How the Fed Helped Pay for World War I
On the 100th Anniversary of the U.S. entering World War I, we look back on the history of that conflict, including how the government financed U.S. participation and the consequences of fighting a “war to end all wars.”
How the Fed Helped Pay for World War I by John Paul Koning
Governments can pay their bills in three ways: taxes, debt, and inflation. The public usually recognizes the first two, for they are difficult to hide. But the third tends to go unnoticed by the public because it involves a slow and subtle reduction in the value of money, a policy usually unarticulated and complex in design.
In this article, I will look under the hood of the Federal Reserve during World War I to explain the actual tools and levers used by monetary authorities to reduce the value of the public’s money in order to fund government war spending. This example will help readers better understand the more general idea of an “inflation tax,” and how such a tax might be used in the future to fund the state’s wars.
It is the government’s monopoly over the money supply that allows it to resort to inflation as a form of raising revenue. Kings and queens, by secretly reducing the amount of gold in coins they issued to the public, could use the gold held back to pay for their own pet conquests. Slowly the public would discover that the coins they were using had less gold than the amount indicated on their face. Their value would be bid down, and the coin-holding public would bear the costs in lost purchasing power.
Legal-tender laws adopted by governments prevented the public from exchanging bad coins at less than their face value. A fall in market value, after all, would cut off a significant future revenue source: the government’s ability to issue bad coins at inflated values.
The use of force to subsidize an inferior coin’s value reduced its capacity to provide the holder with certainty, corrupted the informational value of the prices it provided, and diminished the public’s trust in the money. This decline in a monetary system’s efficacy due to bad money and legal-tender laws is always a cost born by the money-using public.
Just as kings debased coins to help pay for their wars, the Federal Reserve used inflation to help pay for US participation in World War I. It did so by creating and issuing dollars in return for government debt. In effect, the Fed’s balance sheet became a repository for war bonds. Furthermore, the Fed brought this debt onto its balance sheet at a higher price than the market would have paid otherwise, a subsidy born by all those who held money as its purchasing power declined.
Before explaining how this process worked, it is necessary to know a few things about the Fed. The institution began operations in 1914 on the “real-bills” principle. Member banks could borrow cash from the Fed, but only by submitting “real bills” as collateral.
These bills were short-term debt instruments that were created by commercial organization to help fund their continuing operations. The bills were in turn backed by business inventories, the “real” in real bills. By discounting or lending cash to banks on real bills, the Fed could increase the money supply.
The original Section 16 of the Federal Reserve Act required that all circulating notes issued by the central bank be backed 100% by real bills. On top of this, an additional 40% gold reserve was to be held by the Fed. In those days, Federal Reserve notes — a liability of the Fed — were convertible into gold, and the 40% gold reserve added additional security. Thus, for each dollar liability it issued, the Fed held 140% assets in its vaults, or one dollar in real bills and 40¢ in gold on the asset side of its balance sheet.
The Fed was also permitted to engage in open-market purchases of government debt and banker’s acceptances. But government debt was not of a commercial nature, and therefore was not considered a real bill. Because the 100% “real”-backing requirement for notes could not be satisfied by Fed holdings of government debt, the Fed could only issue a limited number of notes for government debt before running up against the 100% requirement.
Thus, the real-bills doctrine as set out in the Federal Reserve Act significantly hemmed off the Fed’s balance sheet from serving as a bin for the accumulation of government debt and claims to government debt. To help finance the war, which it had entered into in April 1917, the US government would have to open up the Fed’s balance sheet to the Treasury’s war debt.
Read the rest at the Mises Institute.