The Federal Reserve System; H. Sennholz

The edefal eserve ystem serted; "a currency that can he made to expand or contract in a,c cordance with the needs of busi ness." This flexibility was to eliminate the recurring periods of financial stress and disorder. The "reformers" pointedap provingly at the currency systems in Western Europe. There was, for example, the Bank of Eng land. It enj oyed a partial monop oly of note issue, and served the government as banker and as a.gent. All other banks kept ac counts with the Bank of England because its currency notes com manded the greatest confidence and widest circulation. At the end of each clearing period, the claims of all other banks were settled through transfers among their respective deposits with the Bank of England. It was the "lender of last resort." In times of financial crisis it was expected to stay liquid, and to grant accommoda245 246 THE FREEMAN April tion to the most esseJ,1tial credit needs. It had done so during the crises of 1873 and of 1890. And in 1907 it had allayed alarm in Eng land by merely increasing its dis count rate.

There ,also was the Reichsbank of Germany. It, too, conducted a discount policy for the protection of general banking liquidity. But the Reichsbank differed from the Bank of England in one important respect, which had great appeal for the planners in the United States. This was the "elasticity" in its note circulation. So our central banking institution was fashioned, in general, after the Reichsbank. While the Bank of England al ways held a full gold reserve for its notes issued, the Federal Re serve System was required to maintain a, gold reserve of only forty per cent against its issue notes; sixty per cent could be held in trade and agricultural paper discounted by member banks. And the Reserve Banks had to keep on hand, in "lawful money," only thirty-five per cent of all their deposits. In an emergency the full reserve requirements could be suspended for thirty days, with renewals of suspension for further periods of fifteen days each - but at a penalty of a graduated tax on the deficiency in reserves. All these features were to give the new bank flexibility and elasticity.

Economic control over the new System was given to seven gov ernors who are appointed by the President and approved by the U.S. Senate. Of course, ultimate control lies in the hands of the President who makes the· appoint ments. In all important policy matters pertaining to American money and credi t, his decision prevails. In this age of radical interven tionism and socialism, a sharp distinction must always be made between economic control that is decisive, and legal ownership that is empty and meaningless. The 1913 Congress that created the Federal Reserve System gave con trol to the President acting through his seven governors, but rested the legal ownership with the commercial banks that were to join the System. The member banks thus could be made to fi nance the System through the forced sale to them of "stock" that lacked any right of control. After all, the new System was to afford support .and stability to commercial banks. Why shouldn't they be made to finance such bene fits? At least, this was the ra, tionale of government in 1913.

If the legal ownership of the System should ever be placed with the Federal government - which the U.S. Congress, the creator of 1972 THE FEDERAL RESERVE SYSTEM 247 the System, may legislate at will - the meaning and substance of the System will remain unaltered. The Federal Reserve was to a,c commodate its memher banks with emergency reserves and credi ts. After 50 years of rapid growth of government it now holds complete powers over our money and bank ing. It works with three important instruments to suit whatever its purposes m,aybe at any given time. In the beginning it had or at least used - only one. This was the rediscoun.t irnstrumen.t. Rediscount Rate Promissory notes, drafts, and bills of exchange, growing out of actual commercial transactions and with a maturity not to exceed ninety days, accepted by the com mercial banks and then redis counted with the Federal Reserve - this constituted, by law, the base and the boundary for the money the Federal Reserve could create.

Thus a direct causal connection was to be established between the money supply and the demand for money. Since the total of com modity bills --rediscounted was sup posed to be determined by the intensity of economic life, basing the money supply on that total was supposed to bring about a perfect adjustment of this supply to the fluctuating "needs of busi ness." This arrangement was to make money "neutral," smoothly rendering the vital service of a medium of exchange without it self affecting prices. Of course, it did no such thing. The volume of "p.aper" thus of fered the Federal Reserve for rediscount - and hence the amount of currency and credit it could feed into the economy - was de termined primarily by the redis count rate which the Federal Re serve itself established and could change ,af will. As so often hap pens, the planners had put the cart before the horse. Also, by 1935, the boundaries in this channel of operations had been materially widened. The paper presented to the Federal Reserve for advances to its mem ber banks no longer had to arise out of commercial transactions. It could even be government securi ties. If the notes, drafts, or bills of exchange had been drawn "for agricultural purposes," they could now have a maturity of nine months instead of three. Not only banks, but individuals, partner ships, and corporations also had been given access to the discount ing facilities of the System. Fin ally, in 1942, the Federal govern ment was authorized to borrow up to five billion dollars directly from the Federal Reserve. And every loan the Federal Reserve System made to any borrower, for· any 248 THE FREEMAN April purpose, under these relaxed con ditions, allowed it to issue that much more currency, or credit in the form of a bookkeeping entry subject to the check of thebor rower.

Open-Market Operations The second tool of the Federal Reserve System is its authoriza tion to buy or sell certain securi ties· in the open ma,rket. The orig inal Act granted it this power to buy and sell obligations of the United States, and of any state, county, district, political subdivi sion, or municipality in the United States. By the 1920's it was recognized that these open-market transac tions by the Reserve Banks offered an important method of central credit control. So a concentration of this power into the hands of one regulatory body was advo cated. Legislation enacted in 1933 decreed that no Federal Reserve Bank should engage in open-market operations .except in accordance with regulations adopted by the Federal Reserve Board. To im prove and formalize this centrali zation, the Open Market Commit tee was organized. And in 1935 an amendment to the 1933 Act finally provided that "no Federal Reserve Bank shall engage or decline to engage in open-market operations ... except in accordance with the direction of, and regulations adopted by,· the Committee."

With this tool in familiar use, the Federal Reserve System no longer had to wait for member banks to ask for .discounts and advances, at whatever rate it might have set, in order to affect the money supply. It could do so directly, on its own initiative, by buying or selling securities to make the money and capital mar kets more liquid or more tight, as it might wish. In payment for securities the Federal Reserve merely draws, on itself, a check which constitutes newly created money. Then, as this check is deposited by the recipient in his bank, and redeposited by that bank, it winds up as an addition to the reserve account of some bank with the Federal Reserve. Open-market operations of the Federal Reserve may deal in long term securities. Thus they may affect, directly and immediately, long-term interest rates and yields. They are, therefore, a quite comprehensive instrumentality of control. For this reason such op erations have high prestige and preference in the plans of the money managers.

Reserve Requirements The third and perhaps most powerful instrument of credit con trol in the hands of the Federal 1972 THE FEDERAL RESERVE SYSTEM 249 Reserve System is its authority to change the reserve requirements of its member banks. Both the rediscount process· and the open market transactions either in crease or decrease member bank reserves, and hence. the amount of credit which these banks can· make available. But changing the per centage of its deposits which a bank must keep as a reserve is an even more drastic form of influ ence over the money and· credit supply. Suppose a, bank has one million dollars of demand deposits. If the reserve requirement is ten per cent, it must .keep one' hundred thousand dollars in its Reserve Bank. It may loan out or invest the rest. But if the reserve re quirement should now be lowered, let us say, to five per cent, our bank would need only fifty thou sand dollars as a reserve against its demand deposits. It can now lend or invest the remaining $50,000.

If' this were the only effect, only $50,000 of additional money would enter the economy. In real ity, however, this is merely the beginning of a chain of money creation .. Let's assume that our bank· decides to hold the reserves thus set free as "excess reserves." It may then extend more credit to its customers. Of course, it would have to proceed very slowly lest it lose its reserves to other banks or customers demanding cash. It can not. proceed any faster than other banks that also are expanding their credits on the basis of their newlywonexGess reserves. This is an oversimplification, 'of course. But the impact on the capital and money markets of changes in reserve requirements is extremely potent. It is esti mated that at present a, fluctuation of only one per cent tends to in crease or decrease the total volume of bank credit by more than six billion dollars. This authority to vary reserve requirements was given to the Federal Reserve Sys tem in 1933, as a special em,er~ gency power. Since 1935 it has been a permanent instrument of credit control.

A Most Important Tool in the Armory of Intervention An appraisal of the good points and bad points of the Federal Re serve System depends on the po litical and economic philosophy of the appraiser. If he fa,vors' gov ernment control over our economy he will regard the Federal Reserve most favorably, for it holds abso lute power over the people's money and credit. If· one is convinced of the bene ficial nature of an enterprise economy, he will unconditionally 250 THE FREEMAN April rej ect the Federal Reserve Sys tem. He will condemn it as the controlling body of an important industry. He will blame it for having shattered the American dollar; for having caused booms, busts, recessions, and depressions; and for having made the fifty-six years of its existence a period of unprecedented economic insta bility. In the opinion of this writer, this instability has fostered the growth of ideologies that are hos tile to individual liberty. The Fed eral Reserve, through its policies of "boom and bust," helped to usher in the New Deal. And it now acts as midwife to ever more extensive government controls.

Since it began operating in 1914, the Federal Reserve System has put some $55 billion in circu lation, has extended some $65 bil lion in credit, and thereby has depreciated the .dollar by almost three-fourths. And it continues to inflate the money supply at an accelerating rate. First, the economic' planners in Washington clamor for an expan sion of the volume of money and credit, in order to bring about or sustain - a boom, prosperity, and full employment. They rejoice over wage boosts, but dislike the parallel price rises and the hard ships wrought upon those with fixed incomes. They approve of additional housing construction, but disapprove of higher prices for houses. They like one set of inflationary effects, but decry the inevitable twin set. And the eco nomic planners are always most anxious indeed to do something about these undesired effects. In order to "fight" inflation, they want to curb economic actions with credit controls, price con trols, wage controls, and all· kinds of other government controls over our economic lives. They want socialism. In my opinion, an ac celeration of the present long range credit expansion will lead us rapidly into the controlled econ omy they desire.

Under these conditions, the F'ed eral Reserve System, is the most i,mportant tool in the armory of ec'onomic interventionism. In the Governors' own words, it is the system's objective "to help coun teract inflationary and deflation ary movements, and to sha.re in creating conditions favorable to sustain high employment, stable values, growth of the country, and a rising level of consumption." This is plain interventionism, with all of the planner's usual assumption of benevolent omni science. An institution which was established as a, cooperative un dertaking by the banks of the country to pool their resources has developed into the right hand of 1972 THE FEDERAL RESERVE SYSTEM 251 the government in promoting its "New Deal" and "Fair Deal" ob jectives. The beautiful fallacies of socialist "central planning" are being substituted for the hard, but lasting and productive, truths of a free market. And the Federal Reserve System supplies the ma gician's cloth under which the substitution is made.

Its part in the colossal meta morphosis of our country is not limited to the maintenance of cheap money, in order to prolong or create a, boom. It also provides the government itself with the money the planners think they should have, beyond the amount they dare take directly in taxes. The Federal Reserve System facilitates the government's own inflationary financing "in periods of emergency." It makes easy the inflationary financing of budget deficits and the inflationary re funding of government loans. It stabilizes the government bond market through inflationary meth ods and manipulates this market to the advantage of the govern ment. It does all of this by wreck ing the purchasing power of the dollar; by subtly stealing from the people of this country what it thus provides for the government, through a process similar to the coin-clipping of ancient kings but. much more diabolical because so much less visible.

Emergency Banking Laws No matter how grave our in dictment for past and present evils, we must anticipate, an even more ominous role of the System in the future. For periods of na tional emergency, an administra tions since that of Eisenhower have issued emergency banking regulations that grant extraordi nary powers to the Federal Re serve System. Although these may differ in detail, in substance they are much alike. For instance, let us look at Emergency Banking Regulation No.1, issued on January 10, 1961. It is probably the most radical order that ever emanated from an American government. Yet, few voices of protest are heard, for few would dare oppose govern ment preparations for a national emergency. Emergency Banking Regulation No.1 is just one of a, number of emergency measures that would impose government control over rentals, prices, salaries -and wages, and introduce rationing. The Reg ulation orders the instant seizure of most bank deposits "in the event of an attack on the United States." The Regulation is based on The Trading with the Enemy Act of October 6, 1917, and covers all banking institutions, including every commercial bank, trust com pany, private bank, savings bank, 252 THE FREEMAN April mutual savings bank, savings and loan association, building and loan association, cooperative bank, homestead association, credit un ion, and United States postal sav ings office.

Section 2 of Chapter V is most shocking in its wanton denial of individual freedom and private property. Lest we· be suspected of misinterpretation, we quote: "(a) No depositor or share or sav ings account owner may transfer in any manner or by any device whatso ever any balance to his credit on the date on which this Regulation be comes effective, except for the pay ment of (i) expenses or reconstruc tion costs vital to the war effort, (ii) essential living costs, (iii) taxes, (iv) payrolls, or (v) obligations in curred before the date on which this Regulation becomes effective, to the end that the best interest of the war effort and the public will be served. (b) Banking institutions shall pro hibit the transfer of credit in any case where there is reason to believe that such transfer is sought for any unauthorized purpose. (c) After this· Regulation becomes effective, banking institutions shall retain until released by Federal au thority the original or a photographic copy (face and reverse sides) of each check and other evidence of transfer of credit in the amount of $1,000 or more."

In short, your money in the bank is blocked unless you propose to spend it toward the war effort, Le., buy U.S. Treasury ob ligations or finance expenditures deemed "vital" by the government. You may withdraw your .money for living expenses, but only sums deemed "essential." You may pay taxes and wages, and discharge old obligations. But any other use of your money is prohibited. Let us assume that you were saving for another car, new furniture, or a house, or for your children's college education. As such objec tives can hardly be called "essen tial," neither for the war effort nor individual living, your money could be blocked. The Emergency Regulation would permit business to pay taxes and wages, but deny all other ex penses of doing business.· After all, manufacturers need materials, tools, and equipment in order to produce goods and services. Mer chants need ever new supplies of merchandise in order. to .stay .in business. Even professional peo ple, such as doctors and dentists, have expenses other than taxes and wages. This is why the Regu lation would halt all economic ac tivity but that of government. In fact, no enemy attack no matter how devastating to human life and property' could conceivably have a more disruptive effect than the Emergency Banking Regula tion.

1972 THE FEDERAL RESERVE SYSTEM 253 Chapter VI, Section 1, .of the Regulation would radically change the very nature of banking. "N0 banking institution may make any loan, extend any credit, or dis count or purchase any obligation or evidence of debt, unless it is estab lished and certified in writing by the borrower and a banking institution that the purpose is to pay (i) ex penses or reconstruction costs vital to the war effort, (ii) essential living costs, (iii) taxes, or (iv) payrolls, to the end that the best interests of the war effort and the public will be served." It is ironic that the stated purpose of the Regulation is "con tinuance of operations and func tions" of all banking institutions. Indeed, banks would be required to "remain open and continue their operations and functions." (Chapter IV, Section 1). In real .. ity, the stated purpose should read "cessation of all banking opera tions and assumption of the ex clusive function of government finance." After all, what is ba.nk ing? It is negotiating credit be tween lenders and .borrowers, and maintaining cash balances for the convenience of depositors. It is obvious that banking ceases to exist if credit can no longer be-ne gotiated and ca.sh no longer be paid upon demand by the deposi tors. The Emergency Regulation would make all financial institu tions agencies of the U.S. Treasury, with the Federal Reserve System as a subtreasury that polices the banking system. ~ IDEAS ON LIBERTY Trade in Good Faith THE ECONOMIC LIFE of the world in 1913 went on in an atmos phere of good faith. Men with liquid capital used the capital themselves confidently in business enterprises or loaned their capital at market rates of interest to others who would use it in productive operations. There were no billions of dollars of "hot money" such as characterized jhe decade of the 1930's, moving nervously. about from one financial· center to another· through fear of confiscation or through fear of further currency debase ment - moving from countries which their owners distrusted more to countries which they distrusted less, but finding no where a place which they could really trust.

BENJAMIN M. ANDERSON, Economics and the Public Welfare A REVIEWER'S NOTEBOOK JOHN CHAMBERLAIN Willmoore Kendall Contra Mundum I KNEW Willmoore Kendall, who is now presented posthumously in a wide-ranging selection called Will moore Kendall Contra, Mundum (Arlington House, $11.95), when he functioned as the book editor at Bill Buckley's National Review. I had heard stories that he was a ,most "difficult" man, forever get ting into trouble with his col leagues, whether at Yale or else where, for disputatious reasons that, according to Dwight Mac Donald, often ended in the "shout ing stage." But, like Jeffrey Hart, who contributes an illuminating biographical introduction to this representative collection of Ken dalliana, I found him to be unfail ingly considerate at all times. I could only conclude that most of the difficulties that Kendall en countered came from the "liberal" bi,as of academia, a bias that re fused to accept the fact (which Kendall insisted upon) that oJPer American orthodoxies that still prevailed beyond the limits of the campus had a continuing legiti macy, even though (as in the ca.se of Senator Joe McCarthy) their proponents sometimes made stupid mistakes in arithmetic. It was the 254 standard opInIon at the Yale of Willmoore Kendall's time that "McCarthyism" imperiled aca demic freedom, yet ironically, the only academic causualty of the "McCarthy period" that I know was Willmoore Kendall, who was chi vvied into relinquishing his professorial tenure because he in sisted on the need for strong means to keep Communist subver sives out of sensitive positions in Washington. The actual "Mc carthyism" of the campus in the Fifties and early Sixties w,as prac ticed by the liberals themselves, and Willmoore Kendall was their most conspicuous victim.