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America’s Fiscal Frontier, Part II: The Peace Dividend

America’s Fiscal Frontier, Part II: The Peace Dividend

The 20th century accustomed Americans to having their cake and eating it, too.

Katherine C. Epstein

From the beginning, as we saw in Part I of this essay, Americans have relied on territorial and commercial expansion to escape political-economic decay. Although that consensus shattered over slavery, it was pieced back together in new form amid the surge of industrial capitalism after the Civil War, when Americans of all classes came to agree that overseas expansion was now necessary—whether to stave off revolution or to ameliorate the status quo. Part II draws together geopolitical change, money, and fiscal policy to trace how this consensus persisted and was reformulated from World War I through the so-called “Nixon Shock” of 1971. Part III will tie this historical perspective to U.S. budgetary dysfunction from the Reagan years to today.

The geopolitical context at the turn of the 20th century made it difficult for the United States to solve its domestic tensions by expanding overseas. On the one hand, despite its growing economic and naval power, the United States remained weaker relative to the European great powers, especially Britain, than is often realized.1 On the other hand, these countries were experiencing domestic tensions of their own, and they too responded by seeking to enlarge their imperial markets. Hence, as the United States moved into a new phase of expansionism during the presidencies of William McKinley and Theodore Roosevelt, it faced stiff competition from Europe and Japan.

Europe’s plunge into World War I made the geopolitical context for U.S. expansion more favorable. The United States took advantage of Europe’s distraction to increase its relative power at Europe’s expense. In keeping with its policy during the French Revolutionary and Napoleonic Wars, the United States maintained its neutrality and proclaimed its right to sell to all belligerents, under the banner of freedom of the seas. As it profited from the war, the United States worked to cut into traditionally British markets, especially in Latin America. At the same time, the way in which the British fought the war increased their financial dependence on the United States. The eventual U.S. entry into the war provided grist for the narrative mill of an American “rescue” of Europe, even though the United States refused to fight as an ally of Britain and France (it fought instead as an “Associated Power”). When the war ended, the United States used the financial leverage gained from Allied indebtedness to shape the peace on American terms. Global financial hegemony passed from London to New York.2

But Americans had no intention of taking on the financial burden which, under the Pax Britannica, was the flip side of financial hegemony. They had spent most of their national existence enjoying what the historian C. Vann Woodward famously dubbed “free security,” surrounded by two oceans and two relatively unthreatening nations, and able to trade across the world’s oceans under the aegis of Britain’s Royal Navy. The security was not perfectly free, of course—the United States had its own army and navy and was almost always fighting with other inhabitants of North America—but unlike Britain and nations on the European continent, it did not face hostile peer competitors armed to the teeth just across its borders.

Accordingly, Americans had never been forced to bear a financial burden commensurate with their global ambitions. That burden was borne by Britain, which levied taxes that enabled it to maintain the security of the global trading system. In the United States, by contrast, the power to levy the types of taxes levied by the British government historically lay with the individual states, so as to prevent the Jeffersonian nightmare of an over-powerful federal government. As late as 1895, the U.S. Supreme Court held that a federal income tax was unconstitutional, and it took a constitutional amendment to overcome this legal obstacle. Thus, the United States did not pass its first peacetime federal income tax until 1913. It did not make the income tax at all substantial or progressive until 1916.

But when it did, it did so in a precedent-setting political bargain. In the Revenue Act of 1916, agrarian Democrats who opposed a military build-up insisted that wealthy Americans pay for the bulk of President Wilson’s “navy second to none.” In so doing, they wedded the left-wing politics of redistribution to the right-wing politics of defense. Although the U.S. government was not yet the welfare state that it would become during the New Deal, the Revenue Act of 1916 established the contours of the political compromise underlying the fiscal merger of the warfare and welfare states.3

At the close of World War I, Americans wanted to return to normalcy, which meant security on the cheap. The Republican Party, which retook the White House in 1920, promptly rolled back most of the wartime fiscal regime—most importantly, the individual and corporate income taxes upon which U.S. military and naval growth had rested. Moreover, with broad public support, the U.S. government refused to forgive or renegotiate the Treasury’s war loans to Britain and France, a step which would have required the government to replace revenue from British and French interest payments, because forgiving or lowering the Allied war debts would have tended to increase the tax burden on Americans.4 Their reluctance to bear this burden effectively transferred it to British and French taxpayers, whose governments needed revenues to pay their U.S. creditors. They in turn tried to transfer as much of the financial burden as possible from their own taxpayers to Germans, in the form of reparations payments.

The destabilizing effects of German reparations on global and U.S. security are well known. Suffice it to say that U.S. policy toward Europe was not isolationist, in the sense of having nothing to do with Europe whatsoever. Rather, U.S. policy toward Europe was isolationist in conventional political-military terms, but highly interventionist in financial terms. Its mode of financial interventionism had consequences that tended to undermine the chances for a stable European peace.5

Climbing the Power Rankings

The Great Depression exacerbated the destabilizing effects of U.S. financial diplomacy. The linchpin of the fragile global economy in the 1920s was a modified version of the pre-war gold standard, which facilitated international trade by maintaining fixed exchange rates but at the cost of constraining domestic policy flexibility. In 1931, Britain quit the gold standard to help alleviate economic distress at home. In 1933, the new Roosevelt administration followed suit. When the major powers met at the London Economic Conference in an effort to restore exchange-rate stability, Roosevelt delivered the so-called “bombshell message,” announcing his intention to place the United States’ domestic well-being ahead of global economic recovery. Regardless of whether these international stabilization efforts could have worked, the point remains that Roosevelt undermined them.6

The politics of removing the “golden fetters” were protean. Roosevelt’s move was hailed by figures as diverse as John Maynard Keynes and Hjalmar Schact. Appointed by Adolf Hitler as president of Germany’s central bank, Schact declared that Roosevelt had the same philosophy as fascist leaders: “Take your economic fate in your own hands.”7 And indeed, the removal of the “golden fetters” freed militarists in Germany and Japan to increase government spending on armaments. Similarly, as the depression persisted and war looked increasingly likely in the late 1930s, leaving gold freed the Roosevelt administration to engage in “military Keynesianism”: that is, spending on the military (especially the Navy) both to prepare for war and to stimulate the economy.8

Expansionary fiscal policy thus had the potential to appeal to both Left and Right. “Hawks and doves, while rhetorical opposites,” as the historian Jon Sumida put it in a different but analogous context, “were by no means irreconcilable political forces; their cooperation… probably explains much about the politics of industrial democracies in the 20th century.”9 Social demands for governments to provide economic security proceeded hand-in-hand with demands for geopolitical security.10

Meanwhile, the United States was also exhibiting a lack of commitment to the liberal logic of the Open Door. Historically, the Republican Party, like the Whig Party before it, had been committed to tariffs, behind which the United States had expanded across the continent and built a vast internal market over the course of the 19th century. In the 1920s, the Republican Party rebuilt the tariff wall that the free-trade Democrats had been chipping away at, undercutting a liberal norm that discouraged against autarky.

The weakening of that norm played into the hands of illiberal powers seeking to challenge the liberal international order. To be able to control their own destinies, Nazi Germany, imperial Japan, and Soviet Russia all sought to accomplish in a matter of decades what the United States had required more than a century to achieve: the creation of continental empires mimicking the economic geography of the United States, with its economically modern metropoles on the coasts inter-linked to its vast agricultural interior.11 Britain, for its part, had long been pondering how to turn its empire into something that more closely resembled the huge internal market of the United States. In 1932, two years after passage of the notorious Smoot-Hawley tariff in the United States, Britain at last decided to abandon free trade and impose a tariff wall around its empire.

Over the course of the 1930s, therefore, the United States found a series of doors once open to its capital and goods slammed in its face. Policymakers were forced to face the terrifying prospect of class warfare. Americans had to consider the possibility that theirs was now a “mature” economy, incapable of further growth, that had to adjust, like other countries, to scarcity, stagnation, and the accompanying threat of revolution.12 “Our population would increase more slowly; our country was largely developed; the frontiers were gone,” as Chester Bowles, an advisor to the Roosevelt administration in the 1930s, recalled the predictions of economists. He went on:

If it were, in fact, true that our national economic pie could not be expected to grow significantly, we faced an explosive political dilemma; the only way labor could raise its wages would be at the expense of stockholders; farmers could expand their slice of the economic pie only at the expense of consumers; and industrialists could earn more profits only by keeping down wages and raising prices to the consumer. This would set labor against management and the farmers, the farmers and labor against the industrialists, with the interest of consumers lost in the shuffle. It was a recipe for class warfare and a dog-eat-dog society in which no group could prosper except at the expense of some other group.13

In short, if doors to expansion abroad closed, then the United States could no longer escape history, with its characteristic decay of republics over time.14

For the United States, World War II was as much a fight to re-open those doors as it was for freedom and democracy. As in World War I, the United States was fighting indirectly against the British Empire as well as against the Nazi, Japanese, and Soviet empires; likewise, the United States’ position in the global power rankings benefited. Once again, the United States entered the war late. Once in the war, its continental base was not bombed, blockaded, or invaded as the territory of every other major combatant was. The U.S. war-related losses were painful, but they were also minor compared to the losses suffered by everyone else.

The disparity in loss greatly increased the United States’ relative power. Its economy had boomed during the war, while the war had flattened its main former economic rivals—Britain, France, Germany, and Japan. The Soviet Union had an enormous army and a powerful armaments industry, but it had lost an estimated 20 million people, had no consumer economy to speak of, and did not yet have nuclear weapons. China had also lost over 10 million people, and it was in the midst of a devastating civil war. Everyone but the United States faced an enormous task of recovery, which would take more than a generation to accomplish.

The Post-1945 Peace Dividend

The United States used its postwar hegemony to structure the peace on terms favorable to itself. On the one hand, with other nations in little position to export goods or capital, the United States propped open the door to foreign markets for American exports by securing the General Agreement on Tariffs and Trade (GATT), which reduced barriers to international trade—such as the tariffs that the United States had imposed when it was climbing the global power rankings. On the other hand, the United States deployed export controls against its Western European allies when they sought to export aircraft and other strategic goods to the Soviet Union.15 Moreover, it placed the U.S. currency, rather than a new international currency proposed by Britain, at the center of the global monetary system with the Bretton Woods agreement.16 Like the British empire a century before, the American empire’s control of trade and territory was now underpinned by its control of international money.

The quarter century following World War II, not the 1990s, was the United States’ most important “peace dividend”—or rather war spoils—in the 20th century. Defined by enormous U.S. power relative to the rest of the world, this peace dividend enabled the United States, at least temporarily, to solve the problem of domestic political-economic tension through expansion. The international context facilitated the triumph at home of what has been dubbed the “New Deal order.”17 Americans now encountered re-opened foreign doors that enabled the pursuit of abundance at home. “Growth” became the United States’ primary macro-economic goal.18

Like the turn-of-the-century version, the mid-century “growthsmanship” added a vertical component to the traditionally horizontal forms of American expansion. Unlike the earlier version, the new version had the theoretical equipment of aggregate national accounting measures behind it. Moreover, where the old version had been devised by financial and industrial elites as an alternative to a redistribution of wealth, the new version was devised by ex-New Deal liberals with explicitly redistributive goals.19

The postwar golden age of relative income equality (at least for some) in the United States owed something to domestic policy. But it also owed something to a favorable—for the United States—international context. American factories, with their unionized labor forces and high wages, faced relatively little competition in global markets. With erstwhile rivals desperate for U.S. goods and investment, the commercial and financial frontier for the United States was wide open.

The only potential threat to U.S. expansion was the Soviet Union. The expansion of the communist bloc threatened to close doors to U.S. trade and investment, choking off the release valve for domestic U.S. tensions. In that event, American leaders feared, the United States would have to fundamentally change its character, turning from a liberal republic into a “garrison state.” Because the Soviet Union possessed an enormous conventional army, an advanced military-industrial base, and after 1949, nuclear weapons, it was a peer military competitor to the United States. But with a much smaller economy that was far less capable of producing consumer goods, the Soviet Union was not a peer economic competitor to the United States. The threat to the Open Door for the United States came from the Soviet military, not from the Soviet economy.20

To meet that challenge, the Truman and Eisenhower administrations maintained high levels of defense spending. At the same time, they modestly expanded the New Deal welfare state, giving something to the constituencies for federal expenditures on the Left as well as the Right. In paying for these expenditures, Truman and Eisenhower benefited from the openness of the commercial and investment frontier for the United States, as well as from the new federal tax regime. During World War II, the federal income tax expanded greatly. Instead of rolling back the wartime fiscal regime as it had during the 1920s, the United States locked the regime in, principally to fight the Cold War—but the tax revenues were just as attractive to those who wanted to spend on welfare instead of warfare.21 The federal income tax thus became the fiscal backbone of both the warfare and the welfare states.

Although the Truman and Eisenhower administrations faced fewer fiscal and monetary limits than their successors, their ideological commitment to fiscal and monetary discipline meant that they did not try to push the limits. As much as he could, Truman insisted that the United States fight the Korean War on a “pay-as-you-go” basis (that is, through tax revenues paid by the current generation rather than borrowing costs borne by future generations), while Eisenhower limited U.S. military commitments abroad rather than borrow more.22 Both administrations also kept the money supply relatively stable. In effect, Truman and Eisenhower behaved as though there were real fiscal and monetary limits on the United States.

Having Cake and Eating It Too

The Kennedy and especially the Johnson administrations abandoned this cautious approach. More accepting of Keynesian ideas than their predecessors had been, Kennedy and then Johnson insisted that economic growth would enable the United States to afford both guns and butter. While increasing government spending (and cutting taxes) at home to pursue the goal of full employment, Kennedy jettisoned Eisenhower’s focus on the nuclear top of the combat spectrum and his preference for limited overseas military commitments, in favor of “flexible response” and an expanded U.S. presence in Vietnam. Johnson further expanded the U.S. war in Vietnam while also initiating a “war on poverty” with the Great Society program at home. But, judging that Americans would not be willing to support the Vietnam War if they had to pay its real costs in the form of higher taxes—let alone if they had to deal with wage and price controls—Johnson opted to pay for the war by printing money. In effect, Johnson chose monetary expansion to enable his expansive policy agenda.23

Johnson’s choice contributed to economic stagnation, inflation, and an international crisis for the dollar. To be sure, U.S. monetary policy was not the sole cause of the crisis. The steady economic recovery of Western Europe and Japan from the devastation of World War II led them to have a growing balance-of-payments surplus vis-à-vis the United States as well as larger holdings of dollars and gold; it also made their currencies relatively more attractive vis-à-vis the dollar to hold as reserves. In other words, as the economic gap between the United States and the rest of the world decreased, forces independent of U.S. monetary policy were bound to place pressure on the dollar’s status as reserve currency. But the inflation caused by U.S. monetary policy—that is, by Johnson’s desire to avoid provoking domestic-political tensions—exacerbated the pressure. It threw off the purchasing power of the dollar relative to other currencies and thus the fixed exchange rates of the Bretton Woods system.

The economic recovery of Western Europe and Japan also served to close the commercial frontier for the United States. For the first time since 1945, U.S. manufacturers faced serious foreign competition in global export markets, and increasingly in the domestic market as well. American industrial workers wailed that the new competition was unfair and even immoral, and they called for redress in the form of tariffs. From their perspective, the United States had generously helped Western Europe and Japan to rebuild after the war. Instead of gratitude, these foreigners had repaid the United States by artificially under-valuing their currencies in order to boost their exports. There was some truth to this charge, but it ignored the role of U.S. money creation in placing pressure on the Bretton Woods system, among other things.

For the Nixon administration, a narrative that externalized U.S. problems by blaming greedy and ungrateful foreigners was politically convenient. As the presidential election of 1972 drew nearer, the last thing Nixon wanted was a prolonged economic downturn. So, rather than hike interest rates, he pressured Western European countries and Japan to revalue their currencies.24 When they refused to bail out the United States, Nixon delivered the three-part “Nixon shock,” none of which tackled the underlying problem of inflation. First, Nixon established a temporary “import surcharge,” or tariff. Second, he imposed temporary wage and price controls. Third, he took the United States off the gold standard, dealing a death blow to the Bretton Woods system.25 In effect, rather than live within monetary limits, the United States unilaterally terminated the international monetary arrangement that it had compelled the rest of the world to accept after 1945.

The takeaway point here is not that the United States acted with malice, nor that U.S. misconduct excused others’ misconduct. To the contrary: American policymakers believed that they were doing good in the world, and the liberal commitments of the U.S. empire—however honored more in the breach than in the observance—distinguished it from illiberal empires.

Rather, the takeaway point is that the United States continued to rely on expansion to lessen its internal tensions. Whereas it had been able to expand only at the expense of weaker peoples in the 19th century, it acquired the strength to do so at the expense of great powers in the 20th century. In World War I, it took advantage of Europe’s self-immolation to climb the global power rankings. In the interwar period, it made policy choices that contributed to the advent of World War II, which in turn damaged the other combatants so badly as to leave the United States with global hegemony. This geopolitical context facilitated the consolidation of the “New Deal order”—but the geopolitics are invisible through a purely domestic lens which looks for explanations in, say, the strength of unions or high marginal tax rates on top income earners.

Nostalgia for a postwar American golden age overlooks the fact that the age was golden for (some) Americans in part because it was so difficult for so many others. Nostalgia also encourages Americans to mistake the abnormal geopolitical conditions of the quarter century after 1945 for the norm.26 That mistake helps to explain why, as more normal conditions have returned since the 1970s, Americans have turned to monetary and fiscal expansion in pursuit of the standard of living that abnormal conditions had helped to make possible.

Katherine C. Epstein is associate professor of history at Rutgers University-Camden.

Image: "There's no way like the American Way," a photograph by Margaret Bourke-White following the 1937 Louisville flood, Kentucky. (Wikipedia)

America's Fiscal Frontier series by Katherine Epstein:

· Part I, The Foundations of Our Budgetary Dysfunction

· Part II, The Peace Dividend

· Part III, The Monetary Soul of Empire.

[1] Katherine Epstein, “The Conundrum of American Power in the Age of World War I,” Modern American History (November 2019).

[2] See ibid. (synthesizing works cited therein).

[3] W. Elliot Brownlee, “Wilson and Financing the Modern State: The Revenue Act of 1916,” Proceedings of the American Philosophical Society(June 1985).

[4] Melvyn Leffler, “The Origins of Republican War Debt Policy, 1921–1923: A Case Study in the Applicability of the Open Door Interpretation,” Journal of American History (December 1972), esp. 593–94; idem, The Elusive Quest: America’s Pursuit of European Stability and French Security, 1919–1933 (1979); and Adam Tooze, The Deluge: The Great War and the Remaking of Global Order (2014), 371–73.

[5] Tooze, The Deluge; idem, The Wages of Destruction: The Making and Breaking of the Nazi Economy (2006), 12–23.

[6] William Leuchtenberg, Franklin D. Roosevelt and the New Deal, 1932–1940 (1963), 197–203.

[7] Qtd. in ibid., 203.

[8] Hugh Rockoff, America’s Economic War of War: War and the US Economy from the Spanish-American War to the Persian Gulf War (2012), 162–64.

[9] Jon Sumida, In Defence of Naval Supremacy: Finance, Technology and British Naval Policy, 1889–1914 (1989), 337.

[10] See Andrew Preston, “Monsters Everywhere: A Genealogy of National Security,” Diplomatic History (2014).

[11] Michael Barnhart, Japan Prepares for Total War: The Search for Economic Security, 1919–1941 (1987); Tooze, The Wages of Destruction; Stefan Link, Forging Global Fordism: Nazi Germany, Soviet Russia, and the Contest over the Industrial Order (2020).

[12] Alan Brinkley, The End of Reform: New Deal Liberalism in Recession and War (1996), 131–35.

[13] Chester Bowles, Promises to Keep: My Years in Public Life, 1941–1969 (1971), 161, partially quoted in Robert M. Collins, More: The Politics of Growth in Postwar America (2000), 17–18.

[14] Collins, More, Prologue.

[15] Jeffrey Engel, Cold War at 30,000 Feet: The Anglo-American Fight for Aviation Supremacy (2007); Mario Daniels and John Krige, Knowledge Regulation and National Security in Postwar America (2022), 85–90, 121–23, 193–230.

[16] Benn Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order (2013).

[17] Gary Gerstle, The Rise and Fall of the Neoliberal Order: America and the World in the Free Market Era (2022).

[18] Collins, More, ch. 1; Stephen Macekura, The Mismeasure of Progress: Economic Growth and Its Critics (2020), 25–39.

[19] Language of “verticality” from Collins, quoting Philip La Follette, More, p. 9.

[20] Walter LaFeber, America, Russia, and the Cold War, 1945–2006 (2006), ch. 1; Melvin Leffler, A Preponderance of Power: National Security, The Truman Administration, and the Cold War (1992); Aaron Friedberg, In the Shadow of the Garrison State: America’s Anti-Statism and Its Cold War Grand Strategy (2000).

[21] James Sparrow, Warfare State: World War II Americans and the Age of Big Government (2004), ch. 4.

[22] John Gaddis, Strategies of Containment: A Critical Appraisal of Postwar American National Security Policy (1982), chs. 5–7; Rockoff, America’s Economic Way of War, ch. 7.

[23] Collins, More, ch. 2.

[24] Michael Bordo, “The Imbalances of the Bretton Woods System, 1965–1973: U.S. Inflation, the Elephant in the Room,” NBER Working Paper No. 25409 (December 2018), 23.

[25] Bordo, “Imbalances,” and Daniel Sargent, A Superpower Transformed: The Remaking of American Foreign Relations in the 1970s (2015), ch. 4.

[26] See here Jay Sexton, “From Triumph to Crisis: An American Tradition,” Diplomatic History (2019).

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