It took no “courage” whatsoever to inflate the Fed’s balance sheet from $900 billion to $2.3 trillion during just 17 weeks in September-December 2008. What it actually took was an epochal con job by a naïve Keynesian academic whose single idea about economics was primitive, self-serving, borrowed and wrong.
The claim that the Great Depression was caused by the Fed’s failure to go on a bond buying spree in 1930-1933 was Milton Friedman’s monumental error. Professor Bernanke’s scholarship amounted to little more than xeroxing Friedman’s flawed work, and then shouting loudly in the Eccles Building boardroom at the time of the Lehman bankruptcy that Great Depression 2.0 was lurking just around the corner.
That was just plain hysterical malarkey. But at the time, it served the interests of the Wall Street/Washington Corridor perfectly.
As Wall Street’s decade long spree of leveraged speculation was being liquidated in September 2008, Goldman Sachs, Morgan Stanley and their posse of hedge fund speculators desperately needed rescue from their own reckless gambles——especially their funding of giant balance sheets swollen by long-dated, illiquid, risky assets with cheap hot funds in the wholesale money market. So what better excuse to override every principle of free market economics, financial discipline and public policy fairness than stopping a reenactment of the 1930s—–putative soup-lines and all?
At the same time, beltway politicians and fiscal authorities were tickled pink. They would be able to unleash a monumental $800 billion potpourri of K-street pork and tax and entitlement giveaways to “fight” the recession, knowing that Bernanke & Co would finance it with an eruption of public debt monetization that was theretofore unimaginable.
In short, no public official has ever committed an economic folly greater than the horrific misdeed of Ben S. Bernanke when he provided the Great Depression 2.0 cover story for the lunatic outbreak of central bank money printing shown below. It destroyed the last vestige of Wall Street discipline in a financialized economy that had already been bloated and deformed by two decades of Greenspan era Bubble Finance.
Now the speculative furies would be unleashed like never before. In one great fell swoop the above monetary explosion destroyed price discovery and financial responsibility entirely, turning Wall Street into a pure casino and enabling windfalls of massive proportion and unspeakable inequity to be showered on a tiny slice of the population.
So just call Bernanke’s 583 page tome “The Courage To Print” and be done with it. He does not even bother to prove that a great depression was imminent. Nor does he show that what would have actually been a short-lived and healthy liquidation of financial speculation on Wall Street would have spilled over to the real economy and taken main street into the drink.
Indeed, in his interview with the Financial Times’ insufferable Keynesian scold, Martin Wolf, Bernanke let slip why he and his Fed colleagues were scurrying about saving the world from an imaginary catastrophe. To wit, Keynesian economists and modern central bankers——which are one and the same thing—-simply assume that capitalism has a death wish; and that absent their constant ministrations, and even occasional bouts of courage and extraordinary interventions, it tends toward breakdowns, slumps and even depressions.
Thus, in justifying the Fed’s brutal war on savers, Bernanke said the following:
But what’s the alternative? Should the Fed not try to support a recovery……And this is certainly not an argument for the Fed to do nothing and let unemployment stay at 10%.
Well, let’s cut to the chase. He’s basically saying that absent the Fed’s massive money printing in the fall of 2008, the US economy could not have ended its recessionary plunge, nor ever crawled out of the resulting economic hole.
But those propositions are manifestly untrue. The main street recession that began in January 2008 was warranted, rational, moderate and self-limiting. It represented the downshift of debt-financed spending by the household sector that occurred when the housing and mortgage bubble collapsed, and when consumer purchases of domestic goods and services were throttled back by the disappearance of the MEW (mortgage equity withdrawal) from home ATMs and other credit sources.
But this decrement to housing and consumption spending was healthy and self-contained because it had never been sustainable in the first place. It represented the purging of phony debt- fueled growth, not the diminishment of production and income based spending nor the reversible loss of “potential” GDP.
Stated differently, the so-called Great Recession excised the effects of the Fed’s financial repression or Bubble Finance from the main street economy—and none to soon. After all, here is what happened to household debt after Greenspan’s panicked reduction of money market rates from 6.25% to 1.0% in just 30 months after the dotcom bust.
Household debt grew at the preposterous rate of 10.2% per annum in the run-up to the January 2008 economic break; it doubled in less than seven years.
It is now abundantly evident that this credit eruption resulted in US households running smack dab into a condition of “peak debt”. Accordingly, incremental spending for vacations, kitchen renovations, trips to the mall, restaurant meals, yoga teachers etc. had to be reduced on a one-time basis in order to realign spending with underlying levels of wages, salaries and other recurring income.
But contrary to Professor Bernanke’s Keynesian catechism, the elimination of Bubble Finance distortions from main street borrowing and spending did not mean that the US economy was descending into an economic black hole or a self-fueling downward spiral. What happened instead is that bubble based jobs in housing, finance, real estate and domestic services and goods production were eliminated on a one-time basis. Likewise, domestic business inventories associated with excess credit based spending were liquidated.
This is what market based economies do to purge and heal excesses. For instance, business inventories plunged sharply for just 12 months after August 2008, dropping from $1.54 trillion to $1.31 trillion or by nearly 15%. But once the system was cleansed of excess, business inventory levels stabilized and by the fall of 2009 began to be replenished.
In this context it is crucial to note that this rational $230 billion inventory liquidation accounted for fully 67% of the $345 billion drop in nominal GDP between Q4 2007 and the recession bottom in the summer of 2009. Accordingly, the Great Recession did not represent an uncontrolled economic implosion; it reflected main street’s self-healing from the distortions imposed by lax central bank policies during the preceding Greenspan housing and credit bubble.
Moreover, the Fed’s post-Lehman mad cap balance sheet expansion had absolutely nothing to do with this reversal. Inventory liquidation had been a rational adjustment to the one-time household spending decrement, not the consequence of interest rates being too high in the first place. Nor was it owing to any other form of un-accommodative monetary policy that the Fed could fix by pegging money market rates at ZIRP.
The proof that the inventory bottoming shown above was self-generated lies in the credit statistics for the 12 months encompassed by the chart. After all, monetary policy transmission to the main street economy operates through the tangible medium of credit growth, not economic magic.
Yet total business credit outstanding shrunk by $525 billion or nearly 5% during the period in which Bernanke exploded the Fed’s balance sheet, and showered Wall Street with free carry trade gambling stakes. Self-evidently, businesses stopped liquidating inventory in late summer of 2009 because the latter had now become realigned with sales, not because the mad money printers in the Eccles Building had induced them to borrow a single incremental dollar of credit relative to the pre-Lehman levels.
In fact, notwithstanding the liquidation of one-half trillion dollars of business credit, inventory-to-sales ratio’s were quickly restored to health within a few months of the recession’s end, and then stabilized at normal levels without any help from the Fed’s easy credit whatsoever. Bernanke’s self-described courage to print was of no moment to the main street economy.
That point is reinforced by the job statistics. Fully 75% of the 8.7 million payroll jobs lost during the great recession occurred in the brief ten-month interval between August 2008 and June 2009. For all practical purposes the bottom was in thereafter, and the natural regenerative processes of capitalism were fully at work restoring employment and income.
Again, the bottoming shown above had absolutely nothing to do with ZIRP and QE. During this entire period, private sector credit market debt in the US continued to decline, dropping from $24.88 trillion on the eve of the Lehman bankruptcy to $23.37 trillion in Q2 2010.
Thus, private credit not only had dropped by $1.2 trillion or by 5% while Bernanke was running the Fed printing presses red hot, but it continued to shrink well after the non-farm payroll job count had begun to rebound in March 2010.
So the Fed absolutely did not cause the household and business sectors to borrow more. As Nixon might have said in another context, its credit channel of monetary transmission had become non-operative.
At the end of the day, Bernanke’s whole case rests on the contra-factual. That is, his assertion that the US would have otherwise plunged into an economic black hole in the absence of the Fed’s massive intrusion into financial markets.
But as will be shown in subsequent parts, the post-Lehman financial meltdown would have burned out within the canyons of Wall Street all on its own. There was never anything more in store than a moderate self-correcting adjustment of excessive business inventories and labor.
Likewise, the myth that a Great Depression 2.0 was avoided by the Fed’s allegedly courageous action is a complete crock. That claim is actually based on a prior myth penned by Professors Bernanke and Friedman that furious Fed bond-buying during 1930-1933 would have prevented the liquidation of bad credit and unsustainable economic excesses during that period.
Absolutely not true.
Part 2:
In explaining to the FT’s Martin Wolf why he bailed out the Wall Street gamblers at Goldman Sachs and Morgan Stanley while crushing millions of ordinary American savers and retirees, Bernanke typically repaired to his go to argument. It had nothing to do with the mild excesses of inventories and labor that had built up in the main street economy owing to the Greenspan housing and credit boom, as explained in Part 1.
That’s because Bernanke was not aiming to ameliorate the mild economic liquidation that ensued after the Lehman event; and which, as previously demonstrated, would have runs its course and self-corrected without any help from the Fed in any event.
No, Ben S. Bernanke will be someday remembered as the world’s most destructive battleship admiral. Not only was he fighting the last war, but his whole multi-trillion money printing campaign after September 15, 2008 was aimed at avoiding an historical Fed mistake that had never even happened!
As Bernanke explained it:
I should have done more (to mitigate anti-Fed sentiments). But I was very much engaged in trying to put out the fire. So I don’t know what to say. It was kind of predictable. The Federal Reserved failed in the 1930s. I think we did much better than in the 1930s.
The claim that the Fed resorted to “extraordinary policies” of ZIRP and QE because it was fighting a recurrence of Great Depression 2.0 is completely, profoundly, unequivocally and destructively wrong.
It is the giant fig leaf that obscures what really happened during and after the crisis. Namely, that the main street economy recovered on its own, and that the flood of money generated by Bernanke never left the canyons of Wall Street, thereby causing the destruction of honest price discovery in the financial markets once and for all.
So doing, the Fed and other central banks have turned financial markets into dangerous, unstable casinos. In the name of precluding the contra-factual——that is, Great Depression 2.0—-they have generated the mother of all financial bubbles.
There is no other possible outcome than another thundering crash after upwards of 90 months of free money subsidy to the carry trade gamblers and upwards of $19 trillion of rank monetization of the public debt and other existing assets by the Fed and its fellow travelers.
At the end of the say, however, the monetary mayhem that was unloosed in September 2008 is the responsibility of two professors of economics would got the causes of the 1930-1933 collapse of the US economy completely wrong. In the excerpts below from the Great Deformation, I refute the two great myths that still pop out of journalists’ keyboards whenever the events of September 2008 are touched upon.
To wit, first, the Fed did not cause the banking crisis of 1930-1933 because by failing to undertake a massive bond-buying campaign; and secondly, the banking system was rotten to the core with bad loans and insolvency after the artificial boom of World War I and the follow-on bubbles of the Roaring Twenties. It could not have been fixed with a 1930s version of QE or any other massive intrusion of the central bank.
WHEN PROFESSOR FRIEDMAN OPENED PANDORA’S BOX: OPEN MARKET OPERATIONS
At the end of the day, Friedman jettisoned the gold standard for a remarkable statist reason. Just as Keynes had been, he was afflicted with the economist’s ambition to prescribe the route to higher national income and prosperity and the intervention tools and recipes that would deliver it. The only difference was that Keynes was originally and primarily a fiscalist, whereas Friedman had seized upon open market operations by the central bank as the route to optimum aggregate demand and national income.
There were massive and multiple ironies in that stance. It put the central bank in the proactive and morally sanctioned business of buying the government’s debt in the conduct of its open market operations. Friedman said, of course, that the FOMC should buy bonds and bills at a rate no greater than 3 percent per annum, but that limit was a thin reed.
Indeed, it cannot be gainsaid that it was Professor Friedman, the scourge of Big Government, who showed the way for Republican central bankers (e.g. Greenspan and Bernanke) to foster that very thing. Under their auspices, the Fed was soon gorging on the Treasury’s debt emissions, thereby alleviating the inconven- ience of funding more government with more taxes.
Friedman also said democracy would thrive better under a regime of free markets, and he was entirely correct. Yet his preferred tool of prosperity promotion, Fed management of the money supply, was far more antidemocratic than Keynes’ methods. Fiscal policy action was at last subject to the deliberations of the legislature and, in come vague sense, electoral review by the citizenry.
By contrast, the twelve-member FOMC is about as close to an unelected politburo as is obtainable under American governance. When in the fullness of time, the FOMC lined up squarely on the side of debtors, real estate owners, and leveraged speculators——-and against savers, wage earners, and equity financed businessmen——-the latter had no recourse from its baleful policy actions.
The greatest untoward consequence of the closet statism implicit in Friedman’s monetary theories, however, is that it put him squarely in opposition to the vision of the Fed’s founders. As has been seen, Carter Glass and Professor Willis assigned to the Federal Reserve System the humble mission of passively liquefying the good collateral of commercial banks when they presented it.
Consequently, the difference between a “banker’s bank” running a discount window service and a central bank engaged in continuous open market operations was fundamental and monumental, not merely a ques- tion of technique. By facilitating a better alignment of liquidity between the asset and liability side of the balance sheets of fractional reserve deposit banks, the original “reserve banks” of the 1913 act would, arguably, improve banking efficiency, stability, and utilization of systemwide reserves.
Yet any impact of these discount window operations on the systemwide banking aggregates of money and credit, especially if the borrowing rate were properly set at a penalty spread above the free market interest rate, would have been purely incidental and derivative, not an object of policy. Obviously, such a discount window–based system could have no pretensions at all as to managing the macroeconomic aggregates such as produc- tion, spending, and employment.
In short, under the original discount window model, national employment, production prices, and GDP were a bottoms-up outcome on the free market, not an artifact of state policy. By contrast, open market operations inherently lead to national economic planning and targeting of GDP and other macroeconomic aggregates. The truth is, there is no other reason to control M1 than to steer demand, production, and employment from Washington.
Why did the libertarian professor, who was so hostile to all of the projects and works of government, wish to empower what even he could have recognized as an incipient monetary politburo with such vast powers to plan and manage the national economy, even if by means of the remote and seemingly unobtrusive steering gear of M1?
There is but one answer: Friedman thoroughly misunderstood the Great Depression and concluded erroneously that undue regard for the gold standard rules by the Fed during 1929–1933 had resulted in its failure to conduct aggressive open market purchases of government debt, and hence to prevent the deep slide of M1 during the forty-five months after the crash.
Yet the historical evidence is unambiguous; there was no liquidity shortage and no failure by the Fed to do its job as a banker’s bank.
Indeed, the six thousand member banks of the Federal Reserve System did not make heavy use of the discount window during this period and none who presented good collateral were denied access to borrowed reserves. Conse- quently, commercial banks were not constrained at all in their ability to make loans or generate demand deposits (M1).
But from the lofty perch of his library at the University of Chicago three decades later, Professor Friedman determined that the banking system should have been flooded with new reserves, anyway. And this post facto academician’s edict went straight to the heart of the open market operations issue.
The discount window was the mechanism by which real world bankers voluntarily drew new reserves into the system in order to accommodate an expansion of loans and deposits. By contrast, open market bond purchases were the mechanism by which the incipient central planners at the Fed forced reserves into the banking system, whether sought by member banks or not.
Friedman thus sided with the central planners, contending that the market of the day was wrong and that thousands of banks that already had excess reserves should have been doused with more and still more reserves, until they started lending and creating deposits in accordance with the dictates of the monetarist gospel. Needless to say, the historic data show this proposition to be essentially farcical, and that the real-world ex- ercise in exactly this kind of bank reserve flooding maneuver conducted by the Bernanke Fed forty years later has been a total failure—a monumental case of “pushing on a string.”
FRIEDMAN’S ERRONEOUS CRITIQUE OF THE DEPRESSION-ERA FED OPENED THE DOOR TO MONETARY CENTRAL PLANNING
The historical truth is that the Fed’s core mission of that era, to rediscount bank loan paper, had been carried out consistently, effectively, and fully by the twelve Federal Reserve banks during the crucial forty-five months between the October 1929 stock market crash and FDR’s inauguration in March 1933. And the documented lack of member bank demand for discount window borrowings was not because the Fed had charged a punishingly high interest rate. In fact, the Fed’s discount rate had been progressively lowered from 6 percent before the crash to 2.5 percent by early 1933.
More crucially, the “excess reserves” in the banking system grew dramatically during this forty-five-month period, implying just the opposite of monetary stringency. Prior to the stock market crash in September 1929, excess reserves in the banking system stood at $35 million, but then rose to $100 million by January 1931 and ultimately to $525 million by January 1933.
In short, the tenfold expansion of excess (i.e., idle) reserves in the banking system was dramatic proof that the banking system had not been parched for liquidity but was actually awash in it. The only mission the Fed failed to perform is one that Professor Friedman assigned to it thirty years after the fact; that is, to maintain an arbitrary level of M1 by forcing reserves into the banking system by means of open market purchases of Uncle Sam’s debt.
As it happened, the money supply (M1) did drop by about 23 percent during the same forty-five-month period in which excess reserves soared tenfold. As a technical matter, this meant that the money multiplier had crashed. As has been seen, however, the big drop in checking account deposits (the bulk of M1) did not represent a squeeze on money. It was merely the arithmetic result of the nearly 50 percent shrinkage of the commercial loan book during that period.
As previously detailed, this extensive liquidation of bad debt was an unavoidable and healthy correction of the previous debt bubble. Bank loans outstanding, in fact, had grown at manic rates during the previous fifteen years, nearly tripling from $14 billion in 1914 to $42 billion by 1929. As in most credit- fueled booms, the vast expansion of lending during the Great War and the Roaring Twenties left banks stuffed with bad loans that could no longer be rolled over when the music stopped in October 1929.
Consequently, during the aftermath of the crash upward of $20 billion of bank loans were liquidated, including billions of write-offs due to business failures and foreclosures. As previously explained, nearly half of the loan contraction was attributable to the $9 billion of stock market margin loans which were called in when the stock market bubble collapsed in 1929.
Likewise, loan balances for working capital borrowings also fell sharply in the face of falling production. Again, this was the passive consequence of the bursting industrial and export sector bubble, not something caused by the Fed’s failure to supply sufficient bank reserves. In short, the liquidation of bank loans was almost exclusively the result of bubbles being punctured in the real economy, not stinginess at the central bank.
In fact, there has never been any wide-scale evidence that bank loans outstanding declined during 1930–1933 on account of banks calling performing loans or denying credit to solvent potential borrowers. Yet unless those things happened, there is simply no case that monetary stringency caused the Great Depression.
Friedman and his followers, including Bernanke, came up with an academic canard to explain away these obvious facts. Since the wholesale price level had fallen sharply during the forty-five months after the crash, they claimed that “real” interest rates were inordinately high after adjusting for deflation.
Yet this is academic pettifoggery. Real-world businessmen confronted with plummeting order books would have eschewed new borrowing for the obvious reason that they had no need for funds, not because they deemed the “deflation-adjusted” interest rate too high.
At the end of the day, Friedman’s monetary treatise offers no evidence whatsoever and simply asserts false causation; namely, that the passive decline of the money supply was the active cause of the drop in output and spending. The true causation went the other way: the nation’s stock of money fell sharply during the post-crash period because bank loans are the mother’s milk of bank deposits. So, as bloated, insolvent loan books were cut down to sustainable size, the stock of deposit money (M1) fell on a parallel basis.
Given this credit collapse and the associated crash of the money multiplier, there was only one way for the Fed to even attempt to reflate the money supply. It would have been required to purchase and monetize nearly every single dime of the $16 billion of US Treasury debt then outstanding.
Today’s incorrigible money printers undoubtedly would say, “No problem.” Yet there is no doubt whatsoever that, given the universal antipathy to monetary inflation at the time, such a move would have triggered sheer panic and bedlam in what remained of the financial markets. Needless to say, Friedman never explained how the Fed was supposed to reignite the drooping money multiplier or, failing that, explain to the financial markets why it was buying up all of the public debt.
Beyond that, Friedman could not prove at the time of his writing A Monetary History of the United States in 1965 that the creation out of thin air of a huge new quantity of bank reserves would have caused the banking system to convert such reserves into an upwelling of new loans and deposits. Indeed, Friedman did not attempt to prove that proposition, either. According to the quantity theory of money, it was an a priori truth.
In actual fact, by the bottom of the depression in 1932, interest rates proved the opposite. Rates on T-bills and commercial paper were one-half percent and 1 percent, respectively, meaning that there was virtually no unsatisfied loan demand from credit-worthy borrowers.
The dwindling business at the discount windows of the twelve Federal Reserve banks further proved the point. In September 1929 member banks borrowed nearly $1 billion at the discount windows, but by January 1933 this declined to only $280 million. In sum, banks were not lending because they were short of reserves; they weren’t lending because they were short of solvent borrowers and real credit demand.
In any event, Friedman’s entire theory of the Great Depression was thoroughly demolished by Ben S. Bernanke, his most famous disciple, in a real-world experiment after September 2008. The Bernanke Fed undertook massive open market operations in response to the financial crisis, purchasing and monetizing more than $2 trillion of treasury and agency debt.
As is by now transparently evident, the result was a monumental wheel-spinning exercise. The fact that there is now $2.7 trillion of “excess re- serves” parked at the Fed (compared to a mere $40 billion before the crisis) meant that nearly all of the new bank reserves resulting from the Fed’s bond-buying sprees have been stillborn.
By staying on deposit at the central bank, they have fueled no growth at all of Main Street bank loans or money supply. There is no reason whatsoever, therefore, to believe that the outcome would have been any different in 1930–1932.
By contrast, the real cause of the Great Depression was the massive and unsustainable expansion of credit and bank lending during the Great War of 1914-1918, and the financial boom of 1924-1929.
Ironically, both of these credit bubbles were financed by the newly created Federal Reserve, as outlined in the additional sections from The Great Deformation. Indeed, even the famous banking crisis of 1933 was not what it is cracked-up to be. As explained below, both the recession and the banking crisis were over by the summer of 1932; a Hoover Recovery had actually begun.
Indeed, the banking holiday declared by FDR upon his inauguration was the result of a 10-day run on the banks that had been caused by his actions during February 1933. In short, Bernanke has spent the last 7-years claiming he stopped a bank run like that of the 1930s, when, in fact, the actual pre-Roosevelt bank run had nothing whatsoever to do with policy actions by the Federal Reserve:
THE GREAT WAR AND THE ROARING TWENTIES: CRADLE OF THE GREAT DEPRESSION
FDR’s mortal blow to international monetary stability and world trade is the pattern through which the New Deal was shaped. Once Roosevelt went for domestic autarky, the New Deal was destined to be a one-armed bandit. It capriciously pushed, pulled, and reshuffled the supply side of the domestic economy, but it could not regenerate the external markets upon which the post-1914 American prosperity had vitally depended.
Herbert Hoover had been correct: the US depression was rooted in the collapse of global trade, not in some flaw of capitalism or any of the other uniquely domestic afflictions on which the New Deal programs were predicated. Indeed, the American economy had been thoroughly internationalized after August 1914 and had grown by leaps and bounds as a great export machine and prodigious banker to the world.
While it lasted, the export boom of 1914–1929 generated strong gains in growth had averaged nearly 4 percent annually, a rate that has never again been matched over a comparable length of time.
The trouble was that this prosperity was neither organic nor sustainable. In addition to the debt-financed demand for American exports, stock market winnings and the explosion of consumer debt generated exuberant but unsustainable household purchases of big-ticket durables at home. So when the stock market finally broke, this financially fueled chain of economic expansion snapped and violently unwound.
The first victim was the foreign bond market, which was the subprime canary in the coal mine of its day. Within a few months of the crash, new issuance had dropped 95 percent from its peak 1928 levels, causing foreign demand for US exports to collapse. Worse still, the price of the nearly $10 billion of foreign bonds outstanding also soon plunged to less than ten cents on the dollar, meaning that the collapse was of the same magnitude and speed as the subprime mortgage collapse of 2008.
Foreign debtors had been borrowing to pay interest. When the Wall Street music stopped in October 1929, the house of cards underlying the American export bonanza collapsed. By 1933, US exports had dropped by nearly 70 percent.
The Wall Street meltdown also generated ripples of domestic contraction which compounded the export swoon. Stock market lottery winners, for example, had been buying new automobiles hand over fist. But after sales of autos and trucks peaked at 5.3 million units in 1929, they then dropped like a stone to only 1.4 million vehicles in 1932. Needless to say, this 75 percent shrinkage of auto sales cascaded through the auto supply chain, including metal working, steel, glass, rubber, and machine tools—with devastating impact.
The collapse of these “growth” industries also caused a withering cutback in business investment. Plant and equipment spending tumbled by nearly 80 percent between 1929 and 1933, while nearly half of all the production inventories extant in 1929 were liquidated over the next three years. This unprecedented liquidation of working inventories—from $38 billion to $22 billion—amounted to nearly a 20 percent hit to GDP before the cycle reached bottom.
Overall, nominal GDP had been $103 billion in 1929 but by 1933 had shrunk to only $56 billion. Yet the overwhelming portion of this unprecedented contraction was in exports, inventories, fixed plant and equipment, and consumer durables. These components declined by $33 billion during the four years after 1929 and accounted for fully 70 percent of the decline in nominal GDP.
The underlying story in these data refutes the postwar Keynesian narrative about the Great Depression. What happened during 1929–1932 was not a mysterious loss of domestic “demand” that was somehow recoverable through enlightened macroeconomic stimulus policies. Instead, what occurred was an inevitable shrinkage in the unsustainable levels of output that had been reached by exports, durables, and a once-in-a-life- time capital investment boom, not unlike the massive China investment cycle of 1994–2015.
It was not the depression bottom level of GDP during 1932–1933 that was avoidably too low; it was the debt and speculation bloated GDP peak of 1929 that had been unsustainably too high. Accordingly, the problem could not be solved by macroeconomic pump-priming at home. The Great Depression was therefore never a candidate for the Keynesian cure which was inherently inward looking and nationalistic.
The frenetic activity of the first hundred days of the New Deal, of course, is the stuff of historians’ legends. Yet when viewed in the context of this implosion of the nation’s vastly inflated export/auto/capital goods sector, it’s evident that the real cure for depression did not lie in the dozens of acronym-ridden programs springing up in Washington.
Contrary to the long-standing Keynesian narrative, therefore, the New Deal contributed virtually nothing to the mild recovery which did materialize during the six-year run-up to war in 1939. In fact, the modest seesaw expansion which unfolded during that period had been already set in mo- tion during the summer of 1932, well before FDR’s election.
THE HOOVER RECOVERY INTERRUPTED
The New Deal hagiographers never mention that 50 percent of the huge collapse of industrial production, that is, the heart of the Great Depression, had already been recovered under Hoover by September 1932. The catalyst for the Hoover recovery was not Washington-based policy machinations but the natural bottoming of the severe cycle of fixed-asset and inventory liquidation after 1929.
By mid-1932, the liquidation had finally run its course because inventories were virtually gone, and capital goods and durables production could hardly go lower. Accordingly, nearly every statistic of economic activity turned upward in July 1932. From then until the end of September, the Federal Reserve Board index of industrial production rose by 21 percent, while rail freight loadings jumped by 20 percent and construction contract awards rose by 30 percent.
Likewise, the American Federation of Labor’s published count of industrial unemployment dropped by nearly three-quarters of a million persons between July 1 and October 1. Retail sales and electrical power output also rose smartly in the months after July, and some core industry which had been nearly prostrate began to spring back to life.
Cotton textile mill manufacturing, for example, surged from 56 percent of capacity in July to 97 percent in October, and mill consumption of wool nearly tripled during the same period. Likewise, the giant US Steel Corporation, which then stood at the center of the nation’s industrial economy, recorded its first increase in sixteen months in its order backlog.
Related indicators also confirmed a broad and vigorous recovery. Wholesale prices rose by nearly 20 percent from their early 1932 bottom, marking the first sustained uptick since September 1929. The stock market quickly grasped the picture and rebounded from its depression low on the Dow Jones Index of 41 on July 7, 1932, to 80 in early September, before fears of a Roosevelt victory set it back.
The most important sign of economic rebound, however, was in the be- leaguered banking sector. After having experienced nearly three hundred bank closings per month for much of the post-1929 period, bank failures dropped sharply to only seventy to eighty closings a month after June.
Indeed, for the period of July through October 1932, deposits held by banks which were reopened during that interval exceeded those of newly failed banks, a complete break with the month-after-month deposit losses that had occurred until then. In a similar vein, the United States experienced five straight months of gold inflows after July, indicating that the panicked gold flight that had commenced after the British default of Sep- tember 1931 had decisively reversed.
As one careful journalistic reconstruction of events published during this period noted, “With the defeat of all threatening inflationary legislation in June . . . [and] the complete restoration of foreign confidence in the American gold position—the breath of recovery began to be felt over the land.”
No less an authority on the national mood than Walter Lippmann, then at the peak of his game and influence, later summarized, “There is very good statistical evidence . . . that as a purely economic phenomena the world depression reached its low point in mid-summer 1932 and that in all the leading countries a very slow but nevertheless real recovery began.”
By election time, however, the rebound had cooled. Subsequently, all the indicators of economic and financial activity weakened sharply during the long interregnum between Election Day and the March 4, 1933, inauguration.
As outlined below, there is powerful evidence that this setback can be attributed to a “Roosevelt panic” in the gold and banking markets that was avoidable and the result of FDR’s numerous errors and provocations during the presidential interregnum. The fact is, every other major industrial country in the world also began to recover in July 1932, but none had a relapse back into depression during the winter of 1932–1933.
THE BANKING CRISIS THAT FDR MADE
The Hoover recovery has largely been omitted from the history books, fostering the impression that the American economy had continuously plunged after October 1929 until it reached a desperate bottom on exactly March 4, 1933. That rendition of events was far from accurate, but it did mightily burnish the Roosevelt miracle legend; namely, that FDR decisively reopened the frozen banking system, restarted the wheels of commerce, and restored a heartbeat to capitalism through the swarm of acronyms which flew out of New Deal Washington during the Hundred Days.
But the received version of the March 1933 banking crisis is an invention of Arthur Schlesinger Jr. and other postwar commentators who postulated FDR’s “bank holiday” as the dividing line between Hooverian darkness and the Roosevelt miracles. By contrast, the most savvy and erudite financial observers at the time saw it far differently, and for a very good reason: on the Friday evening before Roosevelt’s inauguration most of the US banking system was still solvent, including the great money center banks of New York: the Chase National Bank, First National City Bank, the Morgan Bank, and many more.
Indeed, the latter had to be practically coerced into agreeing to the New York State banking holiday signed into effect by Governor Lehman at 4:30 a.m. in the wee hours before FDR’s inauguration. As it happened, the governor was a scion of the banking house bearing his name, but the circumstances of 1933 were the opposite of those which accompanied its demise in 2008.
Back then there had been no bank runs in the canyons of Wall Street because the great banks had largely observed time-tested standards; that is, they had been fully and adequately collateralized on their stock loans and were sitting on cash reserves up to 20 percent of deposits. The stock market crash of 1929–1930 had been brutal, of course, but in those purportedly be- nighted times officialdom had the good sense to allow Mr. Market to make his appointed rounds.
Accordingly, stock market punters by the thousands had been felled quickly and cleanly when upward of $9 billion of margin loans were called after Black Thursday. Indeed, the banks and brokerages liquidated in a matter of months the massive margin loan bubble—$1 trillion in today’s economy—that had built up under the stock averages in the final years of the mania.
The fact that none of the great New York money center banks closed their doors during the four years between the crash and FDR’s inauguration points to the real story; namely, that the bank insolvency problem had been in the provinces and countryside, not the nation’s money center.
In fact, the run of bank failures was largely contained within the borders of the oversized 1914–1929 agricultural and industrial export economy. As the latter collapsed, overloaned banks in industrial boom towns like Chicago, Detroit, Toledo, Youngstown, Cleveland, and Pittsburgh had taken heavy hits.
In the case of the agricultural hinterlands, the Great Depression had started to roll in a decade before the crash, owing to the unique farm coun- try boom and bust which had accompanied the Great War. The unprecedented total industrial-state warfare of 1914–1918 had drastically disrupted European agricultural production and markets, inducing an explosion of export demand, high prices, and soaring output in the American farm belt. There soon followed an orgy of speculation in land and real estate that ex- ceeded in relative terms even the sand-state housing boom of 2002–2007.
Once the agricultural lands of Europe came back into production, how- ever, the great American granary lost much of its artificial war-loan export market, causing farm prices to abruptly plunge in 1920–1921 and then to continue sinking for the next decade. Not surprisingly, thousands of one- horse banks dotting the countryside had been caught up in the wartime frenzy and then suffered massive, unrelenting losses during the long post- war deflation of the farm bubble.
Overall, about 12,000 banks failed during 1920–1933, but 10,000 of these were tiny rural banks located in places of less than 2,500 population. Their failure rate of more than 1,000 per year throughout the 1920s makes for eye-catching historical statistics, but they were largely irrelevant to the na- tion’s overall GDP.
Losses at failed US banks during the entire twelve-year period through 1932, in fact, accumulated to only 2–3 percent of deposits. This extended wave of failures was an indictment of the short-sighted anti-branch banking laws that rural legislators had forced upon the states, as well as a reminder that wartime inflation and disruption had cast a long shadow on the future.
The crucial point, however, is that these thousands of failed banks were insolvent and should have been closed. They were not evidence of some fundamental breakdown of the banking system, or failure of the Fed to supply adequate liquidity, or a systemic crisis of capitalism.
Even after the 1929 crash, when the failure rate accelerated to about 2,400 in the twelve months ending in mid-1932, the periodic spurts of bank closures were not national in scope. Instead, they struck with distinct regional incidence in the agricultural and industrial interior. And almost without exception, these regional bank failure breakouts were centered on cities or banking chains which had indulged heavily in speculative real estate lending and other unsound practices.
That was certainly the case with the first significant outbreak of bank runs in November 1930 when the Caldwell banking chain collapsed. A speculative pyramid of holding companies which controlled more than a hundred banks in Tennessee, Arkansas, and North Carolina, it failed when real estate values fell sharply in the upper Cotton Belt. While there was some spillover on local banks, the runs did not spread beyond the region and quickly burned out because deposits were moved to sounder banks, not to mattresses.
The most powerful evidence of the noncontagious nature of the pre–February 1933 bank failures occurred shortly thereafter with the famous collapse of the Bank of the United States in December 1930. An upstart New York City bank, the Bank of the United States, grew by leaps and bounds in the late 1920s through serial mergers, aggressive real estate lending, and pyramiding of holding company capital.
The bank had been a stock market rocket ship, rising from $5 per share in 1925 to a peak of $230 before the crash. But its promoter, one Bernard Marcus, who had been the Sandy Weill of his day, had been more adept at making deals than making sound loans, and thereby soon rendered his hastily assembled banking empire insolvent. Yet there was virtually zero spillover to other New York banks when state banking supervisors shut- tered what was then the city’s third-largest institution with around seventy branches and deposits on the order of $30 billion on today’s scale.
The same pattern occurred the following June in Chicago. There had been a giant real estate bubble in the Chicago suburbs during the 1920s, but owing to Illinois’s particularly restrictive anti-branch-banking law the Great Loop banks had been sidelined, leaving the suburban real estate lending spree to poorly capitalized newbies.
Chicago had been an epicenter of the 1914–1929 agricultural/industrial/export boom, so when the party ended abruptly after the stock market crash, the region’s economy was hit harder than any other industrial center outside of Detroit. Real estate prices experienced a particularly devastating collapse in the newly developed suburban communities, triggering a wave of defaults in loan portfolios which were heavily laden with commercial and residential mortgages.
Yet with one exception a year later, the Great Loop banks remained sol- vent and experienced no lines at their teller windows. By contrast, the “runs” on the suburban banks were both swift and warranted because they were deeply insolvent.
In short, the Chicago case further illuminates the fact that the wave of bank failures during 1930–1932 was not the result of irrational public sentiment and “contagion,” or a fundamental breakdown of bank liquidity, but instead was evidence of a discriminating, rational flight of depositors from unsound banks and markets.
Even when surges of bank failures extended eastward, such as in the Philadelphia runs of October 1931, there was far more rationality to the pattern than the conventional narrative acknowledges. In this case, the overwhelming share of failures was concentrated among newly formed “trust banks” which had been chartered under state law with far less stringent requirements for capital and cash reserves than was the case with national banks.
Again, the late 1931 wave of bank failures in Philadelphia quickly burned out after deposits had moved from the lightly regulated trust banks, which had been on the leading edge of real estate lending and securities speculation, to the far better capitalized national banks. Indeed, the fundamental solvency of the US banking system was dramatically evidenced during this same period when the Fed raised the discount rate in mid-October.
This Fed action is habitually and roundly criticized by contemporary ad- vocates of central bank money printing, but it was actually the proper move under then-extant gold standard rules. Specifically, the initial impact of the British default on September 1931 had been a run on US gold out of fear that the United States would be the next to default. So a discount rate hike was necessary to stop the outflow and, in fact, the rate of gold losses fell sharply in the months ahead and eventually reversed to an inflow by mid-1932.
More importantly, there was no acceleration of bank failures after the discount rate hike, and within weeks the failure rate slackened dramatically while discount borrowings actually increased. This was proof positive that banks were failing not because they were illiquid or could not get emergency funding from the Fed but because they were, alas, bankrupt.
Indeed, Herbert Hoover’s unfortunate banking cure at the time—the emergency enactment of the Reconstruction Finance Corporation (RFC) in January 1932—was designed to alleviate insolvency, not provide emer- gency funding or replace hoarded deposits. Accordingly, the RFC went on to become a paragon of crony capitalism, rescuing dozens of busted railroads and recapitalizing several thousand insolvent banks.
Yet the outcome was perverse: the stock and bondholders of bailed-out institutions were rescued, competitors were harmed, and the nation’s economy was left to slog it out with far too much railroad capacity and way too many banks that were deeply insolvent.
……..This Fed action is habitually and roundly criticized by contemporary advocates of central bank money printing, but it was actually the proper move under then-extant gold standard rules. Specifically, the initial impact of the British default on September 1931 had been a run on US gold out of fear that the United States would be the next to default. So a discount rate hike was necessary to stop the outflow and, in fact, the rate of gold losses fell sharply in the months ahead and eventually reversed to an inflow by mid-1932.
More importantly, there was no acceleration of bank failures after the discount rate hike, and within weeks the failure rate slackened dramatically while discount borrowings actually increased. This was proof positive that banks were failing not because they were illiquid or could not get emergency funding from the Fed but because they were, alas, bankrupt.
Indeed, Herbert Hoover’s unfortunate banking cure at the time—the emergency enactment of the Reconstruction Finance Corporation (RFC) in January 1932—was designed to alleviate insolvency, not provide emer- gency funding or replace hoarded deposits. Accordingly, the RFC went on to become a paragon of crony capitalism, rescuing dozens of busted rail- roads and recapitalizing several thousand insolvent banks. Yet the outcome was perverse: the stock and bondholders of bailed-out institutions were rescued, competitors were harmed, and the nation’s economy was left to slog it out with far too much railroad capacity and way too many banks.
The Banking Crisis Was Over Before FDR Got Started
…..The trigger for the pre-election panic, in fact, did not occur until the morning of February 14, when the governor of Michigan capriciously declared a one-week bank holiday owing to a funding crisis at Detroit’s second-largest banking chain. The Guardian Trust Group consisted of about forty banks controlled by Edsel Ford and included Goldman Sachs among its principle stockholders.
It was another of the late-1920s banking pyramids that had been organized with a modest $5 million of capital in 1927 and had grown to a $230 million holding company two years later, through a spree of mergers and stock swaps. These maneuvers elevated the stock price from $20 per share to $350 at the 1929 peak.
Unfortunately, the bank’s principle assets consisted of loans to insiders to buy the bank’s own stock and loans to both real estate developers and homeowners in the red-hot Detroit auto belt. Propelled by a population explosion from 300,000 to 1.6 million in the previous three decades, the vol- canic price gains in the Detroit real estate market eclipsed the current era’s Sunbelt booms by orders of magnitude.
Consequently, when auto production dropped by 75 percent and trig- gered mass layoffs, and the Guardian Group’s stock price plummeted by 95 percent, the bank’s loan book became hopelessly impaired. However, what might have been embarrassing investment liquidation for Edsel Ford and his cronies became a national headline when the Guardian Group crisis turned into a brawl between Henry Ford and his despised erstwhile partner and then Michigan Democratic senator, James Couzens.
Senator Couzens was the Tyler Winklevoss (he and his twin brother were involved in the origins of Facebook) of his day and believed that he had been bilked out of his share of Ford Motor Company by Henry Ford. He could not abide a move afoot to have the RFC ride to the rescue of Edsel Ford’s mess, so he mustered his considerable weight as US senator and put the kibosh on the deal.
President Hoover unhelpfully got himself in the thick of the brawl. However, he did quickly recognize that the Detroit headlines were becoming a catalyst for a financial panic that was already brewing due to a complete breakdown of transition cooperation and FDR’s studied silence on his prospective financial policies.
Indeed, the increasing flow of hints and leaks from FDR’s radical brain trusters—such as Columbia professor Rexford Tugwell and secretary of agriculture designate Henry Wallace—that the incoming president would depreciate the dollar and pursue other inflationary schemes had already begun to trigger a run on gold and currency.
Therefore, on February 18 Hoover penned an eloquent private letter to FDR outlining the peril from these developments and the urgent need for a reassuring statement from morning of February 14, when the governor of Michigan capriciously declared a one-week bank holiday owing to a funding crisis at Detroit’s second-largest banking chain. The Guardian Trust Group consisted of about forty banks controlled by Edsel Ford and included Goldman Sachs among its principle stockholders.
It was another of the late-1920s banking pyramids that had been orga- nized with a modest $5 million of capital in 1927 and had grown to a $230 million holding company two years later, through a spree of mergers and stock swaps. These maneuvers elevated the stock price from $20 per share to $350 at the 1929 peak.
Unfortunately, the bank’s principle assets consisted of loans to insiders to buy the bank’s own stock and loans to both real estate developers and homeowners in the red-hot Detroit auto belt. Propelled by a population ex- plosion from 300,000 to 1.6 million in the previous three decades, the vol- canic price gains in the Detroit real estate market eclipsed the current era’s Sunbelt booms by orders of magnitude.
Consequently, when auto production dropped by 75 percent and trig- gered mass layoffs, and the Guardian Group’s stock price plummeted by 95 percent, the bank’s loan book became hopelessly impaired. However, what might have been embarrassing investment liquidation for Edsel Ford and his cronies became a national headline when the Guardian Group crisis turned into a brawl between Henry Ford and his despised erstwhile partner and then Michigan Democratic senator, James Couzens.
Senator Couzens was the Tyler Winklevoss (he and his twin brother were involved in the origins of Facebook) of his day and believed that he had been bilked out of his share of Ford Motor Company by Henry Ford. He could not abide a move afoot to have the RFC ride to the rescue of Edsel Ford’s mess, so he mustered his considerable weight as US senator and put the kibosh on the deal.
President Hoover unhelpfully got himself in the thick of the brawl. How- ever, he did quickly recognize that the Detroit headlines were becoming a catalyst for a financial panic that was already brewing due to a complete breakdown of transition cooperation and FDR’s studied silence on his prospective financial policies.
Indeed, the increasing flow of hints and leaks from FDR’s radical brain trusters—such as Columbia professor Rexford Tugwell and secretary of agriculture designate Henry Wallace—that the incoming president would depreciate the dollar and pursue other inflationary schemes had already begun to trigger a run on gold and currency. Therefore, on February 18 Hoover penned an eloquent private letter to FDR outlining the peril from these developments and the urgent need for a reassuring statement from the President-elect outlining his policies with respect to gold, currency, banking and the budget…..
By Monday morning February 27, Tugwell’s leak spread far and wide in the financial markets. The panic was on.
As Professors Nadler and Bogen noted in their classic 1933 history of the banking crisis, the “gold room” of the New York Federal Reserve Bank soon became a center of pandemonium: “As the panic week [February 27 to March 3] progressed, long lines formed to exchange ever larger amounts of gold there, until finally the metal was being carried away in large boxes and suitcases loaded on trucks.”
During the next five days approximately $800 million, or 20 percent, of the US gold stock was withdrawn by citizens, earmarked by foreign central banks, or implicitly purchased by speculators who took out a massive short position on the dollar. The lessons of the British default of September 1931 were still fresh, and as the smart money took aggressive actions to defend itself, the knock-on effect was almost instantly felt.
As Wall Street historian Barrie A. Wigmore noted in his magisterial his- tory of the Great Depression, owing to the gold hemorrhage “the lender of last resort [i.e., the Fed] for the banking system was in doubt. Frightened depositors lined up for cash, the only working substitute for bank de- posits.”
Wigmore’s point is dispositive. What financially literate citizens knew at the time, and was never grasped by postwar Keynesians, is that Federal Reserve currency notes were then required by statute to be backed by a 40 percent gold cover. The public therefore realized that only a few more days of the panicked gold drain could cause a sharp constriction of both the hand-to-hand currency supply and the banking system overall.
Accordingly, the daily currency figures provide ringing evidence of FDR’s culpability for the crisis. By February 23, the daily increase in currency out- standing had risen from the $8 million early February level to about $40 million, and then in the crisis week soared to nearly $200 million on Mon- day and hit $450 million on Friday, March 3, the day before the inaugura- tion.
All told, the great bank teller window run and currency-hoarding crisis caused currency outstanding to rise from $5.6 billion to a peak of $7.5 bil- lion. Yet $1.5 billion, or nearly 80 percent, of this gain occurred during the last ten days before FDR took office; that is, in the interval between the day Carter Glass said no and the morning FDR took the oath.
Barrie Wigmore’s work consists of seven hundred pages of massive doc- umentation and only occasional viewpoints and judgments. But on the question of culpability for the banking crisis he left no doubt: “Roosevelt exacerbated the crisis. If he had handled the ‘lame duck’ period differently, there would have been no Bank Holiday . . . the banking system was un- usually liquid prior to the bank crisis, and [the] recovery from it was un- usually rapid . . . [proving] that the peculiar circumstances of Roosevelt’s transition were the cause of the crisis.”
Four days after FDR officially closed the nation’s 17,000 banking institutions, the Senate approved, after seventy-five minutes of debate and no written copy of the bill, the Emergency Banking Act, which empowered the secretary of the treasury “to re-open such banks as have already been as- certained to be in sound condition.”
But there was no New Deal magic in the bill at all. It had been drafted by Hoover holdovers and was a content-free enabling act which required no change whatsoever in bank procedures in order to obtain a license to “re- open,” and included no standards for review or approval by the Treasury Department.
In fact, the legislation was the first of many FDR ruses. Once Hoover had been implicitly saddled with the blame for what appeared to be a frozen banking system and prostrate economy on March 4, FDR simply moved along to another topic, having had no intention of closing or reforming any banks. Accordingly, with such dispatch as would have made Internet-era number crunchers envious, the White House began opening banks the next Monday (March 13th), and by Wednesday 90 percent of the deposit basis among national banks had been reopened.
Within the following ten days nearly all of the $2 billion in hoarded currency had flowed back into the banking system, and the Fed’s gold reserves soon reached pre-crisis levels. By early April, fully 13,000 banks with $31 billion of deposits were open and more than 2,000 more quickly followed after they had been given RFC capital injections.
By contrast, at year-end 1933 only a thousand mostly tiny rural banks with aggregate deposits of less than $1 billion had been closed, thus demonstrating that at the time of FDR’s banking crisis only 3 percent of the nation’s bank deposits were still in insolvent institutions. In effect, the severe business cycle liquidation of the Great Depression was over even before Roosevelt was elected, and within weeks of his self-instigated banking crisis the US economy had resumed its natural rebound.
By June 1933, economic activity levels attained in the previous September had been regained and a slow upward climb ensued, led by the steady replenishment of fixed assets and working capital. To be sure, recovery was greatly attenuated by the shutdown of international trade, but in a process that was drawn and halting, nominal GDP eventually reached the $90 billion level by 1939. After seven years of New Deal medication, the nation’s money income was still straining to reach its 1929 level.
