The regulations laid down by the board and the definitions made for eligibility of paper for rediscount have to conform with Section 13 of the Federal Reserve Act. In that act no express condition is made regarding the essential or non-essential charac ter of the transaction giving rise to a commercial paper which may be offered for discount, and the board is not required, and properly could not be expected, to adopt such a criterion of eligibility. That is a matter that should be determined locally by the mem ber bank, which knows the conditions and purpose of the loan. No part of the Federal Reserve Act requires the reserve banks to discount any particular paper or class of paper; the law is simply and entirely permissive. Section 4 of the act requires the direc tors of the reserve bank to administer its affairs "fairly and im partially and without discrimination in favor of or against any member bank," and, subject to the provisions of the law and the orders of the Federal Reserve Board, to extend "to each member bank such discounts, advancements and accommodations as may be safely and reasonably made with due regard for the claims and demands of other member banks." Thus, according to Section 4, the directors of the reserve banks have the power to limit the volume and character of loans which in their judgment may be safely and reasonably made to any member bank. Nevertheless the Federal Reserve Board has taken the position that, while the reserve banks may properly undertake in their transactions with the member banks to dis criminate between essential and non-essential loans, such dis crimination might much better be made at the source by the members themselves. In other words, the board does not assume the whole responsibility of stemming inflation, but relies upon the co-operation of the reserve and member banks.
Safety of Federal Reserve Notes The federal reserve notes also seem as safe as they can be made. They are direct obligations of the United States govern ment, which retains a first lien on all the assets of the federal reserve bank, to protect the federal reserve notes and federal reserve bank notes. The bank is required to maintain a reserve of 4o per cent in gold, and to pledge commercial paper for the remaining 6o per cent, or so much of it as is not covered by gold. This paper, by definition of the board, is restricted to the very best forms of commercial paper, resting upon actual commercial transactions, running for short terms, and bearing two names. These facts, in conjunction with the limitations on inflation, seem to make the federal reserve notes as safe as the credit of the government plus the credit of the business world. The advances based on United States securities, it may be remarked, make the element of government credit still more important in the safety of the notes.
Elasticity of Federal Reserve Notes The intention of the system was to provide an elastic currency, which would provide not only for emergencies but also for the seasonal variations in the demand for money. The system seems altogether capable of doing both. It was not inaugurated in time to meet the emergency in 1914, and since that date no emergencies have occurred to really test it, although the giant operations in financing the war would have proved real emergencies under the old national bank system. The unused potential loaning power of
the federal reserve banks is 2.5 times their surplus gold reserves; but even this does not represent their full potentiality, for the federal reserve banks may loan more than 2.5 times their gold reserves, provided they pay taxes on the deficiency of reserves, and in great emergencies the Federal Reserve Board may suspend all reserve requirements. The real limitation consists, therefore, not in the scarcity of gold reserves, but in the scarcity of paper eligible for rediscount and for hypothecation for notes. The dearth of double-name paper is due to the American system of business with its single-name paper, open book accounts and cash discounts and to the want of a system of bankers' acceptances. Spirited efforts are being made to develop a trade acceptance system, a bankers' acceptance system, and a discount market. In order to facilitate war finance there was developed the plan of member banks selling securities to the federal reserve banks with agreements to repurchase, and the plan of member banks borrow ing from the federal reserve banks on the basis of their notes accompanied by government securities as collateral. By these devices the federal reserve system has attained great capacity to meet emergencies. In practice the member bank in any payments of rediscounts, loans, or collections made to it. largely takes deposit credit at the federal reserve banks, rather than reserve notes, but this is a matter of arrangement between the two banks and is based on convenience.
The Federal Reserve Act planned to effect elasticity of note issue by ready issue of federal reserve notes in payment of re discounted commercial paper, and by the contraction of the issue as this paper matured. If business should increase in a com munity, the loans and discounts of the member bank would increase until its reserve fell to the required minimum; to enlarge its credit reserve with the federal reserve bank and to get quanti ties of federal reserve notes to pay out over its counter, the mem ber bank would rediscount some of its discounted commercial paper to the federal reserve bank. To procure these notes, the federal reserve bank would pledge rediscounted paper with the federal reserve agent. The volume of federal reserve notes issued would, therefore, be determined by the business needs of the federal reserve district. Member banks could not use these notes as reserve, but they could pay them out over their counters, or send them to the federal reserve banks or to the United States Treasury for redemption. The federal reserve bank receiving the note of another reserve bank would be required to send on the note for redemption or credit, and would not be permitted to pay it out over the counter under penalty of a ro per cent per annum tax. When the pledged paper became due it presumably would be covered with federal reserve notes or gold. Federal reserve notes worn out or mutilated would also be sent to the Treasury for redemption. By these devices it was thought that the reserve notes would fluctuate in volume with the business needs of the country.