5. The Federal Reserve and World War I

The Federal Reserve System arrived fortuitously for the financing of U.S. entry into World War I, for it is doubtful whether the government would have been politically able to finance the war through taxes, borrowing from the public, or the simple printing of greenbacks. As it was, the Fed was able to engineer the doubling of the money supply from its inception in 1914 until 1919.

World War I also led to a strengthening of the power of the Federal Reserve System and particularly of the dominance of Benjamin Strong and the Federal Reserve Bank. With banking subject to treasury demands for financing the huge deficits, Secretary of the Treasury McAdoo and Benjamin Strong assumed virtual joint control of the Federal Reserve. As Willis wrote, “It was the entry of the United States into the World War that finally cast a decisive vote in favor of a still further degree of high centralization; and that practically guaranteed some measure of fulfillment for the ambitions that had centered around the Federal Reserve Bank of New York.”[42]

Strong’s new dominance was facilitated by the treasury’s making the Federal Reserve its sole fiscal agent. The secretary of the treasury had not done so before the war arrived, instead continuing the Jacksonian policy of depositing the disbursing funds from its own sub-treasury branches (the Independent Treasury System). Under the spur of war, however, McAdoo fulfilled Strong’s long-standing ambition; the Fed was now clothed with full governmental power. Strong had previously written: “We must, if possible, persuade [McAdoo] to permit the Reserve Banks to become the real, active, and effective fiscal agents for the Government. If he does that, our place in the country’s banking system will be established for all time.”[43] Strong’s biographer summarizes how treasury operations during the war accelerated the dominance of the New York Fed:

The war and the delegation of fiscal agency had a special effect on the New York Bank and on Strong’s position in the System. Situated in the nation’s great central money market, the New York Bank sold and distributed nearly half of all securities offered by the Treasury during the war and collected and disbursed great sums of money. At the country’s foreign exchange center and gateway to Europe, it handled most of the Treasury’s foreign exchange business, made many financial arrangements for the Treasury with foreign countries, acted as a central depository of funds from the other Reserve Banks as well as the New York district for payment to the representatives of foreign countries or to suppliers of munitions to them, and was the principal purchaser of acceptances. Thus it was only natural that the New York Bank came to enjoy the prestige of being the principal bank of the government, the Treasury came to use it as a channel for communicating with the other Reserve Banks, Strong’s counsel was given heavy weight by the Treasury, and both the New York Bank and Strong emerged from the war with greater prestige, both absolutely and relative to the other Reserve Banks and the Board. [44]

Moreover, Strong had long wished to concentrate the country’s gold coin and bullion in the hands of the Federal Reserve and outside the control of the public. In that way, cartelization would be intensified, and the inflationary potential of the Fed, which pyramided its own notes and deposits on top of its gold stock, would greatly increase. In 1917, in view of the war, the law was changed to permit the Federal Reserve to issue notes in exchange for gold (previously it could only issue them for commercial notes) and to require all legal bank reserves to be kept as deposits at the Fed rather than in cash. Furthermore, relaxed federal regulations on state banks in 1917 finally induced a considerable number of state banks to join the system, intensifying the concentration of reserves and of gold still further. Finally, from September 1917 to June 1919, the United States went implicitly, though not formally, off the gold standard—at least for foreigners. Foreign exchange operations were controlled and gold exports prohibited. As a result of all of these measures, gold was virtually nationalized and successfully concentrated at the Fed. At the end of 1916, the gold reserves of the Reserve Banks were only $720 million, or 28% of the country’s monetary gold stock. Two years later, gold reserves at the Fed were up to $2.1 billion, or no less than 74% of the nation’s gold.