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THE Global Justice Movement Website
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Monday, March 29, 2010

Own the Fed, Part XII: The Crisis of 1937 and the Second World War

As we have seen, the Great Depression confirmed that the general policy of the Federal Reserve System had changed from the original intent of the framers of the Federal Reserve Act of 1913. The policy of the central bank of the United States was now and remains based on the tenets of the Currency School. Despite assertions to the contrary that continue to this day (see, e.g., Tim Todd, The Balance of Power: The Political Fight for an Independent Central Bank, 1790-Present. Kansas City, MO: Public Affairs Department of the Federal Reserve Bank of Kansas City, 2009), the increasing degree of political control accompanying the New Deal removed the last effective remnants of the Federal Reserve's claim to independence.

The central bank's loss of what remained of its independence signaled the final shift in monetary policy away from the principles of the Banking School, principally Say's Law of Markets and the real bills doctrine, and made the Federal Reserve System to all intents and purposes an unaccountable branch of the federal government. Its mission was changed into serving political ends of the State, rather than economic and financial ends of the private sector. As Harold G. Moulton observed,
Under the new organization, as we have seen, the powers of the Board of Governors have been greatly expanded, thereby circumscribing the independence of action of the member banks; and at the same time the Board of Governors has been place more definitely under political control. This is accomplished through that provision of the law which makes the governor of the Board removable at the will of the President.

This shift is a reflection of the philosophy that not only is it a proper function of the Government to assume control over the entire credit system, but that only the Government can be depended upon to exercise such control in the interest of the public welfare as a whole. This conception appears to be the result of two factors — the failure of the former system of control to prevent financial crises, and the greatly increased importance of government fiscal and financial operations in the larger scheme of things. Whether the new alignment will be able to avoid the weaknesses disclosed in former periods of political control, time will demonstrate. As will be noted in the following chapter a similar trend is strongly in evidence in other countries. (Financial Organization and the Economic System, op. cit., 417.)
Whether the change in the understanding of money and credit under the Currency School resulted, as John Maynard Keynes asserted, from the growth of State authoritarianism (A Treatise on Money, Volume I: The Pure Theory of Money. New York: Harcourt, Brace and Company, 1930, 4), or whether State authoritarianism gained its foothold as a result of the change in the understanding of money and credit (while an issue of immense importance) is not our interest in this survey. Our concern is not why what happened, happened, but what happened, and, later, how best to correct the situation. Identification, pursuit, and punishment of ignorant individuals and groups guilty only of a lack of understanding and consequent egregious misuse of the system is not our concern, and is a waste of time in any event.

What happened has become increasingly clear as we examine the history of the Federal Reserve. By the time the Crisis of 1920 occurred, the Federal Reserve System had already undergone a major shift in direction. In order to finance the entry of the United States into the First World War without recourse to taxation, the federal government found a way to finance government operations through borrowing and money creation. This was in spite of the strenuous attempts that the framers of the Federal Reserve Act of 1913 made to prevent this very thing from happening, and the decades of misery caused by Salmon Chase's decision to finance the Union war effort in the Civil War the same way.

Almost immediately after the First World War, in 1920, money creation for speculative purposes threatened the health of the economy and the financial system. At that time, the simple announcement that the Federal Reserve was planning on raising the discount rate and reserve ratios to dampen down the "overheated" economy was enough to restore confidence and redirect money creation toward sound investment and away from speculation. Even though the Federal Reserve didn't actually do anything, the announced plan to manipulate the discount rate and reserve ratios gave the appearance that the Federal Reserve had effective tools at its command to control the economy. Confidence was restored and the economy returned to an apparently healthy condition.

The immediate cause of the Crash of 1929 was the creation of massive amounts of money for speculative purposes, principally the purchase and bidding up the price of unsound share issuances on the secondary market. The Federal Reserve attempted to reduce the loans made by commercial banks for speculative purposes (over which it had no real control) by taking punitive action against loans made by commercial banks for productive purposes — over which it did have control. Efforts by the Federal Reserve were completely ineffectual in reducing the loans made for speculative purposes and commercial banks avidly took up the slack. The only result of the Federal Reserve's action was to ensure that productive businesses assumed a burden of debt that they would be unable to service in the ordinary course of events.

Still under the illusion that it could control the money supply indirectly by controlling interest rates and manipulating reserve ratios instead of directly through applications of Say's Law of Markets and the real bills doctrine, the Federal Reserve attempted to stimulate the revival of business following the Crash of 1929 by — as we might expect — controlling interest rates and manipulating reserve ratios. This had, to all appearances, been successful in averting a serious business downturn in the Crisis of 1920, although closer examination of the situation would have revealed that the policy had not actually been implemented. Consequently, the presumably effective yet untested techniques were applied following the Crash, but with disastrous results. Banks stopped lending, and the economy went into a tailspin.

Federal Reserve authorities clearly believed that money and credit would behave in the same manner as a commodity or any other marketable good or service. The Federal Reserve therefore continued to act contrary to the true nature of money and credit, and lowered the discount rate in order to stimulate the economy. Since the problem was not the "price" of money, but the fact that businesses lacked sufficient or adequate collateral to qualify for loans, banks could not justify making loans to business. Consequently, loans were not made.

To explain the failure of banks to make loans, Keynesian economics asserted that the economy was in a "liquidity trap" due to the infinite elasticity of money. The problem with the Keynesian explanation is that money is not a marketable good or service. Money is a derivative of marketable goods and services, dependent on the present value of existing and future marketable goods and services for its legitimacy. Accordingly, the laws of supply and demand do not apply directly to money and credit.

Even given the ineffective remedies implemented by the Federal Reserve to stimulate business combined with the apparent anti-business orientation of much of the New Deal, by the mid-1930s the country was beginning to recover, at least slowly. The Dow Jones Industrial Average would nearly quadruple by August of 1937, although unemployment remained at high, almost intolerable levels, given the potential of America to produce in quantities sufficient both to meet demand and to provide jobs for anybody that wanted one. (See Harold Moulton, America's Capacity to Produce. Washington, DC: The Brookings Institutions, 1934; Harold Moulton, America's Capacity to Consume. Washington, DC: The Brookings Institution, 1934; Harold Moulton, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940.)

Policymakers and Federal Reserve authorities were, however, still unable either to distinguish between good and bad uses of credit, or develop and implement an effective means of curbing speculative money creation without harming the genuinely productive sector. As a result, Moulton observed that, "Business and financial trends since the reorganization of the Reserve system have afforded opportunity to test the new process of control through a period of expansion culminating in a new depression." (Financial Organization and the Economic System, op. cit., 411.) Language of this sort was a departure from Moulton's usual extremely diplomatic phrasing. It puts the blame for the "new depression" squarely on the shoulders of the inept new policies implemented by the Federal Reserve authorities at the behest of New Deal politicians — which is where it clearly belonged.

Specifically, concerned that the economy was growing faster than was warranted — or (more accurately) that it might grow faster than it should, Federal Reserve authorities began applying brakes to the economy by increasing reserve ratios. The Treasury cooperated by implementing a policy designed to inhibit or prevent additional acquisition of gold to use as reserves, a process that became known as "gold sterilization." (Financial Organization and the Economic System, op. cit., 412.) As Moulton commented, "The Treasury and Federal Reserve measures taken together largely eliminated the basis of potential credit expansion." [Emphasis in original.] (Ibid., 413.)

In other words, because the people in authority who fancied themselves in charge of the economy decided that economic growth might become (in today's terminology) "overheated," they ensured that many of the gains that had recently been achieved against almost insurmountable odds were wiped out. Amity Shlaes blames the undistributed profits tax for the sudden downturn, although it is evident that, like the speculative frenzy that preceded the Crash of 1929, the undistributed profits tax was only the trigger that exposed and took advantage of serious weaknesses in the system. As she comments in her "New History of the Great Depression," exhibiting her own adherence to chief tenet of the Currency School (that existing accumulations of savings are essential to new capital formation),
The same day that it reported Mellon's death, the New York Times carried a story on the consequences of the undistributed profits tax. Companies that had formerly sought to retain employees through downturns now no longer had the reserves to do so. They had likewise ceased to invest in new equipment, normally a traditional move in slow periods. The headline on the story was: "Levy on Profits Halts Expansion." What would happen to the meager recovery? Stocks had begun dropping in mid-August. Now they accelerated their decline. . . . By the next Monday the worriers had their answer. Bond prices plummeted farther than they had on any single day in three years. Businesses and investors did not want to buy money anymore because they did not want to use it. . . . As for stock shares, they were down between $2 and $15, the greatest drop in six years. In recent times, before this panic, the market had been "thin" — relatively few shares had traded, at least when compared with pre-Depression days. This panic, though, was so broad and trading so furious that the ticker closed seventeen minutes late. The traders were finally awakening, just as everyone had hoped they would. But they were awakening only to run. (The Forgotten Man: A New History of the Great Depression, op. cit., 334-335.)
The weaknesses in this analysis are immediately evident to anyone familiar with the principles of binary economics, especially as detailed in The New Capitalists: A Proposal to Free Economic Growth from the Slavery of Savings (op. cit.), but that is not the point. What is clear is that government policy and the move toward economic central planning, to say nothing of the not-unexpected results of basing a recovery of confidence in the economy not on the strength of the system itself, but in the admittedly strong personality of FDR, had a result that should have been anticipated.

Ignoring the natural law basis for the principles of the Banking School, notably Say's Law of Markets and the real bills doctrine, could only lead to disaster — and it did. As Horace reminded us, "You can chase Nature out with a pitchfork, but she always comes back." (Naturam expelles furca, tamen usque recurret. Epistulae I.x.24) You cannot separate money — a derivative of production — from the production from which it naturally derives without undermining the stability of the system that relies (as does every economy) on production, not on redistributing what exists, whether marketable goods and services, or claims on marketable goods and services in the form of money.

The only thing worse is separating currency — a derivative of money — from production, and allowing the State to manipulate the "money" supply (narrowly defined) at will for dubious political ends. Perhaps not unexpectedly, to offset the correction, the Federal Reserve decided to reverse its policy, and institute a policy of "easy" credit. Of course, the problem remained: an inability or refusal to differentiate between "bad" uses of credit (speculation, consumption, and government spending), and "good" uses of credit: financing financially feasible new capital formation. The result was only to be expected. As Moulton explained,
In the spring of 1938 it was deemed wise to ease the reserve position again in the hope of promoting a new credit expansion. Hence, on April 14, 1938, reserve requirements were reduced to 12, 17 1/2, and 22 3/4, per cent respectively for the three classes of member banks.

That these policies did not prove effective in controlling the general business situation is all too evident. Since the spring of 1937 we have had a stock market collapse and an acute business depression. As may be observed by referring again to the movement of stock prices in the chart on page 226, and to the general trend of business as shown in the chart on page 342. The current fluctuations have been quite as sharp as those of former times. The inability of the Board of Governors of the Federal Reserve system to control the business situation is simply evidence that many of the forces, which account for business fluctuations, lie beyond the control of monetary policy. (Financial Organization and the Economic System, op. cit., 416.)
It would be more accurate to say that "the inability of the Board of Governors of the Federal Reserve system to control the business situation" lies "beyond the control of monetary policy" — as currently understood. Again, this is an important point that is frequently overlooked. Federal Reserve policy, as well as virtually all academic economics and government policy, is predicated on the assumption that the disproved principles of the Currency School are, in fact, as absolute and unquestioned as any religious dogma. Aside from the obvious problems that result from attempting to base a matter of science on faith rather than reason, the fact remains that, try as you will, you will never get an acceptable result from your efforts if you insist on going contrary to reality.

Keynes, in his famed chiding "open letter" to Roosevelt in the New York Times of December 31, 1933 had attempted to convince the president that all would be well if only FDR would engage in greater redistribution through inflation, which Keynes claimed is not real inflation until full employment is reached: "When full employment is reached, any attempt to increase investment still further will set up a tendency in money-prices to rise without limit, irrespective of the marginal propensity to consume; i.e. we shall have reached a state of true inflation. Up to this point, however, rising prices will be associated with an increasing aggregate real income." (The General Theory of Employment, Interest, and Money, 1936, III.ii; see also V.21.v.) Since many economists define inflation as "rising prices," while others define it as any increase in the money supply, with or without an increase in the price level, we conclude that these different definitions are useful only insofar as they demonstrate a significant problem with basing economic analysis or (worse) government monetary and fiscal policy on the tenets of the Currency School.

Keynes's definition of "true inflation" is extremely valuable in one respect. We can blame Keynes quite properly for validating the New Deal and justifying increasing State intrusion into the economy, but he was not personally responsible for implementing his theories, whether in whole or in part. The blame for that must rest squarely on the shoulders of the politicians who first began using the central bank and distorting its mission to increase the power of the State. When the decision was made to finance yet another war by borrowing, Keynes objected strenuously.

Consistent with his theory that "true inflation" was only possible once full employment had been reached, Keynes was adamant that the United States should have financed its entry into the Second World War solely by increasing taxes (How to Pay for the War, 1940). According to Keynes, this would have prevented "true inflation," the buildup of unnecessary debt (already greatly enlarged as a result of the New Deal), and the imposition of rationing or wage and price controls. "Excess" income would have been taxed away, preventing an increase in the price level — rationing to prevent inflation is unnecessary if people don't have the money to spend and bid up prices.

As many writers have observed, increased spending by the government on New Deal programs did not get the United States out of the "mini-depression" of the mid-1930s. Instead, it was the increased demand for war production that created conditions of full employment.

Whatever actually brought about the full employment of the Second World War, the decision to finance America's entry into the conflict through borrowing rather than taxation was purely political. In this, the Congress simply followed the precedent established by Salmon P. Chase, Lincoln's Secretary of the Treasury, who sought to use his position to lever himself into the presidency (even to the extent of putting his own face on the $1 note to familiarize people with his appearance). The First World War provided a more efficient mechanism for funding government debt, one that (as we have seen) has become established as the normal mode of operation of most of the world's central banks and the means by which the State attempts to assert control over the economy, with increasingly disastrous results, as recent events have shown.

While Eisenhower warned of the dangers of "the military-industrial complex," Ike should rather have directed the attention of the people to the real and present danger inherent in the financial-political complex, the subversion of the financial system to serve the ends of the State rather than the needs of the private sector, as Henry C. Adams pointed out in his 1898 Public Debts: An Essay in the Science of Finance. As Moulton summed up his discussion in 1938 of the evolution of the Federal Reserve System up to that time,
In concluding this discussion of the Federal Reserve system attention should be called to a point of view embodied in the new legislation, which marks a profound departure from the conception that had prevailed during the long period from the Civil War to 1933. As a result of the experience of the early nineteenth century in connection with the First and Second national banks and in the light of banking history in other countries, the opinion had crystallized that an efficient monetary and banking system, responsive to the requirements of business, necessitated detachment from political control. This conviction was responsible for the Independent Treasury system; for the segregation of the monetary from the fiscal functions of the Government in the Currency Act of 1900; for vesting in the National Banking system the power to issue notes; and for the democratic organization of the Federal Reserve system and the independent political position accorded the members of the governing board. While the Secretary of the Treasury was ex officio a member of the Board, the view prevailed that the Treasury should not be permitted to dominate Reserve policies in the interests of government fiscal requirements. (Financial Organization of the Economic System, op. cit., 416-417.)
We can argue whether the Great Depression or the Second World War were avoidable. Doubtless there is a great deal that could have been done to prevent either from happening or to ameliorate the scope of the disasters. What this survey has shown, however, is that, regardless whether the lack of a Just Third Way understanding of and approach to economic problems could have prevented them from happening (certainly true in the case of the Great Depression, and possibly true with respect to the Second World War), how recovery was financed in the first case, and victory in the second case had serious repercussions that have continued to haunt us down to the present day.