America’s Money Machine

THE REVIEW OF THE DEBATE leading to the passage of the Federal Reserve Act, which we have presented in earlier chapters, has made clear that it was the “liberal” or Bryan wing of the Democratic Party that carried its way in the formation of the new system. The one thing it demanded was a mechanism for making money and credit more plentiful. It was the “flexible currency” provision of the act that obtained the endorsement of the commercial and banking community. To the naive or conservative element this meant a release mechanism, a safety valve, for times of emergency, and for emergency use only; for those more sophisticated it meant cheaper and more plentiful money, and the prospect of credit-debt expansion on a scale vaster than ever. To the bankers, it offered the employment of a larger proportion of total assets in the market, hence with greater profit on bank capital; to the commercial community, it provided easier credit, with money more freely available, if not at lower rates at least for a wider and more speculative range of ventures.

A realistic appreciation of these factors was written at the time by the noted journalist C. W. Barron, whom we quote:

The “motif” underlying the Federal Reserve Act is not that which is nominated in the bond. “An elastic currency” could have been had by an enactment of twenty lines. The ‘means of rediscounting commercial paper’ are already at hand and such discounts exist to the extent of at least 100 millions in the national banking system. It is not “to establish a more effective supervision of banking in the United States,” for that could be accomplished by increasing the appropriation and enlarging the salaries of the examiners, so that men with larger experience and breadth of vision would perform more effective supervision.

The purpose of the act most largely in its inception was “for other purposes,” and these “purposes” can never be wisely or effectively carried out; if persisted in they spell disaster to the country. The hidden purpose or “motif ”which inaugurated this legislation, however in effect it may work out under wise administration, is to cheapen money.

The credit leverage provided by the Federal Reserve System, paradoxically enough, was found not so much in the reserve requirements imposed upon the Reserve banks—around which so much of the Congressional debate revolved, as in the reserve requirements for member banks.

At the time of the creation of the System, much emphasis had been placed on the note issue functions of the Reserve banks (the banks being permitted, in effect, to issue legal tender notes against a combined security of gold and certain types of commercial instruments of debt, provided the gold proportion of the reserve constituted at least 40 per cent of the total). Because of the growth of check-money and the expansion of deposit credit, however, the real leverage in the money system occurred in the banking reserve requirements of the System. The opportunity offered for bank credit inflation will be understood by setting forth the various reserve requirements, and the manner in which they were manipulated:

(1) The Federal Reserve System lowered the reserve requirements against deposits. The national banking system had classified banks according to the size of the city in which they were located, as central reserve city banks, reserve city banks, and country banks. For central reserve city banks a reserve of 25 per cent of total net deposits was required to be held in cash in the bank’s own vaults; for reserve city banks a reserve of 25 per cent of total net deposits, of which one-half might be held on deposit with designated correspondent banks; and for country banks, a reserve of 15 per cent of total net deposits, of which three-fifths might be held on deposit with designated correspondent banks.

The Federal Reserve Act classified deposits into two categories, demand and time, with separate reserve requirements for each category. For demand deposits the Act reduced the reserve requirements to 18 per cent for central reserve city banks, of which six-eighteenths (6 per cent of total net demand deposits) were to be held in the bank’s own vault, seven-eighteenths to be held on deposit with the Federal Reserve Bank for its district, and five-eighteenths optional, either in the bank’s own vault or on deposit with the Federal Reserve bank. Reserve city banks were required to maintain against demand deposits a reserve of 15 per cent, of which five-fifteenths (5 per cent of total net demand deposits) should be held in vault, six-fifteenths on deposit with the Federal Reserve bank, and four-fifteenths optional. Country banks were required to maintain reserves of 12 per cent against demand deposits, of which four-twelfths (4 per cent of total net demand deposits) should be held in vault, five-twelfths on deposit with the Federal Reserve bank, and three-twelfths optional. For time deposits the reserve was only 5 per cent for all classes of banks.

(2) By the Act of June 21, 1917, as an aid in floating government war loans, the reserve requirements were further relaxed, the proportionate reserves being reduced to 13 per cent, 10 per cent and 7 per cent, according to the classification of the bank, with 3 per cent for time deposits for all classes. The amendment provided that all reserve cash should be held on deposit with the Federal Reserve banks.

(3) During the decade ending 1930, at a time when the banking power of the country was being strengthened inordinately by large accretions of gold from abroad, the banking system further diluted its reserves by a process of wholesale reclassification of demand deposits into time deposits in order to take advantage of the lower reserve requirements. A special investigation conducted in May, 1931, by the Federal Reserve System revealed that out of $13 billion of time deposits held by member banks at that time, $3 billion consisted of individual accounts with balances in excess of $25,000. Even though accounts of this size may consist of inactive deposits with a low turnover, the Committee on Member Bank Reserves concluded that they were not the typical small savings accounts for the accommodation of which the low reserve against time deposits was primarily instituted. In 1914, when national banks were required to maintain the same reserve against all of their deposits, they held only about $1.2 billion in time deposits. Following the lowering of the reserve requirements against these deposits, time deposits increased steadily and amounted to about $8.7 billion at national banks alone in 1930. During the same period, time deposits of non-national commercial banks, including both state member and non-member banks, increased from about $2.8 billion to $10.2 billion and savings deposits of mutual and stock savings banks from $4.8 billion to $10.5 billion. The increase in time or savings deposits for national banks was over 600 per cent, for non-national commercial banks over 250 per cent, and for savings banks 120 per cent.

“With only a 3 per cent reserve required against time depsoits,” the Committee found, “there is an inducement for member banks to persuade or permit commercial customers to classify a large part of their working accounts as time deposits and then to permit a very rapid turnover on that small part of these accounts that remain in the demand deposit classification.”

As a result of these various provisions and subterfuges, the Committee reported, between 1914 and 1931, the period covered by its survey, total net deposits of member banks increased from $7.5 billion to $32 billion or more than 300 per cent in less than two decades. Some of this increase reflected the accession of state banks to membership in the Federal Reserve System, but the greater part reflected the expansion of member bank credit. While war financing and the huge inflow of gold which followed the war constituted the immediate driving force back of much of this expansion, it was facilitated by a progressive reduction in effective member bank requirements for reserves. Thus member banks actually held (in 1931) about $2.9 billion of reserves against $32 billion of net deposits. These reserves were both the legal reserves which they held with the Federal Reserve banks and cash which they held in their vaults. If the vault cash requirements of national banks prior to 1914 had been retained in the Federal Reserve Act, member banks would have been required to hold about $4.4 billion instead of $2.9 billion. This means that, in the aggregate, total reserve requirements were about 34 per cent less in proportion to their deposits than they were before the Federal Reserve Act was passed. “It is clear, consequently,” said the Committee, “that the largest expansion of member bank credit since 1914 has been facilitated by a progressive diminution in reserve requirements as well as by large imports of gold.”

(4) As the reserves held by member banks against their deposit liabilities are concentrated in the Federal Reserve banks, so these reserves in turn constitute deposits with the Federal Reserve banks. Against these deposits, which are the prime reserves of the commercial banks, the Federal Reserve banks were required to hold gold to the extent of only 35 per cent. In other words, just as commercial banks were enabled to expand their liabilities on the basis of small amounts of cash, so the Federal Reserve banks were enabled to expand their liabilities upon small amounts of gold. This was achieved by permitting member banks to strengthen their reserves with the Federal Reserve banks by borrowing upon the security of government bonds and by the discounting of their commercial paper. If a bank wished to expand its operations, and had not the cash for the minimum reserve requirements it could, in effect, create a fictitious reserve by borrowing the credit of the Federal Reserve bank. The only limit was the legal restriction upon the Federal Reserve bank against permitting its gold reserve to drop below the 35 per cent minimum ratio to its deposit liabilities. Thus, if the average reserves held by the commercial banks against their deposits were taken as 10 per cent, and the gold reserves held by the System against these reserves at 35 per cent, the actual gold held against the commercial deposits of the System could be reduced to as low as 3.5 per cent.

A purchase of investments on the open market is paid for by the Federal Reserve bank either in Federal Reserve notes or by check drawn on itself, depending on whether the bank wishes to increase the actual quantity of money in circulation, or the banking power of the System. If paid in notes, the money passes directly into circulation; if paid by check, the recipient of the check deposits it with his commercial bank, which in turn presents it to the Federal Reserve bank for credit. This credit thus becomes a deposit to the account of the member bank, and as such deposits constitute banking reserves for the member bank, the lending power of the member bank is thereby multiplied. Conversely, of course, the effect of selling portfolio holdings by the Federal Reserve banks is to reduce reserve credit outstanding, and to restrict the lending operations of member banks.

In 1924, with the object of creating money conditions in the international markets favorable to the efforts of Great Britain and a number of lesser European countries to return to the gold standard, the Federal Reserve System embarked on its famous “easy credit” policy, by reducing the rate at which it lent to member banks (the rediscount rate) and by forcing Reserve bank credit into the banking system by heavy open market operations. As a result, between the end of 1923 and the end of 1927, $548 million of Federal Reserve credit had been forced into the banking system by purchases of bills and securities. This amount must be multiplied many times to appreciate its effect on the credit power of the banking system.

During the early years of this policy, the effect of this leverage was nullified to some extent by the more cautious policy of the commercial banks themselves, which took occasion to reduce their own borrowings at the Reserve banks from $857 million to $314 million during the year 1924. They soon began to get the idea, however, and encouraged by the reduction of the rediscount rate from 4.5 per cent to 3 per cent (in New York), they began again to borrow to increase their reserves, and their own lending power. By the end of 1927 they were again in debt by the amount of $609 million.

When the central bank authorities became alarmed in 1928 over the results of their easy credit policy, and attempted to halt the further expansion of credit, it was too late. As rapidly as the Reserve banks drew credit out of the banking system by the process of selling bills and securities, it was siphoned back in by the banks increasing their own borrowing. By the end of July, 1929, the Reserve banks had reduced the volume of their open market purchases to $222 million, but meantime member banks had increased their borrowings to $1,076 million, and when the Reserve authorities began to shake their fingers in warning, the head of the largest American bank replied by thumbing his nose and announcing that his institution would continue to support the security markets, and had $25 million to lend.

The actual degree to which the gold reserves of the Federal Reserve System were thinned out behind the deposit liabilities at any one time cannot be precisely stated as the gold holdings of the System support both deposit and note liabilities. On December 31, 1928, when the speculative frenzy was approaching a climax, the gold holdings of the System amounted to only $2,584,232,000 against note liabilities of $1,838,194,000 and total net deposit liabilities of member banks of $33,397 million. As the Federal Reserve Act required, as a minimum metallic reserve against notes issued, gold in amount equivalent to 40 per cent of note liabilities, or $735,277,000 at this date, the remaining gold holdings represented a reserve of only slightly over 5.5 per cent of the total commercial deposit liabilities of the System. Actually, of the gold held by the Reserve banks, $1,307,437,000 had been deposited as security against notes issued, so that the remaining gold held by the Federal Reserve banks ($1,276,795,000) constituted a reserve of only 3.9 per cent against the total deposits of member banks.

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3United States government securities, and certain types ofagricultural credit obligations, municipal warrants, trade acceptances and bankers’ bills.

4To exclude inter-bank deposits, items in process of collection, and U. S. government deposits.

• 3(5) The final mechanism by which deposits could be inflated was that of “open market operations” by the Federal Reserve banks themselves. Theoretically designed to enable the central banks to regulate the volume of bank credit, and hence to check, as well as encourage, expansion, it proved more effective as a spur than as a restraint to expansion. Under the Federal Reserve Act, a Federal Reserve bank was authorized to invest not only in rediscounts and advances to member banks, but in a defined category of commercial obligations.* These items could be purchased and sold “in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals.” Such dealings in the money market directly with the public were called “open market operations.”
• 4Not all the gold reserves of the country were concentrated in the Federal Reserve banks, nor, on the other hand, did the Federal Reserve System comprise the total banking power of the country. The greater number of banks were outside the System. At the end of 1928 the total adjusted* deposit liabilities (demand and time) of all banks and trust companies, and currency outside banks, amounted to $55,638 million and the total monetary gold of the country amounted to $3,854 million, representing a reserve of 6.9 per cent.