The First World War and the Financial System

Federal Reserve System 1914-1929• Federal Reserve Board in Washington D.C.

– How many members?– Who appoints them?– Independence?

• 12 Regional Federal Reserve Banks– Who belongs? Who owns them?– Who elects the Presidents?– What do their balance sheets look like?– What do they do?

• Monetary Policy– Gold Standard– Open Market Committee----who belongs, what does it do?– Open Market Operations– Discount Window and Discount Rates– Reserve Requirements

• Banking Policy– Disclosure: Who ask for “Call Reports”?– Examination: Who examines banks?– Supervision: What are the rules?

Problems of the National Banking System

• No central bank---inadequate provision of liquidity---Seasonally? Cyclically? Crises? Were there any substitutes?

• Fragmented banking system---prohibition on branching, easy entry, pyramiding of reserves and bankers’ balances

• What changes with the Fed—What doesn’t?

World War I: Quick Chronology• August 1914—World War I begins; U.S. Neutral• German submarine warfare sinks American ships; the

Zimmerman telegram shift Americans away from neutrality

• April 1917 U.S. enters World War I• How to Pay for the War? Liberty Loans, War Industries

Board, Price Controls, War Revenue Act—graduated income tax, corporate profits tax and excise taxes, government control of railroads, War Finance Corporation. Gold Embargo. 18th Amendment to Constitution.

• November 1918 Armistice• 1919 Victory Loan, the Volstead Act and demobilization.• Severe recession 1920-1921

Guns of August (1914)• U.S. in a recession. • Financial crisis erupts in the U.S. European start to

dump their American investments---huge sales.• Secretary of the Treasury is afraid that this will result in a

huge gold outflow that may threaten the U.S. ability to stay on the Gold Standard. Consequently, the New York Stock Exchange and others are shut down for 3 months.

• Soon, the demand for good and munitions in Europe creates a large balance of payments surplus for the U.S.

• Huge benefits for U.S. as a neutral power. A big boom begins and there is a large inflow of gold. Expansion begins December 1914 and continues to August 1918---real GDP grows 26.1%. Labor force increased by 12% and capital increased.

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Real GDP Price LevelWhy is the Price Level Rising Before WWI?????

Debt/GDP

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Debt/GDP

NBER Business Cycles (www.nber.org)

Duration in Months

Peak to Trough

Previous Trough to This Peak

Peak Trough Contraction Expansion

January 1913(I) December 1914 (IV) 23

August 1918(III) March 1919 (I) 7 44

January 1920(I) July 1921 (III) 18 10

May 1923(II) July 1924 (III) 14 22

October 1926(III) November 1927 (IV) 13 27

August 1929(III)

The Cost not measured: the Draft• Resources also

acquired by the draft of 3 million young men into the military at below market wages.

The blindfolded Secretary of War draws the first numbers in the draft

Bayonet Drill

Practice and the Real Thing

Financing WWI, May 1917-May 1919

Civil War WWI WWI

Percent $ Billions Percent

Taxation 21 7.3 22

Borrowing 56 24.0 58

Money Creation 23 6.4 20

Total Cost of War 100 33.0 100

How to Pay for the War? The Debate

• Tax? Borrow? Or Inflate?• Adam Smith—taxes, otherwise hide real costs of war.

Others argue that you should not pass burden on to other generations. (Probably never envisioned that a war would take 25% of one year’s GDP)

• John Maynard Keynes—borrow. • Borrow=“Tax-Smoothing” Higher interest rates

– Encourage saving, Reduces consumption of consumer goods– Encourage more work—accumulate now spend later

• WWI Contemporaries: – Secretary of the Treasury W.G. McAdoo—50% taxes then later

33%, – Banker J.P. Morgan 20%. – McAdoo saw trade-off: debt would be monetized and inflationary,

but too high taxes discourage business and production.

Who should be taxed? Answer—the wealthy and undeserving poor (who are addicted to

alcohol, tobacco and chewing gum)

1. Progressive Income Tax---made possible because: 1913 16th Amendment to the Constitution: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

2. Excess Profits Tax—aimed at “war profiteering”3. Excise taxes on alcohol, tobacco, passenger

railroad traffic, luxuries, jewelry, chewing gum

In 1913, Income tax was 0% up to $5,000 ($108,000 in 2010)

1% up to $25,000 ($515,000 in 2010) 6% for $1million ($21 million in 2010)…then

Debt Policy• Secretary of the Treasury William

G. McAdoo (under President Woodrow Wilson) concluded that the government in the Civil War had made a mistake by using a private firm (Jay Cooke & Co.) to market government securities.

• Instead , he expected bankers, insurance executives and citizens to donate their services. He began a huge public campaign, with movie stars like Douglas Fairbanks and Mary Pickford, with rallies and propaganda to sell bonds.

• Most important bond in Civil War called 5-20 (callable in 5 years and redeemable in 20) now there were four “Liberty Bond” issues and a final “Victory Bond” issue.

Fairbanks and Pickford

• "Shall we be more tender with our dollars than with the lives of our sons?"

----W.G. McAdoo, Secretary of the Treasury

Two Approaches

Did the Government “Capitalize on Patriotism” (McAdoo) and Borrow Cheaply?

Most importantly, if patriotism affected holding of bonds, then after the war a larger differential should have emerged—it did not.

However….Confidence is important

• Campaigns may have encouraged savings overall so that people did not dump other bonds and stocks

• Campaigns may have encouraged “over-subscriptions” to bond issues. All bonds sold at par. If issue is $2 billion, don’t want to end up selling $1.9 billion—looks like a lack of confidence.

Money: the Fed and the War• The Fed ceased to be independent—it is

co-opted by the Treasury. It agrees to keep interest rates on bonds low—”pegged” Why? Keep cost of borrowing low for government.

• Fed buys bonds directly.

• Fed lends to banks with bonds as collateral so that they can lend cheaply to their customers.

• Essentially fixes interest rates---huge expansion of credit and inflation.

The Money Supply = money multiplier x high powered money

• M = [(1 + C/D)/(C/D + R/D + E/D)]H

• C/D = coins/deposits

• R/D = required bank reserves in coin/deposits

• E/D = excess reserves/deposits

• H = Gold, Federal Reserve Notes and Reserves at the Fed

High Powered Money

• Neutrality: August 1914-March 1917-----huge gold inflows

• War: December March 1917- November 1918-----gold embargo, increases in Federal Reserve notes and discounts

• Postwar: November 1918-May 1920---gold outflows and increases in Federal Reserve notes

The Federal Reserve engages only in limited open market operations. BUT it discounts loans to banks that are collateralized by the banks purchases of U.S. government bonds

The Fed Hits the Brakes!!!!!!!

Contraction of 1920-1921

• Continued expansion of Federal Reserve credit outstanding in 1919 plus gold outflow after lifting of gold embargo leads to a decline in the Federal Reserve System’s reserve ratio (gold/deposits)

• Response: Raise the discount rate and reduce purchases of bonds

• Friedman and Schwartz (p. 231) rise in interest rates “not only too late but also probably too much”

• Result: Brief but severe recession

Comparing Recessions

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1920-1921 1923-1924 1926-1927 1929-1933 2007-2009?

Ideological Legacies of the War

• Republicans regain control of Congress and the Presidency

• Scale back spending and taxes and regulation---return to “normalcy” under Harding administration

• Prohibition 1917 (to 1933)---idea that country will be more productive and safer with no alcohol

• Many people became convinced that government regulation could improve the performance of the economy, by controlling prices or rules in industries or activist monetary and fiscal policy.

Legacy of war for International Capital Markets

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Real GDP Price Level

•The Roaring Twenties 1922-1929average 4% real growth of GDP per yearaverage 4 % unemploymentaverage 0% inflationSTOCK MARKET BOOMS!