These economists made two major contributions that had a significant impact on World War II. First, they completed the financial revolution begun by the British in their wars with France, a revolution that made it possible to fund a war waged on an unprecedented scale. Second, they created the concepts of national income accounts, GNP, and GDP, which together provided the statistical basis for determining the growth and production potential of the American economy.4 Admittedly, their figures and calculations remained inexact, but, when put in the context of the scale of what the government would demand for mobilization in a global war, they sufficed.
Moreover, World War II was the first war where money was truly no object. While there were a number of practical concerns about the best method of financing the conflict and the inflationary impact of massive spending policies, there was never any concern in the United States about the nation’s ability to finance the war. Everything American industry could turn out the government could afford to buy. This was also true of Britain, which instituted similar policies in purchasing all the munitions produced by its industry. The financial crisis in Britain came in 1940, when its industry could no longer meet wartime production requirements and the need arose to tap American industrial potential. 5 Within months, Britain had shipped its entire gold reserve to New York and exhausted its credit. To alleviate this payments crisis, Roosevelt pushed Lend-Lease through Congress just in time to avert a financial disaster that could possibly have forced Britain’s withdrawal from the war.6
The Financial Revolution
The Roman statesman Cicero once noted, “Endless money forms the sinews of war.”7 It was not until the twentieth century, however, that governments discovered how to tap their economic systems to provide “endless” streams of money. Although the three historical methods of financing government spending (raising taxes, borrowing, and printing money) remained, governments had become more sophisticated in the employment of these tools. Focusing on these three methods, of course, generally ignores other possible funding sources in war, such as commandeering assets, both at home and in conquered areas; liquidating existing assets (as Britain did to purchase American industrial output); or asking for voluntary contributions. For the most part, however, such additional methods played a minuscule role in the financing of the Allied war effort, particularly in the United States.8
Orthodox economic thinking at the beginning of World War II held that taxes should finance wars on a pay-as-you-go basis.9 This viewpoint had wide support across the political spectrum since most politicians considered the printing of money as inflationary and debt financing as a burden on future generations. Moreover, most believed that adding additional debt to the national balance sheet was particularly reprehensible because the initial burden of paying it off would fall on the same young men who had fought the war.10 Economists also believed that turning on the printing presses would at best represent an emergency stopgap measure that would rapidly lose its effectiveness as hyperinflation outpaced the presses.11
An examination of World War II’s financing, however, indicates that the printing press played a much greater role than commonly assumed, particularly in the early war years.12 Although this rapid expansion of the monetary base would have crippled the economy if it had continued for too long, it was at the time critical to jump-starting rapid increases in production.13 In the first place, the government-instigated monetary contraction, which had extended the length and depth of the Depression more than any other single factor, had not been rectified by the time the United States entered the war. Thus, there was room to expand the stock of money without sparking inflation, particularly because the government had halted the production of high-ticket durable consumer items and because Leon Henderson, head of the Office of Price Administration (OPA), had begun instituting relatively effective price controls. For business to expand would require immediate working capital, and there was plainly not enough of it available in the economic system in 1941.14 In short, the in-circulation monetary base in 1941 was too small to support the daily activities of the massive American economy as it mobilized for war.15 Unless the government added cash to the system quickly, there was a real possibility the entire mechanism would seize up.16
The Federal Reserve Bulletin for December 1942 noted that the government had financed 75 percent of its expenditures in the first year of the war through borrowing, with the remaining 25 percent financed through taxation.17 This is somewhat disingenuous because it fails to reflect on how the Federal Reserve System creates money. Since the start of the Federal Reserve System, the primary method of adding liquidity to the monetary system was by altering the reserve requirement that members of the system had to keep on deposit with the Federal Reserve. In peacetime this is a highly effective method, but in a crisis several overlapping factors often led to lag times between reserve rate changes and expansion of the monetary base. In the emergency of global war, when the funds necessary to finance rapid expansion are needed immediately, the government could not tolerate this lag.18
In spring 1942 the Federal Reserve’s principal method of adjusting the monetary base became a fixed buying rate on Treasury Bills. Under this policy, as the Federal Reserve Bulletin stated, “Member bank reserves are almost automatically supplied, with the initiative being taken by the member banks rather than by the Federal Reserve System.”19 The importance of this policy lay in the fact that, in effect, it authorized the member banks to purchase any volume of U.S. government securities, purchase other securities, or make loans as they desired, provided that among these securities they acquired sufficient Treasury Bills to exchange at Federal Reserve banks for whatever additional reserves may be needed because of the accompanying expansion in reserves.20 That is, the government had turned the formulation and execution of monetary policy over to the commercial banks with a blanket authorization to produce as much wartime monetary expansion as they found profitable.21
How did this work in practice? As the public purchased government securities, the payments were credited to U.S. government accounts in various commercial banks. This process automatically reduced the amount of reserves that banks were required to hold on hand. Eventually Treasury transferred these excess reserves to the various regional Federal Reserve banks, which used them in payment for the purchase of war supplies and other government expenditures. The government’s admonition to keep these reserves fully invested at all times, coupled with the natural desire of profit-making institutions to increase their holdings of interest-bearing investments, encouraged banks to use their reserves to purchase large amounts of government bonds, both during bond drives and on the secondary market. The banks made most of such purchases directly from the Treasury, when possible; otherwise, they bought them from private investors. The need to keep reserves employed until they were called for by the central bank caused banks to make sizable loans to customers for the purchase of government securities, most of which these customers later sold to banks. Both the direct purchase of government debt and the funding of customers to do so tended to increase a bank’s future reserve requirement. This increase showed up several months later, when the Treasury spent its new deposits and the funds reappeared in the accounts of banking customers. The announced policy of the Federal Reserve System to purchase Treasury Bills at a fixed rate, however, eliminated any fear that the bank might have trouble meeting future reserve requirements. As long as this policy continued any bank could purchase any volume of U.S. government securities for its own account, or could loan any volume of money to its customers for any purpose without fear of being embarrassed by its inability to meet future reserve requirements.
In short, the Federal Reserve gave the banks a license to print money. Two things, however, stopped the banks from undertaking an unbridled monetary expansion that could have led to hyperinflation and financial ruin. First, the U.S. banking system remained largely fragmented, with more than sixteen thousand national and state-chartered banks across the country.22 The many
thousands of bankers across the country simply lacked the economic sophistication to spot the opportunity presented to them. More important, though, were memories of the Great Depression and the numerous banking panics of previous decades. Though on a practical basis the new Federal Reserve wartime policies had eliminated the need for reserves, most of the Depression-scarred banking community still thought it prudent to hold sufficient reserves on hand for emergencies.23
What the government was doing was issuing debt in quantities so huge that it would be impossible for the economy to digest those sums without massive interest rate increases to make bond purchases attractive. To clear the debt, the Federal Reserve became the buyer of last resort and purchased as much of the debt as necessary to keep the price and interest rate at a previously agreed pegged rate: this is called monetizing the debt.24 These purchases created government-owned deposits on the books of the central bank, which equated to the banking system receiving additional reserves; banks then used those reserves to expand their asset holdings while creating additional deposit money.25 Thus, one must consider the portion of the debt issued by the government that banks or private investors, using bank financing, bought back as printed money, although the Federal Reserve resisted such thinking at the time.
This means that 75 percent of the government’s expenditures in 1942 were not, in reality, financed through debt securities. Instead, the government funded a substantial portion of its purchases through money creation.26 Estimates are that as much as 42 percent of 1942’s wartime spending was the result of turning on the printing presses, while actual non-government-financed bond sales paid for approximately 34 percent, with taxes paying the remaining 24 percent. This situation had reversed by 1944, when taxes and a much-reduced amount of debt sales sufficed to cover expenses.27
If politicians and economists agreed that money creation was the worst possible measure to finance the war and taxes were the best, how did the reverse become policy, at least in the United States during the early war years? The overriding problem facing the U.S. government during World War II was how to raise the staggering amounts of money required by war.28 If it performed the job well, the government could stabilize the economy, which would make preserving the soundness of the currency immeasurably easier. If it performed the job poorly, the entire economy could be destroyed.
For example, most historians agree that Germany’s failure to adequately address its war financing needs was a contributing factor to the general disruption of its economy in the aftermath of World War I. By failing to adequately tax its economy to meet wartime expenditures, the Germans left it up to their central bank to raise the necessary funds on a credit basis. This negligence, plus military defeat, contributed to the ruinous inflation that wiped out the value of most of German society’s economic assets in the early postwar period.29
During World War II, the Treasury Department had the responsibility of raising sufficient funds to wage the war. In this regard it focused on keeping interest rates low, thereby minimizing the cost of servicing debt.30 The Federal Reserve’s principal concern was to ensure that the means used to raise funds were as noninflationary as possible. To the extent that these funds did not come from taxation or borrowed savings, the United States had to raise its financial wherewithal through the banking system. In other words, the federal government used the banks to create sufficient credit.31
In the process, the Federal Reserve confronted a dilemma. On the one hand, the system had to supply the banks with the reserves required to support credit expansion. On the other hand, it was the system’s responsibility to neutralize the inflationary potential of newly created money. There was no satisfactory way to neutralize the money that would not raise the cost of debt substantially or contract available credit. The most the Federal Reserve could do was go about its business with sufficient care to slow the impact.32
That inflation remained low, or at least within reasonable limits, was the result of three realities. The first was creation of the OPA in 1942. That organization possessed sweeping powers to control prices and establish rationing programs on products in short supply. The second was that conversion to wartime production brought a halt to the manufacture of almost all big-ticket consumer durables, such as automobiles and refrigerators.33 The wartime boom may have given consumers more cash than they had previously, but it did not give them much to buy with that cash. The third, and in many ways most important reality, was the self-restraint exhibited due to consumers’ postwar expectations. Virtually all Americans had vivid memories of the Great Depression and believed that the current prosperity was a wartime boom. There was widespread expectation and trepidation that the Depression would return as soon as the war ended. Many, therefore, took the sensible precaution of saving rather than spending their windfall.
Was it necessary to go this route? During the six fiscal years from 1 July 1940 to 30 June 1946, the federal government spent $387 billion, of which $330 billion was for national defense. The Treasury raised $397 billion, of which taxation garnered $176 billion, or 44 percent.34 Moreover, politicians were aware that taxation provided many benefits over the other two methods of finance. First, taxation distributed the cost of the war while it was being fought rather than imposing the costs on future generations and was therefore considered more ethical and fair. Taxation also fought inflation: it had an almost dollar-for-dollar impact on inflation because consumers cannot spend a dollar on goods that has been taken away by the government. Finally, taxation alleviated many negative postwar economic effects: greater amounts of wartime borrowing meant greater postwar taxation in order to service the resulting debt. Furthermore, large amounts of government securities in private hands at the end of a war could easily provide sufficient liquid assets to stoke serious inflation, as was to happen in 1947–49.35
So why did the government not raise tax levels to cover the expense of war? First was the need to provide incentives to workers. During the war the government wanted every worker to make a maximum effort to increase production levels. Taxes not only discourage workers by making them feel poorer, but also have a negative impact on the human desire to earn extra dollars if they believe those dollars will only end up in the hands of government. Moreover, politicians are reluctant to place tax burdens on constituents to whom they eventually will find themselves accountable. When faced with a vote on a tax increase, politicians can easily forget about the burden to future generations in favor of keeping today’s voters happy.36
By far the major determining factor in financial decisions was the one that received little coverage from the economic historians of the period—namely, time. The emergency was now, and the need to pay for the war was immediate. This need was particularly pressing in the first year of major rearmament, when the American economy had to provide resources to build or expand factories and emplace the infrastructure on which the expansion of the military establishment depended. Passing new tax laws through Congress and then establishing the apparatus on which to assess and collect those taxes would have represented a time-consuming affair. Though Congress authorized a new tax structure in April 1942, it was almost a year before substantial new revenues began to find their way into the treasury.37 Bond drives that focused on sales to private individuals had the same problem, as it took months for the government to organize and publicize them.
The maturity of the Federal Reserve System, born in the early days of World War I, provided an efficient system, already in place, to raise vast amounts of cash in a remarkably short time. It was not without risks but, properly managed, the system provided a stopgap until taxation and bond drives could begin to assume the bulk of governmental funding requirements. Even after taxation had reached its maximum wartime limit, the Federal Reserve continued to guarantee sufficient bank liquidity to ensure that bond drives always met their goals without ever going over the 3 percent interest cost on offered bonds. By any measure, the American banking system, which was controlled by the Federal Reserve System, pro
vided the Allies with a financial engine that relatively easily assumed the burdens of war finance. Although the strains on it were enormous, every indication is that the Federal Reserve could have created substantially greater funding without collapsing the system, if the war had continued.38
The Federal Reserve banks themselves absorbed approximately $22 billion of the public debt, while also creating a favorable environment for absorption of roughly $95 billion more by commercial banks. Moreover, from June 1941 through December 1945 investors other than Federal Reserve commercial banks absorbed approximately $129 billion of government securities.39 In total, this was close to all of the government’s spending on the war, and even in 1945 these sources were far from tapped out. In fact, the continuing high levels of savings that propelled the postwar boom could easily have provided additional war funds, if required. For the first time in history, a government had exhausted production capabilities long before it had exhausted the funding sources required to pay for new munitions. Such a state of affairs could not have continued forever, but it lasted long enough to win the war.
The Federal Reserve held true to the promise it had made almost immediately after Pearl Harbor, when it issued the statements that the “system’s powers would be thrown completely behind the war effort” and that there were “sufficient funds available to prosecute the war on a massive scale until victory.” At the time, many politicians doubted this was possible.40 There is no record, however, that any economist during the period doubted the system could fulfill the Federal Reserve’s boast.41 Governments, through their economists, for the first time in three thousand years had devised methods to pay for total war, over an indefinite period. When the test came, these methods proved effective at managing the fiscal machine. It remains to be seen how economists were able to determine how much the country could produce over a fixed amount of time.42
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