THE FALL
With the creation of the Federal Reserve System the long struggle of the United States to perfect a sensible, conservative monetary system was over. Everywhere in the industrial countries money of whatever kind was now exchangeable, without pretense or delay, into gold. Silver was for silver-plating. It was especially important that the Americans, the most reckless and experiment-prone of people where money was concerned, the most suspicious whenever gold was mentioned, had now, however reluctantly, come abreast. In the Federal Reserve System they had an instrument for doing all that a modern state needed to do for its money—for monopolizing the note issue, regulating bank lending and the resulting deposit creation and for providing banks with the succoring loans of last resort. True, the Federal Reserve System had been crippled by the compromise that allowed it to be born. But this—including the uncertainty as to whether power lay with the Federal Reserve Board in Washington or the twelve Federal Reserve Banks—was as yet undiscovered. The idea of a decentralized central bank—twelve central banks, each operating in some measure of undefined independence of its fellows and of Washington—did not yet seem a contradiction in terms. Rather, it looked a spacious and democratic idea, somehow appropriate to the spacious democracy which the banks would serve. And, as already noted, the shortcomings of the Federal Reserve System were not, like the failure of the mail to arrive, matters to be condemned. In the United States, as in other countries, ordinary bureaucrats are criticized for their mistakes. Diplomats and central bankers are, on the whole, cherished for them. If the errors are spectacularly disastrous, as for example those of the late John Foster Dulles at the State Department or the late Benjamin Strong at the New York Federal Reserve Bank (Strong is thought to have contributed effectively to the 1929 crash), their position in public esteem can be even more secure. They have made a mark on a peculiarly genteel current of history. In 1914, after 2500 years of trial and much error (and in the United States more than a century of bitter and confusing controversy), money could seem, in a sense, finished business.
All historians rejoice in the odd coincidence of great events. It is thought to relieve tedium for the reader, show how sensitive the writer is to paradox and suggest even to the most secular that either a benign, a malignant or an amused hand is ultimately in charge. No historian could be better pleased than by the events in the summer of 1914. On August 10, as the members of the new Federal Reserve Board assembled at the office of Secretary of the Treasury McAdoo to be sworn into their new posts, the August guns were sounding. They were sounding the end of the monetary system of which the new banks could be considered the culminating step.
This, not surprisingly, the members of the new Board did not see. And, in any case, the present had more pressing claims. The Board members were locked in a struggle with Secretary McAdoo over office space—they feared that their present offices in the Treasury Building would make them seem subservient to that Department. They were also deeply concerned by their position in the Washington system of social precedence. On this ladder they had been placed below both the Interstate Commerce Commission and the Civil Service Commission. This for central bankers was a shocking thing. The indignity was appealed eventually to President Wilson who was unsympathetic; he said only that “they might come right after the fire department.”1 The newspapers, however, referred helpfully to the Board as “the new Supreme Court of finance.”
On the outbreak of the war the major industrial participants—Germany, France, Britain, Austria—suspended specie payments. That is to say, notes and deposits could no longer be redeemed in gold; these countries went off the gold standard. In the United States, though continuing noninvolvement was assumed, the same action was proposed and sharply debated. The case for going off gold seemed obvious: For a hundred years Europeans, most notably Englishmen, had been investing in the United States. In consequence, a vast portfolio of American securities—perhaps as much as $6 billion worth—was held abroad.2 If any appreciable part of this was liquidated for cash, American gold reserves would soon be gone. (The Federal Reserve began business that autumn with only $203 million of gold in its vaults.) Better hold on to the gold that was in hand.
In response to fears of such liquidation and calculations of how quickly the American gold stock would be exhausted by sellers thus seeking cash, securities were dumped on the New York market in the first nervous days of the war. And the proceeds were converted, along with other balances, into sterling or gold. As a result, the dollar fell from its normal $4.87 to the pound to a phenomenal $7.00 to the pound. Dollars could be turned in for gold as before, and the gold could be sent to London where it would buy pounds at the old price, more or less. These pounds could then be used back in New York to buy $7.00, not $4.87, for further changing into gold. Here was a truly wonderful profit. Gold did start to flow out to buy pounds in this fashion, though the thought of loss from German U-boats and commerce raiders had a profoundly dampening effect on shipments. By largely immobilizing the gold, this fear was what kept the pound so high. Another course of action suggested itself, and that was to close down the New York Stock Exchange and thus prevent the liquidation of foreign-held securities. This was done.
The foresight of financial experts was, as so often, a poor guide to the future. When the New York Stock Exchange closed down, trading moved out into Wall Street to what reputable traders called the Outlaw Market. The Exchange indignantly forbade its members to have intercourse with the outlaws. The trading continued. By October the more enterprising of the outlaws were issuing typewritten sheets showing closing prices, and soon it was noticed that these were not very different from the prices at the time the Exchange was closed. European investors were obviously having second and more favorable thoughts about selling their investments in a country that was so safely remote from the fighting. And that fighting, it was now seen, was murderous beyond belief and with considerable likelihood of being prolonged. In December the Exchange reopened. Nothing happened. The calculation as regards gold was equally off. The Bank of England had meanwhile opened a branch in Canada to receive gold and thus obviate the risk of ocean shipment. But now gold started to flow in rather than out. Presently the flow was a flood. Soon the United States had more gold than any country had ever possessed before—the increase was from $1.5 billion at the end of 1914 to $2.0 billion at the end of 1915 to $2.9 billion at the end of 1917.3 It was a flood with a double effect. It destroyed the gold standard in the countries whence it came and also in the country where it went.
Some of the gold came for deposit and safekeeping; some came to be invested in American securities; but the fundamental force in the flow was the need of the belligerent powers for American goods. In an age of socialist agriculture and Soviet wheat purchases, it requires an effort of mind to remember that Russia was once a major source of Europe’s wheat. Now this market was cut off, and the United States became an important supplier of bread grain. Also needed were ships, armor plate and, above all, ammunition. By 1915, it was evident that the participants, Britain in particular, could never supply themselves with the infinity of shells which, according to the current concepts of warfare, had to be flung across no-man’s-land before an offensive or even at random on a quiet day. On assuming office as Minister of Munitions in May 1915, Lloyd George proceeded to place orders in whatever amount his buyers thought could be filled.
Some of these supplies were paid for by conscripting and selling in the United States the American securities which earlier it had been thought their frightened owners would dump on their own. The spending of these proceeds involved no movement of gold. Some of the payment was from loans raised from private investors in the United States, which also occasioned no gold movement. In principle, it might be noted, these loans were available to both sides. In practice, the British controlled the oceans. Thus they made it impossible for their enemies to move any appreciable quantity of the products the loans would buy, so the Germans and Austrians had no need for the loans that this even-handed policy allowed. In consequence, William Jennings Bryan was led to the last of his many acts of public inconvenience. He held that such loans to the British were inconsistent with any neutrality that was strict, as Wilson had demanded, as to both thought and deed. For this aberration he was severely rebuked by those who believed that obvious truth should be subordinate to the demands of patriotism or the prospects of pecuniary gain. To the intense relief of such citizens, Bryan left the Cabinet in June 1915 over Wilson’s reaction to the sinking of the Lusitania. He remains one of the tiny handful of Cabinet officers in the American experience to register opposition to a policy of which they disapproved by resigning.
Gold was also used directly to purchase supplies. Some of this came from the reserves of the Bank of England, the Banque de France and the Imperial Bank of Russia. More was gold that previously had been in circulation or private possession. As gold coins came to the British or French banks in the ordinary course of business, notes were issued in their place. And Englishmen and Frenchmen were asked to turn in their gold for paper, a request that caused some to consider the superior rewards of hoarding. Thus, in 1914, private citizens in France were estimated to hold as much as $1.2 billion in gold. The appeal brought in some $240 million.4
For handling problems such as those facing the British or French treasuries during the war, there are no miracle men. Either current earnings from exports, salable assets, loans or credits of one kind or another or gold exist for paying foreign suppliers, in which case the officials involved are a success. Or these assets do not exist, in which case those involved are a failure. However, nothing comes so easily to the press and public mind as the vision of financial genius. Both wish to believe that, where such important matters are involved, there are individuals of transcendental insight and power, men who can make something out of nothing. In Britain during the war (and after) the popular imagination thus stimulated settled on the thirty-one-year-old (in 1914) Treasury official, John Maynard Keynes. His papers of the period, recently published,5 suggest that he was a hard-working, competent and resourceful man who matched resources to payments with attention and skill and who extended his mind to the similar problems of the French and the Russians. That was all.
The effect of removing the gold from Europe was to remove from the reserves of French and British banks, the Banque de France and the Bank of England the metal into which paper could be converted. And by removing gold from hand-to-hand circulation and replacing it with paper, it also increased greatly the proportion of the money supply that, given convertibility, would be subject to conversion into gold. The primary effect of this on the future of the gold standard will be evident. There was much more paper to convert, much less gold with which to do it.
There was, perhaps, a more serious effect. The calling in of the gold was a way of suggesting to the citizens that, as compared with paper or bank deposits, it had a superior significance. Before 1914, people passed on gold coins just as easily as they passed on subsidiary silver or paper. Thereafter gold would always seem better—something that might prudently be held. So it came about that gold coins, which before 1914 were received and passed on without notice or thought, were ever after something to be scrutinized, shown, commented upon and retained. Partly for that reason—Gresham again—not many who were born after 1914 would ever receive a gold coin in the normal course of trade or compensation.
Such was the effect of the outflow. In the United States, meanwhile, the gold standard was being devastated no less by the flood. As noted, between the end of 1914 and the end of 1917, the gold stock of the United States almost doubled. Gold came to the banking agents of the British and French in the United States, was paid into the accounts of suppliers, remained in the vaults of their banks or was sent as deposits to the local Federal Reserve Bank. Had it all been used as reserves by the banks and the Federal Reserve Banks, it would have been capable of sustaining a truly phenomenal expansion in loans, deposits and note issue. This expansion being much in excess of any companion increase in the supply of goods and services, there would have been a very large increase in prices—one that would have appalled the followers of Bryan, for they wanted prices that did not fall or prices that recouped past reductions but not wildly increasing prices. And to their undoubted astonishment this increase in prices would have occurred with money that was fully convertible into gold. The United States faced an inflation caused by gold.
However, the fledgling central bankers of the United States as well as the commercial bankers allowed reserves to accumulate in excess of legal need. The limit on loans (and resulting expansion in notes and deposits) was set not by the reserves as so meticulously spelled out in the Federal Reserve Act. It was set by the needs and demands of borrowers and by what the commercial bankers and the Federal Reserve Banks severally and independently thought it wise to lend. Out of the plethora of gold came a money supply limited not, as in the case of the classical gold standard, by the supply of gold. It was limited by the decisions of commercial bankers and of the new central bankers, and by what borrowers sought to borrow. It was a primitive form of managed currency. It was not precise management. Rather it was the result of numerous uncoordinated actions, the kind of management that one finds in the Democratic Party or in a mental hospital run by the patients. It remains that, all but simultaneously with the appearance of the Federal Reserve, there also appeared the need for divorcing the supply of money from the supply of gold.
In 1917, when the United States entered the war, its loans to Britain and France replaced the conscripted gold (and securities) as the means by which these allies paid for their needs. Accordingly, gold ceased to flow to the United States, and instead a small outward flow began to Spain and the other remaining neutrals. This was stopped by law. The United States thus went off the gold standard where international transactions were concerned. It remained possible, although in the minds of many rather unpatriotic, for Americans to trade paper notes and bank deposits for gold so long as the gold was not taken out of the country. World War I was, domestically speaking, fought on the gold standard. It was—an exceptional thing—a hard-money war. More exactly, the inflow of gold provided a vast and elastic net within which almost anything could occur. The decisive question in this, as in other wars, was not what happened to the money; that, as always, was the servant of wartime need. What counted was how funds to pay for the war were raised.
As always for those not fighting, taxation cast a disagreeable pall over patriotism, one that in the United States in these years was made worse by the recently enacted income-tax amendment. (Things were more agreeable in France, where an income tax, though authorized, did not become fully effective until after the Armistice.) In consequence, conservatives were to be found arguing against an excessive commitment to a pay-as-you-go policy. Secretary McAdoo’s initial instinct was for heavy taxation—he suggested, as a guiding rule, that 50 percent of the cost come from taxes. J. P. Morgan thought that the maximum should be 20 percent. In the event, by common estimate, about 30 percent of the cost of World War I was paid for from current tax revenues. The rest was covered by methods not appreciably different from those used during the Civil War.
For the first time since Sir William Phips returned from Quebec, a serious war did not bring a serious demand for forthright printing of paper currency by the government. That was only because a more subtle arrangement was now available. The Treasury could now borrow from the Federal Reserve System—whatever the latter’s independence in principle, it could not refuse the government in practice or even dream of so doing. In consequence of this operation, the Federal Reserve had newly printed bonds, the Treasury had newly printed Federal Reserve notes or new and equally spendable deposits at the Federal Reserve Banks. In its ultimate nature as well as in the practical effect, this procedure differed only in superficial form from the printing of the greenbacks. Nor were matters much changed when the Treasury sold bonds, as it did, to the commercial banks. The government, in consequence of such sale, had cash or a deposit which it spent. The bank then took the government bond to the Federal Reserve Bank and borrowed on this good government security to replace the funds that the government had used. As with the direct sale to the Federal Reserve, more money was brought into existence to pay wartime expenses.
These transactions were conducted by men of grave and courteous manner, good tailoring and considered speech. There was none of the raucous advocacy that marked the issue of the greenbacks. The Civil War and the greenbacks remain the classic manifestation of irresponsible finance. World War I has no such reputation. Such are the services of style in economics and money management.
In fact, the World War I legerdemain involved an even more elaborate exercise in illusion. As under Jay Cooke during the Civil War, a legion of volunteer bond salesmen was recruited to sell government securities to the public. A commendable aspect of this effort was the three-minute speech—a recognition that exhortations on patriotism and public duty are effective in inverse proportion to their length. Such salesmanship has, in principle, some economic justification. Some people may be persuaded to buy bonds instead of spending money. By saving rather than spending, the individual diminishes the pressure on markets, reduces the severity of the inflation. The labor, materials and capital equipment so unbought or unused become available to the government for war purposes. In World War I, however, buyers of government bonds were encouraged to borrow from the banks for their purchases, using the bonds as collateral. Many did. Again the banks using the bonds so acquired replenished their reserves by borrowing from their Federal Reserve Bank. The immediate effect of this was again indistinguishable, except as it involved even greater indirection, from direct borrowing by the government from the Federal Reserve Banks. Later on there could be a difference. After the war people sought to keep their bonds and repay their bank loans. This had the effect of contracting expenditures for current consumption and thus, conceivably, made the postwar slump in consumer expenditure marginally worse. In the euphoria of war, not surprisingly, none gave attention to such possible effects. Nor, for that matter, did many wonder why people should be urged to borrow money from their banks to buy bonds which the government could as easily have sold to the same banks at less cost.
In the United States during all the war years, wholesale prices about doubled, with much of the increase occurring between mid-1916 and mid-1917, the months immediately before entry into the war. Britain and Germany, although far more deeply involved for a much longer time, had only a slightly greater increase. Taking wholesale prices in July 1914 as 100, they were 216 in Germany four years later. In Britain in 1918, they were 239. France, with her northern industrial territories torn away, the war on her own lands and an exceptionally strong aversion to taxation, had a much greater increase—by 1918, wholesale prices were about three-and-a-half times the prewar level. Italy, though physically less affected by the conflict but with an even greater aversion to taxation, had also a very large increase—by around four-and-a- half times.6 In Britain and Germany serious efforts were made to arrest the price increases by price controls, and these, in turn, were combined with measures to ration scarce staples and materials. In France controls were used but not seriously enforced.
In the United States there were such informal restraints on consumption as the meatless and wheatless days, and, beginning in mid-1917, the United States government, through the Grain Corporation headed by Herbert Hoover, tendered for all wheat produced in the United States at a price of $2.20 a bushel, raised the following year to $2.26. This was a minimum price; it remained open to farmers to get more if they could, and many did. Maximum prices for fuel were formally fixed by the Fuel Administration. Numerous other products, principally although not exclusively those in heavy military or other wartime demand, were made subject to price agreements between the producers and the Price-Fixing Committee of the War Industries Board. Iron and steel, copper, lumber, wool, hides and leather, cotton fabrics, nitric and sulphuric acid, nickel, aluminum, mercury, zinc, brick, cement, hollow tiles as well as crushed stone, sand and gravel were so controlled. Compliance was voluntary or, at the most, subject to the sanction of seizure of the product by the government, the threat of withdrawal of transportation priorities or the charge of being unpatriotic, which, at the time, meant pro-German. An exceptionally distinguished member of the Price-Fixing Committee was F. W. Taussig of Harvard, perhaps the most highly regarded economist of his time. Writing soon after and at some length of the experience, he said of the price-setting that “In the main it was opportunist, feeling its way from case to case.”7 He was somewhat impressed by one circumstance: the most successful experience with price control was of nickel where there was at the time a complete monopoly. That a monopoly or an approach thereto greatly simplified the trials of the price-fixer was to be one of the important lessons of World War II.
While, as Professor Taussig strongly argued, the price controls of World War I no doubt had a modifying influence on the prices of products in exceptional demand, World War I, like the Civil War, was, in the main, fought under the aegis of the market, a circumstance that Bernard Baruch, the Chairman of the War Industries Board, never ceased to regret. (He believed that all prices and wages should have been frozen, a position which, though it was thought wildly eccentric, he was still urging at the outbreak of World War II.) The financing of World War I, the disguise apart, was about the same as that of the Civil War. So was the movement in prices. Everything considered, the management of the Civil War might be the easier to defend.
World War I marked the beginning of the end of the international gold standard—of the single world currency that, at whatever pain, gold had been. Not again was there a reasonably workable distribution of gold stocks between the industrial countries—mostly, and for many years, there was plethora in the United States and paucity almost everywhere else. Efforts at revival were made in the decade of the twenties in Britain, France and the other industrial countries. Except in the United States and briefly in France no major country again looked at its gold reserves and felt secure. None more than briefly allowed citizens to exchange their paper or bank deposits into gold. In its developed form the gold standard was a brief experiment, a matter of a few decades, a half-century at most. It was only the sense that it was the final step, the ultimate money, that made it seem so much older.
1 William Gibbs McAdoo, Crowded Years (Boston: Houghton Mifflin Co., 1931), pp. 287–288.
2 Paul Studenski and Herman E. Krooss, Financial History of the United States (New York: McGraw-Hill Book Co., 1952), p. 281. Other estimates, such as that of Alexander D. Noyes (The War Period of American Finance [New York: G. P. Putnam’s Sons, 1926], p. 60), are somewhat lower.
3 Valued at $20.67 an ounce. U.S. Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1957 (Washington, D.C., 1960), p. 649.
4 According to Noyes, p. 131. Needless to say, there is a major element of imagination in the estimates of such holdings.
5 John Maynard Keynes, The Collected Writings of John Maynard Keynes, Vol. XVI, Activities 1914–1919: The Treasury and Versailles (London: Macmillan & Co., 1971).
6 Comparative movements in wholesale prices are summarized in Bulletin de la Statistique Générale de la France, Paris, Librairie Felix Alcan, Vol. XII, No. IV (July 1923). pp. 347–348.
7 F. W. Taussig, “Price-Fixing as Seen by a Price-Fixer,” The Quarterly Journal of Economics, Vol. XXXIII (February 1919), p. 205 et seq. The quotation is on p. 238.