Is the Reserve Board Keeping Faith?
I
DURING the past two years, the Federal Reserve Board has shifted its position so many times — first making interest rates artificially low, then artificially high; encouraging the financing of business by well-established methods, then proscribing those methods; insisting that price control was not its business, then trying to control prices; issuing warnings, followed promptly by reassurances; first blowing hot, and then blowing cold — that the whole world of commerce and finance has been kept in a state of nervous apprehension.
When the Federal Reserve Board entered upon this vacillating course, economic conditions in the United States were remarkably sound. Real prosperity was high — never higher. Never before, in any country, would wages buy so much. Monetary conditions were precisely what both economists and business men had long hoped to attain. Abundant credit was available at rates sufficiently low to induce steady growth of business. Gold reserves were far in excess of all needs. Commodity prices were remarkably stable, and had been for several years. During these years, real wages, profits, savings, production, capital, and, consequently, real values of business enterprises had increased steadily. Prosperity was not illusory, as it always is when accompanied by inflation of commodity prices.
Under such conditions, sudden reversals of monetary policy are sure to be injurious. They cut to the heart of commerce and industry. Hardly a wage earner, a fanner, an enterpriser, or an investor who is unaffected by changes in the volume of money, or in the channels through which money is allowed to flow. And here, as always, we mean by the term ‘money’ both currency and bank credit.
Money is the blood of the economic body. Whenever it flows, rightly distributed and in sufficient quantity, the various members of the body function; life abounds in energy. When it does not flow, rightly distributed and in sufficient quantity, some of the members cannot do their part of the work. Debility results; the whole body is lethargic. Periodically this condition recurs. There is trouble in the central pumping station. Men, materials, and machines, ready to do their part, lack the driving force which is needed to put them into such relations that they can go on with the world’s work. As a matter of fact, it is almost exclusively through the medium of money that various causes operate to retard or to promote material progress. The flow of money determines what is produced, who is allowed to produce it, and who is allowed to support his family.
The Reserve System was established for the express purpose of maintaining the right flow of money, by making the reserves of all banks available for each individual bank. That is why it was called the Reserve System. Under that System, the entire business structure of the United States was built on the confidence of business men that, by certain established procedure, they could obtain money for constructive business as long as there was money to be had.
II
Then came drastic changes of policy. In the midst of unprecedented prosperity — prosperity so real and sound that it was the envy of the world — the System began to interfere with a method of financing business which is older than the System itself; a method, moreover, upon which the business of the entire country had come to depend, more and more every year, by and with the powerful aid of the System. We refer to the long-established practice of lending money on stock-exchange collateral.
Constantly encouraged by the Federal Reserve Board and aided by the banks, the business of the country to a large extent changed the basis of its financial structure from debts to stocks. This is the most notable and farreaching change in methods of financing since the war. Thousands of corporations, including most of the large ones, reduced bank loans and bonded indebtedness, and in their place obtained funds through the sale of stock.
This has strengthened the industrial structure of the whole country, for it is sounder business to operate on capital subscribed by the owners of the business than on debts. A concern which is financed solely or mainly by the sale of stocks is in less danger of being forced, even though solvent, into the hands of creditors, and in less danger of having its wholesome growth hampered in other ways. It is more likely to have the opportunity to work itself out of temporary troubles. This is better, both for investors and for the public generally, than to have the stockholders squeezed out by banks or bondholders, to have foreclosures, and to have somebody who does not know anything about the business trying to run it. A concern financed by capital stock can go ahead with greater confidence, planning for long-range efficiency, utilizing new inventions, employing more men, and reducing unit costs and prices. Such a concern, moreover, is in a position — as a concern financed on debts is not — to build new equipment and employ more men, precisely when the whole country most needs such capital growth; namely, when a period of business depression is setting in.
This movement toward a sounder method of financing business, as well as the industrial prosperity which gave rise to the movement, would have been impossible without the aid of the credit which has been created on stockexchange collateral. It is difficult to overemphasize the importance of this point. Yet it is a point which the Federal Reserve Board appears to ignore. Nowhere in the reports of the Board is there any indication that it understands to what extent the extraordinary prosperity of constructive American business has depended on the expansion of bank credit based on stock-exchange collateral.
Suppose, for example, the Arno Producing Company needs ten million dollars for the purpose of enlarging its plant, employing more men, increasing its output, thus helping to reduce unemployment and lift standards of living. The company applies, let us say, to a finance corporation. This corporation, however, does not have ten million dollars lying around idle. It could not do business that way. It provides the Arno Producing Company with the needed funds by issuing stock and distributing a large part of that stock to security dealers throughout the country. The dealers are obliged to borrow from the banks, using the stock as collateral, until they can distribute the stock to investors. Most of these investors, in turn, do not carry enough money in their pockets or in the banks to pay for the stocks. The investors also must use bank credit temporarily. Accordingly, many of them take their certificates to the banks and obtain loans. Largely through this process, the new issue of stock is gradually absorbed and paid for. Meantime, the Arno Producing Company has obtained the ten million dollars, and a considerable part of it has already entered the circuit flow of money as wages.
III
The artificially low interest rates formerly maintained by the Federal Reserve Board, coupled with the expansion of bank credit based on stock-exchange collateral, have also had much to do with the growth of installment selling; and installment selling, as everybody knows, has grown so rapidly that it now accounts for sales in excess of six billions of dollars a year. This method of financing consumer buying is, on the whole, sound. Moreover, a large proportion of the goods sold on installments could not have been sold, and therefore would not have been made, bad it; not been for the development of efficient partial-payment plans. Consequently, the rapid growth in installment selling has helped to make the country prosperous. Whether this six billion dollars a year of business is sound, however, is not the question we are discussing. The fact remains that huge, constructive industries — notably the automobile industry, which in a single generation sprang from nothing at all to first place among industries — have attained a growth, and are now operating at a rate, made possible by the recently abandoned policies of the Federal Reserve Board.
Not only has consumer spending been aided in this way, but also consumer saving. During the past eight years, several millions of wage earners have become stockholders in the concerns for which they work. So farreaching in its industrial and social effects is this movement that a Harvard professor of economics has called it The Present Economic Revolution in the United States. Experience proves, moreover, that lending money on stock collateral to a man who has a steady job, and who buys stock with the intention of paying for it weekly out of earnings, is sound credit policy. Incidentally, it should be noted that this is the principle on which building and loan associations operate, and they have long been regarded as thoroughly desirable enterprises, both financially and socially.
Now, the point is that these millions of wage earners have been enabled to buy stocks on installments only because the stocks themselves have in some way been used as collateral for bank loans. To put a stop to such buying of stocks is to place at a great disadvantage every workman of assured earning capacity who desires to share in the growth of the country, or even in the growth of the very concern for which he himself is partly responsible. To deny such opportunities to wage earners is to enable the rich to acquire even larger shares than they can now acquire in our expanding wealth; for it is a fact that the wealthiest individuals and corporations can borrow money without any collateral at all.
Whether this method of financing the growth of industry is the best one that could be devised is not the question at issue. The fact remains that the method is firmly established. The business world has been encouraged to rely upon it, and it has been fundamental in our recent substantial growth. But even if the change to this method were not a change for the better, the Federal Reserve Board would be outside its legitimate sphere in trying to force the business world back to its old methods. The Board was not appointed to tell business men how to finance their business.
Nevertheless, having made the industrial world dependent upon this method of financing capital development and confident that the method would be available for future growth, the Federal Reserve Board suddenly decided to use drastic measures to put a stop to it. The Board did not offer any substitute. It merely said: ‘We dislike what you are doing. Stop it; or we don’t know what dire penalties we may inflict.'
This is what happened. On April 4, the Board requested the ‘voluntary cooperation’ of the member banks in reducing loans on stock-exchange collateral, and informed the banks that unless the Board was satisfied with the extent of their cooperation, the banks would suffer the penalty of being cut off from the resources of the Federal Reserve System.
The System was devised, however, partly for the purpose of placing the banking resources of the country in any emergency behind each solvent member bank; and each bank has built up its business, as contemplated under the Reserve Act, in reliance upon the aid of the System. No member bank, therefore, can function without the possibility of recourse to the System in time of need. Under these circumstances, ‘voluntary cooperation ’ is universal.
Thus the Federal Reserve Board has forced many banks into the embarrassing position of saying to customers who have long relied upon them, ‘We must deny you the services which we have always rendered. We cannot meet your ordinary business needs, as we have led you to suppose that we would. Why, we do not know. Ours not to reason why; ours but to do and die.’
For the banks cannot, without penalty, continue a practice which for generations has been a fundamental part of sound banking. Indeed, from the very beginnings of joint-stock enterprise, loans on stock collateral have been regarded as the safest and most liquid of loans. They have always been treated as such by the member banks themselves. More than that, ‘Borrow and Buy Bonds’ was the slogan of the United States Government in the most extensive campaign of education in finance ever conducted. Thus the people of the nation were taught that it is good business to borrow money on collateral and sound banking to lend the money.
The virtual order of the System in regard to this long-established practice is the most drastic peace-time interference of the Government with business in our generation. It is almost as though the Government had said to the railroads: ‘You cannot have any more rails. Run your trains some other way. We have no idea what other way there is. Find one if you can.’ Both in itself and as precedent, such interference on the part of the Government is fraught with unknown consequences. Indeed, in our complicated mechanism of business, upon the smooth operation of which the happiness of a hundred million people largely depends, it is doubtful if anybody knows enough to tell how far-reaching may be the future effects of this sudden reversal of fundamental banking policy.
IV
Whatever the future effects may be, one immediate effect is a destruction of property values. Millions of investors have bought stocks with the knowledge that call loans, based on such stocks, are and long have been the safest and most liquid of all loans. These investors have acquired this property, therefore, in good faith, with the confidence based on long-established custom that they were buying acceptable collateral for bank loans. Suddenly, however, the Federal Reserve Board, without for a moment questioning the soundness of loans on such collateral, arbitrarily decides to penalize any bank which does not obey orders concerning the reduction of such loans. This discrimination against loans on one particular kind of property constitutes a destruction of property values, and therefore an infringement of property rights.
This discrimination, moreover, puts the Board in an untenable position. Borrowing money on stock-exchange collateral is banned; but borrowing money on buildings or on commodities is not. If you own one tenth of the Equitable Building, the Board decrees that you should not be allowed to obtain bank credit on that property, since your equity happens to be represented by a stock certificate. Loans on such pieces of paper are called dangerous. But if you own precisely the same property, and the evidence of your ownership happens to be a different kind of certificate, that makes all the difference between black and white. In that case, your share in the building is satisfactory collateral. Similarly, if you own a shipload of bananas, you should be allowed to borrow money on the bananas; but if you own United Fruit Company shares, of the same market value as the bananas and supported by equal stocks of bananas, you should not be allowed to borrow money on those shares.
Again, the Board approves expansion of credit in order to enable a man to buy, on installments, a part of a cooperative apartment building; but not to enable him to buy, on installments, a share in the telephone company for which he works; although in the first case he buys for consumption, and in the second case he buys for investment. In the condemned case, moreover, he buys a right to dividends which he can use in paying off his debt. In the opinion of the Board, one of these practices is safe and sound; the other is not. To the safest and soundest of bankers and business men, however, that distinction is meaningless.
The announced ground for this drastic interference with business is that the Board desires to reduce the amount of credit used for the purchase of stocks. But this is another complete reversal of policy. From the beginning of the Federal Reserve System, bankers and business men generally have understood that control of the volume of credit is a proper function of the Board, but control of the uses of credit is not.
On this point, the Federal Reserve authorities, themselves, are explicit. Mr. W. Randolph Burgess, of the Federal Reserve Bank of New York, in an authoritative book on the Federal Reserve System, says: ‘A reserve bank cannot tell from the nature of its loans what the money will be used for. . . . It is thus impossible for a reserve bank to dictate how its credit shall be put to employment. It cannot, for example, restrict loans on the stock exchange and at the same time encourage loans to the farmer. Reserve bank loans to a farming community bank may, and often do, find their way promptly to the stock-exchange money market. The specific use of credit is the business of the individual member and nonmember bank; and the Reserve System is no substitute for sound banking practice.’ This was the position also taken by the late Benjamin Strong, Governor of the Federal Reserve Bank of New York; and Governor Strong was the outstanding leader in the whole Federal Reserve System. Indeed, this was the position firmly held by the Federal Reserve Board itself until the past year. It has now executed a right-about-face.
If the Board, in defense of such a change, asserts that the Reserve System was not established to create bank credit for speculation, the Board should be reminded that the System was not established to create bank credit either for speculation or for any other purpose. Bank credit is not, and never has been, created by the Reserve Board. It is created by the joint act of solvent borrowers and solvent banks. For what purpose the credit shall be created is not for the Board to prescribe.
In attempting to prescribe the uses of credit, the Board has reversed its policy, stoutly maintained with one or two unfortunate exceptions from the very beginning, of noninterference with prices. It is now trying to control stock prices. For the Board to reply that it is merely trying to reduce the amount of credit used in the stock market is childish. There is no difference between controlling the price of securities and controlling the money available for the purchase of securities.
By this change of policy, the Board takes upon itself a difficult task, for how can the Board be sure that stock prices are too high? Consider these facts. The chief function of the Reserve System is to maintain an ample supply of sound money for all responsible borrowers, so that producers may go forward confidently on a stable commodity price level. For several years the Board served that purpose well — exceedingly well. The Board cannot achieve that purpose, however, without increasing real wages, real profits, real capital values, — in short, real prosperity, — thereby increasing the real values of common stocks.
Real values are much higher than they were a few years ago. Nobody doubts that. How much higher? And how much too high are stock prices? How much too low were stock prices in 1921? Again, how much of the money which is now being borrowed represents inflation, and how large a volume of brokers’ loans is necessary to promote a wholesome growth of business?
All these problems are quantitative. All are questions of ‘How much?’ They cannot be answered by opinions.
Three years ago many people were sure that stock prices were too high. What do they think now? What will the Reserve Board itself think about present prices a year from now? What, after all, is the proper basis for the capitalization of present earnings and prospective earnings? Nobody know’s.
All these quantitative problems call for measurements. We do not argue concerning the pressure of steam; we consult a gauge. We do not take a vote concerning the number of cases of smallpox; we count them. Yet on fundamental questions of finance, which are just as susceptible of measurement, we receive from the Federal Reserve Board nothing but opinions.
Even if it were possible for the Board to prove that stock prices are too high, the question would still remain whether the regulation of stock prices is a proper function of the Board. Nearly everybody agrees that the System should not attempt to regulate the prices of anything else. What can justify discrimination? It cannot be the large profits made by speculation in stocks. For, if that is the basis of action, why not restrict the credit available for speculation in real estate? Or, for that matter, in copper? The possible rate of profit through speculation in copper during the past year has been higher than the average rate in the stock market. Why, then, should the Board seek to regulate the prices of securities and of nothing else? Is it not just as sound a policy to regulate prices of wheat, pig iron, shoes, and rent?
Once, however, any board goes into the price-fixing business, it will be overwhelmed with problems which the wisest body of men could not solve. Yet the Reserve Board, through its recent shift of policy, is already a pricefixing body; for regulating the credit available for any one business is the chief way of regulating prices in that business.
V
The Board has also reversed its policy in connection with the purchase and sale of securities in the open market. Under the law, the Reserve System is permitted to invest its funds in government securities and in bankers’ acceptances. Until within the past year, the Reserve System, quite properly, used that power as one means of controlling the total volume of credit. Elsewhere we have explained at length how the wise use of this power helped to stabilize the commodity price level, steady the markets, and thus enable the country to prosper at a safe rate. In pursuit of this policy, the Federal Reserve banks lowered money rates when there was a scarcity of credit, and advanced money rates when there was a superfluity of credit. They used their open market operations to put money into circulation or take money out of circulation, thus helping to make their rates effective.
This action was based on facts, not opinions.
Few people have any idea of the enormous power which the Reserve System exerts over banking, and consequently over business, through these open market operations. The extent of this power can be shown by a single illustration. A few years ago, the Reserve System, in order to make a market for bankers’ acceptances, acquired acceptances to the value of about half a billion dollars. In this way the System created potential bank credit of, let us say, about seven and a half billion dollars; for under our present system a reserve of one dollar sometimes makes possible bank credit of about fifteen dollars.
Recently, however, the Federal Reserve System, in connection with its new policy of controlling the uses of credit, has reversed its policy regarding bankers’ acceptances, and has reduced its holdings to less than one hundred and fifty million dollars. Within a year the reduction has amounted to over two hundred million dollars. This has reduced the available bank credit bv about fifteen times that amount, which is more than three billion dollars.
If such a reduction had been made under conditions like those which prevailed early in 1923, when commodity prices and other measurements of business conditions showed dangerous inflation, the restriction of the total volume of credit would have been in accord with established and approved Federal Reserve policy. It would have been warranted by the facts. The facts of the present sound situation, however, do not warrant such action. The present action of the Board is based on opinions.
The credit stringency of the past few months has been created, deliberately and artificially, by the Board itself. When, on the other hand, international exchange is allowed to operate in a norma! way, high interest rates draw’ gold from abroad. This gold serves as a basis for the expansion of bank credit, and thus tends to bring down interest rates and check the imports of gold. The Reserve Board has prevented the world forces of supply and demand from operating in the usual salutary way. The gold which flowed into this country just prior to April 95 would have been used by the banks, but for the interference of the Reserve Board, in such a way as to prevent the shortage of funds and the rise of call rates to 20 per cent; but member banks were forced by the Reserve Board to use much of this gold to pay off loans instead of using it to prevent credit stringency.
Thus the Reserve Board has so obstructed the operation of an admirable system as to bring down upon the business world the very evils which the System was designed to prevent.
The member banks, in giving up their independence and relying on the reserves of the central banks, were assured that any solvent bank could at all times make loans freely to its customers, and yet maintain a liquid position, through rediscounting with the reserve banks, according to law. The moment any doubt arises concerning the freedom of rediscount, there is a complete change of attitude of the banks toward their customers. The banks can no longer pursue a courageous policy toward solvent borrowers. They can no longer freely encourage the development of sound business enterprises, because they may find that the paper which they take from their customers, and which they had supposed was always eligible for rediscount, is no longer eligible, because of an entirely new interpretation of the word ‘may’ in the Federal Reserve Act.
The Federal Reserve Act says that central banks ‘may’ rediscount paper. It is our conviction that the word ‘ may ’ was used to protect the banks from insolvent borrowers. We feel sure that this provision was not intended to give any body of men power to decide, on the basis of opinions, to which of the solvent banks presenting eligible paper the rediscount privilege should be denied. But whether or not we are right in this conviction, there can be no question about the danger of granting such an option to any body of men. The efficient system which we have built up for financing business simply cannot function if a few men are allowed to deny credit to a solvent bank solely on the basis of their opinion concerning who should, and who should not, be allowed to borrow money of that bank.
VI
The effort of the Reserve Board to reduce stock-market loans involves another reversal of policy; for it is an attempt to restrict the freedom of individuals in the investment of their own savings. The Board does not seem to be aware of this fact, but it is none the less a fact.
Hitherto, the world over, central banking authorities, including the Federal Reserve Board, have had no concern over an increased flow of capital into security markets, as long as that capital represented savings. Quite the contrary. As a matter of fact, such a flow of capital is one of the best measures of the growth of real wealth.
Now it is private funds of this sort — genuine savings — which account largely for the recent increase in the volume of stock-market loans. This is evident from the figures published by the Reserve Board itself. These figures show that the bank funds which have been used for stock-market loans during the past year have increased hardly at all. Loans ‘from others,’ however, have risen over one and one-half billion dollars; and these loans are made up almost entirely of the capital savings of individuals and corporations.
These savings belong in an entirely different category from credit which is created by the joint acts of banks and borrowers. Control of the volume of such credit has always been considered a proper function of the Reserve Board. Such control is necessary if the Board is to succeed, as it has succeeded notably for several years, in preventing inflation of commodity prices. But control of private savings and the uses of savings is wholly unnecessary. Savings cannot cause inflation.
Quite properly, therefore, the Federal Reserve Board formerly did not attempt to tell individuals how they should invest their savings. But that is virtually what the Board has done during the past year; for the chief aim of its tight-money policy, according to its own announcements, has been to check the increased flow of money into the call market; but this increased flow has been made up almost entirely, not of bank credit, but of private savings.
Incidentally, the fact should not be overlooked that this flow of private savings into the stock loan market, which appears to worry the Board, has been caused by the Board itself. For when the Board deliberately sterilizes our more than abundant gold reserves, and mops up surplus funds as fast as they become available, thereby creating rates of 10 to 20 per cent on the safest and most liquid loans in the world, at the same time repeatedly expressing its fear that security prices are too high, it is no wonder that many people invest their savings in call loans rather than in stocks or bonds.
VII
In the past, the Federal Reserve Board, acting upon facts, as does the Bank of England, won the aggressive and almost unanimous support of business men. Recently, by acting on opinions, it has undermined their confidence and undone much of the constructive work which it had performed, throughout the world, in support of stable money and the gold standard. By the lack of a consistent policy, by undertaking the new task of controlling the uses of credit, by employing its open market operations for that purpose, and by alternate vague warnings and reassurances, the Board has kept business men in a state of nervous apprehension. At the same time, it has provided professional speculators with many opportunities to reap profits at the expense of small investors.
“When the Board first took its changed course, we remarked that there was one way, and only one way, whereby the Board could succeed, for more than a little while at a time, in its efforts to stop the rise in stock prices — namely, by injuring business. Indubitably the Board has injured business. How severely, nobody can yet tell; for not all the depressing effects of arbitrary restrictions of credit supply appear promptly. Usually there is a lag of several months.
But already there has been a marked decline in construction activities, especially in home building, directly caused, as the Board admits, by its own arbitrary advance of interest rates. As a result, there has been an increase of unemployment in the building trades and a consequent decrease of consumer income. In addition, a large number of sound, constructive business developments have been postponed solely because, the Reserve System having ceased to function in the established way, these projected enterprises cannot be financed by the sale of stock. Partly for these reasons, there has been a decline in the commodity price level which cannot long continue at this rate without doing further injury to business.
This is a serious matter for all of us. The difference between hard times and prosperous times, as we have explained at length elsewhere, is largely the difference between times in which extensions of private and public capital are adequately financed and times when they are not. We can prosper to-day only by getting ready to prosper tomorrow.
The action of the Board has also complicated foreign exchanges, aggravated the problem of maintaining employment and the gold standard in foreign countries, and thereby hampered the growth of foreign trade. At home, as well as abroad, there is paralyzing uncertainty among business men as to whether the Reserve Board will allow that expansion of bank credit without which such prosperity as we have had in recent years simply cannot last. In short, the Board has created a state of mind which breeds business depression.
Yet the injury which the Board has already done is insignificant compared with the injury which the Board may do in the future, if it is allowed to make further radical reversals of policy based, not on facts, but on opinions. If the Board has power to lay down the decree, subject to review by no authority whatever, that the resources of the only monetary system we have shall not be available to any bank which lends money on stock securities, what is to prevent the Board from refusing to accommodate any bank which lends money on wheat? What is to prevent it from discriminating in this way, whenever it sees fit, against any bank which lends money on real estate? And if the Board can destroy certain property rights, why not other rights? What, indeed, is to prevent the Board from doing anything it takes a fancy to do?
The greatest need of the industrial world is one more right-about-face on the part of the Federal Reserve Board. It should go back to the policies under which it aided powerfully in creating the greatest era of sound and widely diffused prosperity which this country, or any other country, has ever enjoyed. No change in laws is needed. All that is needed is such widespread understanding of the seriousness of the present situation that never shall it happen again.