Economics and The Public Welfare

Chapter 78

Government Borrowing in World War II

The great reason why we had lost perspective is to be found in the borrowing policy of the Government. The Congress had had little to do with this borrowing policy. The Treasury asked for authority and the Treasury received it. The borrowing policy could hardly have been worse. The ideal in borrowing policy is to finance the war with long term funded debt placed in the hands of investors, rather than commercial banks, debt which cannot come back to haunt the Treasury in a subsequent period of tight money, debt which the Treasury may in later years refund and extend in its discretion when money market conditions are favorable.

Borrowing Policy in World War I. The great bulk of our war debt in the first World War was placed in this way. Investors had it. The Government did not borrow from the Federal Reserve banks, and the Federal Reserve banks themselves bought Government securities in modest amounts, for a few days at a time, only during the periods of the flotations of the four great Liberty Loans. The Government did place short term paper with the commercial banks, but as the amounts of this grew to substantial volume, the Government placed funding loans with the people and sharply reduced the short term debt. After each of the four Liberty Loans, the volume of short term debt dropped drastically.

World War II Borrowing from Commercial Banks and Federal Reserve Banks. In World War II, the great reliance was on short term borrowing, with heavy borrowing from the commercial banks and the Federal Reserve banks.

On May 10, 1945, while the war was still on, the present writer prepared a memorandum for private circulation which went to the chiefs of the United States Government, including the Treasury and the Federal Reserve System, appropriate members of the Congress, and to leading economists, bankers, and other responsible students of public finance. Subsequently this memorandum, with the unqualified endorsement of twenty-two other economists, and with endorsement with reservations of two others (all members of the Economists’ National Committee on Monetary Policy), was sent once more to essentially the same list of people by the office of the Economists’ Committee on Monetary Policy. Finally, when the war was over, the document was released to the press. It gives as clear and as compact an analysis as the writer could now make of the Government’s borrowing policy, and it is presented here unchanged (as it would otherwise be necessary to remove the names of the distinguished group of economists who joined in the analysis and recommendations). Those endorsing without qualifications are:

Charles C. Arbuthnot, Western Reserve University

D. W. Ellsworth, E. W. Axe & Co., Inc.

William D. Ennis, Stevens Institute of Technology

Fred R. Fairchild, Yale University

Charles C. Fichtner, Wales-Strippit Corporation

Roy L. Garis, Vanderbilt University

E. C. Harwood, American Institute of Economics

William F. Hauhart, Southern Methodist University

John Thom Holdsworth, University of Miami

Philipp H. Lohman, University of Vermont

James D. Magee, New York University

Roy W. McDonald, Donovan, Leisure, Newton and Lumbard

Clyde W. Phelps, University of Chattanooga

Olin Glenn Saxon, Yale University

Carlton A. Shively, The New York Sun

Alvin S. Tostlebe, The College of Wooster

Rufus S. Tucker, Westfield, N. J.

Russell Weisman, Western Reserve University

Nathaniel R. Whitney, Procter and Gamble Company, Cincinnati

Edward Wiest, University of Kentucky

Ivan Wright, Brooklyn College

Max Winkler, College of the City of New York

The two members who endorsed the paper with reservations are:

Frederick A. Bradford, Lehigh University

Hudson B. Hastings, Yale University.

Memorandum on Inflation Control and the Treasury’s Borrowing Policy (May 10, 1945)

Public Debt, Bank Credit, Interest Rates. “The situation with respect to our public debt, our banking system and our currency has grown extremely dangerous as a result of the unsound policy which the Treasury has been pursuing. It is essential that there be the frankest kind of discussion regarding the matter while there is still time to reverse the policy and to avoid a ruinous inflation.

“We can avoid a ruinous inflation if we act promptly, but not, I believe, unless we do act promptly.

“The public debt has already grown to a gigantic figure and promises to be much bigger before the war is over.

“The ease with which the Treasury has been borrowing money at fantastically low rates of interest from the banks and the Federal Reserve banks has generated a false sense of financial omnipotence which is encouraging the demand for great postwar extravagances, both for governmental financing of exports to foreign countries and for unbearable governmental expenditures at home.

France in World War I and the United States in World War II. “How dangerous our position is may best be revealed by a comparison of our war financing in World War II with that of France in World War I. It will be recalled that France greatly weakened her position during the war by heavy reliance upon the Bank of France and by a great increase in her bank note issue. She failed to pull up at the end of the war. In 1919 and 1920 the franc broke to low levels in the foreign exchanges. At the end of 1926 France made a de facto stabilization of the franc with a gold content of approximately 20% of the old par, and with commodity prices at 641% of 1913 prices.

“With respect to most points we are now a great deal further along the road of inflation than France was at the end of the first World War.

“(1) The relation of Government debt to national wealth is now worse with us. France ended the war with a national debt of 147,000,000,000 francs as against a prewar national wealth estimated at 300,000,000,000 gold francs. The debt at par was 49% of the national wealth. By 1926, when France pulled up, she had a public debt of 287,000,000,000 paper francs (internal), and 23,000,000,000 gold francs (external, including debts to United States and British Governments). (See Chase Economic Bulletin, February, 1927.) We had at the end of 1944, long before the war was over, a national debt of $230,000,000,000, as against a prewar national wealth not exceeding $387,000,000,000.1 Our national debt Dec. 31, 1944, was thus 59.5% of the national wealth.

“(2) The growth of money in circulation in the United States since 1939 is greater in percentage than the growth of money in circulation in France between June 1, 1914, and Aug. 29, 1918. France had about 9,000,000,000 francs in circulation, including about 3,000,000,000 francs of gold, on June 4, 1914. 2,000,000,000 francs of this gold was turned into the Bank of France in the three years that followed, and 1,000,000,000 francs of gold disappeared from circulation. By Aug. 29, 1918, French circulation, chiefly Bank of France notes, had risen roughly to 30,000,000,000 francs, an increase of 233%. This grew to 53,000,000,000 francs by June, 1926. In the United States money in circulation at the end of June, 1939, stood at $7,000,000,000, and it now stands at $26,000,000,000, an increase of 271%.

“(3) The percentage of national debt carried by the banks is far greater with us than with France. On Dec. 31, 1917, the French public debt stood at 123,000,000,000 francs, of which 12,200,000,000, or almost exactly 10%, was held by the Bank of France. But the commercial banks in France took very little of the public debt. The great banks, The Crédit Lyonnais, the Comptoir d’Escompte and the Société Générale, were badly shaken when the war broke out, and taken together, by the spring of 1918, had made virtually no expansion in their balance sheets. To some extent they had substituted government paper for commercial bills in their portfolios, but the amount was small. The only commercial bank that really expanded greatly in France during the last war was a bank of second rank, the Banque Nationale de Crédit, which expanded a few hundred millions of francs, lending both to the Government and to business. At the beginning of 1918 I should estimate that not more than 12% of the public debt was in French banks, including both Bank of France and commercial banks.2

“In the United States, on the other hand, at the end of 1944, 42% of the whole interest bearing public debt was in the commercial banks and the Federal Reserve banks combined. Leaving out that part of the public debt held by Government agencies and trust funds, 46% of our interest bearing public debt was in the Federal Reserve banks and the commercial banks. Finally, looking only at the marketable public debt, and omitting that part held by Government agencies and trust funds, 58% was in the commercial banks and the Federal Reserve banks.

“France had very little increase in demand deposits during the war and almost all was in the Bank of France itself, where there was an increase of about 2,712,000,000 francs between June 4, 1914, and Aug. 29, 1918. Our commercial bank demand deposits (‘adjusted’) plus United States Government deposits stood on June 30, 1939, at $28,147,000,000. On Dec. 31, 1944, the figure stood at $87,500,000,000, an increase of 210%. We have, therefore, enormously outdone France in the increase of a circulating medium, money plus demand deposits, during the war.

“(4) The Bank of France steadily resisted inflationary developments, urging upon the Treasury constantly that it should borrow as much as possible from the people, and its resistance had real results. Our own Federal Reserve System seems to have surrendered its money market policy completely to the borrowing policy of the Treasury.

“But we must now take account of favorable factors in our situation as compared with the French situation in the last war.

“(1) We are now doing very much better than France did in taxation.

“(2) Although France had a strong gold position throughout, we have what appears to be a world dominating gold position. But the outside world is gaining gold from us, and we are now apparently net debtor to the world on current account. (See National City Bank letter of April, 1945.)

“(3) The relation of our national debt to our national income is more favorable by a good deal than it was in France. The estimate for national wealth in France in 1913 was 300,000,000,000 francs, and that for national income was 30,000,000,000 francs, giving a ratio of 10 to 1. Real estate is the biggest factor in national wealth and the French capitalized their real estate on a very low yield basis in 1913. The ratio of national wealth to national income in the United States was only 5 1/2 to 1 in 1912. It was again 5 1/2 to 1 in 1939 if we take the figure of $387,000,000,000 given above for national wealth and compare it with the Department of Commerce estimate for national income for 1939, which was $71,800,000,000.

“We do not know what our national income will be in the postwar period and we are uncertain what our national debt will be.

Our Debt Largely Unfunded. “In the last war we placed the debt with the people primarily and in long-term form. The Government did spend for a few months funds borrowed on short term from the banks, and then issued great funding loans, in which bonds were placed with the people and out of which this shortterm debt to the banks was paid down. The curve for short-term debt rose to peaks just before each funding loan, and then moved sharply down again. The banks always held some of the Government debt. At the peak of the public debt they held about $4,000,000,000, but this included nearly $1,000,000,000 that they had held before the war to secure national bank notes and for other purposes. Of the war debt they held little more than $3,00,000,000 at the peak in direct ownership, and much of this was short, and they had also another $3,000,000,000 or $3,500,000,000 of loans secured by Government bonds which they had made to their customers to help them buy Government bonds.

“The Federal Reserve banks owned almost no Government securities during the last war, except for a few days at a time when each of the great Liberty Loans was being floated.

“When the war was over, the debt was largely funded. The Treasury knew where it stood.

“Our Treasury today cannot know where it will stand when the war is over. The debt is very badly distributed. Of the part held outside the banks, there is a great part in the hands of corporations which are carrying depreciation reserves, maintenance reserves and liquid funds for reconversion purposes in government securities, but which must turn the government securities into cash to accomplish their purposes when the war is over.

‘“A great deal is in the form of tax anticipation certificates which will come back to the Treasury instead of cash.

“The so-called war savings bonds, gigantic in volume, are in effect demand deposits. The holders can get their money at any time. These bonds have been sold in a high percentage of cases with the argument that in buying them the purchaser is buying a post-war automobile or a post-war home or a post-war washing machine. The behavior of the sales and redemptions of these bonds in the fiscal year 1945, as compared with the fiscal year 1944, is disquieting. The Treasury Daily Statement of April 20, 1945, shows that in the fiscal year 1945 to date the Treasury has sold only $10,757,000,000 of these bonds, as against $12,612,000,000 in the corresponding period of the fiscal year 1944. It shows also that in the current fiscal year the Treasury has had to redeem $3,357,000,000 of these bonds, whereas in the preceding fiscal year it redeemed only $1,774,000,000. The net intake of the Treasury on these bonds in the fiscal year 1945 is thus only $7,400,000,000, whereas in the corresponding period of the preceding fiscal year it was nearly $11,000,000,000. (Since March 1, 1945, these redemptions have included redemptions of matured savings bonds, but the tendencies indicated above were strongly in evidence before March 1.) The Treasury may have a very grave problem with these demand deposits when the war is over. It is unfunded debt. The total of these savings bonds was $40,361,000,000 at the end of December, 1944, and the total of the Treasury tax and savings notes was $9,843,000,000.

“Of the marketable issues, a very dangerously high proportion is in unfunded form. The total of marketable issues was $162,843,000,000 as of the end of December, 1944. We may break this up as follows: Treasury bills, certificates and Treasury notes, total $69,868,000,000. To this we ought to add the Treasury bonds maturing within five years, which stood at $7,824,000,000, making a grand total of short marketable debt of $77,692,000,000. To this we should add the war savings bonds and the tax and savings notes mentioned above, making $127,906,000,000 of unfunded debt, out of a total of $230,000,000,000 of interest bearing public debt, or 56%.

“Of funded debt in the form of bonds maturing after five years the total is $83,761,000,000, but this funded debt of over five years’ maturity is very badly held. $31,672,000,000 of this is in the commercial banks. The part that is clearly well-placed consists of $7,567,000,000 in the mutual savings banks, and $17,303,000,000 in the insurance companies, a total of $24,870,000,000 in these two classes of institutions.

“The part that is held by individual investors is pathetically small. The great bulk of the public debt ought to be in the hands of the individual investors and it ought to be in funded long-term form. I cannot give the figure. It is part of $21,321,000,000 listed under the category ‘other,’ which includes business corporations, states and municipalities, educational and charitable organizations, trust funds, investment banks, brokers, and investment companies, as well as individual investors. The rates of 2% on 10-year bonds, and 2 1/2% on 20-year bonds are simply too low to attract investors. The man who knows how to look at a bond table can see to what prices they would go if the rate of interest should rise, and he can look back over the history of government bond yields for the past 25 years and see yields exceeding 5%.

Diagnosis. “The symptoms of pathology in the handling of the public debt are very clear in the figures given above. What is the explanation, what is the cause of the pathology? The explanation is to be found in the fantastically low rates of interest at which the Treasury has been borrowing, made possible by the artificial manipulation of interest rates by the Federal Reserve System.

“The lowest interest rates in all history, at a time when the world is destroying capital on a colossal scale, and when the Government of the United States is borrowing many tens of billions of dollars a year, are obviously an anomaly. Normal interest rates reflect supply and demand of capital, and rise as supply diminishes or as demand increases. There are four normal sources of capital: (1) consumer’s thrift; (2) business thrift, particularly the building up of corporate surpluses out of profits; (3) direct capitalization, as where the farmer uses his spare time in building fences and barns or allows his flocks and herds to increase; (4) governmental thrift, where taxes exceed public expenditure and the government is paying down public debt.

“New bank credit constitutes a fifth source of capital, safe enough when cautiously used and kept in reasonable relation to the growth of the four normal sources of capital and the growth of production in the country, but dangerous in the extreme when used to excess, as we saw in the period 1924-33.

“Bank credit as a substitute for savings is particularly dangerous in wartime. It has been the typical breeder of war and post-war inflation. The classical case is, of course, that where the government leans directly upon credit from the State bank of issue, as Germany and France both did in World War I. The great expansion of bank notes is obvious. But an expansion of bank deposits is in economic essence almost identical with an expansion of bank notes. Notes and deposits alike are demand liabilities, are both media of exchange. Psychologically, the note issue is the more dangerous. We are, however, increasing both now on a colossal scale.

“In World War I, between April, 1917, and December 30, 1918, we expanded bank deposits by $5,800,000,000 and bank loans and investment by $7,000,000,000. In the period from June of 1922 to April ii, 1928, we expanded bank credit by $13,500,000,000 in deposits and by $14,500,000,000 in loans and investments. This generated our wild stock market and stock market crash of 1929 and the resulting troubles of 1930-33. In the present war, as we have seen above, as a result of the Federal Reserve cheap money policy and the policy of the Treasury of borrowing at low rates of interest from the banks, we have generated an expansion of bank credit in the United States of incredibly greater magnitude and have increased our money in circulation from $7,000,000,000 at the end of June, 1939, to $26,000,000,000.

“We had already very greatly overdone cheap money and bank expansion, and government security purchases by the banks, between March of 1933 and June of 1939. The Federal Reserve authorities had been greatly concerned and had raised the reserve requirements of the member banks in late 1936 and early 1937 to double the minimum reserve requirements. The Treasury was concerned and created a ‘sterilization’ fund. But Presidential action compelled both the Treasury and the Federal Reserve authorities to retreat with respect to these matters in early 1938.

The Warning of the Federal Reserve Authorities. “But the Federal Reserve authorities remained concerned. In a report to Congress on Jan. 1, 1941, there was a unanimous recommendation by the Board of Governors of the Federal Reserve System, the Presidents of the 12 Federal Reserve banks and the 12 members of the Federal Advisory Council urging the Congress to forestall inflationary tendencies (1) by increasing the power of the Board of Governors to raise reserve requirements of the member banks; (2) by ending the President’s power to devalue the currency; (3) by repealing the power to issue $3 billion of greenbacks, and (4) by selling government securities directly to investors, rather than to the banks. The first and fourth of these recommendations looked directly toward firmer rates of interest.

“Belatedly, and by action originating in Congress, recommendations (2) and (3) of this report have been adopted or appear to be in process of adoption, but nothing has been done about recommendations (1) and (4). They seem to meet no favor in the Treasury. The Federal Reserve System, having made its protest, today lies supine. It imposes no brakes. It feeds the inflation of bank credit and currency.

Alleged Safety in New Techniques. “We are told that new techniques have arisen which make the policy safe. I see very little in the way of new techniques and rather a very exaggerated use of old techniques.

“We have, first, the purchases of government securities by the Federal Reserve banks, replenishing the reserves of the member banks. In the first world war, the Federal Reserve banks did this in connection with each of the four great Liberty Loans, reducing the strain in the money market for a few days, while the loans were being floated, and then promptly selling the government securities again. The magnitudes were small—for the first three Liberty Loans a few tens of millions, and in the Fourth Liberty Loan, something over two hundred millions—but only for a few days.

“In 1924 and 1927, the Federal Reserve banks bought several hundred millions of government securities and held them for a good many months, in each case generating a very dangerous expansion of bank credit, and in the second case precipitating almost unmanageable difficulties.

“In the present war, the Federal Reserve banks have bought government securities in terms, not of tens of millions or of hundreds of millions, but of many billions. The figure stood at $2,184,000,000 on Dec. 31, 1940, and at $20,153,000,000 on April 18, 1945. This is no new technique, but the vast scale of its use makes one ponder.

Rediscount Rates Below the Market. “In the last war, Federal Reserve Bank rediscount rates were placed below the market rates to facilitate war financing. But they followed the market up as the war went on. The New York Federal Reserve Bank rediscount rate was placed at 3% in 1917, moved up to 3 1/2% at the end of the year, and to 4% early in 1918, remaining, however, below market rates. At the present time, the Federal Reserve bank rediscount rate is 1/2% for advances secured by government obligations maturing in one year or less. Here again there is no new technique, but merely an extreme application of an old one.

Reducing Reserve Requirements. “The Federal Reserve authorities now have power to reduce the reserve requirements of the member banks and they have already done this as far as New York and Chicago banks are concerned. But in the last war we reduced member bank reserve requirements by Act of Congress in 1917—to levels that made us great trouble in the period of the 1920’s.

Unlimited Access to Federal Reserve Banks at 3/8%. “Finally, the Federal Reserve banks buy government bills without limit from the member banks at a fixed rate, 3/8 of 1% discount, with a repurchase agreement. This is designed to make the member banks look upon government bills as ready cash and to make them feel that it is not necessary to carry excess reserves. It may be granted that we have here a new technique. It is obviously a highly dangerous technique and a highly inflationary one.

Using up Ammunition Rapidly. “In the process of this immense bank expansion, we have used up ammunition very fast. The reserve ratio of the Federal Reserve banks to notes and deposits combined stood at 90% in April, 1942, and at 47% on April 18, 1945. Excess reserves, which stood at nearly $7,000,000,000 in early 1941, dropped below $1,000,000,000 in 1943.

Inflation Policy in Last War. “During our own participation in the last war, we held down inflation admirably. The great rise in prices in the last war came between December of 1915 and July of 1917, before our government war policy got into operation. Commodity prices at wholesale in July of 1917 stood at 187% of 1913 prices. Under our war policy these prices receded to 182% in October of 1917 and then rose slowly, under the extreme pressure of the war, to 207% in November of 1918, after which they receded again to 197% in March of 1919.

“Our war policy in the first world war with respect to prices contained four elements: (1) the sudden, very heavy application of war taxation; (2) great concern that bonds be sold to investors rather than to banks; (3) a firm money market to hold down bank expansion. Commercial paper rates in 1918 stood at though the government borrowed more cheaply. Rates were made, however, which would attract investors and which could look reasonable over a long period of time. The First Liberty Loan was issued at 3 1/2%, fully tax free, the Second Liberty Loan at 4%, the Fourth Liberty Loan at 4 1/4%, the last three Liberty Loans being partially tax exempt. (4) We had a limited amount of price fixing, applying to scarce essentials, and accompanied always by commodity control. We had retail price fixing only in the matter of scarce foods and fuels, and here not until after wholesale price fixing had been well established. We relied in the last war primarily on functional controls, rather than direct controls, as far as commodity prices were concerned.

Primary Reliance on Price Fixing in World War II. “In the present war, building up an immense inflationary flood by the expansion of bank credit and money in circulation, we have used as our primary device for controlling inflation, price fixing, covering virtually all wholesale and retail prices and industrial wages.

Price Fixing Must End with the War. “It is quite clear that these price controls cannot be tolerated if we are to have a free post-war economy. Prices have work to do. Prices are to guide and direct the economic activities of the people. Prices are to tell them what to do. Prices must be free to tell the truth.

“Something may be said for the temporary continuation of price fixing, with rationing, in the case of very scarce essential commodities, but each case should be scrutinized carefully. The general idea that price fixing should be continued after the war for the purpose of preventing inflation must be absolutely vetoed. Inflation must be controlled, if it is controlled, by budget balancing and control of money and credit.

Eliminate Inflationary Money and Credit Policies Now. “The existing low interest rates are made possible only by the substitution of bank credit for investors’ savings. If bank expansion were to stop today, interest rates would forthwith rise. If, on the other hand, bank expansion is not stopped, we shall have a tremendous inflation. And then we shall see an immense rise of interest rates, the inevitable accompaniment of a great inflation. The choice is not between continuing low interest rates and not continuing. The choice is rather between a moderate and manageable reversal of policy in the near future and an involuntary submission to very high interest rates at a later date.

Prescription: Fund the Public Debt Now and Reduce Money and Deposits Now. “I believe we should act promptly while the war is still on, while we still have controlled commodity markets, and while we still have wartime motives to work with, in funding the government debt into long-term bonds at rates of interest which will attract investors’ money. The vast scale of the funding operations required means that we should have to supplement the attractive yield with effective bond-selling, including neighborhood pressure. I believe that if we act promptly, these rates can be intermediate between those we paid in the last war and those we are now paying.

“We now have outstanding, as a result of the previous abuse of bank credit, an immense volume of idle money in circulation and an immense volume of idle deposits in the banks. If these grew active, we should have an inflation that would blow us sky-high. The thing to do is to pull them in and get them invested in government bonds before they begin to work actively in other fields.

“I cannot, of course, set exact figures at which investors will take long-term government bonds. Only the market can do that. But this idle cash is a market factor of first importance, tending to hold interest rates down. I think the thing to do is to increase the interest rates on new government securities forthwith to levels at which investors’ money will be forthcoming. This should be accompanied by a sale of government securities by the Federal Reserve banks to tighten up the money market correspondingly.

Existing Excess of Money and Credit Tend to Hold Down Interest Rates for Refunding Purposes. “Now a rise in interest rates would set in motion powerful counterforces which would tend to hold the interest rates down. With rising interest rates, savings banks and other banks would find it worth-while to offer attractive rates on savings accounts to the people, pulling in actual cash from circulation. And commercial banks would be interested in reducing or even dispensing with service charges on demand deposits, which would pull in a great deal of money from circulation. But this money coming in from circulation would ease the bank reserve situation and tend to hold interest rates down. Moreover, investors, attracted by higher yields on government bonds, would make a market for very many of the government securities now held by the banks. As the banks sold these securities to investors, investors would pay for them by checking against deposit accounts, canceling a great deal of the inflated deposits and once more easing the money market situation by reducing the reserve requirements of the banks.3

Protecting the Banks When Government Bond Yields Rise. “There are two main objections to the policy which I propose:

“(1) that it would involve dangers to the capital structures of those banks now too heavily loaded with long-term government securities; (2) that it would increase the tax money required to meet the debt service on the Government’s already enormous debt.

“Let me say with respect to both these points that the problems grow progressively worse the longer we refrain from facing them.

“To protect the banks in this change of policy, I have proposed that the banks holding long-term government bonds be allowed to exchange them for new issues at the higher rates of interest, at a discount of, say, 2% as compared with cash subscribers, leaving them with some loss but not with losses that would ruin their depositors. The FDIC, whose solvency and liquidity are of highest importance, should have the same protection as the banks. Both banks and FDIC should be expected to take shorter maturities in making these exchanges. I have seen no other proposal for dealing with this that looks at all adequate. It cannot be solved by allowing the banks to carry these bonds at par on their books, regardless of the market. Informed depositors would simply withdraw their funds from banks whose capital structures were impaired and put them into banks whose holdings of government securities were predominantly short-term. Nor do you solve any inflation problem by forcing the Federal Reserve banks to take long-term bonds from the member banks at par.

“The present artificiality in the interest structure runs far beyond the regulation of member bank reserves and short-term money rates. The Federal Reserve authorities are also undertaking to regulate the long-term interest rates, by buying and selling government securities of different maturities. (For an exposition of Federal Reserve policy with respect to this matter, see the Federal Reserve Bulletin of July, 1943, pages 590-91.) A good many bankers have come to expect a sure market for their long-term government bonds in the Federal Reserve banks themselves. This is an ominous delusion. The holders of the ultimate reserves of the country must not be investment institutions and must not be looked to, to supply long-term capital or to manipulate the bond market. When the Federal Reserve authorities are finally driven to tighten the money market in resisting a great inflation, they will not be able to protect the prices of long-term government bonds without feeding the very inflation they are trying to control.

The Interest Burden of the Public Debt, “With respect to the interest burden on the government debt, let me say that this problem becomes progressively worse if we delay it. We can now fund the government debt at moderate rates of interest, as above indicated. If, however, we wait for inflation to come, interest rates will rise rapidly and the Secretary of the Treasury will sweat blood as Treasury bills and certificates fall due, as people cash in their war savings bonds, and as he has to borrow money on the rapidly rising money market—or else print, which would not help the inflation.

Drastic Federal Budget Economies Essential. “The notion that we can permanently hold the debt service on the public debt to a 2% rate is fantastic. The notion that we can permanently service three hundred billions of public debt with six billions of interest is fantastic. We had best face the facts now. The facts are that our postwar budget is going to be very difficult to balance and that we face the necessity for drastic economies in the post-war period. The facts are that proposals for expanding Federal expenditures after the war must be fought all along the line. We do not create social security when we endanger the dollar in which social security payments are to be made.

Artificialities Built on Artificialities. “I cannot pretend to know with confidence what is going on in the minds of men inside the government who, seeing the dangers, are still afraid to face them. But I have heard some fantastic suggestions.

“One of them looks to a compulsory holding by the member banks of fixed quotas of non-negotiable government securities as a permanent matter, at nominal rates of interest with, however, the understanding that in times of necessity they may turn these over to the Federal Reserve banks for cash. Now always in the past our government securities in the commercial banks have been looked upon as secondary reserves. Always in the past we have had a free government bond market. The liquidity of the banks, and their ability to make adequate loans to commercial borrowers and their ability to meet depositors’ withdrawals, have always been greatly strengthened by their holdings of government securities. To freeze government securities in the banks is to freeze the banks. Moreover, the volume of bank deposits, which ought to be related to the needs of commerce, would then tend to be frozen, governed not by the needs of commerce, but by the Treasury’s needs. Money market control with respect to the needs of trade and with respect to the need of checking inflationary tendencies would disappear under a system like this. Again the Federal Reserve banks, trying to tighten up and prevent the inflation from becoming a ruinous thing, would find themselves compelled to expand their credit as they took over government bonds from hard-pressed banks. No such artificiality will help.

“I have last Autumn from a man in the government’s financial system, whom I do not wish to identify as he was talking with me privately, an alarming suggestion which may or may not represent a considerable body of inside thought. He told me that we had learned many things, which economists had previously not known, which made it safe to proceed along lines that we had formerly regarded as unorthodox. He said that two years ago he had been afraid of the great expansion of bank deposits and money in circulation which the Treasury’s borrowing involved, and afraid of the unfunded debt, but that today he had no fear at all of inflation. It will be perfectly possible with modern techniques to control the interest rates and to control inflationary tendencies. When I pressed him regarding the methods, he said that the Nazi had developed some very good technical economic ideas. I said, ‘Yes, if you have enough regimentation, if you have control of all commodities and all prices, if you have control of every man’s pocketbook and every man’s bank balance, if you have control of the farmer’s consumption of his own production, if you can control all exports and imports and foreign exchange transactions, and if you have a sufficiently powerful and efficient Gestapo, you can take great liberties with money and credit.’ He said that the trouble with the Nazi is that they do not have consciences.

“I may add, however, that without techniques of the Nazi type described in the preceding paragraph, it is not possible to continue our present course and avoid a ruinous inflation.

“I know at least one man in the Federal Reserve system who was reconciled to inflation nearly two years ago, who held that inflation always follows a great war, and that it is necessary to cover up the great war debt. To this man I would say, first, that I do not believe it. We can, by sound measures taken promptly, protect our currency from further debasement, and protect our price system from ruinous convulsive movements. Moreover, the accomplishment of the measures which I propose would still leave far more inflationary material lying around than I like to see. For one thing, we have not yet felt the main impact of the 40% cut in the gold content of our dollar in 1934 and we have not yet seen the consequences upon the world of the rise of annual world gold production from $430,000,000 in old gold dollars in 1930 to roughly three times that figure in new gold dollars in 1939. I would add that in any case the most hopeless pessimist would wish to have some control of the situation.

“Inflation is not something that you can turn off and on like water at a faucet. Inflation and deflation are not simple terms and they are not simple opposites. There is no financial Westinghouse air brake by means of which an inflationary movement can be smoothly tapered off and brought gently to an end without a shock. Rather, inflationary forces engendered in defiance of sound financial policy may seem harmless for a long time and then suddenly break forth into great violence.

“It is far better for the Federal Reserve System to act now when moderate restraining movements will accomplish a great deal, than to wait until the great inflationary movement is under way and when even violent methods of restraint may have limited efficacy. And it is far better for the Treasury to face the financial facts regarding the public debt service now, while it is possible to fund the debt on moderate terms, than to wait to face the violently rising interest rates which a real inflation always creates.”

Public Debt, Bank Deposits, and Money in Circulation—Mid-1946. This memorandum describes the situation at the end of the war, and indeed in the middle of 1946, except that the figures for the debt are larger and that the figures for money in circulation and bank deposits are larger. In August of 1946, the total gross direct debt to the United States Government was $267,546,000,000. The figure had been higher in February of 1946 when it stood at $279,214,000,000, as a result of a great postwar loan where the Government borrowed more cash than it needed. Part of this cash the Government has since used in reducing the public debt, despite the fact that a deficit of expenditures over revenues continued.

On June 30, 1946, the commercial banks held $83,300,000,000 of the public debt, and the Federal Reserve banks held $23,783,000,000.

Money in circulation, which had stood at $6,859,000,000 at the end of 1938, and at $26,189,000,000 in April of 1945, stood at the end of July, 1946 at $28,254,000,000.

Demand deposits of all commercial banks, which had stood at $28,695,000,000 at the end of 1938, and at $91,644,000,000 at the end of 1944, stood at $98,350,000,000 at the end of June, 1946. This figure was $105,923,000,000 on December 31, 1945. But as a result of the Treasury’s use of its deposits with the banks in buying back Government securities from the banks in the first half of 1946, it had dropped to the $98,350,000,000 stated above. The connection between Government securities in the banks and the volume of demand deposits in the banks is obvious and direct.

Postwar Policy of Federal Reserve Authorities. There is as yet no evidence that the Treasury and the Federal Reserve authorities have any intention of reversing policy and cleaning up the vast excess of bank deposits and money in circulation, which they have created. There was a very disheartening special report on credit policies submitted to Congress on June 17, 1946, by the Board of Governors of the Federal Reserve System.4

Recognize the Dangers. The report points out the inflationary dangers of the great excess of money in the hands of the people. It states:

“There can be no doubt that the country’s money supply, several times greater now than ever before, is and will continue for an indefinite time to be much in excess of available goods. Under such conditions, with the heavy drains of war financing no longer existing, public policy calls for vigorous attack on the basic causes of inflationary pressures. This, in turn, requires that the Government stop and reverse, if possible, the process whereby it has created bank credit. It is all the more imperative that the Government reverse this process as the commercial banking system resumes its peace-time function of supplying credit to private sources whose borrowing will itself create additional funds.”

After this encouraging preamble, the Federal Reserve document becomes discouraging in the extreme. It declines to reverse its low interest rate policy, giving as one reason “the Reserve Board’s assurance to the Treasury that the rate of 7/8% on one-year certificates will be maintained, if necessary, through open market operations.”

But Make Alarming, Irrelevant Proposals. Its own proposals involve the request for additional power for the Board of Governors of the Federal Reserve System to control the use of bank funds. One request is that the Board be granted additional power to raise reserve requirements which, if used, would tend to raise interest rates, but as the general report indicates that they do not wish to raise interest rates, one wonders why they ask for this additional power. Another very alarming proposal is, in principle, that referred to in the memorandum of May 10, quoted above, namely, that there be compulsory holding, by member banks, of fixed quotas of non-negotiable Government securities as a permanent matter, at nominal rates of interest. The Board in its June 17, 1946 report modifies this by substituting Treasury bills and certificates for the non-negotiable Government securities, but it does ask the Congress for power to compel the banks to hold a specified percentage of Treasury bills and certificates as “secondary reserves” against their net demand deposits.

Now this use of the term “secondary reserves,” to a man who understands banking, is an abuse of the English language which it is difficult to characterize justly in temperate words. It is an illustration of New Deal “semantics,” under which the rule is to call a bad thing by a good name, as, for example, calling deficit spending “investment.”

A bank’s secondary reserve is made up of highly liquid assets which the bank is free to use at its own discretion. It may sell them to get additional funds to lend to its customers when they borrow. Country banks regularly accumulate them after the crop moving is over, so that they have them available when the pressure of crop making and of crop moving comes in the following year. Government securities which the banks must hold as a specified percentage against their net demand deposits are not secondary reserves, they are fixed investments available for use only in a fixed percentage as the net demand deposits go down. True secondary reserves are available for any use that the bank wishes to make: to meet runs, to meet seasonal withdrawals, to meet seasonal borrowing needs of customers, to meet any one of a multitude of special problems which may make a bank need additional funds in a hurry.

This proposal is to be denounced as one which would go far to destroy the flexibility and the usefulness of our banking system. It would be one of the Hitlerite controls referred to in the memorandum.

This document of the Board of Governors seems not to contemplate an increased placement of Government securities with investors. It seems rather to visualize a shuttling of Government securities back and forth between the Federal Reserve banks and the commercial banks. It proposes nothing that would operate to bring about a radical decrease in the volume of money and credit outstanding, or to meet the basic danger set forth in the first passage quoted from their report. The Board indeed states, “Under a continued policy of maintaining the existing level of short-term interest rates, the principal effect of an increase in reserve requirements would be a shift of Government securities from the commercial banks to the Reserve Banks.”

The only safety is to be found in a vast shift of the Government securities now held, both by commercial banks and by the Federal Reserve banks, into the hands of investors, and the only way to accomplish this is by a rise in interest rates along the lines indicated in our memorandum above.

Figures of Debt, Not Wealth. The following table will give perspective of a disquieting sort on our swollen structure of Federal Government debt, bank deposits, and money in circulation. The figures show how all of these items have swollen in the period covered by the present book.

Currency, Deposits, and Public Debt, 1914-1946 (in millions of dollars)
	Money in circulation	Total deposits, all commercial banks	Government securities in Federal Reserve banks *	Interest-bearing public debt †
1914, June 30	3,172	17,390	......	......
1916, June 30	......	......	47	972
1918, June 29	4,195	28,011	97	11,986
1920, June 30	5,181	36,114	347	24,061
1921, June 30	4,624	32,987	302	23,737
1924, June 30	4,562	40,656	416	22,008
1928, June 30	4,510	49,215	232	17,318
1929, June 29	4,459	49,036	179	16,639
1933, June 30	5,434	31,911	1,933	22,158
1939, June 30	7,047	53,789	2,591	39,886
1941, Dec. 31	11,160	71,248	2,404	57,451
1944, Dec. 30	25,307	127,950	18,846	228,891
1945, Dec. 31	28,515	150,227	24,262	275,694
1946, June 29	28,245	143,180	23,783	268,111

* The figures for 1916 are annual averages.

† In addition to the direct debt of the United States Government, there were the fully guaranteed securities of Government corporations and agencies, which on June of 1941 stood at $6,360,000,000. This figure had been reduced by August of 1946 to $370,000,000.

The foregoing figures are figures, not of wealth, but of debt. They are figures for the debt of the United States Government to the banks and to the people. The figures for deposits represent the debt of the banks to the people. The figures for money in circulation represent the debt of the Government to the people. This debt rests on the future earning power of the people and the ability of the Government to take from the people in taxes enough of their earnings to service the debt and to prevent a collapse of public credit.

Create Illusion of Grandeur. The ease with which the Treasury has been able to get money by borrowing from the banks and the Federal Reserve banks has created an illusion of grandeur. Because we have already borrowed and spent so much, it is urged that we can easily and safely borrow and spend much more. We are looked upon as the strongest financial power in the world. And doubtless in a world shattered by war, we who have not been invaded and whose physical properties have not been shattered by war, are the strongest. But we are not so strong financially as we were in 1939. Moreover, we are, as a country, rapidly increasing our debt to the outside world.

In the memorandum above, reference was made to a monthly letter of the National City Bank, published in April of 1945, which indicated that we had lately become net debtor to the world on current account and that we had been losing gold. The following estimate is supplied by a great New York bank, as of July 30, 1946, of our current debt to the outside world.

“On current account, it seems likely that we are indebted to the world to the extent of 6 or 7 billion dollars. This includes holdings of U. S. currency and shortterm Government securities. This figure, of course, does not include our payment to the Fund of 2.7 billions nor that to the Bank of 3.2 billions, nor the British credit of 3.7 billions, all of which may be the equivalent of short-term debt in the near future. I take it a substantial part of the U.N.R.R.A. payments amounting to 2.7 billions have already been used. On the other hand, additional loans by the Export-Import Bank may result in current drafts on us.”

Our “Invincible Dollar.” We think of our dollar as invincible and as the supreme currency of the world. But the same source gives the following information regarding the estimate placed upon our dollar as compared with gold in a number of outside countries.

“It is true that there is a very high premium on gold in various parts of the world. Computed in dollars at current exchange rates, these premiums seem fantastically high. In India, I believe, gold has run as high as $70-$75 an ounce. In the Argentine, bars are selling in the neighborhood of $40 and coins from $60 to $70. In Syria and Egypt, the price has been around $50. In Peru, a gold producing country, no such prices have been experienced. Portugal has had quotations around $40, and even Switzerland has seen a price of about $38. Generally, it seems that these prices result largely from the extreme scarcity of gold in different localities and from our own unwillingness to grant export licenses for gold shipments abroad.”

Part of the difficulty here doubtless is the reluctance of our Treasury to discredit the official exchange rates of certain foreign countries by shipping gold to sell at actual market prices in the domestic currency, and to use that domestic currency in purchasing dollars to the extent necessary for bringing the dollar to its gold parity within the country—part of it thus reflects the absurdity of the general scheme of maintaining artificial foreign exchange rates by international coöperation. These high premiums on gold as against the dollar in various foreign countries may well be regarded, however, as a warning that there are parts of the outside world, at least, which very much prefer gold to dollars. Thirty-five dollars should be able to purchase an ounce of gold (with allowances made for the cost of shipping gold) everywhere in the world. Our own people in September of 1946 still had great confidence in the dollar and still have great confidence in the long-term obligations of the United States Government payable in dollars. But there are limits to the abuse to which foreign and domestic confidence can be subjected—as the story of England, contained in this volume, abundantly proves.

• 1This point will be discussed at length in Chap. 34.
• 2I have not been able to find that this article was ever published. However, the reader will find much of it in two books by Veblen: Imperial Germany and the Industrial Revolution, New York, 1915; and The Nature of Peace and the Terms of Its Perpetuation, New York, 1917.
• 3See my book The Effects of the War on Money, Credit and Banking in France and the United States, published by the Carnegie Endowment for International Peace, Oxford University Press, New York, 1919. For London, see the interesting articles by Mr. J. M. Keynes in the British Economic Journal in late 1914.
• 4O. M. W. Sprague: “Crisis of 1914 in the United States,” American Economic Review, September, 1915; H. G. S. Noble: “The New York Stock Exchange in the Crisis of 1914,” Garden City, N. Y., Country Life Press, 1915. These two papers are classics of permanent value.