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BANKING STABILITY— THE ROLE OF THE CENTRAL BANK /0 smt M g m stabilitt- the m m m the central a m Lecture by Dr« Edison H. Cramer, Chief of the Division of Research and Statistics, Federal Deposit Insurance Corpo ration, before the Colorado School of Banking, University of Colorado, Boulder, Colorado, August 19, 1953 The conclusion in our discussion yesterday is that banking stability— meaning stability with a reasonable rate of growth in the deposit liabilities and hence in the assets of banks— is essential for business stability« If we do not have banking stability— that Is, if the aggregate assets and aggregate deposits of banks fluctuate erratically— business men and households do not have a stable circu lating medium to use in their transactions with each other« If the aggregate amount of the cash balances— bank deposits and currencyheld by business and individuals decreases, or fails to grow relative to the need for them, the result is uncertainty and hesitancy in business planning and in the normal spending of families» On the other hand, expenditure sprees are induced by unexpected increases in cash balances« Our subject today is the role of the central banking system in the maintenance or disruption of banking stability. A central talk ing system, consisting of 12 Federal reserve banks, together with the Board of Governors and Open Market Committee of the Federal Reserve System, has existed in the United States for nearly forty years. It was established, according to the preautole to the Federal Reserve Act, "to furnish an elastic currency, to afford means of rediscounting - 2- commerclal paper, to establish a more effective supervision of banking in the United States, and for other purposes." That the system was designed, through these means, to promote econoaic stability, was stated explicitly in the report of the Chairman of the Senate Committee cm Banking and Currency, Senator Bobert D. Oven, in reporting the bill approved by the Committee to the Senate. "The chief purposes of the banking and currency bill is to give stability to the commerce and industry of the United States, prevent financial panics or financial stringencies! make available effective coaaercial credit for indi viduals engaged in aanufacturing, in commerce, in finance, and in business to the extent of their Just deserts; put an end to the pyra miding of the bank reserves of the country and the use of such reserves for gambling purposes on the stock exchange." 1/ The title of the Federal Reserve Act, the names of the new banking Institutions created by the Act, and the emphasis on concentra tion and mobilisation of bank reserves in the Act and in Congressional cosBaiitee reports all indicate that these purposes were expected to be achieved through the management of bank reserves by the Federal Reserve authorities. The emphasis on an ’’elastic currency" and the provisions for the Issue of a new form of currency were also directed to this purpose, in order to avoid the drawing down of bank reserves when additional currency (pocket money) was needed. 2/ l/ Report to accompany H« B. 7837* from the Committee on Banking and Currency, United States Senate, Report 133# 63rd Congress, 1st Session, p. 7. 2/ This purpose was explicitly stated in one of the most influential books published during the period of agitation for establishment of a re serve banking systems Banking Reform, edited by J. Laurence Laughlin (Chi cago: The Batlonal Citi sens League for the Promotion of a Sound Banking System, 1912), p. 18« - 3 ' The need for managing bank reserve« had become apparent during the latter decades of the nineteenth century. This need arose from the combination of three characteristics of the banking and monetary systems (1) the legal requirement that banks maintain so-called reserves of lavful money, or partially lawful money and partially balances in selected groups of banks, equal to specified percentages of their deposits; (2) a tendency of banks to expand their operations close to the limit of their reserves; and (3) an irregularity in the amount of lavful money available for reserves, due in part, as X have Just said, to a fluctuating demand for lavful money for use as pocket currency. The chief mechanisms of the Federal Reserve Act which vere designed to make possible the management of bank reserves by Federal Reserve authorities veres first, the transfer to the Federal Reserve banks of part, and after 1917 of all, the required reserves of national banks and other members of the Federal Reserve system; second, an authori sation to the Federal Reserve banks to discount selected types of assets for its metier banks; and third, an authorisation to the Federal Reserve banks to obtain from the Treasury United States government obligations in the form of currency, with some of those same assets and some gold serving as collateral. By these means additional pocket currency could be provided when it vas needed without affecting the amount of bank re serves; and also, bank reserves could be increased by additional dis counting for member banks. The Federal Reserve banks vere also given large powers of purchasing and selling certain types of assets on the open market— & procedure which also affects the amount of member bank reserves. In the Banking Act of 1935 another power was added to the foregoing, namely, authorization to the Board of Governors of the Federal Reserve System to alter, within specified Units, the percentage reserve requirements. This power makes It possible to alter the effective amount of reserves with so change in their dollar amount. All the these techniques, except the last, have one common characteristic, namely, they are methods of altering the amount of assets, and therefore the liabilities, of the Federal Reserve banks. The lia bilities of the Federal Reserve banks, leaving capital accounts and minor items out of consideration, are of three sorts? (1) Federal Reserve notes which, as we have noted, are really United States Treasury obligations for which the Federal Reserve banks have posted collateral; (2) mester bank deposit accounts, which are both reserve and clearing accounts; and (3) other deposit accounts, chiefly those of the united States government and of foreign banks or governments and international Institutions. The Federal Reserve banks do not, as you know, carry deposit accounts of individuals or business enterprises • This fact is very important in the operations of the Federal Reserve system, because it means that when a Federal Reserve bank acquires assets fro® an individual or business enterprise— such as a government bond or a b i n of exchange purchased in the open market— it cannot pay the Individual or enterprise, as a commercial bank might, by a deposit credit. The Reserve bank pays by a draft, or order, on itself which the purchaser will deposit in his own account in a commercial bank, and the commercial bank (if it is a Federal Reserve member bank) in turn will deposit in its account in the federal Reserve bank. When that is done, the reserve account of that particular master bank, m d hence the aggregate reserves of all member • 5- banka, is increased by the amount of the draft. Similarly, when a Federal Reserve hank sells sosie of its assets in the open market, or receive® payment of an asset that has ¡matured, the reserve account of some member bank is charged, and the aggregate amount of the reserves of member haflk« is reduced. 2h© foregoing leads to a simple principle of action for the Federal Reserve authorities if they wish to control the dollar amenant of member bank reserves. If, for example, they wish to keep those re serves at a constant amount, they must keep at a constant amount the assets of the Federal Reserve banks. of If they wish to make the reserves mankier banks grow by 3, k, or 5 percent per year, the Federal Reserve banks must acquire the requisite amount of assets. This they can do by an appropriate amount of rediscounting or open-market operations. Conse quently by controlling their assets and leaving percentage reserve re quirements unchanged, the Federal Reserve banks control the effective amount of member bank reserves; or, the Board of Governors can change the effective amount of such reserves by changing the percentage re quirements while leaving the amount of Federal Reserve bank assets un changed, The powers of the Federal Reserve authorities to control the assets of the Federal Reserve banks have been enlarged and made more flexible by various amendments to the original Federal Reserve Act. However, the powers given to them by the original Act and the early amendments were very great; and the changes that have occurred, in fact, in the amount of member bank reserves have always been the direct conse quence of the use of those powers. A look at the record will enable us to see how those powers have been used. Before ve do this, let us take cognizance of © very staple fact about the economy: this is the need for growth in the circulating « d i m s and consequently in bank reserves, as the population and productive powers of the country grow. That is to say, in looking at the record of Federal Be serve actions and their inpact of member bank reserves, we must cohere the results, not with stability in the sense of a fixed amount, but in the sense of an amount increasing In accord with a reasonable rate of growth. Studies made by an economist on ay staff at the Federal De posit insurance Corporation suggest that the needed rate of growth, for most of the period since establishment of the Federal Reserve System, has been close to five percent per year. The available statistical data are not good enough to make a very close approximation, but there is some indication that three percent may be adequate today. Now let us compare the changes in the effective amount of mes&er bank reserves, in various periods since the concentration of reserves in the Federal Reserve system, with the rate of growth of 3 percent per year for recent years, and 5 percent per year from the beginning of the Federal Reserve system to the close of World War XIj and in the cases where we find large departures, with changes la the amount of the circulating medium and in business coalitions. As we do this, we will also take notice of the character of Federal Reserve policy, or other circumstances, which produced the change in reserves, Under the Federal Reserve Act all national banks were required to join the Federal Reserve system; and the percentage reserve require ments applicable to national banks were reduced, effective with the organisation of the Reserve banks. year 191^. This occurred near the end of the Under the pressure of wartime conditions in 1915 and 1916, though the United States was not yet a participant, the hanks expanded their operations quite rapidly* When hank reserves vere fully con centrated in the Federal Reserve hanks in June, 1917# percentage re quirements were again reduced. Further, from that tine to the end of 1919# the Federal Reserve hanks assisted the United States Treasury In its war financing hy freely discounting for member hanks, and the result was a large increase in member hank reserves. With the previous re duction in percentage requirements, we can estimate--very roughly— that effective reserves nearly doubled during the $-year period fro® the time the Federal Reserve hanks vere organised until the end of 1919* A n o r m ! growth, compounded at 5 percent per year, would have been less than 28 percent. The excessive rate of Increase in bank reserves permitted the hanks to acquire large amounts of government obligations and to acquire even larger amounts of loans so that their customers could ^borrow and buy” liberty bonds. The excessive rate of increase In bank assets was accompanied by about the same excessive rate of increase in deposits, and resulted, as Is well known, in a rise in prices to a peak in early 1920 about double that of 191^. Toward the end of 1919 the federal Reserve authorities decided that their policies could be independent of the Treasury and that the inflation should be halted by the contraction of bank credit. Discount rates were advanced sharply, and extremely high rates were charged msiher hanks which had been borrowing end continued to borrow most heavily. first, the banks paid the high rates, in order to maintain reserve® sufficient to avoid reducing loans to their own customers, but sold At «•d** United States Government obligations with a consequent sharp break In the bond market. The Federal Reserve banks also reduced their holdings of assets acquired in the open market. The consequence was a reduction, relative to a reasonable growth, or about 15 percent in reserves in about a year and a half. By this tine price® had dropped severely and business had slumped badly. The action of the Federal Reserve authorities had been far more severe than was needed sliaply to stop the previous inflation. There is evidence that the Federal Reserve authorities recognised the difficulty of taking enough but not too much action; but it is clear that they believed that an actual deflation of credit— i.e., monetary con traction— was necessary. to stop inflation It is understandable that in this first effort they did not realise how precise and delicate the monetary machinery is, and therefore seriously misjudged how much down ward pressure was needed to stop the inflation without producing a business depression. By the middle of 1921 the impact of monetary contraction was evident, and the Federal Reserve authorities reversed their policies. Discount rates were reduced and the Federal Reserve banks bou$it United States Goveraaaent obligations sad other assets in the open market. The increase in total Federal Reserve bank assets resulting primarily fro® these actions, rapidly restored the depleted reserves— in fact raising them In the space of about a year and a half (from the summer of 1921 to the beginning of 1923) by spproxiaately 10 percent In excess of the normal rate of growth. With the increase in circulating medium, prices started rising quite rapidly, and business began to boom« In 192^, the Federal Reserve authorities again took action to curtail the rate of expansion of bank reserves and the circulating medium; -9but that action vas such less drastic than in 1919 and early 1920* H w signs of a slight recession appeared, the pressure cm reserves vas quickly reversed. The contractive action vas repasted as business revived and shoved boom symptoms in 1925 and 1926, and again reversed when a snail recession occurred in 1927* By 1928 and 1929, as business vas prosperous again, it vas videly believed among economists that Federal Reserve authorities had learned hov to use their povers to provide the banking stability needed for business stability, and vould continue to use those povers for this purpose. In retrospect, this belief appears to have been Justified, both because of the high plateau of prosperity of the 1920‘s vith only slight recessions in 192fc and 1927, ®Qd because deviations in effective reserves from a reasonable line of grovth vere kept vithln a fairly narrov range* Moreover, the banks did in practice utilise all— or practically all— of their reserves. But in 1928 and especially in 1929* the Federal Reserve authori ties found themselves in vhat they thought vas a dilemma of policy. For som time they had been voarried about speculation, and vere disturbed that they had not succeeded as much as they should in stopping the us© of bank reserves for "gambling purposes on the stock exchange" to vhieh the Chairman of the Senate Banking and Currency Cosaaittee had referred when the Federal Reserve Act vas being debated In 1913* When the Federal Reserve authorities found that the moderately contractive reserve policy initiated in 1928 did not affect stock market prices or the proportion of neater bank assets consisting of corporation securities or loans on securities, they decided to use more stringent action. Unfortunately, that meant abandonment of the criteria of reserve policy on which chief reliance had been placed during the preceding decade, namely, the degree of business activity, the presence or absence of a significant amount of unesg&oymeat, and the upward or downward direction of prices. After the stock market crash had shown how violently effective the moire stringent policy had become, the Federal Reserve banka used the traditional technique of reducing discount rates in an effort to stimulate business revival, but they did this under a set of conditions and policies that discouraged the member banks from reviving the practice of discount ing os a large scale. Except for a few short intervals, and one longer one of about six months in 1932 when the Reserve banks under strong Con gressional pressure purchased Government obligations, the amount of to member bank reserves was permit ted/decline, particularly when currency withdrawals snd later gold withdrawals exerted a downward pressure on reserves. The entire reduction in member bank reserves from the peak in January 1928 to the trough in early March 1933 was nearly 30 percent in dollar amount. And also there had been considerable shifting of deposits from categories with low to those with high percentage require ments and a relative decline in the deposits of nonmeafeer banks. When these factors and also a normal rate of growth over the 9-year period are taken into consideration, the shrinkage in effective reserves was about hO percent. In ®y opinion and in the opinion of many other economists, there is no doubt that if the Federal Reserve authorities in the early I f p * s had reversed their action and had returned to a policy of providing enough reserves to the banking system, the great depression of the 1930*© would not have occurred. And if the depression had not occurred, the entire history of the world since 1930 might have been very different. - 11- Five years with a shrinking circulating stadium, as banks adjusted themselves to the dwindling reserves available to them, finally led to the banking holiday of 1933 and almost total economic collapse. With the change in administration and its abandonment of redemption of the currency in gold, bolstering of the banking system, and numerous activities to provide employment and promote recovery, currency returned to the banks. It was this return of currency and the change in the price of gold early in 193^— not the acquisition of assets by Federal Reserve banks through rediscounting or open market operations— that produced an increase in bank reserves after the banking holiday. The rate of expansion after the change in the price of gold was extremely rapid— the dollar aiaouat rising three-fold by the end of 193&, and doubling again during the next four years. Xa 1933 the President of the United States had announced a policy of restoration of the pre-depression commodity price level. With this governmental policy and the normal tendency of the banks to expand when they have increasing reserves, we would have expected a continuous expansion of the circulating medium— at a rate normal growth. wore than that needed for This is in fact exactly what occurred for nearly four years after the banking holiday, though at a less rapid rate than the expansion in bank reserves. But late in 1936 and again early in 1937 the Federal Reserve authorities increased reserve requirements, and the expansion came to a halt for a year and a half. After this interruption, which was accompanied by a sharp business depression, the expansion of the circulating medium was resumed, at about the same rate as before. It continued to expand for another four years and then, with the outbreak - of war, vae accelerated, 12- But it took more then ten years from the banking holiday before the price level of the middle 1920‘s, and a corresponding rate of business activity, were restored. This was one of the most stretched-out periods of recovery from business depression in the history of the nation. You are familiar with the monetary policy used by our government to help finance the high expenditures of World W*r II. During the six years fro® the end of 19^1 to the end of 19^7 the stock of money, or circulating medium, more than doubled. This was made possible by the excess reserves existing at the beginning of the period, together with large additional amounts of reserves resulting from the acquisition by the Federal Reserve banks of United States government obligations. Tou are also familiar with the resulting price inflation. The increase In effective bank reserves was brought to a halt in early 19^3 by a combination of policies which I described in one of say talks to this school of banking a year ago. These policies included abandonment of Federal Reserve wartime support levels on Treasury bills and certificates so that short-term interest rates rose toward the long term rates, a lowering of the pegged prices for United States government bonds, an increase in percentage reserve requirements, and use of a Treasury surplus for retirement of Government obligations held by the Federal Reserve banks. This action was far less drastic than that taken after the close of World War I. drastic. The results on business were also less Prices reached a peak in the autumn of 19^6 and there was a slight business recession in 19^9* Moderate action, in conformity with what night have been expected from the history of the past, was sufficient to stop the Inflation, and to do so with only a a l l business re cession. For the pest five years— slnee the middle of 19^8— effective bank reserves and the circulating medium have increased at rate of about 3 percent per year. m average While 3 percent m y be slightly lower than desirable, it has been sufficient to maintain a stable price level and stable business. If prices in general should start to fall, uaesploy- m a t to increase, and business to become stagnant, then the Federal Re serve authorities can increase the rate of growth in bank reserves. If the policy with respect to bank reserve® they have followed since 1$&7 is adhered to, we can be confident that we will continue to have business stability without inflation.
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