war finance:theory and history - austrian economic

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    War Finance: Theory and History

    by H.A. Scott Trask

    [February 2, 2004]

    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?

    The Sinking of Capital

    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.


    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.


    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.

    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.


    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.

    The War Between the States

    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.

    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.


    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.

    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.

    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.

    Inflation in 1861

    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.

    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.

    The Legal Tender Act of February 1862

    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.

    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.

    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.

    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.

    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.

    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.

    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.

    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).

    Borrowing Phony Money to Fight a Real War

    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).

    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.

    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.

    The Postbellum Era: Contraction or Inflation?

    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.

    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.


    Historian Scott Trask is an adjunct scholar of the Mises Institute. [email protected] See his article archive.


    Davis Dewy, The Financial History of the United States (New York, 1902).

    Murray Rothbard, History of Money and Banking (Auburn, Ala.: Ludwig Von Mises Institute, 2002).

    William Graham Sumner, A History of American Currency (New York, 1874).


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