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THE FEDERAL RESERVE SYSTEM

ITS ORIGIN AND GROWTH

Reflections and Recollections
BY

PAUL M. WARBURG

In Two Volumes VOLUME ONE

NEW YORK

THE MACMILLAN COMPANY
1930

COPYRIGHT,

1930,

BY THE MACMILLAN COMPANY Published April, 1930. Reprinted June, 1930. All rights reserved—no part of this book may be reproduced in any form without permission in writing from the publisher.

SET UP AND ELECTROTYPED BY THE LANCASTER PRESS, INC. •PRINTED IN THE UNITED STATES OF AMERICA*

TO THE GUARDIANS
OF THE

FEDERAL RESERVE SYSTEM
PAST, PRESENT, AND FUTURE THIS BOOK IS DEDICATED

ADDENDUM

II

THE STOCK EXCHANGE CRISIS OF 1929

R

EVIEWING the Federal Reserve System's record from the second half of 1927 to October-November of 1929, the period of the phenomenal rise and the catastrophic collapse of the structure of brokers' loans and prices of shares on the New York Stock Exchange, future historians are likely to point to two outstanding facts: One, the impressive demonstration of the System's structural strength and, Two, the inadequacy of its form of administration. Unlike the panic of 1907, the convulsion of 1929 did not shake the people's confidence in our banking and currency system. Indeed, where in 1907 the stock exchanges were closed and stock-exchange loans became frozen, where hoarding brought gold to a premium and bank payments were suspended, New York banks in October, 1929, boldly took over some two billion dollars in loans made by out-of-town banks and "other" lenders, domestic and foreign, who had persisted in piling their funds upon the New York Stock Exchange and now had become frightened. It was due to the courageous action of a group of New York banks and of able leaders that the stock-exchange panic was ultimately brought to a halt. But the desperate fight to avert a further spread of the disaster could never have been hazarded and won had it not been for the country's unbounded confidence in the unequalled strength of the Federal Reserve System and the availability of its vast resources to the country's banks. In the face of a sudden and unparalleled shrinkage of stock-exchange values, cutting in half the brokers' loan structure of over eight billion dollars
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THE FEDERAL RESERVE SYSTEM

within the short span of a few weeks,1 bank credit remained unshaken, because it rested on the rock foundation of the Federal Reserve System. Yet, while the fire fighters ultimately managed to check the conflagration, they did not succeed in their efforts until appalling losses of property (and lives) had been suffered throughout the country. Why was it necessary, the historian will ask, for our financial authorities to stand by so long while unheard-of quantities of inflammable material were massed in an unsafe structure, and while cool observers had been warning the public of the threatening, indeed, inevitable catastrophe? That is the only phase of the question which interests us and which we wish to explore here, not with the object of praising or blaming individuals, but for the purpose of ascertaining how far the present form of administration of the Federal Reserve System and its background may be held to have been responsible for its inability to forestall so disastrous a disturbance. It is important to examine the evidence before attempting to judge the case, and in order to enable the reader to grasp the picture, at least in its rough outlines, some graphs have been prepared, which are here submitted for his examination. It will be remembered that in the second half of 1927, under a daring, but carefully devised, plan, the Federal Reserve System, by reducing its discount rates to 31/2per cent and by purchasing government securities on a large scale, had embarked upon a policy of easing money in the United States with a view to aiding European countries, particularly Great Britain, in their efforts to establish or reestablish their gold standards. This plan was entirely justified, not only as a duty towards our neighbors, but as a matter of self-interest— provided the System was prepared boldly to reverse this policy
According to calculations of the New York Stock Exchange the aggregate value of securities listed on the Exchange declined between the end of September and the end of November from 87,074 to 63,589 million dollars, or 27 per cent, while the amount of brokers' loans declined during the same period from 8,549 to 4,016 million dollars, or 53 per cent.
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THE STOCK EXCHANGE CRISIS OF 1929

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THE FEDERAL RESERVE SYSTEM

as soon as it might become evident that excessive ease of money was exercising an inflationary effect, or that it was over-stimulating speculation. Unmistakable symptoms of such adverse effects became evident at the end of 1927. As a

consequence the Federal Reserve System did reverse its policy, and in the first months of 1928 began to resell its holdings of government bonds recently acquired. Unfortunately, however, this policy was not carried through with sufficient vigor and persistency, largely because of the fear on the part of representatives of industry and trade that further sales and the resultant hardening of money rates might "hurt business."

THE STOCK EXCHANGE CRISIS OF 1929

505

From then on, until the final collapse occurred, the charts record with brief interruptions a continuous rise in the prices of stocks and an unprecedented growth in stock-exchange loans.1 The Federal Reserve System's policy in the two years under review may be characterized as the resultant of two contending motives: on the one hand, the desire to see the orgy of speculation brought to a close, and on the other, the fear of coming to close grips with it, lest "business be hurt," or the System be charged with interfering with stock-exchange activities which, it was claimed, did not by the terms of the Federal Reserve Act come under the direct supervision or control of the Federal Reserve Board. It is true that three increases of discount rates (from 31/2per cent to 4 per cent, 41/2per cent, and 5 per cent) were successively granted in 1928.2 But these increases came hesitatingly and by mild degrees and generally post festum (see Chart " B " ) , and when they came, what little psychological effect they otherwise might have had, was frequently weakened by statements, simultaneously given out by men in high political positions, that stock-exchange loans were not unduly high, or that money would remain easy, or that business conditions were excellent and that there was no cause for apprehension. It is small wonder that in these circumstances increases in discount rates were practically without effect in dampening the exuberant spirit of unleashed
Graph "A," showing total investments of all Federal reserve banks, demonstrates the inadequate liquidation of the System's holdings of United States Government bonds in January and February, 1928. It will be seen that, normally, the reserve banks hold the lowest aggregate of investments in these months, and this lowest point offers the basis, as it were, for the year's coming operations. The low point in 1928 will be found some $200,000,000 above the low point in 1927. From chart " C " it will readily be seen how the lines indicating the rise in stock-exchange loans and in stock prices find their starting point at the end of 1927. 2 It will be remembered that the Bank of England as a rule advances its rate by a full per cent.
1

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speculation, which had gripped all classes in all parts of the country. After discount rates had been raised to 5 per cent in July, 1928, the Board until August 9th, 1929 refused to approve any further increases requested by Federal reserve banks. It is true that on February 7th, 1929 the Board published a strong statement in which it warned the people of the dangers involved in the undue absorption of the country's credit supply in speculative uses and in which it indicated its determination to suppress any such excessive absorption of credit, a goal which it thought it could attain without a further increase in discount rates. This warning had only a temporary effect. Stock-exchange prices soon continued their upward trend and the brokers' loan structure went on rising from week to week. The Federal Reserve System in this period showed the most anomalous rate structure ever devised by any powerful central bank (see chart " B " ) . 1 On April 2nd, 1929, the Board issued a second warning which, like its first statement, had only a temporary effect in arresting the upward movement of stock-exchange loans.
1 When prime commercial 90-day paper was selling at 6 per cent to 6 1/4 per cent; when the government borrowed for short periods at 51/8per cent taxfree (being the equivalent of about 5.85 per cent as compared with taxable commercial paper); when rates for call money varied from 7 to 25 per cent and those for time money from 71/2to 91/2per cent; and, finally, when bankers' acceptances were selling at51/2per cent, a bank rate of 5 per cent was beyond all understanding. It meant that the reserve banks were buying in the open market the finest quality of paper at a rate of 51/2per cent and above, while paper of lower quality handed in by the same seller at the rediscount window would have to be taken by the reserve banks at 5 per cent, indeed, in some districts even at 41/2per cent! It was not surprising that in the face of the high price which money commanded all over the country more than a billion dollars of paper was rediscounted with the reserve banks at these tempting rates. An examination of the chart showing the movements of the aggregate investments of the Federal reserve banks indicates that the total rediscounts hovered around the 500 million dollar line in 1925, 1926, and 1927, while from the middle of 1928 until the collapse of October, 1929, they are found around the one billion dollar line.

THE STOCK EXCHANGE CRISIS OF 1929

507

These loans, from the middle of 1927, had then risen by approximately21/2billion dollars. On May 21st, 1929, the Advisory Council submitted to the Board a definite recommendation to increase the prevailing discount rates to 6 per cent. The Board published this resolution (quite against its custom), but remained adamant in its opposition to the demand of Federal reserve banks to move their discount rate above 5 per cent. In May, 1929, several bad breaks occurred in the stock market. On May 27th, particularly, the stock exchange suffered a severe sinking spell which, for a while, created grave apprehension that frantic liquidation might degenerate into a panicky stampede. This danger was arrested by the prompt intercession of New York banks. This was wise in so far as it was obviously desirable to keep the selling movement within the bounds of orderly liquidation. If, however, this support had been given less ostentatiously, and if, instead of giving new courage to the "bulls," a concerted effort had then been made to encourage a quiet but persistent liquidation, the country's interests would have been far better served. As it was, the market had shown unmistakable symptoms of its intrinsic weakness; it had demonstrated to experienced observers that stocks had advanced far beyond a price level at which they might readily be absorbed by conservative investors, and that any concerted attempt to unload some 10 billion dollars in securities carried by brokers' and bank loans might precipitate violent declines with catastrophic consequences. Nevertheless, on this shaky foundation the tottering brokers' loan structure was permitted to rise by another billion dollars, while numberless investment trusts—daring in plan and scope and operating to produce a further pyramiding of prices —were floated almost from day to day and stock quotations soared to new fantastic levels. The Board, in these fateful months, sat still. Finally, on August 9th, 1929—in the author's opinion at least half a year, if not a year, too late—it permitted the New York Reserve

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THE FEDERAL RESERVE SYSTEM

Bank to raise its rate to 6 per cent, which raise was accompanied, however, by a simultaneous decrease in the Federal Reserve System's open market rates. Moreover, the 5 per cent rate remained in force in all other districts. This belated increase, which at best brought the New York rediscount rate into a more reasonable relation to actually prevailing market rates, exercised only temporarily a sobering effect upon the frenzied minds of those wedded to the gospel of investing and speculating in inflated stocks. Spokesmen for that school of thought by that time had become openly defiant. Financial leaders, prominent economists, and men in high political positions had become convinced that a "new era" had arrived, that hopes and expectations of future accomplishments were to be accepted as the test in determining stock values, rather than actual earnings and records of the past, and that those who claimed that some twelve billion dollars in undigested securities constituted an element of danger did not realize that this gigantic amount represented only a safe and reasonable percentage of the new (inflated) value of our securities. The disciples of the gospel of the "new era" were frankly resentful of the "meddling of eight men at Washington" and saw in the Federal Reserve Board's power of interference a danger which a change in the law, if necessary, should eliminate. Views directly opposite were held by the conservatives among bankers, business men, and government officials. They sided with the Board's views—bravely expressed in the beginning, but now strangely inarticulate—that the towering loan pyramid on the stock exchange constituted an element of grave danger; but they were disheartened and alarmed at the Board's apparent unwillingness or inability to bring this ominous run-away movement to a halt. The Board thus found itself subjected to a cross fire from two opposing camps, one blaming it for meddling too much, the other for not meddling enough. To cool observers it was

THE STOCK EXCHANGE CRISIS OF 1929

509

clear beyond doubt, first, that the Board's attempt to bring about a loan contraction without adequately increasing rediscount rates had proved an impracticable and wasteful experiment, and second, that unless a more effective course were pursued the country was headed for a most serious catastrophe. What my own thoughts and apprehensions were in the matter I laid down in a statement published March 7th, 1929, a reprint of which will be found as Appendix ThirtySeven. This statement is referred to, not for the doubtful satisfaction of seeing one's views vindicated, but in order to show that it was entirely possible, indeed easy enough, at that time to foresee what inevitably had to occur unless we promptly mended our ways. In the spring of 1929, it had become apparent that increases in discount rates alone—unless undertaken with a vigor which the Board, unfortunately, could not be expected to display— would not prove strong enough weapons with which to conquer an enemy, who by that time had lost all respect for the authority and power of the Board. Yet, it was still possible to bring the mad fling to a halt before the worst calamity had occurred. What after all was to be accomplished? The Board (and its backers) desired to arrest a further growth of the aggregate of "brokers' loans." The Board had attempted to bring this about by discouraging member banks from borrowing from the Federal reserve banks for the purpose of investing the proceeds in stock-exchange loans. But the New York banks were neither the heaviest borrowers of funds from the Federal reserve banks, nor were they the heaviest lenders, for their own account, of stock-exchange funds. The bulk, as is well known, came from out-of-town banks (able to borrow from their Federal reserve banks at 5 per cent or even 41/2per cent), from corporations, and from foreign lenders. This made it well-nigh impossible—as long as the low rate policy was continued—to attack the problem through the lenders of whom so important a group was entirely beyond

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THE FEDERAL RESERVE SYSTEM

the reach of the Federal Reserve System. It would have been possible, however, to control the situation if means could have been found to secure the cooperation of the borrowers. If the New York Clearing House Committee, acting under the auspices of the Federal Reserve System, had sent for a Stock Exchange Committee and, after explaining to them the dangers and needs of the situation, had invited them to ask every stock exchange firm within a given time to reduce its borrowings—whatever they might be—by a given small percentage of their aggregate loans, the top of the market would have been reached then and there, and liquidation would gradually have set in (if needs be demands for further reductions might have been made at a later stage). Nobody could have resisted the argument that unless the stock exchange reduced its loans by its own volition, the pressure of increased rediscount rates would ultimately have to be applied with subsequent increases in the discount rates of leading central banks in Europe. Higher money rates abroad, with distressing consequences for industry and trade in the countries affected, would result from such a course. Europe, it was clear, could not much longer stand the cruel perversion of our banking policy adopted in 1927 which, originally designed to encourage a free flow of long and short-term credit from the United States to foreign countries, was now draining the Old World of its working capital and its gold. Such conditions finally would have to lead to a slowing down of our business, which in turn would bring about a fall in the prices of our shares on the stock exchanges and, as a concomitant, a corresponding shrinkage of stock-exchange loans. In other words, worldwide distress and a slowing down of our own business would have to be conjured up in order to prevent our stock exchanges from draining the credit reservoirs on both sides of the Atlantic. 1 It could have been made clear that a better process
How completely world money markets had fallen under the control of our speculators is impressively shown by the fact that within six weeks after
1

THE STOCK EXCHANGE CRISIS OF 1929

511

would have been to avoid this circuitous and wasteful road and to aim straight for a contraction of loans which would carry with it an orderly liquidation on the stock exchanges without drastically affecting business in general either here or abroad. If the Federal Reserve System and the Clearing House banks had definitely agreed on the adoption of such a plan, the stock exchanges would have been forced to fall in line; for, no matter how large a volume of funds stock-exchange firms were receiving from "others," they would have realized that, in the final analysis, they were depending upon the strength and good will of the New York banks. A course as above described is not here discussed as an afterthought. A procedure along these lines was definitely urged in the first days of April, 1929. But while everybody seemed to agree on the desirability and practicability of such a plan, it proved impossible to carry it into effect. The Reserve System feared to expose itself to the charge of having gone beyond its lawful field of activity by dealing, even indirectly, with the stock exchanges, and the Clearing House banks, loath in any case to undertake so unpopular a step, did not see their way clear to hazard it at all as long as Federal reserve discount rates were not increased to 6 per cent. So long as the Federal reserve rates stood at 5 per cent, and below, they feared, and justly so, that enforced reductions of loans in brokers' offices would only result in driving the customers into
the October crash on the New York Stock Exchange fifteen reductions of official discount rates were undertaken by eleven European central banks, viz. Bank of England, from 6 1/2 to 6 per cent (October 31), to 51/2per cent (November 21), and to 5 per cent (December 12); Reichsbank, from 71/2to 7 per cent (November 2); Bank of Netherlands, from 51/2to 5 per cent (November 1) and to41/2per cent (November 15); Bank of Belgium, from 5 to 41/2per cent (November 13); Swedish Riksbank, from 5 1/2 to 5 per cent (December 13); Norges Bank, from 6 to 51/2per cent (November 21); Austrian National Bank, from 8 to 71/2per cent (December 9); Hungarian National Bank from 8 to 71/2per cent (November 4); Bank of Danzig, from 7 to61/2per cent (November 2) and to 6 per cent (November 21); Bank of Poland from 9 to 8 1/2 per cent (November 14); Bank of Rumania, from 91/2to 9 per cent (November 25).

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the banks and thus create a highly embarrassing, indeed an impossible, situation. With the Board unwilling at that time to permit the increase, to which four months later it agreed, it is not surprising that the proposal fell through. A glance at the graphs will convincingly demonstrate that, while stock prices and the pyramid of brokers' loans had already reached dizzy heights in the first quarter of 1929, they still were much lower than in the fall of that year. One may readily perceive how much smaller the ultimate shrinkage and losses would have been if liquidation had been brought about at that time. This brief sketch of the conditions which led to the stockexchange panic of 1929 and of the Federal Reserve System's inability to forestall the final disaster or, at least, to prevent it from assuming its overwhelming magnitude, has been prepared for the sole purpose of illustrating once more the imperative need for the adoption of some such measures as have been outlined in Chapter X I I for the strengthening of the System's methods of administration. There is no desire to fasten blame on any individual who took part in fashioning the System's policies in this trying period. No doubt, everybody concerned acted to the best of his knowledge and ability, and the keener his realization of the gravity of his responsibilities, the greater, of course, was the persistency with which he held to his own views. The fact remains, however, that in the face of a most critical situation—possibly the gravest with which the Federal Reserve System has ever been confronted—we find a Federal Reserve Board widely divided within itself and unable to agree upon a definite and effective plan. We find this Board, as rumor has it, at variance with leading Federal reserve banks and, against the advice of the Advisory Council, blocking timely rate increases urged by the Federal reserve banks most concerned. I t is easy to see how differently a composite Board, as recommended in Chapter X I I , would have acted. Instead of deadlocks, there would have been unity of action,

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513

and whatever such action might have been it would have commanded confidence and respect. The writer is profoundly convinced that with a different constitution of the Board, the ominous stock-exchange debauch would have been arrested long before it reached its colossal dimensions. In fairness it must be admitted, however, that any Board —no matter what its constitution—would have found it a Herculean, if not an impossible, task to perform its functions wisely and efficiently in circumstances such as surround it at present. In a country whose idol is prosperity, any attempt to tamper with conditions in which easy profits are made and people are happy, is strongly resented. It is a desperately unpopular undertaking to dare to sound a discordant note of warning in an atmosphere of cheer, even though one might be able to forecast with certainty that the ice, on which the mad dance was going on, was bound to break. Even if one succeeded in driving the frolicking crowd ashore before the ice cracked, there would have been protests that the cover was strong enough and that no disaster would have occurred if only the situation had been left alone. The Board, much to its credit, had the courage to warn the country, but it stayed its hand when it should have driven the people ashore before the ice broke. It hesitated to sacrifice what appeared to the country to be actual prosperity to what might have seemed to the people a problematical disaster. Hence the Board's unwillingness to increase rates beyond 5 per cent; its unwillingness " t o hurt business," even though generally prevailing rates had long reached, or surpassed, the level of a 6 per cent bank rate, and even though it was plainly to be foreseen that, if rates were not increased, business in the end might have to suffer a severe setback, while with quick and determined increases, incisive enough to bring about liquidation, the period of high money rates would probably be so brief that business might hardly be affected by it. It was a trying position for the Board, one

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which called for clear vision, cool heads, and a courageous disregard of all personal and political considerations. But while facing these difficulties the Board found itself harassed by a cross fire from members of Congress. As in the Chicago case, discussed in the preceding chapter, the views pressed upon the Board by these men were diametrically opposed to one another. Each side, however, threatened "legislation'' in case its views were disregarded. The chairman of the House Banking and Currency Committee expressed himself as out of sympathy with the Board's interference with stock-exchange loans, and seemed to advocate the admission to the Federal reserve bank portfolios of paper liberally secured by stock-exchange collateral, while ex-Senator Owen, one of the "framers of the Act," appeared as counsel in a suit to restrain the Federal Reserve Bank of New York from its allegedly "illegal conduct"—"in restricting the supply of credit available for investment purposes" and "from arbitrarily and unreasonably raising the discount rate"—"for the purpose and with the effect of raising interest rates generally and call-money rates on the New York Stock Exchange in particular." Senator Glass, on the other hand, reproached the Board for not having acted energetically enough in fighting the stock-exchange debauch, but, unfortunately, went to the extreme of branding as unlawful the rediscount with Federal reserve banks of eligible paper where the proceeds, after having become intermingled with the funds of the borrowing member banks, were invested in stock-exchange loans. 1
In the latter contention it is impossible to follow Senator Glass. The Federal reserve banks must closely scrutinize the paper a member bank offers for rediscount and must not accept any bills except such as have proved eligible. Once it has rediscounted the bills, the member bank must be left free, however, to keep its proceeds as a balance with the Federal reserve bank, to send them abroad, or to do anything with them that the member bank's charter and the laws under which it operates, permit. If the New York banks, in November, 1929, had not acted on this assumption they could never have
1

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Is it to be wondered at that, thus exposed to attacks on both flanks, the Federal Reserve System found safety in inaction rather than in action? But, looking backward in the light of recent experience, would not those who violently protested against the exertion of any "paternalistic influence"—which they perceived in the Federal Reserve Board's attempt to restrain speculation—freely admit to-day that they were mistaken? President Hoover has received well-deserved commendation for the masterful strategy with which he united industries and railroads, labor and agriculture, Federal, State, and municipal governments in a common effort to counteract the adverse consequences which the stock-exchange panic of 1929 might visit upon the country. Does it not seem absurd that paternalistic guidance should be gratefully accepted in the face of the actual occurrence of a grave calamity, but that it should be resented when connected with an effort to forestall it? Is it not childish that we should be willing to fight an epidemic after it has spread and taken its heavy toll, but should be unwilling to localize the disease before it had gotten beyond our control? Does not the recent disaster teach us that, while the transactions which Federal reserve banks are permitted to engage in must remain strictly circumscribed as at present, it does not follow that the System's field of influence is restricted within the narrow circle of these transactions? A petty Reserve System, that is to be no more than a fire engine or an ambulance, cannot give the country the service and protection, nor the prestige, to which it is entitled. A Federal Reserve System worthy of its name, while "accommodating commerce and business," must at the same time seek its highest aim in preserving for the United
saved the situation by taking over the out-of-town-bank and other loans when the crash came. If they had hesitated to do so, then, indeed, conditions approaching those of 1907 might have arisen. This does not mean, however, that a Federal reserve bank should not be free to act according to its own discretion if a member bank were to use Federal reserve bank credit excessively, or too continuously, or in a manner harmful to the country's interests.

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THE FEDERAL RESERVE SYSTEM

States conditions of stability in which commerce and business may thrive. This does not mean absolute price or business stability. Fluctuations within fairly normal swings may be necessary and healthy, and any attempt to compel the Federal Reserve System uniformly to offset them would be dangerous and Utopian. But whenever extreme economic or financial developments threaten to unbalance the even course of banking or business, including agriculture—the Federal Reserve System must be left free and untrammelled to exercise its influence in forestalling such disturbances and to back its efforts with the weapons with which the Act has endowed it. If this is the position that Congress desires the Federal Reserve System to occupy, it may be worth while to consider the advisability of amplifying the wording of the sub-title of the Federal Reserve Act 1 so that in future emergencies there may be no doubt as to the meaning of the Act with regard to this larger conception of the Federal Reserve System's aims and functions. It appeared opportune to add this brief analysis of the history of the stock-exchange panic of 1929 on account of the overwhelming proof it offers, first, of the need of giving to the Federal Reserve System a form of administration that will weld the Board and the reserve banks together instead of splitting them apart and matching them against one another to the point of deadlock and second, of the necessity of securing from Congress a clear and definite interpretation with regard to essential functions of the System so that a Board, composed of government appointees and representatives of the Federal reserve banks (as recommended in Chapter XII), may devote itself to its difficult task without being needlessly harassed
The sub-title of the Federal Reserve Act reads as follows: " An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."
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by the conflicting views and interpretations of members of Congress, of business men and bankers, or members of the learned professions. The history of the stock-exchange panic of 1929 lends added emphasis to the conclusions presented in previous chapters, viz: That we need an expert and independent administration uniting, instead of separating, the Board and the reserve banks—a Board whose acts, prompt and definite, would be accepted by all as the authoritative conclusions of the common counsel of the best minds which government and business can produce—and that, having secured such a Board, we should see to it that it be exposed to as little interference from politics and business as is humanly possible.

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