BONUS: George Hall on Financing World War II and Managing Post-War Debt

George Hall is a professor of economics at Brandeis University, and was formerly an economist at the Chicago Federal Reserve Bank. In this bonus segment from the previous conversation, George rejoins the podcast to talk about how the US handled the surge in debt resulting from World War II, how COVID changed government financing, his thoughts on the debt ceiling crisis, and more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Hey, Macro Musings listeners, we're back with our bonus segment, as promised, with George Hall, the author of many interesting papers, including, *Debt and Taxes in Eight U.S. Wars and Two Insurrections,* also, *Financing Big US Federal Expenditures Surges: COVID-19 and Earlier US Wars.* And in the previous show, we spent some time working through the theory, the thinking, proper measurements, as well as some of the history. And I wanted to wrap up our conversation by talking about, I think, one of the more interesting and probably the biggest federal government expenditures, and that's World War II, and in particular how we got out of that big surge. So maybe we don't spend a lot of time on how we got to over 100% debt-to-GDP ratio, but how do we come down from that? Because you actually have an exercise in your paper with Tom Sargent where you break down how it got lowered. So walk us through that. How did we lower the debt-to-GDP ratio? Because this might be useful given where we are today, even though we have seen a big drop already. But just moving forward, what are the lessons learned from World War II's big drop in this debt-to-GDP ratio?

Bringing Down the Debt After World War II

George Hall: Actually, let me step back a little bit-

Beckworth: Sure.

Hall: ... and just talk about the debt that we did issue in World War II. So during World War II, we had fixed interest rates, and they fixed the yield curve. And the yield curve was upward sloping, which was fixed so that short-term debt, paid a lower rate of return, lower yield than long-term debt. And because interest rates were fixed, there was no interest rate risk. So nobody had to worry about the value of their bonds falling if interest rates would go up, because interest rates were fixed. And so what it meant was that people wanted to buy long-term bonds because they paid a higher rate of return. And because the yield curve was fixed, there was no worry about them falling in value. So a lot of the debt that was held during World War II was long-term debt, and it was ourselves that owned this. It was almost all domestic investors. No foreigners were buying US debt because they were fighting their own war, so it was there. We also had price controls that were imposed during World War II, so you didn't have to worry about real losses either.

Hall: The war ends. The debt-to-GDP ratio is 120%, and that's either whether you measure it by the par value or the market value, but it's not going to differ, because, again, interest rates are fixed, and the price... So you kind of have forced those values to be very similar. But then the war ends, and they lift the price controls, and immediately, we have two years of 10% inflation. And that's going to knock 20%, in real terms, off the value of the debt. So you think about, that's a default in real terms of 20%, and that gets you a long way home on there. And also, interest rates are going to go up because they're going to undo the interest rate. The interest rates are no longer going to be fixed. Interest rates rise, and bond prices are going to fall dramatically. Particularly because they're in long-term bonds, the interest rate increase is going to hit these people particularly hard.

Hall: Now, some of those bonds are savings bonds, so they're not marketable. So people may not have realized that because saving bonds are not tradable. So they may not have recognized that the value of this claim has gone down. But the value of these promises fell dramatically. The other thing we did during the '50s and the '60s was we ran primary surpluses. We taxed more than we spent. And as we mentioned in the previous segment, that even the Korean War was fought on a balanced budget. We didn't run deficits even during the Korean War. And then, in the rest of the '50s and the '60s, we ran primary surpluses. So by the time the 1970s rolled around, it's a combination of running primary surpluses, real GDP growth, and nominal GDP growth, well, nominal… And we sort of inflated away a big chunk of it as well. So it's sort of those three forces that did it and that helped bring the debt-to-GDP ratio from 120% down to, I think, about 15% in the 1970s.

Beckworth: Well, we're doing good on the inflation front-

Hall: Yes.

Beckworth: ... in terms of replicating this period. But the primary surplus portion, I'm not very hopeful there. In fact, it's interesting to look at the trends, because you provide all of these examples. And one of the trends that I noted in reading your paper is that we would consistently run primary surpluses after the wars, and then, when we get to Vietnam, that ends. After Vietnam-

Hall: Yes.

Beckworth: ... it changes. And I'm guessing that has something to do with the Great Society, the big shift in social spending. Priorities change. But at least up until that point, running primary surpluses was an important facet of getting that debt-to-GDP ratio down.

Hall: I don't know whether your listeners watched the last State of the Union address, and I couldn't help but think, watching that… so you've got a large constituency that's looking out for the taxpayer. So you've got a lot of people in Congress who say, "We're not going to raise taxes. The taxpayer will not pay for COVID." And then you have also a large constituency that says, "Recipients of government spending will not pay for COVID." And I couldn't help but think, "Who in that room is looking out for the bondholder?" And you think, everyone says Social Security recipients, Medicare recipients, veterans, they're not going to pay. Taxpayers are not going to pay. And then you look at who the bondholder is… After the Civil War... We talked about how there was a large political constituency of domestic bondholders who wanted to be paid high returns. And you look at who holds the debt today, and it's a mix of, well, the Federal Reserve owns about 20% or a little less, like 17% of the debt. You have all of these Social Security trust funds and retirement accounts that own 20%. You have foreigners that own 25%, and domestic bondholders own about, a little, 35, 36, 37%, somewhere in there, of which many of us don't realize what we own because it's in some retirement account buried away. Who's looking out for the bondholder? And so I think some of it is, the political constituencies have changed.

Beckworth: That's interesting.

Hall: And I think we need the party of the bondholder, whatever that party is.

Beckworth: So again, where we are today, we are generating high inflation. And it looks like it's beginning to come down. So that's not going to last forever either. We would need low interest rates, or we need more rapid real GDP growth or primary surpluses. Maybe lower interest rates will return. Maybe we'll go back to a secular stagnation world, maybe not. But running primary surpluses definitely seems off the table. And if I had to guess, robust real GDP growth doesn't seem near in our future either. So it doesn't seem like, at least, that we're going to have a whole lot of success on these other possible routes. It might just be inflation is our only available tool that we have for us. So walk us through COVID. We're actually talking about it right now, but I want to bring it up because it was so different than the trends leading up to it. So I mentioned earlier that the trend in the US was increasing reliance on taxes and decreasing reliance on bond financing. So you have a nice chart that shows from the War of 1812, all the way down to World War II, bond reliance is getting smaller, smaller, smaller. Taxes getting larger and larger, and particularly larger after the income tax. You see a big kind of discontinuous jump there. Money financing's roughly… it fluctuates, but it's not too important. But when we get to COVID, taxes don't change at all, as you alluded to. No taxpayer is going to be harmed. You've talked about how the State of the Union… none of the taxpayers want to pay for this, and that's coming out very clearly, but it also speaks to a big change in trends that you outlined in your paper. So maybe walk us through what changed so dramatically in COVID.

How Did COVID Change Government Financing?

Hall: I mean, what's interesting about COVID is that, we had this large expenditure surge. Taxes didn't rise at all. So, usually in the past, when there's been a large expenditure surge, part of the legislation that's authorized… additional spending also has some tax component to it. But none of these did. The Treasury went out and issued these bonds, and then you ask, "Well, who bought these bonds?" And largely, it was the Federal Reserve that bought these bonds. So they put all of these new bonds on the market. The private investors and foreigners don't tend to buy them. The Fed bought most of them. And then you ask, "Well, how did the Fed pay for these?" So the Fed, just to keep things simple, basically increased bank reserves.

Hall: I mean, it's kind of funny. The federal government issued checks to individuals. Those individuals deposited them in the banks. The banks then loaned them to the Fed. And the Fed then used those proceeds to buy government Treasury bonds. So the Treasury issues the bonds. The Fed uses these bank reserves from all the new bank deposits to buy these bonds. So we usually would think of bank reserves as being part of the money supply, but now these bank reserves pay interest. So the question is, are bank reserves money, or are they bonds? And so we kind of say, well, we want to think about them two different ways: are they money or are they bonds? If they're bonds, what the Federal Reserve is doing is borrowing short term from the banks to then lend to the Treasury long term, and they're doing maturity transformation. Or, they're printing up cash in the form of bank reserves and buying these bonds from the Treasury, but they're taking this on.

Hall: And so when you do think about, I mean, just sort of the mechanics of how we paid for this, and so you do think, well, there's been a big large expansion of credit that's going on. Taxes don't seem to be going up. Government spending doesn't seem to be coming down in any ways. And so the only sort of group left standing is going to be the bondholders. And we think sort of going forward, it's going to be much like World War I or World War II, where afterwards bondholders received low returns, and even more so, because at least in World War I and World War II, the much larger share was tax-financed. Here, COVID was solely debt financed and money financed. And if you want to think about bank reserves as being money, boy, a big chunk of it was money-financed. It's always hard to make predictions and particularly about the future, but I think there will be inflationary pressure for quite some time. I think interest rates will stay high. And so those losses that we all took on our retirement accounts aren't coming back anytime soon. Those are high returns. I mean, sort of the easiest way to pay for this, if we're not going to raise taxes or cut spending, is to just simply inflate our way out of it. And we're inflating away on foreigners. We're also inflating away on ourselves indirectly through Social Security and these trust funds and what the Fed holds. But we'll impose some of those costs on foreigners. We'll take advantage of our dollar. It's not all bad. We're taking advantage of our dollar dominance and exporting some of those costs onto-

Beckworth: Some people overseas.

Hall: ... onto others. Yeah.

Beckworth: Yeah, so maybe I spoke too soon that inflation will come down soon. It may not, because the more I think about it, if you think of the stock of total US government debt or all the government liabilities... so Fed reserves, Treasury liabilities... consolidate them into one and think of the real demand for debt, so kind of think an old monetarist, real money demand equation, but more broadly, think of real demand for government liabilities... So that's debt stock divided by the price level. There's some real demand for that. If we're not going to lower the actual stock of the debt, then the price level's going to have to do the adjustment. And I think the point you're making, and I've heard others make, is that the way this is going to be adjusted is people are going to sell or buy with their bonds, and that's going to lead to inflation, which will eventually bring the desired real holdings into what they actually want. And that's going to occur through higher prices. So we may not be over the inflation bump yet. It may be a little bit longer journey, but eventually, it will come to some level that's a desired level. I guess that that's the question then. What is the desired real debt balances that the world wants to hold in terms of US government liabilities?

Hall: Yeah, I mean, I would go back to Hamilton's Blessing a little bit. These are really useful securities to have. I think US Treasury securities, I think if they do pay a modest rate of return, they're extremely valuable in terms of sort of underlying US financial markets and global financial markets. One thing that Hamilton saw was, a small number of highly liquid securities is really valuable. And I think we're providing that to the world. And the world was willing to pay us for that. The question is, how much are they willing to pay us? And we seem to be imposing a larger and larger cost on them. No one else is putting up serious competition with us on that. It's hard for me to look at the CBO reports or the Biden budget and see 10 years of large primary deficits and think we can put that all on the bondholder, year after year after year. I think the lesson of Lucas and Stokey is you can take from the bondholder a little bit, but ultimately you have to promise them higher returns. And I don't see where the promise is of higher returns coming. Maybe it'll come.

Beckworth: Well, in the time we have left, I want to switch gears a little bit since you're an historian of US public debt, and we're in the midst of a debt ceiling crisis, maybe that's too strong of a term, debt ceiling moment. And you have a paper with Thomas Sargent, again, called, *Brief History of US Debt Limits Before 1939.* But in your papers, your other papers too, you note that between 1776 and 1920, Congress authorized and designed each individual Treasury security. It's not until 1939 that all of this responsibility is delegated to Treasury. And so Treasury makes the decision in terms of marketing, design, debt management. And I should add, now the Fed is effectively doing some debt management as well with all the reserves and overnight reverse repos. I mean, it's close to $6 trillion, so it's a sizable chunk, about a quarter of public debt. But what I'm curious about is your thoughts on this debt ceiling. I mean, does this make sense? Because it seems like every few years we're back at this point, and we don't want to destroy Hamilton's blessing. We don't want to ruin this exorbitant privilege that affords us the opportunity to run bigger deficits than otherwise would. So what are your thoughts on the debt ceiling?

George’s Thoughts on the Debt Ceiling

Hall: I think I share the views of many in thinking that it's a very funny constraint, an unproductive constraint, in that Congress has already authorized this spending. Congress has authorized the tax revenue. I will point out that it's a limit on the par value of the debt, not the market value of the debt. But the arithmetic of the par value of the debt dictates that that will be the debt, and so it's trying to outlaw basic mathematics. So in that way, it's not helpful. One thing we point out in our research is… and one thing you sort of look at in the history of the debt is that when the government had a large expenditure to finance, when Congress would authorize large expenditures, say... I'll just take for example the Panama Canal. We want to build the Panama Canal. We're going to need to spend some resources. Congress would then say, "This much is going to be tax-financed. This much is going to be debt-financed. And this is how we're going to pay for it." And that would be part of the legislation. Then, what happens during World War I is there's a disconnect.

Hall: We should also point out that they would put limits on the amount of debt that the Treasury could issue. And the reason for those limits were they were bond for bond, so that the Treasury secretary couldn't divert revenue from one bond to another project. If these were bonds that were issued for the Panama Canal, it had to be used for the Panama Canal. If this was a bond to fight a war, it had to be used to fight this war. It couldn't be diverted for something else. So there have been debt limits since 1775. The debt limit isn't some creation of World War I, but what did change from World War I was the disconnect between revenue and expenditures. Now you authorize expenditures, and you authorize tax revenue, and the tax revenue and the expenditures don't have to line up with each other. And there's no connection between those two things.

Hall: What happened also, in the 1920s, was... Again, we win World War I, Britain goes broke, and Andrew Mellon is secretary of the Treasury, and he realizes that we can move from a pound-dominated world to a dollar-dominated world. And the key to doing this is to create, again, Hamilton's blessing, deep, liquid Treasury markets in a small number of simple securities that are heavily traded. Andrew Mellon wants to also break the debt so that we're no longer issuing Panama Canal bonds, we're just issuing debt that is generic. And again, this is going to de-link debt from spending. He wants to do it because he sees that we can move the center of the financial universe from London to New York. And part of that is, again, it's the same logic that Hamilton had of, "I need deep, liquid securities that can provide a base for other financial markets." And so that’s part of his brilliance there, but it's had this consequence that now we have taxes, debt, and expenditures, and they're not tied together in any sensible way in the way they're authorized. And so then you have this sort of artifact about this sort of debt limit that's ad hoc and artificial. Again, it's on an accounting measure of the debt rather than the market value, which does open up lots of possible accounting gimmicks that I do think the Treasury could use to get around it. State and local governments often use these accounting gimmicks to get around various limits.

Beckworth: And it is using these gimmicks. I mean, there's the date where [inaudible] the money. Then there's the official date when things really, really get messy. So it is using these accounting gimmicks. And it has been interesting to me that not only do they use the par value, but they also use the value on total debt, including intergovernmental liabilities. So it's not the 24, $25 trillion that's the marketable securities. It's this other 6 trillion as well.

Hall: Yeah.

Beckworth: So it's interesting, though, so Andrew Mellon, I didn't realize he’s also played an important role. So maybe we should say Hamilton and Mellon's blessing to the country. So neat to hear that he played a role too.

Hall: Yeah, yeah. Ken Garbade has written a number of books talking about how Mellon transformed the Treasury market in the 1920s and really took it from a backwater to global preeminence.

Beckworth: Well, this is good to know because Mellon is known for that quote, "Liquidate labor, Liquidate everything," right, during the Great Depression. I think he's probably better known for that, but this is something to kind of maybe bring out that he's known for contributing to and growing the amazing US Treasury market as well. Okay. With that, our time is up. Our guest today's been George Hall. George, thank you so much for coming on for this bonus episode.

Hall: Oh, thanks so much for having me. This has all been quite fun.