Monday, March 22, 2010

Own the Fed, Part VIII: The Crash of 1929

The close of business on Wall Street on Monday, October 21, 1929 marked the end of a day that bordered on the surreal. Margin calls had been heavy, but there was to be no respite on Tuesday. A large number of sell calls coming in overnight from Europe, combined with phoned in call loans of more than $150 million from out-of-town banks and corporations threw Wall Street into a complete panic before the exchange even opened for business on Tuesday morning.

Chaos continued to spread through Tuesday and Wednesday. Having since March become used to the roller-coaster activity on Wall Street (when there had been a "mini-crash"), many people still refused to give in to the obvious signs of a shakeup. Their resolve was wearing thin, however. Far too much was at stake, and things were beginning to change even faster than anything for which the previous six months had prepared them.

On Thursday, October 24, almost 13 million shares were traded, a record for the New York Stock Exchange. Demonstrating the speed with which things were moving and the magnitude of the situation, the prior record had been set on March 12, 1928, when just under four million shares changed hands.

Events were happening too fast, overcoming the communications system. Telephones gave permanent busy signals. Telegrams were not delivered. Stock tickers were running up to an hour and a half behind trades. The financial system itself was starting to collapse. Police had to be called in to quell a potential riot. Things slowed during the customary midday break, which calmed the panic. Rumors spread that there were plenty of bargains to be picked up after lunch.

Such was (and remains) the emotional basis of speculation, rooted in endless optimism that there was, in fact, almost a full recovery that afternoon, especially among the blue chips. By Friday morning, it seemed as if things had returned to normal. Bargains galore, resulting from forced sales to meet margin calls and sell orders from Thursday that hadn't been processed, brought some slight gains. A special Saturday emergency session brought the general price level almost back to what it had been on Thursday morning. Brokers asking their clients for instructions over the rest of the weekend were told to stand pat — the previous week had just been another example of the roller coaster ups and downs the market had been experiencing since March. Cash for margin calls was raised by every possible means. Others, more cautious, held back their money. They assumed that there would be another dip on Monday, and they could pick up bargains.

When the exchange opened on Monday, frantic trading began immediately. Prices plunged. Trades exceeded 9.25 million shares. Tuesday, sell orders flooded the exchange as speculators tried to cut their losses. Temporary help had to be hired, and every member of the exchange and employee was present. The Dow closed down 30%. Now came the hunt for the guilty.

Closest to the truth, some experts put the blame for the Crash on margin buying (purchasing shares on credit), short selling and other stock manipulation (as had caused the Panic of 1907), including insider trading — standard speculative techniques. In and of themselves these would not have caused the Crash (at least not of the same magnitude) — had not the banking and financial system been creating huge amounts of money to fuel the speculation. Not unexpectedly, others blamed a vast conspiracy by the Jews and other "international bankers," which phrase was a recognized code term for the Jews. Others had an even more interesting explanation. They declared that everything was due to employee ownership.

Companies had been buying and selling enormous blocks of shares for their employee stock funds to finance fixed benefit pension plans. This was not "employee ownership" by the workers of the companies for which they worked, of course. These were shares of other companies purchased on the secondary, that is, the speculative market, over which the workers had no control. To make matters worse, the stock funds were under the direct control of management, and a significant number of managers used the funds to engage in speculation. The managers misreported earnings and distorted the assets of the corporation in order to boost the value of the shares. The employees, for whose benefit the shares were purchased, had no say-so in the matter.

Naturally, this developed into the paradox that because management is dishonest, ordinary workers can't handle ownership. The issue of risk was also raised, the claim made that, because the secondary market is so risky, workers can't afford to put their savings into Wall Street in a diversified portfolio of investments — even though it was company funds, not worker savings that were put at risk. Paradoxically, many experts today cite the same reasons to support their contention that workers can't afford to invest in their own companies (essentially their own tools to generate income), and declare that only a diversified portfolio of shares purchased on the secondary market and run by management is acceptable.

Strangely — or perhaps not so strangely — no one seemed willing to consider the possibility that the violation of a fundamental precept of commercial and central banking theory might be the cause of the systemic failure. That is, one of the basic principles of the real bills doctrine and Say's Law of Markets was ignored as if it never existed in the first place: money cannot be created at will unless it is tied directly to the real and actual present value of existing or future marketable goods and services.

Virtually every financial panic in history has proceeded from setting aside or ignoring this principle, from the "Mississippi Bubble" blamed on John Law, to the recent sub-mortgage crisis. As Richard Hildreth explained in his History of Banks (1837), "It is now well understood, that the currency of any country, whether it be coin or bank-notes, cannot be increased beyond the mercantile wants of that country, without producing a depreciation in the parts which compose the currency." (Richard Hildreth, The History of Banks. Boston: Hilliard, Gray & Company, 1837, 17.)

Nor was the Crash of 1929 any different. As Moulton analyzed the situation, there were a number of direct causes of the disruption in the system that led to the Crash, but the chief indirect cause was creating money not directly linked to the present value of existing or future marketable goods and services. Of the nine causes of the Great Depression ("maladjustment") that preceded the Crash that Moulton lists in his book, The Recovery Problem in the United States (Washington, DC: The Brookings Institution, 1936, 24-26), every one of them can be directly attributed to rejecting or ignoring Say's Law of Markets and the real bills doctrine, and basing monetary and fiscal policy on the tenets of the mercantilist Currency School:

International trade and financial relations were fundamentally unbalanced, being supported for the time being by a continuous stream of funds from creditor to debtor nations.

This was money creation to support not production, but consumption. Mercantilism (the parent of the Currency School) holds that accumulating as many claims as possible against other countries in the form of money and debt instruments is the road to national prosperity. The ideal situation is one in which the home country produces and sells everything, and all other countries produce nothing, but purchase it from the home country. This makes all other countries colonies or dependents on the home country — a politically as well as financially unstable arrangement.

Under Say's Law of Markets — from which the real bills doctrine is derived — countries as well as individuals can only purchase something to the extent they have produced something. This renders the basic assumption of mercantilism (and thus the Currency School) fundamentally unsound. A country — or individual — that does not produce must either borrow money in order to make necessary or desired purchases of marketable goods and services, or be given those goods and services as charity. In either case, trade and financial relations become "fundamentally unbalanced," and can only be supported "by a continuous stream of funds from creditor to debtor."

The stabilized international exchanges were in many instances dependent solely upon the continuance of credits, particularly those of short duration.

With the change from true investment to speculation on the secondary market for debt and equity ("international exchanges"), it became essential that prices be kept up. Formerly, shares were valued according to the dividend rate paid, so the emphasis was on maintaining a sufficient level of production and thus of profitability out of which to pay dividends.

When the orientation changed to buying and selling shares based on the value per share instead of the dividend rate, profitability and production could be separated from the value per share. To assist the transfer of existing purchasing power instead of creating new purchasing power in the form of the production of marketable goods and services, new money had to be pumped continuously into the system in order to drive speculative demand, maintaining and in many cases increasing the prices of equity issues to levels that could not be sustained or justified by the projected profitability of the company that issued the shares. Directly contrary to Say's Law of Markets, increasing the money supply for speculative purposes presumably ensured that those who were gambling on the stock market could continue to make profits without actually having to produce anything to trade for the productions of others.

The reconstruction of plant and equipment in the old industrial countries of Europe and the fostering of manufacturing development in the new nations established at the end of the war were intensifying international competition and further stimulating the growth of trade barriers.

In another instance of mercantilism (although in this case possibly justified at least marginally), the new countries that were formed following the war were faced with the difficult task of transforming themselves from effective colonies and dependencies, into independent sovereign nations. Naturally this required building up industry . . . which led inevitably to the imposition of trade barriers to protect the infant industries from the more fully developed economies of the world.

This has two bad effects. One, there is always a tendency to keep protective measures in place long after their limited justification has expired. It is simply too profitable to whatever elite often benefits from the situation, as it establishes effective monopolies within a country by artificially limiting competition from outside.

Two, raising trade barriers leads to retaliation by other countries, which impose their own tariffs, quotas, and similar measures. Since two wrongs do not make a right, this only exacerbates the situation, causing both sides in a trade dispute to claim — with some justification — that they are being treated unfairly. This can escalate a trade war into a "real" war, as the justifications given by Japan for attacking the United States a decade later attest.

The recovery and expansion of world agricultural production had depressed the prices of basic farm products everywhere, and at the same time unsold stocks were steadily accumulating.

In what appears to be an example of Alfred Marshall's theories on elasticity of demand (the responsiveness of the quantity demanded of a good or service to a change in its price), changes in the prices of agricultural products were doing little or nothing to change demand. In Marshall's theories, changes in prices of some goods are said to be "inelastic" when changes in price do not significantly affect demand. People continue to purchase approximately the same amount no matter how high the price gets until they can no longer afford it, while lowering prices does not increase consumption. Food and water are believed to fall into the category of goods for which demand is inelastic.

After the war, agricultural production was booming. This drove down prices. At the same time, as Adam Smith pointed out, whether a man is poor or rich, his stomach holds the same amount. Demand did not increase. This caused inventories of agricultural products to expand rapidly, and the income of producers — farmers — to decline as they were not able to realize increased profits from increased production as would otherwise be the case.

The governments of many countries were burdened with domestic indebtedness, and in few cases were budgets safely in balance.

This is actually a refinement of Moulton's previous observation that there was a constant flow of funds from creditor nations to debtor nations. Instead of looking at the global economy as a whole, however, this applied specifically to governments within a national economy.

A country might have a positive trade balance or be in equilibrium (although Moulton observed that few, if any countries were in equilibrium at this time), but the government could be running at a deficit. Governments were spending more than they collected as taxes. This is dangerous both politically and economically, as Henry C. Adams had pointed out in the previous generation. (See Henry C. Adams, Public Debts: An Essay in the Science of Finance, 1898.)

The expansion of private credit, for both productive and consumptive purposes, had proceeded at a pace which could not be indefinitely maintained and which was storing up troubles for the future in meeting interest obligations.

A basic principle of finance is that all credit be extended in ways that optimize the possibility of the credit being repaid. Loans for consumption and speculation should be made only out of existing accumulations of savings. New money can — and should — be created for capital projects that are reasonably expected to produce sufficient marketable goods and services to repay the original loan that created the money as well as provide a sufficient return on top of that to the owner.

Unfortunately, not only was new money being created for speculative purposes by extending private credit, private consumption was being financed the same way. Even when money was being created properly in order to finance capital investment, the interest rates were such that the projects could not produce enough marketable goods and services to meet the debt service payments for the life of the loan.

In the United States the prolonged boom in the construction industry had served to replace deficiencies by surpluses, while the output of automobiles had reached a level difficult to maintain.

This is another example of the importance that financial feasibility plays in Say's Law of Markets and the real bills doctrine. The key to the principles that underpin the position of the Banking School is that, yes, production is essential to drive the economy . . . but the goods and services must be marketable. That is, whatever is produced, whether a good or a service, must be something for which, in a free and open market, there is sufficient demand.

Mistakes in estimating how much to produce in most manufactured goods and, especially, services, are easily corrected in general. If you make too many widgets in one quarter, you simply cut back production the next; if you don't manufacture enough to meet demand today, make more tomorrow.

Agricultural products and manufactured goods such as housing and automobiles, however, are not as rapidly self-adjusting as other goods and services. Most people can reasonably only use one house and, prior to recent decades when having multiple automobiles in a single family has become considered a necessity, one automobile was the norm — when you actually owned an automobile.

Moulton's observation was that the supply of housing and the manufacture of automobiles, like the surpluses of agricultural products, had rendered production unmarketable to a significant degree.

The distribution of income in the United States was becoming increasingly concentrated, and the flow of funds into consumptive channels was persistently inadequate to purchase at prevailing prices the full potential output of our productive establishments.

Moulton raised a point here that exposes the inherent contradiction in Keynesian economics, and which he expressed as "the economic dilemma." As he put it in The Formation of Capital,
The dilemma may be summarily stated as follows: In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption. . . . If an individual with an income of $2,000 elects to save $500 he reduces his potential consumption by one-fourth. Moreover, the aggregate of individuals who make up society must in a given time period restrict aggregate consumption if funds are to be provided, out of savings, for additional capital construction. (Harold Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 28.)
The bottom line is that, within the Keynesian framework, you need income generation to be extremely concentrated in order to provide financing for new capital investment — you cannot (at least according to Keynes) create money backed by the present value of existing or future marketable goods and services. Maldistribution of income is a given in the Keynesian system because only people who have far more income than they can spend can afford to save and therefore finance new capital.

The problem is that every dollar "saved" and reinvested is one dollar fewer spent on the goods and services to be produced by the new capital. This makes the new capital to that degree less financially feasible, that is, less marketable and thus less able to pay for itself.

The flow of savings and of bank credit into investment channels was excessive, producing an inflation of security prices and consequent financial instability.

Moulton would have been more correct to say that the flow of savings and bank credit into speculative channels was excessive. As he pointed out (above), capital projects that ordinarily should have been able to generate sufficient income to service the acquisition debt and provide an acceptable return on investment had, in many cases, been burdened with debt that, in effect, turned what would otherwise have been a sound investment into speculation.

The market plunge of October 1929 has been exceeded since, but the fact that speculation in securities was financed on credit using newly created money magnified what should have been nothing more than a moderate market readjustment into a catastrophe. The change from purchasing securities on credit that could be expected to pay for themselves out of future dividends and interest, to speculating in changes in the prices of securities (also purchased on credit) ensured the disruption of the entire financial system, by making it impossible for the securities purchased to pay for themselves.

Fueled by speculation, this resulted in increasing the instability of the system. The changeover from genuine investment to speculation as the primary activity on Wall Street was thereby reflected throughout the economy. The real, as opposed to the speculative present value of existing and future marketable goods and services was — even omitting the massive decrease in consumption that accompanied the Great Depression — insufficient to sustain the price level in the financial markets. Combined with all the other factors Moulton listed, the result was an extremely volatile situation just waiting for a trigger — a disaster waiting to happen.


1 comment:

Dawn Brohawn said...

Congratulations, Mike, on a profound and frightening analysis of the Crash of 1929 "from a Just Third Way perspective." We can see the whole vicious cycle of wrong uses of credit for speculation repeating itself today, only with much more devastating consequences.

Your mention of "employee ownership" (i.e., managers speculating with the funds of defined benefit pension plans in secondary shares of other companies) being blamed as one significant cause of the Crash, was ironic. As you pointed out, critics at that time placed the blame on "over-diversification", as opposed to critics today who fault mechanisms like the ESOP (which don't involve workers' savings or contributions) for being "under-diversified"in their own companies' shares. The problem shared by both approaches to "employee ownership" is where you have dis-empowered and under-informed workers who have little or no control over their own assets.

Most importantly, you draw an important connection between Kelso's binary economics, Say's Law of Markets and the real bills doctrine (how we balance supply and demand), by pointing out:

"the importance that financial feasibility plays in Say's Law of Markets and the real bills doctrine. The key to the principles that underpin the position of the Banking School is that, yes, production is essential to drive the economy . . . but the goods and services must be marketable. That is, whatever is produced, whether a good or a service, must be something for which, in a free and open market, there is sufficient demand."

The solution to avoiding a repeat of the Crash of '29 is production, but production financed in ways that result in broad-based effective demand -- incomes spent to purchase what is produced and not merely reinvested in new capital instruments by a small number of capital-owners who have already satisfied their consumption needs).

Thanks for this well-written essay that underscores the economic and moral necessity of a Capital Homestead Act to make "Every Citizen an Owner."