occasioned by the rise of prices, and that in due course, as prices
ceased to rise or showed a tendency to fall, the Federal Reserve note
currency which was found to be in excess of the country's requirements
would return to the banks.
~e
Beard's view was most succinctly stated
in its letter of August 8, 1919, to the Chairman of the Senate Committee
on Banking and Currency:
"Federal Reserve notes are not legal tender, nor do they count as
reserve money for rr.ember banks. They are issued only as a need for them
develops, and as they becorr.e r-:;;dundant }n any locality +:hey a:t'e returned
to the Treasury at Washington, or to a Federal Reserve Bank for redemption.
Thus there cannot at any time be rrore Federal neserve notes in circulation
than the needs of the country at the present level of prices require, and
as the need abates the vo1urr.e of notes outstanding will be correspondingly
reduced through redemption. n *
How far the currency theory thus stated has been borne out by recent
changes in the volume of Federal Reserve notes in circulation can now be
determined.
Federal Reserve notes attained their maximum amount for the
year 1919 on December 26th, when they stood at $3,057,646,000.
With the
advent of the year 1920, a retm·n flow of Federal Reserve notes set in.
This movement, 'however, was stort-lived.
Between December 26th, 1919,
and January 23rd, 1920, Federal Reserve note circulation was reduced by
$213,419,000.
Thereafter there was a steady increase in the vo1w:r:e of
Federal Reserve notes issued and in circulation. attaining the amount of
*
Federal Reserve BUlletin, August, 1919, p. 701.
('8
!''l ) ....
C:l,.\_,
..: ..... v
-12-
X-3090
$3,404,931,000 on December 23, 1920, when a return flow of subst~ntial
dimensions set in wbich is still in process.
Tne drop from the high
-point irt December, 1919, to the low :point of 1920, was S213,-H9,000;
and from the bigh :point of 1920 to .A.pril 15, 1921, is ~~536 ,404,000.
The two movements just referred to indicate not only changes in
the volume of currency owing to seasonal needs, but also a connection
between the
volu~e
of credit
c~d t~e
volume of currency, thus lending
much support to tile Bod.l'd 1 s ti:J.eory tillt the expansion of the currency
is a consequence of the expansion of credit
~nd
the rise of prices,
and thdt the expansion of the currency is rtot tberefore to be regarded
as a causal fa.ctor in price moven:ents:
"The increased volume of Federal Reserve notes in circulation
during the past three years, in so far as it is not the result of
direct exchanges for gold and gold certificates wbich have been withdrawn from circulation, is the effect of advancing wages and prices,
ani not their cause. n *
Whether this view (with all it irJplies) of the relation of
currency to credit and prices, which, it must be
a~tted,
has the
sanction of bigh authority in our own and other countries and considerable support from banking cilld currency experience under norwal
conditions, can safely be taken as an invariable principle of
Reserve Bank action in the future will be considered later in this
paper.
3.
Credit Policy.
Credit policy was oaly of theoretical
moment in the first years of the Federal Reserve
Syste~
Easy credit
conii tions in the United Std.tes, because of tne reduction of member
* Federal Reserve Bulletin, August, 1919, p.
702.
X-3090
-13-
bank reserve requirements and the great influx of gold, made reserve
bank credit policy and discount rates of little actual consequence
until the late autumn of 1916.
Then, for the first tirre, did a credit
situation develop which gave to the rates of some of the Federal Reserve
Banks a degree of effectivene3s.
The increasing pressure for credit
funds, wJJ.ic.u ivOuli nave developed in the yea.r 1917 even if tne Un.i ted
States bad not entered tee war. would undoubtedly have led to the
developn:ent of an effective discmmt policy by the Federal Reserve
System--a policy in wnich main
relia~ce
would have been put upon rates,
and. under wnich reserve bank rates would have been adjusted to market
conditions so as to keep tbem, in the
least, at or above tne ordinary
accor~e
lar~er
con~ercial
financial centers at
rate; all of this in
with well-recognized principles of Reserve Bank practice.
Vli th the entry of the Uni te:l States into t.ae war, the outlook was
changed, and the Federal Reserve System wasconfronted with large and
difficalt problems of credit grmving out of the loan policy and loan
operations of the Treasury.
From that time forth to the beginning of
the year 1920, the discount policy of the Federal Reserve System was
shaped not in accordance with money market conditions,--not with the
idea of using .Reserve I}ank rates as an instrument of effective control
of the money market,--but with tl:e primary pp.rpose of assisting the
Treasury in the flotation of its great bond issues and its short term
certificate issues.
In brief, the discount policy of the Federal Re-
serve System was treated as:.:an element of the Treasury•s lo.m policy,
the Federal Reserve System virtually ceasing to exercise, for the time
...I
X-3090
being, its normal function of regulating credit.
The position of the
Federal Reserve Board with respect
of Treasury policy
to tbe bearing
upon the Federal Reserve System has been explained in its several
Annual Reports*, and recently was succinctly stated by the Governor
of the Federal Reserve Board at the Joint Fearings held before the
Senate and House Committees on Agriculture on December 3, 1920:**
"The Federal Reser···.:l Bo~ d ad:JftcU. a poli..:;y ir.. order to assist
in the war financing which was economically unsound. I say this fra~ly.
Congress authorized certain loans. It authorized the Secretary of the
Treasury to determine the rates at which the loans should be issued.
The Secretary of the Treasury aSked the advice of experts and then
fixed the rates of interest to b3 born3 by the several issues of bonds,
notes, and certificates.
During t11A tirr.e we were actually at war,
something like $18,000,000,000 of bonds were sold to the people, an
amount certainly in excess of the normal investment power of the
American people in such a short time, and the only way in which those
loans could be financed was through the instrun:entali ty of the banks.
The only way the banks could undertake to do it was to get some
assistance from the Federal Reserve Banks and at a low rate. The low
rate of interest borne by these bonds was fixed with a view of holding
down the expenses of the Government as far as possible. Anyway, that
is something the Federal Reserve Board has no responsibility for. In
order to make possible tbe floating of these bonds we fixed a rate less
than their coupon rate.
Some member. banks announced that for a period
of six months there would be a rate of 1-!-i- per cent on notes secured by
Gover~ent obligations. The result was there was no loss to subscribing
b~s pending the distribution of the conds to the public.
There were
successive bond issues. The principal reason why discount rates were
not increase~ earlier than they were in 1919 was on account of Treasury
financing. "
This may be taken as the official statement of the Federal Reserve
Board with respect to the discount policy followed by the Federal Reserve
Banks to the end of the year 1919.
*
See Report for 1920, pp. 11-15; for 1919• pp. 67-73; and for 1918, PP•
1-5 and 85-Z7.
** ~ages 62 and 63 of the Hearings entitled "Reviving the Activities of
the war Finance Corporation•.
J
-15-
X-3090
It is clear that the point at which the loan policy of the Treasury
affected the Federal Reserve
Bar~s
was the money rate.
Discount rates
were maintained at artificially low levels from shortly after the beginning of the war in 1917 until the end of the year 1919.
device which was
e~loyed
The particular
in aid of the Treasury's loan policy, as is
well known, was the establishment and maintenance of (1) preferential
rates on bond- .;md
certif~cd.te-~ecured.
paper, and (2) a differential in
f~vor
pdp(;:..:, as
compared with cor.:mercial
of the rate on such bond- and
certificate-secured paper as compared with the interest rate borne by the
bonds and certificates.
The imrDeJse
c~adit
resources of the Federal
Reserve System were thus availed of by the Treasury during this period
to make and maintain an artificial money market.
In effect, the power
of the Federal Reserve Board as the ultimate regulator of the discount
policy of the Federal Reserve
B~nks
was put in commission. and rates were
fixed, not nwith a view of accomodating comnerce and business",* in accordance with no.rma.l principles, but with
.i;t.
view to accon:.od.G..ting the
financial program of the Treasury in accordance with emergancy principles.
Whether the Treasury's loan policy and methods of short
rowing were
\,gell
conceived is not here in qu.es tion.
te~
bor-
Indeed, the time bas
not yet corre for passing judgment upon the policies of the Treasury in
connection with the financial condnct of the w4r.
sible to s:pedk of that
f~a.t-Jl"e
It is, however, pos-
of TreaEUJ.-.1 pclic.Y which n.o.>:. vi tally a.f-
fected the Federal Reserve Banks.
The wisdom and the necessity of the
device of an artificial money rate, carried to the point that it was by
the maintenance of a differential rate upon so-called war loan paper, ma.y(be ·
------·--
-------~
--
.
~----.
*The language of the Federal Reserve .Act , Section 14, paragraph D.
~.
-16questioned.
X-3090
In the light. of sP.bse.quent developments, it may be
questioned whether it was no';", a costly device t.o the country.
the bad. economic consequence':>
~<vere m~niroized
of
While
artificially low discount rates
during the war by the rr.any various controls over the
economic activities of the people that were then set up, a precedent
was established which it was foUPd difficult to s.at aside after the
w?..
r.
'rhe controls which were set up during the war on production,
trade, and consumption- such as the 'War Industries Board, War Trade
Board, Food Administration, Fuel Administration, Railway Administration,
Shipping Board, Capital Issues Committee, New York Money Committee,
etc., had very important financial consequences.
Their bearing upon
the credit situation and upon the eredit problem of the Federal Reserve
B~nks was especially important.
They acted in eff~ct, though that
was not. their intended purpose, as a control of credit expansion at
the source by limiting the occasion for the ·use of credit and by confining its use to such purposes as were deemed essential to the prosecution of the war.*
But with the close of the war,--that is, with the cessation of
hostilities following the Armistice,--these various controls were
soon lifted:
"The moment we knew the Armi$tice to have been si;ned
we took the harness off • 11 **
It was very generally expected that business
and industry
' Federal Reserve Bulletin, October, 1918, pp. 922~924. If these various
controls which were in effective operation·in the last months of the war had
been made equally effective early in the war, it is probable that a better
financial and credit situation would have been maintained throughout the war;
in brief 7 that there would ba.ve been less inflation of credit and prices
than in fact developed.
From President Wilson's Address to Congress, delivered Dec. 2, 1918.
•*
-17X-3090
if freed from restraint, would soon effect their return to a normal
condition.
Early in the j~ar 1919, however, industrial stagnation and
unemployment were in evidenc0, and a fresh survey and diagnosis of the
econo~c
situation was made by the Industrial Board•
* set
up under the
auspices of the Department of Commerce for assisting the readjustment of
industry and trade to a more stable basis.
Its main effort was direc•
ted to bringing about revision of prices and stabilization of the expec~
ted fall of prices.
Events soon showed tbat the policy: of "price stabiliza-
tionn was based on a faulty economic diagnosis.
It '\vas not many months
after the close of the w~r that prices began to rise.
The main impulse
came from the release of buying po'.tver which bad been in restraint d'\ll'ing
the war.
A seller's market began to develop in the spring of 1919.
consumer demanded goods; price was a secondary consideration.
~~e.
Dealers,
both wholesale and retail, were bidding against one another for such
supplies as tb.ere were* and manufacturers were biJ.iing against one another
for raw materials and labor.
The rapid rise of prices induced bUJing for .
speculation, and speculation in its turn accelerated the rise of prices.
Inflation was becoming ~lative and syste~c in its effects, and pervading the whole body economic.
which bas puzzled so many people.
This is the explanation of a phenomenon
During the war. expansion of eredi t
was restrained from working its full economic effects in the form of price
inflation and speculation.
After the war it was let loose when the va.rious .
controls above enwneratei were lifted and the huge volume of credit created during the war was permitted to diffuse itself.
* Federal Reserve Bulletin, March, 1919. p. 246.
-18-
X-3090
The credit an.i business situation which developed in the United
States in 1919 'Was one that neeJ.ed restraint.
A
seller's market usual-
ly needs credit reetraint before it passes the limit of
~afety,
as a bu35r's market Usually needs the l:l.elp of credit support.
just
It would.
have been of the greatest alvantage to tbe country if such restraint*
had been exercised by the Federal Reserve System in the tear 1919,
and the developu:ent of the runaway d.lld speculative markets, which developed in the second half of the year, been measurably prevented.
The Federal Reserve System was the one important agency of control
left to the country after the various war controls had disappeared.
All the more important was it, therefore, that it should bfil in a position to function as effectively as possible.
bili ty,
eve~
Its burden anl responsi-
under the most favo.rable view of the situation, were un-
denia.bly large, and would have imposed.
d
severe test upon the System.
In the light of what transpired in the year
~920,
as is ncw1 a matter
of universal knowledge, there is every reason to believe that if the
* The month of September was the time to AaVe gotten control. The .
public de~t ·reached its maximum. at the end of August, ani a great reduction of the floating debt occurred in September. Total war·loan
paper for the twelve Federal Reserve Ba.nks dropped from ~1,635.233,000
on the 5th of September, 1919, to $1,383,896,000 on September 19th,
following the redemption of certificates on ~he 15th of September of
$431, 910, 000. The rise was then rapid, reaching $1, 771, 028, 000 on ·
November ?th. The movement of total bills discounted paralleled the
variations in war loan paper closely. On September 5th, total bills
discounted for member banks were $1,84?,418,000. They fell to
$1,645,881,000 on September 19th, and rose to $2,189,489,000 on November 7t~ The expansion of the lo~ account of the Federal Reserve banks
during the seven weeks from September 19th to November. 7th amounted
to over $500,000,000.
For the Federal Reserve Bank of Ne·''~ York, total wa.r loan paper
.
dropped from $6?2,070,000 on the 5th of September, 1919, to $483,053,000
on September 19th• It then rose to $795,212,000 on November 7th. On
September 5th, tot~l bills discounted amounted to $724,861,000, falling
-19X-3090
Federal Reserve System bad f<::nctioned as effectively in 1919 in regulating credit as it did in 1920 in retarding anl eventually arresting
expansion, it would have randered an inestirrable service to the country
and v•ould :Cave prevented rr.any of the unheal tnful developrr.ents in business and credit from gaining the rieadway
whic~
made action of so
drastic a character as tl:-.at Nhich was taken in 1920 necessary.
How
much of the business distress and economic hardship experienced by the
country during the past year would have been avoided, had the
to $528,592,000 on September 19th, and r1s1ng to $90±,351,000 on
November ?th. The expansion in total bills discounted in the seven
weeks from September 19th to November ?th amounted to approximately
$37 5, 000. 000.
1
-20-
X-3090
Federal Reserve System been in a position to pursue a discount policy
in the second half of the year 1919 such as the trend of develonments
clearly indicated to be necessary, cannot of course be determined.
Much of the hardship suffered by the country in 1920 might, however,
have been avoided by the adoption in 1919 of an effective precautionary
policy of credit control.
That such a precautionary discount policy
would have been adopted by the Federal Reserve Sys tern, had it felt
free to act, will not be doubted by anyone acquainted with the attitude of the Federal Reserve Board and the Federal Reserve Banks at
this tirre.
As early as June, 1919, after the close of the Victory
Liberty Loan campaign, which, it will be remembered, was announced to
be the last of the war loans, the Federal Reserve Board expressed its
concern over the unhealthful tendencies which were in process.
Counsel
and warnings of similar purport were subsequently repeated.
The
necessity of restraint upon the borrowings of rr.ember banls for
s~culative
purposes by other rr.eans than advances in discouct rates*
was pointed out, and such restraint was urged..
Rere and there, for a
while, there were sorr.e slight evidences that the situation was being
controlled, hut no large results were achieved, and steculative
tendencies of a dangerous character and large dirrensions, involving
• "The Federal Reserve Board is concerned over the existing tendency
towards excessive speculation, and while ordinarily this could be
corrected by an advance in discount rates at the Federal Reserve Banks,
it is not prac tica.ble to apply this check at this tiiLe because of
Govemment financing. • ~·· (From letter sent by the Federal Reserve :Board
to the Chairmen of the Federal Reserve Danks, JWte 10, 1919).,
-?l-
X-3090
speculation in land and
co~odities
as well as in securities, gained in-
creasing momentum through the autwm of 1919.
nnirect actiontt,
as a method of credit control was not succeeding.*
and the rise of prices went on apace.
~a-called,
The expansion of credit
Speculation flourished.
It could
nq longer be doubted that the Federal Reserve Systelli rrust undertake the
regulation of credit by means of discount rates.
A beginning was rrade by
the slight advance in discount rates on war loan paper on December 11th,
1919, with every expectation and intention on the part of the Federal Reserve System of assuming full control of its discount policy with the advent
of the year 1920.
All this is said dispassionately and objectively, by way of explanation
~a
critical period in the history of Federal Reserve policy.
The
Treasury, as well as the Federal Reserve System, had its difficulties.
While the war, in a fighting sense, was over with the advent of the year
1919, it was not over in a financial sense.
fronted with vast financial obligations.
The Treasury was still conThe financial precedent es-
tablished during the war carried over into the year 1919.
Reserve Earik
-
policy continued to be subordinated to Treasury policy, and discount rates
throughout the year 1919 were maintained at artifically low levers.
The
device of an artificial discount rate provided too comfortable an expedient
alike to the Treasury and to the banks of the country, which were still
burdened with comni tments made under the "borrow and beyn Liberty Loan
slogan, to be easily,relinquished.
Thus was the Federal Reserve System
controlled in the matter of its discount policy at the very tirr.e when the
interest of the country at large required that it should be free of control in order that it itself might control.
* nThese warnings~ however, were only a transitory expedient and were
given only momentary attention by xr.eny banks. The Board was prepared,
as soon as Treasury exigencies permitted, to resort to the well-known
method of advancing the rate of discount." Annual Report for 1920, p. 12.
X-3090
-22-
With the year 1920* the Federal Reserve Danks entered upon the
exercise of their function of regulating credit in accordance with
business and economic indications, and, under circumstances of
extr~
ordinary diffi<:ul ty and for the first tirr.e sir.ce the outbreak of the
war, un::lertook to develop a policy of credit control by means of discount
rates.
About the same time the Treasury adopted the policy of adjusting
the interest rate on its short-term borrowings to the state of the money
market.
It is not for the Federal Reserve Board to estimate the wisdom
of the credit policy pursued by it in the year 1920.
lt
~ay.
propriety speak of the a ttitud.e which led to that policy.
11
There was nothing
hesitant"** in the policy adopted by the Board at this time.
ad.v8.nced as follows in January, 1920:
however. with
Ra.t'es were
comnercial paper rate. from 4~ at
ten banks and 5~ at two banks to &f., at all banks; certificate of indebted- '
ness rate, from 4~ to 4~ according to the rate borne by the certificate
t9 4~ on all classes of certificatesi libe~ bond rate, from 4i% at ten
barks and
5<t at two
banks to 5~ at all banks.
Such marked advances of
rate do not betray "hesitation"i they evidence conviction.•*•
This first
advance in rates not proving effective, further advances were made in the ..
early summer -- the commercial rate at the largest
Feder~l
Reserve Banks
being advanced from (1#; to 7'1:., rates on certificates from 4~ to 5~ a.t
seven banks. and from sf:, to ~ at five banks. according to the rate borne
• "Fortunately the con:ii tion of the Treasury is such that the Board can now
feel free to inaugurate discount policies adjusted to peace-time conditions
and needs." ~nnual Report for 1919, p. 69•• The term used by 'Mr. Sprague in the article already cited, page 24.
•••"It was the Board's conviction. however, at the close of the year,(l919)
that a substantial advance in all discount rates 'Mas necessary and that
it should not be long delayed." Annual Report for 1919, p. 4.
-..
,
;
-23-
X-3090
by the certificate, and rates on liberty bonds from
5fd.
to ~ at six banks,
and to 5~ at one bank, the rate being left 1.mchanged a. t the remaining five
banks.
The reserve rati.o.· for the Feder1.l Reserve System as a whole on
January 2, 1920, was 43-7~ as corrpred with 50·~ on July 3, 1919.
declined to 4~.g¢ on July 2, 1920.
It
The Boa~~ action in raising rates
was therefore clearly supported by the reserve position of the banks.
there is nothing in the action taken then or at
an.y
But
time later in the year
to justify the 3taterrent that the Board's discount policy in 1920 was not
"the expression of a voluntary policy."*
The
Boa~'s
attitude is clearly
indicated in its Annual Report for 1919: "The expansion of credit set in
motion by the war nust be checked.
Credit must be brought under effective
control and its flow be once more regulated and governed with careful regard
to the economic welfare of the country and the needs of its producing
industries."**
The action taken by the Federal Reserve Banks in 1920 was
taken, not .primarily to protect their reserves, but to control the rate of
expansion of credit.
It should be distinctly noted in .reviewing the situa-
tion of the Reserve Banks during the years 1919 and 1920 that the reserve
ratio of the Federal Reserve System.was declining, not because reserves were
*"It is. however, by no rr.eans certain that the Reserve Board would have
taken ~reasures to restrain credit during the course of the wi.nter and spring
of this year 0920) if the power of the Reserve Banks to extend credit within
the limits of legal reserve requirements had not beer! nearly eXhausted The
successive advances in discount rates nade during the first half of the
yea~ were not then entirely the expression of a voluntary policy.
lt was a
policy whiCh in large measure was enforced by the reserve position of the
banks.• (Sprague, article cited,p. 23.)
•• Annual Report for 1919, ~· 11.
4
i'
-24-
..
X-3090
t.arougJ:.i. loss of gold, but primarily because the credit
facilities of the System were being too freely drawn upon by tbe
of the country and the liabilities of the
Reser~e Banks
b~nks
in the form
of deposits ~nd notes L~unting at a steady and startling rate.
~he
decline of the reserve ratio reflecteJ quite ciCCurately the credit expansion ~hich w~s in process.*
T~e
solicituJe of t~e Boari arose not
because of loss of goli--for the total gold holdings of the Reserve System showGd little variation (amounting on January 3, 1919, ·to :)2,091,194,000;
on July 3, 1919, to $2,128,9~6,000; on January 2, 1920, to $2,062,615,000;
on July 2, 1920, ~o $1,971,6SS,OOO; and on December 31, 1920, to
•
S2,059,33.3,000)--bu.t because of the unhealthful credit situation which
had been developing since
the
s~er of 1919, and which threatened to
culminate in disaster unless subjected to control.
While this condi-
tion was reflected in the decline of the reser,re ratio, the Board's discount policywas directed toward improving the reserve position of the
Federal Reserve Banks not by increasing their reserves, but by c~ecking
the constant expansion of their liabilities
ana
by setting in operation
forces whic:a would make for a healthier credit situation.
It raised··
rates to protect the Reserve Banks against abuse of their credit fdcilities,
and to protect the community and the general business and econorrdc situation against the consequences of such abuse.
* Studies made by the Statistical Division of t:Ue Federal Reserve Board
indicate that for the larger part of the ;year 1920 the reserve ratio
has fluctuated in close accord with changes in note and deposit liabilities.
As be~¥een notes and deposits, the indications are that for shorter
periods of time cbanges in the ratio follow fluctuations in deposits, while
for longer periods of time the decisive influence on the ratio is exercised by changes in the volun:e of notes. An effort bas been made to
devise an 1'index of divergence", or formula for estimating the relative
effects of changes in liabilities and of changes in reserves on the move. rr..ent of the reserve ratio. See paper by E. A. GoldenNeiser "Index of
Divergence" in the forthcoming se1jt.number of the .American Statistical Review.
X- 3090
-25Whether the Federal Reserve System would have had the support of
public opinion to the extent it had during the past year, had the bad
situation which the Federal Ressrve
~oard
was undertaking to improve
not been unmistakably reflected in the reserve position of the banks,
may well be doubted:
"As a guide to discount policy, i t must be admitted the reserve
ratio has certain conspicuous advantages.
It is definite and obvious.
Public opinion may be expected to support the always unwelcome policy
of credit restraint when that policy is enforced by a depleted reserve.
It is unhappily very doubtful Whether the public would have reconciled
themselves to the advance in rates
had had, let
U$
ma~e
last spring if the Reserve Banks
say, a reserve ratio of 55~. and yet, all other things
being the sarne, an advance in rates would have been no less desirable."*
It is this consideration, thus well stated, which has
giv~n
to the
bank reserve ratio in the past its authoritative pvsition as a credit and
banking indicator.
It is this same consideration Which will assure it
a position of almost equal importance in the future.
Tradition, it must
never be forgotten, has much to do with matters of banking and credit
practice.
The popular tradition that the reserve ratio is the index of
changes in the credit situation will therefore be slow to disappear.
Particularly will this be true in the United States. where long adherence
to the principle
much
of legislatively prescribed minimum banking reserves has
of the sanctity of a first principle.
The :proposals often made in
recent months to abandon the reserve ratio as an inHcator of discount
*
Sprague, article cited, p. 27
26 -
X-3090
policy and to base discount policy hereafter on the observed effects of
credit on prices, •
have, t'terefore, the character
of
academic pronosals,
even in present circumstances, which, it must candidly be admitted, are
less favorable than was ordinarily true in the past to quiCk responsiveness on the part of the reserve ratio to changing business, credit, and
price conditions.
As
an abstract proposition, the proposal to substitute
a price indicator for the reserve ratio as a guide to discount policy has
much economic
n~rit.
The rigors of the recent price
through which the United States, in
co~~n
re~justment
process
with the rest of the COffiroercial
world, has been passing, have emphasized the value of price stability.
Price disturbances not originating from inevitable natural causes are
bad and costly alike to producer and consumer.
It is not surprising,
therefore, in view of the trying experiences of recent years, that effort
should be
~ade,
in reviewing the working of present•day credit and banking
machinery, to find some guide to credit policy that will give to the
community greater protection against unsettling changes in the price level .
.
Recent American experience, it
rray
also be admitted. has demonstrated that
good bariking administration in tiuss of economic disorder, at least,
presents more than a problem of merely maintaining the reserve
ratio~.
in
a conventional or perfunctory sense.
Without entering upon the discussion of controverted questions of
economic theory
touchin~;
the relation of changes in prices to changes in
the volume of credit, it rray be
ass~ed
that the retardation of the flow
of credit in tirres of expansion. and the acceleration of the flow of
credit in tin:es of business recovery following a period of depression,
*S~rague,
~rticl8
c:ted, p. 2e.
-27-
X- 3090
have an appreciable bearing on price movements.
proposition,
therefor~,
As a theoretical
it is entirely conceivable that the discount
policy of the Federal Reserve System might be Igoverned by indications
of impending price changes, with a view of mitigating their cyclical
fluctuations.
While such an undertaking would raise some new and difficult
problems of credit adr.inistration. no doubt in tin:e the technique of a
plan of credit regulation based on price indices
could be worked out and
made ad'llinistratively practicable if public sentiment demanded.
is now no warrant in the
st~tute
But there
under which the Federal Reserve Banks are
organized for undertaking to regulate their credit operations on any such
basis.
The ecor.on!iC logic of the Reserve .Act is clearly predicated upon
the theory trot the
Federal Reserve Banks shall be operated with regard
to reserve ratios, and "rates be fixed with a view of accommodating corrrnerce
and business."
It would irrply a very latitudinarian construction of the
term "accomr.odating commerce and business" for the iederal iieserve Board
and the Federal Reserve 'B<?.nks
t0
adept be
11
observed effects of credit on
prices" as their rule of action in the future.
T~ere
is r.ot, however, the
slightest reason for supposing that such a procedure on the part of the
Federal Reserve Bc:mks would be viewed with public approvo:.l.
contrary.
Public sentirrent in the United
highly sensitive in
~atters
State~
Q-.1i te the
is, and always has been,
of credit control, and precisely, among other
reasons, because of the bearing that such control has, or is believed to
have, upon the movement of priees.
The popular dread of
11
contraction", based, as it is, upon the popular
assumption of a close, immediate, causa.l connection between contraction
and falling prices, has seldom, if ever, been appealed to in vain in the
- 28 -
X-3090
United States in times of economic pressure.
There is not the slightest
warrant in either the remote or recent economic history of the United
States for supposing that.the American public would sanction or tolerate a
discount policy on the part of the Federal Reserve System avowedly based
upon price indexes. even if it were clear that such a practice were otherwise advisable.
It '"lOuld be regarded as tantamount to the setting up of
a credit- and price-despotism.
This .fear of contraction and its conse-
quences is one of the most persistent phases of American popular economis;
practically viewed. it has the force of an instinct and is the explanation
of many. if not most. of tbe other"ise puzzling vagaries of American financial history.
One of
it~
earliest and most energetic manifestations.
it
··is well to recall, was the bitter host·ility aroused against the.Second Bank
of the United States because of the
~inancial
1834, alleged to have been due to the
of
pressure experienced in 1833-
sinister purposes and Czarist methods
the great banking institution against which Jnire.v Jackson was success-
fully arraying the forces of public sentin:ent in mc:.ny
country.
tater manifestations of the same feeling
se~tions
a~oun~
of the
in the decades
fC~llowing th~ Civil ~'tar, when the nation was confronted with the problem of
correcting currency disorders resulting from the Civil
~~r.
Recent events,
in the autumn of 1920, have given evidence of the persistence of a sindlar
strain of sentiment.
The problem of credit and currency regulation in a
tbe United States, and as conplicated in its economic
coun~ry
as vast as
organi~ation
with
different sections of the country in different stages of econondc development and maturity, presents a very difficult problem even ur.der normal
X-3090
conditions.*
Tr.is. among other things, is the explanation and jus-
tification of the use of the regional principle in determining the
structure of our system of reserve banking, as against the principle
of a single central institution, nationwide in the scope of its operation and control,--the regional principle
per~mitting
of a closer adapt-
ation of credit policy to regional or local conditions.
The discount
or credit policy of a reserve bant, .whether organized on the regional
or the central principle, must always be the expression of a judgrrent as
to when a situation has arisen in business, industry, or credit which
indicates the desirability of action on the part of reserve holding and .
credit and currency regulating institutions.
1 ~ve judg)l;ent, not a rr.echanical judgment.
That judgment must be a
A great variety of factors
enter into the determination of appropriate discount :t:olicy.
these may be
~entioned
.An:ong
the state of business, industry, and trade.--
both domestic and foreign, --the state of money markets, --both don.estic
and foreign,-- international gold movements. seasonal conditions and
needs, accidental econorrdc disturbances, sometin:es political· conditions
and the international situation. the stage of the business cycle, price
movements,•*and the state of banking reserves,
can be conclusive of action,.to be taken.
No one of these by itself
Each has its own value and
* See Sprague, article cited, pp. 26-27: "there is no such general
rn.arket rate of discount as in England.
Consequently. the "Bank of
England practice of a discount rate slightly above the rr.arket rate
cannot have so pervasive an influence."
v**•Jhile the Federal Reserve Board will always be mindful of the
interdependence of credit and industry and of the influence exerted on
:prices by the general volume of credit, the Board nevertheless·can not
ass~e to be an arbiter of industry or prices." Anrlual Report for 1919,
:p.
73.
-30-
X-3090
'
significance, and competent judgrr:ent on the part of reserve insUtutions depends in great reeasure upon the skill and capacity
developed to give to each of these several factors its due weight
in any given set of circumstances in determining the rratter of credit
policy.
But when all this is said, it may yet be added that ordinarily
there is no one indicator which is more suggestive of the occasion of
considering action on the part of a Reserve Parik than a change in its
reserve ratio.*
• Sprague, article cited, p. 27: nThere is no substitute for the
reserve ratio which possesses its peculiar virtues of simplicity and
defini teness4"
-31X-3000
. Viewing the lll.:Ltter
satisfactory
techni~e
prd.cticdlly~
the problem of. developing a more
under the Federal Reserve System, and one
adapted to Americcm cond.i tions, is not that of finding a substitute
for the reserve ratio as a guide to credit.policy, but,
of finding how to make our reserve· ratio
a more
rathe~,
·that
sensitive and imnediate
· indicator of changing conditions in the credit situation than it· now
is·.
The problem, it lD.l.St be admitted, has its very considerable dif-
ficulties; and these difficulties would be ·many, even under n~rmal
conditions,
But the problem bas been immensely aggravated by the dis-
organization of the whole mechanism of monetary
standard~
apd inter-
·national credit and price relationships, and the artificial
r~distribu
. tioh of the world's s took of monetary gold, which ba.ve resulted frOm
the war.
It would also deserve careful study, if space permitted,
wheth6r the changes made in the s.tructure and safeguards of
the.
Feder¥ Reserve System by the amendments made in June, l917, as
a part of the financial preparation for war, are not destined to
operate prejudicially to the best functioning of the Reserve
.
credit regulators.
For the effect of the 1917
~e~nts
BG~.nk:s
as
has been to
make the reserve ratio of the Federal Reserve Banks more sluggi~h in
its responsiveness to changing conditions than it was under t_he original provisions of the Reserve Act.
But.even under.the provisions
of the Reserve Act as originally enacted, the reserve ratio of
~r
·
Reserve Banks was probably a less sensitive indicator than that_ of the
Bank of
Engla.n~.
the institution wbich served as a general model after
which our Federal Reserve System was patterned, and the institution
whose methods of operation were believed to supply the best model in
-32-
X-3090
shaping the discount practices of our s:,.,tem.
The essential principle upon which the Bank of Engla.nd. is organized, as I see the matter, is unfettered discretion on the part
of the Bank in the matter of credit issue, combined with rigid restriction in the matter of note issue.
legislation of
184~,
This is the net outcome of the
which specified no required reserve against de-
posits of the Bdnk of England. but a reserve of 100% against all new
issues of notes,.
In practice, how does this system work?
In a word, it bas
wo_rked to make the state of the banking reserve of
d
~e
Bank of England
very sensitive and immediate indicator, and therefore a verysatis-
factory guide to changes in discount policy.
ing
~e~s
~ys\em
and
Under the English Qank-
as it operated before tbe war, any undue expansi_on of busi-
cre~it
would, in swift course, make itself felt in _the fonn
of ·a demand for more than the usual volume of cash at the Bank o_f
England.
The Bank of England having no power to issue fiduciary notes
-to meet such demand, its cash--consisting of gold or Bank of England
- notes. covered by gold-would be. the source from which the demand would
be met.
credit
The depletion of its reserve thus resulting from an undue
exp~sion
would quickly indicate the need of action on the
part of tho Jank to protect its reserve by raising its discount rate,
and thus, by a process which ba.d. become almost automatic in its cba.ra.c- .
ter during the course of. the forty years preceding the war, undue
and unhealthful expansion· of credit would be brought under control
before i t gained too
muc~
headway.
All the more was this the case be-
cause an und.ue expansion of credit usually brought with it a gold export
X-3090
demand, for it
~s
•
particulcirly to be noted that the rigid adherence
to tb.e practices of an effective gold standard and. of a free gold
market contributed greatly to the succes of the English
creiit control.
Sj~tem
of
Under the English system, credit expansion usually
gave rise to an external as well as an internal
holdings of the Bank of England.
to elevate the iwportanca of the
dr~in
upon the cash
The combined effect of the tv;ro was
B~ik's
reserve as a barometer of the
credit situation almost to the position of being an instrument of precis ion.
Engl~d.,
like the United States, in contrast to tbe countries of
the non-English speaking world, is habituated to the use of banl: credit
in the form of the deposit account, ratb.er than of t...1e bank-note.
Her example is, therefore, of particular value for us.
It nas some-
times been argu.e.i, from the fact that the United Sta.tes is a check
using country, that regulation of the currency is a negligible
matter in the technique of banking control in the United States, supposing, of course, that care is always taken to make sure tba.t all
notes which are issued are fully protected by collateral security
of indubitable character and value.
In opposition to this
vi~v,
I
believe that regulation of bank-note currency, even in checkusing
countries, is at times a matter of first importance.
to be rreasurably
tr~~.
I believe this
even under normal coniitions when the com-
mercial worli or the major portion of it is operating under an effective gold stand.arl and there is much gold or gold currency in actual
everyday use and bank-notes are convertible into gold, and principal-
-34-
X-3090
ly for the reason that an increase in deposit credit invariably occasions, in .:lue course, an increase in the demand for currency,
Even
check usin2: countries, like England and the United Statas, cannot do
business without the use of a considerable pr~ortion of hand-to-band
currency,
t~e
proportion of currency to credit in the Uhited States
being about one dollar of currency to five or six dollars of credit.
The conditions upon which the conmuni ty can get additional supplies
of currency are t~erefore an important factor in credit regulation.
The regulation of currency becomes, in fact, ~method of effecting the
flow and. volume of credit.
I:nportant as it is t.ba.t adJ.i tional supplies
of currency s~ould be forthcoming on ready terms in certain circumstances, e. g. in times of seasonal or emergency need, it is equally
important at other times, when an undesirable creJi t or business s1 tuation is developing, tb..;it ti:.e conii tions sb.oul.i r1ot oe easy.
In_ general,
it ma.y be stated. tb.a.t the easier t.t.e conditions, (tnat is, in terms
of the effect on the resarve percentage) upon v;.hicn balli':s of issue can
furnish a:Liitiona.l sup:plies of currency, tne greater will ·oe their
difficulty, especL:.lly :J.t timeswi:.en their reserve ratio runs !J.ig'!l,
of regulating or
co~trolling t~e vol~tie
of
cr~1it.
It is, therefore,
of first importcJ..nce, under any s;~"ste:n of reserve banking whlcb. undertakes to govern creiit by primary reference to the reserve ratio. t~at
the reserve ratio shoul,i fall or rise in quick u.nd close reaction to
cbcinges in tLe volume of credit.
'!.::::.e IrJa.tter is, in last analysis, largely one oi psyc~ology.,
T'ile
banker, no less the central b~3r tha.n tae ord.inary co'lrZ:.erciaJ. banker,
•
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X-3090
looks at the reserve ratio as a gduge of tbe credit sitUdtion.
does the
general community.
So
this should be so need not here be
Why
andlyzed.
It is sufficient to emphasize the fact, ana to point to
one of its
i~fortant
implications in connection witn our scheme of
Federal Reserve. Banking:
fiduci~ry
note is more
----- ----
a~ike to the
-- ----- ------ ---
calculated to bring
the community's attention the fact and
Tnis is a fair deduction froQ
experience before the war.
determination since
t~e
t~~
t~rr.eaning
bar-kers' and
---
of cre1i t expansion
forty years of English bdnkipg
It is dlso tbe explanation of British
•var not to change tl:e
of England note as, in effect, a
~oll
cmracte~~ of t~e
certificate) although
Bank
sue~
c£ange
has frequently been proposed in recent years:
**
'~e
are pf opinion that tLe principle of the act of 1844,
wnich has upon the whole been fully justified by experience, should
be maintainei,
~ely,
t~t
there should be a fixed fiduciary issue
beyond. ··'iTci.ch, subject to emergency arrange1::.ents rJ.hicj:. ··ve recon::iJ::.Snd
below, notes sbould only be issued in excaange for gold. --.,..--We ti:link
that tb.e stringent principles of the act i..ave often nai the. efiect of
preventin~
danserous ievelopments Qni the fact
t~cit
tney
~ve ~d
to
be teWFor·61.:rily susperJ.Iied. o.-1 certain rare cUd e.x..;eptior.ld.l occasions
(and ttose limited to the earlier years of the act's operation when
experience of ;vorking the system was still imoature) does not, in
our opinion, invalidate t:.:Us conclusion. 111
·* From the report of the BrHis.::. Cor.1::d ~;tee on Currency ani Foreign Exch..:mge (freq_uently co,lled. the Cunlif .;::'e Report) reprintei in the Federal
Reserve Bulletin, Deceruber, 1918, pp. 1178-1192.
1 Federal Rese1~a Bulletin, December 1918, Page 1187.
-3611
X-3090
No doubt it would be possible for t.he Bank of England, with
the nelp of the joint stock barUcs, without clnY legal restriction on
the note issue, to keep t:Ue rate of liscount sufficiently higil to
check lodns, keep down prices, and stop t:Ue demand for further notes.
But it is very undesirable to place the whole responsibility upon
the discretion of the banks, subject as they \vill be to very great
pressure in a matter of this kind.
If they l:now· that they can get
notes freely, the temptation to adqpt
great.
~
lax loan policy vdll be very
In order, therefore, to ensure that tnis is not ione, and
the gold standard ther0by endangerei, it is, in our judgment, imperative that the issue of fiduciary notes sDall be, as soon as
practicable, once more limi te;i. by lai'v, anl that the present arran~ements under which deposits at tile Ban:'.: of England. may be exchanged
ing department s::aall be terminated c1t the ea.rliest possible moment.
AdJi tional derr.ands for legal tender currency ot;herwise than in excbange
for gold. sJ.lould be met from the reserves of the Bank of England. ani
not by the treasury, so tl:.c;.t the necessary checl:s upon an undue issue
may be brought ragulc:1.rly into play... ~
11
V{nenever befora tile wa,r ti:i.e bank's reserv<.:s ·;ere being iepletei,
the ra.te of iiscount was raised.
This, as
:~e t:.c:.ve
a.lr3c..d.y e:>.-pla.inei,
by reacting upon the rates for n:onay generally, acted as a check w~ch
operated in two wa.ys.
On t:ae one t..J.nd, ro.ised r.;.oney rates tend.ei
~~ectly to attract p;old to t.:C.is COU11try or to keep £Old here that might
>·
Federal Reserve Bulletin, Dec. , 1918, PP. 1184-1185
-3?-
X-3090
have left.
On
tbe otller hand., by lessening the demands for loans
for business puz:posas, tbey tended. to c.beck expeniiture and so to
lower prices in this country, with tbe result that imports were discouraged and exports
in our favor.
encouraged~
and the ejCcha.nges thereby turned
Unless tilis twofold check is kept .in working order
tne whole currency system will be icperiled..·
To maintain the con-
nection between a gold drain ani a ris·e in tbe ra.te of discount is
essential. n3
An examination of our o<.:m experience during the pa.st tilree years
ioes' muc!l to confirm the w·isdom ani the correctness of the conclusion
of tee Cunliffe report.
T:O.e n:a.c..;;J.nery ani safeguards set up in the
Reserve Act a.s originally e~ctei also bear evidence of wtolesome
appracia.tion by tlle frGirers of the Ac-. of the ;Lmger of la.xi ty in the
a.~inistrGtion
of credit ur~der ~ system of elastic note issue.
power to issue notes was
sep~r~tei fro~ t~
T:ile
power to make discounts.
· T".t.e l<:l.tter wa.s given to t.ae Federa.l Reserve Bdllks, subject to certci.in
review by. the Fed.erd.l .Reserve Bo.:..rJ.; the former was exclusively vested
in t£.e Federal Reserve Board. ·It was not alone for the safety and
protection of t;r.e noteholder • but .:.lso for the protection of the
gener~l
community against the consequences of excessive or ill-regula-
tei issues of creJ.i t ani currency
t~t
this .;1.rrangement was made.
It
was percei-.rea th.:.:t tbe power to regula.te the currency carries with
it
Qll
indirect but considerable power to regulate cred.i t; for power
over currency is, in effect, and, wit:ilin limits, power over reserves;
and: power over reserves is power over credit.
3 - F. R. Bulletin. Dec. 1918#
p. 118}.
Close attention, there-
X-3090.
-38-
fore, should be given by students who ~re interestdd in the development of methods and pnctices of reserve ba.,_Jdng in the United
to the
be~ring
of
cu~'l
.;;ncy issuG
Much more importance, I believe,
~n-l
St~tes
regulation upon credit cc.utrvl.
att~cnes
to tile function of currency
regub.tion tban is ordinarily racogp.iled by aconomists in the United
Shtes.
By increa.sin6 or
Feden.l Resarve
note.~
by diminishing or
diminisnin~
the fiduciary element in the
or--stating the proposition in terms of gold--
incr0asin~;;.
the
~::old
ele;uent in the note, the Feden.l
Reserve Bo:trd has the po-.1er to protect tha res0rves of the Fadenl
Reserve b:mks ag3.insi, or to e:.<pose them
affect their reserve ratios,
faithful economic
~nd
indic~tors.~
thereby
c~pable
of use l.s
3.
c0nce~ved
preventive;
depletion and thus to
m~ke
tneir ratios more
both to the banks and to tne public 1
of the credit situation and outlook.
note issue., if wisely
_to.~
Regul~tion
anJ cor.:petantly
a.~e::toure
of
Feder~l
Reserve
.~dr;..ini.stored,
is
.l.gainst ::tn u.nd.;;sir::tblo expansion
of credit in its e::trlier 1.nd more insidious stl.ges by ... 1.king the
supplying of currency by Fiasarve ba.nks e::tt into tneir reserve .aore
r::tpidly, thereby r.:a.kins their reserve r?. tio
than it now is ::ts
~
guide to credit policy.
J.
"ore tn.'d ..'or't.hy reliance
X-3090
-39-
The line of reasoning :pursued above may seem to overlook or run
counter to the well-established theory that a truly convertible
currency, such as is the
~ederal
Reserve note, is
cannot, except temporarily, be issued in excess.
b~-note
self~regulating,
and
Our Federal Reserve note
is, no doubt, self-regulating in the sense that its volume adjusts itself
to the volume of circulating denosit credit and the level of prices.
is not, rowever. by this
~est
It
a:one, or by this test primarily, that the
self-regulating quality of a convertible currency is to be tested, more
especially. in view of the widespread derangements in the rrachinery of
monetary
sta~rds
and international exchanges which exist at this time
and which promise to continue for a very considerable period of tin:e.
The
theory that a convertible bark-note currency is salf-regulating and
supplies its own corrective against over-expansion was in the nature
of a corollary of the gold standard when the rr·onetary and ba.n':r.ing practices associated with the gold stands.rd ·.r11ere in effect in a considerable
number of countries.
It was on such a3sumptions, and under the
monetary conditions that existed in
Euro~e
before the war, that gold
reserves• and convertible batik-note issues of the several leading
• ~oEing at the rratter of reserves from the economic point of view,
the adjustment of the volume of a country's credit and banking currency
to what is necessary to maintain prices at their proper economic level
may be described as the most important function of a nation's banking
reserve.
The gold of the world and the new gold as it con.es from the
mines is constantly in process of distribution and redistribution. It
is thus that the internaticnal price level is rraintained or rectified
in accordance with underlying conditions governing the equation of
international demand and supply of the different c~tries. As such,
the gold reserve is an economic regulator of the very first importance.
It is a ~ethod of testing the character and volume of a country's
credit and currency and so keeping it fron getting out of line with
economic requirements, particularly in relation to world conditions."
(American Economic Review SUpplerrent, Volume 9, Number 1, p. 142,
article entitled "After-Var Readjustzr:ent: Liberating Gold.").
-40countries had a very definite
an~
X-3090
important significance as econondc.and
credit regulators, more particularly as devices for setting in operation
deterrent or corrective forces against credit expansion and price inflation.
The theory of the self-adjusting character of a convertible bank-
note currency undoubtedly has much validity in normal circumstances.-in such circurr;stances as existed Prior to
1914. When the commercial world,
or a sufficiently large number of the leading commercial countries, are
o:pera.ting on a gold basis, and :prices in tl:ese countries are gold prices.
the international flow of 50ld undouctedly does
to excessive credit and currency
ex~ansion
~ch
to act as a deterrent
in gold standard
countri~s.
Currency and credit expansion, and risin; prices in such curcumstances,
'bring about an unfavorable balance of trade, raise the foreign exchanges,
and set in motion an outflow of
redemption in
~ld
to
meet~
~~old
and a return flow of bank-notes for
.the forai€>n drain.
All of this may be freely
admitted; but the conditions wrict. t!::.e tr:.eory of the self-controlling
character of a convertible
ban:-r~ote
currency assun::es, do not now exist
because t1::e condi ti"ons requisite to the functioning of an effective gold
standard do not exist.
The theory of batik-note convertibility as a
· pro·tection against over-expansion tlerefore breal::s down.
T}:e larger
portion of the C"0!1mercial world is not now on a &old basis, ·though the
United States is.
No
on~
country, hO{iever
im::r;ortan~.
can, by itself alone
and for itself alone, maintain an effective gold standard.
The monetary
history of the United States in recent years conclusively establishes this
proposition.
The gold ll'ovements involving the United States in recent
years have been predominantly one way
rr~vements.
~e
hold a
dispro~or-
tionate part of tr·e world • s steel: of rwnetary gold, and are adding to our
holdings -- a ne•v gold n:ovement of larse dimension and portentous
X-3090
-41-
significance l:laving recently set in.*
na.~
little meaning in such a situation.
Convertibility as a
protectiv~
device
The self-regulo..t·ing quality of our
bank-note currency .has therefore been in abeyance, and has offered, and
could offer, no protection, or at any rate no adequate protection, against
the insidious process of gold-credit inflationLacking tl:le agency of t"vo-way gold flows, in proper relationship, we
must find and set up some other agency, at least so long as present abnormal
cond.i tions contimie, for regulating our currency--and that means primarily
for detennining its volume in accordance with changing conditions and
*Between October 15, 1920, and April 15, 1921, (the le~.test date for
which figures are available) the Federal Reserve Banks have increased their
gold holdings by the amount of $294,778,000. The great bulk of this, aggregating $251,608,000, represents accessions since December 10, 1920.
This is mainly new gold from the South African mines, bought in the London
market for Ainerican account because of the premium on the dollar, and because of the further fact that· the United States is a free gold market.
The increase thus occasioned in the reserves of the Federal Reserve Banks
bas bad. a pronounced effect upon the rise of their reserve r<l.tiO.
Between October 15, 1920 and April 15, 1921, the reserve ratio>,of the
twelve banks combined increased 31 per cent, and that of the New York
Federal Reserve Bank increased 44 per cent, as the tabulation be_low shows.
A careful calculation indicates that the 31 per cent increase for tbe
twelve banks combined is attributable to the three factors involved in the
following proportions: Decline in Federal Reserve note circulation, 11
per cent; decline in depo~its 4 per cent; and increase in reserves, 16 per
cent_ For the New York Bank the ratio shows a rise of 44 per cent, distributed as follows: Decline in Federal Reserve note circulation, 9 per cent;
decline in deposits, 6 per cent, and increase in reserves 29 per cent~
F. R. Dank of New York
12 Benks Combinei
October
13
A~ril 15
October 15
kpril 15
Note: Liabilities
$3,353,271,000 $2,868,527)000 $8?5,737,000 $762,173,000
Deposit liabilities 1,915,731,000
764,466,000
680,283,000
1,?~.943,000
Deposit and note
Liabilities cocbinei 5,269,002,000
4,523,470,000 1,640,203,000 1.442,456,000
Total Reserves
2,154,911,000
2,485,077,000 607,450,000 76?,4?4,000
Reserve Ratio
40.9
53_ 7
37. 0
53. 2
-"108
L,~,
.
"
..__) ··-
X-3090
-42re~uirements--if
a good credit situation is to be ra-Gstc:.blished and rr.ain-
tained in the United States, and the likelihood of tha repetition of costly alternations of
feve~ish
activity and painful recession in business is
to be reduced, or at any rate the violence of such alternations to be rr.i tigated.
The agency I am proposing for this purpose is th.3 adoption and the
develo:pn,ent by the Federal Reserve Systen: of a currency policy and a gold
policy designed to operate upon the reserve ratios of the several
as to
u~e
ba~s
so
those ratios a better index of the cradit situation and a bet-
tc:r guide to credit policy.
I use th<> tern "credit policy" rather than
"discount policy" because the for;.rer is a broader conception and because
the latter
i~~lias ~retty excl~sive
rsliance upon chanees of discount rate
as the instrument of credit control.
ditions ai'Pears to
i1e
The ;r,aintenance of good cradi t con-
to ;.;c:.i::e the !>roblem of credit administration one of
credit regulation ra.th3r than one of credit control.. prevention, rather than
control, should b2 the objective of a ccnnpetent credit policy in t;he United
States.
cr~dit
This is not to say th.::,t changes of <iiscount rate have no place in
policy.
They have, indeed, a very irr.portant place, but creci.it policy
does not place exclusive reliance on rates; because rst;ulation, not control,. is its :ourpose.
It air.us to deal with tendenci%
th~ir
tha rr:al:ing, rather than to await
credit policy uses the rate as an
OI'
situations in
development before actin.(;.
instr~ent,
"'i'Jhile
i t does not make the rate
its only reliance, and when it uses the rate, uses i t in tin.e so as to prevent the necessity of resort to extre•"'e end punitive levels.
Having regard
to the practical and traditional importance of the reserve ratio as the
conventional credit and
ba~ing
indicator,
r
.t
-43-
X-3090
credit policy administers currency and gold so as to support its purpose
by acting on the banking reserve and checking the development of lax
•.
loan-policy tendencies on the part of either Reserve Banks or member
banks.
Thus are gold policy and currency policy not only complementary
to one another, but also inseparable elements, in a comprehensive credit
policy.
It would lengthen this paper unduly, even were this the proper
place and occasion, to describe the modus procedendi which would be
necessary in order to give effect to the ideas which have been set
forth on Federal Reserve policy for the future.
The discussion has
concerned itself with natters of experience, with matters of theory._ and
with questions of principle and of policy, rather than with a program of
action.
The revision of our Reserve Eank practice, and the recasting
of Reserve Bank accounting which would be necessary under a plan designed to give effect to the principles suggested, would not. however,
present a. difficult problem.
The main change in the published
weekly statement of the Federal Reserve :Banks that would be necessary
would be to report the specific note reserve, held by the Federal Reserve .Agent, and the specific deposit reserve, held by the bank.
The
existing practice• of stating the reserve position theoretically in the
*The April 15th statement of the 12 Federal R~serve ~anks stated the reserve position for the 12 banks combined as follows:
Ratio of total reserves to deposit and F.R.
note liabilities combined • • . . • - • • • · •• • • 53·7%
Ratio of gold reserves to F. R. notes in
circulation after setting aside 35~ against
deposit liabilities . . . • • • • • • • . • • • • . • 65-2%
The actual allocation of reserve moneys omt that date showed, however,
that an amount \~.f gold equal to 52 .rf1> of notes in circulation was held
b;r the Federal :r:?eserve .Agent -pr in the Gold Redemption Fund, and that
an amount of gold and lawful money equal to 56.5% of their deposits was
held by, or for account of, the banks.
- t
-44-
X-3090
form of a ratio derived frcnr. a comparison of total reserves with combined note and
de~osit
liabilities should be discontinued, or, if continued,
be given merely for purposes of theoretical comparison, by the Federal
Reserve System, and a form of statement should be set up which would
show the reserves actually held against deposits and notes respectively
and separately 1 as the law contemplates. •
The existing gold holdings of the Reserve Banks should be reapportioned between the deposit reserve and the note reserve.
To the
deposit reserve might be allocated an amount of reserve money equivalent,
say, to 45%** of their deposit liabili·Gies as of the date when the new
form of accounting would become effective***·
To the note reserve should
be allocated all the remaining reserve, and, a.s the law requires, be in
the form of gold.****
The
reserv~
thus allocated to the deposit reserve should be regarded
as the working reserve of the banking or discount department of the
Federal Reserve Bank.
The banks should be expected to conduct their dis-
·*"Ever.y Federal Reserve Bank shall maintain reserves in gold or lawful
money of not less than thirty-five per centum against its deposits and
reserves in gold of not less than forty per centum against its Federal
Reserve notes in actual circulation." Federal Reserve Act, Section 16.
**This would provide a potential basis for an expansion of over
$500,000,000 of reserve bank credit before the deposit ratio would reach
the legal minimum of 35~·
***! reserve of 45~ represents the approximate reserve ratio against
the combined note and deposit liabilities of the 12 banks at the beginning
of the year 1921, when the gold influx began.
****The apportionment above proposed nould result, on the basis of the
April 15th statement, in the shifting of about $200,000,000 of the gold
now held in the banking department to the Federal Reserve Agent's department, and give a reserve ratio against notes of 59-1%.
X-3090
-45count operations on the basis of this reserve.
Until conditions JUstified,
the amount of this reserve should not be changed.
Fresh accessions of gold
received by the banking department should be transferred to the note
reserve by way of substitution for other collateral held by the Federal
Reserve Agent, or in exchange for Federal Reserve notes.
Withdrawals of
gold from Federal Reserve Banks for foreign shipment shoul:d, for the
present at least, be taken out of the note reserve by the presentation
of Federal Reserve notes for redemption in gold or by the substitution
of
co~ercial
Reserve Agent.
collateral for gold in the security held by the Federal
The deposit reserve held by the banking department would
thus be fairly constant in amount; the note reserve, on the other hand,
would be variable in amount, fluctuating mainly in accordance with
changes in the international flow of goln, increasing when an influx was
in process and decreasing when an outflow was in process.
While the deposit reserve under the arrangement proposed above
would be constant, the deposit reserve ratio would not be constant,
but would fluctuate.
Any expansion of the loan account of the Federal
Reserve Banks would quickly reflect itself in the diminution of the reserve ratio below 45~; any diminution of their loan account would quickly
reflect itself in an increase of the reserve ratio above 45%.
In brief,
fluctuations in the reserve ratio would reflect quickly and accurately
changes in the volume of the reserve banks' discounts.
·,From time to time the situation of the Reserve Banks as a whole,
and of the several reserve banks individually, should be reviewed in
the light of
curr~nt
credit conditions and needs in order to determine
whether a.ny reapportionment of reserves should be made; whether, e. g.,
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X-3090
any given bank should enlarge its deposit reserve at the expense of its
note reserve.
The modus operandi for effecting such enlargement would
be for the bank in
~ues tion
to substitute commercial paper for gold as
the collateral security pledged with the Reserve Agent for notes issued
to the bank, the gold thus released being covered into the deposit reserve.
So far as the bankls reserve position was concerned, this would
be tantamount to the transfer of a certain amount of gold from the note
reserve to the deposit reserve in order to give the bank an enlarged
basis of lending.
As a result. the reserve ratios of the Federal Reserve bank$ would
ham~
a meaning not :-;ow possessed by them.
As the banking and business
community came to t.e educated to the new method of stating the position
of the Reserve Banks, primary attention would be paid to the movements
of the deposit reserve ratio; that ratio would be the immediate gauge
of the banking and credit situation.
As credit expansion was in process,
that reserve ratio would decline much more rapidly than it now does.
would be a faithful indicator of what was going on.
It
It would rise only
in reaction to a decline in the rate of expansion or as liquidation was
in process.
Moreover, as the community came to appreciate the signi-
ficance of changes in the deposit ratio, that ratio would come to be regarded witb heightened interest because of the evident bearing, in the
logic of reserve banking, of changes in the reserve ratio upon credit
and discount policy.
And thus would the problem of credit admini3tration
also be sitq)lified and its solution be aided by anticipatory action, both
on the part of the banks and on the part of the borrowing community.
The note reserve ratio, under the scheme of operation here under
consideration, would ha~e real significance as indicating the extent
of the gold cover against Federal Reserve notes. Fluctuations in. the
note reserve ratio would indicate changes in the outstanding volume
-'+7-
of
~ederai
Reserve notes,
X-3090
movexrents of
gold~
and out 2!, the Federal Re-
serve System, and reapportionment of existing gold holdings between the
reserve and the note reserve.
d~posi t
In times like the present, when a heavy flow
of gold toward our shores is in process, the effect of the
~roposed
plan would
be to give, or rather to restore, to the Federal Reserve note more of the
character of a gold certificate, which it had in the first years of the System,
and to set up, under the guardianship of the Federal Reserve Board, a superreserve.
When gold was accumulating* in the hands of the Federal Reserve
banks, the batiks would sUbstitute gold for other collateral pledged with the
Federal Reserve Agent as security against outstanding issues of notes, new issues of Federal Reserve notes being rr.ade only in exchange for gold until con-
ditions arose Which justified the issue of notes against commercial collateral.*•
* Similarly, when silver and legal tenders are accumulating, as has recently
been the case (on April 15 the Federal Reserve banks held $198,198,000 of silver and legal tender notes, the Federal Reserve Barik of New York holding
~130,428,000 of this amount), the Reserve ba~s shouldpay them out in supplying
the demand of member banks for currency..
·
** SUpposing the reserve statement for the Federal Reserve System were revised
so as to report th; deposit reserve and note reserve separately, the following
exanple shows What effect a transfer of $200,000,000 from the deposit reserve
to the note reserve would have on the respective reserve ratios on th~ basis
of the actual allocation of reserves as of April 15, 1921:
:Before transfer
of $200,000,000
to note reserve
Note reserve ..........••..•..........••.. ~1, 493,001,000
(i.e. gold with Federal Reserve
Agent and in bank• s redemption fund) •
Deposit reserve .....••.•••••.•••••••• ,..
992,076,000
(i.e. all other cash reserves)
Federal Reserve notes in circulation
2,868,527,000
Total deposits •...•................•..••• 1,754,943,000
Ratios:
Reserve against notes •.•..•......•.•
52.0
It
"
deposits •..........
56·5
After transfer of
$200,000, 000 to
note reserve
$1,693,001,000
2,666,527,000
1,754.943,000
59-0
45.1
c
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X-3090
Thus would the new accessions of gold brought to us purely because
of the derangements of inter-national exchanges be kept in storage,
a.s a
~-
and sHWr-reserve.
There this gold would be beld
against the day When it will, 1n part, have to be returned to
Europe in the process of restoring the gold standard there,-- an
undertaking in which we, bardly less than Europe, have both an
interest and a.n obligation,--and in the n:ea.ntirr.e would be where 1 t
eould be drawn into the banking or deposit reserve, whenever
eire~
stances justified its use to raise or restore the deposit reserveratio at the expense of the note reserve-ratio.
Thus would these
ratioo attain a significance and value as indicators and guides
not now possessed by the Federal Reserve reserve ratio, and gold
policy, currency policy, and credit policy become constituent and
compensating elements in a balanced scheme of Federal Reserve policy,
whose primary purpose should be to promote and traintain a healthy
condition of business and industry by regulating the flow and volwne
of credit with regard to the trend of business and the volume of
production ..
.
.
@FedFRASER