While the United States pursued a policy of gradually restricting exports to Japan, the alternative policy of financial pressure lay slumbering, out of mind in Washington. Only once, in December 1937 shortly after the invasion of China, had Morgenthau contemplated freezing Japan’s dollar assets, an action the president could have authorized by declaring an emergency under the Trading with the Enemy Act, but Roosevelt had dropped the idea (chapter 2). From 1937 to 1940 analysts and officials of several U.S. government agencies confidently predicted that if Japan continued to wage war in China, it would “bankrupt” itself, that is, spend all its reserves of gold and hard currency to buy essential commodities. The inference of their many studies of Japan’s finances was that the United States need not threaten financial sanctions to deter aggression. Instead, tentatively at first but with increasing intensity, the United States discontinued exporting to Japan most strategic commodities in lieu of deploying its most devastating financial weapon.
Confidence that Japan’s international reserves were rapidly evaporating was due in large measure to precise knowledge of its continuous sales of gold to the U.S. Treasury. Analysts were certain that Japan was spending the dollar proceeds for raw materials because a buildup of dollar balances, whether from gold, liquidating investments, or any other sources, would have appeared on the books of banks domiciled in the United States.1 All banks and banking agencies operating in the United States were obliged to file reports of funds they held for foreign entities and any changes in the balances. The Federal Reserve published aggregated statistics, country by country, without disclosing the data of individual banks and depositors. Japan’s government and trading corporations centralized their hard-currency assets in branches of the Yokohama Specie Bank (YSB) in New York and London. The YSB, founded in 1880, was nominally a private bank, but it served as overseas agent for the Bank of Japan (BOJ), the nation’s central bank analogous to the Federal Reserve. The Specie Bank’s most important branch was its New York agency (YSBNY), also established in 1880.2 The YSBNY was legally required to file weekly, monthly, and semiannual reports with the Federal Reserve Bank of New York, which compiled statistical data of foreign deposits and transactions in the Second Reserve District, including New York City. Until the summer of 1940 the YSBNY’s reports showed no unusual hoard or movements of Japanese-owned dollars.
On 3 August 1940 Walter H. Rozell, an official of the Foreign Department of the New York Fed, spotted an unexpected entry on Form B-2, submitted by the Specie Bank’s New York agency. During the week ending 31 July overdrafts (loans) extended by the YSBNY to an unnamed Japanese bank had diminished by $12 million. Rozell was puzzled. If a bank in Japan was repaying money it had borrowed, previous reports ought to have shown a rise in that bank’s deposits at the YSBNY when it first drew down the loan principal. But other reports, on Form B-1, hadn’t disclosed that a Japanese bank had received or owned unusual dollar balances at any recent time.3 Furthermore, a mysterious deposit of $10.9 million had just popped up on the agency’s books. The YSBNY listed $28.6 million of balances of the puppet Manchukuoan and North Chinese governments, but these did not explain the mystery.4
Rozell, as a good bureaucrat, felt embarrassed. He would have to correct statistics already published. The next week’s B-2 reported a further reduction of $38.7 million of unrecorded loans by the YSBNY to unknown banks in Japan, raising the total of curious debt repayments to $52 million. “Further investigation is called for,” he urged Assistant Vice President J. W. McKeon.5 Mr. Nakano, accountant of the YSBNY, proffered a bizarre explanation for the figures to McKeon. The “borrower” and “repayer” of dollars had been the Bank of Japan. Before 31 July the BOJ had indeed held cash in New York, he said, and perhaps some U.S. securities, altogether $50 million. But the holdings had been in a “custody account,” therefore not recorded on the YSBNY’s books as a deposit. As Nakano explained it, the agency had recently transferred dollars internally on its books from an undisclosed custody account into a deposit in favor of its head office in Yokohama, which apparently acted as an intermediary for the Bank of Japan. For unexplained reasons the dollars were no longer held “in custody.”6
Fed officials were puzzled. A custody account was a safekeeping arrangement for the assets of customers. A custodian bank did not record such assets on its own books. Custody accounts were customarily established to hold stocks and bonds, usually physically segregated in the bank’s vaults from its own security holdings. (Analogously, the Federal Reserve Bank of New York recorded no assets on its books in respect of the gold owned by foreign governments earmarked for safekeeping in its basement vaults.) A custody account sometimes included incidental cash temporarily awaiting investment, or to clear the buying and selling of securities, but an all-cash custody account was practically unheard of. Banks did not physically lock away millions in currency or coins for a customer. While not justifying the bizarre accounting classification and reclassification, Nakano made clear that no funds had recently left or entered the United States.7
During the rest of August L. Werner Knoke, the vice president in charge of international operations of the New York Fed, watched the weekly reports suspiciously. He admonished Nakano and Mr. Nishi, head agent of the YSBNY, that the Fed was required by executive order to report accurately all movements of international capital. Unexpectedly, Nishi confessed that the custody account had earlier amounted to $100 million in cash and U.S. Treasury securities. It had been built up over “a number of years” through gold sales by the Bank of Japan that exceeded the dollars needed to settle Japan’s trade deficits. In a series of convoluted transactions the BOJ had regularly shipped gold to San Francisco for sale to the U.S. Treasury for dollars. The Treasury credited the proceeds to the Yokohama Specie Bank’s San Francisco office, which transferred the funds by telegraph through Chase National Bank to the Specie Bank agency in New York. But instead of the normal accounting procedure of recording a dollar deposit in favor of the Bank of Japan, as required by U.S. regulations, the YSBNY had deemed the money to be held in custody, highly inappropriate accounting for cash. The Japanese bankers promised to investigate further.8 During the autumn of 1940 they filed corrected reports for prior weeks. Fed analysts immediately noted that on 24 July 1940 the custody account had bulged with at least $61.6 million, perhaps more including securities. Joseph B. Knapp, a young banking officer on the staff of the Fed’s Board of Governors, called for corrected statements reaching back to the creation of the exotic custody account.9
On 28 August Frank M. Tamagna of the FRBNY’s Foreign Research Division reviewed Japan’s dollar position for the Federal Reserve Board of Governors in Washington. U.S. officials had naïvely assumed that Japan financed its perennial trade deficit with the United States through short-term credit arranged by overseas branches of Japanese banks, and that such temporary loans were paid off a few weeks later when the Bank of Japan delivered gold to the United States and sold it for dollars. In other words, gold proceeds were supposed to flush through the banking system rapidly, leaving no residual accumulation of dollars. But Japan’s financial behavior had changed on or about 24 October 1939, when it officially cut the yen’s tie to the British pound and pegged its value to the dollar. Japanese funds fled from London, until then an important center for Japanese liquid assets.10 The Department of Commerce had noted, for example, that in 1937 Japan sold $256 million of gold to the U.S. Treasury while its trade deficit with the United States was only $89 million, concluding that “Japan used the difference in these amounts largely to acquire sterling balances.”11
Great Britain, just before and after the outbreak of war on 3 September 1939, had imposed exchange controls to conserve dollars for buying American supplies. Sterling owned by foreigners could not, without approval of the Bank of England, be swapped into dollars and transferred out. British pounds could be spent only within the sterling area, that is, Britain, its colonies and dominions (other than Canada, a dollar country), and a few small countries appended to the sterling area by treaties. All such countries and territories had legislated exchange controls to prevent funds escaping from the “fortified sterling area” without permission. During the relaxed “phoney war” period, however, the Chamberlain government had hoped to maintain London’s stature in world finance by allowing a semblance of convertibility. Banks, companies, and persons who were not legal residents of the sterling area were allowed to sell pounds for dollars, which were provided by the British Treasury from its reserves, and remove them to the United States, which is no doubt what the Japanese banks did. Britain did not impose a truly hard freeze on foreign-owned sterling assets until the collapse of France in May–June 1940. John Maynard Keynes, adviser to the His Majesty’s Treasury, calculated the leakage from Britain at $400 million since the war began, a “major scandal” that came close to paralyzing Britain’s war effort before Lend-Lease rode to the rescue in March 1941.12
In 1939, even though Japan reaped a $35 million windfall due to a spike in raw silk prices, its $40.8 million of gold sales to the United States had again exceeded trade needs. One clue was that the Yokohama Specie Bank had swapped at least $5 million of British pounds into dollars in late 1939, but it and other Japanese banks apparently had converted and withdrawn a far greater sum of dollars converted from sterling through early 1940. As a result of flight from London, excess gold sales, and the usual favorable seasonal trade balance in the spring, the Bank of Japan accumulated $45 million in the YSBNY. The agency temporarily invested the funds through the New York money market in short-term trade bills, and later in U.S. Treasury securities. Its officers may have believed that the brief holding of securities justified the custody accounting travesty.
As excess gold sales continued in 1940 it was thought that the buildup of dollars in New York grew to at least $75 million. Rozell expected that revised data would show a cumulative surge of $100 million of Bank of Japan funds into the United States. Federal Reserve analysts wrote in an angry tone that “it has been a constant policy of the Bank of Japan since last October [1939] to keep a substantial part of the special fund for foreign exchange in dollar balances, rather than in gold as originally constituted.” Japan’s “actual secret war chest” had not been emptying as thought, but had been converted into dollars hidden under the noses of bank regulators in New York. The Fed’s Foreign Research Division summed it up: “This intricate accounting procedure is undoubtedly made to conceal, rather than to clarify, the operations of the Bank of Japan special fund for foreign exchange,” of which the stash in the New York Specie Bank agency was the most important item.13
Knapp also inquired of U.S. brokers why they had failed to report the securities trades of the Japanese as required for a foreign customer. The reason was that the YSBNY had again violated regulations by not telling the brokers that the trades were on behalf of, and settled from funds owned by, a foreign entity, that is, the Bank of Japan.14 The YSBNY and its officers were subject, under a 1933 amendment to the TWEA, to fines of ten thousand dollars or imprisonment up to ten years or both, for willfully misrepresenting the facts. The Fed staff believed that was the case even though the Japanese could mount technical defenses. The Specie Bank agency promised to comply in the future but Charles H. Coe, a vice president of the New York Fed, wanted to pursue the infraction through his bank’s general counsel, if only as a counter to possible abuse of U.S. businesses in Japan.15
Henry Morgenthau may have heard talk of the secret Japanese financial hoard in the fall of 1940 because he began to think anew, after a long lapse, about economic pressures against Japan. On 23 September 1940, Edward H. Foley Jr., general counsel of the Treasury, outlined to him several alternatives. President Roosevelt was empowered under the 1930 Tariff Act to impose retaliatory duties of up to 50 percent on imports if Japan was found to be discriminating against U.S. commerce in occupied China. Under a 1916 act he could restrict imports if Japanese laws restricted U.S. sales to Japan. He could prohibit landing of cargoes carried in Japanese vessels from anywhere in the world. He could stretch the July 1940 act that authorized licensing of exports of materials needed for defense to products as innocent as raw cotton. Foley asserted, however, that such trade pressures would lack the sweeping impact of a financial freeze.16 But Morgenthau, at the moment, was more interested in neutering the dollar assets of Germany, Italy, and their Balkan allies. With annoyance, he wished the press would quit speculating about freezing Japan because the timing was awkward, presumably a reference to rocking the boat during the campaign for Roosevelt’s reelection in November 1940.17
By 1941 the U.S. Treasury had gained considerable experience administering foreign asset freezes. Roosevelt, having stood by futilely without protecting the gold and U.S. assets of Austria, Czechoslovakia, Poland, and Albania, acted with alacrity on 10 April 1940 when the Nazis assaulted Denmark and Norway. His Executive Order No. 8389, promulgated under authority of Section 5(b) of the 1917 TWEA as amended, locked in place the U.S. assets of those luckless countries. His order was sweeping. Unless specifically authorized by the Treasury, blocked Danish and Norwegian funds could not be transferred to a foreign bank or even to another U.S. bank. Dealings in devisen, gold, silver, and securities, both foreign and domestic, required Treasury authorization. Evasive and sham transactions were prohibited. The order also established a system of reporting by all banking entities.
Whenever the dictators invaded another country, or were deemed to have seized control, Roosevelt stretched the protective wing of EO No. 8839: to Holland, Belgium, and Luxembourg on 10 May 1940; to France on 17 June; to three small Baltic states in July; to Rumania in October; and to the rest of the Balkans and Greece when Hitler attacked in March and April 1941. Most victimized nations had formed governments in exile with more valid claims to the funds than Nazi puppet regimes.18 By the spring of 1941 the United States had blocked foreign assets amounting to $4 billion.19 The Treasury Department had learned to administer controls and to grant or withhold licenses for transactions in blocked accounts. The United States, however, had yet to sterilize the funds of a potential enemy power.
On 9 October 1940 the Federal Reserve formally reported its discovery of Japan’s secret war chest to the Treasury Department, the agency responsible, along with the State Department, for foreign financial policy. V. Frank Coe, assistant director of the Treasury’s Division of Monetary Research, demonstrated to Harry Dexter White, his superior and Morgenthau’s right-hand man, that the deception had begun long before the war in Europe. It probably began in July 1938, when the Bank of Japan set aside $95 to $98 million in gold in its Special Foreign Exchange Fund, supposedly for smoothing out temporary fluctuations in foreign trade. Instead, the BOJ had begun converting the gold into dollar deposits. The New York Specie Bank’s false reports had to be restated retroactively for two years.20 Morgenthau himself heard about it first from Herbert Feis, economic adviser to the State Department. He was taken aback that State knew of the problem before him. “Did we miss by a hundred million?” he asked the day after Coe’s report.21
On 31 October Andrew M. Kamarck, a Treasury economist recently transferred from the Fed, estimated that Japan held $102 million in dollar deposits including $10 million of Treasury securities. He advised that Japanese officials, alerted to discovery of the secret war chest, began that month to shrink the dollar funds in New York. It had started with a rush to buy scrap iron prior to the embargo two weeks earlier. But reduced spending after scrap was embargoed, and presumably steady gold output, placed Japan in “a not greatly dangerous position,” he felt.22 Frank Tamagna had guessed gold available to Japan for foreign use at $62 million, about one year’s production, a far cry from his earlier guess of $10 million.23 Kamarck guessed $85 million of free gold.24 From Tokyo, George A. Nakison, first secretary of the embassy, wrote on 22 November (received in Washington on 8 January 1941) that Japan had plenty of dollars as a result of the United States curb of exports of metals and machine tools and Tokyo’s harsh cuts in imports of foreign cotton and wood pulp. Japan was not going broke after all. Japanese liquid assets in the United States were sufficient for another year without further gold shipments, he emphasized, “if these assets are not frozen or voluntarily reduced or withdrawn.”25
On 7 November 1940 Morgenthau prodded FDR to extend funds controls to potential enemies—but not against Japan. J. Edgar Hoover, director of the Federal Bureau of Investigation, reported that German, Italian, or Vichy French funds were subsidizing propaganda and sabotage in the Western Hemisphere. For example, the FBI had traced serial numbers of currency passed from the German consulate for propaganda work and watched Italian funds moving to Latin America. But there were thirty-seven hundred suspect bank accounts in New York City alone, far beyond the FBI’s capacity to scrutinize.26 Morgenthau instructed his staff attorney Wiley to draft a memo to persuade FDR and the recalcitrant State Department to support foreign funds controls on the European Axis immediately. As Wiley wrote, “A situation in which we are not masters in our own house is unenviable,” yet the U.S. government was powerless to regulate or even investigate foreign transactions. Germany and Italy hid investment income behind Swiss and Swedish intermediaries. Washington needed to know the amount and location of Axis and looted assets, the purpose of any money transfers, and who was behind them. A census of all foreign-owned assets was essential. Besides, Congress was thinking of investigating on its own.27
Morgenthau proposed to FDR invoking Section 5(b) of the Trading with the Enemy Act to impose financial controls on Germany and Italy, enforced by penalties. Those countries could not protest because they had already taken control of U.S. assets throughout Europe. With his customary enthusiasm he volunteered the Treasury to mastermind a flexible program, one that would minimize interference with legitimate trade by granting blanket licenses for whole regions of the world.28 Early in December, Jacob Viner, Morgenthau’s distinguished academic adviser, condensed the rambling memo to emphasize counter-subversion, a line that would play well with Congress and the public.29 Morgenthau got his moment of opportunity on 28 December 1940. The president had returned the proposal with orders to haggle it out with the ever-cautious State Department, which opposed it. According to Herbert Feis, Morgenthau mistook Cordell Hull’s silent reaction for agreement, but it was only another chapter of the bureaucratic struggle. Hull and Undersecretary of State Sumner Welles were not about to acquiesce in granting Morgenthau “decisive influence” in foreign policy. Their adamant opposition, Feis later wrote, dissuaded Roosevelt from authorizing financial warfare against any Axis power on the debatable rationale of clandestine activity.30 A freeze of the financial assets of Germany, Italy, and the European neutrals had to wait another six months.
And what of Japan? There was little evidence of a Japanese fifth column observed by the FBI or Army G-2. Brig. Gen. Sherman Miles, chief of military intelligence, learned that the German chargé d’affaires was warning the Japanese embassy that Washington was toying with a freeze.31 But the Wiley-Viner-Morgenthau proposal promised soothingly that if financial controls were imposed on Japan under an “elastic” system, they would not be a casus belli or even a real provocation. Japan needed trade with the United States, so it would seek commercial licenses rather than a rupture of relations. Ambassador Grew advised against financial sanctions until a deal was struck to liquidate at fair value U.S. business assets frozen in Japan.32 (U.S. firms held $47 million of industrial and marketing assets and $41 million of banking funds in Japan in 1936–37, the last available figures.33) Much as Treasury hard-liners wished to clamp down on Japan, it was “a question of very high politics,” in the words of John Pehle, who ran the department’s Foreign Funds Control Office.34 Cooler heads of the administration knew the timing was not yet ripe politically during the push to legislate Lend-Lease to aid Britain. The financial weapon was slipped back in its sheath.
On 6 December 1940 the Fed delivered to Harry Dexter White its final statistical revisions of the clandestine Japanese cache back to 27 July 1938. H. E. Hesse of the Treasury staff calculated that the hidden custody account at the YSBNY had peaked on 10 April 1940 at $110.6 million, in addition to a further $3.4 million held for the Reserve Bank of North China. It was an eye-popping sum, equivalent to twelve months of U.S. silk imports or twenty-two months of the gold mining output of the Japanese Empire. From November 1938 to December 1939 the YSBNY had invested some of the money in short-term securities.35 Treasury staff estimates of the current balance ranged widely. H. Merle Cochran, technical assistant to Morgenthau, reckoned $70 million worth of government bonds “in that strong box.”36 In U.S. eyes, Japan was now wildly imagined to be preserving the war chest by collecting payments for its exports in cash while financing imports on credit. But a look at the three West Coast branches of the Yokohama Specie Bank disclosed insignificant foreign balances and no suspicious concealment. The Bank of America, the largest bank in California, said it extended “liberal credit” only for diplomatic mission costs.37 Frank Coe felt other foreign bank branches ought to be investigated for concealments.38 Harry White later presented an exaggerated estimate of $140 million of secret Japanese funds, sent a man to New York to get details, and considered turning the matter over to administration lawyers, but Morgenthau did not react.39
Upon full knowledge of Japan’s financial fraud at the end of 1940, the anticipated certainty of imminent bankruptcy evaporated. Rozell on 23 January 1941 opined that Japan could subsist on newly mined gold without depleting its gold and dollar hoards and “therefore could go on almost indefinitely at this rate.”40 On 7 February 1941 Wayne C. Taylor, an assistant secretary of the Treasury and former banker, put forth an exceedingly pessimistic conclusion. Even at the spending rate of 1940, which was much higher than spending expected in 1941 because many commodities had recently been embargoed, Japan’s assets in the United States could finance its needs for up to eighteen months. Japan’s total exchange resources could enable it to conduct the war against China for three more years—until 1944!41
Harry Dexter White, director of the Treasury’s Division of Monetary Research, was Morgenthau’s most influential adviser on foreign financial affairs.42 On 25 February 1941 he wrote to the secretary that Japan faced “increasing difficulties . . . that will multiply in 1941,” so that “Japan is particularly vulnerable to the freezing of her assets in the United States.” He warned, “If this is contemplated and is to be effective it must be done at once.” Japan was racing to draw down its war chest.
White’s tabulations of Japan’s dollar position were faulty. He assumed arbitrarily that Japan needed to maintain $100 million of hard-currency working balances overseas. Exaggerating an analysis prepared for him by Assistant Secretary Taylor, White added up $212 million of gold and dollars that he reckoned Tokyo had on hand, plus $78 million of gold to be mined in 1941, less spending of $222 million if continued at the 1940 rate. Thus the $68 million remaining at the end of 1941 would fall short of the need he assumed.43 But White and Taylor had failed to acknowledge that U.S. exports of strategic commodities had been sharply circumscribed by formal and informal embargoes, especially since late 1940. Japan could comfortably shrivel its dollar reserve below the supposedly irreducible $100 million of working balances. Nevertheless, White concluded that “drastic reductions” of Japan’s freely spendable dollars and gold regardless of amount—by a freeze?—would “tend to place Japan’s national economic structure in immediate jeopardy,” a rare acknowledgment by a senior official of the dire impact of a financial squeeze on Japan’s economic life, not just its foreign and military policy.44
On 21 March 1941 Taylor incorporated revised information into a more reasonable review. Japan had stopped selling gold. The Treasury had bought only $6.1 million worth in January and none thereafter, compared with first-quarter purchases of $48.4 million in 1940 and $54.6 million in 1939. In the first week of March Japanese bank balances in the United States stood at $103 million, down 35 percent from the average of $160 million in January–March 1940. (No figures were available for 1939.) White told Morgenthau that the drawdown was a deliberate Japanese policy. Japan was continuing to buy U.S. products, notably oil. Its bank balances were declining because it no longer replenished them by gold sales, a policy Taylor attributed to Japan’s anxiety over “the threat . . . that the United States may freeze Japanese funds. If this is the reason we may expect that Japan’s dollar balances will be allowed to fall even more noticeably in the future.”45 On 3 April White told Morgenthau that dollar removal was a deliberate Japanese policy.46 Harry Dexter White’s urgings to freeze Japan’s assets early in 1941 were not among the postwar charges against him for disloyalty or worse.