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The Federal Reserve

Blackstone Legal Training Lecture

Blackstone Institute, Chicago




A.B., Ph.D.

Federal Reserve Board; Director of Research,
Federal Reserve Board j Professor of Banking, Columbia University.



One of a Series of Lectures Especially Prepared
for the Blackstone Institute

Copyright, 1920, by Blackstone Institute

After receiving his degrees of Bachelor of Arts
and Doctor of Philosophy, in 1897, at the
University of Chicago, Mr. Willis spent several
semesters at the Universities of Leipzig and
Upon his return to America he served as Professor of Economics and Political Science at
Washington and Lee University until 1905, when
he was appointed Professor of Finance at George
Washington University, and in 1912 he was selected to act as Dean of the College of Political
Science in the same institution. During the years
1913 and 1914 he lectured at Columbia University
on economic subjects. Mr. Willis had acted as
expert to the committee which presented the Federal Reserve Act, and was later chairman of the
Technical Organization Committee which planned
the organization of the new banks.. Upon the
creation of the Federal Reserve Board in 1914,
Mr. Willis was selected to act as Secretary. In
February, 1916, he was also appointed President
of the newly authorized Philippine National Bank,
organizing both the parent office of the bank and
its New York agency.
Mr. Willis has also acted as expert for the
Monetary Commission of 1897, the United States
Immigration Commission, and the Joint Committee on Rural Credits. During his long residence
in Washington he has served as Washington correspondent for numerous newspapers and commercial journals, including the New York Journal of
Commerce and the Springfield Republican. He
has visited Japan, China and the Philippines as a
special correspondent for several newspapers and
is now editor of the Journal of Commerce of New
Among Mr. Willis published works are
History of the Latin Monetary Union," ''Reci"
" Our
Philippine Problem,

in 1894,


' '


' '

' '

and Problems of Modern Banking," "American
Banking," "Principles of Accounting," "Life of
Stephen A. Douglas."



The Federal Reserve Act, passed by Congress on
December 23, 1913, is the outcome of a discussion of
banking conditions extending more or less sporadically over the years since the Civil War, but assuming an increasing degree of urgency from and after
the panic of 1893.
The National Banking System had been established during the Civil War, partly as the result of
the Government's financial necessities of that period.
It was, before the adoption of the

of independent



and unrelated banks with

a system

varying from $25,000 to $25,000,000, holding out,
practically irrespective of any definite principles, to
any group of five individuals the right to organize
and incorporate under its terms. Its characteristic
feature, apart from this competitive and independent
aspect, lay in its provision for the issuance of currency protected by the bonds of the National Gov-

ernment which were required to be purchased by
each bank, as organized, to an amount not exceeding
its capital stock, and not less than certain specified
sums. Such bonds were then to be deposited with
the Treasury Department to safeguard the note circulation of the depositing bank.
Defects in the system very early began to make



themselves manifest.
The currency proved to be
while the lack of relationship bewholly inelastic,
tween the banks reduced public confidence in the solvency of the various institutions in times of panic or
stress. Owing to such absence of confidence, individual banks were frequently assailed by withdrawals of
cash leading to the familiar "runs" upon them, and
these often aggravated financial crises. Although,
therefore, sufficiently effective in times of financial
ease and quiet, the National Banking System had
entirely failed to furnish protection to the country
at periods of stringency, over-expansion, or weak-

ened reserves, while


currency was inadequate and


for the reformation of the banking sysproposed during the years from 1893 to

Many bills
tem were

1913, but practically the only step taken by Congress
(apart from some purely incidental provisions in the

Gold Standard Act of 1900) was the Aldrich-Vreeland Act of 1908, wherein it was provided that special
emergency notes might be issued upon security of
bonds other than national, under certain conditions,
as well as upon commercial paper deposited with
so-called "national currency associations" composed
of the associated national banks of a given city or

The intent of the Aldrich-Vreeland Act was
an expansive element in the note circulation, designed to meet emergency calls for new or
additional currency, but it was never called into prac-


to furnish

operation until just before the time at which the
measure was to expire, shortly after the opening of
the European war, which began in August, 1914.



The Federal Reserve Act was intended not only to
meet this demand for an elastic currency, but to eliminate the chief sources of weakness in the old system,
and at the same time to reorganize the whole banking

resources of the country. Its fundamental thought
was the organization of the existing banks of the
country into homogeneous groups, each of which

groups was to establish a cooperative or "central"
institution, whose duty it should be to issue notes,
hold reserves, and rediscount for the individual or
member banks of such group.
Creation of Banking Districts. The Act accordingly provided for a division of the country into not

over twelve separate districts, -in each of which the
member banks should subscribe 6 per cent of their
capital and surplus to the capital stock of an institution to be known as the Federal reserve bank
of the district. One-half of this 6 per cent, or 3 per
cent, was to be actually paid in, and no Federal reserve bank was to be opened unless it had a subscribed capital of not less than $4,000,000, implying,
therefore, a paid-up capital of at least $2,000,000.
Deposit of Reserves. The Act required that a specified

percentage of the reserves required of


banks should be deposited with the Federal reserve
banks and should be kept there. This deposit of reserves could be effected by actually placing cash with
the reserve bank, or by presenting to it for rediscount, paper of specified kinds. The supervision of
all the banks was vested in an organization to be

appointed by the President of the United States, and
known as the Federal Reserve Board, whose headquarters were afterward located at Washington, D. C.



Subsequently, as a war measure, it was required
that all reserves be placed with Federal Reserve
banks, while the required reserve percentage was
set at 13 per cent of demand deposits for banks in
central reserve cities, 10 per cent for banks in reserve cities, 7 per cent for banks elsewhere.
The Act further
Foreign Trade Acceptances.
granted permission to national banks to embark upon
a new kind of business not previously open to them,
that, namely, of accepting or guaranteeing the paper
of importers and exporters engaged in the foreign
trade of the United States. As a further assistance
to foreign trade, national banks of sufficient capitalization were authorized to obtain permission from

the Federal Reserve Board to open branches in foreign countries. Later, an amendment to the Act
passed in 1917 authorized national banks to take
stock in institutions to be created for the purpose
of engaging in foreign trade banking.
Refunding of Bonds. The bond-secured currency

and unsatisfactory; and it was
feared that, as new currency was issued by the
Federal reserve banks it might tend to displace the
national bank currency and so inflict losses upon
the member banks which had paid high prices for
the 2 per cent bonds in the belief that they would

had been


continue to be accepted as protection for national

bank notes, and would thus enjoy an artificial market
or demand. Therefore, the Act made provision for
the gradual refunding of these 2 per cent bonds into
3's, at rates of conversion to be determined by the
Secretary of the Treasury, while it also authorized
the Federal Reserve Board to require Federal reserve banks to purchase $25,000,000 each year of
such 2 per cent bonds.



A variety of other changes of relatively minor importance were made in the existing banking laws
of the United States, but in substance the National
Banking Act was left untouched, the Federal reserve

system being simply introduced as a means of coordinating and combining the already existing institutions.
This, in outline, was the form in which
the Act was passed on December 23, 1913, as already stated, although for the sake of completeness
reference has been incidentally made to some later
Domestic Trade Acceptances. Subsequently some

amendatory legislation was enacted, the first being
the law adopted September 7, 1916. In this act of
September 7, provision was made for the use of the
domestic acceptance through clauses permitting
banks to accept drafts not only in foreign trade, but
also in domestic business, provided that each draft

was protected by actual documents. The Federal
Reserve Board was also authorized to permit member banks to carry as much of their reserves as
they saw fit, over and above the required amount,
in the vaults of the Federal reserve banks. Some

minor additional changes also were made in the
Federal Reserve Act by the terms of the act of September 7, but these were not comparable in importance to the two just referred to. In 1917 the reserve
change already mentioned on page 8 was introduced,
while in 1919 provision was made for a new class
of foreign banks with Federal charters, intended to
help in the reorganization of business on a post-war



The Federal Reserve Act being a constructive
statute and not purely negative or prohibitory in
character, it was necessary to provide for the organization of the various new institutions that had
been authorized. Foreseeing this necessity, the fram"
ers of the Act had provided that a so-called Organization Committee" should divide the country into
districts, organizing a bank in each district. Shortly after January 1, 1914, the organization thus provided for began its task, assisted by a committee of
experts to whom was entrusted the technical and
scientific part of the work.
The Act had required

the creation of not less than eight nor more than
twelve districts, and the committee determined to
establish the full number.


of the Fed-

Reserve Board were appointed and took office on
August 10, 1914, immediately proceeding to complete
the work of the Organization Committee by designating Government directors for each of the several reserve banks. These were to be three in number in


every case, the total number of directors at each bank
being nine, six of whom were to be selected by the
stockholders of the reserve bank. The selection of
Government directors having been completed, the
sixteenth of November, 1914, was set as the date for
the opening of the new institutions, and payments of
capital stock and reserves were ordered to be on
hand on or before that date.

Partly as the result of law, and partly as determined by the regulations and by-laws of the banks.



each Federal reserve bank assumed the following

form of organization:
The Board of Directors. Each bank was controlled
by a board of directors consisting of nine members. Of these nine, three were chosen by the
member banks of the district, voting in three
groups made up according to capitalization, one
member being selected as representative of the
banks of each such group; three other members
were selected by the banks just as before, except that they were to be business men and not
bankers; and three members were chosen by the
Federal Reserve Board at Washington on behalf of
the Government. Of the last or Government-selected
group of three, one was designated as Federal reserve agent" and chairman of the board, while a
second was designated as deputy Federal reserve
agent and deputy chairman. The operation of the
bank was placed in the hands of an officer entitled
Governor, chosen by the board of directors, and
in most cases this officer was assisted by one or more
deputy Governors. A regular bank organization, including cashier, tellers, clerks, bookkeepers, etc., etc.,
was developed along ordinary banking lines. Each
board of directors appointed committees, an executive committee being in charge of business between
regular meetings of the board of directors.
The Federal Reserve Agent. The Federal reserve
agent was in charge of communications with the Federal Reserve Board, and was custodian of Federal reserve notes obtained from Washington upon application to the Federal reserve bank. To him was assigned, in addition to his statutory function as chairman of the board of directors, many duties in shaping
general policies and representing the bank in various




The Governor. The Governor of the bank was to
have principal charge of relations with member
banks, receiving from them their deposits of reserves
and passing upon applications for discounts, purchases of paper and the like. He was the head of the
banking organization.
General Control by the Federal Reserve Board.
Both the bank and the Federal reserve agent were to
report daily to the Federal Reserve Board, giving
any essential details that might be called for by conditions. The Federal Reserve Board fixed the salary
of the reserve and the deputy reserve agents, and its
approval was required in the case of all other salaries.
The banks were to be operated on a uniform
basis under regulations to be supplied by the Federal
Reserve Board from time to time, while rates of discount perhaps the most important function in connection with the banks' operation were weekly
recommended by the board of directors and subsequently submitted to the Federal Reserve Board for
its approval, becoming effective when such approval
had been granted, but not sooner.

Each Federal reserve bank equipped




with a

vault, fixtures and the like, but at the
was not thought well to purchase buildings.


Subsequently Federal reserve banks established
branches equipped like a Federal reserve bank, but
acting under direction of the parent institution. At
present the total number of branches is twenty-one,
located in nine districts, there being three districts
without branches.






The foregoing map presents a rough general
line of the districts as existing at the


middle of the

year 1920. Following is a condensed statement of
the condition of the system

and liability items of the 12 Federal Reserve
Banks combined on September 24, 1920.

Principal asset

[In millions of dollars.]
Sept. 24

Sept. 24

Total earning assets




discounted :


war obligations


All other
Bills bought in open market
Certificates of indebtedness.


Government deposits
Members' reserve deposits.. 1,801
Net deposits
Federal Eeserve notes in



Federal Eeserve






Beserve percentage



The new system had come into existence at a
very critical time in American financial history. At
the opening of the European war and while the
task of selecting and confirming the members of the
Board was still in progress, there had begun an important movement of gold out of the country for the
purpose of liquidating debts owed to persons in the
belligerent countries of Europe. This movement had
caused anxiety among the banks, and specie payments had been practically suspended in many parts
of the United States. Emergency notes, under the
terms of the Aldrich-Vreeland Act, as promptly
amended by Congress, had been issued to meet these
of the new banks found
difficulties, and the opening
the nation at large in an uncertain and depressed condition with little demand for loans, and with a superabundant note currency amounting to some $400,000,000, not issued by the Federal reserve banks themselves but put out under the Aldrich-Vreeland Act as



task of the
new reserve banks was to assist member banks in
retiring such emergency currency, and in this they



in circulation.


were of substantial service.
The country had hardly been restored to a normal
currency basis, however, when heavy demands of foreign nations for our products produced a reverse
movement in international trade, and gold began to
flow into the United States instead of away from the
country. In consequence the reserves of member
banks were continuously high, and they were not in
need of much extra accommodation, so that their demands upon Federal reserve banks for the services
of the latter were naturally small. This obviated the
need of any reliance for the time upon Federal Reserve banks and of course eliminated opportunities of
earning which would otherwise have been open to the
latter, but it gave the reserve banks and the Federal
Reserve Board full opportunity to perfect their regulations and methods of doing business before the
advent of any period of exceptional stress.



Such a period of stress, however, was not slow in
developing. It had been evident for some time after
the opening of the year 1917 that the United
States would be likely to be drawn into the European
war in some way and such in fact proved to be the
case, war being declared on April 6. The declaration of war was necessarily the signal for the acceptance of very great responsibility by the banking system. It was evident from the outset that even with
the heaviest taxation that could be borne by the community it would be necessary for the Treasury to
obtain a very large part of the resources needed to



pay the expense of the war through loans. As time
went on it became equally apparent that such loans
could not be provided for by any means already
familiar to the community, but that they must be
floated through the development of a new and very
This led to the
inclusive system of distribution.
creation of the so-called Liberty Loan organization
which ultimately extended its ramifications throughout the United States, but it was soon apparent that
even these organizations would not be able to place
the bonds unless they had direct assistance from the
banks, which in turn would be obliged to fall back
upon the Federal Reserve banks.

The handling


war loans

as fiscal agents for the

United States, the issuance of temporary and permanent bonds, the receipt of subscriptions, the shifting
of the Government's funds from place to place, and
most important of all, the rediscounting of paper
representing advances made by banks upon the
security of Government obligations, became the
principal functions of the Federal Reserve banks.
It was an unfortunate fact that the first great expansion of its operations which was experienced

by the Federal Reserve system came as the result,
not of ordinary or normal business requirements,
but in consequence of those growing out of war
demands. As the Government, however, gradually
extended the scope of its control over business
operations of every kind, and as business became
more and more engaged in filling Government
orders, the financing of the Government's war requirements became more and more largely a process
of financing the business of the country, through
of approach.

new and unaccustomed methods

The years 1917-1919 were accordingly a period
within which the nature of the nation's business was



being gradually transformed, while a new basis for
the financing of it was being supplied. In this process
the Federal Reserve banks underwent a very great
expansion both of their personnel and of their operations. The statement given on page 14 shows the condition of the system as it existed in September, 1920,
indicates the scope of the expansion of the banks*
operations, for the war, although ended in a military

sense at the time of the armistice on November 11,
1918, was not in a financial sense near its close. Not
only was one of the great war loans (the Victory
Loan of 1919) floated more than four months after
the conclusion of the armistice, but the Government's
regular expenses went on mounting during the first
six months of 1919, due to the fact that many commitments, such as soldiers' pay and the like, had to
be met. The gradual decline of the war demands
was not, as some had expected, followed by an equal
reduction in the scope of the operations of Reserve

Instead of the business depression which some
had predicted as the immediate successor to the
close of the war, a period of speculation and inflated business transactions ensued in the United
States, and this inflation period was unfortunately
financed in large measure through the use of funds
which should have been employed in reducing the

banking commitments. Such funds were to no small
degree obtained from Federal Reserve banks by continuing the practice of rediscounting paper collateraled by Government obligations. Accordingly, the
transactions of the system continued to increase in

reaching their present great magnitude, as
ready illustrated by the statement shown on page






To-day the holdings of Federal Reserve banks
are to the extent of about one-half composed of socalled war paper, that is to say, paper collateraled
by Government obligations, while they are to the
extent of about one-half composed of commercial
paper, including bankers' acceptances, commercial
bills, and other obligations.


The outstanding feature of reserve policy during
the war was seen in connection with the establishment of discount rates. Prior to our entry into the
struggle the discount rate question had not been of
very much importance. Although it was true that
Federal Reserve banks almost from the beginning
established a rate for the rediscount of paper which
was under the market rate, thereby allowing a small
margin of profit to a banker who might choose to
place paper with the reserve institution, this phase of
policy also had been of comparatively little importance. When the reserve act was passed it provided
for a lower basis of reserves than that which existed
at the time, warranting itself in so doing by the fact
that the greater economies of reserve permitted by
the system would allow the relaxation of the more or

requirements which had premaintained the holdings of cash at what
seemed an unnecessarily high point. The effect of
" was to
this release of reserves
place in the hands
of the banks a very large lending power which they
were able to employ in expanding their operations.
As a matter of fact they did largely increase their
dealings on the strength of this greater capacity for
lending, and with this broader power of operation it
was not necessary (as already pointed out) for them
to do much rediscounting at any price, so that the
less stringent legal



Reserve banks had practically no control over the
discount market or the rate of interest. There had
been some modification in this condition shortly before the entry of the United States into the war, due
" slack
to the fact that the
"provided through the
lowering of reserve requirements had been very
largely taken up." In the opinion of some, therefore,
the first three or four months of the year 1917 were
characterized by the development of a certain power
over the money market which the reserve system
had never before possessed. Be this as it may, the
period, whatever it was, within which the system
was able to exert such control was very short.
At the opening of the war the fundamental question
in the financial world was necessarily the rate at
which the new Government bonds were to be floated.
It was necessary that this rate, whatever it might be,
should practically dictate the discount rate to be
fixed by the Reserve banks, for in the event that the
banks declined to rediscount at a rate generally corresponding to the rate on the bonds, prospective buyers would be somewhat discouraged from buying and
paying for them on the instalment plan, since there
would be a distinct item of cost for " carrying" the

was therefore considered by the authorthe United States Treasury very essential to
have the rediscount rate at Reserve banks correspond to the rate borne by the new loans.
securities. It

ities of

In the first Liberty loan the rate of 3% per cent
paid on the bonds was accordingly paralleled by a 3%
per cent rate on notes based upon such bonds, and as
the subsequent issues of Government securities came
upon the market at gradually rising rates of interest,
a corresponding advance in the rate of discount at



Reserve banks was made. During the latter part
of the war, however, the advance in rates at Federal
Reserve banks was somewhat "slowed down" and
the rate was kept constantly a little below that borne
by the bonds. This afforded a certain element of
profit to those banks which were holders of bonds,

Government notes or Treasury

certificates of in-


The Federal Reserve Act has given

to the


the power, subject to broad general restrictions, to
define the character of paper eligible for presentation to Federal reserve banks as a basis for discount.
That body ultimately defined certain types of such
paper, including among them the bankers' acceptance or draft accepted by a banker, the trade acceptance or bill or draft accepted by an individual or a
concern, the single-name or "straight" note, the foreign bill, and so-called "commodity paper" or paper

by warehouse



staple products.
Each of these classes of paper
two basic requirements: (1) It

had to conform to
must grow out of
actual bona fide commercial transactions; (2) it must
not exceed specified maturities 90 days for commercial paper, 180 days for agricultural paper, and
similar periods for bankers' acceptances growing out
of foreign trade. The fact quickly developed that
the commercial paper of the country was in such a
condition as to call for considerable readjustment
in order to bring it strictly within the prescribed
form laid down by the Board. This necessitated
further readjustment of the Board's regulations, and



rectification of various practices in connection with
the creation of commercial paper itself. Rediscount
operations, however, continued to be upon a small
scale for two years or more.
Under the "open market " provisions of the law
it had been provided that Federal reserve banks
might buy from individuals, corporations, or banks
whether or not members of the system, any paper
that they might choose, provided that it complied
with the requirements for discountable paper. The
banks bought considerable quantities of Government
bonds, municipal warrants and bankers' acceptances,
and smaller amounts of trade acceptances. In this
way their earning assets were increased until at the
end of the year 1916 they had about $200,000,000 invested. At the close of 1916 a summary of the entire
operation of the system since its opening about two
years showed that a net earning above organization
expenses had been made of approximately 2.7 per
cent on the capital. During the period in question

gross earnings had been approximately $6,475,000,
and net earnings approximately $2,680,000.

bank which had paid the largest dividend was the
Federal Reserve Bank of Richmond, which had practically

its whole 6 per cent dividend, acand paying it to November 1, 1916.


tually declaring

period of modest earnings and limited
operation, during which the Federal Reserve system
was chiefly occupied with problems of organization
and in which its purchases of paper were comparatively small hardly more than experimental





would naturally have come to a close when the surplus lending power of the member banks which had
been set free through the lowering of reserve requirements in the Federal Reserve Act had been absorbed

and when, therefore, the natural expansion of business led the members to fall back upon Federal ReExactly how long
this process would have required it would be difficult
to say, but it would certainly have been a slow and
gradual expansion. The determination of the United
serve institutions for assistance.

States to enter the war brought the early period to
a close and forced the Federal Reserve system to
enter upon an epoch of very great and rapid growth
instead of awaiting the slower development which
would have been experienced under ordinary conditions.

had been apparent from the close of the year
that the United States was likely to be
drawn into the European war by some means, a fact
which actually came to pass in April, 1917. Even
before the actual declaration of war, the demands
of member banks had begun to increase quite distinctly, so that it was the opinion of authorities in


the Federal Reserve system that the control over
discount rates which it had been supposed would be
exerted by Federal Reserve banks had become real.
This could not be the case as long as the operations
of the members were very small so that the rediscount rate at Reserve banks was only sporadically
availed of. As the demands of the member banks
began to increase consequent upon the enlargement
operations, and perhaps in some measure due to a desire to strengthen themselves and
their customers with a view to possible war developments, the authority of the Federal Reserve rate
of their



to be

more and more generally recognized.



Another factor which tended to increase the inbanks was furnished by the

fluence of the Reserve

decision of the Treasury Department to take advantage of the provision of the Act which authorized

the Reserve banks to act as fiscal agents for the Government. This was put into effect on the first of
January, 1917, and immediately resulted in transferring all Government funds to the Reserve banks
in those cities in which the Reserve banks were sit-

Treasury deposits, however, were retained
in the smaller banks outside of the Reserve bank



first effect

of the advent of the United States

as a participator in the European war was to make
it evident that there would have to be an immense
flotation of bonds and short-time Government obligations for the purpose of providing the

with the means of meeting the demands upon it.
This, of course, had been foreseen, but it had not been
understood that the heavy demands thus to be expected would be brought to bear almost at once because of the fact that the European countries had
reached a point which necessitated immediate financial aid.
At the very outset of our participation
in the war, therefore, Federal Reserve banks were
called upon to supply the Treasury with the funds
it required and to get them back by redistributing
Treasury obligations to member banks. In so doing,
as the Government's policy gradually worked out, it
really undertook to anticipate collections to be obtained from the rank and

file of the population, partly
taxes and partly through the sale of longthrough
term bonds, afterward known as Liberty bonds. The
process of formulating and enacting a tax measure



however, always slow, and the machinery required for the placing of a great loan of the kind
afterward familiar under the head of Liberty loans,
It was therefore evident
is by no means speedy.
that the Federal Reserve banks and their members
would have to sustain a very large burden of floating indebtedness for a good while to come.
Those who were in charge of the financing recognized from the outset the desirability of having the
rank and file of the population absorb these obligations as fast as practicable, but it was also recognized
that rapid absorption of that kind was hardly to be
expected. Even to get the banks of the country to
take the Government's obligations as an intermeis,

diate step to their distribution to the public meant
that the banks must be assured of some means of re*

couping themselves, in the event that they either
became overburdened with the securities through
direct purchase or through the discounting of paper
presented by their customers with these obligations

as collateral, or in the event that hard-pressed customers who had been subscribing heavily for public

bonds required consequently greater accommodation
in order to carry on their business. In consequence
of this situation, the Treasury practically required
the Federal Reserve banks to fix a rate for discount

by Government obligations
which was not higher than the rate on the Government obligations themselves. This might have done
no harm had the rate on Government obligations
been allowed to go to a figure which corresponded
to the commercial worth of money, but through a desire to keep the rate of interest as low as possible
the first Liberty loan was sold at 3% per cent and
for paper collateraled



the Reserve banks undertook to rediscount at this
figure for banks which had loaned to their customers at that rate.


A somewhat

was followed throughout the succeeding Liberty loans, and as time went
on it became necessary for the Treasury to anticipate
the proceeds of Liberty loans by selling what were


similar policy

Treasury certificates of indebtedness.
These were for a long time put out in blocks
at intervals of about two weeks, so that during
the intervals between Liberty loans the banks of
the country would be called upon to absorb great
quantities of Treasury certificates. Thus, when a

Liberty loan was floated the proceeds of the loan
would be used to take up the certificates. When the
proceeds of new heavy taxes were received they were
used as far as they would go to pay off maturing
issues of certificates of indebtedness as well as current expenses of the Government. In this way the
banking mechanism was drawn upon for the current
funds necessary to finance the war and they were
provided in advance of the time when they were
saved, or even subscribed through promises to purchase Government obligations.

was this process which laid the basis for
what came to be known as inflation the creation of

long-term obligations in banks which gave rise to
issues of currency and in any event furnished the
basis of demand for commodities which raised the
price of goods to abnormal figures.

The operation

which has thus been briefly sketched necessitated an
enormous expansion both in the business and personnel of Federal Reserve banks, and consequently
led to a very great increase in earnings.

Prior to



our entry into the war the total personnel of Federal
Reserve banks did not include more than about 850
individuals. At the close of the year 1919 the staff
had increased to more than 10,000 persons, and the
total earning assets which at the close of 1916 were
only about one billion dollars, had risen at the close
of 1920 to $6,500,000,000. Reference has already been
made to the very modest earnings which Federal
Reserve banks reported during the first two years of
the system. The opening of the war period with
its enormous expansion of operations immediately
brought a great growth both of gross and net profits,
and for the year 1917 the total net earnings, after all
expenses, for the combined banks of the Federal
Reserve system rose to about 20 per cent, while for
1918 they reached about 55 per cent, and for 1919
about 100 per cent, the actual net earnings in the
latter year amounting to approximately $80,000,000.
The most recent reports of earnings covering the first
half of the year 1920 show a rate of return on capital
which may be roughly estimated at about 150 per

Brief description has already been furnished as
regards the character of 'paper which was eligible
for presentation at Federal Reserve banks under the
terms of the original act. Had not the war come on
as it did, there would have been good reason to expect a slow, gradual development in American commercial paper usage, and probably a slow alteration
of the kinds of paper composing the portfolios of
member banks of the system. It had been found
through experience during the first two years after
organization that the use of the acceptance would



probably proceed rather slowly and that its best
form would doubtless be the bankers' acceptance
which in turn would find its most desirable use in

Our foreign trade had increased very
greatly during the first years of the European war,
but the financing of it had been upon a conservative

foreign trade.

and with comparatively little change in the
by our banks.
and 1916 only a relatively
small advance in the use of acceptances was made,
while the bulk of the paper which was discounted at
Federal Reserve banks consisted of the familiar
straight single-name note which has for many years
past constituted the basic means of financing Amer-


types of paper employed
During the years 1915

ican transactions.

Shortly after the opening of the war the increasing
tightness of money and the desire to provide on a liberal scale for our constantly increasing export trade
brought about a more liberal use of the acceptance,
and bankers' acceptances, both foreign and domestic,
began to appear in the market in considerably
greater number. It was then believed that the effect of the war would not only be that of increasing
the amount of straight single-name paper discounted
by the banks and by them rediscounted with the
Federal Reserve banks, but that it would also bring
about a very large addition in the form of acceptances to the available volume of paper.
The war financing, however, introduced an unexpected change into the situation. This was due to the
fact that it was impossible to discriminate between
the purposes for which paper was presented. In practhere was no feasible way of determining whether
a business house which asked for an advance and
offered Government bonds as collateral was doing so




in order to subscribe for more Government bonds or,
on the other hand, was merely seeking to get funds
with which to enlarge its plant, or even to engage in
speculative operations. The fact that a special low
rate had been made for the paper collateraled by Government obligations, and the further fact that every
effort had been made to secure a very wide distribution of Government obligations so that they were

held by the population throughout the country, unavoidably involved the transference of our bankloan basis from bona fide commercial paper to paper
collateraled or protected by Government obligations
of various descriptions. Soon after the opening of
the war, therefore, it seemed as if the portfolios of
Reserve banks might come to consist almost entirely
of this so-called war paper. The development of com-

mercial banking practice and of the use of commercial paper in general was given a serious setback.


to the restrictions





which were enforced
enacted by Congress and which
through legislation
continued up to the close of the war, the influence



of inflation and the change in the character of paper
held by Reserve banks did not make themselves as
fully evident as they would otherwise have done.
With the close of the war, however, and the resumption of active stock-exchange operations not long
after, there set in a period of extreme speculative
activity which was the more dangerous because of
the fact that rediscount rates at Federal Reserve
banks were for some time kept at a low level owing
to the circumstance that expenses actually increased
for a number of months after the war because of the
commitments which had been previously entered

These heavy Government expenses necessi*



tated continual sales of Government obligations
which in turn were thought to require the same
methods of financing that had been employed in floating them during the war period. At the same time
immense demands for capital, partly for financing
our export trade, and partly for the expansion of
industries which had been held back during the war,

tended to raise ordinary commercial rates of interest
both for bank paper and for investment securities
while at the same time they led to a search for new
methods of financing. There was therefore during
the year 1919-20 a rapid growth in the acceptance
member banks and an increasing tendency to diversify the character of the paper held by

liabilities of

Federal Reserve banks.

As has been seen, any effort of the Federal Reserve
Board or system during the war to control the credit
situation had been put out of the question by
the fact that it had been obliged to make a low
and preferential rate upon notes secured by Government obligations. It was clear, however, that as soon
as public financing was fairly well out of the way
would be necessary to abandon this low rate policy.
In all the central banks of the world experience has
shown that the most available means of controlling
the volume of credit is that of varying the discount


not only because of the influence of
such variations in regulating the demand for loans,
but also because of the leadership which is afforded
by such changes in discount rates a warning thus
afforded to owners of capital as to conditions existing in the market. As a substitute for this kind of




leadership an effort had been

made both by

the Governmental authorities and by the officers of the Federal Reserve Board and system, in cooperation with
them, to induce voluntary rediscount of demands of

banks by stimulating saving, cutting down unnecessary production, and in various other ways. Appeals
of this kind had been strengthened and supported by
the action of Congress in passing an act creating
what was called the "

to pass upon all prospective
issues of securities, allowing those only to receive
sanction which were regarded as representative of

whose function



essential or necessary goods. This plan could not
continue long after the close of the war and the


of the capital issues committee was terminated
early in 1919 by order of the Secretary of the



evident, as the


restrictions one after

another slipped away, that the Federal Reserve

Board would have to fall back upon the discount
rate as a means of credit control. An advance in
rates was in fact initiated on the 4th of November,
1919. Up to that time the war rates corresponding
to those borne by the Government obligations had
practically fixed the charges at Federal Reserve
banks. These rates corresponded to a charge of about
per cent for 90-day paper. The November ad-


vance was followed by other changes and within the
succeeding six months the 90-day rate had been
shifted practically to a 7 per cent basis throughout
the country, while for 90-day paper collateraled by
Government obligations the rate was 6 per cent.
Meantime the .Secretary of the Treasury had raised
the rate on Treasury certificates of indebtedness to
5% per cent and 6 per cent, according to maturity.


effect of these


changes was to tend to reduce the

price of the outstanding Liberty bonds in the market
because they had been originally issued at rates

which were considerably below the real market value
of money, while this market value had itself risen
as a result of the destruction of capital during the
war. The sharp advance in rates at Federal Reserve

banks corresponded to an even greater advance
which had taken place in the market in the meantime and which carried the charge for good commercial

paper up to a level of 8 per cent or more before

of July, 1920, while the best and soundest
obligations of strong corporations could be marketed



only at a rate varying from 7 to 8 per cent. The application of these high rates naturally had its effect in
restricting credit and in preventing the previously
unrestrained growth of demands for accommodation.
During the war there had been an enormous advance
in the liabilities of banks all over the country. The
total deposits of all banks as reported by the Comptroller of the Currency rose from $12,400,000,000 at
the end of 1916 to nearly $23,000,000,000 at the end
of 1919. It could not be expected that the mere application of higher discount rates by Federal Reserve

banks would immediately restrain this growth of
credit, and as a matter of fact there was no reduction

amount of credit granted during the first
half of 1920. The high rates did, however, restrain
applications for credit which would otherwise have
made themselves felt. On practically all the stock

in the total

exchanges of the country operations, after the beginning of the year, were reduced to a much lower figure
than had been characteristic for a long time past,
"while there

was great reduction in the speculation




lands and in commodities that had been rife all over
the country during the year 1919. By about the
middle of 1920 it was admitted by bankers that the
situation was better in hand than it had been and
that the post-war speculative era had been at least
brought toward a close. It was an unfortunate
element in this process of credit control that some
lines of business in which there had been overtrading
and inflation were obliged to suffer more or less
severely through the price readjustment which grew
out of the high rates for money, not only at Federal
Reserve banks but in the investment market. This
general tendency toward disorganization and price
revision was more or less aggravated by the fact that
lack of equipment and difficult traffic conditions on
the railroads, combined with labor troubles, had
brought about a serious congestion of goods. The
work of the Federal Reserve system was steadily
directed toward assisting in the carrying and maintenance of commercial credit accommodation at the
same time that it, under the leadership of the Federal
Reserve Board, was discouraging the growth of
speculative loans.



of the provisions of the Federal Reserve Act
had aroused most discussion required the Federal Reserve banks to act as clearing houses, and
to receive from their member banks checks on one
another and on outside banks for collections. There
was considerable opposition to this provision, not
only during the time the Act was under discussion,
but subsequently. Nevertheless, it was a necessary
element in the proper administration of the law, due




under the old regime the balances
carried by member banks with their correspondents
in the cities had been used as a basis for collecting
checks, while now that these balances were to be
transferred to reserve banks, it was natural and
to the fact that

necessary to transfer to the latter the duty of making the collections, using the reserve balances to
protect outstanding checks which were in process
of such collection.
The technical Organization Committee had recommended a complete plan for a clearing system at each
Federal reserve bank, as well as for a clearing plan
between Federal reserve banks. The latter was the
first taken up.

The fundamental conception was that of a deposit
of gold to be made by each Federal reserve bank with
the Federal Reserve Board, the actual gold being
held in sub-treasuries for safekeeping, while the


merely held possession of


representing the title to the gold. Each Federal
Reserve bank continued to carry its gold in the Gold
Settlement Fund as a part of its reserves, representing


in this

way on its


Then from week

week the amount of the items due to other Federal
Reserve banks was to be telegraphed to Washington
and there offset on the books of the Gold Settlement
(clearing) Fund. The result would be to bring about


a general cancellation of the bulk of the claims

between Federal Reserve banks.
The Gold Settlement Fund, as thus given a preliminary organization, was so successful and satis-



factory in its working that on July 1, 1918, clearance
was ordered to be made by telegram on a daily basis.
The daily clearance eliminated many technical diffi-

which had previously existed under the weekly
settlement system and brought the clearance system
in its national aspects very close to perfection. As

has already been noted the Federal Reserve system
prior to the entry of the United States into the war
was still in a formative and elementary condition.
With the arrival of a necessity for making enormous
transfers from different parts of the country growing
out of the immense loans placed by the Government,
securities representing which were distributed all
over the territory of the United States, the gold

settlement fund took on an importance which could
Its weekly clearances
hardly be overestimated.

assumed vast proportions from about the middle of
1917 onward. Indeed, had it not been for the existence of the clearance system the Government with
its obsolete sub-Treasury method of collecting the
proceeds of public loans would have found itself in
an almost impossible position. After the placing of
the gold clearance system upon a daily basis, the
idea of clearance in this way attained so strong a
foothold that the introduction of an international
gold clearance fund as an element in the plan for the

League of Nations was advocated. In recent months,
average transfers made through the gold settlement
fund have amounted to about $300,000,000 per day.
There was thus created a general national clearance system, although this was limited in its scope
by the extent of the clearing carried on in the several

under the

intra-district clearance plan.



be observed that there was


for inter-district clearance


lacking any systhat it to say, no


plan had been devised for the depositing of checks
with a member bank if they had been drawn upon
member banks in other districts. The lack of such
a provision prevented checks thus drawn upon member banks in other districts from going through the
Federal Reserve banks in the district in which the
recipient of such checks was situated.

In order to make the system effective a plan was
early devised by the Governors of Federal Reserve
banks for the establishment of a so-called voluntary
clearing system which was to include only those
banks that saw fit to join. Although a considerable
number of member banks did voluntarily join this
system, there were not enough to make it very effective, nor was the plan under which it was conducted
sufficiently inclusive to insure success. Consequently
the Federal Reserve Board itself developed and put

into effect at the opening of July, 1916, a more general and effective plan of collection which has been

developed from time to time and which is now in
force. It has laid the foundation of a general, nation-

wide clearing system.
By the terms of this plan any bank which chooses
to do so may deposit checks upon any other bank and
these checks will be collected and the proceeds placed
to the credit of the depositing bank. Such collections are not immediately credited, but credit is
allowed only after the lapse of a stated time which
corresponds to the period which experience has




to be necessary for presentation



ing the proceeds of such checks.
Member banks, as long as they comply with the
statutory requirements, may continue to carry accounts with correspondent banks in other cities, or
indeed with any banks to whom they may send items
for collection

and from





for similar purposes, checks drawn upon themselves
or upon other banks. They are, however, required to

pay without deduction checks drawn upon themselves and presented at their own counters for payment. Remittance of such checks by the Federal reserve bank of their district through the mail is construed as presentation at their own counters and they
must settle with the Federal reserve bank for such
checks, either by acceptable checks upon other banks,
or by remittance of lawful money or Federal reserve
notes at the expense of the Federal reserve bank.

Checks drawn upon a member bank which have been
received by the Federal reserve bank are not charged
against its reserve account until sufficient time has
elapsed for the checks to reach the member bank and
for returns to have been received in due course by the
Federal reserve bank.
Checks upon about 28,000 national banks, State
banks, and trust companies throughout the United
States are collected by the Federal reserve banks at
par, and it is thought that in the near future checks
upon practically all banks throughout the United
States can be collected at par by Federal reserve

Many banks had found it

necessary in years prior
to 1914 to scatter their available funds by maintain-



ing balances with a number of correspondents for
exchange purposes, or in order to control checks
drawn upon themselves. Banks now, however, find
it expedient to concentrate their balances more
largely and to close many of the accounts which they
have in the past carried with other banks.
which enables them to send all of their checks on
other banks to the Federal reserve banks for exchange purposes or as an offset against checks on
themselves forwarded by the Federal reserve bank,
The release of funds
is, therefore, a convenience.
heretofore tied up in accounts carried with other


banks and their employment at higher rates of interest in commercial loans, offsets to a great degree
the loss of exchange profits which was long looked
upon with apprehension by some of the banks. To


the new clearance system has
an important economy, largely
ready proved

the business



ducing the charges heretofore made him for check




been a principal cause of complaint of the
existing currency situation in the United States for
many years past that our medium contained no eleIt has

ment corresponding





tic" bank-note issue of other countries.

as the "elas-

There have


many kinds of currency, the principal kinds
in circulation before the adoption of the new act
being as follows:
United States notes or greenbacks, legal
tender in payment of debts.
Gold certificates representing actual gold
coin held as a trust fund in Washington.



Silver certificates representing silver coin
held as a trust fund against them in Washington.
Currency certificates representing United
States notes held as a trust fund in Washington or
at sub-treasuries (issued only for the convenience

of banks in very large denominations).
Gold coin, legal tender in payment of debts.




Silver dollars, legal tender in



Silver subsidiary coin, legal tender in payof debts up to $5.

Minor coins of limited

legal tender quality;


National bank notes issued by the banks and
protected by Government bonds deposited with the

Treasury Department.
It is easily seen that of all these classes of currency
and money which have been in circulation none could

be increased save by the actual bringing of metal to
the mint for coinage, with the exception of national
bank notes. The latter could be enlarged in volume
by the deposit of Government bonds with the Treasury Department, and the placing of a 5 per cent re-

demption fund in the same hands. Even in the


amount of national
case, however,
bank notes which could be issued was limited in the
aggregate amount by the total volume of United
States bonds in existence, and was still further
limited by the fact that many such bonds were held
and used to protect public deposits, while still others
were held by investors, and so were not available
for circulation purposes. As the national bank currency had increased in amount until it absorbed
practically all of the available volume of bonds, it
it is

clear that the



has been apparent at certain times in the past that
a great demand for notes could not be satisfied by
the taking out of bank currency.

In order to overcome the " inelasticity" of practically every element in the currency system various
plans have been proposed. The experience of othei!
countries and the theory of banking have both combined to indicate that there is no sound reason for
differentiating between the protection accorded to
notes and that accorded to deposits; but that what
is sufficient in one case should be sufficient in all
others, and that this (as the experience of our nation
indicated) should be the best constituent of the assets
of the banks namely, sound, short-time commercial
paper. The difficulty in applying this standard has
been twofold:
(1) It has been contended that there was not sufficient sound paper of the kind required in the United
States, and
(2) It has been urged that existing bank notes
could not be displaced on account of the injustice to
the banks which had bought bonds to deposit as
security for the notes, and for other reasons.
The problem, therefore, of those who wished to
introduce a more satisfactory method of issuing new
currency was that of protecting the owners of
existing bonds and at the same time of furnishing

an adequate basis of undoubtedly sound commercial
paper deposited to protect the issue of new notes. To
attain these objects there have been offered many
complex plans in the past, and an additional element



of complexity has been added by reason of the attempt usually made to introduce special means of
insuring the safety and goodness of the notes.




the Federal Reserve Act was in process of
drafting, all these considerations were taken under
advisement, and it was sought both to provide for the
proper treatment of existing note currency as well as


Originally the Federal
Reserve Act provided for the refunding of existing
bonds, that is to say, the exchange of the bonds now
outstanding for new bonds to bear 3 per cent infor the issue of



and the gradual retirement of national bank

currency as this refunding proceeded.




for the issue of


bank notes by the

several reserve banks, based upon the deposit of commercial paper of the kind made eligible for re-

discount under the terms of the law; and the general
purpose contemplated by the measure was that in the
course of twenty years the existing national bank
notes should be retired, and the new Federal reserve
notes should take their place.
While the Act was under consideration in Congress
alterations were introduced into it, and the machinery by which the purposes of the Act were to

was altered, although it may be broadly
was no change in the objects ultimately
aimed at. Probably the most important alteration
thus made in the terms of the law was that which



said there

designated the new Federal reserve notes as obligations of the United States, thus making them, in



the technical sense, at least, a Government currency.
Another important innovation was a provision
whereby Federal reserve banks might be required
by the Federal Reserve Board to buy national 2 per

by member banks at a rate not
exceed $25,000,000 per annum, while they were

cent bonds held

be permitted to issue a

new kind


of currency to be

known as Federal reserve bank notes on the


which they thus acquired. The Act,
therefore, provided for two new classes of currency:
Federal reserve notes, and
Federal reserve bank notes,
the former protected by commercial paper of the
kind rendered eligible for rediscount under the terms
of the bonds

of the law, the latter protected

by national 2 per cent

bonds purchased from the member banks of the system, or any other Government bonds owned by the
national reserve banks having circulation privileges.
The ultimate form of the Federal Reserve Act, however, provided for the conversion of 2 per cent bonds
into 3 per cent bonds by Federal reserve banks, such
3 per cent bonds, moreover, to lose their privilege
of deposit to protect circulation.
It will thus be seen that, under the terms of the
Federal Reserve Act, the natural development would
be substitution (at the end of a period of years) of
Federal reserve notes or Federal reserve bank notes
for national bank notes with accompanying retire-

ments of these

latter notes, through the conversion
of the 2 per cent bonds protecting them, into 3 per
cent bonds; while, in the meantime, Federal reserve

notes based on commercial paper would be issued
from time to time as demanded, in quantities sufficient to supply the elastic element in currency, and





up such gaps in

existing national

bank notes as

might be caused through the retirement of note
issues due to the conversion of 2 per cent into 3 per
cent bonds not bearing the circulation privilege.

It is

now time to

works in





this technical proceeding
what has been the effect of it

upon the average man the country over. Let us first
observe with some care exactly what gives rise to a
demand for currency and to consequent issues of
Federal reserve notes. When
trades with B to the
extent of $100,000 worth of goods he thereby creates
a demand for some means of transferring the value
of $100,000. This exchange may be made by the
actual use of money, or by the drawing of a check.
Where the buyer of the goods does not have the
means to pay for them he usually applies to his bank


and such bank may meet his
requirements by giving him a credit on its books
technically known as a deposit," or by issuing to
him its own note or the equivalent thereof. There is
no reason why the bank which is thus applied to, if it
for accommodation,

desires to grant the credit at all, should not give the
accommodation in either form that may be desired by

the customer. The customer is likely to be governed
entirely by the demand of the people with whom he
is dealing as to the form of payment required.
the case of the bill of goods for $100,000 already
spoken of, it is probable that a check on the bank
would be exactly what he wanted, in which case no
question of note issue is raised. But it may also be
that the funds are not wanted for a single payment



of this kind, but that accommodation is sought for
some purpose which necessitates a number of small

payments to persons who do not or cannot employ
bank checks. In this instance notes would be needed.
Or it may happen that a bank discounts some paper
for the purpose of getting notes with which to supply
actual calls for currency made by its customers who
are not necessarily borrowers but who want notes to
carry in their pockets for the purpose of meeting
demands from day to day.
What the Federal Reserve Act does is to permit
a bank to take the promises of individuals to pay at
the end of a designated period, indorse these prom-

with its own signature, and, by the deposit of
them with the Federal reserve bank, obtain in exchange Federal reserve notes issued to that bank by
a Government officer known as a Federal Reserve


fact that these notes are technically
obligations of the Government confuses the situation
to some extent, because it makes the transaction ap-


were one which involved the Governsome way. As a matter of fact, it is the
member bank's demand which gives the signal for
the issue of the notes and determines how many of
them shall come out; while it is the demand of the
customer of the member bank which influences the
action of that bank in applying for them.
Ultimately and in broadest terms, then, the provision of the Federal Reserve Act simply allows individuals to make their own obligations, based on
pear as


if it


commercial, industrial, or agricultural transactions,
and then, by putting these through a local bank, to
get note currency corresponding thereto. As long as
their credit is good they can get the notes, provided



that the Federal reserve


in a position to
with gold. Under the

protect these notes amply
terms of the Federal Reserve Act this protection
must amount to at least 40 per cent of the face of the

note issue; and of this 40 per cent five per cent is
deposited with the Treasury Department for current redemption, the other 35 per cent being held in
the vaults of the Federal reserve bank which issues
the notes.


change introduced into the terms of the currency section of the act in 1917 has always
been open to serious question and criticism. By the
terms of that amendment it was provided that the
40 per cent gold reserve held by a Federal Reserve
bank against notes is to be counted as part of the
protection maintained by the bank against its outstanding circulation.


effect of this


was that whereas under the original Federal reserve
act there was always 100 per cent of commercial
paper and 40 per cent gold behind note issues, the
new plan would permit the combined amount of gold
and commercial paper to fall to 100 per cent of the
outstanding notes. The currency is fairly elastic, inasmuch as it can be increased to the extent of two
and one-half times the supply of gold available
100 per cent being two and one-half times 40 per


it is safe,

inasmuch as the protection


adequate to all ordinary requirements. Nothing
limits the amount of notes that can be issued, therefore, except the needs of the business community

and the adjustment of the country's gold supply to
that of other nations.



It should be frankly stated that the theory of currency issue which is thus set forth as having been

embodied in the Federal Reserve Act has not effectively worked out in practice. From what has been
said it will be plain that the essential and underlying
idea of the Federal Reserve Act or of any legislation
based upon the same general principle is that of using commercial paper growing out of live business

Whenever the
paper which is discounted does not grow out of business transactions the basis upon which the theory
of currency issue rests is changed. As has been
shown at an earlier point, the entry of the United
States into the war made it necessary to raise very
large sums of money, and by the process of financing
which was then employed these sums were first obtransactions as a basis for currency.

tained through the issue of short-term obligations,
which were made available as a basis for rediscount
at Federal Reserve banks, and which were held by
members banks, later, by the issue of bonds which
could be collateraled in the same way. Thus the
paper held by Federal reserve banks came to consist
in no small degree of notes collateraled by Government bonds. Many of these loans were made merely
for the purpose of enabling subscribers to buy and

pay for Government bonds; others were made


purely speculative purposes. Neither kind of paper
represented live transactions or provided a means
whereby liquidation could be assured at maturity.


result was to destroy in large measure the effectiveness of the provisions contained in the law for the
maintenance of elasticity in the currency, as the



currency increased and as deposit credits were
granted upon the books of Reserve banks through
the rediscounting of notes collateraled by Government obligations, since there was built up a large
structure of available funds which were not based
upon commodities currently produced, but were
based upon investment securities. This brought
about what is known as inflation and along with a
relative shortage of production as compared with
demand, tended to raise prices very materially.
By the middle of the year 1920 the index number
of prices, taking the year 1913 as a 100 per cent
base, had risen to 273, and while this advance was
by no means entirely due to banking causes, the inflation to which reference has been made no doubt
contributed in an important way to the general re-

During these years the currency issue of the
Federal reserve banks rose from a merely nominal

figure shortly after organization to about $3,100,000,000 at the middle of 1920, although a part of
this growth represented a substitution of reserve

notes for gold certificates which had been accumulated in banks. The later months of 1920 have seen
a sharp fall in prices reflected in a decided decline
of the index number, and aided by the gradual
elimination of long term and speculative paper

and deflation were
painful processes, though the later was a necessary

from the banks.



consequence of the former.
While Federal Reserve notes had been active in
their movement into and out of the banks, thus showing a good redemptive power, they had not been
they expanded and conin other
tracted freely as business fell and rose
elastic in the sense that



words, they have not shown that close dependence
upon and correspondence to the volume of business
transactions which is the mark of an elastic currency.
The reason is that the basis for credit at Federal
Reserve banks has not been a pure type of business
paper as had been expected to be the case.



of the innovations provided by the Federal
Reserve Act is found in the section relating to foreign branches. It has been a subject of complaint
for a long time that the foreign trade of the United
States was inadequately financed. National banks

not being permitted under existing law to establish
branches abroad, it has been felt that in many cases
Americans doing a foreign business could not get the
accommodation to which they were entitled. It has
been asserted that in those countries where the foreign trade of the United States was still limited in

amount and undergoing development subject to more
or less severe competition, the problem of securing
adequate funds for the trade was particularly

This state of affairs was fully recognized throughout the later years of the agitation for new banking

In the National Monetary Commission's
investigation and report much attention was given to
international relationships, and the report dwelt extensively upon the need of a better method of financing the exports of the United States and the foreign


trade of the nation in general.
When the Federal Reserve Act was under consideration,



at first thought that the plan of joint



banks for the establishment of
branches would be the more desirable provision, but
subsequently this view was abandoned; and in the
final Act provision was made for permitting any national bank having a capital and surplus of not less
than $1,000,000, to establish foreign branches. It
was left to the Federal Reserve Board to determine
by regulation about how much capital should be
allotted to such branches, and what should be the


conditions surrounding their establishment. Owing
demand of business organizations, however,

to the

the Act was further amended on September 7, 1916,
by providing that national banks might join together for the purpose of organizing other banks to
engage in foreign operations under carefully

guarded condition. A few such banks have been
organized but the movement has not gone far.
The Federal Reserve Act, however, approached the
question of financing foreign trade not only from the
standpoint of the machinery involved, but also from
that of practical business methods. It is well known
that foreign business generally is transacted upon
the basis of standard paper known as acceptances."
The National Bank Act, however, never legalized the

use of acceptances, and they had, therefore, been regarded as a prohibited type of paper. The result is
that they had not figured to any great extent in
American banking practice. There was nothing to
prevent State banking laws from providing for the
use of acceptances, but such laws have usually been
modeled upon the National Bank Act, and had, there-

been accustomed either to ignore the acceptance
question or to prohibit this form of paper. The
Federal Reserve Act provided that any national bank



might accept paper growing out of actual commercial transactions

involving the importation or ex-

portation of goods, and having not more than six
months to run; while it also authorized Federal Reserve banks to rediscount such acceptances when indorsed by member banks, or to buy them in open
market whether with or without the indorsement of

member banks.

How this provision bears especially upon financing
our foreign trade, and what are its important indiupon banking and commercial operations
generally, may be understood by reference to prevailing methods of financing foreign trade. In trade
rect effects

between foreign countries the method of procedure
is somewhat as follows: A merchant, A, in Buenos
Ayres, ships coffee to B in Liverpool. It is agreed
that B will accept the draft accompanying the coffee
at ninety days sight. It may be, however, that A,
when shipping the coffee, desires to arrange for a
credit that would enable him to liquidate very

He may, therefore, have agreed with B
that his draft for the coffee shall be accepted by a


Liverpool bank. This bank is induced by B to agree
to accept the draft when it is presented. B may protect the bank in some special manner if the institution demands such action, or he may simply have
made a satisfactory statement and showing to the

bank so that that

institution is willing to accept the
draft in consideration of a moderate commission or

discount paid it by B for the service. When it
has thus accepted the draft that is, agreed to pay
it at maturity,
the paper becomes the obligation of
a bank of known standing, and is, therefore, readily
salable to some other bank. The discount on it will



consequently be low, and the original drawer of the
draft will be able to get his money immediately with
This means that he can sell very
little sacrifice.
much more closely than would otherwise be possible,
because he knows that he will lose very little money
in the form of discount or interest.




in the case of other phases of our banking development, the financing of our foreign trade has

been influenced in a very important way by the war.

had seemed probable that the war would give
us an important leadership. After we entered the
struggle the financing of goods going abroad was,
however, largely taken over by our Government by
reason of the fact that it extended great credits to foreign countries which used them in paying our exporters. After the close of the war and the withdrawal of
It first

the Government from this phase of its financial cooperation with the Allies, there was a period of uncertainty during which American banks were en-

deavoring to get back into the

field of

foreign trade


The year 1919 and the beginning

of the year 1920

were a period of reaction during which the extremely
favorable conditions which had worked in behalf of
the development of New York as an international
market were largely reversed or neutralized. British
banks and British commercial houses naturally took
advantage of the situation to get back as much of
their lost foreign trade and foreign connections as
they could. One result thus, was that, partly in consequence of erroneous policies in the United States,



partly owing to incidental conditions over which
Americans had no control, and partly as a result of
the cumulative effect of war shortage of capital
(which had been masked during the continuance of
the conflict and suddenly allowed to appear upon its
close,) the retrogression, during the sixteen months
since the armistice, in American banking participation in foreign finance

and business was much

greater than it would normally, or perhaps ought
to, have been.
How serious such retrogression has been in some
instances may be illustrated by the case of one
of the leading financial institutions of New York
which during the year 1919 was said to have lost

about two-thirds of its entire foreign bank deposits.
The real character of the problem was also seen from
a study of the bankers' acceptance situation. Whereas during the year 1919 there was a continuous increase in the volume of bankers' acceptances created,
the acceptance being widely used for the purpose of
financing the great foreign trade of the United States
so that acceptance liabilities of the New York district which were estimated at about $275,000,000

September 1, 1918, were about $335,000,000 on
December 31, 1919, the distribution of this increased
volume of bills became more and more difficult. Not
only did discount houses and dealers in bills have to
for that

carry larger portfolios"
funds obtainable only at rates equal to or
higher than those earned by their portfolios, but
Federal Reserve banks found it necessary to absorb

an increasing amount of bills in the open market,
while advancing their rates during the year from
per cent to 5 per cent on 90-day paper.



The natural consequence of this situation was to
drive a great deal of financing abroad which would
otherwise have remained in the United States, and
the prevalence of such conditions for a long period of
time necessarily would make probable further such
transfers of financing.

To sum up

the whole situation

institutions have

made only a

American banking

relatively small degree

of progress abroad. What they have done they have
done in such a way as to avoid so far as possible com-

petition with the banking systems of the other
nations. Federal Reserve banks have likewise been

very cautious about incurring losses due to purchases of exchange, while they have also sought to
steer clear of undue competition with foreigners. The
disturbed conditions succeeding the armistice have

worked very greatly against the general development of international finance which the American
banking system had unconsciously, and in a sense
involuntarily, taken upon itself during the war.
Ground is being lost in international financial relationships and the question of how far a recovery will
be possible depends upon a variety of large factors,
such as the policy of the Federal Reserve system, the
degree of success in the establishment of a discount
market, and others of the same sort. The future of

American banking in the foreign field is certainly
beyond the power of prediction at the present time.



of the features of the Federal Reserve


which has already proven of greatest importance is
found in its relation to the Government. Ever since



the passage of the Independent Treasury Act in 1846
there had been an effort on the part of the Government to keep as much of its funds as possible in subtreasuries. The plan was unsuccessful because when
large surpluses accumulated they were withdrawn
from actual commercial use, and caused a corresponding shrinkage of bank reserves, while if the

Treasury redeposited these funds with national
banks the distribution was not always wisely made.
The Federal Reserve Act, in view of these considerations, endeavored to effect two distinct changes
in the existing relations between the Government

and the reserve


funds in Federal Reserve banks, which were author"
ized to act as "fiscal agents,
It authorized Federal Reserve banks to deal
in Government securities.
These provisions enabled the Government to become a depositor at Federal reserve banks in com(1)

It provided for the depositing of

mon with

the various member banks of the country,
and, through the permission of the reserve banks to
trade in Government securities (while acting as fiscal
agents), practically enabled the Government to resort
to the banks for accommodation should it desire to

In one very special way an important relationship is established between the Government and the
Federal Reserve banks. Provision was made, as has
been seen, in connection with our treatment of the



currency question, for the gradual transfer, at a rate
not exceeding $25,000,000 per annum, of the national
bonds now held by the national banks to the Federal

Reserve banks. The reason for introducing this provision is found in the fact that in order to bring about



an improved currency situation it was necessary to
deprive the national banks of their exclusive power
of issuing notes based on Government bonds. This, of
course, meant that in all equity the banks must, at
some reasonable time, be relieved of their bonds at
a fair figure. The Federal Reserve banks, by taking
over these bonds, were gradually to mass the securities in their own hands, and consequently relieve
their individual members who have disposed of their
Ultimately, it was assumed, the bonds
would be refunded, or otherwise provided for by the
Government of the United States upon some satisfactory basis.
At the beginning of the year 1916 the Secretary
of the Treasury designated the several Federal Reserve banks as depositories, transferring to them the
funds of the Government previously located in
national banks in the twelve Federal reserve cities,
although he retained the funds located elsewhere in
national banks, just as before. The effect was to give

an aggregate deposit
of about $30,000,000 at times, while they were, on the
other hand, called upon to conduct an active checkThe process of
ing business for the Government.
to the Federal Reserve banks

converting the 2 per cent bonds into 3 per cent bonds
proceeded steadily through the intermediation of the
Federal Reserve banks until the entry of the United
States into the war, $30,000,000 having been so converted during the year 1916, while the Treasury

ing 1917.

willingness to convert a like sum durBut with the opening of the war condiits

tions entirely changed.

A description has already been given of the
service performed




Reserve banks as

sellers of


Government obligations and as discounters
by these obligations during the war,

of paper secured

and hence need not be recapitulated

at this point. It
to say here that the war left the
only necessary
Federal Reserve system as practically the recognized

agent of the Government and that this service
has been continued in the handling of short-term
certificates of indebtedness up to the present time.
Congress, moreover, at the session of 1919-1920 voted


to abolish the sub-Treasury system, an action which
transferred important trust and routine functions to

the Federal Reserve banks.

From this time forward,

the relationship between the Reserve
banks and the Government will necessarily be somewhat that which exists in foreign countries, the
banks serving as the active agencies of the Governtherefore,


in the conduct of its ordinary business affairs.


From the foregoing description it will be seen what
are the purposes and success of the Federal Reserve
system up to the present time. It is essentially a
means of combining the resources and strength of
a considerable number of banks for the purpose of

obtaining the benefits of united action.
review of the detailed provisions of the measure
shows that, while the conception of banking reform
upon which it is founded is the same that has constituted the staple of the banking reform movement


of recent years, and while the conception of a union
of banks is directly borrowed, as in other bills of the

years 1900- 1910, from the actual practice of the banks
themselves as developed under the stress of circum-



stances in the form of clearing-house organizations;
while, moreover, certain phases of the technique of
the legislation itself followed the lines of the Aldrich

or Monetary Commission bill, and while other portions of the Act have been adapted from well-known
legislative proposals that have figured within the
past few years of banking discussion, the Act as a
whole is based upon a conception and plan entirely
its own, applies in many fundamental respects meth-

ods of control and administration that have been
given at least a new form, and includes several important innovations, not heretofore conspicuous in banking discussion although admittedly significant, not to

say necessary, to any thorough reorganization upon

That the Act also contains some
elements that may be regarded as reminiscences of
the less desirable and more objectionable phases of
banking agitation, is equally certain. These are seen,
for instance, in the underlying concept of the Federal reserve notes, which are thought of as government currency loaned to banks, and are thus at least
theoretically, although not practically, in line with
government currency schemes of past
years. Fundamentally, the system is based upon experience and upon proved workable principles.
sound principles.