Lessons from the 1930s

“From Mr Thomas Janichen.

Sir, Why create another bad bank ? We have enough already.”

-          Letter to the editor, Financial Times, January 17/18, 2009.”

 

“Conspicuous intelligence seemed actively unwelcome in the Bush White House.”

-          David Frum, speechwriter for George W. Bush during his first term.

 

“His administration staged some 200 ‘town hall’ events attended by pre-screened participants.. yet at the end of it all, support for Mr Bush’s proposal was lower than when it began.”

-          The Economist, January 17-23, 2009.

Bush - or at least his reputation - is dead. Long live Obama. The Economist magazine makes a decent fist of providing a not entirely partisan assessment of the achievements of George Walker Bush (in a special article entitled “The frat boy ships out”, and to be fair they endorsed him the first time around) but it is plain where the journalistic, if not editorial, sympathies broadly lie now. Princeton historian Sean Wilentz is cited: “Many historians are now wondering whether Bush, in fact, will be remembered as the very worst president in all of American history.”

Americans, of course, do not follow the strict Anglo-Saxon “King is dead” protocol that venerates the role, if not necessarily the incumbent, following a change-over in the administrative hierarchy. But then they claim to be republicans, with that small ‘r’. In any case, Barack Obama has inherited a right royal mess of pottage.

Perhaps the biggest danger is to assume, in a crisis, that politicians are in much of a position to help anybody, other than themselves. From what I remember of my pre-O level days, my school didn’t commit the biggest resources to the study of the Great Depression. But I distinctly remember a half hour devoted to the topic, and the general implication was: Franklin Roosevelt helped end it. After reading Murray Rothbard’s “America’s Great Depression” (Fifth edition 2008, by the Ludwig von Mises Institute), I am no longer so sure. In fact, after reading Rothbard’s study of the economic disaster of 1930s North America / rest of the world, I am left wondering whether pretty much everything I had been led to believe about that time is wrong. Since we are poised on the precipice of our very own 1930s, the question bears repeating.

Rothbard died in 1995. He was therefore unable to comment about the colossal bonfire of vanities stoked by Wall Street and the mortgage banking system over the past decade. It is unlikely, however, that he would have approved. He was not exactly a fan of the role of banks, nor of the perhaps fundamentally flawed model known as fractional reserve banking.

If it were a more perfect world, schoolchildren would at least be taught the bare minimum about the real economy, and not least about the way banks work. (One of the statutory objectives of the UK’s Financial Services Authority is to “promote public understanding of the financial system”. If the UK financial regulator can’t pull that trick off now, it will never get a better opportunity in the history of the world.) What we know as fractional reserve banking equates to letting banks keep a tiny fraction of their deposits (their depositors’ money, one should perhaps add) in order to lend out the remainder for profit (theirs, not the depositors’, one should perhaps add). Simultaneously, they retain the obligation to redeem all depositors immediately upon demand. More astute readers, or anyone who has maintained a bank deposit account over the last two years, will see the subtle flaw in this system. In the words of Murray Rothbard,

“Banks are “inherently bankrupt” because they issue far more warehouse receipts to cash (nowadays in the form of “deposits” redeemable in cash on demand) than they have cash available. Hence, they are always vulnerable to bank runs. These runs are not like any other business failures, because they simply consist of depositors claiming their own rightful property, which the banks do not have. “Inherent bankruptcy,” then, is an essential feature of any “fractional reserve” banking system.”

Rothbard goes on to cite Frank Graham (“Partial Reserve Money and the 100% Proposal,” American Economic Review, September 1936):

“The attempt of the banks to realize the inconsistent aims of lending cash, or merely multiplied claims to cash, and still to represent that cash is available on demand is even more preposterous than.. eating one’s cake and counting on it for future consumption.. The alleged convertibility is a delusion dependent upon the right’s not being unduly exercised.”

Rothbard wrote the following in 1963. The subsequent 46 years have not dulled the message:

“There are other values in deflation, even in bank runs, which should not be overlooked. Banks should no more be exempt from paying their obligations than is any other business. Any interference with their comeuppance via bank runs will establish banks as a specifically privileged group, not obligated to pay their debts, and will lead to later inflations, credit expansions, and depressions. And if, as we contend, banks are inherently bankrupt and “runs” simply reveal that bankruptcy, it is beneficial for the economy for the banking system to be reformed, once and for all, by a thorough purge of the fractional reserve banking system. Such a purge would bring home forcefully to the public the dangers of fractional reserve banking, and, more than any academic theorizing, insure against such banking evils in the future.”

But the savaging of fractional reserve banking is only a small part of the message of Rothbard’s “America’s Great Depression”. Contrary to the received wisdom that interventionist government (under, Rothbard points out, the administration of Herbert Hoover for some years before Roosevelt took the presidency) ameliorates and foreshortens a dismal business depression, Rothbard suggests that the very intervention so clamorously called for (both then and now) actually extends and amplifies it:

“If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt ? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favourite “anti-depression” arsenal of government policy. Thus, here are the ways the adjustment process can be hobbled:

1)      Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

2)      Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government “easy money” policy prevents the market’s return to the necessary higher interest rates.

3)      Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.

4)      Keep prices up. Keeping prices above their free-market levels will create unsaleable surpluses, and prevent a return to prosperity.

5)      Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further.. Any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption.. Any increase in the relative size of government in the economy.. shifts the societal consumption-investment ration in favour of consumption, and prolongs the depression.

6)      Subsidize unemployment..”

One does not have to agree with every one of Rothbard’s admonitions to see the value in the general argument. What stand out most ominously amid the current “race to avoid (i.e. cause) depression” are features 1, 2 and 5 in the current crisis. When a surfeit of easy money largely provoked the banking crisis, it is difficult indeed to see how even more of the same can help to resolve it.

Rothbard was a fervent free marketeer. His conclusion:

“Only governmental inflation can generate a boom-and-bust cycle.. the depression will be prolonged and aggravated by inflationist and other interventionary measures. In contrast to the myth of laissez-faire, we have shown (in “America’s Great Depression”) how government intervention generated the unsound boom of the 1920s, and how Hoover’s new departure aggravated the Great Depression by massive measures of interference. The guilt for the Great Depression must, at long last, be lifted from the shoulders of the free-market economy, and placed where it properly belongs: at the doors of politicians, bureaucrats, and the mass of “enlightened” economists. And in any other depression, past and future, the story will be the same.”

The taxpayers’ money committed to the banking crisis has been, by any measure, stunning. Bloomberg suggests the total US tally of liabilities, to date, now sits at $7.8 trillion – or $24,000 for every man, woman and child in the country. The Daily Telegraph suggests that the UK total sum of taxpayers’ liabilities spent or pledged amounts to almost £1 trillion – or £33,000 per taxpayer. One is entitled, as voter and taxpayer, to ask precisely what “improvement” in economic or banking conditions such stupendous capital commitments have provoked.

It is not my wish to carve out of Rothbard’s stirring call-to-arms its fundamental appeal, merely to hint at it. Readers intrigued by his thesis, not least in how it stands markedly at odds with conventional wisdom in fighting the current banking crisis, should simply buy the book and read it for themselves. But profound depression is likely to be the inevitable outcome, in both senses of the word.

Comments

[CHB]

Of course, riding vaingloriously out of the Great Depression on FDR's coat tails was the entire economics profession.

Cheers

[yo]

there are many who see these what is wrong with the bailouts, and how they will prolong and increase the pain.

they are marginalized and scorned.

but, there are many of us.