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Ale yv, 3 uvv, D A 1°.14 F'ed e rut ciik-Aeccefiir idievolteg--a 16etittt_rs' 65, * F95,itetet77 airwr /---AtA tat ecc-A4-, 120/9-iia_C tat it Cilia 'eat' Picti--;,WAvacel-1 4,--(4 nal7 ectr- ukf., k_6174 frafr-i--;-- 0,01a2-4 Etc.,. tri-Ar--- c FIA1 \ -$///4frG "tn- C4A14/."- / 7/9. - MEMORANDUM ON RATE ACTION OF 1919. FEDERAL RESERVE BANK OF NEW YORK. Broadly speaking, the financial disturbances of 1920 and 1921 are, of course, to be ascribed to the war. More particularly, however, the year between the armistice and November, 1919, when the Federal Reserve Bank of New York advanced its discount rates, may be regarded as the critical period in the series of events which antedated and in a measure prescribed the course of financial reconstruction. of the future, in common with No doubt economists certain financial writers of to-day, will scrutinize this period in order to ascertain what, if any, of the disturbances in business and finance could have been avoided had a different policy been pursued by the Treasury and the Reserve Banks. In the follow- ing pages are assembled the records, among others, of the Federal Reserve Bank of New York, bearing upon its discount policies and their relations with public finance. Few will dispute the wisdom, as long as the Treasury remained the chief borrowing agency in the country, of identifying closely the financial policy of the Federal Reserve Banks with that of the Treasury. If the Treasury moved, the Federal Reserve Banks had to move with it. "During the whole period of the war," said R. C. Leffingwell at a meeting of the American Economic Association, on December 29, 1920, "any attempt of the Federal Reserve Board to control credit through rates would have been futile. The Treasury would have had to meet any rate they made at home, and the Federal Reserve bank rate could have no effect upon the international situation, because the international movement of goods, gold and capital was controlled by foreign governments or our own for the purposes of the war. The adoption of a 'dear money' policy during the war, with a view to preventing inflation, would have failed of that purpose unless it had been carried to such an extreme as to -2-- bring about such conditions in war time as exist to-day, in which case we should have lost the war and would have had to inflate afterwards in order to pay the indemnity which Germany would have imposed upon us." The Chamber of Commerce of the State of New York at a meeting held on April 1, 1920, at which inflation and high prices were discussed, adopted a report of its Committee on Finance and Currency, which contained the following paragraphs: "It is not our purpose nor would it be profitable at this time to discuss the question as to whether it was wise for the Government to insist on an artificially low rate of interest to be offered to purchasers of Government bonds. There may be doubt as to whether the Treasury, even if it had wanted to, could have convinced Congress at the time that if the cost of living should rise, owing to the fact that the full absorption of Government loans had been rendered more difficult by an Unduly low rate of return, the country as a whole would lose immeasurably more than the Government would gain by the saving in interest. In those days the argument had little chance to prevail, that Government credit is not established by the face value of the coupon of the bonds, but by the price that the market places upon them. "There is no doubt that the policy of requiring an easy money market for the purpose of placing the long-term Government bonds, and billions of Treasury Certificates to be renewed from time to time, at an artificially low rate of interest, had a very pernicious influence with respect to general credit and currency expansion. The wish for low i terest rates for the Treasury resulted in low interest rates on the part of the Federal Reserve banks, and as a direct consequence, in low rates for commercial borrowers. It was natural that with a low money market and an apparently unlimited demand for goods, borrowers, unchecked by bankers in view of the banking profit, steadily enlarged their demands for credit and loans expanded rapidly. The consequent result has been the huge inflation of bank credits and currency which is considered as one of the main factors responsible for the rise in the general price level." -3- A similar point of view as to the need for unity between the Treasury Department and the Federal Reserve banks, was expressed in a letter from Governor Strong to Governor Harding written under date of February ?8, 1918. In that letter Mr. Strong was replying to a telegram from the board, in which an increase in rates was suggested: "After full discussion our directors have decided that it would be unwise to make any change in the rate at the present time and are of the opinion that when any change is made all of our rates should be reviewed and brought into conformity and that this should be done in concert with the other Federal Reserve banks, so that a uniform policy may be established in general harmony with the financial policy of the Treasury Department." In that letter Governor Strong pointed out that the banks were heavily loaded with certificates of indebtedness and that an increase in the Federal Reserve Bank rate would have the effect at once of making more difficult any possible secondary distribution of those certificates, of raising interest rates, and of obliging the Government to pay a higher rate for succeeding issue. "I cannot help believing in general," said Mr. Strong, "that an increase in our rates at a time when this expansion is really imposed upon the banks, is an unwise policy; that it will not only cause dissatisfaction, but necessitate an increase in the Government rates, and will cause a general increase in all rates, which will embarrass the Government in placing its short loans and selling its long bonds." Mr. Strong then outlined the three possible methods by which expansion, brought about by the Government's necessary program for bank -4- borrowings in the intervals between bond sales could be reduced: "One is to educate the banks as to what loans they should curtail. Our organization above referred to has been instructed on this point, and its influence, I think, will gradually be felt, but large results cannot be expected until some months have elapsed. "The second method which Pay later become necessary might be by a direct control of bank credits. If that does become necessary, we have an organization already established which could be used no doubt with success. "The third method - which we would, of course, expect to employ in time of peace - would be a general increase in the interest rate." Mr. Strong added that he could not believe that it was a wise policy to employ the third method and ignore the consequences. There be no reasonable limits to the level of rates which might result from the policy of successively increasing the rate of the Reserve Banks, then the rate paid by the Government, and so on indefinitely, until money conditions became intolerable. "It is the feeling of our board that the establish+ ment of a uniform consistent policy as to rates in the interval between sales of government bonds and for a similar uniform policy for loans upon government long-time bonds at the time of sale, is imperative in the government's interest, and that the decision as to the rate policy of the Federal Reserve Bank of hew "York is of more importance to the government than that of any other reserve bank." This point of view was reiterated in a letter from Mr. Strong to Governor Harding on larch 6, 1918, and a further suggestion was made that the subject of rates should be discussed at a forthcoming meeting of governors of all Federal Reserve banks, so that a uniform policy in the establishment of rates should be formulated. On March 27 Governor Strong -5- outlined to the board of directors the results of the discussion at the meeting of governors, and on April 3 he submitted a recommendation that rates of discount be increased 1/4 to 1/2 per cent. An increase from 3 1/2 to 4 per cent. for all classes of discounts and advances up to 15 days was not be be effective, however, until the repeal of the then prevailing stamp tax on notes secured by government obligations, which was the equivalent of 1/2 per cent, in the discount rate. A telegram received from Governor Harding on April 2 said that the new rates would be approved upon submission. Re added that the board suggested "that Federal Reserve banks remind their members that when discounting notes of customers secured by Liberty bonds, it would be well to provide definite plans for monthly amortization." In the autumn rates were established for the rediscount of bankers acceptances at rates ranging from 4 to 4 1/2 per cent., according to maturity. A week later, on October 2, Governor Strong submitted to the board of directors a telegram received from Governor Harding, in which it was said that the Federal Reserve Board was prepared to approve a reduction in the form of a special rediscount rate of 4 per cent. for parer of 16 to 90-day maturity, secured by Fourth Liberty loan bonds, where paper rediscounted had teen taken by the discounting member bank at a rate not in excess of the coupon rate. In a letter of the same date, written to Governor Harding, Mr. Strong said: "I reported that I had submitted this matter of a change of rate to a full meeting of the Liberty Loan Committee held yesterday, where, after a thorough -6- consideration of the question with particular reference to its effects upon the success of the Fourth Liberty Loan campaign, it was the consensus of opinion that it would be inadvisable to make any change. "Our directors, after full discussion, inclined to the opinion that the effect of a change from the present rate of 4 1/4 per cent, to the suggested rate of 4 per cent. would probably be to convert short time loans into longer loans and deemed it inexpedient to make the proposed change in this district." The point of view shown in the early correspondence of 1918, that the Federal Reserve Bank rate policy and the borrowing policy of the Treasury Department should be closely coordinated, still prevailed for a month after the armistice. This point of view did not presuppose that the Federal Reserve Bank rate policy should be subordinated to the Treasury borrowing policy, but that the reserve banks and the Treasury should work consistently and in harmony. In a letter dated December 26, 1918, written by Governor Strong to Governor Mores, of the Boston Reserve Bank, the position was taken that the time had not arrived for increasing discount rates. At that time Governor Strong believed that an advance of Federal Reserve rank rates would involve corresponding increases in the rates paid for government loans and that until the Victory Loan was placed the then prevailing level should be maintained, and that banks which were borrowing heavily should be admonished not to employ reserve bank credit simply for profit-making purposes. In this letter Governor Strong said: "The real facts underlying the situation are simple Counting the normal production and consumption of goods in the world as 100, the war, which was dealt with largely as a luxury, necessitated an increase in production of say, for purposes of illustration only, 20 per cent. The competition for labor and materials advanced prices at a tremendous rate, and the advanced enough. -7- price level was recorded on the books, so to speak, to a considerable extent in the form of inflation because this demand for labor and goods was not offset by economies in the normal peace time consumption. Therefore, with the stoppage of the war, we witness on the one hand the return of extravagance and waste, and, on the other hand, the curtailment of production and consumption for war purposes. When this bidding for material and labor stops, prices are bound to decline in many directions and liquidation is bound to take place in consequence, unless the demands for materials and labor for re-construction purposes offset the demands for war purposes, which have disappeared. I doubt if the latter is the case. There will, of course, be a great demand for some kinds of raw materials and some kinds of fabricated materials, and for large quantities of food stuffs, but I can't for the life of me see how these foreign nations are going to be able to pay for goods for reconstruction purposes upon any such scale as they were able to pay for materials when war made the demand an imperative one, and our Government stood in the breach. "Isn't the answer, therefore, clearly that we are going to see declining prices, some idleness, probably easier money conditions, and repayments to the reserve banks as this liquidation takes place, particularly after the Government through borrowing on short notes? is "There lies the crux of our immediate problem. To answer your particular point about rates, let us assume that all the reserve banks raised their rates to 5 per cent. Then the Government would have to raise its rate. Other rates would advance correspondingly, and wouldn't we be be back just where we started, except that we would have materially advanced interest rates without reducing demands for credit? "I admit that such an advance in rates would probably cause some discrimination,likely in stock exchange loans, where we might see a very sharp advance for a time, which, in turn, would attract money that otherwise would go into more ligitimate occupation, and such a development would simply add to the difficulties of the Government's borrowing. "On the whole, my belief is that we should stick it out until this next loan is placed. In the meantime, admonishing the banks that are borrowing heavily from 118 that they must not employ our credit simply for profit-making purposes by going into outside things that pay high prices. We are c,,,_4 -8- watching that closely at the Bank and are hoping to check up on those who misuse our facilities. "I fear that the above will not be of any comfort or assistance to you." At this same time (December 18, 1918) Mr. Leffingwell in a memorandum addressed to the Secretary of the Treasury, took a similar point of view. Ar- riving at it, however, by a somewhat different course of reasoning, he pointed out that the reserve percentage of the Federal Reserve system on December 13 had been almost stationary for two months at about 50 per cent. He saw in the immediate future several favorable elements not existing theretofore, (1) that the end of the war meant an early end to the strain upon our credit structure; that the holding of currency prevalent during the war had largely ceased; that Federal Reserve notes in large denominations up to $10,000 were about to be issued, and that they would replace to a very large extent gold certificates in the possession of banks, thereby strengthening reserve percentages; that the Government's expenditures were largely in liquidation of contracts, which in turn should result in the liquidation of bank credits established in favor of war industries. After remarking that it was"because the Federal Reserve system furnished a normal, healthy, smooth mechanism, through which that expansion of credits could take place, that the war was financed successively and won," he went on: "I firmly believe that the sound measures which we have discussed leading to a restoration of industry to a peace basis and reduction of prices and of wages will certainly be followed by a contraction of credits. If however, the Federal Reserve Board should attempt to force that return to normal conditions by hasty action before the Government's demands have been substantially met, the effort would defeat itself, because the Treasury -9- would be forced to borrow at such high rates of interest that it could only afford to borrow for very short periods and from the banks, pending the inevitable restoration of interest rates to a normal basis. The Federal Reserve Board would thus defeat its own object and force an additional inflation when it would be striving for contraction. Even worse, evidence of timidity at this time and increase of rates would cause such consternation in the business community as would discourage the resumption of normal business activity and might make the cost of necessary readjustment finance prohibitive. I think the contraction of credits should follow along with the cessation of Government borrowing, the reduction of prices, reduction of wages and reduction of business activity. If the effort for contraction precedes the restoration of peace conditions, it will carry with it grave danger of an industrial depression, of unemployment and of social unrest." Late in the year, when the strain of the Fourth Liberty Loan had passed, Governor Strong went to Lake George for purposes of recuperation and, as he said in a letter to Ur. Leffingwell written on February 6, 1919, was able to devote much time to contemplating the major aspects of the Treasury's finance policy and its relation to the rate policy of the Federal Reserve banks. The result was a change in point of view from that voiced in his letter to Governor Morss, and from that which prevailed during the time of this country's participation in the war. The letter of February 6 was a long and comprehensive discussion of financial public policy. He anticipated it with a brief letter to Mr. Leffingwel/ under date of February 3, in which he told him that the long letter was coming and made a preliminary suggestion urging the Treasury most strongly to prevent the reserve banks from taking certificates of indebtedness. "This is the most direct, dangerous and vicious form of inflation in which we can indulge just now," he said, "and will bring trouble hereafter as sure as fate." "Let us suppose for instance that the unsubscribed portions of certificate issues between now and the next loan was taken by the reserve banks and aggregated -10- $500,000,000; it would create a. temporary abnormal ease in money because it would mean $500,000,000 addition to the reserves of the banks of the country, which would mean speculation and higher prices; it would start a bank inflation at the minimum of $2,000,000,000 and it would be very difficult indeed to get rid of this inflation without forcing an advance in the reserve bank discount rates. I sha'n't elaborate on this argument just now because it will appear in my later letter, but I can tell you without the slightest reservation that such a policy would be the most dangerous one that the Treasury Department could indulge in and one that they would never cease to regret." The complete text of the letter of February 6, 1919, is attached. In summary, Mr. Strong said that he felt during the war and continued to feel that the only ways by which the credits required to finance the war could be produced for the Government's needs would be either as the result of: Economy or,- failing that, of Inflation (to the extent that economy was not practiced voluntarily or involuntarily) The methods available to the Treasury for raising the money were limited to: Competitive rate bidding, or Patriotic Appeal. Since sums saved were not adequate resort had to be had in part to inflation, which was furnished by the reserve banks. One school of thought held that economy could and should have been enforced and inflation avoided by the establishment of higher discount rates; another school, to which Mr. Strong said he himself belonged, believed that economy must be enforced through some system of rationing, or by consumption taxes, or by other methods than high interest rates. Mr. Strong said that no doubt some of the inflation could have been prevented by slightly higher rates and more attractive terms on the Liberty Loans, which he believed had been issued at rates somewhat lower than was wise. But accepting the Secretary's decision, a corresponding rate policy by the reserve banks was presupposed. "My only comment upon the past said, "is that both the Treasury Department and the reserve banks were the victims of the failure of our Government to get abetter control of expendi- tures by the people generally. Some part of the inflation might have been avoided by paying higher rates on the Liberty Loans, but how much is anybody's guess." Mr. Strong's estimate of the amount of bank inflation, some of which, however, was not directly attributable to Government borrowing, was about six billions. Yet the greater responsibility of the Treasury lay in the future rather than in the past because, as he said, the day of deflation was approaching. He said: "The process of deflation is a painful one, involving loss, unemployment, bankruptcy and social and political disorders, whereas the process of inflation brings in its train prosperity, employment, rising prices, a happy absence of bankruptcies and general state of contentment, all of which leads me to the point of this letter, namely, that mistakes by the present Treasury Administration from now on will bring retribution of a very certain and definite character which was not likely during the days of war excitement and expansion, but which is now beginning to loom up most definitely during the distasteful days of paying the damages. The object of this letter is to emphasize a few points about the future which none of us can afford to overlook." -42- In analyzing the various contingencies Mr. Strong outlined conditions which in his estimation would develop if public financial policies were not materially changed. His anticipations have in grea measure been confirmed by the experience of 1920 and 1921. His first reference was: 1. PRICE LEVEL: He expressed the conviction that prices in the United States were still out of line with wages and commodity prices in England and on the continent of Europe, where the level was lower than here. The danger to us was not simply that prices here were out of line with those of Europe, but rather that a higher level of prices than former- ly had been established under conditions of such artificial prosperity that merchants and manufacturers who had permitted their inventories to pile up on them at those prices were now confronted with the costly period of,liquidation, involving heavy losses on large stocks of unsaleable goods. Abroad stocks of goods were much reduced; hence the process of reducing the price level would not involve such heavy losses as in the United States. .Already liquidation and price declines had begun. is taking place in the wool industry. "You know," he said,"what The same thing is happening in leather, steel and iron, in fact all along the line. The object of referr- ing to this point is to call attention to the fact that if inflation is arrested at its present level the readjustment of prices and loss resulting will be no greater than that now fixed by the existing price level. If in- flation continues, money grows cheap, - the liquidation will be arrested and oljr later troubles will be the greater." -13- (Note - The Department of Labor price index for February, 1919, was 197. A year later it was 249, reaching its maximum in May, 1920, when it stood at 272. In April, 1921, the decline had carried it 43.4 per cent, below the May, 1920, maximum to 154 per cent.) WE MUST DEFLATE: Deflation was necessary. "If this is not done," he said, "we may face the necessity of either continuing the gold export embargopto the detriment of the rest of the world's financial position, or lose a large amount of gold at a time when it would be inconvenient for us to do so, and necessarily force a more radical readjustment in interest levels than we have yet found necessary to employ. At the moment my thought is that the processes of deflation will follow naturally enough, and gradually, if the Treasury is able to adopt such a policy as will simply prevent further ereflation, which will be referred to later." (Note - The removal of the gold export embargo on June 9, 1919, was followed by a great For the seven lux of gold. months to December 31, t e net outflow was $302,000,000. reduced, however, by about $173,000,000 in gold, representing payment by the German Government for foodstuffs bought in the United States. In November, 1919, the increase in Federal Reserve Bank discount rates, resulting ultimately in the 7 per cent, rate, was begun.) BUSINESS CONDITIONS: Mr. Strong outlined the then prevailing business situation, which had the earmarks of the early stages of deflation. "These various signs of business recession," he said, "indicate that the readjustment is now under way and that we may be approaching a period when active criticism wil/ develop. There is a change of rind - indicating a change in weather." "BORROW AND BUY": The plan implied in this phrase was necessary in order to insure successful financing, and involved the least Vicious form of inflation. But in future it should be abandoned and discountenanced by the Treasury, even though it meant a more moderate success in financing. 5. BANKS MUST NOT BE LOADED: "If anything is to be sold to the banks," said gr. Strong, "it should be short certificates until the time comes when bonds can be sold or when the Treasury is willing to pay the rate to sell them." 6. THE EFFECT OF DIRECT BORROWING FROM FEDERAL RESERVE BANKS: cally, a loan to the Government directly from the reserve banks of a billion dollars would support a bank expansion of ten billions, whereas a loan to the Government by commercial banks causes inflation only in the initial amount of bank loans, the reserve banks contributing reserves of about 10 per cent. to support the inflation. In selling bonds the Government has three choices: A sale to investors who do not borrow, A sale to investors who do borrow, or to the commercial banks, which would result in an inflation to be supported by loans at the reserve banks equal only to the reserve percentage of the inflation created, and (I Borrowings directly from reserve banks, which would create new reserves to the extent of that borrowing and support inflation to many times that amount. "I believe," said Mr. Strong, "every possible effort should be made to confine the next loan to the (a) class." 7. INTEREST RATES: The generally accepted belief, said Mr. Strong, that an advance in rates on Liberty Bonds caused a corresponding decline in security values and consequent embarrassment to investors, was not sound. Irrespective of rates, the investment level would shortly be established by supply and demand in the market, so that the competitive rate between the Government's loans and other securities would adjust automatically. Moreover, our Treasury must in future meet competi- tion from foreign governments, which would borrow in this market at any rates which would produce the credit. A world readjustment of the interest level was to be -15- expected. Our Government must meet that competition unless it was willing to pursue a program of inflation, which might be disastrous. Mr. Strong suggested a policy for SALE OF BONDS TO INVESTORS: 8. the forthcoming Victory Loan. He suggested rates sufficiently high to investors of all classes, who would buy with a minimum of accommodation from The bonds should be taxable and run for not more than five years the banks. and be redeemable, say, after two years. THE BANK RATE: 9. Such an issue would require some readjustment of rates by the reserve banks. "For reasons which need no repetition, he said, "our bank rate has been regularly and promptly adjusted to the Treasury's program." () If the Victory Loan should be issued at a high rate it would pre- suppose action by the reserve banks somewhat as follows: A special rate to enable banks to rediscount existing loans made to original subscribers to the Fourth Loan, probably 4 for all maturities. 1/0 A special rate for new loans to enable banks to carry subscribers to the Fifth Loan, at least equal to the rate borne by the new bonds, but probably not any lower. A special rate for bills arising out of the importation and exportation of goods. The last rate was suggested for international reasons and for the purpose of establishing a protection later to our foreign exchanges. 10. TAX EXEMPTION. A low rate tax exempt bond would be a mistake, particularly in view of the position in which member banks would find themselves under the new tax bill. According to an interpretation of that bill in New York, the member banks would be in a position to earn on a five-year 4 per cent, tax-free bond an equivalent of 18 to 20 per cent, on other forms of loans. The result would place a large portion of the new -16- issue in the hands of the banks, which undoubtedly would borrow from the reserve banks in ordet to carry the bonds. 11. INTERNATIONAL RELATIONS: Our Treasury policy must take into consideration international conditions. A higher level of bank rates was to be expected in London, and it would not be a matter of surprise if bills on the London market should be selling at between 5 and 6 per cent. (Note - In the first half of 1919 bills on the London market reached a point only slightly above 3 per cent., but before the end of the year had advanced nearly to 6 per cent., and in the early part of 1920 went nearly to 7). In conclusion, Mr. Strong said: "Secretary Glass in one or two public statements has expressed the view that the Treasury can still rely upon patriotic impulse for financial support. That is undoubtedly true to some extent, but if patriotic impulse is made the means of placing unattractive bonds which must be forced upon reluctant investors who are induced by artificial rates to borrow money in order to buy them and then shortly turn about and sell them to avoid shrinkage, we experience all of the evils of inflation, the disasters of losses by patriotic investors, an unnatural and severe decline in the Government's bonds and credit, and an investment interest rate ultimately as high.as would have been established in the first place had the Government borrowed at an attractive rate to the investor. "If this letter seems to involve some change of front on my part, (which it really does not, fundamentally) please bear in mind what a change has taken place in conditions. In the face of my persistent, continued recommendation to our friends in Washington that steps be taken to conserve goods and services, I found myself advocating inflation as a means of making up the deficiencies of some failure to adequately control expenditures and to promote economies. Now that the war is over, even such means as were adopted to control private expenditure have been abandoned and there seems to be just one recourse left, which is to -17- interpose obstacles in the way of borrowing, and to do it by a slightly higher rate level. In other words, while the war was on, the proposition stated on page one of this letter resulted in adopting policy (d). Now that the war is over and no control is being exercised, we are forced to the adoption of policy (c). That's the whole story in a nutshell." This long letter to Mr. Leffingweil was supplemented by a short one to Mr. Jay, with which a copy of the former was enclosed. "This Administration," said Mr. Strong, "is piling up a lot of refunding operations for the future which must be undertaken under very distressing conditions if the present policy is continued, and that applies more particularly to the next loan, which will be of short maturity. If the next Administrati whether Republican or Democratic, faces the necessity of refunding a big bond issue, placed at a low rate of interest and then selling at a discount, it will encounter many difficulties that would not develop if a bond or note could be now placed which at maturity would sell at a premium." Mr. Strong concluded his letter to Ir. Jay with a brief summary of what might be hoped for and what might be avoided, cies should be ended. if inflatio He said: "Frankly, but between ourselves, I have a strong instinctive feeling that if we can survive a present wrench in interest rates and in general prices and the possible discomfort and even disorders of temporary unemployment,deur problems are so much less acute and difficult than those of any nation abroad that in a year or two we will be on the crest of the wave with the rest of the wor d at our feet. One thing which would delay this wou1b e the continuance of a policy which would spell inf Ation and defer the period of liquidation and the establishment of lower prices." Four days later, under date of February 10, Mr. Strong wrote a short letter to Mr. Leffingwell summarizing business conditions then prevailing as -18- he saw them in the neighborhood of Lake George. These conditions, involving un- employment and frozen assets, obliged the holders of Liberty bonds to sell them Those who parted with their bonds, particularly laboring people, were at a loss. resentful and did not understand the reason why the bonds were selling for less than they paid for them. "Those who unfortunately must stand these losses," said Mr. Strong, "will not be subscribers to the next loan and will create a sentiment rendering it more difficult to get subscriptions from those who can afford to subscribe." Mr. Leffingwell's reply to Mr. Strong's long letter, written under date of February 12, was more in the way of a response to the economists w0Comments Mr. Strong had referred to incidentally, than in answer to Mr. Strong's proposed program. The full text of the letter s attached. Mr. Leffingwell denied that the credit expansion of war years was .because of high prices. k sion and a decreased buying power of gold He regarded expan- OL4V teeky.e....beew inevitable. As for the next loan, he said: "The next loan is still a perplexing problem. I hope Congress will give us authority to deal with the problem as conditions seem to indicate when April comes. I am, as you know, much opposed in principle to an exempt bond. You are, however, wrong in thinking that a low rate exempt bond would appeal to the banks. The exemption is substantially worthless to the banks owing to a peculiarity of our tax laws. That fact has been the best justification for our policy of issuing Treasury certificates at a higher rate than bonds. The advocates of a high rate short time fully taxable security are to be found very largely among those who believe that the banks will have to take the next loan and my principal objection to that form of security is that it will appeal to the banks and not to wealthy investors." Mr. Strong replied to Mr. Leffingwell's letter on February 18 from Lake George. He met directly the point raised by Mr. Leffingwell, that expansion was the cause of high prices, and then applied the principle to the forthcoming loan as follows: co 104 -19- "If we make it too easy to borrow money, in place of a legitimate demand for goods there ilil develop a speculative demand, which is simply another way of stating that people will be willing to accumulate goods without immediate prospect of marketing them, and the ultimate sale of those goods will present greater difficulties and cause greater losses to the extent that inflation is continued or extended. Now I am very strongly in favor of beginning to take some steps towards checking any further expansion of our bank position, and, other means having been abandoned by the demobilization of the various Government agencies which were at work on this problem, I can see no other instrument available for accomplishing what is needed except through interest rates. Has the time yet arrived, however, to do so? If it can be made a part of the policy of the next loan, involving though it may paying a higher rate on a short security than heretofore, I think it would be a prudent and wise course." On the same day Mr. Strong wrote another letter to Mr. Leffingwell o giving him the substance of a meeting between Secretary Glass and a number of New York bankers on the preceding Friday evening. It appears that different views were expressed and, among others, the suggestion was made that one type of bond only be issued which would be taxable, but which might be converted into a lower rate tax-exempt bond. device suggested a remedy more apparent than real. Mr. Strong felt that As for rates, Mr. Schiff argued that a rate higher than 4 1/2 per cent, would depress all bond prices, and suggested that if a tax_exempt bond should be issued it should bear 3.65 per cent. Mr. Strong did not agree with Mr. Schiff's argument for reasons given in his letter of February 6 to Mr. Leffingwell. At this same time the Secretary of the Treasury, Mr. Glass, had under discussion with the Ways and Means Committee of the House of Representatives, the plans which he had in mind for the Victory Loan. In a letter dated February 10, 1919, addressed to Mr. Kitchin, chairman of that committee, a -20- Secretary Glass said that after most careful consideration, and after considering the views of bankers and others, he was constrained to say that he could not "wisely determine now, in February, the terms of the bonds or other obligations which it would be wise to offer for subscription in April, when the Liberty loan campaign should probably begin." It was in response to this request, which was incorporated also in a hearing before the Aays and Means Committee, that the Secretary of the Treasury received authority to fix rates of interest and also the maturities within the limits of one to five years of the new issue of Victory notes. In discussing conditions then prevailing and in expressing the hope that they would clarify before the Victory loan was issued, Ir. Glass in that same letter said: "A period of rising prices and of intense industrial activity such as we have experienced during the past four years is always a period of great apparent prosperity, and a period of falling prices and of the contraction of credits is always a period of depression. The retardation of the process of readjustment by artificial means can only increase the evils inherent in the situation. Buying will not begin and activity will not set in until the community at large is satisfied that prices have reached bedrock. I am very hopeful that measures now under discussion may result in the rapid acceleration of the readjustment, and I am firmly convinced that if that be done America has before her a new period of great and growing prosperity. I am even sanguine enough to believe that it is within the range of the possible that so much may have been accomplished on the lines above indicated before the expiration of two months from now that the whole situation will have been changed, and that we may look forward to the successful issue of the Victory Liberty loan on terms which to-day would seem quite impossible." The factors in the situation indicating progress toward a more stable business basis at the time the Victory Loan should be issued, were specified by Mr. Glass as follows: -21- "At the moment we are in a period of readjustment. To the slackening of industrial and commercial activity incident to the termination of active warfare has been added the usual dullness of the winter season. The necessary and desirable contraction of our credit structure has begun and wil/ be greatly facilitated by the enactment of appropriate legislation to permit the liquidation of claims arising under informal Army contracts. Steps have been taken to break the deadlock which had arisen growing out of the maintenance, nominally at /east, of war prices in certain basic industries. Upon the enactment of appropriate legislation to enable the Food Administration to protect the guaranties given by the United States, I am hopeful that it win prove possible to restore the operation of the law of supply and demand with respect to foodstuffs, with, as I believe, a consequent reduction in the cost of living." In a letter to Alexander D. Noyes, written on February 19, 1919, Mr. Strong made a vigorous defense of the Treasury's financial policy in the war years. Balancing the Government's requirements against the saving capacity of the nation, be found a difference of about $7,000,000,000, representing the excess of government loans over the estimated maximum capacity of saving. At the same time, he estimated that during the period of our participation in the war our banking position had been inflated about $6,000,000,000, concluding that the entire savings fund of the nation had been swept into the Treasury and that the bank inflation made-up the difference between the Government's requirements and the savings fund. "By no other means," be said, "could the funds have been raised, except absolute curtailment of consumptionlof goods, which was gradu- ally being undertaken through various Government agencies, and had the war lasted, I have confidence that these agencies would have been ultimately effective in reducing consumption, preventing further price advances and checking some part of the tendency to inflate our bank position." In correspondence with Darwin P. Kingsley, who, because of his position as president of the New York Life Insurance Company, was an important figure among -22- prospective large investors in the Victory Loan, Mr. Strong expressed on February 20 his confidence that Secretary Glass would fix reasonable terms for the next loan. 19 believe," said Mr. Strong, "we must appeel to the country partly with the plea of patriotism, and partly with a clear exposition of the investment merits of Government bonds; and if the loan does not sell we are thrown back upon one or two alternatives - borrowing from the banks or taxes, either of which, as I seeA ill be unsatisfactory to everyone." In answering Mr. Kingsley's reply to this letter, in which Mr. Kingsley said that Secretary McAdoo had made a gest mistake in issuing bonds at rates of interest lower than the market, Mr. Strong said that it had been his consistent opinion that higher rates would have been better and that he expected 0 Mr. Glass to go to the limit of his ability in fixing proper rates. In com- menting on Mr. Glass's state of mind, however, Mr. Strong said: "Secretary Glass has been deluged with advice that the next loan must be placed solely on a business basis. One would think, to hear the opinions expressed to him, that he must offer a security at a very high rate of in_ terest. His natural reaction is to give expression to a rather extremely reverse view and to state publicly, and urgently, that he aan rely upon patriotism to place the loan, and that patriotism is an element which must enter into his calculations in fixing the rate." It may be added here that when the rates on the Victory Loan were announced Mr. Strong wrote to Mr. Kingsley under date of April 15, 1919, saying that Secretary Glass's decision was wise and was generally so accepted. "Our task now is to secure the widest possible distribution," he said. The highly important matter of Federal Reserve discount rates in their relations to the Victory Loan were under discussion at this same time. A meeting of governors of Federal Reserve banks was called for March 20, and -23- prior to that meeting there was considerable discussion in the correspondence between Mr. Strong and Mr. Leffingtel/. On February 28 Mr. Strong wrote Mr. Leffingwell that he was planning to attend the meeting in Washington on March 20, going over a day or two in advance, so that he might have a preliminary conference with Ir. Leffingwell and Secretary Glass. He added: "I have, at times, felt that I was so much out of sympathy with the position of some of the members of the Federal Reserve Board, that I wee, in a sense, a conspirator to defeat their purposes. That's the last thing that I want them to feel, and going to Washington in advance of the meeting would be somewhat with the object of endeavoring to agree in advance among ourselves upon a policy. It would be foolish for me to close my eyes to the fact that the governors of the other reserve banks will be very much influenced by my own attitude in the next discount policy, and I would feel much happier if that attitude were the result of a preliminary understanding with you and Secretary Glass, and with the Federal Reserve Board." About two weeks before the meeting Mr. Strong and Mr. Leffingwell had an opportunity to discuss the forthcoming loan, but according to a letter which Mr. Leffingwell sent under date of March 11,they "had only just touched upon the great question of rates when they had to separate." Mr. Leffingwell, however, enclosed to Mr. Strong .a copy of his memorandum to the Secretary of the Treasury, which had been transmitted on December 18 and has been referred Mr. Strong replied on March 15, saying that he had read the memoran- to above. dum with great interest. He went on: "You will observe that my proposal for rates in the long letter I wrote you did not contemplate establishing a rate level that would force liquidation, - my thought was that at the level suggested, it would hold further expansion at a reasonable minimum. This whole subject, you will recall, we decided to discuss when I reach Washington next Monday. "Don't look to the Second Federal Reserve district for any considerable addition to the reserve banks' gold -24- holdings. We have just about pumped the district out, and while some may come in in exchange for the new large denomination notes, I think the very outside that can be counted upon would not exceed $10,000,000 or $15,000,000." The record does not show the substance of the discussion with Mr. Leffingwell prior to the governors, conference. The substance of the recommendations made by the governors appears, however, in the report of that meeting. In response to the question:"How long should reserve banks continue the present differential rates in favor of notes secured by Government obligations?" the governors made the following formal recommendation: "It is the opinion of the meeting that present differential rates in favor of notes, secured by Government obligations, should be continued until after the fifth loan is placed, and for such reasonable period thereafter as will permit a considerable liquidation of such borrowings without imposing undue penalties upon the banks which are required to rediscount with the Federal reserve banks. "It is further suggested that no recommendation for a change in the present differential rates can well be made until it is known at what rate the next loan will be offered, at which time some readjustment of rates for loans to be secured by bonds of that issue may be necessary. The establishment of a different rate for loans secured by the bonds of the Fifth loan may necessitate a review at that time of rates applying to loans secured by bonds of the earlier issues." It was stated further that in the unamimous opinion of the meeting there should be uniformity in all Federal Reserve Banks on rates for loans secured by Government bonds and notes. In early April, particularly when the term for the Victory Loan had been determined upon, there was much discussion as to the wisdom of advancing discount rates. In a statement for the press Mr. Leffingwel/ said that "in fixing the terms of the issue the Treasury had been guided largely by the desire to devise a security which would not only prove attractive to the people -25- of the country in the first instance, but the terms of which should insure a good market for the notes after the campaign was over and identical prices for the two series, and should not affect injuriously the market for the existing bonds of the Liberty loan." Rates were discussed at meetings of the Central Liberty Loan Committee, at meetings of the executive committee and at a meeting of the board of directors of the bank, held on April 15. that no change was made in the existing rates of discount. The result was A week previously, on April 9, the board of directors in response to a telegram from Governor Harding, had fixed a rate on paper secured by War Finance Corporation bonds, which was 1 per cent. above the prevailing rate for eligible commercial paper. This action, however, had nothing to do with the rates on Liberty bonds or on other eligible paper. In explaining why the officers of the Federal Reserve Bank of New York had decided that its discount rates should remain unchanged, Governor Strong sent a telegram on April 14 to Governor McDougal, governor of the Federal Reserve Bank of Chicago, as follows: "Mr. Jay and I have agreed to recommend to our executive committee and directors that present discount rates shall remain unchanged for following reasons: First, it will protect member bank commitments made at four and one-quarter per cent. to borrowers in third and fourth loans; second, it will protect the Treasury in its certificate program subsequent to fifth loan; third, the limitation in amount of present loan will have effect of minimizing borrowing anyway; tendency to abuse fifteen-day rate by too many renewals can be dealt with by requiring resort to ninety-day rate; strong policy by reserve banks will greatly promote wide distribution of bonds and general feeling of optimism regarding Government's financial program. Can give you no assurance of action by our board or reserve board but believe this program is justified and sound." fourth, a fifth, -26- The board of directors, meeting the following day, on April 15, considered Mr. Strong's recommendations, as appears in the following extract from the minutes: "Governor Strong stated that the reason this meeting had been called in advance was to consider what action, if any, should be taken with regard to our discount rates in view of the forthcoming Victory Liberty Loan; that the matter of the discount rate of the bank had been discussed informally by the Central Liberty Loan Committee at its specie/ meeting last Sunday afternoon, and that it was the sense of that meeting that the rate of this bank to its members on advances secured by Victory Liberty Loan notes or by customers' notes so secured and the rediscount rate of paper collateraled by Victory Liberty Loan notes should remain for the present the same as the rates in effect during the Fourth Liberty Loan. He further stated that the matter of making recommendations to the New York City banks with respect to the establishment of a uniform rate for loans to subscribers to Victory Liberty Loan notes was also considered but that it had been decided to postpone a determination of the latter question until this board had acted with respect to the discount rate of this bank. General discussion followed. Whereupon, on motion duly made and seconded, it was VOTED discount." that no change be made in the existing rates of On that same day Mr. Strong sent a telegram to the governors of all Federal Reserve banks announding that the directors of the Federal Reserve Bank of New York had decided to make no change in its discount rates; also that the Liberty Loan Committee had decided to recommend to the banks in New York City the adoption of a policy whereby loans could be made to subscribers to Victory notes for 90 days from May 20, with one renewal of 90 days at 4 3/4 per cent. On the following day, April 16, a telegram was received from Governor Harding saying that the board had concluded that there should be no difference in rates on paper secured by Liberty bonds or by Victory notes, and that the board suggested that member banks refrain from making agreements in -27- connection with the Victory Loan for a longer period than six months, thereby leaving the rate situation clear after the ensuing November. Governor Harding's telegram, which was addressed to Mr. Jay, is given here in full: "For confidential information of your officers and directors. Board has received recommendations from some reserve banks regarding rates of discount on paper secured by Victory loan notes and has reached the conclusion that there should be no difference in rates on paper secured by Liberty Loan bonds or by the new Victory notes. Although the spread on notes secured by Victory loan is wider than that on notes secured by other government obligations there seems to be no reason to expect great volume of additional rediscounts for in view of attractive features of Victory loan, preference in allotment to smaller subscribere, and announcement that it is the final loan, there is every reason to believe it will be well distributed. In the event any particular banks attempt to make excessive use of discount privilege, appropriate action can be taken in each case. Board is informed that many banks are still carrying considerable amount of Fourth Liberty loan bonds under commitments to carry them for a year and this engagement will terminate in October or November next. Board suggests that unless there should be some unexpected change in situation, reserve banks discourage member banks from making agreements in connection with Victory loan for a longer period than six months, thereby leaving situation with respect to loans secured by Covernment bonds entirely clear after November. Board invites comment on policies proposed in this telegram." Governor Strong in his reply referred to loans which would be made by member banks to subscribers to the Victory loan. It was as follows: "Referring to your telegram to Jay regarding rates of discount. Suggestion contained is exactly that adopted by this bank and by Liberty Loan Organization as to loans by member banks to subscribers. Liberty Loan Committee discussed advisability of urging banks to agree speCificatlly not to lend beyond six months period but we felt such agreement would not appear well on record and would be unwisely restrictive in certain special cases like large life insurance companies; so general understanding exists that period will be limited to six months unless special circumstances demand exceptional terms. Hope our program meets entire approval of hoard." -28- These rates remained in effect until the autumn of 1919. Upon Mr. Strong's return from abroad, where he went for the purpose primarily of I/ arranging for the transfer of German gold to the Bank of England and thence to the United States, his discussion was renewed with the Treasury Department. In the interval Ir. Leffingwell had conferred with the Liberty Loan Committee in New York and had outlined to them the Government's financial program, according to which the revenues would shortly overtake expenditures. On September 28 Mr. Strong went to Washington for conferences with the Treasury officials and the Federal Reserve Board, and on October 8 wrote a letter to Mr. Leffingwell in which he referred to his recent conversation with him. Mr. Strong said that their discussions in regard to expansion, prices, interest rates, etc. had not been conclusive and that the situation was at that time very complex. He added that he could not escape a. feeling "that there is a tremendous responsibility in this matter now resting upon some one; whether it be the Secretary of the Treasury, or you, or the Federal Reserve Board, or this bank, remains to be seen. one of those cases where the adoption of no policy may have just an important and far-reaching consequence, as an affirmative decision may have." Governor Strong was reterring to the financial history of the summer and autumn, and particularly to the speculation which was then rife in stocks and commodities. Government necessities had diminished and at the same time commercial and speculative demands were taking their place as absorbers of credit. The September issues of certificates of indebtedness were much less than the amounts redeemed, thereby releasing credit from Government to other uses. Various warnings nd comments by the Federal Reserve Board had not been effective in stemming expansion. Governor Strong referred to two points on which he feared Mr. Leffingwell and he were not in agreement: "One is as to the function of the Federal Reserve System. Your views seem to be that the Federal Reserve System was designed for the purpose of providing the means by which credit and currency would expand as trade demands increase and that when trade demands diminish the volume of credit and currency would automatically contract, without employing rate changes to influence either movement. This, I believe, is contrary to accepted doctrine in regard to credit, currency and prices; contrary to the experience of the world in central bank practice; and I would be most regretful to feel that we differed materially on such a fundamental matter as this. "The second point relates directly to the first and is more a matter of judgment than of theory. You believe, as I understand it, that an increased production of goods, possibly coincident with a reduction in our export trade, can be relied upon to bring down prices and that this will bring down the volume of credit without any stimulation by rate change. That I do not believe will prove to be the case, at any rate permanently." In his response Mr. Leffingwell, under date of October 13, said that he did not give up hope of reconciling his views with Mr. Strong's and thought that Mr. Strong had misunderstood his views and attitude. He added, in res Mr. Strong's suggestion, that he would be glad to have a conference at which he, Secretary Glass, Governor Harding and Mr. Strong should discuss the matters at issue. On October 16 Mr. Strong wrote Mr. Leffingwell saying that many inquir- ies were being received, especially from bankers, as to when the Federal Reserve Bank was "going to take steps to bring some check to the speculative fever that seems to be spreading over the country, not only as to the stock exchange, but real estate, commodities, etc. etc. My associates in the bank tell me that there is a growing feeling that a dangerous situation is developing." Mr. Strong went on to say that he was not disposed to let himself be influenced by discussions of -30- that character, but that the indications were that bankers in general expected action by the reserve banks. "Our invested funds to-day have reached 98 he said, "and I expect will be running above one billion dollars steadily pretty soon." Mr. Leffingwell replied enclosing an article from the Wall Street Journal, prophesying higher Federal Reserve Bank rates, and saying that when those rates should be raised the Federal Reserve banks would begin functioning in a proper manner in the money market. Mr. Leffingwell pointed to this article as being a probable source of the inquiries which Mr. Strong had been receiving. In preparation for a meeting of the governors of Federal Reserve banks on October 28, Mr. Strong suggested to Governor Harding that a questionnaire be sent out by the Federal Reserve banks to their principal borrowers. Governor Harding assented, and figures were obtained as of October 24, 1919, from a large number of the more important banks, giving the volume of loans made by them to subscribers or borrowers upon Government bonds; the amount of certificates of indebtedness carried and loaned upon and the rates charged on such loans; the rates on customers' paper; the rate of liquidation of loans on Government bonds since the first of the year, etc. Following an exchange of views at the meeting of governors, Mr. Strong returned to New York and reported the results of the conference to the board of directors at a meeting held on October 30. The minutes of the board of directors for that meeting contained the following: "The governor outlined his views on the discount rates of the bank and an extended informal discussion followed, during which all present expressed their opinions. Whereupon, on motion duly made and seconded, it was VOTED that it is the sense of this board that a prompt advance in rates of discount is advisable and that action be deferred pursuant to the desire of the Secretary of the Treasury until Governor Strong has further conferred with him." 31- A telegram sent on the same day by Governor Strong to Governor McDougal, of the Chicago Reserve Bank, was somewhat more explicit. Governor Strong said: "Board to-day decided to defer action until Monday in order to comply with request by Leffingwell that I have meeting with secretary in Washington tomorrow to discuss figures received since our meeting last Tuesday. While I cannot say definitely, I believe that on Monday the program we discussed in Washington will be carried on." The directors were requested on October 31 to hold themselves in readiness for a special meeting to be held on the following Monday morning, November 3. The results of Mr. Strong's conference with the Secretary of the Treasury and the Federal Reserve Board were such that he felt warranted in telegraphing on November 1 to the governors of all Federal. Reserve banks a statement that it"has been decided to recommend to our board of directors that certain rates of discount be established immediately." He then gave the rates agreed upon, which were the same as were adopted at the meeting on November 3, the minutes of which included the following: "Governor Strong reported the conclusions reached at his conference in Washington with the officers of the Treasury Department and the members of the Federal Reserve Board in regard to changes in the discount rates of the bank. There followed an extended informal discussion at which all persons present expressed their views at length. Whereupon, on motion duly made and seconded, it was VOTED subject toihe review and determination of the Federal Reserve Board to establish the following rates of discount to be effective as of the close of business to-day and until further notice, superseding all existing rates. (Note - The previous rate of 4 per cent. on advances secured by Treasury certificates bearing 4 1/4 per cent. was increased to 4 1/4 per centrUpon-other Treasury certificates, Liberty bonds and Victory notes to 4 1/2 per cent; 4 40'24eik -32- and upon eligible commercial paper to 4 3/4 per cent. The 90-day rediscount rate for notes, etc. secured by Liberty bonds or Victory notes from 4 1/4 to 4 1/2 per cent. The 90-day rediscount rates on commercial paper and acceptances and the rate on agricultural paper remained unchanged at 4 3/4, 4 1/2 and 5 per cent. respectively.) The statement which was to be issued to the newspapers in connection with the announcement of the increase in rates was carefully discussed by the board of directors. As originally submitted by Mr. Strong and Mr. Jay, and assented to by Mr. Leffingwell, it was considerably longer than the statement finally agreed upon. The original statement reviewed the effects of Government borrowing upon credit at some length. It was pointed out that the demands made by the Government for credit for war purposes exceeded the amount of the nation's Ci savings and that the discount facilities of the Federal Reserve Bank were neces- d sarily employed to supplement the normal volume of credit created by savings. "It was necessary, therefore, the suggested statement said," during this period for the Federal Reserve Bank of New York to give consideration in its discount policy to the interests not only of the Government and of business, but also to those patriotic citizens who anticipated their DAuresavings in order to subscribe to war loans." The statement then went on to say that the requirements of the Government were decreasing and that sufficient time had elapsed since the Fourth and Victory loans for subscribers and member banks "so to adjust their affairs that no undue hardship should result from an advance in rates of discount." The statement then proceeded: "The reason for such an advance at the present time is the unmistakable evidence that some part of the great volume of credit resulting from both Government and private borrowing which war finance required is being diverted to speculative employment rather than to reduction of bank loans. The total volume of the Government's loans is now in course of reduction and corresponding reductions in bank loans and deposits should be made in order to insure an orderly return to dl,,,tt -33- more normal credit conditions. Increasing prices of commodities, real estate and securities cannot be checked and the evil consequences of price inflation avoided unless steps are now taken which will result in a conservation of the resources of the banks and of the Federal Reserve System for the financing of the industry, commerce and agriculture of the country, and for such aid as may yet be necessary for the completion of the Government's program of war finance. "Member banks, and through them the business interests of the country and the public generally, have gained a proper sense of financial security through the existence of the Federal Reserve System, but this must not be misinterpreted as justifying the promotion of an active and widespread speculation at a time when the credit resources of the country are fully required to meet the needs of domestic production and distribution, and, indeed, to carry a large and increasing share of the financial burden which the war has placed upon the world.?? In place of this statement a much shorter one was issued, to which Mr. Leffingwell and the Federal Reserve Board agreed, though Mr. Leffingwell was strongly in favor of the original statement. The statement as issued was as follows: "The reason for the advance in rates announced to-day by the Federal Reserve Bank of New York is the evidence that some part of the great volume of credit, resulting from both Government and private borrowing, which war finance required, as it is released from time to time from Government needs, is being diverted to speculatiVe employment rather than to reduction of bank loans. As the total volume of the Government's loans, is now in course of reduction corresponding reductions in bank loans and deposits should be made in order to insure an orderly return of normal credit conditions." On the same day Mr. Strong made a personal memorandum giving an outline of the steps which had led up to the advance in rates and of his own opinions which had actuated him in advocating its adoption. In his memorandum he said: "The history of the discussion of the rate change goes back to my first visit to Washington on returning from Europe the last of September, and really prior to that, to the date of an informal, -34- personal letter which I wrote to Mr. Leffingwell from Lake George on February 6, 1919, indicating that the time had come or was coming when a change in the Reserve Bank rate policy would be absolutely necessary for the business of the country. "It has been the writer's theory right along that during the period of expanding Government borrowing it would be necessary for the Federal Reserve Bank to increase the available supply of credit by large accommodation to member banks, otherwise subscribers to the Government's loans would be unable to get accommodation of their own banks and,Consequently, unable to subscribe. This was based upon the belief, which I believe has been general among students of the subject, that the Government's requirements for loans were, and would continue to be during a large part of the war, in excess of the amount of credit created by savings, which would be available, first to pay taxes, second for Government loans, and third to finance the enlargement of our industrial and agricultural production and transportation. "The necessary corollary of this theory was that when the Government's borrowing was reduced, or even when the time arrived when the volume of its outstanding loans would be reduced, then a check should be imposed upon the employment of the facilities of the Reserve Banks by increases in discount rates. "In June and July the Government's expenditures still exceeded its revenues and the program of somewhat expanded borrowing was still in operation. In August, at the time of the then governors' conference and of Mr. Leffingwell's visit to meet the members of the Liberty Loan Committee in New York, it had developed that the Government's revenues would shortly overtake its expenditures and that the Department's program anticipated the possibility, or even the certainty, of reducing outstanding loans by $500,000,000. on the 15th of September. This proved to be the case because on that date the gross debt was reduced $400,000,000 and Government bank balances increased $100,000,000. That was the time, (or in August,) when rates should have been advanced, but Mr. Leffingwell's program, which had many elements of strength and merit, was in general adopted and no rate change made by the Reserve Banks. I certainly cannot assume that I would have held any different opinion had I been here. Nevertheless, this was tantamount to the release of $500,000,000 of credit to the money markets, and subsequent,to that date the loans of the Reserve Banks have increased an additional $400,000,000 and we have added to our reserve about $150,000,000. of gold received from Germany. "In view of these facts, which gradually developed following my first visit to tashington OD the 28th of September, I have been regularly urging upon the Treasury Department the necessity for increasing discount rates. This finally bore fruit in a meeting of all governors available on short call, that is to say, all but the governors of the Dallas and San Francisco banks, the latter represented, however, by Mr. Perrin; in five separate visits to tashington; and the fullest possible discussion of the matter with the Secretary of the Treasury, Mr. Leffingwell and the Federal Reserve Board. And, after an exchange of views with the governors of the Reserve Banks on October 28th, and after holding meetings of our directors on Wednesday, October 29th, Thursday, October 30, and Monday, November 3rd, there was finally adopted at the meeting of the directors to-day (Monday, November 3, 1919) a schedule of rate changes, for announcement this afternoon, The statement for the as shown in the attached circular. press is that authorized by the Board, after an hour's discussion." The advance of discount rates made in New York on November 3 was duplicated partially or in full in a number of other Federal Reserve banks at the same time. On November 5, however, the Secretary of the Treasury wrote a long letter to Governor Harding warning him that the Federal Reserve banks should not rely too much upon increasing rates. He advocated rather that the Federal Reserve Board should insist Upon a firm discrimination by the Federal Reserve banks themselves in making loans. Mr. Glass gave as his own belief "that with the curtailment of export demand consequent upon the curtailment of foreign credits and with industrial production proceeding full steam ahead we should soon have reached an equilibrium in this country at least. In the meantime, however, the situation has become so acute as gravely to threaten production and the speculative mania has developed to such an extent as gravely to threaten our credit structure." He then said that conditions were wanting, under which changes in the C) Reserve Bank rates could be expected to operate effectively, because gold would -36- not be attracted to this country, nor would there by any curtailment of imports nor stimulation of exports of goods. Moreover, further increases in Reserve Ban rates might have the effect of penalizing and discouraging the borrower for in- dustrial and commercial purposes, and it might also have a very grave effect upon the Government's finances. He went on: "I believe it to be of prime importance that the Federal Reserve Board should insist upon and that the Governors of the banks should exercise a firm discrimination in making loans to prevent abuse of the facilities of the Federal Reserve System in support of the reckless speculation in stocks, land, cotton, clothing, foodstuffs and commodities generally. We cannot trust to the copybook texts. Making credit more expensive will not suffice. There is no precedent in history for the great war which we have been through nor for the conditions now existing. The Reserve Bank Governor must raise his mind above the language of the textbooks and face the situation which exists. He must have courage to act promptly and with confidence in his own integrity to prevent abuse of the facilities of the Federal Reserve System by the customers of the Federal Reserve Banks, however powerful or influential." He then went on to say that the New York Stock Exchange was the greateat single organized user of credit for speculative purposes and that open and notor ous manipulation of stocks had been taking place during a period of about nine months since the removal of the control of the Sub-committee on Money of the Liberty Loan Committee. This manipulation, "which takes the form of putting up the price first of one stock and than of another," needed only vigorous action to be ended. His concrete suggestion was embraced in the following: "The Federal Reserve Bank of New York in its relation to the Subcommittee on Money of the Liberty Loan Committee, which Committee was at all times in touch with the officers of the Stock Exchange, naturally sought the views of the Treasury by reason of the fact that its prime duty concerned the sale of Liberty Bonds. A control now put into effect will be primarily for the conservation of the general credit situation and should therefore be initiated and supervised, not by the Treasury, but by the Federal Reserve Board. -36- not be attracted to this country, nor would there by any curtailment of imports nor stimulation of exports of goods. Moreover, further increases in Reserve Bank rates might have the effect of penalizing and discouraging the borrower for in- dustrial and commercial purposes, and it might also have a very grave effect upon the Government's finances. He sent on: "1 believe it to be of prime importance that the Federal Reserve Board should insist upon and that the Governors of the banks should exercise a firm discrimination in making loans to prevent abuse of the facilities of the Federal Reserve System in support of the reckless speculation in stocks, land, cotton, clothing, foodstuffs and commodities generally. "We cannot trust to the copybook texts. Making credit more expensive will not suffice. There is no precedent in history for the great war which we have been through nor for the conditions now existing. The Reserve Bank Governor must raise his mind above the language of the textbooks and face the situation which exists. He must have courage to act promptly and with confidence in his own integrity to prevent abuse of the facilities of the Federal Reserve System by the customers of the Federal Reserve Banks, however powerful or influential." He then went on to say that the New York Stock Exchange was the greatest single organized user of credit for speculative purposes and that open and notorious manipulation of stocks had been taking place during a period of about nine months, since the removal of the control of the Sub-committee on Money of the Liberty Loan Committee. This manipulation, "which takes the form of putting up the price first of one stock and then of another," needed only vigorous action to be ended. His concrete suggestion was embraced in the following: "The Federal Reserve Bank of New York in its relation to the Subcommittee on Money of the Liberty Loan Committee, which Committee was at all times in touch with the officers of the Stock Exchange, naturally sought the views of the Treasury by reason of the fact that its prime duty concerned the sale of Liberty Bonds. A control now put into effect will he primarily for the conservation of the general credit situation and should therefore be initiated and supervised, not by the Treasury, but by the Federal Reserve Board. -37- "I need not say that such steps should be taken not only firmly but with discretion and in such a way as not to involve grave hardship to individuals or injury to the general welfare." In conclusion Mr. Glass said that his letter was not written in a spirit of criticism, particularly as the governors of the Federal Reserve banks had been of the highest service during the war. Suggesting that the board take the place of the Treasury as the guide of the Federal Reserve banks, he said: "During the war they (the Governors) have naturally turned for leadership to the Treasury since its operations were the dominating factor in the financial situation. It would,however, be a great misfortune if, now that the Treasury operations are on a diminishing scale, the Governors of the Federal Reserve Banks are allowed to feel that the problems of the future were for them to solve each according to his own best judgment. The need of leadership is no less great, the need of examining the situation from a broad national and international point of view is no less imperative. I look to see the Federal Reserve Board, not critically nor aggressively but patiently and persistently,provide this leadership." Air. Strong, in response to 8 letter from Mr. Alfred L. Aiken, president of the National Shawmut Bank of Boston, said on November 6 that he hoped that the advance in rates was a start in the right direction. "So far as this concerned," he said, "I have definitely stated to Secretary Glass and to Mr. Leffingwell, as well as to the Federal Reserve Board, that our hands must be free in rate making, although we, also, propose, as heretofore, to consult freely with the Treasury in all of these matters." Pertinent, also, to the points raised in Mr. Glass's letter, although not in response to it, are passages in a letter which Mr. Strong sent to Governor Harding on November 6. Mr. Strong said that Governor Harding was aware of his belief, "that the control of credit in New York must, primarily, rest upon rate -37- "I need not say that such steps should be taken not only firmly but with discretion and in such a way as not to involve grave hardship to individuals or injury to the general welfare." In conclusion Mr. Glass said that his letter was not written in a spirit of criticism, particularly as the governors of the Federal Reserve banks had been of the highest service during the war. Suggesting that the board take the place of the Treasury as the guide of the Federal Reserve banks, he said: "During the war they (the Governors) have naturally turned for leadership to the Treasury since its operations It were the dominating factor in the financial situation. would,however, be a great misfortune if, now that the Treasury operations are on a diminishing scale, the Governors of the Federal Reserve Banks are allowed to feel that the problems of the future were for them to solve each according to his own best judgment. The need of leadership is no less great, the need of examining the situation from a broad national and international point of view is no less imperative. I look to see the Federal Reserve Board, not critically nor aggressively but patiently and persistently,provide this leadership." r. Strong, in response to a letter from Mr. Alfred L. Aiken, president of the National Shawmut Bank of Boston, said on November 6 that he hoped that the advance in rates was a start .in the right direction. "So far as this bank is concerned," he said, "I have definitely stated to Secretary Glass and to Mr. Leffingwell, 'as well as to the Federal Reserve Board, that our hands must be free in rate making, although we, also, propose, as heretofore, to consult freely with the Treasury in all of these matters." Pertinent, also, to the points raised in Mr. Glass's letter, although not in response to it, are passages in a letter which Mr. Strong sent to Governor Harding on November 6. Mr. Strong said that Governor Harding was aware of his belief, that the control of credit in New York must, primarily, rest upon rate -38- adjustments, and that effective control cannot be exercised through arbitrary curtailment of loans to specific institutions beyond a very moderate degree." He then went on to say that the reports received from member banks and trust companies indicated that at that time the total fund loaned on the stock exuhange by out-of-town institutions was about $700,000,000. He gave the substance, also, of a conversation with a New York banker who said that his institution during the period of Money Committee operations was lending about $45,000,000 on stock exchange collateral, but that upon the dissolution of the Money Committee it reduced its stock exchange loans and was then carrying considerably less than half that amount. But on the other hand, while formerly it had been lending for out-of-town correspondents on stock exchange collateral up to $25,000,000, it was then lending $90,000,000 for correspondents. Moreover, it had the reports of these institutions examined and had found that in no single case did they report bills discounted with the Federal Reserve Banks of their respeotive districts. Mr. Glass's letter came to Governor Strong with a letter from Governor Harding under date of November 8. Governor Harding said that the letter had been sent by the secretary to the board while the latter was in session on November 8, and the suggestion had been made that mimeographed copies be mailed to the governors of each Federal Reserve Bank. Governor Harding added, however, that it was the board's intention, in view of the references to the Federal Reserve Bank of New York, not to send out copies until Governor Strong had had an opportunity of reading the letter. He suggested that Mr. Strong should give him his thought in the matter verbally, inasmuch as they were to meet within a short time. The records contain the draft of a long letter from Mr. Strong to Mr. Harding, but it does not appear that the letter was sent. that draft Governor Strong sugge,ted that Mr. Glass's letter should be placed in In -39- the hands of all the governors of the Federal Reserve Banks "so that it may be understood that the policy of the system shall be in conformity with this request, which I assume meets with the approval of the Federal Reserve Board and that the board is willing_to 4,assume the responsibility for the program Mr. Strong went on to say that it had been quite unnecessary to outlined." give assurances that it was the desire and intention of the Federal Reserve Bank of New York to cooperate to the fullest extent in all proper methods to check the speculative mania, which was not confined to this district. Inas- much as speculation is based upon the use of credit, its control depended upon the control of credit. He also said that he was in accord with Mr, Glass when the secretary stated that reliance for the control of credit and for a check upon speculation cannot wholly be left to interest rates if results were to be immediately attained, although, he added, "in the long run, I believe it will be found that the old rules still work and that a higher cost for credit, and only that, will provide the necessary check." He then reviewed the period of loan expansion, concluding that there seemed to be three courses open to the management of the reserve banks: (1) The exertion of influence upon individual institutions which were borrowing heavily; (2) rationing credit, and (3) further increases in rates. As to the first, he said, undoubtedly wholesome influence could be exerted and for a year or more it had been the policy of this bank to employ that method where it was believed that the borrowings of any specific institution justified it. But a fuller application probably would lead to injustice, partly because some of the banks which were the largest borrowers were employing little or no credit in furtherance of speculation; of stock exchange loans were placed for partly because a large proportion out-of-town account; partly -40.- because banks borrow from the Federal Reserve Bank generally to restore depleted reserves; and partly because it was impossible to indentify the purposes behind loans which individuals made at the banks. The result might be that the loans of certain banks would be reduced, but that they soon would be transferred to other banks, "thus driving the infection from one place to another without eradieating it." The plan should be discreetly employed as in the past but it would scarcely be effective in accomplishing the broad result sought. An application of the principOvof rationing credit would render the Reserve System as inelastic, as was the old system, and might be disastrous to the business of the country. The chief immediate result, as in the first meth od, he said, would be the calling of loans and a curtailment of credit, which would result in a disorderly money market. As to the third method, namely that of discount rates, Mr. Strong saId that he regretted very much to differ so considerably with the views expressed by Secretary Glass. "To attempt," he said, "to influence 25,000 or 30,000 banks, or, in fact,the vast number of people who are directly or indirectly contributing to this movement in one form or another, except by the wholesome, uniform and just plan which can be adopted by the reserve banks, - namely increased discount rates, - seems to me to be courting failure either by attempting something which will be ineffective, or, on the other hand, if adopted so vigorously as to be effective, to be dangerous as leading to panic and disasters." -40- because banks borrow from the Federal Reserve Bank generally to restore depleted reserves; and partly because it was impossible to indentify the purposes behind loans which individuals made at the banks. The result might be that t of certain banks would be reduced, but that they soon would be transferred to other banks, "thus driving the infection from one place to another without eradicating it." The plan should be discreetly employed as in the past but it would scarcely be effective in accomplishing the broad result sought. An application of the principbiof rationing credit would render the Reserve System as inelastic, as was the old system, and might be disastrous to the business of the country. The chief immediate result, as in the first method, he said, would be the calling of loans and a curtailment of credit, which would 0 result in a disorderly money market. As to the third method, namely that of discount rates, Mr. Strong said that he regretted very much to differ so considerably with the views expressed by Secretary Glass. "To attempt," he said, "to influence 25,000 or 30,000 banks, or, in fact,the vast number of people who are directly or indirectly contributing to this movement in one form or another, except by the wholesome, uniform and just plan which can be adopted by the reserve banks, - namely increased discount rates, - seems to me to be courting failure either by attempting something which will be ineffective, or, on the other hand, if adopted so vigorously as to be effective, to be dangerous as leading to panic and disasters." -41- While this letter does not appear to have been sent, Mr. Strong was in Washington shortly thereafter. On November 24 the board of directors considering that conditions made a further advance in rates mandatory, adopted a schedule providing for an increase of 1/4 of 1 per cent. on advances secured by government obliga- tions (with the exception of certain issues of certificates of indebtedness, the rate on which was not changed) and upon rediscounts of paper secured by Liberty bonds or Victory notes. The rate on advances secured by eligible commercial paper was increased 1/4 of 1 per cent., and the rate upon rediscounts of commercial paper, acceptances and agricultural paper was increased 1/2 of 1 per cent. This action was preceded by a lengthy discussion with respect to the credit situation and the desirability of increasing the discount rates at that time. Mr. Hepburn, member from this district of the Federal Advis- ory Council, attended the meeting and reported what transpired at a recent conference of the Federal Advisory Council, and Governor Strong reported the substance of the discussion as to rates of discount and the credit situation at a recent conference of governors. The preliminary vote of the board of directors was as follows: "VOTED, that in view of the extended credit position in this Federal Beserve district and throughout the country, it is the sense of this board that it is desirable that there should be an immediate upward revision of our rates of discount." -4 2- Mr. Jay asked to be recorded against the resolution because while he was in sympatiq with the desirability of higher rates, he did not consider the time opportune to revise all rates of the bank; and Mr. Peabody asked to be recorded against the resolution because the Treasury had already announced an offering of certificates of indebtedness at 4 1/4 per cent., which was lower than the rate proposed for advances upon such certificates. On the same day Mr. Strong addressed a letter to Governor Harding in which he described the action taken at the meeting of the board. He said: "After full discussion, it was disclosed that it was unanimously the opinion of the members of the board that further advances in rates are necessary in order to adequately check the expansion of credit now taking place throughout the country. It deplored the fact that this action was felt to be necessary notwithstanding that we had now been advised of the determination of the Secretary of the Treasury to make an offering of certificates of indebtedness, dated December 1, at 4 1/4 per cent, which offering will be practically coincident with the increase in rates above reported if such rates become effective, although it was also felt by some that the advance in rates indicated in the schedule would not necessarily interfere with the successful sale of the quota of certificates customarily absorbed in this district. "The directors of the bank renew the expressions of concern formerly made through me that a continuance of present conditions, -43- a generally expanding loan account by the banks of the country, enlarged issues of currency by the Federal. Reserve Banks, and increases in prices of commodities, real estate and stocks will ultimately lead to a situation of great peril to the business and financial interests of the country and that the only effective means of checking this development, as stated above, is by further increases in our rates, which they feel it their paramount duty to urge upon the board without further delay." On the morning of November 26 Governor Strong read this letter at a meeting of the board of directors, and the board voted its aPproval. On the afternoon of that day a telegram was received from Governor Harding, which was read to the executive committee, as follows: "After full consideration, taking into account the Treasury's position and announcement, board has voted to disapprove rates established by your directors on the 24th instant, which were submitted for review and determination of the board. Board feels, however, that your rates on acceptances have for some time past been too low and will, if requested, approve new spread governing your purchases of acceptances." After an informal discussion, Governor Strong was asked to write a letter to the Federal Reserve Board with reference to its action in disapproving the increase in rates. Governor Harding in a letter to Mr. Jay, dated November 26, supplemented the telegram of that date. Governor Harding said: -44- "While there was some appreciation of the view that looking at the existing credit situation merely in its general aspects it might be advisable to attempt to strengthen a policy of control through an advance of rates, it was,nevertheless, felt that in the existing situation, and the turn of the year so near, it would be inadvisable to complicate the Treaury's program already definitely announced, and that probably the speculative feature of the existing situation could be controlled on the basis of the recent advance of rates provided the several reserve banks would take the necessary steps for that purpose. This was not regarded as foreclosing a further consideration of the whole question of the relation of discount rates to the credit situation which might properly come up for a thorough review after the fifteenth of January when the Treasury's present certificate program will be measurably out of the way. Even those members of the Board who favor an advance of rates as soon as the situation is better adapted to such a policy are, nevertheless, of the opinion that changes in rates alone will not fully control the present expansion of credit and that direct restriction upon the use of credit by the borrowing banks is essential to any effective control." Governor Strong's reply, written under date of November 28, addressed itself largely to Governor Hardingls suggestion that "direct restriction upon the use of credit by the borrowing banks is essential to any effective control." -45- He pointed out that up to that time the principal effort of this bank had been directed toward the restriction of the speculative employment of credit in stock exchange transactions conducted on the New York Stock Exchange, and that a reduction in the amount of funds lent upon stock exchange co/lateral, (both by New York and out-of-town banks) amounting to *163,000,000, had been effected between November 10 and November 25. While the total sum so employed measurably fell, the loans by out-of- shown a tendency to increase and so created a town banks, however, had situation which was beyond the control of any action undertaken in this He added that the directors of the bank had Federal Reserve district. instructed him to point out to the Federal Reserve Board the possibilities of danger which might result from attempts to restrict loans on the stock exchange through the uncoordinated effort of the managements of the other eleven Reserve Banks. "You and Mr. Strauss," he said,"have had opportuni- ty to examine the system which we have pursued in dealing with these matters and realize that so far as the Stock Exchange loan account is concerned it has been carefully watched for a long period and every reasonable effort has been made to control it." The directors also asked Mr. Strong to tell the Board that in their opinion the great expansion of credit then taking place was represented only in part by transactions upon stock exchanges, but was principally occurring in many forms of credit arising out of the expansion of the agricultural, industrial and commercial business of the country at the then high levelof prices. Control over such expansion could only be justly and effectually -46- exercised through the rate of discount of the central bank. Mr. Strong then said that it was the intention of the New York Reserve Bank to carry out the policy outlined by the Federal Reserve Board andto exercise its "personal, direct influence upon those banks which are large borrowers." The impartial carrying out of such a policy, however, would appear to make it necessary to submit a statement of policy to all the member banks of the district, a step which was regarded as fraught with the utmost danger. He then asked that the Federal Reserve Board "define as exactly as possible the extent and nature of the restrictions which they believe should be employed by Federal Reserve Banks in order to control credit, and, if they will, to advise whether the Board contemplates any action in other Federal Reserve districts where the facilities of the Federal Reserve System may be abused by banks which are borrowing from the Reserve Banks in their districts, and, at the same time, as mentioned above, are lending funds on the New York Stock Exchange, on the other stock exchanges of the country, or otherwise employing funds so borrowed simply for profit. We repeat our suggestion of the possible hazards of such a policy." In conclusion Mr. Strong added: "I believe it is only right that I should submit to the Board the following facts which influenced our directors in arriving at the decision to submit a new schedule of rates. We were advised by Mr. Hepburn, at the meeting when this matter was submitted, that every member of the Federal Advisory Council favored a further advance in the discount rates, but recommended that rates should not be changed at the present time because of their understanding -47- that it would be detrimental to the program of the Treasury Department. We have consulted a large number of New York bankers generally in regard to the situation, and I believe without exception every one of them stated that they believed rates should be advanced, and, if necessary, that the Government shouldpay highs' rates for short accomodation in order that our rates should be advanced. "My own impression, from the discussions at our Governors' Conference, in hashington, indicated that most of the governors of the Reserve Banks held the same view. "At the time of the conference of governors of the Federal Reserve Banks in Washington, I had in my possession, but did not read, a letter signed jointly by every large dealer in bankers acceptances in New York City, urging that we advance our rates in order to correct the present situation. "In fact, I think it may be generally said that it is almost the unanimous judgment of experienced bankers and those conversant with the present situation that rates should be advanced and that such rate advances only will prove adequate in meeting a situation which contains many elements of danger, although the direct influence we are exerting upon certain borrowers will be partly or wholly effective in many individual cases." - 48 - Before the letter was mailed a telegram was received from Governor Harding conveying a request from the Board that this Bank use all efforts in the "vitally important work of making a success of the current issue of Treasury certificates of indebtedness." idr. Harding then said that in the past week sales of Liberty bonds, and particularly Victory notes, had been exceptionally heavy and that there was some indication that it was coming from banking institutions. He added: "The Board does not look with favor upon the policy of forced liquidation of government securities. Any denial of credit to institutions which are holders of such securities would, of course, This will do much harm and result in heavy liquidation thereof. can do no good." Governor Strong then added a postscript to his letter saying that it was not believed that banks in New York were largely selling Liberty bonds and Victory notes. "We do not believe," he said, "that they are generally selling these bonds, but we do believe that the selling comes from a large number of institutions and individuals that are now borrowing money from the banks and trust companies, which some time ago started to mark up the rates at which they were being carried upon the expiration of the agreements for one year., in the Case of the Fourth Loan, and 6 months, in the case of the Fifth Loan, entered into at the time those loans were placed. Frankly, ' -our telegram has thrown us into some confusion as to the policy which this bank should pursue, and emphasizes the necessity for a better understanding of policy than now exists. The necessity for this seems to be indicated by the fact that our loans today increased by about :50,000,000 to the highest figures which they have so far reached." Governor Strong replied by telegraph to that part of Mt. Harding's telegram which Deferred to the sale of certificates of indebtedness, assuring him that arrangements were already under way. On the same date, November 28, he also replied to that portion of Et. Harding's telegram of November 26, suggesting an increase in the purchasing rates for acceptances. - 49 - On December 2 Governor Harding responded to Governor Strong's letter of November 28, saying that the Board appreciated fully that the Situation was a difficult one and required most careful handling. He said: "The view of the Board is, or at least that of a majority of the Board, that an advance in rates at a Federal reserve bank cannot alone be an effective corrective of the present situation.**** "The Treasury is still the predominant factor in our financial situation. Notes and bonds of the United States are specifically exempted in Section 13 from the investment securities, transactions in which are excluded from the dealings of Federal reserve banks. The Treasury officials have taken a definite stand that no change can be made at present in the Treasury policy of issuing certificates at a low rate and making them attractive by the means of the deposit feature. The Treasury's policy having been definitely announced, the Board has felt it to be its duty to do what it could to cooperate, even though the result has been an unsatisfactory banking stilation. It is probable, however, that the situation would not have been altogether satisfactory in any event, for as long as consumption exceeds production and as long as people generally maintain the extravagant mood which has been very much in evidence for several months past, little if any headway can be made in genuine liquidation, which is absolutely essential for the restoration of more normal conditions. "The Board has noted your views as to the problem of credit control, and recognises the fact that the great bulk of the increase in the loan account of reporting banks has been in miscellaneous loans other than Stock Exchange loans notwithstanding the reduction of loans upon Government securities. It would be exceedingly difficult for the Federal Reserve Board to undertake to suggest, a policy at this time for the restriction of general credit which would not conflict with the very firm conviction of the Treasury authorities as to the effect upon the Liberty Bond market, in which, as you know, the Treasury feels much interested. I believe that I am expressing the general opinion of the Board fairly when I say that no drastic steps should be taken at this time even though the reserves of the Federal reserve banks should continue to decline." Governor Harding concluded with the expectation that there would be an easing of the situation after the first of January, adding that the Treasury officials were of the opinion that Treasury requirements need not be given so much consideration in determining the bank rates after the middle of January. At the meeting of the board of directors on December 3, Governor Strong - 50- read this correspondence and his letter to Governor Harding dated was by vote endorsed and approved. November 28 Ifter lengthy consideration the Board took the following action: "VOTED that the chairman Harding asking for a conference BoArd and the directors of this position and views with respect be fully discussed." be requested to write (tovernor between the Federal Reserve bank, at which the bank's to the rates of discount may In his letter to Governor Harding written in conformity with this resolution, Mr. Jay said, "that there was much dissatisfaction among the members of the board at the position in which the bank now finds itself." He added that criticism was rather widespread and was being brought to the attention of the directors individually; and that the judgment of the directors of the bank was obviously misunderstood by the public. In accordance with Mr. Jay's request, the date for a meeting was set, but in the interval, on December 10, a telegram was received from Governor Harding which entirely changed the situation and opened the way for an advance of discount rates. This telegram was as follows: "Board believes that in order to discourage speculation and check loan expansion it is necessary to use discriminating judgment in making discounts and advancements as provided in secton four, and to have member banks understand that resources of system are not unlimited. Board realizes, however, that advances in rates constitute an important element in making member banks and their customers understand need of such discrimination and limitation. Treasury position at present is sufficiently favorable as to warrant abolition of preferential rates in favor of paper secured by Liberty bonds and Victory &rtes. Maintenance of four and one half per cent rate on treasury certificates seems necessary to insure success of future certificate issues but maintenance of this rate involves no great danger of expansion as that rate affords no profit to banks carrying certificates but on the contrary offers inducement to distrfbutacertificates among taxpayers and other private investors. Treasury does not ask continuance of four and one quarter per cent rate on four and one uuarter per cent certificates. In bringing these facts to your attention board desires to say that if conditions in your 'district are such - 51- as to render desirable four and one half per cent rate on all certificates an abolition of the one quarter per cent differential in favor of rediscount and advances secured by Liberty bonds and Victory notes. Board is prepared to a'rprove such changes." This telegram was brought to the attention immediately of the executive committee to whom Governor Strong said that the rates of discount and for advances,which the changes proposed by Governor Harding would bring about, were among those established by the directors of the bank at its special meeting on November 24, and at that time disapproved by the Federal Reserve Bo.rd. A resolution to fix rates in accordance with the suggestion was then adopted. The effect of these advanceswas to remove the differential previously effective in favor of paper secured by Liberty Bonds and Victory Notes and of making the rate identical with the commercial Darer rate, namely 4 3/4 per cent. The differential in favor of 41/4 per cent certificates of indebtedness was also removed. The Federal Reserve Board approved the advance and it was announced the next day, effective December 12. In view of this action, the conference which had been arranged with membemsof the Federal Reserve Board was indefinitely postponed. 52 - The rates remaining at 4 1/2 per cent. were those on advances secured by certificates of indebtedness and upon re-discounts of acceptances. In a letter to Yr. Leffingwell under date of December 19, 1919 Mr. Strong He ex- expressed the hope that those rates also might be raised to 4 3/4. plained that if agreement between Reserve banks and the Treasury Department could be reached, reasonable control over credit expansion would be attained. In his letter he said "At last, after nearly five years of experience and experimentation, we are upon the eve of completing the last step in making the Federal Reserve Bank a real central bank, with a real bank rate. In fact, in a period of five years, we will have arrived at a position in banking at least as good, if not better than, that Which has been reached in England after 250 years or more in experience and development. When the time comes, as I hope it will Shortly, When the Treasury Department and the Reserve System as a whole can agree upon a policy which will permit of the .establishment of this uniform rate of discount, I am convinced that we will have in our hands an instrument for the exercise Of a reasonable control over credit expansion, and, through that, of price expansion, such as can be accompliahed by no other method. This bank rate, of the character I have described, has been in my mind as the objective toward which we were working ever since our bank was organized. Its success depends upon the development in the market of an adequate volume of bills (as die.. from commercial paper) so that the U2114, by voluntary /tinguished purchases or by refraining from making purchases, can exercise a primary control over the money market Which it could not possibly 53 exercise without such a voluna of paper that may be purchased, or not purchased, at will. During all of our discussions of rates, and, in fact, before the discussions became so important as recently, I have looked at this position as the goal of all of our efforts. Now I want to ask you to consider what a curious situation has arisen, growing out of this perfectly natural ambition for the system: lar. Glass, the author of tde Act became Secretary of the Treasury and finally responsible for the Government's financial policy, and, strange as it may seem, the very man who produced the Federal Reserve System felt obliged to take a position quite hostile to my own views, notwithstanding that for five years I have been doing the utmost that one could do to make this plan of Secretary Glass's a real success. is, of course, a wholly This difference of honest one, but brings to light with curious significance what has always been historically true of the relation between Government Treasuries and Central Banks in time of war, naaely that the Treasury endeavors to assert a control over the policy of the central bank more distinctly in the interest of the Treasury than in the interest of the general business of the country. It is not an unreasonable, in fact in many instances is a necessary, development because in time of war the policy of the central bank must be considered not as an official or economic policy but a military policy and one of the agencies to win battles, rather than to develop theoretically sound banking and financial practices, such as would control in peace times. That situation was thoroughly recognized, and I may say, promoted by the New York bank during the entire period when it was necessary that the bank P.- 54 - Should have a military policy, so to speak. But now that the war is over, the time has cone to abandon a policy designed for military purposes in favor of one Which will better serve the interests of the country as a whole, rather than the separate interests of the Treasury alone. Unfortunately Lal. Glass has not agreed with my feelings about this and one of the results, I fear, has been to drive him to the view that there were some things which might have been done to deal with the credit situation by other methods than by rates, and that in some way I have led a revolt in the System, the object of which, While not openly expressed, was to assert the dominating position of the Reserve System in controlling the policy of the Treasury." Yr. Strang then suggested that a meeting might be arranged with Mr. Glass for a discussion of the whole problem. interested at Mr. Strong was particularly thisime in reconciling the differences because he was about to leave on a long absence from the bank acting on the instructions of his doctors* At the meeting of the Board of Directors held on December 29, Governor Strong reported the results of a conference Which he had held with the Federal Reserve Board alla officials of the Treasury Department and ex- pressed views as to the desirability of establishing as soon as practicable a single bank rate in place of the preferential rates then effective. extended discussion followed, but no action was taken on that date. December 30, however, Ir. Jay An On reported to the Executive Committee that the Treasury Department had made public an issue of certificates of indebtedness bearing 4 3/4 per cent* A discussion followed as to the desirability of increasing to 4 3/4 per cent, the rate for advances secured by certificates of indebtedness and the rate of re-discount of acceptances to the same figure, 55 thereby eliminating the preferential theretofore maintained. The Executive Committee then voted to make uniform at 4 3/4 per cent0 the rate for advances and re-discounts however secured The rate on 3 to 6 months agricultrual paper remained at 5 per cent. hr. Jay then read a draft of a proposed statement to accompany the announcement of the increase of rates. approved the statement The Executive Committee informally Which was sent out as follows: "It seems appropriate at this time to make a brief statement to the member banks in regard to the discount policy of this bank. During the period of active borrowing upon an increasing scale by the Government of the United States, the demands for credit for war purposes exceeded the amount of the savings fund of the nation available for investment in Government securities, so that the discount facilities of the Federal Reserve Bank were, necessarily, employed to supplement the normal volume of credit created by savings. It was necessary, therefore, during this period for the Federal Reserve Bank of New York to give consideration in its discount policy to the interests not only of the Government and of business, but also of those patriotic citizens who anticipated their future savings in order to subscribe to war loans. Now, happily, the income of the Government has overtaken its -expenditures and in the month of September there was an actual decrease in the Government debt of about 4400,000,000; the loans which banks have made to their customers on Government securities are steadily being reduced, and Secretary Glass, in announcing the current offering of 4 3/4% Treasury certificates of indebtedness, states that the success of the issue will assure the consummation of the Treasury's plan for financing the unfunded portion of the war debt. In view of the foregoing, and of the wide distribution of certificates to the public, it being estimated that not over onehalf of the certificates outstanding are now held by the banks, the directors of the Federal Reserve Bunk of New York have eliminated the preferential rates heretofore maintained in favor of advances and rediscounts based on bonds, certificates of indebtedness and acceptances, and for the time being, at least, have establiahed a single rate for credit at the Federal Reserve Bank, thereby greatly sinplifying their future rate policy. While the Federal Reserve Act, by lowering reserves, added permanently to the lending power of the member banks it was not intended that the Federal Reserve Banks themselves Should be used to promote permanent credit expansion or for the purpose of ob- taining funds to reloan at a profit in the general credit market. They were intended to facilitate emergency or seasonal expansion, ' and except for such unusual borrowing as war financing necessitates, N the same principles which governed borrowing by banks prior to the \\\ establishment of the Federal Reserve system Should still obtain. Nor does the existence of the Federal Reserve system relieve bankers from their individual responsibility to prevent unwise expantion of credit at a time like the present when the pressure for credit is very great. On the contrary, with the banks being gradually relieved of the volume of Government securities Which, directly or indirectly, they had to assume, the released credit should be devoted, as far as practicable to the reduction of indebtedness -57- to the Federal Reserve Bank, in order gradually to reduce the present credit expansion." On January 14, 1920, the directors of the New York Reserve Bank took action to advance the rate uniformly to 5 1/2 per cent. The follow- ing minute appears in the records of the board edirectors: "There followed a general discussion with respect to the rates ofdiseount and those present expressed their views at length. Whereupon, after consideration and on motion duly made and seconded, it was "VOTED, subject to review and determination of the Federal Reserve Board, to establish a rate of 5 1/2%, the effective time to be left to the executive committee with power. "Ur. Alexander stated that while he approved in principle of raising the rate to 5 1/2%, he was not in favor at this time of changing the rate on certificates and did not think it desirable to establish, before a consultation as had with the Treasury De- partment, a rateof 5 1/2% on loans secured by certificates of indebtedness. After a full discussion of this point and on motion duly made and seconded, it was "VOTED that Messrs. Case, Jay and Alexander be appointed a committee to confer with the Federal Reserve Board and the Treasury Department on the subject of the rates of discount." At its next meeting, that of January 21, the board of directors received a. report from the committee which had been appointed to confer with -58- the Treasury Department and the Federal Reserve Board. It appears that the Treasury Department did not favor increasing the rate for advances secured by certificates of indebtedness, or on rediscounts so secured. At the same time, however, the Treasury and the Reserve Board indicated that when a distribution of the December issue of 4 3/4 per cent. certifi- cates had been effected they would have no objection to advancing the rate to 5 per cent., assuming that the Treasury would offer a new series of long-term certificates in March. With this information before it, the board of directors rescinded its action of the preceding week and voted a new schedule of rates, which may be summarized as follows: On commercial paper, Liberty bonds and Victory notes, advances and rediscounts 5 1/2% On bankers acceptances, advances and rediscounts 5 1/4% On Treasury certificates, advances and rediscounts - On agricultural paper, 3 - 6Adonths-rediscounts- - - - 4 3/4% - 6% This schedule, however, did not meet with the approval of the Federal Reserve Board. At a special meeting of the board of directors held the same day, Mr. Case stated that he had communicated by telephone to Mr. Strauss, vice governor of the Board, the schedule of rates which had been established that morning, and that lr. Strauss had reported that after the Federal Reserve Board had given the matter careful consideration it suggested the establishment of rates as follows: -59- On commercial paper, advances and rediscounts 6% On Liberty bonds and Victory notes, advances and rediscounts 5 1/2% On bankers acceptances, advances and rediscounts On Treasury certificates, advances and rediscounts 5% - - - - - 4 3/4% There followed an extensive informal discussion, after which the board of directors adopted the following resolution: 'TOTED to convey to the Federal Reserve Board the informal expression of the unanimous opinion of the directors of this bank that an advance to 6% at this time in the commercial paper rate is inadvisable as it represents too sharp an increase to be made at any one time, might result in unsettled conditions and left too large a differential with respect to the rates on certificates of indebtedness. After further consideration, the directors voted to establish rates identical with those propoaed by the Federal Reserve Board, except in the followig particular: On commercial paper, advances and rediscounts - - - - -5 1/2% Mr. Case then communicated to Mr. Strauss the unanimous opinion of the Board as to the commercial paper rate, giving also the schedule which it had voted to establish. The next day, January 22, Mr. Case report- ed to the executive committee that Governor Harding had notified him that morning that the Federal Reserve Board had decided to establish the 6 per 1 cent. rate on commercial paper. The schedule adopted by the Board was in -59- On commercial paper, advances and rediscounts - e% On Liberty bonds and Victory notes, advances and rediscounts 5 1/2% On bankers acceptances, advances and rediscounts On Treasury certificates, advances and rediscounts - - - 5% - 4 3/4% There followed an extensive informal discussion, after which the board of directors adopted the fo/lowing resolution: "VOTED to convey to the Federal Reserve Board the informal expression of the unanimous opinion of the directors of this bank that an advance to 6% at this time in the commercial paper rate is inadvisable as it represents too sharp an increase to be made at any one time, might result in unsettled conditions and left too large a differential with respect to the rates on certificates of indebtedness. After further consideration, the directors voted to establish rates identical with those proposed by the Federal Reserve Board, except in the followig particular: On commercial paper, advances and rediscounts - - - -5 1/2% Mr. Case then communicated to Mr. Strauss the unanimous opinion of the Board as to the commercial paper rate, giving also the schedule which it had voted to establish. The next day, January 22, Mr. Case report- ed to the executive committee that Governor Harding had notified him that morning that the Federal Reserve Board had decided to establish the 6 per cent. rate on commercial paper. The schedule adopted by the Board was in -60.. all respects the same as that which had been communicated to the special meeting of the board of directors on the afternoon of January 21, with the exception that a minimum buying rate for bankers acceptances was fixed at 5 1/4 per cent. A circular was sent out to the member banks announcing the neicilPOVeTtas of the close of business on January 22. The action of the Federal Reserve Board in establishing a 6 per cent. rate on commercial paper was discussed at length at a meeting of the board of directors on January 28, and the following resolution was adopted: "VOTED That the chairman be requested to prepare a letter to the Federal Reserve Board, subject to the approval of the executive committee, expressing the views of the board of directors on the recent action by the Federal Reserve Board with respect to the change in the rates of discount." In point of fact, there had already been an interchange of letters between Mr. Jay and Governor Harding on the subject Primarily of the minimum buying rate for bankers acceptances, which was contained in the schedule of rates determined by the Federal Reserve Board. Mr. Jay sai dated January 23 that it was the feeling of the executive committee that "their conduct of open market purchases would be facilitated if they were advised by the Board just what results the Board desired to accomplish through the medium of these rates,which were originally suggested by the Board." After stating at some length the intent of the Federal Reserv Act that it was the hope of the Board that the rates now established would -61- operate so that the rate on acceptances might advance to a point where acceptances would prove attractive to corporations, firms and individuals having funds available for temporary investment; he said "It is believed =Is& that this result will be more readily attained through general knowledge on the part of member banks that acceptances can, if desired, be rediscounted at rates which take into consideration the superior quality of the acceptance as a liquid investment. It is expected in this way to eliminate the open market operations or, at least, the purchases of the Federal Reserve Banks as the principal factor in making the acceptance market." The letter which Mr. Jay wrote to Governor Harding in accordance with the vote of the directors on January 28, was read by him at a meeting of the executive committee on January 20. It was informally approved. The full text was as follows: "At the last meeting of our directors the proceedings in regard to the establishment of the rates of discount which were announced by this bahk on January 22 were reviewed and considered, particularly with respect to the new minimum rate of 5 1/4% for the purchase of acceptances in the open market, which was fixed by the Board not only without recommendation from or consultation with our directors or officers, but as far as our officers can remember we had had no previous intimation from the Board that it felt our buying rate was too low. "The discount market which centers In New York City is a delicateaffair, the resultant of adverse interests and made up -62- of many elements, including national and state banks, private bankers, branches of foreign banks, discount houses and bill dealers. Stability is one of its essentials and, while it must necessarily fluctuate with the demand for money, yet it is important that such fluctuations should be reasonably gradual. At the time the Board increased the minimum buying rate overnight from 4% to 5 1/4%, our actual buying spread was from 4 3/4% to 5 1/4% for the various maturities and grades of bills. The advance of 1/2% in the effective minimum buying rate, from 4 3/4% to 5 1/4%, was one, the severity of which the bill market had never before experienced, and coming, as itdid, from the Federal Reserve Bank which had always dwelt upon the stability of bill rates, its effect was to demoralize the market completely and discourage primary buyers as to further purchases of bills, except at very high rates and in small volume. this has been largely to keep folios of the accepting banks; bills as The result of mere loans in the port- whereas the distribution does not appear, as yet, to be better than it was at the lower rates prevailing before January 23. "Our directors, accordingly, ask me to request the Board to reduce the minimum buying rate to 5% in order that there may be an element of flexibility available should it be considered ad- visable, from time to time, to buy very short prime import at somewhat less than 5 1/4%. bills -63- "In sending the Board this request our directors have asked me to express to you their unanimous feeling that whatever may be the legal powers of the Board in respect of fixing rates, it is desirable, if the interest and services of responsible directors are to be retained, that there should be a continuance of the practice heretofore followe f arriving at discount r by cooperation between the bank and the Board which seems to them to be the procedure indicated by the wording as well as the spirit of the law." Governor Harding was present at a meeting of the board of directors on February 4, in which the whole matter was discussed, particularly as related to the respective powers of the directors of the bank and the Federal Reserve Board. At this and the next subsequent meeting the Acting Attorney General of the United States rendered under date of December 9 was considered. According to it the Federal Reserve Board had authority under the Reserve Act,from-time to time, to determine rates of discount and to require them to be put into effect. At the meeting of February 11 the board of directors voted to request a written opinion on this subject to Messrs. White & Case, which was subsequently submitted and ordered to be placed on file. On February 18 the board of directors again took action on the rate for advances on Treasury certificates, and for rediscounts of notes secured by them. The Board adopted the following resolution and minute: "VOTED that the bank establish a discount rate of 5% for advances not exceeding fifteen days secured by United States Treasury certificates of indebtedness and for rediscounts of customerb' notes so secured not exceeding ninety days. The directors felt that it would be desirable to put this rate into effect immediately but in deference to Governor Hardingts views as expressed over the telephone to Mr. Case it was decided to refer the matter to the executive committee with power to make the new rate effective as soon as possible." In his letter of that date, reporting the action of the directors to Governor Harding, Mr. Case, then acting governor of the bank, said that there had been considerable discussion as to whether the advance of rates already operative had proved effective. Twoor three of the directors, he said, had reported that the rates were effective and that evidences were2 multiplying every day of different channels through which the increase in rates was having its influence. Mr. Case then referred to a telephone conversation of the preceding day with Governor Harding and said that he had conveyed Governor Hardingts thought to the directors, that it might be wise to defer for a short time putting into operation the 5 per cent. rate on certificates. Mr. Case went on: "Attention wes also onlTed to the report of our special committee which visited Washington a short time since and its report that the Board would approve of the adoption of a 5% rate after a reasonable time allowance had been made to enable the member banks which had purchased the December 15 4 3/4% certificates to -65- distribute them to their customers. "I further reported an investigation at this time which indicated that fully 70% of the $300,000,000 odd of certificates sold in this district had been distributed to taxpayers and in- vestors and probably less than 30% now remain in the hands of our banks. "The pressure for credit which continues unabated, as shown by the accompanying memorandum, leads our directors to fee/ that the time has now arrived for increasing our discount rates on certificates to 5% and they accordingly voted unanimously to recommend a rate of 5% on certificates, to take effeot as soon as approved by the Board. In teking this action, ho Beard, desiring to cooperate fully rlhh you and the Treasury Department, decided that instead of recommending that the change be put into effect at once, that it be left to the executive committee with power,, so that your views and those of the Treasury Department as to the date on which it should become effective could be secured." Prior to the next meeting of the board of directors, that of February 25, Mr. ease discussed with Governor Harding the subject matter of his letter and learned that the Federal Reserve Board had approved the discount rate of 5 per cent. on certificates of indebtedness, established at the February 18 meeting of the directors. He outlined his conversation at the February 25 meeting and reported Governor Harding's views as to a -66- further increase in the discount rate for bankers acceptances. After a full discussion the directors voted to make the 5 per cent. rate for certificates effective as of the close of business of that day, and that there be no other change in the existing rate of discount. But the directors re- quested the officers to discuss with the Federal Reserve Board the desirability of establishing a 5 1/4 per cent, rate for both acceptances and certificates of indebtedness, and to convey to the Federal Reserve Board the opinion of the directors that the establishment of such rates was desirable. This was in line with the policy of this bank to maintain rates of discount as nearly uniform as possible for all classes of paper. That policy had been made effective with the establishment of uniform rates on December 30 and had been followed in the schedule adopted on January 14, but. disapproved by the Federal Reserve Board. At the meeting of the executive committee on the afternoon of Februrary 25, Mr. Case reported the substance of a conversation which he had just had with Governor Harding over the telephone, in which he had discussed the points raised at the session of the board of directors that morning. He reported it was Governor Hardingts opinion that it was most desirable" to announce that afternoon the establishment of the 5 per cent. rate for certifi- cates of indebtedness and that there was not time for the Federal Reserve Board to consider a 5 1/4 per cent. rate, so that if approved it could be made effective on that day. Mr. Case added that Governor Harding would attend a special meeting of the board of directors on Friday, February 27, and would ask Mr. Houston, Secretary of the Treasury, to be present also. -67- The 5 per cent. rate for certificates of indebtedness was announced later in the afternoon. On February 27, at the special meeting of the directors which Governor Harding attended, the proper relation of the discount rate of the Reserve Bank to the rate borne by Treasury certificates was considered at length. Governor Harding read from the forthcoming report of the Federal Reserve Board the chapter dealing with discount policy and credit control. In the course of the discussion on government financing, it was the consen- sus of opinion of the directors that the rate borne by the next issue of certificates of indebtedness should more nearly approximate the market rate for money than theretofore. Mr. Houston was not present at the meeting, but two of the directors were requested to convey informally to him the views of this bsnkfs board. In the interval between the special meeting and the next regular meeting, that of March 3, Mr. Case learned from Governor Harding that the Board was disposed to consider favorably the establishment by this bank of a 5 1/4 per cent, discount rate for certificates of indebtedness, and so reported it to the meeting. . Thereupon the directors voted to advance the rate on both acceptances and certificates of indebtedness, advances and rediscounts, to 5 1/4 per cent. Mr. Case then wrote to Governor Harding the action of the directors, saying: "Our directors feel it is most desirable that this suggested new rate, if approved by the Federal Reserve Board, be made effective prior to the announcement by the Treasury Department of a new certificate issue." -68- This action was considered by the Federal Reserve Board the next day, as appears in the minutes of the executive committee held OD at which Mr. Case reported his conversation with Governor Harding. March 5, Several members of the Federal Reserve Board, however, had favored an increase in the discount rate on commercial paper raised. if i the discount rate on certificates was The executive committee then requested Mr. Case to tell Governor Harding its opinion that in view of the recent substantial advance in the rediscount rate on commercial paper from 4 3/4 per cent. to 6 per cent., of the effectiveness ofMaichto restrain and control credit, there already appeared to he numerous indications,,uit was inadvisable to advance the rate further at that time." Moreover, Mr. Case was asked to tell Governor Harding "that the directors were still of the opinion that the rate of discount of 5 1/4 per cent. for certificates of indebtedness wes the proper one." Mr. Case prepared a memorandum recording the substance of these conversations on March 5, as follows: "I talked this morning with Governor Harding, Mr. Strauss and Mr. Leffingwell, by telephone, with regard to our discount policy. "In expressing the views of our board, I told them that, while our directors fully agree in principle that all our discount rates should eventually be above the open market rates, they nevertheless feel that in view of the recent substantial advance of from 4 3/4% to 6%, on commercial paper, it is inadvisable to advance this rate further at this time; that our judgment is, this action would tend to chill confidence and would create a panicky condition; that we feel we can see numerous indications already of the effectiveness of the higher rates as a regulator and in enabling our bankers to ' discriminate between essential and non-essential borrowings. I stated to them that, moreover, our board feels the proposed amendment to the Federal Reserve Act, providing for a super-rate, will give our bankers additional leverage which can be used to advantage. "I explained to them that, notwithstanding the advance of 1 1/4% in our commercial paper rate during this period, the rate on Treasury certificates of indebtedness has been advanced but 1/3%, that is, from 4 3/4% to 5%, and that something less than 25% of our earning assets consists of loans on certificates. In this connec- tion I told them that at the present time there is something like $50,000,000 of certificates overhanging the market and pressing for sale, without a buyer, merely because of artificial conditions and the unwillingness of the Treasury to have them traded in at anything other than the coupon rate. I stated that our directors feel this rate and the rate on bankers acceptances is out of line with other money rates and that it would be highly desirable to advance the rate on Treasury certificates from 5% to 5 1/4%. "In conclusion, I pointed out to Mr. Leffingwell and the members of the Board that this action represents the unanimous view of our board and has not been taken for the purpose of forcing the Treasury's hand with respect to its newissue of certificates but because the present unsatisfactory condition of the certificates of indebtedness market would seem to warrant an advance in the rate of interest on the new certificates, to 5%." -70- At the meeting of the board of directors on March 10 Mr. Case reported his conversations with the Federal Reserve Board, but no action was taken with respect to rates. en March 12 Mr. Case reported to the executive committee that the Federal Reserve Board had disapproved the 5 1/4 per cent. discount rate on acceptances and certificates of indebtedness. The Treasury Department saw fit to announce on March 10 an issue of certificates of indebtedness maturing in one year from March 15, at a rate of 4 3/4 per cent. This was the first offering after the advance by this bank of discount rates from 4 3/4 per cent. to 5 per cent. The issue was not favorably received by the banks because it was felt that the rate was not sufficiently high to permit secondary distribution, and inasmuch as the rate was below the discount rate at the Reserve Bank, subscriptions for their own account might entail loss in case subscriptions had to be realized upon later. On March 12 Governor Harding wrote to Mr. Jay saying that he had been requested by the Federal Reserve Board to ask if the directors of this bank, in view of the fact that certificates of indebtedness were being offered by the Treasury at 4 3/4%, had any new recommendations to make as to the discount rate on member banks' collateral notes secured by such certificates. "I would also like to inquire, independently of the certificate rate, whether you have any suggestions to make as to the rediscount rate for member banks on bankers acceptances. After discussion at the executive committee meeting on March 15 and at the meeting of the board of directors on March 17, Mr. Jay wrote to Governor Harding as follows: "At our directors' meeting this morning I read your letter of March 12 and after discussing the matter of discount rates we voted -71- unanimously to recommend no change at the present from the existing scale of rates now in force at this bank. It was also suggested to Governor Harding that the subject be discussed informally with the directors the next time Governor Harding came to New York. On March 31 a telegram was received from the Federal Reserve Board saying that it had approved a rate of 5 1/2 per cent. on the rediscount of bankers acceptances for the Federal Reserve Bank of Chicago, and was prepared to approve a similar rate for the New York Reserve Bank. This telegram was read at a meeting of the executive committee on April 1, but no action was taken. On April 7 a meeting of the governors was held at Washington and at it Mr. Case recommended that there should be no change in the then prevailing rate on commercial paper. His motion was carried,' and it was also resolved that there should be no change at that time in the rate on paper secured by Liberty bonds and Victory notes. This action was referred to in a telegram from Governor Harding to Mr. Case under date of April 16 as follows: "Three Reserve Banks have recommended to Board changes in discount rates. One, while suggesting rate of 5 3/4% on member banks/ promissory notes or rediscounts secured by Liberties and Victories all maturities, indicates a real preference for 6%. Another suggests 5 3/4% rate on Liberties and Victories, and 5 1/4% rate on certifi- cates, while the third suggests 5 1/4% and 5 1/2% respectively on three months/and six months/ certificates. Has there been any change in your own views regarding rates since your return from Washington? -72- Do you feel that practice should be continued of having substantial uniformity in all districts in rates on all classes of paper secured by Government obligations? If so, do you regard any change in exist- ing rates on paper secured by Government obligations advisable, and if your local conditions are such that uniformity in rates witb other districts is inexpedient, what rates would you suggest as being necessary to control your rediscount situation? Whether or not rates on Government secured paper are advanced, what do you recommend as regard rates on commercial paper? Does advance of Bank of England rate to 7 per cent, in your opinion call for any action by Federal Reserve Banks?" The telegram was discussed at a meeting of the executive committee on that day, and Mr. Case's reply to it under the same date was as follows: "Answering your telegram of this noon, there has been no material as change in my views/to rates of discount since my return from Washington, and these were confirmed by our directors at their meeting Wednesday. As a practical proposition, I think it desirable to have substantial uniformity in all twelve districts on Government-secured paper, and do not regard any change in existing rates advisable at this particular time. This viewpoint is, of course, entirely flexible and subject to changing conditions from day to day. Advance in rates on Government securities in one district and not in others would doubtless be very unpopular politically, but could be tried out, preferably in a district where normal interest rates are somewhat higher than prevail here in the east. I recommend that no change be made in commercial paper rate. do not think advance in Bank of England rate calls for any action by -73- Federal Reserve Banks at this time, but I believe that we should keep a careful lookout for its effect on our market. Our reserve position is holding steady, with a slight tendency to improve." Meanwhile the Treasury Department had modified to some degree its rate policy on certificates of indebtedness. April The three months' issue dated 1, was offered at 4 3/4 per cent., but on April 12 an offering,due also in three months, carried 5 per cent., and an issue maturing in six months was at At the same time Mr. Houston said in a telegram to the 5 1/4 per cent. Reserve Bank, that it was no longer proper to ask the holders of Treasury certificates, bearing interest at a lower rate, not to make transactions in He expressed the hope that it would be possible to avoid them below par. dealings below the interest bases.established by the current issues. Treasury program The was commented on in a telegram to Mr. Case from Governor Strong, sent from San Francisco on the eve of his departure for the Far East. In this telegram, which included comments on other matters, Mr. Strong said: "Treasury programme strikes me as about right and I am delighted to see evidence of appreciation of requirements of present situation, but anticipate that our policy is forcing British rates higher and that we in turn may need to go higher this fall. It is time to open the market to free trading in certificates which will provide an accurate guide of what the market will do in absorbing new issues and be a great aid in future financing. With rates and reserves at present level, believe we are justified in exercising more rigid control of accomodation to large borrowing banks but have always doubted -74- wisdom of progressive rates as now proposed unless they were onlyiBqmissive and not mandatory. The principle of a progressive rate applica- ble to the present situation, but might prove unfair under more normal conditions." On April 17 a telegram was received from Governor Harding indicating that the Board was prepared to approve a change in discount rates on certificates of indebtedness to 5 1/4 per cent., but limiting the advance only to paper secured by certificates bearing that rate of interest. remain the rate for all other certificates. Five per cent, was to At a meeting of the board of di- rectors on April 21, it was voted, however, that no change be made in the existing rates of discount, and the following supplemental resolution was adopted: "VOTED That it is the sense of this board that interest rates borne by current issues of Treasury certificates of indebtedness are not in due relation to the current rates for money and that the officers be requested to assemble data to enable the board at its next meeting to consider rates and the general credit situation." In his telegram of April 17 Governor Harding referred as a matter of inform- atioñ to the action taken by the board in approving a progressive rate schedule for the Kansas City Reserve Bank. The Kansas City schedule was subjected,to analysis by Mr. Rounds, who reported on April 26 to Mr. Case that in his opinion the schedule was faulty in several particulars. Mr. Case on May 4 addressed a letter to Governor Harding, in which he expressed the opinion that the application of progressive discount rates should not be considered as a substitute for a general increase, but more in the nature of an auxiliary or supplemental measure. He thought the schedule as adopted at Kansas City was scarcely applicable in the -75- Governor Harding on May 8 wrote Mr. Case saying that New York district. he agreed that it would not be practicable to adopt a similar plan in the New York district. On April 28 Mr. Jay presented to the board of directors a set of figures prepared by the officers, analyzing current credit conditions. The directors voted to make no change in the existing rates of discount, but at the same time adopted the following resolution: "VOTED that, as it appears that there has been no contraction during the past four months in the general credit and price situation throughout the country but rather a tendency toward further expansion, the chairman be requested to convey to Governor Harding the concern of the directors of this bank in regard to the situation and ask for a conference with the Board at the earliest convenient opportunity at which the situation may be discussed and remedies considered." On that day Governor Harding telegraphed that while the Board did not feel disposed to make sweeping changes in rates at the moment, it was prepared to approve .-th e f-a 1,1 Commercial paper rate c O r member banks' col- lateral notes secured by Liberty bonds and Victory notes, not Cacttany owned in good faith by the borrowing bank, and on May 1 reported changes approved for Chicago, Minneapolis and San Francisco. At its next meeting, that of May 4, the directors of the New York Reserve Bank adopted a schedule providing for a substantial advance in rates. At that meeting Governor Harding and Secretary Houston were present and the general credit situation throughout the country and the reserve position of the several Federal Reserve Banks were discussed. the following minute: Records of the board of directors contain O -76- "Governor Harding reported on the general credit situation throughout the country and the reserve position of the several Federal Reserve Banks. Secretary Houston stated that the Treasury was experiencing pressure from all quarters for additional credit and that in his opinion there was no single remedy for the present credit situation but that it required an increase in rates, an appeal to the common sense of industrial interests, and the cooperation of the bankers of the country. There followed a general inter- change of views and it was suggested that if an increase in rates were decided upon the announcement of the new rates should be ac- companied by a statement prepared by the Federal Reserve Board with comments by each Federal Reserve Bank to fit its own local conditions, pointing out the danger if the present situation is allowed to continue unchecked and appealing for cooperation in a campaign for retrenchment of expenditures." It appears that the plan of establishing graduated discount rates was discussed, but the board of directors decided to establish fixed rates as follows: For Commercial paper, advances and rediscounts 6 1/2% For Liberty bonds and Victory notes, advances and rediscounts 6% For bankers acceptances, advances and rediscounts - - - - 6% For Treasury certificates, advances and rediscounts - - - 5 1/2% The establishment of these rates was formally reported to Governor Harding by Mr. Joy on May 4, and in his letter Mr. Jay asked Governor Harding, inasmuch as he had been present at the meeting, to convey to the Federal Reserve Board the reasons which led the directors to adopt the schedule. -77- The Federal Reserve Board did not take action on the rates established at the New fork bank because, as appears in the following extract from the minutes of a meeting of the board of directors held on May 12, it was thought wise to defer action: "With respect to the rates of discount established at the last meeting, Mr. Case reported that Governor Harding found most of the other Federal Reserve Banks disinclined to advance rates generally and that he therefore suggested the desirability of postponing action by the Board upon our new rates until after the conference of May 18 with the Class A directors of the Federal Reserve Banks. A full dis- cussion of banking conditions and discount rates followed from which it appeared that since the last meeting there had been no improvement in the credit situation. The impression also prevailed that the busi- ness men of the country were waiting for action by the Federal Reserve banks and doubt was generally expressed as to whether the increase in the commercial paper rate from 6% to 6 1/2% was sufficient to impress them with the seriausness of the situation and whether they might not regard this rate as justifying them in going ahead with their plans for expansion. The delay of a fortnight in putting the new rates into effect seemed an added reason for adopting a higher commercial paper rate. Whereupon, on motion duly made and seconded, it was "RESOLVED that subject to review and determination of the Federal Reserve Board the schedule of rates established by this board on May 4 be amended by substituting a rate of 7% for the rate of 6 1/2% then established for advances not exceeding fifteen days secured by all classes of eligible commercial paper excepting bankers acceptances, and for -78- rediscount of such paper." Mr. Jay reported this action to Governor Harding by letter on the same day. Action was taken at the meeting of the directors on May 19, reaffirming the schedule of rates established at the two preceding meetings. The follow- ing appears in the minutes of the board of directors for that date: "Messrs. Alexander, Smith and Treman made a full report on the con- ference of the Class A directors of the Federal Reserve Banks with the Federal Reserve Board held in Washington yesterday. A summary of Governor Harding's address to the conference was reaiand the views expressed at the conference by representatives of the several districts regarding local conditions and rate policies were presented in detail. There followed a full discussion after which, on motion duly made and seconded, it was unanimously "VOTED that the board of directors of the Federal Reserve Bank of New York having carefully considered the report of its Class A directors and in the light of such report having reconsidered the action taken in regard to the rates of discount at its meetings of May 4 and May 12, re_ affirms its rate action then taken, **** and expresses to the Federal Reserve Board its desire that these rates be confirmed as soon as prac_ ticable; and refers to the executive committee with power the matter of dealing with the rates of discount between now and the next meeting of the board." The Federal Reserve Board did not take action, however, for some days. Secretary Houston attended the meeting of the board of directors on May 26 -79- and said that the Federal Reserve Board had deferred action on the schedule The board of directors then voted to reaffirm until its meeting on May 27. its rates already established. Mr. Jay on the same day wrote a long letter to Governor Harding, setting forth the point of view of the board of directors. Its full text was as follows: At the meeting of our directors this morning me had the good fortune to have Secretary Houston present and he will be able to convey to you orally something of the discussion we had on the subject of rates, resulting in the unanimous reaffirmation of the rates forwarded to the Board last week for review and determination. There appeared to be no new features of importance in the situation since last meek. The price reductions of the past fortnight are encouraging as is also the better price for Liberty bonds, but while these are encouraging features there is an immense volume of financ- ing from all over the country under negotiation with bankers and bond houses which is apt to be brought out at the least sign of a le.kip in the credit pressure, and there are already signs that the fact that the Federal Reserve Bank has not taken the expected g114 action coupled with lower call money rates and a better feeling in the security market, are creating a feeling in some quarters that money is going to work easier. "The directors have seen your letter of May 24 to Senator Omen in which you say The Federal Reserve Board does not take the view that discount rates should be arbitrarily fixed by itlit recognizes the fact that there are certain basic conditions which affect the demand -80- for and the supply of credit throughout this country and throughout the world, and that the formal establishment of a discount rate is merely an interpretation of these conditions.' and it was felt that this position of the Board was the strongest statement that could be made of the feeling of our directors. feel that the public is entitled to find in We Federal Reserve Bank rates a reflection of existing credit conditions and that our rate at the present time do not correctly reflect those conditions and are, therefore, misleading to manufacturers, merchants and others who are now planning their commitments for the future. With our commercial paper rate at 6 per cent., which is a fairly common rate in this country and low for many parts of it, people making plans and business arrangements would be justified in feeling that the Federal Reserve Board saw nothing abnormal in our credit situ& tion, whereas we know that this is not the case. of thousands of individual With our system competitive banks it is necessary not merely to get the cooperation of the banks but it is necessary for us to carry conviction to the borrowers themselves that they must exercise restraint, and nothing will cause this so effectively as the establishment of a rate that indicates that credit conditions are abnormal. "As to our discount rate being an interpretation of credit conditions, it is interesting to note that when we began to raise our rates on November 3, at that time our commercial paper rate -81- being 4 3/4 per cent., the rate for commercial paper in the open market was 5 1/4 per cent. On January 22, when we raised our rate from 4 3/4 per cent. to 6 per cent., commercial paper was selling in the open market at 6 per cent. At the present time commercial paper is selling in the open market at from 7 1/2 to 7 3/4 per cent., so that our proposed rate of 7 per cent, would be an under-statement rather than an over-statement of credit conditions. Even bankers acceptances are selling at 6 1/4 to 8 1/2 per cent. "The question was discussed at some length as to what effect 7 per cent. rates would have upon the loans a bank charged its customers. It was brought out very clearly that the rate the bank would have to pay the Federal Reserve Bank would only be upon that portion of its available funds in excess of those provided by stockholders and its depositors and that the fact that our rate was 7 per cent, would not necessarily mean that the bank would im- mediately raise all its loans from 6 per cent. to 7 per cent., but that it would furnish it a basis for discriminating against those loans of a less necessary and less liquid character which it would like to have reduced and would give it a moral backing in exerting this pressure which is lacking at the present time." The Reserve Board approved the schedule at its meeting on May 27 and the advance was announced at the close of business on May 29, effective at the beginning of the next business day, June 1, 1920. announcement the following brief statement was made: In making the -82- The foregoing action has been taken in order that bankers, their customers and the public generally may find in the discount rates of this bank a reflection of existing credit conditions." These rates remained in effect for nearly a year, except that on February 4, 1921, the preferential rate of 5 1/2 per cent. on Treasury certificates, advances and rediscounts, was discontinued, and a 6 per cent. rate identical with that for Liberty bonds and Victory notes was established in its stead. Lake George, N. Y., February 6, 1919. Dear Leffingwell: This letter is the result of much cogitation about the next bond issue; its terms; and the policy af the Department in financing from now on. If you observe some slight change of attitude on my part, it is brought about as the result of opportunity to do some reading and thinking on these matters which I was unable to do when at the office. When we became involved in the war, it developed very promptly that as prices had already been tremendously advanced as a result of gold imports and of the competitive buying of the Allies in this market, our own war costs and Government borrowings would be correspondingly large. I felt then, and still feel that the only ways by which the required credits could be produced for the Government's needs would be either as the result of: Economy or, failing that, of Inflation (to- the extent that economy was not practiced voluntarily or involuntarily) The methods available to the Treasury for raising the money were limited to: Competitive rate bidding, or Patriotic Appeal. We all know that individual economy was not practiced to such extent as to enable the Government to raise the entire war fund without recourse in part to inflation, and the reserve banks furnished it. The controversy in the Mr. Leffingwel/ 2 2.6.19. Treasury Building during this entire period was between one school believing that economy could and should be enforced and inflation avoided through establishing higher rate levels; the other school, which included the writer, believed that economy must be enforced through some system of rationing, or by consumption taxes, or by other methods more scientific, direct and equitable than high interest rates. During all of this period, as frequently expressed to you, I have, personally, felt that the problem of inflation should be dealt with through enforced economy but that, nevertheless, the interest rates established for the Liberty Loans were somewhat lower than was wise, and that slightly higher rates and more attractive terms would have produced better results. in that view I was wrong. Possibly While higher rates of interest might have restrained some expansion, the amount saved might not have been worth while, nor do we know how much the advanced price level is due to inflation. On the other hand, accepting the Secretary's decision in these matters involved the adoption of a corresponding rate policy by the reserve bank, which was always done without hesitation. My only comment upon the past is that both the Treasury Department and the reserve banks were the victims of the failure of our Government to get a better control of expenditures by the people generally. Some part of the in- flation might have been avoided by paying higher rates on the Liberty Loans, but how much is anybody's guess. We are all familiar with the results of the policy of the Department. The money has been successfully raised, and, as nearly as I can estimate, at a cost of possibly six billions of bank inflation, not all of it, however, directly attributable to Government borrowing. Before expressing some views about the program from now on, I must refer to the report of the Committee on War Finance 3 Mr. Leffingwell 2.6.19. of the American Economic Association and ask you to read it, if you possibly can find time to do so. At any rate you should read articles four and five, starting at page seventy-five. They will bore you some, make you mad some, but, also, they will help you some. Professor Bogart (IV) annoys me, as he will you, and I am proposing to write Kemmerer a blast about the report. Their trouble is the usual and ancient one, of approaching the problem on the theoretical basis of 100% perfection, but leaving out of account entirely the human factor, i.e., what is possible to do, rather than what ought to be done. , They are expressing in these two articles what they think should be done irrespective of the average of the views of all, and it is to that average view which a program must conform if it is to succeed. A college professor finds it impossible to construct his views along these lines. But Kemmerer may be, and likely is, correct about the price level, although again he leaves out of his argument the most important factors of all, which are "relative inflation," and bearing on that "relative price level, and again bearing on that "the relative bulk of gold reserves" as between the various nations of the world. You and Secretary McAdoo, and now Secretary Glass, and possibly the humble writer of this letter, will find in future years that the Treasury and the aeserve System must stand up and justify the policy of the two war years, which involved a rather complacent acceptance of some inflation as a necessary evil, being, in fact, a part of the price paid by the Government for successful war finance. If the Government, in consequence, paid too high prices for its supplies, I think the Treasury Department could maintain that it was not as a result of wilful inflation, but was caused by the failure of the Government to take control of expenditures by the people of the country,thereby 4 Mr. Leffingwell making inflation inevitable or loan failures probable. 2.6.19. We have paid the high prices, we have had some billions of inflation, but from now on the Treasury is charged with an even greater responsibility than heretofore because the day of deflation approaches. The process of deflation is a painful one, involving loss, unemployment, bankruptcy and social and political disorders, whereas the process of inflation brings in its train prosperity, employment, rising prices, a happy absence of bankruptcies and general state of contentment, all of which leads me to the point of this letter, namely, that mistakes by the present Treasury Administration from now on will bring retribution of a very certain and definite character which was not likely during the days of war excitement and expansion, but 0 which is now beginning to loom up most definitely during the distasteful days of paying the damages. The object of this letter is to emphasize a few points about the future which rone of us can afford to overlook. 1. PRICE LEVEL: The level of prices of both wages and commodi- ties in this country has always been much above that of any country in Europe. My belief is that the readjustment of prices throughout the world has not generally eliminated the differential against us, and that with certain special exceptions it will still be found that the level of wage and commodity prices in England as well as on the continent of Europe is much lower than ours. formerly. The relative difference may not be as great as Our danger is not simply that we have continued a level of prices out of line with those of Europe, but rather that we have established a higher level of prices than formerly under conditions of such artificial prosperity that merchants and manufacturers who have permitted their inventories to pile up on them at these prices must now struggle through a costly Mr. Leffingwell 5 2.6.19. period of liquidation, and, in consequence, are bound to sustain heavy losses on large stocks of unsaleable goods. Abroad, where stocks of goods have been greatly reduced, the process of reducing the price level will likely not involve such serious losses as with us. who are already encountering above present prices. Even up in this district I meet men difficulties with stocks purchased considerably A friend of mine who has just been visiting me, who is in the cotton textile business, says that the shrinkage in their inventories is already tremendous. You know what is taking place in the wool industry. The same thing is happening in leather, steel and iron, in fact all along the line. The object of referring to this point is to call attention to the fact that if inflation is arrested at its present level the readjustment of prices and loss resulting will be no greater than that now fixed by the existing price level. If inflation continues, money grows cheap, - the liquidation will be arrested and our later troubles be the greater. 2. WE MUST DEFLATE: Notwithstanding the hardships and losses result- ing, I believe you will agree that it is inevitably necessary that our banking position must be gradually deflated. If this is not done, we may face the necessity of either continuing the gold export embargo, to the detriment of the rest of the world's financial position, or else lose a large amount of gold at a time when it would be inconvenient for us to do so, and necessarily force a more radical readjustment in interest levels than we have yet found necessary to employ. At the moment my thought is that the processes of deflation will follow naturally enough, and gradually, if the Treasury is able to adopt such a policy as will simply prevent further inflation, which will be referred to later. Mr. Leffingwell 6 BUSINESS CONDITIONS: 2.6.19. As briefly mentioned above, I am receiving reports that are disturbing about business conditions; are being cancelled, and sometimes rather ruthlessly. contracts I heard the other day, for instance, of some big contracts made by American mills for South American buyers, the goods being of special construction, and just as soon as prices fell off cables came up here, not only canceling the contracts, but cancel-. ing the bankers credits under which the contracts had been issued. These were special lines of goods which could not be sold in this country and involved purchases of raw material at high prices. I know this same thing will take place in the iron foundries. from experience that Manufacturers of pig iron, I have no doubt, will suffer cancellations of contracts right and left. Such trades as mens' shirts indicate the trend of the department store buyer. A salesman from a shirt factory in this district the other day made the rounds with practically no success except in selling cheap imitation silk shirts, for which there still seems to be some demand from laboring men who are getting unusual wages. The wool auctions in Boston are an indication of the hesitation now developing. These various signs of business recession indicate that the readjustment is now under way and that we may be approaching a period when active criticism will develop. There is a change of wind - indicating a change in weather. "BORRO1N AND BUY": One ground of criticism of our policy in the past has been the "Borrow and Buy" slogan. to insure successful financing. I believe it was necessary in order I believe it involved the least vicious form of inflation, but I believe that for future loans it should be abandoned and discountenanced by the Treasury, even though it mean in financing. a more moderate success 7 BANKS MUST NOT BE LOADED: Mr. Leffingwell 2.6.19. You may suggest, as a conclusion, of No. 4, that the only recourse of the Treasury, failing to place bonds with investors, will be to sell them to the banks of the country. very much. That I doubt If anything is to be sold to the banks, it should be short certifi- cates until the time comes when bonds can be sold or when the Treasury is willing to pay the rate to sell them. THE EFFECT OF DIRECT BORROWING FROM FEDERAL RESERVE BANKS: To illustrate exactly the relative inflation involved by various methods of borrowing would be almost impossible except in theory because the flow of bank loans and deposits throughout the country is so active as to obscure what really takes place. Theoretically, however, the following is true: When a (1 member bank either lends to a subscriber or itself buys some Government bonds it causes inflation only in case and to the extent that it borrows from the reserve bank, and creates no inflation unless it does borrow from the reserve bank. For every dollar borrowed from the reserve bank a possibility of in- flation arises in the ratio of the average of bank deposits to reserve deposits so created by borrowings. If all the banks of the country make loans of this character to or for the Government to the extent of, say, _a billion dollars (and theoretically the average reserves of all national and state banks is 10%) the borrowings from the reserve banks will be only $100,000,000 to support the billion of inflation. elaborate. This can be demonstrated by figures which I will not The process of expansion which takes place as a result of such borrowings from commercial banks is less dangerous than the process of inflation which would result from direct borrowings from the reserve banks. In the first instance the inflation is limited to the initial amount of bank loans, the reserve banks contributing only the amount of reserve required through 8 their discounts. Mr. Leffingwell 2.8.19. But, if the Government, needing a billion dollars, should borrow that sum directly from the reserve banks, it would be throwing a billion dollars of reserve money into the hands of member banks, and theoretically, this reserve money would support a bank expansion of ten billions, if the ratio is one to ten as assumed. We have, therefore, three possible choices: A sale to investors who do not borrow, A sale to investors who do borrow, or to the commercial banks, which would result in an inflation to be supported by loans at the reserve banks equal only to the reserve percentage of the inflation created, and (0) Borrowings directly from reserve banks, which would create new reserves to the extent of that borrowing and support inflation to many times that amount. I believe every possible effort should be made to confine the next loan to the (a) class. 7. INTEREST RATES: We have always considered that too sharp an advance in the rates on Liberty Bonds would cause a corresponding decline in security values and conseqtent embarrassment for savings banks, life insurance companies and other security holders. ment. I doubt if that has been a so No matter at what rate the Government issues its securities, the invest- ment level will shortly be established by supply and demand in the market 3D that the competitive rate between the Government's loans and other securities will adjust automatically. Even if the Government sold a low rate bond it would shortly sell at such a discount as to bring it into direct competition with other forms of investments. On that point I believe we have been mis- leading ourselves a bit in the past. Hereafter, however, a new factor will 2.6.19. Mr. Leffingwell 9 enter into our calculations of the utmost importance. Our markets must gradually be opened to foreign loans, both government and private. Foreign governments, and borrowers generally, are willing and will be forced to borrow in this market almost at any rates which will produce the credit Their refundings and purchases in our markets will make it necessary. It is a competition which our Treasury must meet unless our Government is willing to exclude foreign borrowings from this market, with consequent serious damage to our commerce and finance. It makes little difference also at what rates these foreigners borrow becaueethe same readjustment of market values will take place to bring about this same interest competition. I the doors are now being opened gradually to a normal interchange of goods and of credits, and, ultimately, to shipments of gold, a world readjustment of the interest level is bound to take place. We can not ignore or avoid it and our Government must prepare itself to enter into the competition and advance its rates, or have its loans fail, unless it is still willing hereafter to pursue a program of inflation which might be disastrous. One of the ablest bankers in France, for whose opinion I have the highest regard, told me two years ago that he expected after the war was over fixed to see the very best private credits in Europe paying 10% interest for/capital as distinguished from bank loans, even solvent governments and municipalities doing so. 8. SALE OF BONDS TO INVESTORS: For the next loan I believe the Treasury should adopt the policy of offering a rate of interest on a taxable bond running not more than five years, redeemablesay, after two years, which will be so attractive in terms that it will induce investors of all classes to Mr. Leffingwell 10 buy them with a minimum of bank borrowing in order to carry them. 2.6.19. If this is done, I believe the action of the Treasury will earn and receive the commendation of all thoughtful, intelligent men and that the clamor of politicians can be ignored. Also if this is done, it will require some readjustment of rates by the reserve banks. 9. THE BANK RATE: For reasons which need no repetition, our bank rate has been regularly and promptly adjusted to the Treasury's program. Should the Treasury now place a high rate loan, I should suppose that the reserve banks would be required to adopt the following rates: A special rate to enable banks to rediscount existing loans made to original subscribers to the Fourth Loan, probably 4 1/4% for all maturities. A special rate for new loans to enable banks to carry subscribers to the Fifth Loan, at least equal to the rate borne by the new bonds, but probably not any lower. A special rate for bills arising out of the importation and exportation of goods. Admittedly, this last rate, if fixed at around present levels, with other rates advanced, would drive a large volume of foreign bills into the reserve banks. On the other hand, it might create such a premium or special demand for bills, that banks would be found more anxious than heretofore to hold a portfolio. I would advocate this special rate for international reasons, if for no other, as suggested at our conference in Washington. Expansion to the extent result- ing from that policy, based upon the development of a special market for inter- national bills, would be the least harmful of any in which we could indulge, and would be a later protection to our international exchanges. 11 2.6.19. Mr. Leffingwell 4 TAX EXEMPTION: exempt bond would be a mistake. I have come to believe that a low rate tax The difficulties resulting are illustrated by the position in which any member bank would find itself under the new tax bill. The average gross return on invested money and loan funds under present condi tions will run between 5% in the large cities and 6% or over in the country. If a 4% tax exempt bond is issued, though running but for five years, and redeemable after two, it would pay a return to a member bank, by reason of the tax exemption, that would be equivalent to something like 18% or 20% on other forms of loans from memory. I haven't the table of calculations here and speak roughly It would be the greatest possible inducement for banks to buy these short bonds and turn right around and borrow from the reserve bank so as to scalp the difference between our rate and the rate of net return on this tax exempt investment. It would force the reserve banks into the position of discrimi- nating in loans made for that purpose and loans made for more legitinate purposes. This is an almost impossible thing to do, because a bank can buy the bonds and secure the funds to do so by discounting its eligible paper. I believe I told you that Alexander stated to me that if the Bank of Commerce wanted to take $100,000,000 of notes of that character they could realize a good many million dollars a year profit by borrowing the whole amount from the reserve bank in one form or another. To imi.ose the obligation upon the reserve banks of safeguarding against this form of inflation strikes me as an unjust and unsound thing to do. In fact, an obligation which they could hardly expect to successfully perform. INTERNATIONAL RELATIONS: No policy by our Treasury from now on can ignore the international aspect of our financial position. I am very clear, after reading various British reports, that the London market will in the not 12 Mr. Leffingwel/ 2.6.1P. distant future experience an advance in the level of bank rates generally beyond anything heretofore experienced in the London market except in war or other crises. It would not surprise me to see bills selling at between 5% and 6% in London,and a good part of that business gradually transferred to this country. Lord Cunliffe writes me privately: "I am indeed nervous as to the out- come of all this enormous credit inflation and huge floating debt." Cokayne, Governor of the Bank of England writes: "I am sorry to say that the currency inflation is proceeding I-pace here and I fear it will continue during demobilization --- that a comfort it will be when the Government borrowing can cease. Until thattOd the artificial money rates come to an end, we shall not be able to tell how we really stand." 0 You have doubtless read the report of the Cunliffe committee. These all point to the adoption of plans in London at some time for squeezing out inflation, doing away with artificial conditions, and, of course, accepting the consequences of higher interest rates. 12. IN CONCLUSION: The great temptation of the secretaries of the Treasury in time of war is to borrow cheap money. It is axiomatic that in such emergency the Treasury attempts, and usually succeeds, in obtaining control of the bank of issue and that the bank of issue becomes the instrument for furnishing the Government with cheap loans or irredeemable notes at the expense of sound monetary conditions and of the price level. That is exactly what happened in England during the Napoleonic wars, and it has happened in France (with the possible exception of the Franco-Prussian War) since the days of Napoleon. The Bank of France to-day shows the effect of such a policy as strikingly as any 13 gr. Leffingwell 2.6.19. institution in Europe with whose figures we are authoritatively acquainted. The Reichsbank and the Imperial Bank of Russia both succumbed to this influence, and, in the latter case with a complete collapse of credit. Our policy in this country has so far been the soundest of any, we have avoided a debasement of our circulating media, have taxed liberally, and have had but moderate inflation, and I believe that from now on a courageous policy by the Treasury for one more loan will do more to establish the country's finance, and generally to establish its business upon a sound footing than any other single factor. Secretary Glass in one or two public statements has expressed the view that the Treasury can still ly upon patriotic impulse for financial re/ support. 0 That is undoubtedly true to some extent, but if patriotic impulse is made the means of placing unattractive bonds which must be forced upon reluctant investors who are induced by artificial rates to borrow money in order to buy them and then shortly turn about and sell them to avoid shrinkage, we experience all of the evils of inflation, the disasters of losses by patriotic investors, an unnatural and severe decline in the Government's bonds and credit, and an investment interest rate ultimately as high as would have been established in the first place had the Government borrowed at an attractive rate to the investor. If this letter seems to involve some change of front on my part, (which it really does not, fundamentally) please bear in mind what a change has taken place in conditions. In the face of my persistent, continued recommenda- tion to our friends in Washington that steps be taken to conserve goods and services, I found myself advocating inflation as a means of making up the deficiencies of some failure to adequately control expenditures and to promote 14 economies. Mr. Leffingwell 2.6.19. Now that the war is over, even such means as were adopted to control private expenditure have been abandoned and there seems to be just one recourse left, which is to interpose obstacles in the way of borrowing and to do it by a slightly higher rate level. In other words, while the war was on, the proposi- tion stated on page one of this letter resulted in adopting policy (d). Now that the war is over and no control is being exercised, we are forced to the adoption of policy (c). That's the whole story in a nut shell. This rather rambling letter contains something of what I would say had we opportunity for a meeting. coming up here. I wishNerymuch you could make the opportunity by It is simply an expression of my personal views without confer- ence with my associates. With best regards, Sincerely yours, Honorable R. C. Leffingwell, Assistant Secretary of the Treasury, Washington, D. C. ES:MSB GA1(:)(_)i- COPY TREASURY DEPARTMENT Assistant Secretary WASHINGTON February 12, 1919. Dear Strong I received your letter of February 6th which I have read very carefully with A great deal of interest. get under your skin. Do not let the carping of the economists I have looked at the report of the Committee on War Finance of the American Economic Association of which report my old friend Bogart was good enough to send me an advance copy. 0 I have since college days been more interestdd in economics than any other subject and from the beginning of the war have had an exceptional opportunity to become acquainted with the professors of the dismal science, most of whom have been more or less frequent visitors and correspondents of the Treasury. The reason why the science of economics has not had a larger place in our life is that its professors have found it easier ness and pleasanter to evolve theories out of their inner conscious- and criticize each other's theories than to go through the gruelling work of collecting and analyzing the facts and reasoning from them. Even Hartley Withers, who is by all odds the most illuminating modern writer on the subject, maintains a running fire of bitter criticism of the British Treasury for not selling more bonds and collecting more taxes just as though the amount of bonds sold was a matter wholly within the will of the Treasury and as though you could make up the whole difference by the imposition of taxes without any effect upon necessary war production. As for our American economists, they have proposed Mr. Strong 2 2.12.19. more erratic and unsound plans than all the rest of the country put together. Sprague of Harvard, with his plan for selling bonds by compulsion, Irving Fisher of Yale, with his plan for abandoning the gold standard, Kemmerer of Princeton, who naively assumes that had the Government borrowed to meet its financial requirements at higher rates of interest it would have been enabled to buy its munitions and supplies at lower prices under war conditions, Hollander of Johns Hopkins, and the others who wanted us to finance our requirements without selling Treasury certificates and never succeeded in telling us how to do it, Bogart, whose knowledge of the practical problem is limited to insufficiently understood short talks with me, Willis and Miller, whom we both know, - I have the measure of these fellows. 0 When a merciful Providence relieves me of my present job I hope to find time to give a real account of our war finance and incidentally have some fun with the critics. There is, of course, no doubt that the only two countries in which the war was financed on approximately sound lines are Great Britain and America. The British sold as many bonds and collected as much of taxes as they could and borrowed the balance direct from the Bank of England. The American Treasury has been even braver in its tax policy although hampered by Congress, and has habitually oversold bonds and abstained from borrowing from the reserve banks direct with the effect of avoiding all direct inflation, but, on the other hand, depreciating the market for the bonds. The British, of course, neutralized the evils of of their method and indeed approximated the result which we obtained by the issue of Treasury certificates through the practice of the Bank of England of paying interest on clearing banks' balances. The consolidated banking system of England 3 2.12.19. Mr. Strong made this a simple and on the whole satisfactory solution of the practical problem. It is difficult to see how in America we could have done otherwise than we did in view of the fact that at the beginning of the war the Federal Reserve system was still in its infancy and that the banking resources of the country were divided among some 30,000 institutions, an important part of which were not members of the system. The method adopted here, however costly to the Government in interest and to the people in the depreciation of the Government's bonds. The evils of the British method were limited by many factors favoring economy and thrift and the sale of Government bonds which were absent in this country, such as the long period during which the country was engaged in the war, its proximity to the war, Zeppelin attacks, the actual 0 shortage of supplies of many kinds, the fear of further shortage as a result of submarine war, etc., etc. To what extent the high prices which developed in this country were necessary and desirable in order to stimulate production for war purposes and were the direct result of an unlimited Government demand and a very limited supply no one will ever know. That the war was attended by expansion and high prices is certainly true, but that expansion caused the high prices I deny. Furthermore, it is obvious that the Government of the United States could not have been transformed from a Government spending one billion dollars a year to a Government spending two billion dollars a month without a great expansion. If one takes the broad view of the whole matter world wide one will conclude that expansion and a decreased buying power of gold was inevitable. The world was to a considerable extent inevitably engaged in the business of living on its capital during that period, for production of wealth did not and could not keep pace with consumption and destruction. The consequence was an increase 4 Mr. Strong 2.12.19. in the value of things and a decrease in the value of the media of exchange which was world wide and caused as great concern in the rich and prosperous neutral countries, suffering as they were from a plethora of gold, as in the warring countries which have not enough of it. The next Loan is still a perplexing problem. I hope Congress will give us authority to deal with the problem as conditions seem to indicate when April comes. I am, as you know, much opposed in principle to an exempt bond. You are, however, wrong in thinking that a low rate exempt bond would appeal to the banks. The exemption is substantially worthless to the banks owing to a peculiarity of our tax laws. That fact has been the best justification for our policy of issuing Treasury certificates at a higher rate than bonds. The advocates of a high rate short time fully taxable security are to be found very largely among those who believe that the banks will have to take the next Loan and my principal objection to that form of security is that it will appeal to the banks and not to wealthy investors. The necessity of getting legislation at this session of Congress makes it utterly impossible for me to get away and, indeed, the defection of some of our best war workers and the apparent impossibility of finding substi- tutes for them makes such an additional load for me that I see no immediate prospect of my getting away at all. Faithfully yours, (signed) R. C. Lefeingwell Benjamin Strong, Jr., Esq., Cluneden, Lake George, N. Y. P. S. Since dictating the above I received your letter of February 10th. I supposed that the Treasury was the only place in the United States where anyone cared about the market position of the old bonds. We shall not forget them but it is indeed a puzzling matter to find a method for improving their position.