Tuesday, March 23, 2010

Own the Fed, Part IX: The Great Depression

The major contributing factors to the Crash of 1929 all involved attempts (most of them unconscious or unwitting) to circumvent or ignore the principles embodied in Say's Law of Markets and the real bills doctrine. The most important principle, of course, is that this thing we call "money" is not a commodity, but a derivative of the present value of existing or future marketable goods and services.

Understanding that this principle was either ignored or abandoned, we find it easier to understand just how a shakeup of the stock market, which in real terms directly affected only a very small percentage of the population, had such a catastrophic effect. What should have been a "mere" adjustment in the secondary market for corporate debt and equity was able to spread its malaise throughout the entire economy. As Dr. Harold G. Moulton explained,
The depression was thus the outgrowth not of some one single disturbing element but of a number of factors. Inasmuch as the world economic system was vulnerable in several important respects, it was only a question of time until a break would occur somewhere — the precise moment and place being perhaps more or less a matter of accidental circumstance. Moreover, once a serious break occurred at any place in the complex mechanism the effects would spread throughout the entire system. (The Recovery Problem in the United States, op. cit., 26.)
Simplistic answers or witch hunts were thus clearly not the answer to the Crash. Nor was focus on whatever objective might be desired immediately to the detriment of necessary systemic reforms an adequate or even acceptable response. This is because there is a strong tendency, especially in a modern advanced economy, to demand that the State take care not only of its proper role, that is, to care for the common good, provide a "level playing field," enforce contracts, and so on, but also take direct responsibility for all individual goods and even, ultimately, to ensure an acceptable minimum result for everyone.

The bottom line is that expecting the State to do more than it was designed to do, is to invite not simply tyranny and totalitarianism, but complete functional overload for what may be our only legitimate monopoly. The State is a monopoly that requires effective checks and balances against the abuse of monopoly power in order to function. In more pragmatic terms, expecting the State to do everything for everyone usually ends up meaning that the State does nothing apart from maintaining the position of whatever elite manages to find its way into power — and even that it does not do very well.

The attempt to make institutions, especially at the level of the State (such as the Federal Reserve System) do everything and be everything to everybody usually destroys whatever effectiveness the institutions may have had at one time. (It also offends against human dignity at the most basic level, but that is another argument.) The solution is not to make the State or any other institution try to do more and more, but to identify the specific systemic problem, organize, and work with others to reform the institution so that it can be returned to the principal job of any institution: assisting the people within that institution to develop more fully as human beings.

For a central bank such as the Federal Reserve, the actions carried out following the Crash may have been the best that the authorities could think of within the paradigm provided by the Currency School, but they were clearly not what was required to set matters straight. To make the point perfectly clear, Moulton commented,
In view of these varied sources of maladjustment and the world ramifications of the problem, it was too much to expect that the Federal Reserve system, operating alone or even in conjunction with the Central Banks of other countries, could have maintained stability through monetary policies. As has been previously pointed out, the banking crises that had so commonly ushered in economic depressions in former times had given the impression that the causes of cyclical fluctuations must be primarily financial in character, and hence capable of control by monetary and credit policies. One of the great lessons of the world depression is that the control of the business cycle presents a vastly more complicated problem than had hitherto been assumed. (Financial Organization and the Economic System, op. cit., 407.)
The "vastly more complicated problem" was that there were clearly some serious institutional flaws with the system. To correct the situation or even restore the financial system and the economy to stability would require rethinking some basic assumptions, and then undertaking corrective actions and reforms suitable to the problem. Within the paradigm dictated by the Currency School, however, there wasn't too much that could be done that would be effective.

The obvious response to the Crash was to keep businesses producing. If companies were not producing, they would begin laying off workers, and the economy would start to spiral down into recession or depression as consumption fell in response to the lack of wage system jobs that most people now relied on to provide them with consumption income. The problem was that if the situation were approached from within the wrong framework, the measures applied to correct the situation would only by merest chance have the desired effect, and frequently have the opposite effect of what was intended.

Businesses needed credit to keep producing. Enterprises would otherwise be unable to purchase raw materials, pay labor, or finance new and replacement capital equipment. It comes as a surprise to many people that businesses do not usually have quantities of cash lying about the place in sacks or on deposit in the bank. Instead, the "retained earnings" — savings — we see on corporate balance sheets is equal to — but (and this is important) not the same thing as income retained in the company and reinvested in operations.

To restate that, retained earnings does not consist of cash, or even the capital assets that have been purchased with cash, but of the owners' private property stake in that cash and other assets of the company. "Owners Equity," which consists of outstanding capital stock, contributed capital and retained earnings, is not itself the net assets of the firm, but the ownership of those assets. "Private property" does not consist of the thing owned, but of the right that an owner has to be an owner in the first place, as well as the rights an owner has over the things he or she owns. Thus, while it is true that "savings equals investment," it is a serious error to make the leap that Keynes then made and insist that savings are investment, and consequently it is impossible to finance new capital formation except out of existing accumulations of savings.

However you might understand money, credit, banking, or even private property, the single most important objective following the Crash was to make certain that banks continued to provide the private sector with sufficient liquidity to keep the wheels of industry, commerce, and agriculture turning. Consequently, Moulton observed that, "Almost immediately after the collapse of the stock market boom in October, 1929, the Federal Reserve authorities adopted a policy of easy money as a means of preventing a severe business recession." (Financial Organization and the Economic System, op. cit., 408.) After giving the specific rate changes, Moulton continued,
During this period, also, the Reserve banks made very large purchases of government securities as a means of increasing the reserves and the lending power of the member banks. However, the result was that the member banks merely used the proceeds to reduce their rediscounts at the Federal Reserve banks. Business loans were not in demand, even at cheaper rates; hence the sensible thing for the banks to do was to liquidate obligations. (Ibid.)
Moulton's analysis may be a little off the mark here. Many authorities maintain that businesses and farmers were demanding credit, even desperate for it, but the banks refused to lend. It is entirely possible, of course, that what Moulton meant was that there was no effective demand for business loans, given the inadequacy of existing collateral in light of the drastic plunge in share values.

Keynesians, of course, reject the idea that lack of adequate collateral might have had anything to do with the situation. Viewing money and credit as a commodity instead of a medium of exchange — a system of promises conveyed through the use of symbols — the way to stimulate the demand for money under the tenets of the Currency School is to lower the "price of money" — the interest rate. To do this requires that money be "injected" into the economy, increasing supply and lowering the price.

The problem with the Keynesian solution is immediately obvious once we realize that money and credit are not commodities, and that the "price" is not necessarily bound by the amount of existing accumulations of savings. If banks refuse to lend, and borrowers are not able to borrow, whatever the reasons might be, Keynes declared that the demand for money is "infinitely elastic," that is, regardless of the price of the presumed commodity, the demand for that commodity will not increase. The reason is irrelevant.

This is the Keynesian "liquidity trap." There is no dearth of the "commodity," but the "commodity" refuses to obey the laws of supply and demand. This, of course, is perfectly understandable once we realize that money and credit are not commodities, and that interest is not the price of money (interest, as we explained in a previous posting, and as Adam Smith would agree, is a share of profits, not, properly speaking, an input to production, per se). It is, however, completely baffling to Keynesians, as well as Monetarists and Austrians, for they cannot explain why the alleged commodity refuses to act like a commodity. (Answer: because money and credit are not commodities, but derivatives of the present value of existing or future marketable goods and services; interest is not the price or rent of money, but a share of profits.) All economists and policymakers "know" is that further increases in the money supply will not stimulate the economy. (Unless, of course, the money is created to finance new capital formation through the extension of adequately collateralized bank credit — the issue is not an economic issue of supply and demand, but a financial issue of adequate collateral.)

The situation was not improved when in the middle of 1931 there was an extensive drain of gold due to the worsening of the international economic crisis and the exercise of the standard gold clause written into most contracts in the United States. Hoarding increased domestically as well, as citizens sought a hedge against the fall in prices and decline in the value of assets, as well as the potential (or actual) job loss, by converting their gold certificates into coin, and then shipping the gold overseas. As a result, the Federal Reserve raised the discount rate to try and reverse the flow of gold out of the system.

The issue, of course, was not that there was an infinitely elastic demand for money, but that sufficient and adequate collateral was not being offered to secure bank credit, and may not even have existed at this time due to the drastic fall in share values in October of 1929. Part of the problem was that the Federal Reserve had reversed the usual and sound process by which money is created under the tenets of the Banking School, i.e., first a financially feasible — and adequately collateralized — project is located or developed, and then the money is created to finance it, the loan being repaid out of future savings. Instead, Federal Reserve authorities and policymakers were taking the tenets of the Currency School for granted and assuming that existing savings are necessary to finance new capital formation. The authorities were therefore trying to redistribute savings out into the economy through inflation by manipulating reserve requirements and the discount rate.

Due to insufficient adequate collateral in the system, however, the Federal Reserve, even the commercial banks could create money at a tremendous rate, but it would not have been loaned out. Consequently, as Moulton explained,
Federal Reserve policies during these years were not, however, able to stem the tide of the depression or to prevent the emergence of a banking crisis in the winter of 1933. The drastic decline in the prices of both commodities and securities, and the enormous contraction in the volume of production, threatened in due course the breakdown of the entire financial structure. The earnings of business enterprises generally were reduced to so low a level that the safety of the entire debt structure was imperiled. The collapse of bond values, which was accentuated by the efforts of banks and individuals alike to liquidate assets while some value yet remained, threatened the insolvency of financial institutions generally. (Financial Organization and the Economic System, op. cit., 408.)
We should point out that the last sentence contains a possible typo; the collapse of bond values should, it seems, have threatened the solvency, not insolvency, of financial institutions (or possibly Moulton meant to write, "threatened them with insolvency"). In any event, the economy, as well as the financial system that supports the economy, was in a downward spiral. From within the framework dictated by the Currency School, there did not appear any way out of the situation.

Fortunately — at least for the purposes of this survey and our understanding of the situation — Moulton was clearly not operating within the Currency School paradigm, but was basing his analysis on the principles of the Banking School. While still inadequate as the foundation on which to build a permanent and sustainable recovery — the work of Kelso and Adler was still twenty-some years in the future — Moulton's proposal was to finance increased production through the application of the real bills doctrine.

Financing new capital formation by creating money and repaying the loans out of future savings, rather than cutting current consumption and saving would free businesses from the necessity of using existing accumulations of savings to finance new capital formation. This would enable businesses to use the freed-up profits to increase wages, establish profit sharing, or, better, to reduce prices to consumers. Combined with technological advances, this would distribute and equalize income through price reductions, rather than by redistribution through the tax system or by increasing fixed wages and benefits. (See Moulton's analysis in Income and Economic Progress, Washington, DC: The Brookings Institution, 1935, 117-127.)

This does not take into account the insights of Kelso and Adler, and it failed to solve the collateralization problem (cf. The Capitalist Manifesto. New York: Random House, 1958, 233-236; The New Capitalists: A Proposal to Free Economic Growth from the Slavery of Savings. New York: Random House, 1961, 57-71), but that is not the point. The derailing of the Federal Reserve and the new orientation toward corporate finance virtually ensured that the measures taken would not be effective. Massive money creation was carried out, but the object was not to finance new capital formation. Instead, the effort was, in essence, to bail out already failed enterprises or those that had lost immense amounts of money by gambling it away during the financial euphoria of the 1920s.

This included not just presumably worthy recipients such as farmers who had been caught between the upper and nether millstones of a burden of debt obtained when money was "cheap," and falling prices for agricultural products caused by the tremendous increases in crop production, but companies that had gambled and lost on the stock market. Virtually everyone had been caught by the sudden decline in the speculative price of corporate shares. The market value per share was (and still is) frequently used to gauge the actual value of the underlying company. The drop in share values thus seriously affected the value of collateral that could be offered to secure a loan.

Policymakers and Federal Reserve authorities, painted into a corner by their assumption that capital formation can only be financed out of existing accumulations of savings, misidentified the problem. Consequently they did not develop a substitute for collateral, such as Kelso and Adler were to do in the next generation with the idea of capital credit insurance and reinsurance. Instead, all that could be done was to pump money into the system in the hope that it would somehow solve or, at least, alleviate the problem in some degree. As Moulton explained,
Government financial assistance had to be extended not only for the relief of debt-burdened farmers, but also to aid corporate debtors, including railroads, public utilities, industrial enterprises, and even financial institutions which had no corporate indebtedness. Moreover, the shrinkage of values was so great that regulations with respect to the valuation of the assets of insurance companies and banking institutions had to be relaxed lest wholesale insolvencies result. In effect, something approaching a general moratorium had become necessary. Attention has already been called, in chapter XXI, to the general unsoundness of a considerable part of the banking structure. The epidemic of failures in late 1932 and early 1933 in some of the larger cities disclosed a well-nigh hopeless situation, complicated in some cases by illegal, or at least highly irregular, uses of bank funds. (Financial Organization and the Economic System, op. cit., 408-409.)
Money was being created in unsound ways in an effort to restore the status quo. This was at the expense of money creation for productive purposes, thereby making the ultimate problem much worse than it otherwise would have been, and of which we are seeing the results today. Had it been clearly understood that money is a derivative of production and is not itself a product or commodity, such decisions would probably not have been made. Instead, there would have been some accommodation to the drop in effective demand for business loans by supplying adequate collateral in some form — possibly a government loan guarantee program along the lines of Kelso and Adler's capital credit insurance and reinsurance corporation proposal.

Something to insure the banks against reasonable loss would have been the proper course of action — if the authorities had understood the nature of money, credit, and banking. Instead, trapped by the assumptions of the Currency School and the presumed necessity of existing accumulations of savings to finance capital formation, efforts were directed toward making good the gambling losses that companies had sustained as a result of the Crash.

Redistribution through inflation, not money creation backed by the present value of existing and future marketable goods and services and adequately collateralized, was the order of the day. Whether money is created for current speculation, or to make good the losses incurred as a result of past speculation, the result — or, rather, the lack of result — is the same. The productive sector became starved for credit at a time when it needed it most, and economic inefficiency and speculation were rewarded, sometimes to a ridiculous degree. Just as today, banks and other financial institutions were unwilling to lend to businesses when those businesses did not have access to adequate collateral, and the financial institutions had to be concerned with their own financial wellbeing.

The Crash of 1929 did not directly cause the Great Depression. When the fall in share values was combined with the fixed idea that the value per share of a company on the secondary market accurately reflected the actual productive capacity of that company, however, and the value of other securities that a company might have held as a sinking fund, cash reserves, or working capital declined so drastically, a company had nothing with which to secure the loans necessary for additional capitalization. The decline in share values also ensured that a company would not be able to float any new equity issues.

While there were clearly other factors that contributed to the Great Depression and its severity, it was not the decline in share values per se that crippled the flow of funds into new capital formation, but the decline in the value of collateral and the instability of the value that remained. As credit dried up, the wheels of commerce ceased to turn, just as Charles Morrison had pointed out in 1854 in his Essay on the Relations Between Labour and Capital.

The problem was not that there was nothing that could be done, but that the one thing that could have been done to restore confidence — find an adequate substitute for collateral — was not even considered by economists and policymakers blinded by their devotion to the tenets of the Currency School and the changed understanding of money, credit, and banking derived from those principles.

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