Fed, Banking regulations, Capital Flow, Crisis, Part 2
In 1914, at the time of declaration of World War 1, U.S. general stock of currency was about 3.7 billion. On August 1, 1914, stock of incomplete currency, available for issue, was about 524 millions. Outstanding National bank circulation amounted to about 751 millions. By mid November 1914, it went up to over 1.1 billion. The securities deposited at treasury department for the issuance of emergency funds were accepted at following conditions:
1. State, Municipal and County securities, 85% of face value.
2. Commercial paper, notes secured by warehouse receipts and miscellaneous securities like industrial bonds and others, 75% of face value.
Government collected about three billions in taxes on these additional notes in circulation. The stock market was closed for over four months to avoid the gold claims for securities mostly owned by Britain, which was in dire need for gold to pay for war expenses.
The major cause of the panic were the prospects of World War 1. This is what was happening in 1914:
Britain was the super power of time. It was the richest country with largest navy in the world, and a military might. A very large part of the world was colonized by Britain at the time. Britain had huge strategic interests, all over the world. These interests included raw materials, human resources and markets for the goods and services produced by Britain.
This was the time when two emerging powers and rapidly growing economies started threatening British economic and political superiority in the world. Those were Germany and United States of America. America was relatively far off and previous head on head collisions with America did not go very well for Britain. On the other hand, Germany was European country, right in the neighborhood. Germany’s extra ordinary progress in technology and engineering was seriously threatening the British superiority in those sectors. The demand was rapidly growing for very high quality German products. This growing demand was mostly coming at the expense of Britain, the dominant provider at that time.
So, Britain, under the leadership of a brutal, ruthless, vicious and selfish Churchill, started a very negative propaganda against Germany. Germans suddenly became the most despicable people in the world. This honor used to go to French, before, and now Iran is that target. Gradually, it became very clear that Britain is not going to tolerate that threat for very long. The prospects of war were getting clearer with every passing day. The potential war between Britain and Germany was being predicted as the worse ever.
This started sending the financial and business markets into a panic mode, along with individuals and banks. Just like any other crisis, people, businesses and institutions started hoarding cash, as much as possible. That seriously compromised the demand for services, goods and all type of investments. Money became tight, as banks were reluctant to land, out of uncertainty. Credit crunch along with decreased demand for goods, services and investments started the spiral of recession. At the same time Britain needed cash for war spending while it was holding billions of dollars in U.S. securities. For Britain, it was the time to cash out those securities.
American Treasury secretary Mr. McAdoo realized the oncoming British rush for gold in U.S. stock market. So, he closed the stock market which remained closed for over four months. At the same time the prospects of U.S. involvement in the war were getting higher and higher. This was sending U.S. markets into panic mode, too. This panic had two major components. One, the internal drain due to bank run-offs and two, external drain of gold to Europe. So, the other countries holding U.S. securities were the root cause of stock market closure and imminent drain of gold and cash from country. Governments always make us believe that something like this can never happen.
But, history has taught us that us that it is a very credible possibility, and happens again and again. The reason for that is, as soon as there are signs of an eminent crisis, the investors forget about their margins on securities. They would rather prefer to have cash or gold in hand, instead of paper securities which may worth zero in case of a serious crisis or default or situations like stock market closed, communications disturbed and transactions blocked. Hence, the money that you get in debt by issuing bonds and securities, is in fact a debt.
You promise to pay it back, and holders can call it anytime. This becomes a double or even triple edged sword, in times of crisis. In that situation there is already a crisis which means immense need for short supplied money. The people, institutions and governments that hold your securities start dumping your securities into the market which suppresses the value and raises interest rates, making it even harder to keep the cash flowing. This is what happened to Japan and European economies, too. In addition to this, if you enter into conflict with the country holding your securities, the situation becomes worse possible.
For example, if Japan and China go into war, over the escalating crisis regarding controversial possession of Chinese islands by Japan, we have signed a treaty with Japan. That will bound us to go and help Japan. China, now, holds over a trillion dollars of our securities and bonds. What do you thinks China will do in that case? Of course, it will start dumping U.S. securities in the market. It can virtually bankrupt our economy and we will lose our ability to fight any war or even defend our country properly.
Therefore, following happened in 1914:
1. Government policies and politics crashed the market (World War 1).
2. Market was crashed and closed for over four months (Stock market closure).
3. Demand for state, municipal and county bonds was raised (being accepted as collateral at U.S. Treasury).
4. Government got excuse to print large amounts of money (Money and circulation bounced from about half a billion to over a billion).
5. Federal government was able to sell money for 75-85% percent of face value of securities (out of desperation that persisted).
6. Government secured billions in taxes (over three billions).
7. Government was able to expand and grow (New regulatory setup).
8. Government was able to introduce new regulations increasing its control over markets (Federal Reserve Act).
9. Government was able to reward their sponsors in big banks (establishment of Federal Reserve and handing over the power of issuing money to a private enterprise, instead of government itself).