Not My First Rodeo: Public Money Creation in the USA (A History of Public Money Creation, Part 7)

Despite popular rhetoric, the World’s biggest economy did use the state’s money creating powers to help boost output. Guess what, it didn’t result in hyperinflation!

Throughout history, governments have used their ability to create money to fund public spending. While none of these policies were called, “People’s QE”, “Strategic QE”, “Sovereign “Money Creation”, or “Helicopter Money” (what Positive Money collectively refers to as Public Money Creation), they shared the common trait of using newly created state money to finance government spending, rather than relying on commercial banks to create new money through lending.

Significantly, the times when Public Money Creation has resulted in high inflation or even hyperinflation (inflation of over 50% a year) have been well documented. However, the times when governments have created money in a careful and responsible manner to grow the economy are usually ignored or overlooked.

In our previous posts on this topic, we showed that theory and analysis have been dispensed with at the expense of this widespread misconception. We showed that misleading conclusions have been drawn from the case studies of Public Money Creation in Zimbabwe and the Weimar Republic. We also showed that Public Money Creation happened in the places you least expect, the ancient Roman and Chinese empires and the former British colony of Pennsylvania and the island of Guernsey. In our most recent posts, we looked at why Japan and Germany were so successful at thwarting the global recession of the 1930s. Today we briefly show that in the earlier part of the 20th century the FED created money to temporarily finance Treasury expenditure.

USA (1917-1981)

In a recent paper by the New York Federal Reserve Bank, Kenneth Garbade shows how the FED was able to buy unlimited quantities of Treasury securities outright, through the creation of central bank reserves. The report demonstrates that from 1917-1935, this practice was performed frequently “without incident”. As conservative antagonism gradually increased however, the practice was eventually constrained in 1935, and subsequently completely discarded in the 1980s. Interestingly, the report shows the reasons for discarding this tool were not financial.

Mitchell (2015) shows that in an article in the New York Times (March 28, 1917) the FED used $50,0000 worth of reserves to buy freshly issued Treasury certificates from the government. The New York Times (1917) stated:

“To maintain the working level of the general fund of the Treasury, Secretary McAdoo has borrowed on Treasury certificates from the Federal Reserve Banks $50,000,000 at 2 per cent per annum … The Federal Reserve Banks subscribed with such promptness that at 3 P.M. today the entire amount had been taken.”

In his paper, Garbade reflects on the period between 1917-1935, and shows how it was common practice for the FED to purchase newly issued Treasury bonds. As noted by Mitchell (2015), the report makes two very significant points:

1. “The original version of the Federal Reserve Act provided a robust safety net because the act implicitly authorized the new Reserve Banks to buy securities directly from the Treasury”.

1. “The Banks made active use of their “direct purchase authority” during, and for a decade and a half after, World War I. Congress acted to prohibit direct purchases in 1935, but reversed course and provided a limited wartime exemption in 1942. The exemption was renewed from time to time following the conclusion of the war but ultimately allowed to expire in 1981.”

The report essentially showed that 1917-1935 whenever the US Treasury was running short of cash it could rely on the FED’s money creating powers. Thus, the money creating powers of the FED were not used as a monetary policy tool, but more of a temporary fiscal tool. This perhaps explains why the FED’s money creating powers were not initially used to help stimulate the economy in the aftermath of the 1929 economic crisis.

Garbade then demonstrates that in 1935 a new Banking ACT was put forward, which would prevent the FED from buying public securities outright, forcing the FED to buy securities from the secondary market. Before the senate passed the new act, it was noted by the committee overseeing the legislation, the US House of Representatives Committee on Banking and Currency, that there was very little difference between the FED buying public bonds from the primary or secondary markets:

“There is no logic in discriminating against obligations which, being in effect obligations of the United States Government, differ from other such obligations only in that they are not issued directly by the Government.”

As Mitchell notes “In other words, it was flim flam to prohibit the central bank from purchasing debt from the Treasury directly when it could simply signal to the private bond markets that upon issue, it would buy unlimited quantities of bonds from them (indirectly).”

Whilst the Banking Committee understood this notion, the rest of the US senate did not, and the act was passed. According, to Galbrade the actual reason for the new legislation was actually never explained by the Senate.

Nevertheless, in 1942 the legislation was loosened so that the FED could use its money creating capacity to help fund military expenses. With America beginning to take part in WWII, the US state needed huge quantities of cheap financing that the private sector was generally unwilling to provide. Even the chairman of the FED at the time advocated buying bonds directly from the Treasury, as it would

“…avoid the necessity of having the Treasury offer Government obligations for sale on the open market at a time when the market is demoralized and an additional public offering might add to the confusion and demoralization of the market and do incalculable harm to the Government’s credit and to the holders of outstanding Government obligations.”

Accordingly, an amendment was passed that would allow the FED to purchase up to $5 billion’s worth of newly issued public bonds. This legislation remained in force until 1981.

Why Public Money Creation does not always need to lead to hyperinflation?

At an extremely simplistic level, mainstream economic theory often suggests that long-term price inflation is the consequence of the stock of money increasing faster than the supply of goods. With more money in their pockets, consumers will demand more goods and services. ‘Price setters’ (i.e. firms and sellers) will notice the increased level of demand relative to their available supply, and raise the price of their goods and services, resulting in inflation. In this situation, there is an increased amount of money “chasing” the same amount of goods and services being supplied. So, according to this simple theory, increasing the amount of money in the economy faster than the supply of goods and services results in inflation.

Yet as prominent economist John Maynard Keynes suggested, creating new money does not always trigger price inflation. If new money is created and spent on the production of new goods and services, then the supply of goods and services is increasing alongside demand. In this situation you have an increased amount of money chasing an increased amount of goods and services being supplied. Inflation will not occur if the rate of growth in supply is broadly consistent with rate of growth in the money stock.

This helps explain why many governments, as the case studies throughout this series have shown, have been able to successfully grow their economy through the careful and responsible use of money creation. Their economies were operating below full capacity, and the new money was created and allocated to the sectors that were performing below their potential. The new money created was able to tap into the sectors where resources and inputs lay idle, therefore increasing the supply of goods and services. As supply (the production of goods and services) and demand (the creation of new money) broadly increased alongside in tandem, high levels of inflation were avoided.