Report of the Federal Reserve Board.39 The Report advocated that the Federal Reserve Act be amended so as to allow Federal Reserve notes to be issued directly against gold and that member banks be required to keep all of their reserves with the Federal Reserve System. 40 It was thought that both measures would give the System a more effective control over the heretofore unregulated gold inflow and would decrease the danger of inflation. How such control would check the rise in the price level or the rate at which it was rising, no one has clearly explained. It is an elementary principle that to affect prices, money and deposit currency must be in circulation, must actually be offered in exchange for goods and services. Gold not yet mined or gold which is hoarded whether in the vaults of a central reserve bank (save as it serves for the basis of credit expansion) or in a miser's hovel can have no effect on prices. The incoming gold would then have to be hoarded in the Federal Reserve Banks and not used as a basis for increased credit extensions, if its effect on prices were to be nullified. Had the Federal Reserve Banks, desiring to increase their gold holdings at their own expense, gone abroad and purchased this gold in the European gold mar40 These suggestions were finally enacted by an act passed on June 21, 1917. In the early part of 1917 the Board recommended (Federal Reserve Bulletin, 1917, p. 1) that the date on which balances with central reserve and reserve city banks should cease to count as reserves be drawn back from November 1, 1917 to February or March, 1917, thereby concentrating the reserves of the country to a larger extent. Before June 21, 1917, a Reserve Bank, wishing to issue Federal Reserve notes, was required by the Act to make application to the Reserve Agent for the amount required, accompanying the application by an amount of collateral consisting of notes and bills eligible for rediscount equal in amount to the Federal Reserve notes applied for. When the Reserve Bank paid out the notes so obtained, it immediately set aside a reserve in gold of 40% of the notes in circulation. Thus Federal Reserve notes were backed up by 140% of collateral and were issued against eligible commercial paper alone. To reduce its note liability, a Reserve Bank was permitted to deposit with the Reserve Agent Federal Reserve notes, gold, gold certificates or lawful money. During 1915 and 1916, the Reserve Bank followed the policy of depositing gold with the Reserve Agent, thereby reducing the note liability of the Bank and obtaining the commercial paper originally deposited and then immediately redepositing the commercial paper, securing additional notes, and then in turn obtaining the commercial paper again by deposits of gold. This practice was followed in order that as much of the gold stock in the country as was possible might be lodged with the Reserve Banks. As a result of this policy, the Federal Reserve note was virtually a gold certificate before 1917. See Third Annual Report of the Federal Reserve Board, pp. 25 and 230. ket, it might have been possible for the Regional Banks to have hoarded it and by high discount rates to have discouraged extensions of credit based on it. The gold inflow was not so induced. It came here in payment of goods, and was deposited by exporters in commercial banks. To be in a position to pay interest on these deposits and to provide dividends for the shareholders, the commercial banks had to employ this gold, and they did so by increasing their loans. This they would have done whether the gold were in their own vaults or had been deposited by them as reserve funds in the Reserve Banks. So long then as the banks of the country expanded solely on the basis of the incoming gold, the Federal Reserve Banks were powerless to control the situation; unless through their open-market operations they would have been able to mop up all the surplus funds in the market, by selling their holdings of government bonds, municipal warrants, acceptances, etc., to the member banks, Any attempt of this kind would have been futile. The surplus funds were so plentiful and were coming in at such a rapid rate from Europe that the Federal Reserve Banks could not possibly have absorbed them. Only when the banks of the country had expanded as far as possible on the basis of the incoming gold and had then attempted to expand further by rediscounts with the Reserve Banks. could the Reserve System have controlled the situation. The members of the Board suggested still another plan for the prevention or checking of inflation prior to the war. They urged that the Federal Reserve Act be amended in such manner as to permit them to increase from time to time, the reserve requirements of all member banks in a single district or in all districts upon the affirmative vote of five members of the Board.41 The increases were not to exceed 20% of that part of the reserve of the member bank kept with its Reserve Bank and for periods not to exceed thirty days in length. This suggestion was never enacted. The Federal Advisory Council opposed it on the ground that, as it applied only to member banks and not to non-members, the fear among banks that their reserves might be increased at any time would discourage non-members from joining the System. An increase of the balances of member banks with their Reserve Bank of 20% would have had the following effect on the reserve requirements of that time, assuming that 41 See, the Federal Reserve Bulletin, 1917, pp. 102, 108, also Westerfield, The Reserve Situation in the Federal Reserve System, p. 518. the provisions of the Federal Reserve Act regarding the reserves required to be held by the member banks had gone into full effect: INCREASE IN RESERVE AGAINST DEMAND DEPOSITS Central reserve cities Country banks from 18% to 19.4% from 15 to 16.2 from 12 to 13.0 Inasmuch as this suggestion contemplated but a temporary and slight increase in the reserve requirements, its influence, had it been adopted, would have been negligible in checking the rise in prices in view of the size of the gold imports. As the suggestion mentioned above was not enacted and as the Bank rates were not effective, the Board could do little else than to caution the Reserve Banks to restrict their open-market operations,42 so that the funds in the market, already abundant, would not be increased. Reasons for the Pre-war Advance in Prices. Though there is no unanimity of judgment as to the reasons for the advance in the general price level before 1917, the general consensus of opinion among economists 43 was, that three factors were chiefly responsible for the higher prices. The first of these and one which we have already elaborated was the inflow of gold. Two other factors, hardly less significant, were the reduction of the reserve requirements of commercial banks, and improvements in the mechanism for the collection and clearance of country items. The Reduction in Reserves. Incident to the greater concentration, control, mobility, liquidity, and elasticity of the reserve moneys of the country, brought about by the inauguration of the Federal Reserve System, it was held, and correctly so, that the reserves national banks were required to maintain might safely be lowered. The joint stock banks in Europe, by virtue of their union into an efficient system, had found it possible to operate on much lower reserves than national banks were permitted to hold. These factors justified the framers of the Federal Reserve Act in making the following reductions in the reserves held by national and other member banks: 42 See, for instance, the Federal Reserve Bulletin, 1917, p. 76, and Willis, The First Year of the New Banking System, pp. 612–613. 43 See Report of the Committee on War Finance of the American Economic Association, The American Economic Review, Supplement No. 2, March, 1919, pp. 90-118. Under the Federal Reserve Act, effective November 16, 1914, member banks were required to maintain reserves against deposits as follows: Central Reserve Cities 1. Net demand deposits. . . . 18% 18 2. Time deposits, to be held in the same way as re serves against de 15% first thirty-six 12%; first thirty-six mand de posits .5% 5% .5% 44 See Westerfield, Banking Principles and Practice, p. 403, and Hearing before the Joint Commission of Agricultural Inquiry, Vol. 2, p. 522. It has been estimated that the reductions in the reserve requirements of national banks released $464,919,076 of reserve funds.45 To this amount must be added the funds which were released by lowering, in a number of states during 1915, the reserve requirements of state banks. There was not the same justification for this action as there had been in the case of national banks. National banks had been unified in a system which permitted a lowering of reserves with no weakness to the banking structure. As state banks had not been united into such a system, a lowering of the reserve requirements was not justified.46 Had the war not intervened, the rise in prices resulting from the release of these funds would have been gradually diffused over all gold standard nations, for gold would have flowed from America as prices advanced. This efflux of gold which would normally have taken place was prevented by the sudden and phenomenal increase in the export trade of the United States and by credit expansions in the allied nations. The Increased Velocity of the Circulating Media. A third reason for the advance in prices was the increase which took place in the rapidity of turnover of America's circulating media. This was due to improvements brought about by the Federal Reserve System in the machinery for the collection and clearance of country items. The establishment of the gold settlement fund and other similar devices has cut down the time of collecting such items by half. The dollar was consequently enabled to do a larger quantity of work, to work more efficiently, and to the extent that the velocity of the circulating media increased, prices rose. 45 Few economists have given adequate attention to the importance, as a cause of the rising prices from 1914-1917 to the lowered reserves against time deposits. Prior to 1913 the reserve requirements against time deposits (payable on a notice of 30 days or more as now defined) were the same as against demand. No distinction was made. From the time the Federal Reserve Act became effective to June 21, 1917 the reserves member banks were required to maintain against time deposits were reduced to 5 %. The importance of this will be realized when we remember that in 1914 time deposits were equal to 22.6% of individual demand deposits, in 1915 to 22.8, in 1916 to 25.9, in 1917 to 27.2, in 1918 to 26.1, in 1919 to 30.4, in 1920 to 38.2. See, Hearing before the Joint Commission of Agricultural Inquiry, Sixty-Seventh Congress, First Session, Part 13, p. 523. 46 See, Second Annual Report of the Federal Reserve Board, pp. 13, 14, 104-113. 47 See, Hearing before the Joint Commission of Agricultural Inquiry, 67th Congress, 1st Session, Part 13, p. 523. UNIVE |