John Maynard Keynes. Speaking of the Federal Reserve's manipulation of the value of the dollar, he wrote:
That is the way by which a rich country is able to combine new wisdom with old prejudice. It can enjoy the latest scientific improvements, devised in the economic laboratory of Harvard, whilst leaving Congress to believe that no rash departure will be permitted.... But there is in all such fictions a certain instability.... The suspicions of Congressmen may be aroused. One cannot be quite certain that some Senator might not read and understand this book.2
There was not much danger of that! By then, American politicians had acquired a taste for the heady wine of war funding and stopped asking questions. World War I had created enormous demands for money, and the Fed provided it. By the end of the war, Congressional hostility to the Federal Reserve became history.
PAYING FOR WORLD WAR I
Much of the war debt was absorbed by the public which
responded to patriotic instincts and purchased war bonds. The Treasury launched a massive publicity campaign for 'Liberty Loans' to reinforce that sentiment. These small-denomination 1-Ibid., p. 448; also Murray N. Rothbard,
2- Keynes,
484
THE CREATURE FROM JEKYLL ISLAND
bonds did not expand the money supply and did not cause
inflation, because the money came from savings. It already existed.
However, many people who thought it was their patriotic duty to support the war effort went to their banks and borrowed money so they could buy bonds. The bank created most of that money out of nothing, drawing upon credits and bookkeeping entries from the Federal Reserve, so those purchases did inflate the money supply.
The same result could have been obtained more simply and less expensively by getting the money directly from the Fed, but the government encouraged the trend anyway, because of its psychological value in generating popular support for the war. When people make sacrifices for an endeavor, it reinforces their belief that it must be worthy.
Although the war was financed partly by taxes and partly by Liberty Bonds purchased by the public, a significant portion was covered by the sale of Treasury bonds to the Federal Reserve in the open market. Benjamin Strong's biographer, Lester Chandler, explains:
The Federal Reserve System became an integral part of the war financing machinery. The System's overriding objective, both as a creator of money and as fiscal agent, was to insure that the Treasury would be supplied with all the money it needed, and on terms fixed by Congress and the Treasury.... A grateful nation now hailed it as a major contributor to the winning of the war, an efficient fiscal agent for the Treasury, a great source of currency and reserve funds, and a permanent and indispensable part of the banking system.
THE EMERGENCE OF GOVERNMENT DEBT
The war years were largely a period of testing new strategies and consolidating power. Ironically, it was not until after the war—when there was no longer a justification for deficit spending—that government debt became plentiful. Up until World War I, annual federal expenses had been running about $750 million. By the end of the war, it was running $18 and-a-half billion, an increase of 2,466%. Approximately 70% of the cost of war had been financed by debt. Murray Rothbard reminds us that, on the eve of depression in 1928, ten years after the end of war, the banking system held more government bonds than during the war itself. That means 1. Chandler, pp. 101-102.
2.
THE GREAT DUCK DINNER
485
the government did not pay off those bonds when they came due.
Instead, it rolled them over by offering new bonds to replace the old. Why? Was it because Congress needed more money? No. The bonds had become the basis for money in circulation and, if they had been redeemed, the money supply would have decreased. A decrease in the money supply is viewed by politicians and central bankers as a threat to economic stability. Thus, the government found itself unable to get out of debt even when it had the money to do so, a dilemma that continues to this day.
There is an apparent contradiction here. In his book, The Great Boom and Panic, Robert Patterson says that, on the eve of depression, America was getting out of debt.1 Yet, Rothbard tells us there were more government bonds held by the banking system than during the war! The only way both statements can be true is if there were, in fact, more bonds outstanding during the war but they were held by the public, not by the banking system. That would make it possible for there to be fewer total bonds in 1928 and yet the System could still hold more of them than previously. That would be the expected result of the Fed's growing role in the open market. As the publicly-held bonds matured, the Treasury rolled them over, and the Fed picked them up. Bonds purchased by the public do not increase the money supply whereas those purchased by banks do. Therefore, conditions in 1928 would have been far more inflationary than during the war—even though the government was getting out of debt.
Before 1922, the Federal Reserve bought Treasury bonds primarily for three purposes: (1) for income to operate the system, (2) to pay for the newly issued Federal Reserve Notes which were replacing silver certificates, and (3) to push down interest rates. The iriotive for manipulating interest rates was to encourage borrowing from abroad in the United States (where rates were low).2 It also encouraged investment from the United States into Europe (where rates were higher). By making it possible to borrow American dollars at one rate and invest them elsewhere at a higher rate, the Fed was deliberately moving money out of the United States, with gold reserves following behind. As President Kennedy had said in 1. Page 223.
2. Chandler, p. 211; also Rothbard,
