America's Money Machine

The Wounds of War 119
research, in an article in the Political Science Quarterly, 1 Willis made an
appraisal of the new banking· system.
The first notable defect of the System of which he makes mention was
that of the ineffectuality of the rediscount rate. It had been Paul Warburg's
theory, as we have noted, that changes in the System's rediscount
rate would be the principal moderating influence upon the general interest
rate structure of the economy, since the central bank's lending rate
was in effect the ultimate, or marginal, cost of money to which all other
rates would be related. This was the famous theory first popularized by
Walter Bagehot, in his Lombard Street, a classic first published in 1873, that
had already gone through thirteen editions by 1913 when Federal Reserve
legislation was being debated. Bagehot had demonstrated to the
delight and fascination of bankers how a central bank, by manipulating
its lending rate, could stimulate or retard the state ofbusiness, the movement
of merchandise in trade and of gold in and out of the country, all
mainly by making the price of money cheaper or more costly, and conversely
the price of goods more costly or cheaper. It is an ingenious
theory, supported by a vast amount of data from British experience, in
which central banking authorities still put faith and on which hang most
of their operations to this day, despite the testimony of Willis and the
tragic experience of the 1929 stock market crash, as well as numerous
later evidences to the contrary.
"The outstanding fact," Willis wrote, "is that there has been no time
when the System could be said to be really the leader of the market, or
be able to make its discount rate 'effective' for any considerable period."
During the first two years of the System's operations, Willis explained,
the banks of the country were too well provided with funds and too little
inclined to resort to the Reserve banks for accommodation to permit the
discount rates of the latter to be of serious importance. This was due in
part to the expansion of the note issue at the outbreak of the war, under
the emergency note provision of the Aldrich-Vreeland Act. It was also
due to the lowering of the cash reserve requirements for national banks
which the Federal Reserve Act authorized. The effect of this "release of
reserves," Willis pointed out, was to place in the hands ofthe banks a very
large lending power which they were able to use in expanding their
operations. The banks were not slow to take advantage ofthis power and
did increase their lending, and with this broader power of operation it
was not necessary for them to do any rediscounting. Some of this slack
was taken up shortly before the United States entered the war, and some
observers thought that for a few months, early in 1917, the System was