How The Fed Helped Fund WWII

After reading the last few posts, you know about the series of events that led up to the Great Depression. The collapse of worldwide economies led to the rise of political tensions that kept growing throughout the 1930s, eventually leading to World War II.

Let’s take a look at the role the Fed played during World War II. Did it do any better than it did during the Great Depression?

The role of the Fed during the War

Before the war, America’s military was small and its weapons were increasingly obsolete. After Japan attacked Pearl Harbor and America entered the war, the American military needed to purchase thousands of ships, tens of thousands of airplanes, hundreds of thousands of vehicles, millions of guns, and hundreds of millions of rounds of ammunition. Moreover, it needed to recruit, train, and deploy millions of soldiers across six different continents.

In order to accomplish all this, the US needed to pay entrepreneurs, inventors, and companies to get the job done. As a result, military expenditures rose from a few hundred million a year before the war to $91 billion in 1944.

Financing the war became the Federal Reserve’s wartime mission, which was a far cry from its original mission. The treasury and the Fed came up with a plan to fund the war primarily through taxation and domestic borrowing.

Why taxation?

During the war years there was a huge increase in incomes, employment, and the money supply, but most production was going to wartime goods and services, rather than consumer goods. Basic economic principles tell us that when too much money chases too few goods, prices typically rise (i.e. inflation).

Hence, the treasury decided that it was better to tax people so that less money would be chasing consumer goods, which would theoretically prevent inflation from rising too high.

Why domestic borrowing?

To keep the costs of the war reasonable, the Fed began selling wartime bonds.

Moreover, it pegged interest rates to low levels so that the cost of borrowing for the government would be smaller in the end.

Overall, both the Fed and the treasury believed taxation would help keep inflation in check and borrowing money directly from American citizens would make it easier to reach economic stability once the war was over.

Ad hoc changes to the Federal Reserve Act

In addition to taxation and selling low interest rate bonds to consumers, there were many changes made to the original Federal Reserve Act in order to make funding the war more feasible:

One amendment allowed the board to change reserve requirements in banks in New York City and Chicago without changing requirements for other banks.

A second amendment allowed the Fed to purchase government securities directly from the Treasury.

A third amendment exempted the deposits that people made for purchasing war loans from bank reserve requirements. In other words, if you came to the bank to buy wartime bonds, the bank was not required to keep ANY of your money in its reserves (recall that banks are typically required to keep some portion of the money in the bank as reserves — i.e., the fractional reserve system). In this case, all of your money was used to fund the war, and none of it was kept in reserve (yikes!).

Ad hoc executive orders

Not only were there ad hoc changes to the Federal Reserve act, but FDR also issued a series of executive orders that essentially made it much easier for banks to lend and for people to borrow. All of this was intended to speed up the rate of industrial expansion.

All hands on deck

Handling war savings bonds was the largest single operation ever performed by the Federal Reserve. The Fed nearly doubled its workforce, from 11,000 employees in 1939 to 24,000 employees in 1943.

Different regional banks played different roles in processing, approving, and issuing all these savings bonds. Moreover, different regional banks took responsibility for engaging in foreign transactions and handling remittances from the US to foreign countries during the war.

Reserve banks also acted as agents for the treasury’s foreign funds control operations. The goal was to ensure that the transactions happening across borders were legitimate, without Axis manipulation of dollar assets and Axis access to international markets.

Conclusion

In sum, the Federal Reserve played a big role during World War II by helping to finance the war, fund America’s allies, and embargo our enemies.

Now consider the following questions:

  • Was helping fund wars the original mission of the Fed?
  • Was it important for the Fed to play such a large role in helping fund the war?
  • Was it necessary to make ad hoc changes to the Federal Reserve Act or to sign executive orders behind closed doors?

There is no right or wrong answer. However, this quote by F.A. Hayak comes to mind:

“I don’t believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can’t take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can’t stop.” (Hayek 1984)

About the author

Nicolas van Saberhagen

We created Cryptonote algorithm that has been used in creation of Monero.

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