The Knowledge Problem

On Minimum Wage

2011-07-07T10:48:00.000-07:00

A friend recently sent me this article on minimum wage:

Ending Minimum Wage Likely Wouldn't Dent Jobless Rate

Response:

There are effects of the second order that this article ignores. For example, even if a drop in minimum wage did not increase employment levels (which it would), goods will become cheaper. I experience this first hand in Georgia when I eat out. Even in the city, beers are 1 to 2 dollars less than in California, and meals cost 2 to 4 dollars less on average. The chief culprit? Lower minimum wage.

The real question is: What gives government the right to force owners of factories, restaurants and any other firms to pay workers a wage higher than they would normally agree upon? Nothing but might. The truth is, low wages are important because they allow workers to get experience in in fields with which they unacquainted, they keep prices low, they allow for higher levels of employment, and most of all, because people should be free.

James L Caton Jr wants to keep up with you on Twitter

2011-07-06T20:28:00.001-07:00

James L Caton Jr wants to keep up with you on Twitter

Twitter connects you with everything you want to know, right now. Short bursts of information are readily available from news organizations, corporate entities, politicians, celebrities, local businesses - even your close friends and family. Also, if you have something to share with the world, Twitter makes it super easy. To join for free, click the link below. http://twitter.com/i/8c63d7ca5e386449d0865d840a069b63828a623d

Thanks,

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Economics Without Context: Why Shiller is Wrong about Interest Rates - Revised

2011-05-09T08:46:00.000-07:00

Economics Without Context: Why Shiller is Wrong about Interest Rates

In his article, “Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models,” Professor Robert J. Shiller of Yale argues that an increase in asset prices over the last decade has little to do with real, long-term interest rates – interest rates adjusted for inflation – because the public is not aware of the impact and meaning of real interest rates. They are more familiar with nominal interest rates, and therefore, their decisions to invest are much more dependent on nominal rates, not real interest rates.[1]

Shiller first presents a record of real interest rates over the last 60 years and compares them to asset prices during the same time period. On the surface, his findings are compelling: there is little evidence of an inverse correlation between high asset prices and low real interest rates throughout this time period. Specifically, he looks at the early 1980s, a time period where real interest rates rose dramatically both in the U.S. under Chairman of the Federal Reserve Paul Volker, and around the world. At the end of the first quarter of 1980, both the annualized increase in CPI and the Fed Funds rate were over 17%. Seeing no direct link between real rates and asset prices during this time, he critiques the mainstream interpretation of the Volcker-led Federal Reserve:

Focus on Paul Volcker as the stimulus for change in the worldwide policy stance toward inflation may be misplaced. On a worldwide basis, the major turning point toward lower inflation looks more like 1975 than 1981, before Volcker's term as chairman began.

After real interest rates began rising, the world experienced a second round of price inflation that was a consequence of an irrational market.

Shiller also supports his argument by comparing real interest rates with housing and stock dividend values. Real interest rates reached their height in the U.S. in the early 1980s, and they continued in a downtrend until the present. Housing prices, however, did not show a substantial uptrend until the late 1990s and early 2000s. If the assumption that there is an inverse relationship between real interest rates and asset prices is correct, housing values should have begun their upward trek long before the end of the 1990s. He also applies this logic to stock dividends. During the late 1970s and early 1980s, dividends show a similar trend. He notes that “the correspondence with interest rates is not very tight,” and only shows consistent correlation in recent decades. While a consistent correlation of a longer period of time intuitively makes sense, the dissonance between reality and theory is, according to Shiller, due to a lack of public understanding:

Thus, ex post real rates may have shot up very high even though ex ante real rates did not. From this analysis of changing popular thinking about monetary policy, one is left in some doubt about the public's appreciation of the relation between interest rates and inflation, and their understanding of real long-term interest rates.

But does this confusion lead investors to act irrationally is there more to the story?

Shiller leaves out an explanation of the dynamic relationship between money and interest rates. This information is vital in formulating a theory of interest rates – real or nominal – and asset prices. Increases and decreases in the money supply are non-neutral in their effects. That is, when the supply of money changes, not all prices are affected in the same magnitude nor in the same time period. As Ludwig von Mises notes in Money, Method, and Market Processes, this is due to a combination of asymmetrical distribution of newly created money and the varying of individuals’ subjective preferences for specific goods and services [2] As rates change, so do subjective preferences for consumption and investment – not to be confused with a change in time preference – which alters the distribution of money in the economy. An increase in the money supply and a subsequent decrease in both nominal and real interest rates may increase liquidity but have only a minor inflationary effect on asset prices if the drop in interest rates is either shallow or short term. Likewise, an increase in both nominal and real interest rates after an extended period of credit expansion may, in the short and medium run, lead to inflated asset prices as higher interest rates attract previously latent money into the market. By looking for a direct, synchronous correlation between real interest rates and asset prices that ignores such complexities, Shiller misses this phenomenon.

This lens of monetary non-neutrality and subjective value reveal a strong correlation between asset prices and real interest rates. The asset boom of the early 1980s is a textbook example. The loose credit policies of 1975-77 did not heavily affect asset prices until the money from such policies entered different markets when interest rates rose. Shiller’s observation of a “lack of correspondence” between real interest rates and asset prices loses its mystery as one sees that the new money from open market purchases may simply sit in low yielding assets or in bank reserves. It is more likely to be employed when higher interest rates provide new opportunities for profits. Therefore, a market’s immediate reaction to a contractionary monetary policy can be to increase temporarily the supply of investment capital as investors in bonds and securities take advantage of higher interest rates. In other words, interest rates may, in the short term, react to a change in the money supply with greater magnitude than the actual change itself.

A similar event occurred when the Federal Reserve began to tighten monetary policy in 1928 after having engaged in three major rounds of open market purchases in 1922, 1924, and 1927. Benjamin Anderson of Chase National Bank noted that with other investments saturated, 5 years of expansionary monetary policy led to an extended bull market. When the Federal Reserve attempted to reverse policy in 1928, these efforts proved futile. A rise in interest rates was not enough to offset the boom psychology, and in fact, only emboldened it. Stock investors continued to buy on margin and financiers were more than happy to loan their extra funds directly to them for high rates of return.[3] The Dow Jones Industrial average rose from 197 in February 1928 to 269 in November of 1928: a 36% increase in only 6 months! Once again, a scenario of simultaneously increasing interest rates and asset prices can be logically explained through the flow and distribution of currency.

Shiller not only ignores the effect of currency flows on asset prices, but also the effects of moral hazard created by government sponsored enterprises (GSE) and efforts by the Federal Reserve to prop up failing markets. Most important of the GSEs that supported the boom were Fanny Mae and Freddie Mac. In his recent book, Meltdown, economic historian Thomas Woods shows that, although the two GSEs began as minor operations, by “the eve of the federal government takeover in 2008 they had a hand in about half the country’s mortgages, and nearly three-quarters of new mortgages.”[4] Investors and lenders knew that the government gave these GSEs carte blanc and that it would cover any losses sustained from these mortgages.[5] This especially became a problem as financial firms bought mortgages from Freddy and Fannie, employed them in Collateralized Debt Obligations, insured them with underfunded Credit Default Swaps (insurance), and leveraged them to increase profits. Of course activities like this are usually discouraged by fear of loss, but more moral hazard was added to the situation during the late 1990s and early 2000s when, on multiple occasions, the Federal Reserve flooded the market with liquidity – one need only think of its response to the failure of Long Term Capital Management, the Dotcom Bust, and 9/11 in recognizing a pattern of risk-encouraging market rescues by the Federal Reserve.[6] These interventions allowed many firms to avoid bankruptcy and continue the high risk activities that led to systemic risk.

The growth of the money supply and of moral hazard led to the housing boom and massive price inflation in housing between 1999 and 2006. Low interest rates set the stage for this world-wide boom while the growth of GSE activity, risky investment instruments, and Federal Reserve intervention in the markets gave it momentum. Given this context and others discussed, there is a clear correlation between low interest rates – real and nominal – and increased asset prices. Shiller’s overconcentration on the real interest rate and his inability to take into account the asymmetric effects of inflation distorts his analysis of fundamental market processes, thus leading him to invalid conclusions that rely more on belief in animal spirits than sound economic theory.

[1] Robert J. Shiller, “Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models,” Brookings Papers on Economic Activity 2007, no 2 (2007): 111-132.

[2] Ludwig Von Mises, Money, Method, and Market Processes (Norwell, MA: Kluwer Academic Publishers, 1990), 70.

[3] Employing a metaphor, Economist for Chase National Bank Benjamin Anderson wrote, “When a bathtub in the upper part of the house has been overflowing for five minutes, it is not difficult to turn off the water and mop up. But when the bathtub has been overflowing for several years…a great deal of work is required to get the house dry. Long after the faucet is turned off, water still comes pouring from the walls and from the ceiling. It was so in 1928 and 1929.” Benjamin M. Anderson, Economics and the Public Welfare (Indianapolis, IN: Liberty Press, [1949] 1979), 196-199.

[4] Thomas Woods, Meltdown: A Free Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts will Make Things Worse,” (Washington D.C.: Regnery Publishing, Inc., 2009), 15.

[5] Ibid., 14.

[6] Although not an opponent of the Federal Reserve as an institution, Scott Patterson describes in detail the moral hazard created by its intervention throughout his recent book, The Quants. Scott Patterson, The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, (New York: Crown Business, 2010).

Liquidation, not Consumption, Key to Recovery: A Critique of Martha Olney on the Role of Credit Default in the Great Depression

2011-04-19T16:45:00.000-07:00

In her article, “Avoiding Default: The Role of Credit in the Consumption Collapse of 1930,” Martha Olney claims that high consumer indebtedness in the early years of the Great Depression curtailed consumer spending and amplified the economic hardship. At the same time, major providers of consumer credit faced minimal losses. This was largely due to the structure of debt installments. She explains that this was the result of heavily punitive financial laws and organization:

The 1930 drop in consumption resulted from the unique combination of historically high consumer indebtedness and punitive default consequences. Down payments were large, and contract terms short, so equity was acquired quickly. If an installment payment was just 30 days late, the good being purchased could be and often was repossessed. The defaulting household was not compensated for the "surplus," the difference between the net resale value of the good and the remaining payments.[1]

She closes the articles by arguing that “the vast majority of auto and other installment contracts were completed as scheduled because default would have triggered wealth-reducing repossession. In order to avoid default, indebted families reduced consumption in nearly all spending categories.” According to Olney, this reduction in consumption turned “a minor recession into the Great Depression.”

Olney draws from several others on the subject: Christina Romer, Paul Flacco and Randall Parker. They argue that the market crash at the end of the 1929 increased income uncertainty. While Flacco and Parker establish this with regression analysis, Olney supports her thesis by providing raw data. In March of 1930, “only 7 firms increased wages, but 117 firms cut the wages of over 20,000 employees. Then in July 1930 no firms reported raising wages, but 133 firms reported cutting wages of nearly 25,000 people, 86 percent of the workers in those firms. The depression had begun in earnest.” With the increased possibility of wage decreases and layoffs, most American households decreased consumption. In fact, despite the economic downturn at the end of the decade, delinquency rates on auto loans only increased by from 4.1% in 1928 to 5.4% in 1930. Olney connects this lack of default with an increase in the severity of the Great Depression.

The expectations of consumers during the 1920s changed faster than that of the law. Before the 1920s, consumer debt was viewed as a social anathema, but by the end of the decade dependence on consumer credit became the status quo. Though the habits of consumers changed, the law regarding repayment of credit did not. The law favored lenders over their debtors. When the workers feared loss of work, and therefore a loss of income, “decreasing consumption and setting aside funds with which to make future installment payments was the only…option.” This fear inhibited the individual’s willingness to consume.

Between 1929 and 1930, total consumption decreased by 6.2%. Olney compares this to the recession in 1938 where consumption only fell by 2.2%. The difference, Olney claims, is due debt levels. All lagged data of debt between 1919 and 1941 shows a strong correlation for its effect on consumption. The magnitude of the effect of debt on consumption correlates with the level of debt one must repay. The volume of debt repaid in 1930 was much higher than in 1938 due to an unwillingness of consumers to default at the beginning of the decade. A change in the laws and subsequent reduction in burden of default on consumers explains this discrepancy. Furthermore, Olney shows that an expected 10% decrease in income demands a proportionally larger reduction in consumption if the reduction is expected within one month. Thus, the Crash of 1929, coupled with strict laws regarding consumer debt, slowed the economy – an economy largely dependent on high levels of consumption – to a crawl.

The moral of the story, Olney asserts, is that laws that make default expensive for the consumer only worsen economic downturns:

The strategies households pursue to avoid expensive default can harm those whose livelihoods depend upon the consumer goods industries. Policy makers who want to avoid another consumption collapse similar to that of 1930 should focus their attention on the consequences of default. Avoiding default can do more harm than good.

Olney’s stance is clear: An economy centered on consumption cannot prosper if consumption levels drop dramatically. Therefore, government legislation must make default less burdensome so that consumption can continue. But is Olney’s solution an economic panacea or simply band-aid?

Olney presents a solid case. Clearly a drop in consumption precipitated a shrinking economy and an increase in unemployment. Her underlying, but unstated, assumption is that economic health can be defined by indicators such as unemployment, consumption levels, and GDP. While these can indicate economic health, the information they provide is not differentiated. They only identify values in terms of aggregates.

The crisis of 1929 was a crisis of pricing. Federal Reserve open market purchases encouraged resource misallocation, moving wealth away from rural producers to urban financiers, producers, and consumers.[2] That is, when the Federal Reserve increases liquidity, currency is not uniformly distributed throughout the economy. It clusters into certain sectors: First to the investors who sell their assets to the Federal Reserve, then to banks, businesses, and consumers.[3] This creates a bubble in nascent industries whose existence and growth is largely, though not always wholly, dependent on credit expansion. The indicators aforementioned – unemployment, consumption, and GDP – did not, and still do not, account directly for these problems. The Roaring Twenties experienced unprecedented growth in GDP and low unemployment levels. Though this led many analysts and economists, including Irving Fischer, to predict no end to the prosperity and no crisis in value, their analysis was flawed in that they did not consider the economic distortions created by expansionary monetary policy.[4]

Olney makes a similar mistake. Her analysis is correct in that the unfair terms on the repayment hurt producers of consumer goods and the economy in general. It encouraged higher levels of unemployment than might have occurred otherwise. She errs, however, in her claim that default laws ought to be less harsh for consumers so that they can continue consuming and support producers of consumer goods. Even without harsh terms for default, consumption levels still would have dropped, unemployment rates still would have increased, and credit still would have tightened. These are the short term effects of economic readjustment after a boom induced by credit expansion. In the early 1930s, economic depression, both in the United States and across the globe, were side effects of economic and monetary distortions created by money creation and borrowing during World War I and interventionist central banking policies that attempted to avert these distortions’ negative effects by creating inflation.[5]

A drop in consumption was the inevitable consequence of years of overconsumption and resource misallocation, in addition to unresolved debt insolvency from World War I. Concerning consumer debt in 1930, the problem was not so much that consumers were unable to continue consuming at the same rate as they chose not to default, but that capital was locked up and assets remained overvalued. The law did not permit goods bought on installment to be sold to repay the loan, even if they had equity. This weakened the financial position of individuals as they were unable to increase savings. It also prohibited the liquidation which is pivotal to asset reappraisal and to helping volatile markets find a bottom. If markets had been allowed to bottom, investment would have more than likely resumed as resources would have been more accurately valued and the Great Depression would not have been so great. Again, Olney is correct in almost all of her assertions. She only needs to reevaluate her fundamental assumptions and consider the effects of central banking and government policies and the fundamental causes of volatility after World War I.

[1] Martha L. Olney, “Avoiding Default: The Role of Credit in the Consumption Collapse of 1930,” The Quarterly Journal of Economics 114, no 1 (February, 1999): 320.

[2] Jim Caton, “Urban Prosperity, Rural Chaos: Federal Reserve Policy During the Roaring Twenties,” http://theknowledgeproblem.blogspot.com/2010/12/urban-prosperity-rural-chaos-federal.html

[3] “The primary beneficiaries of inflation are commercial banks, financial centers, and large corporations requiring long-term financing… New projects involving heavy machinery, construction, and research benefit tremendously from new financing.” (Skousen draws his claim from Mises and Wicksell.) Mark Skousen, Economics on Trial: Lies Myths and Realities, (Homewood, IL: R.R. Donnelley & Sons Company, 1991), 91-92; Ludwig von Mises, Theory of Money and Credit, (Auburn, AL: Ludwig von Mises Institute, [1913] 2009), 349.

[4] See The Austrian Business Cycle Theory. Roger W. Garrison, “The Austrian Theory of the Business Cycle,” (Auburn University), http://www.auburn.edu/~garriro/a1abc.htm

[5] During the 1920s, central banking policies in the U.S. and Britain aimed to stabilize the British Pound and weaken the U.S. Dollar. Governor Benjamin Strong of the Federal Reserve Bank of New York stated this goal clearly in a letter to Mellon in 1924: “The burden of the readjustment must fall more largely upon us than upon them [Great Britain]. It will be difficult politically and socially for the British Government and the Bank of England to face a price liquidation…” Jim Caton, “Courting Disaster: How Inflationary Central Banking Policies Made the Great Depression Unavoidable,” http://theknowledgeproblem.blogspot.com/2010/12/courting-disaster-how-inflationary.html; See also Silvano A. Wueschner, Charting Twentieth-Century Monetary Policy: Herbert Hoover and Benjamin Strong, 1917-1927, (Westport, CT: Greenwood Press, 1999); Murray N. Rothbard, America’s Great Depression, (Auburn, AL: Ludwig von Mises Institute, [1963] 2008); Murray N. Rothbard, A History of Money and Banking (Auburn, AL: Ludwig von Mises Institute, [2002] 2005); Benjamin Anderson, Economics and the Public Welfare (Indianapolis, IN: Liberty Press, [1949] 1979)

The Federal Reserve and Wealth Reallocation During the Roaring Twenties

2011-04-12T21:28:00.000-07:00

The Federal Reserve, QE2, and Dollar Instability

2011-02-27T13:04:00.000-08:00

In early November the Federal Reserve initiated a new round of government securities purchases. It committed to buying $600 billion dollars by mid-2011 in an attempt to bolster the U.S. economy.[1] Federal Reserve Chairman Bernanke hopes that an increase in liquidity will encourage consumers to resume borrowing and thus reinvigorate the economy. In addition to an expansion of consumer credit, Bernanke also hopes to maintain bank solvency by keeping the federal funds over-night rate as low as possible. Commentators note that this action looks similar to the Federal Reserve’s 2008 policy. At the end of 2008 the Federal Reserve launched a massive program in which it purchased $1.7 trillion in securities with intent to stabilize the economy during the instability that occurred between November 2008 and March 2009.

Like many main stream economists, Ben Bernanke follows the line of reasoning presented by Milton Friedman and Anna Jacobson Schwartz in A Monetary History of the United States, 1867-1960 which claims that the Great Depression was result of tightening of credit in 1928-29 and a decrease in the stock of money in the years that followed. Speaking at Milton Friedman’s ninetieth birthday he stated, “Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you we won’t do it again.”[2] What Bernanke meant was that as Federal Reserve Chairman, he will maintain a policy of “low and stable inflation.” In other words, he will not allow price deflation to occur. No matter how low interest rates are, if prices intimate any sort of decrease, Bernanke will keep the federal funds rate depressed and continue to increase open market purchases by the Federal Reserve. However, Ben Bernanke is not unopposed.

Several financial experts have criticized Bernanke’s latest round of securities purchases. Former Federal Reserve Chairman Paul Volcker spoke out on November 5^th. He claimed, “It’s hard to have a big impact on the short-term interest rate that is already zero…”[3] In fact, if price inflation becomes a problem, Bernanke’s policy might bring about in real interest rate that is negative.[4] Germany’s finance minister, Wofgang Schauble, voiced similar concerns as Volcker. “It is not consistent,” he argued, “when the Americans accuse the Chinese of exchange rate manipulation and then steer the dollar exchange rate artificially lower.”[5] More dollars in circulation will more than likely result in a devalued dollar and bring further instability to global markets.

Bernanke has responded to critics of his easy money policy. At a conference on Jekyll Island, he attempted to ease concerns and said that his program will not bring about “super ordinary” inflation levels.[6] Investors do not share his confidence. Bernanke’s outspoken attitude concerning easy money has weakened the dollar over the last month as investors anticipate more securities purchases by the Federal Reserve. Many worry that further bond buying could do more harm than good by providing tinder for inflation that will ignite when the recovery finally gains traction. As rising interest rates encourage savings and attract increased investment, the markets may risk another boom much the same way that the stock market boomed in 1928 as interest rates rose. The economic imbalances brought about by Federal Reserve intervention will likely be worse than most anticipate and may even foment a crack-up boom in commodities.[7]

One must consider the role of the interest rate in a free market economy in order to understand the effect of money creation from the central bank. The interest rate is the price of money that allows the supply of savings to equal demand for loans. When supply is increased due to Federal Reserve purchases on the open market, interest rates fall and individuals feel a false sense of abundance. The consequences are myriad. The most immediate problem is that individuals are encouraged to decrease savings and increase consumption. They continue to consume lower order goods, but also increase consumption of goods from lengthened production structures.[8] The tendency is for consumers to begin to rely on credit rather than savings.[9] Over a long enough period of time, savings are liquidated. Meanwhile, industry grows accustomed to the new levels of consumption which were dependent, not on real savings, but on an artificially high level of available credit. Loose credit is no replacement for savings. As the spigot of credit dries due to default and reserve requirements, the economy enters a recession and investments in the higher order goods must be liquidated before recovery can start. [10] The Federal Reserve can respond by expanding liquidity, but it only delays the inevitable correction and increases economic distortions.

Of course central banks are not beholden to reserve requirements in the modern era, so the only limitation to increased liquidity is the bank’s willingness to devalue its currency relative to other currencies. A currency’s value, however, is not only dependent on its supply. If there is a loss of faith in a currency, demand for it will fall, decreasing its value further. The Bretton Woods Conference in 1945 made the U.S. dollar the world reserve currency and, consequently, increased demand for dollars. To this day the dollar has dominated the exchange markets and investors have had little reason to drastically reduce exposure to the currency, but as the dollar devalues a decrease in demand will become more likely.

After the crisis in 2008, the dollars role has received numerous challenges from bankers, economists, and governments. The BRIC countries (Brazil, Russia, India, and China), for example, have made agreements amongst themselves to forego trade in dollars. If the Federal Reserve continues to expand the money supply, other countries may minimize their employment of the dollar or even stop using it entirely. A decrease in demand of large magnitude will likely initiate a period of extensive devaluation. As international demand for dollars plummets, many of the dollars abroad will begin to flow back to U.S. that will shrink further its domestic purchasing power.

Bernanke’s latest decision may make this doomsday scenario a reality. Like the British pound after 1931, the dollar risks a major loss in purchasing power relative to other currencies. Currently the U.S. Dollar Index is on a downward trajectory toward its all-time lows reached in early 2008. If this is the state of the dollar while much of the stimulus lays relatively latent in the vaults of the Federal Reserve – collecting only 1-2% interest – the results will be disastrous as decreased investor confidence drives the interest rate higher. Then the Federal Reserve will lose control over the flow of dollars as investors flock to commodities and high yielding investments in order to shield themselves from dollar devaluation.

[1] “Fed to spend $600 Billion More to Help Boost US Economy,” Reuters 03November 2010, http://www.cnbc.com/id/3990450

[2] Ben Bernanke, “Remarks,” in Milton Friedman and Anna Jacobson, The Great Contraction: 1929-1933 (Princeton, NJ: Princeton University Press, [1963] 2008), 247.

[3] “Volcker: Future Inflation Risk Limits Easing Effect,” Reuters 05 November 2010, http://www.cnbc.com/id/40023233

[4] While many economists point to this as a positive occurrence, a negative interest rate may cause many investors to lose faith in the dollar. As long as the Federal Reserve is so heavily distorting the value of the dollar, it is preventing price from reflecting true scarcity and value at a given time. An inflationary Federal Reserve Policy may thus discourage nations from employing dollars in exchanges, as is evidenced by recent agreements between BRIC countries. Robert F. Mulligan, “A Hayekian Analysis of the Term Structure of Production,” The Quarterly Journal of Austrian Economics 5, no 2 (Summer 2002): 19. (Accessed December 5, 2010) http://mises.org/journals/qjae/pdf/qjae5_2_2.pdf

[5] “World Bank Chief Sparks Gold Standard Debate,” Financial Times 08November 2010, http://www.cnbc.com/id/40064723

[6] “Bernanke Defends new Fed Plan to Boos Economy,” Associated Press 06 Nov 2010, http://www.cnbc.com/id/40043717

[7] “The expectation of a general progressive upward movement of all prices does not bring about intensified production and improvement in well-being. It results in the "flight to real values," in the crack-up boom and the complete breakdown of the monetary system.” Ludwig von Mises, Human Action: A Treatise on Economics (Auburn, AL: Ludwig von Mises Institute, 1998), 466-467.

[8] The description of goods as lower or higher refer to the length of their production processes. The higher the order of the good, the greater the amount of resources consumed when production is finished. See the Hayekian Triangle. http://wiki.mises.org/wiki/Hayekian_triangle; Mulligan explains that the lower the slope of the hypotenuse, the lower the interest rate and the longer and more round about the process of production. Robert F. Mulligan, “A Hayekian Analysis of the Term Structure of Production,” 17-33.

[9]Ludwig von Mises, Theory of Money and Credit (Auburn, AL: Ludwig von Mises Institute, [1952] 1998), 361.

[10] Murray Rothbard, America’s Great Depression, (Auburn, AL: Ludwig von Mises Institute, [1963] 2008), 14.

Thomas Paine v. Edmund Burke: A Look at Their Metaphysical Beliefs and the Nature of Their Arguments

2010-12-13T19:15:00.000-08:00

From its inception, the French Revolution was built upon conflicting ideals. France was to have an egalitarian society, but also individual property rights. Men could act in their self-interest, but not if that interest did not support the “common benefit.” Individual liberty, though it received praise by many revolutionaries, was not seen as good in itself. Rather, it was dependent upon the common good, a concept which is highly subjective and in all practicality, indefinable. The confusing language demonstrated and reinforced a dichotomy that pit the individual against society. Driven by these conflicting ideologies, participants and observers attempted to shape the political environment in France.

This conflict was well represented by one participant, and one observer: Thomas Paine and Edmund Burke, respectively. Burke, who had conservative leanings, wanted to see change that occurred slowly over time and that respected tradition. Most important, he did not want to see the state usurp the power of the individual. Thomas Paine, on the other hand, believed that monarchy was unnatural and evil, and therefore the people had the right to overthrow such an institution at any given time. Paine saw the new state as an agency which represented the people, and he unconsciously ignored the injustice of some of its actions. As the French Revolution intensified and the Oath of the Tennis Court gave way to the execution of Louis XVI and the Reign of Terror, Burke’s arguments proved more consistent, and even Paine’s love for the revolution grew cold.

The political upheaval in France during 1789 grew from public dissatisfaction that had grown throughout the century. Falling grain prices in the two decades preceding the revolution brought hardship to farmers and two years of bad harvest in 1787 and 1788 spread hardship to wage earners.[1] As discontent brewed among the ranks of the lower class, the upper and part of the middle class were economically well off. The nobility and the clergy successfully avoided many taxes and often held seigniorial rights. Many from the upper bourgeoisie held government positions or prospered from investments.[2] Those left out of the relative prosperity included many members of the lower bourgeoisie such as merchants and guildsmen. It was the strength of the middle and upper classes in light of a bankrupt monarchy and discontent among the masses that sparked the Revolution.

Burke noted that the French Revolution grew out of a crisis in government and tradition, and was radical compared to Britain’s Glorious Revolution. Though there was a “small and a temporary deviation from the strict order of a regular hereditary succession,” the deposition of Britain’s King James II by William of Orange “was an act of necessity” and was only a slight variance from tradition. [3] It was the exception, not the rule. The practice of hereditary succession immediately resumed and brought stability.

Political discontent in 1789 France did not find resolution through such minor alterations of the existing system. The unbending attitude of a weak Louis XVI made this impossible. The years preceding the revolution witnessed a massive expansion of government debt due to expenditures which far outpaced revenues.[4] In 1787 the Assembly of Notables refused to aid the king by increasing taxes, and the situation worsened. “The financial crisis of the state was in full swing” within a year and French Finance Minister resigned.[5] The door was opened for the calling of the Estates General and a shift in the balance of power.

The dysfunction of the Estates General quickly led the Third Estate to assert its legitimacy and create the National Assembly. The National Assembly consequently inherited the financial problem and sought a remedy. It took unprecedented action by nationalizing church lands and created a currency, the assignat, which derived its value from those lands. Thus, soon after its inception the National Assembly pragmatically disregarded property rights, and in so doing, laid an unstable foundation on which to build a government that respects individual liberty. It is at this point that the arguments of Edmund Burke and Thomas Paine find their form.

Burke and Paine both held arguments which depend on aprioristic assumptions. Paine’s fell into the camp of Rousseau who held that “Man is born free, but everywhere he is in chains.”[6] Likewise, the Declaration of the Rights of Man and of Citizens declares in its first article that “Men are born and always continue to be free, and equal in respect of their rights. Civil distinctions, therefore, can be founded only on public utility.”[7] In his support for this, Paine makes a metaphysical which assumes that any lack of freedom, outside of that which supports the common good (“public utility”), is incompatible with human nature. This led Paine to see the world in dualistic terms of freedom and slavery, natural and aberrant. His arguments thus inevitably exhibit a flavor of extremism which purports any form of monarchy to be evil, while democracies, like the one formed in revolutionary France, are inherently good. In a monarchy the king “consigned the people, like beasts of the field, to whatever successor they appointed,” and according to Paine’s metaphysical belief structure the legitimacy of kingship “is now so exploded as scarcely to be remembered, and so monstrous as hardly to be believed.”[8] Paine’s belief in an abstract free man as apriori allowed him to deride as illegitimate those social institutions that opposed his ideals. This abstraction, not dependent on time, place, or circumstance, stands in stark contrast to Edmund Burke’s concept of human nature and freedom.

Burke, unlike Paine, did not believe in an abstract man who lacked context. Burke viewed man, not as having an inherent nature, but “as naturally involved with [social] links, and…as those links dissolve, man's identity does too.”[9] Burke correctly sensed the seeds of nihilism which lay in the philosophical soil of the revolution. If man is not confined and influenced by the past, he is defined by nothing. He is then rootless and the society comprised of individuals like him risks social instability. Burke claims instead that freedom is discovered over time and requires context:

Indeed in the gross and complicated mass of human passions and concerns… therefore no simple disposition or direction of power can be suitable either to man’s nature, or to the quality of his affairs…The rights of men are in a sort of middle, incapable of definition, but not impossible to be discerned.[10]

Essentially, Burke takes a subjective view of human nature and opposes any assumptions of an objective, natural man that lack a social environment. This difference in metaphysical worldviews inevitably led to disagreements between Burke and Paine over the legitimacy of monarchy, the role of government, and the nature of individual property rights.

Burke disdained the French Revolution for its disregard for tradition and for its inherent political instability. To move as quickly away from a monarchical state as the French did was to irreparably damage the foundation of society. On stability in government he wrote:

The science of government being therefore so practical in itself, and intended for such practical purposes, a matter which requires experience, and even more experience than any person can gain in his whole life, however sagacious and observing he may be, it is with infinite caution that any man ought to venture upon pulling down an edifice which has answered in any tolerable degree for ages the common purpose of society.[11]

Whether one judged monarchy as good or evil, it maintained order. If society is not defined by its structures and traditions, if it abandons its history, it loses its coherent form. Burke saw the disregard for Louis XVI among many revolutionaries as a disaster. French society was largely defined by “a majestic monarchy,” but after the revolution is was better defined by political chaos.[12] In confronting revolutionaries who looked to England for support, he wrote:

I hear it is sometimes given out in France that what is doing among you is after the example of England. I beg leave to affirm, that scarcely anything done with you has originated from the practice or the prevalent opinions of this people, either in act or in spirit of the preceding.[13]

The Glorious Revolution respected tradition and the past, the French Revolution did not. The Glorious Revolution only slightly weakened the role of the king. The French Revolution destroyed the power of the throne.

Paine and those like him, due to their conceptions of natural rights, failed to see this as a hazard. In fact, it was to them a blessing of the revolution. It was a sign of progress. Paine claimed that monarchy required “a belief from man, to which reason cannot subscribe, and which can only be established upon his ignorance.” He compared this to a republic which “requires no belief from man beyond what his reason can give.”[14] Paine did not believe in continuity. He did not believe in incremental progress. He instead demanded that society shift from its historical foundation toward a radical liberalism. He continued, “A mixed Government is an imperfect everything, cementing and soldering the discordant parts together by corruption.”[15] Paine was an ideological purist. Only an enlightened democracy, he believed, could properly govern a nation.

Burke’s push for gradual reform to better society naturally struck discord with Paine’s chimerical ideal of immediate social perfection. Paine decried Burke as “contending for the authority of the dead over the rights and freedoms of the living.” [16] According to Burke, this was inevitable, and should only be refined, not obliterated. For Burke the revolution was destructive and “was at its roots characterized by a hatred of the very idea of society.”[17] Revolutionaries wanted to destroy and rebuild the government. In the process government took on a new role.

Revolutionaries radically redefined and empowered government. The basis of the new government can be inferred from several articles in the Declaration of the Rights of Man:

1. Men are born and remain free and equal in rights; social distinctions can be established only for the common benefit.

2. The aim of every political association is the conservation of the natural and imprescriptible rights of man; these rights are liberty, property, security, and resistance to oppression.

17. Property being an inviolable and sacred right, no one may be deprived of it unless public necessity, legally determined, clearly requires such action, and then only on condition of a just and prior indemnity.[18]

Government took on a new mandate. It was formed in order to serve the “common benefit.” While a seemingly valid ideal, there was no historical precedent which suggested that a strong, centralized government could help enact the “common benefit.” Furthermore, the government could violate the rights of its subjects if its actions supported the “common benefit.” Many in the National Assembly saw themselves as acting for this cause, but their knowledge of how to enact this good was imperfect and their motives were sometimes questionable.

Burke immediately sensed the danger of the situation. Government in itself is antithetical to egalitarianism. It is the only agency with a monopoly on the legal use of force. Therefore government officials can, in the name of the people, strip away the civil liberties of specific portions of the population. Backed by force, they can redistribute wealth. “Those whose operations can take from, or add ten per cent to, the possession of every man in France,” wrote Burke, “must be the masters of every man in France.”[19] With power conveniently consolidated, individuals empowered themselves through government and the “common benefit” was often obscured by self-interest. Burke elaborated,

France will be wholly governed by the agitators in corporations, by societies in the towns formed of directors of assignats…and adventurers, composing an ignoble oligarchy founded on the destruction of the crown, the church, the nobility, and the people. Here end all the deceitful dreams and visions of the equality and rights of men.[20]

The power vacuum created from the disempowerment of the monarchy was inevitably filled, and, as Robespierre exemplified in his Reign of Terror, the men who took on new positions of power could be far less scrupulous than King Louis XVI.

Still, Paine responded with indignation. In the dualistic fashion of a man raised as a Quaker from childhood, Paine proposes that with the French Revolution:

Monarchical sovereignty, the enemy of mankind, and the source of misery, is abolished; and sovereignty itself is restored to this natural and original place, the nation. Were this the case throughout Europe, the cause of wars would be taken away.[21]

Paine implicitly asserts that republican representatives naturally support the interests of “mankind.” Republican government then took on an aura of holiness while all monarchies, in Paine’s eyes, were forces of evil. Paine’s tendency to reduce governments to these terms disallowed him to judge them according to their merit. Paine projected the success of the American Revolution onto the French Revolution. He consistently refers to both as near equivalents. “From the Revolutions of America and France,” he asserts, “are a renovation of the natural order of things…”[22] Political revolution was the road each nation needed to travel in order to help man reach a more natural state. In the process, the French government’s power was centralized and its control over the population increased. The state grew “infinitely stronger than the monarchy of Louis XIV…[and] it absorbed society in the name of the people. Consequently its ability to force change upon its subjects also increased.[23]

Since government action ultimately translates to the use of force, one should not be surprised that one of the earliest actions of the activist revolutionary government was to confiscate church lands and use them as collateral for its new currency: the assignat. That is, the government, led by the National Assembly, violated the rights of the Catholic Clergy, one of France’s largest property holders.[24] In its first year, the revolutionary government exhibited utter disregard for Article 17 from its Declaration of the Rights of Man. Burke was appalled while Paine applauded. “The property of France does not govern it,” remarked Burke. “Of course property is destroyed, and rational liberty has no existence. All you have got for the present is a paper circulation, and a stock-jobbing constitution…All this policy in the end will appear as feeble as it is now violent.”[25] The stability and prosperity that had existed in France before the revolution was at least in part dependent on property rights. The revolutionary government’s decision to disregard the property rights of the clergy literally shook the foundation of French society and threatened its collapse.[26] From this disorder, Burke saw that embodied in the revolution was the “hatred of the very idea of society.”[27]

Unlike Burke, Paine’s response to this confiscation was enthusiastic. He despised the Catholic Church and defended land confiscation by denouncing the tithe-system. He reasoned that rent should be fixed, however the tithe took a proportion of the tenant’s income. Paine claimed that “the French constitution has abolished tythes,” and since the “land was held on tythe” confiscation was justified.[28] To discharge its debts the National Assembly “ordered it [property of the Church] to be sold for the good of the nation, and the priesthood to be decently provided for.”[29] Paine’s logic here falters. If it is legitimate, the law must apply equally to all subjects. If liberties can be stripped from a few law abiding subjects, it can be stripped from all. Paine’s love for the revolution blinded him to this problem.

Additionally, Paine is ambiguously silent on the danger of assignat inflation. This is especially curious considering a polemical he wrote during the 1780s concerning colonial paper currencies: “Paper Money, Paper Money, and Paper Money! is now…both the bubble and the iniquity of the day…A tender law…operates to take away a man’s share of civil and natural freedom…”[30] Paine’s rhetoric against paper currencies in the United States was also applicable to the assignat. William Playfair, a contemporary observer, wrote of the terrible consequences in France which were similar to those spoken of by Paine:

Gold and silver, by degrees, became dear and scarce; small assignats became necessary, and were created; so that before the end of the year 1791, a traveller might go from one end of France to the other, and see neither gold, silver, copper, nor any currency but the assignats which were at 28 percent loss.[31]

The proliferation and devaluation of the assignats was too dramatic to ignore, and the French Government’s disregard for property rights was too radical for a supporter of liberty to justify. Property rights are a prerequisite to liberty.[32] If property rights are inconsistently upheld by a government, so too will civil liberties be inconsistently upheld. The French government’s disrespect for property rights thus represented an utter disregard for individual liberty. Paine’s loathing for monarchy and nobility allowed him to support a government whose actions were incongruous with ideals of freedom.

Paine did eventually come to judge the actions of the revolution as radical. In a letter to Danton written in May 1793, he expressed dismay at the enforcement of price controls:

I see also another embarrassing circumstance arising in Paris of which we have had a full experience in America. I mean of fixing the price provisions… The People of Paris may say they will not give more than a certain price for provisions, but as they cannot compel the country people to bring provisions to market the consequence will be directly contrary to their expectations, and they will find dearness and famine instead of plenty and cheapness.[33]

The social chaos which resulted in part from assignat inflation could not be solved by price controls. Here Paine’s attitude stands in stark contrast to his exchanges with Burke. Paine also voiced concern as the Reign of Terror transformed the revolutionary government into a dictatorship:

There ought to be some regulation with respect to the spirit of denunciation that now prevails. If every individual is to indulge his private malignancy, or his private ambition, to denounce at random and without any kind of proof, all confidence will be undermined and all authority be destroyed.[34]

A government is only as good as the people who run it. France had been run by the king and then by ideologues, but, according to Francois Furet, during the course of the revolution “’pure’ democracy” restored “without knowing it…the image of the old monarchical power.”[35] The revolution had left French government with a power vacuum, and the Robespierre almost inevitably was drawn to fill it. Only a few years after the revolution began, the chaos that Burke predicted became a reality, and Paine was unable to deny this. Paine’s poorly founded aprioristic assumption of monarchy as evil was no match for Burke’s holistic understanding of society as unfathomably complex.

Bilbiography

Altorfer, Stefan. History of Financial Disaster. London: Pickering & Chatto, 2006.

Breunig, Charles. The Age of Revolution and Reaction, 1789-1850. New York: Norton, 1977.

Burke, Edmund. Reflections on the Revolution in France. New York: Oxford University Press, [1790] 1993.

Hart, Jeffrey. “Burke and Radical Freedom.” Review of Politics 29, no 2 (April 1967): 221-238.

Kates, Gary. The French Revolution: Recent Debates and New Controversies. New York: Routledge, 1998.

Levausseur, E. “The Assignat: A Study in the Finances of the French Revolution.” The Journal of Political Economy 2, no 2 (March 1894): 179-202.

Mises, Ludwig von. Liberalism: In the Classical Tradition. New York: Foundation for Economic Education, 1985.

Paine, Thomas. Rights of Man in Thomas Paine: Collected Writings. Ed. Eric Foner. New York: Library of America, 1995.

Popkin, Jeremy D. A Short History of the French Revolution. Upper Saddle River, NJ: Pearson Prentice Hall, [1995] 2006.

Rothbard,Murray. For a New Liberty: A Libertarian Manifesto. Auburn, AL: Ludwig von Mises Insititute, [1973] 2006.

Rousseau, Jean Jacques. On Social Contract or Principals of Political Right, in Rousseau’s Political Writings. Trans. Alan Ritter and Julia Bondanella. New York: W.W. Norton and Company, 1988.

Spinner, Jeff. “Constructing Communities: Edmund Burke on the Revolution.” Polity 23, no 3 (Spring 1991): 395-421.

White, Eugene Nelson. “Was There a Solution to the Ancien Regime’s Financial Dillema.” The Journal of Economic History 49, no 3 (September 1989): 545-568.

[1] Charles Breunig, The Age of Revolution and Reaction, 1789-1850 (New York: Norton, 1977), 3.

[2] Jeremy D. Popkin, A Short History of the French Revolution (Upper Saddle River, NJ: Pearson Prentice Hall, [1995] 2006), 10-11.

[3] Burke employs the phrase “Privilegum non transit in exemplum:” The exception does not become the rule. Ibid., 17-18.

[4] Eugene Nelson White, “Was There a Solution to the Ancien Regime’s Financial Dilemma,” The Journal of Economic History 49, no 3 (September 1989): 550.

[5] Ibid., 567.

[6] Jean Jacques Rousseau, On Social Contract or Principals of Political Right, in Rousseau’s Political Writings, trans. Alan Ritter and Julia Bondanella (New York: W.W. Norton and Company, 1988), 85.

[7] Thomas Paine, Rights of Man [1791] in Thomas Paine: Collected Writings, ed. Eric Foner (New York: Library of America, 1995), 506.

[8] Ibid., 438.

[9] Jeffrey Hart, “Burke and Radical Freedom,” Review of Politics 29, no 2 (April 1967): 231.

[10] Edmund Burke, Reflections on the Revolution in France (New York: Oxford University Press, [1790] 1993), 62.

[11] Ibid., 61.

[12] Jeff Spinner, “Constructing Communities: Edmund Burke on the Revolution,” Polity 23, no 3 (Spring 1991): 398.

[13] Burke, Reflections, 88.

[14] Thomas Paine, Rights of Man, 522.

[15] Ibid., 523.

[16] Ibid., 438-439.

[17] Hart, “Burke and Radical Freedom,” 224.

[18] Paine, Rights of Man, 506-508.

[19] Burke, Reflections, 195.

[20] Ibid., 196.

[21] Paine, Rights of Man, 539.

[22] Ibid., 538.

[23] Francis Furet, “The French Revolution Revisited [1981],” in The French Revolution: Recent Debates and New Controversies, ed. Gary Kates (New York: Routledge, 1998), 89.

[24] E. Levausseur, “The Assignat: A Study in the Finances of the French Revolution,” The Journal of Political Economy 2, no 2 (March 1894): 180-181.

[25] Burke, Reflection, 52-53.

[26] As economist and philosopher Mises claimed, “the continued existence of society depends upon private property” Ludwig Von Mises, Liberalism: In the Classical Tradition (New York: Foundation for Economic Education, 1985), 87.

[27] Hart, “Burke and Radical Freedom,” 226.

[28] Paine, Rights of Man, 481.

[29] Paine, Rights of Man, 532.

[30] Thomas Paine, “Attack on Paper Money Laws” in Thomas Paine: Collected Writings, 364-365.

[31] William Playfair, “A General View of the Actual Force and Resources of France in January 1793,” in History of Financial Disasters, ed. Stefan Altorfer (London: Pickering & Chatto, 2006), 106.

[32] For the sake of this argument, the author uses the definition employed by economist and historian Murray Rothbard: “Freedom is a condition in which a person’s ownership rights in his own body and his legitimate material property are not invaded, are not aggressed against. Murray Rothbard, For a New Liberty: A Libertarian Manifesto (Auburn, AL: Ludwig von Mises Insititute, [1973] 2006), 50.

[33] Thomas Paine, “Paine to Danton [1793]” in Thomas Paine: Collected Writings, 393.

[34] Ibid., 394.

[35] Francis Furet, “The French Revolution Revisited,” in The French Revolution, 75.

Courting Disaster: How Inflationary Central Banking Policies Made the Great Depression Unavoidable

2010-12-10T08:04:00.001-08:00

After World War I, the world faced economic turmoil in its transition from a wartime economy to a peacetime economy. Losses from wartime speculation, a large drop in the price of commodities, and currency depreciation in France, Britain, and other European countries demanded a painful period of economic restructuring. Federal Reserve and the Bank of England attempted to stabilize financial markets at prewar levels by creating a system of currency exchanges which arbitrarily valued each nation’s currencies. As is often the case, implementing this system proved more difficult and complex than expected. Instability in Europe moved large volumes of capital, especially gold, to banks in the United States. In order to compensate for this increase of reserves, the Federal Reserve initiated a policy of easy money that was intended to provide liquidity to Europe and to businesses in the United States while it simultaneously weakened the dollar against the pound. The attempts by these agencies to stabilize the global economy depended on an inflationary policy throughout the twenties that promoted volatility and birthed the cluster of errors that signaled the start of the Great Depression.

The Great War

The market crash in 1929 the economic instability that ensued was in part a result of economic policies during World War I. The destruction of the war had a decisive impact on the world economy during the 1920s. For the first time in their history, the well-developed capitalist economies of Europe came largely under the control of national governments. Lionel Robbins recalled, “The needs of war called for a huge apparatus of mechanical equipment into being…For four years, the capital resources of belligerent countries of the world were devoted to providing offerings to Mars.”[1] Continuing, he wrote that only “the centralization of control of industrial operations” could give rise to the massive wartime economies which resulted.

This transformation demanded funds in the form of taxes, debt, or inflationary money creation. Government favored the latter two. At the start of 1917, the Federal Reserve Board estimated total European war debts to amount to $49,455,000,000.[2] In modern terms, this was over $2 trillion. Inflation compounded the problem. Several months before the war ended, Walter F. Ford observed the war’s effect on currencies: “With the exception of America, all the countries involved in the war have added largely to their currencies by means of paper money which is inconvertible in fact if not in name.”[3] The effects were devastating. Money created to fund the war was able “to compete for the greatly reduced supply of goods available for public use [and] could hardly fail to force up the prices of those goods.”[4] The inevitable end was that at “each stage [of uncovered credit expansion] it becomes increasingly difficult for the borrower to extricate himself, and there is always a point beyond which he cannot go without becoming bankrupt.”[5]

The problem of debt and currency expansion created not only risk of insolvency, but also rising prices. The burden of this spending fell on the shoulders of the lower and middle classes. Yale economist Irving Fischer recognized the social effects of inflation. The war, he claimed, was paid for “not out of real savings or not followed up, at least, by real savings.” He worried that “when we increase prices then we enforce saving by the poor, and the war will be financed then by the wage-earner, or more particularly by the salaried.”[6] In 1920 Herbert Hoover adequately described the economic reality as well. He wrote, “The universal practice in all the countries at war of raising funds by inflation of currency is now bringing home its burden of trouble.”[7] Belligerent states surrendered not only their economies to the war, but also sacrificed the well-being of their poor and middle-class.

Econometric data also supports this claim. By March 1919, the pound sterling’s value sagged at $3.50, a far cry from its pre-war par of $4.86.[8] Even in the United States “prices of wholesale commodities went up about 81 per cent, and of retail commodities about 47 per cent.”[9] Inflation robbed holders of national currency, mainly wage workers, by transferring wealth to the receivers of the newly minted currency. In this case the state and the war contractors profited from the wartime inflation that destroyed Europe. In addition to an increasing volume of currency, consumers worldwide had to compete with government for precious resources such as food and clothing. An increase in demand alongside a shrinking supply led to fantastic wartime commodity prices, and nearly two years after the war, a severe bust.

Post War Bust?

When the war ended, the Federal Reserve resisted tightening the credit market that expanded during the war. The Federal Reserve Board announced its reasoning shortly before the war’s end, saying, “It would be much better to hold credit within reasonable limits by intelligent cooperation, rather than to attempt to force contraction by establishing high discount rates.”[10] It hoped to avoid an abrupt transition from an inflationary wartime economy to a more sound peacetime economy by keeping inflationary credit available to businesses and by maintaining stable commodity prices. In an article titled “Federal Reserve Policy,” A. C. Miller, member of the Federal Reserve Board, explained:

Its [the Industrial Board’s] main effort was directed to bringing about revision of prices and stabilization of the expected fall of prices... Events soon showed that the policy of ‘price stabilization’ was based on a faulty economic diagnosis. It was not many months after the close of the war that prices began to rise.[11]

The Federal Reserve, in its support for the Industrial Board policy, was thus unable to control the flow of credit and its complementary price inflation.

Thanks to economic conditions encouraged by Federal Reserve policy, businesses continued to operate as they had during the war. American industries had grown dependent on demand from Europe during the war and this did not change after 11 November 1918. According to the economist Benjamin M. Anderson, in June 1919 “we had an export balance of $635 million, of which $601 million represented our excess of exports with Europe alone.”[12] After the Armistice, the U.S. government supplied Europe with over $3 billion in loans in addition to the $7 billion it had supplied during the war.[13] High levels of both loans and exports to European countries signaled coming instability. Demand driven by Europe’s unsound position as debtor – and the U.S. as irresponsible creditor – created shortages of goods in the U.S. In turn, rising prices were “accentuated by an appalling speculation in commodity prices… The year 1919 saw also a stock market boom… [and] speculation in farmlands and other real estate went dangerously far.”[14] In its attempt to stabilize the economy, the Federal Reserve only inhibited the necessary recalibration of the economy. Miller aptly observed, “If the federal reserve system had functioned as effectively in 1919 in regulating credit as it did in 1920 in retarding and eventually arresting expansion, it would have rendered an inestimable service to the country and would have prevented many of the unhealthful developments.”[15] The Federal Reserve’s inflationary postwar policy prevented the liquidation which normally ends speculative bubbles and which is required to maintain a sound economy.

By the end of 1919, the New York Federal Reserve expressed concern and “was more specific in declaring its intention of bringing member bank credit under control by introduction of higher rates.”[16] In early 1920, the Federal Reserve banks all raised their rates on commercial paper to at least 7%. While this moved forced an end to the speculative bubble, the severity of the subsequent depression suggests that the Federal Reserve was tardy in its action. “The American index for foodstuffs,” stated Joseph S. Davis, “reached its peak in June and July 1920 at 215 per cent of the 1913 average, and declined steadily during the following year to a figure of 141 in June 1921.”[17]

The popping of the bubble devastated American farmers. Workers’ wages, along with transportation, energy, and equipment costs, remained well above pre-war levels while commodity prices dropped by 50%.[18] Farmers who had taken out loans to buy land during and just after the war were threatened by default. The Federal Reserve, which was in part responsible for this problem, only aggravated the situation. It was slow to stop the boom in agriculture, and within a year of the boom’s end it began to expand credit to the competing business sector via purchases of government securities.

Historical Problem

It is at this point where many economic historians error. They often focus on the financial climate in the years which immediately preceded the crash of the stock market in 1929 and the years that followed. In his book, The Great Crash, John Kenneth Galbraith begins with a highly optimistic speech from President Coolidge given on 4 December 1928 and proceeds from there making only passing reference to the preceding years.[19] He ignores entirely the economic intervention of the Federal Reserve before 1928. His work only surveys the tail end of the boom and which ended with the crash on Wall Street. In a manner that conveys the prior years as superfluous to his study, he writes:

Until the beginning of 1928, even a man of conservative mind could believe that the prices of common stock were catching up with the increase in corporations earnings, the prospect for further increases, the peace and tranquility of the times, and certainty that the Administration…would take no more than necessary of any earnings in taxes.[20]

Galbraith leaves the impression that booms appear out of thin air and proposes two options: “An immediate and deliberately engineered collapse and a more serious disaster later on.”[21] Policies throughout the Roaring Twenties were integral to the economic boom and crash. Galbraith performs a grave disservice by ignoring this fact.

Milton Friedman and Ann Schwartz make the same mistake of confining their research to the years of 1929-32. Their conclusions differ markedly. They claim that “prevention or moderation of the decline in the stock of money…would have reduced the contraction’s severity and almost as certainly its duration.”[22] They assumed that further credit expansion by the Federal Reserve – the same sort of expansion which caused the boom that brought instability – would have stopped or at least diminished the veracity of the Great Depression. Schwartz explains further: “The Federal Reserve, by failing to act as a lender of last resort during a series of banking panics, permitted a massive contraction of the money supply that was responsible for the compression of aggregate demand, national income, and employment.”[23] Friedman and Schwartz fail to mention, or even notice, that the effects of inflation are difficult, if not impossible to control. Inflationary booms are filled with malinvestments which must be purged, not enhanced. Any rescue by a lender of last resort will result in further malinvestment and hinder, not promote, economic recovery. Market instability is a direct side effect of the monetary expansion and contraction inherent in fractional-reserve banking. Any evaluation of the Great Depression must include a holistic perspective which takes into account the broad effects of an increase in the money supply. It must investigate the causes of the economic imbalances which preceded the crisis, not identify and speculate about failed treatments in post hoc fashion.

A number of economists and historians have accounted for this need. Authors who have provided an accurate interpretation of the Great Depression include Lionell Robbins, Benjamin Anderson, and Murray Rothbard. Each of these authors pays close attention to economic intervention by the Federal Reserve in the years preceding the depression. They all realize that a central bank such as the Federal Reserve causes most other banks to act in sync with one another. In essence, a central bank promotes a national banking cartel in which nearly all banks within a country will extend or curtail credit simultaneously. The key to the success of the aforementioned historians was the Austrian Business Cycle Theory (ABCT).

Methodology

A proper methodology is required in any historical study, but is especially necessary in economic history. Such a method must use an apriori standard against which a posteriori conjectures can be tested. The ABCT provides such a perspective and a framework appropriate for analysis of economic history.

The ABCT presents a modern world view which roots itself in praxeology: the theory of human action. According to Mises, “Every attempt to reflect upon the problems raised by human action is necessarily bound to aprioristic reasoning.”[24] He continues:

There is no means to abstract from a historical experience a posteriori any theories or theorems concerning human conduct and policies. The data of history would be nothing but a clumsy accumulation of disconnected occurrences…if they could not be clarified, arranged, and interpreted by systematic praxeological knowledge.[25]

A theory of human action must draw from a source apriori because it would otherwise draw from human interpretation of reality which is itself limited and often, though not always, irreparably biased.

The Austrian school grounds its understanding in the irrefutable fact that, though one’s intellectual capacity is limited, “man makes use of his reason for the realization of wishes and desires.”[26] Unlike the desires of the ever self-interested homo economicus, Mises’ acting man holds desires which cannot be narrowly defined in advance. Any economic theories conceived through induction – economic science – must, through deduction, agree with the apriori standard of human action.[27]

Holding the axiom of human action as apriori, the ABCT asserts several basic principles and extrapolates upon them. It claims that individuals subjectively value different ends, organizing them, not according to their supposed objective value, but instead grading them in order of perceived importance.[28] An individual’s scale of subjective valuation – preference value scale – is in constant flux. It is an artificial construct which helps one to conceptualize the complexity of individual choice.[29]

The ABCT also shows that, in agreement with theory of human action, “the function of money is to facilitate the business of the market by acting as a common medium of exchange.” It is a means to an end.[30] As a secondary function, money can also serve as a tool for accounting, and further facilitate human action.[31] Individuals employ money to help determine costs and organize their preference value scale. Money helps individuals establish time-preference – their willingness to delay present consumption for future consumption which is reflected in their willingness to save.[32] This time-preference is reflected in the pure interest rate.

When governments and central banks increase the money supply, this time-preference is misrepresented by artificially lowered interest rates. The abundance of currency which results from this credit expansion alters the structure of property ownership and creates the illusion of prosperity.[33] This distortion in the capital structure also alters individuals’ preference value scales. Businessmen react to the lower interest rate by decreasing savings and investments and dedicate excess capital the production of higher order goods.[34] Individual consumers are also less likely to save because the future benefit of savings is largely diminished by a depressed interest rate. Furthermore, because true time-preferences have not changed, as this excess capital spreads through the economy, it is employed to consume lower order goods.[35] As time passes, consumers will realize that, due to decreased savings, they cannot afford to consume goods spawned from lengthened capital structures – higher order goods. Businesses then face a crisis in the value of the capital goods in which they overinvested. As the economy restructures according to the true time-preferences of consumers as represented by higher interest rates, unemployment temporarily increases until capital is reallocated according to market demand.[36]

The Federal Reserve and Fractional-Reserve Banking

The ABCT also identifies the flaw inherent in fractional-reserve banking. It lies in an unclear definition of property rights over bank deposits. Unlike a warehouse for grain, banks accept demand deposits not as a bailment, but rather as a loan. This means that deposits are placed in a pool, most of which is not readily available to depositors. The bank takes the deposit, holds on to a certain percentage of it, and invests the remainder in loans and other investments.[37] Common practice is for banks to hold a reserve of 10% for demand deposits, while they invest the other 90%.[38] The problem almost inevitably arises that in a short period of time, holders of demand deposit accounts will withdraw their deposits in a proportion too large to maintain the bank’s solvency. In the strict sense, banks that practice a fractional-reserve policy with demand deposits are never entirely solvent and, to varying degrees, are always at risk of a bank run.

The role of the Federal Reserve exacerbates this problem. The Federal Reserve Act immediately set the precedent that the Federal Reserve can buy assets on the open market and regulate interest rates.[39] In other words, the Federal Reserve provides economic “‘management’ in the shape of purchases of securities in the open market” and by lending to member banks at an interest rate not established by the market.[40] The Federal Reserve’s stated goal is to foster growth and maintain price stability, but its policy of easy credit inherently creates economic disorder in the long run. Mises writes:

Cyclical changes in business conditions stem from attempts to reduce artificially the interest rates on loans through measures of banking policy – expansion of bank credit by the issue or creation of additional fiduciary media (that is banknotes and/or checking deposits not covered 100% by gold.)…and then some businesses, which did not previously seem profitable, appear to be profitable. It is precisely the fact that such businesses are undertaken that initiates the upswing. However, the economy is not wealthy enough for them. The resources they need for completion are not available...The policy of expanding credit must come to an end – if not sooner due to a turnabout by the banks, then later in a catastrophic breakdown.[41]

Credit expansion initiated by the issuance of fiduciary currency – currency not covered by reserves – creates the illusion that resources are more abundant than they actually are and sends the economy careening on an unsustainable course bound for depression.[42] The issuance of unbacked currency in culmination with money multiplication from fractional-reserve banking made the boom of the 1920s the largest in history to that point and set the stage for the Crash of 1929 and the Great Depression.

Open Market Operations[43]

The depression of 1920-21 marked a new stage in Federal Reserve Policy. Until that time “open market operations played a relatively unimportant part in the policies of reserve banks.”[44] In 1921, however, the Federal Reserve began to make purchases on the open market in order to employ surplus resources and earn profits for their stockholders.[45] Though the government actually decreased the budget every year between 1920 and 1923, the purchase of government securities by the Federal Reserve on the open market increased the availability of credit and artificially stimulated business.[46]

Many authorities, including Benjamin Anderson and Clay Anderson, propose that increased liquidity was an unintended side effect of open market operations, but Murray Rothbard discredits this commentary as a myth.[47] Rothbard cites a letter from Federal Reserve Governor Strong to Undersecretary of Treasury S. Parker Gilbert in which Strong claims that open market purchases would “establish a level of interest rates that would facilitate foreign borrowing in this country and facilitate business improvement.”[48] The policy was successful. Credit became more available as interest rates fell from 8% to 4% between 1920 and 1922.

Two years later, the Federal Reserve Board officially announced its activist open market policies. “The time, manner, character and volume of open market investments,” it declared, “[was to] be governed with primary regard to the accommodation of commerce and business.”[49] This also implicitly signaled that the Federal Reserve would neglect other aspects of the economy. More than any other area of the economy, the farming sector exemplifies the irresponsibility of this policy. Between 1921 and 1928 – before the great crash – over 4700 rural banks shut down because of farm foreclosures.[50] The business sector, aided by easy credit, recovered from the depression of 1920-21, but it did so on the backs of farmers who competed for workers without the benefit of abundant credit. The failing farming sector was symptomatic of the policy as a whole.

Not all economists were fooled by the apparent success of American businesses during the 1920s. From the beginning Benjamin Anderson decried the Federal Reserve’s expansionist policy. In 1924 he prophetically wrote, “We have been blowing up a credit bubble, especially in the form of long-time debts.”[51] He would later note:

In retrospect one may hold that this first dose of strychnine did little harm and some good, and may recognize it as one of the factors, although not the dominating factor, in the strong business revival of 1921 to 1923. Great harm came from the strychnine administered in 1924, and above all, from the renewal of the dose in 1927. There is no racetrack which has a code of ethics which permits doping the same horse three times.[52]

While it can provide temporary relief for some, a policy of easy money cannot, in the long run, bring health to an economy. As the Austrian school has shown, a policy of easy money sows the seeds of overconsumption and an orgy of speculation. In spite of this, the Federal Reserve committed itself to currency inflation during the 1920s.

Stimulus: Round Two

In 1924 the Federal Reserve began its first of three stimulus programs. Between October 1923 and November of 1924, member banks in aggregate repaid 642 million dollars of debt to the Federal Reserve. Meanwhile, the Federal Reserve bought 492 million dollars in government securities.[53] Chairman Strong proposed that these purchases would decrease member bank debt and facilitate economic growth by encouraging member banks not to collect on loans.[54] He was correct. Banks reacted by expanding credit through fractional-reserve lending and trade increased.[55]

[56]

The increase in the volume of currency immediately brought imbalance to the financial system. There was no increase in demand of trade, and therefore much of the new money was seen as surplus and was placed in time deposits.[57] Between 1922 and 1928, time deposits at all member banks at least doubled and in some areas, tripled in volume.[58] In the short term, this was beneficial to banks and investors. Investors received a higher rate of return while banks invested a larger proportion than would have been available if the money remained in a demand deposit account. In the long term, the shift to time deposits laid the foundation for instability. In 1917 the Federal Reserve set the minimum reserve requirements for time deposits at 3%.[59] They were less liquid than demand deposits and therefore became a tool for monetary inflation. Banks invested new deposits in businesses which otherwise would not be profitable. At the time, many interpreted the boom as genuine growth. Statistics from the Federal Reserve showed that “industrial production which had averaged only 67 in 1921 (1923-25=100) had risen to 110 by July 1928, and it reached 126 in June 1929.”[60] The American economy did not absorb the stimulus in an economic vacuum. The effects of the stimulus reached beyond America and into Europe through the Dawes plan and private investment, both of which would not have been readily available without artificially depressed interest rates.

Postwar Instability in Europe

Fighting during World War I consumed much of Europe’s existing capital and left her destitute after the war. Europe was saddled with heavy debts. Between the years 1914 and 1922, the United Kingdom’s debt grew from $3 billion to $38 billion, France’s debt from $6 billion to $52 billion, and Germany’s debt from $1 billion to $79 billion.[61] Debts were not Europe’s only impediment to financial growth.

Inflationary policy brought persistent financial instability which hindered economic growth. Both during and after the war, belligerent nations devalued their currencies. The German mark, which traded at around 12 marks per dollar in 1919, was heavily devalued. By its lowest point, the 16 trillion marks traded for one dollar.[62] By February 1920, the pound lost 34% of its prewar value. Doctor Henry Chandler, economist for the National Bank of Commerce in New York, observed the disastrous effects: “In industrial nations depending largely on international trade, sooner or later a point is reached beyond which further recovery is extremely doubtful until sound financial can be reestablished.”[63] Economic actors in Europe, due to unstable currency exchanges in the continent’s 25 countries, could not efficiently engage in trade because unstable currencies prevented prices from adequately reflecting the costs of the producers and the valuations of the consumers. Without the gold standard, trade between these countries was impossible.

The problem of gold reserves only worsened with pound devaluation. London, once the financial center of the world, lost gold as banks moved their assets to New York where the dollar remained at its prewar value of one-twentieth of an ounce of gold.[64] This gold quickly found its way to the vaults of the Federal Reserve as member banks used the incoming gold to repay their debts. Officials took note of the increase and in 1922 announced that “in formulating a gold policy they would keep in mind the goal of reestablishment of the gold standard for the world.”[65] The Federal Reserve did not simply want a gold standard though. It wanted to restore the Bank of England’s position as the dominant global financial force.

The narrowly tapered policies of the Federal Reserve actually prevented the return to a sound standard. In 1924, instead of allowing currency markets to stabilize at lower parities, the Federal Reserve expanded credit in part to stop the inflow of gold to the US and to help stabilize the pound at its old parity. Governor Strong wrote to Mellon in 1924, “The burden of the readjustment must fall more largely upon us than upon them [Great Britain]. It will be difficult politically and socially for the British Government and the Bank of England to face a price liquidation…”[66] Strong saw the devaluation of the pound to below prewar levels as untenable, but his motivations were questionable. Strong was not only concerned with stability in Britain, but also the investments of the House of Morgan:

Strong’s monetary policy was deliberately guided by the prime objective…to restore “England” – which really meant the Morgans’ English associates and allies – to her old position of financial dominance by helping her establish a phony gold standard. [67]

Strong did not seek what was best for the U.S. economy. Instead, the he propped up the pound and initiated a program of inflationary credit as a service to specific private financial interests.

Loose Credit Comes to Rescue Europe

A stagnant European market in combination with fluctuating fiat currencies provided a textbook example of Gresham’s Law – an overvalued currency which holds a legal tender monopoly naturally forces more valuable money out of circulation.[68] Benjamin M. Anderson keenly described the situation:

During recent years gold has been coming to the United States from Europe for three main reasons:

1. Europe’s great indebtedness to us on current account.

2. The desire of Europeans to place their surplus funds or temporarily idle funds in a safe place from which they could surely get them back, quickly and without loss.

3. The working of Gresham’s Law.[69]

The problem was compounded by US tariffs, especially as the Federal Reserve moved forward with an easy money policy before the tariff problem was remedied. Anderson explained:

If international credits were to be of any use or were ever to be repaid, that the movement of goods from country to country must be facilitated, that tariffs must be lowered, quotas or other trade barriers be removed, and that the men having bank balances in one country be free to dispose of them in the foreign exchange markets without encountering governmentally created difficulties.[70]

High tariffs prevented Europeans from sending goods to America in exchange for gold. Instead, continued instability, encouraged by high tariffs, attracted European gold to American banks.

Meanwhile, American credit to Europeans, enabled by the Dawes Plan and the Federal Reserve’s credit injections, allowed Europeans to purchase American goods without compensating with increased exports to America. Instead European gold flowed on deposit to American banks. George Norris captured the situation perfectly. He wrote, “We ask all of these nations to make payments to us, knowing as we do that those payments can be made only in goods, and at the same time that we ask for payment in goods we raise a tariff-wall to prevent the entry of the goods.”[71] In light of tariff walls, the Dawes Plan, just like inflationary Federal Reserve policy, was not sustainable. Without a healthy export market, European producers were unable to identify the needs of the consumers.

The European economy structured itself around a finite program of credit expansion which did not remove the economic impediments that troubled Europe in the first place. The American system led investors to infect the European economy with easy credit. They invested “in a reckless, emotional manner, not systematically.”[72] In 1931 French ambassador to the US, Henri M. Berenger, complained, “For seven years American bankers have been engaged in entangling the United States with Europe.”[73] He was right, but Europe faced another problem in addition to the Dawes Plan that led it to depression: The gold-exchange standard.

The Gold-Exchange Standard

As inflation from the Federal Reserve’s open market purchases devalued the dollar,the British pound nearly reached its prewar parity in early 1925. The pound reached a postwar high of $4.78 and authorities decided to return it to its prewar exchange value on 28 April 1925.[74] The shift represented the beginning of the gold-exchange standard, a quasi-gold standard intended to restore confidence to investors in Europe. The pound was backed by gold, but the ability of individuals to redeem the pound for physical gold was limited. Persons could redeem their pounds for gold, but only “in the form of bars containing approximately four hundred ounces troy of fine gold.”[75] Furthermore, native Brits were not allowed to exchange pounds for gold.[76] This limited the gold market to rich investors and banks, and therefore provided the Bank of England with the opportunity to create currency without holding additional gold reserves to compensate. Therefore, this new gold standard was only a gold standard in name. It was in fact an intermediate stage between a gold backed currency and an unbacked fiat legal tender. Without the restraint of gold, the Bank of England was free to increase the volume of currency.

The shift to prewar parity was a dramatic change in the world of European finance. Hüllsmann explains:

The significance of the gold-exchange standard of 1925-31 was that it elevated this practice of coordinated inflation into a principle of international monetary relations. Only two banks – the American Fed and the Bank of England – were to remain true central banks, but this time they would be the central banks of the entire world. All other national central banks should keep a more or less large part of their reserves in the form of U.S. dollar notes and British pound notes. This would assure the possibility of inflationary expansion for all banks.[77]

The formation of the gold-exchange standard inherently formed a banking cartel through which all European central banks all simultaneously experienced inflation. The central banks like those in Austria, Germany, and France accounted for British notes as hard currency immediately convertible to gold and kept much of their gold reserves at the Bank of England. Notes from the other central banks were then backed largely by the pound. If depositors in continental Europe wanted to exchange their bank notes for gold, they first had to convert their original notes into pounds, then exchange those pounds for gold at the minimum required amount. Authorities hoped that barriers to exchange of pounds for gold would give Bank of England the ability to inflate the pound.

England had to convince and/or coerce its neighbor countries to accept pound hegemony. Britain took advantage of its influence in the League of Nations and its financial power to accomplish this goal. Emile Moreau, Governor of the Bank of France, complained:

England having been the first European country to reestablish a stable and secure money has used that advantage to establish a basis for putting Europe under a veritable financial domination…The method consists of forcing every country in monetary difficulty to subject itself to the Committee at Geneva [associated with the League of Nations], which the British control. The remedies prescribed always involve the installation in the central bank of a foreign supervisor who is British or designated by the Bank of England, and the deposit of a part of the reserve of the central bank at the Bank of England, which serves both to fortify the pound and to fortify British influence.[78]

More powerful countries begrudgingly accepted the new monetary system. France, for example, had no alternative to the gold-exchange standard if it wished to stabilize its currency. The Bank of France was unable to use the franc to buy gold because French law demanded that gold be exchanged at prewar parity. Gold purchased with newly created francs could thus easily taken back by depositors who realized that the gold was undervalued in nominal terms. The solution was for France to hold the British pound as a reserve while allowing the value of the franc to vary against the pound. In 1926, France began to buy sterling on foreign exchange markets with newly created francs.[79] This allowed the Bank of France to increase reserves without immediately losing them due to adherence to the prewar parity. It also limited franc devaluation because the new francs were not circulated within France. The choice of central banks in smaller countries was simpler. In an article penned shortly after the establishment of the gold-exchange standard, Mises wrote:

Note-issuing central banks, especially those of small and financially weaker states, had found that the holding of large gold reserves involved costs that could be saved. They set about exchanging a part of their gold reserve, which was lying in their vaults earning no interest, for short-term gold claims on foreign countries, gold claims that in contrast to non-interest-earning gold ingots and stock of coins did earn interest.[80]

A mixture of international financial vulnerability and convenience motivated European banks to accept the gold-exchange standard. What began for many as an uncomfortable compromise soon turned into financial catastrophe which, like a sinking ship with no life vessels for those aboard, proved deadly for national economies in Europe.

The Failure of the Gold-Exchange Standard

The failure of the gold-exchange standard resulted from two major causes: the overvaluation of the pound and Britain’s refusal to raise interest rates. Rothbard notes, “At a $4.86 pound British export prices were far too high to be competitive in the world markets.”[81] While American stocks soared, British unemployment remained high and government expenditures made low interest rates a necessity. The Bank of England, like the Federal Reserve soon after it, found itself between the devil and the deep sea. Low interest rates, caused by an increase in the money supply, decreased both the value of the pound and reduced the incentive for other central banks to hold as reserves British pounds in place of gold.[82] The Bank of England could only turn to collusion in order to prevent, at least temporarily, the outflow of gold:

Very often unofficial pressure is borne upon banks to abstain from gold shipments even though they appear profitable. It is an open secret that in June of this year for several weeks the Reichsbank dissuaded the German banks from taking gold from London, although the exchange was well beyond gold export point. Similarly, the Federal Reserve Bank of New York is believed to have put pressure upon American banks to abstain from importing gold from London. As a result, both dollar and reichsmark moved considerably beyond their theoretical gold export points, which caused some uneasiness abroad as to the intentions of this country to carry out gold standard in letter and spirit, and is believed to have been the cause of the withdrawal of some foreign funds from London, accentuating thereby the adverse trend of sterling.[83]

Central bankers and other financiers knew the danger of pound weakness. If the Bank of England proved insolvent, every central bank in Europe would follow the same path.

The overvalued pound had crippled England’s economy, but the Bank of England refused to change course. In 1927, the Bank of England called together an unofficial meeting of central bankers. Benjamin Anderson was in contact several attendees at the time including Deputy Governor Rist of the Bank of France. From conversations with several contacts he was able to gather:

The Bank of England did not wish to pull up [raise interest rates]…Norman and Strong tried hard to get the four countries to go along in a concerted policy of easier money. Professor Rist and Dr. Schacht held back…Following the departure of Rist and Schacht, Norman and Strong forced through their program of cheap money in the United States.[84]

The Federal Reserve dedicated itself to saving the pound, but attempts at stabilization only led to further imbalances.

Stimulus: Round Three

[85]

In 1927 Norman and Strong initiated round three of open market purchases, and the United States entered a period of unprecedented prosperity. The Federal Reserve engaged in this program in an attempt to outpace pound inflation and push the pound to the gold import point. Americans reacted to the arbitrarily decreased interest rates by increasing consumption and engaging in speculation. The Federal Reserve’s easy money policy “encouraged business expansion, new capital issues, and refinancing at low rates, which created large profits and surplus funds in the possession of corporations and individuals.”[86] Corporate growth, sparked by abundant loans, initiated a boom in the stock market. The S&P 500 Index, for example, demonstrated growth after both major open market purchases in 1924 and 1927. With the 1927 purchases, money was once again placed in the hands of many investors who had no immediate use for it. When the program was initiated, interest rates were artificially depressed. In 1924, investors placed their extra capital in time deposits, but by 1927 that market was saturated.[87] Investors instead sought profits via riskier investments: stocks.

Stocks are not as secure as bank deposits, and they tend to rise dramatically in the late stages of a boom. Distortions in the market, artificially depressed interest rates, and a lack of safe investment opportunities made this inevitable in the late twenties. Galbraith misses this point and argues:

This view that the action of the Federal Reserve authorities in 1927 was responsible for the speculation and collapse which followed has never been seriously shaken…Yet the explanation obviously assumes that people will always speculate if only they can get the money to finance it. Nothing could be farther from the case. There were times before and there have been long periods since when credit was plentiful and cheap – far cheaper than in 1927-29 – and when speculation was negligible.[88]

If safe, profitable investments are available, investors will take advantage of those before they venture riskier investments. Galbraith’s hasty generalization that “the explanation assumes that people will always speculate if only they can get the money to finance it” pays no regard to the variety of incentives that guided investors toward risky investments.

[89]

Purchases of securities by the Federal Reserve definitely pushed investors into a speculative mania. From the moment that the Federal Reserve initiated its third round of inflation until the stock markets crashed in October 1929, the Dow Jones and the S&P experienced gains close to 100%. The Federal Reserve attempted to stop this momentous rise in stock prices in 1928, but the situation had grown too complex for a solution as simple as the sale of securities. Albeit, this was its course of action in the first quarter of 1928.[90] Between December 1927 and July 1928, the Federal Reserve sold $671 million in bills and securities and simultaneously increased its bills discounted to member banks in an attempt to increase its influence over them.[91] Still, the security sales did not offset in increase in the total money supply. Time deposits continued to increase thanks to low reserve requirements. The Federal Reserve had proven itself inept in soaking up the currency made available by previous securities purchases. Anderson described the situation with metaphor:

When a bathtub in the upper part of the house has been overflowing for five minutes, it is not difficult to turn off the water and mop up. But when the bathtub has been overflowing for several years…a great deal of work is required to get the house dry. Long after the faucet is turned off, water still comes pouring from the walls and from the ceiling. It was so in 1928 and 1929.[92]

One sale of moderate size was unable to offset five years of inflationary policy.

Higher rates did not stop the boom. The previous credit expansions and their multiplication due to fractional-reserve banking left more than enough money available to investors. Though rates rose with the Federal Reserve’s attempt at monetary contraction, high rates were due mostly to an increase in demand. Investors on Wall Street were willing to pay a high price for capital by 1927. In turn, bank customers who wanted higher yields purchased from banks securities whose funds were loaned to market speculators. This allowed banks to maintain substantial reserves while lowering liabilities owed.[93] Rising interest rates lured latent capital into the market - capital which was abundant thanks to the Federal Reserve’s three major open market purchases. An interventionist monetary policy pushed the market out of balance, and the Federal Reserve lacked the means and knowledge to remedy the crisis. There was no exit strategy.

Conclusion

The crash of October 29 was the inevitable consequence of unprecedented monetary expansion by the Federal Reserve. By November 13, 1929 the Dow-Jones fell from its September high of 311 to 164.[94] The next two years saw the downtrend continue. In any circumstance, the inflationary intervention must sooner or later come to an end as lower interest rates encourage overconsumption and misallocation of resources. Economies are highly complex systems and actors in them are unpredictable. The consequences of economic intervention by central banks, especially large scale interventions like the Federal Reserve’s open market purchases in 1922, 24, and 27, inevitably produce unintended negative consequences. In addition to this, the self-interest of central bankers and other economic authorities obscure their ability to act appropriately even if they had perfect knowledge. Both of these factors culminated in Federal Reserve policy throughout the 1920s and led to a depression that left the world impoverished.

If the same mistakes are to be avoided in the present, historians and economists must take this into account. The economy is not a vehicle to be steered. It is simply the collection of individuals and groups cooperating with one another. The Great Depression was not a result of market failure but was the child of economic intervention that attempted to override the choices of individuals. The free market is not perfect, but it is at least self-correcting. An economy that is dominated by a monetary monolith like the Federal Reserve is robbed of this self-correction and the inevitable result is that booms and busts increase in amplitude as central banks increase intervention. While central banks cannot disappear overnight, the common good – the good of all individuals – demands that their existence ceases as quickly as possible.

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[1] Lionell Robbins, The Great Depression (Auburn, AL: Ludwig von Mises Institute, [1933] 2007), 4.

[2] “Belligerents’ Debt Grows,” New York Times, 5 Jan 1917, p. 8.

[3] Walter F. Ford, “Money and Prices,” The North American Review 208, no 753 (August 1918): 240.

[4] Ibid., 249.

[5] Ibid., 247.

[6] Irving Fisher, “How the Public Should Pay for the War,” Annals of American Academy of Political and Social Science 78, (July 1918): 114-115.

[7] Herbert Hoover, “Memorandum on the Economic Situation,” Annals of American Academy of Political and Social Science 87, (Jan 1920): 109.

[8] Murray Rothbard, A History of Money and Banking (Auburn, AL: Ludwig von Mises Institute, [2002] 2005), 352.

[9] Fisher, “How the Public Should Pay,” 114.

[10] Harris, S.E., Twenty Years of Federal Reserve Policy, Harvard Economic Studies, vol. XLI (Cambridge, MA: Harvard University Press, 1933), 71.

[11] Miller elaborated, “The main impulse came from the release of buying power which had been in restraint during the war. A seller's market began to develop in the spring of 1919. The consumer demanded goods; price was a secondary consideration. Dealers, both wholesale and retail, were bidding against one another for such supplies as there were, and manufacturers were bidding against one another for raw materials and labor. The rapid rise of prices induced buying for speculation, and speculation in its turn accelerated the rise of prices. Inflation was becoming cumulative and systemic in its effects, and pervading the whole body economic.” A. C. Miller, “Federal Reserve Policy,” The American Economic Review 11, no 2 (June 1921): 187.

[12] Benjamin M. Anderson , Economics and the Public Welfare (Indianapolis, IN: Liberty Press, [1949] 1979), 64.

[13] Ibid., 63.

[14] Ibid., 77.

[15] Miller, “Federal Reserve Policy,” 188.

[16]Harris, Twenty Years, 73.

[17] Joseph S. Davis, “World Banking, Currency, and Prices, 1920-1921,” The Review of Economics and Statistics, 3 no 9, (September 1921): 323.

[18]The farmer is the largest victim of the depression in 1921. “Wallace Calls to Aid the Farmer,” 13 Mar 1921, p. 10; Commodities graph of WWI era. Giovanni Federico, “Not Guilty? Agriculture in the 1920s and the Great Depression,” Journal of Economic History 65, no. 4 (December 2005): 957.

[19] John Kenneth Galbraith, The Great Crash: 1929 (New York: Houghton Mifflin Company, [1954] 1997), 1.

[20] Ibid., 11.

[21] Ibid., 25.

[22] Milton Friedman and Anna Jacobson Scwartz, The Great Contraction: 1929-1933 (Princeton, NJ: Princeton University Press, [1963] 2008), 14.

[23] Ibid., ix.

[24] Ludwig von Mises, Human Action (Auburn, AL: Ludwig von Mises Institute, 1998), 40.

[25] Ibid., 41.

[26] Ibid., 67.

[27] “Man is not infallible. He searches for truth – that is, for the most adequate comprehension of reality as far as the structure of his mind and reason make accessible to him. Man can never become omniscient. He can never be absolutely certain that his inquiries were not misled and what he considers as certain truth is not error. All that man can do is submit all his theories again and again to the most critical examination. This means for the economist to trace back all theorems to their unquestionable and certain ultimate basis, the category of human action, and to test by the most careful scrutiny all assumptions and inferences leading from this basis to the theorem of examination. It cannot be contended that this procedure [praxeology] is a guarantee against error. But it is undoubtedly the most effective method of avoiding error.” Ibid., 68.

[28] “Subjective value is not measured, but graded. The problem of the measurement of objective use-value is not an economic problem at all…Neither is objective exchange-value measurable, for it too is the result of the comparisons derived from the valuations of individuals.” Ludwig von Mises, The Theory of Money and Credit (Auburn, AL: Ludwig von Mises Institute, 2009), 38-39, 46-47.

[29] Mises, Human Action, 102.

[30] Ibid., 29.

[31] “Money has… become an aid that the human mind is no longer able to dispense with in making calculations. If in this sense we wish to attribute to money the function of being a measure of prices, there is no reason why we should not do so. Nevertheless, it is better to avoid the use of a term which might so easily be misunderstood. As this. In any case the usage certainly cannot be called correct – we do not usually describe the determination of latitude and longitude as a ‘function’ of the stars.” Ibid., 49.

[32] Mises, Theory of Money of Credit, 195-203; Murray Rothbard, America’s Great Depression (Auburn, AL: Ludwig von Mises Institute, [1963] 2008), 9-10.

[33] Mises, Theory of Money and Credit, 349.

[34] Ibid., 361.

[35] Eg., goods which require a relatively short production process. Rothbard, America’s Great Depression, 11.

[36] Ibid., 14.

[37] Rothbard, The Case Against the Fed (Auburn, AL: Ludwig von Mises Institute, [1994] 2007), 47.

[38] In the case of the 1920s, requirements for demand deposits hovered around 10%. Rothbard, America’s Great Depression, 99.

[39] The Federal Reserve Act of 1913 in Major Documents in American Economic History

[40] Robbins, The Great Depression, 39-40.

[41] Ludwig von Mises, “The Causes of the Economic Crisis [1924]” in The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (Auburn, AL: Ludwig von Mises Institute, 2006), 161-163.

[42] The Federal Reserve also holds the authority to tighten credit, but it employs this method far less often. This is evidence by the devaluation of the dollar. In terms of gold the dollar is worth less than 2% of its original value.

[43] “The major instrument of Fed control of the money and banking system is its ‘open market operations’: its buying and selling of U.S. government securities (or, indeed, any other asset it wished) on the open market.” Murray Rothbard, The Case Against the Fed, (Auburn, AL: Ludwig von Mises Institute, [1994] 2007), 122.

[44] “…Adequate business was available and hence reserve banks were not forced to resort to open market operations in order to increase their earnings.” Harris, Twenty Years, 148.

[45] Ibid., 148, 158-159.

[46] Anderson, Economics and the Public Welfare, 92, 95-96.

[47] Ibid., 96; Clay J. Anderson, A Half-Century of Federal Reserve Policy Making (Philadelphia, PA: Federal Reserve Bank of Philadelphia) 48.

[48] Rothbard, A History of Money and Banking, 375.

[49] John R. Collins, “The Stabilization of Prices and Business,” The American Economic Review, 15, no 1, (March 1925): 43.

[50]The Wilson administration saw 578 bank failures while Coolidge’s administration witnessed over 4700 bank failures. “Calls Coolidge Novelist” New York Times 18 Oct 1928, p. 13.

[51] Benjamin M. Anderson, “Cheap Money, Gold, and Federal Reserve Bank Policy,” Chase Economic Bulletin 4, no 3 (August 1924): 1.

[52] Anderson, Economics and the Public Welfare, 98.

[53] See Chart. Rothbard, America’s Great Depression, 109.

[54] Harris, Twenty Years, 510.

[55] The velocity of money began to increase at the end of 1924 and continued the trend until October 1929. A. Ross Eckler, “Recent Expansion of Bank Credit,” Review of Economics and Statistics, 11, no 1, (February 1929): 48.

[56] Specific attention should be given to the change in total money supply. It grew from $45.3 billion to $73.26 billion from 1921 to 1929. Time deposits also grew from $16.58 to $28.61 billion in that time period. Rothbard, America’s Great Depression, 92.

[57] Anderson, Economics and the Public Welfare, 140.

[58] Ibid., 141.

[59] As mentioned earlier, reserve requirements for demand deposits were 10%. This multiplied the potential for inflation by a factor of more than three. Rothbard, America’s Great Depression, 99.

[60] Galbraith, The Great Crash, 2.

[61] L. R. Gottlieb, “The Public Financial Burdens of the Principal Countries of the World,” Annals of the American Academy of Political and Social Science. 102 (July 1922): 116-117.

[62] Anderson, Economics and the Public Welfare, 108.

[63] Henry A. E. Chandler, “America’s Relationship to the European Financial System,” Annals of the American Academy of Political and Social Science, 108, (July 1923): 44.

[64] Rothbard, A History of Money and Banking, 352.

[65] Harris, Twenty Years, 358.

[66] Rothbard, America’s Great Depression, 146.

[67] Ibid., 270.

[68] In this case, overvalued European currencies forced gold to banks in America which Europeans perceived as inherently stable. Jörg G Hüllsmann, The Ethics of Money Production (Auburn, AL: Ludwig von Mises Institute 2008), 126-127.

[69] Anderson, “Cheap Money, Gold, and the Federal Reserve Bank Policy,” 10.

[70] Anderson, Economics and the Public Welfare, 116.

[71] George W. Norris, “Foreign Liabilities and Assets and the Dawes Plan,” Annals of the American Academy of Political and Social Science, 120, (July 1925): 22.

[72] Garet Garret, A Bubble That Broke the World (Boston, MA: Little Brown and Company, 1932), 65.

[73] Ibid., 71.

[74] Robbins, The Great Depression, 80.

[75] J. M. Keynes, “The Gold Standard Act, 1925,” The Economic Journal 35, no 138 (June 1925): 311.

[76] Ibid., 313.

[77] Hüllsmann, Ethics of Money Production, 215.

[78] Emile Moreau quoted in Rothbard, America’s Great Depression, 152.

[79] Anderson, Economics and the Public Welfare, 177-178.

[80] Ludwig von Mises, “The Return to the Gold Standard [1925],” in Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (Indianapolis, IN: Liberty Fund, 2002), 146.

[81] Murray Rothbard, What Has Government Done to Our Money? (Auburn, AL: Ludwig von Mises Institute, [1963] 2008), 90.

[82]“Britain’s immediate problem stemmed directly from her insistence on continuing cheap money. The bank of England had lowered its discount rate from 5 percent to 4 ½ percent in April, 1927, in a vain attempt to stimulate British industry. This further weakened the pound sterling, and Britain lost $11 million in gold during the next two months.” Rothbard, America’s Great Depression, 153.

[83] Paul Einzig, “Gold Points and Central Banks,” The Economic Journal 39, no 155 (September 1929): 384.

[84] Anderson, Economics and the Public Welfare, 189.

[85] “Figure 25: Standard and Poor’s Common Stock Price Index, 1920 to 1930.” Gene Smiley, “The U.S. Economy,” http://eh.net/encyclopedia/article/Smiley.1920s.final

[86] Ivan Wright, “Loans to Brokers and Dealers for Account of Others [1929],” in History of Financial Disasters, 1763-1995, (London: Pickering & Chatto, 2006), 20.

[87] See chart on page 15.

[88] Galbraith, The Great Crash, 10-11.

[89] Anderson, Economics and the Public Welfare, 202.

[90] Harris, Twenty Years, 526.

[91] Rothbard, America’s Great Depression, 109.

[92] Benjamin Anderson, Economics and the Public Welfare, 196.

[93] Ibid., 198, 199.

[94] Anderson, Economics and the Public Welfare, 219.

Urban Prosperity, Rural Chaos: Federal Reserve Policy During the Roaring Twenties

2010-12-02T06:43:00.000-08:00

*Note - Some pictures used did not format properly when transferred from the original document*

The Roaring Twenties was the decade of conspicuous consumption. Urbanites experienced levels of material prosperity which was unprecedented while American farmers struggled for survival. While the two developments may at first seem unrelated, both derive from a common source: inflationary central banking policies. Beginning with a financial injection in 1922, two more in 1924, 1927, the Federal Reserve attempted to stabilize the dollar at prewar par with the British pound. The injections came in the form of security purchases on the open market. Consequently, the availability of credit increased. The Federal Reserve was already in the habit of increasing liquidity during harvest season, so most of the new loans were given to the growing business sector either directly, or indirectly through loans to speculators. While the farming sector’s income decreased due to the postwar depression of 1920-21, it faced increased operating costs – eg., for workers and resources – due to the credit fueled competition of business and industry. In short, urban areas prospered while rural areas suffered. By the end of the decade, however, both sectors were impacted by defaults and the credit contraction as the chimera of easy money gave way to the reality of limited resources. Thus, the Federal Reserve’s irresponsible inflationary policy simultaneously drove conspicuous consumption and rural poverty, creating an unsustainable economic climate whose collapse was inevitable.

Since the Civil War the banking in the United States became more and more centralized. During the Gilded Era, business interests pushed for the establishment of a central bank akin to those found in Europe. The preceding century had witnessed political tumult over the issue as the early United States established a charter for a central bank which was then revoked under Andrew Jackson as his fait accompli. The consolidation of political and economic power during and after the Civil War allowed a revival of the issue. The powerful banker Jay Cooke, in collaboration with Secretary of Treasury Salmon P. Chase and Senator John Sherman helped establish the National Banking Act.[1] It allowed successful private banks, by the blessing of government charters, to act together as a central banking cartel. Smaller were allowed to deposit 60% of their required reserves in demand deposit accounts at reserve city banks. In a similar manner, the reserve city banks were then allowed to deposit 50% of their required reserves at New York City banks.[2] The system allowed for a massive expansion of money substitutes, eg., unbacked bank notes. In the short term, beneficiaries of such a system are those who receive the new currency first: banks and debtors who receive the new loans.[3] While these groups saw national banking as an improvement over Jacksonian era “free banking,” it lacked the precision of a true central banking system.

A more centralized system took form in 1900 with the passage of the Gold Standard Act, and in 1913with the establishment of the Federal Reserve. The Gold Standard Act moved the U.S. away from a bimetal standard where the value of gold in terms of silver was legally established at a fixed ratio. Before the passage of the act, Americans exchanged dollars for either gold or silver. After, dollars were only exchangeable for gold. Consequently, gold currency was centralized as it flowed into banks. F. W. Taussig of Harvard University explained that in lieu of silver currency, “paper is desired for convenience of use by persons having gold on their hands.”[4] This also had the side effect of increasing the power of the U.S. Treasury which increased the circulation of dollars as gold flowed into its vaults. It was then empowered to intervene into the economy. Beginning in 1903 the Secretary of Treasury, Leslie Shaw, began to use excess reserve to expand the money supply by making purchases on the open market. The Treasury’s attempt to act as a central bank failed miserably as its funds were limited. It was unable to act as a lender of last resort and it could not significantly influence the decisions of U.S. banks. This weakness was made clear with the panic of 1907 and the stage was set for the establishment of the Federal Reserve.[5]

After an intense propaganda campaign which purported that the panic of 1907 occurred mainly because of a lack of liquidity, influential bankers and politicians met at Jekyll Island to lay the foundation for the Federal Reserve Act of 1913. Attendees included Senator Aldrich and powerful business interests “Henry P. Davidson, Morgan Partner; Paul Warburg, Kuhn Loeb partner; Frank A. Vanderlip, vice-president of Rockefeller’s National City Bank of New York; Charles D. Norton, president of Morgan’s First National Bank of New York; and Professor A. Piatt Andrew, head of the NMC… [and] Assistant Secretary of the Treasury under Taft.”[6] Each of the attendees were, as bankers and politicians, in a position to benefit, at the expense of others holders of dollars, from the future Federal Reserve’s ability to expand the money supply and act as lender of last resort. The act which resulted formed a central bank whose mandate was:

To furnish and elastic currency, to afford means of rediscounting commercial paper, to establish a more elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes. [7]

In other words, it was given the means to increase the volume of currency and to cartelize the nation’s banks. The Federal Reserve soon employed these powers.

The Federal Reserve began operation in 1914 just as World War I began, however it did not engage in major economic intervention until 1917 when the U.S. joined the war. At that time, the Federal Reserve benefited from new reserve policies that lowered reserve requirements for member banks, reserve city banks, and country banks, forced member banks to hold their gold on deposits at the Federal Reserve, and allowed the Federal Reserve to issue notes against commercial paper as long as gold holdings amounted to 40% of its reserves.[8] The Federal Reserve’s new policies, along with inflationary policies of European governments and central banks, helped fuel the war efforts and increase demand for food stuffs. Farm profits rose, but operating costs rose as well. The Federal Reserve continued its policy of loose credit for more than a year after the armistice of November 11, 1918. The problem grew worse. A boom psychology had set in and was fostered by artificially low interest rates after the war. Federal Reserve Board member A. C. Miller wrote in hindsight:

Dealers, both wholesale and retail, were bidding against one another for such supplies as there were, and manufacturers were bidding against one another for raw materials and labor. The rapid rise of prices induced buying for speculation, and speculation in its turn accelerated the rise of prices. Inflation was becoming cumulative and systemic in its effects, and pervading the whole body economic.[9]

The cause of the imbalance was an artificially low discount rate which persisted after wartime price controls were lifted. Postwar malinvestment could have been minimized “if the federal reserve system [sic] had functioned as effectively in 1919 in regulating credit as it did in 1920 in retarding and eventually arresting expansion.”[10] Austere measures arrived tardily in 1920, and with them, the beginning of hardship for farmers.

[11]

In 1920 the Federal Reserve finally raised the discount rate on commercial paper from 4.75% to 6%. The speculative bubble in agriculture quickly deflated as both crop and land values lost nearly 50% of their value as measured from their peak.[12] The depression of 1920-21 impacted farmers more than any other group in the country. Operating costs rose dramatically between 1916 and 1920, and they remained high even after the Federal Reserve raised the discount rate. While crop prices had begun falling after 1919 due largely to increased production, farmer demand for a limited supply of production goods – eg., tractors and other farming equipment – did not decrease. Economic readjustment proved painful for farmers. Their plight worsened throughout the 1920s due to Federal Reserve policy that favored American business and finance over American farmers.

The Federal Reserve began to engage in major open market operations in 1922. In other words they increased the money supply by purchasing assets, usually government securities, on the open market. Between July 1921 and December 1922 it purchased $510 million in bills and securities.[13] These open market purchases by the Federal Reserve lowered interest rates as they satiated demand for money. Capital thus flowed into areas of the economy which otherwise would have remained unfunded. The purchases of 1922 were in part an experiment, but the expectations of Federal Reserve officials were clear; lower interest rates were to help “facilitate business improvement.”[14] Pleased with its results, the Federal Reserve followed up with two more major open market purchases: one in 1924 and another in 1927. The Federal Reserve’s loose credit policy helped the business sector recover, but that recovery outpaced and even inhibited recovery in the farming sector.

[15]

Much of the increased funds from the first two open market purchases flowed into time deposit accounts. Reserve requirements for time deposits were only 3% and therefore held a greater potential to increase the total volume of currency than money placed in demand deposit accounts.[16] Consequently, bank loans increased as both time and demand deposit holdings increased. At first businesses and consumers took out many of these loans, but after 1925 speculators in real estate, stocks, and securities. Much of the excess capital then made its way to the business sector through increased investment and consumption.

[17]

Though not the cause of imbalance, the expansion of credit installment plans to consumers was indicative of the growing economic imbalance and set the precedent for business growth throughout the 1920s. Though many debate the influence of installment credit in the buildup to the crash of 1929, increased consumer dependency on these plans is clear. Between 1920 and 1929, aggregate consumer debt more than doubled in nominal terms. The story is more precarious for specific industries. The number of refrigerators produced increased by 4500% in the same time period, due largely to consumer credit.[18] Though not fully responsible for imbalance, installment credit definitely encouraged a psychology of overconsumption to which businesses reacted with expansion.

[19]

In addition to consumer credit, profits from speculation in property also resulted in business gains. Just like loans to consumers, real estate mortgages showed a large increase during the 1920s. Between 1918 and 1927, banks holdings of mortgages securities increased from $460 million to $3 billion.[20] As money flowed into the real estate market, land values increased and speculators earned profits. This phenomenon did not remain isolated from the rest of the economy. Benjamin Anderson, economist for Chase National Bank between 1920 and 1939 observed, “A very considerable part of the supposed income of the people which was sustaining our retail and other markets was coming from …capital gains on stocks, bonds, and real estate.”[21] Business growth and speculative profits gave the impression that many companies were more valuable than they actually were and the foundation was laid for the stock boom of the late twenties.

[22]

The greatest part of the boom in stocks occurred with the Federal Reserve’s third major open market purchase in mid-1927. By this time, the market for time deposits was satiated, and real estate was less attractive than it had been during the decade. The new money flowed into the stock market and the resultant strong gains worried the Federal Reserve. In 1928 the Federal Reserve attempted to tighten credit, but the situation was beyond its control. As interest rates rose, member banks simply withdrew their deposits from the Federal Reserve and provided more loans at high rates of interest to market speculators.[23] Five years of easy credit, exacerbated by the money multiplication inherent in fractional-reserve made impossible a successful reversal in the short time period required by the Federal Reserve. Between 1927 and 1929, the major stock indices nearly doubled. Historian John Kenneth Galbraith argues that the speculative boom in stocks and Federal Reserve policy were not directly related, but the investment statistics

[24]

throughout the decade make his claim dubious at best. [25] Loose credit spawned conspicuous consumption and speculative booms in both real estate and stocks which brought substantial short term gains to those involved. For many, however, loose credit from the Federal Reserve brought only burden.

Farmers faced increasing economic hardship throughout the 1920s. Mortgage foreclosure swelled after the depression of 1920-21 and a large number of bank failures followed. During 1928 nearly 1.8% of American farms were foreclosed upon and between 1921-1928, nearly 4700 banks, most of them rural banks, had fallen into bankruptcy. [26] The situation did not improve for farmers who persisted to the end of the decade:

[By 1929] outstanding debt had fallen by a total of 2.4 billion current dollars while, according to Raymond Goldsmith, foreclosures had wiped out 2.8 billion of debt. Thus farmers who had managed to stay in business were heavily indebted. [27]

Farmers never truly recovered from the postwar fall in crop prices and property values. Their financial problems from the beginning of the decade were instead exacerbated by the Federal Reserve’s monetary policy.

While business and industry experienced a boom dependent on easy credit, the price of agricultural goods remained stagnant and high operating costs forced farmers to operate at a loss.

[28]

Business and industry in the cities acted as a strong pull force for rural workers – so strong that over 3,000,000 rural workers moved to the city during the 1920s. [29] Farmer wages were depressed while wages in industrial jobs offered workers higher wages. Professor Gene Smiley notes that farm wages “fell after the recovery from the 1920-1921 depression” while “real average weekly earnings for unskilled males rose 8.7 percent between 1923 and 1929."[30] The farmers were unable to compete with business and industrial sectors backed by the Federal Reserve inflationary monetary policy. Their losses grew as industrial production reached record highs – production increased from 67 in 1921 to 111 in 1928 (1923-25=100). The Federal Reserve had neglected the farmers in favor of business men, industrialists, and financiers.

[31]

Historians and other academics must confront the reality that the Federal Reserve was not – and still is not – a benevolent or disinterested force. From its founding, powerful individuals held heavy sway over members of the Federal Reserve Board. Economist and historian, Murray Rothbard, revealed the ties between big business, government, and the Federal Reserve:

The Federal Reserve, in its first two decades, contained two loci of power: the main one was the head, then called the governor, of the Federal Reserve Bank of New York; of lesser importance was the Federal Reserve Board in Washington. The governor of the New York Fed…was Benjamin Strong, who had spent his entire working life in the Morgan ambit.[32]

Other affiliates of the House of Morgan included U.S. financial advisor and supporter of fascism Thomas W. Lamont, friend to Calvin Coolidge and later U.S. ambassador Dwight Morrow, and Secretary of Treasury under Wilson, William Gibbs McAdoo. Additionally, Rockefeller associates held a majority on the Federal Reserve Board.[33]

Though Morgan and Rockefeller interests were often opposed, individuals in both parties sought to foster the growth of business and personal gain. Morgan control over the Federal Reserve in its early years was used to aid such interests:

The Morgans played a substantial role in bringing the United States into the war on Britain’s side, and, as head of the Fed, Benjamin Strong obligingly doubled the money supply to finance America’s role in the war effort. After the end of the war, Strong’s monetary policy was deliberately guided by the prime objective…to restore “England” – which really meant the Morgans’ English associates and allies – to her old position of financial dominance by helping her establish a phony gold standard.[34]

This tie with England was one major factor in the Federal Reserve’s final inflationary push in 1927. Governor Strong and Governor Norman , in an attempt to reverse the gold outflow from England, initiated the final round of open market purchases.[35] The self-interest of Federal Reserve members impeded any policies that may have supported general economic stability. Instead, policies that reflected that self-interest produced massive misallocation of resources, conspicuous consumption, and rural poverty.

Government institutions are no better than the individuals that comprise them. The same is true for the quasi-governmental Federal Reserve. Unopposed due to widespread political and economic ignorance, its members, guided by narrowly tailored self-interest, steered the U.S. economy into the Great Depression. The unintended consequences of their actions destroyed the livelihood of many individuals – first of farmers, then those of all classes. If any future academic work regarding the Great Depression is to benefit society, it must transcend the assumption of benevolent government and account for policies influenced by the self-interest of officials involved. Only then can they properly identify and eventually eradicate the injustice inherent in their political and economic institutions.

Bibliography

Anderson, Benjamin M. Economics and the Public Welfare. Indianapolis, IN: Liberty Press, [1949] 1979.

Eckler, A. Ross. “Recent Expansion of Bank Credit.” Review of Economics and Statistics 11, no 1 (February 1929): 46.

Federico, Giovanni. "Not Guilty? Agriculture in the 1920s and the Great Depression."

Journal of Economic History 65, no. 4 (December 2005): 949-976.

Galbraith, John Kenneth. The Great Crash: 1929. New York: Houghton Mifflin Company, [1954] 1997.

Hacker, Louis M. Major Documents in American Economic History, Volume II. New York: D. Van Nostrand Company, Inc, 1963.

Harris, S.E.. Twenty Years of Federal Reserve Policy. Cambridge, MA: Harvard University Press, 1933.

Hüllsmann, Jörg G.. The Ethics of Money Production. Auburn, AL: Ludwig von Mises Institute, 2008.

Miller, A. C. “Federal Reserve Policy.” The American Economic Review 11, no 2 (June 1921): 177-206.

Olney, Martha L. “Avoiding Default: The Role of Consumer Credit in the Consumption Collapse of 1930.” The Quarterly Journal of Economics 114, no 1 (February 1999): 319-335.

Persons, Charles E. “Credit Expansion, 1920 to 1929, and its Lessons.” The Quarterly Journal of Economics 45, no 1 (November 1930): 94-130.

Rothbard, Murray. America’s Great Depression. Auburn, AL: Ludwig von Mises Institute, [1963] 2000.

------ A History of Money and Banking in the United. Auburn, AL: Ludwig von Mises Institute, [2002] 2005.

------ The Case Against the Fed. Auburn, AL: Ludwig von Mises Institute, [1994] 2007

Smiley, Gene. "The U.S. Economy in the 1920s." Economic History Services (accessed November 30, 2010), http://eh.net/encyclopedia/article/Smiley.1920s.final.

Taussig, F. W. “The Currency Act of 1900.” The Quarterly Journal of Economics 14, no 3 (May 1900): 394-415.

[1] Murray Rothbard, “A History of Money and Banking Before the Twentieth Century,” in A History of Money and Banking in the United States: The Colonial Era to World War II (Auburn, AL: Ludwig von Mises Institute, [2002] 2005), 132-135.

[2] Ibid., 136-138.

[3] “Invariably it [inflation] produces three characteristic consequences: (1) it benefits the perperators at the expense of all other money users; (2) it allows the accumulation of debt beyond the level debts could reach on the free market; and (3) it reduces PPM [the purchasing power of money] below the level it would have reached on the free market.” Jörg G Hüllsmann, The Ethics of Money Production (Auburn, AL: Ludwig von Mises Institute, 2008), 175.

[4] F. W. Taussig, “The Currency Act of 1900,” The Quarterly Journal of Economics 14, no 3 (May 1900): 402.

[5] Murray Rothbard, “The Origins of the Federal Reserve,” in A History of Money and Banking in the United States, 202-208.

[6] Murray Rothbard, The Case Against the Fed (Ludwig von Mises Institute, [1994] 2007, 116.

[7] The Federal Reserve Act of December 23, 1913 in Major Documents in American Economic History, Volume II, ed. Louis M. Hacker (New York: D. Van Nostrand Company, Inc, 1963), 31.

[8] Benjamin M. Anderson, Economics and the Public Welfare (Indianapolis, IN: Liberty Press, [1949] 1979), 57.

[9] A. C. Miller, “Federal Reserve Policy,” The American Economic Review 11 no 2 (June 1921): 187.

[10] Ibid., 188.

[11] “Farm Issue Moves Toward a Climax,” New York Times, 2 Jan 1927 p. 140

[12] “Wallace Calls to Aid the Farmer,” 13 Mar 1921, p. 10; Commodities graph of WWI era. Giovanni Federico, “Not Guilty? Agriculture in the 1920s and the Great Depression,” Journal of Economic History 65, no 4 (December 2005): 957.

[13] See Rothbard’s chart. Murray Rothbard, America’s Great Depression (Auburn, AL: Ludwig von Mises Institute, [1963] 2008), 109.

[14] Benjamin Strong quoted in Murray Rothbard, “The Gold Exchange Standard in the Interwar Years,” in A History of Money and Banking in the United States, 375.

[15] Murray Rothbard, America’s Great Depression, 92.

[16] Ibid., 99.

[17] A. Ross Eckler, “Recent Expansion of Bank Credit,” Review of Economics and Statistics 11, no 1 (February 1929): 46.

[18] 75% of the money used to purchase these goods came from consumer credit. Charles E Persons, “Credit Expansion, 1920 to 1929, and its Lessons,” The Quarterly Journal of Economics 45, no 1 (November 1930): 112.

[19] Only 1919 to 1929 shown for simplicity. Martha L. Olney, “Avoiding Default: The Role of Consumer Credit in the Consumption Collapse of 1930,” The Quarterly Journal of Economics 114, no 1 (February 1999): 321.

[20] Benjamin M. Anderson, Economics and the Public Welfare, 182.

[21] Ibid., 186-187.

[22] Figure 25: Standard and Poor’s Common Stock Price Index, 1920 to 1930. Gene Smiley, “The U.S. Economy,” Economic History Services (Accessed November 30, 2010) http://eh.net/encyclopedia/article/Smiley.1920s.final

[23] According to Harris, the Federal Reserve’s move failed because it could not stick to its decision. The Reserve did not want to tighten the money supply and cause a recession in business. Harris, S.E., Twenty Years of Federal Reserve Policy, Harvard Economic Studies, vol. XLI (Cambridge, MA: Harvard University Press, 1933), 526.

[24] Anderson, Economics and the Public Welfare, 202.

[25] John Kenneth Galbraith, The Great Crash: 1929 (New York: Houghton Mifflin Company, [1954] 1997), 10-11.

[26]Wilson administration saw 578 bank failures while Coolidge’s administration witnessed over 4700 bank failures. “Calls Coolidge Novelist” New York Times 18 Oct 1928, p. 13.

[27] Federico, “Not Guilty? Agriculture in the 1920s and the Great Depression,” 966.

[28] Figure 8: Farm Foreclosure Rate, 1920 to 1930. Gene Smiley, “The U.S. Economy.”

[29] “The Farmer’s Revolt,” New York Times 30Sep 1925, p. 140.

[30] Gene Smiley, “The U.S. Economy.”

[31] Agricultural prices never recovered above 1917 values. Federico, “Not Guilty? Agriculture in the 1920s and the Great Depression,” 954.

[32] Murray Rothbard, “The Federal Reserve and Financial Elites,” A History of Money and Banking in the United States, 264.

[33] “But the Morgans not only had by far the most powerful Federal Reserve banker, Benjamin Strong, in their corner, they also had the Republican administrations of the 1920s. Although there were various groups around President Warren G. Harding, as an Ohio Republican he was closest to the Rockefellers, and his secretary of state, Charles Evans Hughes, was a mentor of John D. Rockefeller, Jr.’s, New York Bible class, a leading Standard Oil attorney, and a trustee of the Rockefeller Foundation. Harding’s sudden death in August 1923, however, unexpectedly elevated Vice President Calvin Coolidge to the presidency. Coolidge has been misleadingly described as a colorless small-town Massachusetts attorney. Actually, the new president was a member of a prominent Boston financial family, who were board members of leading Boston banks. One, T. Jefferson Coolidge, became prominent in the Morgan-affiliated United Fruit Company of Boston.” Ibid., 264-265.

[34] Ibid., 270.

[35] Anderson, Economics and the Public Welfare, 189-190.