War is by far the most expensive ""activity"" that humanity can partake in, and this was a wise assessment. Not only is the direct cost of providing ""weapons"" extremely high, but war also results in massive devastation of property, loss of population, trauma, and desolation—truly Hell on Earth.
However, instead of ""a few months,"" the devastation lasted for years, leaving millions dead or disabled and Europe in ruins. How was this possible? Even if England had called on its loans, the amount of money in the treasury was still insufficient to sustain a war lasting years as opposed to just a few months.
The government appears to have only two options if the treasury runs dry: raise taxes or borrow money. Both options were impractical; raising taxes would trigger a revolution, if there was still any taxable income in the economy. If there was any additional money that could be borrowed, it was too expensive.
Thus, the paradox: how could the warring parties pay for mayhem using resources other than the gold in their treasuries? We must look at the evolution of money and the ""traditional"" Gold standard that prevailed during the years leading up to World War I in order to understand this.
A genuine or ""unadulterated"" Gold standard is made up of three parts or ""legs."" According to J. P. Morgan, gold is first and foremost important; silver and copper serve as supplemental currencies to enable smaller transactions. Gold is the only metal that can be used as money. Coins made of gold are too expensive for everyday purchases.
Debt (borrowing) and credit (not borrowing) are the other two legs; presently, debt and credit are grouped together, which is a mistake because they are two distinct phenomena. Mortgages or the bond market are two examples of borrowing. Bonds are unsecured (based on ""confidence and credit""), while mortgages are simply loans with collateral backing.
For instance, the Treasury issues (sells) bonds with the promise to pay interest over the course of the bond's life and to recoup the principal in a specific number of years, depending on maturity. The buyer pays cash to purchase this paper in order to earn interest, or at least that's how it worked in the past. The majority of bonds are bought and sold today with the hope of making a profit; a decline in interest rates will increase the bond's value, and vice versa.
On the other hand, credit is given rather than borrowed; no money is exchanged. A tank truck carrying 20,000 liters of gasoline, for instance, might arrive at the gas station to fill up the tanks. Depending on the current price of fuel, this delivery is equivalent to around $40,000. This amount will never be paid by the gas station attendant; no COD. Instead, a bill or invoice is signed with a payment deadline of 30, 60, or even 90 days.
In reality, continued fuel sales will provide the money needed to settle this amount. The signed bill is still valuable because it will unavoidably be paid in cash; only a genuine catastrophe would stop the selling of gasoline, beer, grain, cabbages, or any other in-demand consumer commodity.
Before World War I, these bills were known as Bills of Exchange or Real Bills, according to Adam Smith. These bills were in widespread usage; in other words, they were accepted as payment in the majority of transactions, playing a crucial monetary role. The Gold Standard's clearing system was represented by the Bill market. Importantly, unlike bonds, which could be manufactured and sold at will, bills could only be drawn against genuine items that had been delivered to retailers.
As more consumer-based purchases are made, more products are provided and more notes are printed, giving rise to the monetary flexibility that ""pure"" (Rothbardian) Gold money circulation lacks. One of the reasons given by critics of gold for its lack of ""flexibility"" is really the absence of a bill market, the clearing mechanism for a true gold standard, which was destroyed with the outbreak of World War I and never rebuilt.
Additionally, bills don't cause inflation because they all mature into gold coins and expire (get paid) in less than 90 days. On the other hand, freshly printed Fiat is always present and serves to support inflation. This is more than simply a theory of money; prior to World War I, Bills of Exchange were used to settle international trade; following the collapse of the Bill market, pre-WWI levels of trade were not recovered until well into the 1970s.
The British empire of ""The Sun Never Sets,"" which predated World War I, was ruled from London, and its central bank held a meager 250 tons of gold. Today, the US Federal Reserve is said to own 8,000 tons, while a number of other nations each hold several thousand tons. Of fact, neither Gold nor Bills of Exchange are in use now.
The majority of bonds are issued on a whim and purchased with cash; they last for years, if not decades. Bills are drawn against delivered real commodities, mature in no more than 90 days, and react immediately to market movements. The maintenance of financial stability depends on this quick feedback mechanism since interest rates and price movements react too slowly to unexpected changes in the markets. The outcome is economic oscillations that are both wild and expanding.
Unfortunately, there was never a pure gold standard; instead, there was a ""leg"" or component known as ""Fiduciary"" that was part of the ""Classical"" Gold Standard. Fiduciary refers to promises rather than actual bills of exchange or cash.
In the past, banks have provided convenient goods. For instance, hundreds of years ago, a merchant arranging a journey to make international purchases went to a bank and paid it gold in exchange for a letter of credit. This way, he could conduct business without taking the risk of traveling with substantial amounts of gold coin; instead, he would produce the letter to a bank once he arrived at his destination to redeem his gold.
In addition, banks maintained both Bills and Gold in their portfolios, which is why they were frequently referred to as ""discount houses."" The paper form that is most similar to actual gold is a bill, which is likewise a productive asset. The discount is the difference between the current value of a bill and its due date, which is 90 days in the future.
This way, if the gas station has a surge in business and sells the 20,000 Liters early, it will have the money to pay the invoice in advance. It is obvious that the retailer and the wholesaler of gasoline can come to an arrangement; the retailer will prepay for a consideration (discount) and be prepared to place an order for a new delivery of gasoline.
However, bills have a few drawbacks. For example, exactly like a letter of credit, a bill must be reassigned in order to be used to pay another party because it is not a bearer instrument. Additionally, bills arrive in a variety of sums rather than round denominations; for example, a truck load of gasoline typically costs more like $38,672.80 than $40,000... Inconvenient when it comes to payments.
Finally, each time a bill is exchanged, the discount must be (re)calculated because the market value of the bill rises with each day that passes before maturity. This fact must be taken into consideration.
In the interest of convenience, banks started to issue bank notes; large denomination notes, bearer instruments, with round number values... and to balance their accounts, they held Gold (and Silver) in their vaults, as well as Bills in their portfolio.
Importantly, the bank's finances must balance both chronologically and in amplitude (assets must equal liabilities). Notes are fully liquid, a cash equivalent; to balance notes issued, assets held must also be cash equivalent (fully liquid) else we run into problems. Of course, Gold and Silver in the vault are cash... but Bills of Exchange in the portfolio are (almost) as good.
In order to keep Bills in their portfolios, banks had to constantly buy new bills as the old ones matured into Gold coin. One hundred percent of Bills mature in not more than ninety days... so, in case of unusually large demand for Gold, the bank would simply cut down on Bill buying... and allow Gold to accumulate and meet the demand. Worst case, stop buying... or even go into the superbly liquid Bill market and sell (re-discount) some bills even before they mature. No runs on the bank!
If we only stick to the three legs, we have a stable, market driven financial system; the Classical Gold standard came close. My father used to refer to pre-WWI days, with a fond faraway look in his eyes as 'The Peaceable Days'. Under the Classical Gold Standard, the world enjoyed the most peaceful and prosperous era in Human history. Unfortunately, the camel had his Note... er nose... in the tent. Chicanery began on two fronts.
On the bank liability side, small denomination Notes were issued; these had only one real purpose, to start convincing people that paper Notes (at first redeemable in Gold) were actually as 'Good as Gold'; a bare faced lie. IOU's are not real stuff; claims on Gold are not Gold.
On the bank asset side, more chicanery; in addition to cash equivalent assets like Gold and Bills, the banks started to use Bonds as assets. This is where the real trouble lies; bonds do not mature into Gold in ninety days or less, rather they mature (if they ever actually do mature) in years or decades. Thus, if there is a large demand for Gold (cash) Bonds must be sold.
Selling bonds causes bond values to drop; capital losses and ill-liquidity if not bankruptcy soon follow. Thus lethal runs on the bank become possible. To counter this, rather than forbid Banks from holding bonds in their portfolios, central banks 'lenders of last resort' were created... as if lending could resolve problems caused by too much lending!
The original law passed by Congress to create the Federal Reserve specified that the Fed's assets be constrained to commercial paper only... holding Bonds (that is, monetizing Government debt) was specifically forbidden... Of course, the law against the Fed not being allowed to hold Bonds was broken almost immediately; the law was changed retroactively.
There we have it; the camel has now taken over the whole tent. Treasuries issued bonds and banks issued Notes 'backed' by the Treasuries. No limits in sight, no market reality. Thus was funded the mayhem of WWI; fake money printed with no firm limits. But it did not stop there; WWII was also funded by Government bonds and paper Notes; the US had the highest debt to GDP ratio in history towards the end of WWII... and the game goes on. Now we come to the crunch; today the US debt to GDP ratio is even higher than it was at end of WWII... and so is the debt to GDP of Western countries.
What cannot go on forever will not. All the Fiat currencies ever issued have failed; and the current crop of Fiat is no different. At the rate Fiat is being created today, the end or as Von Mises called it the 'Crack Up Boom' is now upon us. The only question is, will the world again accept some IOU to play the role of money... say SDR's (special drawing rights issued by the IMF)... if so, the tragedy will repeat down the road. Or, will Gold be recognized as Money... and will an honest society with honest economics be restored.
Hope for the best and prepare for the worst."""