Wednesday, March 24, 2010

Own the Fed, Part X: Recovery

"First of all, let me assert my firm belief that the only thing we have to fear is fear itself — nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory. I am convinced that you will again give that support to leadership in these critical days."

This passage from President Franklin Delano Roosevelt's First Inaugural Address is a concise statement of what FDR believed to be the chief problem facing the country — lack of confidence in the economy, in the financial system, but most of all in the country's leadership. As with Hjalmar Schacht, who was credited with stopping the hyperinflation in Germany ten years earlier, Roosevelt is widely believed to have been personally responsible for bringing the United States out of the Great Depression. Commentators assert that the confidence that both men exuded in their systems — Dr. Schacht with his new Rentenmark currency, and Roosevelt with the New Deal — was, in and of itself, sufficient to turn the situation around.

At first glance, this seems like a reasonable assumption. There was, however, a profound difference between the two men. Schacht's confidence came from basing his program on sound theory, a deep understanding of economics and the science of finance, and a practical grasp of the real bills doctrine, even though he operated within the framework of the socialist Weimar Republic. Schacht believed in his system. This inspired confidence in others and convinced them of the merits of his program. This allowed Schacht's efforts to be successful, despite the socialist economy in which it was implemented.

Roosevelt's success, on the other hand, was achieved in spite of, not because of the soundness of his economic and political reforms. Roosevelt believed not in his system, but in himself. This is reflected in his almost incomprehensible policy changes and sudden, even whimsical shifts in direction, to say nothing of the inherently unsound theory as well as practice embodied in the New Deal programs. His disregard of the traditional inviolability of contracts, of which the best example is the unilateral termination by the State of the “gold clause” in many agreements as a result of the gold surrender order, helped maintain the business community in a state of chaos.

The persistent report that FDR had an "enemies list," and the manner in which individuals and institutions were targeted for what can only be described as unfair and unjust treatment, not to say persecution, argues that Roosevelt operated on the basis of a personality cult, not out of genuine statesmanship, knowledge, or wisdom. We need only cite, e.g., the treatment accorded people like Andrew Mellon, Samuel Insull, and even "nobodies" like the Schechter brothers, kosher chicken processors singled out to provide an example to bring others into line, to substantiate FDR's basic orientation and approach to leadership. Amity Shlaes's book, The Forgotten Man: A New History of the Great Depression (New York: HarperCollins, 2007), presents — if you'll excuse the expression — a depressing but well-documented account of how these and others were punished for their presumed crimes against humanity and the president. To the end of his days, the late Senator Russell Long was convinced that Roosevelt was somehow materially involved in the assassination of his father, Huey Long.

The New Deal "worked" despite its basic unsoundness because most people either believed in Roosevelt, or saw no alternative to redistribution of existing wealth and increasing State control. Fascism by whatever name was the "right" political view to hold in the 1920s and 1930s. The leader principle appeared to work well in Germany, Italy, Spain, and Russia, so its benefits seemed obvious.

FDR, however, was not so much leading a revolution with the New Deal as taking advantage of a sea-change in popular attitudes toward leadership and the role of the State. These were attitudes and beliefs directly contrary to the respect for human dignity on which the United States was founded, as chronicled in Alexis de Tocqueville's Democracy in America (1835, 1840), to say nothing of the essential principles of natural moral law embedded in the Virginia Declaration of Rights (1776), the Declaration of Independence (1776), and the Constitution of the United States (1789)

This last became an extremely malleable tool for social change. This was accomplished with the implementation of the "living Constitution" theory that Roosevelt was instrumental in getting accepted through his packing of the United States Supreme Court, beginning with Justice Hugo Black in 1937. Black, a member of the KKK, in what dissenting Justice Francis Murphy described as "the ugly abyss of racism" into which the federal government had fallen under Roosevelt, validated the president's internment order that resulted in rounding up thousands of American citizens of Japanese birth or descent on the west coast in the Second World War. (Korematsu v. United States, 323 U.S. 214 (1944)).

Black, considered by some authorities to be one of the greatest jurists on the Supreme Court in the 20th century, if not the greatest, abrogated the Court's responsibility in the matter by declaring, "it is unnecessary for us to appraise the possible reasons which might have prompted the order to be used in the form it was." (Howard Ball, Hugo L. Black: Cold Steel Warrior. Oxford, UK: Oxford University Press, 2006, 113.) Black is also credited with inventing the concept of a "wall of separation" between Church and State as a way of denying state or federal aid to Catholic schools.

The term comes from Howard Lee McBain's book, The Living Constitution (New York: The Macmillan Company, 1937). Ironically, Louis Brandeis, targeted by Roosevelt for elimination due to his presumed obstructionism that allegedly inhibited the effectiveness of the New Deal programs, was one of the premier exponents of the theory, along with President Woodrow Wilson and Oliver Wendell Holmes, Jr., while Hugo Black was considered a "strict constructionist." The effect of the living Constitution theory was to vest the State with immense power, and grant it the ability, in the person of the Supreme Court, to create law without having to go through the Congress.

The bottom line was that with a strong and decisive leader in charge of a powerful State, people believed that all would be set aright and they would be well taken care of. Confidence in the leadership of a country was of paramount importance, regardless what that leadership might say or do. Confidence could make even fundamentally unsound economic and financial theories appear to work, and so embed them in economic orthodoxy. In this way the tenets of the Currency School had achieved the status of unquestioned doctrine. The belief that the State could and should do anything and everything for everybody was now working its way into the American subconscious and becoming a part of the mythos of America.

There is even a great deal of truth in believing in the power of confidence. We've made reference a number of times already to Charles Morrison's 1854 Essay on the Relations Between Labour and Capital, and Morrison's statements regarding the importance of confidence in the credit system. The power of confidence in our institutions even averted a disaster in 1920 when, as Moulton pointed out, it was not anything that the Federal Reserve did that staved off the crisis, but public confidence that the new central bank was being effective . . . despite the fact that the Federal Reserve didn't actually implement its proposed measures.

There was, however, a subtle difference between the Crisis of 1920 and the Great Depression. In 1920, public confidence was strong in American institutions, especially the new Federal Reserve System. The machinery seemed to be working. The central bank had just helped American win the war (a somewhat problematical belief in view of the fact that World War I was officially a "draw"), and had done so without burdening the American people with crushing taxes (another problematic belief, since taxpayers would eventually have to retire the debt one way or another). Consequently, when the Federal Reserve took decisive action — or, rather, announced that it planned to take decisive action — confidence in the private sector and the financial markets, especially banks and other financial institutions, was restored. The economy recovered at an astonishing rate, perhaps even too quickly, for good or ill ushering in the "Roaring Twenties."

Roosevelt's New Deal was not, however, driven by confidence in the system. It was fueled by personal faith in Roosevelt — the leader, seemingly viewed almost as a second Augustus, the man credited with restoring the Roman Res Publica single-handed . . . ushering in the direct personal rule by popularly supported Caesars of a world State, and the virtual disappearance of old Republican Rome.

New Deal programs worked not because they were based on good theory. They worked because Roosevelt was personally committed to see that they worked. FDR worked tirelessly to remove all obstacles, legal, cultural, and constitutional, to the success of his efforts. The principles, based on near-universal acceptance of the flawed principles of the Currency School that became embedded in Keynesian economics, were and remain seriously flawed. They constitute a rejection of the economic and political reality found in Say's Law of Markets and the real bills doctrine. It is not for nothing that Louis Kelso described his binary economics that integrates Say's Law and real bills into the theory as "the economics of reality." (Louis Kelso, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967.)

Not surprisingly, Kelso's work relies heavily on that of Harold G. Moulton, especially in Kelso's second collaboration with Aristotelian philosopher Mortimer J. Adler, The New Capitalists (New York: Random House, 1961), that has the provocative yet extremely significant subtitle, "A Proposal to Free Economic Growth from the Slavery of Savings." Milton Friedman once remarked that Kelso's theory is "Marx stood on its head." ("The Man Who Would Make Everybody Richer," Time magazine, June 29, 1970.) Perhaps more accurately, Kelso gave a lot of empty heads reason to reconsider their religious devotion to the principal dogma of the Currency School, the belief in the absolute necessity of existing accumulations of savings to finance capital formation.

From this assumption — shown to be false by Adam Smith (The Wealth of Nations, 1776), Henry Thornton (An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802), John Fullarton (On the Regulation of the Currencies of the Bank of England, 1845), and, especially, Dr. Harold Glenn Moulton (The Formation of Capital, 1935) — the adherents of the doctrines of the Currency School (whether or not they so described themselves) enshrined at least four serious flaws in "the system." There may be other flaws, even critical ones, but these are the fundamental errors that most affected Federal Reserve policy and its application in the New Deal:
1. Money and credit are commodities. (This is a rejection of Say's Law of Markets. According to Say's Law, money and credit are derivatives of production, drawn from the present value of existing and future marketable goods and services. Money and credit are not themselves a good, service, or a commodity.)

2. Interest rate and reserve requirement manipulation are effective, if indirect, tools of monetary policy. (This is a rejection of the real bills doctrine, which holds that creating money backed by the present value of existing and future marketable goods and services by discounting and open market operations involving qualified private sector commercial paper is an effective and direct tool of monetary policy.)

3. The goal of monetary policy is full employment of labor, achieved by redistributing existing accumulations of savings through inflation. (This is a rejection of the stated purpose of the Federal Reserve, given in the preamble of the Federal Reserve Act of 1913 as to provide an elastic currency sufficient to meet the needs of industry, commerce, and agriculture.)

4. Wages for labor, not dividends from owning the means of production, are the only way for most people to gain income. (This, too, is a rejection of Say's Law, which implicitly assumes that people gain income by producing a marketable good or service that they then trade for the productions of others through the media of money and credit.)
The New Deal therefore did nothing to correct the underlying problems in the financial system. Misunderstanding and misuse of the system continued to starve private sector businesses of needed credit. This had the result that more and more people began to look to the State as the savior, indeed, as the only source of assistance for individuals and families, or of making necessary changes in the system. As one State-worshipping enthusiast wrote as late as the 1990s, "the State is the sole intercessor available to the poor." (Rupert J. Ederer, "Solidaristic Economics," Fidelity magazine, July, 1994, 9-15.)

Worse, because popular confidence in and acceptance of Roosevelt's programs was such that the New Deal appeared to be working, the problems remained. The problems themselves became enshrined as accepted policy instead of being the target of corrective action. This was similar to the way disproved Malthusian doctrine and its reliance on past savings and false notions of scarcity became established as "economic orthodoxy" more than a century previously. (Joseph A. Schumpeter, History of Economic Analysis. New York: Oxford University Press, 1954, 578-582.)

Unfortunately, Kelso and Adler were not collaborating in the early 1930s, and Moulton was being ignored in preference to Keynes. Such was the political atmosphere of the time and the influence of Roosevelt's personality cult that — as we might expect — people looked to the State or, at least, increasingly concentrated power at the highest level to effect necessary changes. This meant, for monetary policy, the Federal Reserve System, even though it was dangerously crippled as an effective tool by its adoption of the tenets of the Currency School. Consequently, as Moulton related,
The inability of the Federal Reserve system to check the stock market speculation of 1928 and 1929 and to stem the tide of the business recession was attributed in considerable part to the lack of concentration of power in the Federal Reserve authorities in Washington. The original organization, in the interests of democratic control, had vested large powers in the Reserve banks themselves. For example, the twelve banks were authorized to engage in open market operations and to change discount rates on their own volition. Under this system the power — and indeed the prestige — of the Governor of the Federal Reserve Bank of New York became much greater than that of the members of the Board of Governors. (Financial Organization and the Economic System, op. cit., 409.)
With Roosevelt's program of centralization of power in Washington, the central bank was reorganized to give Federal Reserve officials in Washington direct control over the entire Federal Reserve System, and thus indirect control over the entire economy. Moulton listed five steps by means of which control was centralized and power concentrated:

One, the Board of Governors in Washington was given jurisdiction over the relationships between the individual Federal Reserve banks and all dealings with foreign banking institutions and their representatives. (Ibid., 410.)

Two, the regional Federal Reserve banks were prohibited from engaging in open market operations except as prescribed by the Board of Governors. Further, departing from the clear intent of the original 1913 Act, the goal of open market operations was not to supplement the rediscounting of qualified industrial, commercial, and agricultural paper and regulate the money supply directly through application of the real bills doctrine, but to buy and sell securities on the open market with an eye toward stabilizing the general credit situation through indirect action. (Ibid.)

Three, the regional Reserve banks continued to have the power to set their own discount rates . . . but this was subject to review every two weeks, or more often at the discretion of the Board of Governors. This transferred effective power over interest rates to the Board. (Ibid.)

Four, the Board of Governors was given the power to withhold supplies of notes from any regional Federal Reserve, and to "deny accommodation" (i.e., refuse to extend banking privileges) to member banks whenever the Board deemed such action necessary to maintain sound credit conditions. (Ibid.)

Five, the emasculation of the regional Federal Reserves was completed by giving the Board the power to modify reserve requirements of member banks. (Ibid.)

Of these measures, the second, relating to the restriction of open market operations, is possibly the most subtly damaging. Today we are accustomed to thinking of open market operations as applying exclusively to federal government securities as the primary mechanism by means of which the Federal Reserve monetizes government deficits and tries to control the money supply. Since this assumption is based on acceptance of the tenets of the Currency School, it is a vain hope, but that is not the point. Using open market operations as a means of attempting to stabilize the general credit situation shut off the only access that non-member banks and other issuers of commercial paper had to the money creation powers of the Federal Reserve.

Member banks have (in theory at least) access to the discount window, which is restricted to rediscounting primary issues of commercial banks that are members of the system. No such restriction applied to open market operations — the Federal Reserve was empowered to create money to purchase secondary issues — qualified paper out on the market that had been issued by any commercial bank, even directly by a business, whether or not the issuing institution was a member bank, or even a bank.

As should be obvious, all five of these measures demonstrate conclusively the change in Federal Reserve policy from a solid basis in Say's Law of Markets and the real bills doctrine, to trying to force application of the unrealistic and seriously flawed tenets of the Currency School onto the American economy. It also illustrates the paradox of demanding increasingly centralized yet indirect (and ineffectual) control of the economy in lieu of the decentralized yet direct regulation of the money supply that the system was designed and intended to implement.

Ironically, these measures also graphically demonstrate the fact that indirect control of the economy under the tenets of the Currency School wasn't even working. Instead of reexamining their assumptions, however, Federal Reserve authorities clearly believed that if something wasn't working, it is only necessary to try harder and throw more money at the problem. As Moulton analyzed the Board of Governors' actions,
In the light of this development, it appeared that the member banks would not, for an indefinite period, be in need of any accommodations from the Federal Reserve banks — and consequently the Federal Reserve banks could exercise no effective control through the medium of advancing discount rates. The fear was also expressed that the unrestricted expansion of loans by member banks would sooner or later lead to a very dangerous credit inflation. In any case, it seemed a wise policy to safeguard the situation by giving the Federal Reserve banks the power to change the reserve requirements. (Ibid., 410-411.)
We have made the point before, but it bears repeating. The Federal Reserve authorities could have restored and even improved the system by 1) returning to the original mission of the institution, 2) instituting a 100% reserve requirement, 3) imposing separation of function to improve systemic (as opposed to regulatory) internal controls, and 4) prohibiting dealing in government securities of any kind. Per the real bills doctrine and Say's Law of Markets, this would allow the commercial banking system in concert with the Federal Reserve to monetize not government debt, but private sector hard assets, thereby ensuring an elastic currency with a stable value, fully adequate for the demands placed on it.

Shackled by "the slavery of savings," however, what seems obvious in light of Kelso's breakthroughs simply does not appear to have occurred to either Roosevelt or the Federal Reserve authorities. Trapped by their assumptions, however, their only recourse was to the seriously flawed economics of John Maynard Keynes.


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