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XXIV

RESERVE DEFICIENCIES.

The new Federal Reserve Board will have power to suspend for thirty days and to renew such suspension for fifteen-day periods any reserve requirements," but it must "establish a graduated tax upon the amounts by which the reserve requirements of this Act may be permitted to fall below the level hereinafter provided." But it is specifically provided that when the gold reserve under the notes falls below 40%, the Federal Board shall establish a graduated tax of not more than 1% per annum upon such deficiency until the reserves fall to 321%. Now comes a little new puzzler in taxation.

It reads as follows:

"When said reserve falls below thirty-two and one-half per centum, a tax at the rate increasingly of not less than one and one-half per centum per annum upon each two and one-half per centum or fraction thereof that such reserve falls below thirty-two and one-half per centum. The tax shall be paid by the reserve bank, but the reserve bank shall add an amount equal to said tax to the rates of interest and discount fixed by the Federal Reserve Board.”

How to add an amount of tax on a deficiency, that may exist only for a day, and have it equally applied to a rate of discount requires a little study.

One of the biggest banks in the country replied that, although it had more than four hundred men in the institution, it had not therein brains enough to interpret this into concrete figures.

Professor O. M. W. Sprague, in the Quarterly Journal of Economics for February, 1914, in an article on the Federal Reserve Act, which everybody interested in the working out of the Act should read, says: "The arrangement would seem to be a most unworkable one, since there is no means of knowing to what extent a borrowing bank will have occasion to use the proceeds of its loan in the form of notes. Fortunately this provision of the Act is never likely to become operative."

On the contrary, the whole danger in the Federal Reserve Act is the possibility of expansion or inflation with loss of gold reserves forcing credit contraction.

Provisions that cannot be interpreted or made operative do not beget confidence in their remedial virtues.

The Federal Reserve Act is to operate for very many years and, with threatened export of gold and possible great expansion of reserve bank notes, the possible deficiency in gold reserves must be carefully taken into account and considered.

Reserve banks must hold 35% in "lawful money" against deposits, but when those deposits are called for in currency the reserve requirement so far as currency is issued becomes immediately 40%.

The only safe conduct in respect to Federal Bank reserves is to keep them so far as possible in gold. This should not be difficult, as the member banks, and the entire system, must rely upon the reserve banks to maintain both commercial credit and the gold reserve. As the 35% "lawful money" reserve against the deposit liability is practically interchangeable with the gold reserve (both reserves were previously proposed at 35%), the wisdom of the law making the tax 1% per annum upon deficiency in the gold reserve down to 321% is apparent. The Federal Reserve Board will, therefore, be able to make the same penalties on reserve deficiencies both as respects the gold reserve and the deposit liability reserve.

The question is, How to assess the reserve deficiency tax by adding it to a rate of discount?

Suppose a member bank, approaching the reserve bank with "eligible" commercial paper, and desiring bills for payroll account, is informed that the re-discounts offering that day are liable to so enlarge the issue of Federal reserve notes that the present 40% in gold reserve will drop to, say, 31%, the member bank may elect to borrow on its short-term paper and thereby become liable for only a brief period in which the deficiency exists. Nevertheless, as it passes the reserve notes over to its customer on a longer time discount it may add to the discount rate for the whole period of the discount this day's tax on deficiency, applying it to every day of the discount. The member bank itself must pay in discount 1% above the established rate previously prevailing.

As a 40% reserve is required, a one per centum tax upon the deficiency means four-tenths of one per centum added to the discount rate. This increases by 50%, or to 11% on the deficiency, when the reserve is below 321%, thus adding six-tenths of one per centum, and making one per centum to add to the discount rate.

If the established rate is 6%, and, of course, it would be at least this when reserves are in jeopardy, the whole matter may be put in tabular form as below. In the first column is shown the falling in reserves. In the next column is shown the tax on deficiency. In the third column is this tax on deficiency transposed into a rate of in

terest on the loan. A one per centum tax on the deficiency where a 40% reserve is required, means, of course, 0.4% when applied to principal. The fourth column shows the rate of discount by adding this deficiency tax rate to a normal rate of 6%:

†This and the following rates are the minima permitted.

It will be noticed that when the gold reserve drops below 20% a 10% tax on the deficiency becomes likewise a 10% discount rate. If the gold reserves should fall to 10% the discount rate would be 12.4%.

Any expansion or inflation would be in the way of correction long before extreme rates were reached.

Nothing less than this would be a corrective, for any interpretation that would give borrowers the benefit of a shorter term in the deficiency would be highly speculative and would not correct the situation.

The member bank is under no legal obligation to charge or transfer to its customer the tax of the Federal Reserve bank for federal reserve note accommodation when gold reserves are deficient. Member banks can, of course, at any time charge their customers any interest rate. But the Reserve bank will be taxed by the government daily for its reserve deficiencies, and every day it discounts it must add the government tax to its rate of discount, in its accommodation to member banks.

The member banks must, therefore, pay in a rate of discount the day's tax on the deficiency multiplied by the number of days of discount. This may add to the Reserve bank's profits because it may collect of the banks many times more than the amount it pays the government. However, there is no incentive for profit as in the

end the government gets all the earnings above 6% cumulative dividends on the Federal reserve bank shares.

It may be thought that the member banks can borrow on call of the Reserve banks, but the Act nowhere contemplates any call loans. The Federal Reserve notes are issued only in re-discount of commercial paper and must be secured thereby.

XXV

THREE PER CENT. MONEY.

"A mighty feast of fat things awaits the world of trade," declares Moreton Frewen in the London Financial News, reviewing our Federal Reserve Act and quoting President Wilson's benediction in signing it: "Nothing can be for the interest of the country which is not in the interest of everybody."

Frewen closes as follows:

"Fully reviewing the bill just passed, why should we not, by its help, all enjoy 3 per cent. money rates for some years to come? And if this act, in England, Europe, America, does blaze the trail to cheap money, high wages and brisk business, should not all other governments, even as Uncle Sam, become bill discounters? The act presents us really with a new chapter in monetary science."

"For some years to come," is the refrain of the inflationists. Let it be hoped that the emphasis will rest rather on the permanence of this “new chapter in monetary science."

The jubilation of Moreton Frewen and of all England and of all Europe over Uncle Sam's new bill as "a mighty feast of fat things" for the whole world should not for one moment be forgotten.

It was perfectly clear to some financial observers twenty years ago that if the campaign for the remonetization of silver, so ably supported by Moreton Frewen, failed nationally and internationally, it would be the British Empire, with its crown of gold on a silver base in India, that would within this generation feel the pinch for gold more than America. That time has arrived, and the United States has now reached a position where it could be dominant in the world's money.

Is it to throw away this advantage after twenty years of accumulation?

First, last and all the time, the danger in this bank act is the demand for 3% money. It stalks boldly to the front in Section 27, continuing the Aldrich-Vreeland Emergency Currency as 3% money.

Certainly we have reached "a new chapter in monetary science," if reserve and emergency currency can be safely put out on a 3% basis.

While the Reserve Act was in construction the question was