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FEDERAL RESERVE C O P Y ' BOARD X-6208

Date December 20, 1928.

To Governor Young Subject: Effec t on gold reserves of

From Mr. Goldenweiser retirement of national "bank notes.

At the present time the Federal reserve system has about $1,150,000,000 of

gold in excess of i t s reserve requirements, but owing to the fami l ia r complication

about co l l a t e ra l , the gold in excess of co l la te ra l requirements against notes and

reserve requirements against deposits i s somewhat smaller, $1,086,000,000. The

future growth of reserve requirements to meet ' increased currency needs and growing

reserve balances of membef banks cannot be accurately estimated, but on the basis

of the average for the past six years would be about $45,000,000 a year. At th i s

ra te the excess gold would be consumed in 25 years, and if the gold c e r t i f i c a t e s in

c i rcula t ion were r e t i r e d the gold would l a s t for about 35 years. If to the amount

of annual growth in requirements were added an addit ional requirement for co l la te ra l

against notes issued in place of r e t i r e d national bank notes, our gold reserves

would be consumed in about 9 years, if the national bank notes ' are r e t i r ed over a

period of 10 years, and in about 13 years, i f they are to be r e t i r e d over a period

of 20 years. All of these estimates are conservative because the growth both in

currency and in reserve balances during the past 6 years has been unusually small.

In any case, over whatever period the operation takes place, the net resu l t would

be a useless reduction of our available gold by the f u l l amount of the r e t i r ed notes,

that i s , about $675,000,000.

The d i f f i c u l t y can be obviated by permitt ing the Federal reserve banks to

count United States s ecu r i t i e s as co l l a t e ra l for Federal reserve notes up to the

amount of national bank notes r e t i r e d through the cancellat ion of the bonds back of

them. The program for the retirement of bank notes should, therefore , include a

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recommendation that the Federal Reserve Act "be amended in the way suggested. This

ought not to create much opposition because i t would add nothing to the exis t ing

volume of currency secured by Government obligations and would merely continue

that volume. Giving the Federal reserve banks d iscre t ion in the matter wouM also

be a valuable source of ammunition for open-market pol icy.

A deta i led memorandum with calculat ions has been prepared in th i s o f f i ce and

wi l l be submitted if you wish i t . I thought, however, that a br ief summary would

probably serve your purpose.

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(COPY) X-6208-a

To Governor Young April 36, 1926

From Mr. Rief le r (and Mr. Parry) Subject: The Ef fec t of the He-tirement of National Bank ITote Circulation on Reserve Bank Credit .

In th is memorandum I shal l t ry to describe as simply as possible , the

complicated ser ies of steps "by which a retirement of national "bank notes from

c i rcula t ion due to the maturing of those bonds now bearing the c i rcu la t ion

privi lege would lead to a commensurate increase in reserve bank c red i t . F i r s t ,

howeveri i t is necessary to clear up a misunderstanding which may a r i se from the

statement contained in the a r t i c l e e n t i t l e d "Currency Under the Federal Reserve

System11 in the Federal Reserve Bul le t in for July, 1926, page 472; "Under present

conditions i£ i s changes in the whole of the currency in c i rcu la t ion which a f f e c t

the volume of reserve bank credi t in use and not changes in any pa r t i cu la r kind

of currency.M This statement remains true so fa r as national bank notes are

concerned only under the "present circumstances" implied in i t s qual ifying intro-

duction, namely, that the volume of bonds bearing the c i rcu la t ion pr iv i lege remain

constant and that a l l of these bonds are ac tual ly employed as a basis for currency

issue. Under such circumstances* the to ta l volume of national bank notes outside

the Treasury remains r e l a t i ve ly constant and f luc tua t ions in the c i rcu la t ion of

nat iorpl banks are r e f l e c t e d in corresponding f luc tua t ions in the national bank

note holdings of the reserve banks. I f , under these conditions, there was a

decrease in the public demand for c i rcula t ion, and national bank notes were sent

to the reserve banks, the member banks sending the notes would receive credit in

thei r reserve balances similar to that received for any other notes, and could use

t h i s credi t fo r the retirement of reserve bank credi t outstanding similar to that

for any other notes. The f ac t that the decrease in public demand fo r c i rcula t ion

happened to take place in national bank notes would not change the e f f e c t upon

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reserve tank c red i t , therefore , "but would simply mean that the reserve "banks were

forced to hold more non-reserve cash. So fa r as the volume of reserve "bank credi t

outstanding i s concerned, the s i tua t ion would "be exactly similar to what would

happen were the retirement of c i rcu la t ion from the public to take place in gold

c e r t i f i c a t e s or Federal reserve notes. As "between these cases, the reduction in

to ta l "bills and secur i t i e s of the reserve banks would "be unchanged. If the re-

tirement were to take place in gold c e r t i f i c a t e s , however, the cash reserves of

the reserve "banks would increase, while if i t were to take place in Federal re-

serve notes, the note l i a b i l i t i e s bf the reserve "banks would decrease. So long

as the volume of currency outstanding on Treasury credi t remains constant, only

f luc tuat ions in the t o t a l demand for currency "by the public are r e f l e c t e d in

corresponding f luc tua t ions in the demand for reserve batik c red i t , and f luctuat ions

in the individual elements composing the currency, provided that the to ta l in

c i rcula t ion remains unchanged, ar§ re f lec ted , not in the b i l l and secur i ty hold-

ings of the reserve banks, but in the i r cash reserves, hdn-reserve cash, or thei r

mote l i a b i l i t i e s *

The present memorandum i s di rected toward a s i tua t ion essen t ia l ly d i f f e ren t

from that outl ined above. If the bonds bearing the c i rcu la t ion pr iv i lege are re -

t i r ed , national bank notes to an equivalent amount wi l l be taken both from circula-

t ion aqd from the non-reserve cash holdings of the reserve banks. This wi l l be

r e f l ec t ed in a corresponding increase in reserve bank credi t since the operation

wi l l not a f f e c t the publ ic demand for c i rcu la t ion . Let me i l l u s t r a t e the steps

by which th is wi l l result...

At the present time, the to t a l volume of bonds bearing the c i rcu la t ion privilege

amount to about $675,000,000, p r a c t i c a l l y a l l of which are on deposit in the

Treasury as the bas i s fo r nat ional bank notes outstanding. In addit ion to t h i s ,

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there i s usually a.bout $25,000,000 in cash in the national bank note redemption

fund. Against these two items, national "bank notes to the extent of about $700,-

000,000 are usual ly outstanding. Of these about $20,000,000 are held in the

Treasury in process of redemption, $50,000,000 more are in the reserve banks as

non-reserve cash and about $630,000,000 are in c i rcu la t ion . We wi l l assume these

amounts to be representa t ive of the s i tua t ion on April 1, 1930, when $600,000,000

of the bonds now securing the national bank note issue become payable. We wi l l

fur ther assume that the Treasury a t that time r e t i r e s these bonds and also ca l l s

(as i t i s able to do) the remaining $75,000,000 in bonds bearing the c i rcula t ion

pr iv i lege which are now cal lable but do not f i n a l l y mature u n t i l 1956 and 1938.

The steps by which the retirement of these $675,000,000 in bonds bearing the c i r -

culation pr iv i lege wi l l lead to an increase of $675,000,000 in reserve bank credi t

outstanding are as follows;

When the bonds mature, the Treasury does not pay out any funds to the national

bank which has deposited them to secure the c i rcula t ion, but instead cancels the

bonds and assumes l i a b i l i t y fo r the notes outstanding against them. To meet th i s

l i a b i l i t y i t w i l l have to provide for $675,000,000 in general revenues ei ther from

taxation or securi ty f l o t a t i o n s . We wi l l assume that such provision has been made

and that the Treasury has on deposit a t special deposi tories $675,000,000. As

th i s amount i s f r ee of reserve requirements changes in reserves required wil l not

complicate the ana lys i s .

On April 1, 1930, when the whole issue securing the national bank note

c i rcula t ion matures, the f i r s t event wi l l be the cancel lat ion of the $20,000,000

in national bank notes already presented to the Treasury for redemption. This

wi l l use up $20,000,000 of the $25,000,000 in the national bank note redemption

fund which wi l l be turned over to the general cash fund of the Treasury. The

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second step wi l l "be the presentat ion for redemption by the reserve tanks of $50,-

000,000 in national hank notes which they hold in the i r non-reserve cash. Of

th is amount $5*000,000 wi l l be redeemed by the remaining cash in the redemption

fund fo r national bank notes. The cash reserves of the reserve banks wil l thereby

increase by $5, 000,000. The remaining $45,000,000 wi l l be redeemed by drawing on

Treasury deposits with special depository banks. As these banks presumably would

have reserves equal to requirements and as the i r reserve requirements would not be

diminished by the loss of Government deposits, they would e i ther have to borrow

$45,000,000 d i rec t ly from the reserve banks in order to meet th i s withdrawal, or

e lse would have to obtain $45,000,000 through adjustment of the i r secondary resertes,

thus leading other banks to borrow-$45,000,000 a t the reserve banks. In e i ther casg

i f we assume that the reserve banks are not buying any more secur i t i e s , member bank

borrowing would be increased by $45,000,000.

The th i rd step would be the gradual presentat ion of $630,000,000 of national

bank notes in c i rcu la t ion to the reserve banks in exchange fo r Federal reserve

notes to take t he i r place in the c i rcu la t ion . The reserve banks would then present

the $630,000,000 in national bank notes to the Treasury which would redeem them by

drawing on i t s deposits in special depositories fo r an equivalent amount. Again,

these special deposi tor ies would have presumably no surplus reserves with which to

meet the withdrawal and would e i ther be forced to borrow that amount from the re-

serve banks d i r ec t ly or to adjus t their secondary reserves in the market in such a

way as to force other banks to borrow $630,000,000 from the reserve banks. In

e i ther case, s t i l l assuming that the reserve banks are not buying any more securi-

t i e s , there would be an increase of $630,000,000 in the volume of member bank

borrowing at the reserve banks.

The retirement of the whole national bank note issue, in 1931, therefore,

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would, resu l t (unless the reserve banks purchase secur i t ies ) in an increase of

$675,000,000 in discounts for member banks, of which $45,000,000 would r e f l e c t

the redemption of nat ional bank notes now held in the non-reserve cash of the

reserve banks and. $630,000,000 the redemption of national bank notes in c i rcula t ion .

i t i s to be considered, as indicated* that th i s e f f e c t on member bank borrow-

ing could be stvoidedj p a r t i a l l y or en t i re ly , by coincident purchase of secur i t i e s

by the reserve banks. I t i s to be noted, however, that even if th is should prove

to be possible and should be done the e f fec t of the retirement of the whole issue

of national bank notes would nevertheless be to increase the volume of reserve bank

credi t outstanding by $675,000,000. But the p o s s i b i l i t y i s not so evident upon

examination as i t seems at f i r s t s ight , largely because the purchase of secur i t i e s

does not bring into the system any material e l i g ib l e as cover for the Federal re -

serve notes that would be needed to replace the national bank notes now in actual

c i rcu la t ion . These notes must be covered by gold to the extent of a t l eas t 40 per

cent; 40 per cent of $630,000,000 i s about $250,000,000. The other 60 per cent,

about $380,000,000, may be in the form of discounts for member banks, rediscounts,

and purchased acceptances, but open market operations in secur i t i e s bring in none

of these. Almost a l l of these that the system now has, furthermore, are already

serving as cover for Federal reserve notes already outstanding.

The question consequently a r i s e s as to where the cover for $630,000,000 of

addit ional notes i s to come from. If i t should a l l be set aside in gold the amount

of gold t ied up, in such manner that i t could not be exported, would be very large—

equivalent to at l e a s t three years ' supply of monetary gold from the mines. In any

case $250,000,000 in gold, a large amount in i t s e l f , would have to be t i ed up.

A small increase in purchased b i l l s , e l ig ib le as cover, may be expected, but i t i s

evident that the main reliance for e l ig ib le cover would have to be paper a r i s ing

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from member bank; "borrowings. Thus i t appears that subs t i tu t ion of Federal reserve

notes for national "bank notes, in any substant ia l volume, i s an operation that •

must e i ther t i e up a large amount of gold or else occasion a large increase in the

indebtedness of member banks.

An obvious a l t e rna t ive i s to r e t a in the national bank note c i rcula t ion, which

neither t i e s up gold nor necess i ta tes as cover so-called e l i g ib l e paper. This

a l te rna t ive is so obvious, in f ac t , that i t would seem to "be more l ike ly of a -

doption by the Treasury that any other and possibly be t t e r a l t e rna t ive , unless

the merits of other a l t e rna t ives are properly "brought to the Treasury's a t ten t ion .

The only form of Federal reserve currency that requires as cover neither gold nor

so-cal led e l i g ib l e paper i s the Federal reserve bank note. Federal reserve bank

notes, however, appear to require as lawful cover U. S. secur i t i e s "bearing the

c i rcula t ing p r iv i l ege , and while there appears to "be no doubt as to the authori ty

of the Federal reserve "banks to purchase such bonds, i f any are avai lable , there

does appear to be .some doubt as to whether the Treasury, in the absence of new

l eg i s l a t i on , can issue any more of them.

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