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Source link: http://archive.mises.org/11022/how-the-fed-helped-pay-for-world-war-i/

How the Fed Helped Pay for World War I

November 12, 2009 by

Just as kings debased coins to help pay for their wars, the Fed 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. FULL ARTICLE by John Paul Koning


Jonathan Finegold Catalán November 12, 2009 at 12:57 pm

Mr. Koning,

You write:

Indeed, Friedman and Schwartz estimate that 5% of the cost of the war was funded by Fed inflation.

Indeed, on page 221 they do claim that 5% of the war was paid for by “direct money creation”. Is this figure completely accurate, though? Fractional-reserve banking, at least when the reserve ratio is fixed, leads to the direct creation of money (see: Huerta de Soto, Jesús, Money, Bank Credit and Economic Cycles). Friedman and Schwartz, on the page aforementioned, also claim that 70% of the war was paid for through borrowing. Surely, there was money creation somewhere there, meaning that the total amount of war paid for through inflation was more than 5%. Or, am I missing something?

Benjamin Anderson, in Economics and the Public Welfare, wrote:

The Federal Reserve System performed great and distinguished services for the government and the country in World War I. It is difficult, indeed, to see how we could have handled the financial problems of the war without it. It made possible a smoothness and simplicity in handling huge financial transactions that would have been incredible under the old system. In the summer of 1918, for example, the federal government collected around $4 billion in taxes in a few weeks. In connection with the first liberty loan in 1917, $2 billion were paid into the federal Treasury in a short time. Financial transactions of this magnitude would have led, under the old system, to drains, falling primarily on the New York banks, which would have forced the banks almost instantly to suspend cash payments. Had the old subtreasury remained in full vigor, under which all payments to the federal government were placed in cash vaults of the government itself, the mechanism would have broken down with the first liberty loan. Under the Federal Reserve System, however, these huge financial transactions were largely accomplished by bookkeeping entries.”

It seems as if the war was paid for through a textbook example of fractional reserve banking. And so, the amount of the war paid for by inflation should be much higher than that assumed by Milton Friedman and Anna Schwartz. And, this inflation was just as relevant to the Federal Reserve as its direct transfer of money to buy government securities (what’s the difference if its paying a bank for a government security, or paying the government directly?).

Indeed, it seems as if that without the Federal Reserve the United States would have not been able to afford to enter World War I, at all. Actually, this seems like the perfect topic for a blog entry on my own site! I really never thought about this until now (although, I believe Ron Paul made a similar claim in an article he wrote in the 90s).

Saul Frugman November 12, 2009 at 5:56 pm

Everyone knows that war is good for the economy, and World War I was no exception. We need to start World War III to get us out of this recession, because printing money without creating rebuilding jobs isn’t enough. The unemployed can become cannon fodder and that will boost the economy.

alan November 12, 2009 at 7:38 pm

Let’s see a similar article for WW2.

@Jonathan Finegold Catalán

Thanks for the Benjamin Anderson quote.

George Smith November 12, 2009 at 7:59 pm

The Friedman & Schwartz figure of 5 percent sounds off, by a lot. According to Rothbard, “[the Fed] permitted the U.S. to enter the war and to finance both its own war effort, and massive loans to the allies; roughly, the Fed doubled the money supply of the U.S. during the war and prices doubled in consequence.” (Case Against the Fed, p. 120)

Also, Benjamin Strong’s biographer, Lester Chandler, says, “The Federal Reserve System became an integral part of the war financing machinery. The System’s overriding objective, both as a creator of money and as a fiscal agent, was to insure that the Treasury would be supplied with all the money it needed, and on terms fixed by Congress and the Treasury. . .” (quoted in Creature from Jekyll Island, Griffin, p. 484)

Griffin adds: “[M]any people who thought it was their patriotic duty to support the war effort went to their banks and borrowed money so they could buy [Liberty Bonds]. The bank created most of that money out of nothing, drawing upon credits and bookkeeping entries from the Federal Reserve, so those purchases did inflate the money supply. . .”

Griffin continues: “Up until World War I, annual federal expenses had been running about $750 million. By the end of the war, it was running $18 and-a-half billion, an increase of 2,466%. Approximately 70% of the cost of the war had been financed by debt.”

JP Koning November 13, 2009 at 10:07 am

Firstly, where does the 5% number comes from? According to F&S, total Federal expenditures on the war were about $34 billion. From the chart above, you can see that discounts collateralized by government war bonds rose by about $1.5 billion. Divide the latter by $34 billion and you get about 5%.

Yes, FR banks monetized a large chunk of the $34 billion ie they created new deposits to buy war bonds. But this wouldn’t have been inflationary. Newly created private chequing account dollars would have returned to the issuing banks for redemption through the clearing system; after all, the demand for money hadn’t increased. To redeem, the FR banks would have had to sell off non government assets. So the amount of newly created chequing account dollars conformed to the demand for those dollars; those that were not wanted were cancelled via redemption. All that changed was the composition of private FR assets, since the banks now had much more government debt on their books.

The Fed, on the other hand, is not disciplined by a competitive clearing system, thus there was no way for the excess Reserve notes created via the preferential discount rate to be removed from the economy. That’s why I think the inflation (decline in purchasing power) was the Fed’s fault. The preferential discount rate is key, as is its monopoly.

JP Koning November 13, 2009 at 10:14 am

By FR banks, I mean fractional reserve banks. By inflationary, I mean in the sense in which money’s purchasing power declines.

Central Planning November 13, 2009 at 3:00 pm

Central banking is central planning.

Bob September 26, 2011 at 6:10 pm

Sign the petition to END THE FED:


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