It soon became a direct source as well. On March 27, 1942, the second War Powers Act authorized Federal Reserve banks to acquire direct or guaranteed obligations of the United States by purchase from the Treasury. Eccles supported the bill enthusiastically. At one point he suggested that the FOMC should view the change as a new method of distribution: “Instead of having to . . . price an issue at a figure which would attract heavy over-subscriptions, the securities could be taken by the System and sold to the market as it could absorb them” (Board Minutes, February 3, 1942, 4).
Other Board members accepted the change as a wartime measure needed to ensure that Treasury issues would not fail to find buyers at established rates and to furnish funds for short periods around tax dates. Sproul, who was at the meeting, did not oppose the amendment. He criticized the Board’s failure to discuss the subject with the president before it was included in the War Powers bill, and he opposed Eccles’s suggestion that the reserve banks distribute government securities. He accepted direct purchases as a temporary measure to help the Treasury around tax dates or in an emergency.27
26. At the end of the war, excess reserves of all member banks were about $1 billion. The low yield on Treasury bills and the small size of many country banks probably explain the sacrifice of pecuniary returns. The FOMC considered reducing the discount rate to encourage banks to increase borrowing and reduce excess reserves, but it did not act (Minutes, FOMC, August 3, 1942, 14–17).
The change repealed a section of the Banking Act of 1935 that prohibited the System from purchasing government securities except in the open market. A few months later, the Board told the account manager to combine direct purchases from the Treasury with open market purchases in the weekly statement. The War Powers Act expired six months after the war ended; initial authority for direct purchases expired in December 1944. The Board requested renewal for two more years; later the authority became permanent.
Despite the low interest rates on short-term debt, war finance greatly increased earnings of the reserve banks. Net earnings rose from an average of $11 million for 1937–41 to more than $92 million in 1945. The Federal Reserve had been relieved of payments to the United States Treasury after 1933 in exchange for the capital provided to establish the Federal Deposit Insurance Corporation.28 By September 1942, Vice Governor Ronald Ransom anticipated that the government would reinstate the franchise tax if earnings rose (Board Minutes, September 15, 1942, 2). He was correct but premature. Congress imposed a tax equal to 90 percent of annual net earnings in 1946. The tax offset a substantial portion of the interest payments on Treasury debt held by the reserve banks.29
27. In the course of the discussion Eccles offered his interpretation of central bank independence: “The kind of independence a central bank should have was an opportunity to express its views in connection with the determination of policy, and that after it had been heard it should not try to make its will prevail but should cooperate in carrying out the program agreed upon by the Government. . . . [A]ny other kind of independence would be an impractical position which would result in the loss of authority and influence that it otherwise might have” (Board Minutes, February 3, 1942, 8).
28. The System paid a modest amount to the Treasury from 1936 to 1946 for interest received on industrial loans. The largest annual payment was $327,000.
29. There were other lasting changes. The large increase in wartime debt and in trading led to changes in the market for government securities. The FOMC and the Board considered proposals to use the reserve banks instead of government dealers to make markets in government securities. The reserve banks opposed suggestions that the Treasury sell all government securities to the reserve banks, which would market the debt to the public. Instead, the New York bank agreed to license government security dealers. In exchange, the dealers agreed to provide detailed portfolio and transactions data (Minutes, FOMC, February 29, 1944, 6–8). Another change increased the roles of reserve bank economists at the FOMC. Until the war, only New York had sent an economist to the meeting. During the war, all banks were invited to adopt this practice. Discussion at FOMC meetings continued to be dominated by Eccles, Sproul, and economists at the Board and the New York bank, however.
Reserve Requirements
With the bill rate at 0.375 percent in 1942 and income taxable at high wartime rates, banks outside New York and Chicago did not bother to invest in bills or send excess reserves to correspondent banks. The Treasury wanted to reduce reserve requirement ratios for urban banks to release reserves for purchases of Treasury securities.
The Banking Act of 1935 did not permit the Board to change reserve requirements for only one class of banks. Congress approved the additional authority on July 7, 1942. The change was contentious within the System. The Federal Advisory Council opposed the change, and initially so did the Board. Eccles described the reduction as “a grave mistake” (Board Minutes, February 16, 1942, 2–3). Prodded by the Treasury, once the legislation passed, the Federal Reserve reduced required reserve ratios at central reserve city banks in three steps, from 26 percent to 24 percent on August 19,22 percent on September 14, and 20 percent on October 3. Together the three reductions released $1.2 billion, about 6 percent of the monetary base at the time.
The New York and Chicago banks bought Treasury bills, as expected. The principal effect of the change was not on reserves or the monetary base but on the earnings of the banks and reserve banks. With interest rates rigidly fixed, banks as a group determined the aggregate amount of reserves by buying or selling Treasury bills. Further, New York and Chicago banks could create more deposits and add more to earning assets per dollar of reserves or base money. Contrary to Eccles’s aim, the reserve banks had smaller earnings and the banks had more.30
The three changes brought required reserve ratios for the two central reserve cities to equality with reserve city banks for the first time in Federal Reserve history. There were no further changes in reserve requirement ratios during the war. The only other wartime change removed reserve requirements on war loan deposits as an inducement to banks to buy securities by increasing Treasury deposits during bond drives.
30. The Board did not fully understand the limited effect of the change. On April 9, 1944, it unanimously approved a letter to a Mississippi banker who had written to request a reduction in the reserve requirement ratio for country banks from 14 percent to 7 percent. The Board explained in part that “reserves supplied through open market operations . . . go in the first instance directly to the particular banks needing them” (Board Minutes, June 9, 1944, 4–5). The letter then went on to cite other reasons, including the greater ease of monetary control after the war. There was no mention of earnings.
Discount and Other Rates
Discount rates ranged from 1 to 1.5 percent when the war started. After some prodding from the Board, on April 11, 1942, the reserve banks agreed to a uniform discount rate of 1 percent. In addition to the basic discount rates, the Federal Reserve set a preferential rate for loans collateralized by short-term government securities and a rate on direct loans to military contractors made under its authority to lend to individuals and businesses. The latter provision, a depression measure, was used to finance production of war materials. The amount outstanding on June and December reporting dates never exceeded $35 million (lent in 1936). During World War II, the total outstanding was about $10 million. Almost all the loans were for one year or less (Board Minutes, 1976, 492).31
Analysis at the Philadelphia reserve bank correctly noted that banks would obtain reserves at lowest cost and would hold debt with higher rates and longer terms to maturity. With discount rates above Treasury bill rates, discounting remained small. The memo criticized preferential rates for loans collateralized by government securities. Preferential rates would not affect the volume of borrowing, only the collateral used to borrow and the maturity of bank-held debt (Board of Governors File, box 1452, October 8, 1942, 7–10).
The Philadelphia bank’
s memo was critical of preferential discount rates on other grounds also. The memo rejected the real bills doctrine: “The experience with preferential rates in the last war and the postwar period on the whole was not satisfactory. The general conclusion of Reserve officials and analysts is that the particular paper used to secure an advance has no relation at all to the use that the bank will make of the funds it secures” (ibid., 9).
Despite this correct analysis, the Board adopted a preferential discount rate of 0.5 percent for discounts secured by short-term governments. The main argument for the preferential rate was that it would induce banks to hold more short-term bills instead of higher-yielding bonds. George L. Harrison said that it would be easier to eliminate the preferential rate, when it was time to reverse policy, than to increase the general discount rate (Board Minutes, October 7, 1942, 9).32
31. The New York Federal Reserve bank set the rate on direct loans to war contractors at 4 percent to 6 percent. The Board wanted the rate reduced to from 2.5 percent to 4 percent. The compromise was to lower the rate schedule to from 4 percent to 5 percent (Minutes, New York Directors, May 7 and June 4, 1942).
32. Harrison, former governor of the New York bank, was a member of the Federal Advisory Council. His memory of 1919–20 was faulty. The Treasury was willing to increase the general discount rate before it was willing to raise the preferential rate. See chapter 3.
Harrison underestimated the Treasury. In June 1945 Sproul proposed an increase in the preferential rate to 0.75 percent. All the presidents concurred, but the rate remained at 0.5 percent (Minutes, FOMC, June 20, 1945, 9). The following month, the New York bank directors asked to eliminate the preferential discount rate. The Treasury remained unwilling, so the rate stayed (Minutes, New York Directors, July 19, 1945, 20).
Bankers grumbled occasionally about Treasury tax and interest rate policies. When the opportunity arose, members of the Federal Advisory Council argued for higher rates on short-term securities to get banks to hold more of them. The most strenuous plea came from a member who argued that banks could not be expected to finance the war if they were “‘bled white’ through the maintenance of low interest rates and application of high taxes” (Board Minutes, April 9, 1942, 13).33
Selective Credit Controls
Unable to control money or interest rates, the Board turned first to controls on consumer credit and later to controls on real estate, stock market, and other forms of lending and borrowing. Some of these actions were taken to show that it was “doing something” to control inflation, some in the belief that it had to use existing authority before Congress would grant additional powers, and some at the urging of other agencies.
The Board adopted regulation W to reduce the demand for durable goods. The original order required a 20 percent down payment and limited loans to a maximum of eighteen months. Wartime revisions and amendments extended the range of goods covered, raised the required down payment, and reduced the maximum term.34 Experience with regulation established once again that efforts to control a complex economy produce unforeseen consequences leading to both extensions and exclusions from earlier regulations.35 Since credit is fungible, restrictions on one type of credit shifted demand to less regulated forms and encouraged innovation to circumvent regulations.36
33. Between 1941 and 1945, member bank income after taxes rose from $390 million to $788 million, about a 50 percent increase in real terms. (Since prices were controlled, the price index is biased downward. Using the 1945 price index, the gain is 60 percent; using 1946, after controls were removed, the gain was 43 percent.) To help the Treasury sell debt to the public, the Board discussed lowering the maximum rate that commercial banks could pay on time deposits from 2.5 percent to 1.5 percent. Eccles, Ransom, and Leo Crowley (chairman of the FDIC) favored the change, but it was not made. One reason is that banks feared they would lose savings deposits to nonbank thrift institutions, a problem that returned in the 1960s.
34. By spring 1942, the list included new and used goods, shoes, hats, and haberdashery. Monthly charge accounts were covered also. The regulations became so detailed that the Board agreed to exempt the Boy Scouts and railroad employees required to use a precision watch (Board Minutes, June 29, 1942, 9; August 12, 1942, 1).
By 1943 the Board began to discuss extending credit regulation to include real estate, securities, and traded commodities. Eccles explained to the reserve bank presidents that “the Board was not seeking the authority . . . but was willing to accept it” (Board Minutes, June 29, 1943, 21). Eccles preferred to increase taxes and forgo additional regulation, but he accepted the new responsibility to retain credit control under the Federal Reserve System: “Some of the Presidents indicated agreement with Chairman Eccles’s attitude and expressed doubt as to the ability of any agency successfully to discharge the responsibility” (22).
Enforcement differed across the country because each reserve bank chose the extent of enforcement. Vice Chairman Ransom complained at one point that the Board had chosen a middle course between strict and lax enforcement. Strict enforcement “would antagonize the people whose support was necessary,” and lax enforcement would foster the “impression that the System did not care whether the provisions of the regulation were observed” (ibid., 23).
Years later, W. Randolph Burgess summarized matters: “Looking back at the experience with the control of consumer credit, it would be very hard to make a case that what was done . . . was useful, and it certainly made a great deal of work for a great many people, at a time when there was a shortage of manpower and a heavy surplus of irritating red-tape and procedures to interfere with essential war work” (Letter Burgess to Sproul, Sproul Papers, Board of Governors, Joint Committee on Economic Report, October 7, 1949, 2).
Common stock prices had fallen a total of more than 20 percent from 1939 to 1941. Stock prices rose 20 percent in 1942 but remained below their 1938 value (Ibbotson and Sinquefeld 1989). In March 1943 the Board began discussing increases in margin requirements on securities. The volume of trading had increased to about one million shares a day, making some of the staff uneasy. Earlier, the Board had issued regulations T and U to set margin requirements as authorized by the 1934 Securities Exchange Act. Some staff members urged a preemptive strike against speculation, but the Board decided not to act (Board Minutes, March 15, 1943, 2–4). Prices continued to rise. By the end of 1944, the stock price index was almost 40 percent above the 1936 peak.
35. The Board had to decide such weighty matters as Should reupholstered furniture be treated like new furniture? Should loans for funeral expenses be exempted? Medical and dental expenses? (Board Minutes, August 12, 1942, 1).
36. Studies of the effect of selective controls on housing and durable goods find no evidence of their effectiveness. For housing, see Kane 1977 and Meltzer 1974. For durables, see Hamburger and Zwick 1977, 1979. These studies apply to later periods, but their findings are applicable to the war. A principal finding is that credit controls have clear effect on the form in which lenders extend credit, but there is no evidence of an effect on the allocation of resources or total spending.
On February 5, 1945, the Board increased margin requirements to 50 percent. Eccles argued that there was no evidence of excessive use of credit in the stock market, but the Board approved the increase to show that it was concerned about future inflation (Board Minutes, February 2, 1945, 3–9).
Three weeks later, Eccles reported that the Economic Stabilization Board had suggested a 100 percent margin requirement. Eccles saw no need for the change, but Chairman Vinson of the Stabilization Board thought that Congress would not authorize new powers to control inflation until existing powers had been used. Eccles suggested that Vinson send a letter to the Federal Reserve asking for the increase in margin requirements (Board Minutes, February 23, 1945, 7–8). Vinson sent the letter, but the Board delayed a decision.
By a vote of five to one, the Board agreed to let Eccles tell the Economic Stabilization Board that the System favo
red an increase only to 70 percent. Governor John K. McKee opposed because the government’s anti-inflation program was incomplete, and not much credit had been used for purchasing and carrying securities (Board Minutes, May 3, 1945, 7–8).37
The Federal Advisory Council agreed unanimously that speculation in real estate and stocks should be discouraged, but it saw little evidence of inflationary pressure in asset markets: “Farm lands are about where they were in 1913. . . . There has been a good deal of speculation in the larger apartment buildings and hotels and in some kinds of commercial buildings, but even there the prices are below the cost of reproduction. Stock prices are not above the 1936–37 levels, in spite of the fact that in the interim most corporations have added very materially to their assets” (Board Minutes, May 14, 1945, 2).
By late June 1945, with the war almost over, the Economic Stabilization Board agreed to recommend credit controls on real estate, higher margin requirements on stock transactions, and a longer holding period for capital gains. It considered an increase in the capital gains tax rate. It could not decide whether new construction should be exempt from real estate controls. Eccles believed that the new credit controls would be ineffective and should not be used unless Congress passed a tax increase (Board Minutes, June 21, 1945, 18–19).
37. John K. McKee was appointed to the FOMC in February 1936. He served ten years, leaving in April 1946.
Pressed by the administration, the Board voted to increase margin requirements on new purchases of securities to 75 percent effective July 5. The Board also required that the proceeds of security sales be used to bring the margin on the whole portfolio toward the new requirements before cash could be distributed to the owner. Governor McKee again opposed the increase.
A History of the Federal Reserve, Volume 1 Page 87