Bond Finance and the Great Depression

Attending the Social Science History Association Meetings in Toronto this weekend provided as usual an opportunity to take in new papers and ideas, digest them and then think about what further insight they might add to our knowledge of past economic events.  One such paper was Richard Sutch’s (University of California) “Financing the Great War: A Class Tax for the Wealthy, Liberty Bonds for All” which was part of a session I chaired and discussed in.

The paper was a methodical and detailed account of the financing of the U.S. war effort via taxation and bonds devised and administered by U.S. Treasury Secretary William McAdoo. The war saw the introduction of the pillars of modern government revenue in the United States, namely: personal income taxation, corporate income taxation (excess profits tax), and large scale bond finance.

The results were 17 billion dollars raised for the war effort – 8.8 billion via taxes (1/3) and the remainder via Liberty Bonds (2/3).  This amount represents 46% of the value of nominal US GDP in 1914 ($36.8 billion) and 22% of the value of GDP in 1918 ($76.6 billion).  Using large scale bond finance was done in part to avoid the inflationary pressures that were thought might come with simply printing money but there was inflation nonetheless during the war.

According to Sutch, the legacy of this program of bond finance was ultimately an increase in U.S. savings rates, which remained permanently higher after the war.  My question is, did the bond finance program do even more?  Did the introduction of Liberty Bonds unwittingly lay the groundwork for the stock market crash of 1929 and the Great Depression?

Liberty Bonds-introduced a wide swath of the American public to a new and more sophisticated financial instrument – the government bond.  About 62 percent of the bonds were bought by the general public and with the $50 denomination as the lowest and most popular denomination. The general public developed confidence in a new and relatively secure financial investment.

Money poured into the stock market during the 1920s.  Lower interest rates and the larger pool of savings created by the Liberty bonds may have sparked a search for better returns.  Eagerness to embrace stock market investments by a larger swath of population – did it come from the experience with Liberty Bonds?  Was the stock market boom and subsequent crash also partly a legacy of a public whose appetite for financial assets was both whetted and enabled by the war bond boom? Did the average member of the American investing public just assume that stocks were as safe as government bonds?  This is a fascinating question.

Comments

[Nick Rowe]

Do you know if Canada did the same thing, and whether it was also followed by an increase in the Canadian saving rate?

[Livio Di Matteo]

Nick:
I know we brought in an income tax and a business profits tax. We had "Victory Bonds" during the First World War but am unsure as to the size of the issues or what happened to the saving rate afterwards. Good questions.

[Determinant]

The paper was a methodical and detailed account of the financing of the U.S. war effort via taxation and bonds devised and administered by U.S. Treasury Secretary William McAdoo. The war saw the introduction of the pillars of modern government revenue in the United States, namely: personal income taxation, corporate income taxation (excess profits tax), and large scale bond finance.

The US did the same thing during the Civil War, and the UK did the same thing during the Napoleonic Wars, with the caveat that they abolished the Income Tax afterwards. There was nothing new in WWI in terms of finance.

Canada's debt would have been proportionally larger than the US since we had been at war since 1914.

[Livio Di Matteo]

Determinant:
The U.S. Civil War did use bond finance as well as brought in an income tax, and a corporate receipts tax to fund the war effort as well as a large number of new excise taxes. However, the modern US revenue system does follow from the taxes introduced during WW1 rather than the Civil War. I have seen an estimate of 3 billion dollars in bonds being issue by the Union side during the war which would represent about 30% of US nominal GDP in 1865. However more of the bonds were acquired by financial institutions and higher income/wealth families whereas the bond sales during WW1 reached a much broader range of the American population.

[Frank Restly]

Livio,

"Did the introduction of Liberty Bonds unwittingly lay the groundwork for the stock market crash of 1929 and the Great Depression?"
"Eagerness to embrace stock market investments by a larger swath of population – did it come from the experience with Liberty Bonds?"

http://en.wikipedia.org/wiki/Liberty_bond

"The first three Liberty bonds, and the Victory Loan, were retired during the course of the 1920s. However, because the terms of the bonds allowed them to be traded for the later bonds which had superior terms, most of the debt from the first, second, and third Liberty bonds was rolled into the fourth issue. As a result, the large majority of Liberty bond debt was still outstanding into the 1930s."

And so, I don't think you can make a flow of funds argument that savings in Liberty bonds was liquidated and used to purchase stocks during the 1920's.

[Frank Restly]

"Lower interest rates and the larger pool of savings created by the Liberty bonds may have sparked a search for better returns."

The trend in interest rates for Liberty bonds was higher as the war came to an end.

2nd Issue - Oct 1917 - 3%
3rd Issue - Apr 1918 - 4.5%
4th Issue - Sept 1918 - 4.25%
5th Issue - April 1919 - 4.75%

And so I don't think you can argue that people sought better returns in the equity markets because the interest rate offered on Liberty bonds was falling.

[Ralph Musgrave]

Milton Friedman argued in 1948 that THE ONLY valid reason for issuing government bonds / debt arises in wartime. That’s in his paper “A Monetary and Fiscal Framework…”. See:

http://0055d26.netsolhost.com/friedman/pdfs/aea/AEA-AER.06.01.1948.pdf

He’s got some sort of point, I’d guess. That is, the population is probably happier having $X taken off them via bonds (in the knowledge that those bonds will mature after the war, and they’ll get their money back) than having $X confiscated via tax. Actually those two (bonds and tax) come to the same thing, but appearances and psychology are important.

For relevant passages in his paper, word search for “war”.

[Livio Di Matteo]

Frank:
Thanks for those points. They are helpful. One question is if the returns on the stock market were perceived as even higher than bonds. I suppose the only other leg left for my conjecture is the possibility that the bond experience made the general American public more open to stock market investing. Still, I think it was an interesting idea to throw out and appreciate the feedback.

[Majromax]

This story can still be reconciled. Wartime savings accustomed the American household to both a higher baseline savings rate and direct ownership of national, market-mediated financial instruments (Savings Bonds) over simple deposits at a local bank.

When the Great War ended, the supply of new government debt shrank faster than the savings rate. This left room for the growth of private, "average citizen" investment in the stock market.

Being novel investments for many, people did not fully appreciate the risky nature of the stock market. This led to improper pricing of risk, and consequently larger-than-desired leverage. That in turn caused an ordinary market correction to turn into a crash and ultimately a financial crisis.

I don't know if the above is true, but it seems reasonable. It also applies to the 2007-8 housing crash, at least with regards to risk pricing, leverage, and financial crises.

[Frank Restly]

Livio,

"One question is if the returns on the stock market were perceived as even higher than bonds."

A couple of things. Starting in 1920 and continuing through 1930, the U. S. federal government ran a budget surplus. I think you could make a solid argument that with a growing population, there becomes a market access problem when a government sells bonds and then quits selling them. I don't think it was the promise of necessarily higher returns that drew people to equities - I think it was government budget surpluses. Read below about how things didn't exactly "pan out" (pun intended) for those holders of government bonds payable in gold.

Ralph,

"Milton Friedman argued in 1948 that THE ONLY valid reason for issuing government bonds / debt arises in wartime."

Did Friedman also make an argument that prior to going to war, any previously incurred debt should be defaulted on?

See http://en.wikipedia.org/wiki/Liberty_bond

"The terms of the (4th issue) bond included: The principal and interest hereof are payable in United States gold coin of the present standard of value. This type of gold clause was common in both public and private contracts of the time, and was intended to guarantee that bond-holders would not be harmed by a devaluation of the currency.

However, when the US Treasury called the fourth bond on April 15, 1934, it defaulted on this term by refusing to redeem the bond in gold, and neither did it account for the devaluation of the dollar from $20.67 per troy ounce of gold (the 1918 standard of value) to $35 per ounce. The 21 million bond holders therefore lost 139 million troy ounces of gold, or approximately 41% of the bond's principal."

Your quote:

"..the population is probably happier having $X taken off them via bonds (in the knowledge that those bonds will mature after the war, and they’ll get their money back) than having $X confiscated via tax.."

The holders of those World War I bonds did not get their money back by a long shot.