Download The Origins of the Federal Reserve System and the First World War

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.
260
240
220
200
180
160
140
120
100
1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929
Why is the Price Level
Rising Before WWI?????
Real GDP
Price Level
19
12
19
13
19
14
19
15
19
16
19
17
19
18
19
19
19
20
19
21
19
22
19
23
19
24
19
25
19
26
19
27
19
28
19
29
19
11
19
10
19
09
19
08
19
07
19
06
19
05
19
04
19
03
19
02
19
01
19
00
Percent
Debt/GDP
35
30
25
20
15
10
5
0
Debt/GDP
NBER Business Cycles (www.nber.org)
Duration in Months
Peak to Trough
Peak
Trough
January 1913(I)
December 1914 (IV)
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)
Contraction
Previous
Trough to
This Peak
Expansion
23
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
Taxation
Borrowing
Money Creation
Total Cost of War
WWI
WWI
Percent $ Billions Percent
21
7.3
22
56
24.0
58
23
6.4
20
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
• 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.
Debt Policy
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 “oversubscriptions” 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
120
110
100
90
80
70
60
-4
-3
-2
-1
0
1
2
1920-1921
3
4
1923-1924
5
6
1926-1927
7
8
1929-1933
9
10
2007-2009?
11
12
13
14
15
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
•The Roaring Twenties 1922-1929
average 4% real growth of GDP per year
average 4 % unemployment
average 0% inflation
STOCK MARKET BOOMS!
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120
100
1900 1901 1902 1903 1904 1905 1906 1907 1908 1909 1910 1911 1912 1913 1914 1915 1916 1917 1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929
Real GDP
Price Level