The Great Deformation

by David Stockman

  In a civilian economy bereft of consumer goods, all prices and wages were put under a straitjacket of bureaucratic controls. Likewise, private incomes were drafted into war service either by means of confiscatory taxation or as quasi-forced savings via the incessant war bond campaigns.

  Not surprisingly, the money markets and the capital markets went into deep hibernation in this completely war mobilized economy. Likewise, the Federal Reserve became the financing arm of the warfare state. Making short shrift of any pretense of Fed independence, Treasury Secretary Henry Morgenthau simply decreed that interest rates on the federal debt would be “pegged.” Treasury bills would yield three-eighths of 1 percent and long-term bonds would pay a 2.5 percent coupon.

  Obviously, the only way to enforce this peg was for the nation’s central bank to purchase any and all Treasury paper that did not find a private sector bid at or below the pegged yields. Accordingly, the Fed soon became a huge buyer of Treasury securities, thereby “monetizing” federal debt on a scale never before imagined.

  The magnitude of this bond- and bill-buying campaign is dramatically evident in the Fed’s balance sheet footings, which showed holdings of $2.3 billion of Treasury debt at the start of the war. By the end of 1945, these holdings had soared to $24.3 billion, a twelvefold expansion during the four years of world war.

  The nation’s central bank thus became schooled in the art of rigging the government bond market and the Treasury yield curve by persistent massive open-market purchases of Treasury paper. Today this is business as usual, but then it was a radical departure, a theretofore rarely used tool that now became institutionalized owing to the exigencies of wartime finance.

  The Fed opened its doors in November 1914. But owing to the exigencies of wartime its purpose and modus operandi were twice turned upside down during its first thirty-one years. It can be fairly said that the Fed became a permanent denizen of the government debt market during its service to the warfare state, forging the T-bill standard, as it were, in the crucible of war. But this massive government bond buying was the very opposite of what its legislative authors had in mind when enacting the Federal Reserve Act of 1913.

  A BANKER’S BANK WHEN THERE WAS NO PUBLIC DEBT AND NO RELATIONS WITH WALL STREET

  Schooled in the English banking tradition and “real bills” monetary doctrine, the chairman of the House banking committee, Carter Glass, had seen the new Federal Reserve as an agent of the commercial loan market. In fact, he fervently believed that the Fed should not conduct operations in the government bond market, and certainly never envisioned that it would become a massive repository of government debt.

  Accordingly, it was intended that the new system would provide liquidity to business and industry through a “rediscounting” process in which the “reserve” banks supplied cash advances to local commercial banks. Such “reserve credit” extensions were to be collateralized by the short-term business loan books of participating banks.

  The commercial banking system would thereby be backstopped by a reliable source of cash to meet unexpected depositor withdrawals, while obviating the need for banks to call in business loans and disrupt the flow of commerce. The Federal Reserve System, therefore, was intended to be a “banker’s bank,” not an agent of national economic management. This founding charter has been literally blotted out of modern day discussions, as has the fact that the original Fed could not have operated through the government bond market in any event because in 1913 there wasn’t one.

  Total federal debt outstanding at the time of the Fed’s creation was $1.2 billion. This amounted to only 3 percent of GDP and $12 per capita in the money of the day, a figure which would still be only $400 per capita in today’s massively depreciated dollar. So the Fed was established during an era when policy makers didn’t much cotton to running their government on debt.

  Dramatic proof is that the $1.2 billion outstanding in 1913 was nearly identical to the national debt level first reached a half century earlier at the time of the Battle of Gettysburg. Fifty years with no growth in government debt, even in nominal dollars, is a mind bender in today’s world.

  Given the absence of a modern government bond market, it can also be said with certainty that the Fed’s designers did not anticipate that it would operate cheek by jowl with Wall Street. Only when the Fed entered the government bond dealer markets and conducted a continuous program of buying and selling Treasury securities did a close liaison with Wall Street become unavoidably necessary.

  By contrast, in the mind of Carter Glass and the congressional majority which followed his lead, the very purpose of the decentralized reserve bank system was to wrest control of the nation’s money from the long-standing grasp of Wall Street. And this aim was not simply an expression of countryside populism.

  Glass’s critique of the existing National Banking Act monetary arrangement, which functioned from 1863 until 1914, was cogent and exceedingly relevant to the framers’ intent. The studies that Glass’s congressional committee conducted showed that the existing system had powerful incentives which caused the nation’s liquid banking reserves to drain from the country banks and regional centers into the great city banks of Wall Street.

  These reserves were then employed in the lucrative but risky and volatile business of the call loan market. The latter mainly financed speculation, or as Congressman Glass vividly described the old system, “The country banks would bundle off their surplus funds to the money centers … to be loaned on call for stock and commodity gambling.”

  Such speculative enterprise periodically ended in financial panics on Wall Street and ricocheting waves of upheaval throughout the banking system. So Congress created the twelve “reserve banks” in faraway centers like Atlanta, Dallas, Kansas City, and San Francisco.

  These locations would provide a safe haven for the liquid reserves of the regional and local banks domiciled in each district. Excess deposits from the country banks would no longer need to make their seasonal road trips to Wall Street.

  In attempting to cut off the flow of bank reserves from the hinterlands to Wall Street, Carter Glass exhibited a level of monetary sophistication and learning that has escaped today’s Keynesian propagandists entirely. Professor Paul Krugman, for example, constantly cites the panics of 1873, 1884, 1893, and 1907 as evidence that the gold standard was a failure.

  At the time of the Federal Reserve Act of 1913, however, nearly every attentive student of the matter, ranging from Professor Oliver Sprague of Harvard to the self-taught chairman of the House banking committee, knew better. The evidence clearly shows that the actual culprit was not the gold standard but the deeply flawed National Banking Act system.

  By artificially flushing nationwide banking reserves into the big Wall Street banks, it fostered an unnatural, over-sized and inherently unstable call loan market for stocks. Punters speculating with margin loans would periodically get carried away, resulting in bubbles that would eventually collapse and cause a violent liquidation of overpriced stocks as call money dried-up. For the most part, these “panics” did not spread to the hinterlands, nor were they the cause of the long but constructive deflation that unfolded during the last three decades of the nineteenth century.

  This well understood truth was readily apparent in the new arrangement under the 1913 act. At the time, total deposits in the nation’s banking system were about $20 billion. Under the stringent reserve requirements of the new system, about $3 billion or so of cash and other liquid assets were required to be posted against these deposits as ready reserves, rather than being loaned out.

  But congressional supporters of the new system were fiercely determined to keep these billions of ready reserves out of the hands of the Wall Street money center banks and functionally divorced from them. The act’s principal author later explained this accomplishment in almost lyrical terms. Said Congressman Glass:

  “We cured this financial cancer by establishing the regional reserve banks and making them, instead of private
[Wall Street] banks … custodians of the reserve funds of the nation … making them minister to commerce and industry rather than to the schemes of speculative adventure. The country banks were made free. Business was unshackled. Aspiration and enterprise were loosened. Never again was there to be a money panic.”

  WAR DEBT AND THE FED’S NEW MISSION

  Three decades later, however, the Fed was a caricature of its founders’ vision, having become even more immersed in Wall Street than the old national banking system ever had been. As indicated, this development was the result of two wartime borrowing sprees and the resulting wholesale abandonment of the nation’s historic balanced-budget discipline. The public debt thereby grew from midget to giant dimension.

  Thus, the 1913 national debt of $1.2 billion had exploded to $260 billion by the end of the Second World War, and rather than 3 percent of GDP it was now 125 percent. The epochal nature of the change in the nation’s financial structure represented by these public debt figures is dramatically evident in the per capita comparison. In today’s purchasing power terms, the $400 per capita number for public debt of 1913 was $30,000 per capita by 1945.

  The federal government could never have accumulated debts of this magnitude without a central bank to serve as its fiscal agent and buyer of last resort. The Fed thus became ensconced at the heart of the government debt market, where its operations consisted first and foremost of buying Treasury securities from the Wall Street dealers to prop-up the market for government debt.

  While executing this large-scale debt monetization, the Fed also gained invaluable new experience in stage managing the balance sheets of the commercial banking system and in crafting bank earnings. During the war finance period of 1941–1945, commercial bank holdings of US government debt exploded, rising from $20 billion to $84 billion. This gain amounted to 90 percent of total commercial bank balance sheet growth, meaning that as a practical matter the banks functioned primarily as a receptacle for the government’s massive outpouring of wartime debt. The Fed’s crucial wartime learning experience came from its efforts to make it worthwhile for its wards in the banking system to hold all this government paper. To this end, it capped the discount rate at 1 percent, thereby keeping deposit costs cheap for the duration of the war. At the same time, the banks earned a 2.5 percent coupon from their investments in long-term Treasury bonds.

  The Fed thus enabled commercial banks to harvest a generous profit spread over their cost of funds. During the course of the war, in fact, bank earnings on securities held for investment nearly tripled, and net profits doubled. By 1945, the return on capital in the commercial banking system reached peak levels not to be seen again for another quarter century.

  Still, something of far greater significance than home front prosperity for the nation’s bankers came out of this ad hoc exercise in war finance. What really happened is that the Fed discovered the secret of how to manufacture bank profits by rigging the Treasury yield curve so it sloped in a smartly upward direction—that is, the longer the bond maturity, the higher the yield. Once discovered, this monetary sorcerer’s trick remained a staple in the Fed’s playbook thereafter.

  In its role as fiscal agent of the US Treasury, the Federal Reserve also bade farewell once and for all to the founders’ vision that it function passively as a standby provider of liquidity to the banking system. Under its original mission, banks needing cash would bring their eligible loan collateral to the Fed’s discount window to obtain a short-term advance.

  Accordingly, the commercial banking system was the active agent which drew the Fed’s cash into the economy based on the actual pace of local business activity. That is the inverse of today’s model in which the Fed proactively injects cash into the system through open market operations, based on where its monetary central planners think the national and world economy ought to be.

  Stated differently, under the original vision of the 1913 act, the business economy was in the monetary driver’s seat. It generated the ebb and flow of loans, deposits, and reserves in the banking system and the final aggregates of money and credit. Federal Reserve credit arose from commerce that already existed; it did not seek to add even a dime to existing bank loans or GNP.

  By contrast, during the period of war finance between 1942 and 1945, the Federal Reserve became a powerful, proactive manager and manipulator of the nation’s entire commercial banking system. Its purpose during that interval of national crisis was to manage the nation’s ballooning war debt, but these very same tools of banking system management through manipulation of the yield curve were later adapted to management of the GDP itself.

  Its apotheosis came six decades later, when the Fed orchestrated a veritable dance of the zombies during the aftermath of the September 2008 meltdown. Reaching back to its school days in war finance, the Fed again engineered a steep Treasury yield curve by driving front-end rates to nearly zero.

  In so doing, it gifted legions of insolvent banks with a simulacrum of profits. It thereby reduced depositors to penury, of course, even as it kept zombie institutions alive and their executives in bonuses for a while longer.

  THE WARFARE STATE BUDGET:

  HOW THE FISCAL BOUNDARIES WERE TESTED

  Even as the Fed was being domesticated as a branch office of the Treasury Department during the Second World War, the fiscal boundaries of the warfare state were also being dramatically enlarged. And this was something new under the sun. Notwithstanding the “big spending” reputation that several generations of Republican orators have pinned on the New Deal, the peak federal spending claim on the nation’s GDP averaged only 9 percent in fiscal 1938–1939.

  It was only the arrival of fully mobilized war budgets which actually demonstrated the capacity of the modern state to consume the national income. Accordingly, federal spending reached 44 percent of GDP during 1943–1945.

  At the same time, the fiscally conservative Morgenthau was not about to repeat the grave mistake of the First World War. Back then, most of the combatants had refused to finance the massive cost of industrial warfare with taxes, resorting to a destructive level of bond issuance and printing-press money.

  Morgenthau instead went for heavy current taxation, and jacked up the 8 percent of GDP federal tax burden recorded during the final years of the peacetime New Deal to nearly double that level by 1943. He then tripled the federal tax burden to 24 percent of GDP by 1945.

  The policy measures used to achieve this stunning tax take included confiscatory taxation of the wealthy and merely onerous taxation of everyone else. This tax dragnet included heavy excess profits taxes on corporations and a medley of excise taxes on consumers, along with sky-high income tax rates on all classes of payers.

  Morgenthau therefore accomplished what classic nineteenth-century public finance recommended but none of the European powers had achieved the last time; namely, financing at least 50 percent of wartime fiscal costs from current taxation rather than bonds and the printing press.

  In fact, during the five war budgets of fiscal 1942–1946 the Treasury accomplished exactly that. It collected $180 billion in cumulative receipts, which amounted to precisely one-half of its $370 billion in federal outlays.

  The régime of stiff taxation imposed by the Roosevelt administration during WWII was consistent with an implicit economic model that was classical, not Keynesian. The whole cumbersome bureaucracy of controls and heavy taxes was designed to curtail civilian demand and expand net national savings—the opposite of the Keynesian recipe.

  AMERICA SAVED ITS WAY OUT OF DEPRESSION:

  THE KEYNESIAN MYTH OF MASSIVE WAR DEBT

  To a very large degree the model worked. Approximately $100 billion, or 30 percent, of the five war budgets were financed with private sector savings. This outcome partially reflected the success of patriotic war bond campaigns, but mainly resulted from the reality of empty retail shelves. Citizens were forced to save via war bonds because there was nothing else to buy. Indeed, even sugar, butter, meat, tires, sho
es, bicycles, and candied yams were strictly rationed.

  In summary, then, about 80 percent of the fiscal cost of the massive warfare state that was mobilized to defeat Germany and Japan was paid for with the people’s savings in one form or another. About 50 percentage points of this was through the coerced “savings” (i.e., taxes) extracted by the Internal Revenue Service and another 30 points were derived from “voluntary” investments in war bonds and other savings instruments.

  The truth is, the American economy did not spend its way out of the Great Depression; it essentially saved its way through the most destructive war in human history.

  In the decades since 1945, however, Henry Morgenthau’s sternly orthodox scheme of war finance has been twisted beyond recognition by Keynesian revisionists. They have incessantly claimed that the Second World War demonstrated the power of deficit spending and the economy’s ability to carry a high ratio of government debt to GDP.

  Yet the only thing which is true about this particular Keynesian legend is that for one fleeting moment in 1945 the federal debt outstanding did reach 125 percent of GDP. The far more important data point, however, is the total debt ratio, including both private and public debt. This crucial figure is never discussed or even acknowledged by the Keynesians, and for an understandable reason: total debt outstanding did not rise during the war; it actually declined significantly.

  At the end of the wartime fiscal régime in 1945, the total debt-to-GDP ratio was about 190 percent. This figure, which includes business, household, and government debt, was measurably lower than the 210 percent ratio recorded under the peacetime New Deal in 1938.

  The actual data thus puts the lie to the endlessly repeated canard that the Second World War was a splendid exercise in debt finance. What actually happened during the war is that the private sector went on a huge savings spree, once the command economy was installed.