by Hew Strachan
This reversal in the balance of the relationship between the two would have been hard to predict in 1914. The principal agent in the creation of government credit on the outbreak of war was the Bank of England. Between August and November 1914 the government borrowed £35 million from the Bank. Known as ‘ways and means advances’, these funds represented the Bank’s own borrowings from the commercial banks. When spent by the government, the money returned to the banks, so increasing their deposits and enabling them once again to lend to the Bank. The flow thus ran in parallel with that of treasury notes. The Bank’s commanding position in this relationship was determined by its manipulation of its interest rate, which normally hovered two percentage points above the market rate. In 1915 the Bank rate was at times up to 3 per cent higher than that of the market. Internationally, the effect of the Bank’s control was to give the London market a consistency and stability which it would not have enjoyed if the price for money had been determined by stockbrokers: this was the case in New York, and the rate there varied daily according to the dictates of the stock exchange. Domestically, the rate at which the Bank borrowed was ordinarily 0.5 per cent below that at which new treasury bills were issued. Thus, the Bank helped establish treasury bills, and hence government securities became much more attractive vehicles for investment than general deposits.360
The closure of so many stock exchanges in 1914 left many would-be investors searching for outlets for their funds. On 19 January 1915 the Treasury imposed an embargo on fresh capital issues that were not in the public interest. The effect was to reserve the London money market for government use. In 1916 the total value of capital issues in the United Kingdom was £585.6 million, as against £512.6 million in 1914, but of this total only £31.5 million (as opposed to £180.1 million in 1914) were not earmarked for government loans. The issues in 1917 were valued at £1,338.7 million, and all except for £40.9 million were government securities. The stock exchange was effectively regulated by the issue of treasury bills.361
By 4 November 1914 £82.5 million in six-month treasury bills had been sold at rates of between 3.5 and 3.75 per cent. Their issue was then suspended to allow the first war loan to be offered. The intention was to repay the ‘ways and means advances’ and redeem the outstanding treasury bills. Priced at 95 and paying 3.5 per cent, the war loan’s effective yield on maturity (between 1925 and 1928) would be 3.7 per cent. The Bank of England supported the issue by lending up to the full issue price at 1 per cent below the Bank rate. Not only did it lose on this deal (as the price fell to 90), but it also underwrote £113 million to enable the target figure of £350 million to be reached. The banks collectively subscribed £100 million as opposed to £91 million from the public. There were only 25,000 individual contributors. By pitching the minimum subscription at £100 (albeit payable in instalments over six months), and by keeping the interest rate low, the Treasury had deterred the public, and so failed to use the loan as an anti-inflationary device.362
With the launch of the first war loan completed the issue of treasury bills was resumed—initially with five-year exchequer bonds, and then with three–, six–, and nine-month bills, paying 2.75 per cent, 3.6 per cent, and 3.75 per cent respectively. Their aim was less to raise money than to stabilize the market rate of discount.363
In June 1915 McKenna launched the second war loan. Its aims were Keynes’s—less the raising of new money and more the countering of domestic inflation by attracting small investors and the steadying of international exchange by pulling in American funds. Bonds of £5 and £25 and vouchers for 5 shillings were offered through post offices. McKenna employed Hedley Le Bas of the Caxton Advertising Agency, who had promoted army recruiting, to popularize its terms. ‘We must give the investor something for nothing to make him lend his money to the country,’ Le Bas observed. ‘In other words, why not make patriotism profitable?’364 Although the stock was issued at par, the interest rate was set at the much more attractive level of 4.5 per cent. The banks grumbled at the competition, but were softened by the Bank of England’s readiness to lend to them so that they could in turn enable their customers to borrow in order to subscribe. The units were repayable in 1945, although they were redeemable at the government’s option after ten years and could be converted for any later long-term loans at par. The principle of convertibility was also recognized for past issues, and accounted for £313 million (about a third of the government’s outstanding stock) of the £900 million raised. McKenna had hoped for £1,000 million. Although the loan attracted over a million subscribers, over half of them bought units of £100 or more, and one-third of the new money was contributed by the banks.365
In 1916 government issues were dominated by medium-term stocks. Five-year exchequer bonds, paying 5 per cent, were issued in December 1915. In February 1916 war savings certificates, offered at 15s. 6d. but realizing £1 on maturity after five years, were aimed at the small investor. They were followed in June by war expenditure certificates, repayable in two years but convertible to war loans. In October a significant barrier was breached when exchequer bonds, convertible and paying interest free of tax, were offered at 6 per cent.
The 6 per-cent exchequer bond, designed to attract foreign funds, told a desperate story. Determined to reject exchange restrictions, the Bank had to counter the lure to investors of the New York market. In July it raised its rate to 6 per cent, far higher than that of any other belligerent. Three-month treasury bills, which paid 4.5 per cent in March 1916, were offered at 5.5 per cent in July; one-year bills earned 6 per cent between July and September. Outstanding treasury bills, to the tune of £800 million, clogged the money market in the late summer. The City was unhappy, as government rates were effectively depreciating existing stock. But the issue of a new war loan seemed inopportune as the battle of the Somme dragged on.366
Treasury bill rates fell in the autumn to accommodate the issue of exchequer bonds, and their sale was suspended altogether in January to allow the flotation of the third war loan. By now the American money market had eased, and the loan could be offered at a rate lower than 6 per cent. It was available in two forms—5 per cent stock issued at 95 and repayable in 1947, and 4 per cent stock issued at par, repayable in 1942, and free of income tax but not supertax. The former raised £2,075 million and the latter £52 million. The success of the 5 per-cent stock was interpreted as a reflection of confidence that taxation would fall after the war. But it was also a product of conversion rights: almost all the second war loan was exchanged for the third, and its price soared to 99. The first war loan, which did not enjoy convertibility, fell to 84.75. The arrangements for the third loan, therefore, included provision for a sinking fund to buy war loan bonds when they fell below the issue price. Just under half the total raised constituted new money.367
The third loan was the last of the war. Between 1914 and 1917 government policy was to consolidate floating and short-term debt through the periodic issue of long-term stock. Thus, devices like treasury bills covered the gaps between the major flotations. But after January 1917 short-term and medium-term debt dominated. The effect was to bring interest rates down and so make domestic borrowing cheaper. From April 1917, when treasury bills were available on tap once more, their rate fell until in February 1918 they paid only 3.5 per cent. The commercial deposit rate declined even further to 3 per cent.
The first consequence of this policy was an inability to attract foreign investment. In normal times the Bank would have responded to the market and raised its rate. Its subordination to the requirements of the state meant that it did not. But in November 1917 a differential rate was established for foreign balances, which paid 4.5 per cent.368
The domestic consequence was a disincentive to the private investor. By the end of 1917 the number of individuals holding government securities had swollen from 345,000 in 1914 to 16 million. Of these, 10.5 million owned war savings certificates.369 Lowering interest rates could jeopardize this success, fostering liquidity and pushing up price
s. That the situation did not get out of hand was the result of extending the policy of medium-term stocks begun in 1916. Five-year exchequer bonds paying 5 per cent were made available again in April 1917, but they only netted £82 million. In September they were withdrawn, and replaced by national war bonds. Marketed in several different guises, but embodying the principle of convertibility and interest rates of between 4 and 5 per cent, they raised £649 million in 1917–18 and £987 million in 1918–19.370 Thus, unlike the shorter-term debt of the other belligerents at the end of the war, much of Britain’s was both more fixed and better adapted to absorb private purchasing power.
Nonetheless, the increase in medium-term bonds could not prevent a major surge in the floating debt. ‘Ways and means advances’, which had not been used in 1915 or for most of 1916, were resumed at the end of the latter year. By 31 March 1918 treasury bills totalling £973 million were outstanding. The debt was absorbed by the commercial banks. They contributed £400 million to the government’s financing of the war between June 1914 and June 1917, but provided £470 million between June 1917 and December 1918. This represented the entire increase in the banks’ deposits over the last eighteen months of the war; commercial advances fell from 49.6 per cent of their deposits at the beginning of the war to 32.5 per cent at its conclusion. The banks had become the creditors not of trade and industry but of the government.371
Britain, like the other belligerents, had a floating debt problem at the end of the war. But it was manageable and its reduction could be staged. Of its total domestic debt at the conclusion of the financial year 1918/19, £6,142 million, only £1,412 million was floating; £1,040 million was in medium-term debt due to mature in 1925. Furthermore, Britain had managed to distribute its debt over many sectors: by 1924 £765 million was held in extra-budgetary funds, £740 million in the banking system, £790 million by small savers, £1,775 million by larger individual investors, and £2,315 million in foreign and corporate holdings.372
Thus, through medium-term stock and through the spread of its creditors Britain contrived to mitigate the more inflationary aspects of its change in borrowing policy after 1917. Furthermore, its corollary, the low rate of interest, itself created a continuing confidence in British financial strength. Hindsight, conditioned by the knowledge that ultimately the international money market would shift from London to New York, from sterling to the dollar, might suggest that this was a false optimism. Remarkably, however, London’s status as the world’s creditor emerged from the war comparatively intact. In the month of the armistice the London banks accepted $500 million worth of business compared to New York’s $210 million.373
The crisis in British government borrowing had come in the autumn of 1916, when the interest rate peaked at 6 per cent. Domestically, short-term debt expanded to the detriment of long-term, while the Treasury faced a mounting burden of debt repayment. Internationally, Britain had a double dilemma. To maintain its hold on the money market, its rates had to remain competitive with New York. To draw in overseas funds it could, of course, let its rate rise, but to export its domestic debt it had to offer terms no more advantageous than those prevailing across the Atlantic. Its ability to surmount this crisis lay only partly in its own hands. The reduction in the cost of its own borrowing relied in turn on the maintenance of low interest rates in America. The sequence of exchange-rate crises and the complaints of harassed Treasury officials obscure the two fundamental financial advantages the United States conferred on Great Britain. It followed a policy of low interest rates, and it fostered the developing machinery of credit. Without the creation in New York of favourable conditions for the flotation of debt, the battle to preserve the sterling-dollar exchange would have been meaningless.
In April 1917 the banks of the United States were in an extraordinarily strong position, flush with gold, their structure reformed, and free of debt. But the American Treasury was still concerned that the Federal Reserve System was insufficiently flexible for the demands which it anticipated the United States’s entry to the war would generate. On 21 June 1917 the legal reserve requirements of the member banks were reduced by 5 per cent. The effect was to create excess reserves which could then be used to expand deposits. Between June and December 1917 all deposits increased by 39.3 per cent and government deposits by 65.1 per cent. The member banks were required to pass their excess reserves over to the Federal Reserve district bank, so increasing the reserve ratio from 70.9 per cent to 78 per cent by August 1917. Between March 1917 and November the reserves of the district banks grew by 77 per cent, and by December 1919 by 125 per cent. On this basis the discounts of the Federal Reserve banks increased by a massive 2,548 per cent.374
Expanded reserves also enabled an extension of the note issue. The crisis of August 1914 was bridged by the terms of the 1908 Emergency Currency act, fortuitously extended in 1914 for the purposes of covering the establishment of the Federal Reserve System. The act allowed up to $500 million to be added temporarily to the circulation on the security of shares and bonds. By mid-October 1914 $363.6 million were outstanding, but in November the Federal Reserve System became fully operational and the emergency currency was retired.375
The Federal Reserve act did not establish an absolute ceiling on American circulation; it confined itself to stipulating that a gold reserve of 40 per cent should be held against outstanding notes. The memory of the Civil War served to persuade Americans that the danger of inflation lay primarily in uncovered notes. Thus, their worry in the summer of 1917 was that for the first time since the war began their exports of gold exceeded their imports. Their response, to ban the export of gold and to concentrate holdings in the Federal Reserve System, meant that America ended the war with a gold reserve of $2,090 million against a Federal Reserve note issue of $2,802 million.376 By then the Federal Reserve Bank held 74 per cent of the United States’s monetary gold stock as opposed to 28 per cent at the end of 1916.377 Even in relation to total circulation the gold cover looked more than adequate. In December 1916 $3,679 million were in circulation, in December 1917 $4,086 million, and in December 1918 $4,951 million. The ratio of Federal Reserve notes to the total circulation grew from .044 in June 1916 to .530 by December 1918.
But America’s experience proved an object lesson in the dangers of simple or single explanations for inflation. Federal Reserve note issues rose 754 per cent between March 1917 and December 1919.378 The money supply swelled by 60 per cent between 1913 and 1918, bank deposits increased by 94 per cent, but business only grew by 13 per cent. Thus, the mismatch between the availability of cash and the goods for purchase fed price increases.379 America’s industrial boom, fuelled by the Entente’s orders for war goods, only exacerbated the problem. The pegging of exchange rates fixed American products at—by European wartime standards—artificially low prices. Thus, goods were taken out of domestic consumption while simultaneously overseas payments augmented domestic purchasing power.380
If inflation was the downside of American policy, the expansion of the stock market was the upside. Low interest rates contributed to liquidity but encouraged lending and investment. The Dow Jones index, which fell to 54.63 in January 1915 had recovered to 99.15 by December of the same year. From April 1915 New York was the only stock exchange which did not restrict the trade in foreign securities. As a consequence the growth in loans and non-governmental investments in 1916 was valued at $3,188 million.381 Thus, the private financial sector was gearing up for wartime expansion before the American government itself generated any demands of it.
In April 1917 the United States’s national debt was small and the burden of interest payments trivial. The scope for extension was considerable. But the success of McAdoo’s borrowing policy was vitiated by the maintenance of low rates of interest. Already, between January and April 1917, government bonds suffered a slight fall, thus providing a clear indication that the popular success of war loans would depend on the attractiveness of their terms. McAdoo, however, was persuaded that patriotic
sentiment, not financial self-interest, would woo the small subscriber. He insisted on selling government bonds at rates of interest less than those of the market. In doing so he helped keep down the price of money, to the benefit both of America’s allies and of the industries of the United States. Expansion was never slowed because money was either unavailable or too costly. But the effect on government loans themselves was less positive. The price of the stock was depressed to below that at which it was issued and ultimately deterred the public. Consequently, America’s war loans did not divert the growing purchasing power of its lower-income groups, and so failed to staunch inflation. Instead, the banks became increasingly important to government borrowing. The government’s policy was that, by limiting credit to essential purposes and by encouraging the acquisition of long-term government securities, the war should be funded by ‘the thrift of the people. But in the three years up to June 1919 the commercial banks’ credit increased by $11,350 million, while their holdings of Treasury obligations and the loans on them rose by only half that. Thereafter the favourable conditions for credit were being exploited for non-essential purposes, and—as elsewhere— the expansion of the secondary reserve meant that war loans fuelled rather than quenched the money supply.382
McAdoo’s general principle was that the war would be paid for by a mix of taxation and long-term war bonds. He met the government’s current expenditure through short-term certificates of indebtedness. The Revenue act of 3 March 1917 authorized the issue of certificates of indebtedness to a ceiling of $300 million dollars; they paid 3 per cent interest. The legislation was linked to the receipt of taxation and therefore permitted a maximum maturity period of one year. But with the entry to the war the Treasury issued certificates of indebtedness which anticipated the four major war loans (or Liberty Loans, so called as they were to be used to wage war against autocracy). The first tax anticipation certificates were not offered until August 1918, and proved relatively unpopular—partly because their interest rate of 4 per cent was less than that then available through the loan anticipation certificates, and partly because the latter were more attractive to the banks. The Treasury prompted the banks to take up loan anticipation certificates so that subscriptions to the Liberty Loans proper would effectively be paid for before they were issued. It thus avoided large transfers of cash at any one time, and so prevented temporary restrictions on credit. From February 1918, anticipation certificates were marketed at fortnightly intervals; the banks were urged to subscribe 1 per cent of their gross earnings a week, and from April 5 per cent per month. The interest rate was fixed at 4 per cent in November 1917, and 4.5 per cent in February 1918. The banks responded by taking 83 per cent of the third and fourth Liberty Loan anticipation certificates. Non-bank subscribers, despite various taxation exemptions comparable with those available to holders of Liberty Loans, accounted for only 17 per cent. By 1 July 1919 48 series had been issued, totalling $21.9 million; 79.4 per cent of the Liberty Loan proceeds were used to refund Liberty Loan anticipation certificates.383