The development of Federal Reserve policy

Preface

Owing to the unusual character of the period during which its policy has been developed, many misconceptions have become current regarding the nature and purpose of the Federal Reserve banking system. Some of these misconceptions are so far-reaching as to create serious difficulties for its management. No central banking system can be administered efficiently in an atmosphere of prejudice and misunderstanding. The business public, in its appraisal of the system's management, must be led to apply the tests of sound principles of economics and finance rather than those rnerely of immediate, individual advantage. It, accordingly, has been the writer's endeavor to do what little his capacities permit to stimulate a proper spirit of inquiry regarding Federal Reserve matters.

It has appeared to the writer that a careful examination of the development of the reserve system could be made most opportunely by one not connected with its management. As a minor spur to the writer's efforts there has been the belief that no study offers superior opportunities for investigating the working of the principles of money and credit under contemporary conditions of business and industry. While the book was written for the general reading public, rather than for classroom purposes, it may serve as a second book to follow the reading of one of the elementary texts in college courses in Money and Banking.

On this occasion the writer would like to express his

VI

PREFACE gratitude to those who have helped him to sustain his interest in finance and economics. Among these he would like to mention the names of Professor Kemmerer, of Princeton University; Professor Davenport, of Cornell University; Dean Joseph French Johnson, of New York University; Dean Turner, of New York University; Dean Gephart, of Washington University, now Vice- President of the First National Bank of St. Louis; Professor Willcox, of Cornell University; and Professor A. S. Johnson, at present a member of the editorial staff of the New Republic. Professor Allyn A. Young, of Harvard University, has been a constant source of inspiration. April 30, 1922.

Contents

I. The Working of the Regional System I

II. Check Collections and Clearances under the Federal Reserve 20

III. State Bank Membership in the Federal Reserve 50 ^ IV. Advances of Reserve Banks — Rediscounts 70 V. Direct Collateral Advances to Member

Chapter I

In the matter of structure, organization, and administration, the most characteristic feature of the Federal Reserve banking plan is the system of district reserve banks. The regional system was also the most surprising outcome of the legislative planning which preceded the framing of the final provisions of the act. Since 1907 the question of banking reform had revolved about the idea of establishing, for the entire country, a single large and powerful institution which should hold a portion of the reserves of the member institutions and whose advances should be controlled by a single board or directorate. It was felt by many that a banking organization more centralized in control and resources offered far greater possibilities of avoiding credit collapses than our old decentralized system. Demands for banking reform were thus predicated upon a belief in the desirability of a single central bank. While it was anticipated that such a bank must establish local branches or agencies, it was not expected generally that there would be established in each of a dozen different districts a bankers' bank which should deal for the most part only with the banks of its own territory. It was not anticipated that a group of independently operating bankers* banks would be set up, with no one bank possessing dominating authority. It was not predicted that the board with general control would not be allied to any one bank in particular.

The motives influencing the legislators to this generally unf ore told conclusion are now well known. Despite the admittedly great possibilities of a central bank, there were many fears that such an institution would employ its resources with partiality. Recollections of the old prejudices against such an institution surviving from the time of Andrew Jackson made it appear the part of political wisdom to the Congressional leaders of both parties to soften the emphasis upon the idea of control by the directorate of one all-powerful institution. In the Aldrich Bill the plan which might be said to represent the Republican attempt to secure banking reform, the idea of cooperation and not of control was to be suggested by the name of the new system. It was to bear the name, not of a bank, but rather of the National Reserve Association. Furthermore, its machinery was to be such as not to exert any large measure of continuous control. By the issue of notes carrying a progressively increasing tax, it was designed primarily to offer relief in periods of emergency and threatened credit collapse.

The underlying theory of the Federal Reserve system was somewhat different. The reserve institutions were to bear the names of banks, and it was hoped that they would operate more or less continuously. But lest the objections to the idea of a central bank should prove too strong, attacks were to be parried in another way. There was to be no single, all-powerful central bank. Twelve regional banks, distinct in membership and direction, were to be set up, their several operations to be harmonized and coordinated by a single board. The Democratic plan, the Federal Reserve plan, was thus based upon the idea of preserving for the banks of each locality as much control over the district bankers' bank as seemed financially expedient. Such a solution was indeed typical for a party whose political traditions are founded so largely upon the doctrine of States' rights and local autonomy.

The wisdom of the regional idea was attacked strenuously by many. At the time of greatest controversy, however, the ultimate manner of the operation of the Federal Reserve system was more or less a matter of doubt. There was no experience by which to measure the importance of the numerous objections. But now, after nearly a decade of experience, the value of the regional idea can be appraised more accurately. What, then, does past operation suggest regarding the practicability of the plan? An inquiry, such as this projects, renders it desirable to recall some of the earlier points upon which the regional system was attacked. An advantage of restating these objections now is that by virtue of recent experience the haziness which beclouded the form of their original statement may be avoided, in part at least.

In the first place, it was felt that the regional plan would create too much temptation to the frequent use of the reserve bank's resources. The basic idea was to bring the bankers' bank more close to the member institutions. Direction was so planned as to subject its management to pressure and influence exerted by the member banks of the locality. Six of the nine district directors were to be chosen by the member banks. Moreover, the regional idea was asserted to be merely a substitute for the plan which contemplated only occasional or emergency relief for the member institutions. It was evident to all that many dangers must lie in the path of any system designed to exercise day-to-day control over the money market. To render any such control effective the advances of the reserve banks must be large. The acceptance of ^the European ^ rule of procedure — keeping the central bank's rate above the market — might leave the reserve banks a piece of unused and costly machinery. In view/of the concentration of reserve money and the consequently great possibilities of pyramiding credits, it was perceived that an unexampled expansion of bank advances might take place. In short, the regional plan, instead of guarding against, seemed actually to make provision for, price inflation.

It was asserted, furthermore, that the regional idea was solely a compromise, the outgrowth of the desire to avoid popular objection. Considerations of financial wisdom were held to have been subordinated to those of political expediency. Few have been the occasions when compromise has proved successful in matters financial, and it scarcely could be hoped that banking reform would constitute an exception. If our old difficulties were due primarily to decentralization, in credit control, note issues, and reserve holdings, the greatest advantage could be realized only by utilizing to the utmost the idea of centralization. The greatest degree of benefit could be obtained only by establishing a single bankers' bank dominating the member institutions of the entire country. Any other solution must perpetuate among the reserve banks the old evil formerly pertaining to the individual banks — scrambling for reserves in periods of emergency and excessive competition in the period of business activity. To be sure, attempts could be made to unify the operations of the reserve banks by granting certain powers of control to the Federal Reserve Board. But this, it was argued, would be merely a patchwork device. The regional system must limit somewhere the possibilities of centralized control

^ Only in a very general sense is it correct to imply that the dominating policy of European central banks has been to keep the official rate above the market rate. There are, of course, many exceptions.

and concerted action. Otherwise what would be its advantage over a single central bank?

Opponents of the plan argued also that it represented an attempt to isolate different territories of finance, to establish sectionalism in an impossible field. Finance, any more than trade, cannot be confined within artificial borders. The call-rate policy of the metropolitan bank may affect the Southern cotton planter in as real (though a more indirect) a manner as the credit policy of his own local bank. Even under our old faulty banking system many were the means by which bank capital could be transferred from one locality to another. The call rates of city banks must exert some influence upon the place of investment of surplus bank capital. Our various banking channels cross somewhere, even if in a haphazard manner. The rivulets of credit, sluggish though they be, carry eventually their deposits to the deeper channels. If the various districts of the country are related in fact, why not recognize this relationship in the structure of the banking system? Failure to recognize it must create only difficulty. If twelve different open markets for commercial paper exist, wherein has correction been found for the old evil — inability to mobilize efficiently a large portion of our surplus bank reserves at the point of greatest need?

These were some of the more earnestly developed attacks upon the regional plan. Let us next consider as completely as may be their respective merits. In doing this, however, an attempt must be made to avoid for the present those aspects of the problem which involve ultracomplicated features of reserve banking.

In the light of recent experience much justification is afforded the view that the regional system is peculiarly susceptible to undue credit expansion. Local pressure for enlarged credit grants is always most intense. Business thrives on easy money; rising prices usually create the situation of a widening margin between costs of production and sale proceeds. Those who are injured by price inflation, those whose money incomes are incapable of quick adjustment, exert only feeble pressure upon the banking administration. Wage-earners scarcely ever emphasize this cause of their woes; they are much more prone to employ the devices of strikes and concerted action. The middle class has no influence upon the banking administration. Occasionally entrepreneurial activity is injured by the rising scale of prices, as, for instance, in the public utility and railroad fields. But the petitions of industrial entrepreneurs, in the same manner as those of the wage-earners, are scarcely ever addressed to the banking administration. Prayers for higher rates offer greater prospects of relief. Because of the nature of things, it is peculiarly necessary that the banking structure be such as to make easy denial of demands for excessive credits. It is necessary that banking control be lodged in the hands of those well equipped to resist the credit demands of those who are not responsible for the interests of all classes in society, and who do not have in mind merely the short-time requirements of business.

One means of ensuring conservatism in the operations of the central bank is to emphasize the emergency character of the institution. Let the rates on the advances of the central institution be normally above the market rate. Advances from the central bank are thus rendered unprofitable on ordinary occasions. But aid, costly though it be to secure it, is available for periods of credit strain.

It has been stated previously that the regional idea is based on the theory of continuous control of the money market. It necessitates accordingly constant employment of reserve funds. This, in turn, imposes the necessity of keeping the rates sufficiently low to occasion demand for the funds of the reserve system. The rule of remaining out of the market except in emergencies is not so easy of acceptance under the regional system. Control by member banks is too direct. And so far as the particular facts of the reserve system are concerned, the regional idea was invoked as a substitute for a previous plan in which the emergency character of the institution was emphasized.

It may be that in the course of time a means may be developed whereby the volume of reserve advances may be stabilized in relation to the needs of trade even though the reserve banks are kept continuously in the market. In the opinion of the writer, however, the principles for regulating the volume of reserve advances have not yet been formulated with sufficient definiteness.^

The above paragraphs should not be interpreted as advocating absolute aloofness from the market except in periods of strain. Those who stress the emergency character of the reserve banks would admit the necessity of some measure of continuous functioning. But such operations need not be so extensive in volume. It was asserted, furthermore, that if the share contributions of member banks to the capital of reserve banks could be returned, there would be even less pressure to find continuous use of reserve bank funds. If the idea of emergency advances only were developed, could not the reserve institutions develop enough investment power without share capital contributions from member banks? Reserve banks would still possess the resources based upon their holdings of member banks' reserves. But further discussion of this aspect of the problem can best be postponed till a later chapter.*

»See infra, Chapter XVI. »Seew/m, Chapter XII.

In reply to the second objection, that the regional plan was based upon the idea of divorcing various banking channels, it was replied that the scheme represented no more sectionalism than existed in fact. Attention was called to the great differences in banking customs and needs of the various districts of the country. It was asserted that nowhere in the world was there an illustration of a central bank successfully dominating so large and diverse a banking territory as that of continental United States. In the words of H. P. Willis: '

So far as area is concerned, then, there would be room in the United States for a number of institutions corresponding to the total number of central banks throughout the European continent. The mere fact that international lines divide the Bank of France from the Bank of England or the Bank of Germany has no relationship to the economics of the situation. It is a fact that no such extent of territory as the United States is dealt with by one single central bank. The Federal reserve system, with its series of reserve-holding institutions, therefore, does in fact correspond much more nearly to European practice than would a single central institution with branches. Each Federal reserve bank includes within its district a territory which, as the nation expands and its business increases, will rank with the territory tributary to one of the European central institutions.

From the point of view of directness and efficiency in administration, justification for Mr. Willis's remarks is clear. The regional character of the system has eliminated, undoubtedly, many anticipated difficulties of direction. But has this been accomplished at the expense of destroying all possibilities of financial cooperation between the various reserve banks? Has the reserve system meant the segregation of financial territories and the consequent destruction of any effective means of establishing a country-wide market for commercial paper of various origin, in » The Federal Reserve, p. 128.

such a way as to enable the surplus funds of the country to be mobilized effectively? More precisely, have the reserve banks shown willingness to aid each other, by means of the rediscounting or direct purchase of each other's paper?

In developing this inter-district harmony the succession of events has favored the administration. In the early years of operation, the period when no past experience in cooperation was possessed, a time accordingly when attempts to secure mutual aid would be difficult, there was little demand for this sort of reserve activity. Due to the reduction of reserve minima under the terms of the act and to the importation of gold from abroad, reserves of all the district banks were generally high. When the need of inter-district aid did develop, the Nation was engaged in a war so enveloping as to render apparent to all the necessity of subordinating considerations purely of sectional advantage. In such a situation it was easy for the Board to insist, in the determination of the inter-district shifting of funds, upon principles which ordinarily might have created some objection. At a time when so many devices of expansion were available, concessions by one bank would not necessarily impair its own lending power. Accordingly, as a guiding principle, reserves were to be equalized between the various district banks regardless of the cause of any bank's need for aid.

The accompanying table on page 10 Indicates the volume of such inter-district operations during some of the years when their amount was exceedingly heavy.

Needless to remark, operations so large in volume have affected greatly the reserve positions of the district banks on numerous occasions, increasing the reserves of some and lowering those of others. Indicative of this is the accompanying table on page 11.^

*See Report of the Federal Reserve Board for 1919, p. 8.

lo FEDERAL RESERVE POLICY

Inter-District Movement of Discounted and Purchased Paper'

For the Year 1918

For the Year 1919

For the Year 1920

Bank

Excess

Movement

FROM 2

Excess

Movement

TO*

Excess Movement from

Excess

Movement

TO

Excess Movement

FROM

Excess Movement to

Boston

$ 92.046

$ 131,165

$ 986,280

New York ....

329,491

996,412

$ 764.219

Philadelphia . .

$ 56.562

826.521

191.872

Cleveland

207.534

$ 463,909

1.120.832

Richmond ....

68.732

837.866

699,675

Atlanta

77.722

72,625

250.510

Chicago

195,192

1,583,864

108.054

St. Louis

181,029

302.249

Minneapolis . .

82.907

536,513

253.096

Kansas City . .

27,564

16.060

386.137

Dallas

94.135

337,398

292.513

San Francisco.

93.046

420.612

325.105

$662,805

$662,805

$3,201,987

$3,201,987

$3,140,271

$3,140,271

» The following extract from the Federal Reserve Bulletin for October. 1920 (p. 1015). is explanatory of the relation of the Gold Settlement Fund to the inter-district shifting of funds:

"Originally established for the purpose of expediting the settlement of balances in gold between Federal Reserve Banks arising out of exchange and clearing operations, the shifting of funds from district to district in connection with rediscount transactions between Federal Reserve Banks has become one of the principal services of the fund under present conditions, and its efficacy has been strikingly exemplified during the heavy credit strain incident to the financing of our present crops.

"When a Federal Reserve Bank, through the Federal Reserve Board, has been granted an extension of credit, and such extension has been allocated to some other Federal Reserve Bank, the extension is made effective through the transfer of title t9 gold in the gold settlement fund at Washington. The gold settlement fund . . . consists of deposits of gold which have been made by the Federal Reserve Banks and agents with the Treasury, which holds them in trust. . . . The gold in this fund is seldom physically moved, though it frequently changes ownership, transfer of ownership being effected through the mechanism of the fund without the need of moving. Ownership in the fund being represented by entries in the books of the fund, an applicant Federal Reserve Bank which has been granted credit extension receives its accommodation, and the gold to which it is entitled, through a credit entry in the gold clearing books of the Federal Reserve Board. Inasmuch as the gold settlement fund is a part of the gold reserve of each of the Federal Reserve Banks, this transfer amounts to shifting a given volume of reserve metal from a granting bank to the applicant bank. The effect is to transfer a corresponding amount of credit-granting or credit-lending power from the granting institution to the applicant. The latter is then at liberty to use it as it may see fit in extending further accommodation to the member banks within its district. The transaction has, in short, really amounted to a temporary shifting of banking funds from one district to another."

' By this operation the bank gains in reserve money. It is given credit on the Gold Settlement Fund. See note • for description of the working of this fund.

* By this operation the bank loses in reserve money. It is debited on the Gold Settlement Fund. See not« ' for description erf the working of this fund.

* Figures are compiled from the yearly Reports of the Federal Reserve Board.

Ratio of Total Reserves to Combined Net Deposit and Federal Reserve Note Liabilities, December 26, 1919

Bank

Actual

After Adjustment of Reserves by Deducting Amount of Bills Rediscounted with or Sold to Other Federal Reserve Banks and Adding Amount of Bills Discounted for or Purchased from Other Federal Reserve Banks

Boston

44.0 40.0 40.8

24-3 36.2

New York

Philadelphia

Cleveland

Richmond

Atlanta

Chicago

St. Louis

Minneapolis

Kansas City

Dallas

San Francisco

For all banks

44.8

44.8

The amount of inter-district lending of funds has thus been great. But to what factors shall we ascribe the willingness of the various banks to cooperate in this way? Has it been due to the unusual circumstances of the period when operations of this sort were the greatest? Has it been merely an aspect of the problems of war and post-war finance? Or has it been the desire of the lending bank to establish a basis for its own pleas for aid when it itself should become the needy institution? Answers to such queries as these should throw some light upon the probable future amount of inter-district operations.

Some explanation of the preceding problems is afforded by the following sentence from the Federal Reserve Bulletin for October i, 1920:'

The process of shifting bank resources through inter-reserve rediscounting was necessarily called into play and has become a regular and important feature of the working of the Federal Reserve System.

As to how this function of the reserve has developed, it will be recalled that in the earlier years under the reserve system the effectiveness of the machinery for transferring funds from district to district was not fully tested. The release of reserves on the inauguration of the reserve system and the inflow of gold from abroad in the following years made unnecessary the use of reserve funds to any appreciable extent. But after the period of rising prices during the war and the getting more completely into the market of the Federal Reserve, inter-district aid became necessary on the part of the district subjected to unusual crop-moving or seasonal demands. Since, however, the peak of money demand is not reached simultaneously in all districts, it is possible for the Reserve Board to offset the seasonable fluctuations and changes in demand against one another. In this way the strain previously thrown upon the city banks in the financial centers by the calls from the interior becomes merely a transfer of surplus reserve funds from one district to another.

Various are the circumstances which determine the extent to which any one district bank may require such aid. Industries dependent largely upon agriculture must experience usually greater seasonal fluctuations in the demand for bank capital than those more largely manufacturing. Districts covering a territory diversified in climate and in the nature of their industries may be able more easily to finance exceptional demands in one part by reliance upon surplus funds in another without drawing heavily upon other districts. A section thus diversified is Number 12, the Pacific Coast Section, including States from the Canadian border to the boundary line of Mexico.

By relying upon the principle of reciprocity in the meeting of their mutual seasonal and emergency demands, it may be possible to avoid to some extent the objection of sectional financial isolation. It is true that the regional system creates some obstruction to the free flow of funds from district to district. Some friction will be encountered always in mobilizing effectively free bank funds. But this difficulty can be mitigated greatly and is perhaps justified by the adminrstrative efficiency and political advantage of the regional plan.

One difficulty remains, however. If inter-district shifting of funds is regularly contemplated, wherein lies the advantage of the regional system in meeting objections emphasizing possibilities of sectional discrimination? Rediscounts by one reserve bank for another can be required by the Federal Reserve Board. According to the liberality with which it treats one district, and the conservatism another, the display of sectional partiality is easily possible. If exercised, its results would be identical with the more direct partiality displayed by the directorate of a single central bank.

In the opinion of the writer, however, partiality in requiring reserve banks to render inter-district aid is not nearly so probable. Under the reserve system it will be expected that the borrowing districts in normal years shall not merely clear their books in the off season, but also shall be able to render aid to other districts in the slack season. In the long run the advances to member banks in any one district must bear some relation to the resources of the reserve bank, resources which represented originally the contributions of the members. Under a single bankers' bank the determination of the legitimate amount of advances to any one locality must be based on more hypothetical grounds. Failure to map out definite and permanent districts would create much more difficulty in determining the relative merits of the demands of the various sections of the country. Under the present systern the resources of each reserve bank are real and the advances to any one section do not depend so largely upon the rulings of a single directorate.

A query, of possibly greater importance, relating to the political expediency of the regional plan, necessitates some concluding discussion. How effective has been the regional plan in enabling the general administrative body — the Federal Reserve Board — to confine complaints to the district in which the discontent has arisen? To what extent has the Board been able to disclaim responsibility for policies initiated by the district directorate? In what measure has each district been held responsible by the public for conditions logically the result of its own policies? Very important is the answer to this query because the system is much more likely to be modified by legislative action when complaints are directed against the central administrative body than when directed merely against one of the twelve administrative subdivisions.

It must be admitted at the outset that there has been a persistent refusal by the general public to recognize the regional character of the system. In the period of agricultural depression following the spring of 1920, nothing was more clear than this. Newspapers and journals of the Middle West and South wrote many an editorial and published many a cartoon to establish the partiality of the Federal Reserve Board toward the metropolitan financial interests. In virtually all of these the existence of different reserve banks in the various sections of the country was ignored . * * The men who grew the wheat ' ' could not obtain credit to hold their crops for a fair price, whereas the "men who tried to corner the wheat market," it was asserted, were bountifully supplied with funds emanating from the Federal Reserve. No attention at all was ordinarily paid to the fact that the National City Bank of New York is served by the New York Reserve Bank; whereas the First National Bank of Waycross, Georgia, is served by the Atlanta Reserve Bank.^

Indicative further of this point of view, there is even to be found an address of the former Comptroller of the Currency, and ex-officio member of the Federal Reserve Board, Mr. John Skelton Williams, delivered in Augusta, Georgia, July 14, 192 1.* The following extract may be quoted from this address :

While small banks in the farming districts were being taxed in this manner, great banks in New York were being supplied with practically unlimited amounts of money at 5, 6, and 7 per cent. The official record will show that while the Reserve Bank collected $2100 (equal to 8 per cent on the bank's entire capital stock for 12 months) from a little bank in your adjoining State of Alabama, for the use of about $112,000 for two weeks in crop-moving time, a year ago, a big bank in New York, whose funds were largely employed in speculative operations and deals, for the same cash consideration, or, say, $2100, was given the use of about $800,000 for the same time.

And in his charges of wasteful and uneconomical expenditures before the Atlanta audience the bulk of the illustrations were drawn from the experience of the New York bank. The financial layman could easily gain the impression that the Federal Reserve Board was a bank with its main office in New York City.