Banks and the Stock Market, I: The Stock Market

If you’ve been reading this blog over the past couple of weeks, you might start wondering if the financial system has any relevance to the real world at all — and we couldn’t blame you.  After all, as Adam Smith pointed out in The Wealth of Nations over two hundred years ago, the basic postulate of economics is “Consumption is the sole end and purpose of all production.”  Wall Street seems geared toward making money as an end in itself, not as a tool to facilitate production or consumption.

Hedging Your Bets

When we were taking principles of investment finance in college (centuries ago), we learned various ways of valuing shares on the stock market.  Mostly this was because (as we were taught) the easiest way to buy a company is to purchase its shares on the secondary market.  (It’s not.  The 100% S-Corp ESOP is, under current law, the best way, but it doesn’t apply to anyone who doesn’t work in that particular company. . . .)

The Coming Crash

A short time ago someone referred us to a video about the upcoming financial crash (which, truth to tell, we rather expect ourselves unless Capital Homesteading is adopted soon). The problem is that there was just enough truth in the video to be misleading. Two things in particular undermined the credibility of the presentation:

1. They used the wrong definition of money. Kelso described it very well in Two-Factor Theory as a mere symbol, but it can be summarized even better by giving the legal and accounting definition: anything that can be accepted in settlement of a debt. The video commentators were using the standard Keynesian-Monetarist-Austrian understanding, which is 180 degrees from Kelso.

2. They were correct that in 1929 the private sector was creating money at a tremendous rate for speculation, and at a lesser, but still rapid rate for investment in new capital formation, while today the government is creating money at an even more tremendous rate for non-productive spending. The commentators made no distinction between good uses of credit, and bad uses of credit, however. They made it sound as if all credit is bad, per se, and all that is needed is to stimulate consumption.

The main difference between 1929 and the situation today is that money creation for both productive and non-productive purposes was going hand-in-hand. In the productive sector of the economy, this resulted in a temporary over-capacity, just as it had in 1873 and 1893. Had ownership of the new capital been widespread as Kelso advocated, there would have been no problem, as the expansion of productive capacity and the ability to consume would have grown at the same rate, and the Panics of 1873 and 1893 would likely never have happened, and the video's concern about the drop in consumption from 50 to death would not even be an issue.

Today, however, there is no expansion of productive capacity; demand is drying up as people lose their jobs and do not replace labor income with capital income. Instead, what demand there is comes from inflationary government spending and private sector money creation through expansion of consumer credit.

In 1929 after the Crash, banks stopped lending because the equity shares many businesses were using as collateral, and the market value of the businesses themselves (and thus their creditworthiness) had declined drastically. Again, Kelso's idea of capital credit insurance to replace traditional collateral would have prevented the slowdown in lending that led to the (second) Great Depression. Had not bank lending declined, there would have been no Great Depression simply because there was no other connection between the productive sector and the secondary market for equity.

Today's situation is more akin to what precipitated the Panic of 1825 than the Crash of 1929. In 1825 there was widespread speculation (they called it "investment," of course) in what is today known as "sovereign debt." As a result of new theories of money and credit and national sovereignty, private sector money (bills of exchange) was no longer considered money, only gold, silver, and government-emitted bills of credit. The money supply had become disconnected from the productive sector.

The new republics in Central and South America, including one fictional country, the "Republic of Poyais" ("The greatest fraud in history"), floated large amounts of sovereign debt to get their governments up and running. Since these debt issues were backed by tax bases that no longer existed in most cases, the crash was probably inevitable, and the Panic of 1825 is considered the start of the modern business cycle.

From a Kelsonian perspective, of course, there is no reason there should even be a "business cycle"; it is the result of separating money creation from production and allowing governments to monetize their deficits. The so-called Keynesian counter-cyclical approach is thus a contrived solution to an artificial (man-made) problem, and has the effect of pouring gasoline on the fire.

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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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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.

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Own the Fed, Part VI: The Roaring Twenties

The actions of the Federal Reserve in averting the Crisis of 1920, while ineffective, signaled a profound change in the policy of the central bank as well as in how the government and even private business viewed the institution and understood the role it was supposed to play in the economy. Based on a different definition of money and combined with the actions of Henry Ford and the theories of John Maynard Keynes and the effect they had on the understanding of private property, investment, and finance, the changing perception of the mission of the central bank virtually ensured that the original purposes for which the Federal Reserve had been established — to furnish an elastic currency and afford means of rediscounting commercial paper — would eventually be set aside in accordance with the mercantilist belief that only existing accumulations of savings can be used to finance new capital formation.

To recap briefly, under the tenets of the Currency School — and thus Keynesian, Monetarist, and Austrian economics — the State alone has the right to define and create money. “Money” ceases to be anything that can be used in settlement of a debt, and becomes whatever the State says it is. This makes access to capital credit a political, rather than an economic decision, and turns money and credit into a commodity, strictly limited in amount, and controlled by a small elite. Increasing or decreasing the number of units of the currency, regardless whether it is for productive or non-productive purposes, automatically changes the price level.

To what degree and in what manner changes in the volume of currency affects the price level is a matter of acrimonious debate among the Keynesians, Monetarists, and Austrians. All agree, however, with the basic principle and with the underlying assumption that only existing accumulations of savings can be used to finance capital formation. The change in the price level compensates for the “spreading out” or concentration of the value of the accumulated savings that back the currency, and which the State can eventually tax to make good on the promise it made when issuing the currency.

Consistent with Fisher’s claim that issuing money necessarily implies a property right (Irving Fisher, The Purchasing Power of Money. New York: Macmillan, 1931, 4.), assuming that the general wealth of the economy backs the money supply implicitly assumes that the State has ultimate ownership of everything, just as Hobbes asserted in Leviathan. (If the States creates all money, and “the general wealth of the economy” backs the money supply, the State effectively claims ownership of the general wealth of the economy and thereby abolishes private property.) Added to the accomplishments of Ford and Keynes, this understanding of money virtually guaranteed that most people would never own a significant capital stake, and be forced to rely on wages and welfare for the bulk of their consumption incomes.

There was, however, another important change that Ford and Keynes managed to bring about. This was the change in how people viewed investment in corporate equity. Traditionally, a business would decide whether to finance growth and expansion out of debt, that is, by borrowing, or by equity, that is, by bringing in new owners. For a business enterprise, the downside to debt financing is that the lender assumes fewer risks than an investor. The lender passes the risk off to the owners in the form of fixed interest rates and principal payments. Whether or not a business makes money, the lender must be paid the agreed-upon interest rate and is also due return of the loan principal. The downside to equity financing is that, under traditional rights of property, the old owner must share control and enjoyment of the fruits of ownership (the income) with the new owner(s).

Between the two of them, Ford and Keynes changed the parameters of the decision. Lenders were still due the agreed-upon interest and return of the principal. Equity owners, however, if they owned less than a controlling block, were now effectively denied the right to do anything except sell their shares in the hope of realizing one-time capital gains instead of long-term dividend income. It is not by accident that Ford Motor Company equity is divided into "Class A Common" carrying a single vote per share, and "Class B Common" carrying multiple votes per share, and that the Ford family owns Class B, while ordinary shareholders — now in the majority — own Class A. Consequently, as Dr. Harold Moulton noted,

The proportion of industrial capital raised through stock sales increased rapidly during the twenties at a time when the stability of industrial enterprise was increasing. The great argument in favor of stock issues is that greater flexibility is permitted in adjusting disbursements of income in the light of changing business conditions. (Financial Organization and the Economic System, op. cit., 149.)

In other words, at a time when conditions were stable for industry — which ordinarily would have swayed businesses in favor of fixed cost debt financing — Dodge v. Ford Motor Company, supported by Keynes's economic theories, removed the necessity of sharing control and paying dividends from equity financing. This eliminated the downside of equity financing, and accelerated the concentration of control, if not actual ownership, of the means of production in fewer and fewer hands. (See, e.g., the comments in Quadragesimo Anno, § 105.)

Adding to the popularity of using equity rather than debt to finance capital expansion was the fact that the whole understanding of and orientation toward investment had changed. Instead of purchasing primary equity issues to receive the anticipated future stream of dividends in perpetuity, the investor would buy and sell secondary equity issues on the exchanges to receive a one-time capital gain. That is, investment strategy shifted from investment proper, to speculation. Wall Street, a secondary market for corporate debt and equity — and thus the primary means of carrying out speculative activity instead of true investment — increased enormously in importance in the public consciousness.

This confusion of investment and speculation, combined with a fundamental misunderstanding of interest, had been building up for for some, as exhibited in the great debate over usury in the 16th and 17th centuries. For hundreds of years, "high finance" had been the exclusive pursuit of the rich and of governments. When ordinary people financed anything, it was usually limited to borrowing out of necessity to meet consumption needs, or to finance the acquisition of a farm or small shop. It was not until the 1920s that ordinary people began dealing in corporate equity. Even then, it was not to secure ownership of a capital stake sufficient to supplement and, eventually replace income from labor, but to imitate the wealthy and engage in speculation. "Playing the market" was, and continues to be seen as a way of duplicating the presumed ability of governments and the wealthy elite to get something for nothing and avoid genuine productive activity, i.e., "work."

In consequence, a problem that had afflicted only individuals and governments unwise enough to try and finance consumption through recourse to unproductive borrowing pervaded the financial system. This can be attributed to the almost religious adherence to the tenets of the British Currency School, especially as developed in the economic theories of John Maynard Keynes and the financial practices of Henry Ford, and their adamantine belief — contradicted by the facts and the financial history of the Industrial Revolution — that only existing accumulations of savings can be used to finance new capital formation. The global financial system had become, in the pithy expression of G. K. Chesterton, "the utopia of the usurers." The understanding, even basic definitions of dividends and interest had changed dramatically.

Ethically there is no difference between profit sharing in the form of interest, and profit sharing in the form of dividends. Legally, "dividends" are paid to holders of title, that is, to equity owners, while "interest" is paid to a lender of savings. "Usury" is the taking of interest on a loan of money that financed a project that did not generate a profit; all usury is interest, but not all interest is usury.

These definitions, while more or less adequate, are incomplete. As late as the closing decades of the 19th century, some economists were still using interest to mean the return to an owner. Derived from "ownership interest," profits and interest were generally interchangeable terms. The "rate of interest" as Adam Smith and other 18th century economists used the term is more accurately understood today as "return on investment." "Interest," "dividends," and "usury" were all different terms for various classifications of "profit," as attested to in the title of a document issued by Pope Benedict XIV in 1745, Vix Pervenit, "On Usury and Other Dishonest Profit."

As the tenets of the Currency School gained acceptance, however, definitions changed. "Interest" changed from being construed as profit sharing, to the "rent," "price," or "cost" of money. This is a philosophically untenable definition, but very useful within a paradigm with a limited understanding of money and credit — and very damaging to any effort to gain a better understanding of banking and finance. The change in definition shifted interest from a sharing of profits due to the owner of savings by right of private property, to a cost of supplying money, whatever its origin.

To explain, when interest was understood as profit sharing, the lender or whoever provided the savings, was due a pro rata share of total profits generated by a project, based on the relative contribution of the savings to the productive process. When a "projector" (one who initiates and carries out a project, analogous to today's "entrepreneur") borrowed someone's existing accumulation of savings, the amount of ownership interest due to the lender was based on supply and demand — how much the borrower was willing to share of the profits compared to how much the lender desired to take, based on the anticipated profitability of the project, the risk involved, and other factors. Within a free market, the rate of interest due to a lender tended to approximate the actual value of the lender's contribution to production.

When in the 18th century commercial banks began creating money, the perception of interest started to change. Originally justified as a legitimate share of profits of productive enterprise, interest was now understood as the cost of supplying money. The same rate was therefore interest charged — not profits shared — for the use of money, whether it came out of existing accumulations of savings, or had been created by a bank or other financial institution.

Ethically, of course, this was wrong, although we need not go into the lengthy arguments employed by Aristotelian and Scholastic philosophers here. A lender of existing accumulations of savings is due a share of profits by right of private property. A creator of money that does not derive from existing accumulations of savings is due a fee for the trouble he or she takes to create the money, and a "risk premium" to compensate for the risk that the borrower will default. There are, however, no existing savings on which to base a sharing of the profits of the enterprise. The "lender" of newly created money is not due any interest, there being no prior "ownership interest."

Thus, most interest now tended to be usurious in nature, if not, strictly speaking, usury. Very little new capital formation tends to be financed out of existing accumulations of savings. Savings — retained earnings — are used more often for collateral than for direct investment. Commercial banks create the money for most capital investment, and are due a fee for the service and a risk premium, but not interest.

With the reign of the Currency School secured by the rise of Keynes and his economic theories, however, especially Keynes's insistence even in the face of massive evidence to the contrary that existing accumulations of savings are essential to new capital formation, the way to supply the economy with money is to manipulate the rate of interest, and to inflate or deflate the currency to transfer purchasing power through "forced savings." (In the Keynesian lexicon, "forced savings" refers to the transfer of purchasing power that results from inflating the currency, thereby driving up prices for consumers who then pay producers more for the same amount of goods and services.)

The Keynesian technique is to lower the rate of interest in order to lure businesses into undertaking new investment, and raise the rate to discourage new investment. (Keynesian monetary policy ignores the paradox that if savings equals investment, as Keynes insisted, then there can be no new investment without liquidating old investment.) There is no question of commercial banks creating money directly for new investment through discounting, and rediscounting at the central bank through the operation of the real bills doctrine. Keynes rejected the real bills doctrine and Say's Law of Markets — they undermined his theories, and were therefore impossible.

Bank credit was now viewed as a commodity, and interest as the price of the commodity. (Financial Organization and the Economic System, op. cit., 402.) That being the case, the cost of credit had to be the same (although the rate must be subject to manipulation by the State or the central bank), whether based on existing accumulations of savings, or created out of the creditworthiness of a borrower and the present value of existing or future marketable goods and services belonging to the borrower.

Taking the change in the definition of interest into consideration, we can begin to understand the dramatic shift in the mission of the Federal Reserve in the 1920s, and start to grasp the otherwise incomprehensible "hijacking" of the institution. We have already seen that the Federal Reserve was abandoning the direct creation of money for qualified industrial, commercial, and agricultural purposes with its plan to manipulate the discount rate in response to the Crisis of 1920. It had already violated a fundamental principle of central banking by allowing itself to be used to monetize government deficits to finance the war. An institution founded principally on the tenets of the Banking School — the real bills doctrine and Say's Law of Markets — was being used to implement applications of the tenets of the Currency School: that money is a special creation of the State, and interest is the cost of money, not a share of profits.

Federal Reserve policy now began shifting from using the discount window as its primary tool to provide an elastic currency and supply the private sector with adequate liquidity and a stable currency, to using open market operations to finance government deficits and manipulate the interest rate and reserve requirements of commercial banks. As Moulton explains,

Prior to 1923 the Federal Reserve banks had bought government securities primarily as a means of earning operating expenses; but in that year the principle was enunciated that the purchase and sale of government securities should henceforth be undertaken only as a means of assisting in the regulation of general credit and business conditions. The theory was advanced that, in a time of depression, the Federal Reserve banks might increase the amount of money in circulation by purchasing government securities and in a time of active business they might decrease the circulation by selling such securities. (Financial Organization and the Economic System, op. cit., 400.)

This is pure Keynesian theory, and a fundamental shift from viewing money as conveying a private property right in an exchange, to money as a means whereby the State creates a property right in what is otherwise the personal wealth of private citizens. The quasi-religious character of Keynesian monetary theory is illustrated by the fact that, although applications based on Keynes's theories have never worked and the theory is fundamentally unsound, economists and policymakers continue to implement them with increasing fervor. This is in contrast to real religion, which generally has to show a certain logic through reason and demonstrate some kind of effectiveness, even if the basic premises are accepted on faith. As Moulton analyzed the self-defeating reliance on Keynesian theory,

These security transactions did not, however, automatically control the quantity of credit in the channels of circulation. When securities were purchased Federal Reserve money did, of course, find its way into the money markets and thus into deposits of member banks, but since business was declining these funds were not used by the banks as a basis for expanding credit; rather they were employed to liquidate rediscounts at the Federal Reserve banks. Similarly, the heavy sales of securities in 1923 withdrew large sums from the deposits of member banks; but instead of contracting credit the member banks replenished their reserves by borrowing heavily from Federal Reserve banks through the rediscount method. The purchases of securities in 1924 and 1927 were again accompanied by a decline in rediscounts of like proportions; while in 1928, as securities were sold, rediscounts registered a more or less parallel advance. Thus the open market operations in the main merely shifted the character of bank assets from securities to discounts, or the reverse, without having an appreciable effect upon the total reserves and lending power of the member banks. (Financial Organization and the Economic System, op. cit., 401.)

As Moulton further explained, "It should, however, be clear from the experience cited above that the purchase of bonds in the open market does not put money into the ultimate channels of circulation — that is, into the pockets of the people." (Ibid.) The only way for Keynesian theory to be effective in any degree is to affect reserve requirements of commercial banks through manipulation of the interest rate by engaging in open market operations, (Ibid.) a hit-or-miss method that operates indirectly, based on the assumption that commercial banks cannot create money, and that financing new capital formation necessarily comes out of existing accumulations of savings — neither of which assumptions are true. As Moulton observed,

The truth is that low interest rates on bank loans have little power to stimulate recovery. Throughout the course of the recent depression [Moulton was writing in 1938] we have tried more or less continuously to promote expansion by means of credit policies. The Federal Reserve banks have engaged in open market operations on a vast scale and interest rates have been reduced to the lowest levels ever known. When these attempts did not bring results, cooperating credit committees of business men and banks were organized to help put currency into the channels of circulation. But all efforts were in vain as long as the economic situation as a whole remained unfavorable; money, like labor, remained unemployed. It was not until a combination of various factors started the recovery process that demands for increased banking accommodations began to appear. In fact, a phenomenon of the entire expansion period from 1933 to 1937 was the negligible increase in bank loans, even though interest rates remained at the lowest levels ever known. (Financial Organization and the Economic System, op. cit., 403.)

Thus, in the 1920s, Federal Reserve policy underwent a fundamental change from the direct effectiveness of the real bills doctrine and Say's Law of Markets, to the indirect — and grossly ineffective — use of open market operations and manipulation of the interest rate to meet the demands being put on the system as a result of the misuse of the institution.

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Bernanke, Paulson . . . the New Al Queda?

No, we're not suggesting that Benjamin Bernanke, Henry Paulson, and Osama bin Laden are all cozying up and snuggling together in the same bed in a plan to establish a Fourth Reich . . . but they might as well be. Not that this is surprising. Karl Marx predicted that the capitalists would sell the very rope used to hang them. Why, then, should it surprise us that the most financially influential individuals in the United States are acting as if they were in cahoots with Osama bin Laden and disciples of Karl Marx? To all appearances, they are willingly and eagerly carrying out bin Laden's announced plan to bankrupt America.

To be honest, the program to dismantle every check and balance in the financial system, overthrow the free market, and establish a State-run monopoly over money and credit appears to be based on ignorance, not viciousness or stupidity. Bernanke and Paulson appear honestly to believe that a State monopoly over the most dangerous tool in the world — money — is going to solve all our problems instead of setting up the perfect recipe for the most totalitarian government the world has ever seen. Adolph Hitler came into power in large measure because he promised to restore stability to the economic system — and received essential support from the industrialists and financiers of Weimar in his bid to be appointed Chancellor of Germany in 1933.

Ironically, Hitler's party, the National Socialists (while still the single largest party in Germany), was rapidly losing seats in the Reichstag. Had it not been for the German equivalent of Wall Street, Hitler would never have been able to persuade the near-senile, but desperate Hindenburg to appoint Der Führer as Chancellor.

Yet even Hitler didn't dare to exert such levels of State control over money and credit as Bernanke and Paulson now advocate, especially after Dr. Hjalmar Schacht performed his near-miracle in stopping the hyperinflation. Schacht turned off the printing presses, established an asset-backed currency, and was credited with single-handedly making Germany strong enough economically to finance the war machine of the Third Reich. Later, when Schacht's eyes were opened and he was implicated in a plot to assassinate Hitler, Der Führer didn't dare have Schacht killed, having to settle for imprisonment in a concentration camp.

What have the financial interests in the United States been doing? Going where Hitler feared to tread. Dismantling every check on monopoly financial power, cutting off credit to productive enterprises, divesting ordinary people even of home ownership (to say nothing of keeping them out of ownership of the means of production) — the list is now virtually endless, and still no one seems to see any reason to take a look, serious or otherwise, at Capital Homesteading, or the scholarly analysis contained in "A New Look at Prices and Money: The Kelsonian Binary Model for Achieving Rapid Growth Without Inflation," published in The Journal of Socio-Economics, Vol. 30 pgs. 495-515.

Perhaps they prefer Mein Kampf.

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Forward into the Past: October 1929, Part 2 of 6

In the previous posting in this series we looked at a brief history of financial panics, limiting it to the first third of the 20th century. With that in mind, let's take a look at recent events.

• In 2008, touched off by the exuberant wave of speculation in the sub-prime mortgage market and lending by financial institutions to engage in unsound margin purchases of questionable properties financed with small down payments, the housing market plunged . . . followed by the stock market as investment banking houses and their shareholders, over-invested in mortgage-based securities, saw the value of their portfolios evaporate into the thin air from which they came.

Despite all the reassuring rhetoric that 2008 is not 1929 — we know that — the economy is in very bad shape. Advocating increasing levels of State involvement will only make the situation worse, whether you're taking Senator Obama's line that more regulation and fewer bailouts are needed, or Senator McCain's position that fewer bailouts and more regulation is necessary.

The fact is that the underlying productive economy — the real economy, not Wall Street — is in much worse shape today than it was in 1929. In 1929 America's heavy industries and producers of consumer goods had their capacity fully intact. There was even substantial over-capacity in all sectors, a result of the rapid expansion to meet the needs of the war effort barely a decade previously. Europe still had not recovered its pre-war capacity, and represented a seemingly endless market for American goods and services, as did Asia, attempting to develop as rapidly as possible.

The Crash of 1929 did not affect the real economy . . . at first. The potential was there to correct the situation and move forward in a sound and financially secure manner. What happened? We will look at that tomorrow.

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The New "Yellow Peril"?

If you were under the impression that 1920s-style racism went out with the Stock Market Crash of October 1929, think again. As I write the first draft of this posting on August 17, 2008, the CBS television show Sunday Morning has just finished a segment combining the worst of economic fear-mongering and American guilt. According to the various experts interviewed, the Peoples' Republic of China will soon overtake America economically and displace the United States as world leader. The message seemed to be that the people of the United States consume too much (especially oil), don't produce enough of what we consume, are bullying warmongers, and probably deserve, like the British Empire, to fade gradually into obscurity. (That last does not represent this writer's opinion, but is a slight paraphrase of a statement made by one of the experts.) The message seemed clear: fear the Chinese, for their takeover of the world, especially of the United States through our desperate need for foreign investment and the advance of globalization, is inevitable.

So much for the bad news. Now for the worse news. The only thing allowing the Chinese or anybody else to displace the United States is our own refusal to correct the flaws in our system — flaws that the Chinese (following the lead of the Japanese and other "Asian tigers") are busily copying. The fact is, if things continue as they are, the Chinese economy will overtake that of the U.S. and enjoy a brief period of dominance before the flaws inherent in both capitalism and socialism bring them down, and everybody else with them. No economy in the world, including that of the United States, embodies the "Four Pillars of a Just Economy" that provide the underlying philosophy of the Just Third Way and the foundation of a stable economic order:

1. Limited economic role of the State,

2. Free and open markets,

3. The full rights of private property, and,

4. Widespread direct ownership of the means of production (the fatal omission).

The United States attained its economic preeminence for a simple reason: the tradition of widespread ownership. This does not mean ownership of consumer goods, including houses. Even Karl Marx "permitted" ownership of such things. Direct and widespread ownership of the means of production is the key to lasting and meaningful economic prosperity. Abraham Lincoln can take credit for being the only president, perhaps the only leader in history, to save his country three times: preserving the union, freeing the slaves, and pushing the Homestead Act.

Consumption

It may sound paradoxical, but Americans don't consume enough. People in the U.S. are losing their homes and jobs and lowering their standards of living, and all at a time when there are millions of Americans in want, to say nothing of multitudes throughout the world. By consuming more, Americans would "create demand," thereby spurring capital investment and job creation - ownership and jobs desperately needed by other Americans to supply the production that, in economic "law," equals income. If anyone is truly worried about American consumption of oil, then he or she should immediately begin to demand a "Manhattan Project" scale initiative to develop and implement alternative energy . . . an initiative that would, in and of itself, create thousands of jobs, especially needed to replace those we are going to lose in the petroleum industry.

Production

According to the politicians and the experts on Wall Street, only massive infusions of foreign investment can save American industry . . . at the same time foreign investors undermine the economy by purchasing our industrial base. This results from our massive trade deficit, caused in turn by our increasing costs of production, especially labor. Other countries don't buy from us because they can produce goods and services better and cheaper, taking advantage of the wage arbitrage.

This is, to put it bluntly, insanely ludicrous. The commercial banking system and the Federal Reserve system have the potential to supply the United States with as much financial capital as is required to rebuild and sustain America's industrial base, even the entire economy. This is, in fact, precisely what the Federal Reserve was designed and intended to do. It was never meant to monetize government deficits — and is still technically prohibited from doing so. A program of expanded capital ownership to make owners of the means of production out of Americans who currently own nothing, collaterialized with capital credit insurance, and financed by discounting financially feasible qualified loan paper at the Federal Reserve banks would end the alleged need for foreign investment. Foreign investors will be forced either to build up their own economies, or (better), spend their income, thereby increasing effective demand, spurring investment, and creating jobs.

American Warmongering

If the United States continues to ignore the obvious — end the war in Iraq by instituting CESJ's Iraq oil proposal — then, yes, the only logical conclusion (given the otherwise incomprehensible conduct of the war) is that we must have gotten into the mess because we like to fight just to fight, lose lives senselessly, and spend billions of dollars achieving absolutely nothing. Since Americans don't like to fight just to fight, lose lives, or spend money without getting value for it, then that conclusion is patently absurd. Why, then, is the Iraq oil proposal treated with such open contempt, possibly even fear by those in the U.S. Department of State and the military who have heard of it?

If the United States wants to carry on a war, it should be a war of ideas. Anything else is shortsighted and self-defeating. America's "secret weapon" in the war of ideas is CESJ's Capital Homestead proposal, which would, ultimately, benefit everyone on earth, regardless of color or lack thereof.

The Solution

Step one: go to the CESJ web site and read up on Capital Homesteading, the Iraq oil proposal, the Abraham Federation, and anything else that catches your interest. Step two: read The Capitalist Manifesto (1958) and The New Capitalists (1961), both of which can be downloaded free from the Kelso Institute via the CESJ web site. Step three: write letters to your Representative in Congress, both your Senators, and the presidential candidates. Step four: post to your blog or write letters to your local newspapers — and the Wall Street Journal, which seems locked into a self-defeating and ultimately senseless economic paradigm. Step five: ignore the implicit racism stirred up by the constant references to the growing Chinese economic menace. We have more to fear from our own stupidity than we do from a country bent on making the same mistakes that got us where we are today.

Donations to CESJ are tax deductible in the United States under IRC § 501(c)(3):