In the autumn of 1937 Franklin Delano Roosevelt brooded about deterring foreign military dictatorships from attacking peaceful nations. On 5 October, thirteen weeks after Japan invaded China, the president delivered his famous “quarantine” speech. Likening the spreading aggressions to an epidemic disease, he suggested that law-abiding countries ought to quarantine the aggressors. When pressed by reporters, he denied that he meant economic sanctions, calling sanctions “a terrible word to use.” “There are,” he said, “a lot of methods in the world that have never been tried yet.”1 Roosevelt was not sure what he meant until December, after Japanese bombers sank a U.S. gunboat in China. He turned to his energetic secretary of the treasury, Henry Morgenthau Jr., for a “modern” weapon to wield against Japan. Treasury experts unearthed the perfect device: a relic of the First World War known as Section 5(b) of the Trading with the Enemy Act (TWEA), a single paragraph that empowered the president to paralyze dollars owned by foreign countries, whether enemy or not. Denial of U.S. dollars, a key reserve currency of the world and indispensable to Japan for waging war, could dissuade Japan from belligerence. That surviving section of the act had arisen from an obscure spat in 1917 between government agencies that foreshadowed the bureaucratic graspings for power in Washington during 1937–41 as the United States groped toward invoking its great financial powers to render Japan effectively bankrupt in the world.
Sanctioning to impose a nation’s will on others in peacetime was hardly a novel concept. International law governing trade relations among sovereign states had been laid down by the European jurists Hugo Grotius and Emeric de Vattel in the seventeenth and eighteenth centuries in the wake of dreadful destruction of the Thirty Years’ War. They held that nations had the absolute right to decide what and from whom to import. Refusal to export was also a sovereign right, although Vattel considered extreme actions such as withholding food in time of famine might be construed as acts of war.2 In 1807–9 President Thomas Jefferson applied the Embargo Acts, drastic trade sanctions to protest by means short of war the violations by Britain and France against U.S. shipping and trade and British impressments of American seamen. The acts outlawed incoming and outgoing trade with those empires. Lack of American cotton nearly wrecked the British textile industry, and the Royal Navy suffered shortages of masts from the tall white pines of American forests. Nevertheless, the European powers did not deem Jefferson’s embargo a casus belli, in part because of smuggling and evasion, and the embargo ended in failure.3 In 1812 America had to fight a real war to restore its maritime rights. Money, however, had not been a coercive tool in those early episodes, nor could it be an option of U.S. foreign policy for another century until the United States rose to financial supremacy during and after World War I.
When the United States declared war on Germany on 6 April 1917 it had no legal mechanism for restricting economic dealings with the enemy other than publishing lists of contraband goods under the common law. At the urging of Secretary of State Robert Lansing, Congress added to an espionage bill of 15 June some export restrictions as a stopgap measure. Lansing, in testimony before a House of Representatives committee, noted that although the rules applied to all international trade, they did not cover financial transactions.4 A committee of officials of the State, Commerce, Treasury, and Justice Departments set about drafting a more comprehensive Trading with the Enemy Act focusing on physical trade. Lansing showed little further interest, presumably viewing war measures as outside his diplomatic realm and certainly not expecting any restrictions to outlive the war.
In June and July 1917 Secretary of Commerce William C. Redfield, a strong advocate of regulations, described to the House of Representatives how the proposed TWEA avoided the meddlesome English system of approving or disapproving each and every foreign transaction. By limiting controls to dealings with enemy countries, it preserved as much as possible the U.S. tradition of noninterference in commerce. Although not within his authority, Redfield urged regulation of financial dealings as well, because, he said, “we are now the world’s purse,” having “the greatest present source of credit in the world.”5 Redfield’s deputy, Edward E. Pratt, agreed that “the most important aspect of the whole thing is the financial and credit transactions that might take place.” Although the British blockade had shrunk Germany’s substantial transatlantic trade to a trickle, international transactions were complex proceedings that could be routed through neutrals such as Spain. Most congressmen agreed that “this war is to be won as much by dollars as it is by men and guns.”6 Redfield proposed that his Commerce Department administer both trade and financial dealings involving enemy states.7 The House agreed. Its bill and the subsequent Senate versions included a variety of controls on international financial dealings. Some were exhaustively detailed as matters to be settled after the war.8
Control of physical commerce was straightforward in the draft TWEA. It restricted trade with an enemy nation (Germany) and its citizens and businesses; with “allies of an enemy,” for example, Austria-Hungary, that were not yet at war with the United States; and foreign states and entities that might try as middlemen to circumvent the act. Direct or indirect enemy trade, if any, would be authorized only under licenses granted by the authority of the president. The Department of Commerce, the agency whose customs houses granted clearances to cargoes aboard vessels and trains entering and leaving the United States, would enforce the act.9 The House bill contained no indication that the act was other than a temporary war measure that would lapse when peace returned. The bill passed and moved to the Senate.
During deliberations, Secretary of the Treasury William Gibbs McAdoo had been absent promoting Liberty Bond sales. McAdoo was an influential, practical-minded presence in Washington: a former electric railroad executive, an early supporter of President Woodrow Wilson—he married Wilson’s daughter Eleanor in 1914—and an architect of the Federal Reserve system.10 Upon returning to Washington to testify before the Senate Subcommittee on Commerce, he wholeheartedly supported financial regulations but demanded that the Treasury and Federal Reserve Board, not the Commerce Department, must wield the levers of control. Every transaction, he argued, involved both a physical movement of goods and a money settlement. Shipment of gold abroad was clearly a movement of “money,” not of a commodity. Most elusive were foreign-owned bank deposits that were transferable from a distance by letter or telegraphic wire. To block Germany from obtaining dollars to spend in the United States or in third countries, McAdoo argued that German bank accounts in the United States must be frozen and sale or mortgaging of Germany’s large investments in U.S. factories and securities must be prohibited.11
A bureaucratic dogfight erupted. While Secretary Redfield conceded the Treasury’s authority over financial controls and acknowledged the bank-regulating expertise of the Federal Reserve system established four years earlier, he insisted that the definitive authorization of a regulated transaction must be an export or import license granted by the Department of Commerce.12 In response, McAdoo unleashed Milton C. Elliott, general counsel of the Federal Reserve Board. Elliott, a handsome young Virginia attorney who sported the pince-nez eyeglasses worn by the president, typified the midlevel Washington bureaucrat of this narrative: expert, clever, aggressive, and determined to magnify the power of his agency and his superiors. After a stint as lawyer for the comptroller of the currency, he came to McAdoo’s attention, traveling with him as secretary of a barnstorming mission in 1914, a bit of political theater aboard a lavish private train steaming around the country to organize the regional Federal Reserve banks. He was named counsel of the Federal Reserve Board in 1915, a post he held until after the war, when he returned to private practice.
Elliott’s clever innuendos and bizarre explanations ran rings around bumbling Commerce Department spokesmen in the hearings. His arguments were both genuine, such as providing the Federal Reserve’s banking know-how, and trivial, such as the storage space for confiscated gold in sub-Treasury vaults. Redfield, forced to retreat, conceded a cosmetically joint system whereby Commerce-approved merchandise movements would be deemed automatically licensed by the Treasury. McAdoo and Elliott bridled, demanding coequal status: authorized deals were to be licensed by both Commerce and the Treasury acting independently.
At a key moment in the proceedings Elliott submitted an amendment authorizing the Treasury, assisted by the Federal Reserve, to regulate and license all international financial transactions with all countries. It ultimately emerged, word for word, as Section 5(b) of the TWEA.13 In relevant part, the section read:
That the President may investigate, regulate, or prohibit . . . by means of licenses or otherwise, any transactions in foreign exchange, export, or earmarkings of gold or silver coin or bullion or currency, transfers of credit in any form . . . and transfers of evidences of indebtedness or of the ownership of property between the United States and any foreign country, whether enemy, ally of enemy or otherwise, or between residents of one or more foreign countries, by any person within the United States (emphasis added).14
A great mystery surrounds how and why Section 5(b)’s sweeping applicability to all nations at all times appeared in the Trading with the Enemy Act. According to a congressional study sixty years later, the act’s history was “short and sketchy.”15 There is no record of debate or discussion in Congress on 5(b). Elliott may have inserted it to ensure interception of enemy dealings through neutrals, or to dictate postwar settlements of financial and property claims or, as a good attorney, merely to confer maximum powers on his client without thought of the long-term future. McAdoo had in his pocket the blessing of President Wilson. He prevailed with the help of friendly senators. Congress passed the Trading with the Enemy Act on 6 October 1917. President Wilson signed the bill on 23 November. All financial elements of controlling “enemy” financial dealings were lodged in the Treasury Department. The power over modern economic warfare passed from who controlled shipping, as in Jefferson’s day, to who regulated the money. McAdoo designated the Federal Reserve Board as subagent of the Treasury to administer financial controls. The permanent powers of Section 5(b) apparently escaped everyone’s notice. In February 1918 an authoritative 485-page manual published by a Stanford University law professor as legal guidance to the TWEA merely reprinted 5(b) without comment except a technical cross-reference to shipping.16
Section 5(b) accomplished two things. First, it awarded dominion over licensing financial transactions to the Treasury Department as agent of the president not subject to challenge by other agencies, not even the diplomats of the State Department. Second, it added the fateful words “any foreign country, whether enemy, ally of enemy or otherwise.” Therefore, it endured long after the war ended and no enemy existed, unlike other provisions of the TWEA concerned only with enemies that lapsed after the peace treaties of 1921.17 But 5(b) was not limited to an “enemy” in “time of war.” It continued to empower presidents to regulate financial dealings of Americans with all foreign countries and entities, conferring on them enormous unilateral powers over international finance in a world where the dollar would come to reign supreme.
The TWEA, amended for a few minor details, lay largely unused until 4 March 1933. Immediately upon his inauguration as thirty-second president, Franklin D. Roosevelt invoked it to declare a “bank holiday,” temporarily shutting down the nation’s failing banking system. On 9 March Congress passed, in eight hours, with no hearings and little debate, and even before the bill was in print, “An Act to provide relief in the existing national emergency in banking, and for other purposes.” The president immediately signed it. Congress validated the existence of a serious national emergency and endorsed all the president’s actions in his first five days “pursuant to the authority” of 5(b). It also amended the TWEA so that its provisions could be handled through any agency he designated “during time of war or during any period of national emergency declared by the President.” It added to the definition of covered transactions “transfers of credit between or payments by banking institutions,” astonishingly removing a bar against regulation of purely domestic banking transactions by invoking a foreign emergency. Absolute control of money dealings, foreign and domestic, thereafter required not an act of Congress but only a national emergency as a president saw fit to declare.
Roosevelt invoked Section 5(b)’s transcendent powers later in 1933 for executive orders directing the Treasury to regulate all foreign exchange transactions, to forbid exports of gold, and in 1934 to sponsor legislation to prohibit Americans from possessing gold (other than jewelry, rare coins, tooth fillings, and such). Gold bars and ordinary gold coins had to be sold to the government. Gold ownership, except specially licensed firms such as mining companies, became subject to criminal penalties.18
The TWEA, a relic of the Great War, evolved into the ultimate U.S. weapon of financial power over foreign nations in time of peace, but not until 1940–41.19 In the 1930s lesser schemes of economic control were put into play, focusing on denying specific products to Japan’s army and navy, which did not inhibit much of Japan’s international trade or injure its civilian economy. None packed the awesome power of a monetary blockade. Except for a brief moment after Japan launched its attack on China, financial sanctions were not seriously explored. In the late 1930s U.S. financial experts believed that the war would drive Japan into self-imposed bankruptcy (chapter 5). To understand that development, which helped delay imposition of Section 5(b) against Japan until 1941, it is helpful to explore how Japan historically acquired dollars, through exporting to the United States and accumulating reserves of gold, and the crises it faced as its sources of dollars withered away.