Financial Times

In March of 1951, a year into the Korean War, the US Treasury offered long-term notes at 2 3/4 per cent in exchange for short-term notes at 2 1/2 per cent. According to a narrative written half a century later by the Richmond Fed, the Federal Reserve supported the price of the long-term notes, but: only up to a limited volume it had agreed on with the Treasury. Then it stopped. The administration asked the Fed to keep buying, to keep a ceiling on the yield. The Fed refused. That was it. Yields rose. Treasury was on its own.

This refusal marked the beginning of the modern era of Fed independence. It also marked the end of one of the ways the federal government financed the second world war.

In a resolution this week, in interviews and even in an oped for The Financial Times, Democrats have either hinted or said outright that they would pay to fight climate change by borrowing — the same way the country paid to fight fascists. It's not an absurd comparison. During the war, the US borrowed more than 100 per cent of its gross domestic product and did not subsequently collapse.

Also, though: finance in the US was different in the 1940s. The Federal Reserve explicitly supported the goals of the war, and expanded its balance sheet to keep Treasury yields down. Domestic institutional investors were trapped in the US, with few options for assets other than Treasuries. There weren't really any foreign investors. Within a decade after the war, two runs of inflation — the first of which reached 20 per cent — got the US debt to GDP ratio down to 50 per cent.

But: to borrow at the scale of the second world war is not just a political question for Congress. It's a political question for the Fed, which during the war provided quantitative warfighting to keep yields down on Treasuries. It's a political question for US capital at home, which has spent the last 40 years getting used to buying assets wherever it wants in the world. And it's a question for foreign capital in US markets, which didn't exist during the war, and may not feel compliant now.

The US didn't offset its war appropriations with taxes. But it did raise taxes on capital from 44 to 60 per cent during the second world war. Labour taxes doubled, from 9 to 18 per cent. The numbers come from a 1997 paper by Lee Ohanian for the American Economic Review. The US financed just over 40 per cent of the war through direct taxes, comparable to what the Union did during the Civil War. It was a far greater percentage than during the Revolutionary War, the War of 1812 or the first world war:

The higher taxes, says Ohanian, were to make the borrowing possible, one way to keep interest rates down. But they were necessary, and an adjustment for a lot of people who had never paid income tax at all.

The Department of the Treasury produced The Spirit of 43, for example, a Donald Duck short on saving money to pay taxes. ("Aye laddie, it's your dough," says an Uncle Scrooge-like saver, "But it's your war, too.") Irving Berlin wrote "I Paid My Income Tax Today." Gene Autry, the singing cowboy, even recorded a version. ("You see those bombers in the sky? Rockefeller helped to build 'em so did I") There's a long, amazing list of this kind of thing in James Sparrow's "Buying Our Boys Back." The point is, a lot of thought went into just how high to raise taxes for the war, and just how to make sure the taxpaying was tolerable.

That still left 60 per cent of the war costs to be funded through debt and seignorage. Here's Ohanian, now at UCLA and the Hoover Institution, when we called him yesterday:

The US typically has done a really good job of financing wars that don't impose a huge burden on the economy. There’s a tension in that ideally you'd like finance with debt as much as possible, so you can spread the distorting burden of higher taxation out over as many years as possible. Ideally, you don't want to have someone hit you on the head with a hammer really hard once, but if someone taps you on the head with a hammer very gently for ten years, you’re gonna prefer that.

The Fed kept Treasury yields down, and there was nothing else to buy

We don't have a historical record of what happens to Treasury yields as debt climbs above 100 per cent of GDP, because the Fed was part of the war effort. In 1942, the Fed began intervening in Treasury auctions, keeping 90-day bills at 3/8 of a per cent, with a ceiling for all debt on 2.5 per cent.

We tend to describe the quantitative easing of the last decade as "unprecedented," but during during the second world war, the Fed expanded its own balance sheet to keep borrowing costs down — to help the Treasury borrow to fund the War Department, rather than encourage bank lending.

The Fed could decide to help out with quantitative greening. There are precedents. When the people in the Marriner S. Eccles Building believe the world will end if they don't act, they do tend to act. But co-operative Fed participation in a political program is not something that can be assumed. It would mark a profound transformation in the relationship between the Fed and the Treasury.

Capital is mobile now. It was not then.

Mr Ohanian points out that for domestic institutional investors during the war, this was all the fixed income there was to buy. There were no mortgages, no car loans, no consumer durable loans:

If we were going to fight WWII today, and we said hey, you know what, we’re gonna have the fed work with the Treasury to fix the return at 3/8ths of one per cent, good luck in trying to do that, are you going to find buyers for that? All these financial intermediaries, they’re no longer constrained... [during the war] there’s only one restaurant on the corner, either you take the daily special or you don't.

Capital flies madly around the world now. That may be a bad thing; it sure does a lot of damage as it moves. But US investors in the 40s didn't have that luxury. They could not buy safe assets like JGBs or bunds because their sons were locked in a bloody existential fight with those countries.

Yield on Treasuries, however, looks pretty good right now. It's hard to imagine capital flight to other countries that offer lower yields. But again: we don't know what happens on open markets when we get back above an 100 per cent debt to GDP ratio. The US can hope that capital stays home. But that's not how great-granddad did it during the war.

And, as Carmen Reinhart of the Harvard Kennedy School points out in an email, over 40 per cent of US marketable debt is now in foreign hands. They may have no choice but to keep holding and buying Treasuries, but we just don't know.

After the war, the US kept capital home, then inflated its debts away

"One critical factor that the current discussion is missing," writes Ms Reinhart, "is that was an era of worldwide capital controls (indeed that was a critical component of the postwar financial repression era)." In a 2015 survey of how developed countries got rid of debt in the 20th century, she points out that the postwar financial system created a "forced home bias" through capital controls, and kept high reserve requirements for banks. This built a captive domestic audience of government debt buyers.

Everyone went home after the war and stayed there for a while with their savings.

And, rather quickly, the US debt load... disappeared.

In a paper for the National Bureau of Economic Research in 2009, Joshua Aizenman of the University of California, Santa Cruz and Nancy Marion of Dartmouth College point out that within 10 years of the end of the war, two bouts of inflation dropped US debt by 40 per cent. (They also note that the US, unlike other countries, tends to extend the maturity of its debt when it borrows more. Maturity peaked at 113 months in 1947. It reached a low of 31 months in 1976, and is now back at 69 months.)

But developed-economy central banks can't create inflation now even when they're desperate to. So a 29-year nonmarketable bond at 2 3/4 per cent, like the one Treasury offered as a swap in 1951, might not be the same good deal for Treasury anymore. Maybe it can't be inflated away. Again: we just don't know.

Like we keep saying, it's entirely possible that this might all work out. Perhaps there is bottomless demand for Treasuries, and yields will stay low no matter what the US borrows. Perhaps the Fed will change its culture and its job description. Perhaps the Modern Monetary Theorists are right, and the US can appropriate money for structural improvements in its domestic market, in its own currency, then leave it on the books, managing inflation a variety of ways, including by raising taxes. Perhaps inflation will return, and the US will establish capital controls, capture a domestic market of savers, and inflate away its debt.

We can't afford to be cynical about this, because we see climate change as an existential problem, one that sometimes quite literally keeps us up at night. Democrats have proposed to finance a new program the way the US financed the second world war. They are correct that when Americans really want something, they find a way to pay for it. But a lot of things — including the entire structure and movement of US and global capital —were very, very different during the war. There's consequently no guarantee what worked in the past will work again today.