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December 3, 1940. TO - Mr. Bell FROM - Chairman Lccies Theue are the preliminary •! w o I til lit T e Tl'WiUi $ * icb I disemuted witb you ovev the telephone. STRICTLY CONFIDENTIAL December 3 , IQLI.0 Preliminary memorandum, on Treasury financing based on a discussion by members of the Board of Governors and Mr. Sinclair, President of the Federal Reserve Bank of Philadelphia The Treasury's cash balance is now under a billion dollars, and net expenditures over the next three months will be substantial. These facts clearly indicate the need for some nearby financing. The character of the financing should be considered from the standpoint of its bearing upon the national economy and, immediately, in relation to its effect upon the defense program* Financing the defense program c s it relates to the national economy . raises many problems which cannot be discussed within the limits of this memorandum but which vx shall bo glad to discuss at an appropriate time. In general the monetary and fiscal aspects of the program are concerned with the question of avoiding, on the one hand, undue or premature restriction of our total economic effort before a satisfactory level of national income and employment is reached, while avoiding, on the other hand, the danger of inflation. The further problem, while the defense program is under way, of avoiding serious bottlenecks in production and distribution, which night have effects very similar to those of a general inflation, must probably be approached mainly hy measures other than monetary or fiscal. Aside from these bottlenecks there is still much unemployed labor and industrial capacity and many raw products in abundant supply, and as long as this situation continues the resources for national defense should not be obtained at the expense of peacetime activities and consumption. We have reached a lexrol of output, hovjevcr, well beyond anything previously attained even in the late tvrcnties, and next year the level will almost surely be substantially higher. There are estimates that the national income, this year about '£7U billion, will rise- next year to about ^80 billion and that by 19U2 or 1943 it will reach ^90 billion in terns of the present price level. Obviously in the face of such a prospect, ospccir.lly when the expansion is occurring in response to the stimulus of large defense expenditures and British war purchases, the possibility of an inflation, vhereby the expansion would go into prices rather then into output, must bo an ever-present concern of the monetary and fiscal authorities. On the monetary and fiscal side, we have to reckon with the fact that the volume of demand deposits and currency is larger than ever before, that excess reserves are huge and are increasing, that the Government debt is already large, that Government securities have become the chief asset of the banks, and that purchases of securities by the banks create additional deposits. As to taxation, the new tax measures of I9U0 have substantially increased the revenue in prospect for the coming year, and what is even more important, in considering the problem cf financing the entire defense program over the next several years, have given us a tax structure vjhich will yield substantial further increases in revenue as the national income rises. STRICTLY CONFIDENTIAL -2- December 3, I9U0 The financing program best suited to those circumstances would appear to bo one combining borrowing and taxation in such a manner that borrowing will lessen and tax revenue increase as the national income rises and the danger of inflation draws nearer. As regards borrowing, which is the immediate problem, it appears that under present circumstances—raid this will beeone increasingly important as the defense program proceeds—the Treasury should confine its borrowing as nuch as possible to non-bank investors and thus prevent the further piling up of' deposits by the banks. Pending other steps that nay be taken to this end, a long bond should be issued at this timo in an effort to interest as many non-bank investors as possible and to discourage the further purchase of Government securities by banks. Another advantage of a long-tern issue would be that it would help to supply the present demand for such securities and tend to prevent further increases in market prices. Other means of increasing sales to the savings groups night be considered as part of a longer-tern program* First, sales of the present type of savings bond night be increased by a more intensified canpaign and by again allowing trust accounts to purchase these issues. Second, the Treasury night issue a new type of savings bond which would pay a serii-annual coupon and be redeenable at the Treasury prior to maturity at a discount. Third, the Treasury night issue a registered non-negotiable bond Y/hich would be salable only to the savings grcups of the country and could be no.de either irredeemable prior to maturity, redeemable at a discount on perhaps three months1 notice, or convertible into some selected outstanding issue. The fundanental problen to be met, however, is to find means of reducing the volume of unused reserves in the hands of banks available and pressing for investment. More specifically, it is recommended that the Treasury should refund both the maturing notes and bonds in December and should raise about $500,000,000 to ^750,000,000 of cash. It seems likely that holders of the notes and bonds should be given the option of refunding into either an intermediate or a long-term bond and that cash should be raised through a long-term bond. Other alternatives would be to refund in December and raise cash by a long-term bond in January or to refund in December and raise cash through national defense bills. It would probably be advisable to do the refunding in December, because this procedure would clear the decks for future financing and is expected in the market. It is also recommended that the Treasury should raise §500,000,000 to $750,000,000 of cash in December* The Treasury's cash balance, which is now #900,000,000, would bo down to about $600,000,000 by the end of December and would be entirely eliminated by the end of February if no cash is raised in the interim. The raising of cash might be deferred until January, but it is probably desirable to complete the entire financing at one timo. It appears that the raising of cash up to about $ 7 5 ° * O O O » 0 0 0 vrould still leave a margin of safety within the statutory debt limitation. STRICTLY CONFIDENTIAL -3- December 3, I9I+O Present market conditions are such that the Treasury could without difficulty issue long-term bonds. During the past month long-term bonds have advanced in price by more than two points. Reporting member banks have added 1100,000,000 to their Government bond holdings since October 9, and insurance companies have also been substantial purchasers. There has been a relatively small supply of securities in the market except from the System Account, The present situation tends to induce banks to purchase bonds of longer maturities in order to obtain income necessary to meet expenses and dividends. Under present conditions, therefore, it appears quite certain that intermediate and long-term bonds 7/ould be readily absorbed in the market. Their issuance would also servo to restrain a further sharp rise in prices over the next few months. Such an operation can bo carried out successfully, provided the offering restricts the allotment of long bonds to an amount that the market can comfortably digest. The demand for *teag. bonds during recent weeks has been largely centered in the intermediate issues, and the rise in price of the four longest bonds may be weighed more hy the absence of offerings than size of the demand. This does not imply that there is not a substantial backlog of demand for long bonds, because there is, but there is reason to doubt that the market would readily absorb a long bond in an amount A m excess of $1,000,000.,000. It might be advisable, therefore, to limit the long-term bond to a cash offering, in order to avoid the possibility that due to the large premium on the long-term bond the bulk of the exchanges "would be for this issue, creating an outstanding amount between '^1,500,000,000 and $2,000,000,000, Limiting the long-term bond to a cash offering would also avoid arbitrage transactions and wide fluctuations in the rights between the time of closing the books on cash subscriptions and the time of closing on exchanges. It is recognized that a long-term bond would not be disti-ibuted exclusively to non-bank investors, since a number of banks would purchase the issue for the underwit ing profit, and others -would hold the issue as a permanent investment. A long-term bond, however, vrould fit into the category of an investment suitable for non*-bank investors and -would represent a mile-post in the market by -,ihich further long-tern financing could be more readily gauged. In view of the size of the financing it would probably be desirable to give holders of the maturing bonds and notes an option. The option should be between a long bond and an intermediate bond rather than a note, since most investors have a decided preference for intermediate bonds rather than for notes at current IOVJ yields. The maturing bonds have been outstanding for about 10 years, and a large proportion are in the hands of insurance companies and savings banks. Under these conditions there might be some advantage in permitting the exchange of the bonds for the nev/ long-term bond issued for cash, at the same tine protecting the market by requiring that the new bonds would be issued for exchange only on the basis of a registered bond which vrould be delivered after three to six months. Consideration might be given also to raising the limit on preferred allotments on cash subscriptions to $10,000 or 025,000. Such a step would tend to encourage individual subscrip. tions and to reduce allotments to banks* STRICTLY C01JFTDK7X LA" Docombor 3 The discussion in the roomorandum indiea-ccs quite clearly that the defense program should be financed from the savings of tine country rather than from a further expansion of bank credit and that an influence in this direction "srould "bo the issuance of long-tern bends, Vihilo the general progran should probably be of this nature, there arc certain consideration? that might make ic desirable to follow for the immediate future an interim program of short-tern securities,. In view of the large volume of excess reserves and bank deposits and the possibility of inflationary tendencies developing at sono tine in the future, it seems likely that steps will bo considered for reducing excess reserves to a nore reasonable level,. La addition to the uncertainties that vd.ll be produced in tho market by such diseucsions, there vdll be other uncertainties regarding comprehensive banking legislation., tax legislation, and the proposal for making future issues of public securities fully taxable* Until these questions are settled the market cannot be expected to measure long-tern interest ratos with fairness* With the removal of the influence of 3.urgc surplus bonking funds on the markct; long-tern rates, ?;hich are now at record low levels, nigh'; increase soncwhat to a point that #culd more nearly reflect the level necessary for attracting the savings of the country* If a long-tern, beni should be issued at the present tiara it would bd vulnerable tc an increase in rates. If this condition is anticipated it may be more in the public interest to pi'ot^ct investors frorn impeirment ir market value by doferring the issuance of lon?-term bones until after aucn an adjustment han ocourrod Under thic program short"term &ecuiitifcS wculd bo floated at the present time raid, would later be refunded into long-term bends* If this program should be adopted the Treasury might fine1 it desirable to issue f. stateraent outlining its reasons for this procedure«
