America's Money Machine

The Path of Retreat 105
could not issue circulating notes against commercial paper bought in the
market. Notes could be issued only against rediscounts.*
Actually, because of the increasing use of the bank check as a medium
oftransfers instead ofpaper money (circulating notes), this limitation did
not greatly constrict the monetary authorities; nevertheless, since the
ultimate of liquidity is cash and as some creditors might prefer cash to
a deposit credit, it seemed necessary to make the issue power co-extensive
with the credit power of the system. To cure this difficulty, Congress
was persuaded in 1916 to amend the Federal Reserve Act to permit bills
bought in the open market to be used as security (collateral) for Federal
Reserve notes. This permitted the Reserve banks to monetize this type
of paper by delivering it to Federal Reserve agents and obtaining notes.
Later, in 1917, the act was again amended to permit the use ofmember
bank promissory notes as collateral. It was not until 1932, however, that
the Reserve banks were authorized to use government bonds directly as
collateral for notes.
After having obtained these various new authorities, the Federal Reserve
System was now in a position to do a handsome job of financing
the needs of the war.
When war became apparent, it was recognized that an extensive program
ofTreasury financing would be necessary, and considerable apprehension
was felt among the Reserve authorities as to the extent to which
the System would be employed to provide these funds by way of the
inflationary process of monetizing public debt instead of by taxation.
They soon learned. Secretary of the Treasury McAdoo notified the Reserve
he desired to float an issue of$50 million certificates of indebtedness
at 2 per cent-a rate so low that they would have to be taken up by
the Reserve banks .themselves through direct purchase. The proposal
created consternation in the banking world, but not enough to modify the
program other than to raise the rate to 2 1/2 per cent on subsequent
issues. The Reserve banks in consequence took over the entire issue.
There was some evidence that McAdoo intended to finance the war by
this means ofshort term issues to be sold to the banks, much as Secretary
Chase had done during the Civil War. Fortunately this extremity was
avoided, but the Reserve authorities soon recognized that they would
have to provide the main financing, indirectly, by lending on the security
*Notes could be issued only against application for notes by a Federal Reserve bank and
"the collateral security thus offered shall be notes and bills accepted for rediscount under
the provisions of Section 13 of this Act." Section 16.