From the July 2009 issue of Research Magazine • Subscribe!

July 1, 2009

Stocks, Gold and War

When World War I broke out, American finance was transformed.

On July 28, 1914, Emperor Franz Joseph of Austria-Hungary declared war on Serbia. A month earlier, a Serbian nationalist had killed Archduke Franz Ferdinand, the emperor's nephew and heir to the throne. By end-July, Serbia's ally Russia would mobilize for war. Soon, most of Europe would be plunged into the First World War.

The United States would not enter the conflict until 1917. But the initial onset of war posed an immediate threat to the U.S. financial system. To finance their war efforts, the European powers would seek to get as much gold as possible. One way to do this would be to sell U.S. stocks on a massive scale and demand that U.S. banks convert the proceeds into gold, which the Europeans would then ship out of the country. That in turn could destabilize the dollar, which like other major currencies was backed by gold.

On July 30, the U.S. moved to block such a scenario. At the behest of the Woodrow Wilson administration's Treasury Secretary William Gibbs McAdoo, the New York Stock Exchange's governing board voted to close the exchange on July 31. It would remain shut until mid-December, its longest suspension then or since.

Shutting down a stock market is a serious step. During the Panic of 1907, J.P. Morgan Sr. specifically forbade an early closure of the exchange, since such a move would have panicked investors further. But the situation was different in 1914. Shutting the exchange, combined with other emergency measures such as an expansion of the money supply, kept the banks liquid and enabled the U.S. to stay on the gold standard.

In a 2007 book When Washington Shut Down Wall Street: The Great Financial Crisis of 1914 and the Origins of American Monetary Supremacy, New York University economist William L. Silber (who is not related to the writer of this article) argues convincingly that McAdoo's measures maintained America's financial stability at a pivotal moment.

Indeed, by staying on the gold standard while most of the European combatants were going off it, the U.S. built a degree of financial credibility rivaling that of Great Britain, long the dominant power in global finance. Thus, the stage was set for a growing share of international financial activity to occur in New York rather than London, and for the dollar gradually to eclipse the pound sterling as the world's most important currency.

Seeking Stability

In the Panic of 1907, America's financial sector had avoided a meltdown, but the close call left lingering anxieties about the soundness of the nation's financial institutions. Consequently, legislation was passed in late 1913 creating the Federal Reserve. However, as Europe marched into war, the Fed was not yet functional; its board was just starting to get sworn in during August 1914, and its regional banks did not open until November.

Responsibility for crafting a U.S. government response to the war-caused financial pressure thus rested mostly upon McAdoo, who was a lawyer-businessman by background and a take-charge executive by temperament. Indeed, during the legislative maneuvering of the previous year, McAdoo had argued for making the proposed Fed an arm of the Treasury; Wilson had overruled him, opting for an independent central bank (though in the Fed's early decades, Treasury was represented on its board).

McAdoo, incidentally, had offered the president his resignation in May upon marrying Wilson's daughter, to avoid possible criticism for entangling personal and official ties. Wilson wasn't too worried about that.

On the morning of July 31, McAdoo told Wall Street, in the person of J.P. Morgan Jr., that the exchange needed to be closed -- or more to the point, not even opened, since the opening bell was minutes away. J.P. Jr. and other financiers had just decided the exchange should stay open, and thought American investors would take up the slack in share prices as Europeans departed. But McAdoo's concern was with gold, and only with stocks in that stocks were what Europeans would sell to get gold.

Wall Street's titans acceded quickly to the treasury secretary's view. Soon, the president of the stock exchange, Henry George Stebbins Noble, announced that the venerable institution was closed until further notice. In a curious historical echo, Noble's grandfather, Henry George Stebbins, had been exchange president during the Panic of 1857.

McAdoo then moved to persuade Congress to amend a law that had passed in the aftermath of the Panic of 1907, the Aldrich-Vreeland Act, which permitted banks to issue emergency currency backed by securities the institutions were holding. The amendment loosened restrictions on how much currency could be issued. This meant that banks would have ready cash on hand to reassure worried depositors. And lest anyone think that meant a weakening of the gold standard, McAdoo had sent a conspicuous and well-armed convoy of trucks to deliver piles of the yellow metal to a Treasury office in New York.

Moreover, the Aldrich-Vreeland currency had a built-in safeguard against an explosion of inflationary paper. Banks issuing the emergency cash had to pay a tax, which escalated over a period of months to encourage them to make it a temporary thing.

Still, the dollar was under pressure against the pound. Typically, the greenback had stood around $4.86:?1, trading in a narrow range since both currencies were linked to gold. In the war's early weeks, though, the buck fell below $5:?1. The British authorities were determined to keep their money as good as gold; whether their U.S. counterparts could do the same was in doubt.

In mid-August, McAdoo organized a conference "to provide sufficient ships to move our grain and cotton crops to European markets." If U.S. exports proceeded despite the war, the resulting revenues would bolster the dollar. In September, the Treasury began providing war risk insurance, covering shippers against such exposures as being torpedoed. On another front, McAdoo and the new Fed board got a banking syndicate to bail out New York City, preventing a shortfall on obligations owed to foreign investors, something that would have damaged America's credit standing and buffeted the buck.

The Crisis Fizzles

The dollar strengthened gradually in late October and early November. One reason was that the agricultural exports facilitated by McAdoo were bringing revenues back to America. Another was that the Fed's regional banks were getting ready to open. McAdoo by this point wanted a serious central bank to help fix the crisis. Things were delayed by concerns about getting enough gold into the system first, but by late October McAdoo had put his foot down and set November 16 as opening date for the regional banks.

By mid-November, the dollar was back around its prewar levels against the pound. The danger of an outflow of gold from America was fading. That paved the way for the New York Stock Exchange to get back into business. Bond trading there resumed on November 28, and on December 12 transactions commenced for stocks deemed "not international" enough to cause any problems. Three days later, the exchange resumed its activities in full.

The U.S. had avoided a financial meltdown. But it had done something more. It had done away with its post-1907 image as a country prone to financial crises. In 1915, the dollar would gain new territory against the pound, and foreign governments would begin issuing dollar-denominated bonds on a large scale through offerings in New York; previously, such issues typically had been pound-denominated and conducted in London.

During World War I, the U.S. became, as William Silber puts it, "a financial superpower." For a while, the U.S. and Great Britain shared that status. But by the 1920s, the U.S. was looking like the top dog on the financial heap. Britain, its wealth depleted by the war, suspended its gold standard in 1919 and then restored it in 1925. The overvalued pound had to be propped up with high interest rates, further damaging Britain's economy.

A crucial element of McAdoo's success in handling the financial crisis of 1914 is that his actions were temporary. Emergency currency was issued, but with a tax on banks to ensure they didn't hand out too much of it. The stock exchange was closed, but only for long enough to allow the dollar to be stabilized and the gold standard secured. Thus, investors were reassured that they were seeing a crisis response, rather than a permanent shift to big government dominating the financial sector.

That's a lesson that's worth remembering in the present day.

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McAdoo's Later Years

Treasury Secretary William McAdoo left office in December 1918. He had supervised U.S. government finances through the end of World War I, and also had a hand in running the nation's railroads during the conflict.

McAdoo ran for the Democratic nomination for president in 1920 and 1924, but was edged out respectively by James M. Cox and John W. Davis, neither of whom reached the White House in that Republican-dominated decade.

McAdoo represented California in the U.S. Senate from 1933 to 1938. He and Eleanor Wilson, the presidential daughter whom he had married in 1914, split up in 1934. When the divorce was finalized the following year, the 71-year-old senator married a 26-year-old nurse. He was not reelected.

In February 1941, McAdoo died of a heart attack while traveling in Washington following Franklin D. Roosevelt's third inauguration.

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Buy Liberty Bonds

After the United States entered World War I, the federal government began issuing Liberty Bonds, debt instruments dedicated to financing the war effort. Buying the bonds soon came to be seen as a patriotic duty, and for many Americans the instruments were the first securities they had ever owned.

Treasury Secretary William McAdoo set up a marketing campaign for Liberty Bonds. Movie stars such as Charlie Chaplin and Mary Pickford promoted the securities. So did the Boy Scouts and Girl Scouts. The instruments could be purchased on margin under installment plans.

Liberty Bonds could be traded on the secondary market, exposing their holders to price fluctuations. A young Harry Truman returned from the war and sold his $100 bonds for $80 each; to his amazed chagrin, he later found that such bonds were trading for $125.

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Kenneth Silber is the senior editor of Research. His work on science, economics and history has appeared in a variety of publications, including The Wall Street Journal.

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