Federal Reserve Notes
( Originally Published Early 1900's )
NEED FOR AN ELASTIC CURRENCY
IN PREVIOUS chapters four of the five kinds of paper currency in circulation have been discussed and it was shown that the basis of each of them differs from the others.
The fifth class, which is the Federal reserve note, likewise differs from the other four. This note is similar in some particulars to the national-bank note in character and in the procedure for issuing and redeeming it, but the security back of it is radically different.
The underlying principle on which the Federal re-serve note rests appears novel when compared with the other four classes. It is the youngest of the five, but its success has already been so fully demonstrated that no one doubts the wisdom back of its existence. The creation of the Federal reserve note was determined upon to meet a need that had been recognized for a long time before an agreement was reached in Congress as to how the need should be supplied. An elastic currency was clearly a necessity, and the Federal reserve note was created to meet that requirement.
Prior to the passage of the Federal Reserve Act the aggregate face value of the four classes of currency then in circulation was at times insufficient to meet the needs of business. It seemed to be ample for normal business conditions, but when conditions were abnormal the supply was obviously inadequate.
Disturbance in business frequently brought serious money stringency, with high and injurious rates as a consequence. High rates inevitably resulted in depressed market prices that were injurious to every merchant, farmer, and laborer—in fact, a detriment to everyone in the land. Paper currency in circulation sufficient to meet abnormal conditions would be excessive when conditions were normal; and an excessive supply when conditions were normal would inflate values and encourage ill-advised purchases and speculation.
Before the Federal reserve note was created, business conditions were always unsettled every year immediately before and after the grain harvest. It requires a large amount of cash to move the wheat and other grain from the agricultural districts of the Mississippi and Missouri valleys, where those staples are produced, to the East, where they are consumed. The funds to pay for them had to be moved from the purchasing East to the selling West. The amount of cash needed in the fall was greater than that needed at any other time of year.
The necessity was for a class of currency that would expand and contract in proportion to the needs of commerce. The Federal-reserve-note plan was designed to meet the necessity and it has met it so well that every man in public life who had any part in its creation points with much pride to the result. The matter was very fully investigated by various committees and by several Secretaries of the Treasury. The Monetary Commission about 1908 reported exhaustively on the subject. No definite plan was adopted, however, until several years after that time. The plan finally agreed to was put into operation just before the World War and was invaluable as a means for financing it. With-out that system in operation the Government would have been hard put to meet the war's exigencies—the assistance to the Allies, the Liberty loans, and the payments for the war supplies.
THE FEDERAL RESERVE SYSTEM DESCRIBED
A description of the note and its basis, together with the issue and redemption process, will disclose why it is said to be elastic and why it supplies the needs of business without oversupplying them.
The act that created the Federal reserve system was approved December 23, 1913. It carries a great many specifications regarding the establishment, maintenance, and procedure incident to banking that it is not necessary to discuss in order to describe the currency the act authorizes. This discussion is confined to such parts of the act as relate to the notes the act creates.
There are twelve Federal reserve banks. Every national bank must subscribe to stock in the reserve bank that is situated in the particular district in which the national bank is located; and a bank or trust company operating under state charter may, if it so elects and with the approval of the board, also subscribe to the stock and become a member of the Federal reserve system on the same terms as a national bank. The amount of the stock subscription is required by the statute to be a sum equal to 6 per cent of the member bank's capital and surplus. Each member bank is required to maintain on deposit with the Federal reserve bank a percentage of its demand deposits and of its time deposits as a reserve.
The business of the Federal reserve bank is confined to the purchase and sale of bankers' acceptances, United States bonds, commercial paper, etc., and to financial transactions with the United States Treasury. It is a bank of rediscount and so does not accept deposits or make commercial loans to individuals. It may rediscount short-time commercial paper indorsed by member banks and, when the amount of its supply of currency becomes low, may procure additional currency by depositing proper security. That additional sup-ply, termed Federal reserve notes, is prepared by and is guaranteed by the United States Government, as will be shown below.
The rediscount of commercial notes for member banks and the issue of the Federal reserve notes by the Federal reserve banks constitute the heart of the Federal reserve system. Such rediscount of commercial paper and the privilege of procuring a safe and guaranteed currency formed the gist of the thing the Congress sought, and make the hinge on which the system swings.
As a matter of convenience, the member banks give their own notes, secured by the commercial paper or secured by United States obligations, instead of rediscounting. Approximately two-thirds of the earnings of the Federal reserve banks come from the paper that is discounted with the member banks. The remaining third comes from the earnings that accrue from the other interest-bearing investments of the banks.
THE FEDERAL RESERVE BOARD
General supervision over the affairs of the twelve banks is conferred on a board that consists of eight members. Six of them are appointed by the President. The Secretary of the Treasury and the Comptroller of the Currency are members by virtue of their official Federal Government positions.
The powers of the board include the review and de-termination of rates at which the reserve banks rediscount paper for the member banks, the examination of the reserve banks and the supervision, in general, of the administration of the Federal Reserve Act. The board also supervises the supplying and the redeeming of the Federal reserve currency.
The board also has the authority to appoint certain of the members of the board of directors of each Federal reserve bank and to designate one of them to be chairman of the bank's board of directors. That official is accorded the title "Federal Reserve Agent." His duties are not only those of an officer of the bank, but also those of a custodian of the collateral that the bank surrenders in exchange for Federal reserve notes. The stock of unissued Federal reserve notes is maintained in the joint custody of the bank and the agent.
REDISCOUNTING TO MEMBER BANKS
When a member bank has lent its funds to a point where its reserves are at the minimum required by law, it may borrow additional funds by indorsing its commercial notes that will mature within a period not exceeding ninety days, or its agricultural notes maturing within six months (also certain others within nine months), and rediscounting them with the Federal re-serve bank of which it is a member.
A Federal reserve bank may replenish its supply of currency by delivering acceptable collateral security to the Federal reserve agent in an amount equal to the currency desired. The security required includes notes, drafts, bills of exchange, or acceptances indorsed by member banks, etc., with maturity date not exceeding ninety days, and gold or gold certificates; but the security, whether gold, gold certificates, or eligible paper, must never be less in face value than the amount of notes the agent supplies to the bank. As an additional safeguard, the reserve bank must be possessed of $40 in gold for every $100 of its notes it pays into circulation. The gold possessions of the reserve banks must never be less than 35 per cent of their deposits.
The agent holds the security thus delivered into his custody until the Federal reserve bank repays by re-turning to him the currency he has provided; or the bank may recover the deposited security by making repayment in gold or gold certificates instead of its Federal reserve notes. The notes that the agent accepts must be those of the particular Federal reserve bank that procured the currency from him. The bank is required to take up the rediscounted paper not later than its maturity date.
FEDERAL RESERVE NOTES AN OBLIGATION OF THE UNITED STATES
If one will read a $5 Federal reserve note it will be disclosed that it is an obligation of the United States and payable on demand in gold at the Treasury. It reads as follows:
Federal Reserve Note
The United States of America will pay to the Bearer on demand Five dollars . . .
Redeemable in gold on demand at the United States Treasury or in gold or lawful money at any Federal reserve bank.
The law expressly stipulates that the "notes shall be the obligation of the United States." It also stipulates that each bank shall maintain in the United States Treasury a sum in gold sufficient, in the judgment of the Secretary of the Treasury, to redeem its outstanding notes, but in no event shall the sum be less than 5 per cent of the issued notes less the amount of gold or gold certificates held by the agent as collateral. The Secretary may also require the agent to deliver to the Treasury so much of the gold the bank has deposited with him as security for the notes as may be required for their redemption.
In actual practice, the Government always has had in its possession gold that belongs to the Federal reserve banks in volume greater than the requirements of the law.
On June 1, 1931, the banks, for their exchange convenience, had a gold fund in the Treasury voluntarily deposited by them that was almost as great as the aggregate of the Federal reserve notes then in circulation. That vast amount in gold was under the control of the board and was the property of the twelve banks. The Government held the 5 per cent fund deposited by the banks as required by law in addition to the great gold fund above referred to.
The Federal reserve banks, therefore, appear to be in a fine state of health. It also. seems to be perfectly apparent that there is such security back of the Federal reserve note that its stability is assured, and the Government is amply protected in guaranteeing that the notes will be honored dollar for dollar in gold on demand.
The plan works by the reserve banks and the Federal Reserve Board agreeing upon the rate of interest at which a bank may lend to its member banks. The board, through its examiners and the agents, is in touch with the bank's affairs and controls the actions as to the extension of rediscounts to member banks.
The issue of the currency by the agent, after the eligibility of the security is determined, is but a clerical function—bookkeeping, money counting, and safe custody.
At maturity of the paper, the agent requires the Federal reserve bank to take up the matured commercial notes by returning to him Federal reserve notes of that particular bank. The agent forthwith retires the recovered currency, i.e., takes it out of circulation. It is then in the same status as if it had never been issued. Such notes as are unfit for circulation are canceled and forwarded to the Treasury, verified, and destroyed. In actual practice, matured notes are often recovered by the substitution of new commercial notes. In such case, of course, actual retirement of the Federal reserve notes does not take place until the new commercial notes mature.
The Federal reserve bank, after recovering the paper from the agent, delivers it to and receives payment from the member bank, and the member bank procures payment from the merchant. Thus the needs of the merchant are supplied and, in the process of loan and repayment, the currency expands and contracts in proportion to the need.
AUTOMATIC EXPANSION AND CONTRACTION
Economical management causes the merchant to borrow only when his business needs the money and when he can afford to pay interest to get it, and self-interest causes him to pay his note at maturity to stop the interest on it. Thus the expansion and contraction of the currency meet the needs of the country.
THE PEAK OF FEDERAL-RESERVE CIRCULATION
The aggregate of Federal-reserve circulation reached close to the limit of its possible aggregate in 1920. It rose to a level something like $3,750,000,000 shortly after the World War. The volume is now usually about half that sum. On June 1, 1931, it stood at about $1,956,000,000.
During the past years, when commerce and agriculture have been in a normal state, an increase in the need for currency became noticeable about the latter part of July, due to the shipment of the June and July winter-wheat harvest. The spring-wheat harvest following immediately after has kept up the need and the increased demand for currency. The fall tobacco and cotton crop, the borrowing by farmers to feed hogs, cattle, etc., followed by the movement of the corn crop during the late fall, then the holiday purchases by merchants kept the demand up until January 1. In normal years a reduction of about 10 per cent in the volume of Federal reserve notes takes place shortly after the close of the calendar year. Farmers and merchants procure cash from their crops and from their sales of merchandise in larger volume during January than during any other period of the year, and as a consequence their debts are correspondingly met to an unusual extent at that time. The need for currency thus decreases at that season. The cash used in making holiday purchases likewise finds its way back to the banks immediately after Christmas. From January to July the elastic currency usually stands contracted by something like 10 per cent until the crop movement starts again. Of course, the cycle described has been observed only during normal business years, such as the five-year period from 1925 to 1929. Results as to the expansion and contraction of the elastic currency have clearly demonstrated that the expectations of those who devised the plan have been fulfilled.
PROFIT OVER 6 PER CENT GOES TO THE GOVERNMENT
The Federal reserve system and the Federal-reserve note plan were adopted as a bulwark against disasters such as the country experienced in 1893 and in 1907. It seems to be just what the country needs. It was not intended as a profit-making scheme for the benefit of banks or for any individual. No one can allege either that profit was the object of the Federal Reserve Act or that such has been the result. The statute permits Federal reserve banks to pay not to exceed 6 per cent dividends to the member banks as stockholders. The excess earnings, with provisions for surplus, are required to be paid to the Treasury as a Federal franchise tax. The Government thus acquires any excessive gains. The Treasury has, in fact, received about $150,000,000 in tax from this source since the banks began to operate. It received about $4,250,000 from that source in 1929.
The question whether the dividend permitted to be paid to the member banks is as great as it should be has been debated before a committee in Congress. The argument for the change is that membership in the system is very desirable and that an increase in the rate should be authorized to assure the Government that banks will remain members of the system. The Treasury has thus far expressed no opinion on that subject.
It will be observed that the Federal reserve note is based upon the legitimate commercial credit of the country and is supported by a safe ratio in actual gold. Everyone who has observed the working of the plan believes that the system meets the country's needs and that it has afforded a great public benefit.