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World War Two, as horrible as it was, refocused the American economy. The addition of a real threat mobilized the American people and building liberty ships, tanks, growing food for the soldiers and sailors, and everything else for the war effort did what all of the government work programs of the ’30’s could not do, it stabilized the economy. All of this funded through borrowing by the US government, this debt caused another boost in money creation. The economy improved, but there was also tremendous austerity for the average American. Rationing and funneling so much in the way of the nation’s resources into the war effort made everyday life for Americans not much better than during the depression, if at all.
The main thing that World War Two provided was an enormous borrower that was not there in the necessary magnitude in the '30s. Even though the US government took on large debts for its work programs, it was not sufficient compared to the borrowing that took place in the boom years of the 20's. Remember, the key point, total debt must grow, and even if governmental debt increases, if it doesn't eclipse the collapsing private debt, the money supply will contract and the economy will continue to crash. Politicians now needed to win the war at all costs; the cost of unprecedented new debt was taken on without thinking twice.
The fact that this huge amount of borrowing actually did restart the boom caused Keynesian economists to come to the conclusion that perpetual new debt and thus money was the cure to economic downturns. They should have come to the conclusion that a system that had to grow exponentially may not be the best system in the first place.
These same economists feared, as the end of the war approached, that without this governmental demand for debt to fund war, the economy would once again slip into depression. This fear was never realized. You see, after the war there was only one industrialized nation left that had not had its manufacturing base destroyed. There was tremendous work to be done rebuilding all of the nations that had been decimated. American corporations would provide the products that would complete that rebuilding. They would have to borrow to get that process going so there would be corporate debt demand. Those foreign nations would want to borrow as well to facilitate that rebuilding. Americans would now have steady employment, and wanted homes, cars, refrigerators, ect, and with a reliable income stream they were confident in borrowing to get them.
So while the economists of the time thought nothing could fill the debt void left by a government at war, they were pleasantly surprised that new private debt demand allowed the system not only to continue but to thrive. After a decade of bust, a war finally jumpstarted the economy, again through massive government loans, and that borrowing continued through the private sector at an exponential rate after the war. This allowed Keynesian Economists to believe that the possibility of a perpetually credit created boom was possible. Great for the bankers, they could continue their fractional reserve scheme, and the government was in a great position as well. If private loan creation ever faltered they could save the day by filling the gap and borrowing for whatever pet project politicians thought would best get them re-elected. Wow, even saying it, it sounds possible, but remember Mises’s Quote, and the old saying if it seems too good to be true…well you know the rest.
The end of the war also ushered in a new international "monetary system". There was a meeting of all the allied powered at the Bretton Woods resort in New Hampshire to determine what that system would be. It was decided that the US dollar would be backed by gold at 35 dollars per ounce. Other nations could back there currency with dollars, since the dollars were backed by gold, this system set up a loose form of an international gold standard.
With most nations rebuilding, there were huge payments being made to the United States for goods of all types, these payments were made in what the nations had for international settlement, gold. The gold was held by the Federal Reserve or at Fort Knox and at its peak US gold holdings reached 20,000 tons.
This tie to gold could not work, as we mentioned, a debt based monetary system is completely incompatible with any tie to gold and the consequences’ would come in due time.
This post war private credit created boom lasted through the 1950's, and only began to truly falter in the 1960's. The government though stood ready to pick up the debt slack.
Private debt did not rise exponentially in the 1960’s. L. B. Johnson’s great society as well as the war in Viet Nam gave the United States an excuse to borrow, and with this newly formed debt, new dollars sprang into existence continuing the needed exponential credit growth.
During this time the incompatibility of a debt based monetary system and gold became clear. It became clear to nations who now were running a trade surplus with the United States, particularly France. They realized that the United States was creating dollars, and paying for goods with those dollars without increasing gold reserves. Put another way nations running trade surpluses with the United States realized that they could not trade all of their dollars for American gold as was agreed under Bretton Woods. Those nations didn’t hesitate to get as much gold as possible though.
From the 20,000 ton peak, US gold holdings had dwindled to just over 8000 tons by 1971. If the United States was to keep any of its gold something needed to be done. President Nixon on August 15th 1971, shut the so called gold window preventing other nations from trading their dollars that they were using to back their own currencies for gold as was agreed.
So did the use of gold as the monetary base end because gold had lost its usefulness in the monetary system, had we evolved past it? Did the United States stop using it because it was no longer a store of value? No, the gold window was shut precisely because it had value, and the powers that be, in this case Nixon alone; decided he did not want to give it up to the rest of the world as had been promised. Closing the gold window was a reaction to the largest bank run in history; only in this case the bank (US government) didn’t run out of gold, they just didn’t want to give it all to the depositors.
All the world currencies at once were now fiat, backed up by nothing except the individual nations ability to tax the production of its people, or if those nations backed their currencies with dollars, the productive capacities of US citizens. Many nations objected strongly, but against the military might of the US, they truly had no repercussions at their disposal. They would go along with this new precarious agreement whether they liked it or not. The sole other superpower on earth was communist, not a signatory of Bretton Woods agreement, and was not being cheated by the breaking of those agreements.
The closing of the gold window ushered in economic turmoil in the 1970’s and rampant inflation. This inflation was impossible according to Keynesian economists who thought, prior to the 1970’s, that high inflation was not possible during times of high unemployment. This was proven false, since the 1970’s, in addition to high inflation, also saw high unemployment.
There was another view voiced by the Keynesians’. They felt that since the main demand for gold was as a monetary base, and gold was no longer going to be used in that role, the price of gold would drop. It sounds reasonable; drop in demand would equal a drop in price. But even though Keynesian economists are often very certain of their views, the prediction of a drop in gold price was another example of false logic. The central banks, though officially not holding gold as a monetary base, understood that gold was still good insurance in case this new monetary experiment failed. They did not sell their hoards, and with the pent up demand from individual investors, also weary of the new system, the price skyrocketed. Gold’s role as a store of value was still intact, and the dollar price increased from 35 dollars an ounce to over 800 dollars in about a decade. Granted there were several pull backs during that time, plus a massive drop from the $800+ peak to under $300, but the trend was clear. Up.
By the beginning of the 1980’s something once again had to be done. Enter a new Federal Reserve Chairman, Paul Volcker. He did what the Keynesian playbook said to do to stop inflation; he raised interest rates to above the rate of inflation, up to nearly 20%. This would quell demand for credit, cause people to save instead of spend, slow money velocity, and stop the spiraling inflation. Many economists predicted like after World War Two this would cause a recession that would be too painful for the economy to withstand.
In a way they were right, this would have been the voluntary abandonment of further credit expansion that Mises was referring to, but the caveat was the rise in interest rates would only curb private/rational borrowers from borrowing. The federal government, luckily for the debt based monetary system, isn’t constrained by economic rationality. The government benefits immensely from the debt based monetary system, so what sounds economically irrational to an individual or business makes no difference to the federal government, all that matters to them is, can something be done, and will it perpetuate the status quo.
In 1981 the federal government did have the ability to continue borrowing. The federal income through taxes was over 500 billion dollars per year; the total federal debt was 860 billion. Much of that debt was serviced at rates well below 10% and only new debt, as well as maturing debt that needed to be rolled over would be near the 20% mark. The increase in the debt service cost was a small fraction of the tax receipts, and so the answer was yes the US federal government could borrow at the higher rates implemented by Volcker. These higher rates succeeded in quelling price inflation.
The new debt in the coming years was mostly spent on the military but where the money is spent matters not, as long as someone is borrowing in sufficient quantities the system can continue. The new president, Ronald Reagan, presided over this spending and also implemented pro capitalistic reforms that, after a short recession, caused the economy to boom. Although, there is no doubt the boom was a credit created boom even if real growth occurred.
Continue Reading: Boom and Bust End Game and Why They're Stuck
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