James Lacey - Gold, Blood and Power

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As Keith Hopkins has points out, the Roman Empire had three distinct segments: 1. The outer ring of the frontier provinces in which the defensive armies were stationed; 2. An inner ring of rich, tax exporting provinces (Gaul, Spain, Egypt, North Africa, Asia Minor, Syria); and, 3. The center, Rome, later joined by Constantinople.

The crucial element of Rome’s long-term survival, therefore, rested on keeping the tax-exporting provinces secure and stable. Only by doing so, could the Roman elite maintain themselves in luxury, while still feeding approximately one-quarter million Roman citizens free of charge. Moreover, by the time of the empire, neither Rome nor the Italian peninsula produced sufficient excess wealth to sustain itself, and neither could pay even a small fraction of the cost of a large professional army. Therefore, it fell to the provinces to fund the frontier armies, on which their safety and prosperity depended. Even at the time, Rome recognized that the frontier provinces or zones would never produce enough wealth to sustain the troops stationed there. The great Cicero, a republican who never confronted the expense of empire, was known to complain that many provinces were barely able to pay anything in their own defense.

As the Empire ceased its previously rapid expansion, this source of funding dried up, and it had to rely on its own internal resources to support its strategic policies. Anyone trying to grasp the full range of strategic options available to Rome must first comprehend the extent of this resource base. Using recent estimates, Raymond W. Goldsmith places Roman government expenditures during the Augustan era at between 600 and 825 million sesterces. This amounts to between 3 and 4% of the total national product of the empire. While Rome may have been able to raise a few percent more during times of crisis or civil war, such spending could not be long sustained. Given the practical economic limits placed on Roman expenditures how much of a military force could the empire bear? Through the first 3 centuries of the empire, Rome, on average, spent approximately 450 million (perhaps as high as 500 million) sesterces annually on the maintenance of its military. This represents about half of total imperial expenditures during the early empire. For this, they got a military establishment of 150,000 legionaries, 150,000 auxiliaries, a Praetorian Guard, transport, and a navy. Interestingly, the amount Rome spent on its military is only a fraction of the personal revenues and expenditures of the Roman elite, which was several times that of the empire’s treasury. This disparity likely increased in the later empire, as private fortunes grew even as the Empire began having trouble maintaining its tax base. Rome’s inability, or unwillingness, to access the accumulated wealth of its elites was a crucial handicap when the funds necessary to secure the Empire ran short. Nero may not have fiddled as Rome burned, but many of its richest citizens continued leading the high-life even as the Goths, Vandals, and Franks poured across the frontiers.

At the end of what may be properly called the first truly world war — The War of Spanish Succession (1702-13) — every major nation in Europe was fiscally exhausted. For 3,000 years, wars had been limited by the inability of pre-modern states to raise the financial resources necessary to engage in conflicts on a grand scale. But, by the dawn of the 18th century, new financial methods were coming to the fore, hugely increasing both the scope and cost of warfare. For instance, William and Mary had been forced to issue £6,900,000 in debt to fight the War of the League of Augsburg with France (1688-97). To fight the War of Spanish Succession, however, Britain issued £28,796,006 in new debt. The war was barely affordable to Britain, but proved ruinous to other nations’ fiscal positions, particularly France’s. Various nations attempted a wide variety of schemes to consolidate their debts, and then to follow the British lead in lengthening loan maturities (when they would have to pay them back). No nation was quite able to replicate the British achievement, as it was based on institutions (Parliament) other nations had yet to develop. The most notorious of these schemes was established in France by the Scotsman, John Law. It was Law’s idea that crashed most spectacularly, when the infamous “Mississippi Bubble” popped. Law’s notion involved replacing the use of gold with paper money, expanding government debt, and then transforming all of France’s old and new debt into equity (stocks) of private firms, the most magnificent of which was the Mississippi Company. Law also established the Banque Générale Privée (General Private Bank) to handle paper money transactions, which were issued in large volumes with the bank’s holdings of government debt (three-fourths of the bank’s total reserves) being used as capital. In 1720, Law combined the bank and the Mississippi Company, along with other ventures, into a single entity. Before the year was out, an inevitable run on the bank, coupled with a spectacular drop in Mississippi Company share prices collapsed the entire system, forcing Law to escape France dressed as a woman. The French government chose to walk away from its debt obligations, plunging France into economic turmoil for a generation and ruining the monarchy’s ability to secure international credit up through the Revolution that deposed it. In fact, France’s inability to regain its financial footing in succeeding decades is considered by many historians as the underlying cause of the French Revolution and, by extension, the rise of Napoleon.

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Even swelling tax revenues, with rates increasing by a factor of 4.5 by war’s end, could not begin to meet the voracious funding demands of global war on an industrial scale. Before the war ended, annual British government expenditures were 13 times greater than those of peacetime, similar to the burden all the other major warring states faced. To meet these huge fiscal demands, Britain and other nations resorted to all three major methods for advanced economies to raise revenues: taxes, debt, and printing money. Before the war ended, British national debt increased by a factor of 10, with the debt-to-GDP ratio increasing from 26% to 127.5%. This is remarkably close to the debt-to-GDP ratios set by the United States and Britain during World War II and might therefore be considered the limits of what a nation can afford, even in wartime. … Moreover, Britain, accustomed in previous wars to subsidizing its allies (something it still did for France and others through-out the war), was forced to turn to others, particularly the United States, to fund a substantial portion of the war’s cost. When even all of this proved insufficient, the Exchequer turned to printing money, doubling the monetary base by war’s end. Some of this was inescapable, but as printing money was always an easy escape from immediate financial difficulties, it was kept at too high a volume for too long, stoking a near ruinous inflation.

The financial panics of 1857, 1873, 1893, and 1907 had caused great hardship and greatly undermined faith in the U.S. financial system. It was the Panic of 1907, however, which finally and fully revealed to the general public the impotence of the U.S. Government to deal with a financial crisis. In the face of this crisis, government actions were always a combination of late, insufficient, or ineffectual ones. In the end, the financial system was rescued by J. P. Morgan, who locked 50 top financers in his library and forbade them food or drink until they agreed to provide enough liquidity to fund the banking system and to shore up the foundering U.S. financial infrastructure. … Unwilling to further entrust the U.S. financial future to the good graces of any single individual, Congress embarked on a number of reform measures over the following years. The most notable of these, the imposition of an income tax (soon after the ratification of the 16th Amendment) and the creation of the Federal Reserve System proved crucial to U.S. funding efforts during the war. The income tax was levied for the first time in the year before the war (1913). Approximately 368,000 persons from a total population of over 100 million paid just over $28 million into the treasury. By 1916, the income tax was yielding $68 million, which, when added to the corporate tax ($57 million), was enough to cover half of the nation’s defense budget in that year. Unfortunately, it was only about 1/50th of the annual cost of the budget, once the United States entered into hostilities. The creation of the Federal Reserve (Fed) gave the United States a powerful tool for the management of the nation’s finances. Although the Fed experienced substantial teething pains during its first months of operations, it immediately made itself felt during the war. The Fed, which began operations in 1914, was established to overcome the problem with monetary inelasticity. That is, at the start of every financial difficulty, persons and corporations immediately withdrew their money from the banking system and started hoarding cash, gold, and silver. Such a rapid contraction of the money supply was usually enough to push a minor hiccup in the system into a full-fledged crisis. The Fed, through open market operations, and a host of lesser means that became even more sophisticated, became the lender of last resort. Rather than rely on J. P. Morgan to force bankers to add liquidity to the system, the Fed provided the U.S. Government the means for boosting the money supply at the first sign of a credit crunch.

At the start of the war, the United States held 19% of the world’s gold stock. At war’s end, it had absorbed an additional 16% of the world’s pre-war money gold and increased its own stock by 88%. In addition, Europeans sold $2 billion in U.S. securities, while borrowing $2.4 billion during the first year of the war alone. For the first time in its history, the United States became a creditor nation.

At the start of World War I, U.S. Government spending averaged about $65 million a month, or on an annual basis 2.3% of GDP. By the start of 1917, spending had increased by $20 million a month, but as inflation was roaring, the total expense as compared to GDP fell (2.2%). After America’s entry into the war, monthly expenses increased rapidly. By the end of the war, the government was spending over $2 billion a month, about 32% of GDP on an annual basis. Like all modern wars, the United States had three main options for financing the war — increasing taxes, raising debt, or printing new money. As it turns out, the majority of the war effort was financed by borrowing (58%). The rest was paid for by taxes (22%) and by printing money. As a result of these financing operations, what is now called “high-powered money,” or the monetary base, more than doubled. As the United States had yet to develop the measures to sterilize this excess cash, the resulting inflation had a severe negative impact on the economy.

At an average interest rate of 4%, coupled with preferential tax treatment, these wartime issues of debt were highly competitive with any other investment vehicle. Patriotism may have been part of the selling technique, but purchasers were making a hardy profit on their patriotic feelings. If these bonds were purchased primarily to demonstrate support for the war effort one would expect to see purchases below the prevailing market rates (patriotic duty). This, however, did not occur at any point during the war. Americans in general were apparently only willing to financially support the war if forced to through increased taxes, or if rewarded through high investment returns. Through such measures, some 20 million persons—almost a quarter of the population —purchased Liberty Bonds in one form or the other. Unfortunately, the methods used by the Treasury and the Fed proved to be highly inflationary. There were many causes for this, but the primary one was that the Fed “encouraged” its member banks to make loans to individuals, which they could then use for the purchase of war bonds. Investors could take out cheap loans from banks and then buy bonds paying a higher interest rate than what the banks were charging them on the loans, thereby locking in a guaranteed (often tax-free) profit equal to the spread between the two. In practical terms, the Fed, by giving the banks the money to loan out for this purpose, was printing money, although it went to great efforts to disguise this fact.

An examination of World War II’s financing, however, indicates that the printing press played a much greater role than commonly assumed, particularly in the early war years. For at least the first 2 years of the war, the Fed’s printing presses worked overtime, and the money supply expanded accordingly. Such a rapid expansion, if kept up for too long a period, would, of course, have crippled the economy as inflation took hold. But in the exigency of the moment, it was the only method fast enough to fund the jump-start and rapid growth of production necessary to meet immediate war needs. In the first place, the government-instigated monetary contraction, which had extended the length and depth of the Depression more than any other single factor, had not been rectified by the time the United States entered the war. So, there was room to expand the stock of money without sparking inflation, particularly as the government had halted the production of high ticket durable consumer items. Leon Henderson, head of the Office of Price Administration, began instituting relatively effective price controls. Moreover, if businesses were going to expand, they required immediate working capital, and there was plainly not enough of it available in the economic system in 1941. In short, the in-circulation monetary base (cash or near-cash equivalents) in 1941 was too small to support the daily activities of the massive American economy as it mobilized for war. Unless the government added cash to the system quickly, there was a real possibility the entire mechanism would seize up.