Own the Fed, Part X: Recovery

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

From this assumption — shown to be false by Adam Smith (The Wealth of Nations, 1776), Henry Thornton (An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802), John Fullarton (On the Regulation of the Currencies of the Bank of England, 1845), and, especially, Dr. Harold Glenn Moulton (The Formation of Capital, 1935) — the adherents of the doctrines of the Currency School (whether or not they so described themselves) enshrined at least four serious flaws in "the system." There may be other flaws, even critical ones, but these are the fundamental errors that most affected Federal Reserve policy and its application in the New Deal:

1. Money and credit are commodities. (This is a rejection of Say's Law of Markets. According to Say's Law, money and credit are derivatives of production, drawn from the present value of existing and future marketable goods and services. Money and credit are not themselves a good, service, or a commodity.)

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

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

4. Wages for labor, not dividends from owning the means of production, are the only way for most people to gain income. (This, too, is a rejection of Say's Law, which implicitly assumes that people gain income by producing a marketable good or service that they then trade for the productions of others through the media of money and credit.)

The New Deal therefore did nothing to correct the underlying problems in the financial system. Misunderstanding and misuse of the system continued to starve private sector businesses of needed credit. This had the result that more and more people began to look to the State as the savior, indeed, as the only source of assistance for individuals and families, or of making necessary changes in the system. As one State-worshipping enthusiast wrote as late as the 1990s, "the State is the sole intercessor available to the poor." (Rupert J. Ederer, "Solidaristic Economics," Fidelity magazine, July, 1994, 9-15.)

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

Unfortunately, Kelso and Adler were not collaborating in the early 1930s, and Moulton was being ignored in preference to Keynes. Such was the political atmosphere of the time and the influence of Roosevelt's personality cult that — as we might expect — people looked to the State or, at least, increasingly concentrated power at the highest level to effect necessary changes. This meant, for monetary policy, the Federal Reserve System, even though it was dangerously crippled as an effective tool by its adoption of the tenets of the Currency School. Consequently, as Moulton related,

The inability of the Federal Reserve system to check the stock market speculation of 1928 and 1929 and to stem the tide of the business recession was attributed in considerable part to the lack of concentration of power in the Federal Reserve authorities in Washington. The original organization, in the interests of democratic control, had vested large powers in the Reserve banks themselves. For example, the twelve banks were authorized to engage in open market operations and to change discount rates on their own volition. Under this system the power — and indeed the prestige — of the Governor of the Federal Reserve Bank of New York became much greater than that of the members of the Board of Governors. (Financial Organization and the Economic System, op. cit., 409.)

With Roosevelt's program of centralization of power in Washington, the central bank was reorganized to give Federal Reserve officials in Washington direct control over the entire Federal Reserve System, and thus indirect control over the entire economy. Moulton listed five steps by means of which control was centralized and power concentrated:

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

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

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

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

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

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

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

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

Ironically, these measures also graphically demonstrate the fact that indirect control of the economy under the tenets of the Currency School wasn't even working. Instead of reexamining their assumptions, however, Federal Reserve authorities clearly believed that if something wasn't working, it is only necessary to try harder and throw more money at the problem. As Moulton analyzed the Board of Governors' actions,

In the light of this development, it appeared that the member banks would not, for an indefinite period, be in need of any accommodations from the Federal Reserve banks — and consequently the Federal Reserve banks could exercise no effective control through the medium of advancing discount rates. The fear was also expressed that the unrestricted expansion of loans by member banks would sooner or later lead to a very dangerous credit inflation. In any case, it seemed a wise policy to safeguard the situation by giving the Federal Reserve banks the power to change the reserve requirements. (Ibid., 410-411.)

We have made the point before, but it bears repeating. The Federal Reserve authorities could have restored and even improved the system by 1) returning to the original mission of the institution, 2) instituting a 100% reserve requirement, 3) imposing separation of function to improve systemic (as opposed to regulatory) internal controls, and 4) prohibiting dealing in government securities of any kind. Per the real bills doctrine and Say's Law of Markets, this would allow the commercial banking system in concert with the Federal Reserve to monetize not government debt, but private sector hard assets, thereby ensuring an elastic currency with a stable value, fully adequate for the demands placed on it.

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

#30#

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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News from the Network, Vol. 3, No. 11

From the perspective of trying to educate our policymakers and the academic economists who indoctrinate our policymakers in the dogmas of Keynesian economics, the outlook for the economy is extremely grim. We are told repeatedly that the recession is over, that recovery is underway, and so on, so forth.

Own the Fed, Part VII: Buildup to Disaster

The change in Federal Reserve policy after the war and in response to the Crisis of 1920 did not, in and of itself, cause the overheated financial speculation that led to the 1929 Crash, triggering the Great Depression. It did, however, help set the stage and make a true recovery all but impossible. If we want to oversimplify grossly and blame one thing for the financial panic, we can place it at the door of a changed understanding of money. When the Federal Reserve redefined money to conform to the tenets of the Currency School, thereby putting money and credit, and all contracts involving money, under effective total State control, the ability of the economy to set itself right was seriously hampered, if not actively countered.

The problem with the Federal Reserve in the 1920s — if "problem" is the correct term for having an incomplete understanding of money, credit, and banking — was that Federal Reserve policy had by then almost completely changed over from the principles of the British Banking School to the tenets of the British Currency School. "Money" was no longer anything that could be used in settlement of a debt, but a special creation of the State. As such, the Federal Reserve believed it could not directly affect the money supply by rediscounting real bills — the Currency School did not admit that money could be so created. Instead, the Federal Reserve became self-limited to manipulating what it presumed were existing supplies of money — existing accumulations of savings, the only money recognized by the Currency School as money — by changing reserve requirements and artificially raising and lowering interest rates. "Interest," as we explained in a previous posting in this series, was no longer a share of profits, but the cost of money, that is, the price of bank credit.

Bank credit itself changed from a system of promises that "lubricate" the economy and results in the creation of new money, to a commodity. Construed as a commodity, credit was presumed to be limited in supply, completely dependent on the amount of existing savings, rather than based on the present value of existing and future marketable goods and services in addition to existing accumulations of savings, expanding and contracting in direct response to the actual needs of the economy. As Louis Kelso put it, the financial community became "preoccupied with the monetary shadows of reality, rather than reality itself." As Kelso explained,

This assertion should not be taken lightly. The wide discrepancies between the solutions to economic problems arrived at through monetary thinking and their real-life results, in terms of enabling people peacefully and rationally to produce and consume general affluence, must be attributed to the ease with which symbols are confused with the physical realities for which they stand. Money is not a part of the visible sector of the economy; people do not consume money. Money is not a physical factor of production, but rather a yardstick for measuring economic input, economic outtake and the relative values of the real goods and services of the economic world. Money provides a method of measuring obligations, rights, powers and privileges. It provides a means whereby certain individuals can accumulate claims against others, or against the economy as a whole, or against many economies. It is a system of symbols that many economists substitute for the visible sector and its productive enterprises, goods and services, thereby losing sight of the fact that a monetary system is a part only of the invisible sector of the economy, and that its adequacy can only be measured by its effect upon the visible sector. (Louis O. Kelso, Two-Factor Theory: The Economics of Reality. New York: Random House, 1967, 54.)

To put it more succinctly, "money" is a derivative of the present value of existing and future marketable goods and services. "Currency" — coin and paper money (and, depending on your paradigm, demand deposits) — is a derivative of money, a symbol of a symbol. Money is thus a means of exchanging claims back and forth, whatever specific form it takes. It is based on private property, and thus cannot be treated as if it were a special creation of the State or a commodity without, in effect, abolishing private property (Fisher, loc. cit.) — yet that is how the Keynesian, Monetarist, and Austrian Schools view money. This is a paradoxical and self-defeating understanding that only leads to more confusion, unnecessary acrimony, and ineffectual remedies to economic problems.

By rejecting the reality that commercial banks create money by discounting bills drawn on the present value of existing and future marketable goods and services, and limiting the definition of money to coin, currency, and demand deposits, the Federal Reserve unconsciously encouraged the widespread belief that you could get something for nothing — for that is what it appeared the financial system and the money markets were doing as the decade of the 1920s progressed. Without realizing it — for clearly that was not the intention of either the government or the central bank — by using the wrong definition of money and adhering to the tenets of the Currency School (especially the new definition of interest), the Federal Reserve actually encouraged the speculative frenzy and the misuse of money and extension of credit for non-productive uses that it sought to discourage.

This was inevitable within the framework of thought bounded by the assumptions of the Currency School. Denying the reality of the real bills doctrine and Say's Law of Markets, the contradictions built into the system sooner or later necessarily force an economy into crisis. As just one example, putting money and credit creation — not just regulation — under the State means that what should be purely an economic decision in direct response to the actual needs of private sector business engaged in the production of marketable goods and services (i.e., how much money to create or cancel), becomes a political decision, often determined by the whim of the person in charge.

As a case in point, the depression of the 1830s, "Hard Times," had its origin in President Andrew Jackson's dogmatic beliefs that only gold and silver were "real" money, that banks (except for those run by his friends) were frauds, and that sound economic growth could only be financed by a return to "real" money. Similarly, Amity Schlaes in her book, The Forgotten Man, relates how President Franklin Roosevelt arbitrarily changed the price of gold, often picking the amount out of thin air: "One morning, FDR told his group he was thinking of raising the gold price by twenty-one cents. Why that figure? his entourage asked. 'It's a lucky number,' Roosevelt said. 'because it's three times seven.' As Morgenthau later wrote, 'If anybody knew how we really set the gold price through a combination of lucky numbers, etc., I think they would be frightened.'" (Amity Shlaes, The Forgotten Man: A New History of the Great Depression. New York: Harper Perennial, 2008, 148.)

Still, the reorientation of the Federal Reserve from being an institution based principally on the precepts of the Banking School, to being a tool of the State to implement Currency School policies and programs was a symptom, not the cause of the fundamental change in how people viewed investment in activities intended to produce marketable goods and services. While it seems paradoxical — especially in light of the fact that the purpose of production is consumption — under the reign of the Currency School genuinely productive activity tends to become secondary to manipulating derivatives of production, especially money, credit, and corporate equity issues.

Nowhere was this more evident than in the financial frenzy that led to the Crash. By any standard, the Federal Reserve's policy of discouraging loans for speculation was the right thing to do. The problem was that the Federal Reserve had, in essence — by denying that commercial banks create money — stripped itself (or allowed itself to be stripped) of any direct regulatory control over the creation of money and extension of credit. Only conscious direct regulatory control, not the presumed indirect management that they assumed they were exercising, would have ameliorated in some measure both the scope and the character of the Crash and the subsequent depression.

Shifting Federal Reserve policy from increasing the money supply directly by rediscounting qualified industrial, commercial, and agricultural paper, to affecting the money supply indirectly by manipulating reserve requirements and the interest rate took away a very powerful tool of the central bank. The only direct action the Federal Reserve could take in the late twenties, when commercial banks, hand-in-glove with their investment banking divisions, were creating money at a tremendous rate to finance speculation in stocks on Wall Street, was to refuse to create money for speculative purposes — which the institution was forbidden to do in any event.

The Federal Reserve had rendered itself powerless to do anything substantive about the buildup to the Crash of 1929. The central bank had redefined itself as a different institution than the one established in 1913 specifically to avert such financial panics by directly regulating the amount of money in the economy through the operation of the real bills doctrine. By effectively denying that commercial banks create money by discounting — even while carrying out rediscount operations — the Federal Reserve could not admit that money was being created at an incredible rate in a way the officials running the institution and the policymakers in the government refused to recognize.

Money was being created to finance speculation through misuse of commercial banks' discount powers. The situation was exacerbated by the inappropriate links between commercial banks and investment banks, which were often combined in a single institution — in effect, giving the chicken thief the key to the henhouse, or (perhaps more accurately) a drug addict access to an unlimited supply of heroin. Regardless how bad the situation got, the best the Federal Reserve could do under its Currency School assumptions was to try and engage in indirect management of the money supply by implementing ineffectual changes in reserve requirements and manipulating the interest rate. As Moulton explained,

The Federal Reserve authorities were subjected to some criticism during the period from 1924 to 1927 on the ground that the comparatively easy money policy being pursued was encouraging excessive stock speculation. In the light of the criteria which had been adopted as a guide to Reserve policy, it did not seem to the Reserve officials at the time that stock speculation was having a deleterious effect upon business — for if such were the case the statistics of business should have revealed the fact. As one of the officials state: "The operations of the stock market are not the concern of the Federal Reserve system, except when the stock market is absorbing credit that is needed in general business, as was the case in the fall of 1919, or when the activity of the market and the rapid advance of many stocks threatens to breed a speculative fever which is liable to spread to commodities." [George W. Norris, quoted by George E. Roberts, "Federal Reserve Control of the Money Market," American Bankers Association Journal, December 1925, Vol. XVIII, No. 6, p. 448.] (Financial Organization and the Economic System, op. cit., 405.)

In other words, the official policy of the Federal Reserve — dictated by the tenets of the Currency School and bound by its assumption that only existing accumulations of savings can be used to extend credit for any purpose — assumed as a given that bank credit was a commodity, limited in supply. Within this policy framework, the only circumstance that should cause problems was if the massive speculation began draining the existing supply of this commodity away from the productive sector to the detriment of "general business." The possibility — reality, actually — that commercial banks were not drawing on some existing "inventory" of credit, but creating money for both productive investment and speculation at will without causing any kind of diminution in the amount of credit available does not appear to have been considered.

Consequently, when Federal Reserve officials woke up and decided that the speculative boom in the stock market was a matter for serious concern, they attempted to put the brakes on. This was the right thing to do, but since they approached the problem from the wrong analytical framework, they employed the wrong tools. As Moulton described the situation,

By 1928, however, the Reserve officials began to express genuine concern over the stock market boom. In the first half of the year pressure was exerted toward restraining speculation by open market sales and advancing rediscount rates. At the same time, the credit situation was tightened as a result of a large outflow of gold. Call loan rates advanced from an average of 4.24 per cent in January, 1928 to 6.05 per cent in July. There was, however, no appreciable effect upon speculative sentiment. Moreover, business prosperity and speculation continued to advance together. (Financial Organization and the Economic System, op. cit., 405.)

By refusing to recognize that commercial banks were creating money for both productive uses and speculation at the same time, and that the amount of money created for one did not necessarily affect the amount of money created for the other, the Federal Reserve boxed itself in. By adhering to the tenets of the Currency School, the two obvious ameliorative actions that could have been taken did not even suggest themselves: immediate imposition of a 100% reserve requirement on commercial banks (being careful to define reserves as they were in the original Federal Reserve Act of 1913), and mandatory separation of commercial banking from investment banking. This would have left a number of weaknesses in place (e.g., the power to monetize government deficits and the inclusion of government securities in the definition of reserves), but would have given the Federal Reserve the power to stop commercial banks from creating money for speculative purposes, at least for the time being, and restrict speculative loans to being made out of accumulated savings.

Within its self-imposed constraints, however, the best the Federal Reserve could do was resort to an ineffectual half measure. Coming from the orientation of the Currency School, the Federal Reserve would not, of course, impose a 100% reserve requirement even as an emergency measure. Using the wrong understanding of the role of the central bank, it simply would not occur to the officials that they could thereby eliminate, even if only temporarily, the ability of commercial banks to create money for stock market speculation. Instead, as Moulton described the actions of the Federal Reserve,

In February, 1929, the Reserve officials conceived a new method of exercising control over the stock market. Instead of merely increasing the cost of credit, hoping thereby to curtail its use, they devised a policy of "direct pressure." This involved a refusal of the rediscount privilege to banks having a volume of speculative security loans in excess of an amount deemed reasonable by the Reserve banks. During the ensuing months, however, there was a vigorous controversy between the Reserve officials and those of the Federal Reserve Bank of New York. The bank held that direct pressure was impractical and that the only effective means of control was to "put the brakes on" by raising discount rates, the first effect of which would be to restrict loans of a speculative character. The Reserve officials felt, however, that "advances would have to be so sharp — far beyond six per cent — that other lines of business would be severely affected and that a crisis might in consequence ensure." The Federal Advisory Council supported the position of the Reserve officials. However, the New York Reserve bank refused to cooperate, and in June the policy of direct pressure was abandoned. (Financial Organization and the Economic System, op. cit., 406.)

The actions by both the Reserve officials and the Federal Reserve Bank of New York reveal a fundamental misunderstanding of what was going on. Convinced that a fixed pool of savings was available, the "direct pressure" policy tried to make it more attractive for commercial banks to extend loans for productive investment instead of speculation. Similarly, the New York Federal Reserve assumed that raising the rates would make speculative loans (and, by extension, all loans) less attractive.

Both approaches, however, failed to take into account the fact that the commercial banks could continue to create money at will for both purposes, without having to choose between them. Refusing rediscount to commercial banks simply meant the commercial banks would keep the qualified paper on hand as reserves, rather than changing it into reserves in the form of demand deposits at the Federal Reserve. As for raising the discount rate, that would merely increase a cost that would be passed through to the borrower.

Again, a 100% reserve requirement, even if imposed only as a temporary emergency measure, would have stopped money creation for speculation. It would not have had any effect on speculation carried on using existing accumulations of savings, but that by definition was a risk borne by people who could well afford the loss. It is money creation for non-productive spending and speculation that was the problem, not the misallocation of a presumably fixed pool of savings between productive investment and speculation. The Crash of 1929 was probably inevitable, both to adjust share prices on the secondary market to a more reasonable level and to drain "morbid capital" out of the economy. From the orientation of the Banking School, however, there was no good reason why the Great Depression should have occurred in the first place, or for the recovery to have been so difficult, and, ultimately, ineffective.

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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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