The Second World War not only pulled American economic output closer to its potential capacity, but also transformed its composition. War-related industries were prioritized and the production and consumption of other goods was controlled by rationing. This is fairly well known. What is less well known are the ways credit was mobilized during the war, how the financial system was not only enlarged but also rebalanced to prioritize war-related needs.
Even in America, the war in Europe had already prompted official intervention in the financial markets well before the United States entered the war late in 1941. The Federal Reserve had been intervening in short-term credit markets to promote stability since the war began in Europe in September 1939. After 1941, the Federal Reserve and Treasury reached an agreement whereby the former would purchase government bonds to keep the Treasury’s borrowing costs low. They would meet frequently to ensure the financial resources of the country were being adequately marshaled to aid in the war effort.
The Federal Reserve’s discount rate was lowered to 1% and starting in April 1942, the yield on 3-month Treasury bills was fixed at 0.375%. This was substantially lower than the normal peacetime range of 2.0 – 4.0%. To maintain that yield, the Federal Reserve would purchase or sell any amount of Treasury bills at that price, as needed. Longer-term yields, those on the 25-year Treasury bond, would be kept at or below 2.5%. While this limit was only a ceiling rather than a fixed price, the 25-year bond yield fluctuated within a range of just 2.45 – 2.50% for most of the war and never fell below 2.00% for the rest of the decade. In between, yield caps were set on bonds of different terms: 0.90% for 13-month notes and 1.50% for 4.5-year notes.
These rates would be maintained for two years after the conflict’s end. Setting such a yield cap essentially established a price floor on the bonds, making them more desirable. The commitment to buy or sell short-term bills, as needed, to maintain their price also improved liquidity and made holders more willing to hold them at those reduced yields. For their part, dealers in government bonds themselves agreed to smooth out price movements.
During this period, the Federal Reserve’s balance sheet and the volume of currency in circulation grew. The money supply rose by about 20% per year between 1942 and 1944. Still, price controls and rationing limited inflation, a fact which also encouraged investment in government bonds both by reducing alternative destinations for personal incomes and by taming expectations for future inflation.
Interest rates took on greater importance because the war transformed the state’s borrowing requirements. Defense spending rose to over 35% of GDP and over 80% of federal spending by the later years of the war. That said, the Second World War was not paid entirely by borrowing. To help pay for it, taxes on individuals and corporations increased. Increasing taxes also helped reduce wartime inflation, an inevitability given vastly increased government spending, rising employment, and an enlarged money supply, caused both by the monetary policies and an influx of gold from abroad.
A top individual income tax rate of 91% was introduced. The income tax was extended to more earners and withholdings from regular paychecks became the primary means of collecting tax from ordinary people. The number of individuals paying income tax rose from four million in 1939 to forty million in 1945. The corporate income tax rose to 40% on income up to a limit, above which any ‘excess’ profits would be taxed at close to 100%.
Compared to the First World War, a larger portion of spending this time was paid by increased taxes. Still, large borrowing was required. Borrowing allowed for more war spending which reached $6 billion a month in April 1943 and would climb still higher in 1944.
An alphabet of new Treasury savings bonds had recently been launched. Series A through D bonds were issued between 1935 and 1941 and their replacement, Series E bonds, were introduced in 1941. These were sold at 75 cents on the dollar but paid no interest. They would mature after ten years, earning a superior annual yield of 2.9% if held to maturity. These were designed for small investors; purchases were limited to $3,750 per person. The majority of these savings bonds were issued in small denominations of $25 or less.
A similar Series F bond was purchasable in larger amounts but was otherwise similar to Series E. Series G bonds meanwhile, paying 2.5% interest per year over twelve years, were redeemable before their maturity. Not only the government and the Federal Reserve but even banking firms and other businesses marketed these bonds at their own expense. The Federal Reserve was among the banks that issued the bonds directly to the public.
Besides the sale of savings bonds largely to small investors, eight larger loans were floated during the war. Some of these were issuances of over $10 billion. Overall, the government issued $150 billion in bonds during the war, covering about half of all wartime spending; $45 billion in Series E through G bonds were outstanding at the conflict’s end. Overall, the vast majority of this borrowing was done on a long-term basis. Some 85 million Americans had purchased bonds during the war.
Efforts to mobilize credit for the war also affected private enterprise. Private interest rates were themselves kept low during the war years as the borrowing costs of the highest credit companies continued to track government borrowing costs closely. The prime rate, the interest rate charged by banks on loans to their most creditworthy clients, was about 1.5%. Loans to industries engaged in war production were guaranteed by the federal government which also guaranteed loans to small companies. The Federal Reserve was tasked with approving these guarantees.
The war years and the immediate aftermath saw high inflation, which could have threatened the ability to borrow money on a long-term basis. A modern response, higher interest rates, was out of the question given the need to keep government borrowing costs low. Instead, credit was rationed in such a way that private borrowing could be restricted while the government could still borrow at low rates.
Regulation W, implemented by the Federal Reserve, restricted consumer credit by setting large required down payments and maximum maturities on financing for consumer goods. Installment loans were limited to a term of twelve months, and a loan due in a single repayment could be no longer in term than ninety days. Also, reserve requirements for banks were increased in 1941.
It took some time after the end of the war for the controls on finance to be withdrawn. The Federal Reserve’s fixed price on short-term Treasury bills was lifted in July 1947, though the cap on longer-term yields remained. The Federal Reserve was only formally relieved of its wartime responsibilities in 1951.
How industry was redirected towards the war effort is well known, but credit was mobilized for the Second World War in a similar manner. The commitments of the Federal Reserve expanded credit. Meanwhile, through regulations on consumer credit and increased bank reserve requirements, credit was also rationed to ensure the state’s access to it was prioritized. It was not just a matter of selling large war loans in the market; the structure of the system also needed to change to ensure the new circumstances brought on by the war did not become counterproductive to the goal of funding and fighting it, which would have likely occurred in a less controlled environment.
More from the Tontine Coffee-House
Read about the responses of various central banks to the start of the Second World War in September 1939. Also read about the special military currencies issued during the war, including the ‘Japanese pesos‘. Consider subscribing to this blog’s newsletter here.
1. Markham, Jerry W. A Financial History of the United States. Sharpe, 2002.
2. Richardson, Gary. “The Federal Reserve’s Role during WWII.” Federal Reserve History, Federal Reserve, 22 Nov. 2013.
3. Sanches, Daniel. “The Second World War and Its Aftermath.” Federal Reserve History, Federal Reserve, 22 Nov. 2013.
4. Tassava, Christopher J. “The American Economy during World War II.” EHnet, Economic History Association, 10 Feb. 2008.
5. Toma, Mark. “Interest Rate Controls: The United States in the 1940s.” The Journal of Economic History, vol. 52, no. 3, Sept. 1992, pp. 631–650.