§ 12. Gold hoards and artificial interest rates. The wartime influence and activities of the Federal Reserve Board, and of those controlling the various district banks in general, merit high praise. They steadily urged the sound economic policy of industry, thrift, and self-denial on the part of the people. They fostered no illusions that the magic of banking credit or of paper money could take the place of real production of the goods needed, and of real abstaining from the goods not needed, for the prosecution of the war. Although the banks (district and member) found it necessary to take and hold for a time an increasing proportion of the successive loans ("war paper"), and the local banks to lend heavily at low rates of interest to customers on the security of war paper, great efforts were made to get the public to pay in full and to relieve the banks of this burden.

In two particulars the policy of the Board is more open to question. The Board showed a mercantilist bias in favor of an artificial heaping up of gold in this country, as shown in its fathering and defense of the gold embargo. It defended this on the ground, first, that it was desirable to conserve the available gold supply on the assumption that this would make the country stronger economically. But this could but have the effect, in the end, of artificially inflating our prices at home, of increasing the amount of Liberty bonds to be issued, and of causing the value of the American dollar to depreciate in the countries from which at the time we were buying in excess of our sales. The Board thus contradicted its own sounder doctrine that goods, not artificial inflation of credit and prices, was what was needed to win the war. The Board further attached undue importance to maintaining low interest rates artificially at a time when the natural trend of rates was upward. This could but encourage the increased use of credit by the public, and thus neutralized the Board's own sound policy of keeping down the use of credit for purposes less urgent or of a speculative nature. Throughout the war period (and for a full year thereafter) our banking practice was in violation of the basic principle of central rediscount, "well established in the tradition of Europe, that the official rate of rediscount should be above the market rate."

Fig. 6. Chapter 9. The increasing wholesale prices appear to be even more nearly parallel with the rapidly expending bank deposits than with the monetary circulation.

§ 13. The post-war period. At the sudden termination of military operations, the Federal Reserve Board at once gave expression to wise warnings against the inflation and speculation that usually have occurred at such a time. It declared the immediate problem to be that of "preventing credit from expanding too far, and so far as practicable of reducing any excess that already exists." It again counseled thrift and the acceptance of falling prices by the people, and limitation of credits by the banks. If this policy could have been made effective, the price index of armistice month (which was 206) might have been the peak, and prices might have moved slowly downward to lower levels. As it was, prices wavered, fell as low as 197 in February, 1919, rose again, then with a bound went up in July, 1919, to 219, and still upward to the peak of 272 in May, 1920, then to plunge steeply downward to 151 in May, 1921. Enormous evils of speculation and undeserved profits to some, unjust burdens of rising prices to many others, great waste of productive effort, and finally much unemployment and suffering in the period of crisis, would have been avoided if the price readjustment downward had progressed evenly from the date of the armistice.

To fix the blame precisely is not easy, or indeed possible; but a large part of it must be traced back to the policy of the United States Treasury in fixing the rate of interest on all its issues of loans artificially below the market rate. As a result the bonds had to be marketed more by appeals to patriotic motives, enforced by many measures of popular coercion to induce and compel the public to subscribe to the loans, and still further supported by preferentially low interest rates by member banks to enable customers to carry bonds on bank loans, and preferentially low rediscount rates on such paper presented for rediscount at the Federal Reserve banks. At one time the total of war paper held by all banks (including the Federal Reserve), exceeded $6,000,-000,000, and the very preference given to it for rediscount was a premium to active business not to pay off the loans but rather to use funds for other purposes in a period of rapidly rising prices. The Treasury and the Federal Reserve banks, in this policy of artificially low interest rates, had "caught a Tartar," and did not know how to let go without causing a slump in the price of Liberty bonds, which nevertheless was sure to occur. The 4 1/4 per cents (which composed the larger part of those outstanding) fell somewhat below par early in 1919, fell to 92 in December, 1919, as discount rates and rediscount rates were raised, and as low as 82 in May, 1920. Large quantities of the bonds appear to have been thrown upon the market by holders who had been carrying them on credit. The whole policy above discussed must be looked upon as a case of price-fixing by which the rate of interest on government loans was kept artificially lower through an unsound use of government control over banking policy. The results were speculation, inflation of prices, and eventual disillusionment and loss to investors and to large numbers of other citizens.

§ 14. Future of the Federal Reserve system. The Federal Reserve system rendered valuable service during the war, and was a stabilizing influence in the period of industrial depression that began midway in 1920. While there has been enormous shrinkage in prices, in valuations of goods in stock, in securities, and in "paper profits," and inevitable loss to many investors and business men, the " retreat" has been more orderly than in previous financial crises, and at no time has the banking system as a whole been anywhere near danger of collapse, as in former crises. The Federal Reserve banks have become an indispensable part of our banking system. Probably valuable lessons have been learned from the wartime experience. It is probable that the use of the rediscount privilege will, in normal times, not be extended to the limit, as in 1919 and 1920, but will be kept in large part in reserve for emergencies. This would result in smaller earning assets and earnings for the Federal Reserve banks, and would make the recent figures in these respects appear abnormal, and not to be expected regularly. Altogether, as a piece of financial machinery, the Federal Reserve system has been a demonstrated success, and doubtless is capable of beneficial development. However, the possibility of political interference with banking policy is apparent, and might become a grave danger to the whole financial situation.

References

Federal Reserve Board, The Federal Reserve Bulletin. Monthly. Kemmerer, E. W., The A B C of the federal reserve system. Princeton. Pp. 192. Princeton University Press. 3d ed. 1919.

Phillips, C. A., Readings in money and banking. Ch. XXXI. N. Y.

Macmillan. 1916. White, Horace, Money and banking illustrated by American History.

Bost. Ginn. 1914. Bk. III. Ch. XXII and appendices D and E. Willis, H. P., The Federal Reserve Act. A. E. Rev., 4: 1-24. 1914.