Paying for World War I: the Creation of the Liberty Bond by RICHARD SUTCH
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ECONOMICHISTORY Paying for World War I: The Creation of the Liberty Bond BY RICHARD SUTCH orld War I began in the congressional declaration of war, Editor’s Note: A version of this Europe in 1914, the same the American economy was operating article first appeared on the year the Federal Reserve at full capacity, so the requirements Federal Reserve History website, W System was established. During the of the war effort could not be met by www.federalreservehistory.org. three years it took for the United putting underutilized resources to work. The author is the Edward States to enter the conflict, the Fed William Gibbs McAdoo, secretary of A. Dickson Distinguished had completed its organization and the Treasury and chairman of the Fed’s Emeritus Professor of was in a position to play a key role in Board of Governors, understood that Economics at the University of the war effort. Wars are expensive and, the wartime population would have to California, Riverside and a visit- like every governmental effort, they sacrifice to pay the bill. Shortly after war ing scholar at UC Berkeley. have to be financed through some com- had been declared, he delivered a speech bination of taxation, borrowing, and that he later recorded for posterity: the expedience of printing money. For “We must be willing to give up some- this war, the federal government relied thing of personal convenience, something on a mix of one-third new taxes and of personal comfort, something of our two-thirds borrowing from the gen- treasure — all, if necessary, and our lives eral population. Very little new money in the bargain, to support our noble sons was created. The borrowing effort was who go out to die for us.” called the “Liberty Loan” and was made But the question remained: How operational through the sale of Liberty would the shift in output be arranged? Bonds. These securities were issued by How should the war be paid for? There the Treasury, but the Fed and its mem- were three possibilities: taxation, bor- ber banks conducted the bond sales. rowing, and printing money. Generally speaking, the secretary For McAdoo, printing money was off World War 1 poster of the Treasury proposes a funding the table. The experience with issuing depicting Lady Liberty plan for war financing and works with “greenbacks” during the Civil War sug- Congress to enact the necessary gested that fiat money would generate legislation, while the Fed oper- inflation, which he thought would lower ates with considerable indepen- morale and damage the reputation of dence from both the executive the newly issued paper currency, the and legislative branches of gov- Federal Reserve Note. McAdoo also ernment. But World War I was opposed printing money because it different. The Treasury and the would hide the costs of war rather than Fed, united under one leader, keeping the public engaged and com- worked together in both the mitted. “Any great war must necessarily creation of the financial war be a popular movement,” he thought, plan and its execution. “… a kind of crusade.” McAdoo chose a mix of taxation and Rejecting Printing-Press the sale of war bonds. The original idea Finance was to finance the war with an equal When the United States division between taxation and borrow- entered World War I in 1917, ing. Taxation would work directly and it became immediately evi- transparently to reduce consumption. dent that an unprecedented Taxes are compulsory, and those who effort would be required to must pay are left with less purchas- divert the nation’s industrial ing power. Their expenditures will fall, capacity away from meet- freeing productive resources (labor, ing consumer demand and machines, factories, and raw materi- toward fulfilling the needs of als) to be employed in support of the the military. At the time of war. Another advantage of taxation was IMAGE: LIBRARY OF CONGRESS, PRINTS & PHOTOGRAPHS DIVISION, WWI POSTERS, LC-USZC4-8046 28 E CON F OCUS | F IRST Q UARTER | 2016 that Congress could set the rate schedule to target those they thought should bear the greatest burden. President Any great war must necessarily be a popular Woodrow Wilson and the Democrats in Congress insisted movement. It is a kind of crusade; and like Paying for World War I: The Creation of the Liberty Bond on a sharply progressive schedule — taxing those with very high incomes at higher rates than the middle class and all crusades, it sweeps along on a powerful exempting the poor. The highest marginal rate eventually stream of romanticism. reached 77 percent on incomes over $1 million. Accompanying the personal income tax was an increase — William Gibbs McAdoo in the corporate income tax, an entirely new “excess-profits tax,” and excise taxes on such “luxuries” as automobiles, motorcycles, pleasure boats, musical instruments, talking income tax was designed to target. He chose to keep the machines, picture frames, jewelry, cameras, riding habits, interest rates competitive with the current return on com- playing cards, perfumes, cosmetics, silk stockings, pro- parable assets. To many observers, a massive bond sale on prietary medicines, candy, and chewing gum. These taxes these terms seemed to be an imprudent gamble. The worry ranged from 3 percent on chewing gum and toilet soap to expressed by bankers and bond dealers at the time was 100 percent on brass knuckles and double-edged dirk knives. unanimous: The bonds might not sell without the promise A graduated estate tax on the transfer of wealth at death of an extra-attractive return. Moreover, the critics pointed exempted the first $50,000 and rose progressively thereafter out, only a few Americans had any direct knowledge about from 1 percent to 25 percent. bonds, and fewer still actually owned any. It was at this point that McAdoo conceived of the Roots of the Liberty Bonds Liberty Loan plan. It had three elements. First, the public Some of the prominent economists of the day suggested would be educated about bonds, the causes and objectives that the war should be paid for entirely through taxes, but of the war, and the financial power of the country. McAdoo McAdoo disagreed on grounds that the eventual cost of chose to call the securities “Liberty Bonds” as part of this war was unknown at the outset. If the tax generated less educational effort. Second, the government would appeal money than was required, rates would have to be raised to patriotism and ask everyone — from schoolchildren to again and perhaps repeatedly. Furthermore, changing tax millionaires — to do their part by reducing consumption schedules always requires a controversial, complex, and and purchasing bonds. Third, the entire effort would rely drawn-out political debate. Indeed, as the estimated cost of upon volunteer labor, thereby avoiding the money market, the war effort escalated, McAdoo came to the conclusion brokerage commissions, or a paid sales force. The Federal that, despite the high rates, tax revenues would not cover Reserve Banks would coordinate and manage sales, while the anything like one-half the cost. Given the commitment to bonds could be purchased at any bank that was a member of the progressive structure of rates, taxation had reached its the Federal Reserve System. acceptable limit. The revised goal was one-third from taxes and two-thirds from borrowing. Packaging the Bonds Financing a war by borrowing need not be inflationary To the war planners, the appeal of borrowing funds from if the public diverts income away from consumption to the public was that it would be good for morale. Individuals purchase bonds. Higher saving as a share of income would could demonstrate their support for the war by purchasing necessarily mean lower consumption. Such a change in sav- bonds. Indeed, during the bond campaigns, purchasers were ing behavior, however, would be difficult to engineer and given buttons to wear and window stickers to display, thus far from certain. A high rate of return on the war bonds advertising their patriotism. If bond sales were strong, if would be unlikely to work. High rates might tempt some the offering was oversubscribed, that would demonstrate to take momentary advantage and save more. But there is American resolve. also an opposite effect. With high interest rates, a house- Yet there was a risk. Poor sales would be a sign of weak hold’s wealth would accumulate more rapidly. With that support and insufficient patriotism. To avoid a failure to sell mechanism working on behalf of the saver, less saving from the entire bond issue, the government arranged to sell them current income would be required to ultimately reach a in a series of brief but intense campaigns by subscription. The target level of wealth. The two opposite tendencies would first campaign was announced on April 28, 1917 — 22 days tend to cancel each other. Another problem with offering after the declaration of war. The first offering of bonds was a high interest rate on the war bonds is that it might divert to be for $2 billion and promising a 3.5 percent rate of return. funding away from investments in physical capital when the That was slightly below the rate paid by savings banks on war effort warranted an increase in productive capacity. customers’ deposits (which ranged between 3.5 percent and It is unclear if McAdoo understood that offering high 4 percent) or the yield on high-grade municipal bonds rates of interest would not work. In any case, he was (3.9 percent to 4.2 percent). The fear was that individuals with opposed to high rates because that would be a sign of pre-existing savings accounts or municipal bond holdings weakness and would reward the rich — the very group the would use those funds to purchase Liberty Bonds if the bonds’ E CON F OCUS | F IRST Q UARTER | 2016 29 were collected, the certificate could be exchanged for a $50 Liberty Bond.