In the previous posting in this series we saw how the Federal Reserve was carefully designed to meet the legitimate demands of all parties and interests. Properly employed, there could never again be a "currency famine" as had happened in 1893 following the Panic, nor could there be a run on a bank that would deplete its reserves, as had caused the Panic of 1907. The inelastic, currency of the National Bank system backed by government debt that had caused so many problems would gradually be replaced with an elastic Federal Reserve Note currency backed by private sector hard assets.
The idea was that the Federal Reserve would gradually purchase the government bonds that backed the National Bank Notes. They would thus assume the liability for the National Bank Notes, and replace them with "Federal Reserve Bank Notes," which would then be backed by the government bonds the Federal Reserve had purchased on the open market from the National Banks. These government debt-backed Federal Reserve Bank Notes would in turn be replaced with "Federal Reserve Notes" that would be backed by private sector bills of exchange rediscounted from member commercial banks.
This would just be a book entry, reducing the holdings of government debt and replacing government securities with private sector bills of exchange. The Federal Reserve Bank Notes and the Federal Reserve Notes were indistinguishable in appearance, so it would be unnecessary actually to print new notes — just change the backing of the notes. In this way the debt-backed currency would become an asset-backed currency.
The system was allowed to work properly for two years before World War I changed everything. Salmon P. Chase had decided to finance the Union war effort during the Civil War by issuing debt instead of raising taxes. Chase wanted to be president, and raising taxes is a very unpopular move. According to Charles Conant and other financial experts, had Chase imposed the higher taxes he was eventually forced to adopt even a year earlier, the country would have avoided most of the 600% inflation that eventually destroyed a large number of small businessmen and farmers when the government had to restore its "faith and credit" after the war, and used deflation to do so.
In 1917 the politicians made the same decision as Chase, although in their case it was so they would remain in office rather than get elected. The effect was the same, however. Borrowing money or monetizing deficits is always more popular than raising taxes, even though the potential for harm is infinitely greater, as the world has found to its cost with the current economic downturn and global debt crisis.
The First Liberty Loan issue drained virtually all available liquidity out of the system. When the Second Liberty Loan issue came out, no one had any money to buy the bonds. The commercial banks then stepped in and patriotically purchased the bonds — using the loophole in the Federal Reserve Act intended to provide for the gradual retirement of the National Bank Notes — then turned around and sold the bonds to the Federal Reserve on the "open market." A way had been found to circumvent the intended prohibition against monetizing government deficits.