by Nathan Lewis
This week we will look at a funny and little-known episode in the history of the U.S. dollar and Federal Reserve, notably the wartime years of WWI and the Recession of 1920 that immediately followed.
The Federal Reserve was, of course, signed into law in 1913, just in time for WWI. There was something of a liquidity crisis upon the outbreak of war, but that was handled by the existing “bank clearinghouse system” which was legitimized by the Aldrich-Vreeland Act of 1908. The Federal Reserve system had not yet been set up, and was not operational.
The U.S. entered the war in April 1917. This coincided with the time when the Federal Reserve banks became operational. Virtually from day one, the Fed was pressured into “keeping interest rates low” for the flood of government borrowing that was happening to finance the war. Here’s how Richard Timberlake describes it, in his wonderful and essential book Monetary Policy in the United States: an Intellectual and Political History:
The Federal Reserve banks were just about operational when the United States became involved in World War I. Almost immediately, the
U.S. Treasury Department asserted its dominance. The discount policy of the Board was to maintain rates “in harmony with the low interest rates borne by the Government loans,” stated the Board’s annual report for 1917. Even more pointed was a section in the annual report for 1918, … which began: “The discount policy of the Board has necessarily been coordinated . . . the Treasury requirements and policies, which in turn have been governed by demands made upon the Treasury for war purposes.” Again, in 1918 the annual report admitted that discount rates were based upon rates currently borne by government securities, and “must for the time being continue to be fixed with regard to Treasury requirements.” The Board “recognized its duty to cooperate unreservedly with the Government to provide funds needed for war.”The report for 1919 excused the Fed’s subservience to the Treasury by asserting that no higher rate structure would have been sufficient to persuade the securities market to absorb the Treasury issues: “It was necessary to cooperate with the Treasury in every way,” the report claimed, “to facilitate first the sale of Government securities and then their absorbtion by investors.”
As you might imagine, this involved printing money. Here’s what happened to the monetary base in the U.S. during that time. This data is from Milton Friedman’s Monetary History of the United States, 1867-1960: …
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