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December 3, 1940.



Mr. Bell



Chairman Lccies

Theue are the preliminary •! w o I til lit T e Tl'WiUi $
icb I disemuted witb you ovev the telephone.


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.



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 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
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.



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*


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
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«