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March k* 19U7
STATEMENT BY CHAIRMAN ECCLES IN ANSWER TO QUESTIONS
REGARDING METHODS OF RESTRICTING MONETIZATION
OF PUBLIC DEBT BY BANKS
In connection with my statement to the Banking and Currency Cemmittee
of the House of Representatives regarding H.R. 2235, I was asked by a member
of the Committee questions with respect to proposals made in tha 1945 Annual
Report of the Board of Governors of the Federal Reserve System regarding the
problem of monetization of the debt by banks and ways of dealing with that
problem. It should be made clear that H.R. 2233 is not designed to deal with
this particular problem, which is much broader and more far-reaching in scope
than the bill now before the House. The following statement gives in essence
my answers to those questions:
Nature and cause of debt monétisation.-In connection with financing the war there was a tremendous increase
in holdings of Government securities by commercial banks and by the Federal
Reserve Banks, To a large extent this increase was necessary in order to
facilitate financing of the war and to provide the expanded money supply
needed by thé wartime eotncmy. These holdings are mostly short-term securities but banks also hold s$me longer-term bonds.
T > maintain a stable market for Government securities, the Federal
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Reserve System adopted a policy of maintaining the level of interest rates.
The supported rates ranged from 2 i/2 per cent on long-term securities, purchased mostly by individuals and savings institutions, down to j/Q per cent
on one-year certificates, generally owned by banks and other holders seeking
liquidity. In addition, 90rday Treasury bills, mostly held by Federal Reserve
Banks, were kept at 3/8 P e r cent.
Although some efforts were made to restrict bank purchases of
securitiesf various aspects of war finance made it attractive for banks to
increase their holdings. For example, because of the supported market and
the differential in rates, banks increasingly adopted the practice of selling
short-term low-rate securities to Federal Reserve Banks, thus creating additional reserve funds which were used to purchase longer-term securities in
the market. The reserves i^hus created could provide the basis for an
expansion in commercial bank credit of between six arid ten times the increase
in reserves.
As long as the Reserve System stood ready to purchase short-term
securities at the prevailing rates, the short-term rates could not rise. The
banks could continue to sell short-term securities and buy linger ones, thus
both expanding the amount of bank credit and reducing long-term interest rates.
This practice-^known as "playing the pattern of rates'1—resulted in "monetization of the debt."




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Effect of debt-retirement program.—
During the past year, sine© the preparation of the Board*s 19k5
Annual Report, these tendencies have been suspended* The reason for this is
that the Treasury, in retiring over 20 "billion dollars of maturing debt tut
of war loan deposit accounts with commercial banks, accumulated during the
Victory Loan Drive, has put some pressure on the reserve positions of banks.
Retirement of securities held by Federal Reserve Banks with funds drawn from
commercial banks tends to reduce member bank reserves. In order to maintain
their reserve positions, banks have had to sell securities to the Federal
Reserve. At the same time banks have been increasing their loans to businesses, to consumers, and on real estate, and they needed funds for this
purpose. While banks had to sell securities to meet these needs and have
had many of their short securities retired, they have not sold additional
amounts in order to buy longer-term Government securities.
Problem for future.—
With the debt-retirement program approaching an end, there may be
in the future a resumption of the tendency on the part of banks to sell shortterm securities to the Federal Reserve i i order to buy longer-term securities.
x
This would mean a resumption of the practice of creating bank reserves through
monetising the debt and expanding credit by many times the amounts sojd. It
would also mean a resumption of the decline in long-term interest rates. The
initiative with regard to this practice rests with the banks, which hold large
amounts of Treasury certificates and of Treasury notes and bonds maturing during the next few years. At the same time there are substantial amounts of
bonds held by nonbank investors eligible for bank purchase and a number of
restricted issues which will become eligible at varying times in the future.
The Federal Reserve under present powers and policies could not prevent such
a development.
It would be undesirable| particularly in a period of inflationary
pressures, to have the long«*term interest rates forced down through monetization of the debt. A decline in long-term interest rates resulting from an
excess of savings over the demand for investment funds would be desirable;
but a decline becauae of bank credit expansion would be undesirable. Such a
development would be an inflationary influence; it would also reduce the
return on savings and, therefore, impose a serious burden on individuals and
institutions, such as insurance companies, schools, ajid benevolent agencies,
that are dependent on interest returns for their incomes. Should long-term
rates decline much lower, many of the functions performed by these institutions
would have to be taken over by Government, thus leading in the direction of
socialism.




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Solutions for the problem«—
There are various ways of dealing with this problem; those generally
suggested are as follows*
(1) The proposals made by the Board in its 191+5 Annual Report
would restrict, by one device or another, the ability of banks to
shift from short-term securities to long-term securities and thus
limit the extent to which banks could monetize the debt«
(2) The Reserve System could lift the present support level
for the short-terra interest rate and thus permit that rate to rise
to a level at which banks would no longer be induced to sell shorts
term securities to the Reserve System in order to purchase longerterm securities in the market*
(3) It has been suggested that the decline in long-term rates
might be checked by issuance of sufficient amounts of long-term
securities«
(il) Monetization of the debt could be permitted to continue
until long-term interest rates declined to a level at which it
would no longer l e attractive for banks to sell short and buy
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longer securities«
The Board's proposals would offer a solution striking at the basic
cause of the problem, which is the great expansion in bank holdings of
Government securities that can be readily converted into bank reserves at
the will of the banks • A rise in short-term interest rates would remove
another cause, namely the differential in interest rates, which encourages
shifting short securities to the Reserve Banks and the buying of longer ones
and creates premiums on long-term securities« Action to unpeg the short
rate would be definitely preferable to the fourth solution of permitting
debt monetization and the resulting decline in long-term rates to continue«
As for the third suggestion for checking the decline in long-term
rates by issuing more long-term securities, it should be pointed cut that
if these' securities are issues of the conventional market types, even though
not eligible for purchase by banks, investors, in order to purchase the new
securities, will sell existing holdings of eligible issues to banks« Banks
in turn would sell shortvfcerm securities to the Reserve System and be able to
purchase many times that amount of longer securities« As a result, monetization of the debt would be encouraged rather than discouraged«
Marketable issues, moreover, with Federal Reserve support, can be
readily liquidated at par and thus are in effect demand obligations with the
high rate of return« Because of the difference between long and short-term
rates, prices of long-term bonds rise for many years after their issuance and
holders of these bonds can sell them Qt a premium, thus obtaining not only
the 2 l/2 per pent coupon rate but also an additional amount which may give




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a return of as high as 3 P e r cent. The use of this solution would raise
the interest cost to the Treasury and would encourage debt monetization for
years to come by putting out marketable issues which in the future could
be sold to banks at a premium. This remedy deals with effects not with
causes. A rise in short-term rates would be more effective and less expensive
to the Treasury than this method»
Such long-term bonds as need to be issued to absorb the savings
of the public should be in a nonmarketable form, redeemable on demand prior
to maturity at a discount so as to give a lower yield if not held until
maturity. These bonds would be similar to the present Series G savings
bonds with broader limits on amounts to be purchased and with substantially
longer maturities. A reasonable rate could thus be paid for genuine longterm savings and thus protect individuals and institutions dependent on
savings for their income. Holders would also be safeguarded against loss
in case of necessary liquidation before maturity, but would not be guaranteed
a high coupon rate, plus perhaps a premium, on short-term, highly liquid
investments.
Conclusion.-In summary, my view is that a fundamental solution to the problem
of debt monetization rests in some such measure as those proposed by the Board
in its Annual Report. In the absence of legislation toward this end, it
would be desirable tc permit some rise in short-term interest rates if
necessary to prevent long rates from declining further as a result of debt
monetization by banks. This does not necessarily mean that a rise in shortterm rates is imminent. In case there is no resumption of debt monetization
and declining X^ng^term" rates, then am increase
short-term ratea may not
be needed at all.
Additional investment outlets for long-time savings should be
provided in the form of a nonmarketable obligation of the Series G type,
but further issues of long-term marketable securities should be avoided.