CHAPTER VI

WAR FINANCING

Importance of the Fiscal Services of Central Reserve Banks. It is unfortunate but true that during a war which absorbs the entire activities of a nation, the discount and credit policies of central reserve banks become subordinated to their fiscal functions. At such a time central banks are usually required to transfer and disburse vast sums of money, to assist in collecting the revenue and in selling obligations for the government, and, if the condition of the Treasury should require, to make direct credit advances to their respective governments. In fact, the usual reason for establishing central banks has been the need of warring nations for agencies which might render such services. The fiscal functions of central banks therefore attained importance first and antedated the many other services which they now render and which in times of peace are considered to be of greater significance.1 The Bank of England, for instance, was established in 1694 in consequence of the financial straits to which the Government of William and Mary had been reduced in its struggles with Louis XIV. Alexander Hamilton recommended the establishment of the First United States Bank because it would assist the Government, so he claimed, in obtaining pecuniary aid, in collecting taxes, and in strengthening the public credit. That the Bank did accomplish all this and more, is attested by Gallatin.3 The establishment of the Second United States Bank was urged by Secretary of the Treasury Dallas as a result of the war of 1812, on the ground that it would be of incalculable service in restoring the then depreciated bank notes to a specie parity, in strengthening the credit of the nation, and in acting as fiscal agent of the Government. Even the National Banking System 1 See Raphael-Georges Lévy, Le Role des Banques D'Emission Dans La Guerre Actuelle.

4

2 See American State Papers, Finance, Vol. I., pp. 67–76.

3 Gallatin's report was communicated to the Senate on March 3, 1809.

See American State Papers, Finance, Vol. II., pp. 351–353.

4 This report was sent to the House of Representatives on October 18, 1814. See American State Papers, Finance, Vol. II., pp. 866-869.

owes its origin, in part, to the belief of Secretary Chase that such a system would be of service in increasing the sale of Government bonds and in furnishing safe depositaries for public funds.

At the time of the passage of the Federal Reserve Act, the Treasury Department faced no such serious financial problems as had confronted it in 1791, in 1816 and in 1863. Emphasis was consequently laid on the services which the Regional Banks might render in effecting monetary and banking reform. The fiscal services of the new banks, while considered, were thought of not so much as an entity in themselves, but rather as a part of the whole scheme of banking and currency reform. While their fiscal functions were not important at first, with the entrance of America into the Great War they became the pivot about which all other activities of the Reserve Banks revolved. Because of this the present Chapter must deal largely with the problems of war finance to which the discount policies of the Reserve Bank were subordinated.

War Financing and the Federal Reserve System. For some time before America entered the war, the Federal Reserve Banks had been acting as depositaries of public moneys, had been receiving funds from Government collectors of customs and internal revenue, and had been paying warrants drawn on the Treasury and cashing United States bond coupons. These duties had been assumed on January 1, 1916, in accordance with a letter addressed to each of the Reserve Banks by Secretary McAdoo on November 23, 1915, informing them of his intention to appoint them depositaries and fiscal agents of the Government under the permissive powers of Section 15 of the Act. A little more than a month after America entered the war, on May 14, 1917, the Secretary of the Treasury designated the Reserve 5 See Changes in the Banking and Currency System of the United States. House of Representatives Report No. 69, 63rd Congress, 1st Session, p. 11. 6 Federal Reserve Bulletin, 1915, p. 395.

The Glass Bill by Section 16 would have required the Secretary of the Treasury to deposit all money held in the general fund of the Treasury, except the five per centum fund for the redemption of national bank notes, with the Reserve Banks within twelve months after the passage of the Act. In the Senate Bill this was amended so that the Secretary of the Treasury might use his discretion in depositing such funds with the Reserve Banks, or with legal depositaries or with the sub-treasuries. The final Act followed the Senate Bill. Had the provisions in the Glass Bill stood, the Sub-Treasuries would probably have been abolished within a year after the passage of the Reserve Act. It was not until May 29, 1920, that an act was finally enacted which provided for the discontinuance of the sub-treasuries on or before July 1, 1921.

Banks fiscal agents for loan subscriptions. Their responsibilities and duties were gradually enlarged to include the sale and redemption of certificates of indebtedness; the sale of Liberty bonds; the payment of coupons thereon; the conversion of the bonds of one issue into those of another; the exchange of bonds of different denominations; the administration of deposits of the United States Government in depositary banks resulting from the sale of certificates of indebtedness and bonds; the examination, approval and custody of securities pledged as collateral against Government deposits held by the depositary banks; and the sale of war-savings stamps and thrift stamps.

The Federal Reserve Banks Prepare for War. Though it was not until in May of 1917 that the Reserve Banks were authorized to receive loan subscriptions, the entrance of America into the war had not caught them unawares. For several months they had quietly been strengthening their fiancial position. Their earning assets had been reduced from $221,896,000 at the beginning of 1917 to $167,994,000 in April.8 The percentage of gold reserves had increased in the same period from 82.1% to 89%.9 At the declaration of war their assets were in a highly liquid condition.10 There was little in the way of preparation still to be accomplished. Indeed, so carefully had the officials of the System prepared for the coming struggle, that during the first quarter of 1917 they had placed orders with the Bureau of Engraving and Printing for $900,000,000 of Federal Reserve notes to be distributed to the mints and sub-treasuries throughout the country.11 Their actions throughout the first quarter of 1917 afford a good illustration of the extent to which they cooperated with the war policies of the Government; in fact, throughout the entire war they gave unstinting aid, even when well-recognized principles of economics and finance had to be suspended to do so.12

7 Federal Reserve Bulletin, 1917, p. 423. For a discussion of the fiscal functions of the Reserve Banks, see Chapman, Fiscal Functions of the Federal Reserve Banks.

8 Federal Reserve Bulletin, 1917, p. 335.

9 Ibid., 1918, p. 130.

10 As the excess reserve of national banks amounted to over a billion dollars, they also were in an excellent position to aid government financing. Annual Report of the Comptroller of the Currency, 1917, Vol. I, p. 46.

11 Federal Reserve Bulletin, 1917, p. 335 and Fourth Annual Report of the Federal Reserve Board, p. 2.

12 See Seventh Annual Report of the Federal Reserve Board, p. 11. and Finance Report, 1917, p. 22.

The Impounding of Gold. From the outbreak of the war each one of the belligerent nations endeavored by every possible means to increase and conserve its monetary stock of gold. The larger the gold reserves of central banks, so finance ministers argued, the greater would be the expansibility of the banking system and the ability of the nation to finance foreign purchases. In 1914 the gold reserves of the Reichsbank amounted to 1253 million marks. To increase and conserve this amount the German government deposited in the Reichsbank the gold in the war chest accumulated since the Franco-Prussian war, prohibited gold exports, and launched a campaign to induce citizens to relinquish their gold.13 As a result of these measures, the gold stock gradually increased until on May 31, 1917, it reached a maximum figure of 2,567,100,000 marks.1 During the fall of 1914 and through 1915, the Bank of France increased its gold reserve from 4,766,700,000 francs to 5,367,400,000 francs through deposits of gold on the part of the public and through purchases of gold abroad.15 Exports were allowed only with the permission of the Government. During the war France found it necessary to export 3,000,000,000 francs of gold, most of which went to England and America.16 In England the public and joint-stock banks were induced to turn over their gold holdings to the Bank of England, receiving its notes in return. The gold coin and bullion in the issue department increased from £26,041,070 on August 7, 1914, to £73,878,075 on November 13, 1918.17

The United States, influenced, as were the European nations, by Mercantilist ideas regarding the value of gold, followed similar policies in impounding gold and in increasing and conserving the amount in the Reserve Banks, all of which had considerable influence on the discount policies of the Regional Banks. The measures adopted in the United States were:

1) The Reserve Act was amended in order to lower the reserves held 13 Federal Reserve Bulletin, 1919, p. 430.

14 Ibid., p. 433.

15 Annuaire Statistique, Statistique Générale de la France, 1914 et 1915, pp. 240-241.

16 Federal Reserve Bulletin, 1919, p. 338.

17 The Economist (London) August 8, 1914, p. 289 and November 16, 1918, p. 692. It has been estimated that gold coins to the extent of 600 millions of dollars were in circulation in England in 1914. (Commerce Monthly, October 1921, p. 7)

by the member banks and to provide that they be carried exclusively with the Reserve Banks.

2) State banks were encouraged to join, or to keep their reserves with, the Reserve Banks.

3) Gold held by the public and by banks was taken by the Reserve Banks in exchange for Federal Reserve notes.

4) Exports of gold and silver and dealings in foreign exchange were brought under strict control. The domestic use of gold was discouraged.

A consideration of these measures is of importance to a proper understanding of the war discount and credit policies of the Reserve Banks, since they were instituted either with the idea of loosening up credit, of keeping interest rates low or of promoting inflation.

Lowering and Changing the Character of the Reserve Requirements.18 By amendments passed on June 21, 1917, the reserves required to be held by member banks were lowered to the following percentages which were to be maintained as deposit accounts with the Reserve Banks.

Prior to this amendment, it will be remembered, member banks had kept a portion of their required reserves with the Reserve Banks, a portion in their own vaults, and a portion with their correspondents. Henceforth, however, only the realized deposit

18 The reserve requirements were lowered in addition to the manner described in this section in still another way in that the Board was empowered to lower the reserve requirements of member banks in sections incorporated into large cities. See Congressional Record, April 24, 1918, p. 5579.