In addition, the federal reserve authorities have taken the view that so long as the reserves of the system as a whole are sufficient, it matters little what the condition of any one of the twelve banks may be, for the Federal Reserve Board has author ity to cause any one of the reserve banks to rediscount paper for another, and in this way reserve balances can be shifted at will. The reserve banks may also borrow from one another to "adjust" their reserves. From these operations two technical expressions have arisen: "unadjusted reserves, " signifying the reserves which the banks would actually have if they had not borrowed from the other banks, and "adjusted reserves," signifying the reserves after the money borrowed has been added or money loaned has been subtracted. There are arguments both for and against this interpretation of the law. On the one hand, it certainly gives the system more elasticity and unity and possibly makes it more serviceable in emergencies, and there is no doubt that such meth od of "adjusting" reserves is within the rights of the banks. On the other hand, if the limitations of the law were applied to the banks as individual institutions, more conservative banking would probably be the result.
Another device for obviating deficiencies of reserves has been the substitution of legal tenders for gold. According to the law the legal tenders can be used as reserves only against deposits, and against the notes a gold reserve is required. In recent years legal tenders have constituted a larger proportion of the total reserves of the federal reserve system against its deposits. The substitution of legal tenders for gold in the reserves increases the "free gold" and encourages further expansion. So long as the legal tenders are acceptable freely at par, they will serve as re serve quite as well as gold; but a certain risk is thereby incurred, and such use is a pyramiding of credits. Besides it is a fair sur mise that the framers of the Federal Reserve Act intended that the reserves against deposits should also be gold, no less than was the case with reserves against notes.
Another factor that affects the reserve ratio is the deposit of gold, legal tenders, and silver by the Treasury. By making such deposits the Treasury might in an emergency relieve the banks from deficiencies of reserves. At any rate it is well, in reading the weekly statements of the federal reserve banks, to observe to what degree the increase of reserves arose from this source and to what degree the banks actually contracted their liabilities.
Movement of Reserve Ratio The movement of the reserve ratio of a banking system does not necessarily serve in all cases as a true index of strength. • The ratio may increase as the result of an increase in cash reserve even though the holdings of paper may be non-liquid, or the ratio may decline as the result of the liquidation of credit at a time when the portfolio is in a satisfactory state and when the reserve is sufficient to meet all probable demands of depositors and noteholders. In other words, in estimating the reserve strength the character of the secondary reserve should be considered.
The history of the required and actual reserves is shown in Figure 7. The process by which the gold of the country was con
centrated in the federal reserve banks during 1917, 1918, and 1919 has been described earlier in this chapter. The tide of gold ship ments turned against our country during 1919 and 192o, and most of the net exports were taken from the reserve banks. Throughout the period of the war and into 1920 the liabilities of the federal reserve banks for notes and deposits increased quite steadily. Until May, 1919, the accumulation of gold more than supplied the amount of reserve required by law and the volume of excess reserves ("free gold, " as it is called) was only slowly diminished. The reserve ratio, however, declined meanwhile, but at a moderate rate. But after May, 1919, the conjunction of rising liabilities and declining reserves caused a rapid decline in the reserve ratio, until in February, 192o, the free gold was wiped out and an actual deficit temporarily existed. This served as a danger sign and the federal reserve authorities became more active in stopping expansion.
The expansion from September, 1917, to May, 1919, was almost entirely based upon "war paper." This term signifies notes of the member banks in favor of the federal reserve banks and accompanied with the collateral of Liberty bonds, Victory notes, or certificates of indebtedness, by which the member banks borrowed from the reserve banks. After May, 1919, war paper was contracted, and expansion came through bills discounted for member banks and purchased in the open market. The expan sion after the armistice was encouraged by the prevalence of rediscount' rates lower than market rates of money, so that it was profitable to use the federal reserve banks as a source of funds. (See "Discount Operations of the Federal Reserve Banks," Chapter XX.) Characteristics of Federal Reserve Notes The federal reserve notes are direct obligations of the United States, and are not, therefore, in the strict sense bank notes. They are receivable by all member banks and federal reserve banks, and for all taxes, customs, and other public dues, but they are not a legal tender in settlement of private debts. They are redeemable in gold at the United States Treasury, and in gold or lawful money at any federal reserve bank, and for this purpose each bank is required to carry with the Treasury a redemption fund of 5 per cent or more and to reimburse the Treasury in gold, gold certificates, or lawful money as the fund is depleted by redemptions. The expenses of redemption are charged to the federal reserve bank. The notes of each federal reserve bank bear a distinctive letter and serial number assigned to it by the board. Whenever federal reserve notes of one federal reserve bank are received by another federal reserve bank they must be promptly returned for credit or redemption to the issuing bank. No federal reserve bank may pay out notes issued through another, under penalty of a tax of ro per cent per annum on the face of the notes so paid out. The federal reserve notes together with the federal reserve bank notes constitute a first and paramount lien on all the assets of the issuing bank.