By J.D. Alt
I’m nearly finished with a very long book that may well be the best illustration of the basic principles of Modern Money Theory available. The book is “A Call To Arms,” by Maury Klein. It is an historical account of the U.S. mobilization as it prepared for, and engaged in, war with Germany and Japan. The scale of the task was unprecedented in human history—and the accomplishment of it changed not just the structure of the American economy, but American society as well. What is striking about the story—and the monumental effort to quickly build, virtually from scratch, the largest and most sophisticated war machine ever to exist on the planet—is that there is nary a peep of concern or argument about how this enormous task would be paid for. All of the anguish and struggle had not to do with finding enough “money” to pay for things, but rather with finding enough things to buy—and enough skilled labor to properly marshal it all together. In the end, virtually every real resource available in the continental U.S.—oil, gas, steel, aluminum, rubber, copper, sugar, tin, and man-hours of labor—was purchased by the Federal government to build the Army, Navy, Air Force and Marine Corps that ultimately defeated the Axis powers. The scale of the sovereign spending is almost beyond comprehension—especially given the fact that, at the starting gate, the U.S. economy was still decimated and impoverished by the Great Depression. At the finish line, however—VJ day, September 2, 1945—the U.S. had become the most powerful, efficient, and equitable economic power the world had ever seen. So how did it all get paid for? And even more important, how did we travel from that VJ day of economic triumph to our sorry state of today, where we think we are so “broke” we can’t even afford to hire enough fire-fighters and equipment to put out the forest-fires raging in our western states?
A lot of people will say the mobilization and war were paid for in the same way the federal government always has, and always will have to pay for anything: by collecting taxes and selling bonds. Evidence for this will be the $186 billion in War Bonds the U.S. government sold to the American people between 1941-1945, and the Revenue Act of 1942 which doubled federal tax revenues. Let’s assume, for the sake of argument, that the War Bonds and taxes did pay for the mobilization and war effort. Conceptually, when we say that, what we’re proposing is that the American people had a whole lot of what we call “money” stashed away in bank accounts and mattresses, and the sovereign government needed that money to build an Army and Navy and Air Force. So the sovereign government collected some of the people’s money, and borrowed even more by selling them War Bonds. Now, what did the sovereign do with the “money” it collected and borrowed? It paid the money back to the people in exchange for the materials and labor to build ships and airplanes and bombs and tanks. The war was fought and, through perseverance, the sovereign defeated the Axis powers, while a great deal of the war machinery the people built was destroyed, spent or ruined in the process.
Looking at it from a simple balance sheet perspective, what is the net position after the war is over? The people have gotten their “money” back, apparently having used it to pay themselves (through the actions of their sovereign government) to build all the stuff they had to build, and do all the things they had to do, to win the war. On the sovereign’s side of the balance sheet there’s a big debt: When the sovereign government traded its War Bonds to the people for their “money”, it made a promise to redeem the bonds at maturity, with interest. To redeem the War Bonds with interest, the sovereign needs…what? It needs the people’s “money” all over again! And, once again, our “logic” tells us there’s only two ways the sovereign can obtain the people’s “money”—by collecting taxes or by issuing (what we might this time call) Peace Bonds. Let’s say this is done, and now the sovereign has collected the people’s “money” back again, enabling it to do…what? It pays the “money” once more back to the people to redeem the original War Bonds with interest.
Now the people have their “money” once again—but what has actually been accomplished? The sovereign government now has a new debt: when it sold the Peace Bonds it promised to redeem them at maturity, with interest. To redeem the Peace Bonds with interest, the sovereign needs…what? It will have to get the people’s “money” back again! And, as before, there are obviously only two ways the sovereign can “get” the people’s “money”….
According to my calculations, the people have now paid for World War II three times over: first, when they bought the War Bonds, second when they bought the Peace Bonds so the sovereign could have the money it needed to redeem the War Bonds, and thrice because now the sovereign needs to tax and borrow their money one more time to redeem the Peace Bonds! Can this possibly be the way things actually work?
Fortunately, there’s another explanation for how the U.S. mobilization against Germany and Japan was “paid” for—an explanation that doesn’t, by logic, devolve into mathematical absurdity. Here it is:
When the mobilization began, the U.S. was still struggling to emerge from the Great Depression. Most households had scant savings to spend on War Bonds, and could hardly afford the burden of higher taxes, so the idea of taxing and borrowing their money to pay for the building of a great war machine was not even a viable option. Nor was it necessary. Instead, the sovereign government simply issued the U.S. dollars, by fiat, as it needed them to buy materials and pay wages: It declared the dollars into existence—and then it paid those dollars to the American people to build the ships and planes and guns. In the historical narrative by professor Klein, we never encounter someone saying, “Sorry, Mr. Roosevelt, we need to sell another billion dollars in War Bonds before we can build that new aircraft carrier.” That conversation just doesn’t come up. By the time 1941 rolls around—and especially in the months after the Pearl Harbor attack—mobilization has pushed the economy to virtually full employment: Millions of previously unemployed people (including women who’d never before been in the workforce) were suddenly pulling paychecks as engineers, technicians and machine operators.
These, now, were the well-paid workers who were able to buy the War Bonds—using dollars the sovereign government had already paid them. But why, if the sovereign could simply continue issuing dollars by fiat, did it sell War Bonds—and by so doing, appear to be eliciting the financial help of the people in the war effort? And why, if the sovereign could simply continue issuing dollars by fiat, did Roosevelt feel compelled to force Congress to impose the large tax increases? In a pivotal chapter in the middle of his book, professor Klein gives a very clear answer to these questions—and it’s an answer that is a text-book illustration of the basic principles of Modern Money Theory.
Between 1941 and 1942 the cost of living in the U.S. rose over 16%. Labor was threatening to strike for wage gains matching the rise in living expenses—putting the mobilization effort at risk. A looming inflationary spiral threatened to undermine America’s ability to accomplish what it so desperately needed to do: continue to pay itself whatever dollars were necessary to build the machinery required to defeat Hitler and Hirohito. The cause of the inflationary pressure was clear to everyone: The U.S. was at—or even beyond—full employment. American workers were pulling in more paychecks every week than they’d ever seen before, and were flush with cash to go on spending sprees. At the same time, however, virtually everything there was to buy had been diverted to the war effort: gasoline, tires, sugar, nylon, shoes, clothing, canned foods and automobiles. (Production of new automobiles was halted in February 1942, and all the auto-plants converted to war production.) There was suddenly very little to buy, and the excess money in the private economy began quickly driving up prices for what was available.
In the face of this crisis, the Roosevelt administration had to do everything it could think of to take spending money out of the hands of the people. In other words, it had to destroy money in the private sector to create the “space” that would allow it to continue to pay those same people to produce the war machinery that would still be required to defeat the Axis powers. The War Bonds and the Revenue Act creating the personal income tax, then, were specifically created not for the purpose of “collecting” money so the government could have it to spend—but rather for the purpose of destroying money so the government could then issue and spend even more dollars without feeding an uncontrolled inflationary spiral.
The most astonishing thing is what the unprecedented sovereign spending of the U.S. war mobilization accomplished. The people had paid themselves—through the fiat monetary actions of their sovereign government—to build a monumental war machine that defeated the Axis powers. But more than that, they had also paid themselves to invent an array of new technologies and apparatuses originally conceived for waging war, but which now were clearly seen to have useful applications to peaceful life as well—and they had paid themselves to build a great many factories, research and production facilities capable of adapting and producing these useful things to civilian life—and they had paid themselves to train a very large workforce of engineers, technicians and skilled workers who knew how to make it all work. This was a powerful economic brew—and it was spiced by the fact that the returning G.I.s were getting paid to go to college to explore how to make the whole thing run even better. America never looked back (until now.)
But what happened to the War Bonds? Didn’t the sovereign have to redeem them with interest? Of course it did—but it did not have to fool itself into thinking the only way it could “get” the dollars necessary would be to collect taxes or issue new bonds. It redeemed the War Bonds in exactly the same way it built the aircraft carriers and bombers of World War II: When the War Bonds came due, the sovereign issued the dollars necessary to redeem them by fiat—and then it paid those dollars to the American people who held the bonds.
By my calculations, the fiat money flowed like this: First, the sovereign government issued and paid the people dollars to build the war machine; second, the people paid the sovereign government back some portion of the dollars they’d earned by purchasing War Bonds and paying taxes; third, the sovereign government destroyed the dollars it received in taxes and for War Bonds, thus enabling it to pay the people even more dollars to produce ships and bombers without creating a spiraling inflation; fourth, the sovereign government redeemed the War Bonds with interest, paying the people with new fiat money—but rather than being inflationary, these new dollars were absorbed by the rapidly growing post-war economy, the people using the money to buy the newly abundant goods and services produced by what was now the most technologically sophisticated, creative, well educated, productive and equitable social economy in world history.
But now, somehow, we’ve lost our way and our momentum. We’ve convinced ourselves that our sovereign monetary system works by a different logic—a logic that leads inexorably to a perpetual and growing shortage of Federal spending power. Given the real threats now racing our way with the same inevitability as was Nazism in 1938—climate change, rising sea levels, super-storms, extended droughts, gigantic forest fires, loss of fisheries and ocean acidification, water and food shortages, nuclear terrorism, and the possible failure of democracy itself—it seems we might want to consider another great mobilization to defend ourselves—if we can ever remember how to do it.
I agree with all of it but can’t understand one part. Why do you say the government destroys the money? Can’t the government use that money? It’s illegal to destroy the money. The people at monetary.org take you to task for this argument.
The idea that governments destroyed money after the war figures.
Prior to the war, the private sector would have been short of what MMTers call “private sector net financial assets” (i.e. government debt and monetary base). That explained the excess unemployment.
Come the war, government creates money and spends it. That gives loads of people an incentive to work. But when psnfa reaches the point where household demand rises too far, government has a problem: demand from households will compete with demand from the army, navy, etc. So government has to confiscate some of that money. So it tempts people into buying bonds.
After the war, psnfa is likely to be too high. So government has to confiscate some of it, which is exactly what the UK and US governments did. That is, government debt declined rapidly after the war in both countries: i.e. as bonds matured, government grabbed the money and destroyed it.
Re your question “Can’t government use that money”, you’re assuming money has some inherent value. Fiat money doesn’t. It’s just a book-keeping entry or a number in a computer. The concept “money in the hands of government” is plain meaningless.
Bill, remember most of the government expenditures and tax collections were by check, not in cash. Only a small part was in currency, and that has a limited useful life before it wears out and is destroyed and replaced with new currency. When MMT’s say taxes destroy money, taxpayers gasp at the prospect of their hard earned money being shredded or burned, but again most of it is now electronic bits along with some paper checks. The deficits that the federal government runs are the net difference between the revenue it collects as taxes and fees and the amount of money it spends for goods, services, and interest. For accounting purposes taxes and fees are counted against new expenditures so that the deficits appear smaller. In reality it is not necessary to count revenue against expenditures, it just makes the deficits (somewhat, to some eyes) more palatable. If revenue were not counted against expenditures, the national debt would probable be in the $50 to $100 trillion dollar ranger instead of $16 to $17 trillion. We would still be the same country that won WWII, all those War Bonds would still have been paid off, and the deficit hawks would still be beating their chests about our unsustainable debt.
When the goverment runs a budget surplus, the Treasury normally ‘uses’ the money to retire debt, i.e. to buy govt bonds back from the public
This destroys money as follows:
Say the budget surplus is $100, i.e. the govt has taxed $100 more than it has spent.
1. The Treasury spends the money to buy back $100 worth of govt bonds from the non-govt.
2. The Fed then sells bonds from its portfolio to the non-govt, to drain the reserves added by the Treasury’s purchases.
End result: the overall quantity of outstanding govt bonds is reduced, and the budget surplus money is destroyed* as it returns to the Fed in payment for the bonds.
(*when the Fed receives its own liabilities – i.e. base money – in payment, those liabilities are extinguished and as such cease to exist)
I thing this is a semantic thing. By destroy, JD doesn’t mean physically destroy. He means that the dollars are pulled out of circulation. They don’t get annihilated, they just sit on a government balance sheet doing nothing.
There may have been physical destruction of bank notes (as well as
more fundamental fact of the soaking up of consumer purchasing power).
Warren Mosler has written that if one were to pay one’s USG tax obligation
in Federal Reserve Notes at the nearest offices of the US Treasury, one
would receive a receipt for the taxes paid and the bank-notes would be
shredded. It’s evidently cheaper to print new ones than to employ people
to deal with the incoming paper.
In FY 2012, the Bureau of Engraving and Printing produced around
8 Billion crisp new FRNs:
In 2012, about 3/8 of this was in the form of $100 notes, some of which (I have read) ends
up overseas; in some places the US $100 note is a preferred store of value and medium
of exchange. But even supposing that most of the $100 notes end up overseas,
this production is still tens of paper notes per US capita. Are we really wearing
out paper notes that fast? I’m certainly not wearing out tens of paper notes
I’m wondering what happens when a bank delivers a truckload
of paper notes (received as deposits from retail or commercial customers)
to a regional Federal Reserve bank to exchange for electronic reserves
balances. Something like this must have happened during the War when small
retail purchasers of War Bonds made small denomination bond purchases
from banks which were selling them on behalf of the USG. Some banks
would have been receiving more FRNs in bond purchases than they had
use for in cashing checks. Presumably surplus FRNs would have found
their way back to regional FRBs to be deposited into reserves balances,
out of which the Treasury would have been paid the revenues generated
by the War Bond sales.
Did the regional FRBs put all those notes back into circulation? Sort out
the worn ones for shredding? Shred the entire lot?
Can anyone speak to this operational question (either then or now)?
I cannot speak to the issue of what happens physically to currency payments, but when taxes are payed the government’s asset ledgers are debited and its liabilities ledgers are credited by the amount of the payment. If taxes are paid in cash, and the currency is in good condition it probably gets recycled through the Federal Reserve, and if it’s worn, it probably gets destroyed and replaced by new currency. In either case the amount of currency is kept constant, but it is a tiny fraction of the government’s revenue and spending. If it’s cheaper to destroy and print new money than to sort and handle the old, it would make sense to just destroy all cash payments and replace them with new bills, but the government is not always noted for doing the most efficient thing.
This isn’t really that complex with a consolidated Fed/Treasury view (as our central bank), which removes a little of the confusing accounting mentioned above. The US central bank creates money by spending it into existence (per the instructions of Congress, of course). This in turn creates a liability. It’s that liability that’s floating around getting spent over and over that is actually our money. Eventually, that money will be “spent” paying taxes. At that point, the liability initially created is extinguished, and this is all that is meant when MMT says money is destroyed; that liability has disappeared. This isn’t a problem of course; no fiscal space is lost, because the central bank will create more of these liabilities whenever instructed by Congress to do so.
Thanks for the clearest explanation I’ve seen. I thought that the term ‘destroying the money’ might not mean the actual physical destruction. I’m disappointed with the people on monetary.org that they can’t see this. They are hammering Wray because destruction of money is illegal and can’t be done except when it’s too tattered to be functional.
It just cools down private sector consumption at periods of full employment. We’re a ways from that now. Then it is easy to recreate the money and direct it back to the economy. Hopefully to build factories rather than pay bank exec bonuses…
So does the book talk about financing the war effort? Is it worth reading from the monetary perspective?
PeterP, that’s just the point: the war wasn’t financed. It was paid for directly by sovereign spending—the issuing and spending of fiat dollars by the federal government. The War Bonds and tax increases, the historical narrative makes very clear, were for the purpose of controlling inflation, not for the purpose of financing the war. “Financing” is something you and I do because we don’t have the power and authority to issue sovereign currency.
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“What is striking about the story—and the monumental effort to quickly build, virtually from scratch, the largest and most sophisticated war machine ever to exist on the planet—is that there is nary a peep of concern or argument about how this enormous task would be paid for. All of the anguish and struggle had not to do with finding enough “money” to pay for things, but rather with finding enough things to buy—and enough skilled labor to properly marshal it all together”
One obvious difference between then and now is that the USA had a trade surplus at the time, i.e. it was a net creditor to the rest of the world. Now it’s a net debtor.
Of course it is, otherwise we wouldn’t be the reserve currency. The rest of the world wants to net save in US dollars so it is desperate to sell us stuff so that it can get those US dollars.
The dollar became the world reserve currency when the US was running current account surpluses, not deficits. India has a large current account deficit country, and the rupee is not an international reserve currency.
*India has a large current account deficit, and the rupee is not an international reserve currency.
The US can’t be a reserve currency unless other countries are holding US currency in reserve. The only way that happens is for the US to be running a net current account deficit with those other countries. The US may have been set up to be a reserve currency when it was running a surplus, but it did not actually become a reserve currency until it went into deficit. There’s some sort of idea that we can have it both ways; indeed that it is desirable to have it both ways, but by definition and simple rules of accounting, it’s just not possible.
A great post and it takes us back to the basics. Another factor in who is the world’s reserve currency is which currency is oil traded in. Saddam was threatening to start using the euro and I’m convinced this is one of the major factors in why he was taken out.
“Now the people have their “money” once again”
it’s not that simple though. The “people” are not an undifferentiated mass. There are creditors and debtors within “the people”. The poor don’t buy government bonds and thus “lend money to the government”. The rich creditors buy government bonds and thus “lend money to the government”. They get the interest paid on the government bonds, not “the people”.
Excellent point. One of the concerns I’ve brought up previously (and just the other day on one of Dan Kervick’s posts) is that MMT prefers to focus on the private sector as a whole and neglects segmentation within the private sector. I believe this to be for the sake of simplicity in describing what is a relatively new concept to most people as well as to pull out the politics of income inequality for mainstream audiences. However, it is a very real concern that the mass of borrowing occurs from the financial sector and is then repaid by taxing from all sectors. By pulling not segmenting the private sector, I think it misses out on quite a bit of explanatory power.
Did you mean to write “pooling not segmenting”?
On another note, quite a few individuals did buy War Bonds in small denominations, although I don’t know what the aggregate value of those small purchases was in comparison to large purchases.
Finally, it is debatable whether bonds are repaid by taxing any sector or simply repaid with new funds created by fiat, as in the above discussion following Bill Cash’s comment.
Basic MMT seems to be a means to describe what it really means to be a sovereign issuer of a floating non-convertible currency. And the idea that taxes give credibility to this currency.
Addressing policy issues like income inequality seems to be related but more in the form of ‘functional finance’ where issues like employment take more center stage. The job guarantee program tries to put labor in a more prominent role as an anchor of the currency rather than say gold.
Functional finance would also embrace collaborative fiscal policy such as a more accommodating tax structure and more affordable education opportunities.
No they don’t. Here’s former Deputy Secretary of the Treasury, Frank Newman in his recent book, Freedom from the National Debt.
It’s worth putting in as a more explicit footnote, that the effective function of issuing bonds was to allow people a safe way to defer their income to a future date- specifically to after the war when government purchases would drop and the need for private purchases to take over maintaining productions levels would be most acute (and a fair bit of the post-war recession comes out of the lag between the federal spending cuts and bond income taking over, along with the logistical time needed to read emerging market pressures and re-tool production lines.
Bonds are not “borrowing” so much as they are a contract to defer private spending by way of building secure savings instead.
The debt ceiling law existed at the time, didn’t it? Did the spending just blow right past it in the beginning, too fast for the legislative process and with nobody willing to object or even raise a concern? Or did Congress, more or less by acclamation, keep passing increases whenever they were “needed” so there was always technical compliance with that law?
I’m not sure the debt ceiling law existed then. Anyone know when it was passed?
A quick search says since 1917.
urban legend: This question about the debt ceiling is interesting because it seems to assume that sovereign spending creates “debt”. But that is not the case. Sovereign spending creates financial assets in the private sector—and also, hopefully, causes useful work to be done. And that sovereign spending can be done with completely new dollars created by fiat. So where is the “debt”?
This piece, which is not from an MMT perspective (e.g., “The nation needed dollars — and lots of them — to wage and win the new war. FDR wanted those dollars raised as equitably as possible”), by Sam Pizzigati of the Institute for Policy Studies, is more about how FDR got a steeply graduated income tax but it gives an idea of how FDR handled the debt ceiling battles at the time.
Very well put narrative, JD!
I second Joe’s comment and wonder if, in addition to helping clarify some key MMT insights, it also links them to an emotionally powerful theme: of the U.S. (after a prolonged and painful economic shock) undertaking a vital and very successful national mobilization for the common good.
My sense is that this “mobilization for the common good” theme that could use some serious reinvigorating amidst today’s political environment and economic conventional wisdom. I think JD gets the ball rolling nicely in this post, and would love to see more use of this historical parallel from MMT thought leaders. And, instead of war, today’s “greatest generation” can mobilize for peace, prosperity, sustainability and human dignity. If they could do it then, why can’t we today? Plenty of “reasons,” I suppose, but none of them good ones.
Did you read the book “Keep From All Thoughtful Men: How US Economists Won WWII” by Jim Lacey (2011)? If not, do.
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Thank you very much, JD Alt, for an enlightening discussion. In your next article, could you compare and contrast fiat money creation during WWII with the creation of greenbacks during the Civil War? We need to look at the whole arc of US economic history. Also, I would be very grateful if you could discuss in the future the ostensible reasons why the federal debt limit was created during WWI. The debt limit seems to be a muddle-headed anachronism from the days of the gold standard, and there is no reason the US government should be driving a Model T in 2013. If we understood the precise historical background behind the limit’s creation, that might help us develop powerful and persuasive arguments for demanding that Congress do away with the debt limit.
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Hmmm. So what the global left needs is a big peaceful project with heaps of new forms of labor required and which which doesn’t ruin the environment.
It seems to me that we are ready for that now? Use the fiat to start innovating a whole new paradigm for infrastructure and industrial development activity. Every type of activity we do needs rethinking to break out of the current progress trap.
How accurate is Friedman and Schwartz’ assessment in the following quote?
“In terms of federal government expenditures during the period of war-time deficits, 48 per cent was financed by explicit taxes; 7 per cent by direct government money creation; 14 per cent by private money issue, which can be regarded as the indirect effect of government money creation but had as its nominal counterpart interest-bearing rather than non-interest-bearing government debt; and 31 per cent by interest-bearing government securities not matched by money creation. ”
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Destroying the pound in there?
How do you figure?
Are you referring to replacing the pound as the world’s reserve currency?