America’s Money Machine

THE REVERSAL in German-Russian relations from entente to hostility in 1941 was more world-shaking in its effects than that which occurred about the same time in the Eccles-Morgenthau relations; but in our account of the Federal Reserve System the latter is of interest and significance.

For Eccles, the spender, the involvement in war meant a new fiscal policy of caution and pay-as-you-go. Morgenthau, the advocate of the balanced budget, now insisted that the Federal Reserve exercise its powers to the full to provide the financing needed by the government. The reversal was the less remarkable in the case of Eccles, for he had never urged budgetary deficits except as “compensatory financing”—the theory Hoover had toyed with, of balancing the cyclical declines in private business activity with government spending, mainly for public works.

In support of the cautionary attitude on the part of Eccles and the Reserve authorities was the tremendous increase in the country’s gold reserves resulting from the flight of capital from Europe. During 1939 gold imports had amounted to the enormous sum of $3.4 billion, and at the year end the country held $17,650 million of gold, or two-thirds of the world’s stock. During 1939 total reserves of member banks had risen by $2.7 billion. This had followed a rise of $1.9 billion in 1938; during the two year period the amount of excess reserves of the banking system had increased from $1 billion to $5 billion, the highest on record. At the end of 1939, nearly half of the $ 12 billion banking reserves were in excess of the statutory requirements. This gave the commercial banks a credit power and an independence from restraint that would naturally cause Federal Reserve authorities uneasy nights.

Following this recommendation, the Board, the presidents of the twelve Reserve banks, and the Federal Advisory Council joined in an unprecedented statement in the form of a special report to Congress on monetary and fiscal policy. The report appeared on December 31, 1940.

“While inflation cannot be cured by monetary measures alone,” the Report declared,

the present extraordinary situation demands that adequate means be provided to combat the dangers of overexpansion of bank credit due to monetary causes.

The volume of demand deposits and currency is 50 per cent greater than in any other period of our history. Excess reserves are huge and are increasing. They provide the base for more than doubling the existing supply of bank credit. Since the early part of 1934, $14 billion of gold, the principal cause of excess reserves, has flowed into the country. The necessarily large defense program of the government will have still further expansion effects. . . . Interest rates have fallen to unprecedentedly low levels. Some of these are well below the reasonable requirements of an easy money policy. . . .

Specifically, the report recommended that Congress: (a) increase the statutory reserve requirements for demand deposits to 26 per cent for central reserve city banks, 20 per cent for reserve city banks, 14 per cent for country banks, and 6 per cent for time deposits; (b) empower the Open Market Committee to make further increases of reserve requirements sufficient to absorb excess reserves, to the extent of double the percentages mentioned; (c) consolidate the authority of the Open Market Committee by transferring to it the power vested in the Board of Governors to change the reserve requirements within these limits; (d) make reserve requirements applicable to all deposit banks rather than to member banks only; (e) exempt reserves from assessments of the Federal Deposit Insurance Corporation.

The report also recommended repeal of the authority to issue $3 billion greenbacks contained in the Thomas amendment, as well as the termination of the monetization of foreign silver acquired through the silver purchase program. It recommended also the termination of the President’s power to devalue the dollar.

The report went on to recommend that new gold accretions be insulated by being held in the Treasury rather than paid out to the Federal Reserve banks (in the form of gold certificates).

The report did not please Morgenthau, particularly as the market for governments sold off just in advance of the report; nor did it please the liberal wing within the Party, which raised the cry that it was a bankers’ play for higher interest rates.

As the prospects for war increased, the Federal Reserve retreated still further from its policy of credit stringency and in April, 1942, directed all Reserve banks to purchase all Treasury bills offered at a discount rate of 3/8 per cent per annum. Congress now gave the Board authority to change reserve requirements of member banks in one class of banks without changing the requirements for other classes of banks (Act of July 7, 1942) and the Board now reduced requirements for central reserve city banks from 26 to 20 per cent. The reduction was made effective in three steps, August 20, September 14, and October 3.

Despite some nominal efforts to place government securities with non-bank investors through Savings Bonds, Savings Stamps, and 2 1/2 per cent long-term bonds not eligible to be held by banks for a period of ten years after issue, the commercial banks as a class continued to be the chief buyers of government obligations. At the end of 1941 they held $21.8 billion of the government debt, or some 34 per cent. During 1942 an additional $47.8 billion of debt was incurred, and at the end of 1942 the banks held $41.3 billion, or more than 37 per cent.

Among the legislation of the period affecting the Federal Reserve operations was the Second War Powers Act of March 27, 1942, which authorized the Federal Reserve banks to purchase government securities from the Treasury, not to exceed $5 billion, the power to extend until December 31, 1944.

This authority has been repeatedly renewed, at short term, but so faithfully by Congress that it may be assumed as a permanent feature of Federal Reserve power.1

Like Goths crossing the Danube in the waning years of the Roman Empire, Federal Reserve influence steadily infiltrated and became authority in more and more provinces of the economy long considered the domain of the free market. In 1934, the Securities and Exchange Act had empowered the Federal Reserve to fix margin requirements “for purposes of preventing the excessive use of credit for purchasing and carrying securities.” In 1941, under the 1917 Trading with the Enemy Act, Roosevelt gave the Federal Reserve temporary authority to regulate the terms of instalment sales. This authority lapsed, but was renewed in 1947 and, again, as a temporary measure, during the Korean War. Finally, by the Credit Control Act of December 23, 1969, it was made permanent.

The Act of July 7, 1942, which permitted the Board to change the reserve requirements of the various classes of banks also amended subsection (a) of Section 12(a) of the Federal Reserve Act to provide a regrouping of the representation on the Federal Open Market Committee. Because of the importance of the New York Federal Reserve Bank from its location in the principal capital market, and the fact that it acted as agent of the Open Market Committee, the amendment gave it continuous representation on the Committee. The Boston, Philadelphia, and Richmond banks were to be represented by one member; one representative each was allotted to Cleveland and Chicago; to Atlanta, Dallas, and St. Louis; and to Minneapolis, Kansas City and San Francisco.

As the war continued into 1943, the public debt increased by $57 billion, of which $25 billion was taken by the banking system; the commercial banks taking 34 per cent of the increase as against 41 per cent in 1942. Including the Federal Reserve banks the total purchases by the banking system represented 43 per cent of the increase in the debt as against 49 per cent in 1942. During the year, the rate on government securities was maintained at rates corresponding to 3/8 per cent on three-months bills, and 2 1/2 per cent on long-term bonds.

Additional legislation during 1943 affecting the banking and monetary system was the Act of April 29, 1943, which extended to June 30, 1945, the Stabilization Fund and the powers relating thereto, originally provided by the Gold Reserve Act of 1934, which otherwise would have expired. The act also extended to June 30, 1945, the power of the Federal Reserve banks to use government obligations as collateral for Federal Reserve notes.

During 1944 war expenditures totaled $91 billion, of which more than two-thirds, or $62 billion, was financed by increases in the public debt and of this amount non-bank investors took 59 per cent, compared with 58 per cent in 1943 and 51 per cent in 1942.

Finally, the Act of June 12, 1945, reduced reserve requirements of the Federal Reserve banks from 40 per cent against notes and 35 per cent against deposits to a uniform 25 per cent and extended indefinitely the authority to use direct obligations of the U. S. as collateral for Federal Reserve notes. At the same time the act terminated the authority of the Federal Reserve banks to issue Federal Reserve banknotes as well as the authority to issue greenbacks under the Thomas amendment.

It is important to understand that borrowing from the banking system, whether by Government or others, creates an equivalent addition to the country’s monetary supply. As a consequence (of the war financing) the country’s money supply, as measured by demand deposits and currency in circulation, more than tripled, increasing from $40 billion in June, 1940, to $127 billion at the end of 1945.

The Reserve called upon the government to reverse the process. It pointed out that the policy of maintaining a rate of 7/8 per cent for one year certificates made it possible for banks to increase their reserves by selling short-term, low yield government securities to the Reserve banks, and thus “acquire reserves which, on the basis of present reserve requirements, can support a six-fold expansion of member bank credit.” It pointed out that outside the banks were some $20 billion of bonds eligible for bank purchase plus $34 billion that would become eligible within the next fifteen years, all with inflationary potential.

   It went on to say:

The Board now proposed that the policy of maintaining the government market be abandoned, at least so far as the short-term rate was concerned, while it offered to continue to hold the long-term rate at 2 1/2 per cent.

Eccles was a man who had to be riding a white charger; his responsibilities now being confined, as he said, to a routine administrative job, he began to look around for something to challenge. He now (1944) proposed what he had thought of years before, the unification of the various authorities over the monetary-banking system now distributed among the Federal Reserve Board, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation.

Roosevelt, however, did not think this an opportune time, when the country was still at war, to raise issues that would undoubtedly provoke dissention, particularly as there was the doubtful legality of his war powers to execute such an administrative change under the pretext of war necessity. Eccles tried to find support elsewhere for his proposals, particularly from James F. Byrnes, who had been taken from the Supreme Court bench to head the Office of War Mobilization, but the effort bogged down. Eccles’ term as Chairman of the Board of Governors was now expiring, and Eccles in frustration asked not to be reappointed; but Roosevelt would not hear to it, and he continued as head of the System for another four years, until 1948.

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2Prior to the Banking Act of 1935, there was no question of the authority of the Federal Reserve banks to deal directly with the Treasury. That act restricted such dealings to the open market.

• 1Mrs. Fish’s social invasion of Washington may have been the result of the intimacy that existed between her husband and Roosevelt. It is important to recall this camaraderie in any attempt to understand the tangle of subsequent events. Both were New York aristocrats; both were Republicans; they had a common fondness for rural estate life; they had gone together on hunting trips to the South. It is reported that during the Fish residence in Washington, Roosevelt, who was accustomed to early morning canters in Rock Creek, would ride over to the house and shout up, “Stuy!” and when the railroad president came to the window would joke with him for a while before continuing his ride.
• 2Theodore Roosevelt returned from a year of big game hunting in Africa and a triumphal tour in Europe to find again an opprtunity and a demand for his political talents. Drawn by an appeal to public service, and perhaps to a considerable degree by ambition,* he began to angle for the leadership of the insurgent wing. In a speech at Osawatomie, Kansas, on August 31, 1910, on “The New Nationalism” he backed the Supreme Court’s attitude toward social legislation and announced the political doctrine “that every man holds his property subject to the general right of the community to regulate its use to whatever degree the public welfare may require it.”