When Uncle Sam Bought Back His Bonds: Echoes
When the Federal Reserve’s Open Market Committee meets this afternoon, any decisions or announcements it makes will draw the attention of traders and commentators around the world.
The purchase and sale of U.S. Treasury securities by the FOMC is the main method today by which the government attempts to manage the economy by influencing the price of credit. But the government didn't always undertake this practice of trading in its own bonds with the goal of manipulating interest rates -- its early bond-buying efforts had a very different goal.
In the midst of World War I, the federal government issued Liberty Bonds to pay for rising military costs. After the first two series of bonds were issued in 1917, their price promptly fell below par as they traded on the nation's securities exchanges.
Declines in the market value of the bonds presented an enormous public-relations problem for the administration of President Woodrow Wilson. Wartime propaganda had cast Liberty Bond purchases as votes of confidence in the war cast by loyal citizen-investors. Sales that drove down the market price of those bonds implied that the public lacked faith in the war effort.
At Liberty Bond rallies, Treasury Secretary William McAdoo Jr. refused to accept the suggestion that "fluctuations in the market price of government bonds on the Stock Exchange" expressed "the patriotism of the American people." A notification card signed by McAdoo and mailed to every owner of a Liberty Bond demanded: “You must not sell your bonds!” because “every unnecessary sale” depressed prices and demoralized the public.
But sales continued and prices slid. Policy makers fretted that as the "financially ignorant" disposed of their bonds at a loss, they would turn against "not only Government bonds but against all kinds of securities," losing faith in financial markets, private property and even democracy itself.
To address this potential discontent, Congress authorized the Treasury in April 1918 to set aside 5 percent of the proceeds of the Third Liberty Loan campaign and to expend those funds to acquire prior issues of Liberty Bonds to buoy their price. The War Loan drives had forged a new chain of obligation linking citizen-investors to their debt-issuing government. Investors lent their funds and, in return, the federal government assumed responsibility for limiting their losses.
Ultimately, the Treasury's fund acquired $1.7 billion in Liberty Bonds, while the Federal Reserve System increased its holdings of federal debt sixfold -- to $352.3 million from $57.1 million -- from 1916 to 1920.
This expanded presence of the federal government in the markets for its own debt would long outlast the Great War. In 1922, the Federal Reserve assumed control of the Treasury's bond-purchase fund. Beginning in 1923, the Fed's Open Market Investment Committee began to coordinate the purchase and sale of federal bonds by the Federal Reserve banks with the aim of influencing interest rates to promote economic stability and growth.
The Federal Reserve System, originally designed to act as a lender of last resort to the banking system, now became an agent of federal monetary policy. Open-market operations would serve as one of its most important tools.
How successfully the Fed has employed that tool to modulate the business cycle has been one of the most controversial debates among economic historians ever since.
(Julia Ott is the assistant professor in the history of capitalism at the New School in New York. Her book, "When Wall Street Met Main Street: The Quest for an Investors’ Democracy," was published by Harvard University Press in 2011. The opinions expressed are her own.)
To read more from Echoes, Bloomberg View's economic history blog, click here.
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