Chapter XV The Federal Reserve System during the War

CHAPTER XV The Federal Reserve System during the War The task undertaken in this study has been to set forth the effects of the war upon money, credit and banking, rather than to write a comprehensive history of developments in money, credit and banking during the war. A large volume would be required to treat adequately the extraordinary developments in the United States during the war, in view of the inauguration of our federal reserve system. But it has been possible to trace the main movements in money, credit and banking, growing out of the war down to March, 1917, when the United States broke with Germany, with com paratively little reference to the federal reserve'system. The federal reserve system had not been set going when the great war broke out at the end of July, 1914. The Federal Reserve Board was not organized till August 12, 1914, and the federal reserve banks were not opened for business till November 16, 1914. It was the Aldrich-Vreeland notes, and the close cooperation of existing banks, clearing houses, stock exchanges and the Treasury, which met the first shock of the war. The flood of gold which came to us beginning with December, 1914, made, as shown by our curve for call rates in New York,! the easiest money market in the history of Wall Street, and made it largely unnecessary, before April, 1917, for the banks generally to have recourse to rediscounting at the federal reserve banks.2 Certain of the country federal reserve banks, as those at Dallas, ·Kansas City and Atlanta, began to rediscount substantially soon after they began business, particularly as the rise in agricultural prices and the revival of agricultural prosperity made increasing demands on the loan funds of the member banks in these districts.

1 Page 154. t Another factor was the reduction in legal reserve requirements, under the Federal Reserve Act. 165 ·166 EFFECTS OF THE WAR ON MONEY, CREDIT AND BANKING But the federal reserve banks in the great financial centers were not rediscounting enough to enable them to pay dividends through practically the whole period prior to the entrance of the United States into the war. The existence of the system, of course, lent confidence to bankers and business men throughout the country and the knowl edge that it was available if emergency should come undoubtedly hastened the industrial revival. But the great and distinguished services of the federal reserve banks have come since March, 1917.. One I great service for which the federal reserve system has been designed has been of course to constitute a reserve of lend ing power for the other banks. The system has been designed so that as other banks reach the limit of their own ability to lend on sound security they can turn over to the federal reserve banks parts of their loans and discounts and receive from them new funds which they can lend. At the beginning of 1917, the federal reserve banks had earning assets of $221,896,000, including rediscounted paper purchased from member banks, bills of ex change bought in the open market, various government securities, State and municipal warrants and the like. Their chief asset, however, was the non-earning asset, gold. Foreseeing war from the beginning of 1917, the federal reserve banks sought to 'strengthen their position by reducing their earning assets, and when the war broke out their earning assets amounted to only $167,994,000. With decks cleared for action, they were pre pared to begin rediscounting on an enormous scale as the burden of war finance should compel the other banks to have recourse to the federal reserve system.

1 The growth in virtually all the items of the balance sheet of the federal reserve system since the United States entered the war has been very great indeed, and reflects services of, inestim able importance to the country. With this growth of resources and liabilities has come also an extraordinary increase in earn ings, which has wiped out all arrears in dividends and placed 1 Federal Reserve Bulletin, May 1, 1917, page 335.

THE UNITED STATES 167 the federal reserve system, as jocosely suggested by a distin guished financial writer, in the class of the" profiteers." The following table 1 shows the growth of the system: PRINCIPAL RESOURCE AND LIABILITY ITEMS OF THE FEDERAL RESERVE SYSTEM ON SELECTED DATES (In thousands of dollars) Nov. 26 1915 RESOURCES Dec. 22 1916 Oct. 25 1918 Total gold reserves . Total cash reserves . Bills discounted: Se~ure.d. by government war ob11gatlons . All other . Bills bought in open market . U. S. Government long term securities . U. S. Government short term securities .........................• Total earning assets . Total resources· . LIABILITIES a 492,063 a 529,375 32,794 16,179 12,919 89,200 637,261 a 728,445 a 734,470 32,297 124,633 43.504 11,167 222,158 1,0~,852 a 2,045,132 a 2,098,169 1,092,417 453.747 398,623 28,251 322,060 2,295,122 b 5,270,785 Capital paid in and surplus......... 54,846 Government deposits.. .. .... . ... ... 15,000 Member banks' reserve deposits. . . .. c 397,952 Other deposits, including foreign government credits .

Federal reserve notes in actual circulation 165,304 55,765 29,472 c 648,787 275,046 80,324 78,218 1,683,499 d 117,001 2,507,912 a Includes amounts of gold and other lawful money deposited with federal reserve agents against federal reserve notes issued. b Includes clearing house exchanges and other uncollected items formerly deducted from member bank deposits. C Net amount due to member banks. . d Exclusive of deferred credits on account of uncollected checks and other cash items. One very important item in the. expansion of' the resources and liabilities of the federal reserve banks since the United States entered the war, and an item which represents a great growth in 1 I am indebted to Dr. M. Jacobson, statistician of the Federal Reserve Board, for this table. Changes in accounting methods since the inaugura tion of the system. partly due to. changes in the law, make it difficult to compare off hand the earlier and later statements.

168 EFFECTS OF THE WAR ON MONEY, CREDIT AND BANKING strength for the system, is to be found in the increase in gold on the assets side, matched by the growth of federal reserve notes and member bank deposits on the liability side. The total stock of gold coin (including bullion in the Treasury) in the United States on April 1, 1917, was estimated at $3,088,90[;,000, a figure vvhich has not been substantially altered since, as both ex ports and imports of gold have since been comparatively slight. Of this, the United States Treasury held $203,868,000, the federal reserve system held $938,046,000, and gold" in circula tion," supposed to be largely held by banks, was placed at $1,946,991.,000. 1 Between April 1, 1917, and April 1, 1918, roughly a billion dollars of the gold held by other banks and in general circulation was turned over to the federal reserve banks, raising their gold holdings from $938,046,000 to $1,813,924,000.

By September 20, 1918, the total gold holdings of the federal reserve banks had risen to $2,023,558,000. Over two-thirds, therefore, of the free gold of the country is now concentrated in the hands of the federal reserve banks. The policy of accumu lating gold is expected to continue, and a member of the Federal Reserve Board recently expressed the opinion that the gold hold ings of the system might be expected to reach $2,500,000,000 before the end of the process is reached. 2 It is probable that the estimate for the total stock of gold in the country is too high. It is doubtful if there remained on April 1, 1918, approximately a billion dollars of gold in circula tion or in the hands of other banks. It is probable that the estimates for the gold held in the country before the war have been too high, that there has been an underestimate of the annual consumption of gold in the arts and that the original figure with which the Director of the Mint started his computation was too high. Competent students have suggested to the present writer that the overestimate in th~ total stock of gold may be as great 1 Much of this was in gold certificates, "yellowbacks," of large denomina tions, held by the banks as a convenient means of interbank settlements, or in smaller denominations for general circulation. The actual gold was to a large extent in the United States Treasury.

:l Further concentration of gold will be facilitated by the proposed issue of federal reserve notes in large denominations, which will make it easier for member banks to dispense with their large denomination gold certificates.

THE UNITED STATES 169 as from two to five hundred million, though these figures are . largely guess work. If this view be true, however, then the proportion of gold held by the federal reserve banks is substan tially greater than two-thirds of the total stock. It represents an accumulation which should make us impregnable against any foreign drain on our gold, and which, barring a panic introduced by an injudicious policy on the part of the federal reserve banks themselves, should forever banish doubt as to the ability of the banks of the United States to pay all gold obligations on demand. This policy of collecting gold was greatly facilitated by the amendments to the Federal Reserve Act in the summer of 1917, which reduced the reserve percentages required of member banks and which allowed them to count as their legal reserve only deposits with the federal reserve banks, so that gold or lawful money held in their own vaults no longer counted as legal reserve.

This made it possible for the member banks to turn 9ver all their . gold to the federal reserve banks, receiving in return either deposit credits or federal reserve notes, depending upon their own preference and their customers' needs.1 It may be observed in passing that this fundamental change in the law relating to cash reserve was accepted almost without question, whereas the more moderate proposal to make federal reserve notes available as legal reserve for member banks had led to a violent outcry by those who feared" inflation" only a short time before. Practically, there is little differe"ncebetween the two proposals. It is, if anything, easier to get a deposit credit with a federal reserve bank than to get new federal reserve notes from a federal reserve bank. Federal reserve notes, and deposits with the federal reserve b~nks are in economic nature virtually identical. In the present writer's view, it is perfectly legitimate that either should be used as reserve by member banks. In the present writer's view, the whole system of legal reserve require ments is ridiculous in any case. In the provision that deposits with the federal reserve bank constitute the only legal reserves of 1 "Another amendment in 1917 simplified the process of exchanging gold for federal reserve notes and made it possible to count the gold in the system as reserve for either notes or deposits, interchangeably.

170 EFFECTS OF THE WAR ON MONEY, CREDIT AND BANKING . member banks, we have an achievement in the direction of sound banking of the first magnitude-we have virtually an abandon ment of the legal reserve requirements, since, it is almost always possible for member banks to get additional " legal reserve" by rediscounting paper. Their real reserves become, therefore, their portfolios rather than their cash on hand, bringing them into line with the policy which European bankers had long since taken for granted. Unnoticed by the great mass of the people, the federal reserve banks have introduced a smoothness and simplicity in handling huge financial transactions that would have been incredible under the old system. In the summer of 1918, the federal government collected around $4,000,000,000 in taxes in a few weeks. In connection with the First Liberty Loan, $2,000,000,000 were paid into the federal Treasury in a short time. With each of the succeeding liberty loans, larger amounts have been handled in short periods, funds collected from all over the United States, transferred to the credit of the government and disbursed largely in other parts of the country from those which originally contributed them. Financial transactions of this magnitude would have led under the old system to drains falling particu larly on the New York banks, which would have forced them instantly to suspend cash payments. Had the subtreasury system remained in full vigor, under which all payments to the federal government were ta.ken from the banks and placed bodily in the vaults of the government itself, the mechanism would have broken down with the Fi~st Liberty Loan. Under the federal reserve system, however, these huge financial transactions have been largely accomplished by bookkeeping entries. Various offi cers of the federal reserve banks, and very specially the central office ~f the Federal Reserve Board at Washington, have devel oped a marvelous finesse in balancing debits and credits. This has involved a study in advance of the probable demands to be made on banks in various localities, the effort to route collection items through them in such a way as to give them funds whjch would break the shock of the heavy withdrawals, providing in advance to rediscount paper for them, and suggesting to "the THE UNITED STATES 171 Treasury the best places wllere government deposits might be made to offset heavy drafts. It has also involved the policy of rediscounting on the part of one federal reserve bank for another in such a way as to keep their gold reserve ratios approximately equal.

The Treasury policy of preceding the great loans and heavy tax payments by the marketing of short term Treasury certifi cates, maturing on the dates when tax payments or payments on the liberty loans were due, and receivable by the Treasury for such payments, has in itself been a factor of first magnitude in reducing financial friction. But under the old system, these Treapury certificates themselves would have strained the machinery severely. Shortly after the inauguration of the federal reserve system, the Federal Reserve Board required the federal reserve banks to create a gold settlement fund in Washington, on'the analogy of the gold fund on deposit in the New York clearing house, de signed to lessen the necessity of the physical transfers of gold from one federal reserve bank to another in connection with interregional settlements . This gold fund, originally $12,000, 000, $1,000,000 from each bank, has subsequently been added to very greatly.

On July 1, 1918, daily settlements between the federal reserve banks were inauguiated, reducing, in general, the amount of gold that has to be transferred from one to another at any given date, and making it possible for the Federal Reserve Board at Washington to keep in constant touch with the reserve situation of each bank and to keep reserve' percentages equalized by constant rediscounting. Daily settlements do not necessarily mean daily shipments of gold to and from Washington. "Sus pense accounts" kept by the various federal reserve banks with the gold settlement fund, obviate this. It would be hard to give too much praise to the efficiency and initiative of the men who have worked out this wonderful system of substituting book transfers for the large cash shipments which the old system, despite its great economies, involved. War finance on our present scale could hardly have been carried on 17~ EFFECTS OF THE WAR ON MONEY, CREDIT AND BANKING by the old machinery. It is a supreme vindication of the federal reserve system.

Another important part of the work of the federal reserve' system has been in the control of credits, both in reducing credits to non-essential industries, and in securing credits for essential industries. This has taken place largely in an informal way through advice and suggestions to member banks. Thus in the summer of 1917, the Federal Reserve Board sent out a letter saying that cattle feeders, paying high rates of interest, were finding their interest charges running from 35 to 40 per cent of their total expenses, and urging the member banks to extend them credits more liberally and at lower rates.. At various times and with increasing vigor and definitenes.s, the Federal Reserve Board has urged upon the member banks the policy of restricting credits to non-essential industries. Various federal reserve 'banks have gone far in explicit advice and guid ance of member banks in this matter. In a more authoritative way the Capital Issues Committee of the Federal Reserve Board has sought to limit the issues of new securities by non-essential industries, turning over this work recently to the newly formed War Finance Corporation.

In one respect the Federal Reserve Board and the federal reserve banks have failed to use a powerful means of restricting non-essential credits. They have kept their tediscount rates low, lower than the facts of the money market warranted, and lower than has been consistent with a vigorous control over the credit , situation. In this, as will appear later, they have probably not had a free hand, but have submitted their policy to the policy of the Treasury. Another important policy in which the Federal Reserve Board has been nominally responsible, has been in the control over for eign gold shipments, and in the regulation of foreign exchange rates. 1 The policy has been one of restricting gold shipments, virtuall y prohibiting them, with few and minor exceptions. 1 The Federal Reserve Board has really been acting as the agent of the Secretary of the Treasury in this matter. There is no evidence that the board approved the policy at the time of its inception.

THE UNITED STATES 173 Those who have carried out the detailed application of the gold policy have been loath to discuss ~he matter in detail, and have been unwilling that much should be said in public discussion of it, fearing that their international operations, involving delicate negotiations with foreign banks and even with foreign govern ments, might be interfered with by discussion of their plans and purposes. It is not easy, therefore, to state with justice or with vigor the theory which has animated them. The policy has involved not merely the restriction of gold shipments to fo~eign countries, but it has also involved a restriction of gold payments within the country,t and a limitation upon the gold available for manufacturing jewelers, dentists and others. The present writer finds it impossible to sympathize with this policy or to defend it. The essential elements involved in the gold standard are: (a) the free interconvertibility of bullion into coin, (b) the free interconvertibility of coin into bullion and (c) the instant redemption on demand of paper and other subsidiary money in gold coin. Whatever may be said of the policy of restricting gold shipments abroad, it is difficult to make a case for the failure to preserve the gold standard in its full integrity at home. The voluntary surrender by banks and people of gold to the central gold reserves is desirable, and the effort of the Federal Reserve Board to accomplish this-following the policy of the Reichs bank and of the Banque de France-is praiseworthy. But the wnole point involved in such a policy is to increase the certainty that the federal reserve system can meet its gold obligations on demand.

There is no sure basis for the value of paper money except instant redemption in standard money on demand. It is true that other factors 2-the loyalty of the people and of the banks, the confidence of the people in the credit and success of the govern ment, the mere existence of a huge gqld reserve with the knowl edge that the power to redeem exists-may sustain the value of the paper at par. Value is after all psychological. It appears 1 This feature of the policy is informal. and has involved the cooperation of many agencies. including virtually all the banks of the country. 2 Vide the writer's Value of Money, chap. 7.

1'T4 EFFECTS OF-THE WAR O·N MONEY, CREDIT AND BANKING that paper money in the United States has been so far maintained at par in most places during the past year, but such a basis for the value of paper money is insecure. Overnight changes in the attitude of the people or banks might upset it; a dramatic event, calling attention in a conspicuous way to the fact of inconverti bility, might upset it, leading to just such a depreciation as was witnessed in federal demand notes or in the State bank notes of the North, following January 1, 1862. Assuming that the value of our paper money at home is ·not affected by such a policy, there can be no question at all that our credit abroad is affected. The foreign exchange rates alone should make that clear. But further, and looking to the future, had the United States maintained the record of paying gold to all legitimate creditors without question throughout the war, had New York remained the one free gold market in the world, New York would have needed in the future to carry much less gold in reserve than she will need for years to come. The institu tion or the community that maintains the reputation of honoring its obligations at all times is rarely called upon to honor them unnecessarily. London, with vastly less' in the way of gold resources than the United States have had, preserves her reputa tion in this matter far better than we. Having gol~, she paid it out. London has probably a small amount of gold at the present time. The Bank of England's gold reserves, as shown in published figures, are larger than before the war, but to a very considerable extent the actual reserves are probably to be found in South Africa or in Canada in depositories established by the Bank of England. But by the courageous use of such gold as she has had, London has preserved her credit to an astonishing degree.

A little more than two decades ago, President Cleveland faced a situation in which his gold reserves-little more than $20,OOO,OOO-promisedto be exhausted in forty-eight hours. He continued, however, the policy of paying out gold on demand, and by his courage saved· the gold standard. New gold was secured within the forty-eight hours, the reserves were replen ished, and the country was saved from another period of demorTHE UNITED STATES alization growing out of fluctuating irredeemable paper money or the adoption of the silver standard. It is not a picture to inspire enthusiasm when one sees our federal reserve system, entrenched safely behind over $2,000,000,000 of gold, showing less of courage than President Cleveland manifested with his scant $20,000,000. Surely the history of· money has made sufficiently clea.r the dangers and evils of irredeemable paper, the fundamental disorganization and demoralization that such paper can occasion, to make argument with reference to the essentiai importance of the preservation of the gold standard unnecessary ..

On the part of some of the defenders of the policy of restrict ing gold payments within the country and of restricting gold shipments abroad, there appears to be a wholly irrational fear that the end of the war will bring so great a drain upon the gold resour~es of the country, as foreign countries call upon us for gold, that we can not meet it unless we now hoard our gold. This fear seems baseless. The outside world will owe hundreds of millions a year in interest and dividend payments alone to ~he United States. The probability is rather that we will be left with more gold on hand than it is economical for us to keep. In any case, the main reason for having gold either now or after the war is to be in a position to meet the demands of those who have the legal right to obtain gold from us. The argument has been presented that-by retaining $3,000, OOQ,OOO of gold we will be placed in a position of such great strength that we can finance the world, displacing London as the international center. It is not improbable that London bankers who have seen this statement have smiled quietly. They do not need $3,000,000,000 to finance the trade of the world! Before the war, Gre~t Britain financed the trade of the world with half a billion dollars in gold and with much less than that in the actual reserves of her banks. The banker who can do business with a half billion in gold can undercut in the competition of the world's money market the banker who requires three billions.

An excess of gold is a dead asset, a burden rather than an aid in competition in international finance. America has great 176 EFFECTS OF THE WAR ON MONEY, CREDIT AND BANKING financial strength, but is surely showing a lack of financial finesse and courage, so far as the gold policy is concerned. 1 In connection with these strictures on what we have called " the Federal Reserve Board's gold policy," it is just to repeat that the policy appears to be that of the Treasury rather than that of the board-that the board appears to have surrendered its monetary policy to the fiscal policy of the Treasury.2 The central purpose of the Treasury in this connection appears to be to float liberty bonds at a low rate of interest. For this purpose an easy money market is regarded as necessary. The Treasury policy reacts on the policy of the Federal Reserve Board at two vital points: (1) Rediscount rates must be kept low, thus making the control of credits to non-essential industries harder. (2) Gold must not be allowed to get 'away lest money rates be forced up to stop the outflow of gold.

Viewed as a policy of protecting the credit of the United States Government, this course seems grotesque. Surely, the money of the United States is more sacred than the liberty bonds! Surely it is more important to maintain the demand obligations at par than to protect the current price of the time obligations! Surely, the credit of the government is more dependent on the punctual fulfilment of its contract obligations than on the day by day standing of its long time securities in the market! Viewed as a measure for saving money for the government it is exceedingly questionable. The saving of % per cent or more in interest can be much more than offset by two vital factors: (1) If through the easy money market, non-essential industries can get credits which they would not get if discount rates were higher, then their competition for labor and supplies will raise the prices which the government must pay for the things it buys, increasing the amounts which the government must borrow. (2) More fundamental, if as a consequence of 1 For a variety of opinions on this general problem, see Hearings before the Senate Conlmittee 01'£ Banking and Currenc'j.', on the proposed "Federal Reserve Foreign Bank," summer of 1918; and also an address by Mr. F. I.

Kent, reproduced in Congressional Record, May 1, 1918, pages 6358-6363. 2 So far as the foreign exchange policy is concerned the Federal Reserve Board is really merely the agent of the Treasury, exercising delegated authority.

THE UNITED STATES 177 the failure to redeem the money of the government in gold, the paper money itself should depreciate, that again would lead to higher prices, to larger expenses for the government, to say nothing of great demoralization in the whole business and finan~ cial fabric. Finally, it is probable that liberty bonds will be sold at what ever rate of interest the government proposes in any case. By and large, the American people are not taking liberty bonds as investments; they are taking them through loyalty as a means of winning the war. The difference of a fraction of 1 per cent or even of 1 per cent, in the interest rate would probably make slight difference in the amount of liberty bonds sold, and the loyalty of the people and of the banks is less strained if they are asked to take liberty bonds at an interest rate' below the prevail, ing market rates for capital than when they are expected to protect the value of the paper money of the United States in the absence of gold redemption.

Following the amendments to the Federal Resetve Act in the summer of 1917, which removed certain of the objections which State banks and trust companies had had to entering the system, the President of the United States issued an appeal on October 13, 1917, to the State banks and trust companies to enter the system as a war time measure, that they might contribute their strength to the system and that they might secure for themselves and their patrons the protection which the system afforded. The response has been distinctly gratifying. The great State banks and trust companies of New York City entered rapidly and readily. By June 1, 1918, 486 State institutions with com bined capital and surplus of $621,000,000 and with total re sources of app'roximately $6,000,000,000, had entered the system.1 The great majority of State institutions still remain outside, but many of the largest institutions, whose addition to the system would add most to its strength, have joined.

There have been various minor developments of the federal reserve system, important in themselves, but not so immediately connected witl1 war policy, of which only brief mention can be 1 Federal Reserve Bulletin, June, 1918, page 509.

178 EFFECTS OF THE WAR ON MONEY, CREDIT AND BANKING made. The various federal reserve banks have established branches and agencies at home and abroad. The Banque de France and the Bank of England have become agencies of the federal reserve bank of New yark. The Philippine National Bank has become the agency for the federal reserve bank of San Francisco; theSat:t Francisco federal reserve bCl:nk has established branches at Seattle, Spokane, Portland and Washington; the St. Louis federal., reserve bank has established an agency at Memphis, primarily for the purpose of keeping cotton warehouse certificates, used as collateral, where they could be quickly got at by the borrowers. 1 The federal reserve system has inaugurated a check collection system .. It has pu.t thrqugh a campaign for acceptances which has led to substantial modifications in banking practices in the U~ited States. ~he Federal Reserve Board, in connection with its admirable Federal Reserve Bulletin) has undertaken far reaching statistical plans which involve the development Jf scientific statistics which will be of use in business forecasting.

But it is outside the scope of our program to write a history of the federal reserve system. We are concerned with an outline sketch of the effects of the war upon it, and of its role in meeting the problems of the war. 1 Federal Reserve Bulletin, March 1, 1917, page 168.