- War Finance: Theory and History / Artikel mises.org - - Elli -, 04.02.2004, 14:43
War Finance: Theory and History / Artikel mises.org
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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>War Finance: Theory and History</strong></font>
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<p class="MsoBodyText"><font face="Verdana" size="4">by H.A. Scott Trask</font>
<p class="MsoBodyText"><font face="Verdana">[February 2, 2004]</font>
<p class="MsoBodyText"><font face="Verdana"><img alt src="http://www.mises.org/images3/war.gif" align="right" border="0" width="249" height="199">That
war is not productive may seem self-evident to Misesians but it is not to the
"educated" public who have been taught that World War II ended the
Depression and that deficit spending (of whatever kind it doesn't matter)
spurs economic growth. Americans show not the slightest awareness that every
dollar spent on the ongoing Afghan and Iraqi wars, the continuing occupations,
and the rebuilding of those failed societies is one less dollar that can be
spent at home, and that the whole adventure represents a giant transfer of
American capital to the sweltering deserts and sun-baked slums of the Middle
East. If they were aware of these economic realities would they not be more
skeptical about administration claims that the terror war is enhancing our
security?</font>
<p class="MsoBodyText"><font face="Verdana">The Sinking of Capital</font>
<p class="MsoBodyText"><font face="Verdana">Thus it bears repeating that
warfare, whether victorious or not, retards the accumulation of productive and
livable capital. It does this either by destroying capital outright or sinking
it in logistics and war production, thereby rendering it incapable of
reproducing itself or adding to the complex infrastructure and amenities of
civilization. During peace, capital is expended to sustain life, to provide
comforts and entertainment, and to create new capital (houses, furniture,
autos, machine tools, office building, factories, etc.). During war, capital
is squandered building the implements of war and sustaining armies in the
field. After the war, capital and labor must be expended in reconstruction and
repair. War can give the appearance of prosperity (full employment, busy
factories, high prices), but it is not real. During the War Between the States,
"the mills, forges, and factories were active in working for the
government, while the men who ate the grain and wore the clothing were active
in destroying, and not in creating capital. This, to be sure, was war. It is
what war means, but it cannot bring prosperity." So wrote Sumner.</font>
<p class="MsoBodyText"><font face="Verdana">Taxation</font>
<p class="MsoBodyText"><font face="Verdana">From the standpoint of
productivity, it matters not whether a war is paid for by borrowing, taxing,
or inflating. In all three cases, resources are diverted from the productive
economy of wealth creation to the destructive economy of war-fighting. From
other standpoints, it makes a great difference. Let us take the political.
When government resorts to taxation, it confiscates a portion of the capital
and labor of the population. Except for government contractors and officials,
everyone is immediately poorer, and they know it. This is why Jefferson
insisted that a heavy redemption tax be laid to pay interest and principal of
the war debt. He wanted the people to know how much the war was costing them,
and he wanted to dampen the spirit of militarism and navalism with a heady
dose of reality-enhancing taxation.</font>
<p class="MsoBodyText"><font face="Verdana">Borrowing</font>
<p class="MsoBodyText"><font face="Verdana">When the government borrows, the
case is altogether different. Instead of confiscating resources, the
government pays for them, but it does so belatedly. As a result, the sacrifice
is deferred, but not for everyone. Capitalists lend their capital to
the government for the promise of annual interest and eventual principal. They
make no sacrifice at all. On the contrary, they have a secure,
interest-bearing investment (that is, if the government is not overthrown or
defeated). Those who can afford to buy bonds do so, knowing that it is as
secure as the prospect of victory and the efficiency and potential lethality
of the government's tax-collecting and enforcing apparatus. Those who cannot
afford to buy bonds, or who prefer to invest in productive endeavors, must pay
in future taxes for the reprieve of not being taxed in the present. The
political benefit for the government is obvious. When the state sells bonds,
the public hardly notices. As they do not grasp that they must pay the
interest and principal of the borrowed funds, they offer no opposition to the
bond issue.</font>
<p class="MsoBodyText"><font face="Verdana">The economic significance is less
obvious but no less important. The interest payment represents pure wealth
redistribution. The accumulation of government debt renders productive labor
tributary to the government's creditors. The inequality of wealth and the
formation of distinctive classes might be the natural result of the
differentiation of intelligence, the specialization of labor, the accumulation
of capital, the protection of property, and family inheritance. It might also
be the result of political privilege and power, and fiscal extravagance
supported by the funding system.</font>
<p class="MsoBodyText"><font face="Verdana">Inflation</font>
<p class="MsoBodyText"><font face="Verdana">Inflationary finance combines the
political and economic advantages of borrowing with the immediate rewards of
confiscatory taxation. It is a disguised form of confiscation, redistributive,
and allows government to command immediate resources. When governments finance
a war by printing money and using it to buy supplies and pay troops, the
resulting depreciation acts as a tax, the amount of which is exactly
equivalent to the depreciation. It is taxation by the back door, but it is an
unequal and largely regressive tax. The decline in the purchasing power of the
money does not impoverish all equally. It plunders the wage-earner and soldier
because their wages always lag behind the rise in prices resulting from
monetary inflation. It harms the small producer or trader because they receive
the new money after it has already circulated and depreciated in value.
However, two groups usually benefit from the inflation. Government contractors
receive orders that they would not in peacetime, and enjoy the first use of
the newly printed money. Large capitalists can invest in government bonds, or
they can speculate in stocks and commodities whose price is soaring due to the
inflation.</font>
<p class="MsoBodyText"><font face="Verdana">The War Between the States</font>
<p class="MsoBodyText"><font face="Verdana">The Americans may have been the
first to discover the secret of funding a war with paper money. The New
Englanders pioneered the way in the 1690s, and the republicans of 1775 could
think of no better method of funding their war of independence than by
printing money, the ubiquitous Continental. Later, England demonstrated that
suspending specie payments during a war (in this case her war with
Revolutionary France) need not lead to hyperinflation and financial
Armageddon, as long as it was moderate. Thus, the Bank of England's suspension
(1797-1821), known as the English Bank Restriction, set the pernicious
example that inconvertible bank notes were as"good as gold," and
furnished an abundant sea on which to float bonds. The Americans emulated the
mother country in 1814-17 and in 1861-79. </font>
<p class="MsoBodyText"><font face="Verdana">The 1860 election of Abraham
Lincoln sparked a secession movement in the southern states. In December,
South Carolina seceded, and other Deep South states soon followed. Interstate
commerce was disrupted, and many northeastern banks suspended specie payments.
The atmosphere was one of grave political and economic crisis. Many feared
war; many feared the unknown. Consequently, from December through most of the
first half of 1861 (the months previous to the war), the business community
prepared to weather the coming storm. Banks contracted their loans and
increased reserves. Merchants and traders retrenched, and manufacturers
deferred new capital investments. Everyone reduced debt and expenses. As a
consequence, prices fell, imports slowed, exports boomed, and specie flowed
into the country. Sumner estimated that exports exceeded imports by $67
million and specie flows showed a net gain of $16 million during this period.
According to him, these developments represented a real opportunity for the
government to fund its war without resorting to inflationary finance."The
real financial question of the day was whether we should carry on the war on
specie currency, low prices, and small imports, or on paper issues, high
prices, and heavy imports." The business community and the banks had done
their part; it was now up to the government. The Lincoln administration
hesitated as to which choice to make, but it eventually chose inflation and
extravagance.</font>
<p class="MsoBodyText"><font face="Verdana">Taxation</font>
<p class="MsoBodyText"><font face="Verdana">The Lincoln administration feared
to rely primarily or even significantly upon taxation as a means to pay for
the northern union's invasion of the southern confederacy. Americans had never
yet paid for a war by paying more taxes, not even as colonists of Britain; so
there was no precedent. Besides, Americans were averse to taxation for any
purpose and had not paid internal taxes since the mid-1810s. In addition,
at least half of the northern public was either opposed to the war or would
give it only a grudging and highly conditional support. Raising taxes
significantly would surely increase the vehemence of anti-war sentiment and
push those who were undecided or apathetic to favor an armistice. Nevertheless,
some taxes would have to be raised, if only to maintain the credit of
the bonds.</font>
<p class="MsoBodyText"><font face="Verdana">Treasury Secretary Salmon Chase
could not expect to raise much revenue by increasing tariff rates. Even before
Lincoln took office, the Republican Congress had passed the Morrill tariff (March
2, 1861). Its purpose was to exclude foreign manufactures, not raise revenue.
This tariff represented a major regression in both liberty and economic
thought. Sumner wrote:"The country was once more embarked on the
protective policy, which received an extension in the following years
unexampled save by the most unenlightened nations on earth." By it and
subsequent revisions, average rates on dutiable imports rose from 19 percent
in 1860 to 54 percent by late 1865.</font>
<p class="MsoBodyText"><font face="Verdana">Chase proceeded cautiously, but
every year he recommended new taxes. By the end of the war, Americans were
paying higher taxes than they had ever paid before—even as colonists of
Britain—and more than most of the nations of Europe. In 1860, Americans paid
$53 million in taxes, all in the form of import duties; in 1865, they paid
$295 million. In August 1861, Congress passed a property tax to be apportioned
among the states, and an income tax. In the first year, the property tax
raised $20 million, the income tax nothing. In 1862, the property tax was
repealed, and the income tax brought in only $2.7 million, so Chase
recommended excise taxes (enacted in July 1862). These were the first internal
taxes laid since the War of 1812. It would be tedious to list even a sample of
the things that were taxed by the Internal Revenue Act of 1862. Suffice it to
say that the general principle was to tax everything. Congressman James Blaine
(Me.) praised it as"one of the most searching [and] comprehensive
systems of taxation ever devised by any government." In June 1864,
Congress raised the duties still more. That year was the first in the history
of the republic in which revenue derived from internal taxes exceeded that
collected from the tariff. By the end of the war, the income tax had raised
$55 million, customs $305 million, and the internal revenue duties $352
million. However, these substantial sums amounted to only 21 percent of the
expenses of the war, the other 79 percent having to be borrowed.</font>
<p class="MsoBodyText"><font face="Verdana">Inflation in 1861</font>
<p class="MsoBodyText"><font face="Verdana">Inflation was moderate in 1861.
Secretary Chase issued $33 million in demand notes, which were made receivable
for all government dues and then reissued, and which the banks were pressured
to receive on deposit and redeem in coin. In addition, he floated a $150
million bond issue in the form of three-year, 7.3 percent treasury notes.
Chase insisted that the subscriptions be made in gold or in treasury notes. As
the banking system of the time was a fractional reserve one, with a mixed
currency of gold dollars, fractional silver coins, bank notes, and demand
deposits, the massive transfer of gold to the government, plus the addition of
$33 million in convertible government paper currency, drained bank reserves.
As a result, the banks suspended specie payments in December, 1861.</font>
<p class="MsoBodyText"><font face="Verdana">This suspension was unprecedented
in that it was not preceded by a financial panic or a sudden demand for coin.
The banks were under no necessity to suspend, but they did so because of what
they anticipated would happen in 1862. Confederate military victories
in the summer of 1861 had dispelled the initial expectation of a short war.
The banks now rightly expected heavy bond issues and more government paper
currency. The results of the suspension were predictable. Gold coins ceased to
circulate, and gold rose to a one or two percent premium against paper.</font>
<p class="MsoBodyText"><font face="Verdana">The Legal Tender Act of
February 1862</font>
<p class="MsoBodyText"><font face="Verdana">The Republicans were heirs of the
soft-money tradition of Hamilton, Clay, and the Whigs, so they predictably
turned to currency inflation to fund their expanding war. In 1862, they
proposed a massive legal tender paper issue. Only a handful of hard-money
northern Democrats remained in Congress to contest the measure. According to
Sumner,"the spirit of the debate was that of panic." Republicans
thrust aside economic objections as theoretical nonsense and dismissed
historical warnings as irrelevant to American conditions. Many congressmen
cited the example of the English Bank Restriction (1797-1821) as a
reassuring precedent of the safety of an irredeemable currency. They seemed to
be unaware that the pound had depreciated during this period and had never
been made a legal tender.</font>
<p class="MsoBodyText"><font face="Verdana">When the catastrophe of the
Continental dollar during the American Revolution or the assignats of
the French Revolution was cited, Republicans responded by impugning the
patriotism of the skeptics. Sumner wrote,"When the lessons of history
were quoted they were answered by the flag and the eagle." One Republican
congressman indignantly asked why the government should have to demean itself
by having to"go into the streets to borrow money." Another intoned,
"I prefer to assert the power and dignity of the government by the issue
of its own notes." Thaddeus Stevens of Pennsylvania, a longtime
abolitionist and a leading Radical Republican, even made the astonishing and
ignorant claim that making the government notes legal tender would prevent any
depreciation in its value.</font>
<p class="MsoBodyText"><font face="Verdana">The economic rationale for legal
tender paper money was made by Senator John Sherman of Ohio (the brother of
General Sherman). His arguments were all disguised forms of the argument from
necessity. The government needed money right away. The banks had exhausted
their capital in buying bonds. There was not enough money in the country to
fund the bonds. Gold and silver coin had ceased to circulate. Interest rates
were too high. The issue of legal tender notes was a mere temporary expedient,
and it could do no harm. What these arguments really meant was that Sherman
wanted to command the full productive resources of the country for the war,
and as the public was not willing to make the requisite sacrifice, they had to
be coerced.</font>
<p class="MsoBodyText"><font face="Verdana">When Democrats pointed out,
correctly, that the Constitution conferred no power to make government paper
legal tender, and no one before 1861 had ever suggested it had such a power,
Sherman replied that the necessity and righteousness of the cause overruled
the Constitution. For him, the end justified the means."As a member of
this body, I am armed with high powers for a holy purpose, and I am authorized—nay,
required—to vote for the laws necessary and proper for executing these high
powers, and to accomplish that purpose. This is not the time when I would
limit these powers. Rather than yield to revolutionary force, I would use
revolutionary force." Legal tender paper money was indeed a revolutionary
force.</font>
<p class="MsoBodyText"><font face="Verdana">The Legal Tender Act authorized
the issue of $150 million in government currency and a bond issue of $500
million. The notes, soon known as"Greenbacks," were made legal
tender for all private debts, receivable by the government for taxes and land
sales (but not import duties), and were fundable into the bonds. The bonds
bore six percent interest and were payable in 20 years, but redeemable after
five. The Republican Senate had very cleverly added two specie amendments. One
required import duties to be paid in gold, and the other that the interest on
the bonds be paid out in gold. Senator Sherman explained their purpose. First,
"It was felt that the duty on imported goods should not be lessened by
any depreciation of our local currency." The protectionist Republicans
were determined to preserve the restrictive character of the tariff by
mandating that duties be paid in gold, instead of in a depreciated paper
currency. Second,"This security of coin payment would enable the
government to sell the bonds at a far higher rate than they would have
commanded without it." A gold dividend would enhance the value of the
bond.</font>
<p class="MsoBodyText"><font face="Verdana">The consequences of the legal
tender law and emission of irredeemable notes were such as any economist would
have expected. First, it destroyed American credit abroad. Foreigners dumped
their holdings of American bonds and would not buy the war bonds. Second, it
drove specie out of the country, much of it going to pay for the augmented
imports incident to an inflated currency. Third, they depreciated. Fourth, the
Treasury printed more. In July 1862, Congress approved a second issue of $150
million notes, and then a third issue of $100 million in January 1863 (increased
by $50 million in March). Altogether, in four years, the government issued
$480 million in legal tender notes, $43 million in fractional currency, and
$60 million in demand notes. Of this sum, all but $75 million was outstanding
in 1865. According to Sumner, the total currency in October 1865 was $704
million: $428 million greenbacks; $185 million national bank notes; $65
million state bank notes; and $26 million in fractional currency. Total
currency in 1860 had been only $207 million. The currency supply had thus
risen 240 percent in five years, an increase in 48 percent per annum.
According to Rothbard, the total money supply (currency plus deposits
and coin) rose from $745 million in 1860 to $1.7 billion in 1865, an increase
of 138 percent, or 27 percent per annum.</font>
<p class="MsoBodyText"><font face="Verdana">There are two measures of the
depreciation of the Greenback. One is to follow its downward spiral on the New
York gold market. In March of 1862, a $100 basket of government currency could
buy $98 in gold. By December of 1862, it could buy $76. A year later (December
1863) it could buy $66. By the summer of 1864, it reached its nadir,
exchanging for $39 in gold. By December 1864, it rebounded to $44. Military
victories and the growing certainty of Southern defeat caused it to rise to
$74 in May, 1865, but it fell to $68 by December. The second is to mark the
general rise in prices. From a base of 100 in 1860, prices rose to 217 in
1865, an increase of 117 percent, or 23 percent per annum. Not surprisingly,
wages did not keep up. They rose only 43 percent in five years. Soldiers had
it even worse. Their monthly pay remained $13 for the first three years of the
war, and Congress did not raise it until May, 1864, and then by only $3 a
month. The advance in prices increased both government expenditures and debt.</font>
<p class="MsoBodyText"><font face="Verdana">One of the effects of Greenback
depreciation was to effect a massive redistribution of wealth. Soldiers and
skilled laborers experienced a dramatic fall in income while government
contractors made huge profits. Second, those who had surplus funds could
afford to speculate with them, and thus make a profit off the rising and
fluctuating prices incident to an inflationary period. Third, they could buy
large quantities of government bonds (see below).</font>
<p class="MsoBodyText"><font face="Verdana">Borrowing Phony Money to Fight
a Real War</font>
<p class="MsoBodyText"><font face="Verdana">By the end of 1862, Chase had sold
only $23.7 million in bonds out of the $500 million authorized in February.
The reason? Chase had refused to sell the bonds below par. The Republican
Congress ensured that this would not happen again in the great loan act of
March, 1863. First, it authorized the treasury department to issue $900
million in a bewildering variety of short and long-term notes and bonds, at
different rates of interest. Second, it required the secretary to sell the
bonds at market value but to accept for their purchase the depreciated
Greenbacks at par. That meant a creditor could purchase a 5/20 federal bond,
that paid six percent annual interest in gold, with a currency worth only 65
cents on the dollar. As the currency continued to depreciate into 1864, this
windfall would increase still more (by July, a creditor could purchase a bond
with a currency worth only 39 cents in gold).</font>
<p class="MsoBodyText"><font face="Verdana">Not surprisingly, by December
1863, Chase had sold $400 million of the previous year's 5/20 bonds, and $75
million of the 1863 bonds. Chase came to see the wisdom of accepting
depreciated paper at par. He wrote:"It required the printing and paying
out of $400,000,000 of greenbacks before the five-twenty 6 percent bonds could
be floated easily …, and it will probably require the circulating paper
issues of the government, now amounting to about $625,000,000, to be increased
to $650,000,000 or $700,000,000 before the people will be induced to take 5
percent bonds in order to get rid of the surplus circulation that may
accumulate in their hands, that cannot be more profitably invested in other
modes." An additional factor that increased the desirability and value of
the bonds was the passage of the National Banking Act, in February 1863, for
it required the national banks to buy bonds to back their notes. They could
issue no more notes than the par value of the bond holdings.</font>
<p class="MsoBodyText"><font face="Verdana">An interesting measure of whether
people lent their money to the government out of patriotism or greed is to
contrast the percentage of all loans that were short-term versus long-term by
year. In 1861-62, 85 percent of all loans were short-term (three years or
less). In 1862-63, 71 percent of all loans were short-term. Only after
Northern victories at Vicksburg and Gettysburg in the summer of 1863 seemed to
ensure the defeat of the Confederacy did long-term loans surpass short-term
ones.</font>
<p class="MsoBodyText"><font face="Verdana">The Postbellum Era: Contraction
or Inflation?</font>
<p class="MsoBodyText"><font face="Verdana">According to Sumner,"The war
being ended, the financial question took this form: Shall we withdraw the
paper, recover specie, reduce prices, lessen imports, and live economically
until we have made up the waste and loss of war, or shall we keep the paper as
money, export all our specie which has hitherto been held in anticipation of
resumption, buy foreign goods with it, and go on as if nothing had happened?"
In other words, should the country return to hard money and correct at once
the imbalances and malinvestments wrought by four years of inflation and war,
or should it continue with soft money and attempt to perpetuate wartime boom.
The majority Republicans again opted for inflation. Thus, the inflationary
boom, inaugurated by the war and the Greenback, continued unabated until the
panic of 1873 brought it to a close.</font>
<p class="MsoBodyText"><font face="Verdana">After the war, many Democrats
wanted to pay off the debt in the depreciated greenback. It was known as the
Ohio Idea. While this was just, it was not wise, as it perpetuated inflation
and set a precedent of quasi-repudiation through inflation. The Democrats made
it their major issue in the 1868 presidential campaign, and made its author,
Senator Pendleton of Ohio, their vice presidential candidate. The Republicans
now posed as the party of hard money and sound credit, and painted the
Democrats as the party of inflation and repudiation. The Republican victory
led to the passage of the Public Credit Act of 1869 mandating that government
bonds be redeemed in gold.</font>
<p class="MsoBodyText"><span class="219453716-03022004"><font face="Verdana">________________</font></span>
<p class="MsoBodyText"><font face="Verdana">Historian Scott Trask is an
adjunct scholar of the Mises Institute. </font><font face="Verdana">hstrask@highstream.net</font><font face="Verdana">.
See his </font><font face="Verdana">article
archive.</font>
<p class="MsoBodyText"><font face="Verdana">Sources:</font>
<p class="MsoBodyText"><font face="Verdana">Davis Dewy, The Financial
History of the United States (New York, 1902).</font>
<p class="MsoBodyText"><font face="Verdana">Murray Rothbard, History of
Money and Banking (Auburn, Ala.: Ludwig Von Mises Institute, 2002).</font>
<p class="MsoBodyText"><font face="Verdana">William Graham Sumner, A
History of American Currency (New York, 1874).
</font></font>
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