Credit Control at the Source

October 30, 1950

The Federal Reserve Banks have kept interest rates abnormally low. They have loaded themselves up with nearly $20,000,000,000 of government securities. In brief, they have failed to make proper use of the two best ways to prevent credit expansion—by raising interest rates and through open-market operations. So to compensate for this failure they are planning to increase the reserve requirements of member banks of the Federal Reserve System to the limit permitted by law.

Increasing reserve requirements is a clumsy method of credit control. But it is far better than permitting a further inflation of bank credit. It is ironic, however, that the Federal Reserve authorities who want to impose higher reserve requirements on the member banks have resisted every effort to restore the reserve requirements of the Federal Reserve Banks themselves. Prior to 1945, the Federal Reserve Banks were required by law to keep reserves in gold certificates of 40 percent against their notes in circulation and of 35 percent against their deposits. By act of Congress on June 12, 1945, these requirements were lowered to a uniform reserve ratio of 25 percent. This was done to permit the Federal Reserve System to inflate more in the war emergency—though Germany had already surrendered the month before, and the Japanese surrender, as it proved, was only two months off.

Though the reserve authorities never had to resort to the lower reserve ratio, they have not only failed since then to recommend a restoration of the former reserve requirements, but have opposed all outside suggestions that this be done. Yet the National City Bank, in its monthly letter this September, pointed out that the Federal Reserve Banks could still buy up about $50,000,000,000 additional government securities—a tremendous inflationary potential—before their note and deposit liabilities would reach the present legal limit of expansion permitted with present reserves.

This situation urgently demands action by Congress. The reserve requirements of the Federal Reserve Banks themselves should be restored at least to their pre-1945 levels. As the average reserve ratio of all the Federal Reserve Banks is now 52.5 percent (from 56.4 on June 21), this legal change can fortunately still be made without causing the slightest hardship.

It is true that this action would do nothing to reduce the already outstanding volume of money and bank credit. Its purpose would be to forestall a further inflationary expansion while there is still time. It would, however, have a tremendous immediate psychological importance. It would put not only the Federal Reserve System but the whole country on notice that Congress is determined to prevent inflation and knows the direction in which the danger really lies.

As long as we have legal reserve requirements, they must be adequate. A legal reserve ratio is a declaration of Congressional policy. The present reserve requirement of only 25 percent is equivalent to a Congressional sanctioning of further gross inflation. If the Federal Reserve Board has in fact no intention of inflating to this point, it should welcome a restoration of the former reserve requirements.

Of course even if the legal reserve ratios were restored to their former levels, it would still leave a tremendous inflationary potential. This is no reason for not taking this step; it is a reason for taking additional measures.

So let Congress restore the Federal Reserve Bank ratio requirements to their previous levels. Or better, let it raise the present flat “emergency” 25 percent reserve requirement against both deposits and notes to a flat 40 percent. Then let Congress in addition give the Federal Reserve Board discretionary authority to raise the reserve requirements of the Federal Reserve Banks even further—just as it already has discretionary authority to raise member bank reserve ratios. And let Congress provide still further that the board cannot hereafter raise the reserve requirements of the member banks without raising the reserve requirements of the Federal Reserve Banks correspondingly.