A History of the Federal Reserve, Volume 1
Page 12
FIRST STEPS AND CONFLICTS
The new system took nearly eight months to get organized. A main reason for the delay was that members of the Board and governors of the reserve banks could not be appointed until the size and number of Federal Reserve districts had been set. The act specified that no two members should come from the same district and required that there be at least eight and not more than twelve districts, each with a Federal Reserve bank in a principal city. Decisions about size, location, number, and boundaries were left to an organizing committee consisting of the secretaries of the treasury and agriculture and the comptroller of the currency.15
These decisions were contentious, political, and time consuming.16 By April 2, 1914, the locations were decided, although appeals continued for more than a year.17 By mid-May the twelve reserve banks began to organize. Almost ninety days passed, however, before Charles S. Hamlin, Paul M. Warburg, Frederic A. Delano, W. P. G. Harding, and Adolph C. Miller took their oaths of office on August 10 as the first appointed members of the Federal Reserve Board.18 The president designated one of the members as governor and one as vice governor for renewable one-year terms. The secretary of the treasury was ex officio chairman of the Board, but the governor was the chief operating official of the Board. Hamlin served as governor until 1916, when Harding replaced him. The two remaining members of the seven-person board, Secretary of the Treasury William G. McAdoo and Comptroller of the Currency John Skelton Williams, were ex officio members who had taken office earlier.19
15. The committee used data on trading areas and size and growth of banking facilities. It also took a poll of national banks and usually chose the most popular city. Cleveland was the exception; it came third in the voting after Pittsburgh and Cincinnati. The committee also held hearings in eighteen cities (Reserve Bank Organizing Committee 1914).
16. Warburg’s account of the choice of number of districts and their boundaries shows the importance attached to these issues at the time. Those, like Warburg, who wanted a European-type central bank appear to have resented greatly the decision to create twelve instead of eight districts. See Warburg 1930, vol. 1, chap. 11. Earlier, Warburg had wanted only four districts with multiple branches (Warburg 1930, 2:275).
17. In 1916 the attorney general ruled that the Board could not reduce the number of reserve banks or change the location of reserve bank cities.
The twelve reserve banks opened on November 16, 1914, eleven months after passage of the act.20 Secretary McAdoo’s announcement of the opening said in part: “They will put an end to the annual anxiety from which the country has suffered and would give such stability to the banking business that the extreme fluctuations in interest rates and available credits which have characterized banking in the past will be destroyed permanently” (Board of Governors File, box 659, November 15, 1914).
18. Charles S. Hamlin, the first governor, was a Boston lawyer who was serving as assistant secretary of the treasury. He was a last-minute substitute for Richard Olney, a former secretary of state, who declined because of age (Warburg 1930, 2:143). He is described as organized and conciliatory but a weak leader who was too responsive to the requests of Secretary McAdoo (Katz 1992). Delano, a railroad executive from Chicago, was designated vice governor. Harding was a banker from Birmingham who served as governor from 1916 to 1922. Miller, an economics professor who had taught at Chicago and Berkeley, served as assistant secretary of interior in the early Wilson administration. Miller was also the brother-in-law of Wesley C. Mitchell, a leading economist and founder of the National Bureau of Economic Research (NBER) (Katz 1992). Hamlin and Miller were reappointed twice. Both served until February 3, 1936. By law two of the members were to represent banking and finance. In 1922 this requirement was removed and an eighth member, representing agriculture, was added. Members had ten-year terms with two-year staggered appointments. Other requirements for membership were geographical diversity to satisfy sectional interests and prevent eastern control. The initial salary was $12,000, at the time equal to the salary of a cabinet member. In 1995 prices, the salary before taxes would be approximately $175,000, 40 percent more than the salary in 1995.
19. Charles J. Rhoads, first governor of the Philadelphia reserve bank, described Williams as “the only man I ever knew who could strut sitting down” (Rhoads, CHFRS, June 29, 1955, 4). Rhoads was a Quaker, opposed war, and left the system rather than sell war bonds.
20. Secretary McAdoo was authorized to choose the date on which the reserve banks opened. Under pressure from agricultural groups, he chose November 2 against the advice of Strong and Warburg. The opening was delayed because Federal Reserve notes were not ready for distribution. Also, not much capital had been paid in, so the System had very little gold (Harding and Warburg to McAdoo, Board of Governors File, box 659, October 13, 1914). I will use this reference with box number, date, and page where applicable to identify unpublished records in the “Central Subject File, 1913–54,” stored at National Archives II in College Park, Maryland.
Many in the South and West criticized the delay in opening. The Texas legislature passed a resolution urging prompt opening. The System was expected to release gold by lowering reserve requirement ratios and thus lower interest rates. Rates had increased after August, when war started in Europe. (Prime commercial paper increased from 4.5 percent in May to 7.6 percent in September, and other rates rose commensurately.) Large banks were less eager to rush the opening because the gold outflow at the start of the war made it more costly to deposit reserves and subscribe.
Tension between the Board and the reserve banks began before the System opened for business. Two factions formed within the Board. Delano, Miller, and Warburg worried about Treasury control and loss of independence. They distrusted the Treasury group—Hamlin, McAdoo, and Williams. Harding was in the middle. Typical of the reserve banks’ concerns is a letter from a Chicago director H. B. Joy (president of Packard Motor Company), to Frederic Delano: “I have a little feeling—in fact it is growing on me—that the Federal Reserve Board in Washington is inclined toward dominating the District Banks” (Board of Governors File, box 659 October 10, 1914). Warburg described the problem. Dominance by the Board would allow political considerations to dominate decisions about interest rates. Dominance by the reserve banks “would render a concerted discount policy . . . an impossibility and reduce the Board to a position of impotence” (Warburg 1930, 1:473–74). To resolve some of the issues and coordinate the reserve banks’ activities, the organizing committee recommended appointment of an executive council of the banks’ governors. This is the origin of the Conference of Governors, later the Presidents Conference, that still continues (Board of Governors File, box 659, October 13, 1914).
The dominant personality in the early days of the System was Benjamin Strong, first governor of the Federal Reserve Bank of New York. Strong’s early views were the views of a sophisticated banker, with little formal training, who had gained enough understanding of the functioning of the domestic and international payments mechanisms to be ahead of most of his contemporaries. He saw the Federal Reserve Act as an opportunity to expand the international operations of United States banks, particularly New York banks, and like Warburg, he believed that the development of the market for bills of exchange and acceptances was the means to accomplish this end in a manner consistent with the act. Throughout his life he remained a proponent of fixed exchange rates and the gold standard and an opponent of devaluation or revaluation of currencies and of inflation. In practice, this meant that he accepted deflation when required and came to regard it as the price of international stability.21
Strong’s mature views on the gold standard and on monetary policy reflected his experience in the twenties. His prewar policies can be described succinctly as an attempt to recreate Lombard Street on Wall Street, with the Federal Reserve System, particularly the New York bank, playing the role of the Bank of England.22 He regarded the twelve reserve banks as eleven too many. The appropriate numbe
r was one, he wrote. And he believed it was a major defect to issue Federal Reserve notes as obligations of the government. Government note issues were too reminiscent of greenbacks and other fiat money (Chandler 1958, 34–35, 37).23 Like Warburg, he accepted that real bills should be the base for expansion. To that end he worked to develop and strengthen the money market. One of his first appointees to the New York bank was an American expert on the operation of the London bill market. This effort to develop a market for banker’s acceptances and bills of exchange as the principal means of affecting money market interest rates and to replace the call money market was renewed in the 1920s but did not succeed (Warburg 1930, vol. 2, chap. 12; Burgess 1964, 219). Early in his career as governor, he favored compulsory membership of state banks as a means of centralizing reserves. His views on discount policy read very much like pages from Bagehot and are not noticeably different from British views at the time.24
21. Strong’s views and actions are described in a favorable biography (see Chandler 1958). His starting salary as governor was $30,000, equal to more than $400,000 in 1995. The governors of Boston and San Francisco banks received $15,000 as initial salary.
The first task was to organize and begin operations. For Strong this meant not only staffing the New York bank but organizing the System. Since he regarded the Board as a political agency and saw the banks as the business end of the System,25 Strong moved to enlist the support and cooperation of the other reserve bank governors so as to make the banks the dominant partner. His opportunity came very quickly. The Board called a meeting of the governors for December 10–12 to discuss common problems. The governors used the meeting to organize a permanent Governors Conference, with Strong as chairman.
22. See his letters to Adolph Miller and to Paul Warburg, both of the Board, quoted in Chandler 1958, 90–91. Warburg’s views on real bills, discussed earlier, were similar to Strong’s. The two had worked together on the Aldrich bill. One of the first statements issued by the Federal Reserve appears in the Commercial and Financial Chronicle for November 14, 1914. The statement declares that discount policy is for the purpose of financing self-liquidating loans, or real bills (Mints 1945, 266).
23. In a letter to Warburg, Strong explained that he would decline the offer to serve as governor of the New York bank because of his disagreement over two features of the act—failure to create a central bank and vesting the note issue in a government institution. He accepted the appointment only after a weekend of persuasion by banking friends including Warburg (Chandler 1958, 39).
24. There are many references to Bagehot and Bagehotian principles in speeches at the time of passage. One proposal that did not become law would have made discounting up to twice the amount of the banks capital and surplus a right and not a privilege of membership. This proposal was defeated in the Senate by a vote of thirty-seven to thirty-one (Timberlake 1978, 202). Had it been approved, Federal Reserve history, particularly during the Great Depression, might have been very different.
25. Strong, like Warburg, had favored the Aldrich plan based on foreign central banks. The political role of the Board referred to the presence of the secretary and the comptroller on the Board, its presence in Washington, and the legal requirement that the Board’s accounts were subject to audit (until 1933) by the General Accounting Office. On the other hand, the attorney general ruled in December 1914 that the Board was independent of the Treasury (Beckhart 1972, 31). The Federal Reserve Act was unclear about the specific function and responsibilities of the treasury secretary. He was chairman of the Board bylaw, but the duties of the chairman and his relation to the governor of the Board were not spelled out (Dykes and Whitehouse 1989).
From the start, the Governors Conference tried to control operations. At its first meeting, the governors discussed how the reserve banks would conduct open market operations.26 One of the main issues was whether each bank would operate independently, as prescribed in the law, or whether they would operate collectively, as required for centralized control. Early in 1915, at Strong’s suggestion, the banks agreed to combine operations in both the open market and acceptance accounts to avoid any effect of competitive purchases on market rates. Although effects on the market were recognized, purchases were made principally to increase the earnings of the reserve banks and were allocated to the individual banks in part based on their need for earnings. Reserve banks retained the right to purchase independently (Anderson 1965, 8; D’Arista 1994, 22). Not all the governors were satisfied. Some claimed that New York did not buy enough, so their earnings were held down.
The reserve banks also purchased the 2 percent bonds that continued to serve as collateral for national banknotes. The aim was to replace national banknotes with Federal Reserve notes. At first purchases were made by the individual reserve banks for their own accounts. By 1917 wartime expansion of the reserve banks reduced pressures to increase earnings, so the banks centralized open market purchases of the 2 percent bonds in New York. Concern for earnings returned, however, in the early 1920s and in the mid-1930s. The reserve banks again acted independently in the early 1920s until a new agreement was reached. Centralization of open market operations and the decision about participation remained as problems until the Banking Act of 1933 amended section 14.
The Board also sought control. One of its earliest acts was to rule that the reserve banks could not announce or change discount rates until they had been approved by the Board (letter of Parker Willis to all reserve banks, Board of Governors File, box 1239, November 18, 1914). The Board based its order on the provision of section 13 that gave the reserve banks power to establish rates “subject to review and determination of the Reserve Board.” The governors chose to interpret “review and determination” as pro forma but the Board insisted that discount rates were subject to the Board’s “determination.”27 Early in 1915 the Governors Conference approved a resolution giving the reserve banks sole power to initiate discount rate changes “without pressure from the Federal Reserve Board” (Chandler 1958, 71).
26. The first open market purchase of $5 million of New York City tax anticipation notes was made by the New York bank on December 31, 1914.
Initially, discount rates were set above prevailing market rates; they were penalty rates to provide discount facilities in periods of market malfunction, as proposed by Bagehot.28 This principle was in conflict both with the political desire for lower interest rates during the 1914–15 recession and with the desire of the reserve banks to increase earnings.29
Earnings depended on membership. The act required approximately 7,500 national banks to be members, but state-chartered banks had a choice. Among the obstacles to membership were requirements for par collection of checks cleared at Federal Reserve banks and for holding reserves at Federal Reserve banks without earning interest. As of June 30, 1915, only seventeen of nearly twenty thousand state banks had elected to join. A year later state bank membership had increased only to thirty-four.
Partially offsetting these increased costs of membership, the act broadened the powers and reduced the reserve requirement ratio for national banks.30 Cagan (1965, 140) estimates the reduction as 13 percent in November 1914, when the System started operations. This reduction was partially offset in subsequent years by the requirement that member banks deposit more of their required reserves at Federal Reserve banks. In June 1917, by law all required reserves were held at Federal Reserve banks; vault cash was excluded from reserve computation.31 The legislation increased gold held by the Federal Reserve in excess of requirements by $300 million.32
27. This clause continued as a source of friction. In 1919 and again in 1927, the Board considered or ordered a change in a discount rate without prior action by one of the reserve banks.
28. Until the early 1920s penalty rates were considered the normal arrangement. Warburg wrote to John Perrin, Federal Reserve chairman and agent at San Francisco: “Whenever the market rate approaches the bank rate, the bank rate will be increased” (Board of Gov
ernors File, box 1239, December 13, 1914).
29. The latter was a legitimate concern. The reserve banks were required to cover expenses, including salaries for the Board and its staff and a cumulative dividend for the member banks. Section 10 of the act authorized the Board to assess the reserve banks in proportion to their capital and surplus. The reserve banks as a group had negative earnings (– $141,000 before dividends) for the period from their organization in November 1914 to December 1915. The reserve banks were authorized to assess member banks if necessary to meet expenses. In 1915 the Board discussed an assessment to cover losses and voted in favor, but the reserve banks recognized the effect on membership and were reluctant to choose this option (Board of Governors of the Federal Reserve System, Board Minutes, September 21, 1915, 1154 [hereafter cited as Board Minutes]). Moreover, with the gold inflow providing reserves, banks had little reason to discount. Further, the reserve banks were obligated to pay a 6 percent cumulative dividend on capital stock owned by member banks. Any net earnings in excess of dividend were divided between payments to the Treasury and the surplus account of the reserve banks. (When the surplus account reached 40 percent of paid-in capital, the entire net earnings were to be paid to the Treasury as a franchise tax on the note issue.) The law changed in March 1919 to permit the reserve banks to keep all net earnings after dividends until the surplus reached 100 percent of subscribed capital, after which 90 percent of earnings was paid as a franchise tax and the remaining 10 percent was added to surplus. The franchise tax was repealed in 1933 and restored after World War II (Board of Governors of the Federal Reserve System 1943, 329 n. 7).