Economics and The Public Welfare

Chapter 19

The Causes of and the Responsibility for the Excess Reserves

Factors Feeding and Depleting Member Bank Reserves. It is possible to measure with a great deal of precision the factors involved in the increase or decrease of member bank reserves. “An Analysis of the Money Market” 1 presented a technique for doing this which some of the readers of this book will study. For example, an increase of money in circulation operates to reduce member bank reserves and to tighten the money market. This is regularly true in the autumn, when 300 or 400 million dollars may go out, reaching a peak at Christmas time, followed in the two or three weeks thereafter by a heavy backflow of money to the banks, which enables them to build up their reserves again and eases the money market. An ordinary summer holiday, such as the Fourth of July, may mean an increase of 75 millions in money in circulation, followed in two or three days by a return of the money to the banks. There are many other factors.

The present chapter, however, avoids technicalities as far as possible, and does not discuss those factors which show little variation or which show only a normal seasonal variation. It concentrates attention on the two main significant variables between the middle of 1922 and early 1928, which were: (1) the growth of our gold monetary stock, and (2) the volume and composition of Federal Reserve credit, primarily governed by Federal Reserve policy.

Gold. The gold monetary stock of the country is controllable by five main factors: (a) gold imports, (b) gold exports, (c) gold production in the United States, (d) industrial consumption of gold in the United States, and (e) earmarkings and release from earmark of gold at the Federal Reserve banks, for foreign account. A foreign central bank, which has a deposit account with a Federal Reserve bank, might instruct the Federal Reserve bank to debit its account and earmark gold. The gold would then be the property of the foreign bank, and whether it were subsequently exported or not, it would be effectively withdrawn from the gold monetary stock of the United States. Conversely, a foreign bank with gold under earmark might instruct a Federal Reserve bank to release the gold from earmark and credit its deposit account, which meant that the gold would become the property of the Federal Reserve bank, part of its gold reserve, and part of the American gold monetary stock.

Gresham’s Law and Gold Imports—1920-1924. From October, 1920, to August, 1924, we gained gold steadily from the outside world, our monetary gold stock rising from $2,581,000,000 to $4,234,000,000. The increase from the middle of 1922 to August, 1924, was from $3,498,000,000 to $4,234,000,000, or $736,000,000. Part of this gold would have come in any case, because of the great pressure that Europe was under to pay urgent debts here, but after the great liquidation of 1920-1921 the controlling factor was the operation of Gresham’s Law.

Gresham’s Law is an ancient principle, known apparently to some of the Greeks, but taking its name from Queen Elizabeth’s financial adviser, Gresham, who is said to have explained it to the Queen. It is the principle that bad money drives out good money, and that inferior money drives out better money. It operates particularly when a paper money, formerly redeemable in gold, is no longer redeemed in gold, and consequently depreciates below its gold parity.

Virtually all the important countries of Europe, and most of the important countries of the world outside of Europe, except the United States, had restricted gold payments or had ceased to make them. The paper currencies of the major countries outside the United States were depreciated, and fluctuating in value, in the whole period following the war down to late 1924. Under these circumstances additional gold would not go to the monetary reserves of those countries, and such gold as was free to move tended to leave those countries. A man would not take gold to the Bank of England to exchange it for a Bank of England note, because he would lose 10% of its value thereby. He would not turn in gold to the Bank of France when he thereby lost more than half of its value. He would not use gold in paying debts in England or France. He would use the cheaper paper money instead. He would send his gold to the United States, where he could turn it in to the Federal Reserve bank in exchange for a currency which he could next day or next month or next year redeem in gold at the full face value.

Dangerous Concentration of Gold in United States. This made a dangerous situation. It meant that we were getting a great part of the newly mined gold of the world. It was a situation which could be expected to correct itself when two or three of the other main countries came back to the gold standard, and which did indeed in large measure correct itself when Germany came to the gold standard under the Dawes Plan in 1924, followed by the return of the Dutch guilder and the Swiss franc to par, and in the spring of 1925, by England’s resumption of gold payments. When France came back to the gold standard in 1928 we lost gold heavily for a time.

It was widely recognized in the period following the war and throughout the 1920’s that a considerable measure of redistribution of the world’s gold was needed, and that the way to accomplish this was to restore the full gold standard in several major countries, so that they would compete with us and one another for the floating supply of gold, and so that at least the newly mined gold would go to those countries whose gold reserves were most in need of it and whose interest rates were consequently high enough to attract it.

Peak of Our Gold Holdings Reached in August, 1924. The approximate peak of our gold monetary stock in the expansion period of the 1920’s was reached in August, 1924, at $4,234,000,000. There was a sharp drop in late 1924 and early 1925, due in considerable part to the shipment of gold to Germany following the Dawes Plan loan, and a gradual rise to a slightly higher peak of $4,323,000,000 in April, 1927, followed by a steady decline to $3,822,000,000 in April, 1928—which month, as we have previously seen, marked the peak of our 1922-1928 bank expansion. Incoming gold, in other words, ceased to he an important factor feeding member bank reserves after August, 1924.

Trustees of World’s Gold. We were, and for a time we recognized that we were, trustees for the world’s gold. We had no right to merge it so inextricably with our own financial system that we could not certainly and easily return it. It was in a high degree imprudent so to merge it with our own affairs that we could return it only by means of a painful liquidation. Certainly it was unwise in the extreme to build upon it an unusual and illiquid kind of bank credit. It was unwise in the extreme to adopt a policy which would expand bank credit in capital uses, such as real estate mortgage loans, stock and bond collateral loans, bank investments in bonds, and the like. And yet we did these things.

Unsound Federal Reserve Policy. Had the Federal Reserve System followed orthodox central bank tradition, using no discretion at all but merely obeying the rules, we should have averted the disasters that followed. The orthodox tradition called for rediscount rates above the market rates and for strictly limited use of open market operations. The most important of these two rules related to open market operations.

Rediscount Rates Below Market Minor Factor. Federal Reserve rediscount rates were held below the market throughout this period, meaning by “the market” the prime customers’ rate at great city banks.2

But the banks had learned a lesson in 1919 and 1920 about borrowing to relend at a profit. They had got much too deeply in debt to the Federal Reserve banks in the course of this, and they had been struggling since 1920 to get out of debt to the Federal Reserve banks. The tradition had grown that a bank should not borrow for the purpose of relending at a profit. The tradition was strong that great city banks did not like to be in debt at all to the Federal Reserve banks, and that the country banks, even though borrowing for their seasonal needs, wished to be completely out of debt to the Federal Reserve banks at least once a year.

When the total rediscounts were over 500 million dollars, enough banks were under pressure, partly from this tradition and partly from shortage of paper for rediscount at the Federal Reserve banks, so that the money market was reasonably firm and bank expansion was retarded. Banks would rediscount to prevent a liquidation—they would discount heavily rather than force customers to liquidate. But they would not rediscount heavily, even at low rates, for the purpose of making new loans which their customers did not require or, above all, for the purpose of making investments.

Main Factor Open Market Purchases of Government Securities. The violation, therefore, of the established rule that rediscount rates should be above the market, though a contributing factor to the overexpansion of bank credit from June, 1922, to April 11, 1928, was not the main element in Federal Reserve policy which was responsible. The main factor was their open market purchases of Government securities.

Prewar Open Market Operations of Bank of England. The Bank of England had used open market purchases and sales of government securities in prewar days. But the transactions were small. The motive which commonly actuated the Bank of England in buying government securities seems to have been primarily profit, rather than the desire to make interest rates low. It was the sales of government securities, including Indian Council bills, which most impressed the London market—the purpose of such sales being to take up the floating supply of money and “make Bank Rate effective.” The transactions were small. In one instance the sale of £1,100,000 of Indian Council bills sufficed to make Bank Rate effective. Operations of £5,000,000 were large operations. Often the Bank of England did not have enough securities to sell for the purpose and would go out and borrow money against gold collateral as a means of reducing the money supply. The operations were in general restrictive.

Wartime Open Market Operations in England and United States. At the outbreak of the war in 1914 a new discovery was made. The British Government, needing money, first borrowed from the Bank of England, and the Bank of England also bought short term treasury bills in the open market. This had the double effect of giving the government the cash it immediately needed, and of putting additional deposit balances with the Bank of England into the hands of the Joint Stock Bank. As the government spent its balances with the Bank of England, the government checks were promptly transferred to customers of the Joint Stock Banks and thence to the Joint Stock Banks themselves. The Joint Stock Banks then deposited these checks in the Bank of England, building up their reserve balances there. This increased the volume of reserve money for the banking community, and made money rates go down, permitting an expansion of general bank credit—the banks buying treasury bills and government war bonds and financing the community in buying government war bonds.

The London money market appears not to have understood the operation fully at the beginning of the war, and it is not certain that the government or the Bank of England did. The first recourse to the Bank of England was simply a quick way of getting money. But very speedily the trick was learned.

Each new British war loan was preceded by Bank of England buying of government securities, or by direct loans to the government. When the United States Government entered the war, the Federal Reserve banks began to use similar tactics. Each of the four Liberty Loans was preceded by Federal Reserve purchases of United States Government securities to ease off the money market. When the loan was over, the Federal Reserve banks promptly sold these Government securities again.

Wartime Government Security Operations Small and for a Few Days Only. The magnitudes were not great. For each of the first three Liberty Loans they amounted to less than 100 million dollars and were promptly reversed. With the Fourth Liberty Loan of approximately 7 billion dollars—a loan made at a time when the capital market had already been very thoroughly drained—the operation was larger. The holding of Government securities stood at 96 millions on October 18 and rose to 350 millions on October 25, but promptly dropped again to 118 millions on November 1. These relatively moderate operations were war emergency operations and were short-term operations. They temporarily greased the wheels while vast financial transactions needed for war were put through. But in general the Federal Reserve System financed the Government in World War I, not by buying Government securities, but by lending to member banks against Government securities.

Peacetime Operations, 1922, 1924, and 1927, Gigantic, and for Many Months at a Time. The contrast between the almost microscopic open market operations of the Bank of England before the war and the very moderate, short open market operations of the Federal Reserve banks in connection with the Liberty Loans during the war, on the one hand, and the open market operations of the Federal Reserve banks in the period of 1922-1928 on the other, is thus enormous. Where the Federal Reserve banks bought tens of millions for a few days, in connection with the first three Liberty Loans, they bought hundreds of millions and held them for many months in 1922, 1924, and 1927. And where the Bank of England had primarily used its open market operations for the purpose of tightening its money market in prewar days, the Federal Reserve System used them deliberately for the purpose of relaxing the money market and stimulating bank expansion in 1924 and 1927. At a time when unusual circumstances called for extra caution, they abandoned old standards and became daring innovators in the effort to play God.

Three Great Spurts in Bank Expansion Definitely Connected with Three Great Open Market Purchases. The process of the creation of excess reserves with the resultant great expansion of bank credit did not move slowly and gradually from early 1922 to early 1928. It was concentrated, rather, in three great moves. Each of these three great moves was inaugurated by heavy purchases of Government securities by the Federal Reserve banks. The first of these has already been discussed. It came in 1922. It came because the Federal Reserve banks had very heavy expenses and did not wish their overhead to decline.

In 1924 the Federal Reserve banks bought Government securities on a great scale for the deliberate purpose of expanding bank credit, and the process of bank expansion was resumed on a vast scale, with a carry-over into 1925. In 1926 and early 1927 the bank expansion moved at a much slower rate.

Then again in the latter part of 1927 there came a third great move in the purchase of Government securities, with a new great burst of expansion in bank credit.

The curve for member bank reserves rises very sharply from early 1924 to the year end. It moves very moderately from 1924 through 1926. It starts up again and reaches new highs in 1927. The main responsibility for excessive reserves and for multiple expansion of bank credit based on the excess reserves rests on the open market policy of the Federal Reserve System.

This chapter has ignored a great many factors in the money market in the period under discussion. It has concentrated on the two great essentials, gold and Federal Reserve bank open market policy. These are the two great variables. Responsibility rests with the Federal Reserve System.

Preceding chapters have discussed the open market purchases in 1922 and 1924. A later chapter will discuss more fully the culminating episode of 1927, which touched the match to the powder keg and set the uncontrollable forces working which blew us up late in 1929. But before discussing this it is best to give an account of the developments in the world outside the United States—particularly in Germany, France, and England—which explain the problems facing the Federal Reserve System in 1927, and to give an account of developments in the American securities markets in the years 1924, 1925, and 1926.

• 1This point will be discussed at length in Chap. 34.
• 2I have not been able to find that this article was ever published. However, the reader will find much of it in two books by Veblen: Imperial Germany and the Industrial Revolution, New York, 1915; and The Nature of Peace and the Terms of Its Perpetuation, New York, 1917.