America’s Money Machine

WINDS ALWAYS RISE in the unexpected quarter. This is true of the early years of the Federal Reserve. All the monetary intelligence of the country, all the debates in Congress and in the pages of the journals, were devoted to devising a monetary system that would meet unexpected monetary stringency, a shortage of cash. That sort of crisis arose and was solved well before the new institution had gotten its sea legs. The problem it now had to deal with was of the very opposite—an unexpected plethora of funds.

The panic that had overtaken the markets with the outbreak of war had been followed by a dazzling recovery and boom as the U. S. became the supplier of all sorts of war materials to the Allied combatants. Merchandise exports, which had amounted to $2.6 billion in the year just preceding the outbreak of war, rose to $6.3 billion in the year ended June 30, 1917. U. S. exports went not only to meet European shortages but to fill the gap created by the withdrawal of European exporters from other foreign markets. Within three years the U. S. had piled up credits from exports of $6 billion. Some $2 billion of this was met by sales by Europeans of their holdings of American securities; of the balance, some $1.1 billion was settled in gold. Thus, the year 1914 had seen an export of $165 million of gold but in 1915 the tide returned with $420 million. Most of this went to the banks and from them in turn to the Federal Reserve banks, whose gold stock increased from $227 million to $542 million. At the end of 1916 the total gold stock was $2,556 million, of which $1,574 million was in circulation in the form of gold coin or gold certificates, and $736 million in the Federal Reserve banks.

Actually there was no demand for rediscounts. On November 17, 1916, the member banks of the Federal Reserve System held some $2,536 million of reserves, or something like $1 billion more than they actually required. This is shown in the following table:

The Board’s suggestions were not acted upon at once, but the decision to enter the war was persuasive with the Congress that the Federal Reserve System’s powers should be increased and the changes requested were enacted by an amendment to the Federal Reserve Act approved June 21, 1917.

At the same time, Congress also generously made substantial reductions in the reserve percentages required to be held by member banks. The old National Bank Act, it will be recalled, had required a reserve against deposits and circulation of 25 per cent for reserve city banks and 15 per cent for other banks. The Federal Reserve Act had reduced this percentage to 18 per cent for Central Reserve city banks, 15 per cent for Reserve city banks, and 12 per cent for so-called “country banks,” and 5 per cent for time deposits for all classes of banks. The new percentages against demand deposits established by the amendment were 13 per cent for Central Reserve city banks, 10 per cent for Reserve city banks and 7 per cent for country banks. To secure the concentration of the gold stocks of the country, the act provided that all reserves must henceforth be held with the Reserve banks, eliminating any requirement as to cash in vault. The immediate result of these amendments was to transfer additional gold to the Reserve banks and thereby to increase the lending power of the Reserve banks.

Along with these steps to increase the “elasticity” of the monetary system, that is, to extend the note issue and credit power of the Federal Reserve System, the Congress allowed the gold reserve to count as part of the reserve against note issues. (The Federal Reserve Act had some-what anomalously provided that note issues should be covered by the deposit of collateral to the extent of 100 per cent of the notes issued, which meant in effect 140 per cent coverage, including the gold reserve.)

The Federal Reserve now began the operation of what has since developed into its most significant and powerful mechanism for the control of the amount of banking credit in circulation. This is what is known as open market purchases. Since the commercial banks showed a reluctance, or indifference, or a lack of any necessity to discount their commercial paper with the Federal Reserve banks, Federal Reserve authorities went into the market and purchased such paper. During 1915 commercial banks had discounted $32 million of bills. The Federal Reserve System itself purchased $16 million of government bonds and $24 million of commercial bills. These purchases were made under Section 14 of the Federal Reserve Act which provided originally that “any Federal Reserve bank may, under rules and regulations prescribed by the Federal Reserve Board, purchase and sell in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals, cable transfers and bankers acceptances and bills of exchange of the kinds and maturities by this Act made eligible for rediscount, with or without the endorsement of the member banks.” Section 14(b) of the act also authorized the Federal Reserve banks to buy and sell bonds and notes of the United States as well as certain categories of securities of states and their subsidiary governmental entities.

The process is officially explained by the Federal Reserve System in the following language:

The process through which open market operations by the Federal Reserve are reflected in the volume of member bank reserves, loans and investments, and deposits merits simplified description. If the Federal Reserve decides to buy, say, 25 million dollars of Government securities, it places an order with a dealer in such securities and he buys the securities in the open market, or sells the securities from his own portfolio. In payment the dealer receives a Federal Reserve bank check. The dealer deposits the check with a member bank, which in turn deposits it in its reserve account with a Federal Reserve bank. The dealer then draws checks on these funds to pay the seller of the securities or to retire loans which he had contracted in order to carry the securities in his portfolio. The result is that the Reserve bank has added 25 million dollars to its holdings of United States Government securities, and the same amount has been added to the reserve accounts of some member banks.

Thus, by not waiting for the member banks to use their rediscount privilege, but by going into the open market and buying bonds or commercial paper, the Reserve banks force additional credit, or lending power, into the commercial banking system, by the mechanism just described. To reduce the amount of bank credit in the country the Federal Reserve simply reverses the process.

The pinch met by the Federal Reserve authorities in 1916 was that this mechanism could put bank credit into the economy but not circulating notes. This was because under the law as it then stood, Reserve banks could not issue circulating notes against commercial paper bought in the market. Notes could be issued only against rediscounts.1

Actually, because of the increasing use of the bank check as a medium of transfers instead of paper money (circulating notes), this limitation did not greatly constrict the monetary authorities; nevertheless, since the ultimate of liquidity is cash and as some creditors might prefer cash to a deposit credit, it seemed necessary to make the issue power co-extensive with the credit power of the system. To cure this difficulty, Congress was persuaded in 1916 to amend the Federal Reserve Act to permit bills bought in the open market to be used as security (collateral) for Federal Reserve notes. This permitted the Reserve banks to monetize this type of paper by delivering it to Federal Reserve agents and obtaining notes.

Later, in 1917, the act was again amended to permit the use of member bank promissory notes as collateral. It was not until 1932, however, that the Reserve banks were authorized to use government bonds directly as collateral for notes.

After having obtained these various new authorities, the Federal Re-serve System was now in a position to do a handsome job of financing the needs of the war.

When war became apparent, it was recognized that an extensive program of Treasury financing would be necessary, and considerable apprehension was felt among the Reserve authorities as to the extent to which the System would be employed to provide these funds by way of the inflationary process of monetizing public debt instead of by taxation. They soon learned. Secretary of the Treasury McAdoo notified the Reserve he desired to float an issue of $50 million certificates of indebtedness at 2 per cent—a rate so low that they would have to be taken up by the Reserve banks themselves through direct purchase. The proposal created consternation in the banking world, but not enough to modify the program other than to raise the rate to 2 1/2 per cent on subsequent issues. The Reserve banks in consequence took over the entire issue.

There was some evidence that McAdoo intended to finance the war by this means of short term issues to be sold to the banks, much as Secretary Chase had done during the Civil War. Fortunately this extremity was avoided, but the Reserve authorities soon recognized that they would have to provide the main financing, indirectly, by lending on the security of government bonds. The main concession obtained by the Reserve from the Treasury was that the Reserve banks should act as fiscal agents for the government, as was originally contemplated by the Act but which had until now been resisted by the Treasury. The effect of this transfer of function was to give the Reserve banks control of the large cash funds previously held by the sub-treasuries.

In order to assure success of the various “Liberty” loan issues, the Federal Reserve set a rediscount rate for customers’ notes secured by government bonds that would make it easy for patriotic citizens to subscribe for the bonds, and then pay for them by borrowing against them at exactly the same rate as the bonds yielded. The first Liberty loan carried 331/2 per cent coupon, and the rediscount rate was 31/2 per cent. As the Board frankly stated, in its 1917 Report:

It is worth a look at the effect upon the monetary system as a whole of this subservience of the Federal Reserve to the Treasury. Between April, 1917, and the end of 1918, Federal Reserve note circulation increased from $399 million to $2,629 million and deposit credit increased from $804 million to $1,804 million. During this period the amount of gold coin and gold certificates in circulation was reduced from $1,673 million to $618 million, with most of this gold going into the coffers of the Reserve banks to provide a base for increased credit and circulation. Deposits and note issue became the basis, of course, for an expansion of commercial bank credit and this is reflected in the rise in loans and investment of all banks from $24.6 billion (as of June 30, 1916) to $36.6 billion as of June 30, 1919, an increase of nearly 50 per cent. Banks were encouraged to invest directly in U. S. government obligations—principally the various Liberty loans—and the holdings of government bonds increased from $1.6 billion on June 20, 1917 to $5.8 billion on June 30,1919.

The expansion of Federal Reserve credit had been mainly through the increase in rediscounts on behalf of members, with total bills discounted rising from $28 million at the end of 1916 to $2,215 million at the end of 1919. Bills bought in the open market increased from $128,956,000 at the end of 1916 to $574,104,000 at the end of 1919 and U. S. government securities acquired increased from $55 million to $300 million.

The significance of these statistics may be read in this: that while the banking system itself was not reluctant to utilize the resources of the Federal Reserve System to increase its banking power, even this lavish recourse to the Federal Reserve banks did not seem to be enough, for the Federal Reserve authorities continued to pump credit and circulation into the economy by means of purchases of bills in the open market and U. S. government securities.

All this credit expansion, it may be argued, was merely the response to the enormous drain upon the economy to provide the materials of war both for our own needs and those of our European allies and to keep pace with the steadily rising price level occasioned by the demand for goods and services of all kinds. But this is only part of the story. The availability of free credit stimulated a boom which was becoming beyond the powers of the System to control. This is seen in the continued expansion of bank credit even after the close of hostilities. Thus, by the end of 1920 total reserves of the Federal Reserve System had increased to $2,250 million; bills discounted had risen from $2,215 million to $2,687 million, offset, however, by a decline in bills bought from $574 million to $260 million and a decline of $13 million in holdings of U. S. government securities.

Toward the end of 1920 a new crisis occurred, similar to that of 1907, yet marked by differences, which led the country into new theories regarding the function of money and monetary control.

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2 Notes could be issued only against application for notes by a Federal Reserve bank and “the collateral security thus offered shall be notes and bills accepted for rediscount under the provisions of Section 13 of this Act.” Section 16.

• 1* Notes could be issued only against application for notes by a Federal Reserve bank and “the collateral security thus offered shall be notes and bills accepted for rediscount under the provisions of Section 13 of this Act.” Section 16.
• 2The pinch met by the Federal Reserve authorities in 1916 was that this mechanism could put bank credit into the economy but not circulating notes. This was because under the law as it then stood, Reserve banks could not issue circulating notes against commercial paper bought in the market. Notes could be issued only against rediscounts.*