Credit Policies of the Federal Reserve System

CHAPTER I

STANDARDS OF CREDIT POLICY

The concept of credit policy is an old one in the history of European banking, but is comparatively new in the United States. Prior to the reorganization of our banking system by the Federal Reserve Act of 1913 there was, practically speaking, no such thing as a credit policy designed to protect the public interest, as distinct from the business policies of individual banks. The banking business had indeed been hedged about by numerous restrictions, covering capitalization, liability of stockholders, reserves, permissible assets, and similar matters. These restrictions were designed chiefly to protect depositors from losses incident to bank failures. They set limits within which the banker was free to manage his business as he pleased under the guidance of the profit motive; they did not create a field for the exercise of administrative discretion in the interest of the public at large.

The Federal Reserve Banks, on the other hand, though owned by the commercial banks, are quasi-public organizations, and their activities are intended primarily to forward not merely the interests of bankers, bank stockholders, and bank depositors as such, but those of the general public. To insure freedom from the control of profit considerations, their dividends are limited and a large share of the responsibility for their actions is entrusted to the Federal Reserve Board, a body appointed by the President and in no way responsible to the Reserve Banks or their stockholders. The government is the residual claimant of the Reserve Banks’ profits.

Emancipation from the necessity of earning maximum profits means that the Reserve system either must be given other standards of action or must develop them for itself. The Reserve Act defines the objectives of the management of the System only vaguely. The preamble indicates as purposes of the Act, “to furnish an elastic currency, to afford a means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States.” More important, but very indefinite, is the provision of Section 13 that the rates of discount of the Reserve Banks “shall be fixed with a view to accommodating commerce and business.” There is, therefore, nothing rigid or automatic in the administration of the affairs of Reserve Banks; in planning the system there was purposely left open the widest scope for the exercise of discretion and the utmost freedom to develop appropriate standards of policy.

The policies pursued by the Federal Reserve Banks and the Federal Reserve Board may conveniently be classified into three groups, which we may designate as banking, service, and credit policies.1

Banking policy relates to the influence exerted by a Reserve Bank on the loan and investment policies of individual member banks. Primary responsibility for supervision of the practice of member banks rests with the Comptroller of the Currency in the case of national banks and with state banking officials in the case of state banks and trust companies. The law vests in the Reserve Banks authority to make “special” examinations, but this power is seldom exercised and is intended to furnish a check on reckless and dishonest banking rather than on policies which might have undesirable effects on the general credit situation.

The “banking policy” of the Reserve authorities consists largely in the enforcement of three principles; first, that it is an abuse of privilege to obtain capital by substantially continuous borrowing at a Federal Reserve Bank; second, that a bank should not borrow at a Reserve Bank, even temporarily, merely because it has an opportunity to reloan the funds at a profit; third, that the amount which a bank is entitled to borrow should bear a fair relationship to the amount which it has contributed to the lending power of the Reserve Bank. Occasionally an attempt has been made to enforce a fourth principle, namely that a bank is not entitled to borrow from the Reserve Bank even by rediscounting the best of eligible paper if its intention is to use the funds for purposes deemed to be out of line with public policy.2 Banking policy has but little influence on the total volume of credit extended by the Reserve Banks, although as we shall see, efforts have occasionally been made, notably in 1929, to use the instrumentalities of banking policy to influence the general credit situation.

By service policies we mean policies relating to a large number of miscellaneous activities which the Reserve Banks perform, such as fiscal operations for the government, the maintenance of a system of inter-district clearing; the transfer of funds and securities by telegraph; the compilation and publication of statistical data; and the promotion of a system of par collections. Some of these services are of great value, but once they have been set up, their maintenance is delegated to subordinates and no longer requires the attention of the policy-making authorities of the Reserve system. None of them except the par collection system involves a controversial issue.

Credit policy has reference to the influence that the Federal Reserve system exerts on the volume of credit, its cost, the kind of business that is financed, and the types of instruments that are used. The determination of credit policy cannot be reduced to routine, for it requires constant reconsideration of the advantages and disadvantages of a liberal or a restrictive policy. It involves consideration of such factors as the state of business activity, the flow of gold into or out of the country, the movement of prices, the effect of the American policies on the money markets of other countries, and the balancing of the relative claims of different parts of the country and of different industries. It is the most difficult and probably the most important aspect of Reserve administration.

In this study our interest is in the objectives which the Reserve system has been trying to attain, the means it has utilized, and the degree of success which it has attained. We shall not be concerned at all with the service policies of the System, and banking policy will be considered only to the extent that the forms of banking policy have been used to control the volume of credit extended.

At the time when the establishment of the Reserve system was being considered, students of banking theory had been pointing out for years the advantages of the European system of centralized reserves, centralized note issue, and rediscount of commercial paper. Nevertheless, in spite of the fact that the European system seemed to work more smoothly than ours, there existed in America a profound distrust of the whole idea of central banking. The problem of reforming American banking was largely one of getting the advantages of unified credit policy without loss of local freedom, or, if that was impossible, without overt acknowledgment of centralization of power. The Aldrich plan of 1911 offered central banking under a very thin disguise. The revulsion of sentiment in 1912 against the general policies of the eastern financial groups for whom Senator Aldrich was spokesman increased the necessity for sugar-coating the dose of central banking which experts agreed in prescribing.

The Democratic Party came into power in 1913, pledged against either a central bank or a central reserve association. The Federal Reserve Act, with its provision for twelve independent banks and a central supervisory body, reflects in part a genuine attempt to retain both the advantages of unified policy and those of local freedom; in part the necessity of making the actual centralization as unobtrusive as possible.

Like all paper constitutions, the Federal Reserve Act has grown and changed by a process of interpretation, administration, and the accumulation of precedents. In general, as with the Constitution of the United States, the drift has been toward centralization of the policy-making power. More and more the individual Reserve Banks have come to be administrative agencies performing important services in the supervision of the practice of individual banks, the routine of bank operation, and the performance of service functions, but entirely subordinate to centralized control in matters of credit policy.

So complete has the centralization of credit policy become that we are quite justified in treating Reserve system administration as a case of central banking. The credit problems faced by the Federal Reserve Board and other influential elements in the system are of the same character as those which confront every important central banking system, and the instruments at hand for executing those policies, though administered by twelve separate banks, are precisely the same as the instruments at the command of every central bank. We shall therefore draw freely on European experience with centralized control of banking in forming our judgments as to the desirability and feasibility of the objectives which seem to have controlled the Federal Reserve system, and the effectiveness of the devices which it has employed.

We shall pay little attention to the details of the history of Reserve banking during the years before 1922. For the first two years of its existence the Reserve system operated under conditions which gave it but little opportunity to exercise an important influence over the policies pursued by its members; for the next two years it functioned as an agency of war finance. For more than a year after the Armistice the exigencies of Treasury financing prevented the development of a credit policy aiming at economic as distinguished from fiscal objectives; then after a few months of experimentation there ensued a great liquidation of bank credit. While this was in progress it made very little difference what lines of policy the Reserve system might choose to follow. Only since the completion of this liquidation movement, early in 1922, has there been a real opportunity for the development of a consistent program of bank credit control.

We stand now at the close of a ten-year period in which there has been a fair degree of permanence in the personnel of the Reserve authorities; and one in which they have had a large degree of independence in their policy. The most important task undertaken during this period has been the formulation of a credit policy; we undertake in this volume to estimate the progress which has been made in its accomplishment. For this purpose we shall survey the standards which the Reserve system has set up for its own guidance, comparing official statements of objectives aimed at with the record of actual performance; estimate the success of the system in accomplishing the purposes at which it has professed to aim; and offer an appraisal of the standards themselves, in terms both of the desirability of the objectives sought and of the practicability of their attainment.

A central banking system may take either a passive or an active attitude toward the money market. It may consider that commercial banks are primarily responsible for determining the total amount of credit needed by the country and its best allocation to different uses, and that its own business is merely to facilitate the adjustment of the supply to the changing needs of trade and the flow of funds to the regions which need them most. This was undoubtedly the dominant strain of thought in the planning of the Federal Reserve system. It was phrased as the quest of an elastic currency, and directly expressed in the injunction that the Federal Reserve Banks should fix their rates “with a view of accommodating commerce and business.”3 This viewpoint has found expression in repeated statements of Federal Reserve policy.4

The other strain of thought which runs through the literature of the Reserve system is a philosophy not of accommodation but of control. It assumes that the demand for credit is not an independent norm, but a consequence of the policies of those who are responsible for the supply; that the amount of credit which will be used is a function of the price level and of the state of business activity and that these are in turn a function of the supply of credit.5 This line of thought also runs very far back in the history of banking theory, and is another important element in the background of the formation of the Reserve system. It has had a greatly increased influence in the post-war era and has been accepted by Reserve authorities as justifying repeated departure from the passive attitude which it has usually maintained.

There is, of course, no necessary conflict between these points of view. It is not a priori improbable that there will be some fluctuations in the demand for credit to which the Reserve system can best respond in a passive way by altering its outstanding credit as the demand expands or contracts, and other types of change which it ought to resist or promote. And this is what we find to have been the view of the Reserve authorities. They have interpreted the problem of credit administration as consisting largely in distinguishing between those changes in the demand for Reserve credit which can be accepted as evidences of a change in actual needs, and those which reflect the development of an unwholesome tendency toward a dilution or a concentration of circulating medium.

According to pre-war traditions the most Important Index of credit conditions was the flow of gold into and out of a country’s bank reserves. This was true both of countries like the United States and Canada which had no central banking authorities and of countries where central banks were charged with responsibility for the maintenance of sound credit conditions. In countries where there was no central bank, the effect of outflowing and incoming gold was automatic; an outflow of gold forced banks to curtail their loans or their investments and to raise the interest rate, and an inflow, under the pressure of competition, automatically brought about greater monetary ease.6 In countries with active central banks, however, the effect of the gold movement was modified by administrative action.

Orthodox central bank policy, under the pre-war gold standard, hinged on gold movements, but required the use of judgment as to the causes of such movements. The crucial question was whether the outflow or inflow was due to a temporary situation which would presently correct itself, or to a maladjustment between the volume of credit and the needs of trade for credit which, if unmolested, would grow cumulatively greater until checked by the depletion of the reserves.

For example, if it appeared that a gold outflow was due to a mere seasonal strain which carried no threat of future trouble, or to a financial crisis abroad, the central bank would put credit into the market by purchasing bills or government securities to offset the loss of gold, and withdraw it again when the strain was past. On the other hand, in cases where the pressure appeared to be due to speculative expansion of credit on the part of commercial banks which threatened to grow cumulatively greater, sound policy required the central bank to tighten the market without waiting for the movement to deplete the reserves and thereby compel contraction. In the one case the objective was to enable the commercial banks to ignore the gold movement; in the other case it was to hasten the contraction of credit which must result from the outflow of gold and thereby to shorten the period of adjustment.7

Vice versa, if a gold inflow was due to seasonal conditions and hence was not likely to last long, central banking policy aimed to prevent this reserve from being built into the credit structure through an expansion of credit operations. But if it was believed that an inflow was the result of a balance of payments favorable for more permanent reasons, approved central banking policy was to permit the increased stock of gold to support an increased supply of credit.

Without a central bank, the decisive factor determining the effect of a gold inflow or outflow on the money market was the more or less accidental amount of slack in the reserves; with a central bank the crucial question was not the size of the reserves but the cause and the anticipated duration of any flow of gold into or out of them. Loss or gain of gold was regarded as a symptom of the state of the balance of payments rather than as a thing of immediate importance on its own account. To operate in this way it was necessary that the central bank be governed by consideration of public welfare rather than of private profit. Particularly essential was it that such a bank should sacrifice potential profit by carrying at most times an unproductive surplus reserve.

Under the old national banking system of the United States there was practically no surplus reserve which could be used as a buffer to break the force of gold movements, or to obviate them. The country banks carried their reserves largely in the form of deposits with the central reserve city banks, while the latter carried their reserves in gold and legal tender. If the country banks endeavored to withdraw their balances from the city banks the city banks’ reserves were depleted and those of the country banks were not correspondingly increased—since cash in the vaults of the country banks counted no more as reserves than did the corresponding deposits in the city banks. Since neither the country nor the city banks carried excess reserves, there was practically no true reserve at all—that is no reservoir of funds which could be drawn upon for seasonal and emergency needs.8

Before 1913 no one had a financial incentive to exert a stabilizing influence on credit movements. If all the banks, or all the central reserve city banks, could have agreed to maintain excess reserves in times of seasonal slackness, they would have avoided much of the strain in times of seasonal pressure, and presumably in the slack season they would have obtained some compensation in the form of higher rates for what they would have lost through the restriction of the volume of their loans. But no one bank could do this alone—it would have had to carry all the costs while others got the principal benefit. What was needed was some form of organization to compel all the banks to share the cost of carrying idle reserves in slack times in order that they might be available in times of need. This is the most important service performed by central banks, and the fact that we had no organization which could perform the function constituted the most forceful argument for a reform of the banking system.

The creation of the Federal Reserve system provided the United States with the mechanism necessary for the exercise of both these types of control—the offsetting or prevention of temporary gold movements by credit expansion or contraction, and the stabilization of credit conditions by operations designed to check credit booms before they ran so far that the condition of the reserves made further expansion absolutely impossible. In the first of these tasks, as is shown in detail in Chapter IV, the Reserve system has been highly successful and its operations have given rise to little controversy; the second task has presented greater difficulties and here there is much difference of opinion as to the value of the System’s achievements.

In early post-war years the inflow and outflow of gold did not serve as a satisfactory guide to central bank policy. During the early post-war era of irredeemable paper currencies and government control of money markets the central banks of the world had to devise new standards of policy because the old test, the gold flow, broke down completely. It broke down first because it was not allowed to operate at all. Gold embargoes isolated each country’s stock of gold and made it useless, except for show purposes. When the embargoes were lifted, gold movements did not at once begin to function in the old way, because wherever the currencies were irredeemable the power of the banks to extend credit was not seriously affected by an inflow or an outflow of gold. Under these circumstances new tests had to be developed; and the discussion of tests has drawn attention to the more important question of the objectives to be aimed at.

A great variety of objectives have been suggested as proper criteria of Federal Reserve credit policy. Even before the situation arose which made it impossible, without great danger of inflation, to abide by the principle that credit can be safely expanded so long as gold flows in, there was a wide divergence of opinion as to the objectives which the Reserve system ought to promote and the specific policies by which these objectives could best be attained. Without attempting an exhaustive list of the aims of credit policy, the following important suggestions may be noted:

1. The prevention of panics. At the time when the Federal Reserve system was created, this was unquestionably the most important objective in the minds of the framers and of the American public.

2. Stabilization of business conditions. This is the modern counterpart of the prevention of panics. Whereas in the pre-war period attention centered on the conspicuous breakdown of financial machinery which often ushered in a period of depression, post-war theorizing runs in terms of the business cycle; that is, a more or less continuous alternation of expansion and contraction of business activity in which the panic or financial crisis is only a single stage and one which does not always appear.

3. Stabilization of the price level. The demand for stabilization of price levels is in part a special form of the quest of a panacea for business fluctuations, and in part a reaction against the evils associated with long-time trends of rising and falling prices.

4. Stabilization of the money market itself, particularly with reference to seasonal changes and temporary disturbances such as those connected with quarterly Treasury operations.

5. Assistance to Europe in the establishment and maintenance of stable currencies.

6. Keeping money as cheap as possible for “legitimate” commerce, industry, and agriculture.

7. The prevention of stock speculation and of speculative absorption of funds which might otherwise be available for other uses. In part this is a variant of the preceding point; in part it is a special aspect of (2) above; and in part it is an expression of hostility to the stock exchange on moral grounds.

8. Helping the Treasury borrow on advantageous terms. This was admittedly the primary objective of Reserve policy during the war and during the first year after the Armistice. We shall attempt in Chapter XV to answer the question whether it has dominated Reserve policy in more recent years.

9. Reform of the standards of bank practice through the encouragement of the use of certain types of credit instruments, especially short-term commercial instruments as opposed to investment in securities and lending on stock market collateral.

In Parts II and III we undertake to show what has been the importance of these various suggested objectives in the development of the standard of the Federal Reserve system, comparing the actual record of practice with statements of policy which have been issued in reports and bulletins of the Board and the Reserve Banks, and in public utterances of Reserve officials. As a preliminary to the survey we describe in Chapter II the mechanisms by which Reserve authorities attempt to influence the credit policy of member banks, and in Chapter III we sketch the history of Reserve credit operations during the years since 1921.

“. . . It is this responsiveness of the volume of currency in use to the public’s requirements and the promptness with which the net volume of inflow or outflow of currency of all kinds at the Reserve Banks responds to changes in the demand for cash that constitutes the elastic character of the currency under the Federal Reserve system.” (Annual Report of the Federal Reserve Board, 1924, p. 7. Compare also ibid., 1927, p. 9, and Federal Reserve Bulletin, 1925, Vol. 11, p. 1; 1929, Vol. 15, p. 529, and 1931, Vol. 17, p. 495).

• 1The distinction between “banking policy” and “credit policy” is taken from Annual Report of the Federal Reserve Board, 1928, pp. 9-10.
• 2Compare pp. 132-40.
• 3This is, of course, in substance the position of the Banking School in the British banking controversy of the early nineteenth century.
• 4“. . . When increased credit demands can be met only by recourse to the Federal Reserve Banks, the volume of Reserve Bank lending is a sensitive indicator of credit conditions. . . .” (Federal Reserve Bulletin, 1923, Vol. 9, p. 411).
• 5Annual Report of the Federal Reserve Board, 1923, p. 10 (quoted below, pp. 79-80); Federal Reserve Bulletin, 1928, Vol. 14, p. 6.
• 6The omission of reference to price changes in the text is intentional and without prejudice. I believe that there is need of a thorough reexamination of the orthodox statement of the influence of gold movements on price changes and the extent to which in pre-war days changes in price levels were caused by gold movements and operated to check the gold movements.
• 7For fuller discussion of these points, see Chap. IX; compare also B. H. Beckhart, The Discount Policy of the Federal Reserve System, Chap. II.
• 8The cash balance carried in the United States Treasury was occasionally drawn upon to meet seasonal or crisis demands, either through the depositing of funds in banks or through the purchase of bonds by the Treasury, but the device was very crude and there was no continuity of policy in its management.