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Why the U.S. Treasury Began Auctioning Treasury Bills in 1929

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Why the U.S. Treasury Began Auctioning Treasury Bills in 1929

Fascinating little piece of trivia from the Fed. In this article is documented the seeds of our current financial destruction.

In 1917 the U.S. Gov't began issuing Liberty Bonds to fund our involvement in WWI. By the end of the war, we had issued an amount, $24 billion, of more than half our pre-war GDP. (our debt prior to these issues was less than $1B)

After the war, the gov't did not pay off that debt, but rolled it all into Treasury Bills. Every term, they had to guarantee to sell enough T-bills to roll all the expiring debt, so they set a fixed interest rate higher than the market rate. To create a buffer of funds that could be drawn by the gov't the Fed allowed banks to borrow an amount equal to the purchase price of their T-Bills at a low interest rate. The banks would have to pay that loan back as the gov't required the cash, usually over the course of weeks or months. This set up an opportunity for banks to purchase huge sums of T-Bills with borrowed Fed funds, sell them to the public at a discount, and lend the proceeds at a rate higher than the loan rate from the Fed. Private citizens did not bid on the T-Bills, because they could buy them cheaper from the banks, the banks profited from a huge interest rate arbitrage, and the T-Bills entered the economy as tradeable commodities, in effect, money.

The devaluation of the dollar as a direct consequence is well documented as a price shock in 1920 and continuing through the 20's as huge amounts of "money" (T-Bills) entered wide circulation. Inflation during this time totalled apx 75% of the pre-war dollar value. Assuming a reserve rate of 10% and given a monetary base of $5B at the time, M1 was no more than $50B, and the introduction of $25B in tradeable debt securities accounts for much of the inflationary bubble of the 1920's.

In the late 1920's the gov't finally realized they were providing huge profits to the banks through the issuance of fixed rate T-Bills, and in early 1929, they passed an act shifting to an auction system. This shift eliminated the arbitrage opportunity to banks, and promised to staunch the flow of gov't funds into the banking system. The first auction was held in December 1929, not coincidently, the financial system had collapsed in October.

The monetary crisis continued until 1934, when FDR ended gold convertibility and devalued the dollar by an amount virtually identical to the de facto devaluation created by the Liberty Bond issue. (a 75% inflation correlates to a 43% devaluation. FDR devalued the dollar from a gold exchange rate of $20.67 to $35 - a 41% devaluation)

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