Benjamin Strong Jr. to Carter Glass

Benjamin Strong Jr. to Carter Glass

Strong, Benjamin, 1872-1928

WWP18537

1916 August 26

Benjamin Strong Jr. writes Carter Glass regarding some proposed amendments to the Federal Reserve Act.

Benjamin Strong Jr. Papers, New York Federal Reserve Bank

English

Dear Sir:
Among the proposed amendments to the Federal Reserve Act now before Congress for consideration, is one which authorizes reserve banks to exchange Federal reserve notes for gold and permits them to include the amount of gold so received as a part of their reserves. Understanding that there is some doubt of favorable action by Congress, the following statement is respectfully submitted, in the hope that ir conveys convincing reasons why this amendment should be passed and, if possible, at this session of Congress.
In the preparation of the Federal Reserve Act, Congress recognized that the financing of the foreign commerce of the United States had for many years been dependent upon banking machinery which was under the control of citizens of competing nations, particularly of Great Britain, and that this dependence should be removed as promptly as possible. Congress sought to accomplish this, both by enlarging the powers of national banks so as to enable them to do a foreign business and by conferring upon Federal reserve banks powers and functions which would supplement the new activities of the national banks. The Federal Reserve Act, in fact, recognizes that international finance is inseperable from international commerce and aims to establish our financial system upon a basis where American credit can finance American trade. The English system should be examined in this connection in order to understand why English banks have so long been able to control the largest proportion of the world’s international banking, and what we must do to develop and extend our own System upon an equally secure basis.
The chief and fundamental reason for England’s success, which is emphasized by every English authority writing on this subject, is the ability and willingness of her bankers at all times to meet their foreign obligations in gold. Since the Bank Act of 1844, this has been the pride and foundation of English banking. Does the Federal Reserve Act permit the reserve banks to obtain such cotntrol of gold, as will enable them to discharge their obligations to their members, and to the public, in this new department of American banking, with the same success as the English banks?
If our country is to permanently take over even its own share of this business, and is to finance its own foreign commerce, its banking system must first estavblish in the minds of bankers in every part of the world that it is able and willing to export gold whenever the exchanges make it profitable for its creditors to ask for gold payment. Our past record in that respect is bad. Since this country resumed specie payment, there have been at least three occasions when gold payments were arbitrarily suspended by our bankers, bringing discredit to our banking system and seriously impairing the confidence which should be felt in our banks; such confidence, in fact, as is now enjoyed by the English system and which we must enjoy, if we are to compete with England. In 1907 and in the Fall of 1914, our banks arbitrarily declined to pay gold to their creditors and in the latter case, to their foreign creditors. During a recent visit to London, our action on these occasions was gfrequently mentioned by prominent bankers as creating an almost insuperable obstacle for us to overcome in our efforts to compete with EEnglish bankers in foreign markets, nor did any banker with whom I discussed the matter seem to understand that this suspension of international gold patyment was forced upon the banks of New York, partly by a situation that is now in course of being remedied, and somewhat by the inherited defectxs of our currency system, which we hope in time to correct.
The occurrences of 1914 will illustrate the weakness of our position. WWhen in August of that year, sterling exchange passed the gold export point, the gold held in New York was scattered among 65 CClearing House institutions; no one of them, as I recall, holding in excess of $50,000,000, (The National City Bank), the total of all banks in the city being about $250,000,000. Of these 65 institutions, not over eight or ten had connections and facilities for supplying foreign drafts to enable our merchants and dealers to make payments abroad. Had these few institutions, which alone enjoyed the facialities, undertaken to create all the exchange needed by shipping gold to EEurope, their gold would have been exhausted in a few daays and they had no possible means of replacing it. The drafts which they sold would be paid for by the purchasers by checks on other banks. TThese checks would be collected through the Clearing House and settlement made there, in silver certificates and greenbacks (and later in national bank notes). Not only would that have resulted from the direct transactions of these exchange-drawing banks, but it would have resulted also from the operations of all priivate bankers who had facilities to draw exchange. TThey would have withdrawn gold from these same large banks, with whxich they kept their accounts, making payment therefor with the checks which they received from the purchasers of foreign drafts, in settlement of which, the banks would again receive silver certificates and greenbacks through the Clearing House. In other words, the shipment of gold by the few institutions which had foreign connections, would have been entirely inadequate to meet the situation, even if they had shipped the greater part or all of their gold reserves, and, to the extent shipped, it would have promptly resulted in the conversion of their gold holdings into silver certificates and greenbacks. During the period when Clearing House loan certificates were gbeing issued, they would not even have received silver certificates and greenbacks, but would have received the promise to pay of the various Clearing House banks which had to meet debit balances caused by the presentation of the checks deposited by the banks which had shipped gold, which they in turn had received from the purchasers of the exchange.
The only means preasumably available for theose banks to restore their gold reserves was by presenting large amounts of U. S. notes and silver certificates to the Subtreasury for redem-ption in gold. The average amount of gold held by the Treasury Department in the general fund available for such redemptions during the past two years has been trifling in comparison with the amount of money of this character which might be presented for redemption, especially if we add to the amount of greenbacks and silver certificates, the total amount of national bank notes (including Aldrich-Vreeland notes), outstanding during the Fall of 1914. The combined gold resources of the Treasury, including the 5 % Redemption Fund, was not then over $250,000,000, and during part of the time, much less than this - a very small sum indeed to insure the redemption of about $2,000,000,000 of paper money, the maintenance of a gold basis for all of our currency, and the conduct of the regular financial vbusiness of the Government.
Three times in recent years a situation has arisen where the free payment or exportation of gold would have depleted bank reserves in this way and thrown the burden of furnishing large amounts of gold upon the Treasury Department, when it was not in position to meet the demand. It would have added to the alarm already created, had the gold reserve of $150,000,000 been used for this piurpose nor, in fact, was it so used, or its use even suggested in a crisis of unprecedented seriousness, in 1914.
The foreign exchanges of the country are settled almost entirely through the banks of New York City. They, in turn, will in future years largely depend upon the Federal Reserve Bank of New York for their gold requirements to meet foreign obligations, when exchange is not otherwise vavailable, and the volume of these obligations will increase in proportion to the extent to which our new banking system is successful in financing our own foreign commerce. Enlarged demands for gold will at times arise under the new System through the encouragement, if successful, of the use of acceptance drafts drawn on New York banks and bankers. Such drafts, when drawn on English acceptors are regarded by bankers throughout the world as convertible at once upon arrival in London, into a bank credit which, in turn, can be converted into gold for withdrawal, if the rate of exchange makes that course necessary or profitable. Bills of a like character drawn on Americqan acceptors must enjoy this same quality and reputation if we are to develop successfully the use of dollar drafts for financing our foreign commerce. Foreign bankers will not, if they can avoid it, buy large amounts of New York bills, unless they are assured that they can be certain of immediate discount, and rely upon liquidating the resulting credit in gold, if necessary. It was, in fact, to bring about exactly such a development of our banking business abroad that various provisions were incorporated in the Federal Reserve Act and Congress should now carefully consider whether adequate means are afforded to the reserve banks to accumulate gold in sufficient quantity to meet the demands which may and are almost certain to be made upon us in later years if, as we hope, our international banking assumes important bvolume. Does the Federal Reserve Act, in fact, accomplish what it was designed to accomplish in this repect?
If Federal reserve notes cannot be issued in exchange for gold, or if the gold so accumulated by the present clumsy method of exchange does not count as part of the reserves of reserve banks, then the only source of supply of gold for the reserve banks is the reserve deposits of member banks, (and the CCeneral Fund of the government), the amount of which is limited by law and which we cannot expect will be increased materially beyond the reserve required to be carried. How far will this gold go?
The statement of the 12 reserve banks as of June 30th shows a total gold reserve of $377,000,000, which was about 69 % of deposit and note liabilities, a percentage certainly as low, if not lower than should be permitted for the entire system under present conditions. The amount of earning assets of all the reserve banks at that date was $165,000,000, which earned, roughly, at the rate of 2 ½ % for the month of June. This amount of earning assets at the present average rate of about 2½ % has produced net earnings in the first six months of 1916 for the entire sustem of about 2.9 % on the capital. Assuming a moderate increase in expenses, it will take a further investment of, say, $80,000,000 at present rates to enable the 12 reserve banks to earn their current dividends, regardless of those accrued. This additional investment will cause the reserve banks to pay out an equal amount of their gold reserves so that it is undoubtedly a fact that if the reserve banks were to-day earning their dividends, their reserves would be so low that they could meet no demands of importance from their member banks for gold for export.
It is frequently stated that demands upon the reserve banks for discounts by member banks can be met by the issue of Federal reserve notes, thus enabling them to conserve their gold reserve. That is not a fact. In the first place, only 14 % of the earning investments of the reserve banks consist to-day of the discounts of member banks and the demands for discounts by member banks so discounting has no connection whatever with demands for the issue of Federal reserve notes - that is, for currency. Member banks apply for discounts when they have extended accomodation to their customers to the point of impairment of their reserves. They take credit for the proceeds of the discount in their reserve accounts and draw checks on the reserve banks as these balances are used for loans or otherwise, which checks are ultimately presented through the exchanges, and must be settled by the payment of reserve money, that is, gold. The reserve banks cannot meet these checks by the yuse of Federal reserve notes any more than the Bank of England can require its depositors to accept its notes in payment of deposits or redeem its notes by the issue of its own notes.
The same statement applies to other investments made by the reserve banks, that it, government bonds, municipal warrants and bankers acceptances, (the latter comprising 42 % of all earning investments.) These are purchased from brokers and bankers and paid for by check, which checks likewise are presented through the clearings in the usual course and must be paid by the use of the bank’s reserve money.
The only available means of issuing Federal reserve notes is by delivery or shipment to those member banks whose customers have use for currency, and on these occasions the reserve banks are sometimes able to accumulate, or at any rate, to protect their gold and it is by availing of such demand that the reserve banks have been able to put by a total of $162,000,000 of gold which is now held by the reserve agents, but which does not count as part of their reserves, and is not directly available to meet the needs of member banks.
During the past 14 or 15 months, since the establishment of the Gold Settlement Fund, the RReserve Bank of New York has, as I recall, received from the banks of New York City, either in exchange for Federal reserve notes or through private transactions with importers, in the neighborhood of $200,000,000 of gold, which it could not retain. This imported gold, however, which we should have had the power to hold to meet possible future demands, had to be distributed to the other 11 reserve banks, through the Gold Settlement Fund, in order to settle for exchange sent to New York by the other reserve banks for credit, and through the other reserve banks has vbeen put into circulation. TThis operation simply distributes gold certificates, principally of $10 and $20 denominations throughout the country in hand to hand circulation, whereas it should be impounded by the reserve banks and held against future emergencies. Nor will we be successful, of course, in accumulating gold in a large way against issues of Federal reserve notes until the Congress is willing to make Federal reserve notes reserve money for the banks and until the banks are able to accept reserve notes in settlement of Clearing House balances.
Objection is made that the use of Federal reserve notes for that purpose is unsound, inflational and will result in an undue expansion of our circulating medium. Quite the reverse is true. Under the law as at present, Federal reserve notes, issued against discounted paper solely, will be entirely a fiduciary issue and without as large gold backing as would be the case if reserves could be accumulated by the exchange of Federal reserve notes for gold. Had the Federal Reserve Bank of New York been in position to effect such exchanges and retain the gold received during the past year, it would to-day hold in its note and general reserves possibly between $450,000,000 and $500,000,000 of gold instead of about $225,000,000 as at present. Its percentage of reserves would have been much larger than at present, possibly over 90 %, and it would be in position to meet the demands of its member banks for gold for export when that demand arises without an alarming depletion of theits reserve.
Up to the present time, the loss of gold received by the Federal Reserve Bank of New York has been occasioned first, by the investment of its funds, payment for which investments is made in gold; second, by settlements with other reserve banks through the Gold Settlement Fund of the balances created by deposit of New York exchange, sent for credit, (which operation results in the conversion of our gold reserve into silver certificates and greenbacks.) When, however, a demand for gold for export arises, as it will inevitably some day, the loss of gold will be caused by transactions which will very rapidly impair the bank’s reserve position. Member banks in New York will first withdraw whatever excess balances over their required reserve they may have on deposit with ud. When these are exhausted, they will likely apply to us for the discount of commercial paper and bills, the proceeds of which they will withdraw in gold for export. Our note issue cannot be used to protect our gold, our discounts will increase and our reserve will decrease by the amount of gold paid out against them. And, as stated above, were the Federal Reserve Bank of New York willing to invest a sufficient amount of its funds to earn its full dividends, the amount of its reserve would be so greatly reduced that we would be unable to meet any considerable demands from our member banks for gold for export.
This country differs from other modern banking countries in the vast number of its banking institutions. For security’s sake this condition demands a larger fund of assembled gold than is required even for England. During the past two years, we have witnessed an exhibition of strength by England in the matter of exports of gold, such as has never before been displayed in the history of banking. This country could never have met a situation such as England is now meeting without changes in our laws undertaken in time of emergency, and risking added alarm. Nor does England care to risk the loss of prestige to her foreign banking system by suspending gold exports, even in time of war.
It should be borne in mind that the Treasury of the United States is generally not in position to meet the redemption of United States notes and silver certificates in times of crises and that under the new law, demands upon the reserve banks for gold have the effect of making them the first agency of redemption, principally by the sorting process described above, which takes place at the Clearing Houses. It is highly important, not only to the reserve banks, their members and the public, but to the government as well, that this process of intermediate redemption should be fortified by as large a reserve of gold as can be assembled.
Many New York bankers have inquired of me why the Federal Reserve Bank of New York was not able to accumulate a greater Pproportion of the gold now being imported and a greater porportion of the gold in current circulation in small denomination gold certificates. There are a number of reasons in addition to those named above in connection with the note issue:
At present, when gold is imported from Europe, it is immediately deposited with the Assay Office and Assay Office checks are issued to responsible depositors for 99 % of the assumed value of the gold on the day of deposit. These Assay Office checks are paid through the Clearing House or directly at the New York Subtreasury by the issue of gold certificates. These gold certificates go into the bank areserves and are gradually shipped throughout the country and put into circulation. The English system is quite different and enables the Bank of England to stand between the importers of gold and the Assay Office, or the mint. The English mint takes gold from depositors at the rate of 77 s. 10½ d. peroounce, issuting in payment the actual sovereigns coined at the end of, say 12 days; to avoid the inconvenience of delay to gold importers, the Bank of England is required by law to buy gold bars at 77 s. 9 d. and make immediate payment. 1½ d. per ounce of gold is less than the equivalent of 12 days interest and restliults in practically all gold purchases being made by the Bank of England. Some such plan would be possible in this country, provided the note provisions of the Federal Reserve Act were amended and it is safe to say that practically all the gold imported to the United States in the past two years would now be in the vaults of the Federal Reserve banks, if the Treasury Department discontinued its practice of immediate payment, and if the reserve banks could pay for the gold by the issue of a note which would be accepted in settlement of Clearing House balances.
The Bank of England is understood to go even further than above described in order to insure retaining control of gold receipts; it is currently reported that the bank always has enough gold bars at the mint for coinage, to indefinitely postpone returns by the mint to private depositors, so that all importers of gold are forced to the Bank of England with their gold bars.
Should Congress determine to amend the note provisions and expect reserve banks to avail of that means of accumulating a more adequate gold reserve, the present practice of issuing $10 and $20 gold certificates should be gradually discontinued, and greater discretion vested in the Secretary of the Treasury to determine in what denominations of gold certificates shall be issued in future. The mere discontinuance of the issue of these small denomination notes would lead to the replacement of that amount of gold circulation by the Federal Reserve notes, if they had adequate circulating qualities and some hundreds of millions of gold certificates now in circulation would gradually be driven into the reserves, not only of the reserve banks, but of member banks as well, thereby gradually increasing the strength of the gold reserve of the whole country.
Unfortunately, issues lof Federal reserve notes, particularly of the quality now in use, are exceedingly expensive. In fact, the cost, if entirely borne by the reserve banks, is prohibitive, unless the reserve banks make use of this very method of accumulating reserves to considerably expand their investment account. This, at the present time, is highly undfesirable and I have reluctantly come to the conclusion that whenever Congress is willing to authorize the expansion of note operations by the reserve banks to the degree required, it will be justified in having the Treasury assume the cost of the note issue, as there will be a great saving to the Government in the cost of the present issues of gold certificates. Tehe reserve banks will indirectly recoup the Treasury when they pay a share of their profits to the government.
I have made no reference to the course of exchange after the conclusion of the war which many bankers and economists believe will be adverse to this country, possibly for a long period, and result in the return of some portion of the $500,000,000 gold which we have received from Europe during the period when the exchanges have been in our favor. Without hazarding a prophecy as to any such occurrence, it is nevertheless sufficiently a possibility to require the reserve banks to make every preparation for extensive demands for gold. As I hope has vbeen brought out by this letter, means are not available which will be adequate for this purpose except through amendment to the note provisions of the Federal Reserve Act.
To summarize the above, the provisions of the Federal Reserve Act as they are at present, do not permit the reserve banks to accumulate sufficient gold to meet the demands which may be made upon them during a long period of adverse exchanges. There is considerable possibility of those conditions arising. It will take time to accumulate a sufficient fund of gold to meet such conditions. Unless Congress amends the Act sufficiently in advance of the conclusion of the war, it may be found that the reliance of the community generally, as well as member banks, upon the new banking system will meet with disapointment.
The Federal Reserve Act affords a basis for the reorganization of our banking system, and ultimately of our currency system, on sound lines, but I do not think that it will provide means for adequate development of our foreign banking until the whole subject of the note issue and gold reserves has been conprehensively dealt with somewhat as above indicated. Old prejudices in regard to our currency stystem must be abandoned. The object ultimately to be attained through the agency of the reserve banks is to have but two kinds of major circulating medium in the United States - one gold, and the other Federal reserve notes, with adeqaute gold reserves in the custody of the reserve banks.
Very truly yours,

Letter

Glass, Carter, 1858-1946