Federal Warning

Toward Wall Street last week the Federal Reserve Board shook a threatening finger, spoke a warning word. With loans to brokers standing at $5,669,000,000, the Board felt that too much money was being absorbed by the stockmarket, that other interests were being forced to pay too much for money they borrow, that indus-try as a whole was suffering from diversion of funds to brokers and speculators. It therefore expressed the opinion that a member of the Federal Reserve Banking System is "not within its reasonable claims for rediscount facilities" when it borrows Federal Reserve money to be used in "making or maintaining speculative loans." Further, the board threatened to "restrain the use of Federal Reserve credit facilities in aid of the growth of speculative credit." Taken at face value, this statement would mean refusal of loans for speculative purposes, plus a rise in the rediscount rate, which in turn would mean a stockmarket afflicted with scarce money and falling prices.

Coincident with the Reserve Board's statement came the announcement that the Bank of England had raised its rediscount rate from 4 1/2% to 5 1/2%. With the New York rate at 5% the effect of this change will be to decrease the flow of gold from England to the U. S.

The combined bearish effect of the Federal Reserve statement and the English rediscount raise was immediately observable. Market quotations sprouted a universal crop of minus signs. In a day's trading General Electric was-off 12 1/2 points, Westinghouse 10 5/8, Case Threshing 10 1/2, International Harvester 6 3/8, U. S. Steel 6 1/4. An average of 100 representative stocks declined 3.26 points. The Exchange closed Saturday, allegedly as the result of an influenza epidemic whose peak had long since passed. Stocks reopened on Monday comparatively strong, however, showing a distinct recovery from their first disorderly retreat. Having had time for reflection, traders had apparently decided that sticks and stones would break their bones, but words would hurt them never.

Federal Reserve Power. Speculators have long since realized that Federal Reserve authorities disapprove of their activities. The important question lies in what steps the Federal Reserve can take to translate disapproval into the actual cutting off of credit. Discussions of the power of the Federal Reserve Board (as distinct from its opinions) is obscured by the popular conception of an all-powerful group of government appointees sitting in Washington and turning credit on and off like firemen playing a hose.

The Board is not the entire System. The twelve Federal Reserve banks and some 9.000 national and state banks that are members of the System have large and definite powers of their own. Stock in the 12 Federal Reserve banks belongs not to the government but to the member banks. Most of the money in the Federal Reserve banks belongs not to the U. S. but to the member banks. The essential theory of the Federal Reserve System is that the member banks in each district get together, pool their resources and form a virtually inexhaustible reserve fund upon which all may freely draw. Therefore, although the Federal Reserve Board may frown upon the use of this reserve for speculative purposes, it cannot lose sight of the fact that the Federal Reserve banks are privately owned, are operating largely with private funds, and fundamentally exist for the sake of supplying money rather than withdrawing it.

Refusal of Loans. It is therefore very debatable whether any Federal Reserve bank would or could refuse a loan to a member in good standing. Says W. Randolph Burgess, assistant Federal Reserve agent in New York writing of the Reserve System in 1927*: "A Reserve bank cannot tell from the nature of its loans what its money will be used for. . . . It is thus impossible for a Reserve bank to dictate how its credit shall be put to employment. . . . The specific use of credit is the business of the individual member and nonmember bank. . . . What the Reserve banks do primarily is to fix the price at which their funds may be purchased. ..."

Discount Rate. As for rediscount rates, here again it is the province of the twelve Reserve banks (not of the board) to initiate rate changes/-. Here the Reserve banks have a specific and unquestioned method of making it expensive to borrow money. But this method cannot be indiscriminately applied. In the first place, a high discount rate will attract money from foreign countries. More important, however, is the fact that the Reserve bank cannot make it harder for the speculator to borrow money without making it correspondingly harder for the businessman or the farmer to borrow money. A rise for one is a rise for all. If Wall Street pays dearly for money, so will Main Street.

The ideal rediscount rate is a rate that is high enough to discourage speculative borrowing and low enough to encourage industrial borrowing. The determination of such a rate is obviously a delicate matter involving many considerations other than bulls and bears alone. The New York rediscount rate has, however, been raised three times in the last year (though without any withering effect on the market), t was not raised following the Reserve Board's proclamation of last week.

Significance. It is possible that stock-market speculation has increased or will increase so far as to compel a radical revision of Federal Reserve policies and functions. Meanwhile, however, speculators were inclined to feel that the Reserve Board's big words were larger than any big stick it might produce, that it was perhaps talking chiefly for the not inconsiderable moral effect which its speech actually did have upon a nervous and inflated Exchange.

There remained also the possibility that the Reserve banks would either raise their rediscount rates or attempt to persuade member banks to call in New York call money.

*In THE RESERVE BANKS AND THE MONEY MARKET, Harper & Bros. (1927).

/-The rediscount rate is the rate at which a Federal Reserve bank discounts loans to member banks.