30. Under the National Bank Act, there were three classes of banks. Central reserve city banks in New York, Chicago, and St. Louis were required to hold 25 percent of deposits as reserves in gold, government currency issues, or gold certificates issued by a clearinghouse. National banknotes could not be used as reserves. Reserve city banks also had a 25 percent reserve requirement, but half could be held at central reserve city banks at prevailing interest rates. Country banks had a 15 percent reserve requirement ratio, of which 60 percent could be deposits at reserve city or central reserve city banks. These requirements applied to all deposits, demand and time. Treasury deposits were exempted in 1908. The Federal Reserve Act set different reserve requirement ratios for time and demand deposits. For demand deposits, the initial reserve requirement ratios were 18 percent for central reserve city banks, 15 percent for reserve city banks, and 12 percent for country banks. For time deposits, the ratio was a uniform 5 percent. Initially, vault cash and correspondent balances counted as reserves, up to 6, 5, and 4 percent at the three groups of banks respectively.
Strong, and also Warburg (1930, 2:150–52), regarded the centralization of reserves as critical to the success of the System. Failure to deposit reserves at the reserve banks meant that gold holdings were dispersed, as they had been before the act. Without centralization, the System would be in a weak position to respond if the gold inflow from Europe reversed at the end of the war. Even if the gold remained, Warburg believed, the System required a larger gold reserve so that it would not be forced to contract the note issue in recessions as eligible paper declined. A larger stock of gold could be used to maintain the note issue.33 After June 1917, vault cash no longer counted as part of reserves, so banks deposited more of their gold at the reserve banks.
31. At the same time, requirement ratios were reduced to 13 percent, 10 percent, and 7 percent for central reserve city, reserve city, and country banks and to 3 percent for time deposits, greatly expanding the money multiplier. Cagan (1965, 190) estimates that the 1917 amendment was a 21 percent increase in the monetary base. The increase was partly offset by reductions in the amounts discounted. These 1917 ratios remained unchanged until August 1936. In 1922 St. Louis changed from central reserve to reserve city classification, releasing a modest amount of required reserves. Vault cash did not again count as part of reserves until 1959. Miller (1921, 180) explains the 1917 legislation as a wartime measure to centralize gold reserves and provide for expansion of money and credit to finance the war. Sprague (1921, 19) estimates that the Federal Reserve increased the base money multiplier by 50 to 100 percent compared with the pre–Federal Reserve period.
32. The legislation also made membership more attractive for state banks by permitting them to withdraw on six months’ notice. Warburg also wanted the Board to have authority to raise reserve requirements in case of a large gold inflow. This authority was not granted until the 1930s. Reserve requirement ratios could be reduced for central reserve and reserve city banks if five of the seven members of the Board approved. State banks also disliked having the comptroller of the currency as a member (ex officio) of the Board. They feared he would favor national banks. In 1915 the Federal Advisory Council urged an amendment removing the comptroller, but no action was taken (Board Minutes, 1915, 1158). The Federal Advisory Council consisted of bankers from each of the districts. It was authorized by the Federal Reserve Act and continues to the present as an advisory group to the Board.
Gold flows in 1915 reversed the direction of change in interest rates. Early in January, discount rates followed market rates down. Interest rates continued to fall slowly through the first year of operations. The Board was quick to claim credit. Governor Hamlin wrote that by merely opening the doors, the steadying effect of the act became apparent in the market (Board of Governors File, box 1239, December 17, 1915). The reserve bank governors were more skeptical. When the Board asked all reserve banks to describe the effect of the new system, most attributed the decline in interest rates to gold inflows and the increase in gold reserves. Chairman John Perrin (San Francisco) wrote that there was “very little tangible evidence that the establishment and operation of the Federal Reserve bank has influenced rates in any important way.” Pierre Jay, chairman at New York, wrote that the new system had “no effect whatever” (letters, Board of Governors File, box 1239, December 11 and 13, 1915).
Although the governors invited the Board to send representatives to their meetings, and they sent summaries to the Board, the Board regarded the Governors Conference as a rival organization that weakened its authority by operating independently. It resented decisions by the governors to meet at reserve banks instead of in Washington. It was determined to prevent the governors from meeting too frequently or acting independently.
The Board decided to take control after the Governors Conference criticized the Board for “an exercise of pressure” on the reserve banks. It sent a letter to each of the governors suggesting that the governors hold no more than three or four meetings that year. Although the Board approved $12,900 in expenses for the most recent meeting, it told the governors that their expenditures were too large. The Board did not object to informal discussions among the governors, but “a permanent organization, the appointment of an executive committee, and the election of a paid secretary, are matters . . . of doubtful propriety and beyond the scope and powers of the Federal Reserve banks as defined in the Federal Reserve Act” (Board Minutes, January 20, 1916, 79). The creation of a standing executive committee “might create the impression that certain banks. . . had delegated certain powers to a definite committee” (80). Responding to the governors’ criticism, the Board replied that the governors had “assumed powers which they do not possess . . . when they undertook collectively to direct or to suggest to the Federal Reserve Board the manner of its exercise of the powers conferred upon it by the Act” (81).34
33. Under Warburg’s proposal, the Federal Reserve would not follow gold standard rules.
The Board won the first contest, but the issues of control and power were put aside, not resolved. Late in July the secretary of the Governors Conference notified the Board that the governors planned to meet on August 15. By this time Harding had replaced the conciliatory Hamlin as governor (Katz 1992, 119). Harding responded that the Board did not want a conference held and that in the future conferences could be held only if called by the Board. The Treasury opposed a conference, Harding wrote, and, he added, “plans for the proposed meeting should be abandoned. . . . [I]n matters which concern interbank relations and operation of the Federal Reserve banks as a system, authority is vested by law solely in the Federal Reserve Board” (Board Minutes, July 25, 1917, 99–101). McAdoo attended the meeting and concurred in the decision. He urged the Board to keep the Federal Reserve banks in hand. To rein in the banks, he had considered appointing five additional government directors to the banks’ boards, but he postponed the decision pending a favorable resolution of the dispute.
The following week the Board formally adopted the resolution discussed in the letter to the reserve banks. There was to be no permanent organization and no Governors Conferences unless called by the Board. No further conferences were held until November 1917.35
The Board and the reserve banks also clashed over the obligation of one reserve bank to discount for another and the rate to be charged for inter-district borrowing. The intent of the act was to pool gold reserves by permitting interdistrict borrowing, thereby smoothing regional demands for reserves and borrowing associated with crop movements. The Board had authority under the act to set the rates for interdistrict loans. Strong disliked the provision and sought to limit its scope by permitting the lending bank to set the rate on borrowings (D’Arista 1994, 19). The Board members insisted that this was their responsibility, and they prevailed.
34. On March 9 the Board voted to publish expenses of the Governors Conference in the Federal Reserve Bulletin, but they reconsidered on April 21 and voted to include these expend
itures in the accounts of the reserve banks (Board Minutes, 1916).
35. In March 1918, Strong proposed a Governors Conference to act on interest rates. The Board responded that if a meeting was held, it would be confined to Treasury security sales and a few technical matters. Strong held an informal meeting in New York with about six governors (Board Minutes, March 8 and June 22, 1918). As late as May 1921, Governor Harding appointed a committee of governors to consider whether the Governors Conferences should be continued. The governors responded that they wanted more frequent conferences, with some held at reserve banks. Harding remained opposed to meetings outside Washington, and none were held (Federal Reserve Governors Conference, May 28, 1921 [hereafter cited as Governors Conference]).
In March 1915 the Board established interdistrict rates. No transactions were made until 1916, when rates were set by the Board on each transaction. In the fall of 1920 the Board reestablished a common rate for interbank rediscounts related to the discount rate on member bank borrowing.
POLICY PROBLEMS
Almost from its founding, the System faced a series of major policy problems. First there was an outflow of gold before the reserve banks opened, as foreigners sold dollar securities at the start of the war in August 1914. Exports declined for lack of shipping because German and British ships that had carried much of the freight withdrew. Commodity prices, particularly for exportables, fell sharply. The initial wartime problems were severe enough to send the dollar above five dollars per pound sterling, well above its intervention point. The New York Stock Exchange and most foreign stock markets closed to hinder sales of securities and demands for gold.
Soon after the reserve banks began operations in November, a gold inflow replaced the outflow and produced monetary expansion and inflation. Wartime inflation, resulting from the financing of Treasury bond sales, soon followed. After the war there was the difficult task of establishing independence from the Treasury and developing an anti-inflation policy. By 1920 the System had to deal with its first recession. The System’s response to this series of events—the discussions, the proposals for action, and the actions themselves—reveals the policy approaches and understanding of the Board members and governors at the time and the flaws in the act.
The Federal Reserve System was not fully organized when war started in Europe, so it had a minor role in responding to the gold outflow. In September the Treasury issued emergency currency, authorized under the Aldrich-Vreeland Act of 1908.36 One of the Federal Reserve’s first actions was to oppose issuance of additional Aldrich-Vreeland currency. It worked with the Treasury to organize a group of bankers that subscribed $108 million to redeem United States loans abroad. The organization of the fund may have helped to restore calm; only $10 million was drawn.
36. The act expired in June 1915 and was not renewed. The emergency currency issue helped to prevent a panic (Friedman and Schwartz 1963, 196; Dykes and Whitehouse 1989, 237). At its peak in October, $308 million of emergency currency was outstanding, approximately 15 percent of total currency. In addition, banks issued clearinghouse certificates to pay their adverse balances (Chandler 1958, 56). There were no bank runs and the crisis was overcome, a marked contrast to experiences in 1929 to 1933.
Gold Flows
Within a few months of the start of the European war, exports increased and gold flowed to the United States in payment. In 1914 the United States held 19 percent of the world’s monetary gold stock. By 1918 its monetary gold stock had increased by 65 million ounces, more than $1.3 billion at the official gold price, $20.67 per fine ounce. The increase was 88 percent of the United States monetary gold stock in 1914 and more than 16 percent of the world’s prewar monetary gold (Schwartz 1982, tables SC7 and SC10).37
The Federal Reserve followed gold standard and penalty rate rules by reducing discount rates as market rates fell. By mid-December 1914 it had lowered discount rates at all reserve banks. By February 1915, rates at most reserve banks were two percentage points lower than on opening day.38 Market rates rose briefly in the spring, perhaps in anticipation of the expiration of Aldrich-Vreeland currency issues on June 30. The Board issued a press release urging the reserve banks to “discount as liberally as prudent” (Board of Governors File, box 1239, January 21, 1915). No problems occurred, and interest rates resumed their decline.
The gold inflows substantially increased the monetary base. Table 3.1 shows annual rates of increase in the base from 1915 to 1922. The Federal Reserve was at first powerless to stop or offset the increases even if it had chosen to abrogate gold standard rules by selling securities. The open market portfolio of government securities at the end of 1916 was only $55 million.39 In fact, the System made small net purchases of government securities in 1915 and 1916 and larger net purchases after the United States entered the war in April 1917.40 Many of these purchases were made to increase the reserve banks earnings.41
37. In addition, foreigners sold $2 billion of American securities and borrowed $2.4 billion. The United States became a net creditor.
38. In the early years, discount rates differed by maturity and by district. I have used the rates on thirty-one- to sixty-day commercial and agricultural paper.
39. The Federal Reserve requested authority to increase reserve requirements of member banks, but Congress did not approve. Increases in reserve requirement ratios were often politically unpalatable. Congress resisted or ignored proposals to increase statutory authority both at this time and after World War II.
40. Net earnings before payments to the Treasury rose from $2.7 million in 1916 to a peak of $149 million in 1920. The 1920 earnings were not surpassed in nominal value until 1948. Most of the increase at the end of World War I came from the increased volume of discounts.
41. One achievement of the early years was a reduction of the seasonal swing in interest rates. Warburg (1930, 2:357–58) emphasizes this result. For a modern analysis supporting his view, see Mankiw, Miron, and Weil 1987.
Alarmed at the increase in bank reserves and unable to get Congress to permit changes in reserve requirement ratios, the Board began 1917 by urging all reserve banks to let their aggregate acceptances decline by $40 million to $50 million, 20 to 25 percent of their holdings (Board of Governors File, box 1239, January 19, 1917). Several of the reserve banks ignored the request to maintain earnings.
Discount rates remained mostly unchanged until late in the year. The Board confined its activity to simplifying the rate structure. Reserve banks were requested to post no more than seven discount rates by type and maturity and to unify the rate structure across districts. The reserve banks’ responses to the request show the diversity that prevailed at the time in the United States.42
Wartime Finance
Once the United States entered the war, government spending increased. The nation advanced $7.3 billion to its allies during the war and an additional $2.2 billion after the war (Friedman and Schwartz 1963, 216). Effective income tax rates increased sixfold from 1916 to 1918, but the increased revenue was much less than the increased spending, so the Treasury had to finance relatively large deficits (Bureau of the Census 1960, 716).43 Military spending increased from less than $1 billion in fiscal 1916 to an average of $15 billion a year for the fiscal years ending June 1918 and 1919.
The war reshaped the Federal Reserve System in many ways. Most foreign governments suspended the gold standard, so it no longer served as a guide to policy. The System abandoned the penalty discount rate in the interest of war finance. The number of state member banks rose to more than a thousand by 1919, and they included the largest state-chartered banks, with 40 percent of the assets of all state-chartered banks (Bureau of the Census 1960, 633). Wartime (and prewar) changes made the System more like a central bank, as in World War II. Independence was sacrificed to maintain interest rates that lowered the Treasury’s cost of debt finance. The System became subservient to the Treasury’s perceived needs.
42. For example, the New Orleans branch of the Atlanta reserve
bank had a different structure of rates than Atlanta. Many banks had more than seven rates. Schedules differed by number of rates, type of discount, and maturity.
43. Gross public debt rose from $1.2 billion on June 30, 1916, to $25.5 billion on June 30, 1919 (Bureau of the Census 1960, 720). Deficits for the two fiscal years 1918 and 1919 were $22.3 billion, a large fraction of GNP but not as large as the 50 percent share estimated at the time. Average nominal GNP for the two years is $73.5 billion (Balke and Gordon 1986, 793). Friedman and Schwartz (1963, 221) put the total cost of wartime outlays at $32 billion, with 70 percent financed by borrowing, 25 percent by explicit taxation, and 5 percent by money creation. Their estimate implies a $22.4 billion increase in debt for war finance.
The Federal Reserve’s main wartime activity was selling Treasury bonds. The New York bank wanted to replace the existing Independent Treasury System, carried over from the nineteenth century, by serving as fiscal agent for the government. Its wartime activities, and those of the other reserve banks, included selling almost half of the debt issues. It succeeded in convincing the Treasury that the Independent Treasury System was redundant. In 1920 the New York bank was designated fiscal agent, and the Independent Treasury System ended.
Wartime finance consisted principally of a series of Treasury bond drives or Liberty Loans. The governors of the reserve banks served as chairmen of the committees organized in each district to sell Treasury bonds to the nonbank public. Since the amount borrowed was large relative to the size of the country or previous credit demands, the System ensured the success of the four wartime Liberty Loans by making two types of loans. Short-term loans at preferential discount rates encouraged banks to buy short-term Treasury certificates during the interval between bond drives. Initially the discount rate on these loans in New York was 3 percent for fifteen days and 3.5 percent for sixteen to ninety days. Rates rose to 3.5 and 4 percent in December 1917 and to 4 and 4.5 percent in April 1918, where they remained until November 1919.44 Loans were also made to encourage banks to stretch out the public’s payments for purchases of Liberty Loan bonds over $1,000. The latter was known as the “borrow and buy” policy. Its original intent was to avoid a short-term contractive effect on the money stock and interest rates as buyers drew down their balances to make payments to the Treasury (Governors Conference 1917, 233). Later it became a marketing device for the bonds, since buyers could defer payments for as much as a year from time of purchase.
A History of the Federal Reserve, Volume 1 Page 13
