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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* ^ȟregory, 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&lttee 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.