The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
INSTRUMENTS OF FEDERAL RESERVE POLICY * K arl R. Bopp 1931 This might be a d r a ft of M r. B o p p 's P h .D . d i s s e r t a t i o n , which was t i t l e d "F e d e r a l Reserve P o l i c y , 1 9 1 9 - 1 9 3 1 ." The L ib r a r y of the F ederal Reserve Bank of P h il a d e l p h ia does not have a copy of this d i s s e r t a t i o n . B .A . T u r n b u ll, September 1992 I3ST3taSSIT3 OF FSDSBAL R5SEKV5 POLIOT 7ko federal reserve—cffiei-ai'Si faced with a ¿lven situation which tends, say, to inflations decide to do soaething. Shall that something be an increase ia the rates, sales of Government securities, warnings, direct action, or the use at some other instrument? The decision, as represented, by what actually is dona, indicates a judgment as to tha re!atI / efficacy of the various "© in t u J e f s of policy. sr^tsc Of course r one cannot equate warnings with G . 3 $ & in the volume of .securities, or changes in the rats h83% with penalties. #or example, one cannot say that ^ page warning in the Bulletin equals in effect the sale of $50,000,000 of •Governments, equals an increase of ^ > in the rate of rediscount. A s yet, somehow or other, the reserve authorities mist approxi ni mate just thati In short, the banks, subject to review m d do- termination by the Board must establish whether and in vm&t di rection and to That extent the rate of rediscount is to be changed; the open-market coaaalttee with the approval of the- Board must decide in what direction and to what extent the reserve banks5 portfolio of Governments is to be changed, etc. An Important element in each situation is the flexibility of the various instrments of policy* Although there is nothing absolute about these instruments, so a e are subject to a w ider and more precise adjustment than are others. Bor are these factors independent of the c l r c u a s t ancas under which they 'are used* Thus one cannot hope to enforce a firm control over the volume of credit by tinkering with th e tradition against rediscounting. It is true that rata changes (particularly reductions) may be t alien ad ju stm en t on th e b a s i 3 o f th o t r a d i t i o n i s v e ry cru d e . There 13 no method t o d eterm in e th e e x te n t t o which c e n t r a l b a n k e rs may r e l y upon ch an ges in th e e f f e c t i v e n e s s o f t h i s in stru m e n t t o a l t e r th e volume o f c r e d i t . W arnings f a l l in t o much t h e same c a te g o r y * H erein l i e s th e c h ie f o b je c t i o n t o t h e i r u se a s in str u m e n ts o f p o lic y * Some tim e e l a p s e s betw een th e is s u a n c e o f a w arning and th e d e te r m in a tio n o f i t s e ffe c tiv e n e ss. T h is p e r io d may be s u f f i c i e n t l y lo n g t o p erm it "th e v i c i o u s c i r c l e 1 o f i n f l a t i o n t o g e t underw ay. 1 I f a sin g le w arning p r o v e s i n e f f e c t i v e , e x p e r ie n c e s e e a s t o in d ic a t e t h a t an e n t ir e s e r i e s i s l i k e l y t o prove i n e f f e c t i v e a l s o . In a se n se one may 3 ay t h a t much o f th e e f f e c t i v e n e s s o f th e in stru m en t i s ex h au ste d w ith th e s i n g l e u s e ; and th e r e i s no method t o d eterm in e even ro u g h ly how e f f e c t i v e i t w i l l b e . In t h i s r e s p e c t d i r e c t a c t io n i s more l i k e t h e s e in stru m e n ts th an i t i s l i k e th e r a t e and o;:en-m arket o p e r a t io n s . How con one a d ju s t th e amount o f d i r e c t p r e s s u r e which i s e x e r te d upon th e member b a n k s, be e q u it a b le t o a l l , and y e t produce th e d e s i r e d amount o f c u r ta ilm e n t? i t t o be r e l ie v e d ? I f th e p r e s s u r e i s to o e f f e c t i v e , how i s On th e o th e r hand, i f th e f i r s t a p p l i c a t i o n i s not s u f f i c i e n t l y g r e a t , how i s i t t o be in c r e a s e d ? F or t u i 3 p u rp o se th e r a t e h a s c e r t a i n a d v a n ta g e s . e f f e c t i v e n e s s i s n ot e x h a u ste d w ith a s i n g l e u s e . Its I f th e f i r s t change d o e s n ot produoe th e d e s i r e d e f f e c t , i t may be changed a g a in and y e t a g a in - and in e i t h e r d i r e c t i o n . However, i t i s n ot e f f i c i e n t u n der a l l c ir c u m s ta n c e s . In p e r io d s o f r a p id l y f a l l i n g 1. p r i c e s any r a t e a t a l l iB l i k e l y t o be d e t e r r e n t . The lo w e st F is h e r , I . The Theory o f I n t e r e s t , Olis. I I and XIX and ap p en d ix t o Oh. XIX. o central 3:jik rate i i hi jtory did not encourage bor::o-?in.; e'irly in ; 13131. The bank r a t e can be r a i s e d s u f f i c i e n t l y to curb any r i s e in prices not financed exclusively ’ .vithout reserve fund3; but i t may not be p o s s i b l e t o low er i t s u f f i c i e n t l y to check c fall. l 2. F u rth erm o re, ch an ges a r e made o n e - h a lf p e r c e n t, o r m u lt ip le s t h e r e o f a t a tim e . One can d eterm in e o n ly r o u g h ly , i f a t a l l , how much e f f e c t a ji v e n change t r i l l h a v e . a crude in stru m e n t t o be In s h o r t , th e r a t e i s u s e d f o r m a jo r ch anges o n ly ; an d, even th en , i s l i k e l y t o be i n e f f e c t i v e in d e p r e s s io n s . Open-markct o p e r a tio n s b r id g e b o th th e s e g a p s . P ro b ab ly they v-re th e moat s e n s i t i v e end id j u s t a b le o f a l l th e in str u m e n ts. They .ire e f f e c t i v e in p e r ic iis o f p r o s p e r it y and d e p r e s s io n a l i k e . The c h i e f l i m i t a t i o n upon t h e i r u se i s th e volume o f r c c u r i t i c s W T O. h eld a t any ;;iv e n tim e by th e r e s e r v e b a n k s. W ithin t h i s m argin a d ju stm e n ts may be made *7ith a ^re-it d e g re e o f n i c e t y . For t h i s re a so n th e r a t e sh o u ld be u se d f o r th e cru d e r a d ju s tm e n ts, Trhile th e o p e n -a a rk e t p o r t f o l i o i s r e t a in e d f o r th e f i n e r one3. S in c e th e e x te n t t o *7hich th e s e c u r i t i e s may b e u se d t o c u r t a i l c r e d it i s c o n tin g e n t upon th e s i z e o f th e p o r t f o l i o , i t i s ^rise f o r th e r e s e r v e ban ks t o b u ild up t h e i r h o ld in g s o f s e c u r i t i e s in p e r io d s o f d e p r e s s io n . And i t i s p r e c i s e l y a t such a tim e t h a t p u rc h a se s o f s e c u r i t i e s a r e th e b e s t in stru m e n t t o s tim u la t e r e c o v e r y . 2. Of. P is o u , A. C. I n d u s t r i a l f l u c t u a t i o n s . P a rt I I , Ch. i v ; K eynes, J . M. The N atio n and Athenaeum. liay 1 0 , 1 9 3 0 , p . 1 3 3 . 3. Gov. S tro n g s u g g e s te d ( S t a b . K e a r . 1 9 3 7 . o .4 5 0 ) t h a t a t tim e s Governments a re a lm o st u n o b ta in a b le . P ro b ab ly th e y c o u ld bo se c u r e d a t a s u f f i c i e n t l y f a v o r a b le p r i c e . Should th e t o t a l volurae be red u ced g r e a t l y , o th e r s e c u r i t i e s m ight be s u b s t i t u t e d . E s p e c i a l l y im p o rtan t in t h i s c o n n e c tio n i s th e s u g g e s t io n t o pu t b i l l p u r c h a s e s upon a f o o t in g s i m i l a r t o th a t o f Govern m en ts. I f n e c e s s a r y , th e F e d e r a l R e serv e Act co u ld be amended to su p p ly s u f f i c i e n t in v e stm e n ts. 4 As an a id t o m e tic u lo u s a d ju s tm e n t, i t p ro b a b ly -?ould be ^ is e f o r th e r e s e r v e ban k s t o h an d le th e p o r t f o l i o o f p u rc h a se d b i l l s in a fa s h io n s i m i l a r t o t h a t u s e d f o r Governm ents. I f th e open-m arket com m ittee would p u rc h a se d e f i n i t e amounts o f b i l l s in s t e a d o f t a k in g a l l t h a t a r e o f f e r e d a t th e e s t a b l i s h e d r a t e , th e s i t u a t i o n c o u ld be a d ju s t e d more a c c u r a t e l y . C e r t a in t y and a d j u s t a b i l i t y a r e two c r i t e r i a w hich sh o u ld be im portan t in th e s e l e c t i o n o f in stru m e n ts o f p o l i c y . 1* R ate o f R e d isc o u n t. The t r a d i t i o n a l ^ t h a t i s t o say th e o l d e s t ] in stru m en t o f r e s e r v e bank p o l ic y d e sig n e d t o c o n t r o l th e volume o f c r e d i t i s th e c e n t r a l hank r e d is c o u n t r a t e . A lthough t h e fu n ctio n in g- o f a c e n t r a l bank in the open-m arket seem s t o have been u n d e rsto o d by o• R ic a rd o , c e n t r a l b a n k e rs d id not adopt th e in stru m e n t. R ic a rd o a l s o u n d e rsto o d t h a t a low r a t e would o p e r a te in th e d i r e c t i o n o f 6. i n f l a t i o n , and t h a t a h ig h r a t e w o l d te n d tow ard d e f l a t i o n . He d id n o t , how ever, d i s c u m , ohangges in th e r a t e s£flfcil‘i2 :k tia n .- Nor d id M ill d i s c u s s th e m a tt e r , though h i s gen 7. e r a l a n a l y s i s l e a d s one t o b e lie v e t h a t he u n d e rsto o d i t . B eckh art s t a t e s t h a t th e o p e r a tio n o f th e bank r a t e was u n d er8. sto o d by B r i t i s h c e n t r a l b a n k e rs a s e a r l y a s 1 857. 4 . In 1928-1929 th e p u rc h a se d b i l l h o ld in g s o f th e r e s e r v e ban k s were u se d a s a p a r t o f g e n e r a l c r e d i t p o l i c y . C f . B u r g e s s , * n Hevietr o f Economic S t a t i s t i c s . X I I , p p . 1 9 - 2 0 . 5. R ic a rd o , Works (lic C u llo c h Ed i t i o n ) , p p . 5 0 7 -5 1 2 . P la n f o r th e f l s t a b . o f a fla tl» Bank. S * £ r i n . P o l , aeo n . . p . 2 2 0 . 7P r ln . P o l. S c o n . . Book I I I , Chs. X X III and XXIV; a l s o Rc-port a e l e c t Com, on Bnnk Act s . 8 . D iscou n t P o lic y o f F ed. R e s. 3 y s . . Ch. I . c o n ta in s an accou n t o f th o h i s t o r i c a l developm en t. o now adays, hovyever, t h e r e i3 no lo n g e r an e z c lu s iv o r e l ia n c e upon th e r a t e on th e o a r t e i t h e r o f c e n t r a l b a n k e rs o r o f b an k in g 9. stu d e n ts. Of c o u rse th e l o g i c a l c a s e f o r th e r a t e rem ain s un changed. I t ru n s a s f o llo w s : I f p r i c e s a r e te n d in g t o r i s e , an in c r e a s e in th e bank r a t e w i l l d e c r e a s e borrow in g by m aking i t le s s p r o fita b le . money and c r e d it - L e s s borrow in g w i l l mean a red u ced volume o f The d e c r e a s e d demand f o r goods which r e s u l t s w i l l mean a ten d en cy f o r p r i c e s t o f a l l * L ik e w ise th e ten d en cy o f p r i c e s t o f a l l can be c o r r e c t e d by a r e d u c tio n in th e r a t e which 7 / i l l in c r e a s e th e volume o f money and c r e d i t by making b o rr o\?ing p r o f i t a b l e . I t ’?as o b se rv e d , how ever, t h a t in p e r io d s much d is t u r b e d e s p e c i a l l y th o s e o f p r e c i p i t o u s l y f a l l i n g p r i c e s - any r a t e , how ev er low , T as p r o h i b i t i v e . In o th e r w ords, a r e d u c tio n in th e r a t e d id not have th e d e n ir e d e f f e c t . I t 7 a s o b se rv e d f u r t h e r t h a t i f th e member banks were s u p p o r tin g th e c r e d it s t r u c t u r e w ithout r e s e r v e bank fu n d s, th e y would not pay th e r a t e ; and hence th e p e n a lty f e a t u r e would not be e f f e c t i v e . As a con sequen ce th e r e d e v e lo p e d v a r io u s t h e o r i e s d e f in in g an e f f e c t i v e r a t e . T h is con cept h as gone th ro u g h an i n t e r e s t i n g e v o lu tio n S in c e th e o b v io u s p u rp o se o f r a t e ch an ges i s t o e f f e c t ch an ges in th e volume o f c r e d i t , one m ight su p p o se th a t th e d e f i n i t i o n o f th e 'vord e f f e c t i v e would run in term s o f ch an ges in th e volume o f c r e d i t , o r in term s o f d e v e lo p in g a c r e d it s i t u a t i o n which c o u ld be aeen t o b e le a d in g t o a r e d u c tio n o f r e d i s c o u n t s . F o r , though th e re may be no im m ediate r e d u c t io n , th e in c r e a s e in th e r a t e may 9 . R e c e n tly th e American r e s e r v e b a n k e rs have r e l i e d more h e a v ily upon th e r a t e . For some tim e th e h o ld in g s o f Governments have not been changed g r e a t l y . C f. te stim o n y o f A. C. H i l l e r in O per. o f H a t l, and F ed . R e s. Bank. S y s . H e a r. 1 9 3 1 . p . 1 5 0 . G f. K eynes, j . A T r e a t i s e on Money. V o l. 2 . C han ter 3 2 . s e c s , i and i i i . 1\ • J^ LJ condition a l a t e r d e c r e a s e in th e volume o f c u rre n c y . Un f o r t u n a t e ly s e n s ib l e c o n c lu s io n s have been d r a m 'cut seldom in r e s e r v e ban k in g h i s t o r y , and t h i s i s no e x c e p tio n . D uring th e p e r io d un der c o n s id e r a t io n v a r io u s p h a se s o f th e o ry have r i s e n in t o prom inence. The f i r s t id e a i s t h a t a c e n t r a l bank r e d isc o u n t r a t e , in o rd e r t o bo e f f e c t i v e , must be 11. above th e m arket r a t e . The se c o n d , which i s fu n d am e n tally s i m i l a r t o th e f i r s t , a l s o c e n t e r s a t t e n t io n upon th e r e l a t i o n be tween member bank3 and th e r e s e r v e bank3 . A ccordin g t o t h i s id e a a r a t e cannot be e f f e c t i v e u n le s s some banks a c t u a l l y ^ay i t , 12 th a t i s , a re in d ebt a t th e r e s e r v e b an k s. The t h i r d con cept . o f e f f e c t i v e n e s s i s t h a t th e r a t e i3 e f f e c t i v e i f i t f o r c e s m ar13, ket r a t e s tu fo llo w . F i n a l l y , th e con cept ^ h ich i s b a se d upon th e o b je c t i v e s o f r a t e ch an ges makes th e d e f i n i t i o n c o n tin g e n t upon th e r e l a t i o n betw een r a t e ch an ges and ch an ges in th e volume of c r e d it. These v a r io u s co n c e p ts o f e f f e c t i v e n e s s t r i l l be examined in tu r n . The o ld e s t th e o ry o s t e n s i b l y i s borrow ed from B r i t i s h p r a c t i c e and s t a t e s t h a t th e bank r a t e sh o u ld be above th e m arket 14. rate . The im p lic a t io n i s t h a t th e r e s e r v e banks sh o u ld n ot 15. be u se d e x cep t in c a s e s o f em ergency. As a m a tte r o f f a c t , however, th e e a rn in g a s s e t s o f th e r e s e r v e ban k s c o n t in u a lly rim 10. R o b e rtso n , Money, do. 1 7 4 -1 7 5 . 11. Ann. Ren. Foci. R e s'/ B o a rd , 1921 ( V I I I ) u p .3 0 -3 1 ; 1919 (V I) pp. 2 , 6 8 . 1 2 . Fed. R e s. B u l l . . J u l y 1923 ( V I I I ) p . 7 6 9 . 13. Ann. Rep. Fed. R e s. B o a rd . 1933 (X ; p . 1 0 . • Ann. Rer>. F e d . R e s. B oard. 1931 ( V I I I ) pp. 3 0 -3 1 . At tim e s Kawtrey seem s t o ta k e t h i s v ie ?/. C f. h i s Revier/ o f th e Annual R eport f o r 1923 in S co n . J o u r . . (XXXIV) p . 284. The con cep t of m arket r a t e s i t s e l f h as gone th ro u gh an i n t e r e s t i n g e v o lu t io n . C f. th e fo llo w in g : Ann. Rep. F ed . R es. B o a rd . 1 9 3 1 . ( V I I I ) pp. 3 0 -3 1 , Fed. R e s. B u l l . J u l y 1921, ( V II>7 P- 776. S t a b . H ear. 1 927. p . 934 (te stim o n y o f v7. R. B u r g e s s ) . Ann. Ren. J eq. B o ard , 1 9 2 3 . (XV) p . 1 2 . ----- ----1 5. C f. F u m i s s , E. F o r e i■ £xchan-re, p p . 395-39S and K ey n es, J . H?n A http://fraser.stlouisfed.org/ T r e a t i s e on Money, V ol. 2 , Ch. 32, s e c s , i and i i i . Federal Reserve Bank of St. Louis 7 o v er a 'b i l l i o n d o l l a r s . R ed isco u n t 3 :ilone have been no r e than a b i l l i o n d o l l a r s a t tim e s and t y p i c a l l y run o v e r h a l f - a - 'o i l l i o n . To red u ce t h i s t o z e ro w ith out o f f s e t t i n g p u rc h a se s in th e openm arket m>uld in v o lv e stu p en d o u s d e f l a t i o n . 2 . I*. Keynes h as pointed out t h a t in t h i s r e s p e c t th e .American ban k in g system i s 16. d e c id e d ly d i f f e r e n t from i t s B r i t i s h n e ig h b o r . The Bank o f England r a t e h a b i t u a l l y i s kept a t a p e n a lty h e ig h t . S in c e th e War, th e Bank c o n t r o l s th e r e s e r v e r e s o u r c e s o f th e member bonks p r a c t i c a l l y e x c l u s iv e ly by ¡aeans o f open-m arket o p e r a t io n s . In iJngland, w ith i t s b ran ch b an k in g sy ste m , t h i s in stru m en t T orks very v e i l . A ll o f th e c e n t r a l o f f i c e s have d i r e c t a c c e s s t o th e c e n t r a l f p o o l o f r e s e r v e s . ’ Changes in th e Bank o f England p o r t f o l i o o f open -iaarket s e c u r i t i e s r e a c t upon a l l . In Am erica, however, T/ith r a t h e r more th an 2 4 ,0 0 0 com m ercial banks s c a t t e r e d over th e c o u n try , th e p o o l o f r e s e r v e s i s made more a v a i l a b l e to th e member banks by means o f r e d is c o u n t in g . The q u e s tio n r e s o l v e s i t s e l f in to ch o o sin g betw een th e r a t e and open-m arket o p e r a tio n s a s th e b e t t e r o f in stru m en t o f p o l i c y . S fc ile th e l a t t e r i s u n dou btedly raore p r e c i s e f o r a c c u r a te a d ju s tm e n ts, and a p p e a r s t o be more e f f e c t i v e t o s t im u la t e a re c o v e ry from a se v e r e d e p r e s s io n , i t d o e s n ot fo llo w th a t i t i s b e s t in a l l sy stem s f o r m ajor ch an g e s. S in c e th e War B r i t a i n seeras t o have chosen o*oen-aarket o p e r a t io n s . The re c e n t D o lic y o f th e r e s e r v e 17. board seem s t o in d ic a t e a g r e a t e r r e l i a n c e upon th e r a t e . The secon d th e o r y o f e f f e c t i v e n e s s i s a v a r ia n t o f th e p e n a lty r a t e id e a . A ccordin g t o t h i s th e o r y , how ever, a d i f f e r e n t i a l i3 not o f i t s e l f s u f f i c i e n t . Some b an k s must a l s o pay th e p e n a lty , i . e . must borrow from t h e r e s e r v e b a n k s. I®- I b i d . Ibid- H isto r ic a lly , 3 of things this idea is paradoxical. Since the object of the in crease in rates is the discouragement of borrowing, it ’ rould seem a contradiction in terms to call a rate sufficiently high to discourage all borrowing, an •ineffective* rate. Upon more ex tended study of the statements this contradiction dissolves into an unfortunate selection of terms. Statements of this sort are made T7hen rate increases are combined with reserve bank sales of The argument under those circumstances runs as Governmentg. follow: If the member banks are not in debt at the reserve banks, an increase in the rate cannot curtail credit because no . None Trill be forced to pay the penalty. Consequently, if the * T < aaember ban k s in t o th e r e s e r v e ban k s by f jr le s o f Governm ents. Y Once * 7 V m V . * **• ” y * ^ reducing their WA U bvh otcq • a te W w v w W M mmm extensions of credit. V v v » * • V * In essentials, there fore, these t?/o theories - one that member banks should not normally borrow from the reserve banks, and the other that they must so borrow in order to be discouraged - are built upon the sane base, viz., that an effective bank rate is a rate above the market. Although this may be a convenient rule of thumb under certain circumstances, such as exist in 3ritain for example, it should not be 3 et up as a goal applicable under all conditions. In some of the reasoning of the reserve officials there appears 9 t o be a p r o c e s s o f r a t i o n a l i s i n g t h i s r u le o f thumb in t o an end 18. •oer s e . Thus B u r g e s s , b oth in h i s book on th e r e s e r v e sy stem ^ ------19. and in h i s te stim o n y b e fo r e th e House Com m ittee, c o n c lu d e s t h a t a r a t e betw een t h a t on com m ercial p a p e r and t h a t on b a n k e r s1 a c c e p ta n c e s i s a ’ f a i r p r ic e * f o r r e s e r v e money^ He seem s t o s e t up th e r e l a t i o n s h i p betw een th e bank r a t e and m arket r a t e s a s an end o f p o l i c y . The B oard d o e s n o t alw ay s s e t up th e same g o a l a s d o e s B u rg e ss. In th e R ep o rt f o r 1 9 1 9 , a y e a r o f trem endous i n f l a t i o n , th e B oard s u g g e s t e d a p e n a lty bank r a t e t o make b o rrow in g un p r o f i t a b l e and th u s te n d t o check t h e i n f l a t i o n . When th e B oard r e l i e s upon th e r a t e and s u g g e s t s t h e p e n a lty f e a t u r e a s i d e a l under norm al c ir c u m s ta n c e s , i t p o s i t s a p e r s i s t e n t ten d en cy tow ard i n f l a t i o n on th e p a r t o f th e econom ic sy stem * For i f th e r e i s a ten d en cy tow ard d e f l a t i o n - a s th e r e i s from tim e t o tim e — borrow in g sh o u ld be en cou raged by m aking i t p r o f i t a b l e ; th e r a t e sh o u ld be below th e m a rk e t. I f one assu m es t h a t th e r a t e i s an im p o rtan t f a c t o r in c o n t r o l l i n g t h e volume o f c r e d i t , th e bank r a t e , in g e n e r a l , sh o u ld b@ f i x e d a t w hatever p o in t i© n e c e s s a r y t o s e c u r e th e d e s i r e d r e s u l t . A lthough t h e r e l a t i o n t o m arket r a t e s m ight prove a co n v en ien t r u l e o f thumb i n de te rm in in g th e p r o b a b le r e s u l t s o f c h a n g e s, th e m arket r a t e s t r u c t u r e sh o u ld not be made a s h ib b o le t h . The B oard r e c o g n iz e d no such m e ch an ical fo rm u la a s th e p ro p e r g u id e f o r p o l i c y . 20 th e r e a p p e a r s t o be no c o n s is t e n t p o l ic y a t a l l . . ir Indeed, R e se rv e Banks and t h e Money M ark et, p p . 1 9 1 -1 9 5 . § £ § £ • H ear. 1 9 3 7 . p p . 9 8 5 -9 6 7 * Two c i t a t i o n s from Annual R e p o r ts o f th e F e d e r a l R e se rv e l o a r d may be g iv e n t o i n d i c a t e t h e l a c k o f c o n s is t e n c y . In th e S ix t h R eport ( 1 9 1 9 ,p . 2) a p p e a r s a sta te m e n t o f t h e e a r l i e r c o n c e p t. ftfh e r e d is c o u n t s o f th e F e d e r a l r e s e r v e b a n k s, t h e r e f o r e , in s t e a d o f b e in g h ig h e r th a n th e m arket 10 fh e a n a l y s i s o f th e p e n a lty r a t e i s not com plete w ith out m ention o f a n o th e r f a c t o r - S in c e th e "bank r a t e must be above th e m ark e t, any downward movement o f th e bank r a t e must aw ait e a r l i e r ch an ges in th e m arket r a t e s * Such a change must w ait u n t i l th e m arket r a t e s d e c l in e s u f f i c i e n t l y t o keep th e bank r a t e h ig h e r even a f t e r th e ch ange* fo llo w * In o th e r w ords, th e bank r a t e must I t i s not view ed a s an im m ed iately c a u s a l f a c t o r ; though, o f c o u r s e , i t i s c o n sid e re d a c o n d it io n in g f a c t o r i n d i r e c t l y * A t h i r d con cept o f e f f e c t i v e n e s s m eets t h i s d i f f i c u l t y * I t i s n ot b a se d upon th e r a t e s t r u c t u r e a t any p a r t i c u l a r moment o f tim e * On th e c o n tr a r y , i t c e n t e r s a t t e n t i o n upon t h e r a t e a s an a c t iv e f a c t o r in t h e s i t u a t i o n . A bank r a t e i s e f f e c t i v e 31. p ro v id e d ch an ges in i t a r e fo llo w e d by ch an ges in m arket r a t e s * T h is th e o ry o f e f f e c t i v e n e s s h a s run th e whole gamut fro® d e n ia l t o e x p l i c i t sta te m e n t a s a f a c t * In Ju n e 1 9 3 0 , t h e F e d e r a l R e serv e Board p r e s e n te d a r e v e r s e se q u e n c e . At t h a t tim e i t -sras s t a t e d th a t t h e in c r e a s e in th e bank r a t e r e f l e c t e d , t h a t 23* i s fo llo w e d , m arket r a t e s * T h is i s in k e e p in g w ith th e C ontin*— r a t e s , as in th e o ry a n d n o rm a l p r a c t i c e th e y sh o u ld have b e e n , were made low er th a n t h e m arket r a t e s * f h i s circum s t a n c e i s enough t o p re v e n t th e norm al fu n c t io n in g o f a F e d e r a l r e s e r v e b an k , whose r a t e s sh o u ld be s o f i x e d t h a t r e s o r t t h e r e t o i s u n p r o f i t a b l e t o t h e b o rrow in g i n s t i t u t i o n and th u s h a s a ten d en cy t o ch eck i n f l a t i o n . * I t a l i c s t h o s e o f th e p r e s e n t w r i t e r . In th e c l a s s i c Tenth Beisort (1 9 2 3 , p . 9) a p p e a r s th e l a t e r id e a . "The o u tlo o k f o r F e d e r a l’" r e s e r v e c r e d it r e g u la t i o n would in d eed be u n p ro m isin g , in view o f th e g r e a t d i s p a r i t y o f custom er r a t e s a t member banks in d i f f e r ent s e c t i o n s o f th e c o u n try , i f t h e r e s e r v e ban ks h ad no o th e r means th an d isc o u n t r a t e s by which t o r e g u la t e th e volume o f t h e i r c r e d it u s e d , and i f t h i s d is c o u n t r a t e c o u ld e x e r t no e f f e c t i v e in flu e n c e u n le s s i t were a p e n a lty r a t e * « Of. R eport f o r 1 9 2 5 . p p . 1 5 -1 8 . 21* C f. G rego ry , T . I . F e d e r a l R e se rv e Banking? Sy stem , p . 4 3 . and K eyn es, J . M. T r e a t i s e on Money. V o l. I , p p . 2 0 0 -2 0 1 . * 3 . O f. F e d . R e s. B u l l . , Ju n e 1920 ( ¥ l ) , p . 5 5 8 ; and J u n e - J u l y , 1 3 2 4 ~ ) p p . 457 and §31 ai analysis o f B u rg e ss t h a t p rim ary c o n s id e r a t io n i s g iv e n t o money rates in th e d e te r m in a tio n o f the bank r a t e * A » fa ir * ra te l i e s somewhere betw een th e open-m arket r a t e f o r com m ercial p a o e r and 33. th e r a t e f o r b a n k e rs* a c c e p ta n c e s . Of c o u r s e , su ch a r a t e 34 • s t r u c t u r e s a y be j u s t i f i e d l o g i c a l l y S in c e th e s p r e a d betw een 25. th e s e r a t e s d o e s n ot a s a r u l e ru n a s much a s 1 p e r c e n t . , baxfc r a t e ch an ges g e n e r a l ly a r e l i m i t e d t o i p e r c e n t- However, i t i s anom alous, t o s a y th e l e a s t , t h a t t h e c o n t r o l elem ent s h o u ld fo llo w o th e r f a c t o r s in th e m a rk e t. In d ee d , i t i s a t a c i t ad m issio n t h a t th e main c o n t r o ls l i e e lse w h e re . Another f e a t u r e o f t h i s problem c o n n e c ts i t w ith two o th e r in stru m e n ts o f p o l i c y : open-m arket o p e r a t io n s and th e t r a d i t i o n a g a in s t r e d is c o u n t in g . A s a l e o f s e c u r i t i e s l e a d s , in th e f i r s t in s t a n c e , t o in c r e a s e d r e d is c o u n t in g . I f th e t r a d i t i o n h o ld s , t h e r e f o r e , t h e s a l e w i l l r e s u l t in e f f o r t s on th e p a r t o f member banks t o g e t fu n d s w ith which t o re p a y t h e i r in d e b te d n e ss t o th e 26. r e s e r v e b a n k s. T h is scram b le f o r fu n d s w i l l f o r c e up t h e r a t e s . A ccording t o th e th e o r y p r e s e n te d ab o v e, t h e s e h ig h e r r a t e s w i l l be th e s i g n a l t o th e r e s e r v e ban ks t o in c r e a s e th e bank r a t e . Although o th e r f a c t o r s e n te r in t o t h e r a t e s , t h i s s t i l l p l a c e s th e p rim ary r e s p o n s i b i l i t y upon t h e r e s e r v e sy ste m . A ll t h a t h a s happened i s t h a t more o f th e burden o f r e s p o n s i b i l i t y h a s been p la c e d upon o p en ~ aark et o p e r a t io n s and l e s s upon th e r a t e I t s e l f . At tim e s s u f f i c i e n t a t t e n t io n h a s been fo c u s s e d upon t h e m arket r a t e s t o e x o n e ra te th e bank r a t e e n t i r e l y . T h is i s t r u e , R e serv e Banks and th e Money M arket « p p . 1 9 1 -1 9 5 . ÎM É - and Stab. H ear. . 19 3 ? . p p . 9 6 4 -9 6 7 . ¿ 5 . There a re e x c e p tio n s a s in th e l a s t h a l f o f 1924 and l a t e in b o th 1928 and 1 9 2 9 . * o . Of. H i e f l e r , IT. W., Money R a te s and Money M a rk e ts» 5Ch. 2 . 12 of course, particularly in periods of severe depression. 27. trations may be dra^m from the 1920-1921 depression. After that, however, there was another change. Illus- In the Tenth Annual Report (1933) the Board states that the bank rate is an 38. important and at times dominating element in the situation. This report has been called the matured opinion of the Board. claims It effectiveness for the rate if such effectiveness is by changes in the market rates resulting from changes in 29. the bank rate. This idea of responsiveness of market rates to measured changes in the bank rate is similar to the others given in that all center attention upon the rat3a themselves. However, not the rates but control over the volume of credit is the t>rime objective 30. of banking policy. It is true that an increase in rates will tend to decrease the amount of credit demanded. the first instance by cutting off marginal loans. It will do so in More remotely the change in policy will change the expectancy of borrowers. The prospects of profits are less roseate when the reserve system indicates that it intends to curtail credit than otherwise. If a change in the bank rate is followed by changes in the market rates, it is termed effective because it thus discourages borrowing. Therefore, it would appear that a more useful definition of effectiveness is that which relates rate changes to changes in the volume of credit. This focusses attention upon the heart of the matter - the objective of rate changes - and states that an effective rate is one which accomplishes the object sought. Ifed. Hes7 77&-77S 28. The Bull.% Ja n u a r y i9 3 1 r,(~VI I) p. " 6 T arid J u l y "1 9 2 1 . pp. ..... '1'n " Ann. R t . Fed. Res. Board. 1923 (X) p. 10. e) Ibid. 30. As was indicated in Fed. Rea. Ball.. July 1920 (?I), pp.685-666. 13 concert is useful especially in period'? much disturbed, when all rates nove in the sane direction but too slowly to correct the tendency- Thus, often in periods of rapidly rising prices the ■bank rate is increased and market rates increase, but the volume of borrowing continues to be augmented and prices continue to rise. Likewise, frequently in periods of falling prices, hesitant re ductions in the bank rate do not check the continuous reduction in the volume of borrowings. Such period©, which come from time to t s e (1920 and 1930), indicate a further usefulness of this ia method of attack. Other methods center attention upon the control over inflation; this is equally useful for periods of deflation. An effective rate should not only be high enough to discourage borrowing in periods of rising prices; it should also be low enough to encourage borrowing in periods of felling prices. J o can the rate be abstracted from other instruments of f? policy. Thus if the credit structure is being carried largely without rediscounting at the reserve banks, an increase in the rate cannot appreciably reduce the volume of this borrowing from the reserve banks and consequently cannot decrease the volume of commercial credit. Gold imports under such circumstances would lead to inflation. The rate alone would not be an effective instrument of control. Under such circumstances the rate can be made effective through a reduction of the reserve banks* holdings of open-aarket securities.- either by a sale of Governments or by a reduction in the holdings of Mile bought. This reduction will absorb funds from the market and thereby impair the reserve balances of the member banks. The efforts of the member banks to restore these 14 b a la n c e s th ro u gh b o r r o s in ^ from th e r e s e r v e banks '.T ill be p o s s i b l e only upon payment o f th e h ig h e r r a t e . In o th e r ^ o r d s , even under th e assum ed c o n d it io n s , th e com aeroir.il banks do not su p p o rt th e market in d e p e n d e n tly o f th e r e s e r v e b a n k s. ways con es from fceserve bank c r e d i t . A l a r g e su p p o rt a l I f t h i s r e s e r v e bank c r e d it i s l a r g e l y in th e form o f r e d i s c o u n t s , th e r a t e can c o n tr o l i t e ffe c tiv e ly . I f , on th e o th e r hand, i t i s l a r g e l y in th e form o f b i l l s bought o r h o ld in g s o f Government s e c u r i t i e s , d e c r e a s e s in th e s e h o ld in g s - s i l l c a u se a s h i f t t o d is c o u n t s and th e re b y ¡sake th e r a t e e f f e c t i v e . One may r e l y upon th e s e l f - i n t e r e s t o f b an k ers t o red u ce u n p r o f i t a b l e b o rro w in g s. At th e o th e r extrem e o f th e c y c l e , how ever, s e l f - i n t e r e s t may p o in t tow ard th e f o l l y o f borrow ing a t any r a t e srhich th e r e s e r v e biinks a re l i k e l y t o e s t a b l i s h . I f p r i c e s a r e f a l l in*? a s r a p id ly a s th e y d id in 1920-1921 and a g a in in 1 9 3 0-1931, a nominal r a t e o f a v e ry sm a ll p e r c e n t, w i l l be a r e a l r a t e o f a 31. mucn h ig h e r f i g u r e . C o n se q u en tly , in c r e a s e d open-raarket h o ld in g s by th e r e s e r v e bank3 may be u se d t o su p p ly a d d it i o n a l funds in o r d e r t o s t im u la t e r e v i v a l . A lthough member banks may n ot borrow a t th e r e s e r v e ban ks t o in c r e a s e t h e i r b a la n c e s , n e it h e r w i l l th e y lo n g r e t a i n s u r p lu s reserv es. C o n se q u en tly , p u rc h a se s o f s e c u r i t i e s by t h e r e s e r v e banks which in c r e a s e t h e s e b a la n c e s * r i l l l e a d t o c o m p e titio n amongst th e member ban k s t o lo a n s u r p lu s r e s e r v e s . I f th e b u s in e s s community d o e s not borrow more fu n d s , th e com m ercial banks r i l l in c r e a s e t h e i r h o ld in g s o f s e c u r i t i e s o f v a r io u s t y p e s . These p u rc h a se s by th e com m ercial banks Tidll in c r e a s e th e d e p o s its 31 • Fisher' ~iTvingr~fFe‘~!^1e'^f n5^ere'9t~ ~ 15 Increases in the volume of deposits 11117 be 0£ their oujtoiuers. force^ 1 upon the couniunif y in thia fashionc In fact, this sequence of events probably is ucre efficacious than rat3 de creases, to stimulate s revival out of severe depression. . As is indicated later, open-aiarket operations may also be used far small or temporary operations. Cpen-isarket operations and the rate, therefore, are co ordinate and supplementary instruments of policy. There is no similar conjunction between the rate and the tradition against rediscounting. They not only fail as supplementary instruments; to a cert¿ i extent they are antagonistic. ¿n An interesting paradox arises out of the statements of the reserve authorities concerning the relation of the member banks to the reserve banks on the one hind and the theory of rats changes on the other. Tine and again it is stated that the i e i e i&br ban^s should not resort to the reserve bank3 except in cases of eiaer^ency. They should net resort to the reserve banks for the purpose of profiting by a rediscount rate which is lower than the rate which the member bank charges its customers for the funds secured. In other '^ords, resort should be had to the reserve banks in periods of stress regardless of the rate; and corre spondingly, reserve facilities should not be used at other times no l c t e how favorable the rates. ii^r In developing this concept that the purpose of reserve funds is to neet emergencies only, the reserve banks have fostered what has been termed the tra32. aition against rediscounting. Pressure is brought to bear upon banks ’ -Thich borrow too heavily or too continuously from the 'o ¿ “* » 3' i ' . ) , • ui i 3 . a 3. P?-183-184. The rjaaarve 3ta& a and th e Money liarket, ' ------ IS reserve bank. In other words, every effort is made to keep member banks out of debt at the reserve banks. If that is the object, one might wonder why not legislate member banka* borrowings from the reserve banks out of existence? If the tradition against borrowing were fully developed, of course, the same result would be obtained without legislation* this is not done because it pre cludes the possibility of caring for an emergency. How, there is nothing absolute about such an emergency. In fact, Mr. A. C. Miller implies that there is a continuous emergency to the extent S3. of one billion dollars. Be also favors the operation of the 34. reserve banks solely as institutions of rediscounting. taken together, this may mean that the tradition is not to be effective against the first billion dollars« This fact is mentioned here only to indicate that the member banks as a whole are expected always to be ntn 4 the reserve banks« 1 But a more serious charge may be levied against the tradi tion against rediscounting. If member banks are to resort to the reserve banks in cases of emergency only, and then without regard for profit, the rate should not be a necessary element of policy. An increase in the rate would not discourage borrowing because there would under no circumstances be any but emergency borrowing and that would take place regardless of the rate* More serious, however, would be the fact that a decrease in the rate could not be effective. It might make borrowing more profit able, it is true, but if resort to the reserve banks is not based upon profit, a reduced rate would not encourage borrowing. 33. See h is testim ony in Qper. o f th e H ail, and Fed. R es. Bank. MY3 »Hear.1931. pp. 138-139. The statement would seem to imply ' that the member banks should be expected to borrow fl billion bill8 re§erve banksS holdings of Governments and purchased 34* p . iso. Of course, the reserve officials do consider the rate an integral and essential instrument of policy. Perhaps the T ay to ? lo o k a t the matter is t o consider a reduction in the rate as an announcement t o the business community that the tradition against rediscounting is t o be »suspended» for the time. Contrariwise, an increase in the rate is t o be taken as an announcement of the »reenactment* of the tradition* Heading such a meaning into the term certainly stretches the concept* What is important is that this hiatus between the theory of rate changes and the tradition against rediscounting be recognised. 2. Onen-market Operations. At least three not entirely dissociated points of view are possible in surveying the 1 Reserve Bank Credit Outstanding1 account of the Federal reserve banks* One point of view eapha» sizes the competition of the account. The total at any time equals the sum of the separate items; vis*, »Bills discounted*, "Bills bought*f »United States Securities®, «Other securities% »Foreign loans on gold*, * s e from foreign banks®, and «Reserve Di bank float*. Here we have an automatic balance* The whole equals the sum of its parts* .Another view emphasises changes in the money market cor relative with the changes in «Reserve Bank Credit Outstanding.. * The elements axe as follows; 1* Increase in monetary gold stock. 3« Decrease in money in circulation. 3. Increase in Treasury currency. 4. Decrease in unexpended capital items. 5. Decrease in member balances at Reserve banks. 6 * Decrease in non-member balances at Reserve banks. 18 f excess in the total of these items will be absorbed by equal t ny in the item 0 Reserve Bank Credit Outstanding*. Con decreases versely, any deficit will be counterbalanced by increases in »Reserve Bank Credit Outstanding*» ¿gain we have a balance auto matically* 35 * these two views may be combined* the combination would show the sources of change in the demand for and the supply of reserve bank credit as well as the particular forms which the changes took. It might show, for example, that additional currency requirements or gold exports were supplied with reserve bank purchases of securities rather than through rediscounting. the third view is that changes in the volume of Reserve Bank Credit Outstanding are an index of Federal reserve policy, this view emphasises not how the balance is struck; but - fax more important as a matter of policy - at what amount the elements balance* the emphasis is upon changes as evidences of policy not as matters of correct accounting and arithmetic* these three views will be examined in turn. At times it is stated that the open-market arm of Federal reserve policy is not effective because a sale of securities results merely in an immediate increase of rediscounts, the absorption of funds by the reserve banks through £he sale of securities impairs the reserve balances of the member bank (or banks) which purchases them or whose customers purchase them. to offset this debit item to its balance the member bank may either increase its reserve by rediscounting at the reserve bank ° ° * See K i e f l e r , W ¥ . ' Money ~Bat~es and Money M ark ets in t h e » B a i t e d S t a t e s , t a b l e s p p . 133y 139, 141, 143, 151, 169, 196, and Appendix I I . 19 or ^ jaay reduce its loans and other investments. In other words, the percentage may be restored by increasing the reserve, by decreasing the liability against which the reserve ia held, or by both. Immediately, banks do the former. This is indi cated clearly by the curves showing Government securities held by the reserve banks and rediscounts at the reserve banks. When the first changes, the latter changes almost invariably by an amount roughly the same. In longer perspective, however, especial ly when the sales of securities by the reserve banks are accompanied 3S. by rate increases, the banks decrease loans and investments* It must also be remembered that although the banks may borrow from the reserve banks for short periods to meet an emergency, the reserve bankers exert pressure upon banks- which borrow con37. tinuously. Bankers may be called in and advised that surplus funds could better be used to repay the Federal reserve banks than to increase loans. The immediate effect of a sale of securities, then, just as the isEaediate effect of a gold shipment, may not be an apprec iable curtailment of reserve bank credit; but the tendency in the 38. long run will be in that direction. This tendency can be supplemented by a simultaneous increase in the rate. A purchase of securities operates ia the opposite direction. The additional funds may be used to repay loans at the reserve 36. The banks may trench upon the readily convertible assets first, but the efforts to restore what the banker considers desirable proportions amongst his assets will exert pressure upon customers1 loans and long term investments. 37. More will be said about this tradition against rediscounting in a later section. ¿o* Of. Burgess, W. r. 9 The Reserve Banks and the Money Market, pp. 210-211 and 314-315. Also see Keynes, J . M., A Treatise on Money» f0i# xi, pp. 353-354. 20 banks, or may be used to increase the loan and investment account of the bank. fully discussed. It is this last alternative which is not Yet, from the viewpoint of policy it is of tremendous importance. It appears to be the only way out of the dilemma of a serious business depression. This dilemma of low rates which fail to attract borrowers appeared insoluble. If loans could be increased at such a time, they would mean larger bank balances for the public, larger purchasing power in 39 their hands, and larger purchases resulting in stimulated trade. But it is said, persons simply will not borrow* If, in such a p e r io d , the reserve banks increase very greatly their holdings of securities and bills bought; and the cornereial banks, unable to loan the additional funds, in turn purchase investments, the result will be larger bank balances for the public just m there had bean an increase of loans to the public. if The differ* ence is that the business man, instead of borrowing, sells his investments to the bank. In other words, bank balances - and for present purposes they are of crucial significance - can be increased at a time when any rate at all seems to be deterrent. Changes in the reserve banks1 holdings of bills bought operates in this connection precisely as does a change in the portfolio of Governments. Although this connection has been stated recently, it is something new in reserve bank thinking. The earlier comparisons emphasised the differences between bills bought and Governments. On the contrary, when bills bought were compared with bills discounted, chief attention was paid -Similarit lea. Thus for both purchased and discounted bills One of the characteristics of such a period is an increased demand for currency and bank balances (ile. a lower velocity of circulation). For trade to be stiiaulated, the increase in credit must be more than sufficient to offset this increased demand (the lower velocity). 21 the reserve bank and the Board determine the rate, and the member banks take the initiative in offering the bills to the reserve 40. bank. Furthermore, reversals in the differential between the buying rate and the discount rate led member banks to shift from 41. one to the other in order to secure reserve bank credit. This fact - that member banks are guided primarily by rate differ*entials - is a weighty argument for those who claim that the tradition against rediscounting is not especially effective. Viewed as instruments of policy, bills bought appear to have the essential characteristics of Government securities. Indeed, in 1939 the volume of bills bought was allowed to decrease greatly in order to tighten rates* In other words it was implied that a differential rate unfavorable to purchased bills acts approximately as does a sale of governments. Viewed as instru ments of long-run policy, the newer position places bills bought in essentially the seme category with Governments. Previously, changes in the holdings of purchased bills had been used largely to adjust reserve bank credit to seasonal needs. Usually the low for the year is reached in July or August and the high in December. Intervening months represent gradual approaches to these peaks and troughs. The determinat ion of the proper relation between the reserve banks and the open-market, especially the bill market, kas occupied considerable attention. With regard to open-market purchases the American Bankers1 Association Convention expressed the desire for an investigation into the wisdom of such competition SjpT..Fed'..Res. Board, 1925 TxillT m * 7-67 Of.Fed.Res. m i l .. to, 1925. (XI). p. 52?. 41. Burgess, W. R., In Rev. of Scon. Statistics. XII, p. 17. * ....... < ™ n* iiwi i n. mwvmomm» . n iih m * ■■ ■ » — » » » »' * w * -*> m m m m » 23 m by the reserve banks with their member banks for business- It is not difficult to understand the argument of these bankers that the reserve banks should not enter the open market. fa c e of things they can make out a presentable case. On the In a period o f depression when, to use the bankers* phrase, there is a ple thora of ftmds, the reserve banks typically buy in the open market. They thus add to the supply of available funds when they are large and subtract from investment opportunities when they axe small. In periods of rising prosperity and rates, on the contrary, when there appear to be scanty funds and abundant investment opportunities, the reserve banks add to the latter and subtract from the former. It might appear, therefore, that the reserve banks merely aggravate the evil. Such a policy, however, through its application of additional pressure in periods of increase tends to check the increase - tends to break »the vicious circle of inflation. 1 Likewise the decrease of pressure in periods of decline tends to retard the decline - tends to break the ‘vicious circle of deflation. 1 In other words, such a policy tends to stabilise* Open market purchases also have been made in easy periods with a view to the position in which they will put the reserve banks in the long run. they have been made to equip the reserve banks with an additional weapon for later use. They are part of 43. xne effort to make the rate effective. Such operations are designed to make closer the relation between the reserve banks sad the market. 1^34 Convention in Chicago. Report in the Oommercial and ginancial Chronicle, A. B. A. Convention Section, p. 14. See also testimony of Gov. Strong, Btab. Hear. 1937» p. 317. See section 1 of this paper. 33 If an inflation is being financed largely without resort to rediscounting, say, on the basis of gold imports, a change in the rate would not be effective to curb it. In order to decrease the volume of credit it is necessary to force the member banks into the reservo banks. To do this in a period of large gold imports, however, requires relatively large holdings by the reserve banks of open-market securities. available for sale latfcr. They must be owned in order to be Consequently, they must be bought sometime. These purchases, however, must be carefully supervised. Their effects are inflationary and may bring on the very inflation which their sales are ^signed to control. Recently this fear seems to have become an obsession with the Federal reserve authorities. The ills of the system have been traced to open- market operations. AA •ne• at The recent handling of the account by the reserve banks certainly has differed from that followed earlier. Sarly in 1931, when the portfolio might well have been increased to stimulate revival, not only was it not increased sufficiently to offset decreased rediscounting, but the volume of both Govern ments aad purchased bills was reduced. Apparently every effort was made to use open-market operations to check the volume of bank credit - perhaps on the assumption that the recovery should be ’healthful* and finance itself in spite of a decreasing open45. market portfolio. The second type of analysis of leserve bank credit outstanding 44* By A. c. Miller in his testim'onv on Qper. of'the Hatl. and Ae. Res. Bank Sys., Hear. 1931, p. 150. Such seems to be the position of Mr. A* 0. Miller in Qpe.r. 21 th e Hat I » and F ed . R e s. Bank. S y s , H ear. , 1931, p. 158* Of. Testimony of W. w* Stewart in Stab. Hear. 1937, esp. p. 770. 34 j x secant years has been most common in Board literature. j It consists of a factual statement of changes in the various factors of demand for and supply of reserve bank credit. Since it is composed almost exclusively of factual material, one might wonder why it is offered in addition to the usual tables which give the details much more succinctly* Generally, it may be stated, the purpose of this analysis is to create the impression that central bank policy is a matter of aere arithmetic* involving no judgment. At other times there is an assertion of control over the amount of credit immediately supplied* At still other times there is a further claim for responsibility for the amount immediately demanded. At no time is there a systematic state ment of the longer-run responsibility over demand and supply. Stated otherwise, the analysis has varied from time to time. Unfortunately there is not an orderly evolutionary trend in the development of these ideas* However, acme generality may be claimed for a »cyclical1 interpretation* depression the factual analysis is given. Usually in periods of And with good reason! If the inevitable sweej» of events is fatally responsible for the depression, no mere board - even though it be the central bank ~ can be held accountable* This claim is said to be verified when a decrease in rates, however small, does not lead to an immediate increase in the volume of credit* In a parenthesis it might be mentioned that if the tradition against rediscounting is effective, the decrease in rates cannot be expected to have such an effect* An opinion which gaifes ascendency generally in periods of advance in business is that which attributes to the reserve banks 80216 &®gree of control over the amount of reserve bank credit 0Uppli2d* *n connection it is stated at such tines that the usual practice of compensating far the net change in demand and supply by aa increase or decrease ia the volume of reserve back credit has been modified* At such times gold imports, de creases ia the volume of currency in circulation, etc. are not permitted to have their usual inflationary effects* Instead se curities are told by the reserve banka to mbeorb the incoming funds and thus make them unavailable for expansion. On the other hand, gold exports, increases in the volume of currency* etc. are not offset by security purchases. In other words, not all tendencies toward changes in member bank reserve balance# are. permitted to have their customary effects. When the Board decides upon a deflationary policy, it permits the deflationary influences to have their usual effect*; tot it offsets or, at times, more than offsets inflat ion&ry tendencies, the so-called sterilisation of such of the post-war gold import© has. been an- 43. operation in this category* Attempts to counteract a deflationary tendency lead to the opposite policy of purchasing seeuritiee to offset gold «xgaxtn and increases in the voltme of ourrmoy in circulation. Hold Imports and decreases in the volume of currency are permitted to have their usual inflationary effects* It should be mentioned that although this ©eoond view of reserve bank credit does shoulder the reserve eystasi with some ^responsibility, it still m s w m that the general conditions determining desand are unalterable data* there is no indication it that the Board considers reserve bank policy itself ae one of the conditioning factors* It goes without saying that the Btargese," w. Ju'V 'The Beserve^ Banks 'and the llonay ' M a r k e t * Ch. 1 1 7 . ---------------------------------- *-------------*"----------- * 28 system may over - or undercompensate particular factors. It kas in fact moved in a direction complementary to the action of some factors instead of compensating their effects. Yet the analysis presented by the Board runs in nicely articulated quan titative terms of compensating action. Although these analyses of non responsibility satisfy tolerably well in periods of little disturbance, they are an in adequate basis for a claim of authority when the Board feels the necessity for positive action. In 1928 and 1929, for example, when the Board m s interested in tightening rates to curb specu lation, reliance upon the theory of compensations was not suf ficient. The Board claimed responsibility for some control over the amount of credit demanded* Bate changes are conditioned upon this fact. But though this is a change in the mount demanded, the Board hesitated to state that it is a change in the whole demand schedule. As a matter of fact, the issuance of warnings, the exertion of direct pressure, etc. have a direct effect upon the mount of credit demanded for all uses. This presents system literature upon the matter of reserve bank credit. With infrequent exceptions, It will be noticed, changes are described largely by showing the extent to which gold movement8 , currency requirements, etc. have influenced the composition of the reserve banks1 earning assets. Apparently the Board attempts to leave thé impression that they have little control and that theirs is merely a book-keeping task. always show that the net restait is a balance* They What they do not show - but what is obviously sore important - is that, within limits, they have the power to control the fiture at i*hich the balance is struck. Bor is this control merely immediate. For 27 reserve policy i3 a most important element in the factors *hich 7 condition the demand for credit* The more fundamental analysis, then, would seem to be that which considers these changes as evidences of changes in Federal reserve policy. Here the emphasis is not only upon the distinc tion between bills bought and bills discounted (in which trans actions the member banks take the 'initiative1) on the one hand, as contrasted with holdings of Government securities (in which the reserve banks take the 'initiative1) on the other, nor is it merely the nice adjustment of factors in the money market; rather the eiaphasi3 is placed upon the shift in type of holding and thé change in total as evidences of policy* To what extent have rates, open-ijaarket operations, direct action, etc. con tributed to make the items That they are? and to what extent 7 would a change in those policies lead to a change in the items? In other words, the question here is not only how do the items balance? but the far more important one, at what amount do they 47. balance? Through changes in the open-market portfolio and the rate the reserve system may influence the conditions under which it supplies credit to the market* over the supply of credit. The Board admits such control Occasionally there is some admission of control over the supply of credit in the long run. Thus, when the Board looked to the declining reserve ratio in 1920, it admitted a responsibility for control over the supply* % a t the Board does not admit explicitly is that it exer cises an important influence over the demand for credit. Usually ^Y* ^»üregory, T. s , The Practical Vforking of the Federal Banking System of the United States, Lecture IT, pp. 58-59. the analysis presented assumes the current demand for credit as a fixed datum which has groim out of the past and is not, therefore, s u b je c t to control by the system. According to this view the demand merely records the results of a past business situation. But, as Professor Commons has stated, futurity is an important element in any situation. the basis of prospective profits. Business men borrow on Anything which affects these projects affect© the demand fox credit* Indeed, the assumption which lies behind the use of such instruments as direct act ion, warnings, etc. is that the demand for credit can be influenced by the reserve policy* And this affect is not solely on the amount of credit demanded at a given rate nor does it apply only to undesirable uses; it also affects the whole d m and schedule* The Board apparently tries to create the impression that it has no such responsibility for the demand schedule. In doing so it ignores Federal reserve policy as one of the important ele ments in any given business situation. A change in policy means a change in the prospects of business* In short, the demand for credit in the longer run as well as immediately is conditioned by Federal reserve policy. 3. Direct Action. Tamings, and Publicity. An instrument of policy which was being used at the close °f the ^ r and which was resorted to again in 1929 is so-called direct action or pressure. The object to be attained by the use direct pressure has varied* At times it is used as a part of 48. general credit policy. The object in such cases is to Restrict the total volume of credit outstanding by appealing to *°* 55S. Res. Bull.. Feb. and June, 1920 (VlL pp. llS-117. Also fox Feb. 1929, (XV), pp. 93-94. the non-profit motives of the bankers. At times, to be sure, an appeal is mala to the long run self-interest of the banker. In that event statement a are made indicating that an excessive volume of borrowing will undermine the credit structure and eventually will imperil the banks. Usually, however, the appeal requests the bankers not to take advantage of a favorable re-* discount rats at the reserve bank* Direct pressure, in such cases, is substituted for increases in the rate. The reason for choosing direct pressure in preference to the rate most general ly lies in m effort to control not iserely the volume of funds but their uses as well. this change in instruments follows from the correct assumption that a rate increase will oenalise 49. •legitimate* business as well as 1 undesirable1 uses of credit. Thus in the most illuminating case of the use of this in strument - that in 1929' - the effort was made to control the use of funds for security speculation. In this case the lew York Bank refused to cooperate with the Board in applying direct 50. pressure. Both wished to control the stock market; but the Bank preferred to rely upon the rate* Members of the Board were opposed to rate increases because they thought such increases would not be effective in arresting the speculation bat would 51. penalise legitimate business. the Hew Tork bankers, however, preferred the impersonal rate and open-market operations to the aore personal instruments. The objections of Governor Harrison . 53. to direct action were: first, that the Brokers* Loans of the In other words, it is a recognition of the” act that the ? rate is not the instrument to be used in controlling the uses of funds. The history of this contest was told by Chas. S. Hamlin in ^¿er. of the latl. and Fed. Hes. Bank. S t s . Hear.. 1931, pp.163 51 13* * ^stimony of â.O.Miller, especially pt>. 140-146. I b i d ., pp. 5 5 . 5 7 . 30 Yor.c banks lai not boen increasing; and second, Vnat direct i pressure is an ineffective instrument. The chief obstacle to effectiveness in the use of thiB instrument is the distribution of loans. As Governor Harrison stated, when pressure is applied. to any particular banks, it may lead merely to a shifting of the loans from them to other banks. If chief reliance irere placed upon the tradition against rediscounting for long periods, the borrowing could be shifted from bank to bank every few days. borrow In this manner no bank would/continuously, but the volume of borrowing for the system Tould remain large. In other words, there ^ould be a persistent tendency for rediscounting to be done by member banks rrhose call locns were small. Those members with large volumes of call loans T?ould not rediscount. The use cf rationing in connection -^ith thi3 problem is discussed in section 4 of this paper. Direct pressure also is used as an instrument of so-called 53. banking policy. If £ny particular bank is too heavily or too continuously in debt at the reserve bank, the officers o£ the aember bank may be called in for a conference with some of the officials of the reserve bank. The member bank will be advised 54. to reduce its borrowings* Member banks should not use their rediscounting privilege as a substitute for capital. The reserve banks should not make loans to member banks if such loans are likely to lead to eventual loss to the depositors of the member bank. Such banking policy has been handled ini ependently of 55. general credit policy. For ttLe distinction between credit policy andbanking t>olicy 54. ®ee Jsm* Heo. Fed. Rea. Board, 1931 (YIII), p. 6 8 8 , Topic 10. gg* belo^r, that in-so-far as credit conditions generally are ex— tended, more individual bsnks may be borrowing to excess. oJL Hot only have the objects to " e attained by the use of b direct pressure been various, but the precise forra miich the instrument has f alien as well as the agency 'Thich has initiated t the move has varied from tixae to time. Because they are analogous in many ’ »rayo, warnings also may be considered in this connection. Upon occasions the form has been the publication of statements by the Federal Reserve Board which point cut that reserve bank credit is not to be applied to certain uses, such as loans on securl55. ties. At other times the reserve banks issue the statements. Soinetiia.es the statements issued by the banks are at the instiga tion of the Board; at .times the banks assurae the initiative. Tot again, the bant has refused to cooperate rith the Board in the 57. matter. The typical zaethod of applying direct pressure centers attention upon the individual siesber banks. Although this method usually is U3 ed as a part of banking policy, at times it has been 58 considered an element of general credit control. In general, if, in the opinion of the reserve bank, a menber bank is borrow ing too much or too continuously, an investigation will be ¿aade. Apparently, if the particular circumstances in the bank’s community justify the borrowing, the reserve bank will make ao special effort to effect a reduction. But if there is no local situation tthich justifies to the reserve bank the loans to the 59. member bank, pressure will be exerted to bring about a reduction. Although the function of inspection and control over indi vidual banks is sn inport ant one, a conflict is apt. to arise between 58* See Report of the Joint Commission of Agricultural inquiry. Ill, 3, p. 41; also Burgess, W.R., in Rev, of Scon, statistics» c*7 > P * 15* ' As in the conflict between the Board and the U ^ r York Batok in 1929 • es £2££-of 5atl. and Fed.Res. Bank. Sys. Hear, 1931, p. 1?0. igiii-» P* 67. Cf. Stab. He?jr. 1927, p.~4§6; Fed. Res. Bull. F<S>. 1-20, p. 1 1 3 ; I 3 yiisc, J.Ii., A Treatise on Koney. II, p. 340. v 33 60. it and general credit policy. Thus if a large number of par ticular cases are found which require the extension of credit to particular areas for local emergencies, the reaction upon the banking system as a whole is inflationary* Unless the reserve system takes steps to curtail credit generally to counteract such a tendency* banking policy - which, after all, should be secondary ~ assumes a primary role over credit policy* Question may be raised with respect to the effectiveness of these instruments* Warnings and similar efforts asust act upon individual bankers. They are appeals to non-profit motives. Consequently, their effect upon bankers is in proportion to the timidity or public spirit of the individual bankers* But banks which are heavy borrowers already have violated the tradition, against rediscounting and are not likely to be affected greatly by •human1 appeals# It is possible that some of these borrowers may be bankers who were too timid to refuse loans to customers in the first instance- In that event they are not likeljroto remain bankers very long. Large city bankers, on the other hand, 61. are apt to be able to present a good case for almost any policy. They are generally better paid than reserve bankers and are not all apt to take advice favorably. In any event the result of a contest between reserve bankers and commercial bankers is likely to turn upon personalities rather than upon sound banking prac tice* if all reserve bankers were Benjamin Strongs, the case for direct action would be more favorable* Unfortunately* it is not 80* Probably an important ele&eat in the effectiveness of an instrument based upon non-profit incentives is Its effect upon 33 the bankers1 outlook. Thus, direct pressure indicates the current drift of reserve bank policy* If it is not heeded, it may be fallowed by the application of instruments with *ttethr. A failure to follow the import of a conference with the reserve bankers may lead to rationing. So, perhaps, part of the effective ness is due to the assumption by member banks that the instruments will be reinforced, if necessary, by other and penalty instru ments* this fact should be kept in mind when one attempts to analyze the wide difference of opinion concerning the effective ness of warnings. At the one extreme is C. S. Bamlin of the B oard, who claims tremendous power for it. He places it at 62. times above the rate in curtailing credit. Mr. Treman, Director of the Sew Tork Bank, stated at a meeting of the Board in 1920, that although warnings would hot be effective, direct action in the form of conferences with the commercial bankers would effect 63. a restriction of credit. Mr. Bailey of the Kansas City Bank and most of the Hew fork reserve men place reliance upon the 64. rate and would abandon warnings entirely. Another weapon, which has been suggested by Professor Commons, is publicity. Be states that individuals attempt to anticipate future changes. If no official statements are forth coming concerning the probable course of reserve policy In the the future, statements of those close to authority (a membex of *ne Board, the President) will be gleaned for clues. 65 * fhis, according to Professor Commons, is a crude method likely to lead error and unnecessary fluctuations. Consequently, he suggests . Oper.of the ffatl. and Fed. Res* Bank. Sys. Hear. 1931, pp* 168-175. 0f * Fed. Re s."Bull., June 1920, 581; and Ann. 63 §££• I M * Res. Board, 1920 (Til), p* 11. 6 4 * S H * d°Q* 310» 67th Congress, 4th Session, p. 15. 65* Passim and especially p.31. Also see references m d e r note 1 * i?£ab- Hear., 1937, pp. 1092-1094. 34 that official statements be made from time to time to indicate the possible (likely) action of the system under given circum86stances* Anticipation of the action may result in the desired movement and thus make unnecessary the action itself* In that event it merely hastens the result without requiring the use of the instrument. Thus, if prices are rising and the Board states that it ‘may take this fact into account in considering possible rate changes1, the business community may anticipate & rise in the rate and prospective falling prices and hence may hesitate ff fi Qwt• to buy# The effect will be analogous to that resulting from an actual increase in the rate and may make the increase un necessary# Should the reaction be different, however, or l e a d to additional borrowing, the higher rate can always be p u t in t o 88* effect. 4* Rationing. An effective method of restric&ng the volume of credit is to refuse to grant It* The eligibility rules of the Federal Be serve Board set up a limit to the possible volume of redis counting* Only paper falling within the categories as defined 69« by the Board Is eligible for rediscount* The several reserve banks decide whether any particular piece of paper which Is pre sented falls into an eligible category# The general basis of thèse rules is that the original transaction which gives rise to *be paper determines its eligibility* At times for particular banks, these rules may limit the volume of rediscounting* The §2 * -ibid* T pp* 63—65 * . Çf* the discussion of £• Caiman on Monetary Reform in Scon, a* XXXI?, p. 157* g®. ur. Gregory, T. 3 # in reprint on Fed* Res* Bank* Sys*, p# 43. 2 ¿federal Reserve Act * Sec* 3 1 0* largest amount of reserve bank credit which a member bank could possibly receive is the discounted value of all its eligible p ap er. Hence any rule which places say particular piece of paper into an ineligible category Is, in a sense, a possible rationing of credit* For the system as a whole, however, these regulations are not important from the point of view of restricting the volume of rediscounts* fhe volume of eligible paper is always much larger than that actually discounted at the reserve banks* Rationing means that the rat© is alike for all classes of paper but some requests for credit are granted, and other requests 70. are not granted. It proceeds upto the questionable assumption that the Board is a better judge of legitimacy than is the cri terion of ability to pay* much tact and knowledge. The use of the instrument requires Suoh omniscience is not possessed either by central bankers or others. Rationing may be used as a part of general credit policy ~ which limits the volume of all or a particular class of credit or as a part of banking policy - which deals with the extension of credit to a particular bank* As an instrument of banking policy, the use of the instrument is unexceptional* Reserve bank credit should be available to enable particular banks to tide over emergencies; it should not be available to enable them to postpone bankruptcy. Rat ioning credit in order to protect de positors of member banks by aiding the solvency of banks is a legitim ate function* fhe usual method which is employed is based upon the distinction between eligible and acceptable paper. A particular 7 0 . Sen, Doc. 3 1 0 , 67th Gongrese. 4th Session, p. 1 9 . 36 piece of paper is eligible for rediscount provided that the re serve bank decides that it satisfies all the rules and regula tions of the Board concerning eligibility, re s e rv e nevertheless, the bank may refuse to rediscount it because it is not ac~ VX * cept&ble. In other words, in addition to meeting the Board* s requirements of eligibility, paper must also be acceptable to the loan committee of the reserve bank. In this fashion the reserve bank can further restrict the extent to which a member bank may use reserve credit by narrowing the rules of accepta bility. The widely varying character of particular pieces of paper makes it possible for the loan coas<tee to restrict narrowly the volume of credit granted to any particular bank. Rationing also has been used as a part of general credit policy to control the uses of credit* At times this has aroused the opposition of interested parties. For example, the attempt o f the Atlanta Bank to refuse loans on automobile paper was a failure because interested parties exerted sufficient pressure 72. to have the instrument dropped. The classic instance of the u se of the instrument was that in 1929 to curb stock speculation. Ueabers of the Board stated that the stock-market per se is no 73. concern of the system. Even If one grants that it is a concern, however, there is still the question of the efficacy of rationing t o control the uses of funds. The failure of direct pressure in accomplishing this result has been discussed in section 3 of this Paper and provides the basis for the present discussion. 74. in the hearings on the matter, some questioners of ^laensreiBer, 2. A., Federal Reserve System in Operation. ---------------- --------- 1------72 £§* 147~148. 73! a and financial Chronicle. May 23, 1920, 0*3142. 74. -^-2* fe-S- 1938. p. 396; Stab. Heax~1937. p. 661. ‘ , ■SeSI* °£ Hatl. and Fed. Hes. Bank. St b . Hear. 1931. pp.31-106. 3? governor Harrison stated that control could be exercised by re fusing to grant reserve credit to member banks which were using funds for undesirable purposes. Unfortunately for this position, „kat constitutes a legitimate need is a matter of opinion. If general agreement would besecured on this matter, it sight seem that the Board could regulate by means of its rules on eligibility o f paper for rediscount* which credit is put* But this does not regulate the uses to Eligible paper arises out of past trans actions; credit secured from the reserve banks on the basis of this paper will be used by the member banks in any way they see fit* For example, a bank say purchase an eligible acceptance* This past use of credit may be legitimate and unexceptional in every way* But it does not follow at all that the bank will use the proceeds of the rediscounted bill for legitimate purposes* Indeed, in actual practice the Matter is more complicated still* Bankers do not follow out separate transactions as was done above* Instead, the volume of rediscounting is contingent upon the net result of all the operations of the bank* In addition, to a certain extent legitimacy is a function o f amount* thus, some brokers1 loans are necessary for the e f f i c i e n t functioning of the securities market- It is only when th e volume becomes excessive (and there is no accepted measure of t h i s point) that they become illegitimate uses of credit. Further s t i l l f the volume of legitimate brokers1 loans (and other forms of c r e d it which become Illegitimate when used to excess)Is not a d ir e c t function of the capital and surplus of the member bank* ^t ia contingent upon other factors, such as the location of tkfi bank* 38 Rationing, therefore, must needs be based upon the whole bank statement. It might appear a simple matter to refuse credit to banks which are expanding their brokers1 loans. However, that would not have been effective against the Hew York banks in 1939; because those banks were not expanding such loans at the time, another alternative is to refuse to grant credit to banks which have too large a volume of such loans* This alternative would involve the computation and establishment of basic ratios between the undesirable loans and total loans for member banks. As is indicated above, the ratio might not be the same for all banks. So member bank which had a higher ratio than its predetermined base would be granted reserve credit. It might prove necessary to change the basic percentages from time to time. But credit i s fluid; it has an uncanny knack for avoiding pressure. The possible result of this proposal would be a ihift of undesirable loans from those banks which are heavily stocked to others. As a consequence, all banks may be eligible for reserve credit even though the total volume of undesirable crédit has not been reduced# T h is would necessitate a reduction in the ratio. However, one oaa hardly expect an accurate manipulai ion of such a ratio by a group of men who have handled other instruments as poorly as have th e reserve officials. This almost omniscient system which Is required to use rationing as an instruisent of credit policy is aot with us. Governor Harrison presents a more extreme case to illustrât# *hat would happen. The result, he states, would be merely a shift °f brokers* loans from those banks which are borrowing at the 39 ratio T/ouId not be effective under those circumstances. One may •¡¿so say generally that i - e the sources of undesirable credit shn aje other than the reaerve banks, - as was true of the 'for other* loans on the stock market in 1928-1929 - rationing cannot be an effective method Gf control and the reserve banks sight ,,« 11 not use it. In the discussions of the earlier sections of this paper it was demonstrated that credit could not be directed into desirable uses and out of undesirable uses by means of the rate or openmarket operations. It not? becomes evident that rationing alsb i s ineffective to control the uses of credit. Credit is very fluid, and pressure applied in one sphere is rapidly transferred to all spheres. This is true of the pressure is in the form of direct action or rationing as i?ell as if it is in the form of rate increases or open-market operations. in terms of responsibility. One may express the matter If the Board decides to apply pressure in order to force liquidation of credit in particular lines, it Bast take into account - and accept responsibility for - the added pressure upon all uses. Since the pressure operates through i t s effect upon the uhole credit structure, if the Board decides to liquidate it may very well use the conventional instruments the rate and opeiwaarket operations-. They serve to drive home the inter-relations of credit uses and force the Board to Bhoulder responsibility. 5 . The Tradition Against Rediscounting« An instrument of Federal Reserve policy which has received a great deal of attention is the tradition against rediscounting. B^sgess states, Hodyy there exists generally a feeling against 40 7S. large and continuous borrowing frost a federal reserve ban!:.* ge attributes the development of this tradition to a transference 0f an inheritance from the past to the reserve system. R. garrod, on the other hand, attributes the origin to * *an initial distrust of the new system and the desire of member banks not to 77 * become indebted to it.» they agree upon assigning the origin to the pre-war period. After the entry of the United States into the war, however, the volume of rediscounts increased very rapidly* From $180 millions in Se|$tember 1917, it increased to #2,780 millions in October 1930. After October the volume decreased very rapidly till July, 1922. Seme member banks borrowed in excess of three times their basic line for several years after the conclusion of the ^ar. The Annual Report of the Board for 1922 states that some of the member banks had been borrowing heavily and con78. tinuously. Since the middle of 1932 the volusie of rediscount ing has been over a billion dollars at times and frequently over half-a-billion. Ofcder such circumstances to speak of an effective 79. tradition is anomalous. Member banks have not always availed theaselves of the opportunity to reduce borrowings instead of expanding loans. soaetimes when extending loans is more profitable than repayment, 80 the banks adopt the former course. . In other words, bankers **11 violate the tradition, as W. S. Gilbert would say, only if they are insulted with a sufficiently large tribe Jhe Keserye Banks aad the Money Markets d. 182. that is when ’ 78: |22|* lournal, XXX?IT,~p7 3557^ an* * 5r section ene of this paper. ler* } Money Rates and Money Markets in the United p. 161* Miller testimony in Stab. Hear. 1927, p. 665. 41 borrowing is sufficiently profitable. ^ ticism against the tradition. Thors in lias tho most telling It is not sufficiently effective to curb a persistent demand for credit in periods of rising prices. If rediscounting is sufficiently profitable, banks will indulge in it regardless of the tardition. To rely upon this instrument in preference to rate increases permits the 1 vicious circle of inflation* to develop«. Then successive rate increases and sales of Governments are necessary to curb inflation. It would appear more sensible to rely upon thea in the first instance. In periods of depression, on the othe£ hand, when public interest would be served better if the tradition were violated, it becomes too effective - largely because rediscounting is un profitable in such periods. reverse. The Instrument seess to operate in 81. It has been stated at times that reliance upon open- market operations, rather than rate changes is an Indication that the tradition against rediscounting is considered effective* Open-aarket operations represent, according to this view, merely a shift from one type of reserve bank credit to another. Conse quently, it is argued, if reliance is placed upon that mere shift to reduce the volume of reserve bank credit, the cause must be the dislike of the member banks for the new type of credit * * rediscounts. It should be noted, however, that all appreciable changes in the reserve banks1 holdings of Government s have been followed or accompanied by rate changes. In other words, the reserve banks do not consider the tradition sufficiently effect ive to reduce the volume of credit. ^ W'' .cit.Y g j T 5 y Riefler».f, ' , . 6v« 4;3* Certain special problems have been encountered in the use of tradition* ^ e s e is the concentration of borrowings in a 82* few member banka. If the reserve banks rely upon the tradition enforced 0ne by each member bank upon itself, unscrupulous bankers may take advantage of the situation. Rationing or other banking policy might better be considered separate instruments rather than ancillary to a tradition. A far more serious practical difficulty is that it is possible for banks to follow the letter of the tradition (if one may so sueak of it) without hbiding by its purpose. Certain types of ^ 83. short time borrowing are of this character. fo illustrates If Bank Af after being indebted to the reserve bank for several days, calls loans to repay the reserve bank and thus forces Bank B to rediscount; and Bank 3, in turn, calls loans after the lapse of a few more days, only to force Bank 0 into the reserve bank| no single bank will have violated the tradition against continuous borrowing; nevertheless* the total volume of redis counting may be continuously large* if the action is not deliberate* the same consequences follow The tradition against redis counting simply does not meet the problem at all* This subtlety In evading the pressure of the instrument Illustrates once more the fluidity and adaptability of credit* The tradition would seem to be effective against bankers in Proport ion to their temerity and unscrupulousness. Without the use of direct action and rationing it would appear ineffective 84* against the boldly unscrupulous. It appears further that the ® ~ ^ ^ S ~ S i r i ;id7-R S 7 ^ M d r T 9 l2 r ^ 7 ^ *^ t a 5 7 -H e i? r il2 7 l 5^ 84 pp. 973^973.------ -------- ----d?S t 08timonr of Prof.Sprague, Stab.Hear. 1928. p. 150. «iefior, W* w. t Hottev Rates and Money Markets in the TJ. ., p.34. 8 43 tradition lias a reverse effectivenass. «nien It is most needed to check an expansion, the profitableness of violating it takes u5per band; when every effort is being made to increase the volume of credit, it enters as hindrance. The most telling argument egaias'fc the tradition is a rate decrease designed to stimulate rediscounting. Such an effort is a direct appeal to the profit motive of the commercial bankers. If the tradition against re discounting prevents increased borrowing, a reduction in the rate cannot be effective in stimulating it. The tradition, therefore, mip-ht *i©lX be abandoned in favor of more dependence upon the rate 85. and open-sarket operations* Summary Although no quantitative relationship between the various instruments of Federal reserve policy can be found, it is evident that seme are more efficacious than, others, likewise their effi cacy is conditioned by the development which they are designed to control and by the use of supplementary instruments. Open- market operations appear to be most widely efficienty and adjustible. First, they are effective alike in period© of rising and falling prices. When any rate at all is likely to be deterrent, hank balances can be ‘forced1 upon the cojaxaunity through openmarket purchases. If the resulting reserve balances of the commercial banks do not lead to an extension of loans and de posits, increased security purchases by the commercial banks ^ill increase the latter. In periods of rising prices, open- aarket sales tend to reduce the reserve balances of member banks s^d thus tend to check the expansion. Further, the amount of Pressure exerted by open-market operations may be adjusted with a 6 *eat degree of nicety since the only limit on the volume of such 44 operations is the volume of securities and purchased bill a held ty the re nerve "banka at any given time. The rate likewise is subject to ^ide variations. It can be raised to any height necessary to restrict credit expansion arisi^S ou* rediscounting. It is not always able to stop in flations arising out of imports of gold and other sources of re serves outside the reserve banks theaselve3 . The changes also are more crude than those in open-raarket operations because they are Bade $ or multiples at a tirae. The most serious limitation, however, is the inability of the rate to check a severe deflat ion. If prices are falling very rapidly, any rate at all is likely to be deterrent. The tradition against rediscounting obviously can be used only to retard an advance and not at all to retard a declinc. Further, it appears that the tradition really operates in reverse. When the volume of credit should be expanded, the tradition be comes effective and discourages borrowing from the reserve banks* But 7/hen borrowing is profitable, the tradition does not seera to be effective enough to discourage borrowing. If such a tradition means anything, it is not subject to manipulation at the behest of the central bank for the purpose of ironing out the business cycle. Rationing is effective to curb a rise but is obviously in effective to retard a decline. In addition the use of rationing proceeds upon the questionable assumption that the reserve officials are a better judge of credit demands than is ability to pay. direct action, v/arnings, and publicity also are crude ^struments whose effectiveness cannot be predicted. It appears 45 farther, that if one use is ineffective in any given case, a irhole 3 erie^ (£•&• warnings) is likely to prove ineffective rlso. rely upon them is precarious central bunking policy. are useful at all only to halt a rise. ?o In general However, referee r a m i e s such as statements that ample credit ie available, etc. wfy fL stimulating because they imply an easy policy on the part o f the central hank. Taken in conjunction, open-market operations and the rate are complementary and are effective in both directions with the possible exception of a -rise built solely upon funds whose origin is outside the reserve banks* Even then the increase in ‘external1 funds must bo sufficient to replace all the earning assets of the reserve banks. The tradition and the rate are contradictory (especially in depressions) because whereas the latter appeals to the profit motive of the bankers, the former vould eliminate that motive. Other instruments are effective only to halt a rise and even there their effectiveness cannot be predicted. they may be Of comrse, supported* by one or more of the •penalty* instruments.