Full text of The Work of the Federal Reserve Board

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Reprinted for private circulation from
Vol. XXIX, No. i, January 1921

T h e J o u r n a l o f P olitical E conomy

THE WORK OF THE FED E R A L R ESER V E BOARD
It is quite generally agreed at the present time that the Federal
Reserve Board is striving earnestly to bring to a close the era of
currency and credit expansion. In the opinion of some it is
endeavoring to secure some small measure of deflation. But
whatever measures have been adopted to realize these ends have
called forth the utmost of protest on the part of many powerful
agricultural and business organizations. The last month1 has
witnessed many a conference between the members of the Board
and representatives of certain business interests in the endeavor
of the latter to secure concessions in the way of easier and more
abundant bank credit. Will the pressure of these groups become
too strong to be resisted ? It is obvious that a sufficient answer
to this query will involve two lines of investigation. In the first
place, as a proper background for an understanding of its present
credit attitude, the;re must be a study of the Board’s past deeds
and expressions of opinion and the industrial circumstances under
which these were formulated. In the second place, there must
be a consideration of future difficulties in the endeavor to learn
whether a fitting solution is possible to its most urgent problems
of credit and banking. It is the endeavor of the writer to furnish
a mite of aid in the making of such an investigation.
In many circles it has been felt that in the past the Board has
been much more influenced by the requirements of the entrepreneur
than by the interests of the general body of consumers. But so
far as the opinions of the Board have been expressed in the Federal
Reserve Bulletin there seems no doubt that in the months following
the signing of the armistice a considerable drop in the price level
was sincerely desired. The lot of the recipient of a fixed income
seems to have been fully recogfiized. As typical of many pro­
nouncements on this matter we read the following in the Bulletin
of March, 1919:
The era of inflated prices maintained by aid of legislation or by govern­
ment administrative action thus draws to a dose, and the aim to be sought is
1 This article was prepared in October, 1920.




57

HAROLD L. R EED
not that of perpetuating war conditions but that of returning to a stable
footing upon terms and conditions that would be just and fair to all concerned.
There is much agreement with the Secretary of the Treasury in his statement
that the readjustment must begin with a reduction in the cost of living to the
consumer, sorely tried as the latter has been by the great inflation of prices and
the additions made to his living costs in many directions. 1

Largely as a result, however, of an observation of price move­
ments in past periods of post-war finance it was felt generally
that such a reduction in prices was inevitable. It seems at least
to have been believed by the Board that no definite policy of credit
control was required in order to effect such a change. If, then,
such a decline was bound to occur the credit problem became one
of lessening, so far as possible, the duration of the period in which
industry must be disturbed by the fall in prices. A shortening of
this period would minimize the difficulties of reconstruction,
while at the same time good results would be accomplished for the
general consumer. Accordingly, in the early months of 1919
account was frequently taken of the efforts initiated by certain
governmental agencies to effect as speedily as possible the transi­
tion to the “ rock-bottom” level of prices.
In the first few months of 1919 pronounced price breaks were
experienced in various lines of industry and some justification was
afforded the belief that the familiar cycle was being repeated.
There seems no doubt, however, that these price drops were much
fewer and of lesser extent than generally anticipated. Undoubtedly
a very large majority of observers were amazed at the rapidity
with which industry absorbed the labor returning from the field
and camp and war industry factory. In the writer’s opinion there
has not been one-tenth as much discussion over the reconstruc­
tion problem as most economists expected. In the May, 1919,
Bulletin attention was called to the fact that the recessions were
not proceeding with the anticipated rapidity. Prices of certain
commodities previously held down by price-fixing activities of
governmental agencies began to move upward; others main­
tained themselves because of the influence of world conditions.
Accordingly the Board seemed to assume a more resigned and
* Federal Reserve Bulletin, March, 1919, p. 191.




TH E WORK OF TH E F E D E R A L R E S E R V E BOARD

passive attitude.
the following:

59

Thus in the Bulletin of the same issue we find

What is now happening seems to indicate that business will, after a period
of initial readjustment in prices, proceed upon a level not far removed from
that established during the war, leaving the question as to the ultimate level
of prices to the future and to more slowly acting forces.1

Following this statement there occurs an account of the diffi­
culties any considerable reduction in prices might create in inter­
national trade. Foreign countries with rising money prices could
not hope to find extensive markets in the land of lower production
costs. And the ability of foreign countries to buy from us must
depend finally upon their ability to sell to us.
As thus interpreted, the events of the early part of 1919 seemed
to bring to a close that part of the reconstruction period in which
industry was compelled to adjust itself to a lower level of prices.
By the month of May industrial activity burst forth in renewed
volume and a firm trend toward higher prices was noted. There­
after the Board's policy must be directed toward the problems
resulting from a rise rather than from a decline in prices.
In anticipation of such difficulties the Board early called
attention to what it deemed an abuse of the rediscounting privileges.
The occasion was the inclusion in the New York clearing-house’s
weekly statement, in the account bills payable, acceptances and
other liabilities, of an item which covered rediscounts at Federal
Reserve banks. In the opinion of the Board this seemed to point
toward member banks* regarding the rediscount privilege as a
normal and customary operation. The Board was quick to point
out that this was not its conception. Thus:
Already some well-managed member banks are showing in their statements
the extent to which they are in debt to Federal Reserve banks. It has been
the opinion of the Board that the borrowing of member banks at Federal
Reserve banks might very easily be carried to excess, the loans being placed
there primarily for the purpose of profit and not for any more general public or
fundamental object. In a general letter to banks issued on November (1918)
and referred to in the Federal Reserve Bulletin for December the Board took
occasion to caution member banks which it was thought were in some danger
1I b i d May, 1919, p. 4 11.




HAROLD L. R EED

6o

of overdoing their rediscounting, that the purpose of such rediscount opera­
tions was not primarily that of assisting the member institutions which placed
the rediscount to obtain the funds for further profitable operations but was
rather to be determined upon the basis of general banking advantage or upon
that of relief for banks which found themselves hard pressed or were suffering
from reductions in reserve account.1

If, then, the Board saw clearly by the spring of 1919 that
future difficulties were to be those occasioned by an increase
rather than by a decline in commodity prices, why did it not move
at once to place a check upon further credit expansion ? It is now
common knowledge that far from limiting the volume of redis­
counts it permitted advances to member banks to proceed to
dizzy heights. Not until November, 1919, was there any con­
siderable increase in rediscount rates: the average monthly reserve
ratio fell in this period from 50.4 per cent in July, 1919 to 46.6
per cent in November;2 total gross deposits increased from
$2,436,757,000, on June 27, to $2,807,688,000, on November 7;3
Federal Reserve notes rose in the same period from $2,499,180,000
to $2,806,759,000;4 and in the pages of the Bulletin we read the
following regarding the growth of earning assets:
The advance in the total of earning assets from about the beginning of
March, a date roughly corresponding to the opening of the great growth in
industrial speculative operations throughout the country, to the beginning of
November, at the time of the first application of the higher rate policy, amount­
ed to the difference between $2,348,000,000 on March 7, and $2,923,000,000
on November 7, or about $575,000,000 in round numbers.5

This was fabulously rapid expansion; why was it permitted?
On the basis of present knowledge the following may be offered by
way of explanation: first, the Board felt constrained to modify
its rediscount operations in the interests of the requirements of
the federal treasury and of the holders of war bonds; second, it
adopted no consistent price theory which compelled it to place the
responsibility for rising prices on its own liberal rediscount policy;
third, it was somewhat doubtful as to what would be the effects of
1 Federal Reserve Bulletin, April, 1919, p. 311.
3 Ibid., July, 1920, p. 663.
a Ibid., p. 664.
« Ibid., p. 665*




* Ibid.

TH E WORK OF TH E FE D E R A L R E S E R V E BOARD

61

higher rediscount rates upon the loaning power of member banks.
Let us first of all turn our attention to the matter of governmental
finance.
Difficulties in regard to war paper may be classified under two
heads: first, those which had to do with the long-time or funded
debt; second, those which had to do with the current operations of
the Treasury. It will be recalled that the Victory Loan was
floated in the spring of 1919, and at that time the portfolios of
banks were overflowing with the notes of the buyers of these bonds.
The war bond issues were made successful only by means of the
“ buy and borrow” plea. If member banks could not rediscount
paper collateraled by war bonds the banks could not carry the
buyers of these bonds. In order that the bond buyers might be
carried on a low interest charge it was necessary that rediscount
rates be made low also. Having ignored the market in the period
of bond issues the money market must be made to conform to the
rates borne by the bonds. This necessitated continued inflation.
Higher rates of rediscount might have been, and as a matter of
fact were, exacted on non-war-paper security. But this only
meant that in the great bulk of their applications member banks
picked out the war paper for their collateral. In June, 1919,
discounts secured by government war obligations totaled
$6,036,000,000. Otherwise secured rediscounts totaled only
$292,000,000/ The portfolios of member banks were full of war
paper. The rates borne by the war bonds controlled the situation
unless it should be decided to ignore the rights of those who had
subscribed largely through motives of patriotism.
It may be remarked here that further analysis would have
demonstrated that in no possible manner could the interests of
the bond holder have been fully protected. Only on terms of
inflation could the money value of the bonds be upheld. But
inflation meant the decline in the purchasing power of the dollars
yielded as interest or as the proceeds of the sale of the principal.
Undoubtedly, however, the wisest policy from the standpoint of
avoiding popular discontent was to think first of the money prices
of these securities. Accordingly the Board felt itself obliged for the
1 Ibid., August, 1920, p. 867*




HAROLD L. R EED

62

time being to confine its efforts to imploring the public to do its
part in eliminating war-loan paper from the portfolios of the banks.1
Although the difficulties experienced in accommodating the
Treasury in its current borrowing operations were much the same,
it seems to the writer undeniable that a mistake was made in con­
tinuing to ignore the market. Undoubtedly continued inflation
created evils which far offset any advantage to the public in the
reduction of interest charges on the short-time debt. But this
opinion did not prevail in the minds of the members of the Board.
Thus in the Federal Reserve Bulletin for March, 1920:
In such circumstances it was of course unavoidable that discount rates
should be largely controlled by rates established primarily with a view to
public borrowing.3

And in the words of Secretary Houston: “ it was consequently
impossible for the Federal Reserve Board to exert any effective
control over rates.” 3
It was thus assumed, so far as the public was aware, virtually
without debate, that federal reserve policy must be subordinated to
the needs of the Treasury. The writer is not at all certain that
this is the proper conception of the function of the reserve system.
But space is lacking for an adequate discussion of this matter.
The peak of the war debt was not reached until August 3 1,19 19 ;
nevertheless much progress had been made in the elimination of
war paper from the banks. Accordingly in November the first of
a series of rate increases was established by the Board. A t the
present time these difficulties have been so greatly reduced that
the hands of the Board are no longer so firmly tied because of the
Treasury’s requirements. On July 25, 1920, the following figures
were presented by the Secretary of the Treasury: between June 30,
1919, and June 30, 1920, the floating debt was reduced from
$3,267,875,500 to $2,485,552,500 and the total gross debt from
$25,484,506,160 to $24,299,321,467. And the absorption by the
public of the war paper proceeded much faster than the reduction
in the total of the debt.
1 Federal Reserve Bulletin, April, 1919, p. 310.
7 Ibid., March, 1920, p. 213.




* Ibid.

TH E WORK OF TH E FE D E R A L R E S E R V E BOARD

63

In an address before the Maine Bankers' Association in June
the Comptroller of the Currency presented some interesting
figures regarding the extent to which the war securities have become
lodged in the hands of permanent holders.1
According to his estimates about sixteen billions of these
securities are out of the banks and only about $2,000,000,000
remain in the hands of the national banks. A similar amount was
estimated to be in the vaults of state banks and trust companies.
Record of bills discounted by reserve banks tell much the same
story. In June, 1919, discounts secured by government war
obligations totaled $6,036,000,000.® By June, 1920, this had
shrunk to $4,545,000,000. Otherwise secured rediscounts increased
in this period from $292,000,000 to $1,791,000,000. This represents
an enormous shifting in the quality of collateral from the war
paper to the classes comprising commercial paper. As regards
member banks the high record of bills discounted during the
current year to individuals on the security of government war
obligations for 800 reporting member banks was reached on Janu­
ary 2 with a figure of $1,289,000,000. On Atigust 2 tlus had
shrunk to $959,000,000.
These figures indicate that the reserve banks are rapidly getting
into shape to adopt a rediscount policy independent of considera­
tions pertaining to public finance.
But was this all? Can we find any other explanation of the
Board’s liberal rediscount policy ? All who have read the pages of
the Federal Reserve Bulletin may well be in doubt as to whether
credit and note issue expansion would not have proceeded to dizzy
heights even had there been no difficulty connected with the public
debt. For, not consistently to be true, but frequently nevertheless,
a price theory has been enunciated which would seem to support
the position that liberal credit could not be held responsible for any
subsequent rise in prices. It will be well to learn the statement of
this theory and the circumstances under which it was formulated
for only in this way can we gain a clue as to the Board’s future
1
Cf. Hon. Edmund Platt, “ The Policies and the Administration of the Federal
Reserve Board,” Economic World, September 25, 1920, pp. 437 ff.
3 Federal Reserve Bulletin, August, 1920, p. 867.




64

HAROLD L. REED

attitude in the matter of the relation of the volume of currency and
credit to the level of prices.
It will be recalled that by the end of July, 1919, and largely
as a result of the demands of the Railway Brotherhood leaders,
the cost of living discussion aroused the full attention of certain of
our governmental departments. On August 8 the President
delivered an address to Congress in which he declared that “ the
prices the people of this country are paying for everything that it is
necessary for them to use in order to live are not justified by a
shortage in supply in the present or prospective* ” In the subse­
quent discussion it was inevitable that a prominent place should
be given to the operations of the banks and particularly those of
the federal reserve banks.
On August 8, 1919, in a letter replying to certain queries pro­
pounded by the chairman of the Committee of Banking and
Currency of the United States Senate, Governor Harding expressed
his views regarding the relation of the increasing note issues to the
level of prices. Thus:
The difficulty, indeed the impossibility of keeping in circulation an excessive
volume of Federal Reserve notes should be understood. They are issued
only as need for them develops and as they become redundant in any locality
they are returned to the Treasury at Washington or to a Federal Reserve
bank for redemption. Thus there cannot be at any time more Federal Reserve
notes in circulation than the needs of the country at the present level of prices
require.*

This was in line with a previous statement of the Board:
The increase in the circulation of the Federal Reserve notes has been in
the main in response to actual needs, and that whatever inflation of prices
may be said to exist cannot properly be said to have been induced by over­
issue of Federal Reserve notes.

In the September number of the 1919 Bulletin appears the
following:
While it is technically a true statement to say that the Federal Reserve
note when issued is issued by the Federal Reserve bank, the greater truth in
understanding our present monetary machinery is missed unless it is per­
ceived that the occasion of the issue of a Federal Reserve note is determined
not by the bank for itself but for the bank by the community. The question




1 Federal Reserve Bulletin, August, 19 19, p. 699 ff.

THE WORK OF TH E FE D E R A L R E S E R V E BOARD

65

whether or not a Federal Reserve note shall be issued is decided by the business
and general community in accordance with its circulation needs. It is its
needs rather than the bank's desire which determines the question of issue.1

It would seem to the writer that if this position is taken as
regards note issues it must be also made to apply to the deposit
credits granted by member banks. For the underlying theory of
Federal Reserve note issues was that notes should be issued and
regulated in a manner more similar to that of deposits. Notes
are payable to bearer, book credits to the depositor. The note
issue has a greater circulation power and is needed by banks for
counter money to protect their reserve money, but so far as their
effect on prices is concerned both must be regarded as a part of the
general circulating medium.
This position of the Board is in the main the Laughlin theory
that prices are fixed before credit or currency is called into being;
that accordingly the volume of credit and bank note issues is
determined by the level of prices instead of in reverse manner.
Such a doctrine leaves the Board in a most comfortable position so
far as its responsibility for the cost of living is concerned. For,
according to the terms of this theory all the banks do is to meet
the demands for whatever volume of the circulating media the
existing height of prices renders necessary.
It is no doubt true that such a doctrine runs counter to the
thought of most price theorists. Under certain circumstances,
however, the writer would not deny its applicability. In a period
when orders are behind supplies, when much labor is unemployed,
when the farther back one goes toward the ultimate producers
the more difficulty one finds in sellers’ disposing of their stocks,
liberal bank loans need not create rising prices. Rather easy
credit may facilitate production, the full employment of labor,
the more complete use of existing stocks, in short the bringing on
to the market of goods which otherwise would not be created. To
lock up credit or curtail note issues at such a period would mean
the locking up with it of the country’s productive resources.
But such was not the situation at the time this doctrine was
enunciated in Harding’s letter. The transition from war con­
ditions seemed in the main to have been completed and everywhere
xl b i d September, 1919, p. 814.




HAROLD L . REED

66

entrepreneurial activity was at its height. Business failures were
remarkably few; comparatively little labor was unemployed;
stocks of wholesalers and retailers were, in general, low. Under
these conditions easy credit meant higher money terms on which
business men were to bid for the scanty supply of goods, materials,
and labor. Expansion then must mean price inflation.
Under these circumstances would the Reserve Board continue to
hold its old position ? Or would it revert to a position established
by itself before the cost of living discussion became so acute; a
position which the writer believes to be substantially true:1
The attempt of our financial system to advance credit at a rate more
rapid than justified by the rate of saving would, therefore, simply mean advance
in the “ cost of living” to the average consumer through a further aggravation
of existing conditions of inflation in banking and credit, with harm not only to
ourselves but also to those who receive advances on an unreasonably high
basis of valuation. The natural tendency of the present time is to attempt to
accomplish too much in a short time and to go beyond the natural limits set
by available resources, thus overstraining and crippling the investment mecha­
nism of the country and opening it to the possibility of serious danger as the
result.

Some evidence of a leaning toward the position just stated
appeared in the October, 1919, Bulletin as follows:
Credit affects prices only as it is used in the purchase and payment of
things. It can affect prices, therefore, only when acting in conjunction with
other favoring circumstances.3

May not “ the other favoring circumstances” have had reference
to the full employment of labor and the scanty supply of available
materials ?
And possibly by way of further concession:
While credit, therefore, cannot create a situation which results in high
prices, it is equally true that a situation cannot eventuate without the assist­
ance and mediation of credit.5

And further:
While it may be true as a theoretical proposition that prices at retail
could not rise without an increase in the volume of currency and that refusal




1Federal Reserve Bulletin, January,
2 Ibid., October, 1919, pp. 911-12.

1919, pp. 524 ff.
*Ibtd.

TH E WORK OF TH E F E D E R A L R E S E R V E BOARD

67

to supply currency might impede an upward movement of retail prices, it is
also true that such a method of controlling prices would be at the cost of
business disaster.*

In the writer’s mind it seems as if in these latter statements
the Board is veering toward the position that an answer to the
question as to whether liberal and easy credit would be followed in
the main by increased production or by higher prices must be
decided only on the basis of the existing situation in trade and
industry. But nowhere is this clearly formulated. It seems
probable, therefore, that, despite these later modifications of the
position as expressed in Harding’s letter, the Board cannot be
expected soon to adjust its credit policy in the interests of price
stability as the vigorous application of any clearly understood
price theory. If there is to be such a control we must look elsewhere
to find the motive. Would either of the following afford a clue
regarding the Board’s probable future policy ?
1. Firm insistence on the preservation of the legal reserves of
the reserve banks according to the terms of the Federal Reserve Act.
2. Desire to prevent the bank credit based on advances by
reserve banks from being absorbed by the speculative interests
and thus defeating one of the dominant purposes of the Act.
In regard to the reserves it will be recalled that the Act stipu­
lates a minimum gold reserve of 40 per cent for Federal Reserve
notes and 35 per cent for deposit advances to member banks.
Provision is made, however, whereby these minima may be lowered
upon the consent of the Board. The question which here arises is
whether the provisions for waiving these minima will be regarded
by the Board as having been established for the purpose of taking
care of difficulties human judgment cannot foresee, or whether
they will be regarded merely as provision for the worst of the
contingencies which may be foreseen. If the latter should prove
correct we may find the Board petitioning Congress in the period
of emergency for an amendment lowering reserves. One amend­
ment lessening reserve requirements for member banks was passed
on June 2 1,19 17 , and it is not impossible that another such modifi­
cation applying to reserve banks might be requested. The attitude
xIbid., p. 913.




HAROLD L t R EED

68

of the Board regarding the finality and definiteness of the reserve
minima is more than a mere academic question.
The official pronouncements of the Board will not aid us much
in finding an answer to this query. After diligent search through
the recent pages of the Bulletin the writer has been unable to find
any definite statement of the Board’s opinion. Such a statement,
moreover, would scarcely be expected. It might be regarded as
tying the hands of the Board in a future emergency. We are,
therefore, obliged to rely solely on inference.
In the early months of 1919 the Bulletin contained few refer­
ence to the reserve ratio. In these months the ratio of reserve
moneys to net deposits and note issues combined remained above
50 per cent. But once the ratio had fallen as low as 47.9 per
cent, as on October 31, 1919, the Board appeared to become
somewhat nervous.1
Thereafter in its official announcements the Bulletin contains
regular mention of the ups and downs in the reserve ratio. And
conclusions in many matters of controversy are predicated upon
the assumption that the ability of the banks to manufacture credit
is strictly limited. It is therefore probably correct to infer that the
Board has interpreted somewhat closely its responsibilities in
the matter of preserving the legal reserve ratio.
But after all, dependence upon the maintenance of reserve ratios
offers extremely unsatisfactory assurance to the public. If reserves
become larger in the aggregate as by importations of specie from
abroad or by increased production of gold at home some other
protection is required to avoid the evils of excessive credit grants.
The quantity of gold in the reserves is a more or less accidental
thing. The Board should not permit credit expansion to get to
the point where in insisting upon the rejection of any large volume
of rediscount applications its only defence is to say we have already
gone as far as the law permits.
Of course the writer is not asserting that the state of the reserves
should receive no consideration. Neither is he arguing that the
level of commodity prices should be the sole criterion in determining
the permitted volume of bank deposits. Indeed he feels that a
1 Federal Reserve Bulletin, November, 19 19, p. 1009.




TH E WORK OF TH E FE D E R A L R E S E R V E BOARD

69

weakness of the plan for a “ stabilized dollar” is that in some
situations a rise or even a fall in prices is socially desirable. But
scarcely ever should this rise or fall be encouraged unless such a
course appears necessary to solve some perplexing problem of
distribution or to make function better the productive energies of
the people.
But easy credit has other effects than those discussed. It may
mean the use of funds provided by the reserve institutions in a
manner contrary to the terms of the Federal Reserve Act. And it
is no doubt true that of all the factors influencing the Board to
restrict credit advances this has been the most important. It was
both a matter of observing the terms of the Act and of avoiding
objections previously urged against an earlier formulated plan of
centralized banking. When one recalls the vigorous denunciation
of the Aldrich plan on the ground that it concentrated control of
bank credit too largely in the hands of the dominant banking
interests one can easily understand how anxious the reserve admin­
istration must have been to render impossible a similar accusation
against its own system. And stubbornness in this matter did not
depend upon the successful establishment of any difficult point of
controversial theory. It could be based solely on the formal
declarations of the Act.
Now that so much success has been had in reducing the volume
of war paper in the hands of member banks the Board may proceed
more vigorously in curbing the use of funds based on its advances
in unwarranted speculation. But this is only a small part of the
problem. The volume of security speculation is fanned by other
winds than those of easy credits. Rising commodity prices, made
possible perhaps by excessive liberality in grants of commercial
credit, offer equal encouragement to the speculator. And the
principal objection against the use of reserve bank funds for
speculation was based upon the fear that thereby the volume of
funds for assisting commerce and trade was restricted. Are not
our present difficulties due to an excessive rather than to a deficient
volume of commercial bank advances? It would seem that we
cannot be assured of a proper control of credit solely on the basis
of the insistence that speculative operations shall not be encouraged.




70

HAROLD L. R EED

But may we not find in the methods employed to restrict
rediscounts a better clue regarding the Board’s probable future
policy than in any point thus far discussed ? Let us first turn our
attention to the weapon traditionally regarded as the first line of
defence of a centralized banking system, raising rediscount rates.
Objections in the way of controlling credit by increasing redis­
count rates fall in the main under the following heads:
1. American business has been conducted on the basis of such
liberal margins above costs that higher rates might not restrict
seriously the demand for credit.
2. Since credits obtained by member banks through redis­
counting with reserve banks count as the legal reserves of member
banks effective use of this weapon must mean the imposition of
absurdly high rediscount rates.
3. Increasing interest and discount rates in the market does not
distinguish between legitimate and illegitimate demands for
credit; it imposes the same handicap upon all, regardless of the
genuineness of the demands for credit.
We shall discuss each of these in turn.
Expression was given to the first difficulty in the October, 1919,
issue of the Bulletin as follows:
The extent to which Federal Reserve Bank rates may normally be expected
to be *4effective” in the sense in which that term is used in Continental Europe
still remains to be determined. Our experience under the Federal Reserve
system is too brief to enable definite conclusions to be drawn with reference
to this matter. It seems doubtful, however, whether, for a long time to come
and taking the country as a whole, there will be any such close connection of
Federal Reserve Bank rates with the volume of credit in use as was to be noted,
for example, in prewar days in England, the home of central banking. Our
nearest approach to an effective Federal Reserve Bank rate was reached
in the closing months of the year 1916.1

Then follows a statement of the fact that since American busi­
ness is conducted on the basis of very liberal margins above costs a
slight increase in commercial discount rates might have little or no
effect. In other words member banks could pass on any increase
to the borrowing public without great difficulty.




1 Federal Reserve Bulletin, October, 1919, p. 9 11.

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71

In the matter of the Bank of England’s control over the London
money market much has been made of the difficulty encountered in
rendering effective the “ Official” rate. Often the Bank of England
is forced to rely upon other weapons in the endeavor to make the
market conform. With little experience to guide us in the operation
of our own system it is not startling, therefore, that the Board
refrained from advocating any great increase on the occasion of
the first advance in November, 1919. The general increase on this
date was one-half of 1 per cent, with the differential in favor of war
paper maintained. And on December n , after the autumnal de­
mand for funds had subsided, another slight increase was authorized
by the Board.
The beneficial effect of these increases was undoubtedly greater
than anticipated. And the most decisive results seem to have
been attained in New York City. In the four weeks ending
February 13, 71 banks in the city which report weekly to the
Board reduced loans by $178,000,000/ The 733 reporting banks
elsewhere in the United States increased their loans in this period,
however, to the extent of $67,000,000. But all in all, the results
of what may properly be called experimenting in rate control were
such that increased reliance came to be placed on this weapon.
Accordingly by the late spring of 1920 rates in many districts on
commercial paper were advanced to 7 per cent, thus bringing the
rediscount charge into conformity with the commercial rate.
But one theory was current in a limited circle at this time,
which, if true, would have rendered this weapon of no avail. It
will be recalled that since the amendment of June 21, 1917, all
that counts as a legal reserve of a member bank is credits with a
reserve bank. Among other ways these credits may be established
by rediscounting. But reserves thus established may be multiplied
manifoldly in determining the volume of deposits member banks
may create for their customers. If, for instance, a member bank’s
legal minimum is 10 per cent, it may loan ten dollars for every
dollar of reserves. It could receive interest on ten dollars of
discounts while paying interest on one dollar of rediscounts. Any
slight advance in rediscount rates would appear therefore to be of
March, 1920, pp. 221-22.




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HAROLD L. R EED

small importance. And to be really effective must not the rate
be absurdly high, as for instance, 18 or 20 per cent ?
Various answers were offered to this puzzling question. Some
argued that it was merely a matter of the bankers not understanding
the operation of the reserve system. But in most situations
bankers were correct in refusing to admit the profit if the rediscount
rate was higher than the discount rate. Every dollar advanced to a
customer increases the extent to which checks drawn against that
account will be deposited with other banks. To increase loans
$1,000 might mean the increase of $1,000 debit balance at the
clearing-house. Debit clearing-house balances mean the loss of
cash. The process of creating these deposits would then be profit­
able only if the credits had been obtained from the reserve banks
at a lower rate of interest.
The last difficulty, that higher rates mean the cutting down of
loans to all equally, to the needy possibly on the same basis as
to the extravagant borrower, proved more serious. If obliged to
curtail credits member banks would in many situations begin with
those accounts not regarded as necessary to advance the productive
efficiency of the community. But in other situations credits which
rank highest from the standpoint of advantage to the banker might
not be those most essential to the community. Thus the Board
states:
There is no ready method in reserve banking by which the use of reserve
facilities can be withheld from use in undesirable lines of activity without,
also, being withheld from use in desirable lines.1

A partial answer to the problem of how to check the excessive
borrower was found, so far as the borrower is a bank, in the terms of
the Phelan Bill2 which passed Congress on April 13, 1920. By the
terms of this act rediscount rates may be increased by the reserve
banks to those member banks whose rediscount applications exceed
a specified base line to which the normal rate applies. The increase
in rates for excessive borrowers as it has been worked out in two
districts has resulted in some cases in the imposition of rates as
1 Federal Reserve Bulletin, October, 1919, p. 911.
*
For an explanation of the working of this act, see Federal Reserve BuUetin,
August, 1920, p. 777.




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73

high as 9 per cent. This should be of some assistance in limiting
advances to those banks which seem likely to use the rediscount
facilities.
But no ideal solution can be found solely by the working of
such an indirect force as increase in rates. To supplement it a
more direct method of control is required. Accordingly, by warn­
ings and advice to the member and district banks the Board has
endeavored to restrict the granting of “ unessential” loans. As to
the effectiveness of such advice there is a great difference of opinion.
But in view of the desire of most member banks to avoid contro­
versy with reserve banks and of the Board’s power of direct control
over reserve bank directorates, a power which it can exercise as it
wishes, it appears to the writer that much may be accomplished in
situations where the advice is supported by sound argument. It
seems at least as if experience has shown that banks pay con­
siderable heed to such warnings.
But what definition shall be given to unessential credits ?
The following might be employed:
1. Credits requested by industries which during the period of
hostilities were regarded as unessential.
2. Credits required by industries whose services are not regarded
as useful or beneficial to society.
3. Credits to be used for speculative purposes or to render
possible the withholding of goods from the market.
The uselessness of the first criterion is scarcely debatable at
the present time. Requirements of war time differ from those of
peace. Probably not much would have been heard of this had not
some industries conceived the belief that the Board’s counsel
meant the revival of war-time restrictions. On several occasions
Governor Harding has reiterated that this was not the mind of the
Board.
In regard to the second basis of distinction few would agree
that the time has yet arrived when we wish the banker to sit in
judgment as to the ethical character of our wants.
As to prohibiting the use of reserve bank funds to support
speculation or the withholding of goods from the market, we
encounter many difficulties. Now that the security speculator




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HAROLD L. REED

has had his feast the farmer feels that in this time of need his turn
should come. But any liberality here may mean the taking of a
class position. The consumer feels that after all these years of
waiting the Board should not nullify the first favorable turn the
market has yet brought him. The problem thus becomes one of
granting such credits as are required to provide for the legitimate
needs of the producer without taking undue advantage of the
consumer.
Can such a close distinction be drawn successfully? The
Reserve Board’s answer is that it has endeavored and will endeavor
to grant such funds as are required in the orderly marketing of
crops. Thus we read in the Bulletin for December, 1919, some
remarks addressed to certain cotton growers’ interests:
The Board has consistently advocated during the past five years the policy
of orderly marketing of crops. Assuming that adequate warehousing facilities
are available, it seems to be in the interest of the consumer as well as of the
producer that staple commodities remain as far as possible in the hands of
producers until sold for consumption. This policy gives the producer the
benefit of an average price in that he is not required to “ dump” his products
upon the market in excessive volume, thereby depressing the price to the
advantage of favored consumers or of speculators who do not as a rule pass
;he advantage on to the consumer. Owing to the great number of producers
there will always be competition between them to sell which would not be the
case if larger syndicates were able to acquire control of the bulk of the crop.1

And, in a letter addressed by Governor Harding to a counsel of
the National Canners’ Association we find:
It is evident that there are certain seasons of the year when loans of a
particular kind must be made in large volume and are entitled to more con­
sideration than would be the case at other seasons, this being dependent upon
the character of the industry. There is a wide difference between the granting
of credit by banks for crop moving purposes at a time when crops are moving,
or for canning or cold storage purposes at those seasons of the year when
goods naturally pass into the hands of the canners, and the making of loans on
agricultural products at periods when they should be marketed and not hoarded,
or in lending on canning or cold storage products when they ought to be sold to
jobbers and retailers instead of being held indefinitely for higher prices.*
1 Federal Reserve Bulletin, December, 1919, p. 1109.
*
This letter has been published in the Commercial and Financial Chronicle,
July 10,1920, pp. 137-38.




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75

These statements of the Board’s policy illustrate the extreme
difficulty of the problems with which the Board is now confronted.
It is no doubt true that in such demands as these lies the greatest
danger in the attempt to maintain firm control of credit. If the
Board surrenders in unwarranted manner to one of these interests it
becomes all the more difficult to resist the demands of another,
A simple and scientific manner of defining essential credits would
at least prove welcome.
In the attempt to formulate such a definition some have come
to stress the matter of guaranties of prompt repayment. The test
of essentiality is thus reduced to that of liquidity; to the ability of
the borrower to liquify his paper. In the words of the director
of the Division of Analysis and Research of the Federal Reserve
Board:
If for example, it should appear that a borrower had fallen into a way of
business which required the extension of a longer and longer credit to customers,
or that he was drawing upon securities of which he might stand possessed in
order to protect or collateral paper which he was keeping practically perma­
nently in bank, or for which he was asking repeated renewals, the situation
would be such as to raise a strong presumption against the essentiality of his
borrowing.1

Except in certain minor instances, however, the Board has
steadfastly refused to define essentiality. According to a statement
by Governor Harding:
It is not sufficiently close to the actual day-to-day requirements of business
to lay down rules as to what loans are for essential purposes and what loans
are not. The Federal Reserve Banks in their dealings with member banks
are better situated in this respect, but ultimately the main responsibility of
such decisions must rest with the commercial banks themselves, which in
their dealings with customers are in a position to ascertain the purpose of
each loan and to decide whether this purpose is essential or not.*

It is easy to understand the necessity of the Board’s refusal to
define essentiality so far as the member banks are concerned.
For these institutions Willis’ test of liquidity is undoubtedly as
good as any which can be had. But for the district reserve banks
1 H. Parker Willis, “ Discrimination in Inflation,” Commercial and Financial
Chronicle, September n , 1920, pp. 1040-41.
3 Federal Reserve Bulletin, August, 1920, pp. 774-75.




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HAROLD L. R EED

it will not suffice at all. For what circumstances determine the
liquidity of paper over the general field ? It is obvious that one
factor must be the inflation of the currency. All loans are more or
less liquid in a period of rapidly rising prices.
But this does not mean that the Board should give up the
attempt to define essentiality so far as the district reserve banks
are concerned. For unless there is a clear formulation of the
Board’s belief the district banks in rejecting or accepting rediscount,
applications cannot know whether they are carrying out the
Board's will. There cannot thus be any policy consistently
accepted the country over. Without such a policy the reserve
system cannot function as intended. While liquidity may be made
the test so far as each member bank is concerned, the general con­
ditions affecting and underlying liquidity must be determined for
each district by the district directorate and for the nation as a
whole by the Federal Reserve Board.
The only possible basis for such a test has already been
suggested. Increase in the volume of rediscounts should be per­
mitted so long as the main effect is to enlarge the volume of
production and not to raise the level of prices. Decreases in redis­
counts should be enforced when it appears that the volume of
business and consequently the need for credit is declining. Over
a long period of time increases in rediscounts should be apportioned
to the natural rate of growth in the productive capacities of the
people. To express the matter in terms of the equation of exchange

MV

CP = ~ j r ) M should be altered when its principal effect will be
borne by T and not by P.
What specific and detailed rules should be drawn up to realize
these results the writer has not the necessary facilities to indicate.
But before such specific regulations are formulated it is necessary
that there be a clear and consistently accepted conception of the
relation of increasing bank credits to the level of prices and the
volume of trade. The writer’s principal purpose in writing this
article is to insist upon the necessity of such a formulation.
No other basis of approach can prove adequate in the proper
control of commercial credit. Leaving the definition of essentiality




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77

entirely to each member bank will not do. Requiring all banks to
reduce credits with equal rapidity is obviously unscientific. The
state of the reserve ratio, varying as it does through the working of
accidental forces, will not suffice. If the reserve bank which
increases rediscounts cannot be made to defend such a course on
the ground that it is necessary to unlock unused productive resources
or to meet an enlarged seasonal demand; if production statistics
cannot later be employed to justify the validity of the bank’s
pleas, there is no possibility of a scientific regulation of rediscounts.
And if the desired solution cannot be found along these lines
it is difficult to understand how the desire for sectional or factional
advantage can prevent the employment of political power, with
the danger that the whole matter of reserve bank policy shall
become a football in the arena of politics. At the present time
there are many evidences of such a danger. It may be that ahead
of the reserve system lie times as troublous as those which witnessed
the dissolution of both the First and Second United States Banks.
H a r o ld L. R e e d
W a sh ing t o n U n iv e r sit y