Wednesday, August 10, 2011

Panic in the Streets, Part III: It's Not the First Time

Yesterday's "performance" of the stock market — termed a "recovery" for no better reason than the yoyo was on its upward swing — may very well be the signal for more violent fluctuations to come, possibly culminating in a crash worse than that of 1929.

Why would we say such a thing? Hasn't the Federal Reserve once again saved the day by promising to keep interest rates low?

No. The Federal Reserve has not saved the day. Mister Trouble is still going to hang around.

The problem is that "easy money" has, in almost every case in America's history, been the signal for over-investment in new capital — investment that increases faster than consumer demand generated by production can keep up, spurring increased consumption on credit, expanded government, and wild speculation, triggering yet another financial panic and another depression — what we euphemistically today call a "recession."

The "Economic Dilemma"

The reason is simple, yet supremely difficult for anyone stuck in the past savings paradigm to understand. It's what Dr. Harold G. Moulton in The Formation of Capital (1935) called "the economic dilemma." Most simply put, no rational person invests in new capital formation unless he or she believes that there is sufficient effective demand for the marketable good or service he or she intends to produce.

If, however (as many people still believe), the only source of financing for new capital is existing accumulations of savings, and if the only way to accumulate savings is to reduce consumption, there won't be sufficient effective demand in the economy to justify investment in new capital! Thus, the economic dilemma is that you allegedly cannot finance new capital formation without cutting consumption, but if you reduce consumption, there is no reason to finance new capital.

Obviously, as Moulton observed, the demand for new capital is derived from consumer demand; consumer demand — effective demand, that is, meaning disposable income — leading in all cases. If for some reason consumer demand declines, demand for new capital falls in consequence.

The solution seems simple as well — at least within the past savings paradigm. If consumer demand leads in economic growth and development, then it is only necessary to redistribute purchasing power through inflation, the tax system, or some other mechanism, such as subsidized job creation. As Keynes posited in his General Theory, it is irrelevant how you redistribute purchasing power just as long as you don't add to the glut of unsold marketable goods and services in the economy that you hope to clear by increasing effective demand.

The problem with this solution, however, is that (as Jean-Baptiste Say observed in his Letters to Mr. Malthus, 1821), we do not really purchase what others produce with "money." Money is only the symbol of our property in the present value of what we ourselves have produced with our labor or capital. If we don't produce, we cannot consume. Yes, we may receive what we need as alms, welfare, or as a gift, but distribution on the basis of need is not the foundation of a sound economy. Income received as a result of redistribution discourages gainful employment and the production of marketable goods and services that must provide the basis for a sustainable recovery. (Harold G. Moulton, The Recovery Problem in the United States. Washington, DC: The Brookings Institution, 1936, 114.)

A just market economy demands, obviously, that we give value for value received. Multiplying units of currency or currency substitutes (such as demand deposits) by printing money, emitting bills of credit, or providing credit for consumption, speculation or government expenditures as Keynesian economics requires simply increases the amount of debt without at the same time increasing the means to satisfy that debt.

The Continental Currency

The long history of financial panics in the United States confirms these principles. This was evident even before the official formation of the United States on July 4, 1776. The issues of Continental Currency began in 1775 in an effort to finance the war, and continued through 1781. As one authority described the process,

"This continental currency consisted of bills of credit that were issued in anticipation of tax revenue from the states with which they might be redeemed. However, the tax collections were so few that people lost hope that the continentals could be exchanged for specie, and what was to be a temporary dependence on paper became permanent. As early as 1776, the continental bills began to decline in value, and by the end of 1779, a total of $241 million of these bills had been issued with their value set at about two cents on the dollar. In an attempt to halt the depreciation of the continental currency, the Congress adopted a resolution that became known as the forty-for-one funding measure in March 1780. It called for all old bills to be exchanged at forty paper dollars to one dollar in specie. As quickly as the old bills were returned, new bills were to be issued, valued at one dollar in specie. Though it failed to stop the depreciation, it reduced the national debt in terms of specie from $200 million to about $5 million. By 1781, paper currency had declined drastically in relation to gold and silver." (Edward S. Kaplan, The Bank of the United States and the American Economy. Westport, Connecticut: Greenwood Press, 1999, 3.)

In other words, Congress emitted bills of credit — created money — to finance government expenditures instead of financially feasible capital projects . . . of which State ownership would create even more problems. Congress thereby cheated all holders in due course of its currency and destroyed the faith and credit of the United States government even before the country came into being! Recent events almost fade into insignificance, at least from an extremely narrow and parochial perspective. We haven't (yet) reached the tragicomedy of debtors chasing creditors down the street in an effort to force repayment of debts with worthless currency.

The Panic of 1819

This is supposed to be a short blog posting, merely outlining the major financial panics that almost destroyed the United States. That being the case, we'll skip over minor upheavals and go straight to the Panic of 1819. Generally accepted major causes of the Panic of 1819 were inflationary credit policies to finance land speculation (the sale of land constituting the federal government's primary source of revenue), and a "sizable" unfavorable balance of trade, primarily with Great Britain — the deficits for 1815 and 1816 combined amounted to $125 million. (And a few "other factors" that would take up a few pages to explain.)

A real estate boom that peaked in 1818 resulted in large numbers of loans being made on little or no security. Overinvestment in public works and transportation infrastructure, while desperately needed, temporarily outstripped both demand and the ability of the tax base to support the expenditures.

When the Second Bank of the United States finally realized the dangers of easy money for infrastructure (e.g., "The Big Ditch" — the Wabash and Erie Canal, the central portion of which had its terminus in Evansville, Indiana, on the Ohio, not the Wabash . . .), non-productive expenditures (especially land speculation) or marginally productive capital projects, and began a policy of across-the-board credit contraction to cool down the economy, a financial panic ensued that affected an estimated third of the population, one way or another. (Kaplan, op. cit., 68-69.) The pattern of "boom and bust" now seemed a regular feature of the American economic scene.

"Hard Times"

An exception that might prove the rule that easy money for speculation, consumption and government expenditures causes depressions is "Hard Times," the depression of the 1830s. This was probably caused by the animus of one man, Andrew Jackson, who in a move that baffled both friends and enemies (he had made favorable comments about the Bank in his second inaugural address), suddenly decided to declare war on the Second Bank of the United States. Pouring gasoline on the fire, Nathaniel Biddle, president of the Bank, fearful that the charter wouldn't be renewed when its term was up in 1837, began campaigning against Jackson, using Bank funds to finance the effort to force a decision on the charter ahead of schedule. This infuriated Jackson and alienated former supporters of the Bank.

Jackson began "firing" his Secretaries of the Treasury in rapid order until he found one who agreed to remove federal funds from the Bank and redeposit the monies in other private banks owned by the president's friends, known as "pet banks" for that reason. This effectively shut down the Bank of the United States. (His first Secretary of the Treasury resigned when Jackson tried to force Washington society to accept a woman believed to be of questionable virtue.) The notorious political hack who carried out Jackson's order was later to gain lasting infamy as the Chief Justice of the U.S. Supreme Court who handed down the decision in the Dred Scott case: Roger Taney.

Jackson then declared war on all paper money, believing that only gold and silver were "real money." Unfortunately, there wasn't enough gold and silver in the United States to meet the daily transactions demand for money by consumers, to say nothing of the vast amount of non-consumer transactions that occurred. As we noted previously, Congressman George Tucker estimated in his 1839 book, The Theory of Money and Banks Investigated, that more than 95% of the money supply of the United States in the 1830s consisted of private sector bills of exchange, not gold and silver coin — of which there has never been enough to supply the country with money in any event.

No matter. Jackson issued the "Specie Circular" of 1836 that prohibited the federal government from accepting anything other than gold or silver coin in payment of land or taxes, and left it for Martin van Buren to implement. Both are thus believed to share equal blame for the depression that followed, as banks suspended convertibility of their notes into gold and silver in order to retain sufficient reserves and liquidity for transactions with the government. Trade ground to a halt, and banks and other institutions went bankrupt — including some of the states.

The Civil War

The financing of the Union effort during the Civil War might almost be called a comedy of errors if the effects had not been so devastating. Treasury Secretary Salmon P. Chase combined a naiveté about money, credit and banking with insatiable political ambition. He wanted to be president, and put his own portrait on the $1 United States Note ("greenback") to familiarize voters with his face. He ended up as Chief Justice of the U.S. Supreme Court, dissenting (for the wrong reasons) in the opinion in the Slaughterhouse Cases in 1873 that constitutional scholar William Crosskey characterized in Politics and the Constitution (1953) as the worst decision of the Court since Scott v. Sandford (60 U.S. 393; the Dred Scott case) in 1857, declaring that both those who supported the decision and the dissenting justices managed to get it wrong.

Chase decided it was more politically prudent (i.e., advantageous to his political career) to finance the war by borrowing rather than raising taxes. The major banks agreed to loan the federal government $150 million in gold, secured by three-year bonds bearing 7.3% interest. The bonds were to be redeemed with the proceeds of other bonds sold to the public for gold.

Congress had a few days previously authorized the deposit of federal funds in specie-paying banks, a move that probably influenced the willingness of the bankers to loan money to the federal government. The banks naturally assumed that this authorized them to use negotiable instruments, allowing them to keep the actual gold for the loan they had just agreed to make safely in their vaults to back the paper. After getting the bankers to agree to advance the $150 million, however, Chase declared that Congress intended no such thing, and that the loan proceeds would be handed over to the government in coin. The bankers were, as might be imagined, outraged at Chase's stunt, but complied in order not to harm the war effort.

It was not sufficient. Consequently, Congress authorized additional loans, especially non-interest bearing notes in denominations of less than $50. Naturally inflation set in, but Chase reassured the banks that he would issue no more such notes until all other resources (i.e., taxation) had been exhausted. The banks then began honoring the notes' convertibility into gold, further depleting reserves.

Unfortunately, Chase had lied. Almost immediately he began issuing notes directly from the Treasury again. Gold, silver, and even the new copper-nickel small cents disappeared from circulation, replaced with private token issues, postage stamps, fractional paper currency, and the inflated greenbacks. Inflation hit 600%. As one authority described the situation, "Secretary Chase made the fatal mistake at the outset of relying upon loans to supply the means of carrying on the war instead of appealing to the productive resources and the patriotism of the people." (Charles Conant, A History of Modern Banks of Issue. New York: G. P. Putnam's Sons, 1927, 403.)

It was not until 1863 that Chase realized something was wrong. The National Bank Act of 1863, modeled on the British Bank Charter Act of 1844, which was based on the Currency Principle, was hurried through Congress (and had to be amended a year later). Having put the country into debt up to its neck and beyond, Chase decided to switch to raising taxes to defray the cost of the war. Besides, the government's lines of credit were exhausted, and he didn't have any choice. As Conant observed,

"If [tax collections] could have been moved backwards a single year, the effect upon the credit of the government, the price of gold, and the depreciation of the legal tender paper would have been striking, even if the change had not made it unnecessary to depart from the metallic standard. It is probable that of the $6,844,571,431 computed as the cost of the war up to the resumption of specie payments in 1879, $2,000,000,000 could have been saved to the tax-payers and the public debt would no longer exist. Outside and beyond these considerations, moreover, was the injury done to depositors in savings banks and to other creditors by payment in a depreciated dollar, and the injury to laborers, whose wages were far from keeping pace with the advance in paper prices." (Ibid., 404.)

The Panic of 1873

Matters again came to a head in 1873 when a combination of events triggered a sharp decline in the price of silver. The British abandoned their effort to develop India, virtually eliminating the world market for silver and dumping enormous quantities of devalued metal on the market. The new German Empire demonetized silver. The U.S. Coinage Act of 1873 effectively demonetized silver in an effort to restore full parity of the currency with gold and stabilize prices to encourage trade with Europe and restore the faith and credit of the federal government. At the same time, a number of events had weakened the U.S. economy. The "Black Friday Panic" of 1869 had shaken confidence in the financial markets, while the Great Chicago Fire of 1871 and the equine influenza epidemic of 1872 had seriously shaken public confidence.

Meanwhile, railroad construction had exceeded current demand. This was due to the assumption that the rate of economic development would continue, and Europe and the eastern states would continue to provide a market for western beef and wheat, which was expected to make up for the loss of the silver market. When the decline in the price of silver combined with German Chancellor Otto von Bismarck's financial and political manipulation in a successful effort to weaken the Austro-Hungarian Empire caused business failures in Vienna, panic spread rapidly throughout Europe and then to the United States.

The actual panic began with the failure of a major U.S. bank, Jay Cooke & Company, which headed a consortium to finance the Northern Pacific Railway. This was followed by the failure of another bank, Henry Clewes, and then a wave of bank failures throughout the country. A quarter of the nation's railroads went bankrupt, nearly 20,000 businesses failed, and unemployment reached an estimated 14% by 1876. This inspired both the growth of the Populist movement and the rise of socialism as a significant factor in American politics.

The Panic of 1893

Economic development was again in full swing by 1880, fueled by Lincoln's 1862 Homestead Act. The belief that prosperity would continue unabated combined with speculation in railroad shares led once again to railroad construction in excess of existing market capacity. This in turn fueled general speculation as politicians, businessmen and the general public confused speculative gains in the secondary market for corporate securities, with gains realized from production of marketable goods and services.

Consumer demand began to diminish relative to the increase in productive capacity. This was largely due to the shift from small ownership to the wage system in the East, and a series of droughts that hit the West, reducing farm cash income at a critical time. This appeared to substantiate Frederick Jackson Turner's "Frontier Thesis" and Turner's claim that the end of free land meant the end of democracy. Populists began demanding unlimited coinage of silver to inflate the currency. "Free silver" would, it was believed, make more cash available for loans, raise farm prices, and enable farmers to repay loans with "cheap money."

The Philadelphia and Reading Railroad went bankrupt in February 1893. Spurred on by similarities of the current situation with that of 1873, concern about the soundness of the financial system spread rapidly. The Sherman Silver Purchase Act was repealed due to President Cleveland's belief that it was the cause of the crisis.

Runs on banks caused a further constriction in credit. Foreign investors began selling off American holdings, while domestically people redeemed silver certificates for gold until convertibility was suspended. Many companies had financed growth with bond issues bearing high rates of interest, and began to default on payments as corporate profits fell. Bond values fell sharply along with the price of silver.

The National Cordage Company went into receivership in September 1893, followed by the bankruptcies of three major railroads, an estimated 500 banks (mostly in the West), and more than 15,000 other companies. Unemployment was estimated at 15-20% at the height of what became known as "the Great Depression."

More? You Want More?

We could, of course, continue with the Panic of 1907, the post-war depression of 1920-1921, the Crash of 1929, the (second) Great Depression of the 1930s, and so on, but why? We've made our point. The recent financial fiascos are nothing new, and were caused in almost every case by expansion of credit to finance non-productive spending. It's a clear case of "Been there, done that."

What's new is the possibility for building a sound and lasting recovery based on the principles of binary economics found in the Just Third Way — and we'll get to that tomorrow.

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