The Mystery of Banking

Central Banking in the United States IV
237
2
C.A. Phillips, T.E McManus, and R.W. Nelson, 
Banking and the Busi-
ness Cycle
(New York: Macmillan, 1937), pp. 26–27. In fact, the inflation-
ary potential of the new centralization was not as great as this, since the pre-
vious national banking system was not fully decentralized, but had already
been quasi-centralized to pyramid on top of a handful of Wall Street banks.
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But this was scarcely the only aspect of inflation built into the
structure of the Federal Reserve System. At the beginning of the
Fed in 1913, the most important single item of paper money in
circulation was the gold certificate, held by the Fed and backed
100 percent by gold assets in the Treasury. But in a few years, the
Fed adopted the policy of withdrawing gold certificates from cir-
culation and substituting Federal Reserve Notes. But since the
FRN only had to be backed 40 percent by gold certificates, this
meant that 60 percent of the released gold was available as a base
on which to pyramid a multiple of bank money. 
In addition, as part of the creation of the Federal Reserve Sys-
tem, the previous reserve requirements were cut approximately 
in
half,
thereby allowing for a doubling of demand deposits. The
average reserve requirement of all banks before the establishment
of the Fed was 21.1 percent. Under the provisions of the original
Federal Reserve Act in 1913, this requirement was cut to 11.6
percent, and it was cut further to 9.8 percent in June 1917.
3
It is
no accident that the Fed, as a result, was able to engineer a dou-
bling of the money supply from its inception at the end of 1913
until the end of 1919. Total bank demand deposits rose from $9.7
billion in June 1914 to $19.1 billion in January 1920, while the
total currency and demand deposits increased from $11.5 billion
to $23.3 billion in the same period. Furthermore, the impetus
from the Fed is shown by the fact that nonmember bank deposits
expanded by only one-third over these six years, whereas mem-
ber bank deposits increased by 250 percent. 
Another inflationary step taken at the origin of the Federal
Reserve System was, for the first time, to drastically reduce the
reserve requirements on time or 
savings
deposits as compared to
demand
deposits. During the era of the national banking system,
the reserve requirement, averaging 21.1 percent, applied equally
to time or demand deposits. The original Federal Reserve Act
greatly reduced the reserve requirements on time deposits of
238
The Mystery of Banking
3
Phillips, et al., 
Banking and the Business Cycle
, p. 23n.
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commercial banks to 5 percent, and in 1917 it was further low-
ered to 3 percent. 
It is true that if a deposit is a genuine time or savings deposit,
then it is in no sense part of the money supply, and therefore
needs no reserve requirement (assuming that monetary liabilities
should have such requirements). But any 
creation
of time deposits
through the making of a loan is deeply suspect as not a time
deposit at all, but rather a crypto-demand deposit. With the dras-
tic reduction of reserve requirements on time deposits upon the
inception of the Fed, the commercial banks had an enormous
incentive to shift borrowers into time deposits, and thereby inflate
further. And, indeed, that is precisely what happened after 1913
and during the 1920s. Deposits that were legally time deposits and
only due in 30 days were really