Thursday, March 27, 2014

Did the Government Pay for WW2 with Interest-Free Loans?

Did the government of Canada use the Bank of Canada to fund World War 2 with interest-free loans? It’s a claim that is often made by the Canadian Greenbackers (or Loonies, as I like to call them). The Loonies maintain that, since the BoC is a Crown Corporation, it is essentially “our” central bank and that “we” can loan ourselves paper money to fund infrastructure and government services. It is often asserted that the government used this central banking function from 1934 to sometime in the 1970s. My research shows that it stopped in 1967. And it’s not as cut and dry as the Loonies maintain. The BoC under James E. Coyne (1955-1961) didn’t rely on this function. Coyne was adamant about using domestic savings to increase economic output. Most central bankers are content with importing savings from abroad (as well as creating inflation).  The Loonies reject all this and demand the Bank of Canada make interest-free loans to the Government so they can spend without worrying about creditors.

Austrian economist and historian Gary North has a well of information about the Greenbacker ideology. For an overview of the Canadian position, see one of my previous entries. For the rest of this post, I’d like to focus on the WW2 myth being propagated by the Loonies (followed by some economic illiterate statements made by William Krehm).

For the first twenty-two months of WW2, the Bank of Canada acquired $1.9 billion of government securities. Unlike bonds, these securities matured in the short-term. They did not pay interest prior to maturity, instead being sold at a discount of the par value. Essentially, the Bank of Canada was buying zero-coupon bonds from the Government of Canada (but with some key differences). In a nut shell, the BoC advanced money to the federal government by holding short-term securities. The government then financed the first twenty-two months of WW2 with this money.

But the Loonies have skewed vision of history, as well as economics. This method increased the money supply, causing inflation. Thus – just as in World War 1 – Victory Bonds were introduced to remove money from circulation and to finance the war. A massive propaganda campaign and auctions where the government was the only legal seller made the Victory Bonds a success. Half the war’s expenditures were financed this way. The prior method of creating money and loaning it to the government “interest-free” created inflation and would have depleted the efforts essential to fighting the war. Of course, “interest-free” is ambiguous. Any interest paid to the Bank of Canada reverts to government coffers.

This is essentially the Loonie argument – paying interest to creditors is wrong when we can just loan the money to ourselves interest free. As COMER (the Committee on Monetary and Economic Reform) writes, after WW2 “Canada increasingly had to resort to borrowing from the private banks and other private moneylenders, including foreign sources.” This is because, quite simply, there is no such thing as a free lunch. Savings are required to finance capital projects. Interest is a product of time preference, i.e. $100 now is different from $100 in the future. If I loan you $100 now, I have to go without it. It only makes sense that I would charge you, say, $10, for giving you the money now in hopes that I get it back ten months from now. I take the risk. Now, what if I have a printing press and a coercive monopoly behind me? Well that’s problem with government, not interest. The Loonies don’t follow their reasoning far enough; they support giving the central bank and government more powers.

My sources for this post come from a book by William Krehm, the co-founder of COMER. As you can see, the Loonies don’t understand economics. I was able to take the same facts about WW2 financing and show why what Krehm tries to prove can’t be so. And this shouldn’t come as a surprise. Krehm’s economic reasoning is founded on his mathematical background. In addition he doesn’t like the word inflation because it implies “deflation,” which, according to Krehm, isn’t always the case. Instead, he uses the term “structural price increases.” It’s little wonder that Krehm promotes the inflationary policies he does when his whole understanding of economics is confused. Take this excerpt for example,

A prosperous economy generates private savings, encouraging individual Canadians to purchase government securities. Should inflation resume, excess purchasing power can be diverted by means of compulsory loans that would come into effect in targeted sectors. This in turn would provide a cushion of potential purchasing power to avert future recession. [pg 28]

Since this post is about financing WW2, I’ll leave Krehm’s nonsense for another day. Or for readers to comment below. Seeing as my last post on Loonies caused a bit of a stir, maybe any pro-Loonies out there can explain to me why I should take Krehm’s book (or COMER) seriously.

Also available at Mises Canada


  1. Hi Caleb, I'm not a Loonie or Greenbacker (actually this is the first I've ever heard that expression) nor have I read Krehm, so I'll let you be the judge of the validity of my opinion on this issue. In so far as analyzing historical experience of inflation during war time periods, I'm skeptical that the inflation observed is purely a monetary phenomenon born out of the Bank of Canada buying government bonds, and that central bank operations at the time just happen to be correlated with inflation, rather than its primarily source.

    With so many members of the labor force going overseas to fight, the labor market would have tightened dramatically, which would bid up the price of labor, bidding up wages and thus consumer purchasing power. This would be a pretty traditional Phillips curve explanation of inflation. Furthermore, spare industrial capacity would have been completely used up (and effectively running overtime) as manufacturing dedicated to producing automobiles for instance would have been repurposed for building machines of war instead. So that leaves less industrial capacity to meet consumer demand for non-war goods, and hence would show up as a price increase due to supply shortages.

    Admittedly three month interest rates fell during WWII to levels below even what we see today. This either means that there was strong demand for government debt (there was a significant propaganda machine pushing war time bonds around the world), artificial suppression by the Bank of Canada, or general risk aversion as a result of the war which bid up the price of less risky assets and pushed down yields. I think that price controls and rationing could have been better accomplished simply through higher interest rates, which would have sucked up excess consumer demand by increasing the incentive to save, but it's not obvious from a casual look at the data exactly who the horse and the cart were during WWII. Personally I'm not of the opinion that inflation is purely a monetary phenomenon, but it is fun to debate. Cheers

    1. Hi DismalEconomist,

      The price and wage control, labour market and the overall war-time economy factors are interesting points. Of course, being an Austrian I don't find any validity in the Phillips Curve and I disagree completely with your view on inflation. It is simply a monetary phenomenon because inflation (how I define it) is the increase of the money supply. This is done by the central bank and through the fractional reserve banking of the Chartered Banks.

      May I suggest you post this comment to Mises Canada where I cross-posted this article? I don't have much time to debate but the Mises site gets more traffic with readers willing to refute your position, point-by-point.

    2. Unfortunately your cross-post has disappeared in to the depths of the Mises website, so it's unlikely to get many comments. A good debate is better had in person than over comment boards regardless. I should clarify I don't actually believe in the Philips curve, just that the labor market and price behavior of the war time period exhibited the correlation that brought about the Philips curve popularity. Put differently, the price inflation experienced during WWII could be attributed to labor market tightness. Admittedly there's so many different things going on at once that it's pretty difficult to boil it down to one cause. Anyway, the Krugman position that we need more inflation to heal the labor market is one I disagree with. A strong labor market will likely lead to price inflation, but price inflation doesn't necessarily lead to a strong labor market.

      I agree and sympathize with many of the Austrian positions on the ineffectiveness or inappropriateness of Central Bank action in various circumstances, but disagree that they were the sole cause of inflation in this particular circumstance.