The ABC Of The Federal Reserve System
T H E A B C OF T H EDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. LouisRESERVEFEDERALSYSTEM
THE A B C OF THE FEDERALRESERVE SYSTEMWHYTHECALLEDFEDERALINTORESERVE SYSTEMBEING, T H EMAINWASFEATURESOF ITS O R G A N I Z A T I O N , A N D H O W I TWORKSBYEDWIN WALTER KEMMERER, PH.D.PROFESSOR OF ECONOMICS AND FINANCE IN PRINCETONUNIVERSITY AND MEMBER OF THE BOARD OF REGENTSOF THE AMERICAN INSTITUTE OF BANKINGWith a Preface byBENJAMIN STRONG, LL.D.GOVERNOR OF THE FEDERAL RESERVE BANK OF NEW YORKFIFTH EDITIONPRINCETON UNIVERSITY PRESSPRINCETON, N. J.Digitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. LouisLONDON! H U M P H R E YMILFORDOXFORD UNIVERSITY PRESS1922
COFYIICHT,PRINCETON1920.UNIVERSITYPIXSSPrinceton, N . J.Published September,1918Revised December, 1918Revised March,1919Second printing April,Third edhicr., November,19191919Fourth Edition, April, 1920FifthEdition,January,1922Printed in the United States of AmericaDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
CONTENTSPAGESPREFACE.B y B E N J A M I N STRONGix-XIIIC H A P T E RPURPOSE A N D P L A NI*Lack of familiarity with federal reserve system on partof public, and its dangers, 1.—Purpose of book, 2.—Plan of book, 2.C H A P T E R1-2IIDECENTRALIZATION OF A M E R I C A N B A N K I N G PRIOR TO FEDERALRESERVE S T STEMBanks lacked organization and effective leadership intime of crisis, 3-4.-—Reserves widely scattered, 4-6.—Reserves immobile, 7.C H A P T E RINELASTICITY OF A M E R I C A NRESERVE SYSTEMBANKIIICREDIT PRIOR TO FEDERALExtent to which bank credit is used as a medium ofexchange, 8-10.—Why circulating bank credit should beelastic, 10-ll. Bank-note inelasticity over long periodsunder old banking system, 11-13.— Seasonal inelasticityof bank notes, 13-15.—Bank-note inelasticity in times ofcrisis, 15-17,—Inelasticity of deposit credit, 17.—Evil results of credit inelasticity, 18.C H A P T E RThe "float** and the practice of routing checks, 19-21.—Checks in transit commonly counted as legal reservemoney, 21-22.—Large domestic shipments of currency required under old banking regime, 22-23.—Foreign exchangedifficulties, 2 3 - 2 4 .C H A P T E R19-24VDEFECTIVE B A N K I N G M A C H I N E R Y FOR FEDERAL G O V E R N M E N T . .Difficulty of apportioning government funds among ninesub-treasuries and over fifteeen hundred depositary banks,2 5 - 2 6 . — F o u r evil results o f p r a c t i c e , 2 6 - 2 7 . — S u m m a r y o fdefects of old banking system, 27. -18IVDEFECTIVE E X C H A N G E A N D TRANSFER SYSTEMDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis3-725-27
viCONTENTSPAGESC H A P T E RHowVITHE FEDERAL RESERVE SYSTEM IS REMEDYING T H EOLDE V I L OF THE DECENTRALIZATION OF AMERICAN B A N K I N G . .Division of country into twelve federal reserve districts, 28-29.—Membership in federal reserve system.29-31,—Democracy of federal reserve banks* plan of organization, 31-34.—Coordination of twelve federal reservebanks and centralization of their control provided for bymeans of federal reserve board, advisory council, and classC directors of federal reserve banks, 34-36. District centralization of bank reserves, 36-39.—Mobilization of reserves, 30-40.—Inter-district mobility of reserves, '40.—Rediscounting by one federal reserve bank for another,'40-43.—Open-market operations, 43-45.—Creation of abroader discount market for commercial paper, 4 5 - 4 6 . —Increasing use of the trade acceptance, and advantages oftrade acceptance over open-book account credit, 4 6 - 4 1 . —The bank acceptance, 47-49.—Inter-district mobility ofreserves promoted by increasing use of trade acceptancesand bank acceptances, 48-49.—Intra-district mobility ofreserves increased by federal reserve system, 4 9 - 5 0 .CHAPTER28-50VIICREDIT ELASTICITY UNDER T H E FEDERAL RESERVE SYSTEMProvisions of federal reserve act for bond-securednational bank notes, 51-52.—The federal reserve banknote, 52.—Federal reserve notes, 52-53.—Their elasticity,53-58,—Elasticity of deposit currency obtained in a number of ways: Removal of old rigid legal reserve requirements, 58. New legal reserve requirements less rigidand may be suspended in times of emergency, 59-63.Privilege of rediscounting at federal reserve banks, 6364. Privilege of borrowing on collateral notes with shortmaturities, 64.—Contractility of circulating credit underfederal reserve system, 6 5 - 6 6 .C H A P T E RVIIIDOMESTIC AND FOREIGN E X C H A N G E UNDER T H E FEDERALSERVE SYSTEM51-66RE-Provisions of federal reserve law concerning domesticexchange, 67-70.—Early experiments of the federal reserveauthorities as regards the clearing and collection ofchecks, 70. Present clearning and collection system,71-76.—The gold settlement fund, 76-79.—Foreign exchange, foreign agencies and branches of American bankiorganized for foreign business under the new bankingsystem, 8 0 - 8 4 .Digitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis67-84
CONTENTSC H A P T E RI XT H E FEDERAL RESERVE S Y S T E M A X D T H E FEDERAL T R E A S U R Y . .Federal reserve banks authorized by law to be depositaries of government funds, 85-86.—Extensively used asdepositaries by Secretary of the Treasury, 85-88.—Federal reserve banks as fiscal agents of Government renderinvaluable services in the financing of the war, 89.Digitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louisvii85-98
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PREFACEByBENJAMIN STBONG, L L J XGovernor of the Federal Reserve Bank of NewYorkThe federal reserve banks came into being inthe month of November, 1914. The passage ofthe legislation by which they were created hadbeen preceded by five years of discussion, following the financial upheaval of the fall of 1907,such as might have been expected to prepare theway for the considerable changes in bankingmethods contemplated by the new law.Notwithstanding, however, that Americanbankers had gained a better understanding of thedeplorable defects in the American banking andcurrency system, the managers of the new federal reserve banks soon found that the welcomeaccorded to them by the banks of the countrywas, to say the least, cool. Business men generally welcomed the change for the better, recognizing the protection which the reserve system afforded them; but nevertheless both bankers andixDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
xiiPREFACEbusiness men were regrettably ignorant of whatit all meant.It was the influence of the war which demanded that the federal reserve banks be organized aspromptly as possible. The best banking machinery and the best banking talent in the country seemed to be required to protect the interestsof both bankers and business men. Much wasexpected from the new system, once it was started* Very shortly, however, immense imports ofgold from abroad, general business prosperitystimulated by war profits, and reasonably comfortable conditions in credit and banking, appeared to put the federal reserve banks for thefirst two and one-half years of their existence into the class of expensive luxuries; in fact, theywere regarded as examples of governmental interference with business which were toleratedbut, nevertheless, were not appreciated by manybankers.During this interval, November, 1914, toApril, 1917, the system, by slow stages of progress, found itself. The machinery for conducting actual operations was designed and developedfar beyond the requirements of the moment. Theterms of the Act were perfected where need wasdiscovered, the men engaged in the work becamebetter acquainted with their duties and with eachDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
PREFACExiother, skilled clerks were engaged and trained,and accounting methods were perfected, so thatwhen the test came as a result of our entry intothe war, in April, 1917, the Federal Reservebanks were in large measure prepared for thegrave tasks and responsibilities at once to be assumed.During the first twelve months of our country's participation in the war the reserve systembecame established upon a basis of confidenceand respect, even in fact of admiration, amongboth bankers and business men; and its futuretherefore seems assured so long as good management deserves the support now enjoyed.During these four jTears, however, the workof organization, and during the last year and ahalf the work assumed by the Federal Reserve banks as fiscal agents of the Government,have so occupied the time of all connected withthe system that it has been difficult to overcome,in a comprehensive way, much of the ignoranceand misunderstanding of the functions of thesystem. It is widely accepted as successful andnecessary, but, with some exceptions, it is stillhardly possible to say that it is understood. Ithas come as an enlargement of the scope of agreat banking machine which had become complicated by the dual development of two classesDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
xiiPREFACEof banks, national and state; and, in the case ofstate banks, a development which covered a vastfield of business activity not confined to commercial banking. Under the influence of the newsystem of twelve closely allied banks of reserveand of discount, the tendency will be toward unification and simplicity which will be broughtabout by the state institutions, in increasing numbers, becoming stockholders and depositors inthe reserve banks.Until, however, through evolution in methodsand many changes in both state and nationallaws, we have a truly unified system, banking inthis country will be a puzzle and a mystery to thecasual observer, to the business man, and tobankers abroad, unless its various features arepresented in a concise and comprehensive form,stripped of the technicalities of economic discussion. It is much more difficult to present a complex problem in concise form than in extendeddetail. This task, however, Professor Kemmererhas undertaken with distinct success. A n account of the functions assumed by the federalreserve banks as fiscal agents of the UnitedStates Government, and of the handling of warbonds, certificates of indebtedness and government funds would have complicated, and, possibly, rendered less clear the description of theDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
FREtfACExiiiposition the federal reserve system occupies in thebanking field. It would have involved, further,a discussion of the long felt necessity for a modification of the independent treasury system.These subjects, therefore, have properly not beenenlarged upon.i t is a public service to undertake the difficulttask of preparing an account of this great changein our fiscal system so as to combine accuracywith a comprehensive survey of the subject and,at the same time, to avoid technical details. Allthat is required to give the reader an understanding of the fundamentals of the new regime ofAmerican banking is contained in the followingpages, which will be read with attention and interest by many who have been seeking this information during the past five years.Digitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
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T H EABCOFT H ERESERVEF E D E R A LSYSTEMCHAPTERIPUBPOSE AND P L A N OF BOOKThis book is an attempt to set forth in nontechnical language the chief reasons why the federal reserve system was called into being, themain features of its organization, and how itworks. Although the federal reserve act of 1913is one of the most important pieces of financiallegislation enacted in modem times, and althoughit has been in operation several years, comparatively few people are familiar with its elementaryprinciples. It is looked upon by the majority ofpeople as too technical and complicated a matterto be understood by persons other than bankersand economists. As a consequence there has beena surprising lack of public interest in the workings of the system and in the important legislative and administrative modifications which thesystem has undergone since its establishment.This unfamiliarity is not surprising when oneconsiders the complex character of much of theDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louisi
FEDERAL RESERVE SYSTEM 11federal reserve machinery and the technical language in which this machinery is usually described. In a democracy, however, widespreadignorance, among the voters, of the country'sfinancial system is fraught with danger,America's leading manufacturing, transportation and commercial concerns years ago attainedheights of economic efficiency which made themthe envy of foreigners. None, however, enviedus our banking system. None followed it exceptsoon regretfully to turn back. This was true,despite the fact that our old American bankingsystem had many substantial merits. It wasreasonably safe, it yielded good profits, it wasadaptable to the local needs of widely varyingcommunities, and it developed the check andclearing system to a degree of perfection foundin few if any other countries. Along with thesemeritorious features, however, it contained anumber of very serious defects. The chief ofthese may be grouped conveniently under fourheads: I. Decentralization. II. Inelasticity ofcredit. I I I . Cumbersome exchange and transfersystem. I V . Defective organization as regardsrelationship with federal treasury. In the foursucceeding chapters these four groups of defectswill be considered, and in the following four chapters will be discussed the respective remedies provided by the federal reserve system.Digitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
CHAPTER IIDECENTRALIZATIONOFAMERICANBANKINGPRIOR TO FEDERAL RESERVE SYSTEMIn 1912 the United States had many timesmore commercial banks than any other countryin the world, and these banks averaged muchsmaller than those of any other important country. Official figures at that time placed the number of independent banking establishments of allkinds in the United States at approximately 80,000, and of this number something like 28,000were banks whose business was wholly or partlyof a commercial character. These commercialbanks were owned for the most part by the residents of the communities in which they wereplaced, and the business of most of them waschiefly local in character. The great majority ofnational banks were national in nothing but name.Except for the rather loose association of thebanks in the clearing houses of our principal citiesand a growing community of interest, most ofthese banks were independent units, each working for itself. There was little team work. InDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis3
10THE A B C OF THEtimes of threatened panic the different parts ofthe system worked at cross purposes. They werewithout effective leadership at those times whenprompt cooperation under national leadershipwas urgently needed.Reserves ScatteredThe most serious feature of this decentralization was the scattering of reserves. Thirty thousand different banks meant 30,000 cash reserves,and these reserves for the commercial banks weremore than the mere "till money" which the "cashbalances" of most foreign banks represent. Theywere actual reserves, substantial in amount, uponwhich the banks placed their prime dependencefor times of emergency. It is true that mostbanks had so called deposited reserves," namely, funds on deposit in other banks, which theywere allowed to count as part of their "legalreserves"; and they had so called "secondary reserves," namely, funds invested in securities andcall loans, which were supposed to be quick assetsthat could be liquidated at once in time of need.Strictly speaking, however, neither of these "reserves" was a reserve at all. The deposited reserve was after all merely a deposit in anotherbank, which the depository bank loaned out—commonly at call on the stock exchange—andDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
FEDERAL RESERVE SYSTEM 11against which it held its own reserve, a reservewhich in turn was often further attenuated bybeing placed on deposit in a third bank, thereagain to be loaned out on stock exchange collateral. In times of emergency, therefore, the "deposited reserve" could be realized upon only tothe extent that call loans could actually be called,and this meant to the extent that stock exchangesecurities could be sold. Invested "secondary reserves" could be realized upon, likewise, only tothe extent that securities could be sold. In timesof threatened panic, however, stocks and bondscan not be sold on any extensive scale except atgreat sacrifices and at the risk of financial collapse. Experience has shown that securities arenot sold to any large extent by banks at suchtimes. The losses involved would be too great.The result was that in times of serious danger thebanks of the country were forced to rely to avery large extent upon their own cash reserves,which, as a consequence, had to be maintained ata high level—higher than in other advancedcountries. This situation gave the vault reservein American commercial banks an importancenot found in the commercial banks of Europe.European joint-stock banks normally carry littlecash in vault; they place their reliance foremergency funds directly or indirectly upon theDigitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
10THE A B C OF THEcentral banks. In America bank reserves were soscattered and so jealously guarded that in timesof threatened panic they were comparatively ineffective in staying the storm. The situation wasanalogous to what would happen today if afterdrilling our American army to a high point offighting efficiency, we should scatter the men insmall units all over the United States to protectthe country from a threatened invasion. Eachcommunity would be jealous of its own squad ofsoldiers, but the invader would come and the efficiency of our well drilled soldiers would be practically nil. The point of the illustration will beclear to everyone recalling the mad scramble forreserve money on the part of banks throughoutthe country at the time of the panic of 1907. Oursupply of reserve money was large. In fact wehad at that time in the United States the largestsupply of gold in the world. It was ineffective,however, because widely scattered; hence, suspension of cash payments throughout the country, currency premiums, the breakdown of ourdomestic exchanges, the illegal issue of millionsof dollars of money substitutes, and all the otherdisgraceful accompaniments of an Americanpanic.Digitized for FRASERhttp://fraser.stlouisfed.org/Federal Reserve Bank of St. Louis
FEDERAL RESERVE SYSTEM 11Reserves ImmobileObviously a country's reserve money must toa large extent be concentrated in one reserve or,at most, in a few large reserves, if it is to be effective. It must be marshalled in armies, notscattered in small squads. But these armies mustbe mobile so that they can be quickly movedsingly or in combinations to places of threatenedattack. An army's mobility is a big factor in itsefficiency—a truth which the great mobility ofthe armies of the Central Powers in the recentwar has emphasized. Our American bank reserves were not only scattered, they were also immobile. There was no effective way of quicklygathering them together and massing them at thepoints of financial danger.These then were the three most serious phasesof our banking decentralization: (1) Absence ofa responsible national conservator of our moneyma
Division of country into twelve federal reserve dis-tricts, 28-29.—Membership in federal reserve system. 29-31,—Democracy of federal reserve banks* plan of or-ganization, 31-34.—Coordination of twelve federal reserve banks and centralization of their control provided for by means of federal reserve board, advisory council, and class
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