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THE FEDERAL RESERVE IN TIME OF EUROPEAN WAR ADDRESS BEFORE THE ECONOMIC CLUE OF DETROIT DETROIT, MICHIGAN, APRIL 22, I94O BY ERNEST G. DRAPER MEMBER OF THE BOARD 05’GOVERNORS OF THE FEDERAL RESERVE SYSTEM Released for use not earlier than 10 o ’ clock A.M., April 22, 1940 Z-307 THE FEDERAL RESERVE IN TIME OF EUROPEAN WAR When a devastating catastrophe like the present European war strikes the whole world, it is only natural for every thoughtful Ameri can to take stock of the situation in his own country and to find out, if he can, how well or ill prepared the various branches of his Govern ment are to ride out this storm, regardless of its length or intensity. Except in the last instance, which I intend to mention at the conclusion of these remarks, the information I am giving herewith is, for the most part, factual. I am anxious that you judge for yourself whether the Federal Reserve System is in a favorable position to meet the future with confidence, in spite of financial contingencies either abroad or at home. I The Banking Act of 1935 established a Federal Open Market Com mittee to consist of the seven members of the Board of Governors of the Federal Reserve System and five of the twelve presidents of the Federal Reserve banks. This Committee is empowered to buy and sell Government securities in the open market "with a view"— I am quoting the statute— "to accommodating commerce and business and with regard to their bearing upon the general credit situation in the country". This is a most important power. It is the obvious intent of Congress to see to it that not only the money markets of our country are kept in a healthy condition but also that the Government bond market should at all times be protected against any conditions that might -2- Z-307 seriously impair the general credit situation. The condition of the Gov ernment. bond market determines, to a great extent, the condition of the entire corporate bond structure as well. If prices of Government bonds fluctuate widely or show signs of panicky or distress selling, this condi tion nay be easily transmitted to the prices of corporate bonds and thus affect not only the value of assets of banks and other investing institu tions but also the ability of corporations to float new security issues. Also, and sometimes more important, it is difficult for the Government to do any financing on its own part unless money rates are comparatively stable— a state of affairs that cannot be achieved unless Government bonds themselves are being bought and sold in a relatively quiet atmos phere . As long ago as last spring, the Federal Open Market Committee anticipated that the then recurring crises might result in a European war and that this event might in turn bring about a serious disturbance in the security markets. The Committee gave ample power to its execu tive committee, consisting of three members of the Board of Governors and two presidents of the Federal Reserve banks, to buy and sell Govern ment securities through its agent, the Federal Reserve Bank of New York. Ever since war broke out in Europe and before, 'the executive committee has kept in close touch with the situation. What has been the result? From September 1st to September 21st, 1939, Government bonds— particularly the longer issues— declined; then struck a bottom (whether temporary or more or less permanent we did -3net know), and then recovered. z-307 Tho longest issue— the 2-3/4's of 1960- 65— went from a nigh of approximately 103 to a low of 99 and then recov ered so that as of this date these bonds have regained a substantial percentage of their former loss despite the latest hostilities abroad. During this whole declining movement, the Federal Reserve exerted every effort to provide a market at all times to investor buyers and sellers. There was no effort made to peg the market at any fixed price. We did not know then and we do not know now what should be the exact price cf any Government bond on any one day. But we did feel that if, in this grave crisis, wa should abandon the market entirely and leave it to the whim of panicky forces or unscrupulous speculators, we should have proved ourselves false to the trust which vas originally placed in our hands by Congress. On a number of days, we were forced to enter tho market in a substantial way in order to cushion the decline that was ob viously in progress and to keep the market in as orderly a condition as possible. In fact the published figures show that from August 30th to September 27th the Open Market Committee purchased *470,000,000 of notes and bonds, most of which were purchased in the first 15 days. A large proportion of these securities were in the issues maturing later than ton years. If anyone fuel:-] that this is a large amount of securities for the Federal Reserve banks to buy, even in a crisis, let me revaind him that it represents only 19% of the total portfolio owned by the Federal Reserve System today. While we were accumulating long-term bonds we were -4- z-30? at the same time letting our short-term bills run off as they matured, since there continued to be a strong market for these bills with yields almost negligible. This policy was continued until December when all the System's bill holdings had matured. As a result there was no net addition to the three-year average portfolio of the System. To sum up this experience, it is the feeling of the Federal Reserve that it must at all times protect the public interest, and I am sure that it was with this sincere purpose in mind that when the European war engulfed us, the System moved swiftly, confidently and vigorously to cushion the worst effects of this catastrophe, so far as the interests of both investors and borrowers alike were concerned. II Excess reserves of member banks in the Federal Reserve System are now about $6,000,000,000. Because of these huge reserves, it is ob vious that there is no present need for banks to borrow from the System except in random cases. As a matter of fact, these borrowings at the present time are only about $2,000,000 which is an insignificant percent age of the total amount of reserves now existing. However, this oppor tunity of private banks to borrow from the System in case of need is a powerful weapon against any weakening of our credit system. To secure this opportunity was one of the compelling reasons for the establishment of the Federal Reserve System some 25 years ago. of it at present is reassuring. That there is no need But much more reassuring is the thought that, like insurance, it always stands as a bulwark in the background, ready to be used in case of need. - 5- Z-307 III Shortly after the outbreak of the European War, our Board of Governors announced that all Federal Reserve Banks stand ready at the present tine to make advances to member and ncnmember banks on United States Government obligations at par at the discount rates then prevail ing for member banks. Perhaps I should explain at this point that of the 14,500 commercial banks in existence in the United States today, ap proximately 6,/f00 are members of the Federal Reserve System and 8,100 are nonmembers. But, in spite of this division in numbers, it should also be pointed out that the member banks of the System own about 85% of the total commercial banking assets of the country, the reason for this being that the nonmembers are, for the most part, much smaller in size of assets than the members. However, in time of emergency, the Federal Reserve disregarded the question of membership in so far as loaning on Government obligations is concerned. TJhen you realize that the discount rates on paper secured by Government obligations are now the lowest on record, being 1;S in seven Federal Reserve districts and 1-1/2% in the other five districts, and that those Government obligations would be accepted as collateral at par, regardless of their day-to-day market values, you can readily see that this was a confidence-inspiring decision. We doubted very much if many loans would be made on this basis but we stood, ready to fulfill our part of the bargain at any time. Our latest weekly statement shows that we are now lending only about $1,000,000 on this basis. z-307 - 6- IV When the Securities and Exchange Act was passed in 193/+ there were included additional provisions giving Federal Reserve authorities new powers for restricting undue use of credit for speculating in secu rities. The Board of Governors was given power to ease conditions in the stock market or discourage excessive speculation ty adjusting margin re quirements in connection with loans on securities by banks, brokers or dealers. At present, purchasers of stock must put up 4-0a> of its value in cash and, if need be, can borrow the balance of 60$. sellers, the rule is that they must put up 50% As to short in cash or securities equal to this 50% cash value on each short sales transaction. The pres ent margin requirements have been in existence since November 1937 and, so far as I know, there has been no expectation of a change for the pres ent, \mless, of course, a drastic change in the character of stock market transactions takes place. V Let me quickly conclude the favorable side of this whole pic ture by mentioning only some of the ether means available through 'the Federal Reserve System to protect the public interest in times like these. Federal Reserve Banks may buy and sell, at homo or abroad, eli gible bankers' acceptances and bills of exchange. Discount rates charged by the Federal Fieserve Banks on advances they make to banks (which, as I have said before, are now the lowest on record) may be lowered or raised, as conditions require. -7- Z-307 Through their nation-wide organization with offices located in 37 cities, Federal Reserve banks act as depositaries, fiscal agents and custodians for the Government} they facilitate issuance and re tirement of Government obligations and transfer and disbursement of Government funds; they collect information relating to banking and other financial developments; they have, in previous emergencies, ad ministered foreign exchange regulations and are in a position to do so at any time; and they furnish ready means of quickly reaching all bank ing institutions. Federal Reserve banks, subject to the special supervision of the Board of Governors in Washington, have established correspondent relationships with most foreign central banks and are in a position to serve this Government in international financial transactions. VI So far1 we have confined this discussion to a brief account of the Federal Reserve System in its primary field of monetary and credit policy. There is another responsibility of the System that aids greatly in the determination of these policies. It is the effort on the part of the Board of Governors in general and its Division of Research and Sta tistics in particular to assemble and interpret the latest information, not only on banking and credit conditions, but also on production, trade, prices, employment and the like, and to maintain index numbers for many of the various economic activities so that when the time comes for the Board to act, it will do so in the light of the latest and most reliable information available. Z-307 -3- The Board's production index, generally known as the Federal Reserve Board's Index of Industrial Production, is today probably the most familiar and most used single business statistic. Unfortunately, it is often used for purposes for which it is not suited, namely, as a measure of change in general business activity. This is an error that is difficult to overcome in the public mind. The index of industrial production, as its name indicates, ap plies solely to productive activity in manufacturing and mining. More over, a considerable percentage of the figures that go to make up the total index relates to basic commodities, the production of which is subject to wider swings than the output of more finished manufactures, and than activity in trade and many other fields concerned with the providing of goods and services. For this reason the index is useful as an important guide to the course of economic activity but it should not be considered as a precise measure of the level of economic well being at any given time. Few of us realize that in measuring the general level of business activity, we must ascertain the level of national purchasing power as well as that of industrial production. One of the most valu able indices in estimating our purchasing power as a nation is the amount and kind of our national income. By national income we generally the amount of wag' produced or paid out in any on paro these two indices, i.e. ,0Ra R V -9- Z-307“' the amount of national income paid out, we can secure a much more accu rate estimate of the state of business activity than if we confine our attention solely to either one of these two indices. For instance, from August 193? to May 1938, the index of in dustrial production dropped from 117 to 76, a decline of 35%* But in the same period, national income payments dropped from a level of about , , , , $74- 000 000 000 on an annual basis, to about $, , , , 6 5 000 000 000 a drop of only 12?.«, It is obvious, therefore, that those persons who riveted their attention upon the industrial production index alone gained a much more pessimistic view of the state of trade in that period than was justified ty the facts. It was clear that during the 1937-3S' period, production was declining at a rapid rate, but sinco general purchasing power as in dicated by national income was declining at a much slower rate, it was reasonable to assume from both those facts that the sale of commodities was still going on at a moderate paco and that, therefore, the sharp downward trend of factory production did not in any real sense tell the whole story so far as an over-all estimate of economic activities was concerned. In addition to the study of national income and production figures, the Board1s staff is maintaining closer contacts with current business developments by means of information obtained through interviews with industrial loaders and otners informed on current changes. This has been accomplished largely through the Federal Reserve banks whose person nel have first-hand knowledge of industry and trade in their respective -10- Z-307 regions throughout the country and opportunity through their directors, officers, .member banks, and otherwise for close contacts with business. •iahat has been done thus far by way of improving the under standing of current economic developments has been partly experimental, and the task i3 not yet finished. More information is needed so that the Federal Reserve System will be better prepared not only for prob lems similar to those that have occurred in the past but also for the new problems that will undoubtedly confront it in th4o future. So much for the brighter side of the picture. I think you will agree with me that this brief, factual presentation displays the Federal Reserve System as a mighty weapon of strength for the United States in these days of trouble and confusion abroad. VII Let us now look at the other side of the picture. 1 would not be candid with you if I did not state frankly one potential danger with which the System is powerless to cope under the existing Federal Reserve Act. I refer tc the possibility— and it is only a possibility— that, at some time in the future, a harmful speculative or inflationary boom might develop. Please do not misunderstand me. whatsoever of such a booxa. There are no definite signs In fact, with more than 8 million men m e m - ployed, how is it possible to generate a continuous, general and injuri ous price rise without such a rise being nipped in the bud by competitive -11forces? z-307 But we all realize that conditions have a way of changing rap idly in days like theso. With oxcoss reserves at about $6,000,000,000, our volume of bank credit could bo i’ aisod by aa additional $3.5,000,000,000 or $40,000,000,000. The present Federal Reserve monetary powers arc not adequate to cope with such a contingency. But they could be made so if Congress decided that this should be done. Just what form that power should take I would prefer not to state. And, in any event, the problem is one for Congress to solve since the nature of the difficulty indicates that the problem is at this stage primarily a legislative and not an administrative one. However, let me repeat that this potential danger does exist and I feel that not to mention it and not to stress the im portance of finding a solution for it would bo an -obvious attempt at avoidance of what might turn out to bo a very real and a very serious fi'i&ncial situation in the future. In conclusion, may I say that, in surveying the record of the Federal Reserve System during the first eight months of the European war, we can recall to our minds without embarrassment and perhaps with a sympathetic touch of pride the words of the old whaling captain who, when asked how he came through so many long voyages, replied: the wind blows hardest, this vessel sails her best." "When
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