The memo recognized that the same reduction in excess reserves could be achieved by selling securities. Raising reserve requirements would not affect the government bond market, unlike open market sales, or diminish the earning assets of the reserve banks. It would begin a policy of using the new instrument to adjust to new conditions while reserving traditional methods to expand or contract bank credit. And it would put the Federal Reserve in a better position to control credit expansion by open market operations.
The con case was shorter. There was no evidence of a need for restraint. Policies of restraint should be used when restraint is required, or they risk misunderstanding. Both the open market portfolio and the effect of a maximum increase in reserve requirement ratios would remove current, but not future, excess reserves. It might be better to wait to get the maximum effect “when the need comes.” Action might retard recovery, although it should not.167
On November 15 the directors of the Chicago bank voted to advise the Board that they favored an increase in reserve requirements. One director opposed, preferring a sale of government securities. A month later, New York unanimously endorsed the change (Board of Governors File, box 1450, November 15 and December 16, 1935). The Board was ready to act. The next steps were to discuss the issue with Secretary Morgenthau and to prepare a press release announcing the increase, effective January 1, 1936.
Morgenthau was still chairman of the Federal Reserve Board, but he attended few meetings. On November 7 Eccles briefed him on the Board’s decision to raise reserve requirement ratios. Morgenthau prepared for the meeting by getting opinions from former undersecretary Parker Gilbert, a partner at J. P. Morgan, Walter Stewart, and Jacob Viner. All three urged delay; the economy was recovering but needed stimulus, not contraction (Blum 1959, 354–55). Morgenthau added concerns about financing the 1937 budget deficit that would soon be sent to Congress, and he urged delay for three or four months. Eccles agreed that there was no reason for immediate action, but based on the staff memo about the distribution of reserves, he assured Morgenthau that the increase would have no market effect. Eccles reported his conversation to the Board. No action was taken (Board Minutes, November 8, 1935, 1–5).
In May, stock prices started to rise rapidly. After remaining unchanged through 1934, the Standard and Poor’s index rose 40 percent in 1935, with much of the increase in the second half of the year. Many of those who believed that the 1927–29 stock market boom had caused the economic and financial collapse interpreted the 1935 increase as another speculative boom presaging another collapse.
Eccles had started to issue a press release after every FOMC meeting, announcing the decision, if any, and the main issues discussed. The release following the November 22 meeting discussed inflation and the stock market boom. It defined inflation as “a condition brought about when the means of payment in the hands that will spend them increases faster than goods will be produced” (Press Releases, Board of Governors File, box 1441, November 22, 1935, 1). The memo added that the economy was a long way from inflation. It noted that the increase in stock prices was financed by cash, not credit, a reminder that concern about “speculative credit” remained widespread.
167. The Federal Advisory Council opposed, preferring open market sales because of the “rigidity” of reserve requirements (Board of Governors File, box 1450, November 21, 1935). Open market sales would transfer earning assets to the market; increased reserve requirement ratios would reduce bank earnings.
Many bankers criticized administration policy. Some used devaluation, continued budget deficits, large excess reserves, and rapidly rising stock prices to claim that the administration was bent on inflation.168 As the election year approached, Morgenthau regarded much of this criticism, and many of the pressures to reduce excess reserves, as political efforts to hurt the administration (Blum 1959, 355–56). But he also accepted the argument that rising excess reserves permitted increased inflation. Resisting Harrison’s argument for higher reserve requirement ratios to control the stock market, he recommended an increase in margin requirements instead. Harrison replied that the purchases were for cash, so increased margin requirements would not help. Higher reserve ratios were needed primarily to prevent future inflation and reassure foreigners that we recognized the danger (Memo, Conversation with Secretary Morgenthau, Harrison Papers, file 2012.5, November 21, 1935).
The Board reviewed its policy on December 17 with Harrison and Williams present. Goldenweiser presented the options, now including increased margin requirements. He favored an increase in required reserve ratios, but he warned of a possible bad psychological reaction. He recommended that a press release say that the Board wanted to foster recovery and that “if any action were taken on reserve requirements, it would be in the nature of a precautionary measure . . . rather than a reversal of the System’s easy money policy” (Board Minutes, December 17, 1935, 5).
Goldenweiser was ambivalent about the need for action. He saw the threat of future inflation if the banks expanded but found “no need to worry about inflation at this time with the very large volume of unused plant capacity and unemployment” (ibid., 6).169 He dismissed pressures from bankers to reduce excess reserves as based on a desire for higher interest rates (6).
John H. Williams supported Goldenweiser’s analysis but strongly urged prompt action: “The present volume of excess reserves was considerably greater than anyone considered necessary for the furtherance of the present easy money policy”(6). He wanted to absorb the 1935 excess reserve increase, and he proposed that action be taken in January as soon as the administration announced the 1937 budget proposal.
168. The extent of the hostility is suggested by the proposal at the American Bankers Association convention to boycott the government and, by refusing to purchase government bonds, force the government to reduce spending (Eccles 1951, 251).
169. He estimated industrial production as halfway between the depression low and the 1929 peak. (Current data put the recovery at two-thirds of the decline.) He put the gold inflow in the year to September at $900 million, and $3 billion since the devaluation.
The Board’s only action was to issue a press release after the meeting emphasizing that the volume of reserves, reflecting gold inflows, “continues to be excessive” and warning that “appropriate action may be taken as soon as it appears to be in the public interest” (Press Statement, Board of Governors File, box 1441, December 17, 1935).
The FOMC met the following day. It adopted a resolution calling on the Board to act “as soon as possible without undue risk” to absorb part of the excess reserves. It left to the Board decisions about the timing and size of the increase (Sproul Papers, FOMC Resolution, Excess Reserves, December 18, 1935).
Excess reserves decreased seasonally in December but rose back to $3 billion in January. The relation of the reserve banks to the Board was in an important respect the reverse of the 1920s. The bank governors were the only members of the FOMC for a few remaining months, but having decided to avoid open market operations, the FOMC could only petition the Board to act. On January 21 the committee again adopted a resolution, marked “very confidential,” recommending “a substantial reduction in excess reserves . . . as soon as this may be feasible” (Policy Record, Board of Governors File, box 291, January 21, 1936). The vote was nine to three in favor with Governors Roy A. Young (Boston), Oscar Newton (replacing the deceased Eugene R. Black at Atlanta), and William McChesney Martin Sr. (St. Louis) opposed.170
This was the last meeting of the full membership of the old FOMC. The Board ignored its principal recommendation, choosing instead to replay, in different form, the issue of general versus selective control. Three days later the Board voted to increase stock market margin requirements from 45 percent to 55 percent.171 Two months later, it extended the increase in margin requirements to collateral loans made by banks.172
170. The Board replied by letter, citing the increase in margin requirements and insisting that there had been little chan
ge in the past month (Sproul Papers, Excess Reserves, January 31, 1936). Harrison told the New York directors that the Board would not act until the new Board took office.
171. Legal counsel advised the Board that it had no responsibility for stock prices or the volume of trading. It could act only on a finding that action was “necessary or appropriate to prevent the excessive use of credit to finance transactions in securities.” Earlier in the same meeting the Board noted that the increase in loans on securities was “slight” and “the amount of borrowing at this time is low as compared with some past years.” Most of the purchases—estimated at 80 percent—were for cash. Nevertheless, the Board cited increased borrowing to justify its action and used its decision to increase margin requirements to reject the FOMC’s recommendation to increase reserve ratios (Board Minutes, January 24 and January 31, 1936).
172. Margin requirements are governed by Board regulation T, collateral requirements by regulation U.
These steps did not allay fears of inflation. In February the Federal Advisory Council concluded unanimously that the Board should increase required reserve ratios. The “present huge volume of excess reserves is a most serious menace.” The council did not make a specific recommendation about the size of the increase, but it urged an increase large enough to prevent the country’s credit structure from “being built on that part of the gold holdings which may be deemed to be transitory or temporary.” The council released its recommendation to the public within a week (Board Minutes, Meeting with Advisory Council, February 12, 1936, 2–3).
Reorganization
The Banking Act of 1935 required the treasury secretary and the comptroller of the currency to resign from the Board. The act also reduced the number of Board members from eight to seven and changed the membership of the FOMC.
Eccles did not want to reappoint most members of the Board. J. J. Thomas resigned as vice chairman in February to return to Kansas City as chairman.173 The new members included Ronald Ransom, a banker from the Atlanta district who had served on the legislative committee of the American Bankers Association. The bankers had split on the new legislation, but Ransom and the legislative committee had worked to get a compromise they could support. To gain Glass’s support for Eccles’s appointment, Roosevelt allowed him to choose three members of the new Board. He chose Ransom, John K. McKee, chief examiner of the Reconstruction Finance Corporation, and Joseph A. Broderick, New York state superintendent of banks. Roosevelt chose Eccles and Menc S. Szymczak from the old Board, and Ralph W. Morrison.174 Disagreement about the member to represent agriculture delayed appointment of the seventh member until June, when Roosevelt appointed Chester C. Davis, head of the Agricultural Adjustment Administration. The four new members joined the Board in February 1936. Four of the seven served through the end of World War II. Broderick left in September 1937 and Davis in 1941.175
173. Thomas was paid a salary for three years to encourage his return to Kansas City. In hearings on Eccles’s appointment, Glass again raised the issue of Eccles’s financial interests. Eccles replied forcefully, denying the charges, and the matter ended.
174. Morrison remained only five months. His nomination was pushed by Vice President Garner. He was a Texas rancher but had legal and financial difficulties and fled to Mexico in July 1936 (Hyman 1976, 201).
175. Szymczak served twenty-eight years, twenty-five of them under the new rules. His twelve-year term ended in 1948. He was reappointed for a full term but resigned in 1961. He served also as United States director in charge of German rehabilitation in 1946, on leave from the Board and, in 1944, as an adviser to the Bretton Woods Conference (Katz 1992, 314–16).
As the March 1 date for the new FOMC approached, the Board voted not to approve appointment of any president who was over seventy or would become seventy during a five-year term. Four governors left the System. George Seay (Richmond) had started as a governor in 1914.176 George W. Norris (Philadelphia) and John Calkins (San Francisco) had served since 1920. Of the old guard, only Roy A. Young (Boston), George L. Harrison (New York), and William McChesney Martin Sr. (St. Louis) remained.
The 1935 act did not specify who could be a member of the FOMC. Some reserve banks wanted to nominate people with wide experience in financial affairs who were not officers of the reserve banks. The Board voted that the non-Board FOMC members should be presidents of the reserve banks. At its organizational meeting on March 18 and 19, the new FOMC elected Eccles chairman and Harrison vice chairman and set March 1 of each year as the date for rotation of membership and election of an executive committee to execute transactions and allocate securities to the reserve banks. The new executive committee would have five members as before, but now three came from the Board.
The new bylaws changed the 1933 wording of the governing principle by omitting agriculture. More significant, the new statute now included “bearing upon the general credit situation,” an open-ended commitment to discretionary action. The rules barred individual reserve banks from making purchases and sales except as part of the committee, and the committee reserved the right to require a reserve bank to sell or transfer to the System Open Market Account any securities held or purchased outside the committee. The old issue of individual bank earnings was put to rest. Earnings would now depend principally on shares in the open market portfolio (Open Market Regulations, Board of Governors File, box 1433, March 19, 1936).
The Board now had control. Perhaps recalling October 1929, Harrison moved to permit a reserve bank to purchase government securities in an emergency. The motion was defeated. Eccles was unwilling to have the issue considered.
In May, the Conference of Reserve Bank Presidents and the new FOMC discussed the allocation formula for allotment of securities and earnings to the reserve banks. They agreed to transfer all securities held by individual reserve banks to the System account, but the individual reserve banks retained the right to enter into temporary resale agreements for up to fifteen days. The new FOMC retained the old formula for allocating profits and losses to individual banks (Board of Governors to Reserve Banks, Board of Governors File, box 1452, June 12, 1936).177
176. Governors Fancher (Cleveland) and McDougal (Chicago) had left in 1935 and 1934. As already noted, Black died at the end of 1934. His replacement (Newton) had served as chairman of the Atlanta bank.
The First Increase and Its Aftermath
Although the gold stock continued to increase during the winter and spring, excess reserves fell about $500 million between January and April. The decline did not change the discussion. Harrison and the commercial bankers continued to agitate for an increase in requirements. Harrison, Burgess, and Williams pressed hard at an April Board meeting, but the Board deferred action pending receipt of new information on individual bank positions showing how many banks would lose all their excess reserves. Eccles agreed with Morgenthau, who wanted to delay action until the Treasury completed its June financing (Hyman 1976, 216).
Roosevelt had a different view. With the political conventions starting, he wanted to show that he was alert to the risks of inflation. He told Eccles he preferred the increase in May rather than July (Blum 1959, 356). The political problem was less important to Eccles. The decisive factor for him was the decline in interest rates. During the spring and early summer, government bond yields continued to fall. Eccles’s concern was that banks would lend money and buy securities at low interest rates and suffer large losses in a future inflation (Eccles 1951, 289). Nevertheless, Morgenthau prevailed; the Board did not act.
On July 9 Eccles met with Roosevelt to explain that the Board was about to act and to discuss the political consequences of the action.178 He assured the president that he would not act if he thought interest rates would rise and that the FOMC would purchase bonds if bond prices fell by one point or more (ibid.).
The Board voted on July 14 to increase reserve requirement ratios by 50 percent. The new ratios were 19.5, 15, and 10.5 percent for demand deposits at central reserve city, r
eserve city, and country banks and 4.5 percent for all time deposits. The new requirements became effective on August 15. The vote was four to two, with McKee and Davis opposed.179 The staff estimate showed that the increase would absorb $1.45 billion of excess reserves but would leave excess reserves of $1.95 billion with $400 million to $800 million in excess reserves at the three classes of banks (Board Minutes, Board of Governors File, box 291, July 14, 1936, 4). The press release described the reserves as “superfluous” and the action as preventive, not a change in policy (ibid., 2–3).
177. The formula, proposed by Harrison in December 1929, provided for interbank transfers at book value and for profits and losses distributed at year end based on average annual holdings of securities. Since interest rates had fallen, many of the securities were above purchase price. Reallocation at book value had major effects on individual bank earnings. Additional meetings and some adjustments were required before the transfer could be completed (Minutes, FOMC, Executive Committee, June 24, 1936).
178. Under the new law, Eccles did not need presidential approval, but he believed “the country would hold him responsible for whatever was done” (Eccles 1951, 289). As this and his subsequent actions show, Eccles was not greatly concerned about independence from the executive branch.
The market was not convinced, and Morgenthau was “furious that Eccles had not warned him about the action” (Blum 1959, 356). He did not believe Eccles’s response that Roosevelt had been told the previous week. Bond yields rose by 0.01percent in the week following the announcement. The Treasury ordered Harrison to buy long-term bonds for the trust and stabilization accounts. The Federal Reserve joined in, selling bills and buying bonds.180 By late August, yields were lower than at the time of the announcement.
A History of the Federal Reserve, Volume 1 Page 73
