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Woodlief Thomas*

On© of the inevitable oonsequences of war is the creation of a vast
supply of money and other liquid assets and the exposure of the eoonomy to the
threat of serious inflation. The amounts of such assets created in the second
world war surpassed all previous records, and this superabundance of money9
unless wiped out by inflation and revalorization, will continue for many years.
Careful monetary and fiscal regulation will be needed for many years to come to
avoid, at the worst, serious inflation and collapse or, at the least, instabili^
in prices, oredit, and interest rates. As a result of this heritage of war
finance, the Federal Reserve System is no longer in a position to exercise
effective control over bank oredit expansion--the main function for which the
System was founded—and faces the problem of finding ways to reestablish and
maintain its capacity to influence credit developments.

Methods and Consequences of War Finance
War is inevitably inflationary because people receive incomes for
producing and supplying goeds which are not available fer purchase. War expenditures have to be financed and no country has yet been willing to impose upon
itself a tax burden that will take as much as half of current income, the amtunt
required in this country during the war just ended, or even to adopt a program
of borrowing out of the people*s savings the balance between expenditures and
taxes. Throughout the war, efforts were made in this country to raise as much
of its cost by taxation as was feasible and to finance the rest so far as p#ssible by tapping the savings of the peoplef Fiscal and monetary authorities
were agreed that financing through banks, which results in the creation of new
money, should be kept to the necessary minimum. Nevertheless the banks had to
be relied upon to a large extent, and also policies had to be followed to assure
a high degree of liquidity for securities sold to the public. Purchases by
banks were needed not only to help maintain an active market and to facilitate
the general sale of securities, but also to provide the increased money supply
needed by the expanding and abnormal war economy.
Although some expansion in the money supply and in banks1 holdings of
Government securities was desirable, the amount that actually occurred was no
doubt excessive. w In retrospect,11 to quote from the Annual Report of the
Federal Reserve Board, "it is evident thai more vigorous policies should have
been adopted in order to raise more of the cost of the war through taxation and
to restrict bank purchases of Government securitiesfw Many of the financing
procedures adopted encouraged banks to purchase more securities than it was
necessary for them to bqy and thus helped to complicate the problem of postwar
* Paper to be delivered at Annual Meeting of American Economic Association*
Atlantic City, January 25, 191+7•

- 2 As á result of policies adopted to faóilitate the financing of the
Governments ileeds during the war, there was a tré&endous growth in bank holdings of Government securities.. Total funds raised by the Treasury in the period
from the middle of 19^0 to the end of 19k5 amounted to 383 billion dollars.
Over 1 0 per oent or 153 billion dollars of this amount came from taxes. About
2'30 billion was obtained by borrowing, of which about 100 billion came from the
banking'system, including commercial "banks, Federal Reserve Banks, and mutual
savings banks•
Another policy, adopted during the war to facilitate war finance was
the maintenance of the interest-rate structure at'approximately the level existing at the beginning of the war. This policy served a three-fold purpose 1
(1) it kept down the interest cost to the Government; (2) it encouraged prompt
buying of securities by investors, who might otherwise have awaited higher rates;
and (3) it kept the growth in bank and other investors« earnings to moderate
amounts consistent with the .purposes of war finance«
The interest-rate structure existing at the beginning and generally
maintained throughout the war consisted of very low rates on short-term money,
with a wide spread between thom and rates on long-term securities. This unusual
interest-rate relationship came into being during the years of degression when
there were reduced demands from borrowers and at the same time large gold imports
and unused bank reserves.
Maintenance of the wide differential between short-term and loñg-term
interest rates during the war, howeverj encouraged expansion of bank creiit
because it *ras possible for banlgs to sell short-term securities to Federal
Reserve Banks and buy long-e.r-tenji issues bearing higher rates of interest,
wfcich in turn were stabilized. The new bank reserves created by sales of securities to the Reserve Bank6 provided the basis for a deposit expansion at all
banks in the country of ten times the volume of such sales.
Another result of these policies was a decline in long-term interest
rates. An implied assurance th£t prices of long-term securities would not be
permitted to decline removed an important distinction between long and shortterm securities, a i this policy, together with maintenance of the low rates on
short-term securities, encouraged holders to shift from short-term to long-term
issues« As long as the Reserve System stood ready to purchase short-term
securities at prevailing rates these rates could not rise. The longer-term
rates declined« These low long-tern rates have necessitated substantial adjustments for life insurance companies and other savings institutions»
The method of handling the war loan drives also was a stimulus to bank
credit expansion. Nonbank investors could sell previously acquired issues to
banks and" subscribe for new issues, thus helping to attain quotas. Banks during
the drives had excess reserves because deposite agains-t which reserves were
required were drawn down in the purchase of securities, while Treasury deposits,
against which no reserves were required, increased. This shift of funds resulted
in a reduction in member banks required reserves.

- 3 As a result of these operations, bank holdings of Government securities increased substantially during drives. Between drives, as deposits were
reshifted and required reserves increased, banks sold sufficient 's;eourities to
the Federal Reserve to meet the higher reserve requirements. The net result
was a gradual expansion in bank holdings of Government securities throughout
the war period«
Commercial banks increased their holdings .of United States Government
securities by approximately JO billion dollars. At the same time their loans
expanded to the highest level since 1930». As a result of the growth in assets,
bank earnings increased substantially during the war and in relation to capital
funds were at the highest level on record during 19U5*
Banks, were able to expand their holdings of securities by any amount
they could obtain because additional reserves were almost automatically supplied
by the Reserve System in following its policy of keeping down short-term rates.
The volume of short-term securities outstanding was sufficient to permit a much
further expansion of Federal Reserve holdings. In effect the banking system
wae permitted, in a sense encouraged, to expand its earning assets, and the
necessary reserves were supplied. Banks incurred additional expenses in
servicing the greatly increased wartime monetary demands, but were adequately
compensated by the earnings received«
The result of these developments was a tremendous expansion in the
liquid asset holdings of thp public» The holdings of deposits and currency by
individuals and businesses increased by a hundred billion dollars to 2 l/2
times the prewar level. The inflationary potential in this expanded money
supply is roughly indicated by the increase in its ratio to the annual value
6f the countryfs total production of all goods and services. This ratio is
now about 80 per cent oompared with 7® per cent, or less in the late 1930*s#a
period of considerable unemployment and unused resources, and with a little
over 50 per cent in the 1920*8* a period of active business.and full employment.
In the greatly expanded holdings of deposits and currency, individuals and businesses have nearly a 100 billion dollars of
Government securities, or eight times the prewar level. These can be,readily
converted into cash as long as the Federal Reserve Banks stand ready to buy
them. This is an aspect of the present situation which has no precedent in
economic history and is of incalculable significance.
Inflationary developments that have been evident during the past year
and are now approaching a climax unquestionably had their-seeds in war finance.
As indicated, however, war and its finanoe are necessarily inflationary. Their
effec.ts must be counteracted by direct controls over demand, supplies, and
prices, which cannot possibly be in equilibrium during war and its aftermath
•without stringent taxation. We avoided serious inflation during the war by
the maintenance of controls, as well as through the public's exercise of voluntary restraint.




Current fiscal developments, and monetary policies are not now adding
to inflationary pressures. The budget is balance*. The Treasury's debtretirement program is exerting a drain on bank reserves and has brought to an
ejid over-all expansion in bank credit. Bank holdings of Government securities
and loans on securities have been considerably Qriiti'acted. There has been, it
is true, considerable expansion in bank loans to businesses, on real estate,
and to consumers. These loans reflect in part needs for the expanding production and distribution of civilian goods,.but probably also reflect some speculation and excessive commitments. The more important inflationary pressures, however:, are the result of past developments and are beyond the realm of any shortterm monetary and credit restrictions that could now be imposed.
The superabundant volume of money has already been created through
expansion in the public debt and can be reduoed only through contraction in
that debt or by a shift f*o& banks or other holders who regard their securities
as liquid assets to more peimanent investors. Such changes can occur only
slowly.. To bring them about and in the meantime maintain a reasonable degree
of stability in the Government securities market are the major postwar problems
of fisoal and monetary administration.
The Problem of -»Postwar Monetary Policy
In view of wartime developments, the central problem that will face
the I?e4©ral Reserve "System in the future is to reestablish and maintain oontrol
over bank., credit expansion—the main function .for which the System was founded.
The increases of more than 50 billioji dollars in commercial bank holdings of
Government securities and of 100 billion in holdings of'businesses and individuals,. which can be readily sold'to the Reserve Banks and thus create additional bank reserves, make it difficult, and perhaps impossible, for the System
to exercise effective control. The reserves that could be created wo\ild-provide
the ba&is for a teji-fold expansion in bank credit arid bank deposits.
It has been suggested th&b credit expansion could be. prevented if the
Reserve. System would'refuse to purchase additional Government securities or
would purchase them only at higher rates. It is true that a narrowing of the
spread between the yields on short-term and long-term securities would remove
the incentive for banks and other investors to shift short-term securities to
the.Reserve System in order to purchase longer-term ones.
• policy of permitting sjiort-tesm rates to rise, however, would
focsease the cost to the Treasury o£ carrying its sKort-term debt and would
complicate the Treasury's refunding problem. It would also increase bank
Earnings,, which are already more than adequate. It has been frequently stated
that the System's refusal to follow this course of action is based entirely

- 5 upon these .considerations, expressed in its commitment to the
tain a low level of interest rates, it would be more eorreot
System1 s commitment is based upon its view that under present
in short-term interest rates would not accomplish the desired
ing credit expansion and might have harmful effects.

Treasury to mainto say that the
conditions a rise
result of prevent-

Should the Reserve System refuse to purohase Government securities
offered for sale and not taken by others, then interest rates would be subject
to wide fluctuations. With 260 billion dollars of the public debt broaily
distributed among individuals, businesses, and investment institutions> the
possible effect of fluctuating interest rates upon thfc financial position and
the actions of these holders is difficult te predict. The consequences of
attempting to use such a remedy might be more harmful than the disease.
The System would have to purchase Government securities fet some rate.
It is not possible to know how inuoh of a rise in interest rates would have to
occur to stop sales to the Reserve System. Any rise in short-term rates might
be accompanied by a rise in long-term rates. If short and medium-term rates
should rise, the premium to investors' for making long-term commitments would
be reduoed and shorter-term investment made correspondingly more attractive.
New investment funds would prefer shorter-term as against long-term investment
because of the possibility that long-term interest rates might eventually also
rise. Higher short and medium-term rates would thus generate uncertainty as to
the course of long-term interest rates. It might even bring about shifting by
investors from long to shorter investment, with such shifting itself acting as
a force to raise long-term rates. If long-term rates were permitted to rise,
one effect of uncertainty might be to jeopardize the savings bond sales program
and cause wholesale redemptions,
While some degree of uncertainty may be desirable, particularly when
bonds are selling at substantial premiums, there " s a limit as to how far this
can be carried without seriously upsetting the market. The events of recent
months when long-term bond prices have fluctuated within a range of
indicate that purchases of these bonids at premium prices are not without some
It is doubtful whether any rise in yields on Government securities
would discourage, banks from selling thofe securities in order to make private
loans or to invest in corporate bonds, if attractive loans and investments
were available. Experience shows that changes in Federal Reserve discount or
b,uying rates alorie. Tiave not been sufficient to stop'.or ev$n effectively restrain
a speculative credit expansion. These changes would be even less effective in
a situation where their primary effect would be upon'prices of outstanding
Government securities, rather than upon private borrowers,

- 6 Long experience with brokers1 loans shows that banks will withdraw
funds from the central money market in Order to take care of the demafids of
their customers and that they will not be discouraged from doing so by high
money rates. In the case of brokers1 loans the loans callfed Had to be shifted
to other lenders, whereas in the case of Government securities the banks need
only to sell them to the Federal Reserve and thus create additional reserves.
Some power other ^han that of higher interest rates is needed to deal with such
a development.

Proposals for Additional Controls
In view of this heritage of war finance, the Federal Reserve System
is faced in the postwar period with a two-fold problem* to prevent speculative
or otherwise excessive expansion of bank credit and at the same time to assure
reaspnable stability in the prices of the large volume of Government securities
outstanding. There must be limits to the ability of banks and others to convert
Government securities into additional bank* reserves and this must be accomplished
without widely fluctuating interest rates.
Solution of this basic long-run problem can be assured only by giving
the Federal Reserve System additional instruments of regulation such as those
suggested in the 19I4.5 Annual Report of the Federal Reserve Board.
The three basic plans propo'sed by the Board for consideration by the
Congress may b e designated by the following terms 1
(1) A primary reserve plan
(2) A secondary reserve plan
(3) A bond limitation plan
These three proposals have many similarities and also important differences. In each case adoption Would require legislation, which should permit
considerable administrative flexibility, because of the wide differences between
individual banks and groups of banks. It would also be necessary that they
appiy to all commercial banks, not alone to member banks of the Federal Reserve
System* The.s$ powers cpuld be so applied as to leave banks adequate ability to
take care of the credit nee&s of industry, commerce, and agriculture but wguld
give the Reserve authorities some control over excessive expansion of such
T]ie primary reserve plan.—This plan is simply a further increase in
commercial*bank reserve requirements. In order to keep short-term interest
rates from rising, it would have ' o be accompanied by'Federal Reserve purchases
of securities. The amount of such purchases would probably correspond closely

• 7 tc the increase in requirements. To assure adequate powers to absorb a large
portion of short-term securities held*by basks,, the law should authorize an
increase to twice the present statutory maximum, but any increase in requirements probably should be applied gradually apd might never reach the mayimum.
The principal effects of this measure would be (l) to shift a certain
amount of earning assets, presumably short-term Government securities, from
commercial banks to Federal Reserve Banks, and (2) to reduce the ratio of multiple credit expansion on the basis of a given amount of reserves. It would,
therefore,diminish the amount of short-term securities available to sell to the
Reserve Banks and also reduce the potential credit expansion on the basis of
any reserves that might -be -created by suoh salos.
This measure could be applied to put the banks under pressure to
liquidate securities and thus discourage further purchases of long-term issues,
while Federal Reserve support would keep interest rates from rising above the
established pattern. It would correspond to present banking practices, be
relatively simple to operate, and permit adjustments in the market because of
interbank flows of funds to be carried out as«j£t present.
The proposal would tend to reduoe the earnings of commercial banks
and increase those of the Reserve Banks. If this plan were adopted it might
be desirable for the Reserve Banks to have power to pay some interest on reserve
balances, in ease bank earnings should be unduly reduced.
Legislation authorizing this action might also include provisions for
amending various aspects of the present requirements, such as permission to
count vault cash and greater administrative flexibility in imposing different
requirements on different types of deposits and in classifying banks for reserve
The secondary reserve plan would establish a required secondary
reserve of Treasury bills and certificates oqual to a specified percentage of
net demand deposits. This percentage might be placed initially at a level that
would induce commercial banks as a group to retain their present holdings of
•short-term Government securities—probably around 20 or 25 per cent of net demand deposits would be sufficient. Subsequently the percentage should be sufficiently high to assure for such securities a commercial bank demand large enough
to maintain the desired level of rates without Federal Reserve purchases.
Ta facilitate transition 'to the new plan, as well as regular adjustments of bank positions required by interbank flows of funds, banks should be
permitted to hold cash (including reserve balances) as secondary reserves in
place of bills and certificates. This feature, which distinguishes this plan
from that proposed by Lawrenoe Seltzer*, is essential to .make the plan effective
* Lawrenoe H % Seltzer, ffThe Problem of Our Excessive Banking Reserves,11 Journal
of the American Statistical Association, Vol. ¿5* No. 209 (March Wktfl
pp. 2U-36.

- 8 as a limitation on bank credit expansion. Otherwise it would be necessary for
the Treasury to supply bills or certificates to banks needing them to meet their
secondary reserve requirements against expanding deposits. This would mean
further credit expansion and deposit growth.
This plan has the advantage of permitting banks to retain substantial
holdings of short-term Government securities, but limiting their ability to
sell these to the Reserve Banks in order to make other loans and investments.
This plan is essentially similar to the primary reserve plan, except that under
the secondary reserve plan the commercial banks could continue to hold the shortterm Government securities whereas in the primary plan the Reserve Banks would
hold them.
The secondary reserve proposal has been criticized because it would
purportedly require the banking system to inoroase holdings of Government securities every time there was an increase in deposits resulting from expanding loans.
It is, of course, true that credit expansion would increase the amount of
required reserves, as at present. Banks would have the alternative, as they do
now, of liquidating some other asset or of borrowing from the Reserve Banks.
Under the proposed pirn they could not reduce their holdings of Treasury bills
and certificates, unless they had an exoess, but would have to soil long-term
.issues out of thoir portfolios. The plan would establish short-term Government
securities in a preferred market position over other types of short-term paper.
An important disadvantage of this plan is that the double set of reserve requirements might complicate adjustments necessary in th'e -case of interbank flows of
funds, "but it is possible that such a scheme would be no more complicated in
practice than the present system.
The bond limitation plan would limit a commercial bank's holdings of
bonds to no more than an amount corresponding approximately to savings deposits
and capital accounts plus some percentage of its not demand deposits. In a
sense this plan would merely extend the policy pursued during the war of
restricting bank imsestmejat in lpng-term Treasury bonds. At the outset these
percentages might be established at levels "that would prevent commercial banks
from adding to theix; present holdings of bonds—ari average of about 50 per cent
of net demand deposits ar maybe even higher would cover the bulk of the commercial banks. Eventually the percentages should be sufficiently low tc assure a
commercial bank demand for short-term Government securities large onough to
maintain present rates without Federal Roserve purchases.
This limitation should apply to all bonds, or probably to all single
payment marketable securities having a final maturity of more than one year at
time of issue, or it night be more limited in scope. It yrould have to^ cover
obligations of State and local Governments and of corporations; otherwise United
States securities would have a disadvantageous market position. Bonds within a
year or perhaps within 5 years of maturity night be exempt from the limitation,
but such exemption would cause sudden cdjustments in the market and in the banking position e s large issues oame out from under the limitation.

- 9 This measure would not restrict bank lending activities and might
even encourage them. It would leave, the various sefctof s of the short-terin
market--Government and private—on *a comparable basis. Adjustments of reserve
positions between banks would not be particularly complicated by this plan,
although some reductions in bond portfolios might be necessary if banks lost
deposits, particularly time deposits, and increases would be permissible in
case of additions to deposits. This plan would be less restrictive than the
others because it would not restrict banks in shifting from short-term securities
into loans, although by lowering the amounts of bonds banks could hold, the
authorities could force liquidation of bonds, rather than short-term securities,
to offset any loan expansion.

Application of the Proposals
Any of these various plans could, once established, be fairly rigidly
maintained, while traditional Federal Reserve open-market and discount rate
policies wore relied upon for current policy measuros. Alternatively these
new schemes could be flexible in»their application, with requirements add
limitations being varied as bank oredit and monetary developments and prospects
might justify or require.
It should be made clear that these proposals are not revolutionary or
drastic nor would their application interfere unduly with the detailed operation
of banks. They are not devised to save the Treasury interest or to keep down
bank earnings, although they could have these results, but are primarily to make
possible the use of effective controls over oredit expansion. They are in accord
with the traditional Federal Reserve instruments of open-market operations,
reserve requirements, and discount rates, and are essential for the effective
use of those instruments in the future.
The use of any of the new instruments would not necessarily mean
rigidity in the level and structure of interest rates. It may be said that
some such measure is necessary before policies can be adopted which would
bring about changes in interest rates on private debt. These measures are
designed to set off a large part of the public debt and of bank investments in
a way that would free them from the influence of changing interest rates.
Savings bonds and even a large portion of marketable obligations held by institutional and other permanent investors are ordinarily not seriously perturbed
by variations in interest rates. That portion of the public debt held in the
active money market, as well as private debt, could be traded freely and permitted to fluctuate without the danger of these fluctuations causing widespread
If the economy should be in position where investment demands exceeded
the available supply of savings, then interest rates,might be permitted to rise
rather than have an inflationary expansion in bank credit. On the other hand,
it would be possible to prevent an expansion in credit which would depress the
level of interest rates unduly, as was -the case early in 19U6,

- 10 Nor would those instruments unduly restrict banks in making loans.
Their purpose, of course, is to give the System authorities power to limit
credit expansion--a power they were created to perform but can no longer exercise. Any limitation on the supply of bank reserves, however applied, #r on
the ability of1 member banks, to rediscount is in some degree restrictive on bank
It is hardly impressive to raise the "bogie" of restricting bank lending at a time when many types of bank loans have just expanded more rapidly and
have risen to higher levels than at any time in history. If banks want to take
care of the needs of their customers it would be better for the maintenance of
a stable credit structure if they would sell securities that nonbank investors
will absorb and not those which will bo purchased only by the Federal Reserve
Banks. Through the one process there would be no net credit expansion, whereas
through the other there would be a growth in bank reserves which would permit
multiple credit expansion. Application of th^se new powers by the Foderal
Reserve could, and should, be so regulated as to provide banks with adequate
funds for meeting all sound needs of commerce, industry, and agriculture. It
is the task of the Federal Reserve authorities to supply the banks with enough
reserves to meet those needs, as well as to prevent Expansion in the available
supply of reserves beyond the amount needed for sound credit demands. It has
adequate capacity for permitting expansion but practically no power to prevent
In summary, it may be said that bccause of the large money supply and
the greatly increased capacity for further expansion whxch is the heritage of
war finance, the oredit situation in the postwar period is likely to be an
unstabilizing influence upon the economy. The money supply, actual and potential
is large relative to current output and incomes, even at present inflated prices.
Additional measures may be needed to exercise more effective control over the
supply and use of credit than would be possible undor existing powers.
In concluding, it might be appropriate to quote the London Economist
regarding the Board1s proposals, as follows}
"It comes as a surprise to learn from the thirty-second
annual report nf the Governors jf the Federal Reserve System
that the highest banking authority in the United States is
submitting for the consideration of Congress pr posals for
the control of American commercial banking, the like of which
hrs never even been contemplated in Socialist Britain."

- 11 The Economist then adds the further significant comment;
"Before pushing the paradox too far, allowance should be
made for two factors. The first is that the United States is
a country with a written constitution where every executive
action and every policy must, if possible, receive the garfc
of precise legalism and statutory enactment. What many other
countries prefer to achieve by informal consultation and by
gentlemen's agreements must in America receive the compulsion
and sanction of law. The seqond factor is that the moral
ascendanay of the central banking authorities in the United
States is not quite comparable with its counterpart in Britain
and that an Act . f Congress needed to do less well what
can often be achieved by a nod from the 'Old Lady of Threadneédle
Street' in this country."