Yet American antipathy to sacrificing lives and treasure in fratricidal European wars was so strong after World War I that the United States embraced unilateral disarmament in a period when Germany, Russia, and, belatedly the British and French, were all rearming. Although the United States maintained the world’s largest navy, its army was “a tiny skeleton force” of two hundred thousand men, and its entire air force consisted of 150 fighter planes. In 1940, the United States was spending less than 2 percent of its annual income on defense, and all arms sales to foreign governments were restricted by law. The Johnson Act of 1934 was aimed specifically at Britain. It prohibited arms sales to any country that had defaulted on its World War I debts.
The fall of France and the near destruction of the British expeditionary force at Dunkirk in June 1940 provoked a sharp reappraisal. Even in an election year, it was no longer possible to deny that Germany—especially in alliance with the Soviet Union—posed a serious potential threat to the United States. Hitler, who had a huge program to build navy destroyers and aircraft and was badgering the Caudillo de España, Francisco Franco, to allow German bases in western Spain, clearly had America in his sights. Congress quickly approved some $4 billion in munitions spending and set a target of 2 million “men under arms” for the end of 1941.
Nonetheless, rearmament was described as being strictly for “hemisphere defense.”15 The overwhelming majority of voters were convinced that Britain could not avoid defeat. Ironically, the historian Alan Milward points out, the American decision to rearm made that dismal prospect somewhat more likely. Britain had ordered some $2.4 billion in munitions from American defense contractors—enough ships, planes, and trucks to keep defense plants busy for several years. Now it risked having its orders bumped by American orders.
Lend-Lease was FDR’s inspired strategy for keeping the United States out of the war while keeping Britain in it. Unlike his ambassador in London, Joseph Kennedy, and many of his closest advisors, the president thought that with adequate support from the United States, Britain could and would prevail. Churchill’s “we will never surrender” oration during the Dunkirk evacuation convinced him that “there would be no negotiations between London and Berlin” of the kind that antiwar groups from the Communist Party to the America First Committee, two members of the British war cabinet, and Ambassador Kennedy, were demanding.16
Arming the British was already reviving the American economy and driving down unemployment. The only trouble was that the flow of arms could not continue on America’s cash-and-carry terms, since Britain could no longer earn dollars by exporting—as Churchill explained to the president in his “begging letter,” waiting until FDR’s reelection in November 1940 to send it.17 Roosevelt’s response was delivered at a press conference where he told reporters that “the best immediate defense of the United States is the success of Great Britain in defending herself.”18 He was not above reminding Americans of the economic benefits of supplying Britain. He illustrated the point with a parable: If your neighbor’s house was on fire and you had a water hose, you wouldn’t try to sell it to him; you would lend him the hose and tell him to give it back when he had put out the fire. “What I am trying to do . . . is get rid of the silly, foolish old dollar sign,” he said.19 The United States would send Britain whatever arms and supplies she needed, paid for by American taxpayers, in exchange for Britain’s promise to repay in kind when the war was won. In a radio “fireside chat” on December 29, the night that German bombers reduced London’s financial district to rubble, he declared “We must be the great arsenal of democracy.”20
The proposal required congressional approval because Roosevelt was asking for an initial appropriation of $7 billion. Opponents argued that Lend-Lease would inevitably drag America into the war by provoking a German attack. Others raised the specter that arms sent to Britain would pass to the Nazis after Britain’s inevitable defeat. But the president prevailed and Congress approved the measure, with an amendment that forbade the navy from sending its ships into the war zone, on March 10, 1941.
Churchill hailed Lend-Lease as “the most un-sordid act in the history of any nation,” and, indeed, the new arrangement signaled the start of a $50 billion procession of ships, planes, and food from American factories and farms and a suspension of the traditional American practice of treating loans to allies as strictly business. But, of course, there were strings, and Keynes was determined to loosen them.
• • •
The dispute that broke out between Britain and the United States exactly one day after the White House sent the Lend-Lease bill to Congress turned on the fact that the law would cover only orders placed after the bill went into effect, not those placed before. Churchill maintained that down payments on past orders “had already denuded our resources.”21 When he complained that “we are not only to be skinned, but flayed to the bone,” he was referring to one particularly onerous condition.22 To prove that she truly needed help, Britain was supposed to exhaust all of her dollar reserves before tapping Lend-Lease—in effect, to pay for the construction of the American plants that were going to be producing arms for Britain. That meant handing over the country’s dwindling gold supplies. The United States actually sent a destroyer to Cape Town, South Africa, to pick up $50 million in bullion that London had placed there for safekeeping. Britain was also required to sell stock in American companies and American subsidiaries of British corporations into a weak market. In the weeks before the passage of Lend-Lease, the British Treasury representative in New York, who was liquidating Britain’s stock portfolio at the rate of $10 million a week, detected a jockeying for postwar commercial advantage.
The ever optimistic Keynes was convinced that the United States would never stand by while Britain became another Vichy France, but he failed to appreciate how committed Americans were to staying out of the war. Lend-Lease, of course, was designed to reconcile those goals. Quite apart from his election promise, “I have said this before, but I shall say it again and again and again: Your boys are not going to be sent into any foreign wars,”23 FDR repeatedly assured Congress that the United States would not fight unless attacked. His critics on the left and the right accused him of secretly maneuvering to create provocations, but recent evidence shows that, until Pearl Harbor, the president continued to hope that he could avoid entering the war. “The time may be coming when the Germans and the Japs will do some fool thing that would put us in,” he told his aides. “That’s the only real danger of our getting in, is that their foot will slip.”24 One clear sign that the president meant what he said was that when Keynes arrived in Washington, the United States was monitoring encryptions from the Enigma machine, provided by the British in April, not to hunt down German submarines but to avoid them.25
Keynes accused the United States of “treating us worse than we have ever ourselves thought it proper to treat the humblest and least responsible Balkan country” and argued that Britain had to fight to keep “enough assets to leave us capable of independent action.”26 The point was to limit Britain’s dependence on Lend-Lease and thus American control over the British balance of payments. Keynes went to Washington as the chancellor’s personal envoy in order to try to work out better financing for Britain’s pre-Lend-Lease orders. His target was to replenish Britain’s reserves up to $600 million. Building up cash reserves under the cover of Lend-Lease was precisely what the Americans were on guard against.
His initial meeting with Roosevelt’s Treasury secretary, Henry Morgenthau, was a disaster. Keynes’s condescending professorial manner irritated the secretary. His proposal to the US Treasury to refund $700 million of the previous down payments already made on existing orders ran afoul of the president’s assurance to Congress that Lend-Lease would apply only to future orders. Keynes saw Roosevelt twice, the second time in 1941 after Germany broke its pact with Stalin and invaded the Soviet Union. He managed to raise a loan enabling Britain to postpone the sale of its assets at distressed prices by offering prime
British properties as collateral and agreeing to a hefty interest rate.
• • •
Keynesianism really took hold in the first year or two of the war. The huge deficit-financed military buildup had accomplished what earlier efforts to fight the Great Depression never did; mopping up the huge residue of unemployment left at the end of the 1930s. After the apparent failure of monetary policy to restore full employment, this struck young economists as a convincing demonstration, in the eyes of young economists, that the economy worked the way Keynes said it did in the General Theory. By 1941, self-identified Keynesians were scattered around the wartime bureaucracy in Washington like raisins in a cake.
A forecasting coup early in the war gave the young Keynesians in the government bureaucracy instant credibility. Most of the businessmen who were consulting for the government’s War Production Board were convinced that the economy’s productive capacity was “very limited” and skeptical that the output of weapons and matériel could be ramped up as quickly as the president wanted. The Keynesians at the Office of Price Administration disagreed. On one of Keynes’s trips to Washington, they had asked their leader his opinion. Keynes displayed his knack for coming up with quick and dirty estimates from just a few facts. “Well, how much was 1929 real output over 1914?” he asked. “Well, that was a fifteen year period and it’s been twelve years since 1929, so let’s take 12/15ths of that increment . . . I think that would be a reasonable goal.”27 The OPA forecasters thought so too. Keynes was reasoning that because World War I through the twenties was a long period of low average unemployment, it was a good indicator of how fast the economy could grow when demand wasn’t depressed. His and their forecasts proved to be remarkably accurate. As one OPA staffer said, “The Keynesian wing of the U.S. civil service had been vindicated.”28
By 1941, Keynesians dominated three New Deal agencies: the Agricultural Adjustment Administration, the Bureau of the Budget, and the National Resources Planning Board. There was also a group at the Treasury. A few had risen high enough in the Roosevelt administration to influence economic policy. They included John Kenneth Galbraith, deputy chief of the Office of Price Administration; Marriner S. Eccles, chairman of the Federal Reserve; Lauchlin Currie, one of FDR’s six administrative assistants; and Harry Dexter White, Treasury Secretary Henry Morgenthau’s de facto chief of staff. If old adversaries now found they could make common cause with Keynes, some of his most fanatical fans in Washington were dismayed. At a dinner at the Curries’ house, a number of the younger men tried to convince Keynes that the “Keynes Plan” was the wrong prescription for the United States. The official unemployment rate was still in the double digits, and some industries were still saddled with unused capacity. Spending cuts, tax increases, and other austerity measures would only aggravate these and might abort the recovery long before the economy approached full employment. Keynes happened to be right, and in any case he was not swayed. Still, he allowed, “The younger Civil Servants and advisers strike me as exceptionally capable and vigorous.” He found, however, “the very gritty Jewish type perhaps a little too prominent.”29
• • •
John Kenneth Galbraith, a farm boy from Canada who looked and sounded like an English lord, liked to say that Keynes’s ideas came to Washington via Harvard.30 But it would be more accurate to say that they had also come by way of the University of Wisconsin, Columbia, the City University of New York, MIT, Yale, and, more often than not, the University of Chicago.
Milton Friedman, a recent Ph.D. from Chicago, did not attend the dinner with Keynes at Lauchlin Currie’s house, but in 1941 the future leader of the anti-Keynesian monetarist revival of the Reagan years was nonetheless one of the brightest young Keynesians in the Treasury. And, as it happens, he did more than most to make Keynesianism practically feasible in the United States.
The son of blue-collar Hungarian Jewish immigrants who settled in Brooklyn in the 1890s, Friedman was born just before World War I. He grew up over his parents’ store on Main Street in Rahway, a gritty New Jersey factory town on the railway line between New York and Philadelphia, whose main claim to fame was that George Merck had moved his chemical plant there in 1903. Friedman grew up witnessing his parents struggle unsuccessfully to make a go of one business after another, including an ice cream parlor. His mother essentially supported the family, but his father was the one who died of angina at age forty-nine, when Friedman was fifteen. In high school, he read This Side of Paradise, F. Scott Fitzgerald’s coming-of-age novel about Princeton. Amory Blaine, the protagonist, has “personality, charm, magnetism, poise, the power of dominating all contemporary males, the gift of fascinating all women.” If Friedman’s being less than five feet tall, wearing glasses, and being poor meant that the resemblance was not perfect, he could at least cultivate the trait Blaine valued most: “Mentally—Complete, unquestioned superiority.”31
In Friedman’s world that meant becoming an actuary. The high school debating champion went to Rutgers, not Princeton, intending to do just that. The Great Depression and a young instructor and future Federal Reserve chairman, Arthur Burns, lured him from accounting to economics. To keep his own economy afloat, the undergraduate sold fireworks, coached other students for exams, and wrote headlines for the student paper. When he graduated in 1932, he took a cross-country road trip before enrolling that fall at the University of Chicago, where the faculty were “cynical, realistic and negative” about reform, yet reformers at heart, and where being a lower-class Jew wasn’t a bar to admission.32 By the end of his first year, he had met Rose Director, the younger sister of one of his professors, taken her to the Chicago World’s Fair, and fallen in love.
Three years later, when he had finished his coursework and depleted his savings, the New Deal was “a lifesaver.”33 All during the summer of 1935, he had waited in vain for an offer of a lectureship. Not only was the number of academic openings negligible, but anti-Semitism made the likelihood of his landing one remote. If one of his professors hadn’t gotten him a research post in Washington, he might well have abandoned his chosen career and returned to accounting. But his enthusiasm for the New Deal was real—Rose’s conservative brother attested to Friedman’s “very strong New Deal leanings”34—and he went to assist at the “birth of a new order” that promised social change of all kinds.35
His new employer, the National Resources Committee, was one of the dozen or so “planning agencies” created during the first Roosevelt administration. “Planning” was then enjoying a great vogue. Proposals for setting agricultural production targets, prices in a host of industries, and minimum wages had their roots not in Stalinist economic doctrine but in the platforms of British Fabians and Labourites. In practice, however, the New Deal planners mostly engaged in constructing national income accounts and forecasting future output and employment. John Maynard Keynes had been badgering the governments of Britain and the United States to create a system of national income accounts analogous to a corporation’s annual income statement. Without reliable measures of how much output an economy produced every year, how much income it generated in the form of wages, profits, interest, and rents, or how much and on what households, businesses, and government spent, the government and businesses were operating in the dark. There was no way to detect imbalances between output and demand or to gauge their magnitude. With only desk calculators, constructing national income accounts was an agonizingly labor-intensive, time-consuming project. Thus was born a huge public works program for economics graduate students. Herbert Stein, one of Friedman’s Chicago classmates, once estimated that the number of economists in Washington had shot up from a mere one hundred in 1930 to five thousand by 1938.36
Friedman was put to work assembling the first large database on consumers and their purchases. Although the labor involved was purely statistical, he later credited the experience for some of his best work, including his “permanent income hypothesis,” cited when he won the Nobel Prize in 1976. It explains, among other
things, why consumers typically spend a smaller fraction of one-time tax cuts or other windfalls than of permanent tax cuts or other ongoing additions to income.
Two years later, as the far from completed economic recovery that began in 1933 went into reverse, Friedman left Washington for New York and the National Bureau of Economic Research. There he joined a team assembled by Simon Kuznets, a Columbia professor, who was constructing the first complete set of national income accounts for the United States. In addition to filling gaps in the data, Friedman’s job was to create detailed estimates of the income of self-employed professionals.
In the course of his research, he was dismayed to discover that despite the huge influx of émigré Jewish physicians after Hitler came to power in 1933, the number of medical licenses had not increased in the intervening five years. Furious at the power of professional groups to prevent outsiders from entering their disciplines, he wrote a scathing indictment of licensing. He bore the brunt of power himself when his study’s publication was delayed for three years by a member of the NBER’s board of directors with ties to the pharmaceutical industry. Meanwhile, he wondered why he bothered. “The world is going to pieces . . . and we sit worrying about means and standard deviations and professional income,” he wrote to his fiancée, the younger sister of Aaron Director, in 1938. “But what the hell else can we do?”37
That summer, he married Rose Director, as peppery, energetic, and conservative as her brother. When Friedman returned to Washington the second time, in the fall of 1941, he had finished his doctorate and survived a hellish first academic job at the University of Wisconsin, where sentiment was overwhelmingly pro-neutrality and anti-Semitic. The young couple consoled themselves with the thought that, sooner or later, the United States would have to enter the war. By the time Hitler attacked his Soviet ally, the Friedmans were overjoyed to be going to Washington, where there would be important war work for them to do. Over the summer, Friedman had coauthored a paper, “Taxing to Prevent Inflation,” with a public finance professor on the Columbia faculty who recruited him to join the Tax Research Division at the Treasury. In Friedman’s first stint in Washington he had come there as a statistician. Now he was poised to play a more influential role in shaping policy.