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FEDERAL RESERVE POLICY AND THE DEFENSE PROGRAM

The Reserve System desires to assist by every means in its power in promoting the national defense program.

It recognizes that the economic measures

appropriate to this end are not solely or even mainly monetary and that what is
needed is a program of cooperation among the governmental agencies involved.

What

part can the Reserve System most usefully play in such a program?
In a defense program, as in war, there are special reasons for not relying
upon a general monetary control such as might seem appropriate in dealing with
peace-time expansion of economic activity.
bank reserves and the

A general monetary control, through

quantity of money, is aimed at interest rates and is designed

to affect the cost and availability of funds for investment, which in turn affects
the volume of national income, output and employment.

But in war or in defense

there is the special circumstance that the government is and must be the principal
borrower, and that the success of the defense effort rests essentially upon the
success of the financing program.

The possible dangers Y/hich might arise from an

excessive money supply or from low interest rates must be weighed against the
necessity of ensuring the success of the governments financial program upon which
the military expenditures depend.

Faced with this dilemma, nations are compelled

to consider alternative methods of preventing ordinary consumption and investment
from weakening the military effort and bringing on the general inflation which
would logically follow if neither monetary nor other restrictive measures were
adopted.

It is no accident that other countries, democracies like England and

Canada as well as Germany, have subordinated general monetary controls to other
types of control and are pursuing a program of combining low interest rates and
ample bank reserves with fiscal measures and more specific controls designed to
prevent inflation.

This in general is the type of program upon which this country

has embarked, though it is as yet in an earlier stage of development, and we are
entirely in accord with it.




- 2 There are, however, two ways in which the Reserve System can render
effective assistance in the present circumstances. It can cooperate with the
Treasury in formulating and carrying out the financial program and it can in cooperation with other agencies help to develop special forms of monetary control.
With respect to the financial program we are entirely in sympathy with
the Treasury's desire to finance as large a part of the defense expenditures as
possible through taxation. Such a course would be in keeping with the sound
monetary principle of meeting military expenditures so far as possible out of
current income rather than newly created bank deposits. But it is recognized that
the need for borrowing will be substantial. According to the Board's most recent
estimates, the amount to be borrowed from April, 1941 to July 1, 1942, after
allowing for estimated tax revenue including new taxes and for savings bonds, is
about $11 billion (including direct and guaranteed financing), or at the rate of
$8 to $9 billion a year.
We are fully in accord with the Treasury's desire to finance as much of
its borrowing as possible from non-bank investors, and it may well be that the
receipts under the savings bond program recently announced will exceed during the
fifteen months period the $2.5 billion allowed for in our estimate. We believe
that the borrowing program can be greatly simplified and the appeal to savings
made stronger by adopting a pattern of bond issues which could be repeated from
time to time at unvarying rates of interest attractive to non-bank investors, but
without excluding the banks. The recent 2 1/2 per cent issue would fit well into
such a pattern and there may be needed in addition a longer bond at 2 3/4 per cent.
Such a pattern, especially if accompanied by a statement of the probable needs to
the end of the next fiscal year, would go far to remove any expectation that the
financing is to be done at rising rates, which in turn would provide assurance
that potential investors would not hold back their funds. But in view of the
magnitude of the amount to be borrowed and the uncertainties as to the volume of




- 5 savings available for government securities, we believe it would be unwise at the
present time to risk any impairment of the bank market for such securities either
by actual reduction of excess reserves or by the adoption of the reserve "ceiling
plan"•
With such a program, Treasury financing through the next fiscal year
should not present major difficulties.

But -we believe it would be very desirable

to develop some more regular and continuous procedure of consultation and cooperation between the Reserve System and the Treasury than now exists both to insure
the success of the financing program and to avoid in every way possible its having
any inflationary effects. The subject matter of the consultations could include
the formulation of the program; joint investigations by both research staffs on
fiscal needs, both taxation and borrowing, and the monetary considerations which
should govern the division between these two types of financing, consideration of
how the physical facilities of the Reserve System can best be used to facilitate
the distribution of securities and to perform other services for the defense
program; the extent to which and the means by whicji_j^bj|^es_ejr^^
assist in maintaining orderly conditions in the government security market; the
extent to which and the circumstances under which it might be desirable to make use
in modified form
of the Keynes compulsory savings plan which has now been adopted toy the British
Government; and the exploration of the special forms of monetary control referred
to earlier in this memorandum.
As already stated, the dilemma which we face in a war or a defense program is that if we impose a general monetary control we create special difficulties
for the Treasury, but if we do not impose such a control we run the risk of stimulating an inflation through low interest rates and an excessive supply of money.
The reason in such circumstances why nations have learned to prefer other antiinflationary measures than the monetary, and in this war have even gone so far as
to combine them frankly with an easy money policy, is not merely that such a

http://fraser.stlouisfed.org/
program facilitates
Federal Reserve Bank of St. Louis

Treasury financing, important as that is, but that it is also

- 4 much the more effective method of safeguarding against inflation.

Historically,

there is no proof that if inflation is not prevented by more direct control
measures or by wise fiscal policy, it will or can be prevented by a general monetary
control.

But there are special forms of monetary control which go more directly

to the heart of the problem, and far from interfering with Treasury financing
may positively assist it.
capital market.

One such measure would be the rationing of the private

Such a policy, as practiced in Germany or England, is intended

to prevent private investment from competing with military needs for savings or
bank funds, but as yet no such problem appears to have developed in this country.
Another and more pressing problem is the competition of durable consumer goods
with the needs of the defense industries.

In this area there appear to be important

opportunities for cooperation between the monetary authority and other agencies
of government.

The machinery of price controls, priorities and rationing may well

prove ineffective unless accompanied by monetary measures designed to control
expenditures on durable goods.

The two areas in which this problem seems now most

in need of study with a view to action are the field of instalment credit for
automobiles and other durable consumer goods and the field of residential housing.

April 10, 1941