America's Money Machine

The Fulcrum and the Lever 147
immediate driving force back of much of this expansion, it was facilitated
by a progressive reduction in effective member bank requirements
for reserves. Thus member banks actually held (in 1931) about
$2.9 billion of reserves against $32 billion of net deposits. These reserves
were both the legal reserves which they held with the Federal
Reserve banks and cash which they held in their vaults. If the vault
cash requirements of national banks prior to 1914 had been retained
in the Federal Reserve Act, member banks would have been required
to hold about $4.4 billion instead of $2.9 billion. This means that, in
the aggregate, total reserve requirements were about 34 per cent less
in proportion to their deposits than they were before the Federal Reserve
Act was passed. "It is clear, consequently," said the Committee,
"that the largest expansion of member bank credit since 1914 has
been facilitated by a progressive diminution in reserve requirements
as well as by large imports of gold."
(4) As the reserves held by member banks against their deposit
liabilities are concentrated in the Federal Reserve banks, so these reserves
in turn constitute deposits with the Federal Reserve. banks.
Against these deposits, which are the prime reserves of the commercial
banks, the Federal Reserve banks were required to hold gold to
the extent of only 35 per cent. In other words, just as commercial
banks were enabled to expand their liabilities on the basis of small
amounts of cash, so the Federal Reserve banks were enabled to expand
their liabilities upon small amounts of gold. This was achieved
by permitting member banks to strengthen their reserves with the
Federal Reserve banks by borrowing upon the security of government
bonds and by the discounting of their commercial paper. If a bank
wished to expand its operations, and had not the cash for the minimum
reserve requirements it could, in effect, create a fictitious reserve
by borrowing the credit of the Federal Reserve bank. The only
limit was the legal restriction upon the Federal Reserve bank against
permitting its gold reserve to drop below the 35 per cent minimum
ratio to its deposit liabilities. Thus, if the average reserves held by the
commercial banks against their deposits were taken as 10 per cent,
and the gold reserves held by the System against these reserves.at 35
per cent, the actual gold held against the commercial deposits of the
System could be reduced to as low as 3.5 per cent.
(5) The final mechanism by which deposits could be inflated was that
of "open market operations" by the Federal Reserve banks themselves.