A History of the Federal Reserve, Volume 2 (45 page)

Patman annoyed the Board by proposing to retire $15 billion of the $25 billion in debt held in the System’s account in exchange for a noninterest-bearing Treasury note. The Board’s response stated that the proposal “would result in no constructive changes but, on the contrary, might have grave adverse effects on public confidence in the currency” (Board Minutes, February 10, 1960, letter, Martin to Spence). The Board reminded the Banking Committee that the System paid to the Treasury, monthly, all income above operating expenses plus statutory dividends paid to member banks and allocations to maintain surplus accounts equal to subscribed capital. The risk, the Board said, was that issuance of noninterest-bearing securities to the reserve banks would suggest that the government would be able to finance its expenditures by issuing such paper.
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During most of the 1950s, the System paid about 90 percent of its excess earnings to the Treasury under a rule adopted in 1947. The payment served in lieu of a franchise tax for the right to issue currency. Prodded from one side by Congressman Patman and other members to recognize that the reserve banks were, in effect, government institutions and from the other side by the Budget Bureau seeking additional revenue, particularly if it could be obtained while placating senior members of Congress, the System reconsidered its accounting rules.
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303. Preparation for the Korean War brought out many proposals. The Defense Production Act contained provisions for regulation of consumer and real estate credit. The System participated in measures to restore stability following an attack. These measures included back-up records and provisions for replacing leadership.

304. The argument seems to be that interest-bearing debt sold in the market to finance future expenditures would be replaced by non-interest-bearing debt, after purchase by the Federal Reserve. This argument presumes that what matters is the interest payment not the stock of debt. The consolidated balance sheet of the Federal Reserve and the Treasury would not have been altered, since the System’s debt holdings vanish in the consolidation. Patman’s effort was probably a roundabout way of reducing the System’s gross earnings and getting the Federal Reserve to request an annual appropriation from Congress, a proposal he made several times. The System’s defense of independence contrasts with its actions in 2008 and 2009.

305. Chairman Martin reminded the presidents and governors that members of Congress had raised questions about ownership, accounting structure and contingency reserves, and that the Budget Bureau’s staff had recommended for three years that the government should take all of the reserve banks’ accumulated surplus ($800 million) (Board Minutes, September 23, 1959, 21–22). Martin then discussed the possibility of action by Congress and the “serious concern among friends of the System in Congress” (ibid., 22).

Underlying the discussion of accounting lay a much older issue—the character of the System as a mixed public and private institution. The Banking Act of 1935 settled a main part of the struggle for power between the Board and the reserve banks by giving the Board the dominant role in policy. But the banks retained many of the features of private institutions, and these features irritated populist members. The quarrel over accounting was an effort to take another step away from President Wilson’s mixed private-public compromise.

In its early years, from 1918 to 1932, the reserve banks paid all net earnings into their surplus accounts until the fund reached 100 percent of a bank’s subscribed capital. Thereafter, the banks paid a franchise tax equal to 90 percent of net earnings after dividends. A 1947 decision by the Board levied an interest charge for currency outstanding in excess of gold certificates that it paid to the Treasury. The 1952 Patman Committee questioned the size of the reserve banks’ surplus, and Patman frequently questioned Chairman Martin about the reasons for holding more than $850 million as surplus reserves (in 1959). This was more than twice the banks’ paid-in capital.
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The governors felt vulnerable because, in addition to the large surplus, the reserve banks had allocated more than $100 million as “reserves for contingencies” and more than $60 million additional as allowance for depreciation of buildings and capital assets (Board Minutes, July 15, 1959, 3). The principal rationale was that the banks followed accounting rules similar to the rules followed by private banks, but the Board did not choose to use that argument or to reopen the public-private status of the reserve banks.
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Even the reserve bank presidents agreed that they could dispense with some of the contingency reserves and pay the past accumulation back to the Treasury.

The Board voted unanimously to pay the accumulated reserves to the Treasury and to discontinue the practice of holding contingency reserves. Over the objection of Governor Mills, it agreed to limit the reserve banks’ accumulated surplus to twice the amount of paid-in capital, to pay the Treasury the excess accumulated over 200 percent of paid-in capital, and to pay the Treasury 100 percent of earnings (after expenses and dividends)
once the capital account reached the 200 percent ceiling.
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These decisions increased the Board’s 1959 payment to the Treasury by $261 million, approximately 40 percent more than its scheduled payment of $643 million (Board Minutes, December 23, 1959, 5). Expressed as an interest rate on $26 billion of debt held by the System, the rate paid as a refund rose from 2.5 to 3.5 percent. The Board did not decide to change its depreciation policy or to stop recording depreciation. Mills objected because

306. Between 1947 and 1959 the combined surplus had doubled in nominal value but increased only from 235 percent to 239 percent of paid-in capital. This suggests the dominant role of congressional pressure in forcing the change discussed in the text (Board Minutes, July 15, 1959, letter, Martin to presidents).

307. The Board asked its outside auditor, Price Waterhouse, for an opinion. The auditor expressed doubt about the need for contingency reserves or depreciation by a public entity. It did not express an opinion about the size of the accumulated surplus but was not concerned by the prospect of negative values (Board Minutes, December 17, 1959, 2–3, 9).

acceptance of the proposal would in effect proclaim that the Federal Reserve banks are no longer the mixed type of private and public corporation that was contemplated by the Federal Reserve Act but, instead, are to be integral and direct appendages of the Federal Government. . . .

[I]t is essential that the Federal Reserve banks represent a corporate financial structure . . . which cannot be done if additions to their accounts from earnings are limited in the manner proposed. (Board Minutes, December 18, 1959, 20)

The minutes contain other less detailed statements pointing to complaints by Congress and the Board’s desire to avoid the criticism.
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Under the new rules, as under the old, each reserve bank’s monthly payment to the Treasury was a charge for issuing Federal Reserve notes based on the daily average of its outstanding Federal Reserve notes not covered by gold certificates pledged as collateral. The interest rate differed between banks and over time because earnings and note issue differed.
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The System’s concession on interest payments did not remove the issue. Congressman Patman continued to press for legislation to remove 60 percent of the System’s interest-bearing debt. The issue became less pressing, however, as members of Congress recognized that the Federal Reserve now returned most of the interest it received.

Congressman Patman used the opportunity presented by the proposed Financial Institutions Act of 1957 to request data and responses to ques
tions about System operations, particularly dealer market operations and fiscal agency operations that the New York bank performed for the Treasury. One result of his inquiries was that the System limited the use of repurchase agreements to New York. The dealer market was located there, and New York had always done the repurchase agreements.

308. Governor Robertson joined Mills in opposing payment of accumulated surplus in excess of the limit.

309. For example, Vice Chairman Balderston argued that the reserve banks should not accumulate surpluses “that could not be satisfactorily explained to Congress or in other quarters” (Board Minutes, December 18, 1959, 15).

310. The formula for computing the interest rate had as its numerator the net earnings of the reserve bank after dividends and adjustments to keep its surplus at 200 percent of paid-in capital (100 percent of subscribed capital) and as its denominator the average daily amount of notes outstanding net of gold certificates (Board Minutes, February 1, 1960, letter, Sherman to presidents). To supply notes, each reserve bank submitted a request (by denomination) to the Bureau of Printing and Engraving. The notes were shipped to the reserve bank on demand. When small notes were destroyed, no effort was made to record the district that issued the notes, but large denominations were recorded by district when destroyed.

Hayes and the New Yor
k officers objected to a provision of the act that the Board supported. It made the bank’s fiscal agency operations for the government subject to the supervision and regulation of the Board of Governors. Hayes objected that the proposed regulation would “introduce a lot extra ‘red tape’ into a series of activities which are in an operating area, or at most an advisory area, rather than consisting of policymaking” (letter, Alfred Hayes to William McC. Martin, Board Records, February 18, 1957).

The
Interest
Ceiling

In 1918, Congress set a 4.25 percent interest rate ceiling under the Second Liberty Loan Act for Treasury bonds with five or more years to maturity. Intended as a way of holding down the cost of servicing WWI debt, the restriction remained after the war. It was rarely binding until the late 1950s. In 1959 and 1960, the Treasury asked Congress to remove the ceiling so that it could issue long-term bonds and extend the average maturity of the outstanding debt. The Federal Reserve supported the Treasury’s request.

Congress did not act. Some members, notably Senator Douglas and Congressmen Patman and Reuss, blamed the Federal Reserve’s bills-only policy for the increase in long-term interest rates.
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To get the Federal Reserve to give up bills-only, they tied the two issues together in a senseof-Congress resolution lifting the interest rate ceiling for two years and requiring the Federal Reserve to purchase securities of varying maturities, if it increased the money supply during those years. The Treasury, at first, accepted the resolution, but it withdrew its endorsement after hearing the Federal Reserve’s remonstrances (Joint Economic Committee, 1959, Hearings 6A, 113–19). The Federal Reserve offered two principal reasons for opposing the part of the resolution treating monetary policy. First, Martin argued that any congressional resolution affecting monetary policy should be offered as an amendment to the Federal Reserve Act, not as an afterthought on a measure before the Ways and Means Commit
tee. The rationale was knowledge, not just jurisdiction. Second, “many thoughtful people, both at home and abroad, . . . [will] question the will of our Government to manage its financial affairs without recourse to the printing press” (ibid., 1288). The second argument annoyed the resolution’s author, Congressman Henry Reuss (Wisconsin), who criticized it as metaphysical. Martin held to his position, citing problems of confidence and fear of inflation.

311. John Kareken, a professor at the University of Minnesota on leave at the Joint Economic Committee, gave the standard view: “The bills-only doctrine of the Federal Reserve System . . . is one of the contributory causes for the present high level of interest rates but this is mostly crying about spilt milk. Abandonment of bills-only now would nevertheless help in the future” (Joint Economic Committee, 1959, Hearing Part 6A, 125). See also Barger (1964, chapter 7). The memo does not distinguish between real and nominal rates.

Although no member of the committee mentioned it, the 4.25 percent rate ceiling restricted the Treasury’s ability to undo any effect of bills-only on the outstanding stock of debt and relevant interest rates. By selling long-term bonds and retiring bills or short-term debt, the Treasury could alter the maturity distribution of debt and remove the effect of bills-only. The 4.25 percent ceiling also prevented the debt lengthening to which the Eisenhower administration had committed.
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In fact, average maturity fell almost two years, to four years and four months, between the Accord and 1960. During approximately the same period, the amount of debt ninetyone days and under held by the Federal Reserve rose $4.3 billion. The entire System account rose $4.5 billion. Treasury debt held by the public (including the Federal Reserve) increased $22 billion; without the ceiling rate, additional sales of long-term debt would certainly have been feasible (Board of Governors, 1976, 488–90; Office of Management and Budget, 1990, 144).

In a letter to Senator Harry Byrd (Virginia), the System called attention to a main problem for monetary policy posed by the falling debt maturity. With reduced average maturity, the Treasury had to refinance debt more frequently. Given its even keel policy, frequent refundings (and new issues) restricted Federal Reserve operations to a small part of the year. The problem with this argument was that if the Treasury auctioned its bonds, as the Joint Economic Committee’s staff proposed, even keel support would not have been needed. The market would price the bonds at the auction instead of the Treasury announcing a price that the Federal Reserve felt itself obligated to support (Joint Economic Committee, 1959, Part 6A, 1257–58). Martin’s concern foresaw the problem that arose in the 1960s. Even keel policy of supporting Treasury issues could create “pressures on the Federal Reserve to supply bank reserves in excess of those consistent with the promotion of economic growth and stability” (Board Minutes, March 3, 1960, letter, Martin to Byrd).
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In April 1960, the Treasury was
able, at last, to offer a 4.5 percent bond callable in fifteen years. This was the highest coupon since the 1918 act.

312. Milton Friedman made the point about bills-only in Joint Economic Committee (1959, Part 9A, 3045).

313. The letter to Senator Byrd also responded to the argument that keeping the debt in short-term securities reduced interest cost. The Board rejected this argument, citing experi
ence that year, when the Treasury paid more than 5 percent to borrow. The Clinton administration reopened the issue.