Benjamin Strong Jr. to Russell Cornell Leffingwell

Benjamin Strong Jr. to Russell Cornell Leffingwell

Strong, Benjamin, 1872-1928

WWP18625

1919 February 6

Benjamin Strong Jr. writes Russell C. Leffingwell regarding monetary policy.

Benjamin Strong Jr. Papers, New York Federal Reserve Bank

English

Dear Leffingwell:
This letter is the result of much cogitation about the next bond issue; its terms; and the policy of the Department in financing from now on. If you observe some slight change of attitude on my part, it is brought about as the result of opportunity to do some reading and thinking on these matters which I was unable to do when at the office.When we became involved in the war, it developed very promptly that as prices had already been tremendously advanced as a result of gold imports and of the competitive buying of the Allies in this market, our own war costs and Government borrowings would be correspondingly large. I felt then, and still feel, that the only ways by which the required credits could be produced for the Government’s needs would be either as the result of:
(a) Economy
or, failing that, of
(b) Inflation (to the extent that economy was not practiced voluntarily or involuntarily)The methods available to the Treasury for raising the money were limited to:
(c) Competitive rate bidding, or
(d) Patriotic Appeal.
We all know that individual economy was not practiced to such extent as to enable the Government to raise the entire war fund without recourse in part to inflation, and the reserve banks furnished it. The controversy in the Treasury Building during the entire period was between one school believing that economy could and should be enforced and inflation avoided through establishing higher rate levels; the other school, which included the writer, believed that economy must be enforced through some system of rationing, or by consumption taxes, or by other methods more scientific, direct and equitable than high interest rates.
During all of this period, as frequently expressed to you, I have, personally, felt that the problem of inflation should be dealt with through enforced economy but that, nevertheless, the interest rates established for the Liberty Loans were somewhat lower than was wise, and that slightly higher rates and more attractive terms would have produced better results. Possibly in that view I was wrong. While higher rates of interest might have restrained some expansion, the amount saved might not have been worth while, nor do we know how much the advanced price level is due to inflation. On the other hand, accepting the Secretary’s decision in these matters involved the adoption of a corresponding rate policy by the reserve bank, which was always done without hesitation. My only comment upon the past is that both the Treasury Department and the reserve banks were the victims of the failure of our Government to get a better control of expenditures by the people generally. Some part of the inflation might have been avoided by paying higher rates on the Liberty Loans, but how much is anybody’s guess.
We are all familiar with the results of the policy of the Department. The money has been successfully raised, and, as nearly as I can estimate, at a cost of possibly six billions of bank inflation, not all of it, however, directly attributable to Government borrowing. Before expressing some views about the program from now on, I must refer to the report of the Committee on War Finance of the American Economic Association and ask you to read it, if you possibly can find time to do so. At any rate you should read articles four and five, starting at page seventy-five. They will bore you some, make you mad some, but, also, they will help you some. Professor Bogart (IV) annoys me, as he will you, and I am proposing to write Kemmerer a blast about the report. Their trouble is the usual and ancient one, of approaching the problem on the theoretical basis of 100% perfection, but leaving out of account entirely the human factor, i.e., what is possible to do, rather than what ought to be done. They are expressing in these two articles what they think should be done irrespective of the average of the views of all, and it is to that average view which a program must conform if it is to succeed. A college professor finds it impossible to construct his views along these lines. But Kemmerer may be, and likely is, correct about the price level, although again he leaves out of his argument the most important factors of all, which are “relative inflation,” and bearing on that “relative price level,” and again bearing on that “the relative bulk of gold reserves” as between the various nations of the world.
You and Secretary McAdoo, and now Secretary Glass, and possibly the humble writer of this letter, will find in future years that the Treasury and the Reserve System must stand up and justify the policy of the two war years, which involved a rather complacent acceptance of some inflation as a necessary evil, being, in fact, a part of the price paid by the Government for successful war finance. If the Government, in consequence, paid too high prices for its supplies, I think the Treasury Department could maintain that it was not as a result of wilful inflation, but was caused by the failure of the Government to take control of expenditures by the people of the country, thereby making inflation inevitable or loan failures probable. We have paid the high prices, we have had some billions of inflation, but from now on the Treasury is charged with an even greater responsibility than heretofore because the day of deflation approaches. The process of deflation is a painful one, involving loss, unemployment, bankruptcy and social and political disorders, whereas the process of inflation brings in its train prosperity, employment, rising prices, a happy absence of bankruptcies and general state of contentment, all of which leads me to the point of this letter, namely, that mistakes by the present Treasury Administration from now on will bring redistribution of a very certain and definite character which was not likely during the days of war excitement and expansion, but which is now begining to loom up most definitely during the distasteful days of paying the damages. The object of this letter is to emphasize a few points about the future which none of us can afford to overlook.
1. PRICE LEVEL: The level of prices of both wages and commodites in this country has always been much above that of any country in Europe. My belief is that the readjustment of prices throughout the world has not generally eliminated the differential against us, and that with certain special exceptions it will still be found that the level of wage and commodity prices in England as well as on the continent of Europe is much lower than ours. The relative difference may not be as great as formerly. Our danger is not simply that we have continued a level of prices out of line with those of Europe, but rather that we have established a higher level of prices than formerly under conditions of such artificial prosperity that merchants and manufacturers who have permitted their inventories to pile up on them at these prices must now struggle through a costly period of liquidation, and, in consequence, are bound to sustain heavy losses on large stocks of unsalable goods. Abroad, where stocks of goods have been greatly reduced, the process of reducing the price level will likely not involve such serious losses as with us. Even up in this district I meet men who are already encountering difficulties with stocks purchased considerably above present prices. A friend of mine who has just been visiting me, who is in the cotton textile business, says that the shrinkage in their inventories is already tremendous. You know what is taking place in the wool industry. The same thing is happening in leather, steel and iron, in fact all along the line. The object of referring to this point is to call attention to the fact that if inflation is arrested at its present level the reajustment of prices and loss resulting will be no greater than that now fixed by the existing price level. If inflation continues, money grows cheap, - the liquidation will be arrested and our later troubles be the greater.
2. WE MUST DEFLATE: Notwithstanding the hardships and losses resulting, I believe you will agree that it is inevitably necessary that out banking position must be gradually deflated. If this is not done, we may face the necessity of either continuing the gold export embargo, to the detriment of the rest of the world’s financial position, or else lose a large amount of gold at a time when it would be inconvenient for us to do so, and necessarily force a more radical readjustment in interest levels than we have yet found necessary to employ. At the moment my thought is that the processes of deflation will follow naturally enough, and gradually, if the Treasury is able to adopt such a policy as will simply prevent further inflation, which will be referred to later.
3. BUSINESS CONDITIONS: As briefly mentioned above, I am receiving reports that are disturbing about business conditions; contracts are being cancelled, and sometimes rather ruthlessly. I heard the other day, for instance, of some big contracts made by American mills for South American buyers, the goods being of special construction, and just as soon as prices fell off cables came up here, not only canceling the contracts, but canceling the bankers credits under which the contracts had been issued. These were special lines of goods which could not be sold in this country and involved purchases of raw material at high prices. I know from experience that this same thing will take place in the iron foundries. Manufacturers of pig iron, I have no doubt, will suffer cancellations of contracts right and left. Such trades as mens’ shirts indicate the trend of the department store buyer. A salesman from a shirt factory in this district the other day made the rounds with practically no success except in selling cheap imitation silk shirts, for which there still seems to be some demand from laboring men who are getting unusual wages. The wool auctions in Boston are an indication of the hesitation now developing. These various signs of business recession indicate that the readjustment is now under way and that we may be approaching a period when active criticism will develop. There is a change of wind - indicating a change in weather.
4. “BORROW AND BUY”: One ground of criticism of our policy in the past has been the “Borrow and Buy” slogan. I believe it was necessary in order to insure successful financing. I believe it involved the least vicious form of inflation, but I believe that for future loans it should be abandoned and discountenanced by the Treasury, even though it means a more moderate success in financing.
5. BANKS MUST NOT BE LOADED: You may suggest, as a conclusion of No. 4, that the only recourse of the Treasury, failing to place bonds with investors, will be to sell them to the banks of the country. That I doubt very much. If anything is to be sold to the banks, it should be short certificates until the time comes when bonds can be sold or when the Treasury is will to pay the rate to sell them.
6. THE EFFECT OF DIRECT BORROWING FROM FEDERAL RESERVE BANKS: To illustrate exactly the relative inflation involved by various methods of borrowing would be almost impossible except in theory because the plow of bank loans and deposits throughout the country is so active as to obscure what really takes place. Theoretically, however, the following is true: When a member bank either lends to a subscriber or itself buys some Government bonds, it causes inflation only in case and to the extent that it borrows from the reserve bank, and creates no inflation unless it does borrow from the reserve bank. For every dollar borrowed from the reserve bank a possibility of inflation arises in the ratio of the average of bank deposits to reserve deposits created by borrowings. If all the banks of the country make loans of this character to or for the Government to the extent of, say, a billion dollars (and theoretically the average reserves of all national and state banks is 10%) the borrowings from the reserve banks will be only $100,000,000 to support the billion of inflation. This can be demonstrated by figures which I will not elaborate. The process of expansion which takes place as a result of such borrowings from commercial banks is less dangerous than the process of inflation which would result from direct borrowings from the reserve banks. In the first instance the inflation is limited to the initial amount of bank loans, the reserve banks contributing only the amount of reserve required through their discounts. But, if the Government, needing a billion dollars, should borrow that sum directly from the reserve banks, it would be throwing a billion dollars of reserve money into the hands of member banks, and, theoretically, this reserve money would support a bank expansion of ten billions, if the ratio is one to ten as assumed. We have, therefore, three possible choices:
(a) A sale to investors who do not borrow,
(b) A sale to investors who do borrow, or to the commercial banks, which would result in an inflation to be supported by loans at the reserve banks equal only to the reserve percentage of the inflation created, and
(c) Borrowings directly from reserve banks, which would credate new reserves to the extent of that borrowing and support inflation to many times that amount.
I believe every possible effort should be made to confine the next loan to the (a) class.
7. INTEREST RATES: We have always considered that too sharp an advance in the rates on Liberty Bonds would cause a corresponding decline in security values and consequent embarrasment for savings banks, life insurance companies and other security holders. I doubt if that has been a sound argument. No matter at what rate the Government issues its securities, the investment level will shortly be established by supply and demand in the market so that the competitive rate between the Government’s loans and other securities will adjust automatically. Even if the Government sold a low rate bond it would shortly sell at such a discount as to bring it into direct competition with other forms of investments. On that point I believe we have been misleading ourselves a bit in the past. Hereafter, however, a new factor will enter into our calculations of the utmost importance. Our markets must gradually be opened to foreign loans, both government and private. Foreign governments, and borrowers generally, are willing and will be forced to borrow in this market almost at any rates which will produce the credit - Their refundings and purchases in our markets will make it necessary. It is a competition which our Treasury must meet unless our Government is willing to exclude foreign borrowings from this market, with consequent serious damage to our commerce and finance. It makes little difference also at what rates these foreigners borrow because the same readjustment of market values will take place to bring about this same interest competition. In fact, as the doors are now being opened gradually to a normal interchange of goods and of credits, and, ultimately, to shipments of gold, a world re-adjustment of the interest level is bound to take place. We can not ignore or avoid and our Government must prepare itself to enter into the competition and advance its rates, or have its loans fail, unless it is still willing hereafter to pursue a program of inflation which might be disastrous.One of the ablest bankers in France, for whose opinion I have the highest regard, told me two years ago that he expected after the war was over to see the very best private credits in Europe paying 10% interest for fixed capital as distinguished from bank loans, event solvent government and municipalities doing so.
8. SALE OF BONDS TO INVESTORS: For the next loan I believe the Treasury should adopt the policy of offering a rate of interest on a taxable bond running not more than five years, redeemable, say, after two years, which will be so attractive in terms that it will induce investors of all classes to buy them with a minimum of bank borrowing in order to carry them. If this is done, I believe the action of the Treasury will earn and receive the commendation of all thoughtful, intelligent men and that the clamor of politicians can be ignored. Also if this is done, it will require some readjustment of rates by the reserve banks.
9. THE BANK RATE: For reasons which need no repetition, our bank rate has been regularly and promptlyaadjusted to the Treasury’s program. Should the Treasury now place a high rate loan, I should suppose that the reserve banks would be required to adopt the following rates:

(a) A special rate to enable banks to rediscount existing loans made to original subscribers to the Fourth Loan, probably 4¼% for all maturities.
(b) A special rate for new loans to enable banks to carry subscribers to the Fifth Loan, at least equal to the rate borne by the new bonds, but probably not any lower.
(c) A special rate for bills arising out of the importation and exportation of goods.

Admittedly, this last rate, if fixed at around present levels, with other rates advanced, would drive a large volume of foreign bills into the reserve banks. On the other hand, it might create such a premium or special demand for bills, that banks would be found more anxious than heretofore to hold a portfolio. I would advocate this special rate for international reasons, if for no other, as suggested at our conference in Washington. Expansion to the extent resulting from that policy, based upon the development of a special market for international bills, would be the least harmful of any in which we could indulge, and would be a later protection to our international exchanges.
10. TAX EXEMPTION: I have come to believe that a low rate tax exempt bond would be a mistake. The difficulties resulting are illustrated by the position in which any member bank would find itself under the new tax bill. The average gross return on invested money and loan funds under present conditions will run between 5% in the large cities and 6% or over in the country. If a 4% tax exempt bond is issued, though running but for five years, and redeemable after two, it would pay a return to a member bank, by reason of the tax exemption, that would be equivalent to something like 18% or 20% on other forms of loans - - I haven’t the table of calculations here and speak roughly from memory. It would be the greatest possible inducement for banks to buy these short bonds and turn right around and borrow from the reserve bank so as to scalp the difference between our rate and the rate of net return on this tax exempt investment. It would force the reserve banks into the position of discriminating in loans made for that purpose and loans made for more liegitimate purposes. This is an almost impossible thing to do, because a bank can buy the bonds and secure the funds to do so by discounting its eligible paper. I believe I told you that Alexander stated to me that if the Bank of Commerce wanted to take $100,000,000 of notes of that character they could realize a good many million dollars a year profit by borrowing the whole amount from the reserve bank in one form or another. To impose the obligation upon the reserve banks of safeguarding against this form of inflation strikes me as an unjust and unsound thing to do. In fact, an obligation which they could hardly expect to successfully perform.
11. INTERNATIONAL RELATIONS: No policy by our Treasury from now on can ignore the international aspect of our financial position. I am very clear, after reading various British reports, that the London market will in the not distant future experience an advance in the level of bank rates generally beyond anything heretofore experienced in the London market except in war or other crises. It would not surprise me to see bills selling at between 5% and 6% in London, and a good part of that business gradually transferred to this country.
Lord Cunliffe writes me privately: “I am indeed nervous as to the outcome of all this enormous credit inflation and huge floating debt.”
Cokayne, Governor of the Bank of England writes: “I am sorry to say that the currency inflation is proceeding apace here and I fear it will continue during demobilization --- What a comfort it will be when the Government borrowing can cease! Until that and the artificial money rates come to an end, we shall not be able to tell how we really stand.”
You have doubtless read the report of the Cunliffe committee. These all point to the adoption of plans in London at some time for squeezing out inflation, doing away with artificial conditions, and, of course, accepting the consequences of higher interest rates.
12. IN CONCLUSION: The great temptation of the secretaries of the Treasury in time of war is to borrow cheap money. It is axiomatic that in such emergency the Treasury attempts, and usually succeeds, in obtaining control of the bank of issue and that bank of issue becomes the instrument for furnishing the Government with cheap loans or irredeemable notes at the expense of sound monetary conditions and of the price level. That is exactly what happened in England during the Napoleonic wars, and it has happened in France (with the possible exception of the Franco-Prussian War) since the days of Napoleon. The Bank of France to-day shows the effect of such a policy as strikingly as any institution in Europe with whose figures we are authoritatively acquainted. The Reich Bank and the Imperial Bank of Russia both succumbed to this influence, and, in the mlatter case with a complete collapse of credit. Our policy in this country has so far been the soundest of any, we have avoided a debasement of our circulating media, have taxed liberally, and have had but moderate inflation, and I belive that from now on a courageous policy by the Treasury for one more loan will do more to establish the country’s finance, and generally to establish its business upon a sound footing than any other single factor.
Secretary Glass in one or two public statements has expressed the view that the Treasury can still rely upon patriotic impulse for financial support. That is undoubtedly true ito some extent, but if patriotic impulse is made the means of placing unattractive bonds which must be forced upon reluctant investors who are induced by artificial rates to borrow money in order to buy them and then shortly turn about and sell them to avoid shrinkage, we experience all of the evils of inflation, the disasters of losses by patriotic investors, an unnatural and severe decline in the Government’s bonds and credit, and an investment interest rate ultimately as high as would have been established in the first place had the Government borrowed at an attractive rate to the investor.
If this letter seems to involve some change of front on my part, (which it really does not, fundamentally) please bear in mind what a change has taken place in conditions. In the face of my persistent, continued recommendation to our friends in Washington that steps be taken to conserve goods and services, I found myself advocating inflation as a means of making up the deficiencies of some failure to adequately control expenditures and to promote economies. Now that the war is over, even such means as were adopted to control private expenditure have been abandoned and there seems to be just one recourse left, which is to interpose obstacles in the way of borrowing, and to do it by a slightly higher rate level. In other words, while the war was on, the proposition stated on page one of this letter resulted in adopting policy (d). Now that the war is over and no control is being exercised, we are forced to the adoption of policy (c). That’s the whole story in a nut shell.
This rather rambling letter contains something of what I would say had we opportunity for a meteting. I wish very much you could make the opportunity by coming up here. It is simply an expression of my peronal views without conference with my associates.
With best regards,
Sincerely yours,

Letter

Leffingwell, R. C. (Russell Cornell), 1878-1960