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TO: The Fed er al Res erv e Board X-431 4

257

F ro m: Di v i s i o ns

o f

Bank Ope rat ion s

3;nd

Res ea rch

a n d

S t a t i s t i c s .

THE

MCFAD3EN BILL

TO

REVISE

THE

FEEERAL RESERVE

ACT

Genera l purposes o f t h e amendments

T h e amendments t o t h e F edera l Res erv e A c t pro po s ed by Congressman McFadden

i m m e d i a t e l y p r i o r t o t h e adjournment o f t h e l a s t Co ngres s a pp a re nt l y ha v e two

p u r p o s e s : ( 1 ) T o r e e s t a b l i s h a c l o s e r c o n n e c t i o n b e t w e e n t h e volume o f F edera l

r e s e r v e n o t e s i n c i r c u l a t i o n a n d t h e currency requ i rements o f bu s i ne s s . Wi th

t h i s i n v i ew t h e b i l l p r o h i b i t s t h e u s e b y t e s e r v e b a n k s o f g o l d a n d o f a c c e p -

t a n c e s p u r c h a s e d i n t h e open market a s c o l l a t e r a l f o r F e d e r a l r e s e r v e n o t e s ,

l e a v i n g d i s c o u n t e d p a p e r a s t h e s o l e a u t h o r i z e d c o l l a t e r a l . ( 2 ) T o reduce t h e

l end i ng po wer

o f t h e

res erv e ba nks ,

b y

permitt ing member banks

t o

withdraw from

t h e res erv e ba nks , a n d t o h o l d i n t h e i r ow n v a u l t s , a p a r t o f t h e i r r e q u i r e d

r e s e r v e s . #

Both

o f

t h e s e o b j e c t s a p p ea r

t o b e

b a s e d l a r g e l y

o n

m i s c o n c e p t i o ns a r i s -

i n g f ro m i m p e r f e c t a p p r e c i a t i o n o f t h e e x p e r i e n c e o f t h e s y s t e m . The f i r s t o f

them assume s t ha t t h e volume o f F e d e r a l r e s e r v e n o t e s i n c i r c u l a t i o n c u r r e n t l y

depends upon t h e c h a r a c t e r o f t h e pa per o r o t h e r c o l l a t e r a l w h i c h m a y b e us ed

a s c o v e r f o r t h e n o t e s , b u t e x p e r i e n c e h a s d e m o n s t r at e d t h a t t h i s i s n o t t h e

c a s e . N o t e s

g e t

i n t o g e n e r a l c i r c u l a t i o n o n l y w he n c u s t o m e r s

o f

member

o r

nonraeiaber banks withdraw currency t o meet t h e i r cu rr en t ne e ds . Member banks

r e t a i n i n t h e i r o w n v a u l t s o n l y su c h a n amount o f c u r r e n c y a s they need t o

meet da i l y requ i rements , beca us e

i t

does

n o t p a y

t h e n

t o

keep more,

a n d i t i s

o n l y when th es e da i l y requ i rement s i n cr ea s e , b y reason o f t h e demands o f t h e

pu b l i c , th at member banks f i n d i t n e c e s s a r y t o ob ta in more curr enc y from t h e

r e s e r v e b a n k , u s i n g

a n y

a c c e p t a b l e c o l l a t e r a l t h a t t h e y

n a y

h a v e .

The

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258

- 2 - X-4314

e l a s t i c i t y

o f t h e

Federal reserve note doas

n o t

depend

o n t h e

c h a r a c t e r

o f

c o l l a t e r a l that- member banlcs

u s e t o

obt ain curr ency . Federa l res erv e no tes

i s su ed ag a in s t go ld cone i n f o r re t l i r cnent a s prompt ly a s r o t e s s e c u r c d by

commercial paper. I t i s through t h e Fe de ra l r e s e r v e barics - m e e t i n g t h e c u r -

rency demand when i t a r i s e s t h a t t h e amount o f currency i n c i r c u l a t i o n i s c o n -

s t a n t l y a d j u s t e d

t o t h e

requirements

o f

b u s i n e s s .

The

provis ion author iz ing member banks

t o

hold par t

o f

t h e i r r e s e r v e s

i n

t h e i r ow n v a u l t s , w h i c h i s apparent ly in t ended t o d i m i n i s h t h e lending power

o f t h e re se rv e banks, through a r e d u c t i o n o f t h e i t r e s e r v e s , w o ul d h av e l i t t l e

e f f e c t , when t aken i n conj unc t i on w i t h t h e other proposed amendments, because

member banks would have no inducement t o e x e r c i s e t h e i r o p t i o n t o a n y e x t e n t .

That port ion

o f

t h e i r re so urce s which

t h e l a w o r

e x p e r i e n c e r e q u i r e s

t h e

member

banks t o h o l d a s re ser ve s would remain in ac t i ve a n d unproduc t ive o f earn ings ,

under t h e proposed amendment a s i t i s under ex i s t ing laws , a n d a mere trans-

f e r o f re se rv es from res er ve banks t© member banks would n o t i n c r e a s e t h e

member banks

1

lending power

o r

e a r n i n g c a p a c i t y ,

b u t

wo uld mere ly reduce

t h e

l ending power o f t h e reserve banks#

%

Gold with

t h e

r e s e r v e a g e n t s

n o t t o

count

a s

r e s e r v e s

The p r o v i s i o n i n t h e McFadden b i l l th at g ol d h e l d wi th t h e F edera l r e -

serve agent sha l l n o t count a s p a r t o f t h e r e s e r v e s o f t h e reserve bank i s a

repea l o f a n amendment adopted i n 1 9 1 7 , p r i n c i p a l l y f o r t h e purpose o f f a -

c i l i t a t i n g n ot e i s s u e s

a n d

p e r m i t t i n g

t h e

reserve banks

t o

count

a l l t h e

gold,

whether he ld b y t h e a g e n t o r b y t h e reserve bank, a s p a r t o f t h e i r r e s e r v e s #

Notes were exchanged f o r g o l d p r i o r t o t h e amendment butthis w a s accompl ished

i n a roundabout w a y , a n d i t w a s thought best t o a u t h o r i z e t h e direct exchange#

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- 3 -

X-4314

The e f f e c t o f this proposal a t t h e pr es en t time would be.that o f t h e

$1,700,000,000

of

Federal reserve notes

i n

ci rc ul at io n, only about $400,000,000

could continue

t o be a

l i a b i l i t y

of t he

reserve banks because this

i s t h e

total amount of disc ount ed paper hel d b y t h e twelve re se rv e ban ks. Against

t h e remainder o f t h e no tes , t h e Federal reserve agents now hold gold a n d i n

order t o comply with t h e proposed amendment t h e re se rv e banks would have t o

fo l low

one of two

courses ; e i t he r

t o p a y

this gold

b u t

i n t o c i r c u l a t i o n

i n e x -

change f o r a n equivalent amount o f Federal reserve notes; o r t o impound t h e

gold with t h e agent to be h e l d by him e x c l u s i v e l y f o r t h e redemption of notes.

The reserve banks would probably adopt t h e procedure of l e t t i n g t h e

$1,300,000,000

o f

gold held

b y t h e

agents

a s

cover

f o r

notes

b e

a p p l i e d

to t he

r educ t ion

o f t h e

barks

1

l i a b i l i t y

on

re se rve no te s. Thus

t h e

gold

a s a n a s -

s e t a n d a n equivalent amount of notes a s a l i a b i l i t y w o u l d b e taken out of

t h e reserve banks

1

balance sheet a n d would appear only i n t h e account of t h e

Federal res erv e ag en ts . Under pr es en t con dit ion s t h e reserve banks would

a f t e r t h i s t r a n s a c t i o n s t i l l h a v e

a

r e s e r v e

of

about

6 0 p e r

cent against

their combined note

a n d

de po si t l i a b i l i t y .

I n

some

o f t h e

reserve banks,

however, t h e resul t would b e a d e f i c i e n c y of r e se rve s even a t t h e pr es en t t ime.

The reserve banks could increase t h e volume of p a p e r e l i g i b l e a s note

cover a t t h e i r d i s p o s a l ; i . e . , p a pe r e l i g i b l e a s cover under t h e amendments,

b y

se l l ing accep tances

a n d

s e c u r i t i e s

a n d

thereby causing member banks

t o

discount paper with t h e rese rv e banks. While te ch ni ca l l y th is would be a

method of i n c r e a s i n g t h e volume of p a p e r e l i g i b l e f o r note cover, i t would

involve a complete withdrawing of Federal reserve banks from open-market

opera t ions .

Under

t h e

McFadden proposal

t h e

note- i ssuing power

o f t h e

reserve banks,

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k

- 4 - X—'-JlU

which is new l i m i t e d by reser ve requirements , w i l l oe l i m i t e d i n adJ.i t ion

b y t h e amount of el ig ib le paper avai la.be a s c o l l a t e r a l f o r note i s sue . As

po in t ed o u t ea r l i e r , t h i s add i t i on a l l im i t a t i on does n o t i n c r e a s e t h e e l -

a s t i c i t y o f t h e reserve no te b u t merely erects a cumbersome piece of mach-

inery that might under cer ta in condi t ions prevent t h e smooth performance

of

t h e i r f u n c t i o n s

by the

reserve banks.

A

si tu at io n might even ar is e ,

under

t h e

proposed amendment, where reserve banks,

by

reason

of l ow re -

se rves - n d shor tage of e l i g i b l e paper , cou ld n o t issue Federal reserve

n o t e s to memoir banks unless these banks borrowed $ 3 . ~ 0 from t h e reserve

banks, and kept $2.00 of t h i s on deposit with t h e reserve banks, i n order

t o obtain $ 1 .0 0 o f Federal res erv e not es . Under cond i t ion s of unusual

c r e d i t

and

currency demand, therefore,

t h e

McFadden amendment would cause

u n n e c e s s a r y d i f f i c u l t i e s

to our

banking system,

and

since

t h e

t e s t

of t he

soundness of a banking system i s t he way i t would stand u p under a s t r a i n —

t h i s i s a serious argument against the . propo sa l .

I n

cons ide r ing

t h e

poss ib l e e f f ec t

of

these amendments

i n

decreasing

t h e

gold re se rv es

o f t h e

reserve banks through fur ther increases

of

gold

i n

c i r c u l a t i o n , t h e fact should n o t b e overlooked that th e gold now he ld by

t h e reserve banks f o r t h e most part was n o t withdrawn from domestic ci r c u l -

a t i o n but was i mpo rted f rom abroad* As th e r e s u l t o f paying o u t gold cer t -

i f i c a t e s t h e volume of gold i n c i r c u l a t i o n a t t h e present t ime i s nea r ly a s

l a r g e a s be fo re t h e system was e s t a b l i s h e d , a n d t h e reserve banks i n r e -

cent months have also

met out of

the i r r e se rves

a

considerable demand

f o r

gold

f o r

export .

7/17/2019 frsbog_mim_v22_0257.pdf


The

c hi e f e f f e c t

o f t h e

pro po s ed

:• man

demerit r e l a t i n g

t o

&old cover

appears to b e t J lower t h e r e s e r v e r a t i o o f t h e re ser ve banks b y i m -

pounding a p a r t c f the i r res erv es w i th t h e F e d e r a l r e s e r v e a g e n t s . At

a time when reserves a r e ample, a s a t p r e s e n t , t h e impounding o f t h e

gold would

n o t

b r i n g

th e

res erv e ra t i o nea r

t h e

l e

e

,al minimum,

b u t

u n d e r c o n d i t i o n s o f except ional ly large demand f o r c r e d i t and currency

t h e

amendment woulj interfere with

t h e

smooth operat ion

o f t h e

reserve

banks and might make ne ce ss ar y a s us pens i o n o f res erv e requi rements .

A c c e p t a n c e s i n e l i g i b l e

a s

c o l l a t e r a l a g a i n s t n o t e s

I n p r o h i b i t i n g t h e u s e o f a c c e p t a n c e s a s c o v e r f o r Federal res erv e

n o t e s , t h e amendment pl ac es a cc ep ta nc es i n regard t o i n e l i g i b i l i t y s-s

c o v e r f o r n o t e s o n t h e s ame f o o t i n g w i t h U n i t e d S t a t e s s e c u r i t i e s , t he

o t h e r c l a s s o f open-market pu rc ha se s Of the re se rv e banks . Accep tance s ,

however , a r e a s d i r e c t l y c o n n e c t ed w i t h t h e f i n a n c i n g o f c u r r e n t b u s i -

n e s s a s a r e pro mi s s o ry no tes , an d r e f l e c t t h e underly ing commercia l

t r a n s a c t i o n s

i n

c o n t r a s t

t o

paper secu red

b y

U n i t e d S t a t e s o b l i g a t i o n s

whi ch i s n o w e l i g i b l e and would continue t o be e l i g i b l e u nd er t h e

amendment,

t o

s e r v e

a s

cover

f o r

Federa l res erv e no tes .

I t i s

probable

t h a t t h e o b j e c t o f this amendment i s n o t s o much t o i n c r e a s e t h e e l a s t i c -

i t y o f t h e

Federa l res erv e no te

a s t o

l i m i t

t h e

rese rv e oanks ' open-

market operat ions .

7/17/2019 frsbog_mim_v22_0257.pdf


Autuc r i t y

t o h o i J

p a r t

of

r e se rves

i n

numbers

1

vau l t s

The

proposa l

t o

au th or iz e member banks

t o

hold par t

of

their required

r e s e r v e s

i n

t h e i r

own

vaults would

i n i t s

p r e s e n t form per n. it member banks

t o

count

a s

p a r t

of

t- ie i r reserves

t h e

vault cash which they

now

ca r ry

a s

t i l l money• I f t h e amendment were adopted without increasing t h e reserve

requirements

o f

member banks,

i t

would make a v a i l a b l e

t o t h e

member banks

about $5vC,vCv,CGv which they could

u s e

e i t h e r

a s a

b a s i s

f o r

add i t i ona l

l end ing

o r to

reduce indebtedness

a t t h e

r e s e r ve banks* When

i n 1 9 1 7 r e -

serve requirements changed

so as to

make only balances

a t t h e

reserve

banks count

a s

lega l rese rves

f o r

member banks,

a t t h e

same time required

reserve percentages were reduced

in

recogni t ion

of the

f ac t t ha t

t h e

cash

which member banks would continue t o car ry i n their vaul ts would x?0 longer

count

a s

r e s e r v e s .

The

prese nt proposal

to

permi t

t h e

vaul t , cash

of

member

banks

to be

counted

a s

reserves without correspondingly increasing

t h e

legal reserve requirements would result

i n

reduced borrowing

a t t h e r e - .

serve banks and in member banks see kin g in cr ea se d inve stm ent f o r the i r

re leased funds .

I f t h e

proponents

o f the

b i l l would upon con sid era tio n de cide

t o i n -

c lude i n t h e amendment an inc rea se i n reserve requirements equal to the

amount

of

cash

i n

v a u l t ,

t h e

proposa l would have re la t i ve ly l i t t l e e f f ec t

on the

c r e d i t s i t u a t i o n .

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263

- 7 - X-U^lU

E x ' l s t i n g p r o v i s i o n s n o t emergency measure s

The Mc Fad de n proposa l h a s been genera l ly unders t ood t o have t h e obj ec t

o f r e s t o r i n g t h e Federal Reserve A c t t o i t s o ri g in a l form through repea l

of war time amendments. Exp eri enc e in di ca te s th at t h e 1 ^ 1 ? amendments,

though the ir passage may have been exped ite d by th e war emergency, a r e n o t

i n t h e

n a t u r e

o f

emergency pr ov i s io ns ,

b u t a r e a

l o g i c a l r o u n d i n g

cut o f

t h e reserve sys t em. In e f f e c t t h e McFadden p r o po s a l would hav e t h e system

r e t u r n

t o t h e

i d e a s

and

t h e o r i e s

o f t h e

framers

o f t h e

Federal Reserve

A c t

p r i o r t o t h e s y s t e m ' s e s t a b l i s h m e n t , and wo ul d t h u s s a c r i f i c e t h e l e s s e n s

o f prac t i ca l exper ience acquired dur ing t h e decade o f i t s o p e r a t i o n ,