CENTRAL BANKING IN THE

BY RICHARD W. LINDHOLM FULBRIGHT PROFESSOR IN ECONOMICS PUNJAB UNIVERSITY, LAHORE

HE United States had a central utilized the Independent treasury Tbank during the early years procedure of handling government of its development (1791-1811) called funds with an assist from the system the First Bank of the United States of National Banks after 1867. and again a less efficient copy of the First Bank of the United States The Independent treasury pro- from 1816 to 1836 called the Second cedure provided for the payment Bank of the United States. In of taxes and other amounts due addition to handling the business the government in specie to an of the government, these central office of the treasury. Also all dis- banks also completed with the pri- bursements of the government were vately owned commercial banks of made in specie from an office of the country in meeting the banking the treasury. This procedure eli- needs of the business community. minated the need for the use of It was this competitive activity in banking facilities in the conduct the private economy, plus the ac- of government fiscal activities. It tivity of these two central banks also, of course, meant a considerable in controlling the bank note creation drain of the specie reserve of the activities of the privately owned nation when large tax payments banks, which created the political were made or if the treasury ac- opposition that resulted in popular cumulated a surplus. This was not opposition to this type of central the hardship it appears to be because bank organization. The result was the at that time customs receipts, ordi- refusal of Congress to renew the narily paid in specie, were 90 per charter of the Second Bank of the cent of the treasury receipts. An- United States, and the United States other and more serious difficulty did not have another of the Independent treasury arrange- until 1913. During this interval of ment was that it made the govern- about 75 years the United States ment completely dependent upon 44 private financial and banking agen- the personal check had become by cies if it required funds in addition far the most common means of pay- to tax receipts. This difficulty was ment and a central bank was needed mitigated somewhat by the introduc- to increase the efficiency of check tion of the National banking system clearance procedures. The use of which provided for the issuance of central banking tools to eliminate notes guaranteed by or deflation did not enter the government and backed with actively into the considerations government securities. resulting in the The Independent treasury system System. and the national banking system It seems rather unbelievable existed side by side until the estab- today that a central bank would lishment of the Federal Reserve be established without seriously System in 1913. The Federal Reserve considering its effect on the develop- assumed all the functions of the In- ment of inflationary or deflationary dependent treasury and gradually conditions. However, this was possi- the bank note provision function of ble in 1913 because it was generally the commercial banks. believed that price levels were The Federal Reserve System was caused by the value of gold which established by Congress in 1913 after was in turn determined by the cost over four years of active discus- of mining a specified quantity of sion and debate. The demand gold. Obviously a central bank’s for a central bank arose influence on the availability of gold most directly out of a belief that deposits would be negligible. Also a central bank would avoid the every economist and businessman severe money panics which had at this time confidently expected arisen in 1907 and rather frequently full employment to be the continu- during the previous twenty years. ing normal condition. The money Secondly it was believed that a panics which arose periodically were central bank could make the United short lived, and it was believed that States a more desirable center for they could be eliminated by a better the conduct of international financial organization of the monetary reserves transactions and in this way par- of the nation and this improved tially eliminate the monopoly of organization was to be provided by Western Europe and particularly the Federal Reserve System being London over this activity. Finally proposed in Congress. 45

The Federal Reserve System Governor may be selected from each consists of a Board of Governors of Federal Reserve district, which seven located in Washington and forces a geographical dispersion. twelve Federal Reserve Banks distri- Also the President is advised by the buted throughout the nation. Each law to include in his selections re- of the twelve Federal Reserve banks presentatives of major industries has a nine-man Board of Directors. other than finance. It is of interest The Board of Governors is selected to note that the law does not provide by the President, and his appoint- for the appointment of representa- ments must be approved by the tives of labour to the Board of Gover- United States Senate. The nine- nors. man Board of Directors of each of The powers of the Board of the twelve Federal Reserve Banks Governors over the twelve Federal is divided into three groups of three Reserve Banks were considerably each. One group of three is selected expanded in the banking legislation by the Board of Governors, and it of the 1930s. The Board has be- is from this group that the Chair- come the chief policy-making agency man and Vice Chairman of the of the Federal Reserve System and Board of Directors must be chosen. in addition to the seven board A second group of three is selected members and their secretaries in- by the commercial banks holding cludes a well-organized statistical membership in the Federal Reserve and economic research division and System and located in the district a staff to coordinate the work of the of the on commercial bank examiner staff whose board of directors they serve. of the twelve Federal Reserve Banks. The third group of three is also selected by member banks of the Operations of the Federal Reserve district but is chosen to represent System are carried out by the twelve business interests other than banking Federal Reserve Banks. The mo- of the district, and customarily one netary goal of these operations is represents agriculture, one manu- established by the legislation facturing of mining and one mer- providing for the Federal Reserve chandising. System and by the decisions of the Federal Reserve Board or of System The law gives the President wide committees including represen- some guidance in his selection of tatives of the Federal Reserve Banks Governors. For example, only one and the Federal Reserve Board. By far 46 the most important function of the (7) Chicago, (8) St. Louis, (9) Min- Federal Reserve Banks in terms of neapolis, (10) Kansas City, (11) man hours is the provision of an Dallas, and (12) San Francisco. In efficient medium of exchange. Here addition to the twelve Banks, the the principal job is to clear the System includes 24 branch banks. million of checks which cannot be Over 50 per cent of the assets cleared through local clearing houses. of the twelve Banks are possessed The second job is to keep a flow of by three banks: the New York, Chi- currency adequate to fulfill the needs cago, and San Francisco Banks. of commerce. The third job which The New York Bank is by far the since World War II has grown greatly largest of the twelve and is credited is the management of the fiscal affairs with dominating the Federal Reserve of the Federal government. This System until 1935. The Minne- requires the Federal Reserve Banks apolis bank is the smallest and pos- to act as banker for the United sesses assets only about one States Treasury, which includes the twelfth as great as those of the New management of treasury deposits York Bank. and the sale and redemption of Federal government securities. The The member banks of the Federal operations of the Federal Reserve Reserve System are the commercial Banks related to carrying out the banks of each Federal Reserve dis- monetary policies of the System are, trict that have met minimum require- of course, of vital economic import- ments, requested admission, and ance, but they do not require the been admitted. All commercial quantity of routine operations neces- banks that have a charter granted sitated by the strictly money ex- by the Controller of the Currency, change and banking functions. a division of the Treasury Depart- ment, are national banks and are The twelve Federal Reserve required by law to be member Banks are in the following cities banks also. (the number indicates the number of the district and the district of State commercial banks, banks each bank includes a definite area possessing a charter granted by a contiguous to the city in which the particular state banking commission, bank is located): (1) Boston, (2) are free to become members of the New York, (3) , (4) Federal Reserve System or to Cleveland, (5) Richmond, (6) Atlanta, abstain. Nearly all the large 47 state commercial banks have be- Federal Reserve Banks are owned come member banks. Member by the member banks. The stock banks include about 49 per cent held by member banks is best com- of America’s 14 thousand com- pared to non-voting stock of a mercial banks. These banks hold corporation. In effect, all voting about 86 per cent of all commercial stock of the Federal Reserve Banks bank deposits. is held by the Government through The two greatest deterrents to its control over the Board of membership in the Governors. Federal Reserve System are (1) the The Federal Reserve System has high reserve ratios required of developed in such a way that the member banks by the Federal grant of power by Congress to the Reserve Board and (2) the high System which permits the System capital requirements that must be to purchase and sell government met by a member bank establishing securities, bankers’ acceptances, and out-of-town branches. The most im- other designated credit instruments portant advantage derived by state in the open market has become the banks through membership in System’s most powerful instrument the Federal Reserve is the for the control of the quantity of attainment of direct access to the credit. This activity which is called discount and loan facilities of the open market operations can directly Federal Reserve System. affect the reserves of member banks and therefore the quantity of lend- The funds for the original estab- ing activity of commercial banks. lishment of the Federal Reserve These open market operations are Banks were obtained through a conducted by the Federal Open required stock subscription equal to Market Committee which is a joint 3 per cent of the paid-up capital of Board and Bank Committee and each commercial bank becoming a consists of the seven members of the member of the System. Today this Federal Reserve Board and five comprises only one-half of one per members representing the Federal cent of the assets of the Federal Reserve Banks. One of the five Bank Reserve Banks and is therefore rela- members of the Open Market tively unimportant; but it still Committee is always selected by the represents the only strictly equity New York bank; the other four bank capital, and therefore it is still members represent the four groups legally correct to say that the into which the remaining Federal 48

Reserve Banks have been divided rediscount rate, the reserve require- for this purpose. By actual vote the ments of member banks (within Board controls the Open Market limits), and margin requirements Committee, but voting has never been (within limits) on all transactions recorded to have been on the basis in securities on registered security of Board versus Banks. Actually exchanges. nearly all recorded votes of the Open Market Committee have been In addition to its powers for unanimous. the control of monetary affairs which it continues to possess at the time The Board also utilizes com- this is written, the Federal Reserve mittees representing only the view- System has possessed other points of the Federal Reserve powers. During World War districts. The best established is the II and at intervals of infla- Federal Advisory Council. It is a tionary pressure since then, the council of twelve with one selected Federal Reserve Board has had the by the board of directors of each power to establish the minimum Federal Reserve Bank. The indivi- requirements for the extension of dual selected is nearly always an offi- consumer instalment credit. The cial of one of the largest commercial control of consumer instalment banks of each Federal Reserve dis- credit was provided under the trict. The primary function of the famous Regulation W of the Federal Council is to advise the Board of Reserve Board. Here as in the case how commercial bankers feel con- of margin and commercial bank cerning current monetary problems. reserve requirements, the maximum This function is only advisory. An- amount of restriction was establish- other less formal group which meets ed by legislation adopted by regularly with the Board consists of Congress. During a short period the twelve presidents of the Federal starting with the emergency eco- Reserve Banks. Their function is nomic legislation adopted shortly also only advisory. after the outbreak of the Korean In addition to the use of open War the Federal Reserve Board market purchases and sales to control was given power to restrict the the quantity of credit, the Federal extension of credit to finance the Reserve Board, and in these cases construction of housing. These without the necessity of officially restrictions were formalized under consulting Federal Reserve Bank Regulation X of the Federal Reserve representatives, may change the Board. 49

A final opportunity open to the Federal Reserve System, an inde- Federal Reserve Board to control pendent agency. The Treasury was the quantity of credit extended and not particularly opposed to this the direction in which credit flows transfer because money problems comes under the idea of “moral in those days were arising from suasion”. Moral suasion has taken operations of the private economy the form of letters to bankers’ asso- for which the organization of the ciations and individual bankers. Also Treasury was unsuited to deal. The speeches of Federal Reserve officials powers granted the Federal Reserve and articles in publications of the originally and those which it has Federal Reserve System have been acquired since its establishment used to influence credit decisions of have been aimed at dealing with bankers in the direction considered this type of monetary problem. How- most desirable by the Federal ever, the powers granted were inade- Reserve. Special legislation adopted quate for the solution of the credit shortly after the outbreak of the and money problems of the 1930s, Korean War attempted rather un- and as a result, some of the Treasury successfully to expand moral suasion monetary responsibilities that had into a voluntary program of credit been transferred to the Federal control. The efforts of the adminis- Reserve in 1913 were returned to the trators of the voluntary credit Treasury in the banking legislation control schemes to apply the of 1933 and 1935, in addition, the sanctions provided to prevent Treasury was granted some new credit expansion arising from the monetary powers aimed at the eli- borrowing of state and local govern- mination of deflation. It was believ- ments caused serious difficulties. ed at this time that the new The result was a virtual abandon- legislation added to the basic powers ment of this more elaborate program of the Treasury would return mone- for voluntary control of credit al- tary dominance to the Treasury. though the legislation providing for This was the situation, however, it has not been repealed. only if deflation continued to be a The powers granted to the problem and if a free money market Federal Reserve System in 1913 would result in satisfactory mone- resulted in a considerable transfer of tary policy. As is well known monetary power from the Treasury, this was not the postwar situation, a department of the executive and as a result, monetary power was branch of the Government, to the distributed differently in the l940s 50 and 1950s than had been expected conditions of general inflationary by the writers of the monetary pressures. The effect has been to legislation of the 1930s. return to the Federal Reserve The monetary powers of the System the possibility of dominance Federal Reserve System excluding in the establishment of monetary the control over margin require- policy which was originally envisag- ments and the temporary powers ed in 1913. However, in the post- acquired during World War II and war period the Treasury has not the Korean War are sufficient only shown the same willingness to to control conditions existing in the accept Federal Reserve dominance money market. The possession of that it had demonstrated in 1913. this power by the Federal Reserve The justification for the different did not appear to be particularly Treasury attitude is not difficult to important in the 1930s; however, find or understand and rests basically the changed conditions of the war on ‘the proposition that current period made it very important. The monetary problems are arising from new importance of control over the government credit actions rather money market arose from a shift to than private activity. In this area generally inflated conditions from a the Treasury considers itself to be condition of deflation and in addi- more suitably organized to meet tion the necessity of controlling the the monetary problems involved money market to meet the manage- than is the Federal Reserve System. ment demands arising from the The procedure to be used in the terrific expansion of the size of the management of the money system of Federal government’s debt. the United States is apparently at a Since 1946 the most important crossroad. factor affecting monetary conditions The Federal Reserve System in the United States became the is organized to manage a value the money market placed upon monetary system which is affected government securities. The manage- nearly entirely by credit decisions ment and control of this market was of the private economy functioning definitely within the domain of the under conditions of prevailing full Federal Reserve. In addition, the employment. It is not suitably Treasury found that the new mone- organized to avoid serious deflation- tary powers which it had been given ary conditions as was shown by in the 1930s were useless under developments of the 1930s or to 51 avoid inflationary conditions arising the Treasury and the Federal Reserve from credit decisions of the Federal System ceases. Government as was shown by the The new conditions of the domin- postwar experience. The Federal ant Treasury interest in the money Reserve System through its control market due to the huge unfunded of the money market continues to Federal government debt has made possess the legal power to stop the Treasury very sensitive to money inflationary developments from what- market changes. However, the ever source, but actually it is rather Treasury’s powers are not suitable impotent if the inflationary pressure for controlling the money market. is arising from Treasury debt The Federal Reserve System is management policy. The impotency suitably organized to control the arises from a provision in the legis- money market but its responsibilities lation establishing the Federal were originally developed under Reserve System requiring it to quite different conditions. The assure placement of all indebtedness development of suitable institutional of the Federal government. Under arrangements for monetary manage- these conditions the Federal Reserve ment under the new conditions of a Banks must make open market greatly expanded government debt purchases of securities which may and general expansion of government be offered by the Treasury but which economic activities is the sole do not find private buyers. The responsibility of Congress. In an Federal Reserve Banks can prevent effort to fulfill these responsibilities the Treasury from forcing them to the Joint Committee on the Econo- enter into inflationary open market mic Report has established two sub- purchases only if the Federal Reserve committees during the past six years Banks are willing to sell as large to study the problem. These sub- a quantity of other securities held as committees under the leadership of they purchase of new Federal govern- Senator Douglas and Congressman ment securities offered. This is Patman respectively held long and actually what the Federal Reserve informative hearings. However, officials did in the Fall of 1950 which substantial legislation aimed at a forced the accord of March 1951. At reorganization of the American best the “accord” is a temporary institutional arrangement for the arrangement and will break down any establishment of monetary policy time voluntary cooperation between has not been enacted.